CHAPTER 3

Double entry bookkeeping

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1.1

Assumptions underlying double entry bookkeeping

Introduction

Double entry bookkeeping is a system developed by the accounting profession to meet the demands of management and proprietors. Management need information on a regular basis (daily, weekly, monthly) in order to manage the business. Proprietors (owners) need information on a periodic basis in order to assess the performance (profitability) and financial position of their business. Three assumptions

1.2

Double entry bookkeeping has three underlying assumptions. Every transaction has two effects (the duality concept). A business is a distinct entity separate from its owner (the business entity convention). The net assets of a business represent the proprietors funds. This third assumption can be summarised in the following equation. Assets liabilities = capital + profits losses drawings 1.3 Example

Mr Issey starts his business by investing $10,000 in a business bank account. (a) Dual effect
$ An asset is created (cash) for the business The business owes Mr Issey 10,000 10,000

(b)

Separate entity
Cash $10,000 Proprietor Mr Issey Business owes Mr Issey $10,000 Business

(c)

Net assets
Cash $10,000

= proprietors funds
= Capital $10,000

The balance sheet equation (or accounting equation)

The third assumption is known as the balance sheet equation (or accounting equation). This is now built up step by step in the following illustration.

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2.1

The start of a business the first transaction

On 1 January Mr Sprake starts a business and places $1,000 of his own cash in the business bank account. What has happened (from the business point of view)? We can work it through, using the double entry system. Step 1 What has the business received? (+) $1,000 cash at the bank (owning). Step 2 What has the business given? () It is now in debt to its owner by $1,000 (owing).

Step 3 Check that the dual aspect of this transaction has been recorded from the point of view of the business.
Cash at bank $1,000. A promise to repay the owner of the business a $1,000 liability.

The accounting equation can be stated, at this stage, as follows:

Assets (cash at bank $1,000) = capital (liability to owner = $1,000)

2.2

Definitions

We define the key terms as follows. Assets are those resources, physical objects or rights, which are controlled by the business and from which future economic benefits are expected to be received. Capital is that amount of money (or other resources) that the owner invests in the business and that is therefore owed by the business to the owner.

In its normal course of trading a business will have dealings with other businesses and individuals. Debts owed by the business to other businesses and individuals other than the owner are known as liabilities. 2.3 Liabilities are debts owed by the business to other businesses or individuals apart from the owner. Capital is the debt owed by the business to the owner only. Further transactions

Now that you have been introduced to assets, capital and liabilities, we can develop the accounting equation further. This equation is now stated as follows.
Assets = capital + liabilities

We continue with Mr Sprake. We saw above that on 1 January Mr Sprake puts $1,000 of his own money into the business bank account.

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Chapter 3 Double entry bookkeeping

On 2 January the business receives goods costing $250 from Cooper Ltd. The business agrees to pay Cooper in one month. On 3 January the business buys a vehicle for $500 and pays by cheque.

Enter these transactions into the accounting equation. Step 1 List the assets, capital and liabilities.
Assets = capital + liabilities $ 1 January Cash at bank Accounting equation 1,000 _____ 1,000 _____ Capital Liabilities = $ 1,000 _____ 1,000 _____

Step 2
Assets = capital + liabilities $ 2 January Cash at bank Inventory 1,000 250 _____ 1,250 _____ Capital Liabilities (payable to Cooper Ltd) = $ 1,000 250 _____ 1,250 _____

Accounting equation

Note. The business has secured additional assets of inventory valued at their cost of $250. These were physically received. The business has acquired additional liabilities; the company owes Cooper Ltd $250. It has given a promise to pay this amount at a later date. This makes Cooper Ltd a creditor of the business. A creditor is someone to whom the business owes money. Step 3
Assets = capital + liabilities $ 500 250 500 _____ 1,250 _____ $ Capital Liabilities = 1,000 250 _____ 1,250 _____

