ebook_b291_unit2_e1i1_n9781848735118_l3

B291 Financial accounting

Unit 2Double-entry bookkeeping

Written by Carien van Mourik

Module Team Dr Devendra Kodwani, B291 Chair & Author Dr Carien van Mourik, Author Professor Jane Frecknall-Hughes, Professional Certicate in Accounting Chair & Author Catherine Gowthorpe, Author Kelly Dobbs, Curriculum Assistant Elizabeth Porter, Regional Manager Sam Cooper, Programme Coordinator Emir Forken, Qualications Manager Dr Lesley Messer, Programme Manager Funmi Mapelujo, Curriculum Manager External Assessor Professor Stuart Turley, Manchester Business School Critical Readers Professor Judy Day, Manchester Business School Elizabeth Porter Professor Peter Walton

Developmental Testers Dr Teodora Burnand Sam Cooper Vimal Goricha Vani Shri Goswami Dudley Hughes Production Team Martin Brazier, Graphic Designer Anne Brown, Media Assistant Sarah Cross, Print Buyer Beccy Dresden, Media Project Manager Vicky Eves, Graphic Artist Paul Hoffman, Editor Diane Hopwood, Rights Assistant Kelvin Street, Library

Software Accounting package software was designed by and remains the property of Sage plc. Other Material The Module Team wishes to acknowledge use of some material from B680 The Certicate in Accounting. This publication forms part of the Open University module B291 Financial accounting. Details of this and other Open University modules can be obtained from the Student Registration and Enquiry Service, The Open University, PO Box 197, Milton Keynes MK7 6BJ, United Kingdom (tel. +44 (0)845 300 60 90; email [email protected]). Alternatively, you may visit the Open University website at www.open.ac.uk where you can learn more about the wide range of modules and packs offered at all levels by The Open University. To purchase a selection of Open University materials visit www.ouw.co.uk, or contact Open University Worldwide, Walton Hall, Milton Keynes MK7 6AA, United Kingdom for a brochure (tel. +44 (0)1908 858793; fax +44 (0)1908 858787; email [email protected]). The Open University Walton Hall Milton Keynes MK7 6AA First published 2010. # 2010 The Open University All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, transmitted or utilised in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without written permission from the publisher or a licence from the Copyright Licensing Agency Ltd. Details of such licences (for reprographic reproduction) may be obtained from the Copyright Licensing Agency Ltd, Saffron House, 610 Kirby Street, London EC1N 8TS; website www.cla.co.uk. Open University materials may also be made available in electronic formats for use by students of the University. All rights, including copyright and related rights and database rights, in electronic materials and their contents are owned by or licensed to The Open University, or otherwise used by The Open University as permitted by applicable law. In using electronic materials and their contents you agree that your use will be solely for the purposes of following an Open University course of study or otherwise as licensed by The Open University or its assigns. Except as permitted above you undertake not to copy, store in any medium (including electronic storage or use in a website), distribute, transmit or retransmit, broadcast, modify or show in public such electronic materials in whole or in part without the prior written consent of The Open University or in accordance with the Copyright, Designs and Patents Act 1988. Edited and designed by The Open University. Typeset in India by Alden Prepress Services, Chennai. Printed in the United Kingdom by Cambrian Printers, Aberystwyth. The paper used in this publication is procured from forests independently certied to the level of Forest Stewardship Council (FSC) principles and criteria. Chain of custody certication allows the tracing of this paper back to specic forest-management units (see www.fsc.org). ISBN 978 1 8487 3511 8 1.1

ContentsIntroduction Learning aims and outcomes of Unit 2 Session 1 The accounting cycle, the transaction cycle and source documents Introduction 1.1 The accounting cycle 1.2 Transactions and recordable events 1.3 Data sources and source documents 1.4 The transaction cycle and the accounting cycle compared Summary Session 2 Recording transactions in books of prime entry Introduction 2.1 Books of prime entry 2.2 Recording sales and purchase transactions in the day books 2.3 Recording sales and purchase returns in the day books 2.4 Recording cash transactions in the cash book 2.5 Accounting for petty cash 2.6 The journal 2.7 The non-current asset register 2.8 The inventory register Summary Session 3 Double-entry bookkeeping Introduction 3.1 The functions and foundations of double-entry bookkeeping 3.2 The accounting equation and the nominal ledger 3.3 The rules of double-entry bookkeeping 3.4 Recording transactions in ledger accounts 3.5 Receivables ledgers, payables ledgers and control accounts 3.6 Analysing the day books and posting the totals to the nominal ledger Summary Session 4 Balancing off ledger accounts Introduction 4.1 Introduction to the trial balance 4.2 How to balance and close off ledger accounts 4.3 How to prepare an unadjusted trial balance Summary 5 6 7 7 7 10 16 25 26 27 27 27 28 29 30 34 35 36 36 36 43 43 43 49 53 56 73 82 96 113 113 113 114 116 118

Session 5 Accounting systems and the impact of IT on nancial reporting and control Introduction 5.1 Accounting information systems and sources of information 5.2 The place of the accounting information system in a business organisation 5.3 Accounting information systems and business transactions 5.4 Accounting information systems and the nance function 5.5 The inputs, outputs and controls of the main nancial business systems 5.6 Computerised accounting systems 5.7 Manual versus computerised accounting systems Summary Unit summary Self-assessed Questions References

131 131 131 134 135 137 139 142 144 145 146 146 173

Introduction

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IntroductionWelcome to Unit 2. In Unit 1 you learned what bookkeeping and accounting are, and what accounting information is used for and by whom. In addition, Unit 1 introduced the environmental inuences and constraints on accounting as well as the concepts and principles underlying nancial reporting information. Unit 2 introduces the process of recording transactions, double-entry bookkeeping, and the form and function of manual and computerised accounting information systems. Keeping a record of transactions and summarising transactions through double-entry bookkeeping form the basis of the skills you will learn in this module. There are many activities in Unit 2. All of them are designed to help you understand concepts and master bookkeeping effectively and as quickly as possible. Unfortunately, learning bookkeeping and accounting requires lots of time and practice because there are no short cuts. Note that Session 3 of this unit will be somewhat demanding, but at the end of the session you will have learned the fundamental principles of double-entry bookkeeping. Unit 2 consists of ve sessions. Session 1 introduces the accounting cycle, transactions and recordable events, the difference between a transaction cycle and an accounting cycle, and explains the role of source documents in the accounting system. Session 2 explains how to record transactions in the main books of prime entry. Session 3 explains the logic behind the double-entry bookkeeping system and the basic structure of an accounting system, as well as how to record transactions in nominal ledger accounts. Session 4 illustrates how to summarise the nominal ledger accounts by listing the balances in an unadjusted trial balance and explains the function and limitations of the trial balance. By the end of Session 4 you will be able to perform the rst three steps in the accounting cycle. Session 5 explains the impact of IT on accounting information systems and discusses the differences between manual and computerised accounting systems in relation to the main nancial controls. When working through the unit, please keep in mind that the documents, processes and systems discussed should be regarded as typical examples. However, businesses tend to adopt documentation, processes and systems in accordance with what they need and what works for them. Therefore, the forms and exact content of the documentation, processes or systems discussed in this unit may differ somewhat from one organisation to the next, but should be recognisable. The basic principles of recording the nancial effects of transactions and events using double-entry bookkeeping will remain the same.

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Unit 2 Double-entry bookkeeping

I always wanted to be an accountant

Learning aims and outcomes of Unit 2Upon completion of Unit 2 you are expected to be able to: 1 identify and explain the main types of transactions and events that accountants record in the accounting books 2 identify and explain the role of, and information contained in, source documents 3 record transactions in the appropriate books of prime entry 4 understand and explain the double-entry bookkeeping system, the duality concept, and the accounting equation 5 use books of prime entry, ledger accounts and journals to record transactions 6 balance ledger accounts and extract an unadjusted trial balance 7 understand the basic form and function of accounting records in typical manual and computerised accounting and control systems 8 evaluate the differences between manual and computerised accounting systems and identify their advantages and disadvantages.

Session 1 The accounting cycle, the transaction cycle and source documents

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SESSION

1 0The accounting cycle, the transaction cycle and source documentsIntroductionUpon completion of Session 1 you are expected to be able to:l l l

distinguish between the accounting cycle and the transaction cycle classify transactions identify the information in the different source documents that needs to be recorded in the appropriate books of prime entry.

In Session 1 you will learn about the accounting cycle and the transaction cycles of cash and credit transactions. This will enable you to decide in which book of prime entry to record a transaction. Each type of transaction is recorded in a separate book of prime entry. Session 1 will also introduce the documents that businesses use at various stages of each transaction. This will help you to identify the information from the source documents that needs to be recorded in the books of prime entry. Recording transactions in the appropriate books of prime entry will be the topic of Session 2.

