FA1 Notes

(Business transactions and double entry)

Definitions:

Asset: Any valuable thing or an object, either tangible or

non-tangible, that the business owns and controls and
will benefit the business economically in the future.

Expense: Anything that has already benefited the

business. For instance the cost incurred for receiving
services. (Purchases are also an expense).

Liability: Accountability for paying off debts or a present

obligation arising from past events which will result in an
outflow of economic benefits. Primarily sums owed,
(interest & tax payables are current liabilities until when
they are paid off they become expenses).

Capital: It is simply owner’s investment in business or in

other words owners fair share in business.
Income: Inflow of economic benefits generated from sales
or services provided before any cost charges or expenses
are deducted.

Drawings: The amount taken out of the business by the

owner. It directly decreases the amount of capital
invested by the owner in business.

Profit: Income › expenses

Loss: Expenses › income

Concept:

Current assets and liabilities:

Assets acquired for resale within the accounting period

(generally 12 months) are current assets.

Liabilities payable within the accounting period are

current liabilities.

Non-current assets and liabilities:

Assets acquired for utilization in business and for more

than one accounting period are considered as non-
current assets.
Liabilities that are payable within more than one
accounting period are non-current liabilities.

Transactions in business:

There are only two types of transactions, Cash

transaction & Credit transaction. The only difference
between cash and credit transaction is the timing
difference (when the payment is made).

 Cash transactions are simple they involve cash

payment on purchases at the moment of
reception or possibly in advance.
 Credit transactions however involve liabilities.
Payments and receipts are postponed for some
credit period.

Terms involved with credit transactions:

i) A Debtor is an entity who owes the business

some money, and that money is a Receivable
(business will receive the amount after the
credit period has ended).
ii) A Creditor is an entity to whom the business
owes some money, and that money is a Payable
(business will pay the amount after the credit
period has ended).
 Trade debtor/receivable (current asset) or trade
creditor/payable (current liability) are debts
incurred in the course of trading operations.

 According to the business entity concept, since

the business and the owner are two separate
entities, the capital invested in the business by the
owner is a liability towards the owner hence we
can call capital an internal liability. Therefore the
accounting equation can be written as:

𝐀𝐬𝐬𝐞𝐭𝐬 = 𝐈𝐧𝐭𝐞𝐫𝐧𝐚𝐥 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐲 (𝐂𝐚𝐩𝐢𝐭𝐚𝐥) + 𝐄𝐱𝐭𝐞𝐫𝐧𝐚𝐥 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐲

Which is simply written as:

𝐀𝐬𝐬𝐞𝐭𝐬 = 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 + 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐲

Consequently expenses incurred, drawings and losses

are directly deducted from the capital invested and
profit is directly added to it.
  Gross profit = Sales – Cost of goods sold
 Net profit = Gross profit – Other expenses

(Discounts)

Discount: The reduction on the amount at which the

product is normally sold.

Types of discount:

i) Trade discount:
 Trade discount occurs for bulk purchases or for
regular trading with a particular business.
 Related to both cash & credit transactions.
 It is calculated on the list price (supplier’s quoted
price).
ii) Settlement / Cash discount:
 It is a reduction on the amount payable and
occurs if payment is made very early prior to the
end of the credit period. (e.g. 2/10 Net 30
meaning 2% discount is offered if payment is
 made within 10 days, or else net amount is due
within 30 days).
 Related to only credit transactions.
 It is calculated on the net amount
(Net amount = List price – Trade discount).
 It is never shown on the invoice, only its terms
(e.g. 2/10 Net 30) are mentioned as foot note.

Accounting for discounts:

 Discount allowed: Dr. Discount allowed account (Expense)

Cr. Receivables control account (Asset)
 Discount received: Dr. Payables control account (Liability)
Cr. Discount received account (Expense)

Rebate: Refund of a portion of purchase price for

purchasing a specified quantity of goods within specified
a period.

Allowances: Buy more products get a few free.

(VAT)

VAT (Value Added Tax):

  VAT is a form of indirect taxation charged on
taxable goods and services by the businesses that
are registered for VAT and is periodically paid to
tax authorities.
 VAT paid on purchases is called input tax and on
sales, output tax.
 If output tax exceeds input tax, the excess output
tax is a current liability of the business and a
payable to the tax authorities.
 If input tax exceeds output tax, the excess input
tax is a receivable for the business and can be
reclaimed from the tax authorities.
 If the revenue of a business exceeds the VAT
threshold then that business is required by law to
register for VAT.
 VAT is not charged on sales made to overseas.
 VAT is always calculated on the Net selling price
which is the Sub-total amount ─ (minus) the
amount of cash discount.