3 January

Cash at bank Inventory Vehicle Accounting equation

Now the business has replaced part of the cash asset with a new asset the vehicle. The accounting equation will change after every transaction. This, however, does not mean that every transaction will affect both sides of the equation. The transaction on 3 January shows that both effects may be felt on the asset side only (+ vehicle and bank) leaving the equation totals unchanged. We can now develop the accounting equation further. The assets and liabilities of a business will be changing in response to everyday commercial transactions. For example every time a business buys goods on credit, it simply records an increase in goods (+) and an increase in payables (+). However, what happens when a business sells these goods for a profit? The principles are the same, and the following demonstrates this. 2.4 Continuing with Mr Sprake

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On 4 January goods bought for $150 are sold for $200 cash.
Assets = capital + liabilities $ 4 January Cash at bank Inventory Vehicle Accounting equation 700 100 500 _____ 1,300 _____ Capital Profit Payable = $ 1,000 50 250 _____ 1,300 _____

Cash has increased by the $200 cash sale, inventory has reduced by the $150 sold, leaving an imbalance. The difference is profit. This is the difference between the selling price and the cost price of the goods sold ($200 $150 = $50). Profit should be added to capital because profit belongs to the owner; therefore, if the business makes $50 profit, it automatically owes that $50 to the owner. We can now state the accounting equation as follows.
Assets = = = capital + profit + liabilities capital + profit capital (since profit should be added to capital)

Therefore:

Assets liabilities Net assets

The total of assets less liabilities is called the net assets of the business. 2.5 Movements on capital

The final development to be made to the accounting equation relates to the fact that capital can be further altered (+/) by one of two things. Additional capital. The accounting records for this type of transaction are exactly those which we used to record the opening of a business: assets are received (cash, or other resources (+)) and capital (the debt owed by the business to the owner) is increased (+). Drawings. This term refers to a transaction in which the owner withdraws resources (eg goods or money) from the business. The accounting records for this type of transaction are: account losing resources () (inventory or cash) and the capital is reduced ().

The following illustration shows how the second item affects the accounting equation. (Examples of the first are shown in the opening statements on the previous examples.) 2.6 Continuing with Mr Sprake - drawings

Mr Sprake now has the following assets and total liabilities (capital and payables).
Assets = capital + liabilities $ 700 100 500 _____ 1,300 _____ $ 1,000 50 250 _____ 1,300 _____

Cash at bank Inventory Vehicle Accounting equation

Capital Profit Payable =

On 5 January, Mr Sprake withdrew $100 from the business bank account for his own personal use. The business accounting equation after this is as follows.

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Chapter 3 Double entry bookkeeping

Assets

capital + liabilities $ $ Capital Profit Cash drawings 1,000 50 (100) _____ 950 250 _____ 1,200 _____

Cash at bank Inventory Vehicle

600 100 500

Payable _____ 1,200 _____ =

Note. The withdrawal of $100 from the bank is shown by the bank falling by $100 from $700 to $600. Capital is similarly reduced by the withdrawal of assets from the business. The overall debt of the business to the owner has fallen from $1,050 to $950. One of the main uses of the accounting equation is to ascertain a missing figure. It is possible to do this because we are dealing with an equation which must have both sides equal. This will be dealt with in detail in the chapter on incomplete records. 2.7 The accounting equation: final form

The equation in its final form is stated as follows.

Assets = original capital + new capital + profit loss drawings + liabilities

or
Assets liabilities = original capital + new capital + profit loss drawings

This at first glance may appear long and complicated, but merely summarises the sections you have already worked through. The assets and liabilities remain unchanged. The only part analysed is capital, and this only confirms the work you have already completed. We have stated that the capital owed by a business at any one time must be equal to the capital originally put into the business, plus any additional capital input adjusted for profit (loss) and drawings. If you do not feel confident about this, you may wish to review the previous section before going on. Please note that the accounting equation simply reflects the double entry. You will be tested on this principle many times throughout this work. 2.8 The accounting equation and the balance sheet

You saw the format for the balance sheet in Chapter 1. You should now be able to recognise that a balance sheet is doing no more than stating the accounting equation at the balance sheet date. The assets (on the top half of the balance sheet) equal the capital plus liabilities (on the bottom half of the balance sheet).

