Double entry bookkeeping

To record every business transaction that takes place we use an accounting system known as double-entry bookkeeping. It is believed that the double-entry system of bookkeeping was introduced to Europe in the early sixteenth century by the monk, Luca Pacioli, who tutored Leonardo da Vinci in mathematics. This system has been in use in most of the developed world for over 500 years and it shows no signs of declining in its popularity in recording accounting transactions.

Double-entry bookkeeping, at first glance, appears complex and one might think that bookkeeping would need many years of practice before they can 'keep the books'. Fortunately, looks can be deceiving and almost anyone can pick up the basics of this system in a very short time. This is because the double entry system can be reduced down to some very straightforward rules.

The whole system of double entry bookkeeping can be summarised in the following two rules:

1. All transactions have one entry in two different accounts (the double-entry bit)

2. All transactions have one debit entry (left side of account) and one credit entry (right side of account)

If you can remember these basic rules then financial accounting will be a lot more straightforward. In fact, remembering this rule can help you out of situations where you cannot remember which side one half of the transaction should be entered - just remember, if you know the debit entry then wherever the other entry is, it must be a credit entry and vice versa.

For every type of transaction, from buying new machinery to paying a supplier, there will be separate account. And each account will look roughly as follows;

Name of account

Year £ Year £ Date/Month Details Amount Date/Month Details Amount

Lets, run through what each of these terms mean:

Name of account - the area that the transaction covers. There will be an account for cash, an account for every type of expense (insurance, rent and so on), an account for each type of asset (things like equipment, premises and machinery), as well as an account for each customer we sell to and each supplier we buy from (the personal accounts).

Date/month - the time when the transaction is undertaken

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Details - the other account that is affected by the double entry transactions. Having the details here will help us to remember that there must always be two entries for each transaction.

Amount - the total monetary amount of the transaction.

For each different type of account there will be different rules governing which side of the account it is entered into. This rule will depend upon whether the amount in the account is increasing or decreasing, and also whether the account is an asset, liability or a capital account.

The account will always be split into two sides. It is vital that you enter the transaction not only in the correct account but also on the correct side. The two sides of each account are as follows:

Any account

Left hand side is known as the DEBIT SIDE

Right hand side is known as the CREDIT SIDE

Debit is often abbreviated as Dr. and Credit is often abbreviated as Cr.

To begin with, we will consider the rules for three different types of accounts:

Asset accounts Liability accounts

Capital accounts

Assets

Assets are any resources that are to be used in the business. Examples would include machinery, premises, stocks of goods and cash.

Liabilities

Liabilities refer to any borrowings undertaken by the firm (e.g. Loans or credit offered to us by suppliers).

Capital

Capital refers to the value of the resources put into the firm by the owner(s).

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Some items can be classified as both an asset and capital. For example, cash introduced into the firm by the owner would be classed as capital. However, this cash would also be classed as an asset. This is simply the result of classifying items from two points of view.

Try not to see, as some students sometimes do, assets as being good and liabilities as being bad. The term liability simply refers to the source of the finance, and makes no judgement on whether it is good or bad for the firm.

The rules for entering these types of transactions in the double-entry accounts are as follows:

Any Asset account

Increases are entered on this side Reductions are entered on this side

Any Liability account

Reductions are entered on this side Increases are entered on this side

Any Capital account

Reductions are entered on this side Increases are entered on this side

The following transactions are all based on a firm being set up from the initial starting of the firm. The amounts of money may appear small, but this is simply to get you used to the idea of entering transactions in the double-entry accounts.

Two rules of double-entry bookkeeping:

All transactions have two entries.

Each transaction has one debit (left) and one credit (right) entry

Accounting for purchases and sales

Therefore, we need to keep separate accounts for stock being purchased and stock being sold. In fact, we actually keep four accounts for movements in stock and these are as follows:

Increases in stock:

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Purchases account - stocks of goods bought by the firm for resale Returns inwards account - stocks previously sold that is returned by the customer due to

the goods being unsuitable (e.g. they are damaged, the wrong type of goods, etc.)

Decreases in stock:

Sales account - stocks of goods sold to customers Returns outwards account - stocks previously purchased by the firm which is returned to

the original supplier

The normal double entry rules apply to all these stock accounts. Stock is an asset therefore, increases in stocks will always be debited to the relevant account and decreases will always be credited.

(You may also see returns inwards referred to as sales returns, and returns outwards as purchases returns)

Accounting for expenses and revenues

All firms will have expenses to pay as part of normal business activity. This will occur on a frequent basis. Each separate expense will have its own account. Expenses do not fall into the classification of 'asset', 'liability' or 'capital', but we can still work out the rules for making entries in the expense accounts.

Any expense will require either cash or a cheque payment. Therefore, this will require a credit entry in either the cash or the bank account. As a result, the debit entry must be in the expense account - it cannot be a credit entry as it would not fit the rules of double entry bookkeeping.

Accounting for drawings

Earlier in this section we saw that anything injected into the business for use in the business by the owner is known as capital. However, it is perfectly possible for the owner to withdraw resources (money or stock for example) from the business. This would be represented by a decrease in capital. These reductions are known as 'drawings'.

These 'drawings' are kept in a separate drawings account - which is another form of capital account and follows the same double entry rules.

Balancing off accounts

At the end of each accounting period the firm will wish to balance its accounts off. An accounting period is normally one year but most firms will wish to balance off their accounts on a more frequent basis - usually every month. The more frequently a firm balances its accounts off, the less likely it is to make mistakes.

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The process of balancing accounts off should not be rushed. It is, in effect, the final part of the double entry system of bookkeeping. Once accounts have been balanced off then the firm can begin to assess whether it has made a profit and if so how much profit has been generated.

The balance on each account is simply the difference in the totals of the debit side of the account and the credit side of the account. For example, if the debit side of an account added up to £190 but the credit side of the account added up to £330, then we would say that the account had a credit balance of £330 - £190 = £140.

To balance off accounts the following guidelines should be followed:

1. Each account must have its debit and credit columns totalled up - but don't write anything down yet.

2. The largest total out of the two columns will become the total for both sides and this will be written underneath each column on both sides and double underlined (double - to show that this account is finished with).

3. The column where the total does not add up to the total shown will need a balancing figure to make it add up. This should be entered as the 'balance to be carried down' or 'balance c/d' for short. This amount should be exactly equal to the amount needed to make the columns now both add up to the same total.

Some things to remember when balancing off accounts are:

1. The totals for each column should always be on the same level on the page - never at split-levels.

2. The balance brought down must always be on the opposite side to the balancing figure of the balance to be carried down.

3. The actual balance on the account is the balance brought down not the balance carried down.

4. An account is not really finished until the balance has been brought down to the next period.

Daybooks and ledgers

When a business is very small, all the double entry accounts can be kept in one book, which we would call a 'ledger'. As the business grows it would be impossible just to use one book, as the large number of pages needed for a lot of transactions would mean that the book would be too big to handle. Also, suppose the firm has several bookkeepers. They could not all do their work properly if there were only one ledger.

The answer to this problem is for us to use more books- more ledgers. When we do this, we put similar types of transactions together and have a book for each type. In each book, we will not mix together transactions, which are different from each other.5

Daybooks - books of original entry

When a transaction takes place, we need to record as much as possible of the details of the transaction. For example, if we sold goods to A Smith on credit. We would also want to record the address and contact information of A Smith and the date of the transaction. Some businesses would also record information like the identity of the person who sold them to A Smith and the time of the sale. Ledger accounts cannot give us all this information so, as a further system of keeping records, firms will also keep books of original entry.

Books of original entry are the books in which we first record transactions. These are not accounts; they are simply books that records the details of a transactions, almost like a diary. The firm will have a separate book for each kind of transaction. The type of the transaction will affect which book it, is entered into. Sales will be entered in one book, purchases in another book, cash in another book, and so on. The books of original entry are used to record the following:

The date on which each transaction took place - the transactions should be shown in date order;

Details relating to the sale are entered in a 'details' column;

A folio column entry is made cross-referencing back to the original 'source document', e.g. the invoice;

The monetary amounts are entered in columns included in the books of original entry for that purpose.

Advantages of keeping books of original entry

1. Accounts can be found more easily by the use of the cross referencing nature of the books of original entry being kept.

2. If records are lost then the ledgers and the books of original entry act as a back up for each other.

3. Acts as a 'listing device' for posting totals to various accounts, thereby saving labour

Types of books of original entry

Books of original entry are also known as either 'journals' or 'daybooks'. The term 'day book' is, perhaps, more commonly used, as it more clearly indicates the nature of these books of original entry - entries are made to them every day.

The commonly used books of original entry are:

Sales daybook (or Sales journal) - for credit sales Purchases daybook (or Purchases journal) - for credit purchases

Returns inwards daybook (or Returns inwards journal) - for returns inwards

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Returns outwards daybook (or Returns outwards journal) - for returns outwards

Cashbook - for receipts and payments of cash and cheques

General journal (or just 'The journal' if the term 'Daybook' is used for other books of original entry) - for other items

The cashbook is a combined account of the cash account and the bank account. It is the only one of the six daybooks that is both an account and a daybook at the same time. Apart from the cashbook, all the other double-entry accounts are kept in one of the three ledgers.

Petty cash book

Some firms actually keep a separate cashbook and a petty cash book. The petty cash book is for dealing with small items of money. It may be case that the firm has lots of transactions, which involve relatively small amounts of money (e.g. petrol costs, postage costs and so on). If these were entered in the cashbook then it would quickly become cluttered up with entries for small amounts of money.

To stop this happening some firms will keep a petty cashbook, which deals with these items. At the end of each month the monthly totals can then be transferred to the main cashbook. This has the other advantage of allowing another member of staff (usually a junior) the responsibility of dealing with petty cashbook alone and this frees up time for the main cashier of the firm to deal with the main cashbook.

Some very large firms may actually use the petty cashbook for dealing with all cash items of expenditure. The main cashbook would then only be used for bank transactions.

