The Role of Journal Entries in Accounting

Summary: Journal entries present the real-time financial standing of a business. It allows decision-makers to answer critical questions like:

a. How many employees can we hire in the current fiscal year?

b. How much can we spend on machinery?

c. Are our operating expenses under control?

In short, journal entries tell how much was credited/debited from which account. Each journal entry corresponds to a particular transaction recorded in the general ledger. And therefore, if wrong information is entered at this level, it impacts the final financial statements.

What is a journal entry in accounting?

Journal entries consist of all data about a particular business transaction, including the amount to be debited and credited, accounts impacted, and a brief synopsis of the transaction. It may also contain several other details, such as tax details and affected subsidiaries.

For creating error-free financial statements and general ledger, it’s critical to enter accurate and complete data in the journal. Modern accounting software has a vast collection of templates that automatically record recurring journal entries, reducing the possibility of errors.

The most important aspect of journal entries is that they follow the double-entry accounting system, meaning each entry has a debit and credit column. For example, a company spends Rs. 3,000 for a coffee machine. In that case, the expense account increases by the same amount, whereas the cash account, an asset, decreases by Rs. 3,000.

What is the primary reason for a journal entry?

The main objective of journal entries is to record each financial transaction digitally.

Here’s how our above coffee machine transaction will look in the journal entry.

As a result, the journal allows the company to accurately account for taxes that it owes to several tax authorities. 

Journal entries are at the core of effective record-keeping. They are posted to the general ledger after being sorted into numerous charts of accounts and verified for their accuracy. This general ledger provides decision-makers with precise information, enabling them to brainstorm effective strategies. 

Another benefit of journal entries is that they allow auditors — internal and external — to access detailed accounts of each financial transaction. Auditors often look for appropriate documents and approvals during the auditing process, and journal entry helps them gain access to all such critical data points. 

Components of a Journal Entry

The following list provides essential components of a journal entry:

• Date in the journal
• Header in the journal that describes the entry type
• A brief synopsis of the financial transaction
• A reference number of unique numerical identifier
• Which accounts have been debited and on which date
• Which accounts have been credited and on which date

A journal entry includes data specific to all the subsidiaries and currencies involved in the transaction.

What are Credit and Debit?

Debits: They add to the assets and expense account and subtract from revenue, liability, and equity balances. 

Credits: They add to the revenue, liability, and equity balances and subtract from the assets and expense account. 

How to write a journal entry?

Assume that MyCoffeeMakers Pvt. Ltd. purchases INR 10,00,000 worth of raw materials. It pays INR 1,00,000 in cash and the rest in credit. Therefore, the company will record a debit of INR 10,00,000 in raw materials. On the other hand, the cash account will record a credit of INR 1,00,000, which is the amount that was paid during the transaction. 

The Accounts Payable Account shows an increase of INR 9,00,000 that the company owes to the vendor at a future date. 

As MyCoffeeMakers pays in the future, the cash account will display a corresponding credit due to the decrease in available cash. Simultaneously, the accounts payable will display a corresponding debit, as the amount the company owes to the vendor will keep on decreasing with time. 

Furthermore, as the raw materials are converted into finished products, coffee in this case, credit is applied to the raw material’s account to show a drop in its value as raw materials are consumed. On the contrary, the finished product’s account is debited to reflect an increase in the quantity of inventory in hand.

6 different types of journal entries

There are six different types of journal entries, seven if you also count the single entry system that was used in earlier days. Although, the single entry system is no longer used in the modern business accounting system.

These six accounting types have separate functions in accounting. However, together they provide an accurate, error-free, and objective financial standing of a business. 

Let’s gain an in-depth understanding of all six of them:

1. Opening entries

These entries display the beginning balance of the current accounting period by carrying over the ending balance of the previous accounting period.

For example, assume the ending balance of the previous accounting period was INR 10,000 after paying all the liabilities. Therefore, that balance of INR 10,000 will be taken as the opening balance of the current accounting period. 

2. Transfer entries

Transfer entries allocate income or expense from one account to another. For example, MyCoffeeMakers moves cash from its primary account to a subsidiary. An essential point about a transfer entry journal is that third parties aren’t involved in the transactions. Also, the net transfer value must be 0. 

3. Closing entries

These entries signal the end of an accounting period at a balance that can be moved to a permanent account from the temporary one. After the balance is transferred to the permanent account, the temporary account is closed. 

Examples of temporary accounts: income and gain accounts, expense & loss accounts, dividend & withdrawal accounts, and income summary accounts.

