Understanding Journal Entries in Accounting

Journal entries might not be the first thing on your mind when you’re running a small business, but if you’re going to understand your financial statements and feel confident about your finances, understanding the basics of journal entries is something you shouldn’t skip. 

The framework behind journal entries – double entry accounting – affects all transactions in your accounting system. From purchases as small as a bag of chips to purchasing a whole building, every transaction will affect debits and credits. 

Journal entries are the tool that records these transactions in a systematic way.

This guide is crafted to demystify journal entries for you, breaking down their importance, structure, and how to effectively manage them. 

This article is related to our other guides on the importance of accounting, EBITDA, cash vs. accrual accounting.

This guide is also related to our articles on double-entry accounting: the basics, how to read a balance sheet, and how to do bank reconciliations.

Here’s what we’ll dive into:

• The essentials of journal entries
• Double-entry bookkeeping
• Different types of journal entries
• Guide to making journal entries
• Debit and credit balances accounts
• Examples of common journal entries
• How journal entries affect your statements

Let’s dive in and unlock the potential of journal entries for your business.

The Backbone of Journal Entries

Before we understand journal entries, we first need to understand the principle underlying them. That principle is double entry accounting.

Every financial transaction in your business is going to affect two types of accounts: debit or credit.

Every transaction entries must balance, meaning the total amount debited from one or more accounts must equal the total amount credited to one or more other accounts. 

In the double-entry system, debits and credits serve two primary functions: they record the movement of value in and out of accounts, and they ensure the accounting equation (Assets = Liabilities + Equity) remains balanced after every transaction. Here’s a clearer look at how this works. 

Debits and Credits

Debits (Dr): A debit is an entry made on the left side of a ledger account. It signifies an increase in assets or expenses and a decrease in liabilities, equity, or revenue. 

For example, when a business purchases supplies in cash, it debits (increases) its Supplies account because it has more supplies, and simultaneously, it must credit (decrease) its Cash account because it has spent money.

Credits (Cr): A credit is an entry made on the right side of a ledger account. It signifies a decrease in assets or expenses and an increase in liabilities, equity, or revenue. Continuing with the previous example, the decrease in the Cash account is recorded as a credit because the business now has less cash.

The essence of the double-entry system is that it provides a complete view of a transaction’s impact. 

The Basics of Journal Entries

A journal entry is a way to record debits and credits. While any accounting software will automatically debit and credit a simple transaction (payment on an invoice, purchase of supplies etc.), journal entries are used for more complex transactions like accruals, depreciations, or year-end adjusting entries. 

Each journal entry will debit one or more accounts, and credit the equal amount to one or more accounts.  

A journal entry, in its simplest form, consists of several key components that together provide a complete picture of a financial transaction. 

Date: The date when the transaction occurred is critical for chronological tracking and for preparing financial statements for specific periods, such as monthly, quarterly, or annually.

Description: This provides context for the transaction, offering enough detail to understand the nature of the transaction without needing to refer to other documents.

Ledger Accounts: Every transaction affects at least two ledger accounts (debit or credit), which are categories within your accounting system that help organize and summarize financial transactions. Both debit and credit accounts must always equal each other in every journal entry.

Types of Journal Entries

In the realm of accounting, journal entries are categorized based on their purpose and timing in relation to the financial reporting cycle. 

Understanding these categories—standard, adjusting, recurring, and opening and closing journal entries—helps in organizing financial data accurately and effectively.

Standard Journal Entries are the most common type. These entries record routine transactions that occur frequently within a business’s operations. 

A great example of a standard journal entry is a payroll journal.

When payroll expenses are deducted from a business owner’s bank account, typically the net payroll (the amount going straight into the employee’s accounts) is one withdrawal, and taxes are taken out in a separate withdrawal. 

If we simply assign the employee deposits as payroll and the tax withdrawal as taxes, that’s incorrect, because a portion of the tax withdrawal (let’s say $10,000) is actually employee wages that are deducted from their paycheck. 

A journal entry would debit (increase) Wage Expense and credit (decrease) Payroll Tax expense.

Adjusting Journal Entries are crucial for ensuring that the financial statements of a business accurately reflect its operations at the end of an accounting period. They are typically used when a business is using accrual accounting.

A common scenario requiring an adjusting journal entry is accrued expenses.

Imagine a business incurs utility expenses in December, but the bill isn’t paid until January. Without recording this expense in December, the financial statements for that period would not accurately represent the company’s financial position. The expense was incurred in December, so it must be recognized in December’s financial statements, regardless of when the payment is made.

So, an adjusting journal entry is needed at the end of December. This entry would debit (increase) Utilities Expense for the amount of the bill, acknowledging the expense incurred, and credit (increase) Accrued Expenses, recognizing the obligation to pay this amount in the future.

This adjustment ensures that the income statement reflects the utilities expense incurred during December, and the balance sheet accurately shows the liability that exists at the end of December.

