chapter 3 double entry bookkeeping
TRANSCRIPT
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CHAPTER 3
Double entry bookkeeping1 Assumptions underlying double entry bookkeeping
1.1 Introduction
Double entry bookkeeping is a system developed by the accounting profession to meet thedemands of management and proprietors.
Management need information on a regular basis (daily, weekly, monthly) in order tomanage the business.
Proprietors (owners) need information on a periodic basis in order to assess theperformance (profitability) and financial position of their business.
1.2 Three assumptionsDouble entry bookkeeping has three underlying assumptions.
Every transaction has two effects (the duality concept).
A business is a distinct entity separate from its owner (the business entity convention).
The net assets of a business represent the proprietors funds. This third assumption can besummarised in the following equation.
Assets liabilities = capital + profits losses drawings
1.3 Example
Mr Issey starts his business by investing $10,000 in a business bank account.
(a) Dual effect
$
An asset is created (cash) for the business 10,000
The business owes Mr Issey 10,000
(b) Separate entity
(c) Net assets = proprietors funds
Cash $10,000 = Capital $10,000
2 The balance sheet equation (or accounting equation)The third assumption is known as the balance sheet equation (or accounting equation). This isnow built up step by step in the following illustration.
Business
Business owes Mr Issey $10,000
ProprietorMr Issey
Cash $10,000
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2.1 The start of a business the first transaction
On 1 January Mr Sprake starts a business and places $1,000 of his own cash in the businessbank account. What has happened (from the business point of view)? We can work it through,using the double entry system.
Step 1
What has the business received? (+)$1,000 cash at the bank (owning).
Step 2
What has the business given? ()
It is now in debt to its owner by $1,000 (owing).
Step 3
Check that the dual aspect of this transaction has been recorded from the point of view of thebusiness.
Cash at bank $1,000. A promise to repay the owner of the business a $1,000 liability.
The accounting equation can be stated, at this stage, as follows:
Assets (cash at bank $1,000) = capital (l iability to owner = $1,000)
2.2 Definitions
We define the key terms as follows.
Assetsare those resources, physical objects or rights, which are controlled by the business
and from which future economic benefits are expected to be received.
Capitalis that amount of money (or other resources) that the owner invests in the businessand that is therefore owed by the business to the owner.
In its normal course of trading a business will have dealings with other businesses andindividuals. Debts owed by the business to other businesses and individuals other than theowner are known as liabilities.
Liabilitiesare debts owed by the business to other businesses or individuals apart fromtheowner.
Capital is the debt owed by the business to the owner only.
2.3 Further transactions
Now that you have been introduced to assets, capital and liabilities, we can develop theaccounting equation further. This equation is now stated as follows.
Assets = capital + liabilities
We continue with Mr Sprake.
We saw above that on 1 January Mr Sprake puts $1,000 of his own money into thebusiness bank account.
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On 2 January the business receives goods costing $250 from Cooper Ltd. The businessagrees to pay Cooper in one month.
On 3 January the business buys a vehicle for $500 and pays by cheque.
Enter these transactions into the accounting equation.
Step 1
List the assets, capital and liabilities.
Assets = capital + liabilities
$ $
1 January Cash at bank 1,000 Capital 1,000
_____Liabilities -
_____
Accounting equation 1,000_____
= 1,000_____
Step 2
Assets = capital + liabilities
$ $2 January Cash at bank 1,000 Capital 1,000
Inventory 250
_____
Liabilities
(payable to Cooper Ltd)
250
_____
Accounting equation 1,250
_____
= 1,250
_____
Note. The business has secured additional assets of inventory valued at their cost of $250.These were physically received.
The business has acquired additional liabilities; the company owes Cooper Ltd $250. It hasgiven a promise to pay this amount at a later date. This makes Cooper Ltd a creditor of thebusiness. A creditor is someone to whom the business owes money.
Step 3Assets = capital + liabilities
$ $
3 January Cash at bank 500
Inventory 250 Capital 1,000
Vehicle 500_____
Liabilities 250_____
Accounting equation 1,250_____
= 1,250_____
Now the business has replaced part of the cash asset with a new asset the vehicle.
