the accounting equation anddouble-entry book-keeping · book-keeping book-keeping is the process of...
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Kwame Nkrumah University of
Science & Technology, Kumasi, Ghana
THE ACCOUNTING EQUATION ANDDOUBLE-ENTRY BOOK-KEEPING
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Book-keeping
Book-keeping is the process of recording financial transactions in
theaccounting records(the ‘books’) of an entity.
Transactionsare recorded in accounts, and thereis aseparate
account for each different type of transaction.
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In a manual accounting system (a system that is not computerised)individual transactionsare not recorded in the ledger accounts as they occur,
becausethis wouldbe too time-consuming. Instead, they are recorded initially in books ofprime entry, or books of original entry. They are
transferred at a later time from thebooks ofprime entry to the accounts in the ledgers.
Thebooks of original entryare:
i. asales day book, for recording sales on credit (receivables) from salesinvoices
ii. asales returns day book, for recording items returned by creditcustomers (creditnotes issued to customers)
iii. apurchases day book, for recording purchases on credit from suppliers (trade payables) from purchaseinvoices
iv. apurchases returns day bookfor recording returns of purchases oncredit
v. acash book, for recording cash received into the business bank account andcash paidout of the bankaccount
vi. apetty cash book, for recording transactions relating to petty cash: pettycash consistsof notes and coins held by a business to pay for
smallincidental expensessuch as bus or taxi fares, or coffee and milk for theoffice
vii. ajournalfor recording transactions that are not recorded in any of theother booksof original entry.
BOOKS OF PRIME ENTRY (ORIGINAL ENTRY)
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Thesales day bookisthe bookof prime entry for credit sales. The sales day book is used to keep a list of all invoices sent to customers each day.
An extract from the sales day book might look like this.
SALES DAY BOOK
DateInvoiceCustomerTotalAmount Invoiced
20X0GHS
Jan 10247Asamoah& Co105.00
248OforiCo86.40
249Koree& Co 31.80
250Penton College1,264.60
1,487.80
THE SALES DAY BOOK
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Most businesses ‘analyze’ their sales. For example this business sells boots and shoes. The sale toOforiCo was
entirely boots, the sale toKoree& Co was entirely shoes and the other two sales was a mixture of both.
SALES DAY BOOK
DateInvoice CustomerTotalAmount InvoicedBook sales Shoesales
20X0GHSGHSGHS
Jan10 247Asamoah& Co105.0060.0045.00
248OforiCo86.4086.40-
249Koree& Co31.80-31.80
250PentonCollege1,264.60800.30464.30
1,487.80946.70541.10
Theanalysis gives the managers of the business useful information which helps them to decide how best to run
the business.
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Abusiness also keeps a record of the purchase day book of all the invoices it receives. The
purchase day book is a book of prime entry for credit purchases.Anextract from a purchase
day book might look like this.
PURCHASE DAY BOOK
DateSupplierTotalAmount Invoiced PurchasesElectricityetc.
20X8GHSGHSGHS
Mar 15Cook& Co315.00315.00 -
Acheampong29.4029.40-
EEB116.80-116.80
ShowFair Co100.00100.00- .
561.20444.40116.80
THE PURCHASE DAY BOOK
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Note that:
There is no 'invoice number' column, because the purchase day book
records other people's invoices, which have all sorts of different numbers.
Like the sales day book, the purchase day book analyses the invoices
which have been sent in. In this example, three of the invoices related to
goods which the business intends to re-sell (calledsimply 'purchases') and
the other invoice was an electricity bill.
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Whencustomers return goods for some reason, a credit note is raised. All credit notes are recorded in the
sales returns day book. An extract from the sales returns day book follows.
SALES RETURNS DAY BOOK
Date Credit note Customer and goods Amount
20X8GHS
30 AprilCR008MOppong
3pairs boots 135.00
THE SALES RETURNS DAY BOOK
The sales returns day book is the book of prime entry for credit notes raised.
Not all sales returns day books analyze what goods were returned, but it makes sense to keep as complete a
record as possible. Where a business has very few sales returns, it may record a credit note as a negative
entry in the sales day book.
