Bank Reconciliation

1

Bank Reconciliation One of the most efficient and most commonly used tools for checking the accuracy of the bookkeeping system is a check known as the "Bank Reconciliation". This check is usually carried out once a month, at the end of the month. What is Bank Reconciliation? Let us assume for the purpose of this example that your name is Miles and that you are at the end of June xx. Your accounts show that the current account at Western Union Bank has a debit balance of $ 1,000 (as was explained, it is possible to relate to a current account as a personal account. In other words on June 30, xx, the bank owes you $ 1,000). Logically, on June 30, xx, the Western Union Bank accounts should show that you, Miles, have a credit with the bank of $ 1,000. If the balance in the Bank's accounts (as may be seen easily from the bank statement that is received each month by every business) is identical, this proves that your bookkeeping is incredibly efficient, all communications with the bank, which is usually a main component in the activities of the business, were recorded correctly. In reality, the situation is a little different. Almost always, balance at the end of the month can not be reconciled because, in the main, as a result of data that appear in only one of the systems (our bookkeeping, the bank's accounts) but not in both of them at once. The aim of the Bank Reconciliation is to attempt to locate the reasons for the discrepancies because of which the two balances are not reconciled. It is clear that after "neutralizing" the reasons for the irregularities that are the cause of the lack of reconciliation, the balances in both places must be identical. An example: For purposes of the example, let us assume that the Western Union Bank accounts are to be reconciled to June 30,xx. Details: The balance in Miles' account for the Western Union current account shows a debit balance of $ 1,000. The bank's accounts, on the other hand, show that on June 30, xx, Miles had a credit balance of $ 1,500. The reasons for the lack of reconciliation are as follows: The amounts that appears on only thebank statement: 1. A credit for interest (current account) in an amount of $ 50 for June 30, xx (not recorded in Miles' accounts). 2. A debit for bank charges for the current account in an amount of $10 as of June 30, xx (not recorded in Miles' accounts). 3. A credit for a bank error in an amount of $ 300 dated June 27, xx, that belongs to Miller. Miles' account was credited in error (similar name).

The amounts that appear only in Miles' accounts 1. A check for $ 160 that was paid to a supplier, that had not yet been paid in by the reconciliation date.

Preparing the Bank Reconciliation Statement The basic technique for finding the reason that the accounts are not reconciled is to prepare a "Reconciliation Statement", As a rule, check the following two possibilities for each item:

2 1. Does the transaction actually belong to us (Miles) - if so, if the transaction has only been recorded with the bank and not in our accounts - we must record it (the bank has already recorded it). On the other hand, it the transaction has only be as recorded in our accounts and not in the bank's accounts, a parallel record should be made on the bank section in the reconciliation statement. 2. If the transaction does not belong to us - in this case the bank's records are in error, and the bank should correct its records.

The Bank Reconciliation statement is in fact divided into 2 T accounts. The right side reflects our accounts (Miles' accounts) while the left side reflects the Bank's bookkeeping records that refer to us (in our case, it is reasonable to assume that in the records of the Western Union Bank, your account is called "Miles Account"). It is important to remember that from our point of view the current account with the Western Union may be referred to as a real account (the bank "owes" us or "is owed" by us, as may be the case. We will go on to a presentation of the Bank Reconciliation Statement: RECONCILIATION OF THE WESTERN UNION BANK ACCOUNT AS AT JUNE 30, xx

Details

Miles Accounts Current Account with the Western Union Bank

Banks' Accounts "Miles" Account Credit Debit

Debit Balance to reconciliation date, 30.6.xx Amounts appearing only on the Bank Statement 30.6.xx Credit: Interest 30.6.xx Debit: Bank charges 27.6.xx Credit: Error (belongs to Miller) Amounts that appear only in our accounts 30.6.xx Check to supplier, Not yet presented to bank

1,000

1,500

50 10 300

160 1050

Adjusted Balance as at 30.6.xx

Credit

1,040

10

460

1,500 1,040 Debit

Notice that at in preparing the Reconciliation Statement: Heading: The name of the bank for which we are preparing the reconciliation statement

3 and the date of the reconciliation (June 20, xx). First Row: A record (it is preferable to circle it or mark it in bold) of the balance that appears in our accounts and at the bank as at June 30, xx pre-reconciliation.

