of 44/44
2 1 WHAT IS BOOKKEEPING? 1.1 Why do we prepare accounts? If you invest in a business (whether by buying shares in a company or by putting money into your own business), you need to know how well or badly that business is doing. In particular you need to be updated periodically with answers to two equally important questions: a) Is the business making a profit? b) Has it got enough funds to pay its debts? Accounts are the means by which these questions are answered. 1.2 Form of accounts A set of accounts consists of two principal statements, usually amplified by detailed notes. These statements are: (a) the statement of financial position: a statement of the financial position of a business at a given date; (b) the income statement: a summary of the results of a business’s transactions for a period ending on the date of the statement of financial position. The amount of detail in a set of accounts will vary according to the type of accounts and the people who will be using them. But the same principles will still apply. 1.3 Types of business There are 3 types of businesses which we will consider in Accounting and a brief description of these types of business is given below. What is important to remember is that regardless of the type of business we are looking at, all businesses will produce an Income Statement and a Statement of Financial Position periodically (usually annually). Sole Trader A sole trader is usually a small business, such as a plumber or plasterer, the owner and the ‘manager’ are the same person.

Accounting Pre-course Workbook

  • View
    227

  • Download
    4

Embed Size (px)

DESCRIPTION

Kaplan

Text of Accounting Pre-course Workbook

  • 2

    1 WHAT IS BOOKKEEPING?

    1.1 Why do we prepare accounts?

    If you invest in a business (whether by buying shares in a company or by putting money into your own business), you need to know how well or badly that business is doing.

    In particular you need to be updated periodically with answers to two equally important questions:

    a) Is the business making a profit?

    b) Has it got enough funds to pay its debts?

    Accounts are the means by which these questions are answered.

    1.2 Form of accounts

    A set of accounts consists of two principal statements, usually amplified by detailed notes.

    These statements are:

    (a) the statement of financial position: a statement of the financial position of a business at a given date;

    (b) the income statement: a summary of the results of a businesss transactions for a period ending on the date of the statement of financial position.

    The amount of detail in a set of accounts will vary according to the type of accounts and the people who will be using them. But the same principles will still apply.

    1.3 Types of business

    There are 3 types of businesses which we will consider in Accounting and a brief description of these types of business is given below. What is important to remember is that regardless of the type of business we are looking at, all businesses will produce an Income Statement and a Statement of Financial Position periodically (usually annually).

    Sole Trader

    A sole trader is usually a small business, such as a plumber or plasterer, the owner and the manager are the same person.

  • 3

    The sole trader is legally responsible for all of the losses that their business makes.

    Sole traders produce accounts which are not heavily regulated. The sole trader will usually employ a firm of accountants to prepare the businesss accounts.

    Partnership

    This is a business owned and managed by two or more people examples of such are Accountancy and Law firms. Each Partner in this business is a sole trader for accounting purposes and a Partnership is a collection of sole traders acting together in one business.

    Partnerships produce special Partnership accounts.

    Company

    A company is not owned by the managers of the business (the directors) but instead is owned by Shareholders who buy shares in the company and who elect the Directors to run the company.

    A company has limited liability which means that unlike a sole trader, the owners (i.e. the shareholders) are not responsible for the losses of the company. The company is its own legal entity.

    Companies must produce company accounts and these are heavily regulated by Company Law and Accounting Standards.

    1.4 The purpose of bookkeeping

    If accounts are to be produced periodically, the transactions which are being accounted for (eg. purchases and sales of goods, expenses, receipt and payment of cash) must be recorded as and when they happen.

    As we said in the Introduction, bookkeeping is the recording of a businesss commercial transactions. Its purpose is to enable those transactions to be summarised at the end of a period so that accounts can be produced.

    1.5 Types of accounting records

    The expression books survives from the days before the invention of accounting machines and computers, when everything was written up in leather-bound books. You will see some handwritten records, but much of what we still call books of account or accounting records will take the form of computer print-outs. The same information is being given nonetheless.

  • 4

    1.6 Revision questions

    (a) What are the two basic questions which an investor in a business should ask?

    (i) ....

    (ii) ....

    (b) What are the two principal statements in a set of accounts?

    (i) ....

    (ii) ....

    (c) Fill in the missing words:

    Bookkeeping is the _____________ of a businesss _____________

    ____________________ .

  • 5

    1.7 Answers

    (a) (i) Is the business making a profit?

    (ii) Has the business got enough funds to pay its debts?

    (b) (i) Statement of financial position

    (ii) Income Statement

    (c) Bookkeeping is the recording of a businesss commercial transactions

  • 2

    2 THE STATEMENT OF FINANCIAL POSITION

    2.1 Introduction

    In Chapter 1 we saw that the Statement of Financial Position is one of the principal statements of our financial accounts.

    Lets consider what we mean by position: the SOFP considers what the business OWNS which we refer to as ASSETS and what the business OWES which we refer as LIABILITIES.