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3.1

Cash transactions
The double entry rule

The dual effect of a transaction is shown using the following two entries.
A debit A credit

For every debit there must be a credit and vice versa. There is no exception to this rule. These debits and credits are entered in ledger accounts or T accounts as follows.
Debit Credit

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On the left

On the right

Again this has no exceptions. Debits always go on the left of the account, credits go on the right of the account. The debits and credits to a ledger account represent increases and decreases in the categories on the balance sheet and in the income statement. (a) For balance sheet entries (assets and liabilities) the entries in a ledger account mean the following:
Ledger Account Debit Assets - increase Assets Liabilities Credits - decrease - increase

Liabilities - decrease

(b)

For income statement entries (revenue and expenses) the entries in a ledger account can mean the following:
Ledger Account Debit Revenue - decrease Expenses - increase Credit Revenue Expenses - increase - decrease

A good place to start looking at the rules of double entry bookkeeping is transactions involving cash. (In the next section of the chapter we will look at transactions not involving cash, ie credit transactions.) 3.2 Example

Mr Issey makes the following cash transactions. (a) (b) (c) (d) (e) (f) Introduces $10,000 capital. Buys a non-current asset for $5,000 cash. Makes purchases of $2,000 for cash. Takes out a $10,000 bank loan Makes cash sales of $3,000. Repays half the loan to the bank.

Write up the ledger accounts for these transactions. 3.3 Step 1 Establish the dual effect (ie which two accounts are affected). Step 2 Are you increasing or decreasing those accounts? Use the two proformas above to allocate the debit and credit in each transaction. Receipts of cash are shown as a debit in the cash account, while payments of cash are shown as a credit in the cash account. Step 3 Write up the ledger accounts using the opposite entry account as narrative. 32 Solution

Chapter 3 Double entry bookkeeping

Debit (a) Capital (d) Loan (e) Sales

$ 10,000 10,000 3,000

Cash Credit (b) Non-current assets (c) Purchases (f) Loan

$ 5,000 2,000 5,000

Part (a)
Step 1 Step 2 Cash Increase: debit Capital Increase: credit Capital Debit $ Credit $

Cash Part (b)

Step 1 Step 2 Non-current assets Increase: debit Cash Decrease: credit Non-current assets Debit Cash $ 5,000 Credit

10,000

Part (c)
Step 1 Step 2 Purchases Increase: debit Cash Decrease: credit Purchases Debit Cash $ 2,000 Credit $

Part (d)
Step 1 Cash Loan

Part (f)
Loan Cash

Step 2

Increase: debit

Increase: credit

Decrease: debit Loan

Decrease: credit

Debit (f) Cash

$ 5,000

Credit (d) Cash

$ 10,000

Part (e)
Step 1 Step 2 Cash Increase: debit Sales Increase: credit

Sales Debit $ Credit Cash $ 3,000

Credit transactions
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4.1

Introduction

Up until now we have only considered cash transactions where cash changes hands at the time of the transaction. Credit transactions mean that cash changes hands at a later date. We now need the concept of payables and receivables. Receivables Money owed to the business (by persons called debtors) Payables Money owed by the business (to persons called creditors) 4.2 Example

Going back to Mr Issey, he makes the following credit transactions. (a) (b) (c) (d) (e) (f) Bought goods for resale of $5,000 Made sales of $2,000 Bought further goods for resale of $2,000 Paid his creditors $3,000 by cheque Made sales of $4,000 Received money from debtors of $1,000 by cheque

Using the same three step process as for cash transactions write up these transactions, in the appropriate ledger accounts. 4.3 Part (a)
1 2 Purchases Increase: debit Payables Increase: credit

Solution Part (c)

1 2 Purchases Increase: debit Payables Increase: credit

Purchases $ (a) Payables 5,000 $

(c)

Payables

2,000

Payables $ (d) Bank 3,000 (a) (c) Purchases Purchases $ 5,000 2,000

Part (b)
1 2 Sales Increase: credit Receivables Increase: debit

Part (e)
1 2 Sales Increase: credit Receivables Increase: debit

Sales $ (b) (e) Receivables Receivables $ 2,000 4,000

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Chapter 3 Double entry bookkeeping

Receivables $ (b) Sales 2,000 (f) Bank $ 1,000

(e)

