Cambridge AS & A Level9706

The accounting system

Accounting 9706 Chapter Notes

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The accounting system
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In this chapter

  1. 1Double-Entry for Cash Transactions
  2. 2Double-Entry for Credit Transactions
  3. 3The Books of Prime Entry
  4. 4Balancing Ledger Accounts
  5. 5Classifying Accounts and Ledgers
  6. 6Preparing the Trial Balance

1. Double-Entry for Cash Transactions

The foundation of accounting is the double-entry system. This means every single transaction has two effects, which are recorded as a 'debit' in one account and a 'credit' in another. The total of debits must always equal the total of credits. This system is built around the accounting equation: Assets = Liabilities + Capital. Assets are what the business owns, Liabilities are what it owes, and Capital is the owner's investment. To remember which accounts are debited and which are credited, use the mnemonic DEAD CLIC. DEBIT to increase: Drawings, Expenses, and Assets. CREDIT to increase: Capital, Liabilities, and Income. For cash transactions, the Cash or Bank account is always one of the accounts affected.

Assets = Liabilities + Capital

Capital = Assets - Liabilities

Key term

Double-Entry Bookkeeping: A system of accounting where every transaction is recorded with an equal debit entry in one account and an equal credit entry in another account.

Examiner insight

Examiners look for the correct identification of the two accounts affected by a transaction and the correct application of the debit and credit rules.

Common pitfall

Reversing the debit and credit entries, for example, crediting the bank account when cash is received or debiting it when cash is paid out.

Fun fact

The double-entry system was first documented in detail by Italian mathematician and Franciscan friar Luca Pacioli in 1494. He is often called the 'Father of Accounting'.

Worked example 12 marks

The owner, J. Doe, starts a business by investing $10,000 cash into the business bank account on 1 June. Show the double-entry for this transaction.

  1. 1

    Step 1: Identify the two accounts affected. The business is receiving money in its Bank account (an Asset) and the owner's investment (Capital) is increasing.

  2. 2

    Step 2: Apply the DEAD CLIC rule. To increase an Asset (Bank), you DEBIT it. To increase Capital, you CREDIT it.

  3. 3

    Step 3: Record the entries in the T-accounts:

  4. 4

    Dr Bank Account Cr: June 1 Capital $10,000

  5. 5

    Dr Capital Account Cr: June 1 Bank $10,000

Worked example 22 marks

On 5 June, the business pays rent of $500 by cheque. Show the double-entry for this transaction.

  1. 1

    Step 1: Identify the two accounts affected. The business is paying for a Rent Expense, and the money is leaving the Bank account (an Asset).

  2. 2

    Step 2: Apply the DEAD CLIC rule. To increase an Expense (Rent), you DEBIT it. To decrease an Asset (Bank), you do the opposite of increasing it, so you CREDIT it.

  3. 3

    Step 3: Record the entries in the T-accounts:

  4. 4

    Dr Rent Expense Account Cr: June 5 Bank $500

  5. 5

    Dr Bank Account Cr: June 5 Rent Expense $500

Worked example 32 marks

On 12 June, the business buys office equipment for $2,000, paying by cheque. Show the double-entry.

  1. 1

    Step 1: Identify the two accounts affected. The business is acquiring Office Equipment (a non-current Asset), and the money is leaving the Bank account (also an Asset).

  2. 2

    Step 2: Apply the DEAD CLIC rule. To increase an Asset (Office Equipment), you DEBIT it. To decrease another Asset (Bank), you CREDIT it.

  3. 3

    Step 3: Record the entries in the T-accounts:

  4. 4

    Dr Office Equipment Account Cr: June 12 Bank $2,000

  5. 5

    Dr Bank Account Cr: June 12 Office Equipment $2,000

Recap

  • Every transaction affects at least two accounts.
  • For every transaction, total debits must equal total credits.
  • The accounting equation is Assets = Liabilities + Capital.
  • Use DEAD CLIC to remember the rules: DEBIT increases for Drawings, Expenses, Assets; CREDIT increases for Capital, Liabilities, Income.
  • A decrease in an account is the opposite of an increase (e.g., to decrease an Asset, you Credit it).
  • Cash transactions always involve either the Cash account or the Bank account.

Quick check

  1. What is the double-entry for receiving $200 cash from a cash sale?2 marks
  2. State the accounting equation.1 mark

2. Double-Entry for Credit Transactions

Credit transactions are when goods or services are bought or sold with an agreement to pay later. This creates assets called 'trade receivables' (for credit sales) and liabilities called 'trade payables' (for credit purchases). A trade receivable is a customer who owes the business money. A trade payable is a supplier the business owes money to. The double-entry rules (DEAD CLIC) still apply. For a credit sale, you debit the trade receivable's account (an asset is increasing) and credit the sales account (income is increasing). For a credit purchase, you debit the purchases account (an expense is increasing) and credit the trade payable's account (a liability is increasing).

