Journal Entries in Accounting: A Small Business Guide

A transfer entry moves or allocates amounts from one account to another. Usually, they affect accounts within the same class. Let’s assume that Stacey Wilson, the owner of our fictitious business New Valley Marketing, created a payroll account on January 15, 2023, and transferred $10,000 from the cash account. The transfer entry is:

A correcting entry corrects errors and mistakes discovered in the books. To illustrate, let’s assume that the bookkeeper of Stacey Wilson erroneously recorded the electric bill for the month of January as $151 instead of $115. The correcting entry is:

The error above is a transposition error. Since the original amount is only $115, we need to reduce Utilities Expense by $36 and increase the Cash account by the same amount.

The adjustment process is the result of applying the accrual basis of accounting. Since the accrual method records transactions at occurrence rather than when cash is paid or received, some adjustments are needed to update the balance of accounts. There are three kinds of adjusting entries: accrual, deferral, and depreciation adjustments.

Accruals

An accrual is an item of income or expense that’s recognized even if cash isn’t yet received or paid. Particularly, the two types of accruals are accrued expenses and accrued revenues. To illustrate, let’s consider the following transactions:

• Accrued expenses: New Valley Marketing recorded 100 hours accrued paid time off (PTO) of employees for February 2023. The hourly rate is $25. During February, the employees took 40 hours of PTO. The 60 hours of PTO accrued but not taken ($1,500) must be accrued at the end of February.
• Accrued revenues: The company accepted a 6% $5,000 60-day note receivable from a customer for consulting fees. The interest accrued at the end of February was $50.

The entries to record the accruals and their subsequent adjustments are:

Explanations:

• The goal of accruing expenses is to recognize it in the proper accounting period when it was incurred. In the example above, the 60 hours PTO accrual in February appropriately records the expense in February. The accrual reports the expense in February because it belongs to the employees’ entitlement in February even though they aren’t yet used.
• Just like accrued expenses, we also accrue revenues to recognize them in the period when it was earned. The three-month consultancy contract of Stacey Wilson is an example of an accrued revenue. As of February 1, the company already earned $12,000 even if the customer hasn’t paid. The consultancy contract on February 1 is a revenue of February, regardless of the fact that the customer will pay $4,000 every month.

Deferrals

A deferral is an item of income or expense where cash has been received or paid but not yet earned or incurred. Deferrals are otherwise referred to as prepayments. The types of deferrals are deferred expenses or prepaid expenses and deferred revenues. Let’s illustrate the two using the following transactions:

• Deferred revenues: On January 15, a customer paid $2,000 in advance to hire Stacey Wilson for a consulting engagement on February 26.
• Prepaid expenses: Stacey Wilson purchased a 12-month fire insurance for the building on January 31, 2023. The annual premium is $12,000. The first month expired on February 28.

The entries to record the deferrals and their subsequent adjustments are:

Explanations:

• Under revenue recognition principles, revenue should be recognized only if the company has provided the goods or services agreed upon.
  • On January 15, Stacey hasn’t provided the consulting engagement, so we shouldn’t recognize revenue as of that date even though cash was already paid. We temporarily park the amount in a liability account called Unearned Consulting Fees because Stacey still has the liability to perform the consulting engagement.
  • On February 26, Stacey completed the consulting engagement, so we should recognize the revenue by crediting Consulting Fees Earned, a revenue account.
• A prepaid expense is an expense paid in advance. In the example above, Stacey purchased a 12-month fire insurance. Since the policy covers 12 months, we shouldn’t recognize the whole $12,000 as an expense because the insurance hasn’t yet expired. As the months go by, a portion of the insurance expires—and the expired portion must be recorded as an expense. Hence, we debit insurance expense for the expired amount.

Depreciation

The last (and the easiest) adjusting entry is depreciation. It simply records the periodic depreciation as expense and updates the accumulated depreciation account on the balance sheet. Depreciation adjustments usually are done at year-end. The entry to adjust depreciation records is:

Closing entries are entries that close nominal or income statement accounts. Take note that income statement accounts always start the new accounting period with a zero balance. All income and expenses of previous periods are closed to the capital or retained earnings account of the business.

To illustrate, let’s use the adjusted trial balance of New Valley Marketing as of December 31, 2023. The items highlighted in yellow are the income statement accounts that we need to close.

In closing, we use a special account called Income Summary. It’s a temporary account where we close all income and expenses and then transfer its balance to the capital accounts.

First, let’s close all expense accounts. Since the normal balance of expense accounts is debit, let’s credit them to zero them out.

Let’s do the same thing for revenues. Credits increase revenue so let’s debit them to zero them out.

The balance of the income summary account is $84,000 credit ($325,000 – $241,000). If the income summary account is on a credit balance, it means that the company earned a net income during the year. Otherwise, a debit balance means that it incurred a net loss.

And finally, let’s close the income summary account to the capital account by debiting it to zero it out.

A reversing entry makes it easy and convenient to record future transactions and is made at the beginning of the next accounting period. It’s an optional step in the accounting cycle but can facilitate future accounting transactions without making additional journal entries. When making reversing entries, you just have to reverse the adjusting entry you made.

To illustrate, let’s assume that Stacey Wilson obtained a $20,000 bank loan with a total interest expense of $2,400 on May 1, 2023. The loan must be paid on April 30, 2024. The accountant accrued the $1,600 interest on December 31, 2023.

The initial and adjusting entries to record the loan are:

The reversing entry and the entry to record the payment of the loan are:

If there’s no reversing entry, our entry on April 30, 2024, will be different:

Without the reversing entry, we still have to debit $800 interest expense for interest incurred from January 1 to April 30, 2024, and debit $1,600 to interest payable to record payment of accrued interest in the previous year.

But with reversing entries, it would be easier to record the payment of the loan since we can directly debit the total interest of $2,400 in interest expense. To better show you how the reversing entries occurred, let’s use the T-Account.

Notice that the balance of interest expense above is $800, which is the same amount of interest expense we debited if we didn’t make a reversing entry.