In business and in households, you may find that you will buy certain items, such as vehicles, property, equipment etc. on credit. In these circumstances, you will receive the item immediately, but you will pay for it at a later date. You may also pay it off over time. When money is owed to another business or person, you call that business or person a creditor.
In this lesson I will discuss how to handle credit purchases and credit payments in the general ledger.
How to handle creditors is lesson 8 in my Basic Bookkeeping Course. Please note that the $ symbol in all the examples below represents money. It does not represent a specific currency.
How to handle Creditors in the General Journal
We are going to continue with the Johnson Mechanics example used in the past lessons. A. Johnson has decided that he is going to buy a new computer for his business. The computer will cost him $660. He decided that he was going to buy it on Store Credit from Pete’s Computers. He will pay Pete’s Computer’s over 6 months at $110 per month. Pete’s Computers has a policy that no interest is charged if the amount owed is payed off within 6 months.
The Computer that A. Johnson bought is an Asset. More specifically it is an Equipment Asset. From our previous examples we know that when an asset is bought, the asset account is increased. In this case it will increase by $660 because that is the value of the asset at the time it was purchased.
If A. Johnson had paid for the asset with cash, then the bank account in the general ledger would decrease. A. Johnson did not pay for the computer with cash though, he bought it on Store Credit with Pete’s Computers. For this reason, Liabilities will increase instead of Bank decreasing. A liability is money owed to another business.
We can see the following effect on Assets, Owner’s Equity and Liabilities:
Using the accounting equation (Assets minus Liabilities = Owner’s Equity) we can see that Owner’s Equity remains unchanged.
When we enter the amount into the general ledger, we know that because liabilities is on the left hand side (debit side) of the accounting equation. Because liabilities has a minus sign in front of it, the liability will decrease on the left hand side (debit side) in the general ledger. Logically you can then say that it will increase on the right hand side (credit side).
Here are the accounts in the General Ledger:
It is common practice to open a separate account for each creditor in a new ledger called the Creditor’s Ledger. The total amount owed is then placed in the Creditor’s Account in the General Ledger. I will discuss the Creditor’s Ledger in detail in a later article. For now you can put each creditor’s account as a separate account in the General Ledger.
When money is owed to your business by another business we call that business a Debtor of your business. I am not going to discuss Debtor’s at this time.
How to handle Creditors Payments in the General Journal
At the end of the month, A. Johnson makes his first payment of $110 to Pete’s Computers as partial payment of the computer he bought. A. Johnson paid cash from the business bank account. Therefore it stands to reason that the Asset Cash will decrease by $110 and so will the Liability Pete’s Computers. There is no effect on Owner’s Equity, as we can see by the accounting equation below:
Here are the general ledger accounts:
Conclusion and Tasks
At this point you should have all the knowledge you need to maintain the basic bookkeeping of your household and micro business. Articles that follow on from this one will explore the concepts I taught in these first 8 lessons in more detail. Tasks after this lesson include:
- Add all your Creditor’s into your household’s General Journal.