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Thepurchases returns day book is a book of prime entry for credit notes received from
suppliers. Not surprisingly, the purchase returns day book records credit notes received in
respect of goods which the business sends back to its suppliers.
An extract from the purchase returns day book follows.
PURCHASE RETURNS DAY BOOK
DateSupplierand goods Amount
20X8GHS
29 April Boxes Co
300 cardboard boxes46.60
Once again, a business with very few purchases returns may record a credit note received as
a negative entry in the purchase day book.
THE PURCHASE RETURNS DAY BOOK
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Cashbook
The cash book may be a manual record or a computer file. It records all transaction that go through the bank account.
The cash book is also a day book, used to keep a record of money received and money paid out by the business. The
cash book deals with money paid into and out of the business bank account. This could be money received on the
business premises in notes, coins and cheques, subsequently paid into the bank. There are also receipts and payments
made by bank transfer, standing order, direct debit and bank interest and charges, directly by the bank.
• Some cash, in notes and coins, is usually kept on the business premises in order to make occasional payments for
odd items of expense. This cash is usually accounted for separately in a petty cash book.
• One side (the left) of the cash book is used to record receipts of cash, and the other side (the right) is used to
record payments. The best way to see how the cash book works is to follow through an example. For convenience,
we are showing the cash receipts and cash payments sides separately, but they are part of the same book.
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Example: Cash book
At the beginning of 1 September, Robin Plenty had GHS900 in the bank.
During 1 September 20X7, Robin Plenty had the following receipts and payments.
(a) Cash sale: receipt of GHS80
(b) Payment from credit customer Hay GHS400 less discount allowed GHS20
(c) Payment from credit customer Been GHS720
(d) Payment from credit customer Seed GHS150 less discount allowed GHS10
(e) Cheque received from Len Dinger GHS1,800 to provide a short-term loan
(f) Second cash sale: receipt of GHS150
(g) Cash received for sale of machine GHS200
(h) Payment to supplier Kew GHS120
(i) Paymentto supplier Hare GHS310
(j) Payment of telephone bill GHS400
(k) Payment of gas bill GHS280
(l) GHS100 in cash withdrawn from bank for petty cash
(m) Payment of GHS1,500 to Hess for new plant and machinery
If you look through these transactions, you will see that seven of them are receipts and six of them are payments.
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CASH BOOK (RECEIPTS)
Date NarrativeTotal
20X7GHS
1 Sept Balance b/d*900
Cashsale80
Accountsreceivable: Hay 380
Accountsreceivable: Been 720
Accountsreceivable: Seed 140
Loan: Len Dinger1,800
Cashsale150
Saleof non-current asset200
4,370
* 'b/d' = brought down (i.e. brought forward)
The receipts part of the cash book for 1 September would look like this.
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There is space on the right hand side of the cash book so that the receipts can be
analyzed under various headings – for example, 'cash from receivables', 'cash sales'
and 'other receipts'.
The cash received in the day amounted to GHS3,470. Added to the GHS900 at the
start of the day, this comesto GHS4,370. This is not the amount to be carried forward
to the next day, because first we have to subtract all the payments made during 1
September.
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The payments part of the cash book for 1 September would look like this.
CASH BOOK (PAYMENTS)
Date NarrativeTotal
20X7GHS
1 SeptAccountspayable: Kew120
Accounts payable: Hare310
Telephone400
Gas bill280
Petty cash100
Machinery purchase1,500
Balance c/d (balancing figure)1,660
4,370
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As you can see, this is very similar to the receipts part of the cash book. The only points to
note are as follows.
The analysis on the right would be under headings like 'payments to payables,
'payments into petty cash', 'wages' and 'other payments'.
Payments during 1 SeptembertotalledGHS2,710. We know that the total of receipts was
GHS4,370. That means that there is a balance of GHS4,370 – GHS2,710 = GHS1,660 to
be 'carried down' to the start of the next day. As you can see this 'balance carried
down' is noted at the end of the payments column, so that the receipts and payments
totals show the same figure of GHS4,370 at the end of 1 September.
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With analysis columns completed, the cash book given in the examples above might look as follows.
