V3.0.1 June 2020
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Bookkeeping: Introduction to
Bookkeeping
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Self-study Manual
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Contents
About this Manual ................................................................................. 7
Chapter 1 Financial Accounts Overview ........................................... 11
Introduction .............................................................................................. 11
Learning outcomes and study objectives ................................................ 11
Study advice ............................................................................................ 12
1.1 Types of Business Entity ............................................................................ 13
1.1.1 Sole traders .................................................................................... 13
1.1.2 Partnerships ................................................................................... 14
1.1.3 Limited company ............................................................................ 15
1.1.4 Limited liability partnership ............................................................. 16
1.2 Types of Accounts ..................................................................................... 20
1.2.1 Management accounts ................................................................... 20
1.2.2 Financial accounts .......................................................................... 20
1.3 Users of Financial Accounts ...................................................................... 24
1.4 Form and Content of Sole Trader Accounts ............................................... 27
1.4.1 Trading and profit and loss account................................................ 28
1.4.2 The trading account ........................................................................ 30
1.4.3 The profit and loss account ............................................................ 36
1.4.4 The balance sheet .......................................................................... 39
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1.4.5 Different types of business expenditure .......................................... 48
Review..................................................................................................... 52
Learning check ........................................................................................ 54
Learning check – answers ....................................................................... 56
Before moving on .................................................................................... 60
Learning outcomes and study objectives ................................................ 60
Chapter 2 Accounting Standards ...................................................... 61
Introduction .............................................................................................. 61
Learning outcomes and study objectives ................................................ 62
2.1 Accounting Standards ................................................................................ 63
2.1.1 FRS ................................................................................................ 63
2.1.2 Aim of accounting standards .......................................................... 64
2.1.3 HMRC advisory and forensic accountants ...................................... 65
2.2 FRS 102 ..................................................................................................... 68
2.2.1 The Qualitative Characteristics of Information ................................ 68
2.2.2 Accounting bases and concepts ..................................................... 74
Review..................................................................................................... 82
Learning check ........................................................................................ 83
Learning check – answers ....................................................................... 84
Appendix .......................................................................................................... 86
Before moving on .................................................................................... 88
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Chapter 3 Basic Bookkeeping Principles .......................................... 89
Introduction .............................................................................................. 89
Learning outcomes and study objectives ................................................ 90
Study advice ............................................................................................ 90
3.1 The Separate Entity Concept ..................................................................... 91
3.2 The Balance Sheet Equation ..................................................................... 92
3.3 The Dual Effect .......................................................................................... 97
3.3.1 The dual effect and the balance sheet equation ............................. 97
Review................................................................................................... 118
Learning check ...................................................................................... 119
Learning check – answers ..................................................................... 121
Before moving on .................................................................................. 125
Chapter 4 Double Entry Bookkeeping ............................................. 126
Introduction ............................................................................................ 126
Learning outcomes and study objectives .............................................. 127
Study advice .......................................................................................... 127
4.1 Types of Bookkeeping Systems ............................................................... 128
4.1.1 Single-entry system ...................................................................... 128
4.1.2 Double-entry system..................................................................... 132
4.2 Golden Rules of Double-entry Bookkeeping ............................................ 134
4.2.1 Golden rule number 1 ................................................................... 134
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4.2.2 Golden rule number 2 ................................................................... 135
4.2.3 Golden rule number 3 ................................................................... 135
4.2.4 ‘T' accounts .................................................................................. 139
4.3 Double-entry Bookkeeping – a Practical Example ................................... 145
Review................................................................................................... 164
Learning check ...................................................................................... 165
Learning check – answers ..................................................................... 168
Before moving on .................................................................................. 173
Chapter 5 Financial Accounts Preparation ..................................... 174
Introduction ............................................................................................ 174
Study advice .......................................................................................... 175
5.1 The Trial Balance ..................................................................................... 176
5.1.1 Balancing 'T' accounts .................................................................. 176
5.1.2 Preparation and presentation of a trial balance ............................ 193
5.2 Closing the 'T' Accounts ........................................................................... 200
5.2.1 Income and expenditure accounts ............................................. 201
5.2.2 Asset and liability accounts .......................................................... 207
5.2.3 Capital and drawings accounts ..................................................... 208
5.3 Financial Accounts Preparation ............................................................... 214
5.3.1 Trading account ............................................................................ 215
5.3.2 Profit and loss account ................................................................. 216
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5.3.3 The balance sheet ........................................................................ 222
Review................................................................................................... 227
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About this Manual
This introduction gives you some general information about the self-study manual
(SSM) on Bookkeeping – Introduction to Bookkeeping. It includes notes on the
content and some suggestions on how you can maximise your learning from the
material.
Assessment
All of the material in this manual is assessable. You can assume material outside
this manual, or only given as a margin note or in an appendix, is not assessable
unless we say otherwise.
You can find more details on the particular criteria you'll be assessed on in the
catalogue entry for the product.
You may have some prior knowledge and experience, which means that some topics
covered are already familiar to you.
If you think you can already meet the chapter's objectives you can assess yourself
by working through the learning check at the end of the chapter.
If you get any of the answers wrong, or are unsure about any points, we strongly
advise you to study the chapter. If you get all the answers correct and feel you can
meet the assessment criteria you may go straight to the assessment.
For some of the activities or learning checks you undertake you may want to record
your answers in a separate document.
Content of this manual
In this manual, you'll look at recording transactions in the books and records of a
business and preparing
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financial accounts from those books and records. You'll learn about the principles of
'double-entry' bookkeeping and go on to look at how accountants prepare and
present information in financial accounts.
This manual primarily uses the accounts of sole traders to explain bookkeeping and
accounting principles, but these principles also apply to the accounts of a partnership
or company. The way in which items are presented in the accounts may sometimes
be different with a partnership or a company and these differences in presentation
are covered in the manual Bookkeeping – Financial Accounting for Limited
Companies.
All extracts from accounting standards are:
© The Financial Reporting Council Limited and are adapted and reproduced with the
kind permission of the Financial Reporting Council. All rights reserved. For further
information please visit https://www.frc.org.uk/accountants/accounting-and-reporting-
policy or call +44 (0)20 7492 2300.
Chapter 1 – Financial Accounts Overview
Explains the form and content of financial accounts.
Chapter 2 – Accounting Standards
Outlines the purpose of accounting standards and their role in the preparation of
financial accounts.
Chapter 3 – Basic Bookkeeping Principles
Considers the three basic principles which are fundamental to understanding double-
entry bookkeeping.
Chapter 4 – Double-Entry Bookkeeping
Explains and demonstrates the application of the double-entry bookkeeping system
in detail.
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Chapter 5 – Financial Accounts Preparation
Shows how to prepare a trading and profit and loss account and balance sheet for a
sole trader.
Assessment preparation
This SSM includes some assessment-standard questions at the end for you to
practise on before the assessment. The questions give a suggested timing and you
might like to work them as far as possible under exam conditions. You can then
compare your answer to those given.
Time to complete
We estimate it should take you this long to finish the manual.
Reading main text 7hrs 35m
Completing activities and the learning check 9hrs 35m
Completing and reviewing assessment standard questions 1hr 30m
Total 18hrs 40m
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Other tax professional learning products (TPLPs)
Within this manual you will see references to some other TPLPs which you may find
useful.
We've listed these below, together with their product codes.
Module Manual Online product
code
Bookkeeping Financial Accounting for Limited Companies 0013875
Bookkeeping Accounting Standards and Year End
Adjustments
0013848
Bookkeeping Extended Trial Balance 0013858
Company Tax The Return – Manual 2 0013507
ITSA Business Income 0016342
Known issues
Whilst we aim to ensure that all our products are free from errors, mistakes
sometimes occur.
Before you start studying this manual, please look at the entry for the module in the
TPLP catalogue and click on the 'known issues' link. This will give you a list of any
known errors so you can make the necessary corrections yourself.
Please continue to feed back any other errors you spot to the Maintenance team
mailbox.
DL-TA, Maintenance Mailbox (HR)
Feedback
We value your feedback. The TPLP Maintenance team would like to hear from you if
you have any comments to make about this manual or can suggest how we could
improve it. Please send your feedback to the dedicated Maintenance team mailbox
address given above.
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Chapter 1 Financial Accounts Overview
Introduction
In this chapter, you'll look at the main business entities you'll come across as an
HMRC officer. You'll then look at the types of accounts which they may prepare and
who may be interested in the results they show. Finally, you'll look at the form and
content of a sole trader's financial accounts.
Learning outcomes and study objectives
Learning outcomes
You will
• understand the main types of business entities, the accounts they may
prepare and who may use them
• understand the form and content of sole trader accounts.
Study objectives
To achieve this, you need to be able to
• describe the main types of business entity
• explain the difference between management and financial accounts
• name four users of financial accounts
• describe the form and content of sole trader accounts
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Study advice
We think it will take you approximately this long to finish the chapter.
Reading main text 1hr 45m
Completing activities and the learning check 1hr 20m
Total 3hrs 5m
This is only a guide. The important thing is for you to make sure you understand all
the material in the chapter.
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1.1 Types of Business Entity
The basic bookkeeping principles are the same for all the main types of business
entities you'll come across as an HMRC officer.
These are
• sole traders
• partnerships
• limited companies
• limited liability partnerships (LLPs)
Before you go on to look at bookkeeping, let's look at the differences between the
main types of business entities.
1.1.1 Sole traders
Many people start their business life as a sole trader. The sole trader (proprietor) is
responsible for the day–to–day running of the business and its success or failure.
A sole trader business can vary in size – from one where the proprietor carries out all
the work themselves, to a large concern employing many people.
A sole trader can start up in business with a minimal amount of personal investment
(capital) from their own savings. Or, they may borrow start-up capital from a bank or
other lender.
Advantages
• Fewer legal requirements than limited companies or partnerships.
• Proprietor has complete control of business.
• Can offer a personal service to customers.
• Can make business decisions quickly – no-one to consult.
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Disadvantages
• Unlimited personal responsibility for business debts.
• Potentially difficult to obtain further investment capital.
• Inability to match pricing and marketing of larger competitors.
1.1.2 Partnerships
Reference - BIM 72001
Partnerships are governed by the Partnership Act of 1890 which states that
“a partnership is the relationship which subsists between persons carrying out a
business in common with a view to profit”.
This refers to two or more people in business together. The organisation is usually
more formal than a sole trader's. Partnerships can vary in size – from a husband and
wife trading as a corner shop, to a large firm of solicitors.
Partners may have a partnership deed – a legal agreement setting out the rights and
obligations of each partner. They will also have an agreement setting out how the
profits of the business will be allocated between the partners.
A partnership isn't a legal entity separate and distinct from its members, except in
Scotland.
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Advantages
• The risks of the business are shared with others.
• A partner may bring capital or new skills into the business allowing it to
expand or change.
• A partnership may increase efficiency, for example by sharing common
expenses and reducing duplication.
Disadvantages
• Joint and several liability. The partners' liability is unlimited. Each may have
to contribute own funds up to the full amount of any debts incurred by the
partnership. (Does not apply to individual partner's income tax liability).
• Profits are shared with the other partners in accordance with the profit sharing
agreement.
• No-one has complete control as each partner will usually have a say over the
way the business is run.
1.1.3 Limited company
In this manual, you'll look at companies with limited liability that are registered under
the Companies Act.
Private limited companies have 'limited' or 'ltd' after their name. Public limited
companies have 'plc' or 'public limited company' after their name. Unlike private
limited companies, plcs can offer their shares for sale to the general public.
Companies are owned by their shareholders – the people who have invested in the
company by subscribing for shares. The larger the company, the greater the number
of shareholders (or members) is likely to be. The operations of the company can't
be managed by large groups of people, so the shareholders appoint directors who
are responsible for the day–to–day running of the company.
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The directors are officers of the company.
In law, a company is regarded as a legal entity in its own right, separate and distinct
from its shareholders and directors.
Limited companies can vary in size, ranging from a small company with just one
director, to a large multinational enterprise.
In many small private companies, the directors are the majority shareholders and
have considerable power over the day–to–day operations of the company.
In larger companies with more shareholders, a board of directors takes decisions so
that each director will have less individual power.
Advantages
• Limited liability. Shareholders are only liable up to the amount they have to
pay for their shares in the company.
• Companies can raise investment capital through the issue of shares.
• Tax advantages not available to sole traders and partnerships.
Disadvantages
• Subject to more stringent control and legislation than sole traders or
partnerships.
• Companies over a certain size have to undergo a statutory audit.
• Directors may need to consult with other directors or shareholders.
1.1.4 Limited liability partnership
The Limited Liability Partnerships Act 2000 introduced limited liability partnerships
(LLP) from 6 April 2000. They combine the flexibility of partnerships with the benefit
of limited liability for their members. An LLP has features like a company, but its
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income and gains are usually taxed on its members as if they were partners in an
ordinary partnership.
An LLP must be registered at Companies House. It must publish its accounts and is
regarded in law as a separate person from its members.
Advantages
• The LLP isn't usually taxed. LLP members are normally taxed on their share
of the profits.
• Retains the day–to–day flexibility of a partnership.
Disadvantages
• An LLP has greater legal and financial responsibility than an ordinary
partnership.
• Not entitled to the tax advantages available to limited companies.
From 6 April 2014, new rules apply to members of LLPs who are engaged on terms
that are closer to employment than to self-employment, but who have previously
been treated as self-employed.
Members who meet a statutory test will be treated as employees ('salaried
members') for tax purposes. The salaried member will move from self-assessment to
PAYE and the LLP (the employer) and the salaried member will become liable to
Class 1 NICs.
Now have a go at the activity that follows.
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Activity one
Check your understanding of sole traders, partnerships and companies by
completing the following table. Some of the statements may apply to more than one
entity, so mark X in each box that applies (or record your answer in a separate
document).
All the entities are in England or Wales.
Options Sole trader
Partnership
(not LLP)
Limited company
It provides limited liability for owners.
Owners have joint and several liability for
debts of the business.
Owners make the day–to–day
operational decisions.
The business is owned by shareholders.
It's a distinct legal person separate from
its owners.
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Response
(Options first followed by answer)
• It provides limited liability for owners – Limited company.
• Owners have joint and several liability for debts of the business – Partnership
(not LLP)
• Owners make the day–to–day operational decisions* All – Sole trader,
Partnership (not LLP) and Limited company’
* Although the owners (shareholders) of limited companies don't usually make
the day–to–day operational decisions, we have ticked the limited company
box for the third statement because in many small private companies the
directors are the majority shareholders and have considerable power over the
day–to–day operations of the company.
• The business is owned by shareholders - Limited company.
• It's a distinct legal person separate from its owners - Limited company.
Next you'll look at the main differences between management and financial
accounts.
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1.2 Types of Accounts
In this subchapter you will consider the main differences between management and
financial accounts.
1.2.1 Management accounts
There is no legal requirement to produce management accounts, but businesses
often find that they're a useful tool to ensure they're running successfully.
Management accounting mainly involves preparing accounting information for the
proprietor or management of a business to help them control their business. They
may also include an element of forward planning. This helps them to make more
informed decisions for the future, for example, about future sales and profitability
forecasts.
Management accounts have no specific format because it depends on what areas
are critical to the success of the business. For example, manufacturing companies
are interested in the management of their stock levels; they need to ensure that the
business has sufficient stock on hand to meet all orders, whilst reducing the risk of
stock going out of date.
1.2.2 Financial accounts
Financial accounting involves
• the day-to-day recording of the economic transactions of a business – the
bookkeeping
• preparing financial accounts from the bookkeeping records.
When a business prepares financial accounts, they should ensure that all
transactions have been properly recorded, and the information in the accounts is
relevant to the various users of the accounts. Financial accounts should therefore
be prepared and presented in a consistent manner.
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Accountants are expected to follow legislation and other principles when preparing
financial accounts. We've given a brief overview of these principles in chapter 2 of
this manual.
Companies have to produce financial accounts to comply with the Companies Act. It
isn't a statutory obligation for other types of business to do this, but most do.
Financial accounts are prepared for an accounting period – usually 12 months. They
allow the users of the accounts to review the past performance and current financial
position of the business. You'll look at this in more detail in the next subchapter.
Differences between management accounts and financial accounts
Some of the main differences between financial and management accounts are
summarised in the below.
Financial accounts
• Prepared and presented in a consistent manner for an accounting period,
generally a 12-month period.
• Usually a summary of the entire business operations.
• Comply with basic accounting concepts and are governed by specific rules
and regulations.
• Prepared from the business's bookkeeping records.
• Primarily concerned with the history and current financial position of the
business.
Management accounts
• May be prepared more frequently (monthly or quarterly).
• May focus on specific operations within the business.
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• Comply with basic accounting concepts but are not governed
• by specific rules and regulations.
• May include information from other sources.
• May also include an element of forward planning.
Now try the activity that follows.
Activity 2
Jake is a self–employed electrician. He's been trading for
30 years. He obtains most of his work through recommendations from his customers
and by advertising in the local paper. His turnover is relatively low, but his expenses
are low; he's single and paid off his mortgage years ago. He intends retiring in 2
years’ time.
Based on this information, explain why you think Jake is unlikely to prepare
management accounts for the current year.
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Response
Based on this information there are various reasons why Jake is unlikely to prepare
management accounts for the current year. You may have thought of other reasons
as well as the ones we've shown below.
There is no legal requirement to produce management accounts, but businesses
often find that they're a useful tool to ensure they're running successfully. Jake's
business has been running satisfactorily for many years without them.
Management accounting mainly involves preparing accounting information for the
proprietor or management of a business. Management accounts enable proprietors
or managers to control their business. Jake's business is small enough not to need
this level of control. For example, he wouldn't have to draw up management
accounts to ensure his stock is adequately controlled.
Management accounts may also include an element of forward planning about future
sales and profitability forecasts. As Jake is going to retire soon this isn't likely to be
necessary.
Next you're going to look at the parties who would be interested in a trader's financial
accounts.
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1.3 Users of Financial Accounts
Financial accounts are not just prepared for HMRC. Other parties are also
interested in the business results shown in the financial accounts. Let's look at some
of them.
Business owner/proprietor
Most business owners know how well their business is doing. However, because of
all the costs involved in running a business it can be difficult to know exactly how
much the business is making. This is one of the reasons why financial accounts are
prepared. The business owner may also use them to make business decisions, such
as whether to expand the business.
Financial institutions
Businesses may ask the bank, or other lender, for a loan or overdraft facilities. The
lender's decision to make the loan will be based on a number of factors but one of
the most important will be the results shown by the financial accounts.
The lender will use the financial accounts to see if the business is profitable and
whether it can pay the interest and charges (service the loan) and repay the capital
borrowed.
Some businesses will prepare accounts in a certain way simply to keep the
financiers happy. You shouldn't overlook this factor when you examine accounts.
For some business owners, keeping the financiers happy is more important than
worrying about HMRC. If the lender doesn't continue to provide funding, the
business may close.
Suppliers
Most businesses obtain goods on credit. The business may have to demonstrate its
ability to pay the bills by producing the latest set of financial accounts. The supplier
will use the information in the same way as any other lender.
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Shareholders
Companies attract investment by encouraging people to subscribe for shares in the
company. The shareholders (investors) may hope to get a return on this investment
without having to sell the shares. They get this return in the form of a dividend paid
on their shares. The amount depends on how much profit the company has made
and how much it's prepared to pay out. It also depends on how much the company
needs to retain in the business to finance its future development.
Shareholders are interested in financial accounts because they can find out
• whether the value of their investment is increasing or
• the likely level of income from their shareholding.
Government departments
HMRC makes the most use of financial accounts, but other government departments
may also be interested. For example, DEFRA may look at a farmer's accounts when
considering subsidies and other payments.
Now have a go at the activity that follows.
Activity three
Dmitri is a self-employed joiner. He buys any wood he uses on credit from the local
timber yard. He wants a loan from his bank to buy new equipment.
Explain why his supplier and his bank want to see his latest set of financial accounts.
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Response
Dmitri's supplier and the bank want to see his latest financial accounts for similar
reasons.
The supplier wants to see Dmitri's latest financial accounts so they can see if he's
able to pay their bills.
Dmitri's bank want to see his financial accounts to help them to decide whether to
lend him the money he needs to buy the new equipment. They'll use the information
in the financial accounts to see if Dmitri's business is profitable and whether he can
service the loan and repay the capital he wants to borrow.
Next you'll find out about the general layout of financial accounts.
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1.4 Form and Content of Sole Trader Accounts
In this subchapter, you're going to look at the form and content of sole trader
accounts and their general layout. The financial accounts shown on the following
pages are typical for a sole trader although many of the entries in the accounts
would be very similar if the business was a small partnership or limited company.
However, accountants present financial information in different ways, particularly for
certain types and sizes of businesses. They may provide more pages and
information than shown in the example, or less if the business is a small concern.
At this stage of your learning, you need only a general idea of the layout and content
of financial accounts.
There are two primary financial statements which are fundamental to any set of
accounts, and they are the
• trading and profit and loss account, and
• balance sheet.
The Financial Reporting Standard Applicable in the UK and Republic of Ireland (FRS
102) uses terminology commonly used in International Accounting Standards, in
contrast to terminology used in the UK Companies Act.
For example, balance sheet and profit and loss account are Companies Act terms.
The equivalent terms used in FRS 102 are statement of financial position and
income statement.
FRS 102 allows businesses to retain the Companies Act terminology as long as it's
not misleading. You are therefore likely to see different terminology being used by
different businesses to refer to the same items in accounts.
In this manual, we have used the terminology that we expect most UK
businesses/companies will continue to use. For example, we will continue to refer to
the balance sheet and profit and loss account throughout.
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1.4.1 Trading and profit and loss account
The trading account and the profit and loss account are referred to separately and
together in this manual. You calculate the gross profit in the trading account. In the
profit and loss account, you take the gross profit and deduct overheads (or other
expenses) to arrive at the net profit.
The trading account and the profit and loss account can be considered together to
form one statement known as the trading and profit and loss account.
The trading and profit and loss account is a summary of the trading and business
activities for the whole of the accounting period. It shows whether the business is
making a profit or a loss and reflects the performance of the business for the whole
of the period concerned. It provides details of the income generated by the business
and the expenses incurred in earning this income.
A business's financial year can end on any date. It doesn't have to coincide with the
end of the calendar year or the tax year.
On the following page, you'll find the trading and profit and loss account for Harry's
newsagents business for the 12-month period 1 June 2018 to 31 May 2019. We'll
refer to Harry's trading and profit and loss account, and balance sheet, throughout
this subchapter.
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Here we have Harry’s Newsagents Profit and Loss Account document for the
year ended 31 May 2019. (This is set out in 5 columns).
Description 31 May 2019
31 May 2019
31 May 2018
31 May 2018
Turnover 116,558 114,897
Less cost of sales
Opening stock 11,476 9,625
Plus purchases 94,180 92,938
Less closing stock 105,656
102,563
(11,143) (11,476)
(94,513) (91,087)
Gross profit 22,045 23,810
Less overheads
Rent, rates and insurance 2,059 4,591
Light and heat 609 1,105
Telephone 1,167 1,014
Motor expenses 1,730 1,377
Accountancy fees 300 300
Interest paid 1,280 2,199
Wages 1,175 512
Bank charges 160 844
Depreciation 454 (8,934) 583 (12,525)
Net profit 13,111 11,285
You'll see that 2 years' accounts are shown here – the year ended 31 May 2018 and
the year ended 31 May 2019. This is usual and allows anyone viewing the accounts
to compare the results for the latest period with those of the previous period.
Next you'll look at the entries in the trading account in more detail before considering
what would be shown in the profit and loss account.
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1.4.2 The trading account
The trading account reflects the trading results of the business for the year – whether
the business is making a gross profit or loss on the goods or services it provides.
The trading account normally shows
• the turnover of the business
• the purchase of goods and materials used in the business
• the opening and closing stock.
You'll now look at each of these items in turn.
Turnover
Turnover is the term used to describe the income of the business. You'll also often
see this described as sales. Alternatively, some accountants may use the following
terms
• revenue
• fees
• income
• work done.
In Harry's newsagents business, the turnover will be the amount earned through the
sale of newspapers, magazines, confectionery and so on.
If a business is a service trade, for example, a plumber or an electrician, the figure of
turnover will be made up of the charges for the trader's own labour together with any
charge for materials supplied by the trader.
Have a go at the activity that follows.
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Activity four
a) During a year, Enzo, a plumber, charged his customers £800 a week for his time.
He worked for 48 weeks during the year.
Calculate Enzo's turnover from his labour.
b) Enzo incurred £10,000 on purchases in the year on items such as boilers,
radiators and bathroom suites and supplied these items to his customers. He
charged his customers £11,000 for these items.
Calculate Enzo's total turnover from his labour and the materials he supplied.
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Response
a) Enzo's income from his labour charges is
48 weeks x £800 = £38,400.
b) Enzo has also supplied materials to his customers for £11,000. He therefore has a
total turnover of £49,400.
In chapter 2 of this manual, you'll look at the income which should be included in
turnover and when it should be recognised in the financial accounts.
Purchases
In general terms, purchases is the term used to describe goods that the business
has acquired to sell to its customers. In Harry's case, the likely purchases would be
newspapers, magazines, confectionery and so on.
In a non–retail trade, it may also be the materials a business uses. For example, a
plumber may include piping, washers and so on, as purchases.
Stock
Stock represents purchases that have been made by the business, but which have
not yet been sold. Financial accounts for an ongoing business will normally show
two entries for stock
• opening stock, and
• closing stock.
Opening stock is the value of stock on hand at the start of the accounting period.
Closing stock is the value of stock at the end of the accounting period.
In an ongoing business, the figure of closing stock at the end of one year becomes
the figure of opening stock for the following year. In Harry's case, the closing stock
of £11,476 at 31 May 2018 is the opening stock figure in the accounts to 31 May
2019.
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Businesses need to keep accurate records of their stock, and the valuation of stock
should ideally be arrived at by a physical count of stock on hand. You'll look at stock
valuation and accounting for stock in the manual Bookkeeping – Accounting
Standards and Year End Adjustments.
Businesses use the figures for purchases and stock to calculate the actual cost of
sales. Let's look at this next.
Cost of sales
Cost of sales (COS) is also commonly referred to as cost of goods sold (COGS). In
general terms, cost of sales represents the goods that the business sold to generate
the figure of turnover.
Cost of sales is therefore usually shown in the trading account as follows.
Example
Look at Harry's trading account for the year ended 31 May 2018 and you'll see that
cost of sales of £94,513 is made up of
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Direct costs
The cost of goods sold is a direct cost in the trading account. You may also see
other direct costs included there. Generally, these relate specifically to the core
business activity of producing goods or providing a service.
Example
Roger is a building contractor. Several self-employed subcontractors work for him
and he also employs a secretary.