Key term

Trade Receivable: A customer who owes the business money for goods or services that have been supplied on credit.

Examiner insight

Candidates must clearly distinguish between cash and credit transactions and use the correct accounts (e.g., Sales account for the transaction vs. the customer's personal account).

Common pitfall

Confusing trade receivables (assets) with trade payables (liabilities) and debiting or crediting the wrong type of account.

Worked example 12 marks

On 3 July, the business sells goods on credit for $800 to a customer, B. Brown. Show the double-entry.

  1. 1

    Step 1: Identify the two accounts. The business has made a Sale (Income) and has a new Trade Receivable, B. Brown (Asset).

  2. 2

    Step 2: Apply DEAD CLIC. To increase Income (Sales), you CREDIT it. To increase an Asset (Trade Receivable B. Brown), you DEBIT it.

  3. 3

    Step 3: Record the entries:

  4. 4

    Dr B. Brown Account Cr: July 3 Sales $800

  5. 5

    Dr Sales Account Cr: July 3 B. Brown $800

Worked example 22 marks

On 9 July, the business buys goods on credit for $1,200 from a supplier, S. Supplies. Show the double-entry.

  1. 1

    Step 1: Identify the two accounts. The business has made Purchases (Expense) and has a new Trade Payable, S. Supplies (Liability).

  2. 2

    Step 2: Apply DEAD CLIC. To increase an Expense (Purchases), you DEBIT it. To increase a Liability (Trade Payable S. Supplies), you CREDIT it.

  3. 3

    Step 3: Record the entries:

  4. 4

    Dr Purchases Account Cr: July 9 S. Supplies $1,200

  5. 5

    Dr S. Supplies Account Cr: July 9 Purchases $1,200

Worked example 34 marks

On 20 July, B. Brown pays the $800 she owes by bank transfer. On 25 July, the business pays S. Supplies the $1,200 it owes. Show the double-entries for both transactions.

  1. 1

    For the payment from B. Brown (20 July):

  2. 2

    Step 1: The two accounts are Bank (Asset) and B. Brown (Trade Receivable, an Asset).

  3. 3

    Step 2: Bank is increasing, so DEBIT Bank. The asset 'B. Brown' is decreasing (as they no longer owe us), so CREDIT B. Brown.

  4. 4

    Step 3: Dr Bank Account Cr: July 20 B. Brown $800. Dr B. Brown Account Cr: July 20 Bank $800.

  5. 5

    For the payment to S. Supplies (25 July):

  6. 6

    Step 1: The two accounts are Bank (Asset) and S. Supplies (Trade Payable, a Liability).

  7. 7

    Step 2: Bank is decreasing, so CREDIT Bank. The liability 'S. Supplies' is decreasing (as we no longer owe them), so DEBIT S. Supplies.

  8. 8

    Step 3: Dr S. Supplies Account Cr: July 25 Bank $1,200. Dr Bank Account Cr: July 25 S. Supplies $1,200.

Recap

  • Credit sales create a trade receivable, which is a current asset.
  • Credit purchases create a trade payable, which is a current liability.
  • The double-entry for a credit sale is Debit Trade Receivable, Credit Sales.
  • The double-entry for a credit purchase is Debit Purchases, Credit Trade Payable.
  • When a trade receivable pays, you Debit Bank/Cash and Credit the Trade Receivable's account.
  • When you pay a trade payable, you Debit the Trade Payable's account and Credit Bank/Cash.

Quick check

  1. What is the double-entry for buying goods on credit from 'X Ltd' for $300?2 marks
  2. Define a 'trade payable'.1 mark

3. The Books of Prime Entry

Before transactions are posted to the individual accounts in the ledger, they are first recorded chronologically in a 'book of prime entry' (also called a day book or journal). This creates a detailed diary of all transactions. Each type of transaction has its own book. The main books are:

  • Sales Day Book: Records all credit sales.
  • Purchases Day Book: Records all credit purchases.
  • Sales Returns Day Book: Records goods returned to the business by credit customers.
  • Purchases Returns Day Book: Records goods the business returns to credit suppliers.
  • Cash Book: Records all receipts and payments of cash and bank. It acts as both a book of prime entry and part of the double-entry system itself.
  • General Journal: Records all other transactions that don't fit into the other books, like buying non-current assets on credit or correcting errors.