CASH BOOK (RECEIPTS)
Accounts Cash
Date NarrativeTotalreceivable sales Other
20X7GHSGHSGHSGHS
1 Sept Balance b/d 900
Cash sale8080
Accounts receivable: Hay380380
Accounts receivable:Been720 720
Accounts receivable: Seed140140
Loan: Len Dinger1,8001,800
Cash sale150150
Sale of non-current asset200_______200
4,3701,2402302,000
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CASH BOOK (PAYMENTS)
Accounts Petty
Date NarrativeTotalPayableCashWagesOther
GHSGHSGHSGHSGHS
20X7
1 SeptAccountpayable: Kew120120
Account payable: Hare310 310
Telephone400400
Gasbill280280
Pettycash 100100
Machinerypurchase 1,5001,500
Balancec/d1,660_____________
4,370430100-2,180
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Most businesses keep petty cash on the premises, which is topped up from the main bank account. Under the imprest system, the petty cash is kept at an agreed sum, so that each topping up is equal to the amount paid out in the period.
Mostbusinesses keep a small amount of cash on the premises to make occasional small payments in cash, e.g. staff refreshments, postage stamps, to pay the office cleaner, taxi fares, etc. This is often called the cash float or petty cash account. The cash float can also be the resting place for occasional small receipts, e.g. cash paid by a visitor to make a phone call, etc.
PETTY CASH
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Underwhat is called the imprest system, the amount of money in petty cash is kept at an agreed sum or 'float' (say
GHS250). This is called the imprest amount. Expense items are recorded on vouchers as they occur, so that at any
time:
GHS
Cash still held in petty cash 195
Plus voucher payments (25+5+10+15)55
Must equal the imprest amount250
The total float is made up regularly (to GHS250, or whatever the imprest amount is) by means of a cash payment
from the bank account into petty cash. The amount of the 'top-up' into petty cash will be the total of the voucher
payments since the previous top-up.
IMPREST SYSTEM
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A typical layout follows.
PETTY CASH BOOK
Receipts Date Narrative Total MilkPostageTravel Other
GHS 20X7GHSGHSGHSGHSGHS
250 1 Sept Bal b/d
Milkbill2525
Postagestamps 55
Taxifare1010
Flowersfor sick
staff1515
___Balc/d195_______
2502502551015
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Accountsand ledgers
There are accountsfor:
i. eachtype of asset, liability, income and expense, and accounts for theowners’ capital
ii. eachcustomer who purchases goods or services oncredit
iii. eachsupplier from which goods or services are bought oncredit.
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Accounts are kept together in aledger. A ledger is a term meaning a collection of related accounts. There are
usually three ledgers in a financial accounting system:
1. Themain ledger, usually called either thenominal ledgeror thegeneralledger. Thisledger contains the
accounts for:
i. assets, liabilities andcapital
ii. incomeand expenses.
2. Thereceivables ledger, which contains the accounts for each customer who is sold items on credit. Each
receivables account shows how much the individual customer has purchased on credit, details of sales returns
(i.e. any credit notes), how much he has paid and what he currently owes.
3. Thepayables ledger, which contains the accounts for each supplier of goods or services on credit. Each
trade payables account shows how much the entity has bought on credit from a particular supplier, details of
purchase returns, how much it has paid and what it currently owes to the supplier.
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POSTING TRANSACTIONS FROM THE BOOKS OF PRIME ENTRY TO THE LEDGERACCOUNTS
The process of transferring the details of transactions from the books of primeentry tothe accounts in the ledgers is sometimes called ‘posting’ the transactions. Itis doneas follows.
From the sales day book (or sales returns day book)to:
i. themain ledgerand
ii.thereceivablesledger
Detailsof sales on credit (and also details of any credit notes for sales returns)are postedfrom the sales day book (or sales returns day book) to two ledgers. Thetotal valueof sales (or total value of sales returns) is recorded in the main ledger intwo accounts, the sales account and the account for total receivables, to reflect thedual natureof the transaction. Details of each individual sales transaction withcredit customersare also posted to the personal account for the customer, which is keptin thereceivables ledger.
