Chapter 3: Double-entry bookkeeping

I. Business transactions and documentation

1.1 Purchase documentation
Example of a business that makes ice cream to sell to supermarkets. Let's consider the
process when they need to buy milk to make their product.

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2.1 Sales documentation

Let’s take an example of a business that makes tubs of ice cream. It sells to supermarkets
across the country. Let's imagine that a large supermarket calls the ice cream company and
ask for a quote for them to provide 10,000 units of ice cream. The company will need to
keep a record of the quote provided including the details of the customer, the quantity, and
the price offered. So that, if the order is made, they know what they have promised.

Perhaps the supermarket, after talking to various other suppliers, decides to place the order.
The sales order would have to be recorded, so the ice cream company doesn't forget to
send the product.

The next stage in the process is when the ice cream is sent out to the customer. This is
recorded on a goods dispatch note.

If the customer is a regular one and makes a number of purchases each month, then the
invoices are frequently supplemented by a month end statement to summarize the amount
owed.

Finally, as it when the supermarket pays, a record of the cash receipt will be kept. In
addition, if the customer decides to return any goods that are substandard, then a credit
note will need to be issued.

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Question 1
Which of the following documents would be created to record a warehouse sending goods
out to a customer in response to a sales order?

A. Sales invoice
B. Credit note
C. Goods despatched note
D. Goods received note

Question 2
Select the correct document from the drop-down box to match each statement.

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II. Cash and credit transactions

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III. Books of prime entry
All transactions are initially recorded in a book of prime entry. All similar transactions are
recorded together in sequential order, and regularly subtotalled to post to the ledger
accounts.

1.1 Sales day book

Here is an example of what a sale day book might look like. Note that it lists the date of the
transaction along with the customer name and reference. It also lists the invoice number
along with the amount of the sale.

If a business is required to account for sales tax it will also record the amount of sales tax
along with the net and gross amounts of the sale.

The total from the bottom of the day book will be used when transferring the information into
the general ledgers.

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2.1 Purchases day book
A purchase day book looks fairly similar to a sale day book. Again, it records the date,
supplier reference, invoice number, and the amount.

However, because the business is likely to be purchasing many different things on credit,
ranging from inventory for resale, stationary, the electricity bill, the book normally also
includes a number of different columns. This includes the total of each type of purchase to
be easy transfer to the correct place in the Ledger accounts at the end of day.

3.1 Sales and purchase returns day books

In practise, it's very common for credit customers to return goods to us if there is
unsatisfactory or unwanted quality. We might make returns to our suppliers for unwanted
purchases. You may also see that sales returns referred to as returns inwards and
purchased returns called returns outwards.

For a small business, returns may be infrequent enough to just be recorded in the main
daybook as negative amount. However, for most larger businesses, a separate sales
returns daybook and purchase returns daybook will be kept.

The sales returns day book records the credit notes raised to customers on the return of
any goods sold to them. The purchase returns day book records the credit notes received
from suppliers on the return of goods bought from them.

These will look almost identical to the main day books, except of course, the figures are for
returns rather than sales made.

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 Remember that it's only credit sales returns that would appear in the sales returns daybook,
the refund of cash for goods bought for cash would be entered in the cash book.

4.1 Cash book

Cash book records any transactions that affect the cash balance. When we use the term
cash for accounting purposes, we are also including any bank transactions. These days, of
course, few businesses generally deal in actual cash with the notable exception of retailers.

Our cash book is generally laid out in two parts, with the cash receipt section on the left and
the cash payment section on the right.

Alternatively, a business may instead choose to maintain two separate books, a cash
receipts book and a cash payments book.

Cash receipts book

An entry in the cash receipt side is required whenever a business receives cash. This could
be from a cash sale, or cash received from credit customers. It may also be that we have
received cash from a supplier for the return of goods, or from the sale of our assets. Here
we have an example of the cash receipt section of the cash book.

All money paid into the bank will be recorded here whether it is cash or cheque or amounts
paid directly into the bank.

You'll see columns for the date, the details of the transaction, and where applicable are
reference. You can see that as well as recording the total amount of cash received, we have
a breakdown to show what the cash was received for. This enables us to transfer the figures
into our ledgers quickly and easily at the end of the day.

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Cash payments book
An entry into the cash payment side is required whenever a business pays cash. This could
be for a cash purchase or cash paid to a credit supplier for amounts that we owe. It could
be that we have paid cash to a customer following the return of goods to us. Finally, we
could pay our expenses in cash.

