Basic accounting entries

                                                      Accounting for Sales

As sale results in increase in the income and assets of the entity, assets must be debited whereas income must be credited. A sale also results in the reduction of inventory, however the accounting for inventory is kept separate from sale accounting as will be further discussed in the inventory accounting section.

A sale may be made on cash or on credit.

Cash Sale

When a cash sale is made, the following double entry is recorded:

Debit     Cash

Credit   Sales Revenue (Income Statement)

Cash is debited to account for the increase in cash of the entity.

Sale Revenue is credited to account for the increase in the income.

Credit Sale

In case of a credit sale, the following double entry is recorded:

Debit     Receivable

Credit   Sales Revenue (Income Statement)

The double entry is same as in the case of a cash sale, except that a different asset account is debited (i.e. receivable).

When the receivable pays his due, the receivable balance will have be reduced to nil. The following double entry is recorded:

Debit     Cash

Credit   Receivable.

                                                     Accounting for Sales Returns

There is need to account for sale returns as though no sale had occurred in the first place.

Hence, the value of goods returned must be deducted from the sale revenue.

If sale was initially made on credit, the receivable recognized must be reversed by the amount of sales returned. If the sales in respect of the returns were made for cash, then a payable must be recognized to acknowledge the liability to reimburse the customer the amount he had paid for those purchases.

Sales Return - Credit Sale

In case of credit sale, the following double entry must be made upon sales returns:

Debit     Sales Return (decrease in income)

Credit   Receivable (decrease in asset)

Example:

Bike LTD sells a mountain bike to XYZ for $100 on credit. XYZ later returns the bike to Bike LTD due to a serious defect in the design of the bike.

The initial sale will be recorded as follows:

$              $

Debit     XYZ (Receivable)             100        

Credit   Sales                     100

Upon the return of bike, the following double entry will be passed:

$              $

Debit     Sales Return      100        

Credit   XYZ (Receivable)                             100

No further entry will be required as the receivable due from XYZ has been reversed.

Sales Returns - Cash Sales

In case of cash sale, the following double entry must be made upon sales returns:

Debit     Sales Return (decrease in income)

Credit   Payable (increase in liability)

Example:

Bike LTD sells a mountain bike to XYZ for $100 on cash. XYZ later returns the bike to Bike LTD due to a serious defect in the design of the bike.

The initial sale will be recorded as follows:

$              $

Debit     Cash      100        

Credit   Sales                     100

Upon the return of bike, the following double entry will be passed:

$              $

Debit     Sales Return      100        

Credit   XYZ (Payable)                    100

When Bike LTD will pay XYZ $100 in respect of the sales return, the following double entry will be recorded:

$              $

Debit     XYZ (Payable)    100        

Credit   Cash                      100

Accounting Treatment for Discounts on Sales

Discounts may be offered on sales of goods to attract buyers. Discounts may be classified into two types:

Trade Discounts: offered at the time of purchase for example when goods are purchased in bulk or to retain loyal customers.

Cash Discount: offered to customers as an incentive for timely payment of their liabilities in respect of credit purchases.

Trade Discount

Trade discounts are generally ignored for accounting purposes in that they are omitted from accounting records.

Therefore, sales, along with any receivables in the case of a credit sale, are recorded net of any trade discounts offered.

Example:

Bike LTD as part of its sales promotion campaign has offered to sell their bikes at a 10% discount on their listed price of $100.

Sales will be recorded net of trade discount, i.e. $90 per bike.

Cash Discount

Cash discounts result in the reduction of sales revenue earned during the period. However, not all customers may qualify for the cash discount. It is therefore necessary to record the initial sale at the gross amount (after deducting any trade discounts!) and subsequently decreasing the sale revenue by the amount of discount that is actually allowed.

Following double entry is required to record the cash discount:

Debit	Discount Allowed (income statement)
Credit	Receivable

Debiting discount allowed ledger has the effect of reducing gross sales revenue by the amount of cash discount allowed. Consequently, receivables are credited to reduce their balance to the amount that is expected to be recovered from them, i.e. net of cash discount.

Example:

Bike LTD as part of its sales promotion campaign has offered to sell their bikes at a 10% discount on their listed price of $100. If customers pay within 10 days from the date of purchase, they get a further $5 cash discount. Bike LTD sells a bike to XYZ who pays within 10 days.

Before we proceed with the accounting entries, it is necessary to first distinguish between the two types of discounts being offered by Bike LTD. The 10% discount is a trade discount and should therefore not appear in Bike LTD's accounting records. The $5 discount is a cash discount and must be dealt with accordingly.