Amounts that appear only on the bank statement 1. Credit: Interest - The bank credited the account with $ 50 interest. From our point of view nothing has been recorded and therefore we will debit the bank with $ 50 (the Bank owes us another $ 50 in respect of the interest due to us).

2. Debit: Bank Charges - The bank has debited us with $ 10. From our point of view, the matter has not yet been recorded. It is clear that the bank is entitled to $10 (bank charges due to the bank).

3. Mistaken Credit - Deposit for Miller - The amount does not belong to us at all. The error is that of the bank. Therefore we will indicate in the bank section (the right side of the reconciliation statement) the fact that bank should debit us (this is how the bank will cancel the erroneous credit that appears in Miles' accounts). In the right hand part (Miles accounts) there is no need to record anything as from the start, we (Miles) have not made any record at all concerning the $ 300.

Amounts that appear only in our accounts. Check not yet presented- As at the date of reconciliation, the bank does not yet know that $ 160 is about to be deducted from our account. Had the bank known this, it would have debited us with this amount (debit, reducing our credit balance). The last row - the adjusted balance of $ 1,040. That is the real balance in our account today (and not $ 1,00 or $ 1,500 as appeared in the pre-reconciliation balances. The adjusted - balance - $ 1,040 - must be the same in both sections of the reconciliation statement, If the amount does not agree, it proves that we have not found the cause of the lack of agreement. Journal Entries as a result of the Reconciliation In our accounts (Miles' accounts) we have to make entries in the journal as a result of the amounts that appear on the right side of the Reconciliation Statement. The entries will be as follows: Debit 1. Debit: Western Union current account Credit: Income from Interest Current account interest - 30.6.xx

50

2. Debit: Expenses for bank charges Credit: Western Union current account Current Account Bank Charges - 30.6.xx

10

Credit 50

10

The Nominal Ledger, after the additional entries, will indeed, show a balance of $1,040 as follows: WESTERN UNION - CURRENT ACCOUNT

4 Debit

Credit

Pre-reconciliation balance Interest

1,000 Bank Charges

10

50

1,050 10 1,040

Comment: In the above example, the causes for the lack of agreement were presented at the beginning of the exercise. In real life, they must be "extracted" by comparing our bookkeeping accounts with the bank statement we received.

THE IMPORTANCE OF THE BANK RECONCILIATION If the practice in your business is to reconcile the bank statement each month, your situation is relatively good. It is reasonable to assume that your bookkeeping is good. If, on the other hand, the last Bank Reconciliation is done in your business, let us assume, retrospectively for the last six months, you almost certainly have a problem. There is a reasonable chance that your Current Account in the bookkeeping system (as well as the rest of the system) is not up to date.

Bookkeeping records For your convenience, here are the journal entries that relate to 3 subjects that we will discuss at various points. The subjects are:

Subject Salaries Income Tax Deduction at Source Value added tax

Salaries As a general rule, two Journal Entries will suffice. The first - a reference to the net payment to employees (the figures are "extracted" directly from the payroll). The second - to take into consideration the existing employer's payments (the figures are "extracted" from relevant Income Tax and Social Security forms. The Journal Entry is as follows:

1

Debit: Nathan

$ 833

$

5

. Debit: Warren Debit: Bjorn Credit Bank current account

2 .

1,290 1,330

8.9.xx - Net Salary Payments

3,278 ====

Debit: Salary expenses

4,180

Debit: Employers' tax expense 152 Debit: Social security expenses 412 Credit: Nathan Credit: Warren Credit: Bjorn Credit: Income tax deductions Credit: Social Security deductions _________ 4,744 15.9.xx - Salaries Entry 8/xx ===== = 3 .

