When services are provided on credit, the total amount of liabilities increases. True or False
The correct answer and explanation is:
Answer: False
Explanation:
When services are provided on credit, the total amount of liabilities does not increase; instead, the assets increase.
Here’s why:
- Providing services on credit means the business delivers the service now but expects payment later. This creates an account receivable—money owed to the business by the customer.
- On the accounting equation basis:
Assets = Liabilities + Equity - When services are provided on credit:
- Assets increase because accounts receivable (an asset) goes up.
- Equity increases because the revenue from the service increases retained earnings, a component of equity.
- Liabilities remain unchanged because no debt or obligation is created by providing the service. The business is owed money but does not owe money to others.
Example:
- A consulting company provides a $1,000 service to a client on credit.
- The company records:
- Debit Accounts Receivable $1,000 (increase in assets)
- Credit Service Revenue $1,000 (increase in equity)
- No liability is created because the company has not borrowed money or incurred any payable.
Why might one think liabilities increase?
Sometimes, confusion arises because when a company purchases goods or services on credit, liabilities increase (accounts payable goes up). But here, the business is the provider, not the purchaser.
Summary:
- Services provided on credit → Increase assets (accounts receivable) and equity (retained earnings through revenue).
- No increase in liabilities occurs.
Therefore, the statement that “When services are provided on credit, the total amount of liabilities increases” is False.