The wages paid to the subcontractors are direct costs and are included in the trading
account. The wages paid to the secretary are indirect costs. They're included in the
profit and loss account. The secretary isn't directly involved in the building work that's
the core business activity.
Gross profit
Gross profit is the amount of profit earned by the business from its main trading
activity. Basically, it's the difference between turnover and the cost of sales.
Harry's business made a gross profit of £22,045 for the year ended 31 May 2019.
This is the difference between the income earned from selling goods, and the
expenditure incurred on purchasing the goods that were sold.
This principle applies to most retail trades.
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Here we have an extract from Harry’s trade account
Harry's trading account for the year ended 31 May 2019
Description £ £
Turnover 116,558
Less cost of sales
Opening stock 11,476
Plus purchases 94,180
Sub-total 105,656
Less closing stock (11,143)
Sub-total (94,513)
Gross profit 22,045
The figure of gross profit is then carried forward to the profit and loss account.
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1.4.3 The profit and loss account
The trading account shows the result of the main trading activity for the year, in other
words the gross profit. In addition to the cost of sales, most businesses incur
additional day–to–day running costs (sometimes called overheads or indirect costs).
These costs don't normally form part of the cost of sales of the business so they
should be in the profit and loss account, rather than in the trading account.
Harry's newsagent's business incurred additional expenditure on everyday items
such as rent, lighting and heating costs, motor expenses and so on. These are
included in his profit and loss account.
The entries in Harry's profit and loss account are fairly small and easy to identify. In
larger company accounts with substantial overheads, the entries in the profit and
loss account are likely to be presented in a different way. You'll find out about the
format of company accounts in the manual Bookkeeping – Financial Accounting for
Limited Companies.
You deduct the expenditure in the profit and loss account from the gross profit to
arrive at the net profit for the period of trading.
Now have a go at the activity that follows.
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Activity five
Use the following information to calculate both the gross profit and the net profit.
Description Amount £
Purchases 38,000
Turnover 96,000
Opening stock 3,200
Motor expenses 3,500
Insurance 1,250
Closing stock 3,600
Accountancy fees 650
Bank interest paid 150
Rent 1,750
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Response
By following the general layout of financial accounts that you looked at earlier, the
gross profit and net profit can be calculated as follows.
Description £ £
Sales/Turnover 96,000
Less cost of sales
Opening stock 3,200
Plus purchases 38,000
Less closing stock (3,600)
(37,600)
Gross profit 58,400
Net profit is arrived at by deducting the day–to–day running expenses (overheads)
from the figure of gross profit.
Description £ £
Less overheads
Rent 1,750
Motor expenses 3,500
Insurance 1,250
Accountancy fees 650
Bank interest 150
(7,300)
Net profit 51,100
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1.4.4 The balance sheet
The balance sheet sets out the financial position of the business at the accounting
date and reflects the position at that moment in time only. In other words, it's a
'snapshot' of the financial position of the business at the balance sheet date. The
trading and profit and loss account on the other hand is a summary of the
performance of the business for the whole period, from the last accounting date to
this one.
In practice, many small businesses don't produce a balance sheet with their
accounts. This isn't necessarily a cause for concern. It usually just means that the
business is fairly small, and it's not cost–effective to produce a balance sheet.
In all the examples in this manual, you should assume that the business prepares a
balance sheet, as this is fundamental to understanding the bookkeeping.
Harry's balance sheet as at 31 May 2019 is shown on the following page.
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Harry’s Newsagents
Balance sheet as at 31 May 2019
Description 2019 2019 2018 2018
Fixed assets
Motor vehicles 928 1,237
Fixtures and fittings 820 965
Shop premises 50,000 50,000
Sub-total 51,748 52,202
Current assets
Stock 11,143 11,989
Cash on hand 501 265
Trade debtors 215 248
Sub-total 11,859 11,989
Current liabilities
Creditors (3,200) (4,741)
Trade creditors (3,233) (3,025)
Net current assets 5,426 4,223
Total assets less current
liabilities
57,174 56,425
Long term liabilities
Loan account (11,759) (16.336)
Net assets 45,415 40,089
Capital account
Opening capital 40,089 36,256
Profit for the year 13,111 11,285
Capital introduced 0 648
Less drawings (7,785) (8,100)
Closing capital 45,415 40,089
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If you look at Harry's balance sheet, you'll see that it's divided into three main parts.
• Assets
• Liabilities
• Capital account
Assets
Broadly speaking, assets are items that are owned by the business or owed to the
business. Assets of a business are usually broken down into two categories, fixed
assets and current assets.
Fixed assets
A fixed asset is an asset which is acquired for use in the business, without the asset
itself being sold in the day–to–day activities of the business. Fixed assets are owned
by a business over a period of time and are used to generate income of the
business.
Harry's fixed assets consist of a motor vehicle, fixtures and fittings and the shop
premises.
These items are used in the business, without actually being sold as part of the
trading activity of his newsagents business. Generally, fixed assets are shown at
cost less a provision for accumulated depreciation to allow for wear and tear,
passage of time or becoming out of date.
You'll look at depreciation and the valuation of fixed assets in the manual
Bookkeeping – Accounting Standards and Year End Adjustments.
Current assets
Generally, the value of current assets changes on a day–to–day basis. Current
assets can usually be turned into cash in a short period of time and include items
such as cash itself, stock, funds held in a bank account and debtors.
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A debtor is someone who owes money to the business. More specifically, a trade
debtor is a customer to whom the business has supplied goods or services, but who
has not yet paid the business what they owe. In Harry's case, the figure of trade
debtors will almost certainly represent small amounts still owed by customers for
newspaper accounts on the last day of the accounting period.
Liabilities
Broadly speaking, a liability is something the business owes. Harry's liabilities
include a loan and an amount owed to creditors. In general terms, a creditor is a
third party to whom the business owes money for goods or services provided to the
business on credit. A trade creditor is a supplier from whom the business has
purchased goods on credit terms for resale. Liabilities are also broken down into two
categories – current liabilities and long-term liabilities.
Current liabilities
A current liability is usually something a business owes that it will need to pay within
12 months of the accounting date. Typical current liabilities might include creditors,
short–term loans, VAT or PAYE owed to HMRC or even an overdrawn bank current
account.
Long-term liabilities
Long-term liabilities usually relate to liabilities that are repayable after more than 12
months, typically amounts owed on long-term loans and mortgages.
Capital account
A business is a separate entity from the proprietor. The capital account represents
what the proprietor has invested in the business and shows what the business owes
to the proprietor.
For accounting purposes, the proprietor and the business itself are treated
separately. When Harry started in business many years ago, he used £5,000 of his
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own personal cash to open his newsagents shop. Harry put his own capital into the
business. Until he withdraws any of that capital, it remains in the business and is
owed by the business to Harry.
Harry's capital account is shown below. Look at the other entries appearing in it.
Capital account 2019 2018
Opening capital 40,089 36,256
Profit for the year 13,111 11,285
Capital introduced 0 648
Less drawings (7,785) (8,100)
Closing capital 45,415 40,089
Profit for the year
This is the figure of net profit that's produced by the trading and profit and loss
account each year. Net profit is added to the capital account and therefore
increases the proprietor's investment in the business. If a business makes a loss
instead of a profit, the amount of the loss is deducted from the capital account and
decreases the proprietor's investment in the business.
Capital introduced
Capital introduced is the value invested in the business by the proprietor. A
proprietor usually introduces capital when they first start up in business, but they can
also introduce capital at any time.
Capital introduced can take various forms. You'll often see it described as 'paid out
of the proprietor's own pocket'. However, although it may be personal cash paid out
of their pocket (or a cheque from their private bank account), it may also be assets
that were previously owned privately, such as a car.
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Capital introduced of any kind can be recorded in the drawings account as a credit
entry. This is quite acceptable although it's more usual for these transactions to be
recorded as a credit entry in the capital account.
You can see that Harry introduced capital worth £648 in year ending 31 May 2018.
This was recorded in the capital account.
If capital introduced is included in the capital account, it's added to the capital
account because it increases the proprietor's investment in the business.
The final element in the capital account is the drawings figure. Let's look at this next.
Drawings
Drawings are assets or money taken out of the business by the proprietor for their
own benefit. They reduce the value of the capital account. Drawings can be
• cash taken from the business
• from the till
• from cash takings kept elsewhere
• drawn from the business bank account using an ATM.
• money transferred from the business bank account to the proprietor's
personal bank account, for example, by writing a cheque or by standing order
• personal bills or expenses paid for by the business
• a business asset taken out of the business for the proprietors own use.
Drawings is a term used for sole traders and partners – you won't see it used in
company accounts. Directors of companies obviously take funds for their own use
and similar principles apply but they're recorded in a director's current, or loan,
account, rather than a drawings account.
In larger limited companies, the directors may be paid a salary and other benefits like
other employees of the business. In that case there won't generally be a directors'
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loan account. You'll consider this in more detail in the manual Bookkeeping –
Financial Accounting for Limited Companies.
If capital introduced is included in the drawings account it decreases the value taken
out of the business by the proprietor. (As the balance on the drawings account is
taken to the capital account, any decrease in drawings will increase the amount the
business owes the proprietor.)
Opening capital and closing capital
You won't see the term 'capital' in company accounts.
Capital is invested in a company by the shareholders and it's generally referred to as
'share capital'. You can learn about share capital and shareholders' funds in the
manual Bookkeeping – Financial Accounting for Limited Companies.
The closing capital of one year becomes the opening capital of the following year.
Let's look at an example to see how this works. Look again at Harry's capital account
for the year ending 31 May 2018.
Capital account 2019 2018
Opening capital 40,089 36,256
Profit for the year 13,111 11,285
Capital introduced 0 648
Less drawings (7,785) (8,100)
Closing capital 45,415 40,089
Opening capital for the year was £36,256. Net profit of £11,285 and capital
introduced of £648 were added, drawings of £8,100 were deducted. The result was
closing capital of £40,089.
The closing capital of £40,089 for the year ending 31 May 2018 becomes the
opening capital for the following year.
Now try the activity that follows.
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Activity six
Mark X in the relevant box to show where you would expect to find the following
items in the balance sheet for a haulage contractor (or record your answer in a
separate document).
Description Fixed assets
Current assets
Current liabilities
Long-term liabilities
Capital account
Cash
Overdrawn bank current
account
Loan repayable within 6
months
Premises
Drawings
Lorries
Mortgage on premises –
5 years remaining
Net profit
Capital introduced
Creditors
Debtors
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Response
(Description first followed by answer)
Cash - Current assets
Overdrawn bank current account - Current liabilities
Loan repayable within 6 months - Current liabilities
Premises - Fixed assets
Drawings - Capital account
Lorries - Fixed assets
Mortgage on premises with 5 years remaining - Long-term liabilities
Net profit - Capital account
Capital introduced - Capital account
Creditors - Current liabilities
Debtors - Current assets
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1.4.5 Different types of business expenditure
You've now looked at the general layout of financial accounts. You have also seen
what might appear in a trading and profit and loss account or balance sheet. So how
do you decide which expenditure should be included in the trading and profit and
loss account, and which expenditure should be reflected on the balance sheet?
Generally speaking, whenever a business incurs business expenditure, it's to
• acquire a fixed asset for the business (which would be recorded and reflected
in the balance sheet), or
• meet the normal running expenses of the business (which would be recorded
in the trading and profit and loss account).
When you're considering whether expenditure is for an asset or an expense,
you'll often need to consider the nature of the business.
Look at the following example to see what this means.
Example
Alison and Daniel attend an auction sale. Alison runs a teashop and wants to
buy a cooker to make food to sell in the shop. Daniel runs a second–hand shop
and wants to buy a cooker to sell in his shop. They each buy a cooker.
Alison uses her cooker to make food in her teashop. Once the food has been
sold, she still owns the cooker. This is therefore a fixed asset of her business
and will appear on her balance sheet.
Daniel buys his cooker to sell on at a profit.
Daniel's business involves buying and selling items such as cookers. The cooker
is therefore just part of Daniel's purchases. The cost of the cooker would be
reflected in his trading account as part of his purchases figure.
Try the next activity.
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Activity seven
Below is a list of expenditure for Artem's garage. In each case, state whether the
expenditure should be reflected in Artem's balance sheet as an asset, or in his
trading and profit and loss account (T&P&L a/c) as an expense.
Mark X in the relevant box (or record your answer in a separate document).
Description Expenses in T&P&L a/c
Assets in balance sheet
Rent and rates for a building used by the
business.
Expenses for maintaining the breakdown
lorry.
Two cars bought at a car auction for resale.
Petrol for resale.
Petrol used for the breakdown lorry.
New petrol pumps for the garage forecourt.
Accountancy fees.
Extension to the garage premises.
Repair a broken window in the garage shop.
New hydraulic ramp for carrying out repairs.
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Response
(Description first followed by answer then further information relevant to the option)
• Rent and rates for a building used by the business - Expenses in T&P&L a/c.
This is a day–to–day running expense (an overhead); it will appear in the
profit and loss account.
• Expenses for maintaining the breakdown lorry - Expenses in T&P&L a/c.
The lorry is a fixed asset, but the cost of maintaining it's a day–to–day
expense of the business shown in the profit and loss account.
• Two cars bought at a car auction for resale - Expenses in T&P&L a/c.
The cars are purchases of goods for resale, so they'll be included in
purchases in the trading account.
• Petrol for resale - Expenses in T&P&L a/c.
This is the purchase of goods which will appear in the trading account.
• Petrol used for the breakdown lorry - Expenses in T&P&L a/c.
This is a day–to–day expense of the business, shown in the profit and loss
account.
• New petrol pumps for the garage forecourt - Assets in balance sheet.
Artem doesn't sell petrol pumps, but he does use them to make profits.
They're fixed assets of the business and go into the balance sheet.
• Accountancy fees - Expenses in T&P&L a/c.
Accountancy fees are a day–to–day expense of the business; they'll appear in
the profit and loss account.
• Extension to the garage premises - Assets in balance sheet.
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The premises are a fixed asset of the business and any improvement or
extension is treated in the same way. This is also shown in the balance sheet.
• Repair a broken window in the garage shop - Expenses in T&P&L a/c.
The cost of maintaining or repairing an asset is part of the day-to-day running
expenses of the business. It will appear in the profit and loss account.
• New hydraulic ramp for carrying out repairs - Assets in balance sheet.
The ramp is used to make profits in a similar way to the petrol pumps. It's a
fixed asset of the business and goes in the balance sheet.
That's the end of the material in this chapter.
Now read the review and try the learning check that follows it.
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Review
Although businesses can vary enormously in size and nature, the basic bookkeeping
principles are exactly the same for sole traders, partnerships and limited companies.
It's only the format and presentation which may differ.
A sole trader carries on a business alone whereas a partnership is two or more
people in business together. Partners generally have unlimited liability for any debts
incurred by the business. The liability of shareholders in a limited company is limited
to the amount they have invested into the company.
Management accounts help the proprietor to control their business and can be
prepared at any time.
Financial accounts allow users of the accounts to review the past performance, and
current financial position, of the business. Financial accounts are not prepared just
for HMRC. Other parties have an interest in them including the business owner,
financial institutions, shareholders and other government departments.
The two main primary financial statements are the trading and profit and loss
account and the balance sheet.
The trading and profit and loss account is a summary of the trading and business
activity for the period and shows the performance of the business for the whole of
the period covered by the accounts.
The trading account normally shows
• the turnover of the business
• the purchase of goods and materials used in the business the opening and
closing stock.
The profit and loss account contains the day-to-day running costs (sometimes called
overheads or indirect costs).
The balance sheet is a 'snapshot' of the financial position of the business at the
accounting date.
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It's divided into
• assets (fixed and current)
• liabilities (current and long term)
• capital account (opening and closing capital, drawings, capital introduced and
net profit or loss).
Now test your knowledge of this chapter by doing the learning check that follows.
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Learning check
Please record your answers in a separate document.
1. Oleanna wants to open a vintage clothes shop. She can't decide whether to do
this on her own or go into business with her sister. Oleanna has received a legacy
which she could use to pay the deposit on the premises and buy the initial stock. Her
sister has no money but she's a fashion designer and an excellent dressmaker. She
could work behind the scenes making repairs and so on, whilst Oleanna serves in
the shop, buys stock and does the administration.
a) What are the advantages and disadvantages of Oleanna starting her business as
a sole trader?
b) What are the advantages and disadvantages of Oleanna starting her business in
partnership with her sister?
2. Management accounts are always prepared for an annual accounting period and
are governed by the same rules and regulations as financial accounts.
Explain why this statement is false.
3. Other than the proprietor, list four parties who might be interested in the financial
accounts of a business and say why they might be interested.
4. Delete one of the bracketed words as appropriate to complete the following
statements
The trading and profit and loss account shows whether the business is making a
profit or a loss and reflects the (position / performance) of the business for the
whole of the period concerned.
The balance sheet on the other hand is a 'snapshot' and shows the financial
(position / performance) of the business at the accounting date only.
5. State whether the following items should be reflected in the trading account, the
profit and loss account or the balance sheet of a butcher's shop. In the case of
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balance sheet items, state where in the balance sheet you would expect to find these
(for example, fixed assets, current liabilities etc).
• Business premises.
• Turnover.
• Purchases.
• Motor expenses.
• Trade creditors.
• Heating and lighting expenses.
• Accountancy fees.
• Van used for deliveries.
• Mortgage used to buy business premises – term remaining 10 years.
• Drawings
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Learning check – answers
1. Oleanna wants to open a vintage clothes shop. She can't decide whether to do
this on her own or go into business with her sister. Oleanna has received a legacy
which she could use to pay the deposit on the premises and buy the initial stock. Her
sister has no money but she's a fashion designer and an excellent dressmaker. She
could work behind the scenes making repairs and so on, whilst Oleanna serves in
the shop, buys stock and does the administration.
a) What are the advantages and disadvantages of Oleanna starting her business as
a sole trader?
If Oleanna sets up business as a sole trader she'll need to notify HMRC about her
new source of income but there are fewer legal obligations and requirements
involved in setting up as a sole trader than in setting up as a partnership or
company.
If Oleanna starts her business as a sole trader, she'll have complete control over the
business and will be able to make business decisions quickly without the need to
consult her sister. One common advantage of being a sole trader is being able to
provide a personal service to customers, but this doesn't really apply in this case.
These are the advantages. The disadvantages are that Oleanna would have
unlimited liability for the debts and actions of the business. She may have difficulties
in obtaining further capital to invest in the business and she may not be able to
match the pricing and marketing policies of any larger vintage clothes shops in the
area.
b) What are the advantages and disadvantages of Oleanna starting her business in
partnership with her sister?
If Oleanna forms a partnership with her sister, she'll bring additional useful skills into
the business. But the liability of partners is unlimited, and the two sisters will be
jointly and severally liable. Oleanna's sister has no money so Oleanna would
effectively be responsible for all debts the business incurs.
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She would have to share the profits with her sister in accordance with a profit sharing
agreement. Also, as a partner her sister would have a say in the operation and
direction of a partnership business and neither of them would have complete control
over the business.
This is in subchapter 1.1.
2. Management accounts are always prepared for an annual accounting period and
are governed by the same rules and regulations as financial accounts.
Explain why this statement is false.
Management accounts may be prepared more frequently, for example on a monthly
basis. Whilst management accounts comply with basic accounting concepts, they're
not governed by specific rules or regulations.
This is in subchapter 1.2.
3. Other than the proprietor, list four parties who might be interested in the financial
accounts of a business and say why they might be interested.
Financial institutions – a lender can use the financial accounts to help to determine
whether the business is profitable and whether it can pay the interest and charges
(service the loan) and repay the capital.
Suppliers – they'll use the financial accounts in a similar way to other lenders.
Shareholders – they'll use financial accounts to monitor their investment in the
company's shares.
Government departments – obviously HMRC, but also others, for a variety of
reasons.
This is in subchapter 1.3.
4. Delete one of the bracketed words as appropriate to complete the following
statements.
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The trading and profit and loss account shows whether the business is making a
profit or a loss and reflects the (performance) of the business for the whole of the
period concerned.
Position was deleted.
The balance sheet on the other hand is a 'snapshot' and shows the financial
(position) of the business at the accounting date only.
Performance was deleted.
This is in subchapter 1.4.
5. State whether the following items should be reflected in the trading account, the
profit and loss account or the balance sheet of a butcher's shop. In the case of
balance sheet items, state where in the balance sheet you would expect to find these
(for example, fixed assets, current liabilities etc).
• Business premises.
• Turnover.
• Purchases.
• Motor expenses.
• Trade creditors.
• Heating and lighting expenses.
• Accountancy fees.
• Van used for deliveries.
• Mortgage used to buy business premises – term remaining 10 years.
• Drawings.
Turnover and purchases will both appear in the trading account.
Motoring expenses, heating and lighting expenses and accountancy fees should be
recorded in the profit and loss account.
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The rest of the items will appear in the balance sheet. The business premises and
the van will be recorded under fixed assets. Trade creditors will appear under
current liabilities and the mortgage will be a long-term liability. Drawings will be in
the capital account.
This is in subchapter 1.4.
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Before moving on
If you have answered the learning check correctly, you will have successfully
completed the learning outcomes and study objectives for this chapter, which you
can see below.
Learning outcomes and study objectives
Learning outcomes
You will
• understand the main types of business entities, the accounts they may
prepare and who may use them
• understand the form and content of sole trader accounts.
Study objectives
To achieve this you need to be able to
• describe the main types of business entity
• explain the difference between management and financial accounts
• name four users of financial accounts
• describe the form and content of sole trader accounts
If you had difficulty in achieving any of these objectives, have another look at the
relevant part(s) of the chapter and try the learning check again.
You should be confident that you have achieved them before moving on.
Finally, please note any points you might want to discuss with your line manager or
tutor.
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Chapter 2 Accounting Standards
Introduction
Accountancy isn't an exact science. You'll find that accountants will sometimes
disagree with each other, as well as with HMRC, about how information should be
recorded in financial accounts.
These potential differences can cause confusion for anyone who examines financial
accounts. To help overcome this, the accountancy profession developed
accounting standards so that accounts can be prepared in accordance with
generally accepted accounting practice (GAAP).
In certain circumstances, business entities may prepare their accounts in
accordance with international accounting standards (IAS)/International Financial
Reporting Standards (IFRS). HMRC accepts accounts which have been prepared in
accordance with IAS/IFRS for tax purposes, for accounting periods commencing on
or after 1 January 2005.
This module focuses on the application of UK accounting standards (UK GAAP).
In this chapter, you'll consider what accounting standards are and look at the
concepts and principles that accountants follow when preparing accounts.
You'll also see what is meant by materiality.
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Learning outcomes and study objectives
This is what you will be able to achieve after you have successfully studied this
chapter.
Learning outcomes
You will
• understand why generally accepted accounting concepts and principles are
important to HMRC.
Study objectives
To achieve this you need to be able to
• describe the main aim of accounting standards
• explain the importance of accounting concepts. We think it will take you
approximately this long to finish the chapter.
Reading main text 1hr 15m
Completing activities and the learning check 30m
Total 1hr 45m
This is only a guide. The important thing is for you to make sure you understand
all the material in the chapter.
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2.1 Accounting Standards
In this subchapter you'll look at accounting standards and how HMRC advisory and
forensic accountants can help you in your work.
2.1.1 FRS
Accounting standards describe how particular transactions should be reflected in the
financial accounts. For the UK and Republic of Ireland, Financial Reporting
Standards (FRSs) are mandatory for accounting periods starting on or after 1
January 2015.
• FRS 100 Application of Financial Reporting Requirements.
• FRS 101 Reduced Disclosure Framework (FRS 101).
• FRS 102 The FRS Applicable in the UK and Republic of Ireland (FRS 102).
• FRS 103 Insurance Contracts.
• FRS 104 Interim Financial Reporting.
• FRS105 The Financial Reporting Standard applicable to the Micro-entities
Regime (FRS 105).
Example
FRS102, chapter 13, Inventories (stocks) gives guidance on how stocks should be
provided for in the accounts, and chapter 17 gives guidance on accounting for
property, plant and equipment (tangible fixed assets) and depreciation.
FRS 102 does not apply to entities that are required or elect to apply EU-adopted
IFRSs, FRS 101’s IFRS reduced disclosure framework or FRS 105’s requirements
relating to the micro-entities regime. You can learn more about accounting
frameworks in Accountancy - Increasing Financial Awareness. For the purposes of
this module the focus is on FRS 102.
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2.1.2 Aim of accounting standards
The main aim of the accounting standards is to assure anyone looking at the
accounts that the information in them is presented consistently and that they reflect a
true and fair view of the financial activities for the period they cover.
Accountants are expected to follow accounting standards when preparing financial
accounts.
S25 ITTOIA 2005
Accounting standards are primarily for use when preparing company financial
accounts. However, accountants are also expected to use them when preparing
financial accounts for individuals and for partnerships.
This is because section 25 Income Tax Trading and Other Income Act (ITTOIA)
2005 says that, for tax purposes, the profits of an individual, or a partnership, must
be calculated in accordance with generally accepted accounting practice –
unless the taxes acts state otherwise.
So the process to be followed when calculating the profit for income tax purposes is
to
• prepare accounts in accordance with GAAP to arrive at the figure of net profit
and then
• adjust the figure of net profit because the taxes acts specifically allow or disallow
certain entries in the accounts.
HMRC can insist that profits are computed in accordance with GAAP for tax
purposes, if necessary by adjusting the profits shown by the accounts. But they can't
insist that the accounts themselves follow GAAP for sole traders and partnerships.
In this manual, you'll see how to record transactions in an accounting system so that
financial accounts can be prepared. However, further adjustments may then be
needed for tax purposes. You can learn about these adjustments in the Company
Tax and Sole Traders and Partnerships manuals.
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2.1.3 HMRC advisory and forensic accountants
Although you'll find it useful to have a working knowledge of accounting standards,
you're not expected to be an expert
in financial reporting. HMRC employs advisory and forensic
accountants to give advice on the interpretation and application of GAAP.
Advisory and forensic accountants are professionally qualified accountants, most of
whom trained and spent years in the profession or industry prior to joining HMRC.
Advisory accountants are able to advise tax specialists, policy colleagues, solicitors
and courts on appropriate accountancy treatments in the accounts of our customers.
Forensic accountants support criminal caseworkers including tax specialists with
financial advice and assist the courts through objective reports and giving
independent expert opinion.
HMRC's advisory and forensic accountants provide technical advice and support,
either informally or by a written submission. They'll also attend meetings with
customers and their agents and help with records examinations and interpretation of
accounting records.
HMRC advisory and forensic accountants only get involved in accountancy matters,
not tax issues, technical or procedural matters. They may however, be required to
give expert evidence before the First–tier Tribunal, Upper Tribunal or the Courts.
You're strongly advised to ask them for advice when technical accounting issues are
concerned.
You can find the advisory and forensic accountants' site on the intranet by clicking on
Legal and Accountants from the A – Z index.
