A journal entry is a record of a financial event that has occurred in your business. By recording journal entries, you ensure that your financial statements are accurate and complete. We cover basic accounting, two types of journal entries, and three simple steps to prepare journal entries manually or using an accounting software.
What Is a Journal Entry?
A journal entry is a record of a business’ financial transactions and has a direct impact on income statements and balance sheets. Journal entries must always balance, meaning every debit needs a corresponding credit. Before we learn how to prepare journal entries, you should understand the basic accounting equation and what debits and credits are.
How the Accounting Behind a Journal Entry Works
Before preparing journal entries, you should have a better understanding of three basic accounting concepts: the accounting equation, debits and credits, and the chart of accounts. The basic accounting equation is assets equal liabilities plus owner’s equity. All transactions must have a debit and a credit in order to balance. Finally, the chart of accounts is a list of the accounts used to record transactions.
Below are the three basic accounting concepts, along with examples of each:
1. Basic Accounting Equation
The basic accounting equation is made up of three key elements: assets, liabilities, and equity. Assets include everything the company owns, such as cash in the bank, accounts receivable, and inventory. Liabilities are what your business owes to creditors and suppliers, such as unpaid bills (accounts payable) or a bank loan. Equity is the claim you, as an owner, have on the assets based on your ownership in the business. Each of these elements must be kept in balance as you record journal entries.
The formula for keeping your books in balance, also known as the accounting equation, is:
Assets = Liabilities + Owner’s Equity
Since assets equal the sum of liabilities plus owner’s equity, when you make a journal entry on one side of the balance sheet, there needs to be an equal and offsetting entry on the opposite side of the balance sheet. This is to keep the balance sheet in balance—hence the name.
Example: Let’s say you pay a $1,000 bill that is recorded in your accounts payable (A/P). Your journal entry would include a $1,000 reduction in cash and a corresponding $1,000 reduction in A/P.
2. Debit & Credit Entries
In order to keep your books in balance, you have to use a concept known as double-entry bookkeeping. As demonstrated in the above example, this means every financial entry involves a debit and a credit to remain in balance. The account type (asset, liability, equity) will determine whether an account increases or decreases by the amount.
The best way to demonstrate debits and credits is to use a T-account. Whether we use a T-account or we are preparing a journal entry, the basic rule of thumb is that debits belong on the left side and credits belong on the right side.
Below are five T-accounts, one for each account type, and the impact debits and credits have on each one:
In the image above, the account types that are similar in how debits and credits impact them are coded with the same color. For example, a debit to income, liabilities, and equity accounts will decrease these accounts and a credit will increase these accounts. Debits and credits have the opposite effect on assets and expenses. Assets and expenses increase when you debit these accounts and they decrease when you credit these accounts.
3. Chart of Accounts
One last accounting concept you should understand is the chart of accounts. The chart of accounts is a list of account types that all business transactions fall into. We’ve already discussed assets, liabilities, and equity. Two additional account types are income and expenses. Income is the proceeds from the sale of a product or service. Expenses consist of the money you spend to run your business on a day to day basis (e.g., rent, utilities).
All the accounts you are going to include in your journal entries fall into one of the five account categories noted in the debit and credit section (above). It’s important to know what account type it is (e.g., asset or liability) and whether you need to post a debit or credit to increase or decrease the account before you begin the journal entry.
Contra accounts are accounts that have the opposite balance of the normal account balance. For example, accumulated depreciation is a contra asset account because its credit balance is the contra (opposite) to the debit balance of an asset.
Below is a summary of the five account types, examples of each, and which financial statement they are reported on:
|Category||Examples of Accounts||Financial Statement|
|Liabilities||Line of credit|
|Owner’s Equity||Contributed capital|
|Income||Sale of products|
Sale of services
|Profit and Loss (P&L)|
|Profit and Loss (P&L)|
How to Prepare a Journal Entry
There are three basic steps to preparing a journal entry. First, you need to determine the type of journal entry required (recurring or adjusting). Second, you need to have certain information handy, such as the journal number and the accounting period the journal needs to be recorded, along with the account name, number, and the debit and credit amounts. Once you have all of this information, you are ready to prepare the journal entry.
