8.
How do we create financial accounts?

8.1 Introduction

To produce the financial statements, accounting transactions must be recorded throughout the year. In large organisations, hundreds of thousands of these transactions can occur each day. Judgement is needed for many of these, as a decision is made on when to recognise, and at what value to measure, each transaction. Once this decision has been made, double-entry bookkeeping allows an organisation to show the source and the uses of their funds.

Double-entry bookkeeping is a universally recognised accounting method that helps to prevent errors and fraud, as many discrepancies can be easily identified and it offers a comprehensive view of an organisation’s financial health at any point in time. By tracking both sources and uses of funds, it provides a clear picture of the organisation’s financial position, performance and cash flow. This information is invaluable for making informed business decisions, managing risk and attracting investors, and it has been used for hundreds of years.

Double-entry bookkeeping emerged in Venice in the early fifteenth century. Although the art of accounting has been in place for thousands of years before this. Double-entry bookkeeping as a method for recording transactions allowed Venetian merchants to establish a common understanding, enabling them to show that their businesses were worthy of loans and investments and to compare their records with those of other merchants. It was first documented by Luca Pacioli in his book Summa de arithmetica. Although interestingly, ‘Pacioli did not include bookkeeping in the qualities a true merchant needed’.¹

Modern accounting systems use sophisticated software to record, summarise and analyse the many accounting transactions. Whether manual or digital, advanced or basic, the four stages of preparing the financial statements, including a statement of financial position (SoFP, also known as a balance sheet) and an income statement (IS), are as illustrated in Figure 8.1.

8.2 Source documents

Every organisation maintains a document trail for every transaction. For example, when purchasing inventory, the trail includes a purchase order, a goods received note, an invoice and possibly a remittance advice, all of which will document and evidence exact details of the purchase, the date, the amount and the supplier. These documents are referred to as ‘source documents’ and are vital for the verifiability of financial statements.

The information in this trail is captured and documented using double-entry bookkeeping. Double-entry bookkeeping records the details of financial transactions, entering information in ledger accounts which are needed to produce financial statements. This can be partially automated by accounting software, which deploys the underlying accounting principles explained in Section 8.3. A foundational understanding of double-entry bookkeeping ensures effective analysis, interpretation and error detection, and informed decision-making regarding financial information. It also enables organisations to quickly establish their net worth and profitability for those who are interested, particularly investors.

8.3 Double-entry bookkeeping (DEBK)

When a decision has been made to recognise an asset, liability, equity, income or expense, and an estimate has been made to measure it, a transaction is recorded using the double-entry bookkeeping (DEBK) system. These entries impact accounts such as sales, purchases, salary expenses and trade receivables. Each of these accounts belongs to one of the foundational financial elements: asset, liability, equity, income or expense.

For example, when Rozim makes a sale and receives cash of £100, Rozim’s income account will increase, as well as its assets (cash is an asset).

The accounting equation forms the bedrock of comprehending and confidently applying debits and credits. It encapsulates the fundamental principle that an entity’s assets are equal to the entity’s obligations to the funders, whether lenders (liabilities) or investors (equity). Regardless of how many accounting transactions take place, the total assets will always equal the liabilities plus the equity. The accounting equation will always hold true.

Every transaction has two simultaneous effects on the accounting equation. Because of this, you will never encounter an isolated debit or a solitary credit. Every debit entry necessitates an equivalent amount (or sum of amounts) entered as a credit, ensuring balance and accuracy in accounting records.

At this point ‘debit’ and ‘credit’ can be assigned to each side of the accounting equation. In Figure 8.2, notice that assets are on the left-hand side as a debit, and liabilities and equity are on the right-hand side as a credit.

Remembering that income minus expenses (that is, profit) is part of equity, it can also be shown that Income is on the right-hand side as a credit, and Expenses are on the left-hand side as a debit. In summary:

8.4 Recording transactions

To record a transaction and thus increase or decrease the accounts that are impacted, you must first decide what type of accounts they are. For each account, is it a ‘use of funds’ account or a ‘source of funds’ account?

