AAT LEVEL 2 LESSON 2. Association of Accounting Technicians (AAT) Example Course Materials

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1 LESSON 2 Double Entry Processing On completing this lesson you should be able to: Identify and explain the accounting concepts which underpin the double entry system of processing business transactions Identify and explain the terms which make up the accounting equation Identify assets, liabilities and capital items and make missing term calculations Process business transactions through ledger accounts, applying the principles of double entry processing and balance off account Classify ledger account balances and list balances in trial balance format Introduction The unit Processing Bookkeeping Transactions (PBKT) and the unit Control Accounts, Journals and the Banking System (CJBS) require you to have a sound knowledge and understanding of the system of processing business transactions known as double entry. The information contained within this lesson is designed to introduce you to basic double entry processing and the learning check questions at the end of the lesson give you the opportunity to practise the principles of basic double entry. It is essential to your studies at this level of the qualification that you have an awareness of the main sources of information used in preparing the sales ledger and purchase ledger control accounts, and that you can use information from within the accounting system to demonstrate competence by correctly constructing control accounts. This is a subject area which is regularly assessed within the CBT s. Accounting concepts Those individuals who are responsible for keeping financial records and preparing financial statements on behalf of a business are required to observe a number of rules or principles commonly known as accounting concepts.

2 The system of double entry bookkeeping is underpinned in particular by four accounting concepts. These are: The business entity concept The money measurement concept The dual aspect concept The historic cost concept Business entity concept This concept requires that those individuals who are responsible for keeping financial records and preparing financial statements treat the organisation for which they are doing so as though it were a living person. Therefore, as bookkeepers and accountants, we give each business an identity which is separate from that of its owner or owners. Of course, as you learned in the previous lesson, in the eyes of the law only limited companies have their own legal identity. As unincorporated businesses the law does not distinguish between the identity of the sole trader, or those in partnership, and their business. For those keeping records and preparing financial statements, however, each business is treated as though it were an independent unit or person. As a result of applying the business entity concept we restrict the records we keep to giving an account of transactions which relate specifically to the business entity. We are not keeping records for the owner(s) of the business but for the business itself. The only circumstances in which we record the activities of the owner(s) in the records we keep are when their activities have a direct impact on the financial affairs of the business. For example, when the owner(s) of the business invest capital in their business we record the fact that the business is in debt to its owner(s). Should the owner(s) take goods, or funds, from the business in the form of drawings, this too would be recorded in the books as we need to account for the fact that the claim of the owner(s) on the resources of the business has decreased. You should also note that as a result of applying the business entity concept, the financial records we keep and the financial statements we prepare are headed up in the name in which the business operates. Dual aspect concept This concept is the very essence of the double entry system of bookkeeping. The dual aspect concept, or duality as it is often referred to, requires that we recognise that there are two aspects to accounting.

3 We need to recognise that as a living person the business is itself capable of owning resources and these resources are known as its assets. We must also recognise that the business entity is really a fictitious person, with no means of personally financing the assets it has acquired. The business entity must therefore be financed either by its owner(s) or other financiers. The claim of the owner(s) of the business on its assets is known as capital (or equity in the case of a limited company), whilst the claims on assets of other financiers are known as liabilities. The dual aspect concept determines that the two aspects must always be equal i.e. what the business entity owns (its assets) must be equal to what it owes (its capital and liability claims). This relationship is expressed by the accounting equation: Assets = Capital + Liabilities The above equation reflects the assumption that for each business transaction there is a giver and a receiver. The double entry system of bookkeeping is an expansion of this assumption which results in each transaction being recorded twice in the financial records. One entry is made to the left-hand side of an account (debit side) with a corresponding entry of equal monetary value being made to the right-hand side of an account (credit side). If we start our bookkeeping system with accounts showing that Assets = Capital + Liabilities, i.e. that debits (DRs) equal credits (CRs), and for every transaction we process, we process a debit posting and credit posting of equal monetary value, then debit entries should always be equal in value to credit entries. Money measurement concept In keeping financial records we are classifying, categorising and recording business events (transactions) to which a monetary value can be attached. There are, however, some aspects of business which we cannot value in monetary terms. For example, it is impossible to put a monetary value on the flair, skill and motivation of the owner(s) and workforce of a business and yet these aspects of business life are essential to its well-being and survival. The money measurement concept requires that we confine ourselves to only recording those transactions to which we can attach a monetary value. Historic cost concept The information recorded in the books of account is capable of being influenced by the person recording it, or by what it is required for; as a result the historic cost concept has been adopted. This concept requires that assets are recorded in the books at their original cost to the business. Transactions recorded in the books of account are in the main documented by the invoice or bill. This provides proof of the amount paid to acquire an asset, or in payment of an expense, or of the amount received when goods are sold. The books of account are history books providing a detailed account of the value at which goods and services are bought and sold.

