To record every business transaction that takes place we use an accounting system known as double-entry bookkeeping. It is believed that the double-entry system of bookkeeping was introduced to Europe in the early sixteenth century by the monk, Luca Pacioli, who tutored Leonardo da Vinci in mathematics. This system has been in use in most of the developed world for over 500 years and it shows no signs of declining in its popularity in recording accounting transactions. Double-entry bookkeeping, at first glance, appears complex and one might think that bookkeeping would need many years of practice before they can 'keep the books'. Fortunately, looks can be deceiving and almost anyone can pick up the basics of this system in a very short time. This is because the double entry system can be reduced down to some very straightforward rules. The whole system of double entry bookkeeping can be summarised in the following two rules: 1. All transactions have one entry in two different accounts (the double-entry bit) 2. All transactions have one debit entry (left side of account) and one credit entry (right side of account) If you can remember these basic rules then financial accounting will be a lot more straightforward. In fact, remembering this rule can help you out of situations where you cannot remember which side one half of the transaction should be entered - just remember, if you know the debit entry then wherever the other entry is, it must be a credit entry and vice versa. For every type of transaction, from buying new machinery to paying a supplier, there will be separate account. And each account will look roughly as follows; Name of account Year Date/Month Year Amount Date/Month Amount
Details
Details
Name of account - the area that the transaction covers. There will be an account for cash, an account for every type of expense (insurance, rent and so on), an account for each type of asset (things like equipment, premises and machinery), as well as an account for each customer we sell to and each supplier we buy from (the personal accounts). Date/month - the time when the transaction is undertaken
Details - the other account that is affected by the double entry transactions. Having the details here will help us to remember that there must always be two entries for each transaction. Amount - the total monetary amount of the transaction.
For each different type of account there will be different rules governing which side of the account it is entered into. This rule will depend upon whether the amount in the account is increasing or decreasing, and also whether the account is an asset, liability or a capital account. The account will always be split into two sides. It is vital that you enter the transaction not only in the correct account but also on the correct side. The two sides of each account are as follows: Any account Left hand side is known as the DEBIT SIDE Right hand side is known as the CREDIT SIDE
Debit is often abbreviated as Dr. and Credit is often abbreviated as Cr. To begin with, we will consider the rules for three different types of accounts:
Assets
Assets are any resources that are to be used in the business. Examples would include machinery, premises, stocks of goods and cash.
Liabilities
Liabilities refer to any borrowings undertaken by the firm (e.g. Loans or credit offered to us by suppliers).
Capital
Capital refers to the value of the resources put into the firm by the owner(s). Some items can be classified as both an asset and capital. For example, cash introduced into the firm by the owner would be classed as capital. However, this cash would also be classed as an asset. This is simply the result of classifying items from two points of view.
Try not to see, as some students sometimes do, assets as being good and liabilities as being bad. The term liability simply refers to the source of the finance, and makes no judgement on whether it is good or bad for the firm. The rules for entering these types of transactions in the double-entry accounts are as follows: Any Asset account Increases are entered on this side Reductions are entered on this side
Any Liability account Reductions are entered on this side Increases are entered on this side
Any Capital account Reductions are entered on this side Increases are entered on this side
The following transactions are all based on a firm being set up from the initial starting of the firm. The amounts of money may appear small, but this is simply to get you used to the idea of entering transactions in the double-entry accounts. Two rules of double-entry bookkeeping: All transactions have two entries. Each transaction has one debit (left) and one credit (right) entry Accounting for purchases and sales Therefore, we need to keep separate accounts for stock being purchased and stock being sold. In fact, we actually keep four accounts for movements in stock and these are as follows: Increases in stock:
Purchases account - stocks of goods bought by the firm for resale Returns inwards account - stocks previously sold that is returned by the customer due to the goods being unsuitable (e.g. they are damaged, the wrong type of goods, etc.)
Decreases in stock:
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Sales account - stocks of goods sold to customers Returns outwards account - stocks previously purchased by the firm which is returned to the original supplier
The normal double entry rules apply to all these stock accounts. Stock is an asset therefore, increases in stocks will always be debited to the relevant account and decreases will always be credited. (You may also see returns inwards referred to as sales returns, and returns outwards as purchases returns) Accounting for expenses and revenues All firms will have expenses to pay as part of normal business activity. This will occur on a frequent basis. Each separate expense will have its own account. Expenses do not fall into the classification of 'asset', 'liability' or 'capital', but we can still work out the rules for making entries in the expense accounts. Any expense will require either cash or a cheque payment. Therefore, this will require a credit entry in either the cash or the bank account. As a result, the debit entry must be in the expense account - it cannot be a credit entry as it would not fit the rules of double entry bookkeeping. Accounting for drawings Earlier in this section we saw that anything injected into the business for use in the business by the owner is known as capital. However, it is perfectly possible for the owner to withdraw resources (money or stock for example) from the business. This would be represented by a decrease in capital. These reductions are known as 'drawings'. These 'drawings' are kept in a separate drawings account - which is another form of capital account and follows the same double entry rules. Balancing off accounts At the end of each accounting period the firm will wish to balance its accounts off. An accounting period is normally one year but most firms will wish to balance off their accounts on a more frequent basis - usually every month. The more frequently a firm balances its accounts off, the less likely it is to make mistakes. The process of balancing accounts off should not be rushed. It is, in effect, the final part of the double entry system of bookkeeping. Once accounts have been balanced off then the firm can begin to assess whether it has made a profit and if so how much profit has been generated. The balance on each account is simply the difference in the totals of the debit side of the account and the credit side of the account. For example, if the debit side of an account added up to 190
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but the credit side of the account added up to 330, then we would say that the account had a credit balance of 330 - 190 = 140. To balance off accounts the following guidelines should be followed: 1. Each account must have its debit and credit columns totalled up - but don't write anything down yet. 2. The largest total out of the two columns will become the total for both sides and this will be written underneath each column on both sides and double underlined (double - to show that this account is finished with). 3. The column where the total does not add up to the total shown will need a balancing figure to make it add up. This should be entered as the 'balance to be carried down' or 'balance c/d' for short. This amount should be exactly equal to the amount needed to make the columns now both add up to the same total. Some things to remember when balancing off accounts are: 1. The totals for each column should always be on the same level on the page - never at split-levels. 2. The balance brought down must always be on the opposite side to the balancing figure of the balance to be carried down. 3. The actual balance on the account is the balance brought down not the balance carried down. 4. An account is not really finished until the balance has been brought down to the next period.
Books of original entry are the books in which we first record transactions. These are not accounts; they are simply books that records the details of a transactions, almost like a diary. The firm will have a separate book for each kind of transaction. The type of the transaction will affect which book it, is entered into. Sales will be entered in one book, purchases in another book, cash in another book, and so on. The books of original entry are used to record the following:
The date on which each transaction took place - the transactions should be shown in date order; Details relating to the sale are entered in a 'details' column; A folio column entry is made cross-referencing back to the original 'source document', e.g. the invoice; The monetary amounts are entered in columns included in the books of original entry for that purpose.