• Assets and expenses are ‘uses of funds’. These are known as debit-type accounts. Debiting a debit-type account increases it; crediting the account decreases it.
• Liabilities, equity and income are ‘sources of funds’. These are known as credit-type accounts. Crediting a credit-type account increases it; debiting the account decreases it.

This is summarised in Figure 8.4.

To record accounting transactions using DEBK, the following questions can be used:

• Which accounts are impacted by the transaction?
  Typically, it will be two accounts or more, thus respecting the principle of duality and upholding the accounting equation.

• What is the movement on each account?
  Do they need to be increased or decreased?

• How much are the accounts changing by?
  Calculate the measured change in the accounts, this can involve significant judgement and estimation.

• To which elements do the accounts belong?
  Assets, liabilities, equity, income or expenses?

• What is the debit and the credit?
  Considering the elements being affected, is the movement a debit or a credit? Remember, if debits don’t equal credits the accounting equation does not hold true and the SoFP will not balance!

With the answer to these five questions, along with an understanding of how to use debits and credits, transactions can now be recorded using DEBK.

Consider a cash sale for services provided by Rozim of £500 on 1 February 2035.

• Which accounts are impacted by the transaction?
  A sale has taken place, hence ‘Sales’.
  Cash has been received, hence ‘Cash in bank’.

• What is the movement on the account?
  Sales – increased.
  Cash in bank – increased.

• How much are the accounts changing by?
  Sales – £500.
  Cash in bank – £500.

• To which elements do the accounts belong?
  Sales – Income (credit-type).
  Cash in bank – Asset (debit-type).

• What is the debit and the credit?

To present this formally, we use what are called ‘journal entries’ because these entries were once manually written in book books called journals. These entries contain details such as the date of transaction, the affected accounts and the debit and credits in monetary terms to allow verifiability.

The journal entry for the above transaction is:

This may all feel a little uncomfortable, but over time it will become familiar and instinctive. You might even start to think in double-entry bookkeeping and ask “Where is the opposite entry?” To get to that stage, always return to the accounting equation elements and remember how profit fits into this equation and that ‘debit’ or ‘credit’ simply mean ‘increase’ or ‘decrease’, depending on the flavour of the account it is applied to.

Have a look at this video for a further explanation about debits and credits.

8.5 Double-entry bookkeeping in action

Below are some further examples of double-entry bookkeeping for Rozim, for the accounting period ended 31 September 2035, presented in a journal format.

8.5.1 Cash sale of a service

On 1 October 2034, Rozim makes a cash sale of £500, for a service of advice to M&H, an international retailer.

What is the debit and the credit?

Rozim needs Sales (Income) to increase by £500, and Cash in bank (Current assets) to increase by £500.

8.5.2 Credit sale of a service

On 1 November 2034, Rozim makes a sale on credit (sometimes called a credit sale) of a service of advice to Old Look Limited for £1,200.

The sale will be treated exactly the same as the transaction in Section 8.5.1, so credit Sales (Income, IS), £1,200, but what should the debit be?

Thus Rozim needs Sales (Income) to increase by £1,200, and Trade receivables (Asset) to increase by £1,200.

8.5.3 Settlement of amount owing from customer

On 1 December 2034, Old Look Limited pays the £1,200 owed to Rozim (from the transaction in Section 8.5.2).

Thus, Rozim needs to adjust the Cash in bank (Current assets), which should increase by £1,200 and Trade receivables (Current assets), which should decrease by £1,200. This eliminates the trade receivables balance because the customer has settled the amount owing.

8.5.4 Cash expense

On 1 January 2035, Rozim receives an insurance invoice for the period 1 October 2035 to 31 December 2035 amounting to £2,500, and settles the invoice in cash.

Rozim needs Operating expenses (Expenses) to increase by £2,500, and Cash in bank (Asset) to decrease by £2,500 as cash has been paid out and an expense has been incurred in the period.

