Session 6: Double Entry Accounting Systems

Learning Objective

• Briefing the participants on elements of financial statements
• Outline the Balance sheet equation
• Explain to the participants the basics of double entry accounting systems

• Assets
• Liabilities
• Double entry accounting systems
• Capital
• Income
• Expenses
  

1. Assets
   According to IASB Conceptual framework, an asset is defined as resources controlled by the enterprise as a result of past events and from which economic benefits are expected to flow to the enterprise. In simple terms an asset is defined as something valuable owned by the business.Assets are further subdivided into current and non current. Non current assets are those which are used in conducting business and are held for more than one accounting year with no intention of resale. Examples include Land and Buildings, Vehicles and Machinery. On the other hand current assets are those assets held in form of cash or those which can easily be turned into cash. Examples here include stocks, debtors and cash.
2. Liabilities
   According to IASB liabilities are defined as “entity’s obligation to transfer economic benefits to another enterprise or individual as a result of past transactions or events”. Thus liabilities are amounts which the entity owes other businesses or individuals. Liabilities are classified into current and non current liabilities. Current liabilities are those amounts which are repayable within a period of less than 12 months while non current are those which should be repaid after more than 12 months.
3. Capital
   Represents amount which the owners have invested in the business. Capital will always equal to assets less the liabilities. Remember amount of the resources supplied by the owner are called capital while resources that are then in business are called assets.
   Capital is also referred to as owner’s equity or net worth. It comprises the funds invested in the business by the owner plus any profits retained for use in business less any drawings distributed to the owners.
4. Income
   Income is a broad term but covers all transactions which will result in gross inflow of benefits to the enterprise. Income is subdivided into revenues and gains.
   Revenue is the gross inflow in economic benefits in ordinary activities of an enterprise like sales, dividends ,interest, royalties or rent while gains represents other items that meet the definition of income and may, or may not arise in the ordinary course of an enterprise. i.e. profit made on the disposal of non current assets.
5. Expenses
   Expenses are gross outflow of economic benefits arising in ordinary course of business. Expenses are incurred in order generate revenue for the enterprise. Any expense to acquire a new asset or enhance the capacity of an existing asset is called capital expenditure and should be included as part of the value of such asset.
   

Capital = Assets – Capital

The following transactions can help to illustrate the equation.

Introduction of capital

If Mr. Banda starts his transport business on 1 April 2004 with K500,000 which was immediately deposited into the bank.

Balance sheet as at 1 April 2004

Purchase of assets by cheque

On 2nd April Mr. Banda bought a track worth K300,000 paying by cheque.

With this second transaction the bank balance decreased but the total assets remains the same. The new balance sheet can now be shown as:

Balance as at 2nd April 2004

Purchase of an asset and incurring liability

On 3rd April Mr. Banda bought a computer on credit worth K40,000 from Comptech Ltd.

Balance sheet as at 3rd April 2004

Business start incurring expenses generating revenues

On 5th April Mr. Banda paid K30,000 as fuel by cheque for the business trip hired to carry goods for PTC to Lilongwe and fees charged were K70,000 to be paid at the end of the month.

Balance sheet as at 5th April 2004

Owners takings out of the business and settling of liabilities

On 9th April Mr. Banda took K30, 000 out of business bank account for personal use but also settled half of the amount owing to Comptech Ltd.

Balance Sheet as at 9th April 2003

As can be seen that every accounting transaction affected two items. Like transaction 1 it was an increase in capital and cash at bank. Transaction 2 had a decrease in one asset, cash and an increase in another in form of Motor Truck. While Transaction 3 resulted in increase in asset, computer and also an increase in liability. All these just shows that the Balance sheet equation will always hold. And this can be summarized as:

(a) An increase in an asset will result in:

• an increase in a liability or
• an increase in owner's equity or
• a decrease in another asset.

(b) a decrease in an asset will result in:

• a decrease in a liability or
• a decrease in owner's equity or
• an increase in another asset

(c) An increase in liability will result in:

• an increase in an asset or
• a decrease in owner's equity or
• a decrease in another liability

(d) a decrease in a liability will result in:

• an increase in owner's equity
• a decrease in asset or
• an increase in another liability.

(e) An increase in owner's equity will result in:

• an increase in an asset or
• a decrease in a liability or
• a decrease in another form of owner's equity

(f) a decrease in owner's equity will result in:

• a decrease in an asset or
• an increase in liability or
• an increase in another form of owner's equity
  

Chart of Accounts

This is a family tree of accounts showing how information flows from the source documents up to when the final accounts are prepared.

Double Entry System

As outlined above every accounting transaction will be affect two items. These transactions are supposed to be recorded in a ledger accounts. An account is a place where all the information referring to a particular asset, liability, capital, income or expense.

Each account should be shown on a separate page in the accounting books. The double entry system divides each page into two halves. The left hand side of each page is called the debit side, while the right hand side is called the credit side. When recording a transaction each item record should also include a date when the transaction took place.

The ledger account is usually referred to as a ‘T’ account.

Accounting entries are made on the left side and right hand sides of an account. When an amount is entered on the left side, the account is said to be debited, and when an amount is entered on the right side the account is said to be credited. The difference between the total debits and total credits is the balance of the account. The balance may be either a debit balance if the debit side exceeds the credit side; or a credit balance if the credit side exceeds the debit side. When the total debits equal the total credits, the account is said to have nil or zero balance. The words "debit" and "credit" should not be confused with "increase" or "decrease". Certain accounts may increase when debited and other accounts may increase when credited depending on the type of account involved.

The two rules of double-entry book keeping are that every transaction affects at least two accounts and that the total for the debit and credit sides should be equal. In other words, for every transaction, one or more accounts must be debited and one or more accounts must be credited.

The learners are required to master the following general rules:

As for income account always the recording should be made to the credit side while all expenses account will always be debited.

From above, the increase is in an asset which is a motor truck hence it has been debited, while cash at bank has decreases hence the credit.

On 5th April Mr. Banda bought fuel worth K40,000 paying by cheque and charged PTC K70,000 as transport fees. Payment expected at the month end.

In this transaction there is a decrease in asset (Bank) but also the expense has been incurred. According to the general rule Bank is being credited because there is a decrease in asset while fuel as an expense account it will always be debited.

Here a new asset, debtor is created and as it is an increase the debtors account is debited while the transport fees charged is part of income for the company so it is credited. Remember all income account should always be credited.

On 9th April the owner withdrew K7,000 out of the business bank account.

Drawings account represents capital account and remember a decrease in capital should be debited hence the debit entry in the Drawings account. Cash at bank has been reduced by the drawing made that’s why it is being credited.