Advantages of keeping books of original entry 1. Accounts can be found more easily by the use of the cross referencing nature of the books of original entry being kept. 2. If records are lost then the ledgers and the books of original entry act as a back up for each other. 3. Acts as a 'listing device' for posting totals to various accounts, thereby saving labour
Sales daybook (or Sales journal) - for credit sales Purchases daybook (or Purchases journal) - for credit purchases Returns inwards daybook (or Returns inwards journal) - for returns inwards Returns outwards daybook (or Returns outwards journal) - for returns outwards Cashbook - for receipts and payments of cash and cheques General journal (or just 'The journal' if the term 'Daybook' is used for other books of original entry) - for other items
The cashbook is a combined account of the cash account and the bank account. It is the only one of the six daybooks that is both an account and a daybook at the same time. Apart from the cashbook, all the other double-entry accounts are kept in one of the three ledgers. Petty cash book Some firms actually keep a separate cashbook and a petty cash book. The petty cash book is for dealing with small items of money. It may be case that the firm has lots of transactions, which
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involve relatively small amounts of money (e.g. petrol costs, postage costs and so on). If these were entered in the cashbook then it would quickly become cluttered up with entries for small amounts of money. To stop this happening some firms will keep a petty cashbook, which deals with these items. At the end of each month the monthly totals can then be transferred to the main cashbook. This has the other advantage of allowing another member of staff (usually a junior) the responsibility of dealing with petty cashbook alone and this frees up time for the main cashier of the firm to deal with the main cashbook. Some very large firms may actually use the petty cashbook for dealing with all cash items of expenditure. The main cashbook would then only be used for bank transactions. Source documents All the daybooks are constructed on the basis of transfers from original source documents. These are items of business use that contain financial data related to business transactions. The main source documents a firm is likely to use are as follows:
Purchase invoice: Received by the firm from suppliers when buying goods on credit Sales invoice: Sent by the firm when selling goods on credit Debit notes: Received by the firm from suppliers when goods purchased are returned to the original supplier Credit notes: Sent by the firm to customers who have returned the goods Cheque counterfoils: From the chequebook to show cheques paid out Paying slip; Evidence of money paid into bank accounts Till rolls: Evidence of cash being received Petty cash vouchers: Slips to indicate small amounts of cash being paid Bank statements: A summary of the bank account from the banks point of view.
The following daybooks are constructed by the use of each of the following source documents: Daybook Sales daybook Purchases daybook Returns inwards daybook Returns outwards daybook Cashbook The journal Source document(s) Sales invoice Purchases invoice Credit notes Debit notes Cheque counterfoils, paying in slips, till rolls, etc. Everything else not covered by above
the business. The act of using one book as a means of entering the transaction to the other account, so as to complete double entry, is known as 'posting' the items. One reason why a set of ledgers is used rather than just one big ledger is that this makes it easier to divide the work of recording all the entries between different bookkeepers.
Types of ledgers
The different types of ledgers most businesses use are:
Sales ledger. This is for customers' (debtors) personal accounts Purchases ledger. This is for suppliers' (creditors) personal accounts General ledger. This contains the remaining double entry accounts, such as those relating to expenses, sales, purchases, fixed assets, and capital
Types of accounts
Some people describe all accounts as personal accounts or as impersonal accounts. 1. Personal accounts - these are for debtors and creditors (i.e. customers and suppliers) 2. Impersonal accounts - divided between 'real' accounts and 'nominal' accounts:
Real accounts - accounts in which possessions are recorded. Examples are buildings, machinery, fixtures and stock Nominal accounts - accounts in which expenses, income and capital are recorded
GL General ledger CB Cashbook If the entry 'C' appears in the folio column then this refers to a contra entry. This means that both halves of the transaction are contained in the same account. An example of this is dealt with in the section on cashbooks.
B Griffin H Spence
1 Feb
Balance b/d
However the cashbook combines the two separate accounts into one joint account. The example below is just the two separate examples from above combined into a cashbook format: Cashbook
Cash 2002 1 Jan 2 Jan 5 Jan 7 Jan 12 Jan 18 Jan Capital B Griffin Sales H Spence W Green Rent 250 430
Bank 2002 2,500 2 Jan 2 Jan 150 8 Jan 11 Jan 320 14 Jan 85 15 Jan 21 Jan 31 Jan 3,055 1,915 Office expenses Office furniture T McClure Insurance Motor expenses Purchases P Yarrow Balances c/d
Cash 50
Bank
1 Feb
Balances c/d
680 135
Notice that the accounts have not altered at all. They are still balanced off separately at the end of the month and the balances will obviously be the same as before. The above example is known as a two-column cashbook - the two columns being bank and cash columns. It is possible to have a closing balance which is a debit balance for the cash account but a credit balance for the bank account. The account should simply have balances drawn in for both sides. It is impossible for the cash account to be a credit balance, this would mean that the firm had a negative amount of cash. This cannot be the case - one can have either some cash or no cash but not a negative amount. The bank account can be a credit balance and this means that the firm is overdrawn on the account - the firm has drawn more from the bank account than is actually there and the firm now owes the bank money.
Cash discounts
Although firms will offer terms of credit to their customers, the firm would prefer it if customers settled their account as quickly as possible (i.e. paid what they owed) fairly quickly because the cash flow will be important to most firms. Many firms will offer discounts in return for prompt payments. These are known as cash discounts (also known as settlement discounts) and are usually given as a percentage of the overall invoice total (e.g. 5% off the sales value). The term cash discount does not mean that the amount has to be paid in cash - cash or cheques would both qualify if they were paid within the given time limit. The term cash discount is used
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to distinguish it from trade discounts. The cash discount offered and the terms and conditions will normally be found on the invoice. There are two types of cash discounts that are recorded in the ledger accounts:
Discounts allowed
Cash discounts allowed by a firm to its customers when they pay their accounts quickly.
Discounts received
Received by a firm from its suppliers when it pays their accounts quickly.
There is no alteration to the method of showing discounts in the personal accounts. When balancing the accounts off at the end of the period, you must take care to note that the discounts columns are not balanced off against each other. The discounts columns are simply totalled up and then transferred to the relevant discount account. Therefore the totals are likely to be different for the discount columns. This is a fully worked example of a three-column cashbook: 2005 October 1
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Paid creditors by cheque; G Dawes 440 L Lewes 120 (before discount) and received a 5% discount on invoice totals. Paid 100 cash into bank account Received cheques from suppliers for accounts totals as follows: R Kirk 360 and C Watson 120, in each case allowing a 2.5% discount. Cash purchases 78 Paid rent by cheque 56 Received cheque of 90 from H Knight in settlement of sales worth 95. Cash withdrawn from bank for personal use 50 Received commission by cash 46
Imprest system
The most common system used to maintain the petty cash book is known as the imprest system. This involves co-ordination between the cashier responsible for the cashbook and the cashier responsible for the petty cash book. The cashier will give the petty book cashier just enough money to cover the petty cash transactions of a period of time - usually one month. At the end of the month, the amount actually spent will be totalled up and the amount will be refunded from the main cashbook as follows: Entries needed to refund amount spent on petty cash Debit Petty cashbook
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Credit Cashbook
In this way, the balance on the petty cashbook will always be the same at the start of each period. This opening balance is known as the float or imprest. The float can be changed if it is observed that the petty cash is either being spent too quickly, or is not being spent at all. The idea is that the float should cover the periods' expenses. Most firms who maintain petty cashbooks will do so in a format which categorises different types of petty cash expenditure. This is known as an analytical petty cashbook because it analyses the different types of expenditure. The petty cashbook still follows the rules of any double entry account. However, the credit side of this account will be split into the various categories of expenditure. The following are details of petty cash transactions for the month of February 2004. The business transactions that occur are as follows: Feb 1 The chief cashier debits the petty cashbook with 70 to restore the float 10 4 3 6 2 17 9 4
Petrol costs Stationery Coffee for office Bus fares Milk and tea Rail fares New paper for printer Folders for office
The chief cashier debits the petty cashbook with 55 to restore the float
The 55 received on February 28 is exactly the amount that was spent during February on petty cash transactions. The analysis columns that are to be used in this example are:
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There are no strict rules on what columns should be used or how many of them there should be. It makes sense not to have too many because it may become confusing when filling in the petty cashbook. Advantages of maintaining a petty cashbook 1. It stops the main cashbook being cluttered up with small items of expenditure. 2. It allows the firm to delegate these small times to a junior member of staff, which frees up the time of the main cashier to concentrate on other areas.