The accounting equation will change after every transaction. This, however, does not meanthat every transaction will affect both sides of the equation. The transaction on 3 January
shows that both effects may be felt on the asset side only (+ vehicle and
bank) leaving theequation totals unchanged.
We can now develop the accounting equation further. The assets and liabilities of a businesswill be changing in response to everyday commercial transactions. For example every time abusiness buys goods on credit, it simply records an increase in goods (+) and an increase inpayables (+). However, what happens when a business sells these goods for a profit? Theprinciples are the same, and the following demonstrates this.
2.4 Continuing with Mr Sprake
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On 4 January goods bought for $150 are sold for $200 cash.
Assets = capital + liabilities
$ $
4 January Cash at bank 700 Capital 1,000
Inventory 100 Profit 50
Vehicle 500_____
Payable 250_____
Accounting equation 1,300
_____
= 1,300
_____
Cash has increased by the $200 cash sale, inventory has reduced by the $150 sold, leaving animbalance. The difference is profit.
This is the difference between the selling price and the cost price of the goods sold ($200 $150 = $50). Profit should be added to capital because profit belongs to the owner; therefore, ifthe business makes $50 profit, it automatically owes that $50 to the owner.
We can now state the accounting equation as follows.
Assets = capital + profit + liabilities
Therefore: Assets liabilities = capital + profit
Net assets = capital (since profit should be added to capital)
The total of assets less liabilities is called the net assets of the business.
2.5 Movements on capital
The final development to be made to the accounting equation relates to the fact that capital canbe further altered (+/) by one of two things.
Additional capital. The accounting records for this type of transaction are exactly thosewhich we used to record the opening of a business: assets are received (cash, or other
resources (+)) and capital (the debt owed by the business to the owner) is increased (+).
Drawings. This term refers to a transaction in which the owner withdraws resources (eggoods or money) from the business. The accounting records for this type of transactionare: account losing resources () (inventory or cash) and the capital is reduced ().
The following illustration shows how the second item affects the accounting equation.(Examples of the first are shown in the opening statements on the previous examples.)
2.6 Continuing with Mr Sprake - drawings
Mr Sprake now has the following assets and total liabilities (capital and payables).
Assets = capital + liabilities
$ $Cash at bank 700 Capital 1,000Inventory 100 Profit 50Vehicle 500
_____Payable 250
_____
Accounting equation 1,300_____
= 1,300_____
On 5 January, Mr Sprake withdrew $100 from the business bank account for his own personaluse. The business accounting equation after this is as follows.
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Assets = capital + liabilities
$ $
Cash at bank 600 Capital 1,000Inventory 100 Profit 50Vehicle 500 Cash drawings (100)
_____
950
_____
Payable 250
_____
1,200
_____
= 1,200
_____
Note. The withdrawal of $100 from the bank is shown by the bank falling by $100 from $700 to$600. Capital is similarly reduced by the withdrawal of assets from the business. The overalldebt of the business to the owner has fallen from $1,050 to $950.
One of the main uses of the accounting equation is to ascertain a missing figure. It is possibleto do this because we are dealing with an equation which must have both sides equal. This willbe dealt with in detail in the chapter on incomplete records.
2.7 The accounting equation: final form
The equation in its final form is stated as follows.
Assets = original capital + new capital + profit loss drawings + liabilities
or
Assets liabilities = original capital + new capital + profit loss drawings
This at first glance may appear long and complicated, but merely summarises the sections youhave already worked through. The assets and liabilities remain unchanged. The only partanalysed is capital, and this only confirms the work you have already completed.
We have stated that the capital owed by a business at any one time must be equal to thecapital originally put into the business, plus any additional capital input adjusted for profit (loss)and drawings. If you do not feel confident about this, you may wish to review the previoussection before going on. Please note that the accounting equation simply reflects the doubleentry. You will be tested on this principle many times throughout this work.
2.8 The accounting equation and the balance sheet
You saw the format for the balance sheet in Chapter 1. You should now be able to recognisethat a balance sheet is doing no more than stating the accounting equation at the balancesheet date. The assets (on the top half of the balance sheet) equal the capital plus liabilities(on the bottom half of the balance sheet).
