4.1 INTRODUCTION - A REMINDER
In most businesses, classification and recording of each transaction is based upon the elements of the financial statements (asset, Ilability, income, expense and capital) and is allocated to specific general ledger accounts. For example, there will be a separate general ledger account for income and expense accounts (such as sales, purchases, rent, insurance costs), asset accounts (such as property, plant and equipment and amounts due from credit customers) and liability accounts (such as amounts outstanding to suppliers, bank loans and sales tax due). There is no rule or limit as to how many general ledger accounts a business should have but the system should facilitate effective and efficient accounting and control.
The term 'general ledger' refers to the complete set of ledger accounts used by a business in which transactions are recorded. It may also be referred to as a 'nominal ledger' or 'chart of accounts'. It forms the basis of financial accounting information used to produce a trial balance and, subsequently, the annual financial statements.
A ledger account contains a record of transactions assigned to a specific asset, liability, source of income or expense, along with a capital account for a sole proprietor. It will identify increases and decreases in that item during an accounting period. Collectively, the ledger accounts contain the record of accounting entries relating to all transactions and events during an accounting period. They are the principal books or files for recording, summarising and totalling monetary transactions by account item or type. The trial balance and annual financial statements of a business are generated from summary totals in the ledger accounts contained in the general ledger.
Ledger accounts contain entries of transactions relevant to a particular item based upon the elements of the financial statements. For example, invoices for the purchase of fuel or motor repairs and maintenance on credit are recorded in the motor expenses ledger account. At the same time, a liability is also recorded, which will be reduced or cleared as subsequent payments are made to the suppliers. At the end of an accounting period, a balance is stuck on each ledger account. There will be a debit balance for the total of motor expense incurred during the accounting period. There may be a credit balance outstanding on the liability account if there are unpaid Invoices.| Elements | Elements of the financial statements | ||||
|---|---|---|---|---|---|
| Assets | Liabilities | Capital | Income | Expenses | |
| Accounting equation | Assets = Liabilities + Capital | ||||
| Financial statements | Statement of financial position | Statement of profit or loss | |||
| Ledger accounting | Debit = | Credit + | Credit | Credit | Debit |
The following section moves on to explain and demonstrate the format of a ledger account and how individual transactions are recorded in the ledger accounts using the principles of double-entry bookkeeping
Debits and credits
Individual transactions are recorded in the relevant general ledger accounts using double-entry bookkeeping
An Individual general ledger account may simply be referred to as a ' ledger account or T-account. Traditionally each ledger account was presented as an enlarged 'T' that had two sides which, by established convention, the left-hand side and right-hand side are referred to as the debit side and credit side respectively
An example ledger account is illustrated as follows:
The duality concept means that each transaction will affect at least two ledger accounts. One account will be debited and the other credited . Whether an entry is made to the debit or credit side of a ledger account depends upon the type of account and the nature of the transaction. To increase an asset or an expense, the ledger account would be debited. To increase an income account or a liability, that account would be credited.
This can be summarised as follows:
Consequently, it follows that:
a decrease in an expense, asset or drawings requires a credit entry in that account, and
a decrease in a liability, income or capital requires a debit entry in that account.
You can use the mnemonic ' DEAD CLIC' to help you remember this vitally important double-entry rule.
Summary of steps to record a transaction
Determine the individual ledger accounts that are affected. account, and
Consider whether each account balance is being increased or decreased.
Decide which account should be debited or credited as applicable.
Check that a debit and a credit entry have been made for the same monetary amount (Le. the entries balance).
The following rules of double-entry accounting apply:
An asset is recorded as a debit entry in an asset account.
A liability is recorded as a credit entry in a liability account.
Owner's capital is recorded by a credit entry in the capital account.
Income is recorded as a credit entry in an income account, such as the sales account.
Expenses are recorded as a debit entry in an expense account.