    In this chapter we will look at Assets and Liabilities in the Statement of Financial Position (SOFP) in more detail.

    2.2 Assets

    As above, Assets are defined things which the business OWNS and can be broken down into two types:

    Non-current assets, and

    Current assets. Non-current assets Non-current assets can be defined as assets acquired for use within a business over more than one year (usually several years) with a view to earning profits, but not for resale. Without looking at the answer, try to think of some types of assets which a business would be likely to keep over several years which might help them to make profits.

    Target about 10.

    .

    .

    .

    .

    .

  • 3

    Answer:

    Land, buildings, plant and machinery, patents, motor vehicles, tools, fixtures and fittings, office equipment, computers, long-term investments, ships, works of art, locomotives. Current assets Current assets are defined as assets acquired for conversion into cash in the ordinary course of business. These are any assets which are not non-current assets. In other words, non-current assets are those which a business keeps and uses in the long term (usually more than 12 months), and current assets are those which pass through the business as part of the normal trading process. Just as people or animals cannot live without blood constantly moving through their bodies, so a business cannot exist without the constant movement of current assets. a) Inventories b) Cash Receivables these occur when we sell goods to our customers on credit (i.e they pay us later). When our customer will pay us depends on the credit terms we offer them but it will usually be within 3 6 months.

    2.3 Liabilities

    Above we defined a liability as an amount owed by the business. This means that the business has an obligation to pay money at some future date. As with assets, there are two types of Liability: Non-Current Liability and Current Liability. Non-current liabilities These are amounts owed by the business, payable in more than one year after the date of the statement of financial position. Long-term bank loans are much the common example. Current Liabilities

    A current liability is simply a short-term liability i.e. an amount owed by the business, payable within one year.

  • 4

    The commonest examples of current liabilities are:

    (a) trade payables; - these occur when we buy goods on credit and owe our supplier money. When we will pay our supplier depends on how long they give us to pay but this will usually be less than 12 months.

    (b) bank overdraft we owe the bank the money back

    2.4 The Business Entity Concept

    We saw in Chapter 1 that a Sole Trader is a business which is owned and managed by the same person. However, from an accounting perspective, the Owner and the Manager are two different people. Therefore if the business owner puts anything into the business, the business OWES this back to the owner. This concept is known as the Business Entity Concept.

    For Example, Joe the plumber has his own sole trader business. Joe uses his own money to buy a van for the business which costs 10,000. The plumbing business now has a Non Current Asset in their accounts (a Van). Per the Business Entity Concept, this plumbing business owes Joe 10,000 as the business and Jo are separate people. Anything which Joe puts into the business is owed back to him. The amount which the business owes back to the business owner is known as Capital.

    2.5 Capital

    The term capital represents the total amount which the business owes to its owner, or proprietor. On our SOFP we need to show at that particular date how much capital there is in the business. How we calculate capital:

    Opening capital

    the amount which the proprietor has invested in the business to the start of the year

    plus Capital injections

    any money the proprietor put into the business during the year

    plus Profits funds generated by the business (we will see how to calculate this in the next chapter).

    (or) minus Losses funds lost by the business (we will see how to calculate this in the next chapter).

    minus Drawings any amounts taken out of the business by the business owner e.g the sole trader takes 1,000 per month out of the business as his/her salary.

  • 5

    So:

    Opening capital

    + Capital injections

    + / Profits / Losses

    Drawings

    = Capital owed to proprietor

    2.6 Layout of the statement of financial position

    Below is an example of what a Statement of Financial Position (SOFP) looks like. Remember that the SOFP gives the position at a given date which in this example is 31 January 20X1. Therefore this SOFP shows what the sole trader P PILBEAM owns and owes at this date.

  • 6

    P PILBEAM: Statement of financial position as at 31 January 20X1

    ASSETS

    Non-current assets

    Motor vehicles 4,000

    Current assets

    Inventories 2,000

    Trade receivables

    Cash 6,300

    8,300

    Total assets 12,300

    CAPITAL AND LIABILITIES

    Capital

    As at 1 January 10,000

    Profit for the period 800

    Less drawings (500)

    At 31 January 10,300

    Non-current liabilities

    Current liabilities

    Trade payables 2000

    2000

    Total capital and liabilities 12,300

    As you can see from the illustration, when we prepare a SOFP we present Non-current assets separately from current assets and Non-current liabilities separately from current liabilities. If you look at the numbers in the SOFP you can see that Total Assets = Capital + Total Liabilities. The above equation is known as the Accounting Equation - we will look more closely at this in chapter 3.

  • 7

    2.7 Revision questions

    (1) Define non-current assets.

    (2) Define current assets.

    (3) Are the following non-current or current assets?

    (a) Buildings

    (b) Receivables

    (c) Cash

    (d) Fixtures & fittings

    (e) Long-term investments

    (4) Define a current liability?

