In the previous article we worked through a full example, recording six cash transactions in T-accounts, and promised that credit transactions would come next. This article introduces them properly — the transactions known in everyday language as buying and selling "on credit".
What is a credit transaction?
In a cash transaction, goods and money change hands at the same time: the deal is done on the spot. The real business world rarely works that way. When a supplier delivers goods, they usually do not wait at the door for immediate payment. Instead they issue an invoice stating that payment is due within a set period — thirty or sixty days, for example. The time between the transaction date and the settlement date is called the credit period.
Credit transaction: a transaction in which goods or services change hands first and payment is settled later. The time allowed between the transaction date and the settlement date is called the credit period.
Why do businesses trade this way? Cash flow. A company's money is often tied up in inventory and other assets, and paying cash for every single transaction would make operating very difficult. Credit lets a business take the goods first, sell them, and pay the supplier after the money comes in. The bigger the business, the more common credit transactions become. A newly opened company, as we saw in article five, usually has no track record with suppliers yet and must pay in cash.
Trade receivables and trade payables
The biggest accounting difference between credit and cash transactions is that credit creates a period of owing. When we sell goods on credit, the customer owes us money until they settle — that customer is our debtor. The amount owed to us for goods is called trade receivables. It will turn into cash later — a resource bringing future benefit — so it is an asset of the business, listed under current assets in the statement of financial position.
The reverse also holds. When we buy goods on credit, we owe the supplier money until we settle — the supplier is our creditor, and the unpaid amount for goods is trade payables, an obligation of the business and therefore a liability. Creditors actually appeared back in article five: when a business borrows from a bank or from the owner's relatives and friends, the lenders are creditors too. Trade payables records only what we owe suppliers for goods, which keeps trading debts apart from borrowings.
Trade receivables: amounts not yet collected from customers for goods sold on credit; an asset of the company. Trade payables: amounts not yet paid to suppliers for goods bought on credit; a liability of the company.
Remember the rule from last time — in a cash transaction we never record the third party's name, because the deal is already final? Credit transactions are the exact opposite. Until settlement, we must know exactly who owes us, whom we owe, and how much in each case. So every customer and supplier trading with us on credit gets a separate ledger account under their own name — a "Chan Tai Man account", say — which tracks how the balance with that party changes.
Common credit transactions
1. Buying goods on credit The business buys goods for resale from a supplier without paying yet. As with a cash purchase, the goods go into the Purchases account. The difference is on the credit side: instead of Cash or Bank, we credit trade payables, in an account named after the supplier.
Analysis:
- Expense increases <Debit: Purchases account>
- Liability increases <Credit: Trade payables, named after the supplier>
2. Selling goods on credit The business sells goods to a customer and allows them to pay within the credit period. The revenue still goes into the Sales account, and the amount not yet collected goes into trade receivables, in an account named after the customer.
Analysis:
- Asset increases <Debit: Trade receivables, named after the customer>
- Revenue increases <Credit: Sales account>
3. Paying a creditor Before the credit period runs out, the business settles with the supplier in cash or by cheque. Once paid, the liability is removed.
Analysis:
- Liability decreases <Debit: Trade payables>
- Asset decreases <Credit: Cash or Bank account>
4. Receiving payment from a debtor Likewise, when a customer settles within the credit period, we receive cash or a cheque and the balance in trade receivables is cleared.
Analysis:
- Asset increases <Debit: Cash or Bank account>
- Asset decreases <Credit: Trade receivables>
Look closely at that last transaction: both sides are assets. On the day the money arrives, trade receivables simply turns into cash in our hands. Total assets do not change, and we do not record sales a second time — the sale was recorded on the day it was made on credit. In other words, a credit transaction is recorded on the day it happens, not on the day the money moves. This timing gap is the core idea of credit transactions, and a common trap: record sales both on the credit-sale date and on the collection date, and revenue is double-counted.
One last point: goods are not the only thing that can be bought on credit. A business can also acquire operating assets this way — buying a motor vehicle from a dealer and paying later, for example. The recording principle is identical, but both account names change. The debit goes to the Motor vehicle account rather than Purchases — as the last two articles stressed, Purchases is reserved for goods bought for resale. And because the debt does not arise from goods, it is not trade payables but accounts payables. Likewise, selling a non-current asset on credit gives us accounts receivables, not trade receivables. Keep the goods and non-goods names apart.
Now that the concept is in place, the next article will do for credit what article six did for cash: take one full example and record credit purchases, credit sales and both settlements in T-accounts, step by step. Article nine will then return to trade receivables and payables in more depth. Keep an eye on our blog!
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