In a previous post (click here) we covered the theory of debits and credits.
If you haven’t read that post yet, I recommend that you do because otherwise what we’re about to cover here is not going to make much sense.
Today we’re going to prepare journal entries for some example transactions. We’re going to take some activities of a business and turn them into data. We call this Bookkeeping.
It’s often mixed up with accounting, but it’s not the same.
Bookkeeping is only a part of the overall accounting process, and it covers these two steps.
Step 1: Collect and sort all source documents for each financial transaction. Source documents are the evidence that the financial transaction occurred. It includes things like receipts and invoices.
Step 2: Record and post the relevant data from each source document.
Here’s the thing though.
To record any transaction, it must be analyzed to answer two questions:
- “Which accounts are affected?”
There are only six main account groups we need to worry about, Assets, Dividends, Expenses, Liabilities, Equity, and Revenue (ADEx LER).
- “Did accounts go up or down?”
We also know that to record any transaction you always need at least two accounts. One will be debited, and one will be credited. That’s called double-entry bookkeeping. And the total debits for each transaction we create must equal total credits.
Remember Claudio? We followed his Italian beach business in an earlier post (click here), and now it’s time to record the transactions that happened during this day.
Let’s start with Claudio leaving his home in the morning.
He left with 100 euros in his pockets. This is his private money that he invested to start the business. Let’s record this transaction.
“Which accounts are affected?” (Question 1)
Assets: that’s resources the company owns and uses. He left with 100 euros in cash. Cash is an asset, so yes, assets are affected.
Dividends: that’s a distribution of profits of the business to the owners. That doesn’t happen here.
Liabilities: that’s something we owe to others. At this point, Claudio doesn’t owe anything to anyone, so liabilities aren’t affected.
Equity: this is money owners paid into the company or profits that the business generated that were not distributed to owners. Claudio put in his own money into the business, so we know that equity is affected.
Revenue and expenses are accounts in the income statement. He didn’t earn anything or incur any expenses at this point, so these don’t apply.
We can deduce this transaction will affect only assets and equity.
“Did accounts go up or down?” (Question 2) Let’s see.
Claudio put cash into the business, so the cash account increases, right? At the same time, by putting money into the company, equity increases as well.
So, both accounts go up.
That’s weird, right? Let’s use some T-accounts to figure this out.
T-accounts are what accountants use to visualize a transaction. Each T represents one account.
In our case, we need two Ts, one for cash and one for paid-in capital.
Each T has two sides, a left side for debits and a right side for credits.
In order to figure out the debits and credits for the transaction, we’re going to use our secret weapon, ADEx LER, Accountants Don’t Expect Low Earning Rates.
Cash is an asset. It’s the “A” in ADEx.
ADEx is our shortcut to remember Debits. These accounts increase with debits and decrease with credits.
We already determined that cash is increasing. Therefore, to increase cash, we debit the account. One Hundred euros go to the debit side of the cash account.
The golden rule in accounting is that total debits must equal total credits.
With that in mind, we can easily determine that the second account, paid-in capital, will be credited for 100 euros.
Or to be on the safe side, we use ADEx LER again.
Paid-In Capital is an equity account. It’s represented by the “E” in LER. LER is the shortcut to remember credits. These accounts increase with credits and decrease with debits.
Since equity is increasing, it needs a credit for 100.
That’s it. Both sides of the transaction are in balance.
After Claudio left his home, he went to the manufacturer of the plates. He bought 100 of the colorful plates with his 100 euros in cash.
Let’s run through the steps to record this transaction.
He spent his cash, so we know assets will be affected.
With his cash, he purchased inventory, the plates he’s going to sell to tourists later, right? Inventory is an asset too. Therefore, this transaction affects two asset accounts.
The second question was to determine if accounts go up or down.
He spent his cash, so his cash account will decrease, right? At the same time, in exchange for cash, he got the plates, so inventory will increase.
Here we have our two accounts, cash and inventory.
On the cash account, we already see the first transaction we did on the debit side.
Now we already know from ADEx LER that cash belongs to the “A” in ADEx, which stands for debits. These accounts decrease with credits. Cash is decreasing, so we know we need to credit it. 100 euros go to the credit side of the account.
Where does the debit for this transaction go? We said inventory, right, which is also an asset account represented by ADEx. Inventory is increasing, so it needs a debit. 100 euros go into the debit side of the inventory account.
That’s it. We are in balance. Another transaction recorded.
With his 100 colorful plates, Claudio went to the beach and started selling them to tourists.
Usually we would record the individual sales separately, but to save time and because it’s kind of repetitive, let’s just record the sales of the whole day in one go.