HMRC officers often have to look at historic information. Should you require
information about withdrawn standards that are relevant to your case, please consult
an advisory and forensic accountant.
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Accounting standards become effective from a specific date. It would be
embarrassing to challenge accounts on the grounds that they didn't comply with an
accounting standard, only for the accountant to point out that the standard in
question was not effective for the period covered by the accounts.
You should always get advice from an HMRC advisory and forensic
accountant before making a formal challenge based on accounting standards.
Throughout the Bookkeeping manual, we include the specific relevant accounting
standards where appropriate and, within that standard, the general principles that
you should follow.
Before you can start recording transactions in the accounts you need to be aware of
FRS 102 The FRS Applicable in the UK and Republic of Ireland.
First try the activity that follows.
Activity One
Indicate whether the following statements are true or false.
1. HMRC can insist that the accounts themselves follow
GAAP for sole traders and partnerships.
2. HMRC advisory and forensic accountants can get involved in accountancy
matters, tax issues and technical or procedural matters.
3. You should always get advice from an HMRC accountant before making a formal
challenge based on accounting standards.
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Response
1. HMRC can insist that the accounts themselves follow
GAAP for sole traders and partnerships. - False
HMRC can insist that profits are computed in accordance with GAAP for tax
purposes, if necessary by adjusting the profits shown by the accounts. But they can't
insist that the accounts themselves follow GAAP for sole traders and partnerships.
2. HMRC advisory and forensic accountants can get involved in accountancy
matters, tax issues and technical or procedural matters. - False
HMRC advisory and forensic accountants only get involved in accountancy matters,
not tax issues, technical or procedural matters.
3. You should always get advice from an HMRC accountant before making a formal
challenge based on accounting standards. – True
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2.2 FRS 102
The objective of accounts is to provide information about the financial position,
performance and cash flows of an entity that is useful for economic decision making
by a broad range of users.
2.2.1 The Qualitative Characteristics of Information
In this section you'll look at the qualities that make accounting information useful to
users. FRS 102 refers to these as 'the qualitative characteristics of information'.
FRS 102 identifies 10 characteristics that are likely to make information useful. The
most critical characteristics are relevance and reliability. The other characteristics
are less critical but are still desirable because they enhance.
Reference - FRS 102, 2.5
Relevance
Information must be relevant to the decision making needs of users. This will
only be the case where the information may make a difference to users' decisions.
Reference - FRS 102, 2.7
Reliability
Information is reliable when it is free from material error and bias and it
represents faithfully what it claims to represent.
Information does not have to be accurate in all respects to be reliable. For example,
you may not be able to say with certainty that an estimate of the value of an asset is
accurate. However, the estimate can still be reliable if you describe it as an estimate
and explain its limitations.
Reference - FRS 102, 2.4
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Understandability
Information should be presented in a way that makes it understandable to users.
It is assumed that users of accounts have a reasonable knowledge of business and
are willing to study the information – it is not acceptable to omit information on the
grounds that it is difficult to understand.
Reference - FRS 102, 2.6
Materiality
Materiality is closely linked to relevance. Information is material if its omission or
misstatement, individually or collectively, could influence the economic decisions of
users taken on the basis of the financial statements.
Materiality is the judgement made by preparers of accounts about whether to include
an item to give a true and fair view. They do this so that the information provided is
relevant and important, and not swamped by unnecessary detail.
An item would be material to the financial statements if it could influence the
economic decisions of the users.
It's a question of judgement whether something is material. It's doubtful that £2
would be important in any business, but what if the amount is £2,000? If the turnover
for a year is £48,000, this is turnover for 2 weeks. That's important and could be
said to be material.
If the annual turnover is £48,000,000 it may be less important and not material.
The concept of materiality is considered in more detail in chapter 1 of the Increasing
Financial Awareness manual. If you're carrying out a compliance check and have
any problems concerning materiality, contact your local HMRC advisory and forensic
accountant.
Reference - FRS 102, 2.8
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Substance over form
Transactions should be accounted for in accordance with their substance and
not merely their legal form, which may not reflect the commercial effect. The
concept of substance over form enhances the reliability of information..
A company sells a property to a bank for £1,000,000 and at the same time enters
into an agreement to purchase it back from the bank a year later for £1,080,000.
The legal form of the transaction is that the company has sold the property to the
bank. However, the substance of the two transactions taken together is that the
company has taken out a bank loan of £1,000,000 secured on the property (this is
the commercial effect of the two transactions).
The company should not recognise income from the sale of the property. Instead, it
should recognise a bank loan of £1,000,000 as a liability and continue to recognise
the property as an asset.
Reference - FRS 102, 2.9
Prudence
The uncertainties that surround many transactions and events are acknowledged by
the exercise of prudence. Prudence is the inclusion of a degree of caution when
making judgements necessary to arrive at estimates.
The exercise of prudence does not permit bias. If information is biased it will not
be reliable. In other words, prudence does not allow the deliberate understatement
of assets or income, or the overstatement of liabilities or expenses.
Reference - FRS 102, 2.10
Completeness
Completeness is linked with reliability. To be reliable, information must be
complete (within the bounds of materiality and cost).
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Reference - FRS 102, 2.11
Comparability
Comparability enables users to identify and understand similarities in, and
differences between, items. Information is more useful if it can be compared with
similar information about the company for another accounting period, or with
information about another company.
Comparability can be improved by the use of consistent accounting policies from one
accounting period to the next.
Reference - FRS 102, 2.12
Timeliness
Timeliness means having information available in time for it to influence
decisions of users. Generally, the older
the information is, the less useful it will be. However, some information will continue
to be timely long after the end of an accounting period, because some users may
need it to identify trends.
A conflict between relevance and reliability may arise over the timeliness of
information. A delay in providing information can make it out of date, which affects
its relevance.
On the other hand, reporting information too early can affect its reliability if, for
example, there are significant unresolved uncertainties. Companies need to
consider the needs of users in achieving a balance between relevance and reliability.
Reference - FRS 102, 2.13
Balance between benefit and cost
The benefit derived from information should exceed the cost of providing it.
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It's often difficult to assess costs and benefits because the company providing the
information generally incurs the costs, but other parties usually get the benefits.
An assessment of costs and benefits will not always justify the same reporting
requirements for all companies. For example, differences in the way in which
information is presented may be appropriate because of the different ways in which
companies raise funds (publicly or privately), or different sizes of company, or
differing users' needs.
It is not always possible for information to possess all of the characteristics in FRS
102 and companies may need to strike a balance between them. For example, a
temporary loss of comparability when applying a new accounting policy may be
worthwhile if it improves the relevance of the information presented in the accounts.
FRS 102 does not provide any guidance on the relative importance of each
characteristic. This is a matter of professional judgement.
Now try the following activity.
Activity two
Indicate whether the following statements are true or false.
a) 'Prudence' implies that management should have a bias towards understating
assets and income and overstating liabilities and expenses.
b) 'Prudence' implies that management should have a bias towards overstating
assets and income and understating liabilities and expenses.
c) Information is only 'reliable' when there is little or no uncertainty surrounding its
measurement.
d) Information is 'relevant' when it may make a difference to the decisions of users.
e) It is acceptable for some information to be omitted on the basis that it would be
too costly to gather.
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Response
a) False – Prudence requires the inclusion of a degree of caution but does not
permit bias.
b) False – Prudence requires the inclusion of a degree of caution but does not
permit bias.
c) False – Reliable information must be free from material error but does not have to
be accurate in all respects.
d)True – Information must be relevant to the decision making needs of users.
e)True – The benefit derived from information should exceed the cost of providing it.
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2.2.2 Accounting bases and concepts
FRS 102 recognises the importance of the accrual basis of accounting (or
matching basis) and the going concern concept. These are fundamental to
accounting. Let's look at these next.
The accruals basis
In accordance with FRS 102 the accrual (or matching) basis requires that income
and expenditure are recognised in the period in which they're earned and incurred
and not in the period when money is received and paid. This is important to ensure
that the financial accounts give a true and fair view.
The accrual basis is at the heart of the definitions of assets and liabilities. FRS 102
defines assets and liabilities as follows.
Assets
A resource controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity.
Reference - FRS102, Appendix I Glossary
Liabilities
A present obligation of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic
benefits.
So under the accrual basis you need to see if an asset or liability has arisen before
you can see whether to recognise income and expenditure in the profit and loss
account.
Let's see what this means.
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Assets and income
Example
Louise starts in business as a consultant on 1 January 2018. She makes up her first
accounts to 31 December 2018. During the year, she received payments of £35,000
from customers for the work that she did. In the middle of December 2018, she
completed a job worth £2,000, but agreed to allow the customer 30 days to pay the
amount owed to her.
Although Louise hasn't physically received the cash of £2,000 by the balance sheet
date, this £2,000 is an asset of the business. Louise has earned the right to receive
that income as a result of the work which she had performed by the balance sheet
date.
So the income is accrued (matched) to the period in which it's earned. Louise should
include the £2,000 as turnover in the trading account to 31 December 2018 along
with the £35,000 she had already received. Her total turnover for the year ending 31
December 2018 is £37,000.
She would show the £2,000 as a trade debtor in current assets in the balance sheet
to reflect the amount which the customer owes her.
Generally speaking, a trade debtor arises when the business has clearly made a
sale or supplied a service for which payment is due but hasn't yet been received.
Activity three
Jack is a butcher, who prepares his accounts to 31 May each year. During the year
ending 31 May 2018, Jack received
£45,000 in takings from his customers. All of Jack's customers have paid what they
owe by the end of the year, except for Clive.
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Jack sells meat to Clive each day of the week except Sunday and Clive pays Jack
every Saturday for that week's meat. During the week ending Saturday 2 June 2018,
Jack sold goods to Clive as follows.
Date £
Monday 28 May 40
Tuesday 29 May 45
Wednesday 30 May 30
Thursday 31 May 50
Friday 1 June 55
Saturday 2 June 60
Total sales for the week 280
Using this information, state the entries that you would expect to see in Jack's
financial accounts for the year ended 31 May 2018.
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Response
The financial accounts for the year ended 31 May 2018 should show the following.
At 31 May 2018, Jack should show £165
The sum of, (£40 plus £45 plus £30 plus 50), as a trade debtor in current assets in
the balance sheet. Although he hasn't yet received the cash by 31 May 2018, he has
earned the right to receive this income as the sale was made in the period.
The £165 will also be recognised in turnover, along with the £45,000 which he had
already received for sales made in the period.
The sales that Jack made to Clive from Friday 1 June will be included in his following
year's accounts.
Expenditure and liabilities
Example
Ian started in business as a plumber on 1 January 2018 and prepares his first
accounts to 30 September 2018. His local plumbing merchant allows Ian to settle
what he owes them within 30 days. During the period, Ian paid for purchases costing
£18,000. On 20 September, he bought a bathroom suite and radiators costing £650
from the plumbing merchant, which he fitted the following week.
Although Ian hasn't physically paid the cash of £650 by the balance sheet date, this
£650 is a liability of the business. This is because Ian has incurred an obligation to
pay the supplier as a result of the purchase.
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The £650 would be included as purchases in the trading account to 30 September
2018 along with the £18,000 which Ian had already paid for other purchases by the
balance sheet date.
The liability of £650 would be shown as a trade creditor in current liabilities in the
balance sheet to reflect the amount which Ian owes to his supplier.
Generally speaking, a trade creditor arises when the business has made a purchase
or received a service for which payment is due but hasn't yet been made.
Activity three
Let's look again at the previous activity with Jack and Clive, but this time from
Clive's point of view.
Clive is a market trader who also prepares his accounts to 31 May each year. During
the year, Clive paid for purchases costing £14,000.
Clive buys meat from Jack each day of the week except Sunday. He pays Jack on a
Saturday for that week's meat. During the week ending Saturday 2 June,
Clive bought the following goods from Jack.
Date £
Monday 28 May 40
Tuesday 29 May 45
Wednesday 30 May 30
Thursday 31 May 50
Friday 1 June 55
Saturday 2 June 60
Total sales for the week 280
Using this information, state the entries that you would expect to see in Clive's
financial accounts for the year ended 31 May 2018.
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Response
Clive's financial accounts for the year ended 31 May 2018 should show the following.
As at 31 May 2018, Clive should show £165
The sum of, (£40 plus £45 plus £30 plus 50), as a trade creditor in current liabilities
in the balance sheet. Although he hasn't paid the cash by 31 May 2018, Clive has
incurred an obligation to pay this money to Jack because he made the purchases in
the period.
The £165 will also be in purchases, along with the £14,000 which he had already
paid for purchases in the period.
Purchases made by Clive from Friday 1 June will be included in his following year's
accounts.
Cash basis
The cash basis scheme was launched in April 2013. It can be used from 2013/14 by
most sole traders and partnerships with an annual income of less than £150,000.
Under the cash basis scheme, income is recognised in the period it's received and
expenditure when it's paid.
So a business will show the income it receives in the year less any money spent on
allowable business expenses in its self assessment return.
Next, you'll consider the concept under FRS 102 that's likely to have a significant
impact on all businesses – the going concern concept.
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Going concern concept
An entity is a going concern unless management either intends to liquidate the entity
or to cease trading or has no realistic alternative but to do so.
This means that, unless there is evidence to the contrary, you should assume that
the business will continue to operate for the foreseeable future with no intention to
stop trading or significantly reduce operations.
A balance sheet splits assets between fixed and current. This indicates that the
business will continue to trade in the future, otherwise there wouldn't be any need to
distinguish between the two types of assets. The same is true of current and long-
term liabilities.
If a business intends to stop trading or significantly reduce its operations, this can
affect how the assets of the business are valued. You don't need to know any more
than this for the purposes of this module.
Reference - FRS 102, Appendix I glossary
Activity four
Which of the following do you think are material to the financial accounts?
a) The business records show that Walter withdrew £25 a week in cash to pay for
incidental business expenditure. There is no documentation to support this. The
total expenses of the business for the year are £650,000.
b) Melvin is a self-employed plumber. He says that three deposits totalling £204 in
his business bank account had come from the sale of scrap material accumulated
during the year. He hadn't recorded this in the business records and consequently it
wasn't treated as business income. Total turnover for the year was £125,000.
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Response
These are questions of judgement, so there are no right or wrong answers. In view
of the amounts involved, an accountant would probably take the view that neither of
these was material.
But an HMRC officer carrying out a compliance check may be concerned that Walter
has no documentation to support his claim that it was business expenditure.
This is the end of the material in this chapter.
Now read the review and try the learning check that follows.
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Review
Accounting standards form the basis on which financial accounts are prepared.
Accountants are expected to follow accounting standards when preparing financial
accounts to ensure consistency of preparation and to give a true and fair view.
These standards include Financial Reporting Standard 102 The FRS Applicable
in the UK and Republic of Ireland.
Now you'll look at the qualitative characteristics of information which are considered
to make sure the accounts give a true and fair view of a business's state of affairs.
These are
• relevance
• reliability
• understandability
• materiality
• substance over from
• prudence
• completeness
• comparability
• timeliness
• balance between benefit and cost.
Most important is the 'accruals basis' also known as the matching basis. This
ensures that financial accounts reflect income earned and expenses incurred in the
accounting period, rather than in the period in which any cash is received or paid.
You also saw that the accruals basis results in the creation of debtors and creditors.
A trade debtor is created when a business makes a sale or supplies a service for
which payment is due but hasn't yet been received from the customer.
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A trade creditor is created when a business has made a purchase from a supplier for
which payment is due but hasn't yet been made to the supplier.
Now test your understanding of this chapter by doing the learning check that follows.
Learning check
1. -What is the main aim of accounting standards?
2. Briefly explain what is meant by the accruals basis and why it's important.
3. Grass Roots Ltd is a company specialising in lawn care and landscape gardening.
It has a contract with the local authority to take care of lawns in parks and public
areas.
The company prepares its annual accounts to 30 September each year. During
September 2018, it carried out work worth £10,000 for the local authority and issued
the sales invoice on 30 September 2018. Grass Roots Ltd allows 30 days to settle
the amount owed. The local authority eventually paid the amount owed on 14
November 2018.
a) Should Grass Roots Ltd include the amount of £10,000 in its figure of turnover for
the year ended 30 September 2018 or the year ended 30 September 2019? Briefly
give the reasons for your answer.
b) Where would you find an entry in the company balance sheet for this transaction,
and for which year?
5. What does it mean if a business is a going concern?
6. Complete the following statement by deleting one of the bracketed words.
It's a question of (judgement/fact) whether something is material.
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Learning check – answers
1. What is the main aim of accounting standards?
The main aim of the accounting standards is to assure anyone looking at the
accounts that the information in them is presented consistently and that they reflect a
true and fair view of the financial activities for the period they cover. Accountants
are expected to follow accounting standards when preparing financial accounts.
This is in subchapter 2.1.
2. Briefly explain what is meant by the accruals basis and why it's important.
The accruals basis means that income and expenditure are recorded in the period in
which they're earned and incurred and not in the period when money is received and
paid.
This is a fundamental accounting basis and is important to ensure that the financial
accounts give a true and fair view.
This is in subchapter 2.2.
3. Grass Roots Ltd is a company specialising in lawn care and landscape gardening.
It has a contract with the local authority to take care of lawns in parks and public
areas.
The company prepares its annual accounts to 30 September each year. During
September 2018, it carried out work worth £10,000 for the local authority and issued
the sales invoice on 30 September 2018. Grass Roots Ltd allows 30 days to settle
the amount owed. The local authority eventually paid the amount owed on 14
November 2018.
a) Should Grass Roots Ltd include the amount of £10,000 in its figure of turnover for
the year ended 30 September 2018 or the year ended 30 September 2019? Briefly
give the reasons for your answer.
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Under the accruals concept, income should be recognised when it's earned; it
doesn't matter when payment is actually received. The £10,000 should therefore be
included in the figure of turnover for the year ended 30 September 2018.
b) Where would you find an entry in the company balance sheet for this transaction,
and for which year?
You would expect to find an entry for trade debtors of £10,000, under the heading
of current assets. This would appear on the balance sheet at 30 September 2018.
Grass Roots Ltd is a company but the same answers would apply if it was a sole
trader business or a partnership.
This is in subchapter 2.2.
4. What does it mean if a business is a going concern?
This means that unless there is evidence to the contrary, you should assume that the
business will continue to operate for the foreseeable future with no intention to stop
trading or significantly reduce operations.
This is in subchapter 2.2.
5. Complete the following statement by deleting out one of the bracketed words.
It's a question of (judgement) whether something is material.
Fact was deleted.
This is in subchapter 2.2.
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Appendix
Table of equivalence for company law terminology
The following table compares both UK and Irish company law terminology with
broadly equivalent terminology used in FRS 102.
Company law terminology FRS 102 terminology
Accounting reference date Reporting date
Accounts Financial statements
Associated undertaking Associate
Balance sheet Statement of financial position
Capital and reserves Equity
Cash at bank and in hand Cash (note 53)
Debtors Trade receivables
Diminution in value [of assets) Impairment
Entity [financial statements) Individual [financial statements)
Financial year Reporting period
Financial year end date Reporting date
Group [accounts/ financial statements] Consolidated [financial statements]
Holding undertaking Parent
lAS / IFRS EU-adopted IFRS
Individual (accounts) Individual [financial statements)
Interest payable and similar expenses Finance costs
Interest receivable and similar income Finance income/Investment income
Minority interests Non-controlling interest
Net realisable value [of any current asset) Estimated selling price less costs to complete and sell
Parent undertaking Parent
Profit and loss account Income statement (under the two-statement approach) Part of the statement of comprehensive income (under the single-statement approach) Related undertakings (note 54) Subsidiaries, associates and joint ventures
Stocks Inventories
Subsidiary undertaking Subsidiary
Tangible assets Includes: Property, plant equipment; Investment property
Trade creditors Trade payables
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(53) FRS 102 requires the cash flow statement to reconcile the movement in 'cash
and cash equivalents'. Disclosure is required of reconciliation between amounts
presented In the statement of financial position (i.e. cash) and 'cash and cash
equivalents'.
(54) This would also include entries in which a company has at least a 20 per cent
holding, but when are not a subsidiary, joint venture or an associate. A shareholding
of 20 per cent is pressed to give significant influence to the holder, such that the
investment would be classified as an associate, therefore in practice there are
unlikely to be many related1.11dertaldngs that are not subsidiaries, joint ventures or
associates.
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Before moving on
If you have answered the learning check correctly, you will have successfully
completed the learning outcomes and study objectives for this chapter, which you
can below.
Learning outcomes
You will
• understand why generally accepted accounting concepts and principles are
important to HMRC.
Study objectives
To achieve this you need to be able to
• describe the main aim of accounting standards
• explain the importance of accounting concepts. We think it will take you
approximately this long to finish the chapter.
If you had difficulty in achieving any of these objectives, have another look at the
relevant part(s) of the chapter and try the learning check again. You should be
confident that you have achieved them before moving on.
Finally, please note any points you might want to discuss with your line manager or
tutor.
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Chapter 3 Basic Bookkeeping Principles
Introduction
In chapters 1 and 2, you looked at how financial accounts are set out and who uses
them. You've also considered accounting standards and how they provide principles
to ensure that the financial accounts reflect a true and fair view of the financial
activities of a business.
The term bookkeeping is often used to cover all aspects of recording the financial
transactions of a business. The information recorded is then used to prepare
financial accounts.
The accounts in turn are used to complete tax returns submitted by individuals,
partnerships and companies. The accounts themselves may also be submitted to
HMRC. For example, all companies must submit their financial accounts with their
self-assessment return.
Many businesses use computerised bookkeeping and accounting packages.
However, these packages work on exactly the same bookkeeping principles covered
in this manual.
In this chapter, you'll consider three basic principles that are fundamental to
understanding bookkeeping
• the separate entity concept
• balance sheet equation and
• dual effect
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Learning outcomes and study objectives
This is what you will be able to achieve after you have successfully studied this
chapter.
Learning outcomes
You will
• be able to apply double-entry bookkeeping principles.
Study objectives
To achieve this you need to be able to
• describe the separate entity concept
• explain the balance sheet equation and how business transactions affect it
• demonstrate the dual effect of business transactions.
Study advice
We think it will take you approximately this long to finish the chapter.
Reading main text 1hr 20m
Completing activities and the learning check 1hr 10m
Total 3hrs 30m
This is only a guide. The important thing is for you to make sure you understand all
the material in the chapter.
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3.1 The Separate Entity Concept
Financial accounting is based on the principle that a business is a separate entity to
its proprietor, with its own assets and liabilities. This is also known as the business
entity concept. It ensures that the activities of the business are kept separate and
distinct from the personal activities of the proprietor.
Example
In chapter 1, you looked at the financial accounts for Harry's newsagents business.
Harry's balance sheet only included business assets and liabilities.
If Harry owned, say, a personal motorbike this wouldn't be shown on his balance
sheet because it's a personal asset. If Harry had a personal loan to buy his
motorbike, this would be a personal liability and that wouldn't feature on the business
balance sheet either.
A business should be regarded as a separate entity, with its own assets and
liabilities. If a business owner invests their personal money into the business, the
cash introduced is an asset of the business, but the liability to repay that money is a
business liability. This type of liability is recorded in the capital account in order to
distinguish it from the other external liabilities of the business.
Have a go at the activity that follows.
Activity one
Natalie uses £500 from her private bank account to open a business bank account.
Complete the blanks in the paragraph below. (add a word at each instance of (input
here)).
The cash of £500 is now a business (input here). The business owes Natalie £500.
This is a business (input here) but it's shown in the (input here) rather than in (input
here) or (input here).
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Response
The input words are inside brackets.
The cash of £500 is now a business (asset). The business owes Natalie £500. This
is a business (liability) but it's shown in the (capital account) rather than in
(current) or (long-term liabilities).
Next, you'll look at the balance sheet equation.
3.2 The Balance Sheet Equation
A balance sheet is called this because it always 'balances'.
Assets less liabilities must always equal capital. This is known as the balance sheet
equation. Some accountants may also refer to it as the accounting equation.
In Harry's case, the balance sheet for the year ended 31 May 2018 can be
summarised as follows.
Description £ £
Fixed assets 51,748
Current assets 11,859
Total assets 63,607
Current liabilities 6,433
Long term liabilities 11,759
Total liabilities 18,192
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Look again at Harry's balance sheet in subchapter 1.4 and you'll see that this golden
rule has been followed.
Description £
Assets 63,607
less liabilities (18,192)
equals capital of 45,415
Note that you always use the figure of closing capital in the balance sheet equation.
You arrive at the figure of closing capital by adding net profit and any capital
introduced to the opening capital and deducting any drawings. If the business
makes a loss instead of a profit, you deduct the amount of the net loss in the capital
account.
Activity one
Test your understanding of the balance sheet equation by identifying the missing
figures in each of the following balance sheet summaries.
Balance Sheet 1 summary
Description £
Fixed assets 60,000
Current assets 10,000
Current liabilities 5,000
Long term liabilities
Opening capital 45,000
Net profit 20,000
Drawings 15,000
Closing capital
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Balance Sheet 2 summary
Description £
Fixed assets 50,000
Current assets 15,000
Current liabilities 10,000
Long term liabilities 25,000
Opening capital 52,500
Net loss 12,000
Capital introduced 3,500
Drawings
Closing capital
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Response
Balance sheet 1 summary
You were provided with the figures of opening capital, net profit and drawings. You
could therefore work out the figure of closing capital of £50,000 by adding net profit
and deducting drawings.
Description £
Opening capital 45,000
Plus net profit 20,000
Less drawings of 15,000
Equals closing capital 50,000
You then needed to identify the amount of the long-term liabilities. The balance
sheet equation states that assets less liabilities must equal capital.
Remember it's the figure of closing capital which is used in this equation. The assets,
liabilities and capital can be summarised as follows.
Description £
Total assets of 70,000
Less current liabilities 5,000
Less long term liabilities 15,000
Equals capital of 50,000
In this example, assets less current liabilities equals £65,000. The amount of the
long-term liabilities must therefore be £15,000 if the balance sheet is to balance.
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Balance sheet 2 summary
You were given the amounts of all of the assets and liabilities. You could therefore
work out the figure of closing capital of £30,000 by using the balance sheet equation.
Total assets £65,000 less total liabilities £35,000 equals closing capital of £30,000.
Description £
Total assets 65,000
Less total liabilities 35,000
Equals closing capital 30,000
You then needed to identify the figure of drawings for the year.
Description £
Opening capital 52,500
Deduct net loss 12,000
Add capital introduced 3,500
Deduct drawings 14,000
Closing capital 30,000
Note
You can also work out the missing figures in activity two using 'T' accounts.
You'll learn about 'T' accounts in chapter 4. You may want to come back to this
activity after you've studied chapter 4.
You'll now consider the dual effect of any business transactions before you move on
to double-entry bookkeeping in chapter 4.