8.5.5 Credit purchase of inventory

On 1 February 2035, Rozim purchased more cloth as inventory for resale from EZ Supplies on credit for £12,000.

Rozim needs Inventory (Asset) to increase by £12,000, and Trade payables (Liability) to increase by £12,000.

The double-entry shown here uses what is called ‘the perpetual method’ of cost of sales.

An alternative method for recording the cost of sales is the ‘periodic method’. Using the periodic method, the inventory account is not adjusted with each purchase. Instead, purchases of inventory are initially recorded in the purchases ledger account. At the end of the accounting period, closing inventory is counted and measured, and an adjustment is made to calculate the cost of sales using the formula: Opening inventory + Purchases – Closing inventory. This adjustment converts the total purchases into the actual cost of sales for the period. At the end of the period, the inventory balance in the SoFP and the cost of sales balance in the IS will be the same whether the periodic or perpetual methods are used. Generally, large businesses will use the perpetual method so that they are always aware of their inventory levels, since the periodic method calculates the inventory only at the end of the year.

8.5.6 Settlement of amount owing to supplier

On 14 February 2035, Rozim settles the amount owing (£12,000) to the EZ Supplies (the transaction in Section 8.5.5).

Thus, Rozim needs to adjust the Cash in bank (Current assets), which should decrease by £12,000, and Trade payables (Liability), which should decrease by £12,000 to reduce the amounts owing to suppliers.

8.5.7 Loan from a bank

On 1 March 2035, Rozim borrowed £50,000 from The Bank of Manchester.

Rozim needs Cash in bank (Current assets) to increase by £50,000, and Loans (Non-current liabilities) to increase by £50,000.

8.5.8 Payment of interest

On 30 April 2035, Rozim paid £150 of interest due on the loan from The Bank of Manchester (the transaction discussed in Section 8.5.7).

Rozim needs Finance costs (Expenses) to increase by £150, Cash in bank (Assets) to decrease by £150.

8.5.9 Issuing shares

On 1 May 2035, Rozim issued 10,000 shares at £1.25 each (par value £1). This means they will receive £12,500 cash (10,000 × £1.25).

Now the credit needs to be split between two accounts within equity: ordinary share capital for the par value times the number of shares issued and share premium for the excess.

Rozim needs Cash in bank (Asset) to increase by £12,500 (10,000 × 1.25), Ordinary share capital (Equity) to increase by £10,000 (10,000 × 1.00) and Share premium (Equity) to increase by £2,500 (10,000 × 0.25).

Note that there are three elements here to the double-entry bookkeeping, but the total of the debits still equals the total of the credits.

8.5.10 Credit sale of inventory

On 15 May 2035, Rozim sold 200 dresses to Tinners Plc for £18,000 on credit, made from materials which were in inventory at a cost of £12,000. Rozim uses the perpetual method of inventory.

First, Rozim needs Sales (Income) to increase by £18,000, and Trade receivables (Current assets) to increase by £18,000.

To account for the reduction in cloth in stock, Rozin also needs to decrease Inventory (Current assets) by £12,000 and increase Cost of sales (Expenses) by £12,000.

The double-entry shown here uses the perpetual method of cost of sales.

An alternative method for recording the costs of inventory when a sale is made is the periodic method. Using the periodic method, the inventory account is not adjusted with each sale. At the end of the accounting period, closing inventory is counted and measured, and adjustment is made to calculate the cost of sales using the formula: Opening inventory + Purchases – Closing inventory. This adjustment allocates the costs of the sales to the sales recognised. At the end of the period, the inventory balance in the SoFP and the cost of sales balance in the IS will be the same whether the periodic or perpetual methods are used.

8.5.11 Purchase of non-current asset

On 1 June 2035, Rozim bought a vehicle for use by the sales representatives for £18,000 in cash.

Rozim needs Vehicles (Non-current assets) to increase by £18,000 and Cash in bank (Current assets) to decrease by £18,000.

