RECORDING FINANCIAL TRANSACTIONS 27
The double entry: recording transactions
Businesses use a system of accounting calleddouble entry, which derives from the
late fifteenth-century Italian city-states (see Chapter 1). The double entry means
that every business transaction affects two accounts. Those accounts mayincrease
ordecrease. Accountants record the increases or decreases as debits or credits, but
it is not necessary for non-accountants to understand this distinction.
Transactions may take place in one of two forms:
žCash: If the business sells goods/services for cash, the double entry is an increase
in income and an increase in the bank account (an asset). If the business buys
goods/services for cash, either an asset or an expense will increase (depending
on what is bought) and the bank account will decrease.
žCredit: If the business sells goods/services oncredit,thedoubleentryisan
increase in debts owedtothe business (calleddebtors, an asset) and an increase
in income. If the business buys goods/services on credit, either an asset or an
expense will increase (depending on what is bought) and the debts owedbythe
business will increase (calledcreditors, a liability).
When goods are bought, they become an asset calledinventory(or stock). When
the same goods are sold, there are two transactions:
1 The sale, either by cash or credit, as described above; and
2 The transfer of the cost of those goods, now sold, from inventory to an expense,
calledcost of sales.
In this way, the profit is the difference between thepriceat which the goods were
sold (1 above) and the purchasecostof the same goods (2 above). Importantly, the
purchase of goods into inventory does not affect profit until the goods are sold.
To record transactions, we need to decide:
žwhat type of account is affected (asset, liability, income or expense); and
žwhether the transaction increases or decreases that account.
Some examples of business transactions and how the double entry affects the
accounting system are shown in Table 3.1.
The accounts are all contained within aledger, which is simply a collection
of all the different accounts for the business. The ledger would summarize the
transactions for each account, as shown in Table 3.2.
In the example in Table 3.2 there would be a separate account for each type
of expense (wages, cost of sales, advertising), but for ease of presentation these
accounts have been placed in a single column. The ledger is the source of the
financial reports that present the performance of the business. However, the
ledger would also contain the balance of each account brought forward from
the previous period. In our simple example, assume that the business commenced
with £50,000 in the bank account that had been contributed by the owner (the
owner’scapital). Table 3.3 shows the effect of the opening balances.