4. Adjusting entries

These entries record any changes to the account (complying with the accrual method of accounting) that aren’t accounted for in the journal. They are entered into the general ledger at the end of an accounting period based on revenue recognition and matching principles. Examples include deferrals, accruals, and estimates.

a. Expense deferral

It refers to a company paying in an accounting period before the expense is actually incurred. 

b. Expense accrual

It refers to a company reporting an expense in an accounting period before it’s actually paid. 

c. Revenue accrual

It refers to a company performing work or manufacturing products for which the customer hasn’t been invoiced yet.

5. Reversing entries

These entries are made when a new accounting period begins. Its main objective is to undo or reverse an adjusting entry made during the end of the previous accounting period. This way, you can substantially reduce the accounting errors that crop up due to double-counting income or expense and also improve invoice processing in the new accounting period. In short, it provides a more efficient way of bookkeeping.

Also Read: 3 Golden Rules of Accounting

 6. Compound entries

These entries record multiple accounts to be debited and credited. 

But there’s a catch!

Although the number of debits and credits need not be equal, the total amount of debits and credits must be equal according to the rule of journal entry. It might be the case that there is a single credit but more than one debit. Similarly, there might be a single debit and more than one credit. For example, a company’s payroll has massive numbers of journal entries that can be taken written in compounded form. 

A step-by-step approach to creating journal entries for your business

Appropriately prepared journal entries ensure all financial transactions are accurately recorded. You can begin by zeroing in on which transactions should be entered where. Accounting software will play a crucial role over here as it will enable you to automate journal entries by fetching data from various financial reports and statements.

On the contrary, if you rely on manual bookkeeping methods, you will have to identify each transaction impacting the company’s books.

Here’s a detailed approach for creating journal entries:

1. Find the impacted accounts

Begin the process by identifying which accounts are affected by the transaction. This process can be cumbersome if you aren’t conversant with accounting rules, principles, and terms. In this step, your primary objective is to identify which accounts will gain and which ones will lose during the transaction.

2. Classify transactions

The second step is to sort transactions based on various types, including bank deposits, expenses, purchases, borrowings, credits, and taxes. It will enable you to record these transactions as per accounting rules.

3. Track and trace the money

In this step, consider how it impacts values in terms of debits and credits in associated accounts. Ask yourself the following questions about the transactions:

i. What is the source of the money?

ii. What is the destination of the money?

iii. What did it add to the business?

iv. What did it take away from the business?

4. Identify your account type

Some transactions are simpler to map based on the debits and credits across various affected accounts. Rest may be a little more complicated to track. Remember the following points to assist you in determining the account type:

i. Learn about various account types. There are 5 basic account types: expense, liabilities, revenue, equity, and assets. Once you understand the aforementioned types, you will learn how various kinds of transactions impact them and how they relate to each other.

ii. Apply standard accounting rules to decide where to apply for debits and credits. In journal entries and financial reports, well-established accounting rules allow companies to standardize what goes where. For example, it helps decide where to apply credits and debits for a particular journal entry.

5. Build your journal entry

Adhere to the following process to prepare your journal entry:

i. Put the correct date. Correct date ensures that the data stored in journal entries are applied to the suitable accounting period.

ii. Allocate code and account name. Transactions are coded to a particular account to simplify the accounting process. And accounts are identified using a unique general ledger code and name.

iii. Enter the credit and debit amounts: One of the most significant benefits of using accounting software is automating the debiting and crediting of journal entries. On the contrary, if you are managing them manually, there is a high chance that they will be full of errors.

Examples of common journals

A double-entry accounting system, which consists of a general journal and a general ledger, is a widely used for maintaining financial statements. Sometimes, it might also include the application of special journals for frequent transactions within a particular category. 

General Journal 

It’s a book containing all the financial transactions and their dates. A general ledger is the first place where a transaction is recorded, after which the amounts are posted to the specific accounts, namely cash accounts, accounts receivables, or asset accounts. 

Special Journal

Special journals maintain frequent transactions within a particular category and help in manual bookkeeping, simplifying the process of finding instances of certain types of transactions for businesses. For example, purchase and sales journals group purchases from suppliers and sales to customers at a single location. The best part is that advanced accounting software eliminates the need for special journals by making it easy to sort and find granular details for each transaction. 

Why using automated accounting software is critical for your business?

As your business expands, your journal entries will grow. And if you only rely on manual systems, it will become challenging to track all transactions. 

Here’s why you should implement an accounting software:

• Reduces error rates.
• Simplifies the accounting process.
• Verifies journal entries and checks them for their accuracy.
• Ensures that debits and credits on affected accounts are allocated based on standard accounting rules.