Journal Entries: Business Formation Example - Online Tutor, Practice Problems & Exam Prep

Journal Entries: Business Formation

Alright, so now let's get a lot of practice making journal entries by following through an example of a business formation. Let's check it out. For this example, I thought I would pay homage to Clutch Tutoring back to when we started a few years ago. Initially, we just focused on one university here in Miami, FIU, and we had live tutoring sessions where students would come to our office for tutoring sessions, live reviews for their exams, and things like that. Now, obviously, the business model has changed, but through our example, you can see kind of an homage to the business. So, let's check it out here.

Upon establishing Clutch Tutoring Inc, Johnny Clutch paid $50,000 for which the company issued common stock. In this case, remember what we are doing is taking all these sentences and analyzing them to find out what the transaction is. So what do we see? Johnny Clutch, an owner of the business, paid $50,000 in cash into the business. The business received $50,000 in cash. What did they give up for that $50,000? The company issued common stock. They gave common stock to Johnny Clutch for starting the business. Now, Clutch Tutoring exists with this $50,000 of cash that Johnny put into the business.

You can imagine before this transaction, everything was zero—there were zero assets, zero liabilities, zero equity; essentially, the company didn't exist. Now here we go, we're going to start the company and input $50,000 in cash. Cash, as we know, is an asset account. Now, what about common stock? Do you remember what common stock is? Common stock is an equity account. It totally makes sense here. The owner of the business put money into the business and they get equity; they own that part of the business. They didn't loan this money from a bank or anything; this is money that the owners put into the business, so it's equity. In this situation, what's going to happen is that the company is increasing its cash but also increasing equity.

Remember, there have to be at least two things that happen in every transaction. To increase our cash, do we need a debit or a credit? Cash is an asset and assets go up with debits. So, we're going to debit cash and write here the amount: $50,000. What about the other side of the equation? We are trying to increase our equity. Remember, equity accounts go up with a credit. So, we want to increase our equity because of the common stock that we just issued. We're going to put common stock as the credit. It's indented, and we're giving it $50,000. So, the common stock increased by $50,000, and cash went up by $50,000. Let's see what happens to our accounting equation down here.

Assets equal liabilities plus equity. This goes up by $50,000, resulting in a total of $50,000. Nothing happened with liabilities; we didn't take out any loans, we don't owe anybody any money, but our equity also went up by $50,000. Now, we've got equity of $50,000, and our equation balances. Our assets equal our liabilities plus equity: $50,000 assets equals 0 + $50,000, giving us a balanced equation. So, we're totally good here. This is everything that goes on in this problem.

Alright? So let's go on, and we're going to pause here; in the next video, we'll do the next transaction. Let's do that now.

Journal Entries: Business Formation

Alright. So let's continue here. Clutch purchased $40,000 of land with cash. Alright? So Clutch purchasing land with cash, right? They had $50,000 in cash that Johnny Clutch put into the business and now they're going to spend some of it on this land, alright? So let's see what happens. We have to figure out what accounts are going to be affected. We have $40,000 of land, right? We know that land is going to be affected and cash, right? We paid for that land with cash, okay? So how are we going to do this? We need to build our journal entry with debits and credits. So let's think of the accounts. First, we have land. Is land an asset, liability, or equity? Well, it's a long-term asset, right? Land is a long-term asset. It's something that the company owns and is going to use in their business, right? So this $40,000 in land, that's an asset and cash, well, I'm not going to ask you about cash again, but cash is an asset, right? That's our first pure asset right there is the cash. So they're both assets. That means they go up with debits and down with credits, right? Assets. So which one's going to go up? Land or cash? Well, we purchased land, right? We purchased land so we want the land account to go up. So will that be a debit or credit? It's going to be a debit. Right? So we're going to write land and we're going to put $40,000. So this is increasing the land account by $40,000 but we gave up cash for that, right? So our cash is going down and we have to credit it to make it go down, right? Assets go down with a credit, so the cash is going to decrease, by $40,000 in this transaction. Right, so if we go back above, we had ended the previous transaction with a balance of $50,000, right? That's what we got out of that first transaction and now let's add the effects of this transaction. Well, the land is going up by $40,000, right? So our assets are increasing by $40,000, but our cash is decreasing by $40,000, right? So those are going to wash out there. So after this transaction, our assets are still $50,000, our equity is still $50,000, still no liabilities. But if you think about it, our assets have changed, right? Before this transaction, we just had $50,000 in cash. Now our assets are made up of a mix. Now we have $40,000 worth of land in our assets as well as another $10,000 of cash, right? So we converted some of that cash into a different asset. Alright? So that's about it for this transaction. Let's pause and move on to the next video.