Source documents

All the daybooks are constructed on the basis of transfers from original source documents. These are items of business use that contain financial data related to business transactions. The main source documents a firm is likely to use are as follows:

Purchase invoice: Received by the firm from suppliers when buying goods on credit Sales invoice: Sent by the firm when selling goods on credit

Debit notes: Received by the firm from suppliers when goods purchased are returned to the original supplier

Credit notes: Sent by the firm to customers who have returned the goods

Cheque counterfoils: From the chequebook to show cheques paid out

Paying slip; Evidence of money paid into bank accounts

Till rolls: Evidence of cash being received

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Petty cash vouchers: Slips to indicate small amounts of cash being paid

Bank statements: A summary of the bank account from the banks point of view.

The following daybooks are constructed by the use of each of the following source documents:

Daybook Source document(s) Sales daybook Sales invoice

Purchases daybook Purchases invoice Returns inwards daybook Credit notes Returns outwards daybook Debit notes

Cashbook Cheque counterfoils, paying in slips, till rolls, etc. The journal Everything else not covered by above

Using more than one ledger

Entries are made in the books of original entry. The entries are then summarised and the summary information is entered, using double entry, to accounts kept in the various ledgers of the business. The act of using one book as a means of entering the transaction to the other account, so as to complete double entry, is known as 'posting' the items.

One reason why a set of ledgers is used rather than just one big ledger is that this makes it easier to divide the work of recording all the entries between different bookkeepers.

Types of ledgers

The different types of ledgers most businesses use are:

Sales ledger. This is for customers' (debtors) personal accounts Purchases ledger. This is for suppliers' (creditors) personal accounts

General ledger. This contains the remaining double entry accounts, such as those relating to expenses, sales, purchases, fixed assets, and capital

Types of accounts

Some people describe all accounts as personal accounts or as impersonal accounts.

1. Personal accounts - these are for debtors and creditors (i.e. customers and suppliers)2. Impersonal accounts - divided between 'real' accounts and 'nominal' accounts:

Real accounts - accounts in which possessions are recorded. Examples are buildings, machinery, fixtures and stock

Nominal accounts - accounts in which expenses, income and capital are recorded 8

The use of folio columns

Each double entry account will contain the name of the other account in which the other half other transaction is contained. Apart from very small firms, this does not necessarily make it any easier to locate the other account - there may be hundreds of separate accounts.

A method of speeding up the ability to find an account is the use of folio columns. These are found in both accounts and also in daybooks. An extra column, usually quite small is placed besides the details of each transaction. In this folio column is placed an abbreviated reference to which ledger or daybook the transaction can be located in, and on what page of the relevant book.

For example, if a credit sale was record in the sales daybook with the folio reference SL54, then this would tell us that the customer's account could be found on page fifty-four of the sales ledger. If we actually looked at this relevant account then we would see that it also had a folio reference sending us back to the sales daybook itself. Common abbreviations are as follows:

SL Sales ledgerPL Purchases ledgerGL General ledgerCB Cashbook

If the entry 'C' appears in the folio column then this refers to a contra entry. This means that both halves of the transaction are contained in the same account. An example of this is dealt with in the section on cashbooks.

Cashbooks and petty cashbooks

A cashbook is the cash account and the bank account combined into one single account. We already know how to maintain a separate cash account and bank account. The two accounts below are just straightforward examples of double-entry accounts:

Bank

2002 £ 2002 £ 1 Jan Capital 2,500 2 Jan Office furniture 750 5 Jan Sales 150 8 Jan T McClure 140 12 Jan W Green 320 15 Jan Purchases 250 18 Jan Rent 85 31 Jan Balance c/d 1,915

3,055 3,0551 Feb Balance b/d 1,915

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Cash

2002 £ 2002 £ 2 Jan B Griffin 250 2 Jan Office expenses 50 7 Jan H Spence 430 11 Jan Insurance 55

14 Jan Motor expenses 120 21 Jan P Yarrow 320 31 Jan Balance c/d 135

680 6801 Feb Balance b/d 135

However the cashbook combines the two separate accounts into one joint account. The example below is just the two separate examples from above combined into a cashbook format:

Cashbook

Cash Bank Cash Bank 2002 £ 2002 £ 1 Jan Capital 2,500 2 Jan Office

expenses 50

2 Jan B Griffin 250 2 Jan Office furniture

750

5 Jan Sales 150 8 Jan T McClure 140 7 Jan H Spence 430 11 Jan Insurance 55 12 Jan W Green 320 14 Jan Motor

expenses 120

18 Jan Rent 85 15 Jan Purchases 250 21 Jan P Yarrow 320 31 Jan Balances c/d 135 1,915

680 3,055 680 3,0551 Feb Balances c/d 135 1,915

Notice that the accounts have not altered at all. They are still balanced off separately at the end of the month and the balances will obviously be the same as before. The above example is known as a two-column cashbook - the two columns being bank and cash columns.

It is possible to have a closing balance which is a debit balance for the cash account but a credit balance for the bank account. The account should simply have balances drawn in for both sides. It is impossible for the cash account to be a credit balance, this would mean that the firm had a

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negative amount of cash. This cannot be the case - one can have either some cash or no cash but not a negative amount. The bank account can be a credit balance and this means that the firm is overdrawn on the account - the firm has drawn more from the bank account than is actually there and the firm now owes the bank money.

Cash paid into the bank

Frequently, firms will pay cash into the firm's bank account and also, draw money out of the bank for use elsewhere. The double entry required to record this sort of transaction is unusual because both 'halves' of the transaction are now going to be found in the same account - the cashbook.

Cash discounts

Although firms will offer terms of credit to their customers, the firm would prefer it if customers settled their account as quickly as possible (i.e. paid what they owed) fairly quickly because the cash flow will be important to most firms. Many firms will offer discounts in return for prompt payments. These are known as cash discounts (also known as settlement discounts) and are usually given as a percentage of the overall invoice total (e.g. 5% off the sales value).

The term cash discount does not mean that the amount has to be paid in cash - cash or cheques would both qualify if they were paid within the given time limit. The term cash discount is used to distinguish it from trade discounts. The cash discount offered and the terms and conditions will normally be found on the invoice. There are two types of cash discounts that are recorded in the ledger accounts:

Discounts allowed

Cash discounts allowed by a firm to its customers when they pay their accounts quickly.

Discounts received

Received by a firm from its suppliers when it pays their accounts quickly.

Discounts columns in cashbook

Both discount accounts are kept in the general ledger. There is the danger that, with frequent purchases and sales, these accounts will quickly become cluttered with many small entries. An alternative approach, which avoids this clutter, is to make use of a three-column cashbook.

The three-column cashbook incorporates the cash discounts for each relevant entry into a third column. At the end of each month (or other relevant period) when the cashbook is balanced off, the totals form these discount column would then be transferred to the discount accounts in the general ledger. Discounts received are entered in the discounts column on the credit side of the cashbook, and discounts allowed in the discounts column on the debit side of the cashbook.11

The cashbook, if completed for the two examples so far dealt with, would appear as follows:

Three column cashbook

Discount Cash Bank Discount Cash Bank 2003 £ £ £ 2003 £ £ £ 5 Nov D

Jackson 7 273 3 Nov J O'Neill 23 437

There is no alteration to the method of showing discounts in the personal accounts. When balancing the accounts off at the end of the period, you must take care to note that the discounts columns are not balanced off against each other. The discounts columns are simply totalled up and then transferred to the relevant discount account. Therefore the totals are likely to be different for the discount columns.

This is a fully worked example of a three-column cashbook:

2005 October 1 Balances brought forward: Cash £215, Bank £190 (Cr.) October 3 Paid creditors by cheque; G Dawes £440 L Lewes £120 (before discount)

and received a 5% discount on invoice totals. October 9 Paid £100 cash into bank account October 13 Received cheques from suppliers for accounts totals as follows: R Kirk

£360 and C Watson £120, in each case allowing a 2.5% discount. October 19 Cash purchases £78 October 20 Paid rent by cheque £56 October 22 Received cheque of £90 from H Knight in settlement of sales worth £95. October 25 Cash withdrawn from bank for personal use £50 October 30 Received commission by cash £46

Petty cash book

Some firms actually keep a separate cashbook and a petty cash book. The petty cash book is for dealing with small items of money. Some firms will have lots of transactions which involve relatively small amounts of money (e.g. petrol costs, postage costs and so on). If these were entered in the cashbook then it would quickly become cluttered up with entries for small amounts of money.

To stop this happening some firms will keep a petty cashbook, which deals with these items. At the end of each month the monthly totals can then be transferred to the main cashbook. This has the other advantage of allowing another member of staff (usually a junior) the responsibility of

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dealing with petty cashbook alone and this frees up time for the main cashier of the firm to deal with the main cashbook.

Some very large firms may actually use the petty cashbook for dealing with all cash items of expenditure. The main cashbook would then only be used for bank transactions.

Imprest system

The most common system used to maintain the petty cash book is known as the imprest system. This involves co-ordination between the cashier responsible for the cashbook and the cashier responsible for the petty cash book.

The cashier will give the petty book cashier just enough money to cover the petty cash transactions of a period of time - usually one month. At the end of the month, the amount actually spent will be totalled up and the amount will be refunded from the main cashbook as follows:

Entries needed to refund amount spent on petty cash

Debit Credit Petty cashbook Cashbook

In this way, the balance on the petty cashbook will always be the same at the start of each period. This opening balance is known as the float or imprest. The float can be changed if it is observed that the petty cash is either being spent too quickly, or is not being spent at all. The idea is that the float should cover the periods' expenses.

Most firms who maintain petty cashbooks will do so in a format which categorises different types of petty cash expenditure. This is known as an analytical petty cashbook because it analyses the different types of expenditure.

The petty cashbook still follows the rules of any double entry account. However, the credit side of this account will be split into the various categories of expenditure.

The following are details of petty cash transactions for the month of February 2004. The business transactions that occur are as follows:

Feb 1 The chief cashier debits the petty cashbook with £70 to restore the float

£Feb 4 Petrol costs 10 Feb 5 Stationery 4 Feb 9 Coffee for office 3 13

Feb 8 Bus fares 6 Feb 15 Milk and tea 2 Feb 16 Rail fares 17 Feb 21 New paper for printer 9 Feb 24 Folders for office 4

Feb 28 The chief cashier debits the petty cashbook with £55 to restore the float

The £55 received on February 28 is exactly the amount that was spent during February on petty cash transactions.