Sales

4,000

Part (d)
1 2 Payables Decrease: debit Bank Decrease: credit

Part (f)
1 2 Bank Increase: debit Receivables Decrease: credit

Bank $ (f) Receivables 1,000 (d) Payables $ 3,000

Balancing ledger accounts

At the end of a period once all the transactions have been entered into the relevant ledger accounts, they can be balanced off. This is illustrated with the example receivables account for July below. Step 1 Rule off the ledger account.
Receivables $ 1.7 12.7 15.7 20.7 Sales Sales Sales Sales 200 1,000 800 2,000 _____ ______ _____ ______ 5.7 17.7 Cash Cash $ 200 800

Step 2 Total both sides of the ledger account, inserting the greater total into both sides.
Receivables $ 1.7 12.7 15.7 20.7 Sales Sales Sales Sales 200 1,000 800 2,000 _____ 4,000 _____ _____ 4,000 _____ 5.7 17.7 Cash Cash $ 200 800

Step 3 Enter a balancing figure on the appropriate side. This is the carried forward figure.
Receivables

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$ 1.7 12.7 15.7 20.7 Sales Sales Sales Sales 200 1,000 800 2,000 _____ 4,000 _____ 31.7 Carried forward 5.7 17.7 Cash Cash

$ 200 800

3,000 _____ 4,000 _____

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Chapter 3 Double entry bookkeeping

Step 4 Bring down the balance on the opposite side of the ledger account to open the account in the next period.
Receivables $ 1.7 12.7 15.7 20.7 Sales Sales Sales Sales 200 1,000 800 2,000 _____ 4,000 _____ 1.8 Brought forward 3,000 31.7 Carried forward 3,000 _____ 4,000 _____ 5.7 17.7 Cash Cash $ 200 800

The account had a total of debit entries representing sales to credit customers of $4,000. It also had a total of credit entries of $1,000 representing receipts from debtors. This leaves $3,000 still owed by debtors. Receivables are a debit balance and so the carried forward swaps over to the debit side to show the true balance.

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6.1

Extracting the trial balance

Introduction

Once all the ledger accounts have been balanced the balances on each account can be extracted and a trial balance (also called a list of balances) compiled. The trial balance does not form part of the double entry system. It is merely a memorandum listing of all account balances at a particular date. Throughout this text so far we have been applying the double entry concept: for every debit there should be a matching credit. If this has been completed accurately the sum of the list of debit balances should equal the sum of the list of credit balances, as shown in the example below. Trial balance for Bertie Dooks as at
Debit $ 4,534 2 5,000 38 415 150 25 2 5 5 _____ 5,138 _____ Credit $ 100

Cash in hand J Fox (payable) Schoolmaster (receivable) Capital account Sales Purchases Rent Repairs Advertising Cleaning Drawings

_____ 5,138 _____

In summary:
Debit Credit

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Assets Expenses Drawings Liabilities Income Capital

$ X X X

___ X ___

X X X ___ X ___

6.2

Example

The following are the balances on the accounts of Ernest at 31 December 20X8.
$ Sales Purchases Receivables Payables General expenses Loan from father Plant and machinery Accumulated depreciation on plant and machinery Motor van Accumulated depreciation on motor van Drawings Rent and rates Insurance Bank overdraft Capital 47,140 26,500 7,640 4,320 9,430 5,000 10,500 3,200 4,600 1,950 7,500 6,450 1,560 2,570 10,000

Required Prepare Ernests trial balance as at 31 December 20X8. 6.3 Step 1 Solution Set up a blank trial balance

TRIAL BALANCE AT 31 DECEMBER 20X8

$ Sales Purchases Receivables Payables General expenses Loan from father Plant and machinery Accumulated depreciation on plant and machinery Motor van Accumulated depreciation on motor van Drawings Rent and rates Insurance Bank overdraft Capital $

Step 2

Work down the list of balances one by one using what you have learned so far about debits and credits. The totals of the two columns should agree.