Name of customer Address of customer Date of sale Value of sales Any trade discount Any cash discount - and details of the conditions Invoice number
Trade discounts
Firms may have different types of customers. Some firms will offer further discounts to either regular customers or to other firms. This type of discount is known as a trade discount. There is no double entry for trade discounts. The trade discount may be referred to on the sales invoice, but it should not show up in either the sales daybook or the ledger accounts. To compare with cash discounts: Trade discounts: are not shown in double entry accounts. Cash discounts: are shown in double entry accounts.
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When calculating the actual amount that needs to be paid or is expected to be received it is vital that the discounts are dealt with in the correct order. The correct procedure is to deduct the trade discount first before calculating the cash discount - do not simply add the discounts together then calculate them!
Sales
Sales
2002 1,640
T Wright 2002 Jan 15 2002 220 I Yates 2002 Jan 22 2002 1,100
Sales
Each of these items is posted (transferred from the daybook to the personal account) when the sale occurs. However, at the end of the month, it is the total for the month that is transferred from the daybook to the sales account in the general ledger Effect on general ledger: Sales 2002 2002 Jan 31 3,776
By doing it this way, we save cluttering up the sales account with lots of entries. The customer accounts will remain with each individual entry posted to them when it occurs.
Purchases daybook
Entering into the purchases journal
When purchasing goods on credit, the procedure is similar to the one outlined in a previous section for credit sales. The source document that would be used as the basis for entering up the transactions is the purchases invoice. The purchase invoices is actually the same document as the sales invoice, it is just considered from the point of view of the buyer, rather than the seller (i.e. the firm selling the goods will send out a sales invoice, and this becomes the purchase invoice for the firm receiving it).
We now have a separate purchases ledger containing all the creditor (supplier) accounts. The double entry procedure for credit purchases is as follows: Credit purchases are posted one by one, to the credit of each supplier's account in the purchases ledger. At the end of each period the total of the credit purchases is posted to the debit side of the purchases account in the general ledger. Effect on purchases ledger: D Henson 2002 Feb 3 290
Purchases
Purchases
Purchases
Purchases
As with sales, each will be posted when the purchase occurs. However, at the end of the month, it is the total for the month that is transferred from the daybook to the purchases account in the general ledger
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Effect on general ledger: Purchases 2002 Feb 28 Total credit purchases for month 2002 3,525
Returns daybooks
The customer can return goods sold to the original supplier. This can be viewed from firm's perspective as both a customer and a supplier. Sales returned will be treated as returns inwards and purchases returned will be treated as returns outwards. Each type of returns has its own daybook - one for returns inwards and one for returns outwards.
Returns inwards
If a customer is unhappy with the goods received then they may return them to the firm. This does not happen automatically but returns inwards are a common feature of business transactions (if they were not then why would we bother with a full daybook solely for each type of returns?). If a firm agrees to accept returns inwards (i.e. customer sending goods back) then the source document used as the basis of recording this transaction is the credit note. The credit note is sent by the firm to the customer who has been allowed to return the goods. The credit note takes its name from the fact that because the firm has agreed to accept returns inwards, we will credit that customer's personal account (thus reducing the debtor balance on that account). A credit note would appear similar to the sale invoice and would mainly contain details of the goods to be returned, and the value of these goods as recorded in the account when the sale was originally made. The credit notes may appear as follows - they may appear in red to avoid confusion with sales and purchases invoices: To: A Powell 58 Oxford Road Sheffield S6 5TU S Hopkinson 23 Regent Road 3 March 2002
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Derby DE1 1JK CREDIT NOTE 10045 Per Unit 15 Total 300 75 225
Returns inwards journal The information from the credit notes will be used as the basis for filling out the returns inwards daybook. When posting entries from the returns inwards daybook, we should post each individual entry to the credit side of the personal account of each customer (found in the sales ledger). The total for the monthly returns inwards will be posted to the debit side of the return inwards account in the general ledger. This is completed for the above example below: Effect on sales ledger: S Hopkinson 2002 2002 Mar 3 225
Returns inwards
Returns inwards
I Rowell
19
2002
2002 Mar 18
Returns inwards
145
Returns inwards
Returns outwards
Goods returns by the firm to the original supplier are known as returns outwards. The source document used is the debit note. The firm will send a debit note back to the original supplier which will give details of the goods being retuned and the reason(s) for their return. An example of a debit note appears below: To: A Powell 58 Oxford Road Sheffield G Thompson 29 Swann Road Manchester M12 5RE
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Returns outwards journal The debit notes sent to the original suppliers are used as the basis for completion of the firm's returns outwards daybook. When posting entries from the returns outwards daybook, we will post each individual entry to the debit side of the personal account of each supplier we are retuning goods to (found in purchases ledger). The total returns outwards of the month would be then posted to the credit side of the returns outwards account in the general ledger. Effect on purchases ledger: G Thompson 2002 Apr 6 2002 160
Returns outwards
Returns outwards
Returns outwards
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The Journal
If any transaction is not covered by either the four main daybooks (sales, purchases, returns inwards and outwards) or the cashbook, then it will be entered in the Journal. Although it may seem like the Journal will contain lots of different transactions, you will soon find that the entries that belong in the Journal are more likely to be one-off or unusual transactions and, as a result, it will not contain many entries. Also, the journal will appear different to the main four daybooks we have just seen. The appearance of an entry in the journal will be as follows: The Journal Date Details Name of account to be debited Name of account to be credited Narrative The date of the transaction and the value of the transaction are self-explanatory. In the details section of the journal contains two main entries. These will cover the name of the account to be debited and the name of the account to be credited - we are literally writing up the double-entry transaction in a form of long-hand. The journal represents a sort of extra record of the double entry transactions - remember it is not part of the double entry system itself. The narrative is a simpler description or explanation of the traction that this entry contains. Notice how in the space where we state the name of the account to be credited, the entry is indented slightly. This is always the case - so as to distinguish the entry from the debit entry. The debit entry must always come first. Once the entry has been made in the journal, the entries should then be posted to the actual double-entry accounts, just as described in the journal entry. It is possible to split the debit or the credit entries between two or more accounts. As long as the total of the debit entries, adds up to the same as the total of the credit entries then that is acceptable. This is shown in the example below:
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Dr
Cr
There are no other rules for making journal entries. Although it can cover a wide range of different transactions, common areas for journal entries would include:
Correction of errors Credit purchases and sales of fixed assets Opening and closing down businesses Cancellation and transfers of outstanding debts to the business
Comparing performance - with other firms or with previous periods of time to see if the firm is moving in the appropriate direction Planning ahead - profits will allow the firm to expand Obtaining a loan - most bank managers and other lenders would want to see that the firm is profitable before lending money Income tax purposes - tax payable will usually be based on the profits earned by the firm
The calculation of profit will involve the calculation of both revenue and expenses incurred by the firm over a period of time. In the case of the sole trader, the profit for a firm is calculated in an account known as the trading and profit and loss account. For a trading organisation it is not only the final profit figure that is important. Managers and owners will also want to know how the profit is made on the actual sales that take place before other general expenses are deducted. So this can be seen, the overall trading and profit and loss account is split into two sections; the trading account, which calculates gross profit and the profit and loss account, which calculates net profit.
