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Lesson 2: Journal Entries


(Textbook Libby et al. Chapters 3)
Objectives:
When you have successfully completed this lesson, you will be able to:

 explain the proper use of journal entries and ledgers

 explain the rules of debit and credit

 record accounting transactions

 post from the journal to the ledger

 prepare a trial balance

Reading Assignment

Please read chapter 3 of your textbook. Carefully review terminology, double-entry recording,
recording of transactions, posting from journal to ledger, revenue and expenses, and trial balance
preparation.

Recommended Problem Assignment

Please complete Chapter 3 MC questions plus Exercises 3-1, 3-2, 3-3, 3-4, 3-6, 3-8, and 3-18

Discussion

Formalizing Accounting Transactions

Lesson 1 introduced the concept of an accounting transaction. We defined an accounting


transaction as a financial exchange between two independent parties that is recorded using the
accounting process. Many of the concepts from Lesson 1 will be repeated in Lesson 2, but will
be expanded upon.
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In Lesson 1, when LIMO Co. purchased a minivan, the transaction decreased Cash and increased
another asset called Equipment. The transaction appeared as follows:

Debit Credit
Equipment $30,000
Cash $30,000

This method of recording is called a journal entry. A journal entry has specific parts and
meaning. Note the first line is read as Debit Equipment $30,000. The second line (which is
intentionally indented) is read as Credit Cash $30,000. Recall that debit means we enter the
number on the left side of the account and credit means we enter the number on the right
side, nothing more. Don’t presume that one is positive and the other negative; the accounting
process does not work that way.

Journal entries are recorded in a journal. (Computer programs have now replaced the physical,
hardcover books; however, sometimes it is easier to visualize pages of a book rather than a hard
drive with electrons floating on a disk.) A journal is a chronological listing of all transactions
conducted by a business. It is similar in form to a checkbook register where the date and number
of every check and the name of the person or business to whom the checks were written is
entered. Each journal entry has a date, a name, an amount, and a brief explanation of what
happened. The transactions are listed in sequence by date so that businesses can continuously
update their account balances.

Here is an example of a formal journal entry:

Debit Credit
Date Equipment $30,000
Cash $30,000

To record purchase of minivan on XX/XX/200X

Note the addition of a date and explanation, this information is important so that the accountant
can always go back and review the event that occurred to validate the accuracy of the entry.

In a business, there would also be a reference number to take us to the invoice showing the detail
of the purchase.

Accounts are where similar transactions are summarized. To illustrate, the account Cash keeps
track of all the increases and decreases to the Cash balance over a period of time. When cash is
received, the account balance goes up; when cash is spent, the balance declines. In Lesson 1 the
T account was introduced to track information for each account. For example, the first three
transactions in Lesson 1 were shown in T account form as follows:
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Cash
10,000 (1)
25,000 (2)
30,000 (3)
5,000
(1) Owner contribution
(2) Borrowing
(3) Purchase minivan

An accounting system also has accounts for other assets such as Inventory, Land, Buildings,
Investments, etc. The textbook introduces new accounts such as Accounts Receivable and
Prepaid Expenses. We will discuss these accounts more fully later on. A large company could
have hundreds or even thousands of accounts.

To reiterate, here are some examples of accounts in the accounting equation.

Assets Accounts

Cash: balances in checking and savings, essentially funds immediately available to pay bills

Accounts Receivable: amounts owed to the business for services or products already sold

Prepaid Expenses: services paid for but not used up

Land: owned property being used in the business

Equipment: depreciable property such as cars, desks, computers, and other items that are
relatively small productive assets of a company

Buildings: includes depreciable property such as warehouses, office buildings, and hotels;
often combined with equipment into the Property, Plant and Equipment account

Liabilities Accounts

Accounts Payable: amounts owed by the business for services or products received but not
paid

Notes Payable: legal obligations usually with specified interest rates and terms for
repayment

Accrued Liabilities: liability recorded for any expenses incurred but not paid; common
examples include Interest, Taxes, Salaries and Utilities
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Long Term Debt: liability with repayment terms greater than one year; may include Bank
Loans, Bonds, and Lease Obligations

Owner’s Equity Accounts

Capital: funds the owners contributed to the business; for a proprietorship, Capital is
identified with the owner, such as Pat’s Capital. For partnerships, multiple capital accounts
would be used for each partner. For a corporation, the contributed capital accounts would be
Common Stock and Additional Paid-in Capital. For a proprietorship the account title used
could be “owner’s equity, owner’s capital,” or some other account title.

Owner’s Drawing: in a proprietorship, describes the withdrawals of capital made by the


owner. The withdrawal is actually a reduction of owner’s capital, but accountants track the
withdrawals separately during the period.