Calculation of VAT on a product from Production all the

way to consumption:
Let’s assume that a raw materials business produces
product X costing ₹20 and sells it for ₹30 which means
the value added to the product is (₹30-₹20=₹10). ₹10 is
their gross margin. The standard rate of VAT is 17.5%
so,

Calculation of VAT:

Net selling price is tax exclusive so VAT is calculated by:

𝑵𝑺𝑷 ×𝟏𝟕.𝟓
𝟏𝟎𝟎
Gross selling price is tax inclusive so VAT is calculated by:
𝑮𝑺𝑷 ×𝟏𝟕.𝟓
𝟏𝟏𝟕.𝟓

VAT requirements:

 VAT registration number is unique code used to

enable tax authorities to determine the validity of
the invoice.
 Tax point is the date of issue of invoice.
 Rate of VAT is shown on the invoice. Currently
the three rates of VAT are:
i) Standard rate of 17.5%
ii) Reduced rate of 5%
iii) Zero rate of 0%

Accounting for VAT:

Entries are made in a VAT ledger account.

VAT on sales:

Dr. Receivables ledger control account (Asset)

Cr. Sales (Income)

Cr. VAT account (Liability)

VAT on Purchases:

Dr. Purchases (Expense)

Dr. VAT account (Expense)

Cr. Payable ledger control account (Liability)

(Accounting Records)

Concept chart:

 Source documents are used to update these 3

categories of Books of prime entry.
 Sales and Purchase day books record the
transactions for current and non-current assets,
services given or received on credit and Accrued
revenue (in SDB) and Accrued expenses (in PDB).
 Cash book records all payments and receipts of
money.
 Accrued revenue (income recognized) is what the
business has earned but has not send an invoice to
the customer yet.
Receivable (income still recognized) is when the
business sends invoice to the customer but money
is not yet received.
Receipt (income realized) is when the business
actually receives the money and records it in the
cash book. So is the payment when the business
actually pays the supplier that’s when the
payment is recorded in the cash book.
 The cash book have two sides: debit and credit.
All cash receipts are recorded on the left hand
side, and all cash payments are recorded on the
right hand side. The difference between the left
 and right side shows the balance of cash in hand,
which always shows a debit balance.
 None of the books of prime entries have a specific
format.
 Cash payments side has 3 columns:

Cash (Paid) Bank (Withdrawals) Discount (Received)

 Cash receipts side has 3 columns:

Cash (Received) Bank (Deposits) Discount (Allowed)

After the recordings in books of prime entries, the

transactions are posted to the ledgers
 The Ledgers hold individual T accounts which
have two sides, debit and credit.
 The General Ledger holds all T accounts that can
be used to prepare financial statements.
 The Personal Ledger holds all T accounts related
to specific category or an individual group. for
example a receivables or payables ledger. Personal
accounts are trifurcated into:
i) Natural: People’s accounts (Osama, Jawed
etc.)
 ii) Artificial: Corporate bodies (Ford, Walmart
etc.)
iii) Representative: A responsibility handed to
the agent of the company (Employee,
director etc.)
 The Private Ledger holds all accounts related to
the directors or possibly other highly confidential
accounts.
 The Nominal and Real Accounts:
- The accounts relating to expenses, losses,
incomes and gains are known as nominal
accounts. Nominal accounts are temporary
since the balance is closed at the end of the
accounting year and the new balance next year
begins with zero. That balance doesn’t just
vanish in thin air but the Net amount carried
forward the Retained earning account. Nominal
accounts are reflected in the income statement.
- The accounts relating to all assets and
properties are called real accounts. Real
accounts do not close at the end of the
accounting year their balance is carried
 forward to the next year (except for the
drawings account which is a nominal account
but appears on the balance sheet). Real
accounts are reflected in the balance sheet.

(Control accounts and personal ledgers)

Concept of ledgers:

For this chapter you should focus on the ones under the
red line.
The list of balance holds the total balances of each credit
customer/supplier’s account.

How Day books, Cash books and Journal entries are used
to update the control accounts and the subsidiary
ledgers:

SDB (sales day book), SRDB (sales return day book), CRB
(cash received book) and DA (discount allowed)

PDB (purchase day book), PRDB (purchase return day

book), CPB (cash paid book) and DR (discount received)

Need for control accounts:

 Insures the accuracy of entries made in subsidiary

ledger.
  Can help locate errors in individual balances by
comparing the total figures.
 Helps in calculating missing figures from
incomplete records.
 Acts as a control over subsidiary ledgers.
 Provides total asset (receivables) and liability
(payables) figures for statement of financial
position.
 Extraction of trial balance is quick and
convenient.