Key term

Book of Prime Entry: The book where a transaction is first recorded chronologically before being posted to the relevant accounts in the ledger.

Examiner insight

Marks are frequently awarded for simply identifying the correct book of prime entry for a given transaction. This is a fundamental skill.

Common pitfall

Recording cash sales in the Sales Day Book or cash purchases in the Purchases Day Book. These books are strictly for credit transactions involving goods for resale.

Fun fact

The General Journal is sometimes called the 'book of original entry' because it was the first and only book of prime entry in the early days of accounting, before specialised journals were developed.

Worked example 15 marks

For each transaction below, state the correct book of prime entry.(a) Sold goods on credit to T. Jones, $150.(b) Paid wages in cash, $400.(c) Bought goods on credit from P. Smith, $250.(d) T. Jones returned faulty goods, $20.(e) Bought a motor vehicle on credit from Cars Ltd, $9,000.

  1. 1

    (a) Credit sale of goods -> Sales Day Book.

  2. 2

    (b) Payment of cash -> Cash Book (credit side).

  3. 3

    (c) Credit purchase of goods -> Purchases Day Book.

  4. 4

    (d) Goods returned by a credit customer -> Sales Returns Day Book.

  5. 5

    (e) Purchase of a non-current asset on credit -> General Journal (as it is not a purchase of 'goods for resale').

Recap

  • Books of prime entry are the first place transactions are recorded.
  • The Sales Day Book is for credit sales only.
  • The Purchases Day Book is for credit purchases of goods for resale only.
  • The Cash Book records all bank and cash movements.
  • The General Journal is used for unusual transactions and corrections.
  • Cash sales are recorded in the Cash Book, not the Sales Day Book.

Quick check

  1. Which book of prime entry is used to record goods returned by a credit customer?1 mark
  2. A business buys a new computer on credit. Which book of prime entry is used?1 mark

4. Balancing Ledger Accounts

At the end of an accounting period (e.g., a month), each ledger account must be 'balanced'. This process finds the closing balance of the account, which will become the opening balance for the next period. The steps are simple and must be followed precisely:

  1. Add up all the debit entries and all the credit entries in the account separately. Write these totals in pencil.
  2. Calculate the difference between the two totals.
  3. Enter this difference on the 'lighter' side (the side with the smaller total) so that both sides now equal the larger total. This entry is described as 'Balance c/d' (carried down).
  4. Rule a single line above the totals and a double line below them on both sides. Enter the totals, which should now be equal.
  5. Bring the balance down below the double line on the opposite side. This is the opening balance for the next period and is described as 'Balance b/d' (brought down).

Key term

Balance c/d (carried down): The closing balance of an account, calculated as the difference between the debit and credit totals, which is then carried down to become the opening balance for the next accounting period.

Common pitfall

Placing the opening 'Balance b/d' on the wrong side of the account for the new period. It must always be brought down diagonally from the 'Balance c/d'.

Worked example 14 marks

The following entries were made in the Bank Account for May. Balance the account and bring down the balance for 1 June. Dr Bank Account Cr

May 1 Capital $5,000 | May 5 Rent $400 May 12 Sales $800 | May 20 Equipment $1,500 May 28 P. Ray $300 | May 30 Drawings $200

  1. 1

    Step 1: Total the debit side: $5,000 + $800 + $300 = $6,100.

  2. 2

    Step 2: Total the credit side: $400 + $1,500 + $200 = $2,100.

  3. 3

    Step 3: Calculate the difference: $6,100 - $2,100 = $4,000. This is the closing balance.

  4. 4

    Step 4: Enter the difference on the smaller (credit) side as 'Balance c/d'.

  5. 5

    Step 5: Total both columns. They should both equal $6,100. Rule off the account.

  6. 6

    Step 6: Bring the balance of $4,000 down on the opposite (debit) side as 'Balance b/d' for June 1.

  7. 7

    Final Account Layout:

  8. 8

    Dr Bank Account Cr

  9. 9

    May 1 Capital $5,000 | May 5 Rent $400

  10. 10

    May 12 Sales $800 | May 20 Equipment $1,500

  11. 11

    May 28 P. Ray $300 | May 30 Drawings $200

  12. 12

    | May 31 Balance c/d $4,000

  13. 13

    Total: $6,100 | Total: $6,100

  14. 14

    June 1 Balance b/d $4,000 |

Recap

  • Balancing an account finds its closing balance at the end of a period.
  • The steps are: total, find difference, enter difference on smaller side as 'Balance c/d'.
  • After totalling, bring the balance down on the opposite side as 'Balance b/d'.
  • The Balance c/d is the closing balance.
  • The Balance b/d is the opening balance for the next period.
  • A debit balance b/d means the account is an asset or an expense; a credit balance b/d means it's a liability, income or capital.