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3.3 The Dual Effect
Double–entry bookkeeping is called this because every transaction that's recorded in
a business has a dual effect.
So how does the dual effect work in practice?
Every time there's a business transaction, business assets, liabilities, or capital are
affected by the transaction.
The balance sheet equation will always hold true – the revised total business assets
less total business liabilities after the transaction has taken place must still always
equal capital.
3.3.1 The dual effect and the balance sheet equation
Balance sheet equation not affected
Let's begin by looking at the dual effect and the balance sheet equation at the very
start of a new business. You'll then look at subsequent transactions for the same
business.
Example
Following his redundancy, Lance starts in business as a mobile caterer on 1 April.
He uses £5,000 of his redundancy money to open a business bank account on that
date.
This is a business transaction so you must consider the dual effect and the balance
sheet equation. The business has a new current asset (the money in the business
bank account) and this is reflected by the money that Lance has invested into the
business (capital).
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The dual effect of this is to increase
• current assets (bank), and
• increase capital.
The balance sheet equation at this stage is therefore
Assets Less liabilities equals Capital
Description Amount Amount Amount
Bank £5,000 £0 £5,000
Example
On 2 April, Lance bought a second–hand van to use in the business. The van cost
£2,700 and Lance paid for it with a cheque from the business bank account. A
further business transaction has taken place so you must again consider the dual
effect and the balance sheet equation.
The business now has a new fixed asset (the van costing £2,700) but the value of its
current assets (the bank account) has reduced by the same amount.
The dual effect of this is to
• increase fixed assets (van), and
• decrease current assets (bank).
The revised balance sheet equation is shown below, with the revised figures in bold.
Assets Less liabilities equals Capital
Description Amount Amount Amount
Bank £2,300
Van £2,700 £0 £5,000
Now try the activity that follows.
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Activity three
On 3 April, Lance buys catering equipment. This cost £500 which he paid by cheque
from the business bank account. He also withdrew £25 in cash from the business
bank account to pay for possible business expenses.
a) What is the dual effect of each of these transactions?
b) What is the revised balance sheet equation after both of these transactions have
been taken into account?
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Response
a) In the first transaction, the business acquires new fixed assets costing £500, but
its current asset (the bank account) has decreased by the same amount. The dual
effect of this is to
• increase fixed assets (equipment), and
• decrease current assets (bank).
In the second transaction, the business has a new current asset (cash on hand) but
another current asset (the bank account) has decreased by the same amount. The
dual effect of this is to
• increase current assets (cash)
• decrease current assets (bank).
b) The revised balance sheet equation after these transactions is shown below with
the revised figures in bold.
Assets Less liabilities equals Capital
Description Amount Amount Amount
Cash £25
Equipment £500
Bank £1,775
Van £2,700 £0 £5,000
The overall balance sheet equation is not affected by these transactions. The
business still has total assets worth £5,000; it's just the nature of the assets that has
changed.
Business makes a profit
In the transactions you've considered so far, the dual effect hasn't altered the
liabilities or the capital position of the business. You'll now consider a business
transaction that makes a profit.
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Example
Lance gets his first customer when he is asked to cater for a function at the cycling
club in Readstone on 5 April. On the day of the function, he buys food and drink
costing £300 using his debit card from the business bank account. He uses all of this
food and drink at the event. At the end of the function, he's paid £700 by cheque,
which he pays into the business bank account on the same day.
The £700 is income of the business. It will be included in turnover in the trading
account. The cost of the food and drink will be recorded as purchases in the trading
account. The business earned £700 and incurred expenses of £300. The net profit
from the function is therefore £400. As you have seen already, net profit is added to
the capital account.
Let's now consider the dual effects of this profit making transaction.
When Lance purchased the food and drink for the function, the first dual effect was
to
• increase purchases by £300
• decrease current assets (bank) by £300.
Later that day he received payment for the function and paid this into the business
bank account. The dual effect of this was to
• increase income by £700
• increase current assets (bank) by £700.
The business has increased its total assets by £400 but the liabilities have remained
the same. The balance sheet equation states that assets less liabilities must equal
capital. So the profit of £400 must be added to the existing capital of £5,000,
increasing the capital to £5,400.
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The revised balance sheet equation is shown below, with the revised figures in bold.
Assets Less liabilities equals Capital
Description Amount Amount Description Amount
Cash £25 Opening balance £5,000
Equipment £500 Profit £400
Bank £2,175
Van £2,700
Total £5,400 £0 Closing £5,400
The profit from the function belongs to Lance but it stays in the business capital
account until Lance takes it in the form of drawings from the business.
Activity four
Readstone Rugby Club asks Lance to cater for their annual award ceremony on 9
April. Lance agrees to provide a buffet for £1,000. The rugby club ask if they could
settle the bill a fortnight later and Lance agrees.
On the day of the buffet, Lance buys food costing £550. He pays for this by cheque
from the business bank account. At the end of the buffet, he presents the rugby club
with a sale invoice for £1,000.
a) State the dual effect of each of these transactions.
b) Show the revised balance sheet equation after these transactions have been
taken into account.
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Response
a) When Lance purchased the food for the buffet, the first dual effect was to
• increase purchases by £550
• decrease current assets (bank) by £550.
Lance has supplied food for the buffet, but he hasn't yet been paid, although he's
issued a sale invoice. Income should be recognised when it's earned, rather than
when payment is actually received. A customer to whom a business has supplied
goods or services on credit is a trade debtor. A trade debtor is a current asset
because it represents money that it owes to the business.
The dual effect of this transaction is to
• increase income by £1,000
• increase current assets (trade debtors) by £1,000.
The £1,000 is income of the business which will be included in turnover in the trading
account. The £550 incurred on buying food will be claimed as purchases in the
trading account. The money owed by the rugby club will appear as a trade debtor on
Lance's balance sheet.
The business earned £1,000 and incurred expenses of £550. So the net profit from
the event is £450. This is added to the capital account. Total assets have increased
by £450, which is matched by the increase in the capital account.
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b) The revised balance sheet equation after these transactions is as follows, with
the revised figures in bold.
Assets Less liabilities equals Capital
Description Amount Amount Description Amount
Cash £25 Opening balance £5,400
Equipment £500 Profit £450
Bank £1,625
Van £2,700
Debtors £1,000
Total £5,850 Closing £5,850
So far in this subchapter, you have considered the dual effect and balance sheet
equation for the following transactions.
• Opening capital at the start of a new business.
• Acquisition of fixed assets paid for by cheque.
• Withdrawal of cash from the business bank account.
• A cash sale to a customer which results in a profit.
• A credit sale to a customer which results in a profit.
You'll now consider the dual effect when a business makes purchases on credit, and
the effect on the balance sheet equation.
Business makes purchases and earns income on credit
Example
Lance is asked to provide a buffet for a wedding reception on 15 April. He agrees to
do this for £1,500.
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On the morning of 15 April, Lance makes the necessary purchases costing £600 at
Cash and Carry Ltd. He opens a credit account with the supplier. This credit
arrangement allows him to pay for the goods 14 days later. He uses all the food to
prepare the buffet.
Expenditure should be recognised when it's incurred, rather than when payment is
actually made. A supplier who has provided goods or services on credit is a trade
creditor. A trade creditor is a current liability because it represents money that the
business owes. The business owes £600 to the cash and carry, and this will appear
as a liability (trade creditor) on the balance sheet.
Let's now consider the dual effect of this transaction and the effect on the balance
sheet equation. When Lance purchased the food on credit, the dual effect was to
increase purchases by £600 increase current liabilities (trade creditors) by £600.
Lance provides the buffet as agreed and pays the customer's cheque for £1,500 into
the business bank account on the same day.
When Lance earned the income for providing the buffet, the dual effect was to
• increase income by £1,500
• increase current assets (bank) by £1,500.
Assets increased by £1,500.
The £1,500 is income of the business and will be included in his trading account as
turnover. The £600 incurred on food will be recorded as purchases in his trading
account. It doesn't matter that he hasn't actually paid for the goods at this point.
The business has earned £1,500 and incurred expenses of
£600 in doing so. The net profit from this event is £900, which is added to the capital
account.
The balance sheet equation states that assets less liabilities must equal capital. The
net increase of £900 is matched by the increase in capital when the profit from this
transaction is added to the capital account.
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The revised balance sheet equation after these transactions is shown below, with
the revised figures in bold.
Assets Less liabilities equals Capital
Description £ Description £ Description £
Cash £25 Creditors £600 Opening balance £5,850
Equipment £500 Profit £900
Bank £3,125
Van £2,700
Debtors £1,000
Total £7,350 Total £600 Closing £6,750
Activity five
Lance agreed to provide the catering for a disco at Readstone RFC on 19 April for
£750. He also agreed to allow the club 14 days to pay the amount owed to him.
He purchased food for the event on the day for £300, using his credit account with
his cash and carry supplier. He used all the purchases to cater for the event.
After the disco, he gave the football club a sales invoice confirming that payment will
be due from the club in 14 days’ time.
a) State the dual effect of each of these transactions.
b) Show the revised balance sheet equation after these transactions have been
taken into account.
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Response
a) The business has made a sale on credit and has also purchased goods for resale
on credit. No money has actually changed hands yet, but a business transaction has
taken place.
Income should be recognised when it's earned, and expenditure should be
recognised when it's incurred.
The dual effect of the food bought from the cash and carry on credit is to
• increase purchases by £300
• increase current liabilities (trade creditors) by £300.
The dual effect of the income earned from the disco event is to
• increase income by £750
• increase current assets (trade debtors) by £750.
The £750 earned will be included in turnover in the trading account. The money
owed to the business by the football club will appear as a trade debtor in the balance
sheet.
The £300 incurred on purchases will be included in purchases in the trading account.
The money owed to the cash and carry will appear as a trade creditor in the balance
sheet, and will be added to the amount already owed to Cash and Carry Ltd.
The business earned £750 and incurred expenses of £300 in resulting in a net profit
of £450 from the event, which is added to the capital account.
The balance sheet equation states that assets less liabilities must equal capital. The
net increase in assets of £450 is matched by the increase in capital.
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b)The revised balance sheet equation after these transactions is shown below, with
the revised figures in bold.
Assets Less liabilities equals Capital
Description £ Description £ Description £
Cash £25 Creditors £900 Opening balance £6,750
Equipment £500 Profit £450
Bank £3,125
Van £2,700
Debtors £1,750
Total £8,100 Total £900 Closing £7,200
So far in this subchapter, you have considered the dual effect and balance sheet
equation for the following transactions.
• Opening capital at the start of a new business.
• Acquisition of fixed assets paid for by cheque.
• Withdrawal of cash from the business bank account.
• A cash sale to a customer which results in a profit.
• A credit sale to a customer which results in a profit.
• Goods purchased by a business on credit.
You'll now consider the dual effect when a business receives and makes payment for
goods previously sold or purchased on credit. You'll also consider how this affects
the balance sheet equation.
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Business receives and makes payment for credit goods
Example
It's now 23 April and the rugby club gives Lance a cheque for £1,000 for the buffet he
provided on 9 April. Lance pays the cheque into the business bank account on the
same day.
The dual effect of this is to
• increase current assets (bank) by £1,000
• decrease current assets (trade debtors) by £1,000.
The income from this transaction was correctly recorded as turnover at the time the
income was earned. So the payment of £1,000 by the rugby club doesn't affect the
turnover figure.
The revised balance sheet equation after this transaction is shown below, with the
revised figures in bold.
Assets Less liabilities equals Capital
Description £ Description £ Description £
Cash £25 Creditors £900 Opening balance £7,200
Equipment £500
Bank £4,125
Van £2,700
Debtors £750
Total £8,100 Total £900 Closing £7,200
The bank balance has increased by £1,000 because of the cheque paid in. Debtors
have reduced by the same amount because the rugby club is no longer a debtor of
the business.
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The capital account isn't affected by this transaction as it didn't result in a profit or a
loss or involve any capital being introduced or withdrawn by the proprietor. The
business has simply reduced one current asset (trade debtors) and increased
another (the bank account). So it has the same total assets that it had before, it's
just the nature of the assets that has changed. The overall balance sheet equation
isn't affected.
Activity six
It's now 27 April and Lance decides to pay the cash and carry for the purchases
costing £600 that he bought on credit on 15 April.
a) State the dual effect of this transaction.
b) Show the revised balance sheet equation after this transaction has been taken
into account.
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Response
a) The business has paid £600 that it owes to the cash and carry. The bank account
has therefore decreased by
£600 and the amount owed to the cash and carry has decreased by the same
amount.
The dual effect is to decrease current assets (bank) by £600 decrease current
liabilities (trade creditors) by £600.
The purchase from the cash and carry was already correctly recorded as a purchase
of the business at the time the expenditure was incurred.
So the actual payment of £600 to the trade creditor doesn't affect the figure of
purchases again.
b) The revised balance sheet equation after this transaction is shown below, with
the revised figures in bold.
Assets Less liabilities equals Capital
Description £ Description £ Description £
Cash £25 Creditors £300 Opening balance £7,200
Equipment £500
Bank £3,525
Van £2,700
Debtors £750
Total £7,500 Creditors £300 Closing £7,200
The bank balance has decreased because £600 has been paid out. Creditors have
reduced by the same amount because the business no longer owes £600 to the
cash and carry.
The capital account isn't affected by this transaction as it didn't result in a profit or a
loss. Nor did it involve any capital being introduced or withdrawn by the proprietor.
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The business has simply reduced a current asset (the bank account) and reduced a
liability (trade creditors) by the same amount.
So far in this subchapter, you have considered the dual effect and balance sheet
equation for the following transactions.
• Opening capital at the start of a new business.
• Acquisition of fixed assets paid for by cheque.
• Withdrawal of cash from the business bank account.
• A cash sale to a customer which results in a profit.
• A credit sale to a customer which results in a profit.
• Goods purchased by a business on credit.
• Payment received for goods previously sold on credit.
• Payment made for goods previously purchased on credit.
You'll now look at the final business transactions made by Lance during the month of
April.
Example
It's now 28 April and Lance decides to take out an advertisement in his local
newspaper costing £250. He pays for this by cheque from the business bank
account.
Advertising is a day-to-day running expense of the business, and Lance claims this
as an expense in his profit and loss account.
The dual effect of this transaction is to
• decrease current assets (bank)
• increase advertising expenditure.
Expenses reduce the profit of a business, so because profit is added to the capital
account, the capital account will be reduced by this amount.
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The revised balance sheet equation after this transaction is shown below, with the
revised figures in bold.
Assets Less liabilities equals Capital
Description £ Description £ Description £
Cash £25 Creditors £300 Opening
balance
£7,200
Equipment £500 Expenses (£250)
Bank £3,275
Van £2,700
Debtors £750
Total £7,250 Totals £300 Closing £6,950
Activity seven
It's now 30 April and Lance makes the following transactions for the month.
• Pays motor expenses of £80 by cheque.
• Pays business insurance of £120 by cheque.
• Takes personal drawings of £1,000 for himself by cheque.
a) State the dual effect of each of these transactions.
b) Show the revised balance sheet equation after all of these transactions have been
taken into account.
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Response
a) Motor expenses of £80 and business insurance of £120 are day-to-day running
expenses (overheads) of the business. Lance claims these in his profit and loss
account. The dual effect is very similar to the dual effect for advertisement expenses.
It will
• decrease current assets (bank) by £80
• increase motor expenses by £80,
and
• decrease current assets (bank) by £120
• increase insurance expenses by £120.
These expenses both reduce the profit of the business, and as profit is added to the
capital account, capital will be reduced by this amount.
Drawings are value taken out of the business by the proprietor for their own benefit.
Drawings are not part of the day-to-day running expenses of the business and
they don't go in the profit and loss account. The dual effect of Lance's drawings is to
• decrease current assets (bank) by £1,000
• increase drawings by £1,000.
Drawings are deducted in the capital account and therefore reduce the balance on
the capital account.
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b) The revised balance sheet equation after these transactions is shown below, with
the revised figures in bold.
Assets Less liabilities equals Capital
Description £ Description £ Description £
Cash £25 Creditors £300 Opening
balance
£6,950
Equipment £500
Bank £2,075
Van £2,700 Drawings (£1,000)
Debtors £750 Expenses (£200)
Total £6,050 Totals £300 Closing £5,750
Benefits of considering dual effect
In this subchapter, you have looked at the bookkeeping transactions that occurred in
Lance's first month of trading. In each of the examples that you looked at, you
considered the dual effect and the impact on the balance sheet equation after every
single transaction. It was immediately apparent whether each transaction had an
effect on the capital account.
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Instead of considering the effect on the capital account after every transaction, you
can summarise the effect for the whole of April as follows.
Description £
Opening capital 0
Add Capital introduced 5,000
Add Net profit 1,750
Deduct Drawings (1,000)
Closing capital 5,750
At the start of the period, the value of the capital account was nil. The £5,000 that
Lance introduced into the business 'out of his own pocket' is capital introduced, and
as you've seen already, capital introduced is added to the capital account.
The net profit of £1,750 is the income earned from each of the events less the
expenses (purchases, advertising, motor expenses and insurance) incurred in
earning this income. You add net profit to the capital account. The profit from the
functions belongs to Lance but it stays in the business capital account until Lance
takes it in the form of drawings from the business.
If a business makes a loss, the amount of the loss is deducted from the capital
account.
Drawings represent capital withdrawn for the benefit of the proprietor. Drawings are
deducted from the capital account as they reduce the value of the capital account.
The main benefits of considering the dual effect of every business transaction when
preparing financial accounts are as follows.
• The dual effect ensures that each 'leg' of a business transaction is fully
recorded. For example, if a business makes a sale, the dual effect ensures
that the sale is recorded together with how the sale was actually made (for
example, whether this was a cash, cheque or credit sale, and so on).
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• Every business transaction will affect the assets, liabilities or capital of a
business. The effect on these is immediately apparent if the dual effect is
observed.
• It ensures that balance sheet equation is always maintained.
• A complete record of all dual effect transactions will allow a business to
prepare a fully balanced set of financial accounts.
In chapter 4 you'll look at how the dual effect and impact on the balance sheet
equation and capital account are maintained in a much more manageable and
efficient way.
This is the end of the material in this chapter. Now read the review and try the
learning check that follows..
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Review
Anyone who has to look critically at returns or financial accounts needs a good
understanding of basic bookkeeping principles. There are three basic bookkeeping
principles to follow.
• Separate entity concept.
• Balance sheet equation.
• Dual effect.
A business is a separate entity to the proprietor of the business. This is the separate
entity concept. It ensures that the activities of the business are kept separate and
distinct from the personal activities of the proprietor.
A balance sheet is called this because it always balances.
The balance sheet equation states that total assets less total liabilities must equal
capital.
Every business transaction has a dual effect on the assets, liabilities and capital of a
business.
Now test your knowledge of this chapter by doing the learning check that follows.
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Learning check
1. Explain in simple terms what is meant by the separate entity concept.
2. What is the balance sheet equation?
3. The following figures are extracted from a trader's balance sheet. Calculate the
missing figure of current liabilities.
Description £
Fixed assets 75,500
Current assets 12,250
Current liabilities
Long-term liabilities 50,000
Capital 28,500
4. The following is an extract from a trader's capital account.
Calculate the missing figure of capital introduced.
Description £
Opening capital 12,500
Net profit 15,500
Current introduced
Drawings 17,000
Closing capital 15,500
5. In each of the following three scenarios, state the dual effect of the transaction
and the effect on the balance sheet equation.
a) A business purchases a second-hand van for business use, with a cheque for
£2,000 drawn on the business current bank account.
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b) A business takes out a 12-month loan of £5,000 to build a small extension to the
business premises.
c) A business spends £50 in cash on purchases and sells all of the goods on the
same day for £125 in cash.
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Learning check – answers
1. Explain in simple terms what is meant by the separate entity concept.
It means that a business is a separate entity to its proprietor, with its own assets and
liabilities. It ensures that the activities of the business are kept separate and distinct
from the personal activities of the proprietor.
This is in subchapter 3.1.
2. What is the balance sheet equation?
Assets less liabilities must always equal (closing) capital. This is in subchapter 3.2.
3. The following figures are extracted from a trader's balance sheet.
Calculate the missing figure of current liabilities.
Description £
Fixed assets 75,500
Current assets 12,250
Current liabilities 9,250
Long-term liabilities 50,000
Capital 28,500
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You can work this out as set out below (or by using a 'T' account as you'll see in
chapter 4).
Description £ £
Fixed assets 75,500
plus Current assets 12,250 87,750
less Capital (28,500)
Total 59,250
less Long-term liabilities 50,000
Current liabilities (total) 9,250
This is in subchapter 3.2.
4. The following is an extract from a trader's capital account.
Calculate the missing figure of capital introduced.
Description £
Opening capital 12,500
Net profit 15,500
Current introduced 4,500
Drawings 17,000
Closing capital 15,500
You can calculate this by working out the apparent position before taking into
account the missing figure.
In this example opening capital plus net profit less drawings and closing capital
appears to be £11,000 compared to the actual figure of £15,500. So the missing
figure of capital introduced must account for the difference of £4,500.
You can also calculate this using a T account. For information, we show you how to
do this below.
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Dr £ Cr £
Opening capital 12,500
Drawings 17,000 Net profit 15,500
Closing capital 15,500 Capital introduced 4,500
Totals 32,500 32,500
5. In each of the following three scenarios, state the dual effect of the transaction
and the effect on the balance sheet equation.
a) A business purchases a second-hand van for business use, with a cheque for
£2,000 drawn on the business current bank account. This will
• increase fixed assets (vehicles) by £2,000
• decrease current assets (bank) by £2,000.
The overall balance sheet equation is unaffected as the financial position of the
business is the same. It still has the same total assets that it had before, although
made up of different amounts. The increase in one asset has been matched by a
decrease in another asset.
b) A business takes out a 12-month loan of £5,000 to build a small extension to the
business premises.
When the loan is initially advanced, the dual effect is to
• increase current assets (bank) by £5,000
• increase current liabilities (loan creditor) by £5,000.
The capital is not affected, and the financial position of the business is the same as
before. An increase in an asset is matched by an increase in a liability of the same
amount.
When the work is eventually carried out and paid for, the dual effect is to
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• increase fixed assets (premises) by £5,000
• decrease current assets (bank) by £5,000.
Again the overall balance sheet equation is unaffected as the financial position of the
business is the same. An increase in one asset is matched by a decrease in another
asset.
When the loan is repaid, the dual effect is to
• decrease current liabilities (loan creditor) by £5,000
• decrease current assets (bank) by £5,000.
Again the overall balance sheet equation is unaffected as the financial position of the
business is the same.
A decrease in an asset is matched by a decrease in a liability of the same amount.
c) A business spends £50 in cash on purchases and sells all of the goods on the
same day for £125 in cash.
At the time of purchase, the dual effect is to
• increase purchases by £50
• decrease current assets (cash) by £50.
When the goods are sold, the dual effect is to
• increase income by £125
• increase current assets (cash) by £125.
The balance sheet equation is affected by this transaction. Assets have increased by
£75 (£125 income less £50 purchases). The profit from this transaction is added to
the capital account. An increase in assets of £75 is matched with an increase in
capital of £75.
This is in subchapter 3.3
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Before moving on
If you have answered the learning check correctly, you will have successfully
completed the learning outcomes and study objectives for this chapter, which you
can see below.
Learning outcomes
You will
• be able to apply double-entry bookkeeping principles.
Study objectives
To achieve this you need to be able to
• describe the separate entity concept
• explain the balance sheet equation and how business transactions affect it
• demonstrate the dual effect of business transactions.
If you had difficulty in achieving any of these objectives, have another look at the
relevant part(s) of the chapter and try the learning check again. You should be
confident that you have achieved them before moving on.
Finally note any points you might want to discuss with your line manager or tutor.
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Chapter 4 Double Entry Bookkeeping
Introduction
In this chapter, you'll consider two systems of recording business transactions.
• The single-entry system.
• The double-entry system.
You'll then go on to consider the double-entry bookkeeping system in more detail,
and the fundamental principles which must be followed.
The same principles apply whether you're looking at a sole trader, partnership or
company, although some of the terms used may be different. Also, different
businesses may keep different records because of the way in which they're
structured, but the principles that you'll study apply equally to all businesses.
Finally, you'll see how various transactions are recorded in a double-entry
bookkeeping system.
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Learning outcomes and study objectives
This is what you will be able to achieve after you have successfully studied this
chapter.
Learning outcomes
You will
• be able to apply double-entry bookkeeping principles.
Study objectives
To achieve this you need to be able to
• state the differences between single and double- entry bookkeeping systems
• explain the three golden rules of double-entry bookkeeping
• record transactions in a double-entry bookkeeping system.
Study advice
We think it will take you approximately this long to finish the chapter.
Reading main text 1hr 40m
Completing activities and the learning check 2hrs 25m
Total 4hrs 5m
This is only a guide.
The important thing is for you to make sure you understand all the material in the
chapter.
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4.1 Types of Bookkeeping Systems
Bookkeeping is a broad term that covers all aspects of recording the financial
transactions of a business. A key to efficient management of a business is to have a
bookkeeping system that suits that particular business. Let's look at the first of the
two systems used.
4.1.1 Single-entry system
'Single–entry' bookkeeping is where the bookkeeper makes only one entry to record
a business transaction.
Businesses may keep records of incomings and outgoings and amounts owed to and
by them in
• sales and purchases day books
• petty cash and cash books.
These are called books of single entry, or books of original or prime entry.
Sales daybook
This is normally a listing of all the sales invoices for credit sales issued by the
business. The business also keeps a record of the individual trade debtors.
Purchases daybook
This is normally a listing of all the purchase invoices for credit purchases by the
business. The business may also keep a record of the individual trade creditors.
In the purchases daybook, 'purchases' are usually goods for resale, but they may
include all types of business expenses, if they're made on credit.
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Cash book
A cash book is generally a record of all receipts and payments including both cash
and bank receipts and payments. Small businesses may use the purchases and
sales day books and the cash book to control which invoices have been paid.
Petty cash book
Businesses usually need small amounts of cash to spend on stationery, postage and
so on. Businesses often record this expenditure in a petty cash book under separate
headings for the different types of expenditure.
Example
Joe runs a market stall selling fruit. In his first week of trading, he records his
financial transactions in a notebook. Joe uses a notebook but when it's a
commercially produced product, it's usually called a cash book. Joe's income was all
received in cash and he also paid all of his expenses in cash.
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Joe’s cash Book - Week-ending 5 April 2008 (Accessible version)
Date Description Amount £
Tues 1/4 Fruit 50
Sales 75
Wed 2/4 Fruit 60
Paper bags 5
Sales 90
Thurs 3/4 Fruit 80
Sales 120
Fri 4/4 Sandy (petrol) 5
Fruit 80
Sales 120
Sat 5/4 Stall rental 50
Fruit 100
Weekly phone
Calls 5
Sales 150
Despite being called a cash book, the book is used to record all transactions,
whether in cash, through the bank account or on credit.
