Chapter 1 Fundamental of accounting

1.1 Purpose of Accounting

Bookkeeping: a detailed recording of all the financial transactions of a business
- Entered into books of prime entry and ledger accounts
Accounting: uses bookkeeping records/information to prepare financial statements
Running a business involves the regular exchange of goods or services and money with
many other people or organizations, including:
- Suppliers: provides goods intended for resale to customers, or component parts and
materials to make other goods
- Customers: buy these goods
- Employees: supply their labour to the business in return for wages or salaries
- Suppliers of business services includes electricity, telephone, and insurance
Every exchange is called a business transaction.
The purpose of accounting is to measure the profit or loss and value of a business.
- Income statement: summarises information about the income and different costs
and expenses of the business, and therefore its profit or loss, over a 12-month
period. Example components are revenue, expenses and net income.

- Statement of financial position: summarises financial information about the value

of the business on the final day of an accounting year, notably how much of value the
business owns and how much it owes to other people and organisations.
Financial statements are the most important document a business can produce about its
financial health and performance. Many different groups of people use them to make a
judgement on the performance of the business over time, these includes: entrepreneurs,
suppliers, bank, employees, tax authorities of the government.
1.2 The double-entry system of bookkeeping
Assets: anything that has current or economic value to a business. (owns)
- Non-current assets: remain productive for several years and can be used
continuously to benefit the business. Examples are premises, machinery, equipment,
furniture, and vehicles. (long term)
- Current assets: used up quite quickly. Examples are inventories of goods for resale,
cash either held on the business premises, and cash in bank. (short term)
Liabilities: financial obligations to repay money owed to other people. (owes)
- Non-current liabilities: amounts repayable in more than a year. Examples are bank
loans. (long term loans)
- Current liabilities: require repayment quickly, often within a few months in the
accounting year. Examples are bank overdrafts and debts to suppliers for goods
purchased from them on credit. (short term loans)
Owner’s equity/capital: money invested in business assets by the owner from their own
funds.
*Accounting equation: assets = liabilities + owner’s equity
Ledger accounts: records bookkeeping entries for balance sheet and income statements.
- Personal accounts: for credit transactions with named suppliers and customers.
Examples are trade payables (owes), trade receivables(owed).
- Real accounts: record transactions involving equity, assets and liabilities. Examples
are capital account, accounts for non-current assets, cash and bank accounts and
other payables and receivables.
- Nominal accounts: record expenses including wages, electricity and rent, and
incomes received from different sources such as total sales revenue, interest on
business savings and sales commission. Opened at start of accounting year and
closed at the year end.
Transactions are recorded in
ledger accounts as debits and
credits.
System used to write up
ledger accounts with
transactions recorded in
books of prime entry is
known as the double-entry
system of bookkeeping.
Total debits must always
equal total credits in the
ledger.
1.3 Business documents
- Used to record sales, purchases and payments.
- Examples are invoices, credit and debit notes, statements of accounts and receipts.
Invoice: records goods and services supplied on credit terms and is a request for
payment. Issued by the supplier to customers to inform about the sales on credit terms. The
purpose is to notify the customer of goods supplied on credit, total price and when payment
is due. Contains: name and address of supplier and customer, customer’s account number,
invoice number for reference, full description of items supplied, unit price, any deduction or
trade discounts, carriage charges, and date of invoice, total amount to pay, when payment is
due.

 Trade discounts: reductions in price that a supplier applies to a product's cost when
selling to a reseller. It is used to encourage customers to buy in bulk.
 Cash discount: a discount that sellers offer to incentivize customers to pay bills prior
to due dates. It is used to encourage customers to settle their debts early.
Debit note: a request from customer to a supplier to reduce the total amount charged on an
invoice.

 A customer will issue a debit note if: the supplier has made a mistake and
overcharged the customer, goods were not received because lost or stolen during
transit, customer returned unsatisfactory or damaged goods. Contains: name and
address of supplier and customer, customer’s account number, invoice number for
reference, purpose of debit note (above reasons), details of returned goods, how
much the supplier owes the customer and the date of issue.
Credit note: issued by a supplier if the total price it has charged a customer on an invoice is
more the amount that needs to be paid.

