Unit 1 Quick revision summary

1.1 The role of accounting

●● Business transactions involve the exchange of goods, services and money with
different customers and suppliers.
●● An entrepreneur is someone who risks his or her own time and money to start-up
and run a business organisation.
●● Entrepreneurs aim to make a profit from their investments in business. This means
selling goods or services at a price greater than their total cost.
●● The final profit of a business is its total income less the cost of making and selling its
goods or services and after all its other expenses have been met.
●● A business that is unable to earn enough income to cover its expenses will make a
loss.
●● Good financial management in business requires detailed records to be kept about
every transaction that takes place. Without accurate records a business will not know
whether it is making a profit and has enough money to survive.
●● Book-keeping is the process of recording business transactions as they occur.
●● Accounting is the skill and process of using book-keeping records of a business to
prepare financial statements about its financial health and performance.
●● An accounting year is the 12-month period covered by the financial statements of a
business.
●● An income statement reports how much profit or loss a business has made over the
accounting year. A statement of financial position summarises financial
information about the value of the business on the final day of an accounting year.

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1.2 The double-entry system of book keeping

●● Businesses need productive resources to operate. These include current assets such
as cash and inventory (goods purchased and held for future resale) which are used
up quite quickly in running a business, and non-current assets including premises,
machinery, vehicles and other equipment that can be re-used over many years.
●● Some business assets will be financed by the business owners from their owner’s
capital or equity. Other assets will be financed by liabilities to other people and
organisations including money borrowed from banks and money owed to suppliers
for goods purchased on credit. Current liabilities will have to be settled within the
accounting year but non-current liabilities will be repayable over several years.
●● The total assets of a business will always be equal to the sum of its owner’s capital and
total liabilities. The whole of accounting is based on this accounting equation.
●● A statement of financial position shows how much a business owns (assets) and
how much it owes to other individuals and organisations (the owner’s capital and
total liabilities) on a given date. The financial position of a business will change with
each transaction made.
●● Each transaction will affect two values in the accounting equation and a statement of
financial position. For example, the purchase of additional assets will require an
increase in owner’s capital or an increase in liabilities to finance it. Similarly, the
repayment of a liability will require a decrease in assets such as cash in bank or an
increase in owner’s capital to do so.
●● Business documents including invoices and receipts will be issued or received by a
business for each transaction. These are the source documents for book-keeping
records.
●● Details of transactions contained in source documents will initially be recorded at the
end of each day of trading in books of prime entry, including a sales journal,
purchases journal and cash book. Entries from these books will be transferred or posted
to different accounts contained in the ledger, usually at the end of each month.
●● The ledger is subdivided into three main sections:
The sales ledger: this section contains personal accounts for customers who owe
the business money for items it has supplied to them on credit terms. These ledger
accounts are also known as trade receivables.
The purchases ledger: this contains personal accounts for suppliers who have
supplied items to the business on credit terms. These ledger accounts are also
known as trade payables.
The general ledger (also known as the nominal ledger): this contains real
accounts for assets, liabilities and capital; and nominal accounts for income and
expenses, and all other payable and other receivable accounts.
●● The system used to write up ledger accounts is known double-entry book-
keeping. It is a set of rules for the recording of financial information in which every
transaction will involve a debit to one ledger account and a corresponding credit to
another ledger account.
●● At the end of an accounting year the balances on real and personal accounts and on
other payable and receivable accounts, will be reported in the statement of financial
position. In contrast, balances on nominal accounts for incomes earned and expenses
incurred are transferred to the income statement to calculate profits of loss for the
year.

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1.3 Documentary records
●● Business documents are used to record financial transactions. They are important
sources of information about the goods and services businesses have purchased or
supplied, their total price including any discounts and other charges including
delivery or carriage, and terms of payment.
●● A supplier of goods or services on credit will issue an invoice to the customer
detailing what has been supplied, the total price and when final payment is due.
●● If goods are returned or there is an overcharge on an invoice the customer may issue
a debit note to the supplier. The debit note is a request to the supplier to reduce the
sum charged in the original invoice.
●● A supplier will issue a credit note to notify the customer of a reduction in the total
amount invoiced if the invoice has already been paid or a reduction in the debit
balance on the statement of account.
●● A regular customer who has an account with a supplier will usually receive a
monthly statement of account from that supplier. Each statement will summarise
all the transactions between them within within a given each month and the total
amount owed or balance outstanding on the account or total amount owed at the
end of that month by the customer.
●● A receipt is issued by a supplier when goods or services are purchased by a customer
who pays for them immediately in cash.
●● A cheque is a written order to a bank to pay a stated sum of money to the payee –
the person or organisation named on the cheque. The issue of a receipt by the payee
is not necessary because the cheque will provide sufficient proof of payment.