Retained Earnings: the undistributed, cumulative earnings of the company since its
inception; normally found in the corporate form of business. This account exists for a
corporation, not a proprietorship or partnership.

LIMO Co. Illustration (continued; this example was started in Lesson 1)

In continuing to illustrate how the accounting process works, we will review LIMO Company.
We will add additional transactions in June of operations and evaluate how well Pat did in
growing the business.

During June, Pat received a call from a group that was interested in going fishing. The group
needed Pat to take care of some extras they desired such as boat rental, fishing licenses and bait,
etc. Pat calculated that the additional items would raise her costs; therefore, she requested
$2,000 for the week rather than her previous $1,000 per week rate. This price was fine with the
group. Pat realized the business was growing; so, she decided to look at other business-related
expenses that might be needed.
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1. Pat decided it was time to buy insurance for the business. Pat’s local insurance agent worked
out a business liability policy that would cover all business risks, including the car and her
clients. The policy, however, would cost $600 for the next year (12 months). Pat purchased
the policy on June 1st. She recorded the entry in her journal as follows:

Journal Entry to record insurance expense:

6/1/XX
Debit Credit
Insurance Expense 600
Cash 600

Explanation: Purchased one-year liability policy for limousine business. (Note: in Lesson 3 we
will discuss this transaction more in depth. Also, we will discuss later an alternative way to
make this journal entry.)

The effect on the accounting equation is as follows.

Assets = Liabilities + Equity


Cash Insurance Expense
↓ 600 ↓ 600 (1)

(1) Insurance expense goes up by 600, which reduces equity by 600.

2. A group wanted special arrangements for a fishing trip. The group needed Pat to take care of
some extras they desired such as boat rental, fishing licenses and bait, etc. Pat called the
lodge and made arrangements for all the items the fishing party requested such as rooms,
boat, etc. The lodge said they would send Pat a bill for the total cost of $750. When the bill
arrived on June 4, Pat recorded a journal entry:

Pat read the bill carefully and noted that the lodge gave a grace period for paying. The payment
would not be due until June 10. This was great for Pat, because she could conserve her cash.
Note that we record the bill when received, not when paid. This method, called accrual
accounting, keeps a record of what we owe and also records expenses for the purchases already
incurred. In accrual basis accounting, revenues and expenses are recognized when the
transaction that causes them occurs, not necessarily when the cash is received or paid. That is,
revenues are recognized when they are earned and expenses are recognized when they are
incurred.
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Journal Entry to record fishing trip expense:


6/4/XX
Debit Credit
Fishing Trip Expenses 750
Accounts Payable 750

Explanation: To record fishing party expenses.

The effect on the accounting equation is as follows:

Assets = Liabilities + Equity


Accounts Payable Fishing Trip Expense
↑ 750 ↓ 750 (2)
(2) Fishing trip expenses increases by 750, which decreases equity by 750.

3. When the fishing party tip was complete, Pat sent them a bill for the $2,000 on June 8, and the
agreed terms allowed payment by July 5. Pat had pre-approved this arrangement of letting the
group pay in the future. Knowing the customers were responsible and would almost certainly pay
the bill, Pat constructed an invoice and sent it, recording the following entry in her Journal
immediately upon sending the bill:

Journal Entry to record billing for services rendered:

6/8/XX
Debit Credit
2,000
Accounts Receivable
Service Revenue 2,000

Explanation: Invoice mailed fishing party; agreed to accept payment July 5th.

Pat now realized that the records were going to become confusing if she didn’t organize the
accounts into separate records. At this stage, she developed a second book called a ledger. The
ledger is a book that has a separate account placed on each page (i.e., the first page was Cash,
the second Accounts Receivable, etc.). Pat knew that soon she would have to buy a computer
and use a standard accounting package such as QuickBooks; however, for the next few weeks,
this paper ledger system would be acceptable. Before we transfer our journal entries to the
ledger, we must finish recording all the additional financial activity for the month of June. (Note
that we are describing a manual accounting system that is not often used, but it is instructive to
understand the process. After journalizing, information is transferred to ledger accounts, where
information about a particular item is shown.)
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4. Pat realized she was short of personal cash; so, she withdrew $1,000 to replace her own
depleted checking account. We use the account Capital Withdrawal to recognize that cash taken
by the owner. Capital Withdrawal is a temporary account used during the year to cumulate
amounts disbursed to the owner. The journal entry is as follows:

Journal Entry owner withdraws cash:

6/10/XX
Debit Credit
1,000
Capital Withdrawal
Cash 1,000

Explanation: owner withdrew funds.

Note: this entry actually decreases owner’s capital. However, accountants track the withdrawals
separately during the period, and at the end of the period close out this account (zero it out) and
shown as a decrease in the owner’s capital account.

