What are the Rules of Journal Entries?
Journal is the book of original entryBook Of Original EntryThe book of original entries, or the first entry book, is where the entire journal entries are recorded with all the supporting documents & transactions details. It provides existence & accuracy of the financial transactions posted, recorded or transferred in the individual ledgers.read more, in which any business transaction is recorded for the very first time and in a chronological manner and there are rules of debit and credit which apply to such recording. Such rules vary with the nature of the accounts to be considered in the transaction.
Most popular classification is the Personal, Real & Nominal account and the rules of these are as follows:
#1 – Personal Account
A personal account is that of a person, company, an organization such as a bank, and so on.
- Debit the Receiver, Credit the giver
- Accounts that fall in this category are: Debtors, Creditors and so on
#2 – Real Account
Real AccountReal AccountReal accounts do not close their balances at the end of the financial year but retain and carry forward their closing balance from one accounting year to another. In other words, the closing balance of these accounts in one accounting year becomes the opening balance of the succeeding accounting year.read more is the account of tangible and intangible items such as inventory, cash, bank account, plant and machinery and so on
- DebitDebitDebit represents either an increase in a company’s expenses or a decline in its revenue. read more what comes in, Credit what goes out
- Accounts that fall in this category are: Cash, bank balance, stock of goods, Purchase, Sales, Plant & Machinery and so on
#3 – Nominal Account
This account is the account of profits, losses, incomes, and gains.
- Debit all losses and expenses, Credit all incomes and gains.
- Accounts that fall in this category are Profit, Interest, DividendDividendDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more, DepreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more.
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For eg:
Source: Rules for Journal Entries (wallstreetmojo.com)
Example of Rules for Journal Entries
Now let’s take a few example transactions to understand these rules in the business context:
On 1st April 2020, Ron & Daughters. started business with cash of $2000 that it received from the owner Mr. Ron
- This transaction deals with two accounts, Ron’s account, and Cash account
- Ron’s account is a personal account. Ron is the giver in this transaction, so his account should be credited. Owner’s account is called the Capital account
- Cash is a real account, and it comes in, so it should be debited.
On 2nd April 2020, Ron Inc. bought goods with cash for $200
- This transaction deals with two accounts; Purchase account for goods purchased and Cash account
- The purchase account is a real account. Goods come in, so the account should be debited.
- Cash is a real account, and it goes out, so it should be credited.
On 3rd April 2020, Ron Inc. Sold goods for cash for $300
- This transaction deals with two accounts; Sales account for goods sold and Cash account
- The sales account is a real account. Goods go out, so the account should be credited.
- Cash is a real account, and it comes in, so it should be debited.
On 4rth April 2020 Ron Inc. deposited cash in its bank account $500
- This transaction deals with two accounts, Bank account, and Cash account.
- A bank account is a real account, and it comes in, so the account should be debited.
- Cash is a real account and goes out, so it should be credited.
On 31st April 2020, Ron Inc. paid a salary to the employees $50 in cash.
- This transaction deals with two accounts, a Salary account, and Cash account.
- Salary account is nominal account, and it is an expense, so the account should be Debited.
- Cash is a real account and goes out, so it should be credited.
Rule from the Asset/Liability Classification
Let’s look at the rule from the Asset – Liability classification
- Assets are debited when they increase and credited when they decrease
- Liabilities are credited when they increase and debited when they decrease
Let’s look at all the above transactions of Ron & Daughters from this classification;
1st April
- The firm owes Ron the money he has invested in the firm, and therefore it is a liability from the firm point of view. As liability increases, Ron’s account is credited
- Cash is an asset, and it increases, so it should be debited.
2nd April
- Goods are assets, and they increase so the account should be debited
- Cash is an asset, and it decreases, so it should be credited.
3rd April
- Goods are assets, and they decrease so the account should be credited
- Cash is an asset, and it increases, so it should be debited.
4rth April
- A bank account is an asset, and it increases, so it should be debited.
- Cash is an asset, and it decreases, so it should be credited.
31st April
- Unpaid Salary is a liability, and that decreases so the account should be Debited
- Cash is an asset, and it decreases, so it should be credited.
We need to note a few points:
- Both methods lead to the same entries
- Each entry involves at least two accounts, what is debited, is also credited. It is known as the double-entry accounting system
Now let’s record the above transactions in a Journal Proper:
Note
We need to note a few points:
- Accounts that are debited have ‘dr.’ written against them
- In some countries, the word ‘To’ is avoided in the credit part of the entry
- F. stands for Ledger Folio. It is the column in which we write the page number of the ledger where this entry is posted
- Each transaction has a narration that describes what is happening in this transaction. In some countries, the word ‘being’ is not used while it is mandatory in other countries. These are minute differences, but the over-all accounting process remains the same.
- Journal is prepared for a period, such as a month, and the totals are carried forward to the next period.
- The total of debit and credit column should always match; otherwise, there is an error in recording.
- Sometimes there is an error in recording even when the totals match, such as the omission of entry, so this is not a fool-proof check, but it is still a check.
- Profit and loss are calculated at the time of creating a ledgerLedgerLedger in Accounting, also called the Second Book of Entry, is a book that summarizes all the journal entries in the form of debits & credits to use for future reference & create financial statements. read more and the preparation of Income statement. There are journal entries too for the same; however, for the sake of simplicity, these are not mentioned here.
Conclusion
So, to sum up, there are two classification methods, based on which journal entries are recorded. Each method has its own rules, but the resulting entries remain the same. Both the methods are based on the ‘Double entry system,’ which is the backbone of accounting and implies that every transaction involves recording in at least two accounts, one is debited while the other is credited.
Journal is the first book of accounts where the transactions are recorded in the process of accounting, and it is the most critical step. Any errors here can lead to mistakes in all of the future steps.
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