CHAPTER 2

Double-entry bookkeeping
Introduction

Business transactions are recorded in accounts. The maintenance and recording of

transactions within these accounts is known as double-entry bookkeeping. The
‘double-entry’ term is used because each transaction can be seen to have two separate
effects on the business. For example, buying a new machine for cash would affect
both the asset of machinery, and the asset of cash. Similarly, selling inventory on credit
would affect the asset of inventory, and the liability of trade payables.
A double-entry account would normally appear as follows:

 A double-entry account
 Account name
 Debit side (Dr) Credit side (Cr)

Date Account details Amount ($) Date Account details Amount ($)

What does the account show?

Given the ‘T’ shaped appearance of the accounts they are often referred to as ‘T’
accounts. Each of these accounts will show the following:

● Account name
The name of the account refers to the type of transaction. For example, if the
account is dealing with buying or selling machinery, then the account could simply
be known as ‘machinery’. This means that each different type of transaction would
be recorded in a separate account.

Business Accounting Basics

10
● Debits and credits
The debit side (Dr) and credit side (Cr) refer to the left-hand and right-hand sides of
each account. These terms can be used to refer to how entries are made. For example,
if we talk of ‘debiting’ an account, all we mean is that we would be placing an entry
on the debit side – the left-hand side – of the account.

● Account details
The details element of each side of the account will contain the name of the other
account which the transaction also affects. As a form of symmetry, each transaction
will affect two accounts – hence the term ‘double-entry’ – and the details included
in each account will refer to the other account to be affected.

There are some basic principles that must be applied when recording double-entry
transactions:

1 Every transaction requires two entries to be made in separate accounts.

2 Every transaction requires one debit entry and one credit entry to be made in each
of the two accounts.

Rules for double-entry transactions

It is vital that transactions are recorded correctly. For this we need to establish on
which ‘side’ of the account each transaction needs to be recorded – i.e. should we
‘debit’ or ‘credit’ an account? This will depend on the type of account that we are
dealing with.

In Chapter 1 we were introduced to the terms asset, liability and capital. To start
with we will consider three separate types of account: for assets, liabilities and capital.
The rules for recording the double-entry transactions are as follows:

      all ASSETS accounts  

Debit   Credit
INCREASES entered HERE DECREASES entered HERE

      all Liability accounts    

Debit   Credit
DECREASES entered HERE INCREASES entered HERE

      all Capital accounts    

Debit   Credit
DECREASES entered HERE INCREASES entered HERE
 

These rules will make more sense if we see some examples of them in action.
Example 2.1

On 1 November, the owner places £5,000 of her own money into the bank account
of the new business.

dr   Bank   cr
$ $
 
1 Nov.
2020 Capital 5000
 
 
 

    Capital    
$ $
  1-Nov Bank 5000
 
 

Explanation
The asset of bank has increased – so we debit that account.
The capital of the business has increased – so we credit that account.

Notice how the detail of each transaction cross-references the other account to be
affected – providing a useful way of locating the other account that is to be affected
by the transaction.

Example 2.2
On 3 November, machinery is purchased for £2,000, payment made by cheque.
Explanation

The asset of machinery has increased – so we debit that account.

The asset of bank has decreased due to the payment made – so we credit that account.

    Machinery
$
1 Nov. Bank 2000
 
 
 

    Bank
$
 
 
 
 

Example 2.3
On 9 November, equipment is purchased on credit from Perkins Ltd for £320.

Explanation
The asset of equipment has increased – so we debit that account.
The liability of creditor* Perkins Ltd has increased – so we credit that account.

    Equipment    
$ $
Perkins
9 Nov. Ltd 320
 
 
     Perkins Ltd    
$ $
  9 Nov. Equipment 320
 
 

* Note: A creditor is someone the business owes money to who is likely to be repaid
in the near future.

Example 2.4
On 14 November, the £320 owing to Perkins Ltd is paid by cheque.

Explanation
The asset of bank has decreased – so we credit this account.
The liability of creditor has decreased – so we debit this account.

    Bank    
 
  14. Nov Perkins Ltd 320
 
 

    Perkins Ltd    
11. Nov Bank 320

Further information for double-entry bookkeeping

The books which contain the accounts that record these transactions are known as
ledgers.

In reality, most accounts will contain more than one transaction and one single
account could easily take up many pages in the ledger.

