What is Bookkeeping

Bookkeeping Concepts

This is a very basic but very important question, and it deserves a very basic but important answer. The following is taken from the first page of the first chapter of Bookkeeping by Andrew Lymer and Andrew Piper in the Teach Yourself Series published by Hodder Education. 

What is bookkeeping?

The process of correctly recording in Books of Account cash, credit and other transactions.

What are Books of Account?

The primary Book of Account is called the ledger, so called because all transactions, after first being recorded in subsidiary books, are afterward grouped or summarized in accounts in the ledger.

Why should goods or services be bought or sold on 'credit'?

Almost all business dealings are conducted on a credit basis to avoid the inconvenience and danger of carrying large amounts of cash. The supplier of goods or services is usually content to accept payment at some future date. The main exception is the retail trade for a private individual.

Why is it necessary to record these transactions?

Even in the smallest business the proprietor or manager will want to have accurate and up-to-date information about how much has been bought and sold, how much money has been received for sales, how much has been paid away for purchases, etc. Private individuals often find it convenient to have the same information for their cash receipts and payments. You can imagine that with a very large business, chaos would quickly result without this information.

So bookkeeping really involves analyzing in some way or another these various transactions?

You could say it involves recording these transactions so as to permit analysis in a systematic fashion, in a way that can be applied to all businesses of whatever kind, and that is intelligible not only now but at any future time.

Do you mean by this 'the double entry system of bookkeeping?

Yes.

The term 'Books of Account' has a distinctly old-fashioned sound. It perhaps makes you think of a Charles Dickens novel set in early Victorian England, with rows of clerks perched on high stools writing in large books. Bookkeeping today is likely to be done with the aid of a computer rather than with handwritten books, and this is a virtual certainty in a business of any significance. Nevertheless, modern bookkeepers are doing exactly the same as the clerks in the Dickens novel, though they are doing it much more quickly and perhaps more accurately - though Victorian clerks achieved very high standards. (Whether or not they are any happier is a question for another book!)

The importance of bookkeeping

All businesses, without exception, need to keep accurate and readily accessible records of their financial transactions. Many organizations other than businesses also need to do it, and some individuals too. As a child, I had a neighbor who died at the age of 75 leaving records that accounted for every penny of his income and expenditure since his 21 st birthday. Surprisingly he was a charming, generous man and in no way a miser. Perhaps you too have a personal bookkeeping system to record your own financial affairs, though I would not recommend taking it to these extreme lengths. The benefits to a business of dependable financial records are probably self-evident.
They include:
• The law requires all companies and many other organizations to prepare accounts that conform with certain criteria. This can only be done if the basic, supporting financial records are in place. 
• The tax authorities require it. If you do not believe me, try telling Her Majesty's Revenue and Customs that you cannot do a VAT return because you have not kept proper records.
• It is necessary to manage the bank account, cash and borrowing. Otherwise, cheques might bounce or unproductive surpluses build up.
• Intelligently used, the records should warn of impending financial difficulties or even insolvency.
• Intelligently used, the records should provide the basis for efficiency savings and profitable business decisions.
• Without proper bookkeeping the owners would not know the worth of the business.
• It is, in many instances, essential in order to comply with money laundering regulations.

Single entry bookkeeping

As Julie Andrews memorably sang in The Sound of Music, the very beginning is a very good place to start, and single entry bookkeeping could be said to be the very beginning. In fact, it is extremely basic, which is why it is not used by any business of significance.

Some managers might think that they use it, but what actually happens is that the accountants take the books and documents away and convert them into double-entry records. Single entry bookkeeping is described here in order to show why double-entry bookkeeping is almost universally used. However, a small body, such as perhaps a birdwatchers' club, just might use the single-entry version. So might a sole trader or small partnership, provided that the accounts are not audited. As the name suggests, single-entry bookkeeping involves writing down each transaction just once. It is in fact the simple listing of money paid and received. Every time a cheque is written, the bookkeeper records in a book the date, the amount, and the person or business being paid. Every time something is paid into the bank, the date, amount, and person or business from whom the money was received are recorded elsewhere in the book. Cash paid out and received is recorded similarly.
If the bookkeeper has been very careful, an accurate receipts and payments account can be prepared from the single entry records. It would, though, be wise to verify the figures as far as possible. After allowing for the starting balance, cash actually in the cash box should equal the cash received less the cash paid out. The balance on the bank statement should equal money banked and fewer cheques written, after allowing for the opening balance and items that have not yet reached the statement.