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1.4 Books of prime entry
●● All transactions are entered into a book of prime entry in the date order they occur
before they are posted to the ledger.
●● Credit sales are recorded in the sales journal from copies of invoices issued to
customers and credit notes issued for goods returned or overpayments on invoices
are recorded in the sales returns journal.
●● At the end of each month the values of all the sales on credit recorded in the sales
journal during the month will be credited to the sales account. The total value of
credit notes issued will be debited from the sales returns account in the general
ledger.
●● Purchases on credit of goods intended for resale in the purchases journal from
purchases invoices received and credit notes received from a supplier for any goods
subsequently returned are recorded in the purchases returns journal.
●● At the end of each month the total value of purchases on credit recorded for the
month in the purchases journal will be posted as a debit to the purchases account and
the total value of credit notes received will be credited to the purchases returns
account in the general ledger.
●● Details of trade discounts offered by suppliers to their customers may be recorded
for information only in books of prime entry. A trade discount is an amount or
percentage deducted from the catalogue, list or retail price of an item by its supplier
when it is sold to another business. Trade discounts can encourage customer loyalty
and repeat sales.

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1.5 The cash book
●● Cash in hand kept on the business premises and cash in bank held in a bank
account are business assets from which payments are made.
●● All cash payments and receipts are recorded in the cash book. It is both a book of
prime entry and also provides the ledger accounts for cash and bank transactions.
●● Entries made to the debit side of a cash book are for money received as cash, cheque
or bank transfer.
●● Entries made to the credit side of a cash book are for money paid out by the business
from cash in hand and for cash, cheques and bank transfers drawn from its bank
current account.
●● A bank current account is a bank account that allows the account holder to make
and receive payments using cheques and different forms of bank transfer.
●● A business can instruct its bank to transfer money from its bank current account to
the bank account of a named individual or organisation in a number of ways:
by credit transfer, to pay an instructed amount on a specified date. This is a
popular method used to pay wages and salaries to employees
by standing order to pay the same fixed amount at regular intervals, for
example, each month, quarter or year
by direct debit to make regular but variable payments with the amount and date
of each payment as instructed by the organisation receiving payment – a method
often used to pay electricity, telephone and other expenses that vary monthly or
quarterly.
●● Contra entries to each side of a cash book will be required for transactions that
affect both the cash account and bank accounts at the same time, for example when
cash in hand is deposited into the bank account or when cash is withdrawn from the
bank account to top-up cash held on the business premises.
●● When the cash and bank accounts in the cash book are balanced off at the end of
each month their total debits and credits are calculated. If total debits exceed total
credits in the same period the accounts will have debit balances. This means they
are both asset accounts containing funds available for use by the business in the next
month.
●● If total credit entries to the bank account in the cash book exceed total debit entries
the bank account will have a credit balance. This means the account is overdrawn.
The bank account will be a liability account until the overdrawn amount or bank
overdraft is repaid to the bank by the business.
●● A bank overdraft is a convenient way for a business to borrow money from its bank
at short notice and for a short amount of time when its cash payments exceed its cash
receipts. It allows the account holder to continue to make payments from a current
account even if there are insufficient funds in the account to cover those payments.
●● A business may also borrow money over a longer period of time from a bank in the
form of a commercial loan.
●● Overdrafts and loans are business liabilities because they have to be repaid. Banks
charge interest on the borrowed funds. These are an additional cost of finance for a
business that will reduce its final profit.
●● Cash discounts are often offered by suppliers to their credit customers to encourage
them to settle their invoices or accounts early (before their scheduled due dates).

