Journal Entries Guide

What Is A Journal Entry?

Journal entries involve recording business transactions in the company's records, regardless of their economic significance. Journals serve as the official books where a company maintains sensitive data related to business events, documented by their value and in chronological order.

Accounting is the language spoken by the business to communicate with its users. As per Merriam-Webster, accounting is “the system of recording and summarizing business and financial transactions and analyzing, verifying, and reporting the results.” 

A language requires to be structured and illustrated with logic (grammar) to communicate efficiently to one another. Such a level of structuring logic to communicate exists in the business world, known as Journal Entry.

Unlike the most common complex languages spoken across the globe, the basic concept of journal entries is pretty much straightforward. Back then, the norm was maintaining journals manually by recording the transactions via pen and paper.  

But in the modern era, it is done digitally. The computer revolution in the 90s shook the accounting practice. Shifting from manual recording to computerized recording systems. 

For a company to function properly and prosper in the long run, the journal entries must be nailed to the point. If not, it's only a matter of time before the bulls are out. 

Any functions occurring in the business, even the company’s financial statements, are built upon the foundations laid by the journal entries, and messing that is calling for trouble. Due to this, knowing how to understand and interpret the business language is an essential skill to possess.

Understanding The Journal Entries And Its Foundation

Journals, even though they seem repetitive and boring, are an important element in deciding the break or growth of a company, especially when the journal entries lay the foundations for preparing a company’s financial statements, which many users rely heavily upon. 

Messing up the journal entries is directly proportional to messing up the financial statements, which then opens whole new doors of wrong decisions by the users based on false pieces of information. 

To avoid such adverse scenarios, it’s highly advised to master the journal entries before you post any sensitive entries for the company. The journey to master it begins with understanding the fundamental pillars of journal entry, i.e., the “Accounting Equation.” 

The construction of journal entries boils down to this very basic equation. This equation relies on the simple focus of balance. 

Assets = Liabilities + Equity

It may look so simple, but it has the strength to lift the entire business, making it respectable in both the industry and academia. 

No matter how the equation is shuffled, the balancing figure on the left-hand side (LHS) should balance with the right-hand side (RHS) figures. 

Liabilities = Assets - Equity 

Equity = Assets - Liabilities

Constructing Journal Entries

As mentioned above, constructing journal entries at their base is simple. Still, later on, the journal entry gets complicated as the business circumstances enter complicated scenarios with all the accounting policies. 

But fear not! Knowing just the basics is a stepping stone to more milestones of accounting expertise. It's only a matter of time and effort to achieve great heights in accounting expertise. 

In constructing the journal entries, there are a few things to consider:

1. The nature of the accounts and their effect on other accounts 
2. Post the right date and amount
3. Add a reference to each entry
4. Add a description to each entry explaining the context of the event
5. Balance the accounts

With these in mind, it should be a straightforward task to identify the accounts and construct the journal entries. 

The accounts typically fall under the following categories:

• Assets
• Liabilities 
• Income 
• Loss
• Equity 
• Drawings

Types of Journal Entries

Several varieties of journal entries are used based on the circumstances of the recorded event. Typically, there are five types of journal entries. 

They are:

1. Opening Entries: Entries posted during the organization's initial stage, such as business commencement, first inventory purchases, etc. 
2. Closing Entries: Entries that are posted during the end of the accounting period act as a passage for the transfer of data from the temporary account in the income statement to a permanent account in the balance sheet. 
3. Compound Entries: Compound entries are posted due to circumstances where a single account impacts multiple other accounts without affecting its position in the ledger account. Such events are compounded to reduce repetitive entries. 
4. Transfer Entries: Entries that are posted to transfer data from one account to another. Typically, such entries are posted when any error in the original books has been found. 
5. Reverse Entries: Reversing entries are those entries that are posted to reverse any entries made in the previous accounting period that need to be adjusted. 
6. Adjusted Entries: Adjusting entries are posted to make changes to any previous entries matching the accounting period in which they occur. Typically, these entries are made to convert transactions to accrual-based transactions.

Understanding Double-Entry Bookkeeping System

A double-entry system connects the whole transaction process. It ensures that the movement of money is consistent by balancing both sides of the debit and credit, as no event occurs where there is only a one-sided transaction. 

The double entry system was first written in detail by Luca Pacioli (Father of Accounting), whose bookkeeping method consisted of dual entry recording, i.e., debit and credit. 

This double-entry accounting ensures that the transactions are accurate by reflecting the effect on both the accounts involved in the transaction (debit and credit). It's a great way to ensure consistency and detect and avoid fraudulent activities.  

“How does a typical double-entry journal look like?”

Well, the double-entry bookkeeping system utilizes a specific format that aligns and enables the whole idea of recording both sides of the transaction. This specific format is called Ledger. 

It is where the detailed movement of the events for an account is recorded. This makes it easy to trace all the affected accounts that are linked to the specific account.  

The anatomy of a ledger account would be in a T format.

“So why make a journal entry if there is a ledger available?”

Well, even though the ledger accounts show a detailed movement of the account transactions, it is not possible to post the ledger account WITHOUT the journal entry. 

Journal entry acts as a syntax; therefore, a journal entry is created first, and then the ledger account is updated. Then, trial balances are created using the ledger to tally the balances and prepare financial statements.