The analysis columns that are to be used in this example are:

Travel expenses Stationery

Miscellaneous

There are no strict rules on what columns should be used or how many of them there should be. It makes sense not to have too many because it may become confusing when filling in the petty cashbook.

Advantages of maintaining a petty cashbook

1. It stops the main cashbook being cluttered up with small items of expenditure. 2. It allows the firm to delegate these small times to a junior member of staff, which frees

up the time of the main cashier to concentrate on other areas.

The sales daybook

In many businesses most of the sales will be made on credit rather than for immediate settlement of the amount. For some businesses all sales will consist entirely of credit sales, while for some other firms, all will be for cash settlement. It is realistic to expect most firms to have some cash and some credit sales. All credit sales should be entered into the sales daybook.

The source document for the sales daybook is the sales invoice. A sales invoice is simply a business document containing all the details of the sale made. The business will keep a copy and will send another copy of the invoice to the customer. Details contained on the invoice would include:

Name of customer Address of customer

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Date of sale

Value of sales

Any trade discount

Any cash discount - and details of the conditions

Invoice number

Example - sales invoice

Trade discounts

Firms may have different types of customers. Some firms will offer further discounts to either regular customers or to other firms.

This type of discount is known as a trade discount. There is no double entry for trade discounts. The trade discount may be referred to on the sales invoice, but it should not show up in either the sales daybook or the ledger accounts. To compare with cash discounts:

Trade discounts: are not shown in double entry accounts.Cash discounts: are shown in double entry accounts.

When calculating the actual amount that needs to be paid or is expected to be received it is vital that the discounts are dealt with in the correct order. The correct procedure is to deduct the trade discount first before calculating the cash discount - do not simply add the discounts together then calculate them!

Making entries in the sales journal

From the sales invoice the firm will enter the value of the sales (after deduction of any trade discount but before any cash discount) and other relevant information into the sales daybook. If we use the above example of an invoice as the first entry and then include some more credit sales, the sales daybook for the month of January 2002 would appear as follows:

The above example is a simplified version of full sales daybook. The above example does not contain a column for VAT - which would normally be expected for a UK trader (this is covered later in the section on VAT).

Also, the above example does not have a folio column. If this was the case then each entry in the sales book would have a reference as to where the account would be found. For example, by the entry for D Atkinson on January 1st, the reference could say, 'SL24'. This means that D Atkinson's account would be on page 24 of the sales ledger. By the total figure for the month

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could be something like 'GL3', which means that the total is transferred to the sales account, found in the general ledger on page 3.

In the ledger accounts each account mentioned above would have the reference 'SB 2' - that they were original entered on page 2 of the sales daybook.

Posting from the daybook to the ledger

Credit sales are posted to the debit side of each customer's account in the sales ledger and at the end of each period the total of the credit sales is posted to the credit of the sales account in the general ledger.

Effect on sales ledger:

D Atkinson

2002 £ 2002 £ Jan 1 Sales 816

C Reynolds

2002 £ 2002 £ Jan 3 Sales 1,640

T Wright

2002 £ 2002 £ Jan 15 Sales 220

I Yates

2002 £ 2002 £ Jan 22 1,100

Each of these items is posted (transferred from the daybook to the personal account) when the sale occurs. However, at the end of the month, it is the total for the month that is transferred from the daybook to the sales account in the general ledger

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Effect on general ledger:

Sales

2002 £ 2002 £ Jan 31 Total credit sales for month 3,776

By doing it this way, we save cluttering up the sales account with lots of entries. The customer accounts will remain with each individual entry posted to them when it occurs.

Purchases daybook

Entering into the purchases journal

When purchasing goods on credit, the procedure is similar to the one outlined in a previous section for credit sales. The source document that would be used as the basis for entering up the transactions is the purchases invoice. The purchase invoices is actually the same document as the sales invoice, it is just considered from the point of view of the buyer, rather than the seller (i.e. the firm selling the goods will send out a sales invoice, and this becomes the purchase invoice for the firm receiving it).

Posting credit purchases to the purchases ledger

We now have a separate purchases ledger containing all the creditor (supplier) accounts. The double entry procedure for credit purchases is as follows:

Credit purchases are posted one by one, to the credit of each supplier's account in the purchases ledger. At the end of each period the total of the credit purchases is posted to the debit side of the purchases account in the general ledger.

Effect on purchases ledger:

D Henson

2002 £ Feb 3 Purchases 290

D Morehen

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2002 £ 2002 £ Feb 8 Purchases 1,800

M Bridges

2002 £ 2002 £ Feb 13 Purchases 455

A Smith

2002 £ 2002 £ Feb 19 Purchases 980

As with sales, each will be posted when the purchase occurs. However, at the end of the month, it is the total for the month that is transferred from the daybook to the purchases account in the general ledger

Effect on general ledger:

Purchases

2002 £ 2002 £ Feb 28 Total credit purchases for

month 3,525

Returns daybooks

The customer can return goods sold to the original supplier. This can be viewed from firm's perspective as both a customer and a supplier. Sales returned will be treated as returns inwards and purchases returned will be treated as returns outwards.

Each type of returns has its own daybook - one for returns inwards and one for returns outwards.

Returns inwards18

If a customer is unhappy with the goods received then they may return them to the firm. This does not happen automatically but returns inwards are a common feature of business transactions (if they were not then why would we bother with a full daybook solely for each type of returns?). If a firm agrees to accept returns inwards (i.e. customer sending goods back) then the source document used as the basis of recording this transaction is the credit note. The credit note is sent by the firm to the customer who has been allowed to return the goods. The credit note takes its name from the fact that because the firm has agreed to accept returns inwards, we will credit that customer's personal account (thus reducing the debtor balance on that account). A credit note would appear similar to the sale invoice and would mainly contain details of the goods to be returned, and the value of these goods as recorded in the account when the sale was originally made. The credit notes may appear as follows - they may appear in red to avoid confusion with sales and purchases invoices:

To: A Powell

58 Oxford Road

Sheffield

S6 5TUS Hopkinson

23 Regent Road

Derby

DE1 1JK

3 March 2002

CREDIT NOTE 10045Per Unit Total £ £

20 Medium Density Fibre boards 15 300 Less 25% Trade Discount 75

225

Returns inwards journal

The information from the credit notes will be used as the basis for filling out the returns inwards daybook.

When posting entries from the returns inwards daybook, we should post each individual entry to the credit side of the personal account of each customer (found in the sales ledger). The total for

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the monthly returns inwards will be posted to the debit side of the return inwards account in the general ledger. This is completed for the above example below:

Effect on sales ledger:

S Hopkinson

2002 £ 2002 £ Mar 3 Returns inwards 225

M Skipsey

2002 £ 2002 £ Mar 7 Returns inwards 90

I Rowell

2002 £ 2002 £ Mar 18 Returns inwards 145

J Waite

2002 £ 2002 £ Mar 22 Returns inwards 310

Effect on general ledger:

Returns inwards

2002 £ 2002 £ Mar 31 Total returns inwards for 770

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month

Returns outwards

Goods returns by the firm to the original supplier are known as returns outwards. The source document used is the debit note. The firm will send a debit note back to the original supplier which will give details of the goods being retuned and the reason(s) for their return. An example of a debit note appears below:

To: A Powell

58 Oxford Road

Sheffield

S6 5TUG Thompson

29 Swann Road

Manchester

M12 5RE

6 April 2002

DEBIT NOTE 143Per Unit Total£ £

4 sheets of fibre glass - incorrect specifications 50 200 Less 20% Trade Discount 40

160

Returns outwards journal

The debit notes sent to the original suppliers are used as the basis for completion of the firm's returns outwards daybook.

When posting entries from the returns outwards daybook, we will post each individual entry to the debit side of the personal account of each supplier we are retuning goods to (found in purchases ledger). The total returns outwards of the month would be then posted to the credit side of the returns outwards account in the general ledger.

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Effect on purchases ledger:

G Thompson

2002 £ 2002 £ Apr 6 Returns outwards 160

S Cracknell

2002 £ 2002 £ Apr 17 Returns outwards 55

D Scaife

2002 £ 2002 £ Apr 25 Returns outwards 210

Effect on general ledger:

Returns outwards

2002 £ 2002 £ Apr 30 Total returns outwards for

month 425

The Journal

If any transaction is not covered by either the four main daybooks (sales, purchases, returns inwards and outwards) or the cashbook, then it will be entered in the Journal. Although it may seem like the Journal will contain lots of different transactions, you will soon find that the entries that belong in the Journal are more likely to be one-off or unusual transactions and, as a result, it will not contain many entries. Also, the journal will appear different to the main four daybooks we have just seen. The appearance of an entry in the journal will be as follows:

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The Journal

Date Details Dr Cr £ £

Name of account to be debited Name of account to be credited Narrative

The date of the transaction and the value of the transaction are self-explanatory. In the details section of the journal contains two main entries. These will cover the name of the account to be debited and the name of the account to be credited - we are literally writing up the double-entry transaction in a form of long-hand. The journal represents a sort of extra record of the double entry transactions - remember it is not part of the double entry system itself. The narrative is a simpler description or explanation of the traction that this entry contains. Notice how in the space where we state the name of the account to be credited, the entry is indented slightly. This is always the case - so as to distinguish the entry from the debit entry. The debit entry must always come first.

Once the entry has been made in the journal, the entries should then be posted to the actual double-entry accounts, just as described in the journal entry.

