4.4 Recording Transactions Using Journal Entries
At the end of this section, students should be able to meet the following objectives:
- Describe the purpose and structure of a journal entry.
- Identify the purpose of a journal.
- Define trial balance and indicate the source of its monetary balances.
- Prepare journal entries to record the effect of acquiring inventory, paying salary, borrowing money, and selling merchandise.
- Define accrual accounting and list its two components.
- Explain the purpose of the revenue realization principle.
- Explain the purpose of the matching principle.
The Purpose of a Journal Entry
Question: In an accounting system, the impact of each transaction is analyzed and must then be recorded. Debits and credits are used for this purpose. How does the actual recording of a transaction take place?
Answer: The effects produced on various accounts by a transaction should be entered into an accounting system as quickly as possible so that information is not lost and mistakes have less time to occur. After each event is analyzed, the financial changes caused by a transaction are initially recorded as a journal entryThe physical form used in double-entry bookkeeping to record the financial changes caused by a transaction; each must have at least one debit and one credit and the total debit(s) must always equal the total credit(s)..In larger organizations, similar transactions are often grouped, summed, and recorded together for efficiency. For example, all cash sales at one store might be totaled automatically and recorded at one time at the end of each day. To help focus on the mechanics of the accounting process, the journal entries in this textbook will be prepared for transactions individually. A list of a company’s journal entries is maintained in a journalThe physical location of all journal entries; it is the financial diary of an organization capturing the impact of transactions as they took place; it is also referred to as the general journal. (also referred to as a general journalThe physical location of all journal entries; it is the financial diary of an organization capturing the impact of transactions as they took place; it is also referred to as the journal.), which is one of the most important components within any accounting system. The journal is a financial diary for a company. It provides a history of the impact of all financial events, recorded as they took place.
A journal entry is no more than an indication of the accounts and balances that were changed by a single transaction.
Practicing with Debits and Credits
Question: Debit and credit rules are best learned through practice. In order to master the use of debits and credits for recording purposes, where should the needed work begin?
Answer: When faced with debits and credits, everyone has to practice at first. That is normal and to be expected. These rules can be learned quickly but only by investing a bit of effort. Earlier in this chapter, a number of common transactions were presented (Figure 4.1 "Transactions Frequently Encountered by a Business") and then analyzed to demonstrate their impact on account balances. Assume now that these same transactions are to be recorded as journal entries.
To provide more information for this illustration, the reporting company will be a small farm supply store known as the Lawndale Company that is located in a rural area. For convenience, assume that the business incurs each of these transactions during the final two days of Year Four, just prior to preparing financial statements.
Assume further that this company already has the various T-account balances as of December 29, Year Four, presented in Figure 4.3 "Balances From T-accounts in Ledger" before recording the impact of this last group of transactions. A company keeps its T-accounts together in a ledger (or general ledger). This listing of the account balances found in the ledger is known as a trial balanceList of account balances at a specific point in time for each of the T-accounts maintained in a company’s ledger; eventually, financial statements are created using these balances.. Note that the total of all the debit and credit balances do agree ($360,700) and that every account shows a positive balance. In other words, the current figure being reported is either a debit or credit based on what reflects an increase in that particular type of account. Few T-accounts contain negative balances.
Figure 4.3 Balances From T-accounts in Ledger
Journal Entry for Acquisition of Inventory on Credit
Question: After the balances in Figure 4.3 "Balances From T-accounts in Ledger" were determined, several additional transactions took place during the last two days of Year Four. The first transaction analyzed at the start of this chapter (Figure 4.1 "Transactions Frequently Encountered by a Business") was the purchase of inventory on credit for $2,000. This acquisition increases the recorded amount of inventory while also raising one of the company’s liabilities (accounts payable). How is the acquisition of inventory on credit recorded in the form of a journal entry?
Answer: Following the transactional analysis, a journal entry is prepared to record the impact that the event has on the Lawndale Company. Inventory is an asset. An asset always uses a debit to note an increase. Accounts payable is a liability so that a credit indicates that an increase has occurred. Thus, the journal entry shown in Figure 4.4 "Journal Entry 1: Inventory Acquired on Credit" is appropriate.The parenthetical information is included here only for clarification purposes and does not appear in a true journal entry.
