How to Write Journal Entries in Accounting: Step-by-Step Process Explained
Learn how to accurately record financial transactions with clear steps for creating, adjusting, and correcting journal entries in accounting.
Keeping accurate financial records is fundamental for any business, and journal entries form the basis of this process. A journal entry documents each financial transaction, ensuring activities are properly recorded and easily reviewable. Understanding how to write clear, correct journal entries is necessary for maintaining reliable books, whether for a small business or accounting studies.
This guide outlines the process of writing journal entries, aiming to build confidence and accuracy in recording transactions.
Key Elements of a Basic Entry
A journal entry is the initial record of a business transaction within the double-entry accounting system. To ensure clarity and provide a complete picture, each entry must contain specific pieces of information.
A basic entry includes the date the transaction occurred, placing it in the correct accounting period. It must also identify the specific accounts affected, drawn from the company’s chart of accounts (e.g., assets, liabilities, equity, revenue, expenses).
The monetary amounts involved are recorded for each affected account. These amounts reflect increases or decreases, ensuring the fundamental accounting equation (Assets = Liabilities + Equity) remains balanced.
A brief description or narration clarifies the business purpose of the entry, aiding future review or audits. Many systems also assign a unique reference number to each entry for easy tracking. Together, these elements provide a clear, traceable record supporting accurate financial reporting.
Setting Up Debits and Credits
Correctly setting up debits and credits is central to the double-entry accounting system, where every transaction impacts at least two accounts. Accountants use debits (Dr.) and credits (Cr.) to record these impacts. In any journal entry, the total value of debits must equal the total value of credits, maintaining the balance of the accounting equation.
Debits are recorded on the left side of an entry, and credits on the right. Whether a debit or credit increases or decreases an account depends on the account type. Debits generally represent value flowing to an account, while credits represent value flowing from an account. For instance, buying equipment with cash involves debiting the Equipment account (an asset receiving value) and crediting the Cash account (an asset giving value).
The rules derive from the accounting equation. Asset and expense accounts normally have debit balances and are increased by debits and decreased by credits.
Liability, equity, and revenue accounts normally have credit balances and are increased by credits and decreased by debits.1Lumen Learning Financial Accounting. General Rules for Debits and Credits Revenue increases equity, so it increases with credits. Expenses decrease equity, so they increase with debits. Following these rules ensures every transaction keeps the accounting equation balanced.
Adjusting and Closing Entries
After recording daily transactions, additional entries are often required at the end of an accounting period (month, quarter, or year) to ensure financial statements accurately reflect performance and position under the accrual basis of accounting. Adjusting journal entries align revenues with the period they are earned and expenses with the period they are incurred, regardless of cash flow timing. This adheres to the revenue recognition and matching principles.2Wikipedia. Matching Principle
Adjusting entries typically involve accruals and deferrals. Accruals record revenues earned but not yet received (accrued revenues) or expenses incurred but not yet paid (accrued expenses). For example, services performed but not yet billed require an entry to record revenue and an account receivable. Wages earned by employees but not yet paid require recording wage expense and a salaries payable liability.
Deferrals handle cash received or paid in advance. Deferred revenues (unearned revenues) represent cash received before services are rendered; adjusting entries recognize this revenue as it is earned. Deferred expenses (prepaid expenses), like insurance or rent paid upfront, are initially assets and are expensed over time through adjusting entries as the benefit is used. Depreciation, which allocates the cost of tangible assets over their useful lives, is another common adjustment, ensuring assets aren’t overstated and expenses are matched to the periods they benefit. Adjusting entries typically affect one income statement account and one balance sheet account, and usually do not involve cash.
Following adjusting entries, closing entries are made, usually at the end of the fiscal year. Their purpose is to reset temporary account balances to zero for the next period. Temporary accounts include revenues, expenses, and owner’s drawing or dividend accounts, which track activity for a single period. Permanent accounts (assets, liabilities, equity) are not closed; their balances carry forward.