Journal Entries: Business Formation

Clutch purchased $8,000 of Supplies on Account. Okay. So I put this in bold because it's the first time we're seeing this, but what "on account" means, they use this term in sentences all the time. When you see "on account," that means you didn't pay cash, didn't pay cash, okay? So you basically gave an IOU. You gave an IOU, you're going to pay at some future date, okay?

The journal entry here, what's gonna happen? We have $8,000 of supplies, right? So you can imagine that $8,000 supplies is gonna be one of the things that we're going to be dealing with in this transaction, right? So the supplies is gonna be one of our one of the accounts we're gonna work with here and in supplies, what kind of account is that? Is that an asset, a liability, equity? Remember that supplies could be like office equipment, you know like pens and paper, notepads, things that we needed to start the tutoring company, right? So he bought all these supplies. Those are assets to the company, right? They're things that are owned by the company. They have this value of $8,000 and they're going to be used by the company, right? So supplies is an asset.

But what's gonna be the other side of this transaction? We didn't pay cash, right? We didn't pay for this in cash so how could we account for that? Well, the trick is we have a liability now, right? Since we didn't pay it yet, we have a liability to pay it in the future, right? We didn't pay it off already, but at some future date we're gonna have to do that. So the other side of this transaction is gonna be a liability, alright? Which liability are we gonna use? Well, the one we use for all our day-to-day operations, it's kind of a catch all, is going to be our accounts payable. Okay? Accounts payable. And that's usually the one you're gonna hit when you see this sentence form where you see on account, where you buy something on account, that means you're gonna hit accounts payable as the liability. Remember, accounts payable, that's a liability and that means we have accounts that we have to pay out, right?

So let's go ahead and build this journal entry. We know that we got supplies, right? Supplies are an asset and we increase those with a debit. So we're going to start with supplies here as our debit and we're going to give it 8,000. Right? That is the value of the supplies and what's the value of the liability? That's the amount we're gonna have to pay in the future and that's the 8,000 as well, right? So what we're gonna do is we're gonna credit accounts payable. Okay? So we would write it here with the indentation to show that it's a credit and remember that our liabilities such as accounts payable, they go up with credits, right? When we credit a liability that is increasing the value of the account, so this is now telling us that we owe $8,000 right? Now our balance sheet is going to show an accounts payable that says hey, you owe $8,000, okay?

So let's go ahead and see what happened to our balance sheet equation here. So from the previous equation, we ended in a situation where we had 50,000 in assets and remember that 50,000 we had some cash in there and we have land value in there. There were no liabilities and there was 50,000 in equity from when Johnny Klutch started the business. Right? So now what's going to happen? Well, supplies was an asset account, right? This was an asset here and this was a liability, right? Accounts payable was a liability. We're gonna have to pay this $8,000 in the future. So our assets are gonna go up by 8,000. Now the total value of the company here has 58,000 of assets, but how are we funding those assets now? Well, our liabilities went up by 8,000, right? We have 8,000 that we have to pay in the future and our equity hasn't changed, our equity is still just 50,000, right? So there we go, we're balanced we're still balanced. I'm in the way. Notice we're still balanced, we've got 58,000 of assets, 8,000 of liabilities, 50,000 of equity. The equation stays balanced, alright? So let's go ahead and keep doing more transactions. You'll kind of gonna see a flow and you're gonna get better at this as we do more and more practice.

Journal Entries: Business Formation

Clutch held several reviews throughout the month, charging $5,000 to its customers on account. So on account, look, we're seeing that again. So remember that what we saw on account before, it was a situation where we didn't pay something, right? We had received something, but we didn't pay. In this situation, it's the opposite. We gave something to the students; we gave them the reviews. The reason we're in business is to create these reviews and get the students to come in, but we didn't charge them right away. This might have been an old business model, I'm just kidding, we never really did an on account system, but it just helps with our example here. So, the idea is we had this review, and we had so much faith in the students that they would pay us; we're like, hey, you don't have to pay us right away, just come to the review, and then you can pay us later.

