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 first recorded in the books of prime entry and then recorded on the ledger system.

A prime entry record (or book of prime entry) is where a transaction is first recorded.

These records consist of:

• The cash book: this records amounts paid into and out of the bank account
  

• The petty cash book: this records small amounts of cash paid for day to day expenses, such as buying postage stamps and teas or coffee for the office.
  

• The sales day book: sales invoices issued to credit customers
  

• The purchases day book: purchase invoices received from suppliers
  

• The journal: where adjustments, such as correcting errors, are first recorded.
  

Some businesses also have sales returns and purchases returns day books.

The books of prime entry serve to ‘capture’ transactions as soon as possible so that they are not subsequently lost or forgotten about.

The cash book and the petty cash book are part of the double entry system and record cash coming in and going out.

The day books and journal are not part of the ledger (double entry) system, and entries are made from there to the ledgers.

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 here. 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 here. 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 Computerised accounting systems

Almost every business now keeps these records on a computer rather than on paper. The book-keeping is identical - the same day books, the same ledgers, the same double entry - but the system does some of the work for you. The features you should be able to describe are:

• Single entry of data. An invoice is keyed once and the system writes it to the day book, the control account, the sales or purchases account, the sales tax account and the customer's or supplier's memorandum account at the same time. The double entry cannot be half-made.

• Coding. Every account, customer, supplier and type of expense is given a short code, so that a transaction is posted to exactly one account and cannot be filed under a mis-spelt name. Codes also let the system group transactions for reporting.

• Validation. The system rejects a code that does not exist, a date outside the accounting period, or a posting that does not balance.

• Automatic processing. Standing entries such as depreciation, recurring invoices and the sales tax calculation are computed by the system from the rates you set up.

• Instant reporting. A trial balance, an aged receivables analysis or a control account listing can be produced at any moment, rather than being extracted by hand.

• Access controls and an audit trail. Each user has a log-in and only the rights they need, and the system records who entered or changed each transaction.

• Back-ups. Because the whole record is in one place, losing it would be fatal, so copies are taken regularly and kept away from the office.

Storing the data on external servers - the cloud. Instead of holding the software and the data on a computer in the office, many businesses now use a system run by a provider and reached over the internet.

4 The accounting system in diagrammatic form

The accounting system can be depicted as follows:

To recap:

The double entry system consists of the general ledger, the cash book and the petty cash book.

The receivables and payables ledgers provide details of the total receivables and payables that are recorded in the nominal ledger.

The books of prime entry are the cash book, the petty cash book, the sales day book, the purchases day book and the journal.

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

Bookkeeping relies on a number of linked principles:

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

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

3. 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 has 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.

6 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

A note on the two systems. In this worked sequence every purchase of goods for resale is debited straight to an Inventory account and the cost of each sale is transferred out of it to a Cost of goods sold account. That is done deliberately, because it keeps the accounting equation visible at every step: you can see the inventory asset rise and fall as goods come in and go out.

In manual bookkeeping, and in chapter 7, businesses do not do this. They debit goods bought for resale to a Purchases account - which is what the double entry at the start of this chapter shows - leave the Inventory account untouched all year, and make a single inventory adjustment at the year end: cost of sales = opening inventory + purchases - closing inventory.

The two systems are alternatives, not a contradiction. They give the same gross profit. The exam uses the purchases-account system, so make sure you can do the year-end inventory adjustment in chapter 7.

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

7 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

8 Statements of financial position and statements of profit or loss

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 known 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:

9 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. an asset of $3,200.

In bookkeeping finding the balance is done in a very formal way:

1. At the bottom of the Dr and Cr sides, enter the larger of the two totals. Here that would be 5,100.

2. To make the smaller column add up to that you have to enter the ‘balancing figure’. Here 3,200 needs to be entered on the credit side. This is marked with ‘Balance c/d’ (‘c/d’ meaning ‘carried down’).

3. This figure is brought down below the totals on the other side. Here $3,200 would be brought down (b/d) on the debit side.

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

10 The accounting equation and profit

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

Things owed = Things owned

If $10,000 cash is 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

11 The capital account of a sole trader

Everything in that equation is recorded in one ledger account: the owner's capital account. It opens with what the owner was owed at the start of the year, is credited with any further capital introduced and with the profit for the year, is debited with the drawings, and the balance carried down is what the business owes the owner at the year end - the capital figure on the statement of financial position.

Illustration. A sole trader's capital at 1 January 2014 was $22,000. During the year she paid a further $5,000 into the business, the business made a profit of $18,400, and she drew $1,200 a month to live on.

Two points to watch. Drawings are often collected in a separate Drawings account during the year and transferred to the capital account in one figure at the year end - that is how the Drawings account in Example 3 works. And drawings are never an expense: they do not touch the statement of profit or loss, they reduce capital.