If you ask a banker whether debiting or crediting a liability increases the account’s balance, the financier will tell you it depends on the transaction. The same answer holds true for accounting procedures, even though banking debits and credits are distinct from accounting practices. To understand the effects of journal entries on financial accounts, it’s important to master such terms as liability, record keeping and financial reporting.
A liability is an obligation to pay a sum of money at a specified date. Also called a debt, a liability can be a non-financial commitment. For example, if you co-sign a student loan application of an underage relative, you're liable if the relative defaults. Accountants use the term "short-term liability" for a debt that becomes due within one year. Examples include dividends payable, salaries, taxes due and accounts payable. In contrast, a long-term debt matures in a period that exceeds one year. Examples include bonds payable and notes due. Liabilities are components of balance sheets, also known as statements of financial position or statements of financial condition.
Debits and credits are conduits through which bookkeepers convert economic events into valuable financial data that management can use. They do so by posting journal entries in general ledgers, debiting and crediting financial accounts. A bookkeeper credits a liability account to increase its value and debits the account to reduce its worth. Debt transactions generally give rise to interest payments. To record interest, the bookkeeper debits the interest expense account and credits the interest payable account. The entry to record a debt payment is: credit the cash account and debit the liability account. In accounting terminology, crediting cash means reducing company money.
Besides liabilities, bookkeepers use other financial accounts to post economic events. These include assets, revenues, equity and expenses. Assets are resources a business uses to operate, thrive and expand. Examples include cash, accounts receivable, inventory, real property and equipment. Revenues are earnings from sales and investment activities. Expenses are administrative charges and material costs. Examples include salaries, office supplies, insurance and litigation. Such non-financial expenses as depreciation and amortization also count as operating charges. Depreciation allows a firm to allocate the costs of its long-term assets over several years. Amortization is the depreciation equivalent for non-physical assets, or intangibles, such as patents and copyrights.
Accounting norms require that companies record liabilities in a balance sheet, setting short-term loans apart from long-term obligations. Interest expense is an income statement item. Other financial statements include statements of cash flows and statements of shareholders’ equity.