The initial sale of the bike will be recorded as follows:

		$	$
Debit	XYZ (receivable)	90
Credit	Sales		90

As XYZ qualifies for the cash discount, the following double entry will be required to record the discount allowed:

		$	$
Debit	Discount Allowed (income statement)	5
Credit	XYZ (receivable)		5

The above entries have resulted in sales of Bike LTD being reduced to $85 (100-90-5). The receivable from XYZ has also been reduced to this amount effectively

                                                        

                                                       Accounting for Purchases

As purchase results in increase in the expense and decrease in assets of the entity, expense must be debited while assets must be credited. A purchase also results in increase in inventory, however the accounting for inventory is kept separate from accounting for purchase as will be further discussed in the inventory accounting section.

A purchase may be made on Cash or on Credit.

Cash Purchase

When a cash purchase is made, the following double entry is recorded:

Debit     Purchases (Income Statement)

Credit   Cash

Purchase is debited to account for the increase in expense.

Cash is credited to account for the decrease in cash of the entity..

Credit Purchase

In case of a credit purchase, the following double entry is recorded:

Debit     Purchases (Income Statement)

Credit   Payable

The double entry is same as in the case of a cash purchase, except that the credit entry is made in the payable ledger rather than the cash ledger.

When the payable is paid his due, the payable balance will be reduced to nil. The following double entry is recorded:

Debit     Payable

Credit   Cash

                                    Purchase Returns

Purchases returns, or returns outwards, are a normal part of business. Goods may be returned to supplier if they carry defects or if they are not according to the specifications of the buyer.

Accounting for Purchase Returns

There is need to account for purchase returns as though no purchase had occurred in the first place.

Hence, the value of goods returned to the supplier must be deducted from purchases.

If purchase was initially made on credit, the payable recognized must be reversed by the amount of purchases returned. If the purchases in respect of the goods returned were made for cash, then a receivable must be recognized to acknowledge the asset resulting from the expected reimbursement to be received from the supplier in respect of the returned goods.

Purchase Return - Credit Purchases

In case of credit purchases,the following double entry must be made upon purchases returns:

Debit     Payable (decrease in liability)

Credit   Purchases Return (decrease in expense)

Example:

Bike LTD purchases a mountain bike from BMX LTD for $100 on credit. Bike LTD later returns the bike to BMX LTD due to a serious defect in the design of the bike.

The initial purchase will be recorded as follows:

Debit     Purchases           100        

Credit   BMX LTD                              100

Upon the return of bike, the following double entry will be passed:

Debit     BMX LTD              100        

Credit   Purchases Return                            100

No further entry will be required as the payable due to BMX LTD has been reversed.

Purchase Returns - Cash Purchase

In case of cash purchases, the following double entry must be made upon sales returns:

                                    Debit Receivable (increase in asset)

Credit   Purchases Return (decrease in expense)

Example:

Bike LTD purchases a mountain bike from BMX LTD for $100 on cash. Bike LTD later returns the bike to BMX LTD due to a serious defect in the design of the bike.

The initial purchase will be recorded as follows:

Debit     Purchases           100        

Credit   Cash                      100

Upon the return of bike, the following double entry will be passed:

Debit     BMX LTD (Receivable)   100        

Credit   Purchases Return                            100

When BMX LTD will pay $100 owed to Bike LTD in respect of the purchases return, the following double entry will be recorded in Bike LTD's books:

Debit     Cash      100        

Credit   BMX LTD (Receivable)                   100

Purchase Discounts (Discount Received)

Discounts may be offered by suppliers on sales of goods to attract buyers. Discounts may be classified into two types:

Trade Discounts: offered at the time of purchase for example when goods are purchased in bulk or to retain loyal customers.

Cash Discount: offered to customers as an incentive for timely payment of their liabilities in respect of credit purchases.

Accounting Treatment for Discounts on Purchases

Trade Discount

Trade discounts are generally ignored for accounting purposes in that they are omitted from accounting records.

Therefore, purchases, along with any payables in the case of a credit purchase, are recorded net of any trade discounts offered.

Example:

BMX LTD as part of its purchases promotion campaign has offered to sell their bikes at a 10% discount on their listed price of $100.

Purchases from BMX LTD will be recorded net of trade discount, i.e. $90 per bike.

Cash Discount

Cash discounts result in the reduction of purchase costs during the period. However, not all purchases may qualify for the cash discount. It is therefore necessary to record the initial purchase at the gross amount (after deducting any trade discounts though!) and subsequently decreasing purchases by the amount of discount that is actually received.

Following double entry is required to record the cash discount:

Debit	Payable
Credit	Discount Received (income statement)

Crediting discount received has the effect of reducing gross purchases by the amount of cash discount received. Consequently, payables are debited to reduce their balance to the amount that is expected to be paid to them, i.e. net of cash discount.

