TOPIC TWO: RECORDING BUSINESS TRANSACTIONS

Upon Completion of this topic the learner should be able to:

 Define the meaning of double entry book-keeping system

 Define assets, capital and liabilities

 Explain what is meant by` double entry`

 Explain the debit and credit principles (Rules of double entry)

 Record assets capital and liabilities in accounts

 Extract the ledger balances into trial balances

 Identify the purpose of trial balances

2.1 Introduction

A business can be set up in two ways-

i) Owner supplying all the resources

ii) Owner supplying some of the resources and the rest being supplied by outside parties.

The two cases bring out the accounting equation also called book- keeping equation

Case one: owner supplying all the resources

In this case we say that-

Resources in the business = Resources supplied by the owner…………....................(i)

Resources in business are called Assets and resources supplied by the owner are called
Capital

Therefore equation (i) can be re -written as-

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ASSETS = CAPITAL

Case two: resources supplied by owner and outside parties

In this case we say that-

Resources in business = Resources supplied by the owner + Resources supplied by out-

side parties……........................................................................................(ii)

The new term in the equation is resources supplied by outside parties, in accounting, we
call them liabilities.

Therefore equation (ii) can be re-written as-

ASSETS = CAPITAL + LIABILITIES (Accounting Equation)

2.2 Components of accounting equations

Assets: An asset is a resource controlled by a business entity/firm as a result of past

events for which economic benefits are expected to flow to the firm. An example is if a
business sells goods on credit then it has an asset called a debtor. The past event is the
sale on credit and the resource is a debtor. This debtor is expected to pay so that
economic benefits will flow towards the firm i.e. in form of cash once the customers
pays.

Assets are classified into two main types:

i) Noncurrent assets (formerly called fixed assets).

ii) Current assets.

Non current assets are acquired by the business to assist in earning revenues and not for
resale. They are normally expected to be in business for a period of more than one year.

Major examples include

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  Land and buildings

 Plant and machinery

 Fixtures, furniture, fittings and equipment

 Motor vehicles

Current assets are not expected to last for more than one year. They are in most cases
directly related to the trading activities of the firm. Examples include:

 Stock of goods – for purpose of selling.

 Trade debtors/accounts receivables – owe the business amounts as a resort of

trading.

 Other debtors – owe the firm amounts other than for trading.

 Cash at bank.

 Cash in hand.

Liabilities: These are obligations of a business as a result of past events settlement of

which is expected to result to an economic outflow of amounts from the firm. An

example is when a business buys goods on credit, then the firm has a liability called

creditor. The past event is the credit purchase and the liability being the creditor the firm

will pay cash to the creditor and therefore there is an out flow of cash from the business.

Liabilities are also classified into two main classes.

i) Non-current liabilities (or long term liabilities)

ii) Current liabilities.

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Non-current liabilities are expected to last or be paid after one year. This includes long-

term loans from banks or other financial institutions. Current liabilities last for a period

of less than one year and therefore will be paid within one year.

Major examples:

 Trade creditors or accounts payable – owed amounts as a result of business buying

goods on credit.

 Other creditors - owed amounts for services supplied to the firm other than goods.

 Bank overdraft - amounts advanced by the bank for a short-term period.

Capital: This is the residual amount on the owner’s interest in the firm after deducting

liabilities from the assets. The Accounting equation can be expressed in a simple report

called the Statement of financial position (formerly, balance sheet). The basic format is

as follows:

2.3 Cause of Changes in Capital

The capital in a business does not remain intact but changes over time due to the

following factors: additional investments, profits drawings or losses.

1) Additional investments (I)-occurs when the owner of the business brings in his

personal cash or assets into the business for business use. Addition investment increases

the capital of the business.

2) Profits (P) -defined as the excess revenue obtained after paying costs of a business

increase the level of capital and assets of the business.

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3) Drawings (D)-refer to the money or other assets taken from the business by the owner

for personal use. Drawings reduce the of business capital.

4) Losses ( l )–occurs when the cost of goods or services are greater than their sale

price .losses reduce the level of business capital.