Debit: Income tax deductions Debit: Social Security deductions Credit: Bank current account 15.9.xx - Payment of deductions, Salaries

3,278 3,278 ====

855 1,290 1,133 850 616 4,744 ==== ==

850 616 ________ 1,466 1,466 1,466 ===== ==== = ==

The Explanations for Journal Entry No. 2 a. Salary expenses - $ 4,180 The sum has been extracted from the payroll (the gross taxable total). b. Employers' tax expenses - $ 152 The sum has been taken directly from the relevant tax forms. c. Social Security expenses This is the only amount in the Journal Entry that is not extracted from another source. This amount is arrived at using the following formula:

$ Total due to Social Security (according to the relevant Social Security forms Less: Social Security deductions from

616 204

6

employees (from the payroll data)

The difference is the employer's contribution for Social Security

412 ==== ===

Comment: The three debit accounts above are normal expenses accounts. Their final destination is, of course, in the Profit and Loss Statement. d. Employees' Accounts (Nathan, Warren and Bjorn) These are normal personal accounts that are in credit at this stage, as the employees are eligible to be credited by the employer with their net salary. e. Income Tax/Social Security Deductions There are normal personal accounts in respect of the Salaries for August xx. Both the institutions (Income Tax and Social Security) are entitled to be credited by the employer with the amounts that appear in their relevant forms. Nominal Ledger Records The T accounts for the three above journal entries will look like this: Nathan A/c Debit (1) 855

Warren A/c Credit

Current A/c at Bank A/c Debit

Debit

855 (2) (1) 1,290

Credit

Bjorn A/c Credit

Salaries Expenses A/c Debit

Debit

1,290 (2) (1) 1,133

Credit

3,278 (2) (2) 4,180

Credit 1,133 (2)

Employers Tax Expenses A/c Debit

Credit

(2) 152

1,466 (3)

Social S. Expenses A/c Debit (2) 412

Credit

Income Tax Debit (3) 850

Deductions A/c Credit

Social Deductions SecurityA/c Debit

850 (2) (3) 616

Credit 616 (2)

7

The Journal and Nominal Ledger In order to illustrate the connection between the journal and the nominal ledger, we will use a simple example - a daily paper. It is reasonable to assume that before the paper was printed, news was received in the editing room in a different form. A first, the news is received in the editing room in chronological order and not according to any classification of the news items. However, when the final product (the printed newspaper) is received, the news items have been classified and concentrated according to the common denominator of each section in the paper. Let us assume that items are received in the news room (by telex from various reporters - in the following form:

EDITING ROOM

8

It may be clearly that there are 2 separate systems in the newspaper: 1. The Editing Room -is characterized by a chronological order (and not according to specific subjects). 2. The sections of the newspaper edited according to the various subjects (sport, weather, economics, politics and so on).

In the life of a business as described in bookkeeping, there are the same two systems.

1. The Journal-A textual record of events (Debit and Credit) that is characterized by the fact that all the records it contains are in a sequential chronological order.

2. The Nominal ledger Is made up of separate accounts for each matter (cash, banks, customers and so forth).

The accounts in the Nominal ledger look, technically, like the letter 'T' as was demonstrated previously at the start of this Tutorial. Let's try to describe the flow of the records in bookkeeping

9

Just as you, when you read a newspaper, go directly to the page in the paper that interests you (the sports section, the economics and so forth), when you use bookkeeping data you go directly to the relevant account in the Nominal ledger (the Max Account - will show you how much Max owes/is entitled to receive from/to pay to the business. The Cash Account will show you how much money has been received/paid out.

The Structure of the Nominal ledger At the beginning of the tutorial, it was pointed out that an account in the Nominal ledger looks like the letter T. In fact, there are additional auxiliary data in the account Let us assume that January 1, xx, we received a loan in cash from Max in an amount of $10,000. The Journal Entry will look as follows: (let us assume that it concerns a voucher for which the serial number in the journal is xx): xx Debit: Cash 10,000 Credit: Max 10,000 1.1.xx - Loan from Max, Receipt 013. The Journal Entry will be transferred to 2 accounts in the Nominal Ledger as follows:

CASH ACCOUNT Debit

Credit Or de r No .