Quick check

  1. If an account's debit side totals $1,000 and its credit side totals $300, what is the 'Balance c/d' and on which side is it entered?2 marks
  2. What do the abbreviations 'c/d' and 'b/d' stand for?1 mark

5. Classifying Accounts and Ledgers

All accounts in the ledger can be classified into one of five main types: Assets, Liabilities, Capital, Income (Revenue), and Expenses. Drawings is a special sixth category, representing money taken by the owner, which reduces capital.

  • Assets: Resources owned by the business (e.g., buildings, vehicles, inventory, bank balance, trade receivables). They are split into Non-Current Assets (held for over a year) and Current Assets (held for less than a year).
  • Liabilities: Amounts owed by the business to others (e.g., bank loan, trade payables). They are split into Non-Current Liabilities (due in more than a year) and Current Liabilities (due within a year).
  • Capital: The owner's investment in the business.
  • Income: Money earned by the business (e.g., sales, rent received).
  • Expenses: Costs incurred in running the business (e.g., rent paid, wages, purchases).

To stay organised, the ledger is often divided into three sections:

  1. Sales Ledger: Contains an account for every individual trade receivable (credit customer).
  2. Purchases Ledger: Contains an account for every individual trade payable (credit supplier).
  3. General Ledger (or Nominal Ledger): Contains all other accounts, including assets, liabilities, capital, income, and expenses.

Key term

Ledger: The principal book of accounts where all of a business's transactions are recorded, sorted, and summarised by account type.

Examiner insight

Correctly classifying accounts is a fundamental skill. It is the basis for preparing the Statement of Profit or Loss and the Statement of Financial Position, so mistakes here will cause errors later on.

Common pitfall

Incorrectly classifying items, such as treating 'Drawings' as a business expense. Drawings are a reduction of the owner's capital, not a cost of running the business.

Worked example 16 marks

Classify the following items as either a Non-Current Asset (NCA), Current Asset (CA), Non-Current Liability (NCL), Current Liability (CL), Income (I), Expense (E), or Capital (C).(a) Motor Vehicle(b) Inventory of goods(c) 5-year bank loan(d) Sales revenue(e) Bank overdraft(f) Wages paid

  1. 1

    (a) Motor Vehicle: A long-term resource owned by the business -> Non-Current Asset (NCA).

  2. 2

    (b) Inventory of goods: An asset expected to be sold within a year -> Current Asset (CA).

  3. 3

    (c) 5-year bank loan: An amount owed, due in more than one year -> Non-Current Liability (NCL).

  4. 4

    (d) Sales revenue: Money earned from selling goods -> Income (I).

  5. 5

    (e) Bank overdraft: Money owed to the bank, repayable on demand -> Current Liability (CL).

  6. 6

    (f) Wages paid: A running cost of the business -> Expense (E).

Recap

  • The five main account types are Assets, Liabilities, Capital, Income, and Expenses.
  • Assets and Liabilities are split into 'non-current' (long-term) and 'current' (short-term).
  • The Sales Ledger holds all trade receivable accounts.
  • The Purchases Ledger holds all trade payable accounts.
  • The General Ledger holds all remaining accounts (e.g., rent, vehicles, capital).

Quick check

  1. Classify 'Premises' and 'Trade Payables'.2 marks
  2. Which division of the ledger would contain the account for a credit customer named S. Smith?1 mark

6. Preparing the Trial Balance

A trial balance is a list of all the balances (the 'Balance b/d' figures) from every account in the ledger at a specific date. It has two columns: Debit and Credit. The purpose of the trial balance is to check the arithmetical accuracy of the double-entry bookkeeping. Because every transaction has an equal debit and credit entry, the total of all the debit balances in the trial balance must equal the total of all the credit balances. If they don't, an error has been made in the bookkeeping process. Asset, Expense, and Drawings accounts will have DEBIT balances. Liability, Income, and Capital accounts will have CREDIT balances.

Total of Debit Column = Total of Credit Column

Key term

Trial Balance: A list of all general ledger accounts and their balances, used to verify that the total of debit balances equals the total of credit balances.

Examiner insight

A correctly prepared trial balance is the essential link between the ledger accounts and the final financial statements. Marks are awarded for correct format, headings, and placing each balance in the correct column.