All cash books will be organised in much the same way, with the left-hand side being
used to record money coming in and the right-hand side used for money going out.
Cash receipts Cash payments
Date Description Amount £
Date Description Amount £
12
December
Sales 1,000 13
December
Purchases 500
The main advantage of a single entry system is that each entry is only made once.
This reduces the amount of time the business needs to spend on bookkeeping.
The main disadvantage of a single-entry system is that there is no way of checking
that the dual effect has been complied with. With a double-entry system, as you saw
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in chapter 3, you can check that the dual effect has taken place and the transactions
balance.
As you saw in chapter 1, calculating a figure of profit or loss can be a straightforward
matter. The profit or loss is the result of deducting expenditure from income.
Therefore, as long as you can identify the income and expenditure, the profit or loss
can be calculated.
Have a go at the following activity.
Activity one
Have another look at Joe's notebook.
a) Calculate his profit for this particular week. Assume that all stock has been sold.
b) How do you think Joe could organise the information in his notebook better?
Response
a. By deducting all of the expenditure from the income, you'll arrive at the figure of
profit
b) Joe should use his notebook as a cash book. To do this, he would be better
showing the entries for sales either on a different side of the page from the entries
for expenditure (as shown on the table below) or on another page.
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He can then add up each side to get the total for the week.
Sales Expenditure
Date Amount £ Date/description Amount £
April 1 75 April 1 Fruit 50
April 2 90 April 2 Fruit 60
April 3 120 April 2 Paper bags 5
April 4 120 April 3 Fruit 80
April 5 150 April 4 Fruit 80
Total 555 April 4 Petrol 5
April 5 Stall rent 50
April 5 Fruit 100
April 5 Telephone 5
Total 435
Calculating his profit is now easier. All that's required is to subtract total expenditure
from total sales and you arrive at the figure of profit.
£555 minus £435 = £120.
Next you'll look at the double-entry system.
4.1.2 Double-entry system
Double-entry bookkeeping generally involves two entries in the accounts for each
transaction.
As you saw in chapter 3, in a double-entry bookkeeping system every transaction
has a dual effect. When Lance purchased his new van for £2,700, he acquired a
new fixed asset valued at £2,700. Another asset, his bank account balance, reduced
by the same amount. If this was Lance's only transaction during the year, he may be
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able to remember the details of the transaction when he completes his tax return.
However, what about Harry who trades as Harry's Newsagents?
In the year ended 31 May 2019, he had sales totalling £116,558. As a newsagent,
Harry's sales figure could be made up of thousands of transactions. He would also
have a similar number relating to expenses. Clearly, he needs an organised
bookkeeping system.
In the previous example, it's comparatively quick and easy for Joe to keep his
notebook.
However, there are two immediate disadvantages with Joe's method of record
keeping.
• There are no entries for cash on hand; only cash received or paid out.
• Joe can't be sure that he's recorded all of the money received or paid out. If
Joe had a record of cash on hand, he'd be able to reconcile this to physical
cash on hand, to ensure that he'd recorded all of the income and expenditure.
To help overcome these disadvantages, accountants use the double-entry system.
In chapter 3 you saw what is meant by the dual effect and the impact on the balance
sheet equation. If a business makes very few transactions in a period, the balance
sheet equation could, in theory, be carried out for each transaction. However, this
would be far too laborious in Harry's case – he'll have made thousands of
transactions in the year.
He requires a more practical way of recording transactions so that the dual effect is
maintained (without having to draw up the balance sheet equation after each and
every transaction) and the trading and profit and loss account and balance sheet can
be prepared. This is where double-entry bookkeeping comes in.
You'll consider the golden rules of double-entry bookkeeping next.
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4.2 Golden Rules of Double-entry Bookkeeping
There are three golden rules of double entry bookkeeping.
1. Transactions are recorded in 'T' accounts* using recognised classifications. The
left-hand side is called debit and the right-hand side is called credit.
* T accounts so called because of the way they appear on the page with a line under
the heading and another down the middle of the page dividing debits from credits.
2. For every debit entry there is an equal and opposite credit entry. This ensures the
dual effect is maintained and the balance sheet equation balances.
3. The words increase, and decrease are replaced with debit and credit, depending
on the classification of the transaction.
Next, you'll consider each rule in more detail.
4.2.1 Golden rule number 1
Transactions are recorded in 'T' accounts.
Transactions are recorded in various ledger accounts.
These ledger accounts are often referred to as 'T' accounts, because they look like
large capital 'T's when they're drawn up.
We'll use the term 'T' accounts throughout this manual. However, when you're
dealing with accountants you should use the term ledger accounts.
The left-hand side of the 'T' account is called the debit (Dr) side, and the right-hand
side is called the credit (Cr) side.
It's important that you remember which side is the debit and which the credit. One
way of remembering could be to think of driving a car. You drive (Dr) on the left and
crash (Cr) on the right!
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Most businesses deal in cash and require a cash account. In a double-entry
bookkeeping system the 'T' account would look something like this.
Cash
Debit (Dr) Credit (Cr)
Date Cash received Date Cash paid out
You'll look at how these 'T' accounts are prepared in more detail shortly.
4.2.2 Golden rule number 2
For every debit entry there is an equal and opposite credit entry.
Every time you make an entry on the debit side of an account, there will be an equal
and opposite entry on the credit side of another account. This satisfies the dual
effect and maintains the balance sheet equation.
4.2.3 Golden rule number 3
The words 'increase' and 'decrease' are replaced with debit and credit depending on the classification of the transaction.
All entries in the double-entry bookkeeping system are based on the following
grouping of the types of transaction.
Debit (Dr) Credit (Cr)
Increase expenses Increase liabilities
Increase assets Increase income
Increase drawings Increase capital
You can see that expenditure, assets and drawings are all debit entries and
liabilities, income and capital are all credit entries, within the relevant account.
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You may find it helpful to think of the phrase 'Dead Clic' which uses the first letter of
each type of transaction and entry to create the acronym (as set out below).
For example, a positive bank account is an asset, so a debit entry in the Bank 'T'
account increases assets. Sales are income, so a credit entry in the Sales 'T'
account increases income.
Example
In chapter 3.4 when Lance started in business, he paid £5,000 of his own money into
the business. The dual effect of this transaction was to increase both an asset (bank
account) and capital.
The entry of £5,000 will go on the debit side in the bank account. This is because the
deposit increases the value of an asset – that is, the bank account. The debit entry
fits the grouping of transaction types noted above.
Activity two
Following on from the previous example, what is the equal and opposite entry to
this transaction? Justify your answer by referring to the golden rules of
bookkeeping.
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Response
You've made an entry on the debit side in the bank account.
By following golden rule number 2, you know the equal and opposite entry to this
transaction must be an entry of equal amount, £5,000, on the opposite (credit) side
of another account.
The money that a proprietor introduces into the business is called capital. Therefore,
in this situation, the credit entry will go in the capital account to increase the level of
capital invested in the business. This fits the grouping of transaction types in
accordance with golden rule number 3.
Example
So far, you have only considered the bookkeeping entries for increases in expenses,
assets, drawings, liabilities, income and capital. You'll now consider the
bookkeeping entries for decreases in these transaction types.
Debit entries are the opposite of credit entries. Therefore, if a debit entry increases
an asset, then a credit entry must decrease an asset.
Similarly, if a credit entry increases liabilities, then a debit entry must decrease
liabilities.
So you only need to remember the bookkeeping entries for increases in transaction
types, as you'll be able to work out the entries for the decrease in transaction types
using logic. This is illustrated below.
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Description Debit Credit
Expenses Increase Decrease
Assets Increase Decrease
Drawings Increase Decrease
Liabilities Decrease Increase
Income Decrease Increase
Capital Decrease Increase
Look at the table on the previous page. You can see that sometimes an entry on the
debit side of an account increases the value of something, such as an expense, and
sometimes it will decrease the value of something, such as a liability.
The use of the words 'increase' and 'decrease' is, therefore, not consistent. You
couldn't, for example, say that for every increase there is an equal and opposite
decrease. It's possible for an increase in assets, perhaps the purchase of a new
van, to have an equal and opposite entry of an increase in a liability, such as a loan
taken out to fund the purchase. This would be confusing.
For this reason, an entry on the left is called a debit whether it increases or
decreases a particular transaction group. Similarly, an entry on the right is always
called a credit. Therefore, you can say that 'for every debit there is an equal and
opposite credit'.
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4.2.4 ‘T' accounts
You have already seen the basic format of a 'T' account earlier in this chapter. It is a
method of keeping a clear division between debit and credit entries in a particular
account.
'T' accounts are prepared for each type of transaction.
For example, there may be a 'T' account for motor vehicles and another one for
motor expenses.
You'll use 'T' accounts as the main form of recording transactions to understand the
basis of the double entry system. Although it's rare for a business to keep its records
using 'T' accounts, you'll find that when problems arise the accountant will invariably
use 'T' accounts to discover the solution. If you're involved in compliance checks,
you'll find yourself doing the same.
Entries in 'T' accounts generally include three specific pieces of information. These
are
• the date of the transaction
• where you can find the corresponding entry and
• the amount of the transaction.
Example
Lucy, a professional photographer, decides it's time to buy a new camera. She can't
decide which camera to get, but knows she'll need to take out a loan to cover the
cost. The cameras she's considering cost up to £2,000, so she decides to take out a
loan for that amount so that she'll have the money available when she finds the right
one. The loan is agreed, repayable over 3 years, and the money is paid into her
business bank account on 1 August.
So what has happened?
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Lucy has taken out a loan (a liability) and increased the value of her bank account
balance (an asset).
The dual effect of this transaction is to increase current assets (bank) and increase
long–term liabilities (loan).
The balance sheet equation would look like this.
Assets less Liabilities equals Capital
Bank - £2,000 Loan - £2,000 = £0
If she records these transactions in 'T' accounts, they will look like this.
Bank
Dr Cr
1 August Loan £2,000
Loan
Dr Cr
1 August Bank £2,000
Do these entries fit in with our bookkeeping rules?
The answer is yes.
1. They're recorded in 'T' accounts, in which the left side records debit entries and
the right side records credit entries.
2. For every debit (bank account) there is an equal and opposite credit (loan
account).
3. The debit entry increases an asset (bank balance), and the credit entry increases
a liability (loan outstanding). This satisfies the grouping of transaction types.
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Interpreting 'T' accounts
In the example on the previous page, the bank account shows you what money Lucy
has deposited into the account. You can see that on 1 August she deposited £2,000.
The description 'Loan' shows where the opposite entry for this transaction can be
found. Remember, the dual effect of bookkeeping means that for every debit entry
you make on the left, there will be an equal and opposite credit entry on the right.
By following the description 'Loan' to the loan account, you can find the opposite
entry. As the entry in the bank account was a debit entry of £2,000, you would
expect the entry in the loan account to be a credit entry of £2,000.
This is confirmed by the loan account, and you can check that the details agree. The
date and amount are the same, and the description of 'Bank' confirms where we can
find the corresponding entry.
Remember the rule that every debit entry has an equal and opposite credit entry.
This ensures that your balance sheet equation remains in balance, but it can also
help your learning. So long as you can decide which side of the relevant 'T' account
one entry goes, you know that the other entry must go on the opposite side of the
other account involved. Then all you need to decide is which account it is.
Now have a go at the two activities that follow.
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Activity three
Two weeks after paying the loan into her bank account, Lucy buys the new camera
to use in her business.
Lucy pays £1,900 for it on 15 August by cheque from the business bank account.
Record the entries in the appropriate 'T' accounts to reflect the purchase of the new
camera.
Bank
Dr Cr
1 August Loan £2,000
Camera
Dr Cr
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Response
Your 'T' accounts should look like this.
Bank
Dr Cr
1 August Loan £2,000 15 August Camera £1,900
Camera
Dr Cr
15 August Bank £1,900
The payment for the camera has come from the bank account. Golden rule number 3
tells you that to decrease an asset, such as a bank account balance, you need to
make a credit entry in that account. If you increase an asset, such as buying a new
camera, you must make a debit entry in that account. Golden rule number 2 has
also been complied with because for every debit entry there is an equal and opposite
credit entry.
As there wasn't a 'Camera' account at that time, you just need to prepare a new 'T'
account and name it appropriately. Make sure the name you give to the account is
reflected in the description entered in the account containing the opposite entry.
Activity four
On 20 August, Lucy receives an inheritance from her great aunt and decides to
introduce this into the business. So she deposits £5,000 into the business bank
account.
Record the entries in the appropriate 'T' accounts to reflect the introduction of the
money into the business.
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Response
Your 'T' accounts should look like this.
Bank
Dr Cr
1 August Loan £2,000 15 August Camera £1,900
20 Aug Capital £5,000
Capital
Dr Cr
20 Aug Bank £5,000
Lucy has deposited the inheritance in the business bank account. Golden rule
number 3 tells you that to increase an asset, such as a bank account balance, you
need to make a debit entry in that account. Lucy has invested £5,000 of her own
money into the business and has increased capital. Golden rule number 3 tells you
that to increase capital, you need to make a credit entry in that account. Golden rule
number 2 has also been complied with because for every debit entry there is an
equal and opposite credit entry.
As there wasn't a 'Capital' account at that time, you just need to prepare a new 'T'
account and name it appropriately. Make sure the name you give to the account is
reflected in the description entered in the account containing the opposite entry.
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4.3 Double-entry Bookkeeping – a Practical Example
In chapter 3 you considered the dual effect and balance sheet equation for Lance, a
mobile caterer. In this subchapter you'll see how to draw up his 'T' accounts.
The transactions are summarised below.
Date Transaction
1 April Invested £5,000 of his own money into a business bank account.
2 April Bought a van for £2,700 by cheque.
3 April Bought cooking equipment for £500 by cheque.
Withdrew £25 cash from the business bank account.
5 April Purchases of food and drink for £300 by debit card using the business bank
account.
Sales of £700 by cheque.
9 April Purchases of £550 by cheque.
Sales of £1,000 on credit to Readstone RFC.
15 April Purchases of £600 on credit from Cash and Carry Ltd.
Sales of £1,500 by cheque.
19 April Purchases of £300 on credit from Cash and Carry Ltd.
Sales of £750 on credit to Readstone RFC.
23 April Received cheque for £1,000 from Readstone RFC.
27 April Paid cheque for £600 to Cash and Carry Ltd.
28 April Placed an advert for £250 by cheque in the Readstone Gazette.
30 April Paid motor expenses of £80 by cheque.
Paid insurance of £120 by cheque.
Took out private drawings of £1,000 by cheque.
You saw the dual effect of these transactions and proved that the balance sheet
equation was satisfied in each case. You also found that it was a fairly laborious task
to carry out the balance sheet equation every time.
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One of the advantages of preparing 'T' accounts over the balance sheet equation, is
that it saves time. Once a 'T' account has been opened, you can start to build up
entries in it.
Using the transactions for Lance, summarised above, let's now consider how these
would be reflected in 'T' accounts.
Example
The first transaction carried out by Lance as a businessman was to invest £5,000 of
his own money into a business bank account.
You have seen that the dual effect of this transaction was as follows.
• Increase to current assets (bank), and
• Increase to capital.
The balance sheet equation at this stage was, therefore
Assets less Liabilities = Capital
Bank - £5,000 0 = £5,000
This transaction can be reflected by making bookkeeping entries in 'T' accounts, in
accordance with our golden rules of bookkeeping. You know that this transaction will
have both a debit and credit entry. By following the transaction grouping, you can
see that the capital introduced will be a credit entry. The opposite entry must be an
equal debit. In this case, Lance's business now has an asset, £5,000 in a bank
account.
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Therefore, the required bookkeeping entries are
Bank
Dr Cr
1 April Capital £5,000
Capital
Dr Cr
1 April Bank £5,000
Example
When Lance bought his new van on 2 April, the dual effect and balance sheet
equation looked like this.
Increase fixed assets - the van.
Decrease current assets – money in the bank.
The revised balance sheet equation was
Assets less Liabilities = Capital
Bank - £2,300 0
Van - £2,700 0
Total = £5,000 0 = £5,000
Again, let's consider how this transaction would be reflected in 'T' accounts.
The 'T' accounts concerned are 'Bank' and 'Van'. Both accounts are assets, so the
account that increases must have a debit entry and the account that decreases must
have a credit entry.
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The van account is clearly increasing and, as there is less money in the bank
account than there was before this transaction, that account must be decreasing.
Therefore the 'T' accounts would look like this.
Van
Dr Cr
2 April Bank £2,700
Bank
Dr Cr
1 April Capital £5,000 2 April Van £2,700
As you can see, the bank 'T' account is starting to build up a picture of all
transactions that have gone through this account.
Activity five
Now complete 'T' accounts to record Lance's transactions on
3 April when he bought cooking equipment for £500 by cheque and withdrew £25
cash from the business bank account.
Remember that where an account has already been opened, such as bank, you
should continue to use it, so that you begin to build up a picture of all transactions
through that account.
Once you have completed this activity, check your answer with the response. You
should keep your workings, as you may need to refer to them again or expand on
them as the activities and examples progress.
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Response
The dual effect for the first transaction on 3 April was to
• increase fixed assets (equipment), and
• decrease current assets (bank).
The transaction would be reflected in the 'T' accounts as follows.
Cooking equipment
Dr Cr
3 April Bank £500
Bank
Dr Cr
1 April Capital £5,000 2 April Van £2,700
3 April Cooking
equipment
£500
The dual effect for the second transaction on 3 April was to
• increase current assets (cash), and
• decrease current assets (bank).
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This transaction would be reflected in the 'T' accounts as follows.
Cash
Dr Cr
3 April Bank £25
Bank
Dr Cr
1 April Capital £5,000 2 April Van £2,700
3 April Cooking
equipment
£500
3 April Cash £25
Both of these transactions represent movements in assets. Cash held in the bank is
a current asset. The cooking equipment is a fixed asset, and cash on hand is
another current asset.
The balance sheet equation is maintained by an increase in one asset being
balanced by a decrease in another.
Look at the transactions for Lance on 5 April. He purchased food and drink for £300
by debit card using the business bank account. Sales of £700 were paid for by
cheque.
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Example
The dual effect for the first transaction on 5 April was to
• increase purchases, and
• decrease current assets (bank).
This transaction is a purchase of goods for resale, so you'll need a purchases
account. Purchases are an expense, and golden rule number 3 tells you that to
increase an expense, you need to make a debit entry in the expense (purchases)
account.
This means that you already know that the opposite entry should be a credit entry.
The account affected is the bank account and, again, golden rule number 3 confirms
that to decrease an asset (bank), you should make a credit entry in that account.
This is the first purchase, so you need to draw up a new 'T' account, but you'll make
the entry for the bank account in the existing bank 'T' account.
Purchases
Dr Cr
5 April Bank £300
Bank
Dr Cr
1 April Capital £5,000 2 April Van £2,700
3 April Cooking
equipment
£500
3 April Cash £25
5 April Purchases £300
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You don't need to check the dual effect and balance sheet equation for all
transactions. Once you're satisfied that you understand how the transactions
translate into 'T' account entries, all you need to show are the 'T' accounts.
Activity six
Now complete the bookkeeping entries to record the sales of £700 on 5 April, paid
for by cheque, and the purchase of £550 by cheque on 9 April, by either updating the
accounts you have already started to prepare or creating a new account if required.
Response
The bookkeeping entries required are
Sales
Dr Cr
5 April Bank £700
Bank
Dr Cr
1 April Capital £5,000 2 April Van £2,700
5 April Sales £700 3 April Cooking
equipment
£500
3 April Cash £25
5 April Purchases £300
9 April Purchases £550
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Purchases
Dr Cr
5 April Bank £300
9 April Bank £550
The dual effect of the sale is to increase current assets (bank) and increase income.
You know from golden rule number 3 that an increase in assets is a debit entry, and
therefore the debit entry will be made in the bank 'T' account to reflect the increase in
the asset. From golden rule number 2, you also know that for every debit there must
be an equal and opposite credit. Therefore, the credit entry will be made in the sales
'T' account to reflect the increase in income.
The purchase is recorded in exactly the same way as before.
Example
The purchases on 9 April that you have just recorded resulted in sales of £1,000. On
this occasion, Lance didn't receive the money from Readstone RFC straightaway.
Instead, he agreed to allow them terms of up to 2 weeks to settle their bill.
The dual effect of this transaction is to increase income and increase current assets
(trade debtors).
A sale has been made, and golden rule number 3 confirms that income is a credit
entry in the income or sales account. The next step is to decide where to make the
debit entry.
No money has been received by Lance, so the debit entry isn't in either the bank or
the cash account.
However, the income that Lance has not yet received is an asset. Readstone RFC
owes Lance £1,000. They are a trade debtor, so to record the debit side of the
transaction a new account must be opened.
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Sales
Dr Cr
5 April Bank £700
9 April Readstone
RFC
£1,000
Readstone RFC (debtor)
Dr Cr
9 April Sales £1,000
You can see that by following the basic golden rules, the correct bookkeeping entries
can be made. Some bookkeepers may just open one account for all trade debtors,
rather than have a separate account for each individual debtor. Both methods are
acceptable. The important point is to ensure that the transactions are recorded on
the correct side of the accounts in question.
Activity seven
In the previous transaction, Lance made a purchase by cheque and a sale on credit.
On 15 April, the reverse happened; he made purchases of £600 on credit from Cash
and Carry Ltd and sales of £1,500 by cheque.
Complete the 'T' accounts required to record the transactions on 15 April.
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Response
The 'T' accounts should look like this.
Purchases
Dr Cr
5 April Bank £300
9 April Bank £550
15 April Cash &
Carry
Limited
£600
Cash & Carry Limited (creditor)
Dr Cr
15 April Purchases £600
Sales
Dr Cr
5 April Bank £700
9 April Readstone
RFC
£1,000
15 April Bank £1,500
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Bank
Dr Cr
1 April Capital £5,000 2 April Van £2,700
5 April Sales £700 3 April Cooking
equipment
£500
15 April Sales £1,500 3 April Cash £25
5 April Purchases £300
9 April Purchases £550
The first bookkeeping entries required are for the purchases made on credit from
Cash & Carry Ltd. The dual effect of this transaction is to increase purchases and
increase current liabilities (trade creditors). The purchase can be debited in the
purchases account in the same way as the earlier purchases.
Unlike the earlier purchases, Lance hasn't paid for these yet, so the opposite credit
entry can't go into the cash or bank account.
Cash & Carry Ltd are a trade creditor of Lance's. He now owes money to this
supplier, and so his records need to reflect this outstanding liability. This is done by
opening an account in the supplier's name and making the opposite credit entry in
there.
As you saw with trade debtors, the bookkeeper may just open one account for all
trade creditors, rather than have a separate account for each individual creditor. The
important point is to ensure that the transactions are recorded on the correct side of
the accounts in question.
The second bookkeeping entries required are for the sales received by cheque. The
dual effect of this transaction is to increase income and increase current assets
(bank). The sale is credited to the sales 'T' account in the same way as earlier sales.
The opposite debit entry will be recorded in the bank 'T' account to reflect the
increase in current assets.
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Activity eight
Now update your 'T' account workings, or prepare new accounts as necessary, to
reflect the transactions that occurred on 19 April, which were purchases of £300 on
credit from Cash and Carry Ltd and sales of £750 on credit to Readstone RFC.
Response
Purchases
Dr Cr
5 April Bank £300
9 April Bank £550
15 April Cash &
Carry
Limited
£600
19 April Cash &
Carry
Limited
£300
Cash & Carry Limited (creditor)
Dr Cr
15 April Purchases £600
19 April Purchases £300
Readstone RFC (debtor)
Dr Cr
9 April Sales £1,000
19 April Sales £750
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Sales
Dr Cr
5 April Bank £700
9 April Readstone
RFC
£1,000
15 April Bank £1,500
19 April Redstone
RFC
£750
So far, you have looked at how to record investment of capital, expenditure on
assets, transfers of money between the bank account and cash account, and
purchases paid for at the time as well as on credit. You have also looked at the
bookkeeping entries required for sales by cheque and on credit. You'll now look at
what happens when a debtor makes a payment.
Example
On 23 April, Lance received a £1,000 cheque from Readstone RFC for the sale
originally made on 9 April.
When the original sale was recorded, a credit entry was made in the sales account,
with a corresponding debit entry in an account in the name of Readstone RFC.
So no new entry needs to be made in the sales account, but this time Lance has
received a cheque and this needs to be recorded in the bank account.
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The entries required in the 'T' accounts are as follows.
Bank
Dr Cr
1 April Capital £5,000 2 April Van £2,700
5 April Sales £700 3 April Cooking
equipment
£500
15 April Sales £1,500 3 April Cash £25
23 April Redstone
RFC
£1,000 5 April Purchases £300
9 April Purchases £550
Readstone RFC (debtor)
Dr Cr
9 April Sales £1,000 23 April Bank £1,000
19 April Sales £750
The receipt of the cheque has been entered in the bank account as a debit entry
(increase an asset). The opposite entry is a credit entry (reduce an asset) in the
account for Readstone RFC.
Take a look at the account for Readstone RFC. You can see that Lance's debtor (an
asset) has been reduced, but another asset, the bank, has increased by the same
amount. This maintains the dual effect and balance sheet equation.
Activity nine
On 27 April, Lance paid £600 that he owed to Cash & Carry Ltd with a cheque. This
is a similar situation to the one with Readstone RFC. This time however, Lance has
made a payment to a creditor rather than received a payment from a debtor.
Update the necessary accounts to reflect this transaction.
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Response
The only accounts affected are the bank account, to record the payment and the
Cash & Carry Ltd creditor account, to reflect receipt of the payment. These are
shown below.
Bank
Dr Cr
1 April Capital £5,000 2 April Van £2,700
5 April Sales £700 3 April Cooking
equipment
£500
15 April Sales £1,500 3 April Cash £25
23 April Redstone
RFC
£1,000 5 April Purchases £300
9 April Purchases £550
27 April Cash &
Carry Ltd
£600
Cash & Carry Limited (creditor)
Dr Cr
27 April Bank £600 15 April Purchases £600
19 April Purchases £300
The dual effect of this transaction is to decrease current liabilities (Cash and Carry
Ltd (creditor)) and decrease current assets (bank). You know from golden rule
number 3 that debit entries decrease liabilities. So the debit entry must be made in
the Cash & Carry Ltd trade creditor account. The opposite credit entry must be
shown in the bank 'T' account to reflect the decrease in the bank account.
Remember, the descriptions used should reflect the name of the account in which
the opposite entry will be located. They shouldn't be a description of what has
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happened. The credit entry in the bank account is described as Cash & Carry Ltd
(creditor) not purchases.
Activity ten
Now complete the bookkeeping entries for the remaining transactions.
On 28 April - placed an advert for £250 by cheque in the Readstone Gazette.