    (5) Name two types of current liability.

    (a)

    (b)

    (6) How do we calculate capital?

  • 8

    2.8 Answers

    (1) Non-current assets are assets bought by the business for use over a number of years, with the aim of earning profits, but not for resale.

    (2) Current assets are assets acquired for conversion into cash in the ordinary course of business.

    (3) (a) non-current

    (b) current

    (c) current

    (d) non-current

    (e) non-current

    (4) A current liability is an amount owed by the business which is payable within one year.

    (5) (a) Trade payables

    (b) Bank overdraft

    (6) A opening capital + capital injections + profit drawings.

  • 2

    3. THE INCOME STATEMENT

    3.1 Introduction

    As mentioned in chapter 1, the Income Statement is a summary of the results of a businesss transactions for a period ending on the date of the statement of financial position.

    The income statement summarises sales that a business has made and expenses a business has incurred over a period of time. This leads us to determine whether the business has made a profit (more sales than expenses) or if they have made a loss (more expenses than sales).

    3.2 Income statement format

    The pro forma Income Statement below shows you the items which most businesses are likely to have in their accounts.

    Income Statement for the year ended 31 December 20X1

    Revenue X Less cost of sales Opening inventories on 1 January 20X1 X X Purchases X Less closing inventories on 31 Dec 20X1 (X) ____ (X) ____ Gross profit X Less expenses Rent X Rates X Lighting and heating X Telephone X Postage X Insurance X Stationery X Office salaries X Accountancy and audit fees X Bank charges and interest X Delivery costs X Van running expenses X Advertising X ____ (X)

    ____ Net profit X ____

  • 3

    3.3 Revenue

    Revenue includes sales made for cash and sales made on credit.

    3.4 Cost of sales

    As the pro forma shows, the way to find the cost of the goods actually sold during a period is to take:

    (a) the cost of goods in stock at the beginning of the period known as opening inventories

    and add

    (b) the cost of goods bought during the period purchases.

    and then deduct

    (c) the cost of goods in stock at the end of the period: closing inventories.

    What this does is to take the cost of goods available for sale during the period (opening inventories plus purchases) and deduct the cost of the goods which werent sold during the period (closing inventories). This results in the cost of the goods which were actually sold.

    The thing to remember here is that, whereas revenue should be a larger amount than cost of sales, the actual number of units of goods concerned will be the same. Cost of sales or cost of goods sold means exactly that: the cost of the goods actually sold during the year or period. Revenue thus means the selling price of the goods during the same period.

    3.5 Gross Profit

    The first part of the income statement (down as far as gross profit) is known in many businesses as the core profit, since it shows the results of the actual buying and selling operations of a business (sales we have made compared to how much it costs us to buy the things which we have sold i.e. the cost of sales).

    As you can see from the pro forma, the gross profit arrived at is the result of subtracting cost of sales from revenue.

    The resulting gross profit is a very useful figure, since it shows how successful the main activity of the business has been (i.e. the buying and selling of goods, as opposed to incidental expenses). You would have to be supremely incompetent to achieve a large loss.

  • 4

    3.6 Net Profit

    After arriving at gross profit, we must show other items of income and expenditure (mainly expenditure) which are relevant to the business but are incidental to it and not part of the buying, selling or manufacturing of the goods.

    After we have taken off all other expenditure of the business the result is Net Profit as we can see in the Income Statement.

    3.7 Relationship between Statement of Financial Position and the Income Statement

    If you remember from the previous chapter, we included in the SOFP what the business owes back to the business owner, this being called Capital.

    Capital is calculated as:

    Capital at the start of the year + capital injections in the year + Profit or loss Drawings.

    The net profit/loss from the Income Statement is therefore included in the calculation of capital in the SOFP.

    If a business makes a profit (sales are higher than expenses) then capital will increase. If the business makes a loss (expenses are higher than sales) then capital will decrease.

    We can therefore see that making sales or incurring expenses can have an effect on Capital.

    We will explore this further in the next chapter.

  • 5

    3.8 Revision questions

    (1) (a) What is revenue less cost of sales?

    (b) The final figure in the income statement is called what?

    (2) A businesss sales for a year amount to 120,000. Only 100,000 of these have been paid for by customers. What will revenue be?

    (3) How is cost of sales calculated?

    (4) A business has opening inventories of 20,000 and closing inventories of 30,000. During the year it bought goods costing 70,000 of which 10,000 have not yet been paid for. What is the cost of sales for the year?

    (5) Using the numbers from (4), assuming sales of 100,000, calculate gross profit.

    (6) Following on from (4) and (5), if the business has rental expenses of 5,000 and telephone expenses of 3000,

    How much net profit have they made?

  • 6

    3.9 Answers

    (1) (a) Gross profit

    (b) Net profit

    (2) 120,000 (includes sales where customer has not yet paid).