C ont ra Acc oun t

D ate Rec ord ed

Va lu De Re e tail $ f. Da s te

L oa 1. R. n 1 28.2 xx Max 1.x 01 fro 0,0 .xx x 3 m 00 ma x

MAX ACCOUNT Debit

Credit Or de r No . xx

C ont ra Acc oun t

D ate Rec ord ed

Va lu De Re e tail $ f. Da s te

C 1. R. 1 C 28.2 ash 1.x 01 0,0 ash .xx Loa x 3 00 n

10 Let us analyze, for example, the "Cash" account. As you see in addition to the sum of $ 10,000 debited, there are other auxiliary data as follows:

1. Order Number-In our example, order xx. This is an important detail as the original document (Receipt 013) is filed under Journal Order Number xx

2. Contra Account This is the account that assisted, in the Journal entry to balance the record. If we go back to the journal entry, you will see that the contra account for the Cash is "*** Account". Therefore, in this column, we record "*** Account".

3. Date recorded The date on which the nominal ledger was updated. In the present instance, despite the fact that the event occurred on 1.1.xx, it was recorded in the nominal ledger only on 28.2.xx.

4. Value Date The date of the original document (in our case, the receipt was issued on 1.1.xx).

5. Reference This is the number of the original document (Receipt, invoice, etc.) 6. Details A short verbal description, similar in character to the details that appear in the Journal entry.

Account - Flow and Balance Let us go back a little, to the example that was explained at the beginning of the tutorial, The Cash Account (in the Nominal Ledger) looks like this: Cash

Accounts

Debit 600 700

Credit 200

We will now learn two new concepts - Flow and Balance

1. Debit Flow This is all the records on the debit side of the account (in the example before us $ 1,300) (600 + 700).

2. Credit Flow This is all the records on the credit side of the account (in the example before us $ 200).

3. Debit Balance The difference between the debit transactions and the credit transactions (when the debit transactions exceed the credit transactions).

4. Credit Balance The difference between the credit transactions and the debit transactions (when the credit transactions exceed the debit transactions).

In our example, there is a "Debit Balance" in the Cash Account (the total debit transactions exceed the credit transactions) of $ 1,100 (1300 - 200). Before we go on to a comprehensive example, we will change the reference to the "Goods Account" a little. Until now, to keep matters simple, we have referred to the Goods Account

11 as to a real account (the Warehouse Account), when on purchasing goods, we have debited the Goods Account (the warehouse 'received") and on selling goods, we have credited the Goods Account (the warehouse 'gave'). In fact, the reference to goods is different as the purchase prices ( 'in' to the warehouse) is normally lower that the price on leaving the warehouse (sale price). The correct reference to the Goods Account is as to a normal profit and loss account, as for this purpose, 2 temporary bookkeeping accounts are opened: the first "Goods Purchased" (an expense - and therefore the account will normally be debited), the second "Goods Sold" (income - and therefore the account will normally be credited). A simple example appears below (the example ignores Value added tax): 1.1.xx We bought goods for cash for a sum of $ 1,000. 5.1.xx All the goods were sold for $ 1,200 cash. The journal entries will be as follows:

Debit Credit 1. Debit: Purchase of goods Credit: Cash Purchase of Goods, Invoice ..... 2. Debit: Cash Credit: Sale of Goods Cash sale. Receipt.....

1,000

1,200

1,000

1,200

Comprehensive Example We will go on now to a comprehensive example that we will use until the end of this tutorial (in the example, we will try to imagine that your name is Miles and that you are the owner of a new business). Business data

1.1.xx We opened a new business in which we invested $ 10,000 dollars in cash. 2.1.xx We transferred $ 4,000 in cash to open a current bank account at the City Central Bank. 3.1.xx We bought office furnishings in the sum of $ 1,000 in cash. 4.1.xx We paid $ 600 in cash for office rental. 5.1.xx We bough a telephone with a check for $ 300. 30.1.xx We paid electricity expenses (by check) in an amount of $ 400. 1.2.xx

12 We bought goods with a check for $ 1,200 (ignore the Value Added Tax). 2.2.xx We sold part of the goods for $ 1,000; the money received was deposited directly into the bank account. 3.2.xx We bought more goods with a check for $ 3,000. 4.2.xx We sold all the remaining goods for $ 5,000. The money received was deposited directly into the bank account. 28.2.xx The bank credited our account with interest in the amount of $ 100.