3 Cash transactions
3.1 The double entry ruleThe dual effect of a transaction is shown using the following two entries.
A debit A credit
For every debit there must be a credit and vice versa. There is no exception to this rule.
These debits and credits are entered in ledger accounts or T accounts as follows.
Debit Credit
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On the left On the right
Again this has no exceptions. Debitsalways go on the leftof the account, creditsgo on therightof the account.
The debits and credits to a ledger account represent increases and decreases in the categorieson the balance sheet and in the income statement.
(a) For balance sheet entries (assets and liabilities) the entries in a ledger account mean thefollowing:
Ledger Account
Debit Credits
Assets - increase Assets - decrease
Liabilities - decrease Liabilities - increase
(b) For income statement entries (revenue and expenses) the entries in a ledger accountcan mean the following:
Ledger Account
Debit Credit
Revenue - decrease Revenue - increase
Expenses - increase Expenses - decrease
A good place to start looking at the rules of double entry bookkeeping is transactions involvingcash. (In the next section of the chapter we will look at transactions notinvolving cash, ie credittransactions.)
3.2 Example
Mr Issey makes the following cash transactions.
(a) Introduces $10,000 capital.(b) Buys a non-current asset for $5,000 cash.(c) Makes purchases of $2,000 for cash.(d) Takes out a $10,000 bank loan(e) Makes cash sales of $3,000.(f) Repays half the loan to the bank.
Write up the ledger accounts for these transactions.
3.3 Solution
Step 1
Establish the dual effect (ie which two accounts are affected).
Step 2
Are you increasing or decreasing those accounts? Use the two proformas above to allocate thedebit and credit in each transaction. Receipts of cash are shown as a debit in the cashaccount, while payments of cash are shown as a creditin the cash account.
Step 3
Write up the ledger accounts using the opposite entry account as narrative.
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Cash
Debit $ Credit $
(a) Capital 10,000 (b) Non-current assets 5,000
(d) Loan 10,000 (c) Purchases 2,000
(e) Sales 3,000 (f) Loan 5,000
Part (a)
Step 1 Cash Capital
Step 2 Increase: debit Increase: credit
Capital
Debit $ Credit $
Cash 10,000
Part (b)
Step 1 Non-current assets Cash
Step 2 Increase: debit Decrease: credit
Non-current assets
Debit $ Credit $
Cash 5,000
Part (c)
Step 1 Purchases Cash
Step 2 Increase: debit Decrease: credit
Purchases
Debit $ Credit $
Cash 2,000
Part (d) Part (f)
Step 1 Cash Loan Loan Cash
Step 2 Increase: debit Increase: credit Decrease: debit Decrease: credit
Loan
Debit $ Credit $
(f) Cash 5,000 (d) Cash 10,000
Part (e)
Step 1 Cash SalesStep 2 Increase: debit Increase: credit
Sales
Debit $ Credit $
Cash 3,000
4 Credit transactions
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4.1 Introduction
Up until now we have only considered cash transactions where cash changes hands at thetime of the transaction. Credit transactions mean that cash changes hands at a later date. Wenow need the concept of payables and receivables.
ReceivablesMoney owed to the business (by persons called debtors)Payables Money owed by the business (to persons called creditors)
4.2 Example
Going back to Mr Issey, he makes the following credittransactions.
(a) Bought goods for resale of $5,000(b) Made sales of $2,000(c) Bought further goods for resale of $2,000(d) Paid his creditors $3,000 by cheque(e) Made sales of $4,000(f) Received money from debtors of $1,000 by cheque
Using the same three step process as for cash transactions write up these transactions, in theappropriate ledger accounts.
4.3 Solution
Part (a) Part (c)
1 Purchases Payables 1 Purchases Payables
2 Increase: debit Increase: credit 2 Increase: debit Increase: credit
Purchases
$ $
(a) Payables 5,000
(c) Payables 2,000
Payables
$ $
(d) Bank 3,000 (a) Purchases 5,000
(c) Purchases 2,000
Part (b) Part (e)
1 Sales Receivables 1 Sales Receivables
2 Increase: credit Increase: debit 2 Increase: credit Increase: debit
Sales
$ $
(b) Receivables 2,000
(e) Receivables 4,000
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Receivables
$ $
(b) Sales 2,000 (f) Bank 1,000
(e) Sales 4,000
Part (d) Part (f)
1 Payables Bank 1 Bank Receivables
2 Decrease: debit Decrease: credit 2 Increase: debit Decrease: credit
Bank
$ $
(f) Receivables 1,000 (d) Payables 3,000
5 Balancing ledger accountsAt the end of a period once all the transactions have been entered into the relevant ledger
accounts, they can be balanced off. This is illustrated with the example receivables account forJuly below.