It is possible to split the debit or the credit entries between two or more accounts. As long as the total of the debit entries, adds up to the same as the total of the credit entries then that is acceptable. This is shown in the example below:

There are no other rules for making journal entries. Although it can cover a wide range of different transactions, common areas for journal entries would include:

Correction of errors Credit purchases and sales of fixed assets

Opening and closing down businesses

Cancellation and transfers of outstanding debts to the business

Trading and profit and loss accounts

The main objective of businesses is referred to as profit maximisation, whereby the managers or owners of the firm will aim to make as much profit as is possible. The calculation of these profits is one of the most important functions of accounting. The owner will wish to know the profit for various reasons, such as:

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Comparing performance - with other firms or with previous periods of time to see if the firm is moving in the appropriate direction

Planning ahead - profits will allow the firm to expand

Obtaining a loan - most bank managers and other lenders would want to see that the firm is profitable before lending money

Income tax purposes - tax payable will usually be based on the profits earned by the firm

The calculation of profit will involve the calculation of both revenue and expenses incurred by the firm over a period of time. In the case of the sole trader, the profit for a firm is calculated in an account known as the trading and profit and loss account.

For a trading organisation it is not only the final profit figure that is important. Managers and owners will also want to know how the profit is made on the actual sales that take place before other general expenses are deducted. So this can be seen, the overall trading and profit and loss account is split into two sections; the trading account, which calculates gross profit and the profit and loss account, which calculates net profit.

Trading account - to calculate gross profit (the profit earned on the buying and selling of goods - before all other expenses have been deducted)

Profit and loss account - to calculate net profit (the profit after all overhead expenses have been deducted from the gross profit - this is the overall profit earned by the firm)

It is possible that the firm may make a gross loss, where the cost of purchases is greater than the sales revenue, but this is unusual. More likely, a firm may make a gross profit, but may find that the other expenses are greater than the gross profit and the firm has made a net loss.

You will find that most questions will be concerned with firms that buy and sell goods. In reality, many firms will not sell physical goods, and that they will provide services. In this case, the firm would only need a profit and loss account rather than a full trading and profit and loss account.

We will consider firms that actually make their own goods later in Module 3 (manufacturing accounts).

To construct a trading and profit and loss account we will need to use information from the firm's trial balance. In this example, we will use the following trial balance:

D Ball - trial balance as on 31 December 2003

Dr (£) Cr. (£)Sales 6,000 Purchases 4,000 Insurance 650

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Lighting & heating 450 General expenses 120 Machinery 2,100 Debtors 890 Creditors 980 Bank 1,970 Discounts allowed 130 Discounts received 110 Cash in hand 80 Drawings 700 Capital 3,000 Loan 1,000

11,090 11,090

Stock in trade as at 31 December 2003 was valued at £300

In the double entry accounts we have no single account for stock. The value for closing stock would have to be calculated by taking an actual stock count. As stated in the section on trial balances, any stock which remains unsold (closing stock) will be listed underneath the trial balance.

Trading account

In the trading account we calculate the firm's gross profit. To calculate the gross profit we use the following calculation

Sales - cost of goods sold = gross profit

The cost of goods sold is simply the cost to the firm for those goods that were actually sold. The total cost of purchases would be the cost of the goods sold. However, if any stock were unsold at the end of the year then we would not count this, as it has not contributed towards the value of sales. Hence, cost of sales:

What we bought during the period Purchases Less: Goods bought but not sold during the period Closing stock

= Cost of goods sold

From our example, closing stock at the close of business (i.e. 31 December 2003) was valued at £300. The cost of goods sold for D Ball will therefore be:

£

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Purchases 4,000 Closing stock 300Cost of goods sold 3,700

To transfer balances from the double entry accounts we 'close down' the ledger account and transfer all that was paid or received during the year to the trading and profit and loss account. In effect we are 'emptying out' the relevant accounts for the year and we will start filling them, up in next year.

The double entry accounts will have already been balanced off and their balances will have been brought down for us to close off.

For sales, we should make the following entries:

Debit the sales account, thus closing it. Credit the trading account.

Sales

2003 £ 2003 £ Dec 31 Trading account 6,000 Dec 31 Balance b/d 6,000

The balance of the purchases is transferred to the trading account by:

Debit the trading account.Credit the purchases account.

Purchases

2003 £ 2003 £ Dec 31 Balance b/d 4,000 Dec 31 Trading account 4,000

Although there is no double entry account for stock left unsold at the end of the period we actually now create one. The value of closing stock is found by a physical count on the quantity of stock - a process known as stocktaking

Debit the stock account with the value of closing stock.Credit the trading account.

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Stock

2000 £ 1995 £ Dec 31 Trading 300

It is usual for the trading and profit and loss accounts to be shown under one heading. The trading account is the top section and the profit and loss account is the lower section.

It is possible to present the trading account and the profit and loss account as double entry accounts. This would be known as the horizontal presentation. However the practice is fast becoming outdated and now nearly every trading and profit and loss account you will see will be presented in the vertical manner.

Remember the rules for the titles of financial statements. It should say who it is for, what it is, and for what period of time we are dealing with. Both the trading account and the profit and loss account are drawn up for a period of time and not on a particular date. This is because the profit can only be earned over a period of time.

D Ball - trading account for year ended 31 December 2003

£ £Sales 6,000 Less Cost of goods sold: Purchases 4,000 Less Closing stock 300 3,700Gross Profit 2,300

Notice how we use both columns, not as debits and credits but for performing sub-totals. Sometimes there will be two, three or even four columns. There are no formal rules as to how many columns you should use. As long as it is presented well then that is fine. In this case, the subtotal for purchases less closing stock is carried over into the right hand column.

Profit and loss account

The profit and loss account can now be drawn up. This is where we use all the other balances for types of income and other expenses that are not connected directly with the buying and selling of goods.

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For most firms, there will be only one or two other forms of income. In our example, the only other form of income is the entry for discounts received. This, and other forms of income would be directly added on to the gross profit. All the other expenses (known as overhead expenses) will be listed in one column, then totalled up, and then deducted from the total income for the firm to give us the overall net profit.

As before, we will have to transfer the totals form each account by closing the account down for the year. This is done below:

Insurance

2003 £ 2003 £ Dec 31 Balance b/d 650 Dec 31 Profit and loss 650

Lighting and heating

2003 £ 2003 £ Dec 31 Balance b/d 450 Dec 31 Profit and loss 450

General expenses

2003 £ 2003 £ Dec 31 Balance b/d 120 Dec 31 Profit and loss 120

Discounts allowed

2003 £ 2003 £ Dec 31 Balance b/d 130 Dec 31 Profit and loss 130

Discounts received

2003 £ 2003 £ Dec 31 Profit and loss 110 Dec 31 Balance b/d 110

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Although machinery was purchased during the year and is a sort of expense it should not be transferred to the profit and loss account. This is because the purchase of machinery is known as an item of capital expenditure that means that it is not 'used up' completely in this single year and therefore it would be inappropriate to transfer the value of this expense in the profit and loss account. We will see how we deal with this later in module 3.

All the other balances relate to balances on asset, capital and liability accounts. These are not to be used here as they will be used later on when we construct the balance sheet for the firm.

The full trading and profit and loss account will appear as follows:

D Ball - trading account for year ended 31 December 2003

£ £Sales 6,000 Less Cost of goods sold: Purchases 4,000 Less Closing stock 300 3,700Gross Profit 2,300 Add Discount received 110Less Expenses: 2410 Insurance 650 Lighting & heating 450 General expenses 120 Discounts allowed 130 1350Net profit 1060

Note that it is common to refer to the trading and profit and loss account as just the profit and loss account. This may be confusing initially but you will soon get used to the idea.

To summarise:

Gross profit = Sales - cost of goods soldNet profit = Gross profit - expenses

Opening stock

So far, we have looked at a firm that has only recently begun trading. If a firm has been trading for more than one accounting period then it is likely to have stock that remains unsold from an earlier period. This stock is referred to as opening stock.29

Opening stock is available for use and for resale, therefore we should add this on first when calculating he cost of goods sold. Opening stock, the stock in business sat the start of the current accounting period will be in the trial balance as a debit entry. Closing stock, however, is always outside the trial balance.

Stock in the trial balance

Opening stock Debit entryClosing stock As a note to trial balance

Carriage

Carriage refers to the costs of transporting goods to and from the firm. In most cases, the cost of transporting goods to the customers will be paid for by the customers, but on some occasions this will also be paid for by our firm. The terms used to refer to these types of transport and distribution costs are as follows:

Carriage inwards Cost of transporting goods form the suppliers (in)to the firm Carriage outwards Costs of transporting goods (out) of the firm to the customers

Each type of carriage will be an expense and therefore will have a debit balance in the trial balance. However, these will appear in different sections of the trading and profit and loss account.

Carriage inwards is connected with the cost of getting goods into the firm and ready for sale. As a result, it will be added on in the calculation for the cost of goods sold. Carriage outwards does not have anything to do with the cost of getting goods into saleable condition. Therefore it will appear with all the other overhead expenses and the profit and loss account.

Carriage inwards Trading account expenseCarriage outwards Profit & loss account expense

Returns

You may remember that earlier in the section on double-entry bookkeeping (1.1.1) we dealt with the idea that goods purchased and sold could be returned to wherever they originated. Sales could be returned back to us as returns inwards and purchases could be returned by us to the original supplier as returns outwards.

In this case, we should make adjustments in the trading account by adjusting the purchases and sales figures for these deductions.

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Returns inwards Debit balance Deduct from salesReturns outwards Credit balance Deduct from purchases

When adjusting the cost of goods sold for returns inwards and carriage inwards, there is no exact rule on which one should be adjusted first. The best advice is to decide on one method and stick to it - this way it will help you memorise it earlier.

Carriage outwards would appear as a normal expense in the profit and loss section

You must always be careful when drawing up a trading account. Questions may include some or all of the above adjustments. For example, returns inwards may appear without returns outwards. You should not write down an entry for each adjustment until you have verified that it will be included.

Balance sheets

Balance sheet - introduction

The balance sheet is a list of balances arranged according to whether they are assets, capital or liabilities, to depict the financial situation of the business on a specific date. It is often referred to as a 'snapshot' of the firm on a particular date - as if we had entered in the firm and taking photographs of the various components that make up the business. It can only be constructed on one date and not over a period of time as the values for assets and liabilities will change frequently.

The balances that are featured in the balance sheet would be the balances remaining on our trial balance after the trading and profit and loss account for the period has been completed. All the balances remaining have to be assets, capital or liabilities. All other balances would have been closed off when the trading and profit and loss account was completed.