Need for individual accounts:

 A customer might want to enquire about his

outstanding amount.
 Credit check may need to be carried out to assess
the position of a customer who is demanding
further credit.
 Managers might want to assess the timing of cash
inflows so that they can be matched against the
payments that are to be made to the suppliers of
the business.
Entries in control accounts:

Any entry that will reduce our total receivables will end
up on credit side and vice versa.

Receivables control account

Dr (increase) Cr (decrease)

1) Opening debit balance. 1) Cash/cheques received

(from previous month) from customers.
2) Discount disallowed. 2) Discounts allowed.
3) Sales. (Income) 3) Return inwards.
4) Cheques received dishonored. 4) Bad debts.
(since the person still owes 5) Contra.
us) 6) Opening credit balance
5) Interest charged on overdue (from previous month)
accounts. (Refund) may arise if the customer
6) Closing balance. (if any) has overpaid or payment
is received in advance of
raising invoices.
7) Closing balance.
Contra entries may arise in a situation where two
interactive bodies are each other’s suppliers as well as
customers. Instead of both owing each other money, it
may be agreed that the balances are contra’d (cancelled).

The double entry for this is:

Dr Payables ledger control account

Cr Receivables ledger control account

Similarly any entry that will reduce our total payables

will end up on the debit side and vice versa.

Reconciliation of control accounts:

Reconciliation is necessary to identify any differences

between the control accounts and subsidiary ledgers.

Differences may arise because of the following errors:

 Posting error: An incorrect amount may be

posted to control account which can be fixed by
making a journal entry.
 Transposition error: (i.e. writing 270 as 720) this
error can be fixed by simply altering the figures.
  A transaction may be recorded in the control
account but not in the subsidiary ledger or vice
versa. This can be fixed by just posting.
 A wrong figure may be drawn from personal
accounts. This would simply involve correcting the
total of balances.

The list of balances will be affected if the errors are made

in the following:

 Individual accounts (supplier/customer)

 Debit balance taken as credit balance and vice
versa. (to fix this, double posting is required)

The control accounts will be affected if the errors are

made in the following:

 Totaling/casting of the books of prime entry.

 Totaling/casting of the subsidiary ledger accounts.

Both will be affected if the errors are made in primary

entries:

 Wrong figure drawn from source documents into

the books of prime entry leading to error in total
 figure (affecting control account) as well as an
individual account (affecting the subsidiary ledger
hence the list of balances).
 Complete omission of a transaction from the
books of prime entry.

Payables involved other than in the main trade are not

recorded in the payables ledger instead they are
recorded directly in the general ledger. For instance:

 Liability related to wages and salaries.

 Output VAT.

Age analysis report:

https://www.accountingtools.com/articles/what-is-accounts-
receivable-aging.html

(Bank reconciliation Statement)

Concept chart:
 BRS is generally prepared on monthly basis.
 Favorable balance is our positive cash at bank.
(Asset)
 Unfavorable balance (Overdraft) is our negative
cash at bank. (Liability)
 Differences between the bank statement and cash
book arise because of:
1) Unrecorded items (in cash book):
Payments made but not recorded:
i) Direct debits,
 ii) Standing orders,
iii) Bank and interest charges,
iv) Dishonored cheques.

Payments received but not recorded:

i) Direct credits, (borrowing from
bank, receiving from an investor
etc.)
ii) Interests received.
2) Timing differences (in bank statement):
i) Outstanding/unpresented cheques.
ii) Outstanding/uncleared cheques.

(Look up page 151 on FA2 for detailed information

and 152 for the way to prepare a BRS.)

(Errors and their rectification)

 Concept chart:

Accounting Errors Description

Error of Principle Correct amount, wrong category

Errors of Omission Entry missed from accounting records

Error of Commission Correct amount and category but wrong account

Compensating Error Two or more errors balance each other out

Error of Original Entry Correct account, wrong amount

Complete Reversal of Entries Correct amount and account but wrong side
One sided errors give rise to the creation of suspense
account, some are:

 Partial errors:
i) Partial omission.
ii) Partial error of original entry where either
the debit or the credit side is wrong.
 Transposition error. (i.e. Writing 215 as 251)

All errors are explained and practiced here:

http://wizznotes.com/accounts/control-systems/types-of-
accounting-errors
http://www.double-entry-bookkeeping.com/bookkeeping-
basics/accounting-errors/