Records kept in this way have severe limitations. Among them are:

• If a receipt or payment is entered in the book as an incorrect amount, the mistake may not be noticed.
• If the amount of a receipt or payment is entered correctly but the type of receipt or payment is wrongly classified, the mistake may not be noticed. It is only fair to say that this can also happen with double entry bookkeeping, though it is perhaps less likely.
• Money owing to or by the organization is not shown. Just possibly nothing is owing to or by the organization, but it is a severe limitation.
• Long-term assets are not shown. A car purchased two years ago for £20,000 does not appear at all in the records for the current year, even though it still has a significant value.
• Important things like depreciation and bad debts are not shown. With considerable care, it may be possible to prepare accurate receipts and payments account, and this is certainly better than nothing, but double entry bookkeeping is much superior.

The concept of double-entry bookkeeping

Double entry bookkeeping is much superior to single-entry bookkeeping and all significant businesses keep their accounting records in this way. At the heart of double-entry bookkeeping is the concept that every transaction involves both the giving of a benefit and the receiving of a benefit. Consequently, every transaction is written into the books twice, once as a debit and once as a credit. It follows that the bookkeeping system must always be balanced, which is a big advantage. Some types of mistakes will cause the system to be out of balance, and as a result, the bookkeeper will be alerted to a problem. 
  

Double entry should not be taken to imply that two transactions are entered. It means that an inherent feature of a single transaction is that it is entered into two different accounts, one as a debit and in one as a credit.

    Consider as an example a cheque for £5,000 to insure the company cars. £5,000 is entered into the Insurance Account as a debit. This account will eventually be charge to the profit and loss account. At the same time, £5,000 will be credited to the Bank Account. This reduces the balance of money in the bank or increases the overdraft. The balance of the bank account will eventually appear on the balance sheet. Debits and credits are explained in the next section of this chapter.

Three basic rules of double entry bookkeeping

The founding father of double-entry bookkeeping was a Franciscan monk called Luca Pacioli. He did not invent it, but in 1493 he wrote down the principles of the system being used by him and others.

Given his calling, he must have been a man of considerable education and wide-ranging interests. His work has stood the test of time because the fundamental principles are timeless. If he was able to visit a modern accounts office, once computers had been explained to him he would recognize that his principles were still being applied. The bookkeeping system (the ledger) will contain several accounts, perhaps just a few or perhaps many thousands. The previous section of this chapter gave an example of a cheque for £5,000 paying an insurance premium.

This resulted in postings to the Insurance Account and the Bank Account. Each account has a separate page in the ledger, though in practice the records are likely to be computerized. In a manual system, the layout of each account will be the same.

The following show the two entries resulting from the payment of the insurance premium. 

As you look at these accounts please keep in mind:
• They might seem rather cramped, but in reality, the paper would almost certainly be considerably wider than this book.
• Debit is often abbreviated to 'Dr' and Credit is often abbreviated to 'Cr'.
• The entry may incorporate a folio reference. This is not shown but it enables each entry to be cross-referenced to the correct input document.

It is time now to list and explain three fundamental rules that apply today and which Luca Pacioli would undoubtedly recognize.

1. Debit on the left, credit on the right

Why this way round? It does not matter so long as everyone does it the same way. It is rather like driving - it does not matter which side of the road we drive so long as everyone follows the same law or convention. A long time ago most people did it this way, so that's the way we all do it. On my first morning as a trainee accountant, I was told that debit was nearest the window and that it was best not to talk to the boss until he had had a cup of tea. I found both pieces of advice invaluable, but I always sat with my left shoulder next to the glass.