1.1 The accounting cycle1.1.1 What is an accounting cycle?The accounting cycle is the process which commences when a transaction is rst recorded and ends at the time that the nancial statements are prepared. The steps in the accounting cycle are shown in Figure 1. Figure 1 also shows where in this module you will learn about each of the steps in the accounting cycle. These steps are discussed in more detail below. Step 1: Recording the transaction in the books of prime entry and keeping the source documents as evidence. The books of prime entry include the sales and purchase day books, the cash book and the journal. You will learn how to record transactions in the appropriate books of prime entry in Session 2 of this unit. Step 2: Recording the dual aspect of transactions in the general ledger, also called the nominal ledger, using the technique of double-entry bookkeeping. The general ledger holds all the ledger accounts that are used to prepare the nancial statements and which constitute the double-entry system. In a computerised accounting system the recorded transactions are automatically linked to the double-entry bookkeeping system. However, in a manual accounting system all the individual transactions are recorded in the day books in Step 1, and the individual sales and purchase transactions are then also posted to the personal accounts

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Step 1: Recording individual transactions evidenced by source data in the books of prime entry and posting them to the memorandum books (Unit 2: Session 2)

Step 2: Recording the dual aspect of transactions and recordable events in the nominal ledger by posting the totals in the day books to the nominal ledger accounts (Unit 2: Session 3 and Unit 3: Sessions 18)

Step 3: Preparing an unadjusted trial balance by collecting balances from all the nominal ledger accounts (Unit 2: Session 4)

Step 4: Extending the trial balance by making the necessary end of period adjustments in order to match revenues and expenditures for the period (Unit 4: Sessions 15)

Step 5: Preparing the financial statements in accordance with the appropriate measurement and disclosure rules and regulations (Unit 4: Session 6 and Unit 5: Sessions 1, 3 and 4)

Step 6: Closing the temporary nominal ledger accounts: the revenue and expense accounts, the income and expense nominal ledger account and the drawings account (Unit 4: Session 6)

Step 7: Reversing the prepayment and accruals entries, and preparing a post-closing trial balance (Unit 4: Session 6)

Figure 1 The accounting cycle owchart

in memorandum ledgers (also called subsidiary ledgers) by means of journal entries. The totals in the books of prime entry are periodically posted to the appropriate nominal ledger accounts which constitute the double-entry bookkeeping system. This is the topic of Session 3 of this unit. Step 3: Preparing an unadjusted trial balance by collecting the balances of all the nominal ledger accounts. This is the topic of Session 4 of this unit. In a computerised accounting system this is done automatically. Step 4: Extending the trial balance to include the end of period adjustments which are required to prepare nancial statements on an accruals basis instead of a cash basis. Examples include adjustments for inventory and cost of sales, prepayments and accruals, and the depreciation of non-current assets. Other end of period adjustments include those for irrecoverable receivables, the allowance for receivables, and the correction of errors. Unit 4 covers the end of period adjustments using the knowledge of how to account for all the related transactions and events provided


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Step 5:

Step 6:

Step 7:

by Unit 3. The extended trial balance serves as a worksheet that aids in the preparation of nancial statements. Preparing the nancial statements. Unit 4, Session 6 deals with the nancial statements of sole traders and Unit 5 for partnership accounts and company nancial statements. Closing the temporary nominal ledger accounts, which consist of the revenue and expense and drawings accounts, so that only the balance sheet nominal ledger accounts remain open (this is covered in Unit 4). Preparing a post-closing trial balance to make sure that the accounting system is ready for the next accounting cycle (this is covered in Unit 4).

By the end of Session 4 of this unit you will have become familiar with the rst three steps in the accounting cycle, and by the end of Unit 4 you should be able to perform all the steps necessary to produce nancial statements for a sole trader, close the temporary accounts and prepare a post-closing trial balance. Although the steps in the accounting cycle are the same for partnerships and companies, the actual nancial statements are different. You will learn more about this in Unit 5.

1.1.2

How long is an accounting cycle?

A transaction can be completed in as little as a few seconds (e.g., retail sales for cash) or as much as several years (e.g., large building and infrastructure projects). In other words, transaction cycles are extremely variable in length. As you learned in Unit 1, accounting information must be useful as an input to decisions regarding the allocation of scarce resources. For an organisation to know if it is meeting its objectives, and to be able to report to its stakeholders, it needs periodically to summarise and analyse the information it is collecting about its transactions. An accounting cycle comprises the process of recording transactions and posting them to the nominal ledger where, together with other similar transactions, they become information that is periodically summarised, adjusted and presented in a form that serves a particular purpose. For management purposes, accounting cycles are often monthly, quarterly and annual, but management reports can be produced whenever the need arises. Management reports are typically concerned with costs and budgets or actual and projected sales and revenues. In addition, enterprises close their accounting books at least once a year for nancial accounting purposes, often but not necessarily at the end of the scal year. The scal year is determined by the tax authorities within a country. They are interested in calculating how much tax revenue they can collect from a business every year. Different countries have different scal years. For example, the scal year can run from 1 January to 31 December or from 1 April to 31 March. In many countries, for example, the UK, the USA, Japan and the Netherlands, most companies choose to make their nancial year follow the scal year, although they are allowed to choose a nancial year that is different. However, there may be countries, where the nancial year has to be the same as the scal year. The

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nancial year is the annual accounting reference period for external (nancial) reporting purposes. For many businesses their nancial accounting cycle is annual. However, companies listed on a European stock exchange are obliged to provide their current and potential shareholders with annual reports as well as interim nancial reports for shorter periods typically six months. Companies listed in the US must prepare interim nancial reports every three months. In such cases these constitute shorter accounting cycles within the annual nancial reporting cycle.

1.2 Transactions and recordable events1.2.1 Identifying transactions and recordable eventsIn every day life, a transaction takes place when one party exchanges or promises to exchange a good or service with another party for money. Any transaction that is not in exchange for money is called a barter transaction. An example of a barter transaction is when your neighbour mows your lawn in exchange for a haircut from you. Barter transactions are potentially difcult to account for because it may not be easy to put a monetary value on either side of the exchange. As mentioned in Unit 1, the monetary measurement concept dictates that bookkeeping and accounting deal with transactions and events that can be measured reasonably objectively in monetary terms. In any business, the most frequent transactions are sales of goods and/or services. This is how businesses increase their revenue. Businesses can sell their goods and services for cash or on credit. In order to be able to sell, a business needs to purchase goods for resale, or in case of a manufacturing business, it needs to purchase raw materials which it will turn into products for sale. These transactions are called purchases. Of course, businesses also buy goods or services for their own use. Some of these will be used within one accounting reference period, such as stationery, electricity, telephone or legal services. Such expenditures are called revenue expenditures. Others are meant to last for multiple periods, such as buildings, computers, desks, chairs, etc. Such expenditures are called capital expenditures. Bookkeepers and accountants not only record transactions, but they also record the nancial effects of other events. Examples of recordable events include the loss of inventory due to water damage, a loss of sales revenue because of a debtors bankruptcy, or end of period adjustments to the accounts in order to produce nancial statements that reect the matching principle. In essence, bookkeepers and accountants record all transactions and events that directly affect the nancial situation of the business as reected in the elements of nancial statements, which are: assets, liabilities, revenue and expenses. These elements were introduced in Unit 1.


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Activity 1.1There are many types of transactions and events. Can you give some examples of transactions and events that accountants record in accounting books?

FeedbackYou may have suggested any of the following. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Sales of goods for cash. Purchasing a stock of goods for resale, or raw materials, and paying by cheque. Sales of goods on credit. Purchasing a stock of goods for resale, or raw materials, on credit. Purchasing ofce supplies on credit. Paying cash into the bank. Receiving money for goods sold on credit by cheque or bank transfer. Paying a creditor by cheque for goods or services received. Returning damaged or unwanted goods to a seller. Receiving damaged or unwanted goods returned by a customer. Receiving discounts from suppliers or extending discounts to customers. Borrowing money from a bank in order to buy ofce equipment to use for several years in the business. Using the borrowed money to buy ofce equipment to use for several years in the business and paying by bank transfer. Depreciating the cost of the ofce equipment after one year by the amount used up during the year. Incurring expenses such as telephone, electricity, insurance, business rates, etc. Paying salaries to employees. Paying or reclaiming Value Added Tax (VAT). VAT relates to the obligation that VAT registered businesses have to the tax authorities (HMRC in the UK). Unit 3 will elaborate on VAT (which is effectively a sales tax) and explain how accountants record VAT.