Step 1
Rule off the ledger account.
Receivables
$ $
1.7 Sales 200 5.7 Cash 200
12.7 Sales 1,000 17.7 Cash 800
15.7 Sales 800
20.7 Sales 2,000
_____ ___________ ______
Step 2
Total both sides of the ledger account, inserting the greater total into both sides.
Receivables
$ $
1.7 Sales 200 5.7 Cash 200
12.7 Sales 1,000 17.7 Cash 800
15.7 Sales 800
20.7 Sales 2,000_____ _____
4,000
_____
4,000
_____
Step 3
Enter a balancing figure on the appropriate side. This is the carried forward figure.
Receivables
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$ $
1.7 Sales 200 5.7 Cash 200
12.7 Sales 1,000 17.7 Cash 800
15.7 Sales 800
20.7 Sales 2,000
_____
31.7 Carried forward 3,000
_____
4,000_____
4,000_____
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Step 4
Bring down the balance on the opposite side of the ledger account to open the account in thenext period.
Receivables
$ $
1.7 Sales 200 5.7 Cash 200
12.7 Sales 1,000 17.7 Cash 800
15.7 Sales 800
20.7 Sales 2,000
_____
31.7 Carried forward 3,000
_____
4,000
_____
4,000
_____
1.8 Brought forward 3,000
The account had a total of debit entries representing sales to credit customers of $4,000. It alsohad a total of credit entries of $1,000 representing receipts from debtors. This leaves $3,000still owed by debtors. Receivables are a debit balance and so the carried forward swaps over
to the debit side to show the true balance.
6 Extracting the trial balance
6.1 Introduction
Once all the ledger accounts have been balanced the balances on each account can beextracted and a trial balance (also called a list of balances) compiled.
The trial balance does not form part of the double entry system. It is merely a memorandumlisting of all account balances at a particular date.
Throughout this text so far we have been applying the double entry concept: for every debitthere should be a matching credit. If this has been completed accurately the sum of the list of
debit balances should equal the sum of the list of credit balances, as shown in the examplebelow.
Trial balance for Bertie Dooks as at
Debit Credit
$ $
Cash in hand 4,534
J Fox (payable) 100
Schoolmaster (receivable) 2
Capital account 5,000
Sales 38
Purchases 415
Rent 150
Repairs 25Advertising 2
Cleaning 5
Drawings 5_____ _____
5,138_____
5,138_____
In summary:
Debit Credit
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$ $
Assets XExpenses XDrawings XLiabilities XIncome XCapital
___X
___
X___
X___
6.2 Example
The following are the balances on the accounts of Ernest at 31 December 20X8.
$
Sales 47,140Purchases 26,500Receivables 7,640Payables 4,320General expenses 9,430Loan from father 5,000Plant and machinery 10,500
Accumulated depreciation on plant and machinery 3,200Motor van 4,600Accumulated depreciation on motor van 1,950Drawings 7,500Rent and rates 6,450Insurance 1,560Bank overdraft 2,570Capital 10,000
Required
Prepare Ernests trial balance as at 31 December 20X8.
6.3 Solution
Step 1 Set up a blank trial balance
TRIAL BALANCE AT 31 DECEMBER 20X8
$ $
SalesPurchasesReceivablesPayablesGeneral expensesLoan from fatherPlant and machineryAccumulated depreciation on plant and machineryMotor vanAccumulated depreciation on motor van
DrawingsRent and ratesInsuranceBank overdraftCapital
Step 2 Work down the list of balances one by one using what you have learned so farabout debits and credits. The totals of the two columns should agree.