Figure 4.4 Journal Entry 1: Inventory Acquired on Credit
Notice that the word “inventory” is physically on the left of the journal entry and the words “accounts payable” are indented to the right. This positioning clearly shows which account is debited and which is credited. In the same way, the $2,000 numerical amount added to the inventory total appears on the left (debit) side whereas the $2,000 change in accounts payable is clearly on the right (credit) side.
Preparing journal entries is a mechanical process but one that is fundamental to the gathering of information for financial reporting purposes. Any person familiar with accounting could easily “read” the previous entry: Based on the debit and credit, both inventory and accounts payable have gone up so a purchase of merchandise for $2,000 on credit is indicated. Interestingly, with translation of the words, a Venetian merchant from the later part of the fifteenth century would be capable of understanding the information captured by this journal entry even if prepared by a modern company as large as Xerox or Kellogg.
Recording Payment of an Expense
Question: In Transaction 2, the Lawndale Company pays its employees salary of $300 for work performed during the past week. If no entry has been recorded previously for this amount, what journal entry is appropriate when a salary payment is made?
Answer: Because the information provided indicates that no entry has yet been made, neither the $300 salary expense nor the related salary payable already exists in the accounting records. Apparently, the $60,000 salary expense appearing in the trial balance reflects earlier payments made during the period to company employees.
Payment is made here for past work so this cost represents an expense rather than an asset. Thus, the balance recorded as salary expense goes up while cash decreases. As shown in Figure 4.5 "Journal Entry 2: Salary Paid to Employees", increasing an expense is always shown by means of a debit. Decreasing an asset is reflected through a credit.
Figure 4.5 Journal Entry 2: Salary Paid to Employees
In practice, the date of each transaction could also be included here. For illustration purposes, this extra information is not necessary.
Journal Entry When Money Is Borrowed
Question: According to Transaction 3, $9,000 is borrowed from a bank when officials sign a note payable that will have to be repaid in several years. What journal entry is prepared by a company to reflect the inflow of cash received from a loan?
Answer: As always, recording begins with an analysis of the transaction. Cash—an asset—increases $9,000, which is shown as a debit. The notes payable balance also goes up by the same amount. As a liability, this increase is recorded through a credit. By using debits and credits in this way, a record of the financial effects of this transaction are entered into the accounting records.
Figure 4.6 Journal Entry 3: Money Borrowed from Bank
An accountant looks at a journal entry found in a company’s journal that shows a debit to notes payable and a credit to cash. Which of the following events is being recorded?
- Money has been borrowed from a bank.
- Money has been contributed by an owner.
- Money has been received from a sale.
- Money has been paid on a liability.
The correct answer is choice d: Money has been paid on a liability.
Cash is an asset that decreases by means of a credit. Notes payable is a liability that decreases with a debit. Both cash and notes payable decreased, indicating that a payment was made.
Recording Sale of Inventory on Credit
Question: In Transaction 1, inventory was bought for $2,000. That journal entry is recorded earlier. Now, in Transaction 4, these goods are sold for $5,000 to a customer with payment to be made at a later date. How is the sale of merchandise on credit recorded in journal entry form?
Answer: As discussed previously, two events happen when inventory is sold. First, the sale is made and, second, the customer takes possession of the merchandise from the company. Assuming again that a perpetual inventory system is in use, both the sale and the related expense are recorded immediately.
In the initial part of the transaction, the accounts receivable balance goes up $5,000 because the money from the customer will not be collected until a future point in time. The increase in this asset is shown by means of a debit. The new receivable resulted from a sale. Thus, revenue is also recorded (through a credit) to indicate the cause of that effect.
Figure 4.7 Journal Entry 4A: Sale of Inventory Made on Account
At the same time, inventory costing $2,000 is surrendered by the company. The reduction of any asset is recorded by means of a credit. The expense account that represents the outflow of inventory has been identified previously as “cost of goods sold.” Like any expense, it is entered into the accounting system through a debit.