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 ●● A record of the discounts allowed by a business to its credit customers and discounts
received from its suppliers can be kept in a three column cash book before their
totals are posted to separate ledger accounts
●● A discount allowed by a business is a loss of income and is therefore an expense of
running the business. A discount received by a business is a reduction in the
amount it must pay to settle an invoice or statement of account. It is therefore a
saving and is recorded as an income received.
●● A bank will issue regular bank statements, usually at the end of each month, to
each of its current account holders detailing their individual bank transactions.
Differences between bank statement and cash book records can occur because:
bank charges, interest on bank overdrafts, and some payments and receipts
included in the bank statement may have been omitted from the cash book
the cash book contains entries that are not in the bank statement including
unpresented cheques and uncredited deposits
●● An unpresented cheque is a cheque that has yet to be submitted for payment.
●● An uncredited deposit of money will have been paid into the bank account but too
late for it to be processed in time to be included in the bank statement.
●● A business will produce a bank reconciliation statement at the end of each month
to identify and account for any differences in the balances on its cash book and bank
statement.
●● A petty cash book is used to record transactions involving small items of business
expenditure usually incurred by employees on behalf of their employer. An employee
must complete a petty cash voucher and produce a receipt to reclaim petty cash.
●● Most businesses with employees operate an imprest system for petty cash. The
petty cashier is given a fixed sum of money at the start of each week or month called
the imprest or cash float sufficient to pay for (reimburse) small expenditures. At
the end of each imprest period the float is restored to the same fixed amount for the
start of the next period.
●● Keeping a separate petty cash book to record small items of expenditure has the
following advantages:
It allows the cash book to be used to record larger, bank-only transactions.
The job of managing petty cash can be given to a petty cashier freeing up the time
of the business manager, accountant or finance director to concentrate on more
important tasks.
The total amount of cash paid out can also be checked easily at any time.
●● Additional “analysis” columns may be added to either side of a cash book to monitor
different uses of cash. In an analysed cash book each analysis column corresponds
to a different account in the ledger so that column totals can be easily transferred
from the cash book to the ledger at the end of each week or month.

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1.6 The general journal
●● The general journal is a book of prime entry used to record transactions that cannot
be entered in any of the other books of prime entry.
●● A transaction will be recorded in the general journal with details of the date it
occurred, the ledger account and amount to be debited followed by the ledger
account and amount to be credited and a narrative to describe the transaction and
explain why it took place. A reference to the source document for the transaction will
also be included.
●● The general journal provides a diary-like record of less common transactions, one-off
purchases or sales of non-current assets on credit and the writing off of bad debts.
By providing a full record of these transactions the general journal reduces the scope
for fraud.
●● Opening entries for assets, liabilities and capital are recorded in the general journal
when the business starts to operate or when accounting records are started for the
first time.
●● The general journal is also used to correct errors discovered in the recording of
previous transactions in the journal or when they were posted to ledger accounts.
●● Recording transactions in the general journal before they are posted to the ledger
helps to reduce the risk of making errors in ledger accounts.

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1.7 The ledger
●● The process of transferring journal entries to ledger accounts is called posting. A
business will open and maintain ledger accounts for every type of asset, liability,
source of income and expense it has and also for each of its trade payables and trade
receivables.
●● Ledger accounts are arranged in a “T” format. The title of the ledger account is
printed on top of the “T” and debit (Dr) and credit (Cr) entries are made either side of
it.
●● In double-entry book-keeping every transaction will affect two ledger accounts. For
every entry to the debit side of an account there will be a corresponding credit entry
to another. This also means that a debit to one account will have a corresponding
credit to another.
●● Something of value coming in to the business will be recorded as a debit to a ledger
account. Something of value going out of the business is recorded as a credit.
●● Purchases of goods intended for resale can be with cash or on credit. The purchases
ledger contains trade payable accounts for named suppliers of goods on credit to
show the amounts owed to them.
●● Sales of goods can be for cash or on credit. The sales ledger contains trade
receivable accounts for customers who have been supplied goods on credit to show
the amounts they owe.
●● It is important to record all purchases and sales, and any goods returned by customers
or to suppliers. Purchases and sales returns will increase the inventory of goods
available to sell for revenue. Sales and purchases returns to suppliers will reduce
inventory.
●● The general ledger contains all remaining double-entry accounts for income,
expenses, assets and capital.
●● It is important for a business to balance off its ledger accounts at the end of each
month to monitor financial performance. This also needs to be done at the end of
each accounting year to prepare its annual financial statements. Balancing off a
ledger account means adding up all the debt entries and all the credit entries on the
account and finding the difference (the balance carried down).
●● A ledger account has a debit balance if total debits exceed total credits. A debit
balance on a trade receivable account shows the amount owed to the business by that
credit customer.
●● Accounts for assets, purchases, expenses and drawings will all have debit balances.
●● A ledger account has a credit balance if total credits exceed total debits. A credit
balance on a trade payable account shows the amount owed by the business to that
supplier for goods supplied on credit.
●● Accounts for sales, liabilities, incomes received and capital will all have credit
balances.
●● Drawings from cash or in goods from inventory by the business owners for their
own use will reduce the assets of the business.

