Double Entry Bookkeeping

1 Introduction

In the previous chapter we looked at the fact that every transaction has two effects, and also looked at the layout of the financial statements.

In order to be able to produce the financial statements at the end of the period, a record needs to be made of every individual transaction as it occurs. This is known as bookkeeping, and in this chapter we will look at the standard way in which bookkeeping is done.

2 The nominal ledger

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Every item in the Statement of Financial Position or Statement of Profit or Loss will have an ‘account’ in which we will keep a record of that item. The ‘account’ used to always be a page in a book, but these days may be a page in a book, or, more likely, a record on a computer.

The book or file containing the accounts is known as the nominal ledger (or general ledger), and the accounts are called ledger accounts.

If the account is in a book then when we open the book there are two pages facing us. We use both of the pages for the recording, and we represent the two pages as below:

The left hand page is always called the debit side, and the right hand page is called the credit side.

If we make an entry on the debit side, we say that we debit the account. If we make an entry on the credit side, we say that we credit the account.

For every transaction there will be two entries – one on the debit side of an account and one on the credit side of another account. We call this double entry.

Against each entry we write the name of the account that holds the other half of the double entry, so that it can always be traced. The abbreviations are Dr for debit and Cr for credit, and “a/c” for account. In practice most transactions are first listed in a book of prime entry (Chapter 10) and then posted to the ledger accounts. Most businesses now keep the nominal ledger on a computer, but the software follows exactly the same rules.

3 The general rules of double entry

A debit entry represents one of the following:

• an increase in an asset

• a decrease in a liability

• an item of expense

• a decrease in capital (for example, drawings by the owner)

A credit entry represents one of the following:

• an increase in a liability

• a decrease in an asset

• an item of income

• an increase in capital (for example, capital introduced by the owner)

The same rules in one table:

Day by day, almost every transaction is one of four types. If you remember that cash received is a debit in the cash account and cash paid is a credit, the rest follows:

Goods bought for resale are always debited to a Purchases account, not to inventory: the word inventory is kept for goods still unsold at the end of the period (Chapter 9). Every sale is credited to Sales, whatever the goods cost.

4 Worked example

We will work through the following entries together (use big t-accounts, because we will do other things later with the same accounts):

5 Balancing the accounts

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In the previous example we have now recorded all the entries. However, before we can go further we need to calculate the net figure, or balance, on each account.

With such a small example, the balances may be obvious. However we should balance it neatly.

The rules for balancing are:

1. draw total lines on both sides of the t-account

2. add up the bigger of the two sides and put this total on both sides of the account

3. fill in the missing figure on the smaller of the two sides – this figure is the balance on the account

4. carry forward this balance by also writing it on the opposite side of the account, below the total lines.

The figures above the total lines can now be effectively ignored, because we have replaced them by the net figure or balance, below the total lines.

An account with only one entry does not need balancing — the entry is the balance. You may see the balance labelled “c/d” (carried down) above the total lines and “b/d” (brought down) below them; this chapter simply writes “Balance”.

6 The trial balance

Although we now know the balance on each account, there are many mistakes that we could have made. For instance, when recording the transactions we could have accidentally debited and credited with different figures. A very common error is to enter (say) $1,200 in one account but $2,100 in the other account. This is known as a transposition error.

There is a very simple and quick check we can make to see if the debits and credits are equal.

The check is to list the balances on every account. The total of the debit balances should equal the total of the credit balances.

We call this list the Trial Balance.

Note that the trial balance is not a T-account – simply a list.

Note also although there must be errors if the trial balance does not balance (and we would have to check everything to find the errors), there can be errors that will not be found by preparing a trial balance.

Errors that will not be revealed from the Trial Balance:

These errors leave the total debits equal to the total credits, so the trial balance still agrees. The examples use Christine’s purchase of a car for $1,000 cash (correct entry: Dr Car, Cr Cash):

Errors that are revealed (because the debits no longer equal the credits) include an entry made on one side only, a different amount on each side (such as the transposition error above, $1,200 and $2,100), both entries on the same side, and a mistake in adding up an account. A small difference on a trial balance may still hide large compensating errors. Chapter 13 shows how errors are corrected.

7 Closing off the accounts

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Now that we have recorded all of the transactions and have checked that the double entry is correct, we are in a position to produce the financial statements.

We do this by examining each account in turn and ‘closing off’.

The rules for this are as follows:

Statement of Financial Position items:

These are assets and liabilities. They exist at the end of the period, and still exist at the beginning of the next period.

We therefore simply leave the balance on the account.

Statement of Profit or Loss items:

These are total income or expense for the period. We have now finished with the current period but wish to use the same accounts to record the income and expenditure of the next period.

We do this by opening a new account in the nominal ledger called Statement of Profit or Loss.

For items of income, the entry is:

• Debit the Income t-account, and

• Credit the Statement of Profit or Loss t-account

For items of expenditure, the entry is:

• Debit the Statement of Profit or Loss t-account, and

• Credit the Expense t-account

Each income and expense account is left with a nil balance, ready to record the next period’s income and expenses. Drawings are not an expense: the drawings account is a statement of financial position item and its balance is left in place.

8 Preparation of the Financial Statements

Having closed off all of the t-accounts, the balance remaining on the Statement of Profit or Loss account is the profit (or loss) for the period.

We can now produce a ‘pretty’ version of the Statement of Profit or Loss suitable for presentation to the owner by re-writing the figures from the t-account in the standard format.

The balances remaining on the accounts all represent Statement of Financial Position items. We can now list them in the standard format to produce our Statement of Financial Position.

Note that this preparation of the Statement of Financial Position and Statement of Profit or Loss does not result in any additional entries in the t-accounts.

9 ‘Tidying up’ the owner

Although the financial statements are now finished, the amount owing to the owner at the end of the period is split between three accounts in the nominal ledger – the Capital Account, the Drawings Account, and the Statement of Profit or Loss Account.

Our very last task is to put all the balances together so that we leave on the Capital Account a balance equal to the final amount owing.

We achieve this by making the following two entries:

1. Debit Statement of Profit or Loss t-account, and Credit Capital Account

   with the balance on the Statement of Profit or Loss account.

2. Debit Capital account, and Credit Drawings account

   with the balance on the Drawings account.

10 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.