Methods To Construct A Journal Entry

There are some rules/methods to apply to create a journal entry. These rules are in place to guide the user in posting the right account for the right event at the right date and the right amount.

There are two methods by which a journal entry can be made. But one of the two is outdated. Let's explore what they are:

The Golden Rule 

The method of the golden rule is a simplified set of guidelines that guides an accountant to post the right type of account in the right given scenario for an accurate account posting. 

The golden rule comprises three rules of the nature of the transaction:

• Personal Account 
• Real Account 
• Nominal Account

Let's dive into each of the account rules:

1. Personal Account 

A personal account refers to an individual's financial account that records transactions related to personal assets, liabilities, income, and expenses. 

Rule:

• Debit the receiver 
• Credit the giver  

Example: Albert Co is a computer trading store and has purchased 25 laptops for USD 400 each from Comp Co. Here, the accounts involved in the transactions are: Purchase and Account Payable.

2. Real Account 

Real accounts deal with those accounts that are permanent in nature, i.e., don't close at the year's end, such as capital expenditures. These accounts are also called Permanent Accounts. 

Rule:

• Debit what comes in 
• Credit what goes out

Example:

David decided to renovate his office with new aesthetics and furniture to comfort his employees, clients, and investors. So he decided to purchase some sofas from Ikea at $499.99 for every 5 pieces. 

Here, the accounts involved are Furniture and Cash.

Since the sofas (assets) come into the business, they get debited under the “Furniture” account. 

And cash is paid upfront; therefore, cash as an asset gets reduced (cash goes out of the business). 

3. Nominal Account 

Nominal accounts deal with accounts whose nature of the transaction is gain or loss. These accounts are temporary in nature, i.e., close at the year-end, due to which Nominal accounts are also called Temporary accounts. 

Rule:

• Debit the expenses and losses
• Credit the incomes and gains

Example 1: Gain

David, who indulges in dropshipping as a side hustle, sold 20 computer parts worth $4,000 in total. David takes cash upfront as the credit base business is too hard on his side hustle. David wants to maintain his record and posts the following journal entry. 

Here, the accounts are Sales and Cash.

Here, his inventory is reduced via sale; therefore, he debits the loss “Sales” and credits the cash as he receives income from his sale. 

Example 2: Loss

David, who has a side hustle as a drop shipper, purchases the next few computer components based on the market demand. He purchased components at a total cost of $3,250. David pays cash upfront.

Here, the accounts are Purchases and Cash.

Here, the purchases cause a drop in cash due to acquiring assets (components). But in return, cash comes in as an asset (component). 

The Modern Rule

The Golden Rule gets confusing over time when you have to look at more than one rule depending on the nature of the account and the transaction. The modern rule is the Golden Rule upgrade, which has a comprehensive pattern for posting journal entries accurately. 

Below is the table in which one can easily observe the pattern.

The following explores a few examples to better grasp the Modern Rule.

Example 1: Purchasing machinery. 

ABC Co. brought 5 machineries worth $230,000 each.

Here, the affected accounts are Machinery and Cash. 

• The account “Machinery” is debited because any asset increase gets debited. 
• The account “Cash” is credited because cash is used to purchase machinery, i.e., cash got reduced. Any asset decreases get credited. 

Example 2: Purchasing Land and Building 

ABC Co. acquired land to expand the business for its Electronic trading. ABC Co. also acquired the building to function as an outlet. The land cost about $570,000, whereas the building was valued at $290,000.

Here, the affected accounts are Land and Building, Cash, and Accounts Payable. 

• The Land and Buildings are assets, and acquiring them increases the asset in hand. Therefore, debit it. 
• The Cash used to acquire the Land and Buiding is an asset that decreased. Therefore, credit it.
• The remaining amount to pay is taken was Account Payable, and as the name suggests, it's a liability. And an increase in liability means a credit.

Example 3: Borrowing money.

ABC Co. borrowed some money to smoothen the operations. Therefore, they took a loan of $500,000 from the bank.

Here, the affected accounts are Cash and Bank. 

• Since ABC Co. is borrowing money, i.e., money comes into the business, making the Cash an asset. An increase in assets means a debit. 
• At the same time, the cash comes from a loan, i.e., borrowed from the bank, which needs to be returned. Therefore, it is a liability, and increasing liability means a credit. 

Example 4: Making a Presence

ABC Co. commenced the business in the new location. ABC Co. approached the advertising company and paid $10,000 to advertise the newly launched outlet selling the latest electronics and appliances on a “Grand Opening” discount for 15 days. ABC Co has made a sale worth $36,000 by the end of the day.

Here, the affected accounts are Cash, Advertisement, and Sales.

• ABC Co. paid advertisement for 15 days, which is an expense. An increase in expense is posted on the debit side. 
• ABC Co. made a sale on the first day, which is an income. An increase in income is posted on the credit side. 
• ABC Co. cash, being an asset to the business, impacted both events.
  • Paying advertisers reduces cash, i.e., credit.
  • Income increases via sales; here, income is cash. An increase in cash is debited.

Researched and authored by Muhammed Ishfaque Ishaque | LinkedIn 

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Accounting

• Accounting Equation

• General Ledger

• IFRS vs. US GAAP

• Trial Balance