8.5.12 Depreciation of non-current asset

On 30 September 2035, Rozim recorded the annual depreciation expense for the vehicle. The vehicle is depreciated on a straight-line basis over three years, with a full year’s depreciation in the year of purchase.

For details of different depreciation methods, see Unit 7.

Assuming that Rozim’s policy is straight-line depreciation, with a full year’s depreciation charged in the year of acquiring the tangible asset, Rozim needs Depreciation expense (Expenses) to increase by £6,000 (18,000/3), and the net book value of the vehicle (Assets) to decrease by £6,000.

8.5.13 Double-entry bookkeeping summary

Double-entry bookkeeping is a universally recognised accounting method that provides several advantages for organisations. Primarily, it ensures accuracy and consistency in financial records by requiring every transaction to be recorded with both a debit and a credit entry. This dual recording system helps to prevent errors and fraud, as most discrepancies can be easily identified. Additionally, double-entry bookkeeping offers a comprehensive view of an organisation’s financial health at any point in time. By tracking both assets and liabilities, income and expenses, it provides a clear picture of the organisation’s financial position, performance and cash flow. This information is invaluable for making informed business decisions, managing risk and attracting investors.

However, double-entry bookkeeping also has some potential drawbacks. One limitation is the complexity involved in setting up and maintaining a double-entry system. It requires a thorough understanding of accounting principles and practices, and it can be time-consuming to record transactions accurately and consistently. Additionally, double-entry bookkeeping can be more labour-intensive than single-entry systems, especially for small businesses with limited resources. It is also open to misuse. Sangster (2010) discusses some major abuses of the system:

Xerox over a five-year period treated future income from equipment rentals as current income and so overstated earnings by $1.5 billion; or when WorldCom improperly capitalised $3.8 billion of operating expenses (Patsuris 2002); or when, as the Hyderabad (India) Public Prosecutor alleged, B.R. Raju invented 13,000 fictitious employees (there were 40,000 ‘real’ employees) at an Indian IT conglomerate, Satyam, and took an estimated $4 million a month for his own use (Leahy and Sood 2009).

Each of these organisations recorded a double-entry for these transactions. Sangster goes on to argue that ‘Understanding double-entry means students can understand how these deeds were enacted, devise control mechanisms to present their recurrence, and better explain their implications.’

8.6 Trial balance

A trial balance is a summary statement showing the closing balances of all accounts, presented as a list, with the figures appearing either in the debit or credit column. The totals of the debit and credit columns must be equal. If they don’t, an error has been made.

A trial balance is produced at the end of an accounting period and is used as a starting point to produce the financial statements. There will also be several year-end adjustments to the trial balance for items such as accruals, prepayments and depreciation.

Note that at the start of the next accounting period, all the income and expense accounts will be set to zero, as a new story of financial performance commences. However, asset and liability accounts begin the new accounting period with the same figures as they ended with in the previous accounting period. The organisation will ‘carry forward’ the balances, as they still have control over the assets, and still are required to settle their obligations.

8.7 Year-end adjustments

Once the trial balance has been prepared there will be a series of year-end adjustments to prepare the final SoFP and the IS. Examples of these are shown below.

8.7.1 Accruals

You can download the Rozim trial balance here.

Accruals refer to the recognition of an expense and corresponding liability, when no invoice has yet been received. Unlike trade payables, where the amount is determined by an invoice, accruals require estimation.

A common example of an accrual is when a business has used electricity in its day-to-day business, but at the end of the accounting period (the year end), has yet to receive an invoice. The company would be required to estimate the electricity expense for the period it has yet to be invoiced for and recognise:

• an accrued expense to be added to Electricity costs (IS)
• an accrual to be recognised as a Current liability (SoFP).

There is no effect on the cash balance when an accrual is recognised here.

In the following accounting period, when Rozim receives and pays the invoice for electricity, the accruals balance is removed (since the liability no longer exists) and cash is decreased by the amount paid. If the actual expense differs from the initial accrual estimate, adjustments are made in the IS: any underestimation results in an additional expense, while any overestimation results in a reduction in the expense.