Common pitfall

Placing balances in the wrong column, for example, putting a Sales balance (which is income) in the debit column or a Motor Vehicles balance (which is an asset) in the credit column.

Worked example 16 marks

From the following list of ledger account balances as at 31 December, prepare a trial balance for XYZ Trading.

  1. 1

    Step 1: Create a heading: 'Trial Balance as at 31 December'.

  2. 2

    Step 2: Create three columns: Account Name, Debit ($), Credit ($).

  3. 3

    Step 3: Go through the list of balances and place each one in the correct column. Remember: Assets/Expenses/Drawings are debits; Liabilities/Income/Capital are credits.

  4. 4

    Bank: Asset -> Debit $4,500

  5. 5

    Capital: Capital -> Credit $10,000

  6. 6

    Drawings: Reduction of Capital -> Debit $1,000

  7. 7

    Motor Vehicle: Asset -> Debit $8,000

  8. 8

    Purchases: Expense -> Debit $5,000

  9. 9

    Rent Expense: Expense -> Debit $1,200

  10. 10

    Sales: Income -> Credit $11,500

  11. 11

    Trade Payables: Liability -> Credit $1,700

  12. 12

    Trade Receivables: Asset -> Debit $3,500

  13. 13

    Step 4: Total both columns. The Debit total is 4500+1000+8000+5000+1200+3500 = $23,200. The Credit total is 10000+11500+1700 = $23,200.

  14. 14

    Step 5: Since the totals are equal, the trial balance 'balances'.

  15. 15

    Final Trial Balance:

  16. 16

    Account | Debit ($) | Credit ($)

  17. 17

    Bank | 4,500 |

  18. 18

    Capital | | 10,000

  19. 19

    Drawings | 1,000 |

  20. 20

    Motor Vehicle | 8,000 |

  21. 21

    Purchases | 5,000 |

  22. 22

    Rent Expense | 1,200 |

  23. 23

    Sales | | 11,500

  24. 24

    Trade Payables | | 1,700

  25. 25

    Trade Receivables | 3,500 |

  26. 26

    Total | 23,200 | 23,200

Recap

  • A trial balance lists all ledger balances to check if total debits equal total credits.
  • It is a proof of the arithmetical accuracy of the ledger.
  • Asset, Expense, and Drawings accounts have debit balances.
  • Liability, Income, and Capital accounts have credit balances.
  • A trial balance that does not balance indicates an error in the accounting records.
  • Some errors, like omitting a transaction entirely, will not be revealed by a trial balance.

Quick check

  1. In which column of the trial balance would a 'Bank Loan' balance appear?1 mark
  2. What is the primary purpose of preparing a trial balance?1 mark

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

  1. Explain the concept of double-entry bookkeeping, referring to the accounting equation.3 marks
  2. For each of the following transactions, state the correct book of prime entry: (a) Sale of goods on credit to R. Singh. (b) Return of goods from R. Singh. (c) Owner takes cash for personal use. (d) Purchase of a new machine on credit from 'Machinery Ltd'. (e) R. Singh pays his account by cheque.5 marks
  3. Explain the difference between a trade receivable and a trade payable, giving an example of a transaction that creates each.4 marks
  4. A business has the following account balances: Sales $25,000; Purchases $14,000; Capital $10,000; Bank $5,000; Premises $16,000. Prepare a trial balance as at the period end.5 marks
  5. Classify the following accounts as either an asset, liability, income, expense or capital/drawings: (a) Loan from bank; (b) Commission received; (c) Office furniture; (d) Rent paid; (e) Inventory.5 marks
  6. Describe the five main steps involved in balancing a ledger account at the end of a period.5 marks
  7. A business completes the following transactions in its first week: 1. Owner invests $20,000 into the bank. 2. Buys goods on credit from A Ltd for $3,000. 3. Sells goods on credit to B Ltd for $4,500. 4. Pays rent of $500 by bank transfer. Prepare the T-accounts for Bank, Capital, Purchases, Sales, A Ltd, B Ltd and Rent.7 marks
  8. A trial balance fails to balance. The debit side totals $54,100 and the credit side totals $51,400. Suggest two different types of error that could have caused this difference of $2,700.4 marks
  9. Explain why a trial balance might still balance even if errors exist in the ledger accounts. Provide two examples of such errors.4 marks
  10. On 1 March, a business had a bank balance of $5,600. During March, it had cash sales of $1,200, credit sales of $3,000, paid wages of $800, and bought equipment for $2,000 cash. A credit customer paid $1,500 they owed. Prepare the Bank T-account for March, balance it, and bring down the opening balance for 1 April.6 marks

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