Well, so what happens in that situation? We charged $5,000 to the customers, but we didn't receive that in cash. We sold we told them they can pay us later. So this one's actually going to be kind of tricky; this is where things get a little hairy in the minds of students. When they see this charging $5,000, they might think that we received $5,000 in cash. No. What we did is we gave the students $5,000 value of services. We provided these services that were worth $5,000, and these reviews are the reason we're in business. So this $5,000, this is actually revenue. This is the reason we're in business: to do these reviews, and we earned this $5,000 by having this review throughout the month, and we brought in $5,000 worth of revenue.

So, notice it's not cash that we got in this situation. We got $5,000 in revenue, but what else? On this side, they didn't pay us right away, so we didn't get cash. What we got was an IOU from the customer. So, in this case, we're receiving the IOU. So what we have is accounts receivable in this case. We have an asset where we're going to eventually receive some money. Let me write 'receivable' better for you so you can see it. Accounts receivable. This means that at some future date, we're going to receive some money, right, and that is due to this $5,000 from the review.

So, since the $5,000 is revenue, do revenues go up with a debit or a credit? So remember that revenues go up with a credit. And what about accounts receivable? Is that an asset, liability, or equity? Well, that's an asset. Accounts receivable, we have the right to get money in the future, so that is an asset to the company. We are going to eventually get some money from our customer that they already owe us, right? Not eventually they're going to take another review in the future. No, this is money they already owe us because we gave them the review.

The accounts receivable is an asset. So assets go up with debits, and we received this accounts receivable, we need to increase the accounts receivable account. So we're going to debit accounts receivable because we want to increase the value of that account. We want accounts receivable to reflect this $5,000 that the students owe us. Now, what's the other side of the transaction? We have a debit here; we need to credit something. And we said we're going to credit revenue. This is the money we brought in from having these reviews. There's a bunch of different things we could call it; we could call it sales, we could call it revenue, sales revenue, service revenue, fees earned, all sorts of things. There's no correct way to label it, but the most common is going to be something like sales revenue. That is what I suggest you always use if you don't have any other inkling to go. If the teacher didn't cue you to use something else, just use 'sales revenue' for your revenue account. So we're going to credit that $5,000, and remember that revenue accounts increase with credits.

So, that's what's happened here. And if you remember from our previous problem, we had ended with assets of $58,000, liabilities of $8,000, and equity of $50,000. Our equation was balanced, and we had these amounts. So what's going to happen here? If you think about it, our accounts receivable, well, we know that's an asset. What about sales revenue? Where do you think that's going to fall? Is it going to fall under an asset, a liability, or equity?

So we had talked about this a little, but I feel like it could be tricky. The revenues and the expenses are all equity. Everything that the company does, every time we hold a review and make money, every time we pay our tutors, every time we do something, that goes into the equity of the company. So every time we have a revenue, that's going to increase our equity, and every time we have an expense, that's going to decrease our equity.

This should make sense because we receive more money. We received more assets in this case of $5,000, but we don't owe anybody money for that. There's no liability. We don't owe somebody money for earning this; this money is ours because we earned it. So what's going to happen is our assets go up by $5,000, bringing it to a total of $63,000. That $5,000 increase is the accounts receivable. Eventually, our customers are going to pay us, and we're going to have that $5,000 in cash. But we already have rights to that money, our liabilities aren't going to change. There's nobody that we owe anything from this transaction, but our equity is going to increase as well. So all those revenues increase our equity, all the expenses will decrease our equity. In general, when we prepare this stuff, these revenues and expenses, we're going to wait to produce an income statement before we affect equity. We would total all our revenues for the year, all our expenses, get a net income, and that's what would affect our equity, but really on a transaction by transaction basis, this is what's really happening: This revenue increased our equity, and if we have an expense, it's going to decrease our equity.

Cool? Alright. Let's pause here and move on to the next transaction.

Journal Entries: Business Formation

Clutch paid its tutors for the month in cash for a total of $3,000. So boom, when you see cash, well, we've got that part down, right? Cash is going to be affected here for $3,000, and was cash increased or decreased in this case? Well, Clutch had some money and they paid it to their tutors, right? So they're going to have less cash. Therefore, we are going to end up crediting cash. So I am going to write the cash part and I am going to leave it indented already. I know cash is going to be credited for $3,000, right? We're going to credit cash for $3,000; that one's the indented one because we know we have $3,000 less in cash.

