Maintain nancial records Book 2: Understanding Double Entry Accounting

A resource for: BSBFIA301A BSBCMN308A Maintain nancial records Maintain nancial records

The

small

management SERIES

Understanding double entry accounting

A resource for: BSBFIA301A Maintain financial records BSBCMN308A Maintain financial records

T R A I N I N G C E N T R E The Small Business Training Specialists

Small Business

About this resource

This resource has been written to provide the underpinning knowledge and skills for the Unit:

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BSBSCMN308A Maintain financial records BSBSFIA301A Maintain financial records

This unit is from the Small Business Management domain of the Business Services Training Package. This unit involves covers the day to day financial management of a small business through implementing a financial plan and monitoring actual performance against that plan. It also covers the analysis and review of financial strategies over the longer term. Completion of this unit will count towards the qualification:

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BSB40407 Certificate IV in Business (Small Business Management) BSB40401 Certificate IV in Business (Small Business Management)

Important disclaimer No person should rely on the contents of this publication without first obtaining advice from a qualified professional person. This publication is distributed on the terms and understanding that: 1. 2. the authors, consultants and editors are not responsible for the results of any actions taken on the basis of information in this publication, nor for any errors in or omission from this publication. the publisher is not engaged in rendering legal, accounting, professional or other advice or services.

The publisher, and the authors, consultants and editors, expressly disclaim all and any liability and responsibility to any person, whether a purchaser or reader of this publication or not, in respect of anything, and of the consequences of anything, done or omitted to be done by any such person in reliance, wholly or partially, upon the whole or any part of the contents of this publication. Without limiting the generality of the above, no author, consultant or editor shall have any responsibility for any act or omission of any other author, consultant or editor.

The SMALL BUSINESS M A N A G E M E N T Series

Understanding double entry accounting

Contents
Introduction An overview of the double entry system Computerised accounting Accrual accounting Learning double entry accounting The general ledger Assetswhat the business owns Liabilitieswhat the business owes Equitythe owners investment in the business Revenue (income) Expenses Chart of accounts Exercise 1 Principles of double entry The Accounting Equation Exercise 2 Accounting rules Debits and credits Where are the corresponding entries? Exercise 3 Posting entries to the ledger Exercise 4 The Trial Balance If it does not balance Exercise 5 Exercise 6Practice set Dealing with GST Exercise 7 Subsidiary ledgers Accounts Receivable subsidiary ledger Accounts Payable subsidiary ledger Exercise 8 The General Journal Buying plant and equipment on credit Writing off bad debts Correction of posting errors Commencing entries Exercise 9 Conclusion Answers to self-testing exercises 1 3 6 6 6 9 9 11 12 12 13 14 16 17 17 19 20 21 23 26 29 35 39 40 42 43 49 52 55 55 60 61 65 65 66 68 69 71 73 75

Understanding double entry accounting

Introduction
This text covers a particular system of collecting and recording financial information relating to a business known as double entry accounting. Many of you will have heard of this system and may also have heard stories about how hard it is to learn or how it has no relevance to small business. We hope to dispel these myths as you work through this text. Why bother to learn double entry accounting? Well, firstly, it is a highly accurate method of financial record keeping which is the basis of most of the computer accounting packages available. With the introduction of GST, more and more small businesses are computerising their accounting function. Yet, accountants tell many stories of clients whose financial records are a complete mess, even though the client has used a commercial software package such as MYOB or Quickbooks. This has happened because the business owner did not understand what the program was doing behind the sceneshe or she did not understand double entry accounting. Secondly, the main financial reports for a business, the Profit & Loss Statement (or Statement of Financial Performance) and Balance Sheet (Statement of Financial Position) are the result of the double entry accounting process. If you keep your financial records on a single entry basis (that is, keep journals only), the information will have to be processed further to create these two financial reports. In a double entry system, these reports can be extracted at any point in timemonthly, quarterly in addition to the end of the financial yearallowing you to more effectively manage your business. Hopefully by now you will appreciate the value of understanding double entry accounting. This text will only cover the basic principles of double entry accounting suitable for use by a sole trader or partnership. No attempt is made to cover the more complex requirements of limited liability companies. What follows, therefore, will not make you into a qualified bookkeeper. However, it should give you a better appreciation of the advantages and disadvantages of the double entry system when compared to a single entry system, allowing you to choose the right system for your business. If you choose double entry, you will understand how your computerised accounting package works and will be able to take advantage of its many functions.