Example:

BMX LTD as part of its purchases promotion campaign has offered to sell their bikes at a 10% discount on their listed price of $100. If customers pay within 10 days from the date of purchase, they get a further $5 cash discount. Bike LTD purchases a bike from BMX LTD and pays within 10 days of the date of purchase.

Before we proceed with the accounting entries, it is necessary to first distinguish between the two types of discounts being offered by BMX LTD. The 10% discount is a trade discount and should therefore not appear in Bike LTD's accounting records. The $5 discount is a cash discount and must be dealt with accordingly.

The initial purchase of the bike will be recorded as follows:

		$	$
Debit	Purchases	90
Credit	BMX LTD (Payable)		90

As Bike LTD qualifies for the cash discount, the following double entry will be required to record the discount received:

		$	$
Debit	BMX LTD (Payable)	5
Credit	Discount Received (income statement)		5

The above entries have resulted in purchases of Bike LTD being reduced to $85 (100-90-5). The payable to BMX LTD has also been reduced to this amount effectively.

                                    Cash Transactions

Cash transactions are ones that are settled immediately in cash. Cash transactions also include transactions made through cheques. Cash transactions may be classified into cash receipts and cash payments.

Cash Receipts

Cash receipts are accounted for by debiting cash / bank ledger to recognize the increase in the asset.

Following are common types of cash receipt transactions along with relevant accounting entries:

Cash Sale:

Debit     Cash

Credit    Sales

Cash receipt from receivable:

Debit     Cash

Credit    Receivable

Capital contribution from shareholders:

Debit     Bank

Credit    Share Capital

Receipt of loan from a bank:

Debit     Bank

Credit    Loan

Cash Payments

Cash payments are accounted for by crediting the cash / bank ledger to account for the decrease in the asset.

Following are common types of cash payment transactions along with relevant accounting entries:

Cash payment to a payable:

Debit     Payable

Credit    Cash

Purchase of inventory for cash:

Debit     Purchases

Credit    Cash

Purchase of a machine for cash:

Debit     Machinery - Asset

Credit    Cash

Cash Drawings by owner:

Debit     Drawing

Credit    Cash

Repayment of loan installment:

Debit     Loan

Credit    Cash

Fixed Assets

                        Capital and Revenue Expenditure

Expenditure on fixed assets may be classified into Capital Expenditure and Revenue Expenditure. The distinction between the nature of capital and revenue expenditure is important as only capital expenditure is included in the cost of fixed asset.

Capital Expenditure

Capital expenditure includes costs incurred on the acquisition of a fixed asset and any subsequent expenditure that increases the earning capacity of an existing fixed asset.

The cost of acquisition not only includes the cost of purchases but also any additional costs incurred in bringing the fixed asset into its present location and condition (e.g. delivery costs).

Capital expenditure, as opposed to revenue expenditure, is generally of a one-off kind and its benefit is derived over several accounting periods. Capital Expenditure may include the following:

Purchase costs (less any discount received)

Delivery costs

Legal charges

Installation costs

Up gradation costs

Replacement costs

As capital expenditure results in increase in the fixed asset of the entity, the accounting entry is as follows:

Debit     Fixed Assets

Credit   Cash/Payable

Test Your Understanding

Which of the following are examples of capital expenditure?

Cost incurred in testing whether a newly installed asset is functioning properly

Cost incurred in relocating a machine to a new factory

Cost incurred in replacing an old engine of the aircraft with a new one

Revenue Expenditure

Revenue expenditure incurred on fixed assets include costs that are aimed at 'maintaining' rather than enhancing the earning capacity of the assets. These are costs that are incurred on a regular basis and the benefit from these costs is obtained over a relatively short period of time. For example, a company buys a machine for the production of biscuits. Whereas the initial purchase and installation costs would be classified as capital expenditure, any subsequent repair and maintenance charges incurred in the future will be classified as revenue expenditure. This is so because repair and maintenance costs do not increase the earning capacity of the machine but only maintains it (i.e. machine will produce the same quantity of biscuits as it did when it was first put to use).

Revenue costs therefore comprise of the following:

Repair costs

Maintenance charges

Repainting costs

Renewal expenses

As revenue costs do not form part of the fixed asset cost, they are expensed in the income statement in the period in which they are incurred. The accounting entry to record revenue expenditure is therefore as follows:

Debit     Revenue Expense (Income Statement)

Credit   Cash/Payable

                               Accruals and Prepayments

                                         Accrued Income

Accrued income is income which has been earned but not yet received.

Income must be recorded in the accounting period in which it is earned. Therefore, accrued income must be recognized in the accounting period in which it arises rather than in the subsequent period in which it will be received.

