Capturing Economic Events
This lesson introduces you to the concepts of debit and credit, and demonstrates bookkeeping activities. After reading this lesson you should be able to:
- Prepare common journal entries
- Post to the Ledger accounts
- Prepare a basic Income Statement
The Accounting Cycle
The Accounting Cycle is a sequence of procedures used to record, classify and summarize accounting information in financial reports, on a regular basis.
Steps in the Accounting Cycle
- Record (journalize) transactions.
- Post journal entries to Ledger accounts.
- Prepare a Trial Balance.
- Make adjusting entries.
- Prepare an Adjusted Trial Balance.
- Prepare financial statements.
- Journalize and post closing entries.
- Prepare After-Closing Trial Balance.
The General Journal and Journal Entries
Every business transaction is recorded in the General Journal. The General Journal is called the book of original entry. A journal is a chronological record of transactions - they are in date order.
Each entry is called a journal entry, and represents a different business transaction. Each transaction is recorded once, and only once. All journal entries follow the rules of debit and credit.
Journal entries should be made contemporaneously with the event they are recording, or reasonably soon after the event. Keep in mind that a journal is a chronological record of events. A contemporaneous writing is one that takes place at the same time as the event. This is the best time to record an event, because the facts and details are still fresh in our minds. Necessary documents, conversations, calculations, etc., are readily available to create a correct record of the event. If we wait too long, the event will be much more difficult to reconstruct.
In a legal sense, a contemporaneous writing carries much more weight than a writing made at a later date. And a writing carries much more weight than a mere recollection of events, months or years after the event has taken place. The courts recognize that people's memories about events are much clearer right after the event has taken place. As to the sale of real estate, state laws require a contemporaneous writing, to establish the exact terms and conditions of the sale. In contract law, this is called a "meeting of the minds, and must be present for a valid contract to exist.
We will use verifiable, tangible evidence whenever it exists. Tangible evidence has physical existence - we can touch it, fold, staple, copy and file the document. We will look for a check, invoice, purchase order, contract or other business document that is a record of the event, a confirmation of payment received and goods delivered, etc. These documents become the back-up documentation for our journal entry.
The General Ledger
Transactions are classified into accounts appropriate to the business. Accounts represent major classifications, or categories, organized according to the 5 account types covered in the financial statements lesson. The accounts are listed in a Chart of Accounts.
Posting - journal entries are copied to the accounts in the Ledger. After posting, the balance in each account is updated. Accounts always carry the most current balance.
Balances in Ledger accounts == become ==> Financial Statements
Books & Bookkeeping
Journals and Ledgers were historically written in by hand. They were actual books, which is where many of the terms we use come from. Terms like bookkeeping, journal, balanced books, etc. all came from the days of manually recording entries in books. Today we use computers to do the same job, but much of the terminology is the same.
Debits and Credits
Journals and Ledgers can be viewed as pages of a book. Each page has lines and columns. A journal page has columns for the date, account name, and two columns for dollar amounts, referred to as the Debit and Credit columns.
Sample General Journal Page
We enter dollar amounts in the Debit and Credit columns.
The totals in the Debit and Credit columns must be equal.
Caution! Do not confuse the concepts of debit and credit we use here, with what you read in your bank statement. Banks copy their records, and send them to you. It reflects your bank account, from the bank's perspective - which is opposite of your perspective, in an accounting sense.
Sample Ledger page
The Ledger page has an additional column to calculate the balance in the account. The balance is updated after each entry.
A Credit balance is usually indicated by enclosing the number in parentheses: $(500) would indicate a $500 Credit balance.
|Jan-1||Balance forward from Dec-31||(500)|
The Dollar Sign $ is usually omitted in actual practice. We will always assume that we are using the US Dollar in all transactions, journals, ledgers and financial statements.
Entries are transferred (Posted) from the journal to the ledger pages on a regular basis.
When do we use Debit or Credit?
When to use a debit or credit to record a journal entry is one of the biggest problems for beginning accounting students. It doesn't have to be difficult, if you remember a few simple rules.
First, you will always use both a debit and credit. That's the idea of the double-entry system. You have two columns, so every journal entry will have an equal dollar amount in each column.
Remember the Accounting Equation?
|Left side||Right Side|
|Debit side||Credit Side|
Debit = Increase
Credit = Decrease
Credit = Increase
Debit = Decrease
Accounts on the Left side will INCREASE with a Debit (Left column) entry. Accounts on the Right side will INCREASE with a Credit (Right column) entry. They will each DECREASE with the OPPOSITE entry.
Refer to the Chart of Accounts to determine whether an account falls on the Left or Right side of the Accounting Equation.