If more than two accounts are used to record a transaction (for example, to record sales tax on a transaction), the total value of the debit entries and the total value of the credit entries for the transaction must still be equal . In the ACCA FA1 exam, you may be presented with accounting information presented in the form of a T-account, and be asked to complete it or to identify and rectify missing or erroneous information.
EXAMPLE
A summary of some of the most common transactions entered into by a business are presented below.
| Transaction | Debit | Credit |
|---|---|---|
| Purchases for cash | ||
| Purchases on credit | ||
| Cash sales (making profit on sale) | ||
| Credit sales (making profit on sale) | ||
| Obtain a bank loan | ||
| Bank payment for wages | ||
| Bank interest received | ||
| Bank receipt from credit customer | ||
| Bank payment to credit supplier |
Which accounting entries are required to record the transactions noted in the general ledger?
| Transaction | Debit | Credit |
|---|---|---|
| Purchases for cash | Purchases | Cash at bank |
| Purchases on credit | Purchases | Payables |
| Cash sales (making profit on sale) | Cash at bank | Sales |
| Credit sales (making profit on sale) | Receivables | Sales |
| Obtain a bank loan | Cash at bank | Loan liability |
| Bank payment for wages | Wages | Cash at bank |
| Bank interest received | Cash at bank | Interest received |
| Bank receipt from credit customer | Cash at bank | Receivables |
| Bank payment to credit supplier | Payables | Cash at bank |
EXAMPLE
These basic rules can be illustrated using the transactions noted below for a business started by Hopper as a coffee trader.
Transaction 1: Hopper set up the business with $5,000 cash.
Here there is an increase in capital and assets. The asset is cash in the bank, which is recorded in an account called 'Bank'.
Commonly there is a folio or reference column in the T-account. This provides a reference so that the transaction can be traced through the accounting records if required.
The reference column is used to indicate the other account in the general ledger where the 'other side' of the double-entry can be found. So here, there is a reference to 'Bank' or 'Cash' in the Capital account and a reference to the Capital account on the Bank or Cash account.
Transaction 2: Purchase furniture for $1,500 using a bank payment.
Here, there is an increase in one asset (furniture) and a reduction in another (cash in the bank).
In the bank account, the debit entry exceeds the credit entry by $3,500 ($5,000-$1,500). We therefore say that there is a debit balance on the account. The debit balance is $3,500, showing that the business has $3,500 cash in the bank.
Transaction 3: Purchase equipment for $2,000 and tableware for $800 by bank payment.
Here we actually have two transactions, similar to the one above and are recorded as follows:
The total value of the credit entries in the bank account is now $4,300. The debit entry exceeds the credit entries by $700, so there is a debit balance on this account of $700, indicating that the business still has $700 in its bank account.
Transaction 4: Hopper takes out a business bank loan of $1,000.
A bank loan creates a new liability, but also adds to cash in the bank (an asset). The balance on the bank account now rises from $700 to $1,700, which is the amount by which total debit entries ($6.000) exceed total credit entries ($4,300)
Transaction 5: Purchases of $700.
Purchases of materials are recorded in a purchases account, which is an expense account. Since the purchases are paid for by bank payment, there is a credit entry in the bank account and a reduction in the bank balance to $1,000.
Note that purchases of materials or goods are recorded in the purchases account. Sales of materials or goods are recorded in a sales account. Only the start and end of year balance of goods or materials is recorded in an inventory account. There are no accounts called 'materials' or 'goods' and these terms should not be used in the bookkeeping system.
Transaction 6: Sales of $1,050 which was banked.
Sales are recorded in a sales account, which is an income account. Since the income is all in cash, there is a debit entry in the Bank account for the increase in the bank balance of $1,050.
Transaction 7: Rent payable of $200
Rent payable is a type of expense. It will therefore be recorded in an expense account, just like purchases, with a debit entry. Since the amount is paid by a bank payment, there is also a credit entry in the bank account.