Now, what about the other side of the transaction? We know it's going to be a debit, right? We paid our tutors an amount of money. Is there an asset related to this? A liability? Maybe a revenue? Or what about an expense? This is an expense, right? We're paying our tutors. The tutors are employees of the company, and we're paying them for doing their job, which earns us our revenue, right? So, this money that we pay to our tutors is going to be an expense. OK? So it's going to be an expense, but we always want to be a little more clear. We want to be transparent with what kind of expense this really is. So when we talk about paying our employees, we usually say something like wage expense. OK, wage expense, maybe salary expense if they are salaried employees, something like that, right? So, wage expense is going to be our debit here, right? Remember that expense accounts go up with a debit.

So, let's go ahead and put that in, and notice I had done my credit part of the entry first because it was easy since I knew that cash was going to be credited. So I got it out of the way and then spent my time figuring out the more difficult part, the wage expense. Right? So we have the debit to wage expense for $3,000. So, there's our full journal entry, right? It balances out. Our debits equal our credits. Wage expense for $3,000, cash for $3,000. Alright?

So what's going to happen here? Let me scroll up and see our final balances from before. So, we had ended with $63,000 in assets, $8,000 in liabilities, and $55,000 in equity, and we were balanced at that point. Assets equal liabilities plus equity. And what happened in this transaction? Well, our cash went down by $3,000, right? So our assets are going to decrease by $3,000 to a new total of $60,000. What about the wage expense? We just talked about this, right? Revenues increase our equity and expenses decrease our equity, right? So, that's exactly what's going to happen here. We don't owe anybody any more money, right? We don't owe the tutors any more money, we don't have a liability to them, we just paid them. So what's going to happen is an equity transaction, and we are going to decrease - sorry, I'm trying to get out of the way here. I'm just going to do that and we are going to decrease equity by $3,000, right? Minus $3,000 to a total of $52,000.

And I want to make one more point about this revenue and expenses in equity. If you remember, equity goes up with credits, right? And when we have a revenue, we're crediting equity to increase equity, and when we have a debit to expenses, well, that's a debit to equity, which decreases equity, right? You following me? Equity goes up with credits, so do revenues, and debits to equity bring it down, which is what the expenses do. Alright, so that's the flow there and notice we still have a balanced equation. Now we have assets of $60,000, liabilities of $8,000, and equity of $52,000. Alright. So let's go ahead and pause and continue on to the next transaction.

Journal Entries: Business Formation

All right. Clutch received payments on account from customers totaling $3,500. So remember when we had those reviews for the customers? Well, they were allowed to pay us on account; we didn't tell them to pay us right away, they could pay us in the future. We had some accounts receivable, right? And what's happening in this transaction is we're receiving some of that money. We had an IOU where people were going to pay us money in the future and the time has finally come, the money has been received and we have now received it. So, that's exactly what I'm getting at.

So, we received $35,100, right? There's actual cash that we received in the mail or whatever, we got $35,100. So this $35,100 is cash that we received. But what's the other side of the transaction here? Well, if you think about it, we were previously owed $5,000, right? The accounts receivable was $5,000 but we're no longer owed $5,000; we received some of that money. So our accounts receivable need to go down. We no longer have the $5,000 in accounts receivable, we have less, right? Minus this $35,100.

The other side, received payments, when we see these received payments on account, we're receiving something so it had to be a receivable. This is accounts receivable is the other side of the transaction. Accounts receivable and I'm going to take this liberty right now to use an acronym for accounts receivable, AR. This is a very common acronym that we use—AR for accounts receivable, okay? So throughout the course, we'll probably just start using AR to save time and you will get used to all sorts of little acronyms and stuff that we'll use throughout the class.

So what happened here? Cash. We received 3,500 in cash, so is that a debit or a credit? Well, we debit cash, right? Assets go up with a debit. That's an asset right there. So we're going to have $35,100 right here and that's a debit to cash to increase the cash since we just received some and the other side is going to be the accounts receivable, right? We have to credit that. We have to decrease the value of accounts receivable because we're no longer owed the same amount of money. Some of that money has come in.

So I'm going to go ahead and I'll just write it all out here since it's still early. Accounts receivable and that was $3,500, right? So there's our credits for $3,500. We decrease the amount of money that is owed to us because we received some of it.