Normal Account Balances
All Accounts have a normal account balance - the balance they would have if increases to the account are more than decreases to the account. If the account has a balance opposite its normal balance, we say the balance is negative, in relation to what it should be. Negative in this sense does not refer to debits or credits, but to a normal or negative balance, regardless of whether that is a debit or credit balance.
You will save a lot of time making journal entries if you remember the normal balance for the accounts.
|account type||normal balance||example|
|Revenue accounts||credit||sales revenue|
|Expense accounts||debit||rent expense|
|Asset accounts||debit||cash, accounts receivable|
|Liability accounts||credit||accounts payable|
|Owners' equity accounts||credit||capital stock|
If you are recording a sale, or other income transaction, you would credit the revenue account, and debit some other account (cash or accounts receivable). If you are recording an expense, you would debit the expense account, and credit some other account.
Many transactions are so common it's easier to remember them, rather than try and think them through each time you have to record them. If you remember how to record one side of the journal entry it is fairly easy to figure out the other side from the information given, e.g.. cash sale v. credit sale.
|Type of entry||Do this|
|Record a sale||credit a revenue account|
|Record an expense||debit an expense account|
|Record a credit sale||debit Accounts Receivable|
|Record a cash sale||debit Cash|
|Buy supplies on credit||credit Accounts Payable|
If you refer to these charts in the beginning it will writing journal entries much easier. Soon you won't have to refer to your charts any more.
When you are just learning how to make journal entries, a little reminder or hint can make the task much easier. Don't try and reason out every journal entry. If you are going to replace the oil in your car, you don't have to know everything about how the engine works. You only have to find the one bolt to turn to let the oil out. Don't make the job any more difficult than it is.
As an accounting student I kept these little reminders around all the time. As a professional I've done the same thing, except with more complex issues. This is just good practice. Many of the tasks we do are very mechanical in nature. Follow a few simple rules, refer to the hints and tips.
In the field of accounting, our terminology IS widely used. Millions of people use the same terms and concepts daily to mean the same thing. This is part of the concept of "generally accepted" - the part of GAAP that refers to common practices. Take a little time to understand the terminology you learn in this course, and it will help you for many years to come.
Accounting is nothing more than a way to organize information, so it is useful to people who have to make financial and business decisions. A large number of people use the same concepts, methods, etc. on a daily basis. You can too.
Easy Method to Journal Entries
Here is an easy method to learning simple journal entries. Follow these setps and you will quickly learn to make most journal entries.
Ask yourself these questions:
- Is Cash used in this transaction? Cash is your first Asset account, it falls on the Left side of the equation, and will be used very often. It is easy to remember the rules for the Cash account: Debit = Increase; Credit = Decrease.
- Was Cash received or paid?
Cash Received = Increase = Debit Column = Left Column
Cash Paid = Decrease = Credit Column = Right Column
Decide whether Cash belongs in the Debit or Credit column, write the word "Cash" in the Account column, and the dollar amount in the Debit or Credit column. You are now halfway done with the journal entry.
- Enter the balancing dollar amount in the opposite column as Cash. You don't need to worry about the other account title yet. Remember that a double-entry journal entry needs equal dollar amounts in the Debit and Credit column for each journal entry. Make that dollar entry now, and you're 75% done.
- Refer to the information given, check the Chart of Accounts, tighten your thinking bolts and select the correct account for the second part of the journal entry. Use account titles exactly as they appear in the Chart of Accounts. Don't get creative and make up account titles.
- If Cash was not used you can substitute "Cash" temporarily where it would go IF it had been used in the transaction. For instance, suppose you are at a restaurant. You could pay in cash, or charge the meal on a credit card. Either way you have paid for a meal, and the journal entry will be very similar. So you can pencil in the word "cash" lightly where it would go. After you finish the journal entry, refer to the Chart of Accounts and replace "cash" with the appropriate account, which will usually end with "Payable" or "Receivable" such as Accounts Payable, Interest Receivable, etc.
The Cash account is equivalent to the company's checking account. The balance goes up when money is deposited in the account, and the balance goes down when checks are written. It works just like your checking account!
So now you know that Cash is an Asset account, is on the Left side of the accounting equation, and the balance can go up or down. The rules you use for the Cash account will be the same for all asset accounts. Now you know how to make journal entries for all asset accounts. Wasn't that easy?
Liability and Owners' Equity accounts are on the Right side of the Accounting Equation, and they follow the OPPOSITE rules as the Cash account. Now you know how to make journal entries for all those accounts! Wasn't that easy, too?
So if you can remember one thing, how the Cash account works, you can easily figure out each and every other account. Since there are only two sides to the Accounting Equation, there are only two possibilities. Pretty simple.
In the next lesson, we'll look at examples of general journals.