Chapter 2 Accounting Equation and Journal Entries PDF

CHAPTER TWO The Accounting Equation and Journal Entries OBJECTIVES Knowledge  To explain the accounting process  To explain the meaning of the term transactions and to distinguish between internal transactions and...

CHAPTER TWO The Accounting Equation and Journal Entries OBJECTIVES Knowledge  To explain the accounting process  To explain the meaning of the term transactions and to distinguish between internal transactions and external transactions  Explain the link between the accounting equation and the system of debits and credits used in double entry bookkeeping.  To explain the purpose and structure of a journal.  To explain the purpose and structure of the general ledger  Explain the causal link between the analysis of transactions, entries in the books of account, and the preparation of financial statements.  Explain the principles of how a set of books can be kept on a computerised accounting system. Problem solving skills  To analyse and explain transactions  Be able to write up a simple journal, post the entries to the ledger, balance accounts and prepare a trial balance.  Be able to adjust the trial balance in accordance with the accrual convention.  Be able to prepare a simple set of financial statements from the post- adjustment trial balance. -1- Chapter 2 – The Elements of Course Notes Double-Entry Bookkeeping Glossary of terms Accounts payable Short-term liabilities, or amounts owing to suppliers. Sometimes known as ‘creditors’ or ‘trade payables’. Accounts receivable Amounts owing by customers. Sometimes known as ‘debtors’ or ‘trade receivables’. Accrual convention The convention whereby income and expenses are brought to account in the period in which they are incurred, regardless of when the related cash transactions take place. The expenses relating to an accounting period are matched as far as possible to the income for that period. Books of account Books used to record financial transactions. With the advent of computerised accounting, these are likely to be computer printouts. Chart of accounts A list of ledger account numbers Journal The primary book of account where financial transactions are first entered. Ledger The secondary book of account where entries are posted from the journal. It contains a separate account for each type of income, expense, asset, liability and capital. Trial balance A list of all the balances in the ledger at a specific time (usually the end of an accounting period). -2- Chapter 2 – The Elements of Course Notes Double-Entry Bookkeeping Introduction Double-entry bookkeeping seems to have been in use for many thousands of years but the first formal treatise on the subject was set out by the Italian renaissance mathematician, Fra Luca Pacioli, as a chapter in his book Suma de Arithmetica, Geometria, Proportioni et Proportionalita, published in 1494. The basic principle of double-entry as formulated by Pacioli seems to follow a natural law similar to the third law of motion set out by Isaac Newton, “For every action there is an equal and opposite reaction”, and we have already learnt in chapter one that every financial transaction must have a dual aspect in order to keep the accounting equation in balance. While systems of bookkeeping and accounting have evolved over the centuries, culminating in the development of computerised systems since the 1980’s, the principles laid down by Pacioli have not altered in any way. Pacioli gave us the terms ‘debit’ and ‘credit’, the journal, cash book and ledger, and showed us how to close off the ledger. Being a monk and a man of great spirituality, he placed enormous emphasis on care and attention to detail in the recording of one’s business transactions. Students studying accounting for the first time may disagree, but the system set out by Pacioli is the easiest, quickest and most efficient system of recording financial transactions. But while some may enthuse over the joy and beauty of the system, it should always be borne in mind that its sole purpose is to produce financial reports that are useful in making financial and business decisions. Bookkeeping and accounting have no other purpose. Financial transactions and the accounting process. Only transactions that have an effect on the elements of the accounting equation (assets, liabilities, and owners’ equity) will be processed as an accounting transaction. Businesses are involved in a large number of transactions each day but not all will have an effect on the accounting equation. For example, although staff are described by some businesses as ‘our most valuable asset’1, hiring a new member of staff will not per se have an effect on the accounting equation, because staff do not fall under the definition of an asset for accounting purposes. We have already learnt that every accounting transaction has a dual effect on the Statement of Financial Position. Double-entry bookkeeping uses the same fundamental principle as illustrated in this diagram. Debit Credit Assets = Liabilities + Owner’s equity 1 ABSA Bank, for example, says, ‘In our books, it’s our customers and staff who are our most valued asset.’ Of course, customers who owe the bank money will be shown as assets in the bank’s books. -3- Chapter 2 – The Elements of Course Notes Double-Entry Bookkeeping Every ledger account (see glossary above) has a debit and a credit side. Thus the basic rules of double entry are as follows:  To increase an asset, enter the amount on the debit side.  To decrease an asset, enter the amount on the credit side.  To increase a liability, enter the amount on the credit side.  To decrease a liability, enter the amount on the debit side.  To increase an aspect of the owner’s equity (capital, income); enter the amount on the credit side.  To decrease an aspect of the owner’s equity (drawings, expenses); enter the amount on the debit side. Thus assets generally have debit balances, while liabilities and owner’s equity accounts have credit balances. Accounting recording and reporting routines Monthly routines Source documents─► Recorded in subsidiary journals These subsidiary Accounts are journals are totalled and balanced/totalled and a posted to the General trial balance will be Ledger (and subsidiary drawn up ledgers –being debtors and creditors ledger) Annual routine─► Record the year end adjustments Post these adjustments Draw up a post to the ledger adjustment trial balance Close all income and Draw up a post closing expense accounts to- trial balance  Trading account  Profit & loss account Annual reporting Preparation of financial routine─► statements  Statement of comprehensive income  Statement of Financial Position  Statement of changes in Owner’s equity  Cash flow statement  Directors report  Auditors report -4- Chapter 2 – The Elements of Course Notes Double-Entry Bookkeeping Fundamentals of double-entry bookkeeping Every financial transaction entered into the accounting records of the business must conform to the principles of the accounting equation. Thus every transaction has a debit aspect and a credit aspect and the debit amount must equal the credit amount. The Journal Every financial transaction is entered first into a book of primary entry known as a Journal. This entry shows both the debit and credit amounts, and these amounts must, in accordance with the principle discussed above, be equal. The entry in the journal will also have a narration that describes the reason or purpose of the transaction. Consider the following financial transactions and how they have been entered into the journal: On 1 March 20x0 Sherlock Traders was started by Sherlock Holmes. The following transactions took place in March 20x0: Mar 1 Sherlock Holmes paid in R30 000 to start the business. Mar 2 Equipment for use in the business was purchased for R9 000. Two- thirds of the price was paid in cash, the rest was due in a year. Mar 10 Service fees earned were R60 000; R6 000 of this was on credit. Mar 15 Operating expenses incurred were R35 000; R4 000 on credit. Mar 20 Half the money owed to Sherlock Traders was collected. Mar 20 R2 000 owed by Sherlock Traders was paid off. Mar 27 Sherlock bought a car for R12 000 for his personal use, half paid for now from his personal savings and half to be paid in a year. -5- Chapter 2 – The Elements of Course Notes Double-Entry Bookkeeping Sherlock Traders - Journal Date Details Dr Cr (Amount paid in by Sherlock Holmes to start business) (Purchase of equipment) The Ledger This is a secondary book of account in that entries in the journal are posted to the various accounts in this book. Each asset, liability, income, expense and owner’s capital account is represented in this book, usually in the shape of a ‘T’ with debits posted to the left-hand side and credits to the right-hand side. A ledger could contain many hundreds of accounts depending on the requirements of the business. If we were to post the entries in the journal of Sherlock Traders, it would look something like this: -6- Chapter 2 – The Elements of Course Notes Double-Entry Bookkeeping  LEDGER OF SHERLOCK TRADERS Bank Description R Description R Capital 30 000 Equipment 6 000 Fees Earned 54 000 Expenses 31 000 Accounts Receivable 3 000 Accounts Payable 2 000 Balance c/d 48 000 87 000 87 000 Balance b/d 48 000 Sherlock Holmes’s Capital Description R Description R Bank 30 000 Equipment Description R Description R Bank /Accts Pay 9 000 Accounts Payable Description R Description R Bank 