Understanding double entry accounting

An overview of the double entry system

The double entry accounting system can be divided into several stages as shown on the diagram on page 5. The first stage is the recording of transactions as they occur, on some suitable source documentan invoice, sales docket, cheque butt, bank deposit slip etc. You learned how to complete source documents in Book 1 of this course. At the end of each day, or other selected period, the various source documents are sorted into some designated orderalphabetical, serial number, chronologicaland become the basis for entering the accounting information into books of account known as Journals. You will recognise the first four journals on the diagram from your previous study. You already know how to prepare a Cash Receipts Journal, a Cash Payments Journal, a Credit Sales Journal and a Purchases Journal. While a journal is not the first record of a transaction, it is the first place where a full record is made of the transaction in a book of account. Hence, journals are often referred to as books of original, or first, entry. The information written in a journal is usually done chronologically. Consequently, transactions relating to the same person or business activity may be entered on different pages in the same journal. For example, if you wished to view all the sales transactions relating to a particular customer in this financial year, you would have to thumb through the Sales Journal to find the relevant invoices. Similarly, if you wished to view all the transactions relating to motor vehicle costs in a given period, you would have to peruse several pages of the Cash Payments Journal.

Understanding double entry accounting

The tracing of individual transactions is made easier by the use of a Ledger, commonly called the General Ledger. A Ledger may be a bound book, a collection of loose sheets in a binder, a series of cards in a tray, or a computer database. The information in the journals is enteredpostedat regular intervals into what are called ledger accounts. A ledger account is merely a page or sheet in the ledger which has a heading identifying the type of information it contains. For example, the total payments made for rent of business premises would eventually be recorded in a ledger account called Rent A/c. (A/c is the abbreviation of Account.) The transactions (invoices and receipts) relating to your customer J. Jones would be posted to a ledger account called Accounts ReceivableJ. Jones. Through this process, the transactions first recorded in the journals are re-sorted into the ledger. The advantages of ledger accounts are: Because the detailed information relating to transactions is already recorded in the journals and source documents, the information entered in the ledger accounts can be in summarised form. This makes it easy to use the information for decision-making purposes. All the information relating to a particular person or business activity will now be found in one place. In one spot, you have a summary of your dealings with each particular customer or supplier. At one glance, you could tell how much you had spent on any individual expense in this financial year. The entries in each ledger account are balancedthat is, they are reduced to a single net amount, just like the deposits and withdrawals on your bank statement are used to calculate the final balance of your account. The balance of each ledger account is included in an accounting report known as a Trial Balance. The purpose of this is to check the accuracy of the postings from the journals to the ledger. Finally, the figures in the Trial Balance are used to prepare the financial reports (Profit & Loss Statement and Balance Sheet) and other management reports. The diagram on page 5 represents the double entry system kept on a manual basis. As you can see, it is quite a long process to first write up the journals then enter the information into the ledger. In the present day, no-one keeps a double entry system on a manual basis as computerised accounting packages can complete the process in a fraction of the time. For some small businesses, the single entry bookkeeping system outlined in Book 1 is quite sufficient. This process stops at the journal stage of the diagram. At the end of the year, their accountant will complete the double entry process, using the balanced journals they have prepared throughout the year, and will produce their financial reports. Other small businesses may decide to computerise their accounting function and will therefore be using the full double entry accounting process. It is important that the person using the computerised accounting package understands the principles of double entry accounting.

Understanding double entry accounting

Understanding double entry accounting

Computerised accounting
The process of the double entry system changes somewhat when it is computerised. There is no need to first create journals and then post the information in those journals to the ledger. The power of the computer allows us to enter individual transactions directly into the General Ledger and the program automatically generates transaction reports which replace journals. This process is shown on the diagram on page 7. The only journal retained as a 'book of first entry' in the computerised system is the General Journal.

Accrual accounting
The double entry system is an accrual accounting method. This means that it records all transactions as they occur. It records income as it is earned regardless of whether or not it has been received. It records expenses as they are incurred, regardless of whether or not they have been paid. It also records all cash transactions, that is, all money received or paid out. In this way, business owners can gain complete, up-to-date reports on the financial performance of the business. The accrual accounting system organises transactions into four types. You first learned about these in Book 1 of this course (See Bookkeeping with GST page 10). The type of transaction dictated which journal you used to record it. Type of transaction: CASH IN CASH OUT CREDIT RECEIVED CREDIT OFFERED Transactions recorded in: Cash Receipts Journal Cash Payments Journal Purchases Journal (Credit) Sales Journal

Even though you will not create journals in computerised accounting, you still need to clearly understand the difference between cash transactions and credit transactions. The work you have done in Book 1 will provide a foundation for your understanding of double entry accounting.

Learning double entry accounting

This course will teach you a manual process of double entry accounting that mimics the computerised system. That is, you will learn to analyse transactions and then enter them directly into the General Ledger. You will also learn how to extract a Trial Balance report. You already understand how to organise source documents into type (the first stage of the double entry process). The next step is to set up the General Ledger. This is covered in the next chapter.

Understanding double entry accounting

Understanding double entry accounting

What do you consider to be the main benefits of using a double entry accounting system in managing a small business? Check your answers against those shown on page 76.

Understanding double entry accounting