Chapter 3 Double entry bookkeeping and preparation of financial statements

Question 1

1.1 Double entry bookkeeping

Answer 1

Debits and credits: debits and credits are the two sides of a transaction. A debit (increase) is an expense, asset, or drawings. A credit (increase) is a liability, income, or capital.
Every debit must have a corresponding and equal credit, these are recorded in ledger accounts (also known as T accounts). Debits are recorded on the left side and credits are recorded on the right. There is a ledger account for each assets, liability, drawings and capital, income, and expense item.

Question 2

1.2 Summary of steps to record a transaction

Answer 2

• Identify the two accounts that are affected
• Consider whether they are being increased or decreased
• Decide whether each account should be debited or credited
• Check that a debit entry and a credit entry for equal amounts have been made

Question 3

1.3 Sales, purchases, and inventory

Answer 3

A business will normally adjust inventory at the year-end, rather than as each transaction occurs. We record sales and purchases as:
Purchases: Dr Purchases (expense)
Cr cash/ trade payables

Sales: Dr Cash / trade receivables
Cr Sales income

Question 4

2.1 Ledger accounts

Answer 4

Debits and credits are recorded in ledger accounts. There is a ledger accounts for each type of asset, liability, drawings and capital, income, or expense.
Balancing off a ledger account: at the end of the period, the ledger accounts must be balanced off to obtain a closing balance. The process to achieve this is:
- Add up the debit and credit side of the ledger account to see which is the highest
- Take the higher total and include as the total for both sides of the account
- On the side with the smaller total insert the figure needed to make it add up and call this figure balance c/f
- On the opposite side of the ledger, below the total figure, insert the amount of the balance c/f figure and call it the balance b/f
An asset, expense or the drawings ledger account should have the balance b/f on the debit side. A liability, income or the capital ledger account should have the balance b/f on the credit side.

Question 5

3.1 Trial balance and preparation of final accounts

Answer 5

The trial balance is a list of all the closing balances on the ledger accounts according to whether the balance b/f is on the debit or credit side. If the double entry system has been maintained correctly, then total debits equal total credits. The trial balance is then used to produce the statement of profit or loss and statement of financial position.

Question 6

4.1 Preparing the accounts for next year

Answer 6

Statement of profit or loss ledger accounts – in the next period the ledger accounts must start from nil again to show the position in that period. The closing c/f balances need to be removed and transferred to the profit and loss ledger account. This ledger account is a summary of the statement of profit or loss. Individual statement of profit or loss ledger account balances (income and expense accounts) are not c/f to next year, they start from nil again.
Statement of financial position ledger accounts:
Asset and liability ledger accounts – the statement of financial position shows the assets and liabilities at a particular date. Therefore, the closing c/f balance becomes the opening b/f balance for the next period.
Capital ledger accounts – the closing c/f balance on the drawings ledger account is transferred to the capital ledger account. The closing c/f balance on the profit and loss ledger account is transferred to the capital ledger account.
The capital account is therefore a summary of the capital section of the statement of financial position.