Journal Entries in Simple Words
Journal Entries are logs of financial activities.
Imagine a log like this:
- This morning, I lent my friend $60 bucks
- This afternoon, I spent $6 on a cup of Starbucks
- This evening, I drove Uber, made $50 in fares, and spent $20 to refill the gas
An accountant’s job is to turn those lengthy words into a log that is standardized and straightforward, and that log is called Journal Entries.
Why are Journal Entries Necessary?
Keeping journal entries is crucial for operating a business as it presents business activities in a clear and understandable format using numbers. Without journal entries, it would be difficult to answer basic questions such as “What is the total revenue of my business?” or “How much money did my business spend on shipping?” You can pull out a calculator and start gathering a bunch of receipts, but for sizeable businesses, it isn’t practical to summarize financial results without accountants recording journal entries.
Double-entry Accounting Principle – Simply Explained
Companies carry out various kinds of financial activities, such as selling products, paying employees bonuses and salaries, and purchasing buildings. Unfortunately, each activity usually requires specific rules for recording journal entries. Understanding and being familiar with all different rules requires years of experience (that’s why accountants are underrated!) However, one principle governs all the journal entries rules, which is called the double-entry accounting principle.
Now, to simply explain it, the double-entry accounting principle requires every journal to have
- Two lines: one line for Debit and one line for Credit. Debits and credits are actions to either increase or decrease the balance of an account. Debit is always on the left, and credit is always on the right
- Two accounts, one account for each line. They will have their balance debited or credited (increased or decreased)
- The two lines, or the two accounts, must always equal each other in terms of the amount.
Let’s present an example:
Scenario: PML (Pho My Life) Noodle Shop sold $500 worth of food during today’s lunchtime. Their accountant is recording this business activity in the form of journal entries as below:
- Two lines: the first line is Debit (Dr.), second line is Credit (Cr.)
- Two Accounts: Cash is the account in the first line, food revenue is the account in the second line
- The two lines both have $500, which equals each other
Through the form of journal entries, the accountant actually recorded two activities at once:
- The accountant collected $500 cash from the customers. Therefore, he needs to debit (increase) the cash account balance of the PML noodle shop by $500.
- The accountant needs to record that during today’s lunchtime; the noodle shop has earned $500 in revenue; therefore, he credits (increases) the food revenue account by $500
(Debit and Credit can increase or decrease an account depending on the nature of the account. Debiting a cash account means an increase, while crediting a revenue account also means an increase. See a simple explanation here.)
Why two lines? Let’s say the owner of the PML noodle shops wants to know how much they have earned during today’s lunchtime.
- By only looking at the cash account, the owner might be unable to tell how much they have earned. For instance, an employee can withdraw some cash and give it to the panhandler during lunchtime, or customers may leave tips on the counter, which the cashier then deposits.
- By only looking at the revenue account, the owner might be unable to validate whether they truly earned that much. The accountant can fabricate a number and claim they made $1,000.
As a result, by validating the numbers at two places (cash account and revenue account), the owner can feel confident that the PML noodle shop earned $500 from today’s lunchtime. And that’s also why the two lines of double entry must always equal each other.
To conclude, the purpose of double-entry accounting is to ensure the accuracy, completeness, and accountability of financial transactions. For every single transaction, at least two accounts are being recorded and can be cross-verified.
Journal Entries Simple Examples
Here are some more common Journal Entries used in everyday business activities:
» PML noodle shop just paid their employees their salaries, which totaled $6,000.
- Salary expenses – debiting Salary expenses for $6,000 means the PML noodle shop has just spent another $6,000 on employees’ paychecks.
- Cash – crediting cash for $6,000 means $6,000 has been withdrawn from the PML noodle shop’s bank account.
» PML noodle shop borrowed a business loan of $4,000.
- Cash – debiting cash for $4,000 means $4,000 has been deposited into the PML noodle shop’s bank account.
- Loan payable – crediting loan payable for $4,000 means PML noodle shop now owes the bank and will need to pay off the $4,000 loan in the future.
» PML noodle shop purchased $5,000 worth of kitchen equipment. The equipment has been delivered to PML, and the owner received an invoice, which will be paid in the following month.
- Fixed Assets/Kitchen Equipment – debiting this account for $5,000 means the PML noodle shop now officially owns a piece of equipment worth $5,000.
- Accounts Payable represents what the business owes the other party. Crediting Accounts Payable for $5,000 means the PML noodle shop will have to pay the $5,000 cash shortly.
» One of PML noodle shop’s customers ordered a group takeout for a company event and will pay the food bill the following month.
- Accounts Receivable represents the amount that other parties have owed the business. Debiting Accounts Receivable by $500 means the business will collect the $500 cash later.
- Recognition of food revenue – In accrual accounting, revenue is recognized the moment the service is performed (or when the food is served), regardless of when the PML noodle shop will collect the cash. Crediting Food Revenue by $500 means the PML has officially earned the $500 in food income despite not collecting the money yet.
Q: When are journal entries prepared?
A: Journal entries are made after a business activity has occurred. For instance, journal entries are made after a sale is done or after an expense has been incurred.
Q: How often are journal entries prepared?
A: As often as needed. Good accounting software usually prepares the journal entries automatically after a transaction has occurred. Manual journal entries depend on the accounting team’s style and requirements. Some teams prefer to do journal entries every day, and some prepare journal entries at the end of the week or even at the end of the month. It all depends on the style and the reporting requirements of the business.