    (3)

    Opening inventories X Add Purchases X Less Closing inventories (X) _____ Cost of sales X _____

    We are determining the cost of goods sold in the period. Closing inventories will be sold next year.

    (4)

    Opening inventory 20,000 Add Purchases 70,000 Less Closing inventories (30,000) _____ Cost of sales 60,000 _____

    (5)

    Sales 100,000 Cost of sales (60,000) _______ Gross profit 40,000 _______

  • 7

    (6)

    Gross profit 40,000 Less Rent (5,000) Telephone (3,000) ______ Net profit 32,000 ______

  • 2

    CALCULATIONS MADE EASY

    Contents

    1 Percentages the quick way

    2 Rearranging equations some simple rules using typical exam examples

  • 3

    1. Percentages the quick way

    First, youll save time if you dont use the % button on your calculator.

    Just convert the % given in the question to a decimal, and put that decimal into your calculator directly.

    Examples

    5% = 0.05

    15% = 0.15

    One half of a percent

    = 0.5% = 0.005

    125% = 1.25

    3.894% = 0.03894

    Just remember to move the decimal point two places to the left

    Second, dont waste time by writing down separate numbers!

    Example

    A sales value of 150,000 will increase by 5% next year. What is next years value?

    The slow way:

    This year 150,000

    5% of this is 0.05 x 150,000 = 7,500

    Add together = 157,500

    The quick way:

    150,000 x 1.05 = 157,500

  • 4

    Examples to try

    40,000 with a 3% increase = ___________

    40,000 with a 23.75% increase = ___________

    Example

    A sales value of 150,000 will decrease by 10% next year. What is next years value?

    The slow way:

    This year 150,000

    10% of this is 0.10 x 150,000 = 15,000

    Subtract decrease = 135,000

    A 10% decrease means that the new figure is 90% of the old value.

    A 15% decrease would be 85%, a 3% decrease 97% and so on..

    The quick way:

    150,000 x 0.90 = 135,000

    Examples to try

    40,000 with a 30% decrease = ___________

    40,000 with a 6.40% decrease = ___________

  • 5

    2. Rearranging equations some simple rules using typical exam examples

    The rules:

    You must do the same thing to both sides of an equation

    When you move an item to the other side of the equation by adding or subtracting, it changes its sign [ positive (+ve) to negative (ve) and vice versa].

    When you move an item to the other side of the equation by multiplying or dividing, it changes from underneath a fraction to on top [and vice versa]

    If you know any numbers, and they are separate from the unknown youre trying to find; just write the numbers down it can make life easier.

    Proceed step by step, and leave a trail for a marker to follow

    Example 1

    Y = a + bx

    If Y = 100,000; b = 4 per unit; and x = 2000 units: What is a?

    Solution

    100000 = a + 4 x 2000

    100000 = a + 8000

    100000 8000 = a

    a = 920000

    Example 2

    D0 P0 =

    Divi yield

    If P0 = 20 million and D0 = 1 million; what is Divi yield?

  • 6

    Solution

    20m = 1m/divi yield

    Divi yield x 20m = 1m

    Divi yield = 1m/20m

    Divi yield = 0.05m

    Example 3

    Assets = Liabilities + Capital

    Cash = 3000, Inventory = 7000, Loans = 1000

    What is capital?

    Solution

    Assets are cash + inventory = 3000 + 7000 = 10000

    Loans are liabilities = 1000

    10000 = 1000 + capital

    Capital = 10000 - 1000

    Capital = 9000

    Example 4

    Closing capital = opening capital + capital injected + profit drawings

    A sole trader business has closing capital of 30000, opening capital of 10000.

    The sole trader took drawings out of the business of 5000.

    How much profit did he make?

  • 7

    Solution

    30000 = 10000 + 0 + profit 5000

    30000 = 5000+ profit

    Profit = 30000 - 5000

    Profit = 25000

  • 8

    Have a go

    1. A business has Cash of 5000 and receivables of 6000, Payables of 4000 - what is capital?

    2. A sole trader has capital of 100000, inventory of 60000, loans of 40000 - what is cash?

    3. A sole trader has Assets of 50000, Liabilities of 20000, opening capital of 5000 - how much profit did the business make?

  • 9

    Answers

    1. Assets = liabilities + capital

    Cash + receivables = loans + capital

    5000 + 6000 = 4000 + Capital

    11000 = 4000 + Capital

    Capital = 11000 - 4000

    Capital = 7000

    2. Assets = Liabilities + Capital

    Assets = 40000 + 100000

    Assets = 140000

    Inventory + cash = 140000

    60000 + cash = 140000

    Cash = 140000 - 60000

    Cash = 80000

    3. Assets = Liabilities + Capital

    Assets = Liabilities + Capital

    50000= 20000 + capital

    Capital = 50000-20000

    Capital = 30000

    Capital = opening capital + capital injected + Profit Drawings

    30000 =5000 + 0+ Profit 0

    Profit = 30000 - 5000

    Profit = 25000

  • 2

    4 THE ACCOUNTING EQUATION

    If you recall from chapter 2, the Accounting Equation is defined as:

    Assets = Liabilities + Capital

    This equation will always hold true and the assets of a business will always be equal to the liabilities of a business plus what the business owes back to the business owner (capital).