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1.8 The trial balance
●● A trial balance is a statement of the balances on ledger accounts on a particular
date.
●● A trial balance is not part of the double-entry system of book-keeping: it is used to
check the arithmetical accuracy of book-keeping entries at the end of each month
and to help prepare financial statements at the end of each accounting year.
●● A trial balance should balance. The total of debit balances entered from the ledger
should be equal to the total of credit balances entered from the ledger.
●● A trial balance will fail to balance if:
the debit and credit columns are added up incorrectly
a debit has been entered to one account that does not match a credit to another
account
a credit has been entered to one account that does not match a debit to another
account
an account balance has been entered in the wrong column
an account balance has been left out.
●● A trial balance can still balance even if one or more of the six types of recording
errors have been made in the ledger accounts:
An error of omission has been made if the double entries for a transaction have
not been recorded.
An error of commission is present when the correct transaction has been
entered but in the wrong account in the same ledger.
An error of principle has been made if a transaction has been entered correctly
but in wrong class of account.
Compensating errors occur when two or more errors in the accounts cancel
each other out.
An error of original entry has been made if the value of a transaction has been
recorded incorrectly in a source document or book of prime entry.
An error of complete reversal has been made if a debit entry has been placed
on the credit side of an account and the corresponding credit entry has been
placed on the debit side of the other account.

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1.9 Adjustments to ledger accounts

●● Not all expenses are incurred or incomes earned at the same time at which invoices
or payments are recorded in the accounts. To calculate profit or loss for any given
accounting year expenses incurred during the year should be matched with the
incomes they helped to earn in the same accounting year. This is called the
matching principle.
●● Adjustments will be needed in the ledger at the end of an accounting year to ensure
that it records all incomes earned and all expenses incurred during the year. This is
regardless of whether or not they have been invoiced and paid, in order to calculate
the profit or loss for the year in the income statement.
●● An accrued expense is an expense that has been used up or incurred by a business
but not paid for by the end of the accounting year. It should therefore be charged to
profit for that year. An accrued expense is a current liability of the business.
●● A prepaid expense is an expense that has been paid for in advance and remains
unused by the end of that accounting year. It should only be charged to profit when
it is incurred to the benefit of the business in the next accounting year. Until then the
unused expense will be a current asset of the business.
●● Any income earned but still owing at the end of an accounting year is an accrued
income. It should be credited to the income statement to include in the calculation
of profit for that year. Until the income is finally received the amount owed or
outstanding will be a current asset of the business.
●● A prepaid income is an income that has been received in advance but remains an
unearned income by the end of that accounting year. The prepayment will be a
current liability of the business until it supplies the goods or services paid for in
advance. The income received will not contribute to profit for the year until the
business has settled its liability and earned the income.
●● An irrecoverable debt is debt on a trade receivable account that will be impossible
to collect. An irrecoverable debt written off represents a loss of income. It should be
recorded in the irrecoverable debts account and charged to profit for the year.
●● An irrecoverable debt recovered occurs when a business receives a payment to
settle a debt that it was previously written off in its accounts. An irrecoverable debt
recovered is an addition to the income of the business and should be credited to profit
for the year.
●● It is prudent to include a provision for doubtful debts in the accounts. The
provision assumes the business will be unable to collect a proportion of the income it
has earned from the supply of goods and services to customers on credit that are due
for payment in the next accounting year.
●● A provision for doubtful debts is created by crediting a provision for doubtful debts
account. The credit balance on the account at the end of an accounting year records the
reduction the business expects in the value of its trade receivables due to irrecoverable
debts. The loss of value is charged to profit in the year the provision is created.
●● Selling too many goods or services on credit to customers in a weak financial position
and with a poor repayment history will increase the risk of bad debts. This in turn
will weaken the financial position of the supplier. Good credit control is essential in
business to reduce the risk of debts becoming irrecoverable and the need for large
provisions for doubtful debts.

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