Recording business transactions within the accounting and double entry system

1 Introduction

This chapter gives a brief description of how transactions are recorded in accounting systems.

2 Recording transactions.

Transactions are in the ledger system.

The word ‘ledger’ means a book. In accounting systems there are usually three ledgers:

• The general or nominal ledger, which records amounts such as wages, sales, purchases, electricity, travel, advertising, rent, insurance, repairs, receivables, payables and non-current assets. The cash and bank accounts are technically part of this ledger but are usually physically kept in a separate book because cash and bank transactions are so numerous.
  

• The payables ledger (also known as the creditors’ ledger and sometimes the purchase ledger). Although the total amount owed to suppliers is recorded in the general ledger, details of exactly what is owed to whom are also recorded in the payables ledger. There is a separate account for each supplier. The sum of the amounts owing in this ledger should agree with the payables balance in the general ledger.
  

• The receivables ledger (also known as the debtors’ ledger and sometimes the sales ledger). Although the total amount owed by customers is recorded in the general ledger, details of exactly what is owed from whom are also recorded in the receivables ledger. There is a separate account for each credit customer. The sum of the amounts owing in this ledger should agree with the receivables balance in the general ledger.

3 The accounting system in diagrammatic form

The accounting system can be depicted as follows:

4 The accounting equation and the principles and practice of double-entry book-keeping

Bookkeeping relies on a number of linked principles:

The transactions of the business are separate from those of its owners

Every transaction gives rise to two effects (or two entries). One entry is known as a credit entry and the other a debit entry.

Things owned by the business equals things owed by the business.

The double entries are often displayed in ‘T’ accounts:

The accounts are collected together into ledgers. Remember ‘ledger’ just means ‘’book’ and it used to be that each account had its own page in the books.

Here are some simple, common transactions: remember every transaction has two effects: one debit, one credit. The amounts of debits must equal the amounts of credits.

Purchase of office stationery for cash:

Debit   Office stationery   (increase in an expense)

Credit   Cash   (decrease in an asset)

A cash sale:

Debit   Cash   (increase in an asset)

Credit   Sales   (increase in income)

A credit sale:

Debit   Receivables   (increase in an asset)

Credit   Sales   (increase in income)

Payment by a customer of an amount owing:

Debit   Cash   (increase in an asset)

Credit   Receivables   (decrease in an asset)

Purchase, on credit, of goods for resale:

Debit   Purchases   (increase in an expense. ‘Purchases’ is the name given to purchases for resale)

Credit   Payables   (increase in a liability).

You should understand that if the double entry as been carried out properly, then the sum of the debit entries should always equal the sum of the credit entries. This should be regularly checked by compiling a trial balance, which is simply all the accounts listed in debit and credit columns and the lists added up. The totals should always agree.

5 Starting a business and its initial transactions

Transaction 1

The owner starts up the business in 1/1/2013 by putting $10,000 of cash in as capital.

From the business’s point of view, its cash has increased by $10,000 and its capital has increased by $10,000. Cash is an asset (something owned) and the capital is the amount owed by the business back to its owner.

The double entry would be:

Notice the cross-referencing between the accounts. The entry in the Cash account is described as ‘Capital’, which is where the cash came from; the entry in the Capital account is described as ‘Cash’, the nature of the capital injected.

Accounting equation:

Things owned, cash $10,000 = Things owed, capital 10,000

Transaction 2

The business buys some equipment for $2,000 cash on 3/1/2013.

Cash has decreased $2,000 and the cost of equipment has increased by $2,000

Note the balance on this account is Dr 8,000, the net of the Dr and Cr sides

The asset of cash decreases and that of equipment increases

Accounting equation:

Things owned, cash $8,000 + equipment $2,000 = Things owed, capital $10,000

Transaction 3

On 10/1/2013, the business purchases goods for resale for $5,000 on credit.

The asset of inventory increases and the liability to suppliers increases

Accounting equation:

Things owned, cash $8,000 + equipment $2,000 + inventory $5,000

= Things owed, capital $10,000 + suppliers $5,000

Transaction 4

On 15/1/2013, sells half the goods for $4,000 credit.

