SEARCH, INDEX, UPDATES, CONTENTS, bookkeeping - full double entry set of books
In the 1300’s the Italians devised the system of bookkeeping which is still used today and referred to as “double entry”. The principle behind this is that for one person to receive an amount of money another person has to pay that amount of money. For any transaction to occur there has to be a second transaction which can be recorded.
When you understand the basics of double entry, you can decide what records you will need to keep. You are unlikely to keep a full double entry system, but following the examples which follow will help you understand the principles. These principles are used in all accounting software which effectively records both sides of each transactions that you record.
At this stage, you might well be baffled by a question such as ‘whether a discount is a debit or credit on a sales ledger total account’ but if you work through the examples in this letter step by step you will find there is nothing difficult about bookkeeping or accountancy, and you will be able to recognise whether entries have been recorded correctly or not.
Bookkeeping can become difficult when there are very many transactions and they have not been dealt with in a consistent or logical manner. It can be time consuming when we have to identify which of the entries represent transactions correctly and which do not. The more time we spend understanding your figures the more we will want to charge you as accountancy fees, so please try to be consistent, and ask for advice where you are uncertain.
If you decide to adopt an analysed cash book, your financial accounts should give the same result because your column totals will be put into the double entry accounts instead of the individual transactions.
Even very large numbers of transactions can be recorded accurately in a manual system, and provide very valuable management information, but a well maintained computer system can generate management reports very quickly. However there is little point in having a report generated very quickly and easily if it is not correct or you do not have confidence in your records.
Because double entry bookkeeping forms the basis of modern accounting, we will also explain some aspects of financial accounts as we record some transactions for an example business
The Cash Book
There are many possible variations to a cash book. We can
consider cash received from customers, and petty cash a little later.
At this stage, please accept that a ‘cash book’ can record transactions through your bank account, or through your credit card, and ‘cash’ includes cheques as well as currency in the form of notes and coins.
Businesses which do not use full double entry bookkeeping often use ‘analysed cash books’ and cash books for 'multiple accounts' which are not discussed here.
Let us start with a simple cash book which is quite like a bank statement with three columns as shown below:-
This example records the transactions for a newly formed limited company. Occasionally we will refer to differences which apply to a sole trader or partnership, but similar bookkeeping principles apply throughout.
We strongly recommend that business transactions are kept completely separate from personal transactions. However a company has to be funded by someone and those funds will normally come from the proprietor. In the case of a company the proprietor will normally be a shareholder and director. Rather than the proprietor making sundry payments from their private account we recommend the proprietor makes a loan to the business or the company. In this example the shareholder has made an advance of £1,000 to the company to open the company’s bank account.
Also in this example the company will have issued 2 shares at a par value of £1 each and in respect of those 2 shares each shareholder should therefore pay £1 to the company giving rise to another banking of £2 and a bank balance of £1,002.
It will have been necessary to incur some expenses before the company’s bank account could have been opened. Whoever has paid those expenses should list those expenses and then draw a cheque from the company to reimburse themselves for those expenses so that the company incurs the expense. In this case the suggestion is that the company reimburses £350 in respect of company formation costs reducing the bank balance to £652.
What is a Balance Sheet and what does double entry bookkeeping make it
balance?
For you to be in debt to me for an amount of money I will
have to done something to cause you to owe me the money. I may have provided you
with a product or a service.
One of the two transactions is referred to as a ‘debit’, the other as a ‘credit’. A debit occurs in the receiving account and should always be recorded on the left. A credit occurs in the ‘giving’ account and should always be recorded on the right.
It is better to ‘give’ than to ‘receive’ because the receiving account will then owe the giving account. Putting money into the bank, the bank entry is a debit, and you will be quite happy that the bank owes you the money which you can withdraw at a future date.
As these transactions are recorded in both sides of a ledger the debits and credits will then balance, which is the part of the derivation of the term ‘Balance Sheet’.