The word 'account' generally indicates if something is part of the double entry system. Therefore, both the trial balance and the balance sheet are not part of the double entry system. No entries are made in the ledger accounts to record the fact that we have drawn up a balance sheet. All we are actually doing is listing the assets, capital and liabilities balances so as to form a balance sheet.

As with the trading and profit and loss account, there are two ways of presenting a balance sheet - horizontal and vertical. The vertical style will be adopted in this course although we will briefly show you what a 'horizontal' balance sheet is.

Balance sheet layout

Assetswill appear under two headings:fixed assetsandcurrent assets.

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Fixed assets can be characterised by the following features:

1. They are expected to last for at least one year (i.e. long-term) 2. They are to be used in the business to help generate income for the firm (e.g. they could

be used in production)

3. They were not bought specifically for resale - although they may be sold later

4. Examples of fixed assets would include land & buildings, machinery, fixtures & fittings.

Current assets can be characterised by the following features:

4. They have a short life within the firm (less than one year). 5. They can be converted into cash fairly quickly (i.e. they are liquid).

6. Their values will change frequently - stock levels fluctuate, banks balances move up and down, and debtors and creditors will alter as personal accounts are settled.

7. Current assets are stock, debtors, bank and cash.

The order that current assets appear is in relation to how quickly they can be turned into cash. This means that cash will appear at the bottom of the list because it is the most liquid of all the assets, closely followed by debtors, then stock.

As we know from the accounting equation, and our work on double entry bookkeeping, all transactions are considered in their dual affect on the business. The balance sheet is no exception. As the name suggests, there will be two 'sides' to the balance sheet which must, obviously, balance. A balance sheet which does not balance is an incorrect balance sheet.

Other balance sheet sections

Capital

Here we list the total resources that have been injected into the firm by the owner as at the end of the financial period under analysis. This figure will need to be adjusted for items which increase capital and items which decrease capital.

Net profits would be added to the capital balance, whereas net losses would be deducted.

Drawings are reductions in capital and therefore will always be deducted on the balance sheet.

Liabilities

Liabilities relate to any amounts of money that have been borrowed by the firm. Technically, capital is a special form of liability in that the business is 'borrowing' money and resources from

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the owner of the business. However capital will always be kept separate from the liabilities of the firm. Liabilities are split into two sections - defined below:

Long-term liabilities

Money owed by the firm which will not be repayable until after one year or more (e.g. bank loans and mortgages).

Current liabilities

This is money owed by the firm which will be repaid during the next year (e.g. creditors and bank overdrafts).

As stated earlier, we need the remainder of the balances from the trial balance which were not used in the construction of the trading and profit and loss account - we will use the previous example of D Balls.

D Ball - trial balance as on 31 December 2003

Dr (£) Cr. (£)Sales 6,000 Purchases 4,000 Insurance 650 Lighting & heating 450 General expenses 120 Machinery 2,100 Debtors 890 Creditors 980 Bank 1,970 Discounts allowed 130 Discounts received 110 Cash in hand 80 Drawings 700 Capital 3,000 Loan 1,000

11,090 11,090

Stock in trade as at 31 December 2003 was valued at £300

The lines in bold will be used in the construction of the balance sheet - note that closing stock appears in both the trading and profit and loss account as well as the balance sheet. The balance sheet drawn up on this date will look as follows:

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D Ball - balance sheet as at 31 December 2003

£ £ £Fixed assetsMachinery 2,100

Current assetsStock 300 Debtors 890 Bank 1,970 Cash 80 3,240

Less Current liabilities Creditors (980)Working capital 2,260

4,360 Less Long term liabilities Loan 1,000Net assets 3,360

Financed by:Capital 3,000 Add Net profit 1,060

4,060 Less Drawings 700

3,360

Notice the following features of the balance sheet:

1. The top 'half' of the balance sheet shows the following calculation:

£Fixed assets

+ Current assets - Current liabilities - Long-term liabilities = Net assets

2. Within the top 'half' there is the following calculation:

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£Current assets

- Current liabilities = Working capital

Working capital is a very handy concept used by businesses. Basically it shows us how liquid the firm is - has it got enough 'near' cash items (items that could be converted into cash quickly without losing their value) to pay its short-term debts (current liabilities). If this figure is negative then the firm may have problems in the near future.

3. The term 'Financed by' explains where the resources have come to finance the firm's operations - other than the borrowing that is. The capital figure here is adjusted by profits (or losses) and drawings made, to give us the new capital figure for the new trading period. The adjustments needed in the actual capital account would be as follows:

Capital

2003 £ 2003 £ 31 Dec Drawings 700 1 Jan Balance b/d 3,000 31 Dec Balance c/d 3,360 31 Dec Profit & Loss 1,060

4,060 4,06020041 Jan Balance b/d 3,360

Notice that profits add to the capital because they are credited to the capital accounts. Any net loss would be debited to the capital accounts. Drawings always reduce the capital balance and therefore are always transferred to the capital account at the end of the trading period on the debit side.

4. The section on long-term liabilities is not always present. Actually, if there are no long-term liabilities then this section can be missed out totally. Be careful though, some texts present the long-term liabilities as added on to the bottom half of the balance sheet. This should not matter, adding this section on to the bottom is exactly the same as subtracting the amount form the top 'half' of the balance sheet - jus be consistent.

Horizontal balance sheet

The horizontal balance sheet simply lists assets on the left hand side and capital and liabilities are the right hand side. Follow the link below to see how the balance sheet of D Ball would look as a horizontal balance sheet.

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Features of the VAT system

VAT - introduction

Value-added tax (VAT) is the sales tax used in the UK. This means that whenever we buy something from a high street shop, part of the selling price is likely to include an amount that will not contribute to the firm's profits but will be passed on to the government as tax revenue.

VAT is administered and collected by the HM Customs and Excise (a department of the UK government). Although some goods and services and small traders are exempt from VAT, most are taxed at a standard rate, which is 17.5%. A firm with a taxable turnover of more than a certain set amount is obliged to be registered for VAT and to make payments to the Customs and Excise department on a regular basis.

VAT is collected by all firms involved in the production of a good or service who then sell this on to another consumer (with a turnover of over £80,000 per year). It is possible that the consumer is actually another firm that wants to add something more to the product before selling it on to yet another consumer. For example, a manufacturer of microchips will add VAT on to the selling price of the microchips before selling them on to a computer manufacturer who will, in turn, add VAT on to the selling price of computers. Each firm adds this VAT onto the price it charges to consumers.

However, because firms are dealing with other firms in the buying and selling of inputs (materials and products to be sued in the production process) which are subject to VAT, the firms are allowed to 'claim' back VAT paid when purchasing inputs. Rather than having to collect VAT on any sales and also pay VAT on any purchases, firms can use the amount paid on purchases to offset (or reduce) the amount paid on any sales made. The final consumer of the product has no one to sell the product on to the final consumer will pay the full 17.5% VAT.

If you are given the net total for any invoice then the VAT on that invoice can be calculated by multiplying it by the following:

VAT on invoice = 0.175 x Net invoice total

Gross total for invoice = 1.175 x Net invoice total

The gross total will include the original net invoice amount plus the VAT due on that invoice.

VAT and discounts

Trade discounts do not appear in any of the ledger accounts and will only appear on the original invoices therefore trade discounts must always be first deducted before calculating the VAT total

However, adjustments must be made for cash discounts. The VAT will always be calculated on the net invoice total assuming that the cash discount will be obtained. Even if the payment for the 36

invoice is too late to qualify for the cash discount, the VAT will always be calculated on the assumption that the cash discount is taken.

Calculating Value Added Tax

If the firm sells or purchases goods for cash (i.e. for immediate payment) then VAT will still need calculating. However, this will not be recorded in anything other than the cashbook and the VAT account. On some occasions it is possible that the amount of VAT would have already been included and therefore the VAT will have to be calculated.

If an invoice is quoted at the gross amount (already calculated with VAT added on) then we will need to separate the amounts to calculate the net amount for the invoice and the actual VAT total. To find out how much VAT was added on (and therefore how much the original invoice was) we can use the following formula:

VAT total = 17.5 x Gross amount117.5

(Alternately, the formula can be reduced down to 7/47 instead but this makes no difference)

All that remains is for us to consider the double entry adjustments needed to record transactions containing VAT.

VAT and the double entry system

So far, all our double entry transactions have assumed that there is no VAT to be accounted for. However, we now need to adjust our adjustments to take VAT into account. When we buy or sell goods we know part of the selling price will include VAT (assuming that the firm is registered for VAT). This amount will need to be separated out from the actual net invoice total on both purchases and sales totals.

On May 8 2000, we sell goods on credit to A Westwood for £200, with VAT on this sale at £35. The total invoice for the sale will be £235. The entry in the sales daybook would appear as follows:

Sales daybook

2000 Net VAT Gross £ £ £

May 8 A Westwood 200 35 235

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Notice how the net and gross totals for the invoice (with and without VAT) are listed separately. This is important, as we will need both totals to make entries in the ledger accounts.

Example 2

Following on with the same example, on May 15 2000 we purchase £100 of goods from C Stringer. The VAT on this purchase would be £17.50. The entry in the purchases daybook would appear as follows:

Purchases daybook

2000 Net VAT Gross £ £ £

May 15 C Stringer 100 17.50 117.50

The general rules for entries for VAT on sales and purchases can be formulated form the above two examples. These will be as follows:

VAT on sales

Debit Credit Personal account

with gross invoice total

Sales account

with net invoice total

and

VAT account with amount due

VAT on purchases

Debit Credit Purchases account

with net invoice total

and

VAT account with amount due

Personal account

with gross invoice total

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VAT and returns

When dealing with returns, both inwards and outwards, then we cannot subject these to our VAT calculations. It would be unfair to have to VAT on goods sold that we actually returned to us by customers. Similarly, we cannot reclaim VAT on goods purchased that we end up returning to the original supplier.