2.4 Initial Capital and Final Capital of a Business

Initial capital refers to any funds and other assets invested into the business by the

owner at the beginning of the trading period.

Final capital refers to the business capital at the end of the trading period. Thus, final

capital is initial capital when it has been influenced by factors such as additional

investment, profits, drawings and losses.

The formula for determining initial capital is represented as follows:

Initial capital =final capital – addition investment – net profits +drawings

i.e : I .C = F.C - I- P+D

Example

The following information was extracted from the books of Lima traders for the year

ended 31st dec 2009.

a) Closing capital as at 31st /12/2009 -: sh 4000,000.

b) Made profit of -: sh .200,000.

c) The proprietor invested into the business from her personal use -: sh. 250,000.

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d) The proprietor withdrew in cash for her personal use -:sh 60,000.

Required

Using initial capital formula, find the intial capital

Solution

I.C = F.C – I – P + D

I,C =sh 4000,000 – sh 250,000 –sh 200,000 +sh 60,000

I.C =sh 3,610,000.

2.5 Double Entry Aspects

The Accounting equation forms the basis of double entry and therefore it should always

be maintained. Any change in assets, liabilities or capital will have a double effect such

that assets will always be equal to liabilities plus capital. If the owners put in additional

capital then this will increase the cash at bank and the capital amount therefore the

equation is still maintained.

Name of the Account

Date Particulars Folio Amount Date Particulars Folio Amount

In this account the date will show the opening period of the asset, liability or capital i.e.

the balance brought forward. It will also show the date when a transaction took place

(i.e. either an asset was bought or liability incurred). The detail column (also called the

particulars column) shows the nature of the transaction and reference to the

corresponding account. The Folio Column for purposes of detailed recording shows the
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reference number of the corresponding account. The amount column shows the amount

of the asset, liability or capital. The left side of the account is called the debit side and the

right side is called the credit side. All assets are shown or recorded on the debit side

while all the liabilities and capital are recorded on the credit side. Each type of asset or

liability must have its own account whereby all transactions affecting them are recorded

in this account. Therefore there should be an account for Premises, Plant and Machinery,

Stock, Debtors, Creditors etc. Under the accounting equation if all assets are represented

by liabilities and capital therefore all debits should be the same as credits. For the double

entry to be reflected in the accounts, every debit entry must have a corresponding credit

entry. The transactions affecting these accounts are posted in the account as debit entry

and credit entry to complete the double entry.

Double entry rules

When we make a debit entry we are either:

i. Increasing the value of an asset.

ii. Reducing the value of a liability.

iii. Reducing the value of capital.

When we make a credit entry we are either:

i. Reducing the value of an asset.

ii. Increasing the value of a liability.

iii. Increasing the value of capital.

Illustration 1

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H Jumps has the following assets and liabilities as on 30 November 2002:

Creditors Sh.39,500; Equipment Sh.115,000; Motor vehicle Sh.62,900; Stock Sh.61,500;

Debtors Sh.57,700;Cash at bank Sh.72,800 and Cash in hand Sh.400.

Compute the balance on the capital account as at 30 November 2002.

During the first week of December 2002, Jump:

a. Bought extra equipment on credit for Sh.13,800.

b. Bought extra stock by cheque Sh.5,700.

c. Paid creditors by cheque Sh.7,900.

d. Received from debtors Sh.8,400 by cheque and Sh.600 by cash.

e. Put in an extra Sh.2,500 cash as capital.

You are to record the above transactions in respective accounts.

Illustration 2

Write up the asset, capital and liability accounts in the books of M Crash to record the

following transactions:

2002

June 1 Started business with Sh.50,000 in the bank.

“ 2 Bought motor van paying by cheque Sh.12,000.

“ 5 Bought Fixtures Sh.4,000 on credit from Office Masters Ltd.

“ 8 Bought a van on credit from Motor Cars Ltd Sh.8,000.

“ 12 Took Sh.1,000 out of the bank and put it into the cash till.

“ 15 Bought Fixtures paying by cash Sh.600.

“ 19 Paid Motor Cars Ltd by cheque Sh.8000.

“ 21 A loan of Sh.10,000 cash is received from J Marcus.

