Double-Entry Bookkeeping: Assets and Liabilities

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1 Double-Entry Bookkeeping: Assets and Liabilities The purpose of this chapter is to introduce the fundamentals of double-entry bookkeeping and its role in accounting for business. The objectives of accounting Bookkeeping systems, like the double-entry system, exist to meet the objectives of accounting for business. What are those objectives? Some of them are listed below. You could probably think of many more. Good accounting enables us to know; how much money we have how much cash is in the bank what we are owed what we owe to other people how successful, or profitable, our business is how profitable are the various different activities within our business If we have done our accounting properly then we should be able to provide all the financial information that is needed to make good business decisions. For instance we might be able to tell that we are losing money selling CDs but we are selling DVDs at a profit and decide that we ll concentrate on DVDs in future. Or we might be able to tell that the reason why we have an overdraft is because too many of our customers haven t paid us what they owe. Accounting & Bookkeeping Courses <Software Title> ~ <Level or Module> 1

2 What is a business? So we know that accounting is an essential part of running a business but can we define what a business is? The simplest answer is to say that we all know a business when we see one. It has characteristics like; it is there to make a profit it sells things it either makes things or it buys things that it expects to sell at a profit it employs people Actually the people or organisations that need to make sure that they keep reliable accounting records might not be doing any of these things. A charity, for instance, certainly wouldn t exist to make a profit and might not sell anything or employ anyone, if it relied on volunteers. It would be shameful, though, for a charity not to know what money it had, where the money was coming from and where it was going. That leads us round in a circle. Accounting is for people who need proper business information. Exercise: list four things that people in business might expect to find out from the accounts. Now go back and see whether your list matches the one earlier in this chapter. Well done if you thought of some items that weren t in that list! Double-entry bookkeeping If you haven t already learned all about it then double-entry bookkeeping can sound awfully technical. It doesn t always seem any simpler when it is described as the accounting equation. We ll come back to the accounting equation later. 2 <Software Title> ~ <Level or Module> Accounting & Bookkeeping Courses

3 For now the best way to think of double-entry bookkeeping is that we write down every transaction twice: once for where the money (or movement in value) has gone to and once more for where it has come from. For example, we might have paid 50 to our stationery supplier, Paper Chase Ltd. Using double-entry we write down that money has come out of the bank account (first entry) and that it has gone to Paper Chase Ltd (second entry). The two entries needn t come first and second, we just have to make sure that we have made both entries in our books. If you can imagine that every entry that we make in the accounts is really a movement in value from one place to another then you will have understood the true nature of double-entry bookkeeping. For some reason, probably to do with Luca Pacioli ( ) who wrote the first book about accounting, the movement in value is always shown as going from right to left. A diagram might help; Value goes here to Value comes from here Returning to our previous example where we paid our stationery supplier; Paper Chase Ltd 50 Our bank account Accounting & Bookkeeping Courses <Software Title> ~ <Level or Module> 3

4 There are special names for the right-hand side and the left-hand side. This is accountancy, after all. The technical, jargon word for the right-hand side is Credit and the left-hand side is Debit. Debit Credit That is all that Debit and Credit mean, left and right. From these words we get two more special accounting terms, Debtor and Creditor. These do start to have real meaning: a debtor is someone or something where more value has gone to it than has come back from it (i.e. someone who owes money) and a creditor is the opposite, where more value has come from a person or thing than has been returned to it. So, when we describe our bank account as being in credit, for instance, we are actually looking at it from the bank s point of view because we have put more money into the account than we ve withdrawn from it. The bank is actually our debtor, but it might not feel like that. If, for example, by a miracle we receive into our bank account a repayment of tax:- 1. Where did the value, in this case money, come from? 2. Where did the money go to? 3. On which side would the bank account go? Assets We generally think that an asset is a good thing. It certainly should be. In accounting terms it is something that the business has acquired for value and still has the benefit of at least some of that value. We might, for instance, have bought a substantial number of things that we intend to sell later, stock in other words. The remaining value of that stock is an asset. Not everything that our business buys is something that we plan to sell. It could be something that we want to use in the business like an office building or a delivery van. 4 <Software Title> ~ <Level or Module> Accounting & Bookkeeping Courses

5 Name three assets that a business might buy The office building, which is something that the business expects to use for a long time, is an example of a fixed asset. The stock, which the business plans to sell in the near future, is called a current asset. Give an example of a fixed asset. What sort of asset, fixed or current, is cash in the till? In the case of every asset it is something that the business has spent money on. In other words it is somewhere that value has moved to. That means it must be on the left-hand, or debit side, of our accounts. All assets, therefore, are represented by debit accounts in our books. Remember, debits and credits aren t either good things or bad things in bookkeeping. They are just left and right. Movements of money come from the right and go to the left. A final example of an asset, then, is an amount that is owed to the business, a debtor. We are expecting the debtor to pay our business money sometime in future so a debtor is definitely an asset. Usually the debtors would be customers that the business has made sales to but who haven t yet made payment for the goods that they ve bought; Debit: Customer (debtor) Credit: Sales Accounting & Bookkeeping Courses <Software Title> ~ <Level or Module> 5