The cash payments section of the cash book records all money paid out of the bank.

You'll see that we still have columns for the date, the details of the transaction, and if
applicable are reference. In the example, we have just one heading for expenses paid. In
reality, there could be many columns under this heading. The more analysis we have within
the daybook itself, the easier we will find it to transfer the information to the ledgers.

Question 1:
In which book of prime entry would each of these transactions be recorded?

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Question 2:
A business had a balance brought down in its cashbook at the start of the day of $390.
During the day, it had the following transactions:
• cash sales of $300
• credit sales of $900
• cash purchases of $200
• credit purchases of $1 00
• receipts from credit customers of $850
• payments to credit suppliers of $180.
What was the closing balance of the cashbook?

A. $1,960
B. $1,160
C. $1,860
D. $770

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5.1 Petty cash book
Most businesses have very few actual cash transactions, but there are still a few items such
as tea and coffee or refreshments for the Friday meeting that are paid for with cash (‘notes
and coins’). To this end the business will hold a petty cash tin with a small amount of cash
that has been taken from the bank. Let's say $100.

Each time cash is spent, a voucher is completed to detail how much cash was spent and
on what. The voucher replaces the cash in the tin. On a regular basis, once a week maybe,
we will take the vouchers out of the tin and used them to complete the petty cash book. We
will then take the amount of money from the bank needed to replenish our petty cash tin to
the agreed level, in our case $100.

An example of petty cash book is shown. On the right-hand side are the amounts drawn
from the bank in order to replenish the petty cash tin. On the left-hand side are the amounts
paid out in petty cash. We would analyse the expenditure so that it is easier to transfer into
the Ledger account.

Many business entities use an imprest system to account for and control petty cash
transactions and balances. An amount is withdrawn from the bank account which is referred
to as ‘a petty cash float’. The ‘float’ is then used to pay for various sundry expenses. Any
expenditure must be evidenced by an expense receipt or voucher. At any point in time the
cash balance, together with the expense vouchers, should agree to the total of the float.
Periodically, the cash balance will be replenished to the predetermined amount to reimburse
amounts paid out.

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 Question 1:
A business starts the week with $100 in their petty cash tin, and they use an imprest system
of recording. The following transactions occur:

What amount will be withdrawn from the bank at the end of the week?

IV. The Journal

Inevitably, a business will sometimes have unusual one-off transaction that don't really fit
into the other books of prime entry, but they do need to be entered into the accounts
somewhere. These transactions are listed in the Journal and then enters one at a time into
the Ledger.

Examples of things that might be entered into the Journal are buying or selling a non-
current asset on credit. Buying or selling for cash would go into the cash book.

Depreciation. This is an adjustment that a business makes at the end of each year to take
account of the wearing out of its non-current assets.

Writing off irrecoverable debts. For example, if a customer goes out of business but still
owes us money, it will be necessary to adjust the accounts to remove the debt.

Accruals and prepayments. This's also year-end adjustments that you will learn about in
a later session. They help to ensure that costs are correctly matched to the correct period
in our account.

Also, if it made any errors in the day books that come to light later on, then rather than going
back and changing the day books and corresponding entries each day in the Ledger, we
record the adjustment needed to fix the error in the Journal.

The basic rule of thumb is that if you see something unusual that doesn't seem to fit nicely
into the day books then you would put it in the Journal instead.

Noted that every journal entry should have an equal value of debits and credits to post into
the general ledger.

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V. Ledger accounting
The general or nominal Ledger is the heart of the double entry bookkeeping system. Of
course, these days the Ledger is computerised, but it might help to think of it as a large
book.

Within the book there are many different pages and on each page is an individual Ledger
account. There will be one Ledger account for each item in the statement of financial
position and the statement of profit or loss. So, there will be a Ledger account for
receivables, one for inventory, one for cash, and so on.

Each page of the book has two sides. We will always refer to the left-hand side as a debit
and the right-hand side as the credit. This allows us to put increases in the account of one
side of the page and decreases on the other side. It also means that we never need to use
negative numbers in the Ledger account.

There are no set rules about how many Ledger accounts our business maintains within its
general Ledger. Depending on the size of the business, there might well be more than one
Ledger account for some lines in the financial statements. For example, a small business
might just have a single Ledger account for non-current assets, but a larger business might
have an account for buildings, another one of the motor vehicles, and the third one for office
equipment.