1.2.2 The cash basis of accounting and the accruals basis of accountingThe distinction between cash transactions and credit transactions is fundamental to bookkeeping and accounting. In the case of a cash transaction, goods or services are exchanged for cash. In the case of a credit transaction, the seller extends credit to the buyer and the buyer pays the seller at a later date, as specied in a contract or agreement. If a business only buys and sells goods and services for cash, the business records the transactions at the time of payment or receipt of cash. At the end of the accounting period, there would not be any need for end of period adjustments apart from the correction of errors because any increase (or decrease) in cash would be prot (or loss) for the period. For such a business, the cash basis of accounting would be sufcient to calculate periodic prots that truly and fairly represent the economic reality of the business. Under the cash basis of accounting any recorded increase in cash counts as revenue and any recorded decrease in cash counts as expense for the determination of prot in a given accounting period. There would not be any timing differences between the receipt of money and the recognition of revenue for the purpose of periodic income

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determination or between the payment of money and the recognition of an expense for the period determination of prot or loss. Most businesses, however, buy and sell on credit, and borrow money from banks or other lenders to invest in assets that last longer than one accounting period. Some businesses engage in projects that last multiple years, such as long-term construction projects for buildings, bridges, roads, etc. All businesses need periodically to prepare nancial statements and determine their prot or loss for a specied accounting period. Sole traders and partners in partnerships want to know how well or badly they are doing, and how much money there is to invest in the business or how much money can be withdrawn without endangering the future existence of the business. In the case of companies, prot or loss indicates how much money, if any, can be distributed to the shareholders in the form of dividends. However, the cash basis of accounting for most businesses results in prot or loss numbers that are very volatile and provide a poor reection of the nancial performance and nancial position of the business. Over time, bookkeepers and accountants developed the accruals basis of accounting to deal with this problem. Under the accruals basis of accounting, revenues and expenses are recognised for the periodic determination of income when they are accrued that is, earned (for revenues) and incurred (for expenses) rather than when cash is paid or received. As a result, in general, cash received during an accounting period does not equal revenues earned during that period. Similarly, cash paid during an accounting period does not usually equal expenses incurred during that period. In practice, this means that at the end of an accounting period adjustments need to be made to the nominal ledger accounts. The idea is that accrual accounting makes the revenue and expense accounts in the income statement better reect the economic performance during the accounting period, and the asset and liability accounts in the balance sheet better reect the nancial position of the business at the end of the accounting period. Examples of such end of period adjustments include prepayments and accruals and the depreciation of non-current assets. Activity 1.2Consider a case where a business pays 1,200 for 12 months of insurance on 1 October 2010. The business prepares nancial statements as at 31 December 2010. How much would the insurance expense for the year be under the cash basis of accounting? How much would the insurance expense for the year be under the accruals basis of accounting?

FeedbackUnder the cash basis of accounting the insurance expense for the year would be 1,200. On the other hand, under the accruals basis of accounting the insurance expense for the year would be 3/12 months 6 1,200 = 300. The 900 difference is then recorded as an asset called prepaid insurance. You will learn how to do this in Unit 3.

Beyond cash-based accounting, the question of how best to allocate revenues and expenses over accounting periods so as to determine prot or loss, and the carrying amount of assets and liabilities, is


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also known as the allocation problem in accounting. How do accountants determine whether revenues have been earned and expenses have been incurred? There are two ways of practising accrual accounting. The rst is to determine prots for the period by matching the expenses to the revenues that have been realised in an accounting period. The second is to determine prots for the period through the valuation of assets and liabilities. According to the latter method, revenues and expenses are recognised as the by-products of valuation. In other words, the values of assets and liabilities are measured or estimated at two points in time as best as possible, and the increase (or decrease) in the difference between the two totals is called prot (or loss) for the period. In practice, nancial accounting standards usually follow the matching approach, although you will see an example of the valuation approach in Unit 3.

1.2.3 Capital expenditures and revenue expendituresIn addition to the use of credit, a second reason for the allocation problem in accounting is the use of assets that are not purchased for the purpose of resale but in order to serve the business for longer periods. The cash basis of accounting for large amounts of cash spent on non-current assets may lead to losses instead of prots in the period when the non-current assets were bought. Therefore, another way of differentiating between transactions is to consider the purpose of the goods or services involved in the transactions. As mentioned above, some goods are purchased in order to be resold. Session 2 of this unit will explain that these transactions are called purchases. The goods bought are in another category called current assets. However, for example, ofce equipment, motor vehicles and buildings are normally purchased to serve the business for several years. Such investments in non-current assets typically involve large sums of money and are often nanced by debt. Money spent on non-current assets is also called capital expenditure. Similarly, businesses also purchase goods and services for consumption by the business and the employees in order to carry out their work. The money spent on such goods and services is called revenue expenditure. Examples include electricity for the ofce, stationery, and coffee or tea for employees. Unit 1 introduced the distinction between current and non-current assets. Unit 3 will explain in detail the difference between accounting for capital and revenue expenditures.

1.2.4 Transaction cycles for cash transactions and credit transactionsA transaction cycle starts with the order of a product or service, and ends with the exchange of the good or service for payment. In the case of a cash transaction, the whole transaction cycle could take as little as a minute. An example of a cash transaction would be buying a good or service from a retailer and paying straight away in cash. The exchange of the good and the payment take place at the same time. Usually the buyer gets a till receipt as evidence of payment.

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A cash transaction is recorded as a receipt in the cash book of the seller and as a payment in the cash book of the buyer. Cash transactions do not give rise to liabilities for either the seller or the buyer. In the case of a credit transaction, the transaction cycle takes as long as the seller is willing to extend credit to the buyer. This could be two weeks or 30 days, but it could also be six months or more. An example of a credit transaction is when Business 1 orders goods from Business 2 on, say, 1 July. Business 2 despatches the goods on 7 July and at the same time sends out its sales invoice for the goods, asking for payment within two weeks. Business 1, the purchaser of the goods, receives the invoice and the goods on 8 July and instructs the bank to pay the amount due on 21 July. In this case, the whole transaction cycle takes three weeks to complete. For a credit transaction, the transaction cycle lasts from the moment a buyer places an order to the moment the seller receives payment for the goods or services delivered. The accounting cycle, however, starts for the seller when the goods have been delivered and the sales invoice sent and for the buyer when the goods and the purchase invoice have been received. The very same invoice represents the sales invoice to the seller and the purchase invoice to the buyer. It is common practice for many businesses to buy and/or sell on credit. Therefore, transaction cycles could take weeks or months to be completed. In the case of large-scale construction projects they could even take years. Retail businesses often buy their stock on credit and sell their goods for cash. Credit enables businesses to increase their sales and purchases faster than they would be able to do on a cash basis. On the other hand, the advantage of cash sales and purchases is that a business does not run the risk that its customers will not pay their invoices or that it will not be able to pay its trade creditors. Activity 1.3What determines whether or not a transaction is a cash or credit transaction?

FeedbackThe distinction between credit and cash transactions rests on whether or not the seller allows the buyer a period for payment. In the case of credit transactions, the seller will then need to record an account receivable in the books. In other words, the books need to indicate the goods that have been sold, the date and amount of the sale, and when payment should be received. The buyer needs to record an account payable which indicates the goods that have been bought, the date and amount of the purchase, and when payment is due.

Activity 1.4Suppose that a buyer purchases a television for 500. The buyer has the following payment options. Option 1 Option 2 Option 3 Pay in cash immediately. Pay by debit card. Pay by cheque.

Option 4 Pay by credit card. Do all these options result in the transaction being a cash transaction? What difference is there between the perspective of the buyer and that of the seller in any of the above cases?


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FeedbackThe rst two options result in a cash transaction. The third option is considered a cash transaction although there is a possibility that the cheque will not be honoured. Paying by credit card results in the transaction becoming a three-way credit transaction. Option 1 Option 2 Cash transaction for both the seller and the buyer. From both the perspective of the seller and the buyer, it is a cash transaction (although in the UK it usually takes a few days before the money leaves the buyers bank account and enters the sellers bank account). Payment by cheque means that the money goes from the buyers account to the sellers account. There may be a three day delay due to the national clearing system. As there is always the possibility that a cheque will not be honoured, the seller could record a note receivable until the money is received and the buyer could record a note payable until the money leaves the bank account, but this is not usual. In the case of payment by credit card, the situation is more complicated for the following two reasons: (1) there are three parties involved instead of two (2) the credit card company may require a fee of, say, three per cent from the company selling the television. For all three parties involved, this is a credit transaction. From the perspective of the seller, the credit card company owes the seller 500 less three per cent (i.e., 485), which the seller records as receivable from the credit card company. The buyer owes the credit card company 500 and records this as a payable. The credit card company records a receivable from the buyer for 500 and a payable to the seller of 485.