If these examples were the only relevant transactions that had taken place during the month then we could balance off the VAT account at the end of the month to see how much VAT was due. This is done below:

VAT

£ £Purchases daybook 17.50 Sales daybook 35.00 Returns inwards daybook 8.75 Returns outwards daybook 3.50 Balance c/d 12.25

38.50 38.50Balance b/d 12.25

The credit balance indicates that the firm is liable for VAT of the amount £12.25. This is normally settled by a bank or cash payment. If the balance had been a debit balance then the firm could claim for a refund. However, because this is not normal, it is more likely that the firm would simply wait until the balance had 'slipped back' into credit.

VAT is not an expense. It is simply a tax payable. The double entry needed to clear the amount owing would be from either cash account or bank account. In our example this would look as follows:

VAT

£ £Cashbook 12.25Balance b/d 12.25

Cashbook

£ £VAT 12.25

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This gives us a simple way of memorising whether or not we owe VAT or are owed VAT. A credit entry in the cashbook implies a payment had been made. Therefore the debit entry in the VAT account from the cashbook must be there to clear the amount owing.

Until the amount has been paid, the VAT due should also appear as a current liability on the balance sheet (or as a current asset if it is a debit balance).

VAT and fixed assets

VAT is payable on expenditure relating to fixed assets purchases as well as other expenses related to the running of the business. Some firms will be able to reclaim the VAT paid on fixed asset purchases by offsetting it against the VAT payable on sales, in the same way that VAT paid on purchases is used.

For example, if a firm buys a machine for £5,000 and the VAT included amounted to £800, then the firm would only enter the net value of the machine in the assets account (i.e. Debit machinery £4,200) and the VAT would be entered in the account (Debit VAT £800).

If a firm cannot reclaim VAT on these items that the full value of the purchase will be entered into the asset account.

Example 6

Construct VAT account from the following information:

8. Sales for the month were £1,976 which included VAT of £350. 9. Purchases for the month were £1,666 that included VAT of £250.

10. Returns inwards for the month were £800 including VAT of £140.

11. Returns outwards for the month were £588 including VAT of £200.

Example 7

Construct extracts from the sales, purchases and both returns journals for the month of May 2001 and transfer the totals for the month to the VAT Account.

In each case VAT will need adding to the appropriate transaction and is set at 17.5%.

2001 May 1 Bought goods on credit: £700 from G Sibon, £500 from P Evans. May 8 Sold goods on credit from S Donnelly worth £700. May 12 Sent goods back to Sibon worth £450. May 14 Sold goods on credit to S Haslem worth £300. May 15 Goods returned to us by S Donnelly worth £200.

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May 21 Purchased goods on credit from P Evans worth £850 May 27 Goods retuned to us by Haslem worth £100. May 28 Sold goods to A Quinn worth £800. May 30 Goods returned by us to Evans worth £50.

The trial balance

When entering transactions in the double entry accounts we see that for every entry made on the debit side of the account there will always be a credit entry made in another account for the same amount of money. When we balance off the individual accounts in the ledgers, we should therefore find that the total of all the debit balances should be exactly equal to the total of credit balances. If the totals are not the same then a mistake must have been made in the bookkeeping.

To see if the two totals are equal we draw up a trial balance at the end of an accounting period. When the totals of the trial balance are equal we say that the trial balance totals agree.

The uses of the trial balance as follows:

It provides a check on the accuracy of the ledger account balances - ensuring that entries have been made correctly.

It makes preparation of the final accounts easier - we can simply use the balances from the trial balance, rather than having to refer to all the individual accounts.

Certain errors will be highlighted or avoided as outlined below.

The trial balance will ensure that the following errors are avoided or highlighted:

12. Only entering one half of the transaction (e.g. a debit but no credit entry) 13. Entering different figures for the two halves of the transaction

14. Entering two debits or two credits for a transaction

If any of the above errors have been made then the trial balance totals will not agree and investigative work can begin to see where the mistakes are. Technically, it could be possible for these errors to be made and the trial balance would appear as if the mistakes had not taken place. For example, if we missed out an entry of £50 on the debit side of an account and then later we missed out on another transaction a credit entry of £50, the trial balance totals would still agree. However as far as examination questions go, you will know when you are dealing with errors - it will be indicated in the question itself.

Even if the trial balance totals do agree this does not mean that the books are completely correct. These errors outlined here could have been made:

Entering correct figures in the wrong account (but on the correct side) Reversing entries so that both entries are made on the incorrect side of the each account

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Entering the incorrect total on both sides of the account.

We would need to know how to identify these errors, how to correct them and also how to recalculate the firm's profits if they have been affected.

A lot of students believe that the profit and loss account, and the balance sheet could not be constructed without a trial balance. This is not true. We would, if we wished, use the balances from each account. However this approach would take a lot longer and we would not have the check on the accuracy that the trial balance provides.

As a rule the entries for the trial balance will be as follows:

Type of account Entry Assets, expenses & drawings Debit Liabilities, revenues & capital Credit

The following is a trial balance for S Halls, which was extracted from the books on 31 December 2002

S Halls - trial balance as on 31 December 2002

Dr (£) Cr (£)Capital 1000 Cash 210 Bank 270 S Knight 66 Purchases 118 Office supplies 24 Sales 216 K Curnock 87 A Hynam 95 Returns out 12 Wages 140 Office fixtures 350

1294 1294

The title of any financial statement is very important. It should always contain the following three pieces of information:

Who it is for. In this case it is for S Halls.What it is. In this case it is a trial balance.When it is for. In this case it is as at 31 December 2002.42

Remember! Who? What? When?

In this trial balance we have the balances from three personal accounts. S Knight is a creditor of the firm (it is in the credit column - indicating that it is a liability). A Hynam and K Curnock are both debtors (in the debit column - indicating that they are an asset). Normally, debtors and creditors are listed in a trial balance as just 'debtors' or 'creditors', rather than as their individual names.

Also, if a firm has unsold stocks of goods left at the end of a period, these will be listed underneath the trial balance. This is because the account for closing stock is not part of the double entry system. However, any stock that was in the firm at the start of a period will be listed in the debit balances of the trial balance.

Bank reconciliation statements

The cashbook of the firm will show the cash payments and receipts that arise out of transactions. It will also show money being paid into and out of the firm's bank account. On a fairly frequent basis, the firm will actually receive a copy of a bank statement which is produced by the bank in which the firm holds an account with. This will detail the money paid into and out of our bank account. In theory, the bank column of the cashbook and the banks statement from the bank itself should be identical, they are, after all, the same account. However, in reality the two are unlikely to give us the same data, and the banks statement and the cashbook may well give us different figures for the balances.

This may seem worrying initially, how can this be? Surely something must have gone wrong. Well it is possible that a mistake has been made, but there are often sound reasons why the two balances are not the same. Let us consider possible explanations for any differences:

1. Error - by us or by the bank. 2. Items in the cashbook but no on the bank statement.

3. Items on the bank statement but not in the cashbook.

Of course, if the balances do not agree (i.e. are different) then we need to know why. In this case we can construct a bank reconciliation statement to show why they disagree and hopefully prove that no errors have been made. In fact, most examination questions on this topic will often ignore the prospect of errors and will concentrate on other reason why the balances are not the same.

The term reconciliation simply means to bring together. In this case, it involves a process where we actually try to show how the two balances are acceptable, given items in the cashbook and on the bank statement that do not appear in both.

Terminology used

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When dealing with bank reconciliation statements we will use new terms to refer to items appearing in the cashbook and on the bank statement. Terms will be used to describe cheques that we have both received and have paid out of our cashbook that have not yet appeared on the bank statement.

When we receive a cheque, or when we write out a cheque, we would normally enter this into the cashbook straight away. Therefore, from the firm's view, the money has already been paid or received. However in reality, this does not happened. Cheques will normally take a few days (assuming the cheque was deposited in the bank immediately - which may not happen thus further delaying the process) before they are cleared. Only when the cheque is cleared will the money be paid into the bank account (or paid out in the case of us writing cheques).

The ways in describing cheques in the clearing process are as follows:

Unpresented cheques

These cheques have been paid out by us (i.e. credited to the cashbook) but have not yet been deducted by the bank from the firm's account (they have not yet been 'presented' for payment).

Undeposited cheques

These cheques have been received by the firm (i.e. debited to the cashbook) but they have not yet been entered by the bank into the firm's account. It may also be that we have not yet physically taken the cheques to the bank and deposited them. These are also sometimes known as 'banking lodgements not yet cleared' or 'uncleared cheques'.

Dishonoured cheques

Sometimes the firm will receive a cheque from a customer that the bank will not give us money for. It will not honour the cheque and therefore the money will not be received as it stands. The reasons for this could be as simple as that a mistake appeared on the cheque (wrong date, not signed, discrepancies in amounts written, etc.) or it could be that the customer has insufficient funds in their account and the bank will not allow more to be paid out of their account. Any cheque more than 6 months old will not be honoured as it considered being 'stale'.

Bank accounts and direct transfers

In addition to the types of cheques that will appear on a bank reconciliation statement, there will also be items that will appear on the bank statement that are not yet in the cashbook. These will normally refer to items automatically paid into and out of our account without us first having entered into our cashbook. These items could include:

Standing orders

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This occurs when a firm sets up a process for a regular amount to be paid out of bank account. The amount does not change and is used by many firms making payments to either a firm or an individual.

Direct debits

Similar to standing orders, these involve amounts paid out of the firm's bank accounts. However, the amount paid out is not fixed and can be different. A firm normally will give another firm permission for it deducted amounts from the firm's accounts. Many bills are paid by direct debit arrangements.

Credit transfers

These involve amounts being paid directly into our bank account. They are normally from other customers, or other people who owe the firm money. Technically they could actually involve payments out of an account, but normally a credit transfer is used to refer to money paid into the account.

Bank charges

Firms may be charged money buy their bank for services they have used. This may be a one-off fee, or it could be a regular amount. A common example would be a charge for allowing the firm to go overdrawn on its account. These will be directly deducted from the firm's balance and will appear on the bank statement.

Interest

Interest may be both paid and received directly into the firm's bank account. If it is being paid out then it will normally be the charge for the firm being overdrawn on its account. As long as the firm keeps a positive balance of money in the account then any interest is likely to be received (most current accounts now give interest on positive balances).

