There are three general rules of accounting
General Rule One
All transactions must be recorded.
General Rule Two
The Double Entry method must be used to record transactions.
General Rule Three
Every transaction is recorded in General Ledger, also known as the Nominal Ledger.
The Double Entry System
As per Rule Two, accounting operates on the Double-Entry system. This means that every entry to an account requires a corresponding and opposite entry to a different account. The double entry has two equal and corresponding sides known as debit and credit. In the old hand-written ledgers books the left-hand side is debit and the right-hand side is credit.
The Accounting Equation
The Accounting Equation is expressed as Assets = Liability + Equity or alternatively Equity = Assets – Liability and is the foundation of the double-entry system.
The equation shows that what the company owns (its assets) is purchased by either what it owes (its liabilities) or by what its owners invest (its shareholders’ equity or capital).
Transactions are captured into General or Nominal Ledger Accounts. These accounts fall into one of the following types:-
- Assets. The items of value owned by a business, such as cash, equipment, money owed to the business and also intangible items such as goodwill, copyright, patents etc.
- Liabilities. The obligations of the business, such as money owed to suppliers, bank overdrafts, taxes due, wages and salaries due etc.
- Equity (Capital). This is the value of the business owners’ investment in the company. It also includes any accumulated reserves (usually profit) earned by the company.
- Revenue or Income. The value of money coming into the company.
- Expenses. The costs incurred by the company.
How to work out if an account should be debited or credited
Under the Double-Entry system, remembering which accounts must be debited or credited and when can be a challenge. According to Wikipedia, there are two methods to help remember which accounts have to be debited or credited and when. These are the Traditional Approach and the Accounting Equation Approach.
Accounting Equation Approach
- Assets. Debit increases the asset and credit decreases the asset.
- Equity (Capital). Credit increases the equity and debit decreases the equity.
- Liabilities. Credit increases the liability and debit decreases the liability.
- Revenue (Income). Credit increases the revenue and debit decreases the revenue.
- Expenses (losses). Debit increases the expense and credit decreases the expense.
Traditional Approach
Accounts are divided into three types:-
- Real accounts are accounts relating to assets and liabilities including the capital account of the owners.
- Personal accounts are accounts relating to persons or organisations with whom the business has transactions and will mainly consist of accounts of debtors and creditors.
- Nominal accounts are revenue, expenses, gains, and losses.
Transactions are then captured according to the account type
- Real account: Debit what comes in and credit what goes out.
- Personal account: Debit the receiver and credit the giver.
- Nominal account: Debit all expenses & losses and credit all incomes & gain.
The Accounting Cycle
When a transaction occurs, a document is created. The documents can be produced internally, such as sales invoices or originate externally, such as supplier invoices or utility bills. Both types of documents are referred to as ‘source documents’. Some types of transactions do not always have a traditional document, but normally this only applies to internal transactions such as depreciation etc.
Source documents are captured into a Journal or a Ledger and both the debit and corresponding credit sides of the transaction must be captured. The Journal is often referred to as a Subsidiary Journal or Ledger. Examples of Subsidiary Ledgers are:
- Sales Ledger. This will contains transactions from any sales related transactions, such as sales invoices, credit notes etc.
- Cash Book. This will contain transactions related to any movement of cash such as money received from customers and money paid to suppliers. Bank Statements are a source document as are receipts and deposit slips. Petty cash will also be captured into a Cash Book.
- Purchase Ledger. This contains all transactions relating to suppliers such as invoices from suppliers, electricity bills, rent etc.
All of these subsidiary ledgers or journals feed into the main General or Nominal Ledger. This General (Nominal) Ledger is made up of accounts as described above (Assets, Liability, Income etc.) and the transactions are all posted to accounts using the Double Entry method.
Journals may also be posted directly into General Ledger and this would consist of transactions such as monthly depreciation, some payroll-related transactions etc.
All the various accounts in General Ledger are often referred to as the Chart of Accounts. This list of all General Ledger accounts together with their totals is referred to as a Trial Balance report. This Trial Balance must balance, in that the total of all the credits must equal the total of all the debits. If it does not balance then the error must be found and corrected before any of the Financial Statements are produced.
Financial Statements
The main financial statements or reports are:
- Statement of Income and Retained Earnings (Income Statement)
- Statement of Financial Position (Balance Sheet)
These reports are all derived from the Trial Balance.
Statement of Income and Retained Earnings
This report shows the income versus the expenses of the business for the accounting period and often includes the totals for the financial year. The general format of the report is:-
Gross Revenue (income)
– Cost of Sales
= Gross Profit
– Operating Expenses
+ Extraordinary income
= Nett Profit (Income)
Statement of Financial Position
This report lists all the business’s assets and liabilities and equity. It shows the long term viability of the business. It is also basically a representation of the accounting equation.
There are two common formats for a Balance Sheet. They each follow one of these versions of the Accounting Equation.
The Equity = Assets – Liability format is as follows:
Fixed Assets
+ Current Assets
– Current Labilities
– Long Term Liabilities
= Assets Less Liabilities
Nett Income Year to date
+ Retained Income (Accumulated Reserves)
+ Share Capital
= Equity
The Assets = Liability + Equity format is as follows:
Fixed Assets
+ Current Assets
= Assets
Current Labilities
+ Long Term Liabilities
+ Nett Income Year to date
+ Retained Income (Accumulated Reserves)
+ Share Capital
= Liabilities plus Equity
The report must balance. In other words, the value of Assets less Liabilities must equal the value of Equity or the value of assets must equal the value of Liabilities and Equity depending on which format is used.