Alright, so we ended the last transaction with $60,000 in assets, $8,000 in liabilities, and $52,000 in equity. So what happened in this transaction? Cash is an asset, accounts receivable is also an asset, right? So we're going to increase our assets by $35,100, but then also decrease our assets by $3,500, and we're left with $60,000 in assets again, $8,000 in liabilities, and $52,000 in equity.

Alright? So nothing changed in the accounting equation, but the balance of the accounts changed, right? Cash now there's more cash on our books, there’s less accounts receivable on our books, right? So that's about it for that transaction. Let's go ahead and pause and move on to the next one.

Journal Entries: Business Formation

All right, how about here? Clutch paid a dividend to its stockholders in the amount of $500. So they're going to pay a dividend to their stockholders, so then you know we're going to be dealing with dividend expense. Just kidding, right? There is no such thing as dividend expense. This dividend is a pull from our retained earnings, from the money that the company has brought in, well, we're going to take $500 out of that money, out of our equity and pay it out to the stockholder, right? So that's what's going to happen. This $500, it's cash, right? We're going to pay the stockholder cash, but it's coming out of our equity. It comes out of the equity of the company when we pay a dividend, okay? So there's no such thing as dividend expense, this is strictly coming straight from retained earnings. This isn't going through the income statement, we're not going revenues and expenses and dividends is going to be listed in there, no. Dividends come straight out of the equity, it doesn't affect our income statement, our revenues, expenses, none of that.

Okay? So dividend is an equity account, but it's an interesting equity account because it works opposite of equity. If you think about it, we're not increasing our equity in this case, right? We're decreasing our equity, right? We want to decrease our equity because we're taking $500 out of the company. So what's going to happen here? We know that this cash, right? We had $500 in cash, and we paid it to the stockholder, right? So what's going to happen is a credit to cash, right? We need to decrease our cash with a credit for $500, right? So that's the credit side of this transaction to decrease cash, but what about the debit side? We need to decrease equity, right? Equity, if you remember, equity goes up with credits and down with debits, right? So what's going to happen here is we're going to debit this dividends account, and this dividends account is basically where we're going to hold all the amount that we paid in dividends, and it's going to go into our retained earnings.

So $500 was paid in dividends, and remember that a debit to dividends being an equity account and this one was an asset account, right? Dividends being an equity account, a debit there decreases the value of the equity, okay? So that's what's going to happen here. In our last question, we ended with $60,000 in assets, 8,000 in liabilities, and 52,000 in equity, right? But now, our assets are going down, right? We paid $500 out, but it doesn't affect our liabilities, this is nothing we have to owe people. This is coming straight out of our equity. We're gonna decrease our equity by $500 as well, okay? So this is gonna get us to a total here of $59,500. Liabilities are still $8,000. We now have our equity of $51,500. So this still balances out, our assets equal our liabilities plus our equity, cool? Let's go ahead and move on to the next one.

Journal Entries: Business Formation

Johnny Klutch was excited about the company's success and bought his girlfriend a new car for $20,000. Alright, so in this case, we've got a new car for $20,000, right? But this is a trick, right? Johnny Klutch bought this car for his girlfriend; this has nothing to do with the company itself. This is a personal transaction of Johnny Klutch, right? This doesn't have anything to do with the company, Klutch Tutoring. He took his own money and bought his girlfriend a car. Regardless of whether the money came from the company or not, this has nothing to do with the company, so there should be no journal entry. Okay? And it's not going to affect the books at all. There should be nothing written about this. This is just a personal transaction of Johnny Klutch. This goes back to the assumptions that we have in financial accounting. One of the assumptions is the economic entity assumption, and this is where we separate the economic entity, Tutoring, from Johnny Klutch, the stockholder, right? So the personal transactions of Johnny Klutch should not affect the company, Clutch Tutoring. Alright, so this was a trick question here and you could expect to see things like this where you're going to see that they give you some kind of odd entry that has nothing to do with the company, okay? In that case, we don't make a journal entry; it shouldn't go into the company's books. Alright? Obviously, in future accounting classes, we're going to teach you all sorts of ways to evade taxes and you know, do all sorts of accounting gymnastics, but as of now, I'm just kidding, we're not going to get into any of that, but it would be pretty fun, right? Alright. Let's go ahead and move on to the next video.