Transaction 8: Stationery of $50 bought on credit from Green Supplies
This is another type of expense. A business will have many different types of expenditure that it needs to record in separate T-accounts, for management accounting purposes, financial reporting purposes and tax purposes. The stationery costs will therefore be recorded in a T-account by a debit entry. This time, however, there is no cash payment and therefore another T-account needs to be set up for the liability due to the supplier, referred to as a 'payable', which will be credited with $50. (Note that there will be a separate memorandum record maintain in a payable ledger to identify which credit supplier is owed $50.)
Transaction 9: Credit purchases of $1,000 from Blue Supplies
We saw in transaction 5 that purchases require debit entries in expense accounts. The only difference with these purchases for $1,000 is that they are made on credit, rather than paying for them in cash. Therefore, we need to debit purchases with $1,000 and record the liability in the payables general ledger account. (Note that there will be a separate memorandum record maintain in a payables' ledger to identify that Blue is owed $1,000.)
Transaction 10: Credit sales of $2,000 to Grey
We saw in transaction 6 that sales are recorded in an income account, with a credit entry. The only difference with these sales is that they are made on credit, rather than the cash being received immediately. Therefore, we will post the credit entry to the sales account in the usual way, but this time we will set up a general ledger account to record amounts owed by credit customers, referred to as 'receivables'. There will also be a separate memorandum receivables' ledger to record amounts owing by individual credit customers.
Transaction 11: Wages of $50
Hopper decides to employ a part-time worker. In the first week, Hopper pays the employee $50 from the business bank account. Again, wages are simply another type of expense account. The double entry is therefore to debit wages with the $50 and credit bank.
Transaction 12: Full payment of $2,000 received from Grey
When a credit customer pays the balance or part of the balance owing on their account, cash is received into the business. This increase in an asset (cash) is reflected by debiting the bank account with the $2,000. At the same time, there is a reduction in another asset, the receivables'. This reduction is reflected by a credit entry to the receivable account for $2.000.
Transaction 13: Full payment by Hopper of $50 to Green Supplies and $1,000 to Blue Supplies
When a business pays an account payable, it reduces a liability the payables' account and reduces an asset - cash at the bank. Reduction of a liability is a debit entry and reduction of an asset is a credit entry. Therefore, we need to debit the payables' general ledger account with $50 and $1,000 respectively, and we also need to credit the bank account with these two amounts. (Note, that the memorandum payables ledger accounts for Green and Blue will also be updated.)
Transaction 14: Partial repayment of $100 against loan
Hopper makes the first loan repayment of $100, which reduces the liability due to the bank by $100. It also reduces an asset, bank by $100. A reduction in a liability is a debit and a reduction in an asset is a credit. Therefore, we need to debit the loan account with $100 and credit the bank account with $100.
The memorandum receivables ledger and payables ledger accounts are not part of the double-entry bookkeeping system maintained in the general ledger In an integrated computerised accounting system, these accounts are updated simultaneously with the general ledger accounts. For information, here are the updated individual accounts for each individual credit supplier and credit customer.
Record the following transactions in general ledger accounts.
Balance off the 'Cash at bank' account.
| Transaction | Details |
|---|---|
| 1 | Set up the business by introducing $150,000 in cash. |
| 2 | Purchase property costing $140,000. Pay in cash. |
| 3 | Purchase goods costing $5,000. Pay in cash. |
| 4 | Sell goods for $7,000. All cash sales. |
| 5 | Purchase goods costing $8,000. Pay in cash. |
| 6 | Pay a sundry expense of $100, by cheque. |
| 7 | Sell goods for $15,000. All cash sales. |
| 8 | Pay wages of $2,000 to an employee. |
| 9 | Pay postage costs of $100 by cheque. |
Note: A payment by cheque = a payment in cash.
Tip: Remember there is no such account as 'goods'.
For a suggested answer, see the 'Answers' section at the end of the book.