    4.1 Dual Effect

    A consequence of the Accounting Equation is that every transaction will have two effects (a dual effect).

    Lets think about how we can apply that to an example.

    Suppose you are in business as a shopkeeper.

    (a) You start up the business by putting 10,000 into the business. What are the two effects of this?

    (i) The businesss cash goes up by 10,000. (Assets )

    (ii) The businesss capital goes up 10,000 (Capital )

    Expressed as an equation, this shows:

    Total assets = Liabilities + Capital Cash 10,000 Capital 10,000

    The business then has the following transactions:

    (b) You buy goods from a wholesaler for 4,000 cash. What are the two effects of this?

    (i) The business gains more inventories 4,000 (Assets )

    (ii) The businesss cash falls by 4,000. (Assets )

  • 3

    Accounting equation:

    Assets = Liabilities + Capital Inventories 4,000 Capital 10,000 Cash 6,000 ________ ________ 10,000 10,000

    ________ ________

    (c) You buy goods from another wholesaler for 2,000, who says he will send you a bill later. What are the two effects of this?

    (i) The business gains more inventories of 2,000. (Assets )

    (ii) The business now has a payable to the wholesaler of 2,000 (Liabilities )

    Accounting equation:

    Assets = Liabilities + Capital

    Inventories 6,000 Payables 2,000 Capital 10,000 Cash 6,000 ________ ________ 12,000 12,000

    ________ ________

    (d) You sell goods to a customer for 4000 and allow them to pay you at the end of the month. What are the two effects of this?

    (i) The customer now owes the business money ( i.e. a receivable of 4,000). (Assets )

    (ii) The business inventories fall by 4,000. (Assets )

    Assets = Liabilities + Capital

    Inventories 2,000 Payables 2,000 Capital 10,000 Cash 6,000 Receivables 4,000 ________ ________ 12,000 12,000

    ________ ________

    There is nothing that a business can do which will not have this dual effect not even right at the beginning, when you first started up the business and put your money in as capital.

  • 4

    4.2 Inventory

    You will consider Inventory a lot in future studies but for now we need to be happy that Inventory is a current asset. However, when we are considering the Accounting Equation and the Dual Effect we do not need to consider whether Inventory has gone up or down.

    This is because Inventory is something called a year end adjustment and therefore is only thought about at the end of the year when the accounts are being completed. You will see a lot of year end adjustments later in your studies.

    When looking at the dual effect and Inventories are involved we consider buying Inventory to be a Purchase, which is an expense in the Income Statement and this will reduce profit. The sale of Inventories is regarded as Income in the Income Statement which will increase profits.

    Remember that if we make a profit then Capital goes up and if we make a loss Capital goes down.

    4.3 Impact on the Accounting Equation

    Let us now consider the above example again

    (a) You start up the business by putting 10,000 into the business. What are the two effects of this?

    (i) The businesss cash goes up by 10,000. (Assets )

    (ii) The businesss capital goes up 10,000 (Capital )

    Expressed as an equation, this shows:

    Assets = Liabilities + Capital

    Cash 10000

    0

    Capital 10000

    10000 = 10000

    The business then has the following transactions:

    (b) You buy goods from a wholesaler for 4,000 cash. What are the two effects of this?

    (i) The business has a purchases expense of 4,000 (Expenses , therefore Profit hence Capital )

    (ii) The businesss cash falls by 4,000. (Assets )

  • 5

    Assets = Liabilities + Capital

    Cash 6000

    0

    Capital

    10000 4000 = 6000

    6000 = 6000

    (c) You buy goods from another wholesaler for 2,000, who says he will send you a bill later. What are the two effects of this?

    (i) The business has a another purchase expense of 2,000 (Expenses , therefore profit hence Capital )

    (ii) The business has a liability (a payable) of 2,000. ( Liabilities)

    Accounting equation:

    Assets = Liabilities + Capital

    Cash 6000

    Payable 2000 + Capital

    6000 2000 = 4000

    6000 = 6000

    (d) You sell goods to a customer for 4000 and allow them to pay you at the end of the month. What are the two effects of this?

    (i) The customer now owes the business money ( i.e. a receivable of 4,000). (Assets )

    (ii) The business has income from a sale (income therefore profit , hence Capital)

    Assets = Liabilities + Capital

    Cash 6000

    Payable 2000 + Capital

    4000 + 4000 = 8000

    Receivables 4000

    10000 = 10000

  • Test your understanding so far Part 1

    This was the activity that we asked you to complete. The answers are set out below.