6 Is a debtor a current asset or a fixed asset? Liabilities You will not be surprised to learn that liabilities are the opposite of assets. Liabilities are amounts owed by our business to somebody else like our stationery supplier, Paper Chase Ltd, from earlier in this chapter. If we imagine that Paper Chase Ltd had sold us the 50-worth of goods a little while before we paid them, then the original transaction would have looked like this; Debit: Purchases of stationery 50-worth of goods Credit: Paper Chase Ltd (creditor) Obviously the supplier account for Paper Chase Ltd in our books will appear on the right-hand side as a creditor. Creditors aren t just people who let us buy goods on credit. The bank account, for instance, is a creditor if we have taken more money out than we have put in. Other people might lend money to our business so perhaps, instead of paying entirely in cash for our office building, we might take out a loan. We might buy our delivery van on hire-purchase. All these creditors have put money into the business. They all expect to get their money back sooner or later and may well charge interest for the money that they have leant. There is another category of people who put money into a business, the investors. The special accounting term for the money that goes into a business from its owners is Capital. Capital Karl Marx s book on Capital is not about bookkeeping but he would have been familiar with the idea that a business is a separate entity from its owners. 6 <Software Title> ~ <Level or Module> Accounting & Bookkeeping Courses

7 The accounting books of a business should always treat the business as a separate entity from its owners. This treatment is unavoidable when the business is formed as a limited company, as most are. Some characteristics of a limited company are; it issues shares it is owned by the shareholders its shareholders are not liable for its debts it can return profit to its shareholders in the form of dividends it is a legal person in its own right it is managed by directors who are appointed by the shareholders it can enter into contracts it can borrow money it is subject to Corporation Tax The money invested in a company by the shareholders when they buy shares is its share capital. Let s say that the shareholders invested 50,000 and the money went straight into the company s bank account; Debit: Bank account 50,000 Credit: Share Capital Accounting & Bookkeeping Courses <Software Title> ~ <Level or Module> 7

8 Many smaller businesses, though, are owned by sole-traders or partnerships. In law the business assets and liabilities of these unincorporated firms are not separate from the private property of their owners. Even so, the bookkeeping treatment is very much the same. Let s say that a sole-trader puts 2,000 into her business, Glossy Decorators, to get it started; Debit: Bank account 2,000 Credit: Owner s Capital Shareholders in limited companies cannot simply take back their money when it suits them. Sole-traders and partners, on the other hand, can withdraw money from the business, called drawings whenever they want. So, if our sole-trader needs to take back 300; Debit: Drawings 300 Credit: Bank account By making these entries in the books we have made sure that we have followed the basic principle of double-entry bookkeeping and made corresponding credit and debit entries showing where money has come from and where it has gone to. Capital is money put into a business by its owners with the intention of earning a profit. As it is money coming from somewhere it is rather like the money that comes from creditors and other liabilities. 8 <Software Title> ~ <Level or Module> Accounting & Bookkeeping Courses

9 Identify four characteristics of a limited company The Accounting Equation All the time we have been following the double-entry rule that says we have to make each entry in the books twice, once on the credit (right-hand) side to show where the money came from and again on the debit (left-hand) side for where the money went to. As a result, after any series of entries we should find that the total of all the entries on the credit side comes out exactly the same as the total on the debit side. Accountants talk about balancing the books which originally referred to a check that all the debits added up to the same amount as all the credits. Going back to our example of Glossy Decorators we can see that, after the owner introduced her 2,000 the books balanced like this; Assets ( 2,000 in business bank account) = Capital ( 2,000 from owner) If the first thing she did was to take back the 300 then the equation would become; Assets (now 1,700 in bank) = Capital Drawings If, after that, she bought 200 worth of paint on credit from a builders merchant then; Assets ( 1,700 cash & 200 stock) = Capital Drawings + Liabilities ( 200) The owner of Glossy Decorators carries out a job, using all the paint, for a grateful customer who readily agrees to pay her fee of 600 in a month s time. It is not difficult to work out the profit for this job; Sales 600 Less: cost of paint -200 Profit 400 Accounting & Bookkeeping Courses <Software Title> ~ <Level or Module> 9

10 The profit is treated, like capital, as money introduced by the owner. She could, after all, close down Glossy Decorators at this point and the money would be hers. She decides to carry on trading so her equation looks like this; Assets ( 1,700 cash & 600 debtor) = Capital Drawings + Liabilities + Profit The amount of profit left over in a business after the owners have taken their drawings (or the shareholders have had their dividend) is called the retained profit. Calculate for Glossy Decorators :- 1. its retained profit (i.e. profit drawings) 2. its total assets 3. its capital + retained profit + liabilities Assuming you have ended up with the same figure for items two and three in the activity above you should be able to agree with the accounting equation in its final, complete form; Assets = Capital + Retained Profit + Liabilities 10 <Software Title> ~ <Level or Module> Accounting & Bookkeeping Courses