Trading account - to calculate gross profit (the profit earned on the buying and selling of goods - before all other expenses have been deducted) Profit and loss account - to calculate net profit (the profit after all overhead expenses have been deducted from the gross profit - this is the overall profit earned by the firm)
It is possible that the firm may make a gross loss, where the cost of purchases is greater than the sales revenue, but this is unusual. More likely, a firm may make a gross profit, but may find that the other expenses are greater than the gross profit and the firm has made a net loss. You will find that most questions will be concerned with firms that buy and sell goods. In reality, many firms will not sell physical goods, and that they will provide services. In this case, the firm would only need a profit and loss account rather than a full trading and profit and loss account.
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We will consider firms that actually make their own goods later in Module 3 (manufacturing accounts). To construct a trading and profit and loss account we will need to use information from the firm's trial balance. In this example, we will use the following trial balance: D Ball - trial balance as on 31 December 2003 Dr () Sales Purchases Insurance Lighting & heating General expenses Machinery Debtors Creditors Bank Discounts allowed Discounts received Cash in hand Drawings Capital Loan 4,000 650 450 120 2,100 890 980 1,970 130 110 80 700 3,000 1,000 11,090 Cr. () 6,000
In the double entry accounts we have no single account for stock. The value for closing stock would have to be calculated by taking an actual stock count. As stated in the section on trial balances, any stock which remains unsold (closing stock) will be listed underneath the trial balance.
Trading account
In the trading account we calculate the firm's gross profit. To calculate the gross profit we use the following calculation Sales - cost of goods sold = gross profit The cost of goods sold is simply the cost to the firm for those goods that were actually sold. The total cost of purchases would be the cost of the goods sold. However, if any stock were unsold at
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the end of the year then we would not count this, as it has not contributed towards the value of sales. Hence, cost of sales: What we bought during the period Less: Goods bought but not sold during the period = Purchases Closing stock Cost of goods sold
From our example, closing stock at the close of business (i.e. 31 December 2003) was valued at 300. The cost of goods sold for D Ball will therefore be: 4,000 300 3,700
To transfer balances from the double entry accounts we 'close down' the ledger account and transfer all that was paid or received during the year to the trading and profit and loss account. In effect we are 'emptying out' the relevant accounts for the year and we will start filling them, up in next year. The double entry accounts will have already been balanced off and their balances will have been brought down for us to close off. For sales, we should make the following entries: Debit the sales account, thus closing it. Credit the trading account. Sales 2003 Dec 31 2003 6,000 Dec 31 6,000
Trading account
Balance b/d
The balance of the purchases is transferred to the trading account by: Debit the trading account. Credit the purchases account. Purchases
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2003 Dec 31
Balance b/d
Trading account
4,000
Although there is no double entry account for stock left unsold at the end of the period we actually now create one. The value of closing stock is found by a physical count on the quantity of stock - a process known as stocktaking Debit the stock account with the value of closing stock. Credit the trading account. Stock 2000 Dec 31 1995 300
Trading
It is usual for the trading and profit and loss accounts to be shown under one heading. The trading account is the top section and the profit and loss account is the lower section. It is possible to present the trading account and the profit and loss account as double entry accounts. This would be known as the horizontal presentation. However the practice is fast becoming outdated and now nearly every trading and profit and loss account you will see will be presented in the vertical manner. Remember the rules for the titles of financial statements. It should say who it is for, what it is, and for what period of time we are dealing with. Both the trading account and the profit and loss account are drawn up for a period of time and not on a particular date. This is because the profit can only be earned over a period of time. D Ball - trading account for year ended 31 December 2003 Sales Less Cost of goods sold: Purchases Less Closing stock Gross Profit 6,000
4,000 300
3,700 2,300
Notice how we use both columns, not as debits and credits but for performing sub-totals. Sometimes there will be two, three or even four columns. There are no formal rules as to how
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many columns you should use. As long as it is presented well then that is fine. In this case, the subtotal for purchases less closing stock is carried over into the right hand column.
Balance b/d
Balance b/d
Balance b/d
Balance b/d
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Balance b/d
Although machinery was purchased during the year and is a sort of expense it should not be transferred to the profit and loss account. This is because the purchase of machinery is known as an item of capital expenditure that means that it is not 'used up' completely in this single year and therefore it would be inappropriate to transfer the value of this expense in the profit and loss account. We will see how we deal with this later in module 3. All the other balances relate to balances on asset, capital and liability accounts. These are not to be used here as they will be used later on when we construct the balance sheet for the firm. The full trading and profit and loss account will appear as follows: D Ball - trading account for year ended 31 December 2003 Sales Less Cost of goods sold: Purchases Less Closing stock Gross Profit Add Discount received Less Expenses: Insurance Lighting & heating General expenses Discounts allowed Net profit 6,000
4,000 300
1350 1060
Note that it is common to refer to the trading and profit and loss account as just the profit and loss account. This may be confusing initially but you will soon get used to the idea. To summarise: Gross profit = Net profit =
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Opening stock
So far, we have looked at a firm that has only recently begun trading. If a firm has been trading for more than one accounting period then it is likely to have stock that remains unsold from an earlier period. This stock is referred to as opening stock. Opening stock is available for use and for resale, therefore we should add this on first when calculating he cost of goods sold. Opening stock, the stock in business sat the start of the current accounting period will be in the trial balance as a debit entry. Closing stock, however, is always outside the trial balance. Stock in the trial balance Opening stock Closing stock Debit entry As a note to trial balance
Carriage
Carriage refers to the costs of transporting goods to and from the firm. In most cases, the cost of transporting goods to the customers will be paid for by the customers, but on some occasions this will also be paid for by our firm. The terms used to refer to these types of transport and distribution costs are as follows: Carriage inwards Carriage outwards Cost of transporting goods form the suppliers (in)to the firm Costs of transporting goods (out) of the firm to the customers
Each type of carriage will be an expense and therefore will have a debit balance in the trial balance. However, these will appear in different sections of the trading and profit and loss account. Carriage inwards is connected with the cost of getting goods into the firm and ready for sale. As a result, it will be added on in the calculation for the cost of goods sold. Carriage outwards does not have anything to do with the cost of getting goods into saleable condition. Therefore it will appear with all the other overhead expenses and the profit and loss account. Carriage inwards Carriage outwards Trading account expense Profit & loss account expense
Returns
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You may remember that earlier in the section on double-entry bookkeeping (1.1.1) we dealt with the idea that goods purchased and sold could be returned to wherever they originated. Sales could be returned back to us as returns inwards and purchases could be returned by us to the original supplier as returns outwards. In this case, we should make adjustments in the trading account by adjusting the purchases and sales figures for these deductions. Returns inwards Returns outwards Debit balance Credit balance Deduct from sales Deduct from purchases
When adjusting the cost of goods sold for returns inwards and carriage inwards, there is no exact rule on which one should be adjusted first. The best advice is to decide on one method and stick to it - this way it will help you memorise it earlier. Carriage outwards would appear as a normal expense in the profit and loss section You must always be careful when drawing up a trading account. Questions may include some or all of the above adjustments. For example, returns inwards may appear without returns outwards. You should not write down an entry for each adjustment until you have verified that it will be included.
