Do we debit or credit income? Why do we account for income that way, and do the rules change if we receive income in advance?
Anyone who has ever studied accounting has probably wondered about these questions one time or another. Learning the rules of debit and credit can be quite a challenge when you’re just starting out. Once you learn the basic principles that are explained in this article, I’m sure you will find accounting for income much easier.
Income is always credited. Credit entry is made to an income account unless the income is unearned, in which case the credit entry is recorded in a liability account.
Income is recorded as a credit because it increases the owners’ equity, which appears on the credit side of the accounting equation.
Income that is earned by a business is recorded in the accounting books by crediting the relevant income account, such as the revenue account.
Jane sells clothes and accessories at her shop.
After much bargaining, a customer purchased a shirt from Jane for $20, paying her in cash.
The revenue received on cash sale is an earned income of the business. Jane will record the transaction by passing the following accounting entries:
- Debit Asset Account Cash in hand $20
- Credit Income Account Sales Revenue $20
Income is recorded according to the accruals basis of accounting. This means that we credit the income account as soon as the business earns income rather than waiting for the cash inflow.
Business is said to have earned its income when either one of the following applies:
- It has delivered its product to a customer.
- It has provided a service to a client.
- Its resources have been used by another person that entitles the business to receive rent, dividends, or interest based on the duration of use.
Lynda is a painter who commissions portraits and landscapes.
Last week, her friend Mike ordered a portrait of himself with his dog Pluto. Lynda finished the painting over the weekend and dispatched this masterpiece to her friend’s address.
Lynda charged $500 for the painting, which her friend promised to pay from his next month’s salary.
Lynda should immediately record the income now by passing the following accounting entries in her books.
- Debit Asset Account Receivable from Mike $500
- Credit Income Account Income from commissions $500
- Debit Asset Account Cash in hand $500
- Credit Asset Account Receivable from Mike $500
Any income received by a business in advance of delivering a product or service is treated as unearned income.
For example, if a business receives rent on its leased property in advance, it will be treated as unearned income until the period for which the rent was paid has lapsed.
Unearned income is not credited to an income account until it is earned. It is recorded instead by crediting a liability account to acknowledge the fact that the business has an obligation to deliver something in return for the advance.
Lilly is a fashion designer.
Donna has placed an order with Lilly for designing a dress for her wedding. She has quoted $5000 for the dress, $2000 of which is payable in advance. Donna has deposited the advance in Lilly’s business account.
The remaining payment will be made in cash when Donna collects the dress from Lilly’s studio.
The advance represents an unearned income for Lilly who should recognize it as a liability by passing the following accounting entries:
- Debit Asset Account Cash at bank $2000
- Credit Liability Account Customer advances $2000
- Debit Liability Account Customer advances $2000
- Debit Asset Account Cash in hand $3000
- Credit Income Account Sales revenue $5000
How much do you know about income accounting?
Take the free below quiz and find out!
Instructions for solving quiz:
- Click on one of the given options that you think is correct.
- If you are not sure about a question, review the lesson above.
- Mark yourself out of 7 by rewarding 1 mark for each correct answer.
Income is always ________________ .
Income is never debited.
Increase in revenue has the effect of _____________ owners equity.
Increase in revenue is added to the retained earnings which is part of the owners equity.
When income is earned from a cash sale, ________________ will be debited.
Cash sale is recorded by debiting cash in hand (assets) and crediting revenue (income).
Betty is a florist. She received an order for supplying 100 bouquets of flowers for her friend Sara’s wedding next month. Sara paid Betty in advance, the entire amount of the order in cash.
a) What accounting entries should Betty record for the advance revenue?
Unearned income should be recognized as a liability in the balance sheet until it is earned.
Sara weds Jamie
b) What accounting entries would Betty record after she delivers the flowers to Sara’s wedding?
This cancels the liability that Betty had recorded previously. Because the income is now earned, there is no need to keep it as a liability in the accounting books.
Since the income from Sara's order is now earned, Betty can show it as such in the income statement.
How many questions did you answer correctly?