Each of the three transactions referred to above will be allocated to a separate ledger account and could be recorded as follows:-
Where the sum of £1,000 received from the shareholder as a loan is a debit to the bank account, it is a credit to the ledger account for the loan from the shareholder.
Where the amount received from the shareholders for the issue of shares is a debit to the bank account it is a credit to the share capital account.
Where the reimbursement to the shareholder for the company formation costs is a credit to the bank account it is a debit to company formation expenses.
The Trial Balance
This is another accountancy term that you might hear.
With these four accounts we can take out a Trial Balance as set out below:-
The total debits equal the total credits because each transaction has been recorded as a debit and as a credit.
Purchase of goods or expenses for re-sale
Most retail businesses will buy goods at a price which they
sell at a higher price and will hold stock of unsold goods. Some service
business will incur expenses which they re-charge and on which they may
re-charge at a price in excess of cost. The following example shows the purchase
of two watches for re-sale.
When one watch is sold a ledger transaction records the banking direct to sales and then makes an adjustment from stock to cost of sales so that the cost of sales account shows £235 and the retained stock for re-sale also shows a balance of £235.
The updated cash book showing these two entries updates the closing balance to £532.
The revised trial balance is set out below and again the debits equal the credits of £1,352 each.
Personal Ledger Accounts
Let us now record the purchase of another 200 watches at the same price, this time on credit which introduces the concept of a personal ledger account for XYZ Supplies Ltd.
Again we create a credit entry on the XYZ Supplies Ltd account of £47,000 and we create a debit entry on the stock for resale of £47,000 so that the trial balance must again continue to balance.
We can also incur an expense of insurance for these watches in a particularly vulnerable environment at a cost of £600 which again we obtain on a credit account. The ledger transactions will be:
The updated trial balance still balances and now shows:
If there were a lot of suppliers then this trial balance would be very long and not particularly easy to read. It is normal to put suppliers accounts into a personal ledger called “the Purchase Ledger” which will include goods bought for resale as well as expenses. We can then create a purchase ledger total account which summaries all of the individual accounts and incorporate that into the trial balance as the Purchase ledger total account.
Let us now record the sale of say 150 watches on credit for £53,000. The personal sales ledger account is very similar to the personal purchase ledger account except that an invoice appears as a debit not a credit and the balance is shown as a positive value not a negative.
The sales account and cost of sales and stock accounts are also updated with one debit entry and one credit entry for each transaction so that the accounts continue to “balance”. The updated accounts show:
And the updated Trial Balance shows:
Taking the figures from the Trial Balance, we can now construct a set of accounts for the month of January comprising a Profit and Loss Account and a Balance Sheet.
Until the ‘vertical format’ became accepted as the standard layout around 1970, a Balance Sheet was often printed in ‘horizontal format’. That would have shown the debits being the assets on one side totalling £65,517, and the credits on the other side also totalling £65,517 – balancing and being the Balance Sheet.
Prepayments and Accruals
Do you believe that the Profit of £16,915 is correctly stated?
The business is unlikely to cease at 31 January 200x because it still has £11,985 of stock to sell, but if it did find a buyer for that stock at the cost price of £11,985, and had no more trading transactions, then the profit might be correct.
Assuming the business does in fact continue, then the profit is probably incorrect, because it does not include adjustments for prepayments and accruals.
Let us assume that the insurance premium has been agreed as £600 for the year to 31 December 200x. At the 31 January 200x, we have recorded a cost which does not all relate to January 200x.
Accountancy attempts to match income and expenses to accounting periods whether those periods are years, quarters, months or whatever.
We can therefore enter a credit to the insurance account of 11/12ths of the premium paid amounting to £550 and because every credit has to have an associated debit we create a new account for prepayments which is a debit of £550.
Similarly there may be expenses which have been incurred for which a bill has not yet been received. For example purposes we can create a debit of £100 to the Accountancy expense account. Credit for that item can be put to another new account for accruals.
Expenses which are typically prepaid are rent, rates and insurance. Expenses which are typically accrued are accountancy fees, electricity, gas, metered water charged.