The effect on the accounting equation is as follows.

Assets = Liabilities + Equity


Cash Capital Withdrawal
↓ 1,000 ↓ 1,000 (3)

(3) The capital withdrawal account increases, but equity is decreased.

5. For the rest of the month Pat received and additional $3,500 in Service Revenue (all cash) and
paid various operating expenses of $1,500: room and meal, 800; gas and car, 220; office
supplies, 400; miscellaneous, 80. On June 30, Pat recorded the following summary journal
entries for all the activities (two journal entries are used, but one could be used):

Journal Entry to record service revenue:

6/30/XX
Debit Credit
Cash 3,500
Service Revenue 3,500

Explanation: To record collection of Revenue for several sight-seeing trips for the month of June.
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Journal Entry to record various expenses:

6/30/XX
Debit Credit
Room and Meal Expense 800
Gas and Car Expense 220
Office Supplies Expense 400
Miscellaneous Expense 80
Cash 1,500

Explanation: To record various expenses paid in the month of June.


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Payment of Accounts Payable

On June 30 Pat paid $700 of her accounts payable

The effect on the accounting equation is as follows.

Assets = Liabilities + Equity


↓Cash 700 ↓Accounts Payable 700

Journal Entry. Payments of accounts payable


6/30/XX

Debit Credit
Accounts Payable 700
Cash 700

Explanation: Payment of accounts payable.


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Pat then went through the journal and posted all the entries to the ledger. Posting is the process
of transferring journal entries to the ledger.

Before posting any additional June entries just described, the trial balance (listing of all the
account balances) was as follows: Note that this was the ending Trial Balance in Lesson 1.

Accounts & Balances Debit Credit


Cash 8,820
Equipment 30,000
Notes Payable 24,590
Owners’ Equity 10,000
Service Revenue 4,600
Gas & Car Expense 120
Room and Meals Expense 500
Miscellaneous Expense 80
Accounts payable 580
Interest expense 250
Total 39,770 39,770
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After posting the June additional journal entries, the June 30 trial balance is as follows.

Accounts & Balances Debit Credit


Cash 8,520
Equipment 30,000
Accounts Receivable 2,000
Notes Payable 24,590
Accounts payable 630
Owners’ Equity 10,000
Capital Withdrawal 1,000
Service Revenue 10,100
Gas & Car Expense 340
Room and Meals Expense 1,300
Miscellaneous Expense 160
Interest Expense 250
Insurance Expense 600
Fishing Trip Expenses 750
Office Supplies Expense 400
Total 45,320 45,320
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Financial Statements

Pat is now ready to prepare a balance sheet and income statement for June (which reflects the
transactions in Lesson 1 and Lesson 2).

LIMO Co.
Income Statement
For the Month of June 20XX
Service Revenue $10,100
Expenses
Gas & Car Expense 340
Room and Meals Expense 1,300
Miscellaneous Expense 160
Interest Expense 250
Insurance Expense 600
Fishing Trip Expenses 750
Office Supplies Expense 400
Total Expenses 3,800
Net Income $6,300

The income statement indicates that LIMO Co. made a June profit of $6,300. (Recall that on an
income statement, debits and credits are not used. Thus, the two columns do not reflect debits
and credits). Rather, the inner column is used for detail, and the outer column for important
totals and subtotals.
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A balance sheet lists the account balances for assets, liabilities, and owner’s equity. The balance
sheet for LIMO Co. is as follows:

LIMO Co.
Balance Sheet
June 30, 20XX
Assets
Cash $8,520
Accounts receivable 2,000
Equipment 30,000
$40,5
Total Assets
20
Liabilities & Owner’s Equity
Accounts Payable $ 630
Notes payable 24,590
Total Liabilities 25,220
Owners’ Equity* 15,300
$40,5
Total Liabilities & Owner’s Equity
20

*Owner’s Capital = $10,000 owner capital – 1,000 owner withdrawal + 6,300 net income.
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Statement of Owner’s Equity. The June Statement of Owner’s equity is as follows:

LIMO Co.
Statement of Owners’ Equity
June 30, 20XX

Beginning balance $0
Capital contributions 10,000
Net income 6,300
Capital withdrawals (1,000)
15,30
Ending balance
0

Conclusion

In this lesson, we have continued the study of accounting by explaining the process used to
record, classify, and summarize financial information. The process starts with a transaction,
which records the effects of an economic event. Transactions are recorded in journals through
the use of journal entries (in enterprise systems, the journal is electronic). Journal entries are
then posted to their respective accounts to make the information more useful. Account
balances are totaled forming a trial balance. The trial balance becomes the basis for preparing
financial statements. In Lesson 3, we will finish the accounting process discussing adjusting
journal entries, closing journal entries, and a post-closing trial balance.

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