TRIAL BALANCE AT 31 DECEMBER 20X8
$ $
Sales 47,140
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Purchases 26,500
Receivables 7,640
Payables 4,320
General expenses 9,430
Loan from father 5,000
Plant and machinery 10,500
Accumulated depreciation on plant and machinery 3,200
Motor van 4,600Accumulated depreciation on motor van 1,950
Drawings 7,500
Rent and rates 6,450
Insurance 1,560
Bank overdraft 2,570
Capital______
10,000______
74,180______
74,180______
7 Closing the ledger accounts
7.1 Introduction
Once the accounts have been finalised at the end of any accounting period where an incomestatement and balance sheet are to be compiled, the ledger accounts must be closed off readyto start afresh in the next accounting period.
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Step 1
Split the ledger accounts between income statement accounts and balance sheet accounts.(You may want to refer back to the proformas in Chapter 1.)
Revenue accounts Income statement
Expense accounts Income statement
Assets Balance sheetLiabilities Balance sheet
The two exceptions are capital and drawings. These will be dealt with later.
Step 2
A balance on a balance sheet account represents an asset or a liability at the balance sheetdate.
All balance sheet accounts remain as carried forward/brought forward balances because allassets and liabilities are taken forward into the next accounting period.
Step 3
A balance on an income statement account represents revenue or expenses to be shown inthe income statement for the period.
All income statement balances are transferred into a new ledger account, called the incomestatement ledger account. This will be done using double entry.
Follow the transfers in the following illustration.
7.2 Example
Sales
$ $
Income statement 3,000 Cash 1,000
Receivables 1,500
_____
Cash 500
_____
3,000
_____
3,000
_____
Purchases
$ $
Payables 1,000 Income statement 1,800
Cash 800
_____ _____
1,800
_____
1,800
_____
Income statement
$ $
Purchases 1,800 Sales 3,000
Now introduce closing inventory of $300.
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$ $
Debit inventory Balance sheet 300
Credit inventory Income statement 300
Income statement
$ $
Purchases 1,800 Sales 3,000Closing inventory 300
Gross profit c/d (bal fig) 1,500_____ _____
3,300_____
3,300_____
b/d 1,500
The trading section of the income statement now shows the gross profit carried down andbrought down. If we introduce the expenses, net profit will be the result.
Rent
$ $
Cash 200 Income statement 400
Cash 200
____ ____400
____400
____
Wages
$ $
Cash 100 Income statement 300
Cash 200____ ____
300____
300____
Income statement
$ $
Purchases 1,800 Sales 3,000
Gross profit c/d 1,500_____
Closing inventory 300_____
3,300_____
3,300_____
Gross profit b/d 1,500
Rent 400
Wages 300
Net profit in the period 800_____ _____
1,500_____
1,500_____
What is the relationship between this income statement ledger account and the incomestatements we discussed in Chapter 1? The answer is that the income statement ledger
account is a part of the double entry bookkeeping system. However, in itsraw
form it may notconvey clear information to users of accounts. To overcome this problem, we extract and
summarise the information from the ledger account and present it in the type of format shownin Chapter 1. Essentially, the income statements we saw in Chapter 1 are simply a re-arrangement of information extracted from an income statement ledger account.
Step 4
The net profit figure is then transferred to capital along with the balance on the drawingsaccount.
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Capital
$ $
Drawings 500 Brought forward 10,000
Carried forward 10,300
______
Income statement 800
______
10,800
______
10,800
______Brought forward 10,300
8 SummaryLedger accounts for income and expense items are closed off at the end of each period bytransferring their balances to the income statement. In the normal case, this means that nobalance remains on the income and expense ledger accounts: we begin the next accountingperiod with a clean sheet. (We will see an exception to this when we discuss accruals andprepayments.)
The income statement ledger account is then closed off by transferring its balance (the netprofit for the period) to the capital account. No balance remains to be carried forward to thenext accounting period. The same procedure applies to the drawings account; again, thebalance is transferred to the capital account.
This means that the only accounts remaining with balances to be carried forward are those forbalance sheet items (namely assets, liabilities and capital).
The process so far is as follows.
In the next four chapters we consider the end of period/year adjustments made to the trialbalance figures to complete the final accounts.
Cash and credittransactions
Ledger accounts
Balanced
Trial balance extracted
Ledger accounts closed
Financial statementsproduced