2. Debit receives the benefit, credit gives the benefit

Again, why this way round? Again, because it was decided a long time ago and that's the way it is. The rule may be hard to grasp and it is probably the opposite of what you would instinctively expect. After all your bank statement is credited when money is paid into your bank account. But look at it from the bank's point of view, and it is the bank that issues the statement. The bank's records are a mirror image of your records, so credit for the bank is a debit for you, and vice versa. It may help you to remember the rule if you keep in mind that assets in the balance sheet and costs in the profit and loss account are both debits. So if you buy a new factory or if you buy some postage stamps, the appropriate accounts will be debited. Liabilities in the balance sheet and income in the profit and loss account are both credits. So if you buy something on credit, the amount is credited to the supplier's account. This is because it is a liability. Similarly, if you make a sale, the amount is credited to the sales account and it will eventually contribute to revenue in the profit and loss account. It is all explained further in the next chapter.

3. For every debit there must be a credit

This is a fundamental and implicit consequence of double entry bookkeeping, and there are no exceptions. One account gives the benefit and one account receives the benefit. Scientists sometimes help themselves remember the rule by thinking of the law of physics: 'for every action, there is an equal and opposite reaction. We have already seen how this works about the insurance premium payment of £5,000, but it is not always so straightforward. In fact, it may be exceedingly complicated. A batch of postings may include a large number of debits and credits, but the total of the debits must always equal the total of the credits. If they do not, a mistake has been made. As an example consider the entries resulting from an approved expense claim. The amounts are large, so perhaps the expenses were incurred by a senior manager or just possibly a journalist. 


Five individual accounts would be debited with a total of £6,499.
One account would be credited with £6,499.
So please remember the first fundamental rule of double entry bookkeeping: 'for every debit, there must be a credit. There are no exceptions and it ranks alongside 'The sun always rises in the east, 'Water does not flow uphill', and 'A Government initiative to cut bureaucracy always creates extra work.

Two examples of double-entry bookkeeping postings

This section of the chapter illustrates two practical examples of the principles already explained. The first is extremely straightforward. In the section about single entry bookkeeping the point was made that a birdwatchers' club might not see the need for double entry records, but let us suppose that a new treasurer has instituted a double entry system and that the following four events occur on the first day:
• A member pays her annual subscription of £50.
• The club buys a new telescope for £400.
• The treasurer is reimbursed £100 for stamps that he has bought.
• The annual subscription of £75 is paid to The Federation of British Birdwatchers.

Bank Account

You will no doubt have noticed that the debits have received the benefits and that the credits have given the benefits, and also that the total of the debits equals the total of the credits. You may also have noticed that more has gone out of the bank than has been received. Let us hope that the birdwatchers have an agreed overdraft facility or started the period with money in the bank.

The second example relates to a business and involves purchases and sales made on credit. The accounts reflect the posting for the following transactions.

• A sale of £110 is made for cash which is banked.
• A sale of £4,000 is made on credit to J. K. Patel Ltd.
• A sale of £60 is made on credit to Cohen and Levin Ltd.
• Payment of £3,200 (relating to a previous sale) is received from J. K. Patel Ltd.
• Widgets for resale costing £2,700 are purchased on credit from Widget Supplies Ltd.
• Wages of £6,000 are paid.
• An invoice for £2,000 relating to advertising is received from King Brothers.


Questions to test your understanding

1. Does credit give the benefit or receive the benefit?
2. The treasurer of Kidwilton Village Football Club keeps the books using a double entry system. Write up the accounts to reflect the following transactions:
• Annual subscriptions of £50 are received in cash from each of four members and the money is banked.
• Rent of £500 is paid to the farmer who owns the football field.
• An invoice from a firm of solicitors (Lafferty and Reed) is received. The amount is £300.
• An invoice from a printer (K. Klaus Ltd) is received. The amount is £170.
• A donation of £5,000 is received from the club's president. The cheque is banked. INSTANT TIP For every debit there must be a credit. If there is not, a mistake has been made.