What is a journal entry in accounting?
Transaction by transaction, money changes hands every single day. In fact, 1.01 billion credit card transactions alone take place globally in just the space of 24 hours. Failing to track just one of them has the potential to cause a domino effect of problems, making journal entries integral to the profession of accounting.
Defining a journal entry
Created every single time that a transaction takes place, getting journal entries correct is extremely important. So what exactly are they? Put simply, every transaction which goes through your company is recorded via a journal entry. For example, a bank payment, raising a sales invoice or taking out a loan. Journal entries therefore update the status of at least two ledger accounts each time a transaction takes place, stating whether a transaction results in them being debited or credited by a certain amount. When added together, the total of the related debits and credits must always equal zero.
The accounting equation
Journal entries therefore have a lot of responsibility. However, none is bigger than ensuring that Assets = liabilities + equities. That is the principle equation of accounting.
In order to keep the accounting equation level, it is crucial that when creating journal entries, accountants employ what is known as double-entry accounting. This simply means that whenever a transaction takes place, the impact it has must be recorded across at least two accounts. For example, if a company takes out a loan, this will result in an increase in both the firm’s loan liabilities and its assets.
With this in mind, let’s look at some typical accounting processes which help make this equation stack up.
Journal entry processes
As demonstrated above, journal entries are pervasive across the entire finance and accounting system. As a result, the act of creating journal entries requires a lot of versatility. This is reflected by the number of different processes which can take place regarding journal entries:
Maintaining the accuracy of financial figures is of utmost importance for organisations both from the perspective of ensuring compliance and having correct numbers at their disposal to make informed decisions. This becomes more complicated when income or expenses don’t occur in real-time. For example, when a company is buying or selling services annually in advance, which results in deferred revenue or prepaid expenses.
Accrued revenues and expenses, deferred revenues, and prepaid expenses are all regular occurrences for organisations. Due to the time at which payments relating to these transactions take place differing from when they take effect, these types of transactions can result in financial statements not marrying up perfectly with a company’s true financial position. Instances such as these are overcome through the use of adjusting entries, offsetting their difference in time to give a true reflection of a company’s current financial position.
Companies that decide to deploy adjusting entries at the end of each accounting period opt for the method known as accrual accounting rather than cash-based accounting. Despite increasing complexity by adding accounts payable and receivable into the mix, the accrual basis of accounting is heavily favoured thanks to it accounting for revenue the moment it is earned, consequently delivering a true monetary position to firms.
Adjusting entries are a temporary fix. Whilst they level financial statements to reflect true financial positioning, in the near future, what they offset will actually take place and become true. Consequently, whenever adjusting entries are used, reversing entries will inevitably be required later to literally reverse and counteract an earlier adjusting entry.
However, this is not the only application of reversing entries. For example, they are also used when errors occur and need to be rectified.
A compound entry is a journal entry which includes two or more accounts. Instead of creating separate entries for each account which is affected by one transaction, it allows for this to be done in a single neat entry.
For example, when a monthly business loan is paid, this will see the payment not just affect the loan balance, but also be used to pay interest. With a compound entry, the changes to an Interest Expense account and Loans Payable Account, can be combined into one entry. As a result, fewer entries are made, reducing the mess found within ledgers, shortening audit trails and appeasing auditors.
Byproducts of journal entries
Generating journal entries is not simply a matter of keeping accurate accounts, they are also the backbone for:
Managing revenue or expenses
For a business, revenues and expenses are perpetually in movement. As a result, they must report upon revenue-generating and expense-related transactions (i.e. cost of sale, operating expenses) in journal entries. Doing so with higher levels of input and accuracy results in their journal entries being more valuable due to the fact that they will be able to create accurate cash positions with them and know what their gross and net margins are.
When cash changes hands immediately, it is easy to understand whether money is gained or lost. However, in other instances, businesses incur an obligation to pay money in the future which in turn creates a liability. Examples of this include loans or unpaid bills, and collectively they are known as liabilities.
Despite the fact that their payment is delayed, liabilities must still be accounted for from when the obligation is created in order for organisations to ascertain their true financial position. As such, liabilities must also be updated via journal entries as new transactions arise which affects the liabilities’ subsequent measurement.
Accountants are not only tasked with recording numbers, they are responsible for monitoring everything which generates economic benefits. As a result, assets such as Property, Plant and Equipment (PPE) are also brought about within journal entries.
Unlike cash which trades nearly instantaneously these days, assets like investment property are usually for long periods of time. Consequently, their value can either appreciate, depreciate or hold. Accountants must be mindful of any such changes, updating their books accordingly through new journals whenever they occur.
Assisting with tax management
When it comes to managing taxes, raising the correct journal entries are key for businesses to have a view of their tax position. Given that taxes are unavoidable, this is extremely important, especially when related to VAT, payroll-related taxes and Corporation Tax, which apply to all businesses in the UK.
In the instance of VAT for example, businesses act as a holding partner for HMRC, receiving VAT funds when they gain income from qualifying sales. Yet at the same time, whenever they make qualifying purchases, they must expend VAT. As a result, the sum of VAT funds they hold on behalf of HMRC continuously changes. Come to their quarterly return - when they will either have a VAT liability or be owed a VAT refund - this total must be correct. Inevitably, journal entries are therefore integral.
The same is true for when it comes to managing Corporation Tax. Ultimately, this is calculated via the total which is found in a company’s Profit and Loss (P&L) Account. However, due to tax laws differing from accounting laws, even this total can find itself being altered. In order for tax advisors to ascertain whether this should be the case, they will require pristine account records. For example, the adding back of client entertainment - which would need to be easily identifiable within the company’s ledger - could occur. As a result, accurate records are needed on all incomes and expenses so that tax advisors can make informed decisions on whether to alter a company’s P&L total which will ultimately inform the sum of Corporation Tax which they must pay.
Other unavoidable taxes which companies must pay are those relating to payroll. Each month they will have to pay a sum to HMRC, which will be a combination of taxes paid automatically on behalf of employees, plus those owed by the company. With accurate journal entries, any anomalies can be swiftly rectified if a detailed analysis is provided within the ledger of how these balances are made up. Details affecting these balances could be pension schemes, student loans, health insurance etc. all of which will affect employees’ take-home pay and related taxes.
An entry of note
Every single journal entry can be described as an “entry of note” when inputted into a general ledger. After all, every transaction is important to a company.
The development of journal entry automation is therefore something which accountants are taking extreme note of. Systems like Aurum are automatically reconciling millions of transactions per day, and every accountant knows that what gets reconciled, has to find its way back into the finance/ accounting system. That’s why Aurum extends its automation to handle journal entry creation and even journal posting via APIs.
By eliminating the need for manual intervention, Aurum’s automation achieves the accurate creation of journal entries every time, giving organisations the figures they need to inform business decisions and prove to auditors that they are complying with regulations.
Guarantee timely and accurate journal entries with Aurum’s journal entry automation today.