Pay attention to the journal entries while referring to the general debit/credit table at the beginning of the tutorial.

JOURNAL ENTRIES Journal No.

Date

1.

1.1.xx

2.

2.1.xx

3.

3.1.xx

4.

4.1.xx

5.

5.1.xx

6.

30.1.x x

7.

1.2.xx

Debit Cash Owners Equity Owners Investment in Cash Current account at City Central Cash Cash Deposit Fixed assets Cash Purchase of furniture for Expenses for office rental Cash Payment of rent in cash Fixed assets City Central current account Purchase of telephone Electricity expenses City Central current account Payment of electricity Purchase of goods City Central current account

Credit

10,000 10,000 4,000 4,000 1,000

Real Personal*

Debit and Credit Rule No. 2 1

Real/Persona 1-2 l** 2 Real

1,000

Real Real

2 2

600

Temporary Real

3 2

600

300 300

400

Account Type

Real 2 Real/Persona 1-2 l

400

Temporary 3 Real/Persona 1-2 l

1,200

Temporary 3 Real/Persona 1-2 l

1,200

13

8.

3.2.xx

9.

3.2.xx

10.

4.2.xx

11.

28.2.x x

Purchase of goods City Central current account Sales of goods Sale of goods Purchase of goods City Central current account Purchase of goods City Central current account Sale of goods Sale of goods City Central current account Income from interest Income from interest, City and Central Current Account

1,000 1,000

3,000 3,000

5,000 5,000

100 100

26,600

Real/Persona 3 l 1-2 Temporary Temporary 3 Real/Persona 1-2 l Real/Persona 1-2 l 3 Temporary

Real/Persona 1-2 l 3 Temporary

26,600

Owners Equity Account A normal personal account that is in credit as the owner of the business (Miles) "is credited as eligible" to receive from the business (refer to the business as a separate body) his basic investment in the sum of $ 10,000. To differentiate between the external creditors of the business (suppliers, lenders and so forth), and the owner of the business, the prefix "Owners Equity" appears at the beginning of the name of the account. Remember that from the point of view of the business, the business owners eligibility to be credited with $ 10,000 is not as important as the financial eligibility of a normal supplier to receive $ 10,000. In the current cash management of the business, the eligibility of the owner of the business can be almost completely ignored as this obligation is not immediately repayable. ** Current Account The account can be referred to as both a real account (like Cash) or as a personal account. 1. Real account Imagine for a moment that the money in the bank is in a metal cash box that belongs to you. On depositing money, the box "received" money (received - debit) while when drawing a check the box "gave" money (gave - credit) 2. Personal Account In making a deposit in the current account it is as though the bank manager (personal) owes you money. When you draw money out of the account, the bank manager owes you less

14 than he did a moment before you made the withdrawal. (A reduction of a debit is expressed in bookkeeping as a credit transaction).

Structure of the Nominal Ledger Comment: For the sake of brevity, only the following details appear on each account page. 1. The journal entry number. 2. Name of the contra-account. 3. Description of the transaction. Cash

Accounts

Debit

Credit

1. Owners Equity Investment

10,000

2. City Central current account Deposit

4,000

3. Fixed assets - Furnishing

1,000

4. Rental expenses - Rental

600 ____________

_________

5,600

10,000

OWNERS EQUITY ACCOUNT Debit

Credit 1. Cash - Owners Investments

10,000

CITY CENTRAL CURRENT ACCOUNT Debit

Credit

2. Cash - Deposit

4,000 5. Fixed Assets - Telephone

8. Sale of goods - Sales

1,000 6. Electricity expenses - Expenses

10. Sale of goods - Sales

5,000 7. Purchase of goods - Purchases

11. Income from interest - Current interest

100

9. Purchase of goods - Purchases

_________ 10,100

300 400 2,200 3,000 _________ 4,900

FIXED ASSETS ACCOUNT Debit 3. Cash - Furniture Purchase 5. City and Central current account Telephone