Similarly, a small business might just have a single account for office expenses, but a larger
business might want a separate account for electricity, rent, and insurance.

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VI. Basic principles of accounting
1.1 Types of elements of business
John is adventurous and lucky, having won £20,000 in the lottery and inspired by various
cooking programs, he decided to invest £5,000 in a bakery business. So, let's think about
the things that John may have in his business.

Well, first of all, he may have some assets.

Now that's quite a complex definition. An asset is something that the business controls that
will bring benefits in the future, either by increasing sales or reducing costs or by getting
more cash into the business. At this stage in your studies, many people think of it as what
the business owns or what is owed to the business.

Now let’s think of the things that John may own in his business. First of all, he may own an
oven to bake the cakes, a van to deliver the cakes, a till to collect the money from the sale
of his cakes, a computer to record the transactions, some ingredients to make the cakes
and hopefully the business will own some cash which is also an asset.

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But who might owe the business some money? Well, maybe some local coffee shop owners
and bought some of John's cakes because they're going to sell them on to their customers
but they haven't paid John yet. We called these customers who bought goods on credit
“Receivables”.

These are all assets of John's business.

John's business may also have some liabilities.

At this stage in your studies, most people think of that as something the business owes.

Usually the business owes someone else. Maybe a formal loan to the bank which they will
promise to pay back in the future or maybe the entity is gone overdrawn. If you are in
overdrawn situation you effectively owe bank, the balance on your overdraft.

The final liability that you should be aware of is when a business buys raw materials but
doesn't pay for them. So, maybe John has bought some strawberries from a local farmer
but he hasn't paid for them. This is called “payables”.

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 The final element you should be aware of is capital.

But really what that means is the amount of money the owner first put into the business,
original money they invested plus any profits less any money they have taken out of the
business to spend on personal use. What we call “drawings”.

Sometimes you hear people calling capital as equity. Equity is the same as capital. You
see why we have a separate section on capital when we look at the separate entity concept,
but you may think of capital as what the business owes the owner.

2.1 Separate entity concept

Let's go back and use John. John was very lucky and he won £20,000 on the lottery. So
personally, he has £20,000, but he decided to invest £5,000 of that in the business.

So, his business, the bakery business has by £5,000 worth of cash in it. He kept £15,000
for himself. So, he has £15,000 and his business has £5,000 cash in it.

Now it’s in legal sense. John still has £20,000 cash in total, £15,000 in his pocket and £5,000
he invested in his business. However, from an accounting perspective, it is vitally important
that we treat the business as if it was a completely separate entity. This is called a single
entity concept. We must account for the business completely separately than John, the

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 person. So, by putting £5,000 into the business, John has made the first transaction of the
business. The business now has £5,000 worth of cash in it, but it owes John as the person,
£5,000. Now remember when the business owes the money back to the owner, we call that
capital.

3.1 The dual effect principle

Here is that for every single transaction there's always two effects. It like the law of physics.
For every action, there is an equal and opposite reaction and you need to become an expert
in identifying the two effects of the transaction as they form the very basis of double entry
bookkeeping.

For example, John invests $5,000 in his bakery business.

So, the first effect was to increase cash, an asset in the business, by $5,000. Because of
that single entity concept that we just talked about; the second effect was to increase capital
by $5,000. That one transaction had two effects. We increase cash and capital.

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John pays himself $200.

Ultimately, he's taking $200 out of the business. So, we're reducing cash in the business by
$200. Remember, any money taken out of the business is called drawings. So, the other
side is to increase drawings $200. Ultimately, drawings will reduce capital, so the business
will owe John $200 less.

John buys a van for $1,000 cash.

The business now has an asset, a van. So, increased non-current assets, a van, by $1,000,
but he spent the money buying that van and therefore he's got $1,000 less. So, decreased
cash by $1,000. Again, one transaction had two effects.

Finally, John’s business buys a computer for $500 and promises to pay later.

So, increased non-current assets, a computer, by $500. He hasn't paid, so we can't

decrease cash. What has increased is payables by $500. He owes his supply some money
and that's what we call it payables. Again, that transaction had two effects.

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4.1 Accounting equation
The fact that every transaction has two effects we make an accounting equation and you
must learn this equation because everything we do in bookkeeping always comes back to
this equation. Assets equals liabilities plus capital. If you have always recorded your
transactions correctly, if you always recorded both sides of the transaction, this will always
hold true no matter how complex the transaction you are dealing with.