30 April - paid motor expenses of £80 by cheque, paid insurance of £120 by cheque
and took out private drawings of £1,000 by cheque.
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Response
Advertising
Dr Cr
28 April Bank £250
Bank
Dr Cr
1 April Capital £5,000 2 April Van £2,700
5 April Sales £700 3 April Cooking
equipment
£500
15 April Sales £1,500 3 April Cash £25
23 April Redstone
RFC
£1,000 5 April Purchases £300
9 April Purchases £550
27 April Cash &
Carry Ltd
£600
28 April Advertising £250
30 April Motor
expenses
£80
30 April Insurance £120
30 April Drawings £1,000
Motor expenses
Dr Cr
30 April Bank £80
Insurance
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Dr Cr
30 April Bank £120
Drawings
Dr Cr
30 April Bank £1,000
The first three transactions all have the dual effect of increasing expenses and
decreasing current assets (bank). You know from golden rule number 3 that debit
entries increase expenses. Therefore, the debit entry must be made in the relevant
expenses 'T' account. The corresponding credit entry will be made in the bank 'T'
account to reflect the decrease in the asset.
The dual effect for the final transaction is to increase drawings and decrease current
assets (bank). You know from the above example that decreases in cash are credit
entries. The corresponding debit entry must go to the drawings account. Golden rule
number 3 says that debit entries increase drawings. So you can be satisfied that
these entries have been accounted for correctly.
This is the end of the material in this chapter. The next stage will be to balance off
the accounts and prepare a trial balance. You'll look at this in the next chapter.
Now read the review and try the learning check that follows.
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Review
A 'single-entry' bookkeeping system is where you only make one entry to record a
business transaction. A typical example of this is a cash book.
A 'double-entry' bookkeeping system is where there are always two entries for each
transaction. Transactions are recorded in a systematic way using 'T' accounts. This
makes it easier to follow each business transaction and keep a closer control of
cash.
It's important that transactions are recorded in a systematic and efficient way. As the
number of bookkeeping transactions increases, it becomes even more important that
you are methodical, consistent and logical in your approach. Make sure each
transaction is fully dealt with before moving onto the next.
There are three golden rules of double-entry bookkeeping.
1. Transactions are recorded in 'T' accounts using recognised classifications. The
left-hand side is called debit and the right-hand side is called credit.
2. For every debit entry there is an equal and opposite credit entry. This ensures the
dual effect is maintained and the balance sheet equation balances.
3. The words 'increase' and 'decrease' are replaced with debit and credit, depending
on the classification of the transaction.
Debit entries increase expenses, assets and drawings (Dead).
Credit entries increase liabilities, income and capital (Clic).
If debit entries increase expenses, assets and drawings, then credit entries must
decrease expenses, assets and drawings.
Similarly, if credit entries increase liabilities, income and capital, then debit entries
must decrease liabilities, income and capital.
Now test your knowledge of this chapter by doing the learning check that follows.
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Learning check
1. Correct the following statement.
Delete one of the bracketed words as appropriate to complete the following
statements.
All cashbooks are organised in a similar way, with the left-hand side being used to
record money (coming in / going out), and the right-hand side used to record
money (coming in / going out).
2. Complete the following phrase by adding a word at (enter here).
For every (enter here) there has to be an equal and opposite (enter here).
3. Complete the table below with the words increase or decrease in the spaces
provided in the Debit and Credit columns.
Description Debit Credit
Expenses
Assets
Drawings
Liabilities
Income
Capital
4. On 26 July 2018, Joe purchased a new notebook in which to record his
transactions. He paid £3 in cash for this. Joe has decided to open a 'T' account
under the title 'stationery'.
Would the entry in the stationery 'T' account for the cost of this new notebook be a
Dr or Cr entry?
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5. Joe prepared the following 'T' accounts and has asked you to confirm that there
are no mistakes.
What is your response?
If any of the entries are incorrect, draw up the corrected 'T' accounts.
Cash
Dr £ Cr £
11 April Purchases 70 11 April Sales 90
Sales
Dr £ Cr £
11 April Cash 90
Purchases
Dr £ Cr £
11 April Cash 70
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6. Record the following transactions for Jamie in the relevant 'T' accounts.
Date Transaction
1 Jan Introduced £5,000 capital into the business bank account.
3 Jan Purchased plant and machinery using the business debit card costing
£3,000.
5 Jan Made purchases of goods for resale of £500 paid for using the business
debit card.
9 Jan Cash sales of £600.
10 Jan Sales of £300 on credit to Byron Ltd.
15 Jan Made purchases of goods for resale of £350 on credit from Cash Traders
Ltd.
20 Jan Took out private drawings by cheque of £200.
25 Jan Paid £200 by cheque to Cash Traders Ltd.
30 Jan Paid insurance of £110 using the business debit card.
31 Jan Received a cheque of £200 from Byron Ltd.
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Learning check – answers
1. Correct the following statement.
All cashbooks are organised in a similar way, with the left-hand side being used to
record money (coming in), and the right-hand side used for money (going out).
This is in subchapter 4.1.
2. Complete this phrase - For every (enter here) there has to be an equal and
opposite (enter here).
Answer - For every Debit there has to be an equal and opposite Credit.
Or for every Credit there has to be an equal and opposite Debit.
This is in subchapter 4.2.
3. Complete the table below with the words increase or decrease as appropriate.
Description Debit Credit
Expenses Increase Decrease
Assets Increase Decrease
Drawings Increase Decrease
Liabilities Decrease Increase
Income Decrease Increase
Capital Decrease Increase
This is in subchapter 4.2.
4. On 26 July 2018, Joe purchased a new notebook in which to record his
transactions. He paid £3 in cash for this. Joe has decided to open a 'T' account
under the title 'stationery'. Would the entry in the stationery 'T' account for the cost of
this new notebook be a Dr or Cr entry?
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It will be a debit entry. By purchasing the notebook, Joe has incurred expenditure.
Expenditure creates a debit entry in the appropriate expense account in the trader's
books (the credit entry will be in the cash 'T' account).
This is in subchapter 4.2.
5. Joe prepared the following 'T' accounts and has asked you to confirm that there
are no mistakes. What is your response?
If any of the entries are incorrect, draw up the corrected 'T' accounts.
Joe has become slightly confused when recording purchases and sales.
Joe had to spend cash to buy fruit on the morning of
11 April. So the entry in the cash 'T' account for those purchases should be a credit
entry. The corresponding entry in the purchases 'T' account should be a debit entry.
Joe receives cash for goods sold and the entry in the cash
'T' account should be a debit entry. The corresponding entry in the sales 'T' account
should be a credit entry.
The correct entries should look as follows.
Cash
Dr £ Cr £
11 April Sales 90 11 April Purchases 70
Sales
Dr £ Cr £
11 April Cash 90
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Purchases
Dr £ Cr £
11 April Cash 70
Joe made two debit entries, £70 and £90, and two credit entries in equal amounts.
So the accounts would balance but the records are wrong as the entries are on the
wrong side.
This is in subchapters 4.2 and 4.3.
6. Record the transactions for Jamie in the relevant 'T' accounts.
Capital
Dr £ Cr £
1 Jan Bank 5,000
Bank
Dr £ Cr £
1 Jan Capital 5,000 3 Jan Plat &
Machinery
3,000
31 Jan Byron
Limited
200 5 Jan Purchases 500
20 Jan Drawings 200
25 Jan Cash
Traders
Limited
200
30 Jan Insurance 110
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Plant and machinery
Dr £ Cr £
3 Jan Bank 3,000
Purchases
Dr £ Cr £
5 Jan Bank 500
15 Jan Cash
Traders
Limited
350
Cash
Dr £ Cr £
9 Jan Sales 600
Sales
Dr £ Cr £
9 Jan Cash 600
10 Jan Byron
Limited
300
Byron Limited (debtors)
Dr £ Cr £
10 Jan Sales 300 31 Jan Bank 200
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Cash Traders Limited (creditors)
Dr £ Cr £
25 Jan Bank 200 15 Jan Purchases 350
Drawings
Dr £ Cr £
20 Jan Bank 200
Insurance
Dr £ Cr £
30 Jan Bank 110
This is in subchapters 4.2 and 4.3.
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Before moving on
If you have answered the learning check correctly, you will have successfully
completed the learning outcomes and study objectives for this chapter, which you
can see below.
Learning outcomes
You will
• be able to apply double-entry bookkeeping principles.
Study objectives
To achieve this you need to be able to
• state the differences between single and double- entry bookkeeping systems
• explain the three golden rules of double-entry bookkeeping
• record transactions in a double-entry bookkeeping system.
If you had difficulty in achieving any of these objectives, have another look at the
relevant part(s) of the chapter and try the learning check again. You should be
confident that you have achieved them before moving on. There is also a space for
you to note any points you might want to discuss with your line manager or tutor.
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Chapter 5 Financial Accounts Preparation
Introduction
In this chapter, you'll see how to balance off accounts at the end of a period of
trading. You'll consider the purpose of a trial balance and the stages involved in
closing the various accounts.
You'll then see how these processes help you to prepare the financial accounts. The
same principles apply whether you're looking at a sole trader, partnership or
company.
The purpose of the trading and profit and loss account is to establish whether a
business has made a profit or loss over a given period. You'll look at how to prepare
a trading and profit and loss account.
Finally, you'll consider the importance of the balance sheet, how it's prepared and
how certain transactions affect it.
Learning outcomes and study objectives
This is what you will be able to achieve after you have successfully studied this
chapter.
Learning outcomes
You will
• be able to prepare the initial financial accounts of a sole trader.
Study objectives
To achieve this you need to be able to
• demonstrate how to draw up a trial balance
• demonstrate how to close off the various accounts at a period end
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• prepare a trading and profit and loss account and balance sheet.
Study advice
We think it will take you approximately this long to finish the chapter.
Reading main text - 2hrs 25m, completing activities and the learning check - 2hrs
25m, Total - 4hrs 50m
This is only a guide. The important thing is for you to make sure you understand all
the material in the chapter.
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5.1 The Trial Balance
You can spend a lot of time preparing financial accounts and you can lose even
more time if they don't balance (in other words the balance sheet equation doesn't
balance: assets less liabilities do not equal capital). One of the main reasons for this
could be an error in recording transactions in 'T' accounts.
To avoid this, accountants prepare a trial balance before preparing the financial
accounts. The first stage in preparing a trial balance is to calculate the balance on
each 'T' account and you'll look at this next.
5.1.1 Balancing 'T' accounts
Balancing means adding up both sides of a 'T' account and checking that they agree.
Accounts are balanced for a number of reasons, including
• to establish the amount outstanding or accumulated at any particular time.
For example, the total on a sales account indicates the amount of sales a
business made in a financial period
• as a start to preparing a trading and profit and loss account, and a balance
sheet.
Example
Lucy's Bank 'T' account at the end of August showed the following transactions.
Bank
Dr £ Cr £
1 August Loan 2,000 15 August Camera 1,900
20 August Capital 5,000 20 August Purchases 550
20 August Sales 3,500 21 August Electricity 20
25 August Sales 750 28 August Telephone 25
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To balance off this account, Lucy will need to follow these steps.
1. Total up the entries on each side of the 'T' account to establish which side has the
highest amount. Take the largest figure and enter this as the total on both the debit
and credit sides.
2. Now deduct the smallest total from the largest. The difference is the balance.
Enter this on the side of the
'T' account which had the smallest total so that both sides of the account now
balance.
3. This entry is described as 'Balance c/d' or 'Balance c/f', which means balance
carried down or carried forward.
4. If the balance c/d is an entry on the credit side of the 'T' account, the opposite
entry will be a 'balance b/d' (brought down) or 'balance b/f' (brought forward) on the
debit side of the 'T' account. This is entered below the total figure showing the total
of the debit entries. Similarly, if the balance c/d is an entry on the debit side of the 'T'
account, the opposite entry will be a 'balance b/d' or 'balance b/f' on the credit side of
the account. This is entered below the total figure showing the total of the credit
entries. This maintains golden rule number 2 – for every debit there is an equal and
opposite credit.
Balance brought down dates
The convention used in this SSM is that 'T' accounts for assets and liabilities, which
will be reflected in the balance sheet, show the start of the following accounting
period as the balance brought down date.
So for accounts for the year ending 31 December 2019, the balance brought down
date for 'T' accounts for assets and liabilities would be 1 January 2020.
For income and expenditure (such as sales and purchases), which will go in the
trading and profit and loss account, the balance brought down date is the end of the
current accounting period.
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So for accounts for the year ending 31 December 2018, the balance brought down
date for 'T' accounts for income and expenditure would be 31 December 2018.
The balance brought down date for the drawings account is the end of the current
accounting period.
So for accounts for the year ending 31 December 2018, the balance brought down
date for the drawings account would be 31 December 2018.
The balance brought down date for the capital account may be either the end of the
current accounting period or the start of the next. You may start off as the end of the
current accounting period before you include the entries for drawings, net profit and
capital introduced. Once you've included these, the balance brought down date will
change to the date of the start of the next accounting period (like any other liability).
Balancing 'T' accounts is easier to demonstrate by example.
If Lucy's Bank 'T' account was balanced on 31 August it would look like this.
Bank
Dr £ Cr £
1 August Loan 2,000 15 August Camera 1,900
20 August Capital 5,000 20 August Purchases 550
20 August Sales 3,500 21 August Electricity 20
25 August Sales 750 28 August Telephone 25
31 Aug Bal c/d
(2 & 3)
8,755
(1) 11,250 (1) 11,250
1 Sept Bal b/d (4) 8,755
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The additional entries have been made in bold. The figures in brackets indicate
which of the steps from the earlier page has been used.
The balance on an account is described as a credit balance or a debit balance
depending on which side of the account the balance is shown at the start of the
following period. For example, Lucy's bank 'T' account has a debit balance brought
down of £8,755 on 1 September because the opening balance on the account in the
following period will be on the debit side.
Another way of thinking about whether the balance should be described as a debit or
credit balance is to consider which side of the account is the highest. If debits
exceed credits, the balance on the account is a debit balance and if credits exceed
debits, the balance on the account is a credit balance.
It may help you if you remember 'Dead Clic' again (take the first letter of the key
words in the next two sentences)
• a debit balance for expenses, assets or drawings
• a credit balance for liabilities, income or capital.
All individual accounts are balanced in the same way. All accounts must be balanced
correctly if accurate trading and profit and loss accounts and balance sheets are to
be prepared.
Because all accounts are balanced in much the same way, the process can become
monotonous. So you must be consistent and methodical in your approach to the
task.
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Example
In chapter 4 you prepared individual accounts for Lance for his capital, bank, van,
cooking equipment, cash, purchases, sales, Readstone RFC, Cash & Carry Ltd,
advertising, motor expenses, insurance and drawings.
At the end of April Lance decides to review his business performance for the first
month of trading. To do this he needs to start by balancing off all the accounts he
has opened so far.
The first two accounts that he opened were the capital and bank accounts so start
with these.
Bank
Dr £ Cr £
30 Apr Bal c/d
(2 & 3)
5,000 1 Apr Bank 5,000
(1) 5,000 (1) 5,000
30 Apr Bal b/d (4) 5,000
Add up both sides of the account and insert a balancing figure on the smallest side
to make sure they add up to the same amount.
This figure is then brought down to the opposite side of the account.
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Let's see how Lance's bank account, which has more entries, would be balanced.
Bank
Dr £ Cr £
1 Apr Capital 5,000 2 Apr Van 2,700
5 Apr Sales 700 3 Apr Cooking
Equipment
500
15 Apr Sales 1,500 3 Apr Cash 25
23 Apr Readstone
RFC
1,000 5 Apr Purchases 300
9 Apr Purchases 550
27 Apr Cash & Carry
Ltd
600
28 Apr Advertising 250
30 Apr Motor
Expenses
80
30 Apr Insurance 120
30 Apr Drawings 1,000
30 Apr Bal c/d
(2 & 3)
2,075
(1) 8,200 (1) 8,200
1 May Bal b/d (4) 2,075
To balance the bank account both the debit and credit side entries need to be
totalled. The debit entries total £8,200 and the credit entries £6,125. As debits
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exceed credits this immediately says that the balance on this account will be a debit
balance. In other words, an entry needs to be made on the credit side to balance the
account and this balance will be brought down to the debit side.
Remember it's the side to which the balance is brought down that dictates whether
it's known as a debit or credit balance.
Both sides need to add up to £8,200. To achieve this, make a credit entry of £2,075,
which is then carried down. As you have seen this is brought down as a debit
balance.
It's worth checking whether the balances brought down are as you would expect.
The capital account has a credit balance and so will be shown as a liability in the
financial accounts, meaning the business owes Lance £5,000. This is how much
Lance has put into the business and so he is due this amount back at some point. In
the circumstances, you would expect the capital account to have a credit balance.
Similarly more money has been paid into the business bank account than has been
withdrawn, so you would expect the bank account balance to be an asset of the
business. This is confirmed by the debit balance on the bank 'T' account.
Now try the next activity.
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Activity one
Now balance the van, cooking equipment and cash accounts for Lance. In each case
consider whether it's a debit or credit balance brought down and whether this is what
you would expect.
Van
Dr £ Cr £
2 Apr Bank 2,700
Cooking equipment
Dr £ Cr £
3 Apr Bank 500
Bank
Dr £ Cr £
3 Apr Bank 25
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Response
Here are the balanced accounts.
Van
Dr £ Cr £
2 Apr Bank 2,700 30 Apr Bal c/d
(2 & 3)
2,700
(1) 2,700 (1) 2,700
1 May Bal b/d (4) 2,700
Cooking equipment
Dr £ Cr £
3 Apr Bank 500 30 Apr Bal c/d
(2 & 3)
500
(1) 500 (1) 500
1 May Bal b/d (4) 500
Bank
Dr £ Cr £
3 Apr Bank 25 30 Apr Bal c/d
(2 & 3)
25
(1) 25 (1) 25
1 May Bal b/d (4) 25
All of the accounts have debit balances, and all are assets so this is what you would
expect.
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Example
The next account to be balanced is purchases. Purchases are an expense of the
business and so you would expect the balance to be a debit balance.
The balanced account is as follows.
Purchases
Dr £ Cr £
5 Apr Bank 300
9 Apr Bank 550
15 Apr Cash &
Carry
Limited
600
19 Apr Cash &
Carry
Limited
300 30 Apr Bal c/d
(2 & 3)
1,750
(1) 1,750 (1) 1,750
30 Apr Bal b/d (4) 1,750
The account has a debit balance as expected. As purchases will go into the trading
account, the balance brought down date is 30 April (the end of the accounting
period).
Try the activity that follows.
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Activity two
You have seen what the purchases account looks like once it has been balanced.
Sales are, essentially, the opposite of purchases and so you would expect this to be
reflected in the accounts. Balance the sales account for April.
Sales
Dr £ Cr £
5 Apr Bank 700
9 Apr Read RFC 1,000
15 Apr Bank 1,500
19 Apr Read RFC 750
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Response
Sales
Dr £ Cr £
5 Apr Bank 700
9 Apr Read RFC 1,000
15 Apr Bank 1,500
30 Apr Bal c/d 3,950 19 Apr Read RFC 750
3,950 3,950
30 Apr Bal b/d 3,950
The balance on the sales account is a credit balance. This is opposite to the
purchases account and is exactly what you would expect.
Example
The accounts for Readstone RFC and Cash & Carry Ltd does need to be balanced
and this is done in the same way as all the other accounts.
Readstone RFC
Dr £ Cr £
9 Apr Sales 1,000 23 Apr Bank 1,000
19 Apr Sales 750 30 Apr Bal c/d 750
1,750 1,7507
1 May Bal b/d 750
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Cash and Carry Limited
Dr £ Cr £
27 Apr Bank 600 15 Apr Purchases 600
30 Apr Bal c/d 300 19 Apr Purchases 300
900 900
1 May Bal b/d 300
The debit balance on the Readstone RFC accounts shows that they are a debtor of
Lance's business and owe them £750.
The credit balance on the account confirms that
Cash & Carry Ltd will be a creditor of Lance's business. He still owes them £300 for
purchases made during April for which payment has not yet been made.
Now balance the 'T' accounts in the next activity.
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Activity three
There are now only four accounts that need to be balanced.
These are the accounts for advertising, motor expenses, insurance and drawings.
Balance each account off as at 30 April.
Advertising
Dr £ Cr £
28 Apr Bank 250
Motor expenses
Dr £ Cr £
30 Apr Bank 80
Insurance
Dr £ Cr £
30 Apr Bank 120
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Drawings
Dr £ Cr £
30 Apr Bank 1,000
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Response
Advertising
Dr £ Cr £
28 Apr Bank 250 30 Apr Bal c/d
(2 & 3)
250
(1) 250 (1) 250
30 Apr Bal b/d (4) 250
Motor expenses
Dr £ Cr £
30 Apr Bank 80 30 Apr Bal c/d
(2 & 3)
80
(1) 80 (1) 80
30 Apr Bal b/d (4) 80
Insurance
Dr £ Cr £
30 Apr Bank 120 30 Apr Bal c/d
(2 & 3)
120
(1) 120 (1) 120
30 Apr Bal b/d (4) 120
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Drawings
Dr £ Cr £
30 Apr Bank 1,000 30 Apr Bal c/d
(2 & 3)
1,000
(1) 1,000 (1) 1,000
30 Apr Bal b/d (4) 1,000
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5.1.2 Preparation and presentation of a trial balance
The purpose of the trial balance is to check the arithmetical accuracy of the double
entry bookkeeping system. This is a key advantage of a double entry system
compared to a single entry system.
The trial balance is extracted by following three basic steps.
1. Balance all 'T' accounts to a particular date. Usually this is at the end of a
financial period, but it can be more regularly, for example on a monthly basis.
2. Extract the balances from the 'T' accounts and list all the debit balances in one
column of the trial balance and the credit balances in another.
3. Add up both columns. The totals should agree, and the accountant will then go on
to prepare the financial accounts.
If the totals don't agree then there's a problem. The accountant will need to carry out
remedial work in order to achieve a balance.
Remember that a debit balance is one that's brought down to the debit (left) side
and a credit balance is one that's brought down to the credit (right) side of the
'T' account. So when you prepare a trial balance the entries
in the debit column will be from 'T' accounts with a debit balance brought down and
entries in the credit column will be from 'T' accounts with a credit balance brought
down.
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Example
Here is an example of what a typical trial balance could look like.
Trial balance 2018
Description Dr Cr
Capital £30,000
Cash £250
Bank overdraft £2,250
Purchases £185,000
Sales £320,000
Debtors £39,000
Creditors £6,500
Loan £10,000
Motor vehicles £76,000
Wages £18,600
Rent and rates £10,000
Stationery £575
Motor expenses £5,750
Insurance £1,000
Drawings £32,575
Totals £368,750 £368,750
Some accountants may use a four-column approach to distinguish between the
trading and profit and loss account and balance sheet entries as shown on the next
page.
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Trial balance as at 31 December
Description Trading and profit and loss account
Balance sheet
Dr Cr Dr Cr Capital £30,000 Cash £250
Bank overdraft £2,250
Purchases £185,000 Sales £320,000
Debtors £39,000
Creditors £6,500 Loan £10,000
Motor vehicles £76,000
Wages £18,600
Rent and rates £10,000
Stationery £575 Motor expenses £5,750
Insurance £1,000
Drawings £32,575
Totals £220,925 £320,000 £147,825 £48,750
In this example, the sum of the debit entries (£220,925 and £147,825) still equals the
sum of the credit entries (£320,000 and £48,750).
You can often anticipate whether an account is likely have a debit or credit balance.
For example, cash on hand can never be a negative figure. Either you have some
cash on hand or you have nothing. So if there is cash on hand, it will always be a
debit balance on the cash on hand account.
One account that you can't anticipate as a debit or credit balance is the bank
account. If there are funds in the account, it is an asset and it will have a debit
balance. If the account is overdrawn, it will be a liability and therefore have a credit
balance.
Now you have balanced all of the 'T' accounts for Lance you can prepare a trial
balance for him as at 30 April.
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Activity four
The trial balance for Lance as at 30 April has been started below.
Use the balances from the 'T' accounts you have already prepared to complete the
trial balance.
Trial balance as at 30 April
Description Dr Cr
Capital £5,000
Bank
Van
Cooking equipment £500
Cash £25
Purchases
Sales
Cash & Carry Ltd
Readstone RFC
Advertising £250
Motor expenses
Insurance
Drawings
Totals £9,250
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Response
Here is the completed trial balance.
Description Dr Cr
Capital £5,000
Bank £2,075
Van £2,700
Cooking equipment £500
Cash £25
Purchases £1,750
Sales £3,950
Cash & Carry Ltd £300
Readstone RFC £750
Advertising £250
Motor expenses £80
Insurance £120
Drawings £1,000
Totals £9,250 £9,250
If your trial balance didn't balance go back and note alongside each figure in the
activity whether it's a debit or credit balance brought down. Then check that you
have included it on the correct side of your trial balance.
The trial balance is the starting point in the production of financial accounts for a
business. However, you also need to consider how to close off the various 'T'
accounts at the end of a period. You'll look at this in the next subchapter. But before
then let's look at what may happen when the person who's prepared the 'T' accounts
and/or the trial balance finds out that although the totals of the debit and credit
columns may agree, data has been omitted from the 'T' accounts or entered
incorrectly.
The accountant may correct these when they draw up an extended trial balance.
You'll look at this in the manual Bookkeeping – Extended Trial Balance.
Alternatively they could redo the relevant 'T' accounts and amend the trial balance to
include the revised balances. Let's look at an example of this.
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Example
Rashmi's bookkeeper has prepared the trial balance at the end of the accounting
period, but she then realises that bank charges of £45 have not been recorded in the
business records or the relevant 'T' accounts.
The bookkeeper draws up a 'T' account for bank charges and amends the Bank 'T'
account. She then includes the revised balances for these 'T' accounts in the trial
balance. In this case, the totals of the debit and credit columns will remain the same
because whilst the balance for one debit entry (bank) has decreased, another (bank
charges) has increased by the same amount.
Original trial balance
Description Dr Cr Capital £499
Bank £1,237
Van £3,700
Cash £25
Purchases £1,699
Sales £22,650
Motor expenses £1,488
Drawings £15,000
Totals £23,149 £23,149
Bank charges
Dr £ Cr £
Bank 45 Bal c/d 45
45 45
Bal b/d 45
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Revised Bank
Dr £ Cr £
Bal b/d 1,700
Expenditure 23,113
Income 22,650 Bank
charges
45
Bal c/d 1,192
24,350 24,350
Bal b/d 1,192
Revised trial balance
Description Dr Cr Capital £499
Bank £1,192
Bank changes £45
Van £3,700
Cash £25
Purchases £1,699
Sales £22,650
Motor expenses £1,488
Drawings £15,000
Totals £23,149 £23,149
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5.2 Closing the 'T' Accounts
Once the trial balance has been drawn up and you're satisfied that it balances, the
next stage would be to deal with any year-end adjustments such as accruals and
prepayments or depreciation. These adjustments are considered in the manual
Bookkeeping – Accounting Standards and Year End Adjustments.
