Lesson Objectives:- Defining normal accounting balances.
- Applying the financial accounting equation.
- Understanding how the RED accounts fit in.
- The normal balances of revenue, expense and dividends
Every account maintains either credit or debit as the normal balance. The fundamental concept is that in order to increase an account with a normal balance of credit, the company would use a credit.
This also works the same way with a normal balance of debit, as a debit is used to increase the account.
The normal balance is basically what defines whether we should credit or debit the specific account in order to increase the balance.
Now let's look at what the normal balance is for each type of account that falls within the accounting equation.
The easiest way to remember this is to think of the accounting equation as having two sides, each with a different normal balance. The left side of assets are increased using debits while the right side of the equation is increased by credits.
The above graphic further demonstrates the normal balance and whether you need to use a debit or credit to increase or decrease the account.
Assets have a normal balance of debit, meaning a debit is used to increase the accounts. In contrast, liabilities and equities have a normal balance of credit.
While assets, liabilities and equity are the main types of accounting elements, there are specific types of accounts that fall into each category. Assets involve cash, supplies, intellectual property and equipment. Liabilities involve long term debts, accounts payable, salaries payable and taxes. Equity accounts include common shares, preferred shares and dividends.
Take a look at the table above to see some additional examples of each account type.
As you can see from the above acronym, RED stands for revenues, expenses and dividends.
Here is what each means and how the normal balances are applied.
Revenues are associated with equity accounts as they have an indirect relationship with retained earnings. This simply means that when revenues increase the amount of income that the company receives also increases. More income also translates into more retained earnings which can either be distributed to shareholders or kept as equity. Revenues have a normal balance of a credit. To increase the revenue accounts, they must be credited.
Expenses are an essential part of every business as they are needed for operations but they do lessen the income that the company receives. In contrast of revenues, expenses lead to a reduction in income and subsequently a decrease in retained earnings and equity. This also means that the normal balance for expenses are a debit, because in order to increase the expense, they must be debited.
Dividends are the income that is disbursed to shareholders after taxes. When dividends are issued, the level of retained earnings and equity is reduced because the income is being paid out instead of kept as equity. Again, since the amount is being reduced, the normal balance is a debit.