2 000 Equipment 3 000 Balance c/d 5 000 Operating Expenses 4 000 7 000 7 000 Balance b/d 5 000 Service Fees Revenue Description R Description R Bank / Accts Rec 60 000 Accounts Receivable Description R Description R Service fees 6 000 Bank 3 000 Balance c/d 3 000 6 000 6 000 Balance b/d 3 000 Operating Expenses Description R Description R Bank /Accts Pay 35 000 -7- Chapter 2 – The Elements of Course Notes Double-Entry Bookkeeping In practice, each account would have a date column to the left of the ‘Description’ column on both the debit and credit sides. There would also be a reference column for the journal entry, so that the original journal entry could be traced if necessary. As you can see, each entry in the journal has been split to various accounts in the ledger, and it is not always possible to trace the other side of the entry without going back to the journal. If you look at the Bank, Accounts Payable and Accounts Receivable accounts in the ledger, you will see that they have been ‘balanced’, i.e. the debit totals agree with the credit totals. This is done by putting the difference between the original debit and credit totals on the side that is ‘short’. This balance is then carried down to the ‘correct side’ as the balance at the start of the next period. -8- Chapter 2 – The Elements of Course Notes Double-Entry Bookkeeping Preparation of a trial balance At the end of a period (month, quarter or year), all the ledger accounts will be balanced as described above, and a trial balance can then be prepared. This is simply a list of all the ledger accounts together with the balance of each account. The balance is shown in either the debit or credit column, and assuming the balances are correct, the total of the debit column should equal the total of the credit column. If we were to do a trial balance of the ledger balances of Sherlock Traders, it would look like this: Trial balance at 31 March 20x0 Dr Cr Bank 48 000 Capital 30 000 Equipment 9 000 Accounts Payable 5 000 Service Fees Revenue 60 000 Accounts Receivable 3 000 Operating Expenses 35 000 95 000 95 000 Preparation of a trial balance is important for a number of reasons:  In a manual set of books it will indicate whether any errors have been made in postings (eg. debit entry posted to the credit side of a ledger account), or in calculating the balance of any ledger account. This will show up because the total debits will not equal the total credits. It will not show other errors such as a posting to the wrong account, or omission of postings from the journal.  It gives a snapshot of all the balances in the ledger and enables the accountant to investigate any ‘funnies’ such as debtors’ accounts showing a credit balance, without having to plough through the entire ledger. The above trial balance is for a very simple set of books; many businesses have general ledgers running into hundreds of accounts. -9- Chapter 2 – The Elements of Course Notes Double-Entry Bookkeeping Adjusting entries After the preparation of the initial trial balance (such as the one above), the accountant will prepare any necessary adjusting entries. Examples of these would be:  Depreciation of fixed assets  Accounting for the closing inventory  Bringing to account any expenses incurred in the current period that have not being paid for and not yet entered in the books or taking out any expense paid for that belongs to the next financial year.  Bringing to account any income that was earned in the current period but has not yet been entered in the books or taking out any income received that belongs to the next financial year. For Sherlock Traders, the following adjustments have been identified:  Depreciation of equipment: R75.00  Telephone expenses for March not yet paid: R150.00  Of the fees paid by clients of R54 000, R1 000 was a deposit for work to be done in April. The journal entries for the above adjustments would be as follows: Date Details Dr Cr These journal entries would entail opening three new ledger accounts:  Depreciation expense  Accumulated depreciation  Service fees liability. These journal entries would then be posted to the respective ledger accounts, and a new trial balance drawn up. Some accountants prefer to show the adjusting entries in columns to the right of the initial trial balance and this would be shown as follows: - 10 - Chapter 2 – The Elements of Course Notes Double-Entry Bookkeeping Trial balance at 31 March 20x0 Initial TB Adjustments Final TB Dr Cr Dr Cr Dr Cr Bank 48 000 Capital 30 000 Equipment 9 000 Accounts Payable 5 000 Service Fees Revenue 60 000 Accounts Receivable 3 000 Operating Expenses 35 000 Depreciation expense Service fees liability 95 000 95 000 1 225 1 225 95 150 95 150 It should be noted that