There are numerous ways of processing prepayments and accruals on a monthly basis but for this example we will reverse the entries at the beginning of the next month as will be shown in a later example.
Let us now move into the month of February and add some more transactions such as the purchase of a van on hire purchase.
The above four ledger accounts introduce a number of concepts. The deposit is a bank payment. The amount funded on hire purchase borrowing is the balance of the cost bringing the balance on the account at 1 February 0x to £10,000 with the corresponding entry to a hire purchase borrowing liability account.
The re-sale value of a van purchased for £10,000 is probably significantly less than £10,000 from the day it is purchased but for accounting purposes its use to the business is charged to the profit and loss account over its anticipated useful life. There are a number of ways of apportioning this but the common way used in this example is to reduce the value by 25% per annum and 1/12 of that sum is therefore charged to the profit and loss account as depreciation in the month of February 0x with a credit reducing the value of the van and a debit to depreciation expense account of £208.33.
Hire purchase borrowing of £8,000 will give rise to an interest charge. The amount of interest in each repayment decreases as the amount outstanding is repaid and one way of reflecting this is to use the rule of 78 which adds up the digits 12:11:10..….3:2:1 representing the 12 months of a 12 month agreement to equal 78. It then takes 12/78 of the interest in month 1, 11/78 of the interest in month 2 and 1/78 of interest in month 12. This allows us to add £123.08 to the hire purchase amount outstanding at the end of the first month with a corresponding debit to the hire purchase interest expense account.
A 24 month agreement would start with 24/300 x the total interest charge. A 36 month agreement would start with 36/666 x the total interest charge.
Capital and revenue expenditure
The van is a fixed asset. Fixed assets are assets which are purchased for the intention of using in the business rather than be sold or to be consumed as a Revenue expense.
A Revenue expense such as insurance may cover a period spanning the end of the accounting period and therefore be carried forward as a prepayment but it has a finite life. A fixed asset generally will be of use to the business after the end of the accounting period. Its expected useful life might be estimated but will depend upon the actual use.
It has been explained above that fixed assets depreciate but are useful in the business for a period of time. Small items of equipment purchased may be written off in the profit and loss account immediately as a practicality but HM Revenue & Customs consider that an item such as a table to be used at boot fairs has an expected life of more than 12 months and is therefore a fixed asset even though the cost might be only £20.
A fixed asset register with photographs
Without looking, can you describe list all of the items in the room that you are very familiar with, such as your home kitchen?
What make is your washing machine, you fridge etc.? What are the serial numbers?
In the event of a theft, how would you identify your property? The police will not return stolen property to you unless you can quote the serial numbers.
In this business, we only have two assets, and one of those does not have a serial number. When your business has grown substantially, you may have numerous fixed assets.
We recommend that you maintain a fixed asset register, and use it to record serial numbers together with photographs of individual items, and the rooms that they are located in.
An example fixed asset register might be laid out as follows –
Recording cash transactions in a cash book
As a further example let us record the purchase of some cheap watches, the purchase of a table, the payment of a pitch fee and the sale of some watches at a boot fair. All transactions are carried out in cash from a float of £200. These transactions should be recorded as a separate cash account and we will therefore create a separate cash book for cash transactions.
Arising from the above transactions where is the £549 as the balance on the cash transactions cash book? It is probably in the director’s pocket on behalf of the company but bearing in mind the company is a separate entity from the individual directors and therefore should have a safe or some other secure place, perhaps a petty cash tin to retain its cash funds.
Being VAT registered makes a difference
A business which is VAT registered will normally recover all the input VAT it incurs, so accountancy fees of £100 plus £17.50 VAT are a cost to the company of £100, not £117.50 as for an unregistered or exempt business.
Similarly, charging a fee of £117.50 including £17.50 VAT is only a benefit to a registered business to the value of £100, not £117.50 as for an unregistered or exempt business.
Such payments can be recorded as follows –
See also
Confidence in your records
Analysed cash book
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