In Chapter 4 we show how these ledgers are sub-divided.

dr   Bank   cr
 $ $
 
1 Nov. 2020 Capital 5000 1 Nov. Machinery 2000
 
  14. Nov Perkins Ltd 320
 
  30. Nob Bal B/d 2680
5000 5000

    Capital    
$ $
30. Nov Bal b/d 5000 1-Nov Bank 5000
 
 

When completing questions that involve maintaining double-entry accounts, it is a

good idea to read through the complete list of transactions first so as to get a rough
idea of how many entries will be needed in each account.

This will mean that you can leave sufficient space to make all the entries in that account – it will start to
look untidy if you have to restart an account later on in your workings due to leaving insufficient space
for transactions.

Typically, the bank and cash accounts are used frequently, whereas the capital account
is only affected by one or two entries.

Accounting for inventory

Goods that are bought with the intention of being sold are referred to as inventory.
Inventory is an asset and will therefore follow the rules of an asset account. However,
bookkeeping for inventory is not as straightforward as you might think.
Consider the following account:

    INVENTORY    
2010 $ 2010 $
 
PURCHASE
8-Apr S 300 6-May SALES 300
 

It would be tempting to think that the balance on this account is zero – with the
inventory purchased in April all being sold in May. However, it is likely that the selling
price of the inventory differed from the purchase price of the inventory (i.e. it was
sold for a profit) and, as a result, we cannot determine how much inventory
is left within the business.

The solution is to have separate accounts for different movements of inventory.

There are four separate accounts to record different movements in inventory:
 The four accounts for inventory
1 Purchases – for purchases of inventory
2 Sales – for sales of inventory
3 Returns inwards – when a customer returns inventory to the firm.
4 Returns outwards – when the business returns inventory to the supplier.

What do we mean by inventory?

Inventory refers to goods that the firm buys with the intention of selling at a profit.
What is counted as inventory will depend on the type of business we are dealing with.

For example, a business buying and selling computers would count purchases of computers
as inventory – and would enter these into the purchases account. However,
another firm may see the purchase of a computer as the purchase of an asset and the
entry for this purchase would be in a ‘computer’ account.

Many accounting students are initially unsure whether something counts as the
purchase of an asset or the purchase of inventory. This distinction between purchases
of assets and purchases of inventory is important as it has implications later on for
calculating the profit of the business.

Double-entry transactions for inventory

Inventory is an asset and will therefore follow the rules of an asset account. It is
possible that both purchases and sales will be either for immediate payment or
receipt – these would be referred to as ‘cash transactions’. However, they may be on
‘credit terms’ where the payment or receipt is made at a later date.
It is worth pointing out that the term ‘cash’ – as in ‘cash sales’ – can include payment
or receipt by cheque; it is only referred to as ‘cash’ to distinguish it from credit terms.

Nature of inventory transaction

Cash transaction = Immediate payment
Credit transaction = Payment made at a later date

Credit terms are normally offered when one business trades with another business.
The credit period offered can vary, but 30 days is a typical period offered. The double entry
transactions for credit transactions will be completed in two stages: firstly, the
initial credit transaction, and secondly, the payment made or received in final settlement
of the account owing or owed.

Example 2.5: purchases of inventory

On 10 November, the business purchases £450 of inventory.

Whether the firm pays for this immediately by cheque, or purchases it on credit
terms, can be shown easily in the following accounts.
The purchase of inventory will require a debit entry into the purchases account as
an asset has increased, but there are two options for the corresponding credit entry:

A = Cash purchase
B = Credit purchase

A: CASH PURCHASE
     purchases    
$ $
10-Nov BANK 450
 
 

  BANK    
$ $
  10-Nov PURCHASE 450
 
 

Explanation
If the inventory is paid for immediately, then a credit entry will be made in the bank
account – an asset has decreased.

B Credit purchases

    Bank    
2010 $ $
10-Nov CREDITOR 450
 
 

CREDITOR (NAME OF
    CREDITOR)    
$ $
  10-Nov purchases 450

Explanation
If the inventory is bought on credit, then a credit entry will be made in the creditor’s
account – a liability has increased.