“ 25 Paid Sh.8,000 of the cash in hand into the bank account.

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“ 30 Bought more Fixtures paying by cheque Sh.3,000.

Note:

Note that the difference between the debit side and the credit side is the balancing figure.
Most assets will have a balance on the credit side and most liabilities and capital accounts
will have a balance on the debit side.

2.6 Accounting for Sales, Purchases, Incomes and Expenses.

Sales: This is the sell of goods that were bought by a firm (the goods must have been
bought with the purpose of resale). Sales are divided into cash sales and credit sales.
When a cash sale is made, the following entries are to be made.

i. Debit cash either at bank or in hand.

ii. Credit sales account.

For a credit sale:

i. Debit debtors/ Accounts receivable account.

ii. Credit sales account.

A new account for sales is opened and credited with cash or credit sales.

Buying (Purchases :) of goods meant for resale. Purchases can also be for cash or on
credit.

For cash purchases:

i. Debit purchases.

ii. Credit cash at bank/cash in hand

For credit purchases, we:

i. Debit purchases.

ii. Credit creditors for goods.

A new account is also opened for purchases where both cash and credit purchases are

posted. Note: no entry is made into the stocks account.

Incomes:
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A firm may have other incomes apart from that generated from trading (sales). Such
incomes include:

 Rent Received

 Bank interest received

 Discounts received.

 Salary received

When the firm receives cash, from these incomes, the following entries are made:

1. Debit cash in hand/at bank.

2. Credit income account.

Each type of income should have its own account e.g. rent income, interest income.
Incomes increase the value of capital and that is the reason why they are posted on the
credit side of their respective accounts.

Expenses: These are amounts paid out for services rendered other than those paid for

purchases. Examples include:

 Postage and stationery

 Salaries and wages

 Telephone bills

 Motor vehicle running expenses.

 Bank charges.

When a firm pays for an expense, we:

i. Debit the expense account.

ii. Credit cash at bank/in hand.

Each expense should also have its own account where the corresponding entry will be
posted. Expenses decrease the value of capital and thus the posting is made on the debit
side of their accounts. The following diagram is a simple summary of the entries made
for incomes and expenses.
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2.7 Returns Inwards and Returns Outwards.

Returns Inwards: These are goods that have been returned by customers due to various

reasons e.g.

i. They may be defective/damaged,

ii. Being of the wrong type.

iii. Excess goods being delivered.

Goods returned may relate to cash sales or credit sales. For the goods returned in relation
to cash sales and cash is refunded to the customer the following entries are made:

i. Debit returns – inwards

ii. Credit cashbook.

For goods returned that relate to credit sales; no cash has been given to customer, the
following entry is to be made.

i. Debit returns inwards.

ii. Credit debtors.

Returns Outwards: These are goods returned to suppliers/creditors. They may be for
cash purchases or for credit purchases. For cash purchases a cash refund given to the
firm by the supplier,

i. Debit the cashbook (cash at bank/hand).

ii. Credit returns outwards.

For credit purchases and no refund has been made:

i. Debit creditors.

ii. Credit returns outwards.

Illustration 3

You are to enter the following transactions, completing the double entry in the books for

the month of May 2002.

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2002

May 1 Started business with Sh.2,000 in the bank.

“ 2 Purchased goods Sh.175 on credit from M Rooks.

“ 3 Bought furniture and fittings Sh.150 paying by cheque.

“ 5 Sold goods for cash Sh.275.

“ 6 Bought goods on credit Sh.114 from P Scot.

“ 10 Paid rent by cash Sh.15.

“ 12 Bought stationery Sh.27, paying in cash.

“ 18 Goods returned to M Rooks Sh.23.

“ 21 Let off part of the premises receiving rent by cheque Sh.5.

“ 23 Sold goods on credit to U Foot for Sh.77.

“ 24 Bought a motor van paying by cheque Sh.300.

“ 30 Paid the month’s wages by cash Sh.117.

“ 31 The proprietor took cash for himself Sh.44.

