Financial Accounting / Chapter 5
Recording of transactions
Overview
The first step in the accounting process involves the identification of transactions that are monetary in nature. The accountants use documents like purchase bills, sales invoices, etc to do the same. After identification of the transactions, the accountant records them by applying GAAP. All these records are arranged in chronological order in the book of accounts called a General Journal or the Book of original entries. This process of recording the transaction in the journal book is called Journalising the transactions. Earlier, the recording of transactions was done by accountants manually in books or registers. However, these days everything is digitalised and hence, there are many softwares such as SAP, QuickBooks, etc for this purpose.
Learn how various financial transactions are recorded to maintain the Book of Original Entries.
Scope:
- Debit & Credit
- Application of a Journal Entry
- Simple & Compound Entry
Debit & Credit
While journalising the transactions, the most important aspect to be considered is the dual nature of accounting. Remember, one transaction impacts at least two accounts i.e with an increase in the balance of one account, there’s a decrease in another account’s balance. This increase or decrease is referred to as debit or credit. Whether the increase is a debit or credit depends upon the nature of the account and the respective rules of that account.
Notably, the total balances of both sides of the equation should match.
Understanding a Journal
Let’s take the example we used in the previous chapter to understand the recording of transactions in a Journal.
Ranveer starts a popcorn business on 1st March 2022 by investing INR 2,00,000. However, later he realised that this amount is not sufficient.
Therefore, he takes a loan of INR 2,00,000 on 2nd March 2022 for the business and promises to pay it back at a certain interest rate after 5 years. With this money in his business account, he buys machinery to make popcorn for INR 50,000 in cash on 3rd March 2022.
He bought the initial inventory of raw material i.e, popcorn seeds for INR 20,000 on 4th March 2022. He did not pay for the raw material upfront. He promised to pay the supplier after a month. With this, he is happy to start preparation of his initial stock of finished goods i.e. popcorn.
The accountant will record these transactions in a journal book using the software. Let’s look at these transactions and how they would appear in the book of entries.
- Transaction 1: Ranveer starts a popcorn business on 1 March 2022 by investing INR 2,00,000.
Explanation: The first aspect of this transaction is simply the cash received from the owner. Hence, the business cash increases by INR 2,00,000. Since cash is a real account, we follow the rule of a real account which states - Debit what comes in and Credit what goes out. Also, cash is an asset and all increases in the assets are to be debited. Thus, cash coming into the business is to be debited.
As already discussed, the other aspect of this transaction is the increase in the Owners’ equity by INR 2,00,000. Since the business owes this money back to the owner, it should be treated as a liability of the business towards the owners. Thus, any increase in owners’ equity is to be credited.
Journal entry Date Accounts and explanation Debit Credit March 1, 2022 Cash
Ranveer's capital (Capital issued by the owner)200,000 200,000 - Transaction 2: He takes a loan of INR 2,00,000 on 2nd March 2022 for the business.
Explanation: The loan amount received reflects the cash for the business has further increased by INR 2,00,000. Like the previous transaction, cash coming into the business is to be debited.
However, the business owes this back to the bank after a period of 5 years. Therefore, the business has generated a liability i.e. notes payable to the bank worth INR 2,00,000. Increases in liabilities are to be credited.
Journal entry Date Accounts and explanation Debit Credit March 2, 2022 Cash
Notes Payable
(Received bank loan)200,000 200,000 - Transaction 3: He buys machinery for making popcorn at INR 50,000 in cash on 3rd March 2022.
Explanation: Machinery is a resource for the business that will be used to make popcorn and help in generating revenues for the business. Hence, a new asset i.e. machinery is generated under the assets by a value of INR 50,000. Any increase in assets is to be debited. Hence, Machinery is to be debited.
However, as the machinery is bought in cash. The cash comes down by INR 50, 000. Any decreases in assets are to be credited. Thus, the cash decrease here is debited.
Journal entry Date Accounts and explanation Debit Credit March 3, 2022 Machinery
Cash
(Purchased machinery in cash)50,000 50,000 - Transaction 4: He bought an initial inventory of raw materials for INR 20,000 on 4th March 2022.
Explanation: Inventory of raw materials is yet another resource for the business which will help in generating revenues for the business. Hence, a new asset i.e., inventory is generated under the assets by a value of INR 20,000. Remember, any increase in assets is to be debited. Hence, inventory is to be debited.
However, the raw material is bought on credit. As the business will pay it in future. Thus, the business has generated a new liability of INR 20,000 (creditors). Remember, any increase in liabilities is to be credited. Hence, creditors are to be credited.
Journal entry Date Accounts and explanation Debit Credit March 4, 2022 Inventory
Creditors
(Purchased inventory on credit)200,000 200,000 Let’s extend this example to add the transactions related to expenses and revenues.
- Transaction 5: Salaries paid to employee INR 15,000 on 31st March 2022.
Explanation: Salaries paid to employees are an expense of the business. Remember the rule - Debit all expenses and losses, and Credit all incomes and gains. Thus, any increase in expenses is to be debited. Hence, the Salaries account is to be debited.
However, the salaries are paid in cash. Remember, any decrease in assets is to be credited. Hence, cash is to be credited.
Journal entry Date Accounts and explanation Debit Credit March 31, 2022 Salaries
Cash
(Salaries are paid in cash)15,000 15,000 - Transaction 6: Cash sales of INR 5,000 on 31st March 2022.
Explanation: Sales are revenues that help in generating income for the business. Remember the rule - Debit all expenses and losses, and Credit all incomes and gains. Thus, any increase in sales or revenues is to be credited. Hence, Sales revenue is to be credited.
However, the sales are done in cash implying cash coming into the business. Remember, any increase in assets is to be debited. Hence, cash is to be debited.
Journal entry Date Accounts and explanation Debit Credit March 31, 2022 Cash
Sales
(Sales made in cash)5,000 5,000
Simple and compound entry
Simple entry is a journal entry for a transaction that affects only two accounts. For instance, acquired inventory on credit INR 10,000 on 8th March 2022. In contrast, a compound entry is a journal entry for a transaction that affects more than two accounts. For instance, acquired inventory for cash INR 10,000 plus credit INR 20,000 on 10th March 2022.
| Journal entry | |||
|---|---|---|---|
| Date | Accounts and explanation | Debit | Credit |
| March 8, 2022 | Inventory Creditors (Purchased inventory on credit) | 10,000 | 10,000 |
| March 10, 2022 | Inventory cash Creditors (Purchased inventory partly in cash) | 30,000 | 10,000 20,000 |
Here, the transaction on 10th March is a complex transaction impacting more than three accounts (Inventory, cash & creditors) and hence, is called a compound journal entry.
Closing summary
Thus, a journal entry is simply the recording of any business transaction in chronological order by the accountant. Being a date-wise record, this process reduces the chances of omission of any transaction and improves the authenticity of accounting.
The subsequent chapter discusses the second step of the accounting process i.e., classification into accounts or simply, posting these journal entries into the ledger books using individual accounts.