Balance sheets
Balance sheet - introduction
The balance sheet is a list of balances arranged according to whether they are assets, capital or liabilities, to depict the financial situation of the business on a specific date. It is often referred to as a 'snapshot' of the firm on a particular date - as if we had entered in the firm and taking photographs of the various components that make up the business. It can only be constructed on one date and not over a period of time as the values for assets and liabilities will change frequently. The balances that are featured in the balance sheet would be the balances remaining on our trial balance after the trading and profit and loss account for the period has been completed. All the balances remaining have to be assets, capital or liabilities. All other balances would have been closed off when the trading and profit and loss account was completed. The word 'account' generally indicates if something is part of the double entry system. Therefore, both the trial balance and the balance sheet are not part of the double entry system. No entries are made in the ledger accounts to record the fact that we have drawn up a balance sheet. All we are actually doing is listing the assets, capital and liabilities balances so as to form a balance sheet.
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As with the trading and profit and loss account, there are two ways of presenting a balance sheet - horizontal and vertical. The vertical style will be adopted in this course although we will briefly show you what a 'horizontal' balance sheet is.
Liabilities relate to any amounts of money that have been borrowed by the firm. Technically, capital is a special form of liability in that the business is 'borrowing' money and resources from the owner of the business. However capital will always be kept separate from the liabilities of the firm. Liabilities are split into two sections - defined below:
Long-term liabilities
Money owed by the firm which will not be repayable until after one year or more (e.g. bank loans and mortgages).
Current liabilities
This is money owed by the firm which will be repaid during the next year (e.g. creditors and bank overdrafts). As stated earlier, we need the remainder of the balances from the trial balance which were not used in the construction of the trading and profit and loss account - we will use the previous example of D Balls. D Ball - trial balance as on 31 December 2003 Dr () Sales Purchases Insurance Lighting & heating General expenses Machinery Debtors Creditors Bank Discounts allowed Discounts received Cash in hand Drawings Capital Loan 4,000 650 450 120 2,100 890 980 1,970 130 110 80 700 3,000 1,000 11,090 Cr. () 6,000
11,090
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The lines in bold will be used in the construction of the balance sheet - note that closing stock appears in both the trading and profit and loss account as well as the balance sheet. The balance sheet drawn up on this date will look as follows: D Ball - balance sheet as at 31 December 2003 Fixed assets Machinery Current assets Stock Debtors Bank Cash Less Current liabilities Creditors Working capital Less Long term liabilities Loan Net assets Financed by: Capital Add Net profit Less Drawings 2,100
3,240
+ =
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Fixed assets Current assets Current liabilities Long-term liabilities Net assets
Current assets - Current liabilities = Working capital Working capital is a very handy concept used by businesses. Basically it shows us how liquid the firm is - has it got enough 'near' cash items (items that could be converted into cash quickly without losing their value) to pay its short-term debts (current liabilities). If this figure is negative then the firm may have problems in the near future. 3. The term 'Financed by' explains where the resources have come to finance the firm's operations - other than the borrowing that is. The capital figure here is adjusted by profits (or losses) and drawings made, to give us the new capital figure for the new trading period. The adjustments needed in the actual capital account would be as follows: Capital 2003 31 Dec 31 Dec Drawings Balance c/d 2003 700 1 Jan 3,360 31 Dec 4,060 2004 1 Jan Balance b/d 3,000 Profit & Loss 1,060 4,060 Balance b/d 3,360
Notice that profits add to the capital because they are credited to the capital accounts. Any net loss would be debited to the capital accounts. Drawings always reduce the capital balance and therefore are always transferred to the capital account at the end of the trading period on the debit side. 4. The section on long-term liabilities is not always present. Actually, if there are no long-term liabilities then this section can be missed out totally. Be careful though, some texts present the long-term liabilities as added on to the bottom half of the balance sheet. This should not matter, adding this section on to the bottom is exactly the same as subtracting the amount form the top 'half' of the balance sheet - jus be consistent.
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The horizontal balance sheet simply lists assets on the left hand side and capital and liabilities are the right hand side. Follow the link below to see how the balance sheet of D Ball would look as a horizontal balance sheet.
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Trade discounts do not appear in any of the ledger accounts and will only appear on the original invoices therefore trade discounts must always be first deducted before calculating the VAT total However, adjustments must be made for cash discounts. The VAT will always be calculated on the net invoice total assuming that the cash discount will be obtained. Even if the payment for the invoice is too late to qualify for the cash discount, the VAT will always be calculated on the assumption that the cash discount is taken.
(Alternately, the formula can be reduced down to 7/47 instead but this makes no difference) All that remains is for us to consider the double entry adjustments needed to record transactions containing VAT.
Net
VAT
Gross
May 8
A Westwood
200
35
235
Notice how the net and gross totals for the invoice (with and without VAT) are listed separately. This is important, as we will need both totals to make entries in the ledger accounts. Example 2 Following on with the same example, on May 15 2000 we purchase 100 of goods from C Stringer. The VAT on this purchase would be 17.50. The entry in the purchases daybook would appear as follows: Purchases daybook 2000 May 15 C Stringer Net 100 VAT 17.50 Gross 117.50
The general rules for entries for VAT on sales and purchases can be formulated form the above two examples. These will be as follows: VAT on sales Debit Personal account with gross invoice total Credit Sales account with net invoice total and VAT account with amount due VAT on purchases Debit Purchases account with net invoice total
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The credit balance indicates that the firm is liable for VAT of the amount 12.25. This is normally settled by a bank or cash payment. If the balance had been a debit balance then the firm could claim for a refund. However, because this is not normal, it is more likely that the firm would simply wait until the balance had 'slipped back' into credit. VAT is not an expense. It is simply a tax payable. The double entry needed to clear the amount owing would be from either cash account or bank account. In our example this would look as follows: VAT 12.25 Balance b/d Cashbook
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Cashbook
12.25
VAT
12.25
This gives us a simple way of memorising whether or not we owe VAT or are owed VAT. A credit entry in the cashbook implies a payment had been made. Therefore the debit entry in the VAT account from the cashbook must be there to clear the amount owing. Until the amount has been paid, the VAT due should also appear as a current liability on the balance sheet (or as a current asset if it is a debit balance).