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Sales day book/
sales returns day book
Main Ledger
1. Sales account or sales returns
account and
2. 2. Total receivables account (main
ledger )
Receivables ledger
Individual accounts of the customers
Total value of
transactions
Individual
transactions
SALES ON CREDIT/SALES RETURNS
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Suppose that a sales day book contains the following three transactions that havenot yetbeen posted to the ledger accounts.
Ifthese transactions are posted to theledgers:
• Salesof $750 will be recorded in themain ledger, both as $750 of sales and $750 ofmoney now owed by customers (trade receivables).
• Inthereceivables ledger,sales on credit of $250 will be recorded in theindividual account for Entity Green, sales of $100 in the account for P Roseand salesof $400 in the account for Yellow Company.
EXAMPLE
Customer Saleson credit/amount owed by customer
$
Entity Green 250
P Rose 100
Yellow Company 400
750
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From the purchases day book (or purchase returns day book) to
i. the main ledgerand
ii. thepayablesledger
Detailsof purchases of goods on credit (and also details of any credit notesfrom suppliersfor purchase returns) are posted from the purchases day book (or purchasereturns day book) to two ledgers.
Thetotal value of purchases (ortotalvalueof purchase returns) is recorded in the main ledger in two accounts,the purchasesaccount and the account for total trade payables, to reflect the dualnature ofthe transaction.
Detailsof each individual purchase transaction with suppliersare alsoposted to the personal account for the supplier, which is kept in thepayables ledger.
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Purchases day book/
Purchases returns day book
Main Ledger
1. Purchases account or Purchase
returns account and
2. 2. Total Payables account (main
ledger )
Payables ledger
Individual accounts of the
suppliers
Total value of
transactions
Individual
transactions
PURCHASES ON CREDIT/ PURCHASES RETURNS
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The purchase ledger is also used to record purchase invoices from suppliers ofother items, as well as purchases of goods. For example the purchase ledger is usedto recorddetails of invoices for rental costs of buildings or equipment, and invoicesfor telephoneexpenses and electricity and gas supplies.
Details of these expenses are posted from the purchases ledger to the mainledger, andthe accountsfor:
i. therelevant expense,and
ii. totaltrade payables.
Detailsof each individual invoice are also posted to the account of theindividual supplierin the payables ledger.
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Fromthe cash book to
i. themain ledger and
ii. thereceivables or payables ledger
Thecash book in a manual accounting system is often used as both a book ofprime entryand as an account in the main ledger. However it might be convenient tothink ofthe cash book as a book of prime entry and a different account, the bankaccount, asan account in the main ledger.
Thecash book has two sides, a side for receipts of money and a side for payments.
Detailsof cash received are posted to the main ledger, where the dual nature ofthe transactionis recorded. For example money received from a credit customeris recordedas an addition to money in the bank and a reduction in tradepayables. Moneyreceived for a cash sale is recorded as an addition to money in the bankand anincrease in total revenue from cashsales. Ifthe cash is received from a credit customer, the details of the money receivedare alsorecorded in the customer’s personal account in the receivables ledger.
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CASH RECEIVED/PAID
Cashpayments are recorded in a similar way to cash receipts. Payments arerecorded in both the main ledger and (if the payment is to a supplier) in theaccount ofthe supplier in the payables ledger.
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Example
Suppose that the cash book (payments side) contains the following transactionsthat havenot yet been posted to the ledgers.
Thesetransactions are posted to the ledgers as follows:
• Paymentsof $1,000 will be recorded in the main ledger, both as paymentsof $1,000from the bank account and $1,000 of money paid to suppliers (tradepayables).
• Inthe payables ledger, a payment of $300 will be recorded in theindividual accountfor Sepia Company, a payment of $150 in the account for G Red anda paymentof $550 in the account for Blue Company.
Supplier Cash payment to the supplier
$
Sepia Company 3,00
G Red 150
Blue Company 550
1,000
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Financial transactions are recorded in the accounts in accordance with a set ofrules orconventions. The following rules apply to the accounts in the mainledger (nominalledger or general ledger).
i. Everytransaction is recorded twice, as a debit entry in one account and asa creditentry in anotheraccount.
ii. Totaldebit entries and total credit entries must always be equal. Thismaintains theaccounting equation.
iii. Ittherefore helps to show accounts in the shape of a T, with a left-hand and aright handside. By convention:
a. debitentries are made on the left-hand sideand
b. creditentries are on the right-hand side.