8.7.2 Prepayments

Prepayments work on the same principle as accruals, ensuring expenses are recorded in the time period to which they relate. However, prepayments involve expenses that have been paid in advance, with the economic benefit of that expenditure yet to be used. Rent is a common example where payments are often made a year in advance. This may be the case for start-ups, for which the landlord may not wish to accept the credit risk of default. Prepayments are current assets in the statement of financial position as they represent economic value due or available to the company – in this case, in the form of occupying the premises being rented. Prepayments require recognition of:

• a decrease in cash as a payment is made (Cash, SoFP)
• a prepayment to be recognised as a current asset (SoFP).

Here, conversely to accruals, cash is adjusted first when the full invoice is paid, but the expense is not recognised until the time period in which it is ‘consumed’.

During the year, Rozim received and paid an annual insurance invoice amounting to £7,764. The insurance covers the period from 1 April 2035 to 31 March 2036. Because Rozim’s accounting year ends at 30 September 2035, only six months of this insurance has been ‘consumed’ (1 April 2035 to 30 September 2035), with the remaining six months being paid in advance.

This constitutes a prepayment and requires the following adjustment.

Note that there are three elements here to the double-entry bookkeeping, but the total of the debits still equals the total of the credits.

8.7.3 Bad debt

At the year end, Rozim became aware that a customer with a balance of £66,325 had gone bankrupt, resulting in what we call a bad debt. A bad debt occurs when it is assumed that the customer will not pay the amount owed. To avoid overstating profit and assets, the company must make a bad debt adjustment, which includes:

• a Bad debt expense (IS)
• a reduction in Trade receivables (SoFP).

It’s important to note that sales are not reduced but, instead, an expense is recognised.

The required adjusting entry for Rozim is:

8.7.4 Provision

At the year end, Rozim became aware of a potential legal dispute over copying a patented design. Rozim’s lawyers estimated that a potential loss of £200,000 would be a reasonable estimate of the costs and that it was likely that Rozim would have to settle the obligation after a year.

If the three criteria are met for a provision, it must be recognised. This involves:

• An expense (IS). This will be estimated, often relying on experts such as lawyers.
• A liability (SoFP). Whether this is current or non-current depends on whether it will probably be paid within a year (current) or after a year (non-current).

The required adjusting entry for Rozim is as follows:

Together, these entries are added across to the preliminary trial balance figures to arrive at the final trial balance, which can then be mapped and formatted into the SoFP and IS. Note that the resultant profit of £199,437 needs to be added to the opening retained earnings to arrive at the final retained earnings value in the SoFP.

Once all the adjustments have been made, the organisation is ready to construct financial statements. They would first classify all items on the trial balance as either income, expense, asset, liability or equity. Then these are recorded in the IS and SoFP. Reviewing the layout of Rozim Limited, see the usual subtotals which are calculated and the order on the SoFP from non-current assets, current assets, current liabilities, non-current liabilities and equity. These numbers come from the adjusted trial balance.

Finally, the disclosure notes will be prepared, along with the cash flow statement and, for larger organisations, detailed narratives including environmental, social and governance reports, directors’ reports and audit reports.

In conclusion, double-entry bookkeeping serves as the foundation for generating reliable and informative financial statements. By recording every transaction with equal and opposite debits and credits, a picture emerges of an organisation’s financial health.

This unit explored the crucial role of accounting transactions in generating financial statements. It highlights the vast number of transactions that occur daily in large organisations and how these are captured and recorded on a day-to-day and year-end basis, in order to prepare financial statements.

8.8 Summary

This unit has explained that:

• Double-entry bookkeeping serves as the foundation for generating reliable and informative financial statements.
• All information ties back to source documentation for each transaction.
• Transactions are summarised in a trial balance.
• The trial balance is updated for certain year-end adjustments before the main financial statements can be constructed.
• Despite the application of the accounting rules, judgement remains in the classification of cash flows and other accounting choices, for example, bad debt estimations, provisions or depreciation methods applied.