Steps one and two in the accounting cycle are to analyze transactions as they happen to determine what, if any, journal entry should be made, and to make the journal entry.

Let’s go back to NeatNiks to see how these steps are done.

Remember that Nick Frank started NeatNiks as a sole proprietorship in October. NeatNiks provides customized cleaning services to high-end homeowners in the Santa Fe area of New Mexico.

On October 1, Nick opened a bank account in the name of NeatNiks using $20,000 of his own money from his personal account

There will be documentation to back this amount up if the company is ever audited (checked by an external source such as the IRS or an accounting firm). For instance, there will be a deposit slip and an entry on the bank statement, and maybe a canceled check from Nick. In any case, for most transactions, there will be some kind of paper trail that provides objective, verifiable evidence (remember these principles from the section on accounting concepts?).

In a prior section, we looked at this transaction and made this entry:

The checking account is an asset that increased when the owner made a deposit, so we show the increase with a debit. The capital account tracks owner’s equity, which is on the right side of the accounting equation (A = L + E) so we show that increase with a credit.

The next transaction was on October 4. Nick rented a truck for $12,000 cash for October thru March (6 months).

This one is a bit tricky. Remember that the matching principle states that expenses are recognized (recorded) when they are incurred, not when they are paid (although sometimes they are incurred and paid at the same time.) An accountant analyzing this transaction would create the following journal entry:

Prepaid Rent is an asset account because the rent will be incurred with the passing of time. In other words, if for some reason Nick turns around and cancels the rental agreement, or the car company doesn’t deliver the vehicle, Nick will get the rent back. The rent doesn’t belong to the car company until Nick actually uses the vehicle (remember that the word “expense” means “to use up.”). At some point, probably at the end of the month, we will have to adjust Prepaid Rent to account for the expiration of one month’s rent, but for now, we will simply record the cash paid to the car company as our asset: Prepaid Rent. Notice that we are going to post a credit to the checking account, noting that we are reducing that account by the amount of the check written.

This is a good time to point out that the journal we are creating here, the book of original entry, is like an instruction manual to whoever is going to post these transactions to the ledger.

On October 7, Nick purchased $2,600 of supplies on account from Cleaning Supplies, Inc.

Supplies are an asset until they are used up (expended). To buy “on account” means that we picked up the items but did not yet pay for them. Cleaning Supplies, Inc. will send us a bill. We bought these supplies on credit (which means we owe money for them).

Notice that when we write the journal entries, we indent the title of the account with the credit side of the entry.

Also, notice that total debits always equal total credits. This is a hard and fast rule with no exceptions.

See if you can analyze this one yourself:

October 15 Received $1,500 cash for services performed.

Let’s try this entry: October 20 Billed customers for work done in October $7,250.

If we were using the cash basis of accounting, we wouldn’t have anything to enter here because we haven’t received any cash yet. However, the cornerstone of the accrual basis of accounting is to recognize (record) revenue as it is earned, regardless of when the cash is received. We use an account called Accounts Receivable to show revenue billed but not yet collected.

Refer back to Nick’s purchase of supplies on October 7. Nick owes Cleaning Supplies, Inc. $2,600 for supplies he bought but hadn’t yet paid for, and we recorded that entry as Accounts Payable. For Cleaning Supplies, Inc., that same amount shows as Accounts Receivable. Nick’s payable is their receivable. Nick’s expense is their revenue. And the opposite holds true: Nick’s revenue is someone else’s expense, and Nick’s receivable is someone else’s payable.

Here are the rest of the transactions, and the completed journal. See if you can reverse analyze these entries and understand the logic behind the debits and credits.

• 25 Paid cash: $1,500 for insurance and $1,100 for contractors’ salaries
• 26 Paid $1,000 to Cleaning Supplies, Inc. on account
• 30 Collected $1,600 from customers on account
• 31 Withdrew $4,000 cash for personal use

These last two will be adjusting journal entries, so we’ll address these in a later section.

• 31 Nick owes independent contractors $1,200 for work done in October—he’ll pay it in November
• 31 Nick had $1,000 of supplies leftover at the end of the month

Just looking at a journal can be a bit confusing. Remember that a journal is a chronological listing of all transactions and is just raw data at this point. The process of turning raw data into information begins with posting these journal entries to the ledger pages. As you post entries, the reasoning behind the journal entries will become more clear.