Every transaction has two effects and each effect will happen equal and opposite impact on
this equation.

We can use that equation and apply it to our original transactions.

Our first transaction, John invested £5,000 in his bakery business.

That would increase cash, an asset by £5,000 and that would increase capital £5,000. So,
if we put that in our equation, we've got cash, an asset going into the assets column. We've
got capital, going into the capital column.

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Our second transaction, John pays himself £200.

We decreased cash by £200 and increased drawings by £200. While the cash goes into our
assets, we did have £5,000 but we've just taken £200 out so we've got £4,800 left. Our
original capital was £5,000 and if you remember our equation, capital equals original
investment plus profit minus drawings. So, our capital now is £4,800 that was the original
capital less the drawings.

Our third transaction, John buys a van for £1,000 cash.

That would increase non-current assets, a van £1,000, but that would decrease cash. So,
we need to take that £1,000 off the cash balance that we already had £4,800. That gives
us a revised cash balance £3,800. But we've also got a new asset, a van £1,000. So, if we
total down our equation now, our total assets are still £4,800.

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Our last transaction, John’s business buys a computer for £500 and promised to pay
later.

We had a new non-current asset, a computer but this time we didn't pay cash. We promised
to pay later so we increase payables by £500. So, we can see that non-current asset, a
computer, coming in on the asset side but this time we've got our first liability. We got
payables of £500 slotting into our liability’s column.

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VII. Ledger accounts
A ledger account is a record of the transactions relating to a particular item, for example
heat and light, bank charges and interest, sales revenue, plant and equipment, bank loan
etc.

In this chapter we are concerned with the nominal or general ledger, which is the ledger
containing all of the accounts necessary to summarise an entity’s transactions and prepare
a statement of financial position and statement of profit or loss.

Each Ledger account has two sides. The left-hand side is referred to as the debit side,
shorted (Dr) and the right-hand side is referred to as the credit side, shorted (Cr).

Each side contains the date, the details of the transaction, and the amount. The details
column allows us to maintain an audit trail of the transactions. It would contain the name of
the other column affected.

As a quick example, if the businesses spent $500 on rent, we would show this in two T
accounts, the rent T account and the cash T account. In the rent T account, we would show
the date and the value of $500. In the detail, we would include cash, so we can clearly see
where the other side of the dual effects being included. In the cash T account, we would
again show the date and the value of $500 and the detail we would include rent. So again,
we can clearly see where the other side of the dual affect being included.

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VIII. Debits and credits
It is essential to become experts and knowing when to debit and when to credit transaction.
So, we will use the new mnemonic “PEARLS” to help remember the rules.

The debit represents an increase in purchases, expenses and assets. The credit represents
an increase in revenues, liabilities and shareholder’s equity. It is important to note that the
opposite entry would reflect decreases.

Example:
The first transaction: Ivy commenced business introducing $1,000 in cash.

We need to identify the accounts affected with the transactions. Remembering that each
transaction will affect two accounts. In this case, these will be cash and equity.

• If we consider the impact on the cash account, the business has more cash so the
asset is increasing. To record an increase an asset we would debit that account.

• The other side of the transaction is to recognize that the business owes the owner. To
show an increase in a liability to the owners we would credit equity.

The second transaction: Ivy bought a motor car for $400 cash.

• Cash is an asset and that we have decreased this asset because we've spent the cash.
This would be reflected by crediting cash.

• The motor car is also an asset of the business and this asset has increased. An
increase in assets are reflected with a debit.

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The third transaction: Ivy received an additional $1,000 in the form of loan.

• We would show the additional cash received by debiting cash account.

• The Loan itself will need to show as a liability as we have that obligation to repay. To
show an increase in a liability we would credit the loan account.

The fourth transaction: Ivy purchased goods for resale for $300 in cash.

• An increase in purchases is reflected on the debit side of the account while a decrease
in the cash asset is reflected on credit.

The final transaction: Ivy made sale on credit for $400.

• As this is a sale on credit, no cash has yet been received. So, this would not be reflected
within the cash account. Instead, we would show this as an amount owing to us from
the customer. This is called a receivable and is an asset of the business. So, we need
to debit receivable account.

• We need to show the income that has been earned. So, we need to credit revenue
account.

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