    Record the accounting equation for Doras business after each of the following transactions:

    (1) Dora starts her business with 20,000 paid into a new business bank account.

    (2) Goods for resale are bought on credit for 2,000.

    (3) A new motor van is purchased for 5,000. Dora pays by cheque.

    (4) Stock which had cost 2,000 is sold for 3,500 on credit.

    (5) 1,800 is paid to a credit supplier.

    (6) Dora borrows 5,000 from Explorer Bank plc.

    (7) A cheque of 2,700 is received from a credit customer.

    (8) Rent of 300 for the past month is paid by cheque.

    (9) 250 wages are paid by cheque.

    (10) Dora withdraws 200 from her business.

    Answers (1) Cash 20,000

    Capital 20,000

    Assets = Liabilities + Capital

    Cash 20,000

    Capital 20,000

    20,000

    20,000

    (2) Purchases 2,000

    Trade Payables 2,000

    Assets = Liabilities + Capital

    Cash 20,000 Trade payables 2,000 Capital 20,000

    Profit / (loss) (2,000)

    20,000

    2,000 18,000

    (3) Cash 5,000

    Non-current assets 5,000

    Assets = Liabilities + Capital Cash 15,000 Trade payables 2,000 Capital 20,000

  • Test your understanding so far Part 1

    (20,000 5,000) Profit / (loss) (2,000) NCA 5,000 20,000 2,000 18,000 (4) Trade receivables 3,500

    Revenue 3,500

    Assets = Liabilities + Capital Cash 15,000 Trade payables 2,000 Capital 20,000 NCA 5,000 Profit/(loss) 1,500 Trade receivables 3,500 (3,500 2,000)

    23,500 2,000 21,500 (5) Cash 1,800

    Trade payables 1,800 Assets = Liabilities + Capital Cash 13,200 Trade payables 200 Capital 20,000 (15,000 1,800) (2,000 1,800) Profit / (loss) 1,500 NCA 5,000 Trade receivables 3,500 21,700 200 21,500 (6) Non-current liabilities 5,000

    Cash 5,000

    Assets = Liabilities + Capital Cash 18,200 Trade payables 200 Capital 20,000 (13,200 + 5,000) NCL 5,000 Profit / (loss) 1,500 NCA 5,000 Trade receivables 3,500 26,700 5,200 21,500 (7) Cash 2,700

    Trade receivables 2,700

    Assets = Liabilities + Capital Cash 20,900 Trade payables 200 Capital 20,000 (18,200 + 2,700) NCL 5,000 Profit / (loss) 1,500 NCA 5,000 Trade receivables 800 (3,500 2,700) 26,700 5,200 21,500 (8) Rent expense 300

  • Test your understanding so far Part 1

    Cash 300

    Assets = Liabilities + Capital Cash 20,600 Trade payables 200 Capital 20,000 (20,900 300) NCL 5,000 Profit / (loss) 1,200 NCA 5,000 (1,500 300) Trade receivables 800 26,400 5,200 21,200

    (9) Wages expense 250

    Cash 250

    Assets = Liabilities + Capital Cash 20,350 Trade payables 200 Capital 20,000 (20,600 250) NCL 5,000 Profit / (loss) 950 NCA 5,000 (1,200 250) Trade receivables 800 26,150 5,200 20,950 (10) Cash 200

    Drawings 200

    Assets = Liabilities + Capital Cash 20,150 Trade payables 200 Capital 20,000 (20,350 200) NCL 5,000 Profit / (loss) 950 NCA 5,000 Drawings (200) Trade receivables 800 25,950 5,200 20,750

  • 33

    5 Double Entry

    5.1 Introduction

    In the previous chapter we considered the impact of transactions on the Accounting Equation.

    In this chapter we take this a step further and think about the impact of transactions using the

    terminology debit and credit to show the dual effect of each transaction.

    5.2 Debit and credit entries

    The first thing we need to consider is what type of account the transaction we are looking at

    will impact. There are 6 types of account which we consider

    expenses (e.g purchases, gas bill, phone bill, electricity bill, salaries)

    assets (e.g cash, receivables, factory, cars, remember that we no longer consider inventory when looking at the dual effect)

    drawings (arise whenever a sole trader takes something out of the business).

    liabilities (e.g payables, loans)

    income (e.g sales, interest income)

    capital (what the business owes back to the business owner).

    To increase expenses, assets or drawings we say we Debit the account.

    To increase liabilities income and capital we say we Credit the account.

    We can use the handy acronym DEAD CLIC:

    DEBIT (increase) CREDIT (increases)

    Expense (income statement) Liability (balance sheet)

    Asset (balance sheet) Income (Income statement)

    Drawings (balance sheet) Capital (balance sheet)

    It follows that:

    a decrease in an expense, asset or drawings is a credit, and

    a decrease in a liability, income or capital is a debit

    Note that by convention we sometimes abbreviate Debit to Dr and Credit to Cr

  • 34

    The acronym DEADCLIC is fundamental to Accounting and therefore will be used

    throughout your studies. Write the acronym down and keep it beside you throughout this

    chapter.