There are two transactions we need to account for. Let’s start with the first part, his sales.
He sold 100 plates for five euros each, so that’s 500 euros in total.
How do we account for that? Which accounts are affected? We need at least two.
We know the tourists paid cash for the plates, so cash is definitely affected.
We also know that when a business is selling goods or services, it creates sales or revenue. That’s the other account we need.
Which one is going up or down?
Cash is going up because he collects that from the tourists. Therefore, cash will be debited, and we can safely assume that the credit will need to go to revenue.
With ADEx LER, we can confirm that. The “R” in LER stands for Revenue. So, we know it’s a credit.
Credits increase with credits, which means our assumption was correct.
Instead of T-accounts, let’s now do a journal entry.
This is what bookkeepers will use to transform the transaction into data that can be processed.
Years ago, that was actually written manually in a book, but nowadays we use accounting software for that.
A journal entry looks like this:
It will include the date; that’s the date the transaction occurred.
It has one line for each account that was affected by the transaction.
To the right are the columns for the amounts; one for debits and one for credits. Sometimes we will also see the abbreviations Dr for debits and Cr for credits. Usually some description for the transaction will be added too.
Let’s create the journal for Claudio’s sales.
First the date, let’s say that was August 15th, 2019 for Augusto in Italy, high season for any beach business.
Then the accounts, I usually start with the debits.
Claudio received cash, so we write that down and put in 500 euros in the debit column for it.
The credit goes to revenues. We put the 500 euros in the credit column.
Last, we add a short description, and that’s it.
That’s how this transaction would look like as a journal entry.
But Wait, There’s More!
There is another part of this transaction that may not be so obvious at first and that we didn’t account for yet. Do you know what that is?
So far, we only recorded the sales part, but while his cash was increasing by selling the plates, his inventory was decreasing as well but not by the same amount.
This is where it can get a bit complicated because there are different methods how inventory can be valued.
- First In, First Out (FIFO)
- Weighted Average Cost
- Last In, First Out (LIFO)
But those are for another post.
Basically, we need to account for the cost of goods sold, or COGS, so let’s create the journal entry for that.
First the date, same day, August 15th, 2019, then the accounts.
Claudio incurs cost of goods sold, or COGS, because he didn’t get the plates for free. COGS are expenses. Expenses are the Ex in ADEX, and therefore, debits. They increase with the debit. So, we need to debit expenses.
We already know that Claudio’s inventory decreased. Inventory is an asset. Assets are debits. Debits decrease with a credit.
Now for the amount.
Remember, the plates were 100 euros for 100 pieces. Since they’re all sold, that’s Claudio’s COGS.
So, the journal entry is a debit of 100 to COGS and a credit of 100 to inventory.
So those were the transactions of his day.
Wrapping it up with a nice, neat bow.
Let’s just quickly wrap this up by creating the P&L and the balance sheet for Claudio based on these transactions. This way we can see how these accounts roll into the financial statements.
First, I’ll just visualize all transactions with T-accounts. We used Cash, Paid-In Equity, Inventory, Revenue, and COGS. These were our transactions.
Claudio leaving his home with 100 euros in cash, that goes to cash in equity.
Then Claudio goes to the manufacturer and buys the plates. That goes to inventory and cash.
Finally, Claudio successfully sells all his plates. That goes to cash and revenue (3.1) and also to COGS and inventory (3.2).
Then we calculate the closing balances or totals for the accounts. It needs to add up the debits and credits on each side of the T. Then we deduct the total credits from debits or vice versa for the credits accounts.
Cash has 600 debits minus 100 for credits. This results in a debit closing balance of 500.
Paid-in equity has a credit closing balance of 100.
Inventory is zero.
Revenue has a credit balance of 500 and COGS a debit balance of 100.
Let’s create Claudio’s P&L:
The P&L; includes revenues and expenses. Therefore, we just need the T-accounts for revenue and COGS.
The closing balances for these accounts flow into our simplified P&L and we calculate a net profit of 400.
Next, the balance sheet.
Only the accounts for cash and paid-in equity are relevant because the closing balance in inventory is zero.
Cash is an asset and goes to the debit side of the balance sheet. Paid-in equity goes to the credit side.
In our introduction post to accounting, we said that net profit is the link between the P&L and the balance sheet.
So, the net profit of 400 from the P&L flows into retained earnings on the credit side of the balance sheet.
This way everything is balanced like it should.
I hope this post was helpful to apply the theory behind debits and credits to record actual transactions.
Always remember “Accountants Don’t Expect Low Earning Rates”, ADEx LER, and you’re going to be fine.
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