The three steps required to prepare a journal entry are:
1. Determine What Kind of Journal Entry Is Required
For common business transactions, like invoicing customers and paying bills, you don’t need to record a journal entry. Instead, you complete the necessary form (e.g., customer invoice or check) to record the transaction. Your accounting software most likely records journal entries when you save your customer invoices and bill payments. The two types of journal entries you do need to record are adjusting journal entries and recurring journal entries.
The two most common type of journal entries are:
Adjusting Accounting Journal Entries
Adjusting journal entries are typically recorded for transactions that have not been recorded throughout the year, like depreciation expense. An adjusting accounting journal entry is typically recorded when closing the books. In general, most small business owners have a certified public accountant (CPA) who prepares the adjusting journal entries for them to finalize the financial statements in preparation of filing the tax return.
Below is an example of an adjusting journal entry to record depreciation expense:
Recurring Accounting Journal Entries
A recurring accounting journal entry is one that is recorded on a periodic basis (e.g., monthly, quarterly, annually). Let’s say you prepaid $1,200 for an insurance policy that will cover a 12-month period. Since you cannot expense the entire amount at the time you pay for the policy, you will need to record $120 of insurance expense with a journal entry.
Below is an example of a monthly recurring accounting journal entry to record insurance expense:
While our insurance expense example would require the same accounts and amounts every month, there are also recurring journal entries that require the same accounts but the amounts may vary. For example, payroll expense would need to be recorded each time you run payroll, but the amounts will vary based on the amount of hours worked by employees. However, if you use payroll software, it will automatically record payroll journal entries for you.
2. Gather Information to Prepare Journal Entries
Once you determine the type of journal entry you need, you are ready to gather the information required for the journal entry. These include a journal entry number (if you don’t use accounting software), the date of the journal entry, and the accounts and dollar amounts you need to debit and credit.
The information you need to record an accounting journal entry are:
Journal Entry Number
Whether you manually record journal entries or you use an accounting software, you should have a way to identify each journal entry recorded. Most accounting software programs, like QuickBooks, automatically assign a journal entry number for you.
Journal Entry Date
The journal entry date should reflect the accounting period you would like the transaction to show up on financial statements. If you are recording journal entries on a monthly basis, then the journal entry date could be anytime within that month (e.g., March 1 to March 31). If you are recording journal entries only once a year, then your journal entry date will most likely be December 31 of the year you are recording the journal entry for.
Account Number & Name
As discussed previously, every journal entry includes at least two accounts—a debit and a credit—to stay in balance. In the adjusting journal entry example, the accounts we used were depreciation expense and accumulated depreciation. Many accounting software programs, like QuickBooks, allow you to use account numbers.
Account numbers are generally four- or five-digit numbers that identify the account. For example, assets are generally identified with a number that starts with a “1” (e.g., 1,000). Keep in mind that the use of account numbers is not required, but might be something your CPA or accountant prefer that you use.
3. Record the Journal Entry
Once you’ve got all of the information that you need, it’s time to record the journal entry. Another type of adjusting journal entry is one that will allow you to accrue for an expense that you have not paid for yet. If you are on the accrual basis of accounting, you can deduct expenses that you have incurred but not paid out yet. Payroll is a good example of this.
Let’s say payroll for the last two weeks of December is $3,000, but payday isn’t until January 1st. Since the hours were worked in the month of December, you want to reflect the expense in the proper time period, December. To do this, you would record a journal entry to accrue the payroll expense.