Other common examples include adjusting for accrued revenues, prepaid expenses, and depreciation.

Reversing journal entries are exactly what they sound like: they reverse previous journal entries. 

Continuing with our scenario above, we recognized the utility expense in December. At the beginning of January, when the new accounting period starts, a reversing journal entry can be used to negate the impact of the adjusting entry made in December. This is done to prevent double-counting the expense when the actual utility bill is paid.

The reversing entry would be

This entry effectively “resets” the Utilities Expense and Accrued Expense accounts related to the December utilities consumption. 

When the utility bill is paid in January, the payment can be recorded straightforwardly as Utilities expense, without impacting the Utilities Expense in January. 

Opening Journal Entries are used at the beginning of an accounting period to carry forward the balances from the previous period’s accounts into the current period. For a new business, the opening entries establish the initial investments and assets brought into the business. For example, you’re starting a new business and you contribute $25,000 to the business to fund operations. 

You would debit (increase) Cash and credit (increase) Owner’s Investment. 

Closing Journal Entries are recorded at the end of an accounting period to clear out the balances of temporary accounts—revenues, expenses, and dividends or withdrawals—and transfer their net balance to permanent accounts, such as retained earnings. 

This process resets the temporary accounts to zero, ready to track transactions in the next period, and updates the equity section of the balance sheet to reflect the period’s earnings and distributions. Closing entries are crucial for finalizing the accounts for the period and preparing the books for the next accounting cycle.

Each type of journal entry plays a specific role in the accounting and financial reporting process. Standard entries capture day-to-day transactions, adjusting entries ensure the financial statements are accurate and complete, and opening and closing entries mark the beginning and end of accounting periods, respectively. 

How to Record Journal Entries: A Step-by-Step Guide

Creating accurate journal entries is a fundamental skill in accounting, essential for maintaining a clear financial record of a business’s transactions. Here’s a concise step-by-step guide on how to make journal entries:

Step 1: Identify the Transactions

The process begins with identifying the transactions that need to be recorded. Transactions can range from sales, purchases, payments, receipts, or any other business activity that affects the financial statements.

Step 2: Analyze and Classify the Transactions

Once identified, each transaction must be analyzed to determine its nature and how it affects the business’s financial position. Classify each transaction into one of the five main categories: assets, liabilities, equity, revenue, or expenses. This classification is crucial for understanding which accounts will be affected and how.

Step 3: Determine the Accounts Affected

Identify the specific ledger accounts that the transaction will impact. This could involve more than two accounts, especially in complex transactions. For instance, selling goods on credit affects the Accounts Receivable and Sales Revenue accounts.

Step 4: Decide on Debit and Credit Entries

For every transaction, decide which accounts to debit and which to credit, adhering to the double-entry bookkeeping principle that for every debit, there must be an equal credit. Remember, assets and expenses increase with debits and decrease with credits, whereas liabilities, equity, and revenue increase with credits and decrease with debits.

Step 5: Record the Journal Entry with All Necessary Details

With the accounts and their respective debits and credits determined, record the journal entry in the accounting system. In most cases, you should include clear and detailed notes and attach backup documentation to your journal entry (if available) for maximum clarity. 

Following these steps systematically for every transaction ensures that your business’s financial records are accurate, up-to-date, and reflective of its true financial position. 

Examples of Common Journal Entries in Small Businesses

Here are detailed examples of common journal entries:

Example 1: Recording a Sale on Credit

When a business makes a sale on credit, it increases both its revenue and its accounts receivable.

Transaction: Sold goods worth $5,000 on credit.

• Debit: Accounts Receivable $5,000 (increases assets)
• Credit: Sales Revenue $5,000 (increases equity through increased revenue)

This journal entry reflects that the business expects to receive $5,000 from the customer, increasing both its accounts receivable and its sales revenue.

Example 2: Purchasing Inventory with Cash

Purchasing inventory with cash decreases the business’s cash account and increases its inventory.

Transaction: Purchased $3,000 worth of inventory with cash.

• Debit: Inventory $3,000 (increases assets)
• Credit: Cash $3,000 (decreases assets)

This entry shows that $3,000 in cash was spent, reducing the cash account, but the inventory, another asset, increased by the same amount.

Example 3: Paying off a Debt

Paying off a debt decreases both the business’s liabilities and its cash or bank balance.

Transaction: Paid off a $2,000 debt.

• Debit: Loans Payable $2,000 (decreases liabilities)
• Credit: Cash $2,000 (decreases assets)

This entry reflects the reduction of debt in the loans payable account and the decrease in the cash account by the same amount.

Example 4: Adjusting Entries for Prepaid Expenses

Prepaid expenses require an adjusting entry as the expense is recognized over time.

Transaction: Initially recorded a prepaid insurance of $1,200 for a 12-month policy.