Example 2.6: sales of inventory

On 19 April, the business sells £870 of inventory. Again, we can illustrate the accounts
for both cash sales and for credit sales.
Chapter 2 • Double-entry bookkeeping
15
The sale of inventory will require a credit entry in the sales account as the asset
of inventory is being reduced. Again, there are two options for the corresponding
debit entry:
A = Cash sale
B = Credit sale

A Cash sales

    SALES    
 $ $
  19-Apr BANK 870
 
 

    BANK    
$ $
10-Apr SALES 870
 
 

Explanation
If the sale is for immediate receipt, we would debit the bank account – as an asset is
being increased.
B Credit sales
    SALES    
$ $
  19-Apr DEBTOR 870
 

    DEBTOR    
$ $
10-Apr SALES 870
 
 

Explanation
If the sale is on credit then we would debit the account of the debtor,* as an asset is
being increased.

* Note: Debtors are people or other businesses that owe the business money – usually
for sales made to them on credit. The repayment of the amount owing is expected in
the near future.

Returns of inventory

It is possible that goods will be returned to the original supplier. This is not something
that the supplier will allow automatically, but if there is some issue with the order,
such as the order itself being incorrect, or the items faulty, then it is normal practice
for the goods to be returned.

Both returns inwards and returns outwards are asset of inventory accounts and will
therefore follow the rules of an asset account.

Returns inwards refer to the goods which are sent back to the firm from the
customer. For this reason they are also known as sales returns.

Example 2.7

Goods previously sold on credit to C Smith for £189 were returned to the firm on
12 March due to the goods being faulty.
Returns inwards
££

Example 2.7
Goods previously sold on credit to C Smith for £189 were returned to the firm on
12 March due to the goods being faulty.

    RETURN INWARDS    
$ $
12-Mar C. SMITH 189
 

    C SMITH    
$ $
RETURN
  12-Mar INWARDS 189
 
 

The returns inwards represent an increase in the asset of inventory which means we
will debit that account. By returning goods C Smith will owe the firm less money
which reduces the asset of debtor which means we credit Smith’s account.

Returns outwards refer to the goods which the business returns to the original
suppliers. They are purchases that are unsuitable and for this reason are also known
as purchases returns.

Example 2.8
Goods previously purchased from L McCormack for £212 were found to be faulty and
were subsequently returned to him on 5 April.

Returns outwards
    RETURN OUTWARDS    
$ $
  5-Apr L McCORMACK 212
 

    L McCORMACK    
$ $
l.
5-Apr McCornack 212
 

Returns outwards represent a decrease in the asset of inventory which will mean we
credit this account. By returning goods we will owe McCormack less money which
reduces the liability of trade payables which means we debit McCormack’s account.
 Returns

Returns inwards (sales returns) Inventory returned to the business from the customer
Returns outwards (purchases returns) Inventory returned by the business to the supplier

Handy hints
The following hints will help you avoid errors.
● Always ensure that you make two entries for each double-entry transaction.
● Always complete one debit entry and one credit entry for each transaction.
● Memorise the basic rules for asset, liability and capital accounts – use a prompt card
until
you can memorise these rules.
● Leave plenty of room when drawing up accounts – for extra entries and also room for
balancing off the account.
● Inventory is accounted for just as any other asset.
● Each separate expense should be kept in a separate account.
● Incomes and expenses should be kept in separate accounts and not combined

Key terms
Bookkeeping The system of recording and maintaining financial transactions in
accounts
Double-entry The system by which accounting entries are recorded in two
accounts
Debit Accounting entry on the left-hand side of an account
Credit Accounting entry on the right-hand side of an account
Account A place where a particular type of transaction is recorded
Ledger A book containing double-entry accounts
Inventory Goods purchased with the intention of being sold by the business for
a profit
Debtor A person or business that owes a business money and will repay in the
near future
Creditor A person or business that a business owes money to and that is
expected to be
repaid within the near future
Purchases Inventory purchased by a business for the purpose of resale
Sales Inventory sold by a business
Returns inwards Inventory previously sold by a business which is returned to
the firm
by the customer (usually because of unsuitability of the inventory)
Returns outwards Inventory previously purchased by a business which is
returned to
the original supplier (usually because of unsuitability of the inventory)
Drawings Resources (e.g. cash) taken out of a business by the owner for private
use
Expenses Costs incurred by a business in the day-to-day running of the business
Income Revenue earned by a business as part of the business’s operations
Balance The outstanding amount remaining when an account is balanced –
measured
by the difference between the totals of the debit column and the credit column
in an individual
account