    Steps to record a transaction

    Identify the two accounts that are affected. Consider whether they are being increased or decreased. Decide whether each account should be debited or credited. Check that a debit entry and a credit entry for equal amounts have been made

    Let us now consider the example which we saw in the previous

    chapter:

    You start up the business by putting 10,000 into the business. What are the two effects of this?

    (i) The businesses cash goes up by 10,000. (Assets ) (ii) The businesss capital goes up 10,000 (Capital )

    An increase in the value of an asset is a debit entry

    So we make a debit entry in the cash account.

    Capital is the amount owed by the business to its proprietor.

    An increase in the value of capital is a credit entry.

    Double Entry Dr Cash 10000

    Cr Capital 10000

    The business then has the following transactions:

    Buy goods from a wholesaler for 4,000 cash. What are the two effects of this?

    (i) The business has a purchases expense of 4,000 (Expenses , hence Capital ) (ii) The businesss cash falls by 4,000. (Assets )

    Although expenses have an ultimate impact on Capital, Expenses are one of the 6 types of account which

    we consider so we dont need to look just at the impact on capital but can consider expenses on their own.

    Therefore, as purchase expenses have increased we debit purchases.

    Cash is an asset and cash has fallen. We debit to increase assets an conversely we credit to reduce assets

    and we need to reduce cash by 4,000

  • 35

    Double Entry

    Dr Purchases Expenses 4000

    Cr Cash 4000

    You buy goods from another wholesaler for 2,000, who says he will send you a bill later. What are the

    two effects of this?

    (i) The business has a another purchase expense of 2,000 (Expenses , hence Capital )

    (ii) The business has a liability (a payable) of 2,000. ( Liabilities)

    Again, we have a purchase expense and to increase our total purchases expenses we

    need to debit purchases expenses another 2,000.

    We have bought the goods on credit but this time we have not paid cash and

    therefore we do not need to reduce cash. Instead we have paid on credit and created

    a liability. Therefore we want to increase liabilities. To increase a liability we credit.

    Double Entry

    Dr Purchases Expenses 2000

    Cr Payables (Liabilities) 2000

    You sell goods to a customer for 4000 and allow them to pay you at the end of the month. What are

    the two effects of this?

    (i) The customer now owes the business money ( i.e. a receivable of 4,000). (Assets ) (ii) The business has income from a sale ( profit, Capital)

    Here we have made a sale which means that we will have income in our income statement. To increase

    income we credit. The customer has not paid us yet, they still owe us money and therefore we have a

    receivable which is an asset. To increase assets we debit.

    Double Entry

    Dr Receivables 4000

    Cr Sales 4000 (income)

    You must always have an equal and opposite debit and credit.

  • 36

    5.3 Double Entries - examples

    Lets assume that we are in business selling fruit and vegetables.

    Consider the double entries for the following transaction:

    (1) Sold all the vegetables 2,500 cash.

    Dr Cash 2500

    Cr Sales 2500

    Since cash is an asset and we debit to increase assets and Sales are income and we credit to

    increase income.

    (2) Bought 6,000 worth of fruit from Wooster Wholesalers on credit.

    Dr Purchases 6000

    Cr Payables 6000

    Since purchases are an expense and we need to increase expenses to do so we Debit. As we

    now owe our supplier money, we have a payable which is a liability. To increase liabilities we

    credit.

    (3) Bought 3,000 worth of vegetables for cash.

    Dr Purchases 3000

    Cr Cash 3000

    As above, purchases are an expense and we need to increase expenses therefore we debit

    expenses. This time we have paid in cash and therefore we need to reduce the cash of the

    business and to reduce an asset, which is what cash is, we credit.

    (4) Sold all the fruit bought in (2) above for 7,500 on credit to R Glossop.

    Dr Receivables 7500

    Cr Sales 7500

    Whenever we make a sale we will have income in our income statement and to increase

    income we credit. When we make a sale on credit the customer owes us money which for us

    is an asset (called a receivable) and to increase an asset we Debit.

  • 37

    (5) Paid Wooster Wholesalers 3,500.

    Dr Payables 3500

    Cr Cash 3500

    Remember in (2) above we bought the goods from Wholesalers on credit. Therefore we had a

    payable which is a liability.

    If we are now paying some of that Liability off we are reducing how much we owe. To reduce

    a liability we Debit the liability. Also, we are paying out cash and therefore cash is falling.

    Cash is an asset and to reduce an asset we Credit.

    (6) R Glossop paid for his fruit in full.