This will create a profit of 4,000 – 5,000/2 = $1,500. The profit is owed to the owners and is a liability of the business to its owners.

We can look at the sale in two parts: earning $4,000 for a cost of 5,000/2 = 2,500.

Accounting equation:

Things owned, cash $8,000 +equipment $2,000+inventory $2,500 + due from customers $4,000 = $16,500

= Things owed, suppliers $5,000 capital $10,000 + profit [4,000 – 2,500] = $16,500

Transaction 5

On 31/1/2013, the suppliers are paid what they are owed and $100 is paid for rent.

The rent is an expense and decreases the profit. Paying suppliers what is owed to them has no effect on profits.

Accounting equation:

Things owned, cash $2,900+equipment $2,000+inventory $2,500 + due from customers $4,000 = $11,400

= Things owed, capital $10,000 + profit [4,000- 2,500 – 100 (rent)] = $11,400

6 Trial balances

At any stage, the sums of debit balances and credit balances should be the same. This is because we were strict to always have equal debit and credit entries.

These totals are the trial balance

7 Statements of financial position and statements of profit or loss and other comprehensive income

The accounts can also be used to produce a statement of financial position and a statement of profit or loss.

• Statement of financial position: the assets and liabilities (things owned and things owed) at a point in time
  

• Statement of profit or loss: income and expenses for the period.
  

Note that capital put in or taken out by the owners is neither income or expense. It is simply the owner changing his or her investment in the business.

The trial balance amounts can be marked up with SOFP or P/L to show which document they form part of:

Statement of profit or loss for January 2013

Statement of financial position as at 31 January 2013

The net profit of 1,400 in the statement of profit or loss is carried into the statement of financial position as Profit, 1,400.

Note that the profit made by the business is added to the capital in the SOFP. This is because profit is owed to the owners and becomes part of the capital of the business.

Profits taken out of the business are know as ‘Drawings’ (derived from ‘withdrawals’). If the owner removed $1,000 profits then cash would go down $1,000 and drawings up by $1,000. The capital section of the SOFP would then look like:

8 Carrying down balances

Look at this account:

To find out how much cash there is now, you have to find the balance on the account ie the net debit or credit amount.

Debits = 2,000 + 3,000 + 100 = 5,100

Credits = 200 + 1,400 + 200 + 100 = 1,900

Therefore balance = Dr 5,100 – Cr 1,900 = = Dr 3,200

This means that there is $3,200 cash i.e. and asset of $3,200.

A balance brought down on the debit side of the cash account means that there is an asset of cash.

9 The accounting equation and profit

You have seen how the accounting equation should always hold true:

Things owed = Things owned

If $10,000 cash in introduced as capital, then the equation is:

(1)   Things owed $10,000 (Capital) = Things owned $10,000 (Cash)

If the business trades and makes profits of, say $6,000, then the business has become ‘richer’ by $6,000 and the owner’s stake in the business (capital) will have increased by $6,000.

(2)   Things owed [$10,000 + $6,000] (Capital) = Things owned $16,000

If the business borrows $2,000, then cash will increase by that amount, but the business will also owe money to the bank:

(3)   Things owed [$10,000 + $6,000] (Capital) + $2,000 = Things owned $18,000

or

(4)   [$10,000 + $6,000] (Capital) = $18,000 – $2,000 [Loan] = Net assets $16,000

Comparing equations 1 and 4, Capital has increased by $6,000 because a profit has been made and this is reflected in the increase in net assets from $10,000 to $16,000.

Profit makes businesses richer.

However, profit and capital can be withdrawn from a business and this will reduce the net assets of the business. So, if the owner withdrew money to live on (made drawings) of $2,000, the assets would reduce by $2,000 and the equation would be:

(5)   [$10,000 + $6,000 – 2,000] (Capital) = $16,000 –$2,000[Loan] = Net assets $14,000

So, comparing equations 1 and 5, we can say that:

Increase in net assets between two dates $(14,000 – 10,000) =

Capital introduced in the period ($Nil) + Profit ($6,000) – Drawings ($2,000) = $4,000.

Remember:

Increase in net assets = capital introduced + profit - drawings

10 FA1 exam focus — Chapter 2