Option 3

Option 4

Activity 1.5Most businesses purchase and/or sell goods on credit as well as for cash. Why do you think that credit is so important in business? What is the disadvantage of credit transactions?

FeedbackExtending and receiving credit enables businesses to increase the number of their purchases and sales transactions faster than would be possible on a cash basis only. Credit allows business to grow faster. The disadvantage is that there is always the risk that some customers will be unable to pay the amount owed.

1.2.5 Other ways of distinguishing between transactionsAnother way of distinguishing between transactions is by international (import and export) and intra-national transactions. International transactions can be more complicated because the transactions are not necessarily conducted in the home currency of an enterprise. For example, if there is a transaction between a seller in the UK and a buyer in France, the transaction price can be set in British Pound Sterling or Euros. Pounds will be the home currency for the seller and Euros will be the home currency for the buyer, so in this case either the seller or the buyer needs to account for the transaction by converting the foreign currency into their home currency. This module deals exclusively with transactions in the home currency of a business. In addition, the terms of trade (such as payment and shipping) are often

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longer and may involve bank or export guarantees and additional insurance. For example, payment may involve credit periods as long as 18 months. Shipping containers from, say, Rotterdam to Tokyo may take four to six weeks. Accounting for such transactions is also a little more complicated and beyond the scope of this module. The list in the answer to Activity 1.1 gives an idea of the transactions that you will learn to record in the books of prime entry and the double-entry system. Recording transactions in the books of prime entry is the rst step in the accounting cycle. In Session 2 of this unit you will learn how to record transactions in the appropriate books of prime entry, but rst you will learn more about the accounting cycle and the source documents that serve both as the source of the data to be recorded and the evidence that the records are correct.

1.3 Data sources and source documents1.3.1 The purpose of business documentationBusiness transactions can take weeks or months to complete. Therefore, it is important to document the whole process so each party to the transaction knows exactly what is happening at any moment in time. Enterprises, depending on their size, may be involved in hundreds or thousands of different transactions at the same time and the documentation helps businesses to keep track of all these transactions. Thus, businesses record all of their transactions on source documents, and these documents contain the information that accountants record in the account books or the computerised accounting system. The source documents or copies thereof are usually kept with the books of prime entry to serve as evidence for the transactions.

1.3.2

Source documents in credit transactions

In a cash transaction the source document for the buyer could be an invoice marked paid or a receipt, and for the seller would be a copy of the same. For credit transactions the transaction cycle is longer, and the whole process could involve the following source documents. See Figure 2.Source Document Price quotation Purchase order Sales confirmation Delivery note + goods SELLER Invoice Debtors statement Debit note Credit note Payment by cheque or BACS Remittance advice Receipt CUSTOMER Direction Source Document

Figure 2 Source documents in credit transactions


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Price quotation: Written offer by a business to a customer. In reality, a quotation often takes place over the phone and may be conrmed via e-mail. See Figure 3. A quotation could include:

l

the name and address of the business quoting the price the name and address of the customer the date of the quotation the date until which the quotation is valid the details of the goods the details of the price the terms of delivery and/or shipment the terms of payment.

l l l l l l l

Purchase order: The customer agrees with the price, payment and delivery terms in the quotation and orders the goods or service. See Figure 4. A purchase order could include:

l

the name and address of the business placing the order the name and address of the supplier the date of the purchase order the purchase order number the VAT registration number of the business placing the order, if applicable the details of the goods ordered the quantity of the goods ordered the details of the price the delivery address, if different from the billing address the terms of delivery and/or shipment the terms of payment.

l l l l

l l l l

l l

Sales conrmation: Delivery note:

The seller conrms the order, price, payment and delivery terms and planned date of delivery and attaches a sales order number to the transaction. The seller despatches the goods accompanied by a delivery note and the customer signs the delivery note in order to conrm receipt or to conrm that the service has been performed. The delivery note will mention the sales order number and will bear a delivery note number.

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T Printer heFast and reliable Print Street, Print City, PC7 7PP Phone (01666) 222233 Fax (01666) 222234 v.roy@emailaddress TO Mary Malony The Open University Walton Hall Milton Keynes, MK7 6AA (01908) 123456 Customer ID [ABC12345] SALES PERSON Vikas Roy SHIPPING METHOD UPS Parcel SHIPPING TERMS Delivery included DELIVERY DATE 14 days after receipt of order PAYMENT TERMS Up to 14 days after delivery

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TOTAL DISCOUNT

1,500 Subtotal 16,000 2,800 18,800

SALES TAX (VAT) TOTALQuotation prepared by: Vikas Roy This is a quotation on the goods named, subject to the conditions noted below: This quotation is valid for 14 days. A minimum charge of 35 will apply to all authors corrections. To accept this quotation, sign here and return:

THANK YOU FOR YOUR BUSINESS!

Figure 3 Example of a price quotation


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Purchase OrderDATE: 5 FEBRUARY, 2010 PO # [100] Vendor Vikas Roy The Printer Print Street Print City, PC7 7PP Phone (01666) 222233 ID XYZ123 SHIPPING TERMS Delivery included Ship To Mary Malony The Open University Walton Hall Milton Keynes, MK7 6AA (01908) 123456 Customer ID [ABC12345] DELIVERY DATE

SHIPPING METHOD UPS Parcel

QTY 10,000 1,000

ITEM # OBU Coast B291

DESCRIPTION 010 Booklet B291 D0 Reader

JOB OBU Coast B291 DO


LINE TOTAL 13,500 2,500

Subtotal Sales Tax Total 1. 2. 3. 4. Please send two copies of your invoice. Enter this order in accordance with the prices, terms, delivery method, and specifications listed above. Please notify us immediately if you are unable to ship as specified. Send all correspondence to: address in Wellingborough.

16,000 2,800 18,800

Authorised by Mary Maloney

Date 5/2/2010

The Open University, Walton Hall, Milton Keynes, MK7 6AA, Registration No. RC000391. Tel: (01908) 123456 E-mail: MM@emailaddress

Figure 4 Example of a purchase order

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Invoice:

Usually at the time of despatch the seller sends the sales invoice to the customer, often by post so that it arrives shortly after the customer has received the goods or services. It is a document that requests the customer to pay the amount owed. See Figure 5. A sales invoice typically includes:l l l l l l

the name and address of the supplier the name and address of the customer the invoice date the invoice number the VAT registration number (if applicable) the delivery note number (if already delivered) the customers account number the details of the goods the details of the price (excluding and including trade discounts and VAT if applicable) the terms of delivery and/or shipment the terms of payment

l l l

l l l

payment instructions or the suppliers bank account details. Terms of payment and delivery: If the agreement is that the customer pays on delivery of the goods, the invoice will state cash on delivery (COD). If the agreement is that the supplier pays for delivery of the goods, the invoice will state carriage paid. If the price quoted does not include delivery of the goods, the customer must organise and pay for the collection and delivery of the goods. The suppliers invoice will then state ex works. An invoice could also mention the period of payment. Often this may be two weeks or a month. Invoices could also mention a discount if the customer pays the supplier early, for example, within two weeks. This is called a cash discount or settlement discount. Discounts will be explained further in Session 2 of this unit. Debtors statement: Also called the statement of account or simply statement, a document sent by the seller/supplier to a customer listing all the invoices, credit notes sent to and payments received from the customer over a specied period, for example, one month. See Figure 6.


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T Printer heFast and reliable Print Street, Print City, PC7 7PP Phone (01666) 222233 Fax (01666) 222234 v.roy@emailaddress TO Mary Malony The Open University Walton Hall Milton Keynes, MK7 6AA (01908) 123456 Customer ID [ABC12345] SALES PERSON Vikas Roy SHIPPING METHOD UPS Parcel SHIPPING TERMS Delivery included SHIP TO

INVOICEINVOICE # [100] Date: 8 FEBRUARY, 2010

The Open University Materials depot Wellingborough Contact person: Sarah Jackson

JOB

DELIVERY DATE 8 February, 2010

PAYMENT TERMS Up to 14 days after delivery

DUE DATE 22 February, 2010

OBU Coast

QTY 10,000 1,000

ITEM # OBU COAST B291 D0

DESCRIPTION OBU COAST 010 BOOKLET B291 D0 Reader


DISCOUNT 10%

LINE TOTAL 13,500 2,500

TOTAL DISCOUNT

1,500 Subtotal 16,000 2,800 18,800

SALES TAX (VAT) TOTAL

Pay to: Open Bank, Account number: 987 54 32 10 or make all cheques payable to The Printer THANK YOU FOR YOUR BUSINESS!