4 Accounting terms The dual aspect concept referred to above made the point that the system of double entry processing has its foundations in what is known as the accounting equation i.e. Assets = Capital + Liabilities Before you explore further the principles of double entry bookkeeping, it is important that you have an understanding of each of terms within the equation. Assets These are the resources owned by the entity, or amounts owed to it. At this level of your studies it would be acceptable to regard assets as items of value to the business, although a more precise definition of the term assets will be required as you progress to the next levels of the qualification. Assets can be further classified as being either non-current or current. Non-current assets These are items of value acquired and owned by the business for the specific purpose of being used within the business over a number of accounting periods (years). Non-current assets form the framework of the business and make a long-term contribution to the business in terms of the profits it generates. Examples of non-current assets include: Business premises (land and buildings) Plant and machinery Fixtures and fittings Office machinery and equipment Vehicles Current assets These are items of value which are held by the business in the form of liquid funds (cash in hand or cash in a bank current account), or which are held in a form that facilitates them being converted by the business into liquid funds at short notice. Examples of current assets include: Inventory (stock of finished goods held for resale, raw materials held for use in the production process, work in progress i.e. partly finished goods awaiting completion). Trade receivables (amounts due from customers who have been sold goods on credit but have not yet settled the amount they owe the business). Short-term investments (money in a bank deposit account). Cash in hand.

5 Capital This is the claim of the owner(s) on the assets of a business after the liabilities have been deducted from the value of its assets. In accounting for limited companies capital is also referred to as equity. Liabilities These are the claims on the assets of a business, i.e. its financial obligations. In theory, all claims on the assets of a business represent a liability. However, we tend to make a distinction between the claim on assets of the owner(s), which is referred to as capital, and the claims of other providers of funds, which are normally referred to as liabilities. Liability claims are classified as being either non-current liabilities or current liabilities. Non-current liabilities These are the financial obligations of the business which the business is not expected to meet within the next twelve months and include: A bank loan repayable over several years. Debentures a method of raising funds used by limited companies. Current liabilities These are the financial obligations of a business that are repayable in the short-term (within the next twelve months). Examples of current liabilities include: Trade payables (amounts owed to suppliers for goods or services purchased on credit, but for which the business has not, as yet, made payment). An overdrawn balance on the business bank account (a bank overdraft is meant to be a short-term arrangement with the bank and in theory is repayable on demand). The accounting equation calculating the missing term Wherever we know two of the terms within the accounting equation (Assets = Capital + Liabilities) we can calculate the missing term. For example: If we are told that the assets of a business have a value of 200,000, and its liabilities are 60,000, we can calculate that the capital claim of the owner of the business must be 140,000. Assets 200,000 less Liabilities 60,000 = Capital 140,000 If we are told that the assets of a business have a value of 500,000 and the capital contribution of the owner to the business