the adjustments take into account the ‘Accrual Convention’ whereby expenses incurred in the period (depreciation and telephone) are brought to account, and fees paid in advance by a client are treated as a liability and not as income earned. - 11 - Chapter 2 – The Elements of Course Notes Double-Entry Bookkeeping From the final trial balance, the financial statements can now be prepared. Preparation of financial statements 1. Statement of comprehensive income Statement of comprehensive income of Sherlock Traders for the month ended 31 March 20x0. R R 2. Statement of Financial Position Statement of Financial Position at 31 March 20x0 for Sherlock Traders. R R Assets Non-current Assets Equipment Accumulated depreciation Current Assets Receivables (Accounts receivable) Cash and cash equivalents (Cash in bank) Owner’s Equity & Liabilities Owner’s Equity Sherlock – Capital Retained profit Current Liabilities Payables Accounts payable Service fees liability - 12 - Chapter 2 – The Elements of Course Notes Double-Entry Bookkeeping Computer Accounting In a manual bookkeeping system a bookkeeper would:  enter all financial transactions into a journal (receipts, payments, sales, purchases, or general journal);  post these entries into the ledger accounts (general ledger, debtors or creditors ledgers);  add up the debit and credit sides of each ledger account at the end of an accounting period, and arrive at a balance for each account;  prepare a trial balance using the balances of each ledger account;  if the trial balance does not balance, go back and check each step above;  if the trial balance does balance, prepare adjusting entries where necessary;  prepare the financial statements;  close the income and expense accounts in the general ledger and transfer the profit or loss to the owner’s capital account. In a computerised accounting system, only the first step is necessary. The computer program will do the postings to the ledgers, all the necessary calculations, preparation of the trial balance and the financial statements. At the year end a special year-end procedure will automatically close off all income and expense accounts and transfer the profit to either the owner’s equity or to a ‘retained income’ account. Today there are many ‘off-the-shelf’ accounting programs that can carry out the above steps. However, the efficiency of the program will depend largely on the set-up of the set of accounts, an important feature of which is the chart of accounts. Every ledger account must have a unique reference number and this number will indicate important aspects of the ledger account, e.g.  whether the account belongs in the statement of comprehensive income or Statement of Financial Position;  if in the Statement of Comprehensive Income, whether the account is an income account or expense account;  if in the Statement of Financial Position, whether the account is a capital, asset, or liability account. - 13 - Chapter 2 – The Elements of Course Notes Double-Entry Bookkeeping For example, a chart of accounts may have a six digit numbering system (000/000). Here the first three numbers indicate the main ledger account number, and the last three numbers indicate sub-accounts. The chart of accounts could then be set up as follows: 001 to 499: statement of comprehensive income accounts 500 to 999: Statement of Financial Position accounts. There may also be further sub-divisions as follows: 100 Income from main operations 200 Cost of sales (trading operations) 300 Other income 400 Expenses 500 Capital and long-term liabilities 600 Fixed assets 700 Current assets 800 Current liabilities 900 Bank accounts and sundry control accounts Using this system, Sherlock Traders chart of accounts may look like this: 900/000 Bank 500/000 Capital 600/000 Equipment 800/000 Accounts Payable 100/000 Service Fees Revenue 700/000 Accounts Receivable 410/000 Operating Expenses 420/000 Depreciation expense 610/000 Accumulated depn. 810/000 Service fees liability Finally, there would be a retained income account, under the above system, probably 510/000. This is a special account in that no postings are ever made to this account, but at the end of a financial period, all the income and expense accounts are closed off and the resulting profit or loss transferred to this account. In a manual system, this is a long and time-consuming task; in a computerised system, it takes microseconds. - 14 - Chapter 2 – The Elements of Course Notes Double-Entry Bookkeeping  ASSETS = LIABILITIES + OWNER’S EQUITY Bank Accounts Supplies Equipment Suppliers Capital Drawings Income Expenses receivable -1- Chapter 2 – The Elements of Course Notes Double-Entry Bookkeeping  -1- Chapter 2 – The Elements of Course Notes Double-Entry Bookkeeping