Once these adjustments are made, the next step is to close off the 'T' accounts so
that the financial accounts can be prepared.
• Any accounts which show income and expenditure are cleared by
transferring the balance on the account to the trading and profit and loss
account. Finally, the balance on the drawings account and the trading
and profit and loss account are cleared by transferring the balances to the
capital account.
The capital account is then balanced off in exactly the same way as you saw in
subchapter 5.1 and the remaining balance is transferred to the balance sheet.
It's brought down to the start of the following accounting period in the same way as
any other liabilities. You'll now consider each of these steps in more detail.
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5.2.1 Income and expenditure accounts
Let's see how Lance would close off his income and expenditure 'T' accounts.
Lance's sales account would be closed as follows.
Sales
Dr £ Cr £
5 Apr Bank 700
9 Apr Readstone
RFC
1,000
15 Apr Bank 1,500
30 Apr Bal c/d 3,950 19 Apr Readstone
RFC
750
3,950 3,950
30 Apr To Trading
A/c
3,950 30 Apr Bal b/d 3,950
3,950 3,950
The balance on the sales account will be cleared and transferred to the trading
account, the accounting entries being debit sales account £3,950, credit trading
account £3,950.
The trading profit and loss account continues to follow the double-entry bookkeeping
principles. The trading profit and loss account is another 'T' account and could be
presented as such.
We've included some examples of this in the following pages but you're unlikely to
see it in practice and you should normally prepare the trading account, profit and
loss account and balance sheet from the trial balance that you'll see described
shortly.
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Trading and profit and loss account
Month ended 30 April
Dr £ Cr £
Sales 3,950
Lance's purchases account would be closed in a similar manner.
Purchases
Dr £ Cr £
5 Apr Bank 300
9 Apr Bank 550
15 Apr Cash &
Carry Ltd
600
19 Apr Cash &
Carry Ltd
300 30 Apr Bal c/d 1,750
1,750 1,750
30 Apr Bal b/d 1,750 30 Apr To Trading
A/c
1,750
1,750 1,750
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The balance on the purchases account will be cleared and transferred to the trading
account, the accounting entries being
• debit trading account £1,750
• credit purchases account £1,750
The revised trading and profit and loss account 'T' account would now look as
follows.
Trading and profit and loss account
Month ended 30 April
Dr £ Cr £
Purchases 1,750 Sales 3,950
Activity five
Lance still has three income and expenditure accounts that need to be closed off.
These are the accounts for advertising, motor expenses and insurance.
Close off each account as at 30 April and transfer the balance to the trading and
profit and loss 'T' account.
Advertising
Dr £ Cr £
28 Apr Bank 250 30 Apr Bal c/d 250
250 250
30 Apr Bal b/d 250
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Motor expenses
Dr £ Cr £
30 Apr Bank 80 30 Apr Bal c/d 80
80 80
30 Apr Bal b/d 80
Insurance
Dr £ Cr £
30 Apr Bank 120 30 Apr Bal c/d 120
120 120
30 Apr Bal b/d 120
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Trading and profit and loss account
Month ended 30 April
Dr £ Cr £
Purchases 1,750 Sales 3,950
Response
The closed accounts are shown below.
Advertising
Dr £ Cr £
28 Apr Bank 250 30 Apr Bal c/d 250
250 250
30 Apr Bal b/d 250 30 Apr To P & L 250
250 250
Motor expenses
Dr £ Cr £
30 Apr Bank 80 30 Apr Bal c/d 80
80 80
30 Apr Bal b/d 80 30 Apr To P & L 80
80 80
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Insurance
Dr £ Cr £
30 Apr Bank 120 30 Apr Bal c/d 120
120 120
30 Apr Bal b/d 120 30 Apr To P & L 120
120 120
The completed trading and profit and loss 'T' account is as follows.
Trading and profit and loss account
Month ended 30 April
Dr £ Cr £
Purchases 1,750 Sales 3,950
Advertising 250
Motor expenses 80
Insurance 120
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5.2.2 Asset and liability accounts
Assets and liabilities are shown on the balance sheet. Remember that the balance
sheet is a snapshot of the business assets, liabilities and capital at a particular
moment in time.
In Activity one, you balanced off Lance's cash account (asset) at 30 April. This
looked as follows.
Cash
Dr £ Cr £
3 Apr Bank 25 30 Apr Bal c/d 25
25 25
1 May Bal b/d 25
The cash on hand (asset) of £25 as at 30 April will still exist on 1 May. It doesn't
disappear; it will be the opening balance for the next accounting period starting on 1
May.
The same can be said of Lance's liabilities. As at midnight on 30 April, Lance owes
£300 to the Cash and Carry Ltd.
He will still owe the Cash and Carry Ltd £300 as at 1 minute past midnight on 1 May.
This will be the opening balance for the next accounting period commencing on 1
May.
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5.2.3 Capital and drawings accounts
In subchapter 5.1, the capital and drawings accounts were balanced off. These
looked as follows.
Capital
Dr £ Cr £
30 Apr Bal c/d 5,000 1 Apr Bank 5,000
5,000 5,000
30 April Bal b/d 5,000
Drawings
Dr £ Cr £
30 Apr Bank 1,000 30 Apr Bal c/d 1,000
1,000 1,000
30 Apr Bal b/d 1,000
In chapter 1 you learned that the capital account as shown on the balance sheet is
made up of the following components.
At the moment, Lance's capital 'T' account shows opening capital of nil (as it was the
first year of trading) and capital introduced of £5,000. However, it doesn't yet show
the drawings or the overall profit or loss for the period.
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Drawings
The balance on the drawings account needs to be cleared and transferred to the
capital account.
The accounting entries required to close the drawings account are debit capital
account £1,000, credit drawings - £1,000.
The capital and drawings 'T' accounts will now look as follows.
Capital
Dr £ Cr £
30 Apr Bal c/d 5,000 1 Apr Bank 5,000
5,000 5,000
30 Apr Drawings 1,000 30 April Bal b/d 5,000
Drawings
Dr £ Cr £
30 Apr Bank 1,000 30 Apr Bal c/d 1,000
1,000 1,000
30 Apr Bal b/d 1,000 30 Apr To Capital 1,000
1,000 1,000
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Trading and profit and loss account
In activity five, you transferred all of the balances on the income and expenditure 'T'
accounts to the trading and profit and loss 'T' Account.
This looked as follows.
Trading and profit and loss account
Month ended 30 April
Dr £ Cr £
Purchases 1,750 Sales 3,950
Advertising 250
Motor expenses 80
Insurance 120
The balance on the trading and profit and loss account needs to be closed off and
transferred to the capital account.
The accounting entries required to close off the trading and profit and loss account
are as follows.
If an overall profit for the period has been made
• debit trading and profit and loss account
• credit capital
or
if an overall loss for the period has been made
• debit capital
• credit trading and profit and loss account.
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The capital and trading and profit and loss 'T' accounts will now look as follows.
Trading and profit and loss account
Month ended 30 April
Dr £ Cr £
Purchases 1,750 Sales 3,950
Advertising 250
Motor expenses 80
Insurance 120
Net profit – to
Capital A/c
1,750
3,950 3,950
Capital
Dr £ Cr £
30 Apr Bal c/d 5,000 1 Apr Bank 5,000
5,000 5,000
30 Apr Drawings 1,000 30 April Bal b/d 5,000
30 Apr T P & L 1,750
As Lance has made a net profit for the year, you can see that the accounting entries
required to close off the trading and profit and loss account are
• debit trading and profit and loss account
• credit capital.
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Capital
Now that you have closed off both the drawings account and the trading and profit
and loss account, all that remains is to balance off the capital account.
The capital account is balanced off in exactly the same way as you have learned in
subchapter 5.1.
Remember that capital is shown on the balance sheet, which is a snapshot of the
business assets, liabilities and capital at a particular moment in time.
In the same way as for asset and liability accounts, the closing capital account
balance as at 30 April will still exist on 1 May. It doesn't disappear and it will be the
opening balance for the next accounting period starting on 1 May.
Activity six
Now balance off the capital account.
Capital
Dr £ Cr £
30 Apr Bal c/d 5,000 1 Apr Bank 5,000
5,000 5,000
30 Apr Drawings 1,000 30 April Bal b/d 5,000
30 Apr T P & L 1,750
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Response
The capital account will now look as follows.
Capital
Dr £ Cr £
30 Apr Bal c/d 5,000 1 Apr Bank 5,000
5,000 5,000
30 Apr Drawings 1,000 30 April Bal b/d 5,000
30 Apr Bal c/d 5,750 30 Apr T P & L 1,750
6,750 6,750
1 May Bal b/d 5,750
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5.3 Financial Accounts Preparation
You can now prepare the financial accounts using the information from the trial
balance and the 'T' accounts.
The financial accounts show how profitable the business has been, what the
business owns and how it's financed.
As you saw in chapter 1, financial accounts include the trading and profit and loss
account and the balance sheet.
Here is Lance's trial balance again from activity four. However, this time each entry is
noted to show where each balance features in the financial accounts.
Description Dr Cr
Capital (balance sheet) £5,000
Bank (balance sheet) £2,075
Van (balance sheet) £2,700
Cooking equipment (balance sheet) £500
Cash (balance sheet) £25
Purchases (trading account) £1,750
Sales (trading account) £3,950
Cash & Carry Ltd (balance sheet) £300
Readstone RFC (balance sheet) £750
Advertising (profit & loss account) £250
Motor expenses (profit & loss account) £80
Insurance (profit & loss account) £120
Drawings (balance sheet) £1,000
Totals £9,250 £9,250
The first stage is to prepare the trading account.
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5.3.1 Trading account
The trading account is the top part of the account, down to gross profit.
Lance's trading account should look like this.
Trading account Month ended 30 April
Description Dr Cr
Sales £3,950
Less cost of sales
Opening stock 0
Add purchases £1,750
Sub-total £1,750
Less closing stock (0)
Total (£1,750)
Gross profit £2,200
The only significant differences between Lance's trading account and those you're
most likely to see in practice is that no stock has been included. As this is Lance's
first period of trading he didn't have any opening stock. As all of his purchases were
used in the period, he had no closing stock either. So there's no opening or closing
stock to be included in the trading account. Stock is considered in more detail in the
manual Bookkeeping – Accounting Standards and Year End Adjustments.
You can see that the trading account is essentially in two columns, just like the trial
balance. The trial balance is prepared to help the preparation of the trading and
profit and loss account. The figures are therefore extracted from the trial balance and
entered on the same side of the trading account as they appear in the trial balance.
The credit entry for sales is extracted from the trial balance and included as a credit
entry in the trading account. Similarly, purchases is a debit entry in the trial balance
and appears as a debit entry in the trading account.
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5.3.2 Profit and loss account
The profit and loss account shows the remaining business expenses, often called
overheads or indirect costs, to be deducted from the gross profit computed in the
trading account.
Activity seven
Use Lance's trial balance (above) to complete the trading and profit and loss
account.
Description Dr Cr
Sales £3,950
Less cost of sales
Opening stock 0
Add purchases £1,750
Sub-total £1,750
Less closing stock (0)
Total (£1,750)
Gross profit £2,200
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Response
Lance's completed trading and profit and loss account should look like this.
Trading and profit and loss account Month ended 30 April
Description Dr Cr
Sales £3,950
Less cost of sales
Opening stock 0
Add purchases £1,750
Sub-total £1,750
Less closing stock (0)
Total (£1,750)
Gross profit £2,200
Advertising £250
Motor expenses £80
Insurance £120 (£450)
Net profit £1,750
As you saw earlier, the trading and profit and loss account continues to follow the
double entry bookkeeping principles. You could present it as another 'T' account.
However, in practice, the trading profit and loss account is more likely to be
presented in the above format.
All of the debit entries for expenditure in the trial balance are debit entries in the
profit and loss account.
Because Lance's first month of trading didn't involve a large number of transactions,
his profit and loss account is small and straightforward. However, you apply exactly
the same process to preparing the profit and loss account regardless of the amounts
involved, or the number of accounts listed in the trial balance.
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Grouping expenditure
As the number of entries increases, businesses will often group their expenses
under broad headings when preparing final accounts. This will certainly be the case
with company accounts. Company accounts are considered in more detail in the
manual Bookkeeping – Financial Accounting for Limited Companies.
The headings you're most likely to see are things such as
• property expenses
• administrative expenses
• selling and distribution expenses
• financial expenses.
A typical profit and loss account will contain most of these elements but may simply
list them without categorising them under the above expense headings.
Some businesses may class a certain type of expense differently to other
businesses. For example, insurance could be a property, an administrative or a
motor expense. It depends on the nature of the insurance and the nature of the
business.
Grouping expenditure in this way makes the accounts easier to follow. There are no
hard and fast rules, but the following example provides an indication of a common
layout you may expect to see.
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Example
The following is a list of income and expenditure to go into the trading and profit and
loss account for Malcolm's Motorbike Shop.
Year ending 31 March 2019
Description £
Purchases £71,000
Salaries £18,000
Sales £134,000
Rent £10,000
Rates £7,500
Insurance £3,500
Bank overdraft interest £1,000
Heat and light £2,000
Telephone £1,500
Advertising £1,000
Bank charges £500
Marketing £1,500
Stationery and postage £1,000
The trading and profit and loss account, based on the information provided, is shown
on the next page.
Note that Malcolm's stock on hand as at 1 April 2018 was £2,300 and at 31 March
2019 it's £2,600.
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Trading and profit and loss account Year ended 31 March 2019
Description £
Turnover £134,000
Less cost of sales
Opening stock £2,300
Purchases £71,000
Closing stock £2,600
Sub-total (£70,700)
Gross profit £63,300
Rent £10,000
Rates £7,500
Insurance £3,500
Heat and light £2,000
Salaries £18,000
Telephone £1,500
Stationery and postage £1,000
Advertising £1,000
Marketing £1,500
Bank charges £500
Bank overdraft interest £1,000
Sub-total (£47,500)
Net profit £15,800
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The net profit figure is easy to identify but the nature of all of the expenses may not
be. This can be made easier by formatting the profit and loss account to include sub-
headings for particular groups of expenditure as follows.
Trading and profit and loss account Year ended 31 March 2019
Description £
Turnover £134,000
Less cost of sales
Opening stock £2,300
Purchases £71,000
Closing stock £2,600
Sub-total (£70,700)
Gross profit £63,300
Less overheads
Property expenses
Rent £10,000
Rates £7,500
Insurance £3,500
Heat and light £2,000
Administrative expenses
Salaries £18,000
Telephone £1,500
Stationery and postage £1,000
Selling and distribution costs
Advertising £1,000
Marketing £1,500
Financial expenses
Bank charges £500
Bank overdraft interest £1,000
(£47,500)
Net profit £15,800
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There would be nothing wrong with just listing the various expenses after the entry
for gross profit but, as you can see, separating them can make reviewing the
accounts easier. This is clearly even more important as the number of entries
increases.
5.3.3 The balance sheet
As you saw in the previous subchapter, income and expenditure balances from the
trial balance are taken to the trading and profit and loss account and used to
compute the profit or loss for the period.
The remaining trial balance entries relate to assets, liabilities, capital and drawings –
these items are all taken to the balance sheet.
The balance sheet in any business should, at a given date, reflect
• the value of resources owned by the business – assets, and
• the value of amounts owed by the business – liabilities and capital.
The balance sheet is a 'snapshot' of the business' financial position at the date it's
drawn up.
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The format of the balance sheet
In chapter 1, you were introduced to the format and content of a balance sheet.
We've reproduced an outline of a typical balance sheet below.
Balance sheet as at 31 December 2018
Description £
Fixed assets
Fixtures and fittings £1,000
Current assets
Closing stock £150
Cash £100
Bank £250
Sub-total £500
Less current liabilities
Trade creditors (£400)
Net current assets £100
Total assets less current liabilities £1,100
Long term liabilities
Bank loan (£400)
Net assets £700
Capital account
Balance b/f £600
Add net profit for the year £300
Add capital introduced £100
£1,000
Less drawings (£300)
Closing capital £700
In chapter 3 you learned that the balance sheet equation is
Assets less liabilities equals capital
This is demonstrated above.
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The capital account on the balance sheet
The majority of the balance sheet is essentially a summary of outstanding account
balances at the balance sheet date. So in the example above the figure of £1,000 for
fixtures and fittings represents the balance brought down on the fixtures and fittings
'T' account at 31 December 2018.
The capital account, however, is shown differently. The details included for the
capital account represent a summary of the movements on the account for the
period. It's the capital 'T' account in a linear format.
In the above example the capital account would look like this if it was presented in a
normal 'T' account format.
Capital account
Dr £ Cr £
31 Dec
2018
Bal b/d 600
31 Dec
2018
Drawings 300 31 Dec
2018
Net profit 300
31 Dec
2018
Capital
introduced
100
31 Dec
2018
Bal c/d 700
1,000 1,000
1 Jan 2019 Bal b/d 700
The capital account follows the double entry bookkeeping principles you have
already learned. The entry for drawings is the equal and opposite entry to balance
the credit entry in the drawings account.
Drawings are not a business expense but a withdrawal of capital. So the net figure
of drawings is included in the capital account and is deducted from any balance
brought forward.
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In subchapter 5.2 you saw how the trading and profit and loss account would look if it
was drawn up as a 'T' account. The net profit was entered on the debit side to
balance the account. The equal and opposite entry for net profit is the credit entry in
the capital account. This entry, therefore, clears the trading and profit and loss
account. There is no balance to carry down on this account and the next period
starts afresh.
The closing balance on the capital account of £700 will be carried forward to the
following accounting period.
In subchapter 5.2 you closed the capital account for Lance by transferring both the
balance on the drawings 'T' account and the trading and profit and loss 'T' account to
the capital 'T' account. Lance's completed capital 'T' account has been reproduced
below.
Capital
Dr £ Cr £
30 Apr Bal c/d 5,000 1 Apr Bank 5,000
5,000 5,000
30 Apr Drawings 1,000 30 Apr Bal b/d 5,000
30 Apr Bal c/d 5,750 30 Apr T P & L 1,750
6,750 6,750
1 May Bal b/d 5,750
You have almost completed the financial accounts for Lance's first month of trading.
All that now remains is the balance sheet.
Activity eight
Use the trial balance you have already prepared for Lance and the closing capital 'T'
account above to draw up the balance sheet as at 30 April.
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Response
Here is the completed balance sheet.
Balance sheet as at 30 April
Description Dr Cr
Fixed assets
Van £2,700
Cooking equipment £500
Sub-total £3,200
Current assets
Bank £2,075
Cash £25
Debtor (Redstone RFC) £750
Sub total £2,850
Less current liabilities
Creditors (Cash and Carry Ltd) (£300)
Net current assets £2,550
Net assets £5,750
Capital account
Opening balance 0
Add net profit for the year £1,750
Add capital introduced £5,000
£6,750
Less drawings (£1,000)
Closing capital £5,750
Although the closing capital account shows a balance of £5,750, the movement in
the year is actually shown in the balance sheet as above.
It doesn't matter if your balance sheet doesn't look exactly the same as the one
above. As your experience grows, you'll see that the information will be presented in
a number of different ways.
It's important, however, that the balance sheet balances and that entries have been
classified correctly. For example, there shouldn't be any entries on the balance
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sheet that ought to go in the trading and profit and loss account and fixed and
current assets should be included under the correct headings.
This is the end of the material in this chapter. Now read the review and try the
learning check that follows.
Review
A trial balance consists of balances from 'T' accounts and is the first step towards
preparing financial accounts. Its purpose is to confirm the arithmetical accuracy of
the double entry bookkeeping system.
The first stage in preparing a trial balance is to establish the balance on each 'T'
account. All debit balances are included in the debit column of the trial balance and
all credit balances are included in the credit column.
Both columns are totalled. If they balance then this suggests that the dual effect has
been complied with and 'for every debit entry there is an equal and opposite credit
entry'. If the trial balance doesn't balance, it may not have been prepared
accurately.
The next step in preparing financial accounts is to close off the 'T' accounts.
• Any accounts which show income and expenditure are cleared by
transferring the balance on the account to the trading and profit and loss
account. There is no balance to bring down to the following year. So the
date of the balance brought down figure is the accounting date.
• The balance on any assets and liabilities accounts is transferred to the
balance sheet and brought down to the start of the following accounting
period. So the date of the balance brought down figure is the start date of the
next accounting period.
• Finally, the balance on the drawings account and the trading and profit and
loss account are cleared by transferring the balances to the capital account.
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The capital account is then balanced off. Any balance remaining is
transferred to the balance sheet. So the date of the balance brought down
figure is the start date of the next accounting period.
The purpose of the trading and profit and loss account is to establish the profit or
loss made for a particular period.
The balance sheet shows at a given date, what the business owns, what it's owed
and what it owes.
Now test your knowledge of this chapter by doing the learning check that follows.
Learning check
1. Give two reasons for balancing the 'T' accounts in a trader's books.
2. The balance brought down in Karen's cash account was a debit balance of £195.
What does this mean?
3. a) Balance the following 'T' account at 30 September.
Drawings
Dr £ Cr £
1 Sept Cash 100 3 Sept Petrol 25
8 Sept Cash 100 10 Sept Petrol 30
15 Sept Cash 100 17 Sept Petrol 20
22 Sept Cash 100 24 Sept Petrol 35
29 Sept Bank 500
b) What do you think 'the balance' means in broad terms?
4. State the purpose of a trial balance.
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5. Ken has decided to prepare financial accounts for the 6-month period to 30
September. The 'T' accounts showing the balances brought down at 29 September
are shown below together with a list of transactions to 30 September.
You should enter these transactions into the relevant 'T' account (printed below),
balance each 'T' account and then prepare a trial balance.
29 September
Purchased goods on credit from Ajay for £50.
Withdrew £420 cash from business deposit account and paid Ajay £420.
Total sales for the day were £75, which included cash sales and a credit sale of £10
to Julian.
30 September
Purchased goods on credit from Ajay for £60.
Total sales for the day were £80, which included cash sales and credit sales to
Julian of £10, and to the publican of the King's Horse, of £15.
Purchased a new tyre for the business van from own money. Cost £50.
There was no opening or closing stock.
Cash
Dr £ Cr £
29 Sep Bal b/d 42
Capital
Dr £ Cr £
29 Sep Bal b/d 425
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Bank
Dr £ Cr £
29 Sep Bal b/d 1,430
Motor van
Dr £ Cr £
29 Sep Bal b/d 350
Ajay
Dr £ Cr £
29 Sep Bal b/d 1,260
Julian
Dr £ Cr £
29 Sep Bal b/d 5
King’s Horse
Dr £ Cr £
29 Sep Bal b/d 30
Purchases
Dr £ Cr £
29 Sep Bal b/d 10,870
Sales
Dr £ Cr £
29 Sep Bal b/d 16,305
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Stall rent
Dr £ Cr £
29 Sep Bal b/d 1,300
Motor expenses
Dr £ Cr £
29 Sep Bal b/d 330
Telephone
Dr £ Cr £
29 Sep Bal b/d 130
Paper
Dr £ Cr £
29 Sep Bal b/d 133
Drawings
Dr £ Cr £
29 Sep Bal b/d 3,370
For the remaining questions in the learning check, you'll need several pieces
of paper.
6. Close off the income and expenditure 'T' account balances for Ken from question
5 by transferring the balances to the trading and profit and loss 'T' account.
7. Close off the trading and profit and loss 'T' account and drawings account for Ken
from question 6 by transferring the balances to the capital account you prepared in
question 5.
8. Use the trial balance you completed for Ken in question 5 above to prepare the
trading and profit and loss account for the 6 months to 30 September.
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9. Use the trial balance you completed for Ken in question 5 above, and the closed
capital account from question 7 above, to prepare the balance sheet as at 30
September.
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Learning check – answers
1. Give two reasons for balancing the 'T' accounts in a trader's books.
You could have said two of the following. Accounts are balanced
• to check accuracy
• to establish the amount outstanding or accumulated at any particular time.
For example the total on a sales account indicates the amount of sales a
business made in a financial period
• as a start to preparing a trading and profit and loss account, and a balance
sheet.
This is in subchapter 5.1.
2. The balance brought down in Karen's cash account was a debit balance of £195.
What does this mean?
This means that in balancing the 'T' account the amounts included on the debit side
exceeded those on the credit side. This is what you would expect in a cash account.
The balance should represent the amount of business cash on hand.
This is in subchapter 5.1.
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3. a) Balance the following 'T' account at 30 September.
Drawings
Dr £ Cr £
1 Sept Cash 100 3 Sept Petrol 25
8 Sept Cash 100 10 Sept Petrol 30
15 Sept Cash 100 17 Sept Petrol 20
22 Sept Cash 100 24 Sept Petrol 35
29 Sept Bank 500 30 Sept Bal c/d 790
900 900
30 Sept Bal b/d 790
b) What do you think 'the balance' means in broad terms?
In broad terms, the balance of £790 shows that the trader has taken a net amount of
£790 out of the business by way of drawings in the month of September.
You can see from the 'T' account that the trader took £900 out in cash and from the
bank and they put in £110 by buying petrol for the business out of their 'own pocket'.
This is a form of capital introduced. It's shown here as a credit entry in the drawings
account. This is quite acceptable although it's more usual for these transactions to
be recorded as a credit entry in the capital account.
Don't worry if you found it difficult to describe the meaning of the balance. You'll look
at interpreting accounts in more detail later. Just start thinking in this manner. It
doesn't matter if you didn't get the same answer as us at this stage.
This is in subchapter 5.1.
4. State the purpose of a trial balance.
The purpose of a trial balance is to check the arithmetical accuracy of the double
entry bookkeeping system.
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This is in subchapter 5.1.
5. Ken has decided to prepare financial accounts for the
6-month period to 30 September. The 'T' accounts showing the balances brought
down at 29 September are shown below together with a list of transactions to 30
September.
You should enter these transactions into the relevant 'T' account, balance each 'T'
account and then prepare a trial balance.
29 September
Purchased goods on credit from Ajay for £50.
Withdrew £420 cash from business deposit account and paid Ajay £420.
Total sales for the day were £75, which included cash sales and a credit sale of £10
to Julian.
30 September
Purchased goods on credit from Ajay for £60.
Total sales for the day were £80, which included cash sales and credit sales to
Julian of £10, and to the publican of the King's Horse, of £15.
Purchased a new tyre for the business van from own money. Cost £50.
There was no opening or closing stock.
Your answer should have been as follows.