TRIAL BALANCE AT 31 DECEMBER 20X8

$ Sales $ 47,140

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Chapter 3 Double entry bookkeeping

Purchases Receivables Payables General expenses Loan from father Plant and machinery Accumulated depreciation on plant and machinery Motor van Accumulated depreciation on motor van Drawings Rent and rates Insurance Bank overdraft Capital

26,500 7,640 4,320 9,430 5,000 10,500 3,200 4,600 1,950 7,500 6,450 1,560 2,570 10,000 ______ 74,180 ______

______ 74,180 ______

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7.1

Closing the ledger accounts

Introduction

Once the accounts have been finalised at the end of any accounting period where an income statement and balance sheet are to be compiled, the ledger accounts must be closed off ready to start afresh in the next accounting period.

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Step 1 Split the ledger accounts between income statement accounts and balance sheet accounts. (You may want to refer back to the proformas in Chapter 1.) Revenue accounts Expense accounts Assets Liabilities Income statement Income statement Balance sheet Balance sheet

The two exceptions are capital and drawings. These will be dealt with later. Step 2 A balance on a balance sheet account represents an asset or a liability at the balance sheet date. All balance sheet accounts remain as carried forward/brought forward balances because all assets and liabilities are taken forward into the next accounting period. Step 3 A balance on an income statement account represents revenue or expenses to be shown in the income statement for the period. All income statement balances are transferred into a new ledger account, called the income statement ledger account. This will be done using double entry. Follow the transfers in the following illustration. 7.2 Example
Sales $ Income statement 3,000 Cash Receivables Cash _____ 3,000 _____ Purchases $ Payables Cash 1,000 800 _____ 1,800 _____ Income statement $ 1,800 Sales Income statement $ 1,800 _____ 1,800 _____ $ 1,000 1,500 500 _____ 3,000 _____

Purchases

$ 3,000

Now introduce closing inventory of $300.

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Chapter 3 Double entry bookkeeping

$ Debit inventory Credit inventory Balance sheet Income statement Income statement $ 1,800 Sales Closing inventory 1,500 _____ 3,300 _____ b/d 300

300

Purchases Gross profit c/d (bal fig)

$ 3,000 300 _____ 3,300 _____ 1,500

The trading section of the income statement now shows the gross profit carried down and brought down. If we introduce the expenses, net profit will be the result.
Rent Cash Cash $ 200 200 ____ 400 ____ Income statement $ 400 ____ 400 ____ Wages Cash Cash $ 100 200 ____ 300 ____ Income statement $ 300 ____ 300 ____

Purchases Gross profit c/d

Rent Wages Net profit in the period

Income statement $ 1,800 Sales 1,500 Closing inventory _____ 3,300 _____ Gross profit b/d 400 300 800 _____ 1,500 _____

$ 3,000 300 _____ 3,300 _____ 1,500

_____ 1,500 _____

What is the relationship between this income statement ledger account and the income statements we discussed in Chapter 1? The answer is that the income statement ledger account is a part of the double entry bookkeeping system. However, in its raw form it may not convey clear information to users of accounts. To overcome this problem, we extract and summarise the information from the ledger account and present it in the type of format shown in Chapter 1. Essentially, the income statements we saw in Chapter 1 are simply a rearrangement of information extracted from an income statement ledger account. Step 4 The net profit figure is then transferred to capital along with the balance on the drawings account.

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Capital $ Drawings Carried forward 500 10,300 ______ 10,800 ______ Brought forward Brought forward Income statement $ 10,000 800 ______ 10,800 ______ 10,300

Summary

Ledger accounts for income and expense items are closed off at the end of each period by transferring their balances to the income statement. In the normal case, this means that no balance remains on the income and expense ledger accounts: we begin the next accounting period with a clean sheet. (We will see an exception to this when we discuss accruals and prepayments.) The income statement ledger account is then closed off by transferring its balance (the net profit for the period) to the capital account. No balance remains to be carried forward to the next accounting period. The same procedure applies to the drawings account; again, the balance is transferred to the capital account. This means that the only accounts remaining with balances to be carried forward are those for balance sheet items (namely assets, liabilities and capital). The process so far is as follows.
Cash and credit transactions

Ledger accounts

Balanced

Trial balance extracted

Ledger accounts closed

Financial statements produced

In the next four chapters we consider the end of period/year adjustments made to the trial balance figures to complete the final accounts.

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