Figure 5 Example of an invoice

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T Printer heFast and reliable Print Street, Print City, PC7 7PP Phone (01666) 222233 Fax (01666) 222234 v.roy@emailaddress BILL TO Mary Malony The Open University Walton Hall Milton Keynes, MK7 6AA (01908) 123456 Customer ID [ABC12345] COMMENTS

STATEMENTSTATEMENT # [0100] Date: 10 FEBRUARY, 2010

DATE 15/1/2010 8/2/2010

DESCRIPTION Invoice no. 65 re: envelopes A4 size Invoice no. 100 re: OBU Coast 010 Booklet and B291 Reader

BALANCE 4,000 18,800

AMOUNT 4,000 18,800

CURRENT 18,800

1-30 DAYS PAST DUE 4,000

31-60 DAYS PAST DUE

61-90 DAYS PAST DUE

OVER 90 DAYS PAST DUE

AMOUNT DUE 22,800

Remittance Statement # Date Amount Due Amount Enclosed 0100 10 February, 2010 22,800

Pay to: Open Bank, Account number: 987 54 32 10 or make all cheques payable to The Printer THANK YOU FOR YOUR BUSINESS!

Figure 6

Example of a debtors statement


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CREDIT NOTEBubbles plc 100 Bubble Street Bubble City, BC10 12N (01079) 570001 Billy.Bubble@emailaddress TO Sigmund Alpha Alpha Ltd Moon Crescent Winter City, WC1 7HJ (01910) 020030 Customer ID A205 JOB BS357 No tears DATE: 10 MARCH, 2010 CREDIT NO. CN001

QTY 500

ITEM # BS357

DESCRIPTION Shampoo (No tears)

UNIT PRICE 1

LINE TOTAL 500

SUBTOTAL SALES TAX TOTAL

500 0 500

Figure 7 Example of a credit note

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Debit note:

Credit note:

A document sent by the customer relating to goods returned or an overpayment made. A debit note can be interpreted as a request for a credit note. On the face of the document there will always be a debit note number. A document sent by the seller/supplier to the customer relating to goods returned or overpayments made by the customer. It is usually a cancellation of part of an invoice. A credit note will have a credit note number. See Figure 7. A document that instructs a bank to take money from the account of the drawer and give it to the payee. These days, however, many payments are made by credit transfer. In most European countries cheques have all but disappeared since the early 1990s and have been replaced by bank transfers and electronic payments. In December 2009, the UK Payment Council voted to phase out cheques by 2018. A document that the customer sends to the supplier indicating which invoices are being paid and which credit notes are being offset. A written or printed conrmation of payment.

Cheque:

Remittance advice: Receipt:

Source documents such as the ones above provide the basis and evidence for the information recorded in the books of prime entry. Bank statements can be used as source documents for direct debits, standing orders, bank transfers, and bank interest and charges. Activity 1.6Spend ve minutes carefully studying the above examples of source documents. Make sure you can nd all the relevant information that needs to be recorded in the accounting records.

1.3.3

Credit transactions and the accounting cycle

The above discussion of source documents in the transaction cycle raises the following question: At what stage of the transaction cycle do accountants generally record credit transactions in the account books? For example, when does an accountant record a sales transaction in the appropriate book of prime entry? In Unit 1 you learned about the general recognition criteria for the elements of nancial statements such as assets, liabilities, revenues and expenses. Unit 1 also introduced you to the realisation concept with regard to revenues. This means that revenues can only be recorded when their realisation is reasonably certain. A cash sale is certain when goods and cash are exchanged. Accountants consider the realisation of a credit sales transaction reasonably certain at three points: 1 when payment is received 2 at the time of delivery 3 at the time that the invoice is sent to the customer.


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In practice, credit sales transactions are often recorded in the appropriate book of prime entry, in this case the sales day book, of the seller when the business sends out the sales invoice to the customer. Conversely, credit purchases are recorded in the purchase day book of the purchaser at the time that the goods and the purchase invoice have been received. The seller will, of course, keep a digital or hard copy of the invoice as evidence. Until an invoice is sent out, copies of the price quotation, purchase order, sales conrmation and shipping documents are kept in a le by the person or department in charge of the transaction (usually in the sales department). When a sales invoice is sent out to the customer, a copy of the invoice will be passed on to the accounts department (or the bookkeeper or accountant) so that the invoice can be matched to the payment received in due course. It is also possible that it is the accounts department which issues the sales invoice.

1.4 The transaction cycle and the accounting cycle comparedYou should now have a good idea of what the transaction cycle and the accounting cycle are and how they relate to each other. Within an accounting cycle, many transactions are recorded and accounted for. Within a transaction cycle, the point at which the transaction is recorded in the accounting system is when the transaction is realised, either at the point of delivery of the good or service, or at the time of payment. Source documents serve as evidence. Below is a visual expression of how the transaction cycle and the accounting cycle relate to each other.Credit transaction cycle 1 Price quotation 2 Sales/purchase conrmation 3 Delivery Delivery note and invoice Step 1: Recording receivable or payable in the books of prime entry Step 1a: Posting individual transactions to the personal accounts in the memorandum (or subsidiary) ledgers 4 Payment or receipt of payment Cheque, bank statement Step 1: Recording payment or receipt of payment in the cash book Step 2: Posting total receivables and payables, and total cash receipts and payments, to the double-entry system in the nominal ledger accounts Step 3: Preparing an unadjusted trial balance Step 4: Performing end of period adjustments Step 5: Preparing the nancial statements Source documents Accounting cycle

Individual transactions

Aggregated transactions

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SummaryIn this session you have learned that the transaction cycle is not the same as the accounting cycle and you should now be able to distinguish different types of transactions. The accounting cycle starts with recording transactions and events in the appropriate books of prime entry and keeps the source documents as evidence for every step in the transaction process. In Session 2 you will learn about the rst step of the accounting cycle. Session 2 will explain what the main books of prime entry are and how to record transactions in the appropriate day books.

Session 2 Recording transactions in books of prime entry

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SESSION

2 0Recording transactions in books of prime entryIntroductionUpon completion of Session 2 you are expected to be able to:l

identify the main books of prime entry, explain their function and describe their format record sales in the sales day book and purchases in the purchase day book record sales and purchase returns in the appropriate day books record payments and receipts in the cash book record petty cash in the petty cash book understand the imprest system understand the purposes of the journal.

l

l l l l l

In Session 2 you will learn about the main books of prime entry, their function and format and the type of information that is recorded in each of these books. This is Step 1 in the accounting cycle in Figure 1 that you encountered in Session 1.

2.1 Books of prime entryBooks of prime entry are also called subsidiary books of account. Their purpose is to keep records of source documents relating to transactions. The main books of prime entry are: 1 2 3 4 5 6 7 8 9 sales day book purchase day book sales returns day book purchase returns day book cash book petty cash book journal non-current asset register inventory register.

Very small cash-based businesses would probably only use a cash book. The rst seven items in the list above are covered in Session 2, although the journal will be discussed in greater detail in Session 3 of this unit. The non-current asset register and the inventory register will be discussed in Unit 3. In a computerised accounting system the transactions recorded in the books of prime entry are automatically linked to the general ledger. The general ledger accounts make up the double-entry bookkeeping system. Books of prime entry are not part of the double-entry system, and in a manual accounting system posting the totals in the day books to the nominal ledger accounts will have to be done manually. In this session you will learn how to record individual transactions manually in the books of prime entry. Later, in Session 3, you will

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learn how to record the summarised transactions in the nominal ledger accounts and record individual transactions in subsidiary ledgers when required. Note that some people prefer to use the term general ledger instead of nominal ledger. The two terms are interchangeable. As mentioned above, the books of prime entry are not part of the double-entry bookkeeping system. They are simply lists of transactions of the same type that make it easier to summarise and total these transactions and record these totals in the nominal ledger accounts. Under a manual bookkeeping system in a business with a large volume of transactions, the books of prime entry will be totalled daily as the name day book suggests. In enterprises with relatively few transactions they could be totalled weekly or monthly. These totals will then be posted to the appropriate nominal ledger accounts. In computerised accounting systems, totals are posted to the nominal ledger accounts automatically.