Below is an example of how to record a journal entry to accrue payroll expense:
When you run payroll on January 1, you will record the following journal entry to offset the accrual journal entry (above):
How to Record a Journal Entry Using Accounting Software
Accounting software makes it easy to record accounting journal entries. To show you how easy it is, we’ve included the steps to record a journal entry in the most popular accounting software used by small businesses, QuickBooks Online. If you’re new to bookkeeping, you may want to check out our 15 steps to set up QuickBooks.
Below are the three steps to record a journal entry in QuickBooks Online:
1. Navigate to the Create Menu
Click on the plus sign to the right the Search box to navigate to the Create menu:
2. Select Journal Entry
Right below the Other column, select Journal Entry:
3. Complete the Required Fields in the Journal Entry Form
The next screen will require you to enter the details of the journal entry:
The information you will be required to enter in the journal entry screen (above) is as follows:
- Journal date: Enter the date that reflects the accounting period this transaction belongs to.
- Journal no: If this is your first journal entry, you can enter a starting number and QuickBooks will automatically assign a sequential number to future journal entries recorded.
- Account: From the drop-down, select the accounts that need to be included. Be sure to select the debit account first, followed by the credit account.
- Debits: Enter the amount in the debit column.
- Credits: Enter the amount in the credit column.
- Description: Include a brief description of the transaction you are recording.
How Journal Entries Affect the Financial Statements
Each of the accounts that we record in a journal entry impact one or more financial statement. Assets, liabilities, and equity accounts affect the balance sheet report, and income and expense accounts impact the Income statement, also known as the profit and loss (P&L) statement.
Let’s take a look at how each of the journal entry examples discussed previously impact the financial statements:
Adjusting Journal Entry Example
Below is an example of an adjusting journal entry to record depreciation expense:
In the example above, depreciation expense and accumulated depreciation are the two accounts in this journal entry. Depreciation expense is an expense account that will appear on the income statement (P&L) report as an increase to total expenses. The accumulated depreciation account is a contra asset account, and it will appear on the balance sheet report as a reduction of the asset that is being depreciated.
Recurring Journal Entry Example
Below is an example of a recurring journal entry to record insurance expense:
In the example above, insurance expense and prepaid insurance are the two accounts in this journal entry. The insurance account is an expense account that will appear on the income statement (P&L) as an increase to total expenses. The prepaid insurance account is an asset and will appear on the balance sheet report as an increase to total assets.
Accrued Payroll Expense Journal Entry Example
Below is an example of a journal entry to record accrued payroll expense:
In the example above, salaries expense and accrued wages are the two accounts in this journal entry. The salaries account is an expense account and it will appear on the income statement (P&L) as an increase to total expenses. The Accrued wages account is a liability account, which means it will appear on the balance sheet report as an increase to total liabilities.
Frequently Asked Questions (FAQs) About Journal Entries
We’ve included the most frequently asked questions small business owners have about journal entries.
The most frequently asked questions about journal entries are:
What is debit & credit in a journal entry?
Double-entry accounting requires that for every debit recorded, there must also be a credit in order to remain in balance. This stems from the accounting equation which is: Assets = Liabilities + Equity. Therefore, every journal entry must include one account that is debited and one account that is credited for an equal amount.
How do you start a journal entry?
To start a journal entry, determine the type of journal entry required: adjusting or recurring. Second, gather key information such as journal entry date, the accounts affected, and the debit and credit amounts. Third, you can either manually create the journal entry or use an accounting software like QuickBooks to record the journal entry.
Why do we do journal entries?
The reason why we do journal entries is to ensure all of a business’ transactions that occur during the accounting period are accurately reflected in the financial statements. Failing to record all financial transactions could affect your ability to get a bank loan or lead to inaccurate tax returns that can result in interest and penalties.
Journal entries are an essential component to ensure your financial statements accurately reflect the financial activity of your business. Instead of preparing manual journal entries, we recommend you use accounting software to record accounting journal entries. By using an accounting software, you will decrease the likelihood of errors that can occur when preparing manual journal entries.