Figure 4.8 Journal Entry 4B: Merchandise Acquired by Customers
The Role of Accrual Accounting
Question: In the previous transaction, the Lawndale Company made a sale but no cash was to be collected until some later date. Why is revenue reported at the time of sale rather than when cash is eventually collected? Accounting is conservative. Delaying recognition of sales revenue (and the resulting increase in net income) until the $5,000 is physically received seems logical. Why is the revenue recognized here before the cash is collected?
Answer: This question reflects a common misconception about the information conveyed through financial statements. As shown in Journal Entry 4A, the reporting of revenue is not tied directly to the receipt of cash. One of the most important components of U.S. GAAP is accrual accountingA method of accounting used by U.S. GAAP to standardize the timing of the recognition of revenues and expenses; it is made up of the revenue realization principle and the matching principle.. It serves as the basis for timing the recognition of revenues and expenses. Because of the direct impact on net income, such issues are among the most complicated and controversial in accounting. The accountant must constantly monitor events as they occur to determine the appropriate point in time for reporting each revenue and expense. Accrual accounting provides standard guidance for that process.
Accrual accounting is really made up of two distinct elements. The revenue realization principleThe component of accrual accounting that guides the timing of revenue recognition; it states that revenue is properly recognized when the earning process needed to generate the revenue is substantially complete and the amount to be received can be reasonably estimated. provides authoritative direction as to the proper timing for the recognition of revenue. The matching principleThe component of accrual accounting that guides the timing of expense recognition; it states that expense is properly recognized in the same time period as the revenue that it helped generate. establishes similar guidelines for expenses. These two principles have been utilized for decades in the application of U.S. GAAP. Their importance within financial accounting can hardly be overstated.
Revenue realization principle. Revenue is properly recognized at the point that (1) the earning process needed to generate the revenue is substantially complete and (2) the amount eventually to be received can be reasonably estimated. As the study of financial accounting progresses into more complex situations, both of these criteria will require careful analysis and understanding.
Matching principle. Expenses are recognized in the same time period as the revenue they help to create. Thus, if specific revenue is to be recognized in the year 2019, all associated costs should be reported as expenses in that same year. Expenses are matched with revenues. However, when a cost cannot be tied directly to identifiable revenue, matching is not possible. In those cases, the expense is recognized in the most logical time period, in some systematic fashion, or as incurred—depending on the situation.
Revenue is reported in Journal Entry 4A. Assuming that the Lawndale Company has substantially completed the work required of this sale and $5,000 is a reasonable estimate of the amount that will be collected, recognition at the time of sale is appropriate. Because the revenue is reported at that moment, the related expense (cost of goods sold) should also be recorded as can be seen in Journal Entry 4B.
Accrual accounting provides an excellent example of how U.S. GAAP guides the reporting process in order to produce fairly presented financial statements that can be understood by all possible decision makers.
Which of the following statements is not true?
- Accrual accounting is a component of U.S. GAAP.
- According to the matching principle, revenues should be recognized in the same period as the expenses that help to generate those revenues.
- The revenue realization principle and the matching principle are components of accrual accounting.
- Revenues should not be recognized until the amount to be realized can be reasonably estimated.
The correct answer is choice b: According to the matching principle, revenues should be recognized in the same period as the expenses that help to generate those revenues.
Accrual accounting is the U.S. GAAP that structures timing for reporting revenues and expenses. It is made up of the revenue realization principle and the matching principle. Revenues are reported when the earning process is substantially complete and the amount to be received can be reasonably estimated. Expenses are recognized in the same period as revenues they help generate. The answer is b; it is stated backward. Expenses are matched with revenues; revenues are not matched with expenses.
After the financial effects of a transaction are analyzed, the impact is recorded within a company’s accounting system through a journal entry. The purchase of inventory, payment of a salary, and borrowing of money are all typical transactions that are recorded in this manner by means of debits and credits. All journal entries are maintained within a journal. The timing of recognition is especially important in connection with revenues and expenses. Accrual accounting provides formal guidance within U.S. GAAP. Revenues are recognized when the earning process is substantially complete and the amount to be collected can be reasonably estimated. Expenses are recognized based on the matching principle. It holds that expenses should be reported in the same period as the revenue they help generate.