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Cash
Dr £ Cr £
29 Sep Bal b/d 42 29 Sep Ajay 420
29 Sep Bank 420 30 Sep Bal c/d 162
29 Sep Sales 65
30 Sep Sales 55
582 582
Oct 1 Bal b/d 162
Capital
Dr £ Cr £
30 Sep Bal c/d 475 29 Sep Bal b/d 425
30 Sep Mot Exp 50
475 475
30 Sep Bal b/d 475
Bank
Dr £ Cr £
29 Sep Bal b/d 1,430 29 Sep Cash 420
30 Sep Bal c/d 1,010
1,430 1,430
1 Oct Bal b/d 1,010
Motor van
Dr £ Cr £
29 Sep Bal b/d 350 30 Sep Bal c/d 350
350 350
1 Oct Bal b/d 350
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Ajay
Dr £ Cr £
29 Sep Cash 420 29 Sep Bal b/d 1,260
29 Sep Purchases 50
30 Sep Purchases 60
30 Sep Bal c/d 950
1,370 1,370
1 Oct Bal b/d 950
Julian
Dr £ Cr £
29 Sep Bal b/d 5
29 Sep Sales 10
30 Sep Sales 10 30 Sep Bal c/d 25
25 25
1 Oct Bal b/d 25
King’s Horse
Dr £ Cr £
29 Sep Bal b/d 30
30 Sep Sales 15 30 Sep Bal c/d 45
45 45
1 Oct Bal b/d 45
Purchases
Dr £ Cr £
29 Sep Bal b/d 10,870
29 Sep Ajay 50
30 Sep Ajay 60 30 Sep Bal c/d 10,980
10,980 10,980
30 Sep Bal b/d 10,980
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Sales
Dr £ Cr £
29 Sep Bal b/d 16,305
29 Sep Cash 65
29 Sep Julian 10
30 Sep Cash 55
30 Sep Julian 10
30 Sep Bal c/d 16,460 30 Sep King's
Horse
15
16,460 16,460
30 Sep Bal b/d 16,460
Stall rent
Dr £ Cr £
29 Sep Bal b/d 1,300 30 Sep Bal c/d 1,300
1,300 1,300
30 Sep Bal b/d 1,300
Motor expenses
Dr £ Cr £
29 Sep Bal b/d 330
30 Sep Capital
(Tyre)
50 30 Sep Bal c/d 380
380 380
30 Sep Bal b/d 380
Telephone
Dr £ Cr £
29 Sep Bal b/d 130 30 Sep Bal c/d 130
130 130
30 Sep Bal b/d 130
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Paper
Dr £ Cr £
29 Sep Bal b/d 133 30 Sep Bal c/d 133
133 133
30 Sep Bal b/d 133
Drawings
Dr £ Cr £
29 Sep Bal b/d 3,370
30 Sep Bal c/d 3,370
3,370 3,370
30 Sep Bal b/d 3,370
Ken's purchase of the tyre with his own money is a form of capital introduced. It's
more usual for these transactions to be recorded through the capital account and
here it's shown as a credit entry in the capital account.
However, you could have correctly included it as a credit entry in the drawings
account instead.
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Trial balance as at 30 September
Description Dr Cr
Capital £475
Cash £162
Bank £1,010
Ajay £950
Julian £25
King’s Horse £45
Motor van £350
Purchases £10,980
Sales £16,460
Drawings £3,370
Paper £133
Motor expenses £380
Rent £1,300
Telephone £130
Totals £17,885 £17,885
This is in subchapter 5.1.
If you have made mistakes in preparing or balancing your 'T' accounts, then you may
need to refer back to chapter 4.
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6. Close off the income and expenditure 'T' account balances for Ken from question
5 by transferring the balances to the trading and profit and loss 'T' account.
Your answer should have been as follows.
Trading and profit and loss account
Dr £ Cr £
30 Sep Purch 10,980 30 Sep Sales 16,460
30 Sep Paper 133
30 Sep Motor 380
30 Sep Rent 1,300
30 Sep Tel 130
Purchases
Dr £ Cr £
29 Sep Bal b/d 10,870
29 Sep Ajay 50
30 Sep Ajay 60 30 Sep Bal c/d 10,980
10,980 10,980
30 Sep Bal b/d 10,980 30 Sep To trade 10,980
10,980 10,980
Sales
Dr £ Cr £
29 Sep Bal b/d 16,305
29 Sep Cash 65
29 Sep Julian 10
30 Sep Cash 55
30 Sep Julian 10
30 Sep Bal c/d 16,460 30 Sep King's
Horse
15
16,460 16,460
30 Sep To trade 16,460 30 Sep Bal b/d 16,460
16,460 16,460
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Stall rent
Dr £ Cr £
29 Sep Bal b/d 1,300 30 Sep Bal c/d 1,300
1,300 1,300
30 Sep Bal b/d 1,300 30 Sep To P & L 1,300
1,300 1,300
Motor expenses
Dr £ Cr £
29 Sep Bal b/d 330
30 Sep Capital
(Tyre)
50 30 Sep Bal c/d 380
380 380
30 Sep Bal b/d 380 30 Sep To P & L 380
380 380
Telephone
Dr £ Cr £
29 Sep Bal b/d 130 30 Sep Bal c/d 130
130 130
30 Sep Bal b/d 130 30 Sep To P & L 130
130 130
Paper
Dr £ Cr £
29 Sep Bal b/d 133 30 Sep Bal c/d 133
133 133
30 Sep Bal b/d 133
This is in subchapter 5.2.
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7. Close off the trading and profit and loss 'T' account and drawings account for Ken
from question 6 by transferring the balances to the capital account you prepared in
question 5.
Your answer should have been as follows.
Capital
Dr £ Cr £
29 Sep Bal b/d 425
30 Sep Bal c/d 475 30 Sep Mot exp 50
475 475
30 Sep Drawings 3,370 30 Sep Bal b/d 475
30 Sep Bal c/d 642 30 Sep T P & L 3,537
4,012 4,012
1 Oct Bal b/d 642
Drawings
Dr £ Cr £
29 Sep Bal b/d 3,370
30 Sep Bal c/d 3,370
3,370 3,370
30 Sep Bal b/d 3,370 30 Sep To capital 3,370
3,370 3,370
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Trading and profit and loss account
Dr £ Cr £
30 Sep Purch 10,980 30 Sep Sales 16,460
30 Sep Paper 133
30 Sep Motor 380
30 Sep Rent 1,300
30 Sep Tel 130
30 Sep To capital 3,537
16,460 16,460
This is in subchapter 5.2.
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8. Use the trial balance you completed for Ken in question 5 above to prepare the
trading and profit and loss account for the 6 months to 30 September.
The trading and profit and loss account will look like this.
Trading and profit and loss account 6 months ended 30 September
Description Dr Cr
Sales £16,460
Less cost of sales
Opening stock 0
Add purchases £10,980
£10,980
Less closing stock (0)
(£10,980)
Gross profit £5,480
Rent £1,300
Telephones £130
Paper £133
Motor expenses £380 (£1,943)
Net profit £3,537
This is in subchapter 5.3.
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9. Use the trial balance you completed for Ken in question 5 above and the closed
capital account from question 7 above to prepare the balance sheet as at 30
September.
The balance sheet will look like this
Balance sheet as at 30 September
Description Dr Cr
Fixed assets
Motor van £350
£350
Current assets
Bank £1,010
Cash £162
Debtor (Julian) £25
Debtor (King’s Horse) £45
Sub total £1,242
Less current liabilities
Creditors (Ajay) (£950)
Net current assets £292
Net assets £642
Capital account
Opening balance 425
Add net profit for the year £3,537
Add capital introduced £50
Sub total £4,012
Less drawings (£3,370)
Closing capital £642
This is in subchapter 5.
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Consolidation Exercise – Question
James
The following consolidation exercise will test whether you have understood how to
• record business transactions using 'T' accounts and the dual effect of each
transaction
• prepare a simple trial balance from 'T' accounts that you have prepared
• close off the various 'T' accounts at a period end
• use the trial balance and the closed 'T' accounts to prepare a trading and
profit and loss account and balance sheet.
James started in business on 1 April and decides to make up his first financial
accounts to 30 April. You're provided with a list of his initial business transactions.
We think it will take you about an hour to complete this exercise.
Instructions
Task 1
Prepare and then balance the 'T' accounts to 30 April for each transaction.
Task 2
Use your 'T' account balances to prepare a trial balance as at 30 April.
Task 3
Close off the income and expenditure 'T' accounts by transferring the balances to the
trading and profit and loss 'T' account.
Close off the trading and profit and loss 'T' account and drawings account by
transferring the balances to the capital account.
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Task 4
Prepare a trading and profit and loss account to 30 April.
Task 5
Prepare a balance sheet at 30 April.
You may find it helpful to check your answer at the end of each task, before moving
on to the next.
Data for tasks 1, 2, 3, 4 and 5
1 Apr - James used £5,000 of his own personal savings to open a business bank
account.
2 Apr - James made purchases of £2,000 and paid for these by cheque.
3 Apr - Bought a delivery van for £1,500 by cheque.
4 Apr - Made a sale for £500 in cash.
4 Apr - Made a sale of £2,000 on credit to Nicole.
8 Apr - Purchased a computer for £800 by cheque.
11 Apr - Purchased £4,000 worth of stock on credit from Brad.
13 Apr - Made a sale for £6,000 cash.
15 Apr - Paid £300 rent for the business premises in cash.
17 Apr - Paid £250 motor expenses in cash.
18 Apr - Made a sale for £1,000. The customer paid by cheque.
20 Apr - James took drawings of £1,000 in cash.
21 Apr - Nicole gave James a cheque for £700 towards what she owed him.
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25 Apr - James paid Brad £2,500 in cash for purchases previously bought on credit.
26 Apr - James paid business insurance of £450 in cash.
27 Apr - James made a further sale to Nicole for £500 on credit.
29 Apr - James obtained a loan of £6,000 and immediately bought fixtures and
fittings costing this amount. The loan will be repaid over the following 12 months.
There is no closing stock.
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Consolidation Exercise – Answer
Task 1
'T' Accounts
Bank
Dr £ Cr £
1 Apr Capital 5,000 2 Apr Purchases 2,000
18 Apr Sales 1,000 3 Apr Van 1,500
21 Apr Nicole 700 8 Apr Computer 800
30 Apr Bal c/d 2,400
6,700 6,700
1 May Bal b/d 2,400
Capital
Dr £ Cr £
30 Apr Bal c/d 5,000 1 Apr Bank 5,000
5,000 5,000
30 Apr Bal b/d 5,000
Purchases
Dr £ Cr £
2 Apr Bank 2,000
11 Apr Brad 4,000 30 Apr Bal c/d 6,000
6,000 6,000
30 Apr Bal b/d 6,000
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Cash
Dr £ Cr £
4 Apr Sales 500 15 Apr Rent 300
13 Apr Sales 6,000 17 Apr Motor exp 250
20 Apr Drawings 1,000
25 Apr Brad 2,500
26 Apr Insurance 450
30 Apr Bal c/d 2,000
6,500 6,500
1 May Bal b/d 2,000
Van
Dr £ Cr £
3 Apr Bank 1,500 30 Apr Bal c/d 1,500
1,500 1,500
1 May Bal b/d 1,500
Sales
Dr £ Cr £
£ £
4 Apr Cash 500
4 Apr Nicole 2,000
13 Apr Cash 6,000
18 Apr Bank 1,000
27 Apr Nicole 500
30 Apr Bal c/d 10,000
10,000 10,000
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Nicole (trade debtor)
Dr £ Cr £
4 Apr Sales 2,000 21 Apr Bank 700
27 Apr Sales 500 30 Apr Bal c/d 1,800
2,500 2,500
1 May Bal b/d 1,800
Computer
Dr £ Cr £
8 Apr Bank 800 30 Apr Bal c/d 800
800 800
1 May Bal b/d 800
Brad (trade creditor)
Dr £ Cr £
25 Apr Cash 2,500 11 Apr Purchases 4,000
30 Apr Bal c/d 1,500
4,000 4,000
1 May Bal b/d 1,500
Rent
Dr £ Cr £
15 Apr Cash 300 30 Apr Bal c/d 300
300 300
30 Apr Bal b/d 300
Motor expenses
Dr £ Cr £
17 Apr Cash 250 30 Apr Bal c/d 250
250 250
30 Apr Bal b/d 250
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Drawings
Dr £ Cr £
20 Apr Cash 1,000 30 Apr Bal c/d 1,000
1,000 1,000
30 Apr Bal b/d 1,000
Insurance
Dr £ Cr £
26 Apr Cash 450 30 Apr Bal c/d 450
450 450
30 Apr Bal b/d 450
Fixtures and fittings
Dr £ Cr £
29 Apr Loan 6,000 30 Apr Bal c/d 6,000
6,000 6,000
1 May Bal b/d 6,000
Loan
Dr £ Cr £
30 Apr Bal c/d 6,000 29 Apr Fixtures 6,000
6,000 6,000
1 May Bal b/d 6,000
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Task 2
James
Trial balance as at 30 April
Description Dr Cr
Capital £5,000
Bank £2,400
Purchases £6,000
Van £1,500
Sales £10,000
Cash £2,000
Nicole (trade debtor) £1,800
Brad (trade creditor) £1,500
Computer £800
Drawings £1,000
Loan £6,000
Fixture and fittings £6,000
Rent £300
Motor expenses £250
Insurance £450
Totals £22,500 £22,500
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Task 3
Trading and profit and loss account
Dr £ Cr £
30 Apr Purch 6,000 30 Apr Sales 10,000
30 Apr Rent 300
30 Apr Motor
expenses
250
30 Apr Insure 450
30 Apr Net profit
(to capital)
3,000
10,000 10,000
Capital
Dr £ Cr £
30 Apr Bal c/d 5,000 1 Apr Bank 5,000
5,000 5,000
30 Apr Drawings 1,000 30 Apr Bal b/d 5,000
30 Apr Bal c/d 7,000 30 Apr T P & L 3,000
8,000 8,000
1 May Bal b/d 7,000
Drawings
Dr £ Cr £
20 Apr Cash 1,000 30 Apr Bal c/d 1,000
1,000 1,000
30 Apr Bal b/d 1,000 30 Apr Capital 1,000
1,000 1,000
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Purchases
Dr £ Cr £
2 Apr Bank 2,000
11 Apr Brad 4,000 30 Apr Bal c/d 6,000
6,000 6,000
30 Apr Bal b/d 6,000 30 Apr To trade 6,000
6,000 6,000
Sales
Dr £ Cr £
4 Apr Cash 500
4 Apr Nicole 2,000
13 Apr Cash 6,000
18 Apr Bank 1,000
27 Apr Nicole 500
30 Apr Bal c/d 10,000 10,000
10,000 10,000
30 Apr To trade 10,000 30 Apr Bal b/d 10,000
10,000 10,000
Rent
Dr £ Cr £
15 Apr Cash 300 30 Apr Bal c/d 300
300 300
30 Apr Bal b/d 300 30 Apr To P & L 300
300 300
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Motor expenses
Dr £ Cr £
17 Apr Cash 250 30 Apr Bal c/d 250
250 250
30 Apr Bal b/d 250 30 Apr To P & L 250
250 250
Insurance
Dr £ Cr £
26 Apr Cash 450 30 Apr Bal c/d 450
450 450
30 Apr Bal b/d 450 30 Apr To P & L 450
450 450
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Task 4
James - Trading and profit and loss account for month to 30 April
Description Dr Cr
Sales £10,000
Less cost of sales
Opening stock 0
Purchases £6,000
Less closing stock 0
Sub-total (£6,000)
Gross profit £4,000
Less overheads
Rent £300
Motor expenses £250
Insurance £450
Sub-total (£1,000)
Net profit £3,000
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Task 5
James – balance sheet as at 30 April
Description Amount Amount Amount
Fixed assets
Fixtures and fittings £6,000
Vans £1,500
Computer £800
Total £8,300
Current assets
Cash £2,000
Bank £2,400
Trade debtors £1,800
Total £6,200
Current liabilities
Trade creditors (£1,500)
Loan (£6,000)
Total (£7,500)
Net current liabilities (£1,300)
Net assets £7,000
Opening capital 0
Capital introduced £5,000
Add net profit £3,000
Deduct drawings (£1,000)
Closing capital £7,000
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Before moving on
If you have answered the learning check correctly, you will have successfully
completed the learning outcomes and study objectives for this chapter, which you
can see below.
Learning outcomes
You will
• be able to prepare the initial financial accounts of a sole trader.
Study objectives
To achieve this you need to be able to
• demonstrate how to draw up a trial balance
• demonstrate how to close off the various accounts at a period end
• prepare a trading and profit and loss account and balance sheet.
If you had difficulty in achieving any of these objectives, have another look at the
relevant part(s) of the chapter and try the learning check again. You should be
confident that you have achieved them before moving on.
Please note any points you might want to discuss with your line manager or tutor.
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Assessment Practice – Sample Questions
In this part of the Introduction to Bookkeeping manual, we've included a small
selection of multiple-choice questions (MCQ) and one example of a longer question
of the type you'll encounter in the assessment for this module.
Both the MCQ and long question are indicative of the standard which you're
expected to achieve for assessment purposes. The suggested marks are provided.
The questions and answers are arranged as follows.
• MCQ questions.
• MCQ answers.
• Long question.
• Long question – answer.
We think you should allow approximately 20 minutes to complete the MCQ
questions.
The value of the question is indicated after each question.
MCQ questions
For all of these questions Mark X in column 3 to indicate your choice (or record your
answer in a separate document).
1. Which of the following is most likely to be a sole trader?
A-D Option Input X
A Tim Taylor
B Taylor Tiles PLC
C Tim and Tony Tiles
D Taylor Tiles Ltd
1 mark
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2. The extracts from a trading and profit and loss account are as follows.
Gross profit £48,425
Turnover £270,445
Opening stock £29,315
Closing stock £35,667
Net profit £27,130
What is the figure for purchases for the period?
A - D Options Mark X
A £215,668
B £228,372
C £236,963
D £249,667
3 marks
3. Liam starts in business as a joiner on 1 June 2018.
He draws up his accounts to 31 May 2018. At the end of the accounting period he
owes his creditors £500. He has received payments totalling £56,450. One of his
customers still owes him £200, which they eventually pay in July.
What is Liam's total turnover for the year ending 31 May 2019? 2 marks
A - D Options Mark X
A £56,250
B £56,450
C £56,650
D £56,950
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4. The financial accounts of a business include the following.
Opening capital £13,675
Current liabilities £2,560
Current assets £19,225
Fixed assets £40,000
Net profit £17,430
Drawings £15,750
What is the value of the long term liabilities of the business?
A £33,570
B £41,310
C £46,475
D £54,670
3 marks
5. Victor bought 20 kitchen timers for £60 cash for sale in his shop.
The dual effect of this transaction could be described as
A-D Options Mark X
A Increase purchases £60 and increase cash £60
B Increase creditors £60 and increase stock £60
C Increase creditors £60 and decrease cash £60
D Increase purchases £60 and decrease cash £60
2 marks
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6. Hussein buys stock for £300 on credit.
The double entries that are most likely to reflect this transaction are
A-D Options Mark X
A debit purchases and credit cash
B debit trade creditors and credit purchases
C debit purchases and credit trade creditors
D debit purchases and credit trade debtors
2 marks
7. What is the balance on the bank T account at the end of the accounting period?
Bank
Dr Cr
Bal. b/d £100 Purchases £150
Sales £250 Purchases £125
Sales £300
Sales £300
A-D Options Mark X
A A credit balance of £675
B A credit balance of £275
C A debit balance of £675
D A debit balance of £950
2 marks
Total 15 marks
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MCQ answers
1. Which of the following is most likely to be a sole trader?
Answer - A. Tim Taylor
This is in subchapter 1.1.
1 mark
2. The figure for purchases for the period?
Answer B - B. £228,372
This is calculated as follows.
Description Amount Amount Turnover £270,445
Less gross profit £48,425
CoGS * £222,020
Less Opening stock £29,315
Plus Closing stock £35,667
Purchases £228,372
(You calculate CoGS as opening stock plus purchases minus closing stock. It's the
reverse to calculate purchases.)
This is in subchapter 1.4.
3 marks
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3. Liam starts in business as a joiner on 1 June 2018.
Liam starts in business as a joiner on 1 June 2018 etcetera.
What is Liam's total turnover for the year ending 31 May 2019?
Answer - C. £56,650
Total turnover (£56,450) is payments received (£56,450) plus income earned in a
period for which payment hasn't yet been received (£200).
This is in subchapter 2.2.
3 marks
4. What is the value of the long term liabilities of the business?
Answer - B. £41,310
Description Amount
Opening capital £13,675
Plus profit £17,430
Less drawings £15,750
Closing capital £15,355
Fixed assets £40,000
Plus current assets £19,225
Less current liabilities (£2,560)
Less closing capital (£15,355)
Long term liabilities £41,310
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You can also use 'T' accounts to answer this question.
Dr £ £ Cr
Opening capital 13,675
Drawings 15,750 Net profit 17,430
Closing capital 15,355
31,105 31,105
This is the equivalent of assets less liabilities equals closing capital.
You can then use the closing capital figure in another 'T' account (effectively the
balance sheet in 'T' account form) to find the drawings figure.
Dr Assets Cr Liabilities
Fixed assets 40,000 Current liabilities 2,560
Current assets 19,225 Closing capital 15,355
Long term
liabilities
41,310
59,225 59,225
This is in subchapters 3.2 and 4.2.
2 marks
5. Victor bought 20 kitchen timers for £60 cash for sale in his shop.
The dual effect of this transaction could be described as….
Answer - D. Increase purchases £60 and decrease cash £60
This is in subchapter 3.4.
2 marks
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6. Hussein buys stock for £300 on credit.
The double entries that are most likely to reflect this transaction are….
Answer - C. Debit purchases and credit trade creditors
This is in subchapter 4.2.
2 marks
7. What is the balance on the bank T account at the end of the accounting period?
Answer - C. A debit balance of £675.
Bank
Dr Cr
Bal. b/d £100 Purchases £150
Sales £250 Purchases £125
Sales £300
Sales £300 Bal. c/d £675
£950
£950
Bal. b/d £675
This is in subchapter 5.1.
Total 15 marks
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Long question
Don Hamilton Autoparts
Time allowed 40 minutes 60 marks
You are required to
a) prepare T accounts to update the balances of those accounts affected by the
information provided. (16 marks)
b) prepare a trial balance using the T accounts prepared for a) above. (14 marks)
c) prepare the trading, profit and loss account and balance sheet for the period
ending 30 September. (30 marks)
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Information
You are the accounts assistant at Don Hamilton Autoparts. The main business
activity is the sale of motor parts. A computer malfunction on 29 September has
prevented the completion of the accounts for the year ending 30 September.
You extracted the following balances from the T accounts on 28 September.
Description Amount £
Property 127,500
Bank 18,260
Capital 205,455
Drawings 32,420
HMRC creditor 1,450
Loan from bank 27,240
Purchases 192,157
Sales 266,330
General expenses 33,890
Plant and machinery 76,248
Trade debtor (Vittex & Son) 20,000
The following transactions took place on 29 and 30 September.
1. On 29 September, the business purchased goods on credit from Alloy Holdings for
resale. The value of the transaction was £2,320.
2. On 29 September, wages of £642 were paid by cheque for casual labour. This
should be included in general expenses.
3. On 30 September Don Hamilton paid £2,000 off the bank loan. This was a cash
payment from the proceeds of a personal insurance policy that had matured on 15
September, which Don had received in cash.
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4. On 30 September a cheque for £10,000 was received from Vittex & Son as part
payment for supplies previously received from Hamilton Autoparts. Don banked the
cheque on the same day.
5. Don carried out a stock take on 30 September, which confirmed that the stock
value was £16,220. (This should be included as a current asset in the balance
sheet).
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Long question – answer
Don Hamilton Autoparts
a) T accounts 16 marks (total)
Purchases
Dr £ Cr £
28/09 Bal b/d 192,157
29/09 Alloy 2,320 30/09 Bal c/d 194,477
194,477 194,477
30/09 Bal b/d 194,477
Alloy (creditor)
Dr Cr
29/09 Purchases 2,320
30/09 Bal c/d 2,320
2,320 2,320
01/10 Bal b/d 2,320
Bank
Dr £ Cr £
28/09 Bal b/d 18,260 29/09 Wages 642
30/09 Vittex 10,000 30/9 Bal c/d 27,618
28,260 28,260
01/10 Bal b/d 27,618
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Bank loan
Dr £ Cr £
30/09 Cash 2,000 28/09 Bal b/d 27,240
30/09 Bal c/d 25,240
27,240 27,240
01/10 Bal b/d 25,240
General expenses
Dr £ Cr £
28/09 Bal b/d 33,890
29/09 Bank 642 30/09 Bal c/d 34,532
34,532 34,532
30/09 Bal b/d 34,532
Capital
Dr £ Cr £
28/09 Bal b/d 205,455
30/09 Bal c/d 207,455 30/09
Cash
(introduced) 2,000
207,455 207,455
01/10 Bal b/d 207,455
3 marks for cash introduced (also give 3 marks if this is dealt with through the
drawings a/c or by another acceptable method)
Cash
Dr Cr
30/09
Capital
(introduced) 2,000 30/09 Bank loan 2,000
2,000 2,000
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Vittex (debtor)
Dr Cr
28/09 Bal b/d 20,000 30/09 Bank 10,000
30/9 Bal c/d 10,000
20,000 20,000
01/10 Bal b/d 10,000
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b) Trial balance 14 marks
(2 marks for each amendment)
Account Total £ Dr £ Cr £
Property 127,500 127,500
Bank 27,618 27,618
Capital 207,455 207,455
Drawings 32,420 32,420
HMRC creditor 1,450 1,450
Bank loan 25,240 25,240
Purchases 194,477 194,477
Sales 266,330 266,330
General expenses 34,532 34,532
Plant and
machinery 76,248 76,248
Vittex (debtor) 10,000 10,000
Alloy (creditor) 2,320 2,320
502,795 502,795
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c) Financial accounts 30 marks
12 marks (Deduct 3 marks for each bookkeeping error and 1 mark for each
arithmetic error)
Trading and profit and loss account
Description £ £
Sales 266,330
Less cost of sales
Opening stock 0
Purchases 194,477
Less closing stock (16,220) 178,257
Gross profit 88,073
General expenses 34,532
Net profit 53,541
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Balance sheet 30 September
Fixed assets £ £ £
Property 127,500
Plant and machinery 76,248
203,748
Current assets
Stock 16,220
Debtors 10,000
Bank 27,618
53,838
Current liabilities
Trade creditors 2,320
Other creditors 1,450
3,770
Net current assets 50,068
Total assets less current liabilities 253,816
Less long term liabilities
Bank loan 25,240
Net assets 228,576
Opening capital 205,455
Add capital introduced 2,000
Add net profit 53,541
Less drawings 32,420
Closing capital 228,576
Total 60 marks