Principles of Financial Accounting: The Accounting Equation and Double Entry - Normal Balances of Accounts

What It Is

Normal balances of accounts refer to the expected debit or credit balance in a general ledger account. This concept is crucial in financial accounting as it helps accountants identify the correct direction of transactions and ensure accurate financial statements. For instance, if a company buys $10,000 of inventory, the inventory account should have a debit balance, indicating an increase in assets.

Key Concepts & Formulas

• Debit (Dr.): A debit is an entry on the left side of a T-account, increasing an asset, expense, or drawing account. Example: If a company purchases office supplies for $500, the office supplies account would be debited $500.
• Credit (Cr.): A credit is an entry on the right side of a T-account, increasing a liability, equity, or revenue account. Example: If a company receives $1,000 in cash from customers, the cash account would be credited $1,000.
• Asset Accounts: Typically have debit balances, representing the company's resources or assets. Example: Cash, Accounts Receivable, Inventory
• Liability Accounts: Typically have credit balances, representing the company's debts or obligations. Example: Accounts Payable, Notes Payable, Salaries Payable
• Equity Accounts: Typically have credit balances, representing the company's ownership or net worth. Example: Common Stock, Retained Earnings, Dividends
• Revenue Accounts: Typically have credit balances, representing the company's income or revenue. Example: Sales, Service Revenue, Interest Revenue
• Expense Accounts: Typically have debit balances, representing the company's costs or expenses. Example: Salaries Expense, Rent Expense, Utilities Expense
• Gross Profit Formula: Gross Profit = Sales – COGS (Cost of Goods Sold) Example: If a company has sales of $100,000 and COGS of $60,000, the gross profit would be $40,000.
• Net Income Formula: Net Income = Gross Profit – Operating Expenses Example: If a company has gross profit of $40,000 and operating expenses of $20,000, the net income would be $20,000.

Journal Entry Examples

Example 1: Purchasing Office Supplies

Dr. Office Supplies $500 Cr. Cash $500

Explanation: The office supplies account is debited to increase the asset account, and the cash account is credited to decrease the asset account.

Example 2: Receiving Cash from Customers

Dr. Cash $1,000 Cr. Sales $1,000

Explanation: The cash account is debited to increase the asset account, and the sales account is credited to increase the revenue account.

Example 3: Paying Salaries

Dr. Salaries Expense $5,000 Cr. Cash $5,000

Explanation: The salaries expense account is debited to increase the expense account, and the cash account is credited to decrease the asset account.

Common Mistakes

Mistake 1: Confusing Debits and Credits for Expense Accounts

• Correction: Expense accounts typically have debit balances, while revenue accounts have credit balances.
• Mnemonic: "DE" for Debit Expense

Mistake 2: Incorrectly Identifying Normal Balances

• Correction: Asset accounts typically have debit balances, while liability, equity, and revenue accounts have credit balances.
• Mnemonic: "ADE" for Assets, Drawings, Expenses

Mistake 3: Forgetting to Reconcile Accounts

• Correction: Reconcile accounts regularly to ensure accurate financial statements.
• Example: Reconcile the bank statement with the general ledger to ensure accurate cash balances.

Exam Tips

• A debit increases assets AND expenses – remember "ADE" (Assets, Drawings, Expenses).
• Be cautious of reversing normal balances, which can lead to incorrect financial statements.
• Review the accounting equation: Assets = Liabilities + Equity.

Quick Practice

Problem 1: Adjusting Entry for Accrued Salaries

What is the adjusting entry for accrued salaries of $5,000?

Answer: Dr. Salaries Expense $5,000, Cr. Salaries Payable $5,000

Explanation: The salaries expense account is debited to increase the expense account, and the salaries payable account is credited to increase the liability account.

Problem 2: Purchasing Equipment

What is the journal entry for purchasing equipment for $10,000?

Answer: Dr. Equipment $10,000, Cr. Cash $10,000

Explanation: The equipment account is debited to increase the asset account, and the cash account is credited to decrease the asset account.

Problem 3: Receiving Cash from Customers

What is the journal entry for receiving cash from customers of $2,000?

Answer: Dr. Cash $2,000, Cr. Sales $2,000

Explanation: The cash account is debited to increase the asset account, and the sales account is credited to increase the revenue account.

Last-Minute Cram Sheet

• Dividends are NOT an expense – they go directly to retained earnings.
• Asset accounts typically have debit balances.
• Liability, equity, and revenue accounts typically have credit balances.
• Expense accounts typically have debit balances.
• Gross Profit = Sales – COGS (Cost of Goods Sold).
• Net Income = Gross Profit – Operating Expenses.
• A debit increases assets AND expenses – remember "ADE" (Assets, Drawings, Expenses).
• Be cautious of reversing normal balances, which can lead to incorrect financial statements.
• Review the accounting equation: Assets = Liabilities + Equity.