2.2 Recording sales and purchase transactions in the day books2.2.1 The sales day bookThe sales day book is a list of the invoices that an enterprise has sent out during a given period. In other words, it is a list of all the credit sales transactions for that period, which is often a day, but could be longer in the case of a business with relatively few transactions. An extract from a sales day book could look like this:Sales day book Date 28 May 28 May 28 May Invoice 0203 0204 0205 Customer Alpha Ltd Beta Ltd Gamma Ltd Description Shampoo Toothpaste Shampoo Invoice amount 2,500 1,200 1,500 5,200

Some businesses analyse their sales by product group. In that case, an extract from the sales day book could look like the one below. Keep in mind that the analysis columns can easily be tailored to the specic needs of the individual business. For example, in a business that is registered for VAT there would also be a column for VAT, as will be illustrated in Unit 3.Analysed sales day book Date 28 May 28 May 28 May Invoice 0203 0204 0205 Customer Alpha Ltd Beta Ltd Gamma Ltd Invoice amount Shampoo Toothpaste 2,500 1,200 1,500 5,200 1,500 4,000 1,200 2,500 1,200


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2.2.2

The purchase day book

Similarly, the purchase day book is the book of prime entry for credit purchases and is, therefore, a list of all the purchase invoices to be processed for a given period. However, because not all invoices received relate to the purchase of goods for resale, or (in the case of a manufacturing business) raw materials for producing goods, a business is likely to make a distinction between purchases and other expenses. Invoices that relate to capital investments in assets that the business intends to use for several years are usually not recorded in the purchase day book. Instead, these are recorded in the journal, which will be discussed below and in Session 3 of this unit. An extract from the purchase day book could be laid out as follows:Purchase day book Date Supplier Description Woolly jumpers Cardigans Telephone Invoice amount 28 July Delta plc 28 July Epsilon plc 28 July Zeta plc 7,000 8,000 500 15,500

An extract from an analysed purchase day book could look like this:Analysed purchase day book Date Supplier Description Invoice amount 28 July 28 July 28 July Delta plc Epsilon plc Zeta plc Woolly jumpers Cardigans Telephone 7,000 8,000 500 15,500 15,000 Purchases 7,000 8,000 500 500 Other expenses

2.3 Recording sales and purchase returns in the day books2.3.1 Sales and purchase returnsOccasionally it happens that goods bought or sold are returned. Possible reasons could be that the goods supplied were the wrong quantity, type, size or colour, or that the goods were damaged or otherwise unsatisfactory. Upon delivery a buyer will inspect the goods to see if they are in accordance with the specications of the contract, that is, the sales and purchase conrmations. When a buyer returns goods for some reason, the buyer usually sends a debit note to the seller. Upon delivery, the seller will inspect the returned goods, record the details for memorandum purposes and then send a credit note to the buyer. The buyer will record that credit note in the purchase returns day book.

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2.3.2

The sales returns day book

A sales returns day book is a list of all the credit notes sent to customers. Every credit note sent out by the seller is recorded in the sales returns day book. Sales returns are also called returns inwards. The layout is the same as that of the sales day book except that the invoice number is replaced by a credit note number.Sales returns day book Date Credit note no. CN 001 CN 002 CN 003 Customer Description Invoice amount 30 May 30 May 30 May Alpha Ltd Beta Ltd Gamma Ltd Shampoo Toothpaste Shampoo 500 200 100 800

2.3.3

The purchase returns day book

A purchase returns day book is a list of all the credit notes received from suppliers. Every credit note received by a buyer is recorded in the purchase returns day book. Purchase returns are also called returns outwards. For example, the credit note received by Alpha Ltd for 500 of shampoo returned will be recorded in Alpha Ltds purchases returns day book as follows:Purchase returns day book Date 1 June Supplier Bubbles plc Description Shampoo Credit note no. CN 071 Invoice amount 500 500

2.4 Recording cash transactions in the cash book2.4.1 CashIn Session 1 you learned about the distinction between cash and credit transactions. In cash-based transactions payment is settled immediately, whereas in credit-based transactions the seller grants the buyer credit for a certain period of time. In bookkeeping and accounting, the denition of cash is much broader than the coins and notes we associate with the word cash in every day use. It denotes all forms of money including cheques, credit transfers, direct debits and money in the bank. Activity 2.1Keeping in mind the above denition of cash and the fact that in accounting cash means more than just notes and coins, what kind of information do you expect to nd in the cash book?

FeedbackThe cash book contains the amounts received and paid by cheque, details of direct debits, credit transfers and bankers drafts. It also contains information about bank notes and coins paid into the business bank account.


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Activity 2.2Which source documents are used as evidence to record transactions in the cash book?

FeedbackFor payments: For receipts: cheque counterfoils, receipts or invoices, bank statements cheques, paying-in slips, remittance advice statements, bank statements

2.4.2

The cash book

In accounting, the cash book is a record of monetary transfers. The cash book is the book of prime entry for all transactions concerning money. In many businesses the cash book deals with money paid into and out of the business bank account only. This means that any cash sales will be deposited every day. Such businesses usually keep a small amount of cash in notes and coins for certain odd items of expense in a petty cash oat. You will learn how to record cash payments and receipts in a petty cash book in Section 2.5. In other businesses the cash book deals with payments in and out of the bank account as well as the payments and receipts related to cash purchases and sales. Cash books come in different forms and sometimes full slightly different functions. In manual accounting systems there could be a separate book for cash receipts and a separate book for cash payments. There could also be one cash book in which the pages on the left-hand side are for cash receipts and the pages on the righthand side are for cash payments. The simplest cash book has receipts on the left side of a page and payments on the right side. No matter which form the cash book takes, the principle is the same and it looks something like this:Cash book Receipts Date 1 July 1 July 1 July 1 July 1 July Narrative Balance b/d* Cash sale banked Cheque from Alpha Ltd Bank transfer from Beta Ltd Cheque from Gamma Ltd Amount 50 750 2,000 1,000 1,200 5,000 * b/d stands for brought down. It means that there was 50 of cash available on 30 June. ** c/d stands for carried down. It means that there was a cash balance of 250 available at the end of 1 July, which is also the beginning balance on 2 July. *** Notice that 100 was taken out of the bank account to be used as petty cash. Petty cash will be explained in Section 2.5. 1 July 1 July 1 July 1 July 1 July Cheque to ABC Ltd Cheque to Soap plc Gas bill Petty cash*** Balance c/d** Payments Date Narrative Amount 800 3,200 650 100 250 5,000

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Businesses also use analysed cash books. An extract from an analysed cash book could look as follows:Cash book: receipts Date Narrative Amount received 1 July 1 July 1 July 1 July 1 July 2 July Balance b/d* Cash sale banked Cheque from Alpha Ltd Bank transfer from Beta Ltd Cheque from Gamma Ltd Balance b/d 50 750 2,000 1,000 1,200 5,000 250 2,000 1,000 1,200 4,200 750 0 750 Receivables Cash sales Other

Cash book: payments Date Narrative Amount paid 1 July 1 July 1 July 1 July 1 July Cheque to ABC Ltd Cheque to Soap plc Gas bill Petty cash*** Balance c/d** (5,000 4,750) 800 3,200 650 100 4,750 250 5,000 * b/d stands for brought down. It means that there was 50 of cash available on 30 June. ** c/d stands for carried down. It means that there was a cash balance of 250 available at the end of 1 July, which is also the beginning balance on 2 July. *** Notice that 100 was taken out of the bank account to be used as petty cash. Petty cash will be explained in Section 2.5. 4,000 100 100 650 Payables 800 3,200 650 Petty cash Other

Note that on the receipts side of the cash book the totals in the analysis columns will not add up to the total amount received if there is an opening balance. On the cash payments side, however, the totals in the analysis columns do add up to the total amount paid as there will not be an opening balance. Analysed cash books can have as many columns for analysis as suits the needs of the business. In some businesses where sales and purchases transactions are paid in coins and notes, the cash book deals with both physical cash as well as bank transactions. Therefore, the layout of a cash book in which both payments and receipts for cash and credit sales and purchases are recorded would have columns for both cash and bank. See the example below for an illustration.Cash book Receipts Narrative Cash Bank Payments Narrative Cash Bank


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Alternatively, such a business could use separate cash books for physical cash and bank transactions. Although you need to know that different forms of cash books exist, this module focuses solely on the scenario where the cash book is used as the book of prime entry for money paid into and out of the bank account. This may take the form of the above examples from the cash book for 1 July. Please note the underlying assumption here is that any cash sales are deposited into the bank daily. Activity 2.3Looking at the cash book example above, we see that on 1 July a cash sale of 750 took place. How was this sale paid for?

FeedbackWe do not know if this sale was paid for by notes and/or coins, debit card or cheque. We only know that payment was settled immediately and thus it is contrasted with credit sales. If it was paid for using notes and/or coins, the amount was paid into the business bank account on that day.

Activity 2.4Laura is an accountant working for Momoko Toys Ltd. She receives the business bank account statement and nds that there is a difference between the balance in her bank account according to the bank statement and the balance according to the cash book. What could have happened that might explain this difference?