Bank statements

A bank statement is a summary of recent transactions (usually one month) that have taken place in the firm's bank account. The balance on the account is normally displayed as a running total (i.e. the balance is adjusted as each transaction occurs). A sample bank statement may look as follows:

Bank statement

2003 (Dr) £ (Cr) £ Balance £ April 1 Balance b/f 1,970 Cr. April 3 Cheque 80 2,050 Cr. April 8 Cheque - 1145 270 1,780 Cr.

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April 16 Credit transfer: K Smith 35 1,815 Cr. April 23 Cheque - 1146 560 1,255 Cr. April 29 Bank charges 25 1,230 Cr.

April 30 Balance c/f 1,230 Cr.

The statement is always drawn up from the bank's point of view. This means that if we have money in the bank then from the bank's viewpoint, the bank owes us money. This is why the account is presented as a credit balance. If we were overdrawn (taken out more than we have in the account) then the balance would be a debit balance - i.e. we now owe the bank money. This can be confusing, because the cashbook will still be drawn up on the principles of double entry - debits involves money paid into the account, and credits involve money paid out of the account.

Notice how each cheque paid out of this account has a number attached to it - this refers to the actual number of the cheque - the person or firm it is paid to will not appear into the cheque.

Now we can compare the above bank statement with the firm's own cashbook. In this example we will only concern ourselves with the bank column of the cashbook, as this is the amount we are trying to reconcile with the bank statement.

Cashbook

2003 £ 2003 £ Apr 1 Balance b/d 1,970 Apr 11 T Lawton 270 Apr 6 L Preston 80 Apr 26 C Groves 560 Apr 28 J Mason 140 Apr 29 J Cowens 195

Apr 30 Balance c/d 1165 2190 2190

May 1 Balance b/d 1165

So we have a discrepancy. According to the bank statement we have £1,230 in the bank. According to our cashbook we only have £1,165.

To see if this can be explained, we will draw up a bank reconciliation statement.

Procedure for bank reconciliation

1. We need to eliminate items that appear in both the cashbook and on the bank statement, as these will not be the reason for the discrepancy.

2. The cashbook will need to be brought up to date by entering items found only on the banks statement and not in the cashbook.

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3. Draw up a reconciliation statement using the updated cashbook balance and items appearing in the cashbook that were not on the bank statement.

A bank statement was received by M Sim on 31 July 2002. It appeared as follows:

Bank statement

2003 (Dr) £ (Cr) £ Balance £ July 1 Balance b/f 650 Cr. July 3 Cheque 45 695 Cr. July 6 Standing order: A May 300 395 Cr. July 8 Cheque - 011654 290 105 Cr. July 12 Interest 5 110 Cr. July 22 Cheque - 011655 250 140 Dr. July 27 Cheque 560 420 Cr.

July 31 Balance c/f 420 Cr.

The cashbook for July 2003 appeared as follows:

Cashbook

2003 £ 2003 £ Jul 1 Balance b/d 650 Jul 11 P Willmott 290 Jul 6 L Wosko 45 Jul 25 M Goulding 250 Jul 21 J Thompson 230 Jul 29 S Davey 75

Jul 30 Balance c/d 310 925 925

May 1 Balance b/d 310

Bank statement balance = £420

Cashbook balance = £310

The procedure is always to add unpresented cheques and to subtract undeposited cheques from the updated cashbook balance. It is possible to start with the balance on the bank statement, in this case, undeposited cheques would be added and unpresented cheques would be subtracted.

The reconciliation has worked. This means that no errors have been made. If the two balances could not be reconciled then errors would have been present. The differences in the balances on 47

the cashbook and banks attempt can be explained and reconciled by firstly, updating he cashbook and secondly, by adjusting for cheques that have not yet shown up on our bank statement.

Bank reconciliation without updating the cashbook

It is possible to prepare a bank reconciliation statement without bothering to update the cashbook first. In this case, all the items that do not appear in both the cashbook and on the banks statement would go on the reconciliation statement.

If we use our previous example, then the reconciliation statement would appear as follows:

M Sim - bank reconciliation statement as at 31 July 2003

£ £Balance as per cashbook 310 AddS Davey (unpresented cheque)

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Interest received 5 Credit transfer 560 640

Less 950 J Thompson 230 Standing order 300 530

Balance as per bank statement 420

Other than for unpresented and undeposited cheques, there is no actual method of working out whether items found on the banks statement but not in the cashbook should be added or subtracted. It has to be worked out intuitively. Consider the following explanations for the above example:

1. Interest received - is not in the cashbook so if added on to cashbook figure then we will be closer to the bank statement.

2. Credit transfer - is not in the cashbook so if added on to cashbook figure then we will be closer to the bank statement.

3. Standing order has been deducted in bank, so if deducted from the cashbook figure we are more likely to get a closer approximation to the bank statement balance.

Control accounts48

For a small firm, the trial balance alone may prove sufficient in providing a check on the numerical accuracy of the ledger accounts. Whilst still useful, the trial balance will not necessarily speed up the location of errors.

If a firm operates ledgers for sales, purchases and general accounts then control accounts can be used as a further check on the accuracy of the ledgers. In effect, a control account is like a trial balance for each of the sales and the purchases ledger. If the control account does not tally with the accounts in each ledger, then an error will exist in that ledger.

Two control accounts

Sales ledger control account (also known as the total debtors account)

Purchases ledger control account (also known as the total creditors account)

Each control is a summary total of the respective ledger. It has the totals for all balances and all entries as found in the sales or the purchases ledger.

It is easier to imagine them as an overall debtor account (for the sales ledger account) or an overall creditor account (for the purchases ledger account).

Construction of control accounts

The information for constructing each control accounts are taken from both the personal accounts of debtors and creditors, as well as information form the main daybooks (e.g. sales daybook for total of credit sales). The main sources of information are found in the following locations:

Information for sales ledger control account

Information needed: Information located: Opening balance of debtors Debtor accounts in sales ledgerCredit sales Sales daybookReturns inwards Returns inwards daybookMoney received from customers CashbookDiscounts allowed General ledger or cashbook (3rd column)Closing balance of debtors Debtor accounts n sales ledger

Information for purchases ledger control account

Information needed: Information located: Opening balance of creditors Creditor accounts in purchases ledger

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Credit purchases Sales daybookReturns outwards Returns outwards daybookMoney received from customers CashbookDiscounts received General ledger or cashbook (3rd column)Closing balance of creditors Creditor accounts in purchases ledger

A control account will appear as if it is a personal account - with amounts relating to purchases and sales, returns, discounts as well as payments made and received. The examples below are to remind you of what a debtor and what a creditor account looks like:

Debtor accounts

Balance owing to us at start Cash/cheques received Credit sales made during period Returns inwards

Discounts allowed Balance owing to us at end (*1)

(*1 this is a debit balance but it is initially carried down from the credit side when the account is balanced off)

Creditor accounts

Cash/Cheques paid Balance owing by us at start Returns outwards Credit purchases made during period Discounts received Balance owing to by at end (*2)

(*2 this is a credit balance but it is initially carried down from the debit side when the account is balanced off)

Set-offs

Some firms may find that they have customers who are also suppliers. In this case, there will be an account for this firm or person both in the sales ledger (as a customer) and in the purchases ledger (as a supplier). It could appear to be common sense that rather than both parties send a cheque to each other, the amounts owing (both to and by the firm) should be partly offset against each other. If you owe someone £5 who also owes you £10, then it would be sensible for you to offset the debt and accept £5 in full settlement of both debts. This can also be achieved with firms and are known as set-offs.

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As a general rule, set-offs will appear in both control accounts and on the following sides:

In the sales ledger control account - on the credit side

In the purchases ledger control account - on the debit side

Memorandum records

For some firms, the control account will be used as a check on the numerical accuracy of the sales and purchases ledger. The control account in this case is not part of the double-entry system. In this case, the control accounts would be known as memorandum records - they are simply there as a back up to the normal double entry system.

However in some larger firms, all the control accounts are kept as an integral part of the double-entry system of bookkeeping. The personal accounts as found in the sales and purchases ledger would then become the memorandum records and would be used for information only. Here, the control accounts, as found in the general ledger, would be used for the trial balance and so on.

Benefits of maintaining control accounts

If the control accounts are kept purely as memorandum records then they are not necessary for the double entry system to function fully. However the control accounts will still have some uses for the firm and these are as follows:

1. If the control accounts do not balance then it is obvious that a mistake has taken place in the respective ledger. This will save time in the locating of the error. If we relied on the trial balance alone then we would have to check all the three main ledgers as well as the cashbook.

2. Control accounts can be kept by a person who is not he same person who maintains the personal accounts of debtors and creditors. In this case, fraud is less likely to occur (unless both the ledger clerks and the person maintaining the control accounts are in collaboration together!).

3. The debtors and creditor figures can be ascertained more speedily for construction of the trial balance, than having to balance off each individual personal account in the sales and purchases ledgers.

4. Errors not affecting the trial balance5. Given the many entries that are made in the ledger accounts, it is not surprising to know

that errors will be frequently made when making these entries. Most firms, even if using computerised system will make mistakes in the double entry accounts. Fortunately, there are various ways in which an account can be checked or verified, such s the use of control accounts, bank reconciliation statements and the trial balance.

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6. When errors are made, they will have an effect on the final accounts of the firm, possibly giving us an incorrect profit calculation. Understandably, it is important to correct these errors as soon as they are found.

7. In double entry bookkeeping, the trial balance can be used to check the accuracy of the ledger accounts. If the totals of the debit column and the credit column of the trial balance disagree (are not the same) then mistakes must have been made in the entries. However, even the totals agree (both columns total the same figure) mistakes may still have been made. There are various ways in which entries can be made which follows basic rules of double entry (one debit and one credit entry - both same amount) but still produce mistakes. The errors that do not affect the trial balance agreement are normally classified as follows:

Name of error Description of error 1. Error of omission Double entry is missed out (omitted) completely from

ledgers.2. Error of commission One half of entry is made in wrong personal account.3. Error of principle One half of entry is made in wrong type of account.4. Error of original entry Incorrect amount is entered in both halves of entry.5. Complete reversal of entries Debit entry is credited and vice versa - in correct

accounts and correct amounts.6. Compensating error Two or more errors cancel each other out in terms of

their affect on the trial balance.8.9. Once an error has been located, it will need to be corrected with both an entry in the

journal (regardless of the original transaction) and also in the ledger accounts. The following examples, illustrate the errors and the method of correction.