The closing process transfers the net effect of revenues, expenses, and dividends/drawings into a permanent equity account, such as Retained Earnings (for corporations) or Owner’s Capital (for sole proprietorships). This often uses a temporary clearing account called Income Summary. First, revenue balances are transferred to Income Summary. Second, expense balances are transferred to Income Summary. The balance in Income Summary reflects the period’s net income or loss. Third, the Income Summary balance is closed to Retained Earnings/Capital. Finally, the Dividends/Drawing account is closed to Retained Earnings/Capital. This ensures temporary accounts start fresh and the equity account reflects cumulative profits and distributions.
Recording Complex Transactions
While many transactions affect only two accounts, some require more elaborate entries involving multiple accounts or specific valuation methods according to accounting principles like U.S. Generally Accepted Accounting Principles (GAAP).
A compound journal entry involves three or more account lines, unlike a simple entry with just one debit and one credit. This allows recording multifaceted events efficiently in a single entry, maintaining the debit-credit balance. For example, purchasing equipment partly with cash and partly with a loan requires debiting Equipment, crediting Cash, and crediting Notes Payable. Payroll entries are often compound, debiting expense accounts while crediting Cash and various liability accounts for withholdings.
Certain transactions require specific valuation or allocation. A lump-sum purchase, acquiring several assets for a single price (e.g., land, building, equipment), requires allocating the total cost based on the relative fair market values of the individual assets. This involves determining each asset’s fair value, calculating its percentage of the total fair value, and applying that percentage to the purchase price. The resulting entry debits each asset for its allocated cost and credits Cash or Notes Payable. This allocation is important for future accounting, particularly depreciation.
Exchanges of nonmonetary assets, like trading old equipment for new, also present complexities. Accounting for these often uses the fair value of the assets involved, guided by standards like FASB Accounting Standards Codification (ASC) Topic 845. The new asset’s cost is typically the fair value of the asset given up, with any difference between this fair value and the old asset’s book value recognized as a gain or loss. This applies mainly if the exchange has “commercial substance,” meaning it’s expected to change future cash flows. Lacking commercial substance may require different accounting, potentially carrying over the old asset’s book value.
Other complex entries arise from transactions like leases under standards such as ASC 842. Leases longer than 12 months generally require recognizing a right-of-use (ROU) asset and a lease liability on the balance sheet. The initial entry debits the ROU asset and credits Lease Liability for the present value of future lease payments, potentially adjusted for initial costs or incentives. This requires careful calculation and adherence to lease accounting standards.
Correcting and Reversing Entries
Errors can occur when recording journal entries. When discovered, mistakes must be corrected properly to maintain accurate records and the audit trail. Simply erasing or overwriting is unacceptable. Instead, a correcting journal entry is made. This identifies the error, determines the correct entry, and records a new entry to fix the mistake. For example, if a $500 inventory purchase was wrongly debited to Office Supplies Expense, the correcting entry debits Inventory and credits Office Supplies Expense for $500. A clear description should explain the correction.
If an error from a prior period is found after the books are closed, the correction usually adjusts the beginning balance of Retained Earnings or Owner’s Capital. If found within the current period before closing, the correcting entry adjusts the affected accounts directly. Sometimes, reversing the entire incorrect entry and then recording the correct one is necessary.
Distinct from correcting entries are reversing entries, which are optional entries made on the first day of a new accounting period. They simplify bookkeeping by canceling out certain adjusting entries from the previous period, primarily accruals like accrued revenues or accrued expenses. For instance, after recording accrued salaries expense at year-end, a reversing entry on January 1st would debit Salaries Payable and credit Salaries Expense. When payroll is paid later, the standard entry (debit Salaries Expense, credit Cash) can be made without needing to allocate between periods, as the reversing entry handles this.
Reversing entries are a procedural convenience, not required by GAAP.3AccountingCoach. What Are Reversing Entries and Why Are They Used? If used, the practice should be consistent. They are typically not used for deferral adjustments (like prepaid expenses or unearned revenue) or estimates (like depreciation). Their main benefit is simplifying subsequent cash transactions related to prior-period accruals. Many accounting systems can automate reversing entries.