As income will be credited to record the accrued income, a corresponding receivable must be created to account for the debit side of the transaction. The accounting entry to record accrued income will therefore be as follows:

Debit     Income Receivable (Balance Sheet)

Credit    Income (Income Statement)

Example

ABC LTD receives interest of $10,000 on bank deposit for the month of December 2010 on 3rd January 2011. ABC LTD has an accounting year end of 31st December 2010.

ABC LTD will recognize interest income of $10,000 in the financial statements of year 2010 even though it was received in the next accounting period as it relates to the current period. Following accounting entry will need to be recorded to account for the interest income accrued:

$              $

Debit     Interest Income Receivable        10,000  

Credit    Interest on Bank Deposit (Income)                          10,000

On the date of receipt of interest (i.e. 3rd January of the next year) following accounting entry will need to be recorded in the subsequent year:

$              $

Debit     Bank      10,000  

Credit    Interest Income Receivable                        10,000

                                         Accrued Expense

Accrued expense is expense which has been incurred but not yet paid.

Expense must be recorded in the accounting period in which it is incurred. Therefore, accrued expense must be recognized in the accounting period in which it occurs rather than in the following period in which it will be paid.

As expense will be debited to record the accrued expense, a corresponding payable must be created to account for the credit side of the transaction. The accounting entry to record accrued expense will therefore be as follows:

Debit     Expense (Income Statement)

Credit    Expense Payable (Balance Sheet)

Example

ABC LTD pays loan interest for the month of December 2010 of $10,000 on 3rd January 2011. ABC LTD has an accounting year end of 31st December 2010.

ABC LTD will recognize interest expense of $10,000 in the financial statements of year 2010 even though it was paid in the next accounting period as it relates to the current period. Following accounting entry will need to be recorded to account for the interest expense accrued:

$              $

Debit     Interest Expense             10,000  

Credit    Interest Payable                               10,000

On the date of payment of interest (i.e. 3rd January of the next year) following accounting entry will need to be recorded in the subsequent year:

$              $

Debit     Interest Payable               10,000  

Credit    Cash                      10,000

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                                             Prepaid Income

Prepaid income is revenue received in advance but which is not yet earned.

Income must be recorded in the accounting period in which it is earned. Therefore, prepaid income must be not be shown as income in the accounting period in which it is received but instead it must be presented as such in the subsequent accounting periods in which the services or obligations in respect of the prepaid income have been performed.

Entity should therefore recognize a liability in respect of income it has received in advance until such time as the obligations or services that are due on its part in relation to the prepaid income have been performed. Following accounting entry is required to account for the prepaid income:

Debit     Cash/Bank

Credit    Prepaid Income (Liability)

Example

ABC LTD receives advance rent from its tenant of $10,000 on 31st December 2010 in respect of office rent for the following year. ABC LTD has an accounting year end of 31st December 2010.

ABC LTD will recognize a liability of $10,000 in the financial statements of year 2010 in respect of the prepaid income to acknowledge its obligation to make the office space available to the tenant in the following year. Following accounting entry will be recorded in the books of ABC LTD in the year 2010:

$              $

Debit     Cash      10,000  

Credit    Prepaid Rent Income (Liability)                  10,000

The prepaid income will be recognized as income in the next accounting period to which the rental income relates. Following accounting entry will be recorded in the year 2011:

$              $

Debit     Prepaid Rent Income (Liability)  10,000  

Credit    Rent Income (Income Statement)                            10,000

                                           Prepaid Expense

Prepaid expense is expense paid in advance but which has not yet been incurred.

Expense must be recorded in the accounting period in which it is incurred. Therefore, prepaid expense must be not be shown as expense in the accounting period in which it is paid but instead it must be presented as such in the subsequent accounting periods in which the services in respect of the prepaid expense have been performed.

Entity should therefore recognize an asset in respect of expense it has paid in advance until such time as the services that are due in relation to the prepaid expense have been performed by the suppliers/contractors. Following accounting entry is required to account for the prepaid expense:

Debit     Prepaid Expense (Asset)

Credit    Cash

Example

ABC LTD pays advance rent to its landowner of $10,000 on 31st December 2010 in respect of office rent for the following year. ABC LTD has an accounting year end of 31st December 2010.

ABC LTD will recognize an asset of $10,000 in the financial statements of year 2010 in respect of the prepaid expense to recognize its right to use office space in the following year. Following accounting entry will be recorded in the books of ABC LTD in the year 2010:

$              $

Debit     Prepaid Rent      10,000  

Credit    Cash                      10,000

The prepaid expense will be recognized as expense in the next accounting period to which the rental expense relates. Following accounting entry will be recorded in the year 2011:

$              $

Debit     Rent Expense (Income Statement)          10,000  

Credit    Prepaid Rent                      10,000