This is a short article to answer the question we see some people asking on the net. That question is, what should I include in the journal entry to record a credit sale of services transaction?
The quick answer is a debit to accounts receivable (debtors) and a credit to sales. For example, for a $1,000 credit sale, you would prepare this type of journal:
|May 1||Accounts Receivable||1,000|||
If you would like more detail on why we use these accounts, please read on.
Cash v Accrual Systems
The question people are asking assumes we are dealing with an accrual accounting system. Why is this assumption important? How is it different to a cash-based system?
Under a cash-based accounting system, we only record a transaction when cash moves. If there is no cash, there is no journal entry to make. So in the question about the sale of services on credit, cash has not moved. And therefore, there is no transaction to record. Although the service has been performed and the customer has been billed, cash is yet to change hands.
On the other hand, an accrual accounting system is interested in the movement of economic resources. Under the conceptual accounting frameworks, the focus shifted from income and revenue towards assets and liabilities. Or in other words, the focus has shifted from the income statement (statement of financial performance) to the balance sheet (statement of financial position).
So it’s worthwhile to take a quick look at these frameworks to understand better the transaction we are making with the sale on credit.
Economic Resources and Benefits
The change in how we would record transactions in accounting saw the move away from the importance of the inflow and outflow of money and towards the control of economic benefits. So what is an economic resource? I’m so glad you asked. International Finacial Reporting Standards (IFRS) Conceptual Framework defines an economic resource as:
“… a right that has the potential to produce economic benefits.” (para 4.4)
It then goes onto talk about what economic benefits are. These are either the gain of control over economic resources (i.e. assets), including cash, or the extinguishment of debt (liabilities). Accounting now is much more interested in the control over economic resources rather than legal ownership. The changes in lease accounting with IFRS 16 Leases is an excellent example of the focus on the substance of control over resources rather than the legal form of ownership.
We now need to get specific again and come back to the credit sale question we started with. Why do we debit accounts receivable, an asset? We recognise the asset under the conceptual framework because we now have a claim or right to economic benefits. Those economic benefits being the receipt of money for the service ABC performed. IFRS defines an asset as:
” … a present economic resource controlled by the entity as a result of past events.” (para 4.3)
We have to assume that a contract is in place that gives us a right to bill the client, and we have a reasonable expectation that they will pay. Through this contract, we control who they pay (hopefully us). And because we have performed the service already, it is the result of a past event. Based on this quick analysis, we have an asset.
This then brings us to the credit side of the journal entry. IFRS defines revenue as:
“… increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims.” (para. 4.68)
Our credit sales transaction increases assets (i.e. debtors), which increases our business’s equity value. So we have revenue (income) to record, which is what we do with a credit entry. And this money is not coming from an owner of the business, but rather a customer of services.
Example Journal Entry
Let us bring in our trusty ABC Ltd and look at an example with some figures. ABC has done some landscaping for a local business and has issued them an invoice for $5,000. On July 5, ABC issues the invoice, and the local business pays on July 20. What journal entries would you record to account for these events?
Journal Entry – Sale of Services on Credit
|July 5||Accounts Receiveable||5,000|||
The July 5 journal entry increases accounts receivable, the asset account and increases sales, the revenue account. So the accounting equation remains in balance, as you can see in the table below. And as we mentioned under conceptual frameworks, because we are dealing with revenue, ABC Ltd’s net worth is now $5,000 higher.
Journal Entry – Receipt of Cash
On July 20, the customer pays ABC Ltd, and so the following journal entry is recorded. The debit to the bank of $5,000 increases this asset account. At the same time, the credit to the accounts receivable reduces this asset. As you can see in the table below, this keeps the accounting equation in balance. But you will notice that there is no change in the net worth of ABC Ltd. The plus and minus to two different asset accounts offset each other. Income and expenses are the only transactions that can change a firm’s net worth (excluding equity and reserve changes).
We suspect most people have not made it to the end of this article as they were after the quick answer of what account to debit and which one to credit. Hopefully, the article’s first few lines got them to the solution of what to include in the journal entry to record the sale of services on credit. If you did reach it this far, we would be interested to hear any comments or feedback.