bookkeeping transactions

Lesson 2: The Accounting Equation and Double Entry

Bookkeeping Transactions

UNIT 1

2

The Four Main Topics of this Lesson

UNIT 1

3

In the last lesson we looked at how information flows through the accounting system. We discovered that the information that we gather is used to produce the financial statements.

The two most common statements are the Statement of Profit & Loss and the Statement of Financial Position (The Balance Sheet).

Sorting Information

UNIT 1

4

● Assets are simply things that we have or are owed to us, like buildings, vans, cash or receivables (moneys owed to us)

● Liabilities are what we owe, for example loans or mortgages or payables (moneys owed to suppliers)

● Expenses are day to day running costs, like electricity, purchases (buying goods) or wages

● Revenue is income from sales or other sources of income

The Four Categories of Accounts

UNIT 1

5

Which category do you think should apply to each of these accounts?

Account Name Asset Liability Revenue Expense

Cash

Sales

Receivables

Rent

Internet fees

Payables

Bank overdraft

Salaries

Computers

Categorising Accounts - Quiz

UNIT 1

6

Within each category of information there are many accounts.

If we spend money on vans or electricity we will record the cost of electricity in an account called ‘electricity’, or perhaps one called ‘power’. We will record the cost of the van in a ‘Van at Cost’ account, or perhaps a ‘Motor Vehicles at Cost’ account.

However any running expenses for the Van, like tax or repairs, will be recorded in a ‘Van (or Motor Vehicles) Expense’ account as it is revenue expenditure and not capital expenditure. This means that we keep the money spent on buying the van (an asset) separate from the expense of running the van.

We will start a new account for any information that we need to record that doesn’t fit into an existing account, making sure that we categorise it correctly.

Assets and Expenses

UNIT 1

7

Assets and Expenses (cont.)

UNIT 1

8

How many did you get correct? For those you didn’t, do you understand why?

Account Name Asset Liability Revenue Expense

Cash ✔

Sales ✔

Receivables ✔

Rent ✔

Internet fees ✔

Payables ✔

Bank overdraft ✔

Salaries ✔

Computers ✔

Categorising Accounts - Answers

UNIT 1

9

As well as sorting into Assets, Liabilities, Revenue and Expenses we need to understand the difference between capital expenditure and revenue expenditure.

When we buy something like a van or a computer, we expect it to last several years. This is capital expenditure.

When we pay for electricity or car tax these are day to day running costs of the business. This is revenue expenditure.

We also differentiate between revenue income (sales) and capital income (where we might get money by selling our van).

The Difference Between Capital and Revenue Expenditure

UNIT 1

10

If you start a new business, you usually begin by putting some capital into the bank. Let’s say that we started a business with £10,000 on 1st January.

When an owner puts capital into the business, he/she is lending the money to the business and the business owes the owner the money.

So we have two effects: £10,000 cash in the bank and a £10,000 liability to record.

The Dual Effect of Transactions

UNIT 1

11

At this point in our business our asset (the £10,000 in the bank) equals our liability (the £10,000 owed to the owner).

In fact there is an equation for this, known as The Accounting Equation.

The Accounting Equation

UNIT 1

12

Because capital is generally recorded separately from the other liabilities that a company may have, the equation is also written as:

The Accounting Equation including Capital

UNIT 1

13

Suppose we buy a van for £3,000 using the money in the bank. Our assets change to:

● Van £3,000● Bank £10,000 - £3,000 = £7,000● Liabilities (other than capital)

remain at zero● Capital remains at £10,000

The Accounting Equation: Buying a Van with Cash

UNIT 1

14

Now, suppose we buy the same van for £3,000, but using a loan instead.

Our equation changes to:

● Van £3,000● Bank £10,000● Liabilities (other than capital)

change to £3,000 to show the loan

● Capital remains at £10,000

Our balancing figure has risen to £13,000 because there is an extra £3,000 in the business from the loan.

The Accounting Equation: Buying a Van with a Loan

UNIT 1

15

We have discovered that every time we make a transaction it has a dual effect.

