Entering Transactions in the Journal

The financial statements that are the end product of the accounting cycle are only as good as the journal entries that happen at the beginning of the cycle. In order to better understand how bookkeeping entries are constructed, here is a simplified case study of the accounting process, starting with the daily log of transactions—the journal.

On January 10, you start a gift shop called Holiday Gifts. The first thing you do file for an assumed business name with the state and then, when you get the business name, you go to a local bank and make a $10,000 transfer from your personal checking to a new business checking account. In order to keep track of your financial results, you decided to follow GAAP and best bookkeeping practices, so you buy an accounting journal and make the following entry:

Note that you have written the debit portion of the entry first, and that you indented the account name for the credit entry, according to common practice. You decide to wait for a few more transactions before posting to the general ledger.

On the 12th, you pay insurance in the amount of $600 and you journalize the transaction as follows:

On January 15 you paid $1,000 in rent for the next 5 months ($200 per month for January through May).

The journal entry to record both the rent paid in advance and the rent for the current month would be:

On January 16 you bought 10 picnic baskets to resell. The vendor gave you 30 days to pay in full. You paid $60 each for them and you plan to resell them for $100 each.

The journal entry to record the purchase of inventory would be:

On January 20 you hired a part-time sales person to mind the store so that you could spend time building the customer list. Your sales person is paid twice a month on the 10th and 25th and will start immediately.

No journal entry in needed for this activity since it did not rise to the level of a financial transaction.

On January 21 you borrowed $15,000 from the bank for working capital.

On January 30 you sold 4 picnic baskets to various cash-paying customers.

Note in the last entry on the 30th we reduced the amount of inventory we are reporting as having on hand (an assets) by the amount of picnic baskets we sold, and matched that as an expense against the sales price. That specific matching concept results in an amount accountants call Gross Profit. Gross profit is the sales price of an item less its cost. In this case, the Gross Profit per item is $40, and the total Gross Profit for January was $160.

On January 30 you paid $2,750 cash for a small travel trailer that will serve as a mobile store. You expect it to last for five years and then you’ll sell it for about $750.

Posting Entries to the Accounts

Once all the transactions for the month are journalized, they are posted to the ledger pages. Each journal entry is transferred line by line to the appropriate account. For instance, the cash ledger would appear like this:

Notice that in the cash account, which is an asset account, a debit (entry to the left side of an account) represents an increase, and a credit (entry to the right side of the account) represents a decrease, and the balance is the combination of the two. This is the exact opposite for accounts on the right side of the accounting equation:

Assets = Liabilities + Equity

In liability and equity accounts that represent increases in those major categories, account balances are increased by a credit and account balances are decreased by a debit. The opposite is true for accounts that decrease those major categories.

In the ledgers, the reference number is to the page in the journal (also called the General Journal) where the entry is found. In the journal, the reference number is the company-assigned account number to which the journal entry is posted. Assume all the following entries have been posted to the appropriate ledger “pages”. The highlighted entries are the ones posted to the Cash account ledger. Notice that the ledger provides a running total but the journal does not, since it is chronological by transaction, rather than by account.

The Trial Balance

The next step in the accounting cycle is to create a trial balance, to make sure that all the debit entries are balanced out by credit entries. The trial balance is simply a list of all the accounts with the ending balances in the correct column, debit or credit, taken right from the general ledger.

On February 3, you calculate that your employee earned $500 in wages from January 20 through January 31, to be paid on the 10th of February, and you record an Adjusting Journal Entry (AJE) to match January wages earned (incurred) with January revenue.

Note that you are backdating this AJE to the last day of January so that it shows up in the correct month on the financial statements. This is called an accrual. It is written in the journal and posted to the ledger. Page 2 of the journal would now look like this:

Wages decrease equity, since they offset revenue. Equity is on the right side of the accounting equation which means that an increase to equity is shown by a credit entry and a decease is shown by a debit entry. Wages always decrease equity, so wage expense, in fact, every expense account, is always debited and always has a debit balance.

The Adjusted Trial Balance

Once all of the adjusting journal entries are posted to the ledgers, the accountant runs one final check of debits and credits, called the adjusted trial balance. In this simplified example, the adjusted trial balance would look like this:

These transactions, including the adjusting entries, give us enough information to create the adjusted trial balance so that we can move on to the next step in the accounting process—creating the financial statements.