 The purpose of a credit note is to record an overcharged amount. Reasons: supplier

made a mistake and overcharged the customer, customer did not received goods as
lost or stolen in transit, and goods were unsatisfactory or damaged. Contains name
and address of supplier and customer, relevant invoice number, customer’s account
number, details of goods returned and date of issue.
Statement of accounts: a summary of transactions between a supplier and its credit
customer. At the end of the month, a supplier will usually issue a credit customer a
statement of account. A request to the customer for payment of the balance outstanding on
the account. Shows how much the customer owes the supplier at the end of previous month.
Contains: name and address of supplier and customer, customer account number, balance
brought forward from the last account statements, month and date of the statement, record
of all transactions made with the customer including all invoices, credit notes issued to the
customer and any payment received, balance on the account after each transactions and
closing balance owed by the customer.

Cheque: a written order to a bank to pay a stated sum of money to the person or business
named on the order.
Receipt: a written acknowledgement of money received and acts as a proof of payment.
These are: sales receipt, cheques, statement of accounts, and bank account statements.

1.4 Books of prime entry

Book of prime entry:
- Purchases Journal: record purchases on credit of goods intended for resale to
customers.
- Purchases Returns Journal: record any goods subsequently returned to their
suppliers.
- Sales Journal: record goods sold to customers on credit terms.
- Sales Returns Journal: record any goods subsequently returned by customers.
- Cash Book: record all cash and bank account payments and receipts.
- General Journal: record transactions that are not entered in any other books of
prime entry, for example: purchases and sales of non-current assets on credit.

1.5 The cash book

- Every transaction of a business involving the exchange of cash should be recorded in
its cash book.
 Cash discounts: a reduction in the amount payable.

 Discount allowed: customer makes payment to business before due date.

(an expense to the business/loss) DEBIT
 Discount received: business makes payment to supplier before due date.
(a gain in income for business) CREDIT
~ everytime theres a RECEIVED word just CREDIT!
1.6 The general journal
- Transactions that cannot be recorded in any other books of prime entry are recorded
- Shows: the date of the transaction, the name of the account to be debited and
credited and the amount, a narrative

1.7 The ledger

- Contains all different accounts of an organisation providing a permanent summary of
all the transactions entered in journals.
- Posting: the process of transferring journal entries to the ledger.
- Every ledger will affect two accounts.
- Anything coming in > debit
- Anything being taken out> credit
Inventory: current asset (can be sold off)
- Purchases of goods increase the inventory while sales of goods decrease the
inventory.
- Purchase returns or returns outwards will decrease inventory of goods. (goods are
sent back to supplier)
- Sales earn revenue and reduce inventory.
- Sales returns is when goods are returned by customers. (increase inventory)

Expenses: payments for items needed to run the business in order to earn revenue or to
generate other incomes. Examples are premises, equipment, electricity, and the efforts of
employees that help a business sell its goods or service. Debit an expense account to
record items coming in. Credit cash or bank account to record money paid out for the
expense.
Commission: paid as a percentage of the price of each product sold to encourage the
business to sell more.
Drawings: withdrawal of cash from the business by its owners for personal use. (reduces
assets)
Balancing off: adding up all the debit and credit entries on that account and finding the
difference between them. The difference is the balance on the account at the time.
1.8 Trial Balance

-
- A list of the balances on the accounts in the ledger on the given date.
- Has a debit and credit column
- When equal means that no errors have been made
Advantages of trial balance:
- Provides a check on accuracy of account balances in the ledger to ensure that
entries have been made correctly
- Helps to identify and avoid certain errors that can be made in the accounts
- Makes preparation of financial summaries and statements much easier because they
can be prepared from the balances in the trial balance rather than having to refer to
every individual account
Errors in a trial balance: can be the result of mistakes made recording transactions in
journals and in the preparation and balancing off of ledger accounts.
- Errors of commission: double entries have been made correctly for a transaction
but in the wrong account name. Example: M.Robert instead of J.Robert
Correction: reverse the incorrect amount and then enter the correct amount.

- Compensating errors: involves two or more errors in the same account which
cancelled each other out that results in the trial balance still balance.
The mistake cannot be corrected by offsetting it.

- Errors of complete reversal: a situation where an account that has to be debited is

credited and vice versa.
Correction: the amount is multiplied by two or posted twice in the correct entry side.
- Errors of omission: failure to record double entries for a transaction. Example: did
not debit nor credit.
 - Errors of original entry: incorrect value for a transaction is recorded. Example: 600
instead of 60.

- Errors of principle: transaction recorded correctly in the right side but wrong type of
account name. Example: Rent instead of Sales.

Depreciation
- Devaluation of a non-current asset (machinery, furniture)
Causes of depreciation:
- Physical deuteriation
- Obsolescence: outdated
- Depletion of an asset:
- Passage of time:
Method to calculate depreciation
- straight line
- reducing balance method
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