2.8 Accounting for Drawings, Discounts Allowed and Discounts Received.

Drawings: The owner makes drawings from the firm in various ways:

i) Cash or bank withdrawals: When the owner withdraws money from the business
we debit drawings and credit cashbook (cash in hand or cash at bank).

ii) Taking goods for own use: When the owner takes out some of the goods for his own
use, we debit drawings and credit purchases.

iii) Personal expenses, paid by the business Here we debit the drawings and credit
expense account

Taking some of the other assets from the business e.g. motor vehicles or using part of the
premises. Sometimes the owner may take over some of the assets of the business e.g.
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vehicle or converting business premises into living quarters or not paying into the
business cash collected personally from the customers. When this happens we debit
drawings and credit the relevant asset e.g. motor vehicles, premises or some building or
even debtors.

Discounts

Discounts received: A discount received is an allowance by the creditors to the firm to

encourage the firm to pay the amount dues within the agreed time. It is an amount
deducted from the invoice price. When a discount is given by the supplier then we debit
creditor’s account and credit discounts received e.g. A. Ltd sells some goods on credit to
B Ltd.Sh.1,000 under the terms of sale, B Ltd, will receive a discount of 5% if they pay
the amount due within one month. B decides to take up the offer and pays the amount
within the given time. B will record the transaction as follows.

Debit: Creditor – A Ltd

Credit: Discounts Received

Discounts Allowed: These are the allowances made by a firm on the amounts receivable
from the customers to encourage prompt payment. The amounts deducted from the sales
invoice. In the previous example when A Ltd issued the discount and was taken up by B
the entries will be:
i. Debit - discount allowed
ii. Credit - debtors - B Ltd.

2.9 Trial Balance

The trial balance is a simple report that shows the list of account balances classified as
per the debits and credits. The purpose of the trial balance is to show the accuracy of the
double entries made and to facilitate the preparation of final accounts i.e. the trading,
profit & loss account and a statement of financial position. The debits of the trial balance
should be the same as the credits; if not then there is an error in one or more of the
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accounts. From the trial balance please note that assets and expenses are on the debit side.
Capital, liabilities and incomes are normally listed on the credit side.

Illustration 4

Write up the following transactions in the books of S Pink and extract a trial balance
once all the postings have been made in the relevant accounts.

2003

March 1 Started business with cash Sh.1,000.

“ 2 Bought goods on credit from A Cliks Sh.296.

“ 3 Paid rent by cash Sh.28.

“ 4 Paid Sh.1,000 of the cash of the firm into a bank account.

“ 5 Sold goods on credit to J Simpson Sh.54.

“ 7 Bought stationery Sh.15 paying by cheque.

“ 11 Cash sales Sh.49.

“ 14 Goods returned by us to A Cliks Sh.17.

“ 17 Sold goods on credit to P Lutz Sh.29.

“ 20 Paid for repairs to the building by cash Sh.18.

“ 22 J Simpson returned goods to us Sh.14.

“ 27 Paid A Cliks by cheque Sh.279.

“ 28 Cash purchases Sh.125.

“ 29 Bought a motor vehicle paying by cheque Sh.395.

“ 30 Paid motor expenses in cash Sh.15.

“ 31 Bought fixtures Sh.120 on credit from R west.

Illustration 5

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The following transactions took place during the month of May, 2003. Enter in the
relevant books of accounts and extract a trial balance.

May 1 Started firm with capital in cash of Sh.250.

“ 2 Bought goods on credit from the following persons: R Kelly Sh.54; Pcombs Sh.87;
J Role Sh.25; D Mobile Sh.76; I. Sims Sh.64.

“ 4 Sold goods on credit to: C Blanes Sh.43; B Long Sh.62; F Skin Sh.176.

“ 6 Paid rent by cash Sh.12.

“ 9 C Blanes paid us his account by cheque Sh.43.

“ 10 F Skin paid us Sh.150 by cheque.

“ 12 We paid the following by cheque: J Role Sh.25; R Kelley Sh.54.

“ 15 Paid carriage by cash Sh.23.

“ 18 Bought goods on credit from P Combs Sh.43; Mobile Sh.110.

“ 21 Sold goods on credit to B Long Sh.67.

“ 31 Paid rent by cheque Sh.18.

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