Bought goods on credit: 700 from G Sibon, 500 from P Evans. Sold goods on credit from S Donnelly worth 700.
Sent goods back to Sibon worth 450. Sold goods on credit to S Haslem worth 300. Goods returned to us by S Donnelly worth 200. Purchased goods on credit from P Evans worth 850 Goods retuned to us by Haslem worth 100. Sold goods to A Quinn worth 800. Goods returned by us to Evans worth 50.
It provides a check on the accuracy of the ledger account balances - ensuring that entries have been made correctly. It makes preparation of the final accounts easier - we can simply use the balances from the trial balance, rather than having to refer to all the individual accounts. Certain errors will be highlighted or avoided as outlined below.
The trial balance will ensure that the following errors are avoided or highlighted: 12. Only entering one half of the transaction (e.g. a debit but no credit entry) 13. Entering different figures for the two halves of the transaction 14. Entering two debits or two credits for a transaction If any of the above errors have been made then the trial balance totals will not agree and investigative work can begin to see where the mistakes are. Technically, it could be possible for these errors to be made and the trial balance would appear as if the mistakes had not taken place. For example, if we missed out an entry of 50 on the debit side of an account and then later we missed out on another transaction a credit entry of 50, the trial balance totals would still agree. However as far as examination questions go, you will know when you are dealing with errors - it will be indicated in the question itself. Even if the trial balance totals do agree this does not mean that the books are completely correct. These errors outlined here could have been made:
Entering correct figures in the wrong account (but on the correct side)
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Reversing entries so that both entries are made on the incorrect side of the each account Entering the incorrect total on both sides of the account.
We would need to know how to identify these errors, how to correct them and also how to recalculate the firm's profits if they have been affected. A lot of students believe that the profit and loss account, and the balance sheet could not be constructed without a trial balance. This is not true. We would, if we wished, use the balances from each account. However this approach would take a lot longer and we would not have the check on the accuracy that the trial balance provides. As a rule the entries for the trial balance will be as follows: Type of account Assets, expenses & drawings Liabilities, revenues & capital Entry Debit Credit
The following is a trial balance for S Halls, which was extracted from the books on 31 December 2002 S Halls - trial balance as on 31 December 2002 Dr () Capital Cash Bank S Knight Purchases Office supplies Sales K Curnock A Hynam Returns out Wages Office fixtures 210 270 66 118 24 216 87 95 12 140 350 1294 Cr () 1000
1294
The title of any financial statement is very important. It should always contain the following three pieces of information:
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Who it is for. In this case it is for S Halls. What it is. In this case it is a trial balance. When it is for. In this case it is as at 31 December 2002. Remember! Who? What? When? In this trial balance we have the balances from three personal accounts. S Knight is a creditor of the firm (it is in the credit column - indicating that it is a liability). A Hynam and K Curnock are both debtors (in the debit column - indicating that they are an asset). Normally, debtors and creditors are listed in a trial balance as just 'debtors' or 'creditors', rather than as their individual names. Also, if a firm has unsold stocks of goods left at the end of a period, these will be listed underneath the trial balance. This is because the account for closing stock is not part of the double entry system. However, any stock that was in the firm at the start of a period will be listed in the debit balances of the trial balance.
Of course, if the balances do not agree (i.e. are different) then we need to know why. In this case we can construct a bank reconciliation statement to show why they disagree and hopefully prove that no errors have been made. In fact, most examination questions on this topic will often ignore the prospect of errors and will concentrate on other reason why the balances are not the same. The term reconciliation simply means to bring together. In this case, it involves a process where we actually try to show how the two balances are acceptable, given items in the cashbook and on the bank statement that do not appear in both.
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Terminology used
When dealing with bank reconciliation statements we will use new terms to refer to items appearing in the cashbook and on the bank statement. Terms will be used to describe cheques that we have both received and have paid out of our cashbook that have not yet appeared on the bank statement. When we receive a cheque, or when we write out a cheque, we would normally enter this into the cashbook straight away. Therefore, from the firm's view, the money has already been paid or received. However in reality, this does not happened. Cheques will normally take a few days (assuming the cheque was deposited in the bank immediately - which may not happen thus further delaying the process) before they are cleared. Only when the cheque is cleared will the money be paid into the bank account (or paid out in the case of us writing cheques). The ways in describing cheques in the clearing process are as follows: Unpresented cheques These cheques have been paid out by us (i.e. credited to the cashbook) but have not yet been deducted by the bank from the firm's account (they have not yet been 'presented' for payment). Undeposited cheques These cheques have been received by the firm (i.e. debited to the cashbook) but they have not yet been entered by the bank into the firm's account. It may also be that we have not yet physically taken the cheques to the bank and deposited them. These are also sometimes known as 'banking lodgements not yet cleared' or 'uncleared cheques'. Dishonoured cheques Sometimes the firm will receive a cheque from a customer that the bank will not give us money for. It will not honour the cheque and therefore the money will not be received as it stands. The reasons for this could be as simple as that a mistake appeared on the cheque (wrong date, not signed, discrepancies in amounts written, etc.) or it could be that the customer has insufficient funds in their account and the bank will not allow more to be paid out of their account. Any cheque more than 6 months old will not be honoured as it considered being 'stale'. Bank accounts and direct transfers In addition to the types of cheques that will appear on a bank reconciliation statement, there will also be items that will appear on the bank statement that are not yet in the cashbook. These will normally refer to items automatically paid into and out of our account without us first having entered into our cashbook. These items could include: Standing orders
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This occurs when a firm sets up a process for a regular amount to be paid out of bank account. The amount does not change and is used by many firms making payments to either a firm or an individual. Direct debits Similar to standing orders, these involve amounts paid out of the firm's bank accounts. However, the amount paid out is not fixed and can be different. A firm normally will give another firm permission for it deducted amounts from the firm's accounts. Many bills are paid by direct debit arrangements. Credit transfers These involve amounts being paid directly into our bank account. They are normally from other customers, or other people who owe the firm money. Technically they could actually involve payments out of an account, but normally a credit transfer is used to refer to money paid into the account. Bank charges Firms may be charged money buy their bank for services they have used. This may be a one-off fee, or it could be a regular amount. A common example would be a charge for allowing the firm to go overdrawn on its account. These will be directly deducted from the firm's balance and will appear on the bank statement. Interest Interest may be both paid and received directly into the firm's bank account. If it is being paid out then it will normally be the charge for the firm being overdrawn on its account. As long as the firm keeps a positive balance of money in the account then any interest is likely to be received (most current accounts now give interest on positive balances).
Bank statements
A bank statement is a summary of recent transactions (usually one month) that have taken place in the firm's bank account. The balance on the account is normally displayed as a running total (i.e. the balance is adjusted as each transaction occurs). A sample bank statement may look as follows: Bank statement 2003 April 1 April 3 April 8
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(Cr) 80
270
35 560 25
The statement is always drawn up from the bank's point of view. This means that if we have money in the bank then from the bank's viewpoint, the bank owes us money. This is why the account is presented as a credit balance. If we were overdrawn (taken out more than we have in the account) then the balance would be a debit balance - i.e. we now owe the bank money. This can be confusing, because the cashbook will still be drawn up on the principles of double entry debits involves money paid into the account, and credits involve money paid out of the account. Notice how each cheque paid out of this account has a number attached to it - this refers to the actual number of the cheque - the person or firm it is paid to will not appear into the cheque. Now we can compare the above bank statement with the firm's own cashbook. In this example we will only concern ourselves with the bank column of the cashbook, as this is the amount we are trying to reconcile with the bank statement. Cashbook 2003 Apr 1 Apr 6 Apr 28 1,970 80 140 2190 1165 2003 Apr 11 Apr 26 Apr 29 Apr 30 270 560 195 1165 2190
May 1
Balance b/d
So we have a discrepancy. According to the bank statement we have 1,230 in the bank. According to our cashbook we only have 1,165. To see if this can be explained, we will draw up a bank reconciliation statement.
3. Draw up a reconciliation statement using the updated cashbook balance and items appearing in the cashbook that were not on the bank statement. A bank statement was received by M Sim on 31 July 2002. It appeared as follows: Bank statement 2003 July 1 July 3 July 6 July 8 July 12 July 22 July 27 July 31 (Dr) Balance b/f Cheque Standing order: A May Cheque - 011654 Interest Cheque - 011655 Cheque Balance c/f (Cr) 45 300 290 5 250 560 Balance 650 Cr. 695 Cr. 395 Cr. 105 Cr. 110 Cr. 140 Dr. 420 Cr. 420 Cr.
The cashbook for July 2003 appeared as follows: Cashbook 2003 Jul 1 Jul 6 Jul 21 650 45 230 925 310 2003 Jul 11 Jul 25 Jul 29 Jul 30 290 250 75 310 925
May 1
Balance b/d
Bank statement balance = 420 Cashbook balance = 310 The procedure is always to add unpresented cheques and to subtract undeposited cheques from the updated cashbook balance. It is possible to start with the balance on the bank statement, in this case, undeposited cheques would be added and unpresented cheques would be subtracted. The reconciliation has worked. This means that no errors have been made. If the two balances could not be reconciled then errors would have been present. The differences in the balances on
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the cashbook and banks attempt can be explained and reconciled by firstly, updating he cashbook and secondly, by adjusting for cheques that have not yet shown up on our bank statement.
75 5 560
640 950
230 300
530 420
Other than for unpresented and undeposited cheques, there is no actual method of working out whether items found on the banks statement but not in the cashbook should be added or subtracted. It has to be worked out intuitively. Consider the following explanations for the above example: 1. Interest received - is not in the cashbook so if added on to cashbook figure then we will be closer to the bank statement. 2. Credit transfer - is not in the cashbook so if added on to cashbook figure then we will be closer to the bank statement. 3. Standing order has been deducted in bank, so if deducted from the cashbook figure we are more likely to get a closer approximation to the bank statement balance.
Control accounts
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For a small firm, the trial balance alone may prove sufficient in providing a check on the numerical accuracy of the ledger accounts. Whilst still useful, the trial balance will not necessarily speed up the location of errors. If a firm operates ledgers for sales, purchases and general accounts then control accounts can be used as a further check on the accuracy of the ledgers. In effect, a control account is like a trial balance for each of the sales and the purchases ledger. If the control account does not tally with the accounts in each ledger, then an error will exist in that ledger. Two control accounts Sales ledger control account (also known as the total debtors account) Purchases ledger control account (also known as the total creditors account) Each control is a summary total of the respective ledger. It has the totals for all balances and all entries as found in the sales or the purchases ledger. It is easier to imagine them as an overall debtor account (for the sales ledger account) or an overall creditor account (for the purchases ledger account). Construction of control accounts The information for constructing each control accounts are taken from both the personal accounts of debtors and creditors, as well as information form the main daybooks (e.g. sales daybook for total of credit sales). The main sources of information are found in the following locations: Information for sales ledger control account Information needed: Opening balance of debtors Credit sales Returns inwards Money received from customers Discounts allowed Closing balance of debtors Information located: Debtor accounts in sales ledger Sales daybook Returns inwards daybook Cashbook General ledger or cashbook (3rd column) Debtor accounts n sales ledger
Information for purchases ledger control account Information needed: Opening balance of creditors
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Credit purchases Returns outwards Money received from customers Discounts received Closing balance of creditors
Sales daybook Returns outwards daybook Cashbook General ledger or cashbook (3rd column) Creditor accounts in purchases ledger
A control account will appear as if it is a personal account - with amounts relating to purchases and sales, returns, discounts as well as payments made and received. The examples below are to remind you of what a debtor and what a creditor account looks like: Debtor accounts Balance owing to us at start Credit sales made during period Cash/cheques received Returns inwards Discounts allowed Balance owing to us at end (*1)
(*1 this is a debit balance but it is initially carried down from the credit side when the account is balanced off) Creditor accounts Cash/Cheques paid Returns outwards Discounts received Balance owing to by at end (*2) Balance owing by us at start Credit purchases made during period
(*2 this is a credit balance but it is initially carried down from the debit side when the account is balanced off)
Set-offs
Some firms may find that they have customers who are also suppliers. In this case, there will be an account for this firm or person both in the sales ledger (as a customer) and in the purchases ledger (as a supplier). It could appear to be common sense that rather than both parties send a cheque to each other, the amounts owing (both to and by the firm) should be partly offset against each other. If you owe someone 5 who also owes you 10, then it would be sensible for you to offset the debt and accept 5 in full settlement of both debts. This can also be achieved with firms and are known as set-offs.
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As a general rule, set-offs will appear in both control accounts and on the following sides: In the sales ledger control account - on the credit side In the purchases ledger control account - on the debit side
Memorandum records
For some firms, the control account will be used as a check on the numerical accuracy of the sales and purchases ledger. The control account in this case is not part of the double-entry system. In this case, the control accounts would be known as memorandum records - they are simply there as a back up to the normal double entry system. However in some larger firms, all the control accounts are kept as an integral part of the doubleentry system of bookkeeping. The personal accounts as found in the sales and purchases ledger would then become the memorandum records and would be used for information only. Here, the control accounts, as found in the general ledger, would be used for the trial balance and so on. Benefits of maintaining control accounts If the control accounts are kept purely as memorandum records then they are not necessary for the double entry system to function fully. However the control accounts will still have some uses for the firm and these are as follows: 1. If the control accounts do not balance then it is obvious that a mistake has taken place in the respective ledger. This will save time in the locating of the error. If we relied on the trial balance alone then we would have to check all the three main ledgers as well as the cashbook. 2. Control accounts can be kept by a person who is not he same person who maintains the personal accounts of debtors and creditors. In this case, fraud is less likely to occur (unless both the ledger clerks and the person maintaining the control accounts are in collaboration together!). 3. The debtors and creditor figures can be ascertained more speedily for construction of the trial balance, than having to balance off each individual personal account in the sales and purchases ledgers.
balance disagree (are not the same) then mistakes must have been made in the entries. However, even the totals agree (both columns total the same figure) mistakes may still have been made. There are various ways in which entries can be made which follows basic rules of double entry (one debit and one credit entry - both same amount) but still produce mistakes. The errors that do not affect the trial balance agreement are normally classified as follows: Name of error Description of error 1. Error of omission Double entry is missed out (omitted) completely from ledgers. 2. Error of commission One half of entry is made in wrong personal account. 3. Error of principle One half of entry is made in wrong type of account. 4. Error of original entry Incorrect amount is entered in both halves of entry. 5. Complete reversal of entries Debit entry is credited and vice versa - in correct accounts and correct amounts. 6. Compensating error Two or more errors cancel each other out in terms of their affect on the trial balance. 8. 9. Once an error has been located, it will need to be corrected with both an entry in the journal (regardless of the original transaction) and also in the ledger accounts. The following examples, illustrate the errors and the method of correction. 10. When we refer to incorrect amounts being entered in accounts, we often use the words 'overcast' to refer to when too much has been entered in an account, and 'undercast' when too little has been placed in an account.
If any of these errors are made (one or more) then the trial balance totals will not agree. In this case, the errors should be located. However, this may take time - days, weeks or even months the more errors that have been made, the longer their location will take. If the trial balance does not agree, then we would not be able draw up the profit and loss account and balance sheet correctly. As a part solution to this (finding the errors should always be a priority), a firm can, in effect, make the trial balance agree by entering the amount needed to make the two columns agree again. The difference between the two columns of the trial balance is filled with the creation of a new entry - this is entered in the suspense account.
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Example On 31 December 2007, the trial balance is drawn up for J Mickley. This is a summary of the trial balance: J Mickley - trial balance as at 31 December 2007 Dr 47,500 Cr 46,900
To allow us to construct the final account, we enter the amount, in this case, in the credit column, and the trial balance will now appear as follows: J Mickley - trial balance as at 31 December 2007 Dr 47,500 47,500 Cr 46,900 600 47,500
The entry in the trial balance has to be represented by an account. Therefore, we will now open up a suspense account with a credit balance of 600. Suspense 2007 2007 Dec 31 Difference in trial balance 600
Normally, we would be now forced to make a debit entry in another accounts somewhere else in the ledgers. However, in this case we make no entry as there need for the credit entry in the suspense account must be the result of excess debit entries made, or shortages on the credit side elsewhere in the accounts - i.e. the mistakes that we are trying to locate. This balance will remain in the accounts until the errors has been located and corrected. If we assume that the error that had been made was that the capital account had been undercast by
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600 then this would explain why we appeared to have shortage on the credit column. However, it is possible that the error was that a debit entry (e.g. purchases) had been overcast by 600. Let us assume that the error in our example, was due to Motor vehicles being overcast by 600, then the procedure to correct this would be as follows: 1. Enter up the correction in the journal 2. Enter the amendment to correct the error 3. Enter the other half of the transaction in the suspense account. If the error affects the trial balance then one entry in the transaction needed to correct the error must be in the suspense account. The error is found on Jan 15, 2008 - the motor vehicles had been overcast by 600. A credit entry in this account will correct the errors. Therefore, a debit entry will be made in the suspense account. The Journal Details Suspense Motor vehicles Motor vehicles account overcast - now corrected Suspense 2008 Jan 15 Motor vehicles 2007 600 Dec 31 Difference in trial balance Motor vehicles 2008 2008 Jan 15 600 600 Dr 600 Cr 600
Suspense
Notice that once the errors have been corrected, the balance on the suspense account disappears. While a balance remains, we know that there must be at least one error remaining undetected which affect the agreement of the trial balance.
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Example 2 Your bookkeeper extracted a trial balance on 31 December 2004 which failed to agree by 180, a shortage on the debit side of the trial balance. A suspense account was opened for the difference. In February 2005, the following errors, made the previous year, were found: 1. Goods purchased on credit from E Lewis of 230 was entered correctly in the purchases account but was entered in the personal account as 320. 2. Advertising paid for 115 by cheque had been completely omitted from the books 3. Discounts received of 80 cash was entered on the debit side of both accounts. 4. Purchases daybook had been undercast by 250.
115 250
365
1,575
Computers in accounting
Uses and advantages and disadvantages of computers in accounting
Traditionally accounts were kept by the means of handwritten record. Computers have only begun to be used in some of the functions of accounting over the last fifteen years or so. As computers became cheaper, easier to use, and more powerful, more firms have decided to computerise their own accounting records. However, some firms, (albeit a declining number) still prefer to use handwritten accountings. This leads us to believe that there must be reasons for and against using computers in accounting. What we need to consider here is how computers are used in accounting, and then we should be able to evaluate the potential uses and limitations of using computers in accounting.
One of the attractions of using a spreadsheet is that the calculations can be done by the computer. Some data, such as sales and cost of goods sold would need to be manually typed in, but then the gross profit can be automatically calculated by inserting a formulae into the relevant 'cell' which states how the profit is to be calculated, Once inserted then the formulae can apply to the whole row (or whole column) which makes the process both easier and more less likely to be inaccurate.
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Obviously the example above is a fairly limited illustration of how spreadsheets can be used but for many small firms, the use of a spreadsheet is the main way in which computers are integrated into the work of the accountant. Accounting software There are accounting software packages then can be purchased by a firm that will perform many, if not all of the tasks that would normally be manually entered by the person responsible for the firm's accounts. These packages will be able to produce many of the accounting records that were previously produced by hand. Transactions may be entered into the computer package and many will produce the double entry records based on this one entry. Although the exact capabilities of each package will vary, it is possible that most, if not all of these packages will be able to produce invoices for purchases and sales. They calculate VAT returns, discounts and all the other areas of the accounting information system. Logically, these packages will also produce the final accounts for the business when required. For larger firms this software can actually be tailor-made for the firm's own specific requirements. This sort of tailor made package is known as a 'bespoke' system. These packages are normally produced by a specialist computer software firm who have experience in producing accounting packages. Technically, these packages are available for any firm, but given the expense of a bespoke system and the general low cost of a 'off the shelf' system (one that can be used by any firm), most firms will simply purchase a general package.
Once the data has been inputted, it is possible to manipulate the existing data to produce variations on the firm's overall performance. Even a simple spreadsheet can be manipulated to consider different scenarios. For example, a firm may wish to see the effects of am increase in sales of the overall profit level. A range of forecasted accounts can be generated to see how well the firm could expect to produce in the future (this is known as sensitivity analysis). The data can be manipulated into accounting ratios automatically, which allow managers to assess the overall performance. For example, the profits can be related to sales, to capital or to assets to see how effectively the firm is operating. Job satisfaction The use of computers in accounting will free up time for the accountant to concentrate on more wide ranging tasks. This means that there is likely to be increased job satisfaction within he firm. Studies suggest that if workers are more satisfied or more motivated in the workplace, they are likely to be more productive in their output.
Conclusion
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The fact that nearly all firms make some use of computers in accounting suggests that the benefits outweigh the costs. Most firms have found computers a very valuable addition to their abilities in processing the vast amounts of finical data. However one can never underestimate the benefits of having a skilled human operator who understands the who accounting system and can reason and use intuition in a way that computer cannot.
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