DEBIT AND CREDIT ENTRIES, AND T ACCOUNTS
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Account Name
Debit Side $ Credit side $
Debit transactions
entered on this sideAmount
Credit transactions
entered on this sideAmount
Enter reference to the
account where the
matching credit entry
is made
XX
Enter reference to the
account where the
matching debit entry is
made
XX
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Therules of debits and credits
In the main ledger, there are accounts for assets, liabilities, equity, income andexpenses. The rules about debits and credits are as follows.
Debit Side Credit Side
Record as a debit entry: Record as a credit entry:
An increase in an asset An increase in a liability
(asset account) (liability account)
An increase in an expense An increase in income
(expense account) (income account for example, sales in the sales account)
An increase in capital
(capital account: for example profit or new capital introduced to the business
Record as a debit entry: Record as a credit entry:
A reduction in a liability A reduction in asset
(liability account) (asset account)
A Reduction in income (for example, a debit In the sales
returns account )
A reduction in an expense (expense account: for example, purchase returns are
a debit in the purchase returns account, because they reduce the cost of
purchases)
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Forexample, if a purchase invoice is received for electricity charges for $2,300,the doubleentry is (ignoring sales tax):
• Debit: Electricity charges (= increase inexpense)
• Credit: Total trade payables (= increase in liability)
Therules of double entry apply only to the main ledger and not to thereceivables ledgeror payables ledger, because there are accounts for total receivables andtotal payablesin the main ledger. Transactions recorded in individual customeraccounts inthe receivables ledger or in individual supplier accounts in the payablesledger areentered in just one side of the appropriate individual customer orsupplier account.
Dr and CrBy convention, the terms ‘debit’ and ‘credit’ are sometimes shortened to ‘Dr’and ‘Cr’ respectively.
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Double entry book-keeping and the cash account
It might help to learn the rules of double entry by remembering thattransactions involvingthe receipt or payment of cash into the bank account are recordedas follows:
• TheCash account, also called the Bank account, is an asset account (moneyin thebank is an asset).
• Receiptsof cash: These are recorded as a debit entry in the Cash account orBank account, because receipts add to cash (an asset).
• Paymentsof cash. Payments reduce cash, so these are recorded as a creditentry inthe Cash account or Bank account.
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Debit Side Credit Side
Record as a debit entry:
Record as a credit entry:
Transactions that provide anINCREASEin cash Transactions that results in aREDUCTIONin cash
The matching credit entry might be to
The matching debit entry might be to
(1) A sales account, for cash sales,) expenses (1) an expense account, for payments of cash
(2) The total trade receivables account, for payments
received from credit customers
(2) The total trade payables account, for payments to suppliers for purchases
on credit/amounts owing,
(3) The capital account (for new capital introduced by the
owner in the form of cash)(3) A payment in cash for a new asset
(4) A drawings account, for withdrawal of profit by the business owner
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EXAMPLE
Transaction 1: Sam sets up a business by putting $5,000 into a bank account.
Transaction 2: Sam purchases goods for $4,000, paying $1,000 in cash andbuying
$3,000of goods on credit.
Transaction 3. Sam sells goods for $6,000. $2,000 of these sales are in cash and the
other $4,000 are on credit.
Transaction 4. Sam purchases some equipment for the business, costing $3,000.He
paysby cheque.
Transaction 5. Sam pays rent of $1,000 for six months, for office accommodation.
Rent is an expense.
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Example
This increases the cash of the business, and its capital.
Notes:(a) The entry in each account shows the other account where the matchingdebit orcredit entry appears.(b) The numbers are included for illustrative purposes only, to help you to matchthe debit and credit entry for each transaction.
Capital Account
$ $
(1) Bank 5,000
Bank Account
$ $
Capital 5,000
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Total purchases are an addition to expenses (purchases). The purchases reducecash by$1,000 and increase trade payables by $3,000.