6 is 400,000, we can calculate that the obligation of the business to providers of funds other than its owner(s) i.e. its liabilities must be 100,000. Assets 500,000 less Capital 400,000 = Liabilities 100,000 Given the information that the capital contribution of the owner to the business is 300,000 and that its liabilities are 50,000, we can calculate that its assets must have a value of 350,000. Capital 300,000 + Liabilities 50,000 = Assets 350,000 Double entry processing The processing of business transactions on a double entry basis requires that the giver and receiver element of each transaction (the dual aspect concept) be identified and applied. Each business transaction is posted with a left-hand side or Debit (DR) entry to a suitable account, with a corresponding posting of equal monetary value then being made to the right-hand side or Credit (CR) side of another suitable account. Suitable accounts are those accounts which categorise transactions so that account balances provide us with information from which we can prepare final accounts at the financial year end. The system starts by opening accounts in the books that reflect the accounting equation (Assets = Capital + Liabilities). The accounts we keep are known as ledger accounts and the books are known as the ledgers. Assets are recorded as debit balances within accounts, with Capital and Liabilities being recorded as credit balances. As a result, at the start debit balances will be equal in value to credit balances. If all transactions which follow are then posted with a debit entry and corresponding credit entry then arithmetical accuracy in terms of debit values being equal in value to credit values will always be maintained. For example: Assets Capital and Liabilities

7 Each transaction which follows will then be analysed, the giver and receiver aspect identified, and appropriate debit and corresponding credit postings made. The following postings are necessary to increase or decrease debit and credit balances: To increase a debit balance a debit entry is made in a ledger account. To decrease a debit balance a credit entry is made in a ledger account. To increase a credit balance a credit entry is made in a ledger account. To decrease a credit balance a debit entry is made in a ledger account. The following information will also help in processing business transactions: Goods bought for resale (purchases) are posted (debited) to a Purchases Account. Goods originally bought on credit and later returned to the supplier are posted (credited) to a Purchase Returns Account. Goods sold from inventory (stock) are posted (credited) to a Sales Account. Goods originally sold on credit and later returned by the customer are posted (debited) to a Sales Returns Account. Where goods are bought on credit from a supplier, an account is opened in the name of the supplier. The amount owed to the supplier is credited to the supplier account. Any goods returned to the supplier are debited to the supplier account. Payments made to a supplier and any settlement discounts (cash discounts) received are also debited to the supplier account. Where goods are sold on credit to a customer, an account is opened in the name of the customer. The amount owed by the customer is debited to the account. Any goods returned by the customer are credited to the customer account. Payments received from a customer and any settlement discounts (cash discounts) given are also credited to the customer account. Although a detailed analysis of transactions is recommended, some transactions may be grouped together under one account title. For example, road tax, vehicle insurance, petrol, diesel and vehicle repairs are usually posted (debited) to a Vehicle Expenses Account. Cash taken from a cash box or from the business bank account by the owner for private purposes, or goods taken by the owner from stock by the owner for private use, must be recorded in the books and posted (debited) to a Drawings Account. Settlement discounts (cash discounts) allowed to credit customers are posted (debited) to a Discounts Received Account. Settlement (cash discounts) received from credit suppliers are posted (credited) to a Discounts Received Account.

8 The ledger account In its simplest form a ledger account will take the following format. This is commonly known as the T account format: Example Ledger T account DR Account Title CR Date Details Date Details By using the layout above each transaction can be recorded in terms of: The date of each transaction The details of each transaction (usually the title of the opposite account(s) used or, if we are posting a total, the name of the book or prime entry where the total came from) The amount (monetary value) of each transaction Note: the majority of ledger accounts shown within this textbook will be presented in T account format. Nowadays, accounts tend to be computerised or machine-generated and are presented in the format shown on the next page.

9 Example Ledger T account Account Title Date Details DR CR Balance DR/CR One advantage of the machine-generated ledger account being kept in the format shown above is that, whilst it contains all the details of the T account, it also provides the reader with an ongoing account balance. This is not, unfortunately, a feature of the traditional T account. To see the balance on an account in T format the account will have to be balanced off periodically.