FeedbackIn the UK, the most likely explanation would be that the balances are different because of the timing difference between writing out a cheque to pay for goods and the bank deducting the money from the bank account. Also, when a cheque is received and paid into the bank account, it usually takes a few working days before the money appears on the bank statement but it has already been entered into the cash book. In other words, the money is lodged between bank accounts during the time it takes to be transferred from one bank account to another. In the case of credit transfers, in some countries, such as the UK, there is still a delay between the remittance of the amount by the payer and the date that the amount is credited to the payees bank account. This delay allows the bank to earn some additional interest. It looks like cheques will be abolished in the next few years, even in the UK. A second possible explanation is that bank charges or bank interest appear on the bank statement but have not yet been recorded in the cash book. A third possible explanation is that one or more errors have been made, either by the bank (which is very rare but not impossible), or in the cash book. In Unit 4 you will learn how to account for differences between the cash book and the bank statement by preparing a bank reconciliation statement.

2.4.3

Discounts allowed and received

For accounting purposes we distinguish between two types of discount: the trade discount and the settlement discount. Invoices sometimes mention a trade discount. Trade discounts are simply reductions in price, and are the consequence of buying in bulk or of tough negotiation. Businesses sometimes mention the trade discount given on the invoice. However, the amount to be recorded in the accounting books is the sale or purchase price net of the trade discount.

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Cash discounts or settlement discounts are nancial incentives to motivate the customer to pay promptly. For example, an invoice may state that a 10 discount is allowed if the customer pays within seven days. The discount could also be a percentage of the purchase price. For businesses that allow and receive settlement discounts, cash books therefore include memorandum columns for cash discounts allowed and received. Although cash discounts do not actually represent movements of cash, they need to be recorded. The reason is that if a settlement discount is taken up, the amount received or paid is different from the invoice amount. The layout of a cash book with memorandum columns for cash discounts could look like this:Cash book Receipts Payments Date Narrative Amount Receivables Discount Date Narrative Amount Payables Discount received allowed paid received 90 100 10 1,900 2,000 100

In the example above the business allowed a cash discount of ten per cent if the customer paid the invoice amount of 100 within a specied number of days, and the customer took up the discount. The business received a cash discount of ve per cent on the invoice amount of 2,000 from the supplier when it settled the payment within a specied number of days. Note that the total amount received equals the amount of receivables less the discount allowed, and on the payments side the total amount paid equals the amount of payables less the discount received.

2.4.4

VAT in the cash book

As with the sales and purchases day books, a business registered for VAT will also have columns for VAT on the receipts and payments side. VAT and how to record it will be explained in Unit 3.

2.5 Accounting for petty cash2.5.1 Petty cashMost businesses keep a relatively small amount of cash on the premises to make minor cash payments such as for delivery charges, taxi fares, postage stamps, stationery supplies, refreshments for employees working overtime or to reimburse employees for their travel expenses. To permit these cash payments and still maintain adequate control over cash, businesses often establish a petty cash fund, also known as a petty cash oat (or petty cash account), of a round gure, such as 500, by writing a cheque or withdrawing money from the business bank account. Usually one individual, the petty cashier, is in charge of the petty cash oat. When an employee claims expenses, the employee must complete and sign a petty cash voucher indicating the details of the claim. In addition, the employee must present evidence of incurring the cost such as till receipts or invoices which should accompany the voucher. Depending on the amount of the claim, it is often necessary to obtain authorisation from the employees manager to incur the cost and reimburse the employee.


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2.5.2

The petty cash book

Petty cash receipts and payments are recorded in the petty cash book very much like the receipts and payments in the cash book. However, there are usually more payments than receipts as the cash oat is generally replenished once per month or sooner if necessary. Petty cash books are also often analysed, and could look like this:Petty cash book Receipts Date 500 2 Jan 3 Jan 10 Jan 12 Jan 17 Jan 20 Jan 25 Jan 31 Jan 500 Cash Postage Taxi fare Taxi fare Files Notepads Sandwiches Balance c/d 100 50 30 70 20 80 350 150 500 100 90 80 70 20 80 80 100 50 30 Narrative Payments Total Postage Stationery Travel Other

2.5.3

The imprest system

Under the imprest system the petty cash oat is always replenished to the amount agreed so that the total amount of the payments plus the amount in the cash oat equals the agreed amount. For instance, suppose that in the above example the agreed amount is 500. Because the balance in the petty cash oat at the end of the month is 150, the petty cashier needs to top up the cash oat by 350 (the amount paid out) in order to arrive at a cash oat of 500 again. The vouchers totalling 350 can be presented by the petty cashier to the cheque signatory for approval when the cheque is being signed. Alternatively, the petty cashier may receive the 350 in cash from the person who is allowed to withdraw cash from the business bank account.

2.6 The journalThe journal is the book of prime entry for transactions and events that are not recorded in any of the above books. In practice, this means that the journal is used to record transactions and events that do not occur very frequently. Examples include:l

the credit purchase or sale, as well as the depreciation, of non-current assets the correction of errors the initial contribution of capital the transfer of amounts from one ledger account to another ledger account (ledger accounts will be discussed in Session 3).

l l l

The layout of the journal and how to record transactions in it will be discussed in more detail in Session 3.

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2.7 The non-current asset registerThis is a list and description of each non-current asset owned by the business. It contains details of registration numbers, serial numbers or any other identifying marks in respect of each asset. The non-current asset register will be discussed in detail in Session 2 of Unit 3.

2.8 The inventory registerThe inventory register is also called the stock ledger. It is a list of raw materials and other goods held for resale. It identies goods by type and indicates the quantities held in stock. The inventory register will be discussed in detail in Session 1 of Unit 3.

SummaryIn this session you have learned about the function and format of the sales and purchases day books, the sales and purchases returns day books, the cash book and the petty cash book. Session 2 has also indicated which source documents serve as evidence for the transactions and events recorded in these subsidiary books. Unit 3 will discuss the non-current asset and inventory registers. As mentioned before, the books of prime entry are not part of the nominal ledger. They are the source of double-entry data and, therefore, feed into the nominal ledger accounts. Double-entry bookkeeping is used to enter the data into the nominal ledger accounts. Session 3 of this unit will introduce the double-entry bookkeeping technique and its underlying principles. Before moving on to Session 3, the following three activities will enable you to check whether you have fully understood the books of prime entry. Activity 2.5Tom: Cash receipts and payments

At the beginning of 31 October, Tom OMalley had 1,100 in the business bank account. During 31 October, Tom had the following receipts and payments.l l

Cash sales: 565. Cheque received from credit customer Nelly Smith in settlement of a 1,000 invoice amount with settlement discount of 5 per cent allowed: 950. Cheque paid to Robin Visser in settlement of a 500 invoice amount with a 1 per cent settlement discount taken: 495. Payment to supplier Claudia Cannon by bank transfer: 300. Payment of telephone bill by direct debit: 130. Payment of gas bill by direct debit: 75. Cheque received from credit customer Maurice Baker: 100.

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Required

Prepare Tom OMalleys analysed cash book for 31 October.


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Cash book: receipts Date Narrative Amount received 31 Oct Accounts receivable (debtors) Cash sales Discounts allowed

1 Nov

Cash book: payments Date Narrative Amount paid 31 Oct Payables Petty cash Discounts received

31 Oct

FeedbackCash book: receipts Date Narrative Amount received 31 Oct 31 Oct 31 Oct 31 Oct Balance b/d Cash sales banked Cheque from Nelly Smith Cheque from Maurice Baker 1,100 565 950 100 2,715 1 Nov Balance b/d 1,715 1,000 100 1,100 565 50 565 50 Receivables Cash sales Discounts allowed

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Cash book: payments Date Narrative Amount paid 31 Oct 31 Oct 31 Oct 31 Oct Cheque to Robin Visser Payment to Claudia Cannon Telephone bill by direct debit Gas bill by direct debit Total payments 31 Oct Balance c/d (2,715 1,000) 495 300 130 75 1,000 1,715 2,715 Note that on the receipts side the total amount received is actually 1,615, which is the total of receivables plus cash sales less discounts received. 2,715 is the total amount received of 1,615 plus the opening balance of 1,100. On the payments side the total amount of payments (1,000) equals the total amount of payables (800) and other (205) less the total of discounts received (5). 800 Payables 500 300 130 75 205 5 Petty cash Discount received 5

Activity 2.6Angus: Petty cash book

Angus Anderson maintains a petty cash book with an imprest of 250. On 5 May a balance of 127 was brought down from 4 May. The imprest was replenished with a 123 withdrawal from the business bank account, and the following payments were made: l 25 for postagel l l l l

19 for stationery 8 for taxi fare 37 for train fare 10 for owers for a colleague who is ill 2 for milk in tea/coffee.