• Monthly Adjustment: ($1,200 / 12 months = $100 per month)
• Debit: Insurance Expense $100 (increases expenses)
• Credit: Prepaid Insurance $100 (decreases assets)

Each month, this adjusting entry decreases the Prepaid Insurance account and increases the Insurance Expense account to recognize the expense incurred with the passage of time.

Example 5: Recording Depreciation

Depreciation is recorded to account for the reduction in value of a fixed asset over its useful life.

Transaction: Depreciating a piece of equipment costing $12,000 over a 12-year lifespan with no salvage value.

• Annual Depreciation Expense: ($12,000 / 12 years = $1,000 per year)
• Debit: Depreciation Expense $1,000 (increases expenses)
• Credit: Accumulated Depreciation – Equipment $1,000 (increases contra asset account)

This entry recognizes the cost of using the equipment over one year, increasing expenses through Depreciation Expense and recording the cumulative depreciation in a contra asset account, reducing the net book value of the asset.

These examples illustrate how various transactions are recorded in a small business’s accounting records, affecting different ledger accounts and ultimately influencing the financial statements.

Debit vs credit account balances

Since we’ve seen that every account in your financials has a debit or credit balance, here’s a list of the most common accounts and what kind of balance they carry. 

A basic rubric to remember is “DEA-LOR” – it stands for Dividends, Expenses, Assets (Debit balances) and Liabilities, Owner’s Equity, Revenue (Credit balances).

Accounts with Debit Balances

• Assets (BS): Increase with debits; decrease with credits. Examples include:
  • Cash
  • Accounts Receivable
  • Inventory
  • Prepaid Expenses
  • Equipment
  • Buildings
• Expenses (P&L): Increase with debits; decrease with credits. Examples include:
  • Cost of Goods Sold
  • Salaries Expense
  • Rent Expense
  • Utilities Expense
  • Depreciation Expense
• Dividends (BS): Increase with debits; decrease with credits. Though not an expense, dividends reduce retained earnings (an equity account) when declared.

Accounts with Credit Balances

• Liabilities (BS): Increase with credits; decrease with debits. Examples include:
  • Accounts Payable
  • Accrued Liabilities
  • Notes Payable
  • Mortgages Payable
• Owner’s Equity (BS): Increase with credits; decrease with debits. Examples include:
  • Common Stock
  • Retained Earnings
• Revenue (P&L): Increase with credits; decrease with debits. Examples include:
  • Sales Revenue
  • Service Revenue
  • Interest Income

The Role of Journal Entries in Financial Statements and Analysis

Now that we’ve seen how debits and credits relate to journal entries, let’s explore how they flow onto the three most common financial statements: Balance Sheet, Profit & Loss, and Cash Flow Statement.

Connection to the Balance Sheet

The balance sheet reflects a company’s financial position at a specific point in time, showing what the business owns (assets) versus what it owes (liabilities and equity). Journal entries directly affect the balance sheet by altering the balances of these accounts. 

For instance, when inventory is purchased with cash, an entry debits the Inventory account (increasing assets) and credits the Cash account (decreasing assets). This transaction doesn’t change the total assets’ value but alters the composition. 

Similarly, paying off a debt with cash decreases both an asset (Cash) and a liability (Loans Payable), directly impacting the equity and liquidity represented on the balance sheet.

Connection to the Income Statement

The income statement, or profit and loss statement, shows a company’s revenues and expenses over a period, culminating in net profit or loss. Journal entries related to operational activities, like sales revenue and various expenses (cost of goods sold, salaries, utilities), flow into this statement. 

Each sale increases revenue (credit to Sales Revenue account and debit to Cash or Accounts Receivable), and each expense decreases net income (debit to an Expense account and credit to Cash or Accounts Payable). The aggregation of these entries over the period forms the basis of the income statement, illustrating the business’s profitability.

Connection to the Cash Flow Statement

The cash flow statement provides a detailed breakdown of a company’s cash inflows and outflows, categorized into operating, investing, and financing activities. Journal entries influence this statement by tracking the actual movement of cash within the business. 

Entries that involve the cash account, like receiving payment from customers or paying for expenses, directly contribute to the operating activities section. Purchases or sales of assets would appear in investing activities, while transactions related to debt, equity, or dividends influence the financing activities section. This statement is essential for understanding the liquidity and cash management of the business.

Through journal entries, businesses can maintain a detailed and accurate record of all transactions, which systematically feed into these three financial statements. Together, these statements offer a comprehensive view of a business’s financial health, informed directly by the granular detail provided by journal entries. 

Conclusion

Through this journey, we’ve seen how journal entries are not just about recording transactions but are integral to the financial storytelling of a business, enabling you to make informed decisions, comply with regulations, and ultimately guide their businesses towards financial health and growth.

Next, check out our articles on understanding owner’s equity, what is a chart of accounts?, and bookkeeping vs. accounting. 

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