Liabilities are financial arrangements (normally called debt or loans) that create an obligation on a business to expend economic benefits to a third party. The accounting for liabilities is through the firm’s statement of financial position the transaction must have already taken place and its repayment will be in the form cash or some other outflow of economic benefits leaving the firm.
An example using ABC Ltd would be to take on a loan to purchase a new truck for its freight haulage business. The asset taken on, the new truck, will be used by the firm to generate income and if used prudently will generate the firm a greater source of income then the costs incurred on taking out the loan and its repayment.
In double entry bookkeeping debt, also called a loan or more generally a liability, is a credit account. When new debt is taken on the balance increases through crediting the account. When debt is repaid the account is debited, reducing its balance.
Let’s look at the accounting entries that would be made by ABC Ltd.
On June 10 ABC Ltd purchases a shinny new truck for $250,000 to be used in its haulage business. To finance this purchase a loan for the full amount is taken out with XYZ Finance Ltd. The following entries would be made in ABC’s accounting system:
The first accounting entry below reflects the increase in funds in the bank account, the $250,000 received from XYZ Finance Ltd.
Accounting for liabilities with a credit entry isn’t necessarily matched by a debit to assets as it is in this case. The debit could be to another liability, ie a new loan is paying off an old one. Or the debit could be to expenses where the borrowing is cover operating expenditure – perhaps as a short-term funding measure.
The next accounting entry then reflects the reduction in cash at the bank through the purchase of the new machinery. This entry has a nil effect on the balance of total assets as it reduces one, the bank account, while increase another, the machinery account.