10. When we refer to incorrect amounts being entered in accounts, we often use the words 'overcast' to refer to when too much has been entered in an account, and 'undercast' when too little has been placed in an account.

Suspense accounts and the correction of errors

Many errors that are made will affect the trial balance agreement. These errors will normally consist of:

1. Entering different amounts in both entries of the transaction. 2. Making two debit entries (or two credit entries) for a transaction.

3. Only entering one entry for a transaction.

If any of these errors are made (one or more) then the trial balance totals will not agree. In this case, the errors should be located. However, this may take time - days, weeks or even months - the more errors that have been made, the longer their location will take. If the trial balance does not agree, then we would not be able draw up the profit and loss account and balance sheet correctly.

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As a part solution to this (finding the errors should always be a priority), a firm can, in effect, make the trial balance agree by entering the amount needed to make the two columns agree again. The difference between the two columns of the trial balance is filled with the creation of a new entry - this is entered in the suspense account.

Example

On 31 December 2007, the trial balance is drawn up for J Mickley. This is a summary of the trial balance:

J Mickley - trial balance as at 31 December 2007

Dr Cr £ £

Total of all entries 47,500 46,900

To allow us to construct the final account, we enter the amount, in this case, in the credit column, and the trial balance will now appear as follows:

J Mickley - trial balance as at 31 December 2007

Dr Cr £ £

Total of all entries 47,500 46,900 Suspense account 600

47,500 47,500

The entry in the trial balance has to be represented by an account. Therefore, we will now open up a suspense account with a credit balance of £600.

Suspense

2007 £ 2007 £ Dec 31 Difference in trial

balance 600

Normally, we would be now forced to make a debit entry in another accounts somewhere else in the ledgers. However, in this case we make no entry as there need for the credit entry in the

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suspense account must be the result of excess debit entries made, or shortages on the credit side elsewhere in the accounts - i.e. the mistakes that we are trying to locate.

This balance will remain in the accounts until the errors has been located and corrected. If we assume that the error that had been made was that the capital account had been undercast by £600 then this would explain why we appeared to have shortage on the credit column. However, it is possible that the error was that a debit entry (e.g. purchases) had been overcast by £600.

Let us assume that the error in our example, was due to Motor vehicles being overcast by £600, then the procedure to correct this would be as follows:

1. Enter up the correction in the journal 2. Enter the amendment to correct the error

3. Enter the other half of the transaction in the suspense account.

If the error affects the trial balance then one entry in the transaction needed to correct the error must be in the suspense account.

The error is found on Jan 15, 2008 - the motor vehicles had been overcast by £600. A credit entry in this account will correct the errors. Therefore, a debit entry will be made in the suspense account.

The Journal

Details Dr Cr £ £

Suspense 600 Motor vehicles 600 Motor vehicles account overcast - now corrected

Suspense

2008 £ 2007 £ Jan 15 Motor vehicles 600 Dec 31 Difference in trial

balance 600

Motor vehicles

2008 £ 2008 £

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Jan 15 Suspense 600

Notice that once the errors have been corrected, the balance on the suspense account disappears. While a balance remains, we know that there must be at least one error remaining undetected which affect the agreement of the trial balance.

Example 2

Your bookkeeper extracted a trial balance on 31 December 2004 which failed to agree by £180, a shortage on the debit side of the trial balance. A suspense account was opened for the difference. In February 2005, the following errors, made the previous year, were found:

1. Goods purchased on credit from E Lewis of £230 was entered correctly in the purchases account but was entered in the personal account as £320.

2. Advertising paid for £115 by cheque had been completely omitted from the books

3. Discounts received of £80 cash was entered on the debit side of both accounts.

4. Purchases daybook had been undercast by £250.

Errors affecting profits

Once the errors have been corrected, the firm will need to reconsider if the net profit needs calculating again. There are no general rules we can infer from the type of error and whether profit is or is not affected.

Let us use the previous example and take each error in turn:

1. This error does not affect profits as it is only in a personal account which is a balance sheet item.

2. We have missed out an expense of £115, therefore profits will be lower as a result.

3. Discounts received has been undercast by £160 and this will need adding on to the profits.

4. Purchases have been undercast which is an expense, therefore profit will be lower as result.

Example 3

Using the example, the net profit for 2005 was £1,780. This will need recalculating based on the errors mentioned above:

Statement of corrected net profit for 2004 as at 28 February 2005

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£ £Net profit b/d 1,780 Add:Discounts received 160

1,940 Less:Advertising 115 Purchases 250 365

Correct net profit for 2004 1,575

Computers in accounting

Uses and advantages and disadvantages of computers in accounting

Traditionally accounts were kept by the means of handwritten record. Computers have only begun to be used in some of the functions of accounting over the last fifteen years or so. As computers became cheaper, easier to use, and more powerful, more firms have decided to computerise their own accounting records. However, some firms, (albeit a declining number) still prefer to use handwritten accountings. This leads us to believe that there must be reasons for and against using computers in accounting.

What we need to consider here is how computers are used in accounting, and then we should be able to evaluate the potential uses and limitations of using computers in accounting.

How are computers used in accounting?

Most firms will make some use of a computer within accounting at some point. Some firms will have all their accounting performed by computers. What we need to understand is how the computer can be used.

Spreadsheets

A computer-generated spreadsheet is commonly used by firms when presenting their accounts. A simple spreadsheet will appear as a grid to which both numbers and text can be inserted. Each 'cell' of the spreadsheet can be used to insert data. A typical spreadsheet will appear as follows:

2000 2001 2002 2003 £ £ £ £

Sales 25,000 27,500 29,750 32,000 Cost of goods sold 13,000 14,500 16,900 17,500

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Gross profit 12,000 13,000 12,850 14,500

One of the attractions of using a spreadsheet is that the calculations can be done by the computer. Some data, such as sales and cost of goods sold would need to be manually typed in, but then the gross profit can be automatically calculated by inserting a formulae into the relevant 'cell' which states how the profit is to be calculated, Once inserted then the formulae can apply to the whole row (or whole column) which makes the process both easier and more less likely to be inaccurate.

Obviously the example above is a fairly limited illustration of how spreadsheets can be used but for many small firms, the use of a spreadsheet is the main way in which computers are integrated into the work of the accountant.

Accounting software

There are accounting software packages then can be purchased by a firm that will perform many, if not all of the tasks that would normally be manually entered by the person responsible for the firm's accounts.

These packages will be able to produce many of the accounting records that were previously produced by hand. Transactions may be entered into the computer package and many will produce the double entry records based on this one entry. Although the exact capabilities of each package will vary, it is possible that most, if not all of these packages will be able to produce invoices for purchases and sales. They calculate VAT returns, discounts and all the other areas of the accounting information system. Logically, these packages will also produce the final accounts for the business when required.

For larger firms this software can actually be tailor-made for the firm's own specific requirements. This sort of tailor made package is known as a 'bespoke' system. These packages are normally produced by a specialist computer software firm who have experience in producing accounting packages. Technically, these packages are available for any firm, but given the expense of a bespoke system and the general low cost of a 'off the shelf' system (one that can be used by any firm), most firms will simply purchase a general package.

Advantages of using computers within accounting

The main benefits of using computers (to any level within accounting) can be summarised as follows:

Increased accuracy

Computers are less likely to make errors. In fact they should not make errors at all. Things will still go wrong, but this is likely to be the fault of the person entering the data into the computer, rather than the computer itself making an error.

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Time saving

The use of a computer should be able to speed up the whole process of keeping accounting records. This is especially likely to be the case when the firm wishes to produce the final financial statements at the end of a period. The computer will be able to extract a trial balance (if necessary at all- perhaps this won't be needed?) and produce the trading and profit and loss account as well as the balance sheet almost instantaneously, based on the data already inputted.

Performance analysis

Once the data has been inputted, it is possible to manipulate the existing data to produce variations on the firm's overall performance. Even a simple spreadsheet can be manipulated to consider different scenarios. For example, a firm may wish to see the effects of am increase in sales of the overall profit level. A range of forecasted accounts can be generated to see how well the firm could expect to produce in the future (this is known as sensitivity analysis).

The data can be manipulated into accounting ratios automatically, which allow managers to assess the overall performance. For example, the profits can be related to sales, to capital or to assets to see how effectively the firm is operating.

Job satisfaction

The use of computers in accounting will free up time for the accountant to concentrate on more wide ranging tasks. This means that there is likely to be increased job satisfaction within he firm. Studies suggest that if workers are more satisfied or more motivated in the workplace, they are likely to be more productive in their output.

Disadvantages of using computers within accounting

The use of computers does not provide a perfect solution. There are drawbacks associated with the introduction of computers.

Cost

Computers have fallen in price over the last ten years. Also, computers are far more powerful then earlier models. However, the cost of the computer and of any associated software packages can still present a large item of expenditure for the small firm. The purchase will not affect profits, but will affect the firm's cash flow position. The cost of training staff will also have to be factored into the equation when deciding if and what sort of accounting package to purchase.

Reliability

Computers are generally very reliable but problems do occur. If the computer hardware (they physical computer and other devices used in the system) or the software develops a fault, then it

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is likely that the whole system will not able to be used until the fault can be addressed. This could be very problematic if the fault takes time to found and corrected.

Training time

It may take time for operators to be trained in using any accounting package on the computer. This requires personnel to be diverted form other areas that they may have been working on. However, this problem is becoming less important as newer software packages have become increasingly 'user friendly' (easier to use to even a novice).

Conclusion

The fact that nearly all firms make some use of computers in accounting suggests that the benefits outweigh the costs. Most firms have found computers a very valuable addition to their abilities in processing the vast amounts of finical data. However one can never underestimate the benefits of having a skilled human operator who understands the who accounting system and can reason and use intuition in a way that computer cannot.

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