An invoice for some new office equipment is received, but it is not due for payment until next month. What would the journal entry be? This problem seems harder to solve when you look at it from a different perspective. We can separate the problem into two steps. First, we determine what the business got and what the business owes. Second, we decide which category each part belongs in.
The equipment is an asset because the business obtained control over something that might help with future operations. The amount that is yet to be paid to the supplier is a liability.
An asset is something the business has control over. Cash, accounts receivable, equipment, inventory, and prepaid items are some of the common types of assets. An asset doesn’t necessarily need to be tangible, nor does it have to be bought with cash. If the business has provided some services and a customer has yet to pay them, then Accounts Receivable is an asset. It may be true that there’s no cash involved, but the business has received something of value that hasn’t been used up yet.
To determine if something is an asset, ask yourself if the business obtained something or if the business spent something. Is it still valuable after the transaction?
A liability is an amount owed to another party. Accounts payable, loans, and accrued expenses are good examples. If the business takes out a $1,000 loan from the bank, Cash is debited. The deposit isn’t revenue because the business will need to repay the loan. So the other account is a liability. This prevents incoming cash from being recognized as revenue. It also prevents the balance sheet from being unbalanced.
Equity is the owner’s share of assets after liabilities have been taken away. Owner capital investments increase equity, and owner drawings decrease equity. Revenue and expenses change equity because of normal business activity, but they are recorded under different accounts throughout the year. If the owner contributes $700 into the business’ bank account, Cash is debited and owner equity is credited. No revenue is recorded because the money wasn’t earned through business activity.
Revenue is what the business earns through its normal course of operations. Expenses are the resources consumed to facilitate operations. Even if a customer hasn’t paid yet, the business has earned revenue because the service has been performed. A utility bill or office supplies may be expenses. There may be cases where classification is tricky. For example, an item bought for the business may provide value over more than one period. A computer you buy to use right away usually counts as an asset in a basic exercise, while a monthly internet bill counts as an expense.
Before you start to figure out whether something should be debited or credited, it helps to classify the accounts first.
Write down five headings on a piece of paper: Asset, Liability, Equity, Revenue, and Expense. Take a few practice transactions, then explain where each account goes.
- A sale made for cash debits Cash and credits Revenue.
- Payment of accounts payable debits Accounts Payable and credits Cash.
- Purchase of equipment for cash debits Equipment and credits Cash.
- Payment of rent expense debits Rent Expense and credits Cash.
Once the accounts are classified, it’s worth checking to make sure the accounting equation still balances.
When you do the classification, you’re looking at what happened, not the document that is attached to it. An invoice can represent an asset, an expense, inventory, or a liability. A receipt may be evidence of revenue, an investment from the owner, or a loan. Everything starts with the economic event. Before you record the entry, complete the following sentence: “The business got, used, earned, contributed, or owed…” The words that fill in the blank will help you choose the correct categories.