Normal Balances

An account's normal balance is the side on which increases are recorded, and therefore the side on which a healthy, non-contra balance should appear. Assets and expenses are debit-normal. Liabilities, equity, and revenue are credit-normal. Recognizing normal balances is the fastest way to spot a posting error: an unexpected balance calls for investigation, but a real overdraft, refund or accumulated deficit can explain it.

The rule is not arbitrary. It follows from the accounting equation, and it tells you, for any account, whether a debit or a credit makes it grow.

Why every entry has two equal sides

The accounting equation states that a corporation's economic resources always equal the claims against those resources. Creditors have the first claim (liabilities) and shareholders hold the residual claim (equity). The equation must hold after every transaction, which is why double-entry bookkeeping records two equal and offsetting effects for every event, and why total debits must equal total credits in every journal entry.

• In the simplified example, equity consists of share capital and retained earnings; other businesses may also have contributed surplus or other equity components. Net income and dividends flow through retained earnings.
• During the year, before revenue and expense accounts are closed, the expanded form is: Assets = Liabilities + Share Capital + Retained Earnings + Revenue − Expenses − Dividends. This is where the normal balances come from. Revenue increases equity, so it grows on the credit side with the rest of equity. Expenses and dividends reduce equity, so they grow on the debit side.
• Total assets on the balance sheet must equal total liabilities plus total equity at every reporting date.
• The Income Tax Act (s.230(1)) requires every person carrying on business to keep records and books of account in a form, and with the information, that lets the tax payable be determined. CRA does not prescribe a bookkeeping system. A corporation still reports a full balance sheet on Schedule 100 and an income statement on Schedule 125 of its T2, and a double-entry ledger is what produces both directly.

Two entries for a new corporation show the equation holding after each one. A new BC corporation receives $10,000 from its sole shareholder in exchange for common shares, then buys a $2,500 laptop on a company credit card (sales tax is left out to keep the entries short).

Entry 1. Share issuance
Debit:  Cash (Asset)                        $10,000
Credit: Share Capital (Equity)              $10,000

Entry 2. Laptop purchase on credit
Debit:  Computer Equipment (Asset)           $2,500
Credit: Credit Card Payable (Liability)      $2,500

After both entries: Assets $12,500 = Liabilities $2,500 + Equity $10,000.

What a debit and a credit do to each type of account

Debits are entries made on the left side of an account and credits are entries made on the right side. Neither is good or bad: whether one raises or lowers a balance depends entirely on the type of account it touches. The side that raises the balance is the account's normal balance.

• A single journal entry can have more than two lines, but total debits must still equal total credits.
• Contra accounts (for example, accumulated depreciation or contra revenue) follow the opposite rule of their parent account.
• The words "debit" and "credit" on a bank statement describe the bank's books, not yours. A bank treats your deposit as a credit because, from the bank's perspective, your balance is a liability to them. In your own books the same deposit is a debit to cash.

Normal balance by account class

• Contra accounts always sit opposite to their parent and reduce the parent on the financial statements.
• Shareholder loan accounts can swing between debit and credit. A credit balance means the corporation owes the owner. A debit balance means the owner owes the corporation, which makes it an asset and triggers ITA 15(2) review.
• A negative balance on a normal-balance account is possible but unusual and should always be explained (for example, a bank overdraft reported under current liabilities).

Worked example: an invoice, its payment, and the trial balance

The corporation invoices a client for $5,000 plus 5% GST on account. Two weeks later the client pays in full.

At invoice date
Debit:  Accounts Receivable (Asset)   $5,250
Credit: Consulting Revenue (Revenue)  $5,000
Credit: GST Payable (Liability)         $250

At payment date
Debit:  Cash (Asset)                  $5,250
Credit: Accounts Receivable (Asset)   $5,250

Each entry has equal debits and credits, so the accounting equation stays in balance. The invoice raises an asset (a debit) and raises revenue and a liability (credits). The payment swaps one asset for another.

At period end, the balances are listed in a trial balance. A partial pre-adjustment trial balance for a BC consulting corporation at March 31:

Account                         Debit    Credit
Cash                           12,400
Accounts Receivable             6,300
Accumulated Depreciation                  1,800
Accounts Payable                          2,100
GST Payable                                 540
Share Capital                            10,000
Retained Earnings                         1,900
Consulting Revenue                       18,000
Rent Expense                    3,000
Software Expense                  640
Salaries Expense               12,000
                              -------   -------
                               34,340    34,340

Every account sits on its normal side. Accumulated depreciation is credit-normal because it is a contra-asset.

Posting errors the normal balance exposes

• Assuming a debit always means "money out" because of personal banking vocabulary.
• Recording only one side of a transaction, which leaves the trial balance out of agreement.
• Treating money the owner puts into the corporation as revenue. It is either a loan to the corporation (a credit to the shareholder loan account) or, if shares are issued for it, share capital. Neither is income.
• Setting up an owner's drawings account in a corporation. Drawings belong to a sole proprietorship. Money a corporation's owner takes out that is not salary or a declared dividend goes to the shareholder loan account, where a debit balance is an amount the owner owes the corporation.
• Recording a dividend as an expense. Dividends debit retained earnings (or a dividends declared account that closes to retained earnings) and are not deductible for tax.
• Reversing the entry for customer prepayments. Cash received before revenue is earned is a liability (unearned revenue), not revenue.
• Debiting expense when the corporation pays down a credit card. The expense was recorded when the card was originally used; the payment is a decrease to cash and to the credit card liability.
• Expensing the purchase of a capital asset. Buying equipment swaps one asset for another, or adds an asset and a liability. The cost reaches the income statement through amortization, and the tax deduction comes through capital cost allowance.
• Crediting GST paid on purchases to GST Payable (a credit-normal liability) as if it were tax collected. GST paid is a debit, either to an ITC receivable or to GST Payable, where it reduces the liability.
• Posting a customer refund as a new positive sale. Record the reversal consistently, using a returns account where useful.
• Leaving accumulated depreciation on the debit side because it "reduces" the asset. It is credit-normal.
• Letting retained earnings show a debit balance without disclosing the accumulated deficit on the balance sheet.
• Using a shareholder loan account as a dumping ground for unclassified personal charges, which can flip it into an asset position without detection.

Related concepts

Each transaction is captured in a journal entry and posted to the general ledger. Normal balances then give the first sanity check on any trial balance: an account on the unexpected side needs an explanation; it does not by itself prove a reversed posting. The equation is presented to readers on the balance sheet and reported to CRA on Schedule 100. Contra-account logic is revisited in asset topics such as capital cost allowance.