Credit 1,000 300 _________ 1,300

15 OFFICE RENTAL EXPENSES ACCOUNT Debit

Credit

4. Cash - Rent

600

ELECTRICITY EXPENSES ACCOUNT Debit

Credit

6. City Central current account Payment of expenses

40 0

PURCHASE OF GOODS ACCOUNT Debit

Credit

7. City Central account-Goods purchase

1,200

9. City Central account -Goods purchase

3,000 _________ 4,200

SALE OF GOODS ACCOUNT Debit

Credit 8. City Central current account Sales

1,000

10. City Central current account Sales

5,000 _________ 6,000

INCOME FROM INTEREST ACCOUNT Debit

Credit 11. City Central current account Income from interest

Tax Deduction at Source In general, 2 different bookkeeping accounts are needed:

10 0

16 1. The "Deductions at source from suppliers" Account - the account organizes the tax that was deducted from your suppliers or service providers as well as the tax paid to the tax authorities on the due date each month. 2. The tax deducted at source from customers. = the account organizes the tax deducted from you by your customers.

Records in the "Tax Deduction at Source from Suppliers" Account Data : 1.4.xx - You paid $100 plus VAT of $15 for printing. You deducted tax at source at a rate of 20%. (115 x 20% = $ 23) 7.5.xx - You transferred a sum of $ 23 to the tax authorities. Bookkeeping records Debit 1.4.xx

1.

Credit

100 15

Office expenses Value added tax on inputs

92 23

Bank current account tax deduction at source

115

7.5.xx

2 Tax deducted at source from suppliers

115

23 23

Bank current account

23 ===

23 ===

Visually, the accounts would look as follows: Office expenses Debit

VAT on inputs

Credit 1 00( 1)

Debit

Bank current a/c

Credit

Debit

1 (1)92 5(1 )

Credit

Deductionsurce from at sosuppliers Debit (1)

Credit 23

2 3

Take care as the "Deductions at source from suppliers" account is, in all ways, a personal

(1 )

17 credit and debit account. The card indicates the amount that the Income Tax is entitled to receive from you for tax you have deducted from suppliers. The balance of the account may be in credit (before you have transferred the deductions on the due date) or it may be at zero (after you have made the payment to the income tax) but it can never show a debit balance.

Records in the "Deductions at source from customers" account Data: On 5.4.xx, you issued a tax invoice in the amount of $ 1,000 plus $ 150 value added tax. The payer deducted 20% ( $ 1,150 x 20% = $ 230). The cash balance was deposited directly into the Western Union Bank. The Bookkeeping records

Debit 5.4.x Western Union current x account

Credit

920

Customer's deduction at source Receipts VAT on transaction

230 1,000 150 1,150

1,150

Visually, the accounts will look as follows: Western Current A/c Union Debit

Credit 920

Customer'sction at dedusource Debit

Credit

Income Debit

VAT on transactions Credit 10 0

Debit

Credit 15 0

Take care as the "Deductions at source by customers" account is in all ways a personal debit and credit account. The account indicates the amount that the Income Tax owes you as a result of the fact that tax was deducted from you at source. The balance of the "deductions at source by customers" accounts may show zero if no tax was deducted from you, or it may show a debit but the account may never be in credit.

18

VALUE ADDED TAX (V.A.T.) For the purposes of value added tax records, three bookkeeping accounts must be kept. 1. The VAT on inputs account. 2. The VAT on transactions account. 3. Debit and Credit VAT account.

1. The VAT on Inputs Account - This account will usually show a debit (the VAT authorities "owe" you money for the VAT you have paid and that are entