Chapter 3: Double entry bookkeeping

Chapter learning objectives

Upon completion of this chapter you will be able to:

• explain the concept of double entry and the duality concept
• explain the debit and credit principle
• explain the meaning of the balance on each type of account
• record cash transactions in ledger accounts
• record credit sale and purchase transactions in ledger accounts
• illustrate how to account for discounts
• explain sales and purchase returns and demonstrate their recording
• illustrate how to balance a ledger account
• extract the ledger balances into a trial balance
• identify the purpose of a trial balance
• prepare a simple income statement and statement of financial position from a trial balance
• explain and illustrate the process of closing the ledger accounts in the accounting records when the financial statements have been completed.

1 The duality concept and double entry bookkeeping

• Each transaction that a business enters into affects the financial statements in two ways, e.g.

  A business buys a non-current asset for cash.

  The two effects on the financial statements are:

  (1) There is an increase in non-current assets.

  (2) There is a decrease in cash.

• To follow the rules of double entry bookkeeping, each time a transaction is recorded, both effects must be taken into account.
• These two effects are equal and opposite such that the accounting equation will always prove correct:

• Traditionally, one effect is referred to as the debit side (abbreviated to Dr) and the other as the credit side of the entry (abbreviated to Cr).

2 Ledger accounts, debits and credits

• Transactions are recorded in the relevant ledger accounts. There is a ledger account for each asset, liability, revenue and expense item.
• Each account has two sides – the debit and credit sides:

• The duality concept means that each transaction will affect at least two ledger accounts.
• One account will be debited and the other credited.
• Whether an entry is to the debit or credit side of an account depends on the type of account and the transaction:

Summary of steps to record a transaction

Recording cash transactions

Cash transactions are those where payment is made or received immediately.

Cheque payments or receipts are classed as cash transactions

Double entry involves the bank ledger:

• a debit entry is where funds are received
• a credit entry is where funds are paid out.

Test your understanding 1

Recording cash transactions

Show the following transactions in ledger accounts: (Tip: the ledger accounts you need are Bank, Rent, Drawings, and Sales)

(1)Kamran pays $80 for rent by cheque.

(2)Kamran sells goods for $230 cash which he banks.

(3)He then takes $70 out of the business for his personal living expenses.

(4)Kamran sells more goods for cash, receiving $3,400.

Test your understanding 2

Yusuf enters into the following transactions in his first month of trading:

(1)Buys goods for cash for $380.

(2)Pays $20 in sundry expenses.

(3)Makes $1,000 in sales.

(4)Receives a bank loan of $5,000.

(5)Pays $2,600 for fixtures and fittings.

What is the total entry to the credit side of the cash T account?

A$6,000

B$6,380

C$3,000

D$2,620

Recording credit sales and purchases

Credit sales and purchases are transactions where goods or services change hands immediately, but payment is not made or received until some time in the future.

Money that a business is owed is accounted for in the receivables ledger.

Money that a business owes is accounted for in the payables ledger.

Test your understanding 3

Norris notes down the following transactions that happened in June.

(1)Sell goods for cash for $60.

(2)Pay insurance premium by cheque – $400.

(3)Sell goods for $250 – the customer will pay in a month.

(4)Pay $50 petrol for the delivery van.

(5)Buy $170 goods for resale on credit.

(6)Take $57 out of the business for living expenses.

(7)Buy another $40 goods for resale, paying cash.

(8)Buy a new computer for the business for $800.

Record these transactions using ledger accounts

Test your understanding 4

For each of the following individual transactions state the two ledger accounts affected, and whether the ledger account should be debited or credited:

(1)Ole purchases goods for $5,000, and pays by cheque.

(2)Ole makes a sale to a customer for $500. The customer pays in 30 days’ time.

(3)Ole pays a telephone bill amounting to $40, and pays by cheque.

(4)Ole receives bank interest income of $150.

(5)Ole purchases stationery for $12 and pays cash.

(6)Ole makes a sale to a customer for $400. The customer pays cash.

3 Recording sales and purchases returns

• It is normal for customers to return unwanted goods to a business; equally the business will occasionally have cause to return unwanted goods to their supplier.
• The double entries arising will depend upon whether the returned goods were initially purchased on credit:

Test your understanding 5

For each of the following, state the double entry required to record the transaction in the accounts:

(1)Alfie invests $10,000 of his life savings into his business bank account.

(2)He then buys goods from Isabel, a supplier for $1,000 and pays by cheque.

(3)A sale is made for $400 – the customer pays by cheque.

(4)Alfie makes a sale for $600 and the customer promises to pay in the future.

(5)Alfie then buys goods from his supplier, Kamen, for $500 on credit.

(6)Alfie pays a telephone bill of $150 by cheque.

(7)The credit customer pays the balance on her account.

(8)Alfie pays Kamen $340.

(9)Bank interest of $30 is received.

(10)A cash customer returned $20 goods to Alfie for a refund.

(11)Alfie sent goods of $100 back to Kamen.

4 Discounts

Trade discounts

Trade discounts are given to try and increase the volume of sales being made by the supplier. By reducing the selling price, buying items in bulk then becomes more attractive. If you are able to source your products cheaper, you can then also sell them on to the consumer cheaper too. For example, if we were to buy over 1000 items, the supplier might be able to drop the price of those items by 5%.

Accounting for trade discounts

From an accounting perspective, trade discounts are deducted at the point of sale. When accounting for a sale that is subject to a trade discount - it is the net amount that should be recorded i.e. the trade discount does not get recorded separately.

Test your understanding 6

Oliver sells goods with a book value of $1,000 to Sam on a cash basis and allows her a trade discount of 10%.

Required:

Show how the above should be recorded in both the books of Oliver and Sam.

Early settlement discounts

This type of discount encourages people to pay for items much quicker. If you pay for the goods within a set time limit, then you will receive a % discount. For example, a cash discount of 3% is offered to any customers who pay within 14 days.

Whilst offering this discount makes the cash flow in quicker, it is still a 'lost cost' to the business who offers such a discount.

Accounting for settlement discounts

Discounts may be given in the case of credit transactions for prompt payment:

• A business may give its customer a discount – known as Discount allowed.
• A business may receive a discount from a supplier – known as Discount received.

The correct double entries are:

Discount allowed

The expense is shown beneath gross profit in the income statement, alongside other expenses of the business.

Discount received

The income is shown beneath gross profit in the income statement.

Settlement discounts and sales tax

Settlement discounts are always assumed to be taken for sales tax purposes (even when not) as the sales tax needs to be calculated on the invoice immediately.

For example a company sold goods for $100 net of sales tax and allowed its customer a settlement discount of 10% if paid within 14 days. Sales tax is charged at 17.5%.

What is the sales tax required for this transaction?
$100 × 90% × 17.5% = $15.75

As settlement discounts have an effect on the calculation of sales tax, the following procedure should be followed when dealing with cash discounts and sales tax.

(1)Calculate the net amount (usually given in the question)

(2)Deduct the settlement discount

(3)Calculate the sales tax on the after settlement discount amount

(Note: the accounting for sales tax will be studied in chapter 5)

Test your understanding 7

George owes a supplier, Herbie, $2,000 and is owed $3,400 by a customer, Iris. George offers a cash discount to his customers of 2.5% if they pay within 14 days and Herbie has offered George a cash discount of 3% for payment within ten days.

George pays Herbie within ten days and Iris takes advantage of the cash discount offered to her.

What ledger entries are required to record these discounts?

5 Balancing off a statement of financial position ledger account

Once the transactions for a period have been recorded, it will be necessary to find the balance on the ledger account:

(1)Total both sides of the T account and find the larger total.

(2)Put the larger total in the total box on the debit and credit side.

(3)Insert a balancing figure to the side of the T account which does not currently add up to the amount in the total box. Call this balancing figure ‘balance c/f’ (carried forward) or ‘balance c/d’ (carried down).

(4)Carry the balance down diagonally and call it ‘balance b/f’ (brought forward) or ‘balance b/d’ (brought down).

Test your understanding 8

Balance off the following account:

Test your understanding 9

Balance off the following account:

6 Closing off the ledger accounts

At the year end, the ledger accounts must be closed off in preparation for the recording of transactions in the next accounting period.

Statement of financial position ledger accounts

• Assets/liabilities at the end of a period = Assets/liabilities at start of the next period, e.g. the cash at bank at the end of one day will be the cash at bank at the start of the following day.
• Balancing the account will result in:
  • a balance c/f (being the asset/liability at the end of the accounting period)
  • a balance b/f (being the asset/liability at the start of the next accounting period).

Income statement ledger accounts

• At the end of a period any amounts that relate to that period are transferred out of the income and expenditure accounts into another ledger account called the income statement.
• This is done by closing the account.
• Do not show a balance c/f or balance b/f but instead put the balancing figure on the smallest side and label it ‘income statement’.

Capital account

• At the start of the next accounting period the capital account will have an opening balance, i.e. a balance b/f equal to the amount that is owed to the owner at the start of that period.
• This amount is equal to what was owed to the owner at the start of the previous period, plus any capital that the owner introduced in the period, plus any profits earned in the period less any drawings taken out in the period.
• Therefore we transfer the balance on the income statement and the balance on the drawings account to the capital account at the end of the period so that it will have the correct opening balance at the start of the next.

Test your understanding 10

Oddjob had $7,800 capital invested in his business at the start of the year. During the course of the year he took $3,100 cash out of the business for himself and also paid his wife, who did some secretarial work for the business, $500. The business’ overall profit for the year was $8,900. Oddjob also paid $350 for a new personal suit using the business cheque book during the year.

What is the balance on the capital account at the end of the year?

A $12,750

B $13,250

C $13,600

D $13,100

7 The trial balance

• Once all ledger accounts have been balanced off a trial balance is prepared.
• A trial balance is a list of the ‘balance b/f’ on the ledger accounts according to whether they are on the debit or credit side. Trial balance as at 31 December 2005

Trial balance as at 31 December 2005

What does the trial balance prove?

The trial balance will balance if for every debit entry made, an equal credit entry was made and the balances were correctly extracted and cast (added up!).

• The purpose of a trial balance is:
• to check that for every debit entry made, an equal credit entry has been made.
• as a first step in preparing the financial statements.

Note that a number of adjustments will be made after the trial balance is extracted. These adjustments do not therefore appear in the trial balance.

8 Opening balances in the ledger accounts

• If a business has been in operation in the previous year, then at the beginning of any accounting period it will have assets and liabilities such as cash and non-current assets.
• Any opening amounts are shown in statement of financial position ledger accounts as opening balances.
• The opening balance on an asset account is a debit entry.
• The opening balance on a liability account is a credit entry.
• Transactions during the year are then entered as normal in the ledger account, and at the year-end it is balanced off taking into account the opening balance.

Note: Income statement ledger accounts do not have an opening balance.

Test your understanding 11

Johnny had receivables of $4,500 at the start of 20X5. During the year to 31 December 20X5 he makes credit sales of $45,000 and receives cash of $46,500 from credit customers.

What is the balance on the receivables account at 31 December 20X5?

A $6,000Dr

B $6,000Cr

C $3,000Dr

D $3,000Cr

9 Preparation of financial statements

The process seen thus far is as follows:

Examination questions may draw on any particular stage of this process.

Test your understanding 12

Matthew set up a business and in the first nine days of trading the following transactions occurred:

Required:

(a)Complete the relevant ledger accounts.

(b)Extract a trial balance.

(c)Prepare the income statement for the first nine days.

(d)Prepare the Statement of financial position as at 9 January.

Chapter summary

Test your understanding answers

Test your understanding 1

Test your understanding 2

The correct answer is C

Test your understanding 3

Test your understanding 4

Test your understanding 5

Test your understanding 6

Oliver's books:

Sam's books:

Test your understanding 7

The correct answer is A

Test your understanding 8

Test your understanding 9

Test your understanding 10

The correct answer is B.

Test your understanding 11

The correct answer is C.

Test your understanding 12

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