Required

Prepare the petty cash book with analysis columns for postage, stationery, travel and other.Petty cash book Receipts Date Narrative Total payments Postage Stationery Travel Other


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FeedbackPetty cash book Receipts 127 123 5 May Bal b/d Paid in Postage Stationery Taxi fare Train fare Flowers Milk 25 19 8 37 10 2 101 5 May 250 Bal c/d 149 250 25 19 45 25 19 8 37 10 2 12 Date Narrative Total payments Postage Stationery Travel Other

The 127 balance brought down on 5 May plus the 123 top up for the petty cash oat makes total receipts equal 250. Total payments on 5 May are 101, and the 149 balance carried down makes a total of 250. Activity 2.7Nadia: Day books

The following transactions took place for Nadias business. 20 Nov Invoice No. 3407 for 500 sent to customer Paula Perrera. 21 Nov 21 Nov 23 Nov 24 Nov 25 Nov 26 Nov 26 NovRequired

Invoice No. 3408 for 700 sent to customer Ali Hanan. Invoice received for goods purchased from Alex Chung for 430. Credit note CN 080 sent to customer Paula Perrera for goods returned to the value of 25. Credit note ACC022 received to the amount of 75 for goods returned to Alex Chung. Invoice No. 3409 for 800 sent to customer Ali Hanan. Credit note CN 081 sent to customer Ali Hanan for goods returned to the value of 80. Invoice received for goods purchased from Mary Smith for 750.

Enter the above transactions into the relevant day books.

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Sales day book Date Invoice Customer Description Invoice amount

Purchase day book Date Supplier Description Invoice amount

Sales returns day book Date Credit note no. Customer Description Invoice amount

Purchase returns day book Date Supplier Description Credit note no. Invoice amount

FeedbackSales day book Date 20 Nov 21 Nov 25 Nov Invoice 3407 3408 3409 Customer Paula Perrera Ali Hanan Ali Hanan Description Invoice amount 500 700 800 2,000


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Purchase day book Date 21 Nov 26 Nov Supplier Alex Chung Mary Smith Description Invoice amount 430 750 1,180

Sales returns day book Date Credit note no. CN 080 CN 081 Customer Description Invoice amount 23 Nov 26 Nov Paula Perrera Ali Hanan 25 80 105

Purchase returns day book Date 24 Nov Supplier Alex Chung Description Goods returned Credit note no. ACC022 Invoice amount 75 75

Session 3 Double-entry bookkeeping

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SESSION

3 0Double-entry bookkeepingIntroductionUpon completion of Session 3 you are expected to be able to:l

understand and explain why the accounting equation is the foundation of double-entry bookkeeping understand and explain the effect of transactions in terms of asset and liability nominal ledger accounts using the duality concept understand and explain how revenue and expenses, prots (or losses), drawings, payables and receivables t into the accounting equation understand and apply the rules for debit and credit entries for nominal ledger accounts and subsidiary ledger accounts, the journal, and for posting totals from day books to nominal ledger accounts understand and explain why many enterprises use receivables and payables ledgers understand and explain why the receivables and payables ledgers are not part of the double-entry system.

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In Session 3 you will learn how the individual transactions listed in the books of prime entry are analysed and then summarised in the appropriate nominal ledger accounts. This is Step 2 in the accounting cycle. In order to do this, you will rst learn to understand the accounting equation and the form, principles and rules of the doubleentry bookkeeping system, and the difference between impersonal and personal accounts. Session 3 will teach you what double-entry bookkeeping is, what the rules are and how to apply them. Upon completion of this session you need to be condent that you understand the logic and the technique of double-entry bookkeeping because the rest of this module builds upon the skills you learn here. At the end of this session there are four activities that will help reinforce your understanding of doubleentry bookkeeping. Make sure that you practise until you can enter transactions into ledger accounts without difculty. The activities throughout and at the end of the session may take some time, concentration and effort to complete. Unit 2 will get easier once you have mastered the material in Session 3.

3.1 The functions and foundations of double-entry bookkeeping

3.1.1 From single-entry to double-entry bookkeepingIn Unit 1 you learned that accounting is the process of identifying, organising, classifying, recording, summarising and communicating information about transactions and events. Session 2 of this unit explained how to record transactions in day books. Recording transactions in day books is practising single-entry bookkeeping.

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For centuries, single-entry bookkeeping was how businesses kept track of their transactions. It follows that in the early days the main purpose of bookkeeping was to provide a record of transactions for the owner of the business rather than to provide information about debtors, creditors or protability. Over time, societies have developed in such a way as to enable enterprises to grow larger. Legal systems have developed laws that protect private property rights. Money has become the most important means of payment, and methods of extending credit (whilst at the same time securing guaranteed repayment) have been developed. With businesses growing larger and the number of creditbased transactions increasing, historically it became harder to keep track of all the information a business needed to carry out its operations. Double-entry bookkeeping developed out of the need to summarise large numbers of credit transactions in order to keep control over credits extended and debts owed. Double-entry bookkeeping is the result of the accumulation of bookkeeping practices by merchants and traders in Mesopotamia, India, China, the Middle East and Europe. In 1494 the monk and mathematician Luca Pacioli published a book in which one chapter summarised and explained double-entry accounting as it was then used by Venetian merchants. The title of the book was Summa de Arithmetica, Geometrica, Proportioni et Proportionalitia. The doubleentry system as described in Paciolis book was popularised in the rest of Europe via translations of the ideas into Dutch, French and English. This is the reason why, for many centuries, double-entry bookkeeping was called Italian bookkeeping.

The rst modern publication on double-entry bookkeeping was a treatise published in 1494 by an Italian monk, Pacioli

Three concepts form the basis of double-entry bookkeeping. These are the entity concept, the duality concept and the accounting equation.

3.1.2

The entity concept

Double-entry bookkeeping is rst and foremost based on the entity concept (also called the business entity concept or entity convention). This is the idea that for accounting purposes, the proprietor of the business is separate from the business itself.

Session 3 Double-entry bookkeeping

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As a consequence, the money that the proprietor pays into the business as contributed capital is on the one hand accounted for as a resource (or asset) of the business. On the other hand, it is accounted for as a source with which the asset has been nanced. The resources (or assets) of a business must be equal to the sources with which the assets have been nanced. The equation that expresses this relation is: RESOURCES OF THE BUSINESS = SOURCES OF FINANCING In many continental European countries we nd assets on the left-hand side (called actives) and sources of nancing on the right-hand side (called passives). ACTIVES = PASSIVES It may help to think of actives as being resources that are actively employed in the business to create value and make a prot. Examples include machines, premises, computers, inventory, etc. In contrast, passives make it possible for the business to purchase the actives, but they do not create value. Over time, the convention has been adopted that in a horizontal balance sheet actives are on the left-hand side and passives are on the right-hand side. The sources of nancing usually include the proprietors capital (Capital) as well as money borrowed from others (Liabilities). This translates into the following accounting equation, which will be discussed in greater detail below. ASSETS = LIABILITIES + CAPITAL It is important to note that there is a difference between the legal entity concept and the business entity concept in accounting. A legal entity has rights and responsibilities before the law in more or less the same way that a person does. The law allows a legal entity (also called a legal person) to engage in property ownership and contracts, and it can therefore be involved in lawsuits for the purpose of enforcing property rights and contracts. As you learned in Unit 1, the law does not distinguish between the legal entity and the accounting entity in the case of sole traders and partnerships. The proprietors bear legal and personal liability for the debts that the business incurs. However, in the case of limited liability companies the owners can only be held liable for the debts incurred by the company to the extent of the amount that they have agreed to pay for the companys shares. The shareholders personal assets are protected by limited liability.

3.1.3

The duality concept (or dual effect)

Double-entry bookkeeping is based on the idea that there are at least two sides to every transaction. In other words, a transaction produces at least two effects, the net result of which is that total assets continue to equal total liabilities plus total capital. For example: Tina pays 25,000 of her private savings into a business bank account and starts a business as a sole trader. The two effects are:l l

the business has an asset of 25,000 in the bank the business has an obligation to Tina of 25,000 in respect of owners capital.

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The business opens an asset account (cash) of 25,000 and a capital account (owners capital) of 25,000. Consider another example. Tina purchases a second-hand delivery van for 5,000, paying by debit card. The two effects are:l l

the asset of cash in the bank is reduced by 5,000 to 20,000 the business has an asset in the form of a van worth 5,000.

It is important to remember that each transaction produces at least two effects that are recorded in ledger accounts using double-entry bookkeeping. The double entry is made by at least two entries in the appropriate ledger accounts. There are two types of entry, which are referred to as debit and credit entries. For every debit entry there is at least one equal and opposite credit entry. Therefore, total assets continue to equal total liabilities plus total capital. Later in this session you will learn what ledger accounts, debits and credits are, and how to make debit and credit entries in ledger accounts to record the dual aspects of transactions.

3.1.4

The accounting equation

As mentioned above, in a sole proprietorship or basic partnership all the debts of the business are in fact th

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