Question

What do we mean by a "normal balance"? Can you explain this to us in plain old English? If you know what it means when we say that Cash has a normal debit balance, or Accounts Payable will have a normal credit balance, this will help you in better understanding the big picture for this week's key topics!

Answer 1

Normal or Natural Balances in accounting, T-Accounts have a natural balance side. This relates to the basic accounting equation:

Assets = Liabilities + Stockholders’ Equity / Owners equity

If a company keeps accurate records, the accounting equation will always be "in balance," meaning the left side should always equal the right side. The balance is maintained because every business transaction affects at least two of a company's accounts. For example, when a company borrows money from a bank, the company's assets will increase and its liabilities will increase by the same amount. When a company purchases inventory for cash, one asset will increase and one asset will decrease. Because there are two or more accounts affected by every transaction, the accounting system is referred to as double-entry accounting.

Assets have a natural balance on the Debit side of the T-Account. When the balance of Assets is increased, the entry is placed into the debit (left) side of the account. Cash coming in is always a debit as is any other asset being acquired: Accounts Receivable, Equipment, Property, Plant, Investments, and Inventory. Reductions in assets are placed on the credit (right) side of the T-Account, such as when cash is paid out.

A credit balance on an asset account would indicate a problem with the T-Account. Why? An asset with a balance on the credit side would indicate a negative asset. What is negative cash? This cannot exist in accounting as a balance on the credit side would be indicative of a liability rather than as an asset. The same is true for equipment as a credit balance would indicate that the equipment's value is less than zero.

Can an Account Receivable be negative? This would indicate that someone overpaid their invoice and therefore is entitled to a refund, therefore a credit balance in the Account Receivables could be considered a liability.

Liabilities have a natural balance on the Credit (right) side of the T-Account. When liabilities are increasing such as Accounts Payable, the T-Account is credited with the transaction. When a liability is paid, a debit is entered to reduce the balance of the account.

The general ledger account Accounts Payable or Trade Payables is a current liability account, the amounts owed are payable as per the agreement. As a liability account, Accounts Payable is expected to have a credit balance. Hence, a credit entry will increase the balance in Accounts Payable and a debit entry will decrease the balance. A bill or invoice from a supplier of goods or services on credit is often referred to as a vendor invoice. The vendor invoices are entered as credits in the Accounts Payable account, thereby increasing the credit balance in Accounts Payable. When a company pays a vendor, it will reduce Accounts Payable with a debit amount. As a result, the normal credit balance in Accounts Payable is the amount of vendor invoices that have been recorded but have not yet been paid.

Stockholders’ Equity or SE has a natural balance on the Credit side of the T-Account. When stock is purchased by an investor, the cash received by the company is debited as it increases the cash asset; in turn the common stock account is credited.

Retained Earnings has a natural Credit balance as most companies hope to earn a profit. Should the balance be on the Debit side that would indicate the company is losing money?

Dividends have a normal balance of on the Debit side.

Why? Because cash was used to pay the dividend and the dividends paid also reduce Retained Earnings.

Expenses have a normal balance on the Debit side.

Why? When cash was paid or liabilities were incurred those transactions were recorded on the Credit Side. To balance the accounting equation, expenses must be entered on the debit side.

Revenues have a normal balance on the Credit side.

Why? When cash was received or an Accounts Receivable was earned, those entries are Debits, therefore, to balance the accounting equation, revenues must be entered on the credit side.

Conclusion:

A negative balance is an indicator that an incorrect accounting transaction may have been entered into an account, and should be investigated. Usually, it either means that the debits and credits were accidentally reversed, or that the wrong account was used as part of a journal entry. Thus, when closing the books at the end of an accounting period, the investigation of negative account balances is a standard procedure that may uncover several transaction mistakes.