If we pay internet fees:

● We record the amount in the computer expense account● We record the amount paid out of the bank

If we sell goods:

● We record the amount in the sales revenue account

● We record the amount paid into the bank

This is known as double entry.

The Dual Effect of Transactions Revisited

UNIT 1

16

The accounts we will be using are called T accounts, simply because they are in the shape of a ‘T’. Each account has a debit side and a credit side.

Debit Account Name Credit

Date Details £ Date Details £

Assets and Expenses are recorded on the Debit side

Revenue and Liabilities are recorded on the Credit side

The name of the other double entry account for the transaction is usually entered into the details column.

Using a ‘T’ Account

UNIT 1

17

We put £10,000 capital in to our business.

Debit Cash at bank Credit


01 Jan Capital 10,000

The money in the bank is an asset so it will be entered into the debit side of the cash at bank account

The name of the other account is usually entered into the details column.

The money owed to the owner (the capital) is a liability so it will be entered into the credit side of the capital account

Debit Capital Credit


01 Jan Bank 10,000

Recording the Original Capital

UNIT 1

18



01 Jan Capital 10,000 01 Jan Van at cost 3,000

The van is an asset so it will be entered into the debit side of the Van at cost account

The money coming out of the bank is reducing the value of the asset, so it will be entered into the credit side of the cash at bank account

Debit Van at cost Credit


01 Jan Bank 3,000

Buying a Van with £3,000 from the Bank

UNIT 1

19






01 Jan Bank 3,000



01 Jan Bank 10,000

The Three T Accounts Together

UNIT 1

20




06 Jan Sales 500 05 Jan Computer expenses

150

Debit Sales Credit


06 Jan Bank 500

Debit Computer expenses Credit


05 Jan Bank 150

Expenses are debits. Money spent reduces the value of the cash at bank asset account.

Sales revenue is a credit, and the money coming in is increasing the value of the cash at bank asset account.

Paying Internet Fees and Making Sales

UNIT 1

21

All Five Accounts TogetherDebit Cash at bank Credit



06 Jan Sales 500 05 Jan Computer expenses 150



05 Jan Bank 150

Debit Sales Credit


06 Jan Bank 500



01 Jan Bank 3,000Debit Capital Credit


01 Jan Bank 10,000

UNIT 1

22

Balancing the Accounts

At the end of the week we will ‘balance off’ the accounts. Most accounts only have one entry, but the Cash at bank account has several.





150

06 Jan Balance c/d 7,350

10,500 10,500

07 Jan Balance b/d 7,350

Effectively, we add up the moneys that have been entered into the account and deduct the moneys paid out. So, for this account, that would be:

10,000 + 500 – 3,000 – 150 = 7,350

UNIT 1

23

Balancing the AccountsDebit Cash at bank Credit




150

06 Jan Balance c/d 7,350

10,500 10,500

07 Jan Balance b/d 7,350

As part of the process of balancing an account, we show a total on each side. Here, it is £10,500.

We also show a balance carried down (c/d) to make both sides add up to the same total, and a balance brought down (b/d) on the opposite side of the account, below the totals.

In this case, we are showing the balance b/d of £7,350 as an asset on the debit side.

To learn more about this, follow the link to the AAT e-learning module on balancing accounts. The link is in the Lesson Materials section of this VLE.

UNIT 1

24

The Trial Balance

Accounts Debit Credit

Bank 7,350

Computer expenses 150

Sales 500

Capital 10,000

Van at Cost 3,000

Total 10,500 10,500

The Trial Balance is a list of all our account balances. It’s a check to see that our debit entries match our credit entries - we are ‘trialling' our balances to see if they match.



05 Jan Bank 150



01 Jan Bank 10,000

If the original account has a debit balance, it will show as a debit in the Trial Balance

If the original account has a credit balance, it will show as a credit in the Trial Balance

UNIT 1

25

In this lesson we have looked at:

• Categorising accounts as either an asset, expense, revenue or liability

• The difference between capital and revenue expenditure

• The dual effect of transactions and the accounting equation

• The basics of double entry bookkeeping

• The Trial Balance

Recap

bookkeeping transactions

Documents