    Dr Cash 7500

    Cr Receivable 7500

    Remember from (4) above that we sold to R Glossop on credit and therefore we had a

    receivable since he still owed us money. As he has now paid us we need to reduce this

    receivable (asset) and to reduce assets we credit. Also, he has now paid us some cash and to

    increase cash we debit cash since cash is an asset.

    (7) Paid 200 for his telephone bill.

    Dr Phone Bill expense 200

    Cr Cash 200

    The phone bill is an expense and to increase expenses we Debit. Also, we have paid out cash

    and cash is an asset. If we want to reduce and asset we credit the asset.

    (8) Drew 400 cash out of the business.

    Dr Drawings 400

    Cr Cash 400

    If a sole trader takes anything out of the business this is called drawings.

    Although Drawings will ultimately reduce capital, Drawings is an account which we keep

    separate and is one of the 6 accounts which we can consider for the dual effect.

    To increase Drawings we Debit. If the cash of the business has gone down then we need to

    reduce cash. Cash in an asset and to reduce and asset we credit.

  • 38

    (9) Bought a Van for 300 on cash

    Dr Non current Asset (Van) 300

    Cr Cash 300

    The Van is an asset and to increase an asset we debit. Once again, cash has fallen. Cash is an

    asset and to reduce cash we credit.

    Hopefully you will see from the above illustration that there is always and equal debit and credit to every

    transaction. Remember to always consider what are the two accounts which are being affected and then to

    use DEAD CLIC.

  • Test your understanding so far Part 2

    This was the activity that we asked you to complete. The answers are set out below.

    Edward opened a bookshop. The following transactions took place:

    (1) Started business with 20,000 in a business bank account.

    (2) Paid rent of 1,500 cash.

    (3) Made purchases for 350 cash.

    (4) Bought stationery for 55 cash.

    (5) Made further purchases from Joe for 245 on credit.

    (6) Sold books to a school for 1,200 cash.

    (7) Paid Joe 150 cash.

    (8) Bought a second hand van for 3,500 cash from MV Ltd

    (9) Sold a book on credit to Christine for 150.

    (10) Took 250 from the business to pay for a holiday.

    (11) Bought more stationery for 30 cash.

    (12) Paid 120 cash for motor expenses.

    (13) Received 75 from Christine.

    (14) Paid electricity of 30 cash.

    Write down the double entries for the above transaction. Answers

    1 Dr Cash 20,000

    Cr Capital 20,000

    2 Dr Rent expenses 1,500

    Cr Cash 1,500

    3 Dr Purchases 350

    Cr Cash 350

    4 Dr Stationery 55

  • Test your understanding so far Part 2

    Cr Cash 55

    5 Dr Purchases 245

    Cr Trade payables 245

    6 Dr Cash 1,200

    Cr Sales 1,200

    7 Dr Trade payables 150

    Cr Cash 150

    8 Dr Motor vehicles 3,500

    Cr Cash 3,500

    9 Dr Trade receivables 150

    Cr Sales 150

    10 Dr Drawings 250

    Cr Cash 250

    11 Dr Stationery 30

    Cr Cash 30

    12 Dr Motor expenses 120

    Cr Cash 120

    13 Dr Cash 75

    Cr Trade receivables 75

    14 Dr Electricity expense 30

    Cr Cash 30

  • Preparing Financial Statements

    If you remember back to the earlier chapters, we looked at our basic Financial Statements, the

    Income Statement and the Statement of Financial Position. In this exercise we will return to these

    statements thinking about how they look and attempt to produce them ourselves.

    Task

    Using the numbers provided, try to prepare an Income Statement and Statement of Financial

    Position.

    Hint:

    It helps if you draw up an Income Statement and a Statement of Financial Position with no numbers

    in it first. You can use the illustrations provided in Chapter 2 for the Statement of Financial Position

    and Chapter 3 for the Income Statement.

    You also need a complete Income Statement before you complete the Statement of Financial

    Position as what we get for profit or loss from the Income Statement is included in the Capital part

    of the Statement of Financial Position.

  • Cash 15,290

    Capital

    20,000

    Rent expense 1,500

    Purchases 595

    Stationery 85

    Trade payables

    95

    Sales

    1,350

    Motor vehicles 3,500

    Trade receivables 75

    Drawings 250

    Motor expenses 120

    Electricity expense 30

  • Answer

    Income statement

    Sales

    1,350

    Cost of sales

    Opening inventory

    Purchases 595

    Closing inventory

    (595)

    Gross profit 755

    Expenses

    Rent 1,500

    Stationery 85

    Motor expenses 120

    Electricity 30

    (1,735)

    Net loss

    (980)

    Balance sheet

    Non-current assets

    Motor vehicles

    3,500

    Current assets

    Inventory -

    Trade receivables 75

    Cash 15,290

    15,365

    18,865

    Caital

    Capital introduced 20,000

    Loss (980)

    Drawings (250)

    18,770

    Current liabilities

    Trade payables

    95

    18,865