Thepurchases account is an expense account and the trade payables account isa liabilityaccount.
Bank Account
$ $
Capital 5,000 Purchases 1,200
Purchases Account
$ $
Bank1,000
Tradepayables3,000
Trade Payables Account
$ $
Purchases 3,000
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Total sales (income) are $6,000, and the sales result in an increase in total assetsof $6,000, consisting of cash ($2,000) and trade receivables ($4,000).
Bank Account
$ $
Capital 5,000 Purchases 1,000
(3a) Sales 2,000
Receivables Account
$ $
(3b) Sales 4,000
2,000
Sales Account
$ $
(3a) Bank 2,000
(3b) Receivables 4,000
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This transaction adds to the non-current assets of the business, and reduces cash. An increase in one asset (equipment) is therefore matched by a reduction in another asset (cash).
Bank Account
$ $
Capital 5,000 Purchases 1,000
Sales 2,000 (4) Equipment 3,000
Equipment Account
$ $
(4) Bank 3,000
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Therental cost adds to expenses and reduces cash.
BankAccount
$ $
Capital 5,000 Purchases 1,000
Sales 2,000 Equipment 3,000
Rent 1,000
Rent Account
$ $
Bank 1,000 Purchases 1,000
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Account balances and a trial balance
Atany time, the balance on an account can be established. The balance
onan accountis the difference between the total value of debit entries and
the totalvalue ofcreditentries.
• Iftotal debits exceed total credits, there is a debitbalance
• Iftotal credits exceed total debits there is a credit balance.
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Debit Balances $ Credit Balances $
Bank 2,000 Capital 5,000
Purchases 4,000 Trade Payables 3,000
Receivables 4,000 Sales 6,000
Equipment 3,000
Rent 1,000
14,000 14,000
Example
Total debit balances and total credit balances should always be equal. A list of the debit and credit balances in the main
ledger accounts is called atrial balance.
At any time, it should be possible to ‘extract’ a trial balance from the main ledger, and prepare a list of debit balances
and credit balances. If the accounts have been prepared correctly, total debit balances and total credit balances must be
equal.
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Atthe end of an accounting period, an account is closed off. On manyaccounts (particularlyasset, liability and capital accounts), there will be abalance.
• Balanceson expense accounts and income accounts are transferred to theincome statement.
• Balanceson the asset, liability and capital accounts are carried forwardas closingbalances at the end of the period, and become opening balances atthe beginningof the next period.
Toclose off an account, the closing balance is entered in the T account so thattotal debitsand total credits are equal. The debit and credit columns are then totalledand aline drawn underneath the entries. Below the line, the opening balance forthe beginningof the next period is entered.
Closing balance and opening balance
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Inthis example, there is a debit balance on the bank account at the end of theperiod. Theclosing balance to carry
forward is entered on the credit side, so that total debits and total credits add up to $7,000. The debit balance of
$2,000 is brought forward as the opening balance on the account at the beginning of the next period.Thisindicates
that the business has an asset (a debit balance) of cash in the bank account totalling $2,000.
Bank account
$ $
Capital 5,000 Purchases 1,000
Sales 2,000 Equipment 3,000
Balance c/d 1,500 Rent 1,000
9,000 closing bal c/f 2,000
7,000 7,000
Opening balance b/f 2,000
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NOTEc/fstands for carried forward.
Youmight alsosee:
• c/fwd(for carried forward),or
• c/dfor ‘carried down’.
Similarly,b/fstands for brought forward.
Youmight also see:
• b/fwd(for brought forward),or
• b/dfor ‘brought down’.
Asimilar method of carrying forward the closing balance is used forliability accountssuch as trade payables, and the capital account. When the tradepayablesaccountbelow isbalancedthere is a closing balance of $1,500 indicating that $1,500is payableto suppliers in total – this is a credit balance as it is a liability.
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Trade payables account
$ $
Bank 2,500 Purchases 3,000
Bank 5,000 Purchases 2,000
Balance c/d 1,500 Purchases 4,000
9,000 9,000
Balance b/d 1,500
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ENDOF LECTURE
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