Accounting Pre-course Workbook

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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.

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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 business’s 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 business’s 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.

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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 business’s _____________

____________________ .

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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 business’s commercial transactions

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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.

Let’s 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.

…………………………………………… ………………………………………….

…………………………………………… ………………………………………….

…………………………………………… ………………………………………….

…………………………………………… ………………………………………….

…………………………………………… ………………………………………….

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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.

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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.

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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.

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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.

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(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?

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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.

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3. THE INCOME STATEMENT

3.1 Introduction

As mentioned in chapter 1, the Income Statement is ‘a summary of the results of a business’s 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 ____

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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 weren’t 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.

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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.

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

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

(2) A business’s 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?

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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 _______

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(6)

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

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CALCULATIONS MADE EASY

Contents

1 Percentages the quick way

2 Rearranging equations – some simple rules using typical exam examples

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1. Percentages the quick way

First, you’ll save time if you don’t 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, don’t waste time by writing down separate numbers!

Example

A sales value of £150,000 will increase by 5% next year. What is next year’s 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

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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 year’s 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 = ___________

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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 you’re 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’?

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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?

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Solution

30000 = 10000 + 0 + profit – 5000

30000 = 5000+ profit

Profit = 30000 - 5000

Profit = 25000

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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?

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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


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

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4 THE ACCOUNTING EQUATION

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


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).

Let’s 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 business’s cash goes up by £10,000. (Assets ↑)

(ii) The business’s 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 business’s cash falls by £4,000. (Assets ↓)

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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 ↑)


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.

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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 business’s cash goes up by £10,000. (Assets ↑)


Expressed as an equation, this shows:


Cash 10000

0

Capital 10000

10000 = 10000


(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 ↓)


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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)



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?


(ii) The business has income from a sale (income ↑ therefore profit ↑, hence ↑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 Dora’s 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


Cash 20,000

Capital 20,000

–––––

–––––

20,000

20,000 –––––

–––––

(2) ↑ Purchases £2,000

↑ Trade Payables £2,000


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


(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


↓ 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 ––––– ––––– –––––

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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 ↑)


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


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 ↓)


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

we consider so we don’t 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?


(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

Let’s 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.

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(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.


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


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

Documents

Accounting Pre-course Workbook