In an increasingly automated world, the humble journal entry can seem like something relegated to textbooks.
In truth, the journal entry is the foundation of the accounting process used for centuries (since 1300!): Double-Entry Accounting.
NPR’s “Planet Money” describes how this system of tracking money was developed in Europe as the Arabic numerals (1, 2, 3, 4) became more widely used. The concept, at its most basic level, was this: as a merchant would sell a product each day, such as pepper, they would record the increase in gold coins and the decrease in the amount of pepper.
Prior to this new process of tracking money, a merchant would stack up the number of gold coins they had received for the day, but there was no way of tracking the impact on inventory and no methods existed for evaluating which products were selling well. We take this for granted today, but it doesn’t take someone with an MBA to see how the use of double-entry accounting revolutionized the business world.
Obviously, business has gotten much more complex in the years since 1300, but the journal entry is still the method used to make double-entry accounting happen and produce those exciting financial statements we love to analyze.
We look at journal entries as going into one of two buckets: The traditional journal entry and the adjusting journal entry.
The traditional journal entry needs to happen in order to make basic financial statements a reality. Usually handled by the business’s accounting software of choice, these journal entries are posted to the general ledger.
The adjusting journal entry helps us fine-tune the financial statements and present the most accurate financial picture possible. These entries require knowledge of accounting principles and a good understanding of the business side of the company. Some of these entries might be made by our accounting software, but some are not and require an accountant’s professional judgment.
The Journal Entry — Behind the Scenes
We’ve all heard of the old-school accounting ledgers and maybe even seen some pictures. Lots of lines and numbers. One look at these makes us wonder if accountants also invented the pencil and eraser.
We love our modern systems and software, and it doesn’t take long to see how much time accountants save now compared to 100 years ago. However, it is important we understand what exactly those solutions are doing.
Take office supply expenses as an example of the basic journal entry. We hopped on Amazon last week and ordered some paper with our debit card connected to our business checking account. When we do the accounting for the month, we will jump into our accounting software and code that Amazon purchase to office supplies. But behind the scenes, your software is making the following journal entry:
Debit: Office Supplies Expense
Credit: Cash
Reduce cash and increase expenses… boom, just like selling pepper in 1300 AD! Well…not exactly because pepper is inventory and office supplies aren’t inventory, but you get the concept.
The Adjusting Journal Entry – Star of the Modern-Day Accounting Show
Most of the time, you won’t have to think twice about what journal entries your accounting software is making behind the scenes; it’s pretty basic stuff. Conversely, the modern-day star of the show is the adjusting journal entry.
Without digging into the difference between cash and accrual accounting (Investopedia has a great summary here: Accrual Accounting vs. Cash Basis Accounting: What’s the Difference), there are a few main reasons you would need to record a journal entry these days.
Accruals
Revenue is a good example. Revenue that has been earned but not received. An example would be a product that has been delivered to your customer and you have not received the cash. Going back to our spice merchant of 1300 AD, you sent a pepper delivery out to your customer and he is coming into town next week to give you the gold coins. The entry you would make today would increase accounts receivable (no gold coins yet but they are coming soon) and decrease inventory. Next week, when your buddy shows up with the payment, you would make an adjusting journal entry to increase cash and decrease accounts receivable.
Deferrals
Most commonly, these are prepayments where you have received (or outlaid) the gold coin but have not delivered the product or consumed the expense. Our spice merchant may have a restaurant customer that buys a lot of pepper and paid him in advance in order to secure a discount. In this case, he would record an increase in cash and unearned revenue. When he delivered the pepper to his customer, he would record an adjusting entry to increase sales and decrease unearned revenue.
Estimates
These are the most frequently non-cash items that allow us to present the most accurate financial picture possible. Depreciation and allowance for bad debt are the most common modern-day examples of adjusting journal entries to record estimates.
Though it’s a major part of modern accounting today, journal entries are easy to overlook because of a few reasons. First, it’s because of how basic they are — it’s hard to get excited about documenting some sort of transaction. Second — and this isn’t a bad thing — is because of the bevy of accounting software available for consumers, businesses, and enterprises. Gone are the days of a physical general ledger (well, in most cases). But understanding the importance of journal entries and how they impact other aspects of accounting cannot be overlooked.
We hope this introduction to journal entries took some of the mystery out of this accounting unicorn and will leave you with this quote from an unknown source:
“Life is like accounting; everything must be balanced.”
