All small businesses need a record of their financial transactions. The accounting journal entry is the first step in the financial reporting process. It is the basis for all the other financial reports prepared by the business. Each financial transaction requires a debit to one of the business's accounts and a credit to another to fully show the transaction. This is called double-entry accounting and it acts as a safeguard that allows a business's books to balance.
The first step in double-entry accounting is to record journal entries for every financial transaction that your business makes on a daily basis.
What Is an Accounting Journal Entry?
When you make a financial transaction, you make a journal entry in the general journal to record that transaction. The general journal is a detailed record of the financial transactions of the business. The transactions are listed in chronological order. Depending on the size and complexity of your business, a reference number can be assigned to each transaction. The debits and credits must equal each other and reflect the principle of the accounting equation.
An accounting journal page has columns for the date, the account name and number, the amount debited and credited, the reference number of the transaction, and any detail that should be included with the transaction.
There is always a general journal for a business, but there can also be specialized journals depending on the business. You may have a sales journal, a purchases journal, and an accounts receivables journal among others.
Who Should Use an Accounting Journal?
The smallest of businesses can use a single-entry accounting system where there is one entry recorded for each financial transaction. Each entry is either a cash receipt or a cash disbursement. Either the business receives money or pays money to someone else. Single-entry accounting is more like using a checkbook than an accounting journal, although businesses will still want to keep receipts and the details about their financial transactions.
Most businesses use double-entry accounting systems for accuracy in balancing the books. Any business that uses a double-entry accounting system should use at least a general accounting journal and may need to use specialized journals depending on the complexity of their business.
Other Types of Accounting Journal Entries
There are more complex accounting journal entries than the general journal entry.
- A compound journal entry occurs when more than two accounts are involved in a journal entry. For example, there may be one account debited and two or more credited. The amount of the debit(s) and credit(s) must still be equal. An example of a compound journal entry is depreciation. Accumulated depreciation is credited, but you might decide to show detail in the way depreciation is debited. You can do this by debiting each individual expense account where depreciation is a factor such as automobiles and computer equipment.
- An adjusting journal entry is made at the end of an accounting period to take care of anything that was unresolved during that accounting period. An example is when a vendor ships goods to your business, but that vendor's invoice wasn't processed by the end of the accounting period. Adjusting entries convert real-time transactions to the accrual accounting system to make your books balance.
- Closing journal entries are made at the end of an accounting period to prepare for the next accounting period. They are entries that reset the income statement accounts of revenue and expenses to zero.
- Reversing journal entries are made at the beginning of an accounting period to cancel out adjusting journal entries from the end of the previous accounting period. Reversing journal entries are made because items like accruals will be paid off during the new accounting period and the adjusting entries are no longer needed.
When to Use a Debit and Credit in a Journal Entry
One of the most difficult things to grasp is when to use a debit and when to use a credit for a financial transaction. This is confusing because our society is conditioned to think of bank accounts with debits as funds flowing out and credits as funds flowing in.
In double-entry bookkeeping, the debits and credits are different. Every transaction debits one account and credits another. There are five types of accounts:
- Shareholders' equity
Your chart of accounts will list the account sub-type (such as cash is an asset account), account number, title, how to increase it (debit or credit), and a description of the account. Looking at a firm's Chart of Accounts combined with debits and credits makes this easier to understand:
|Chart of Accounts|
Here is an example of how to use this Chart of Accounts. Imagine that you own a small business and you get a water bill for $200. You will pay that bill soon. You would debit, or increase, your utility expense account by $200, and credit, or increase, your accounts payable account by $200. Those are equal and opposite journal entries.
A debit increases an asset or expense account, while a credit increases a revenue, liability, or equity account. Consider this—when you make a purchase, one account decreases in value (value is withdrawn), and another account increases in value (value is received.) A chart of accounts can help you decide whether to debit or credit a certain type of account.
Here is an example of the format of the Chart of Accounts:
|No.||Account Title||To Increase||Description|
|101||Cash||Debit||Checks Received, Cash|
How It All Works
Let's put all of this together and look at a day in the life of the owner of XYZ, Inc. Every time a financial transaction is made, an entry has to be made to the general journal. The entries should be in chronological order. Since the first transaction would be when the owner formed the corporation, here is the journal entry. The owner purchased 20,000 shares at $1 per stock:
|Start of Business|
Next, the owner had to purchase a computer system and printer for XYZ, Inc. The following is the journal transaction:
|Computer System Purchase|
|Plant and Equipment||$5,000|
If you purchased a computer system and printer for $5,000, cash is withdrawn from your bank account and transferred to the business you bought it from. In double-entry bookkeeping, you took $5,000 from your cash account and moved it to your equipment account.
Both accounts are asset accounts. So, you credited your cash account and debited your equipment account. If you then sold the same system for $5,000, you would credit your equipment account and debit your cash account. While this may not sound correct, your chart of accounts tells you that an equipment account decreases with a credit and a cash account increases with a debit.
The owner purchased $25,000 in inventory on account. The inventory account would be debited for $25,000 and accounts payable would be credited for $25,000. The journal entry would look like this:
These are a few examples of common journal entries for a typical small business.
- An accounting journal entry must be made for every financial transaction made by a business firm.
- Equal and opposite debits and credits are recorded for each journal entry. This is what the system of double-entry bookkeeping is based on.
- A Chart of Accounts, which lists the accounts for a business, tells you if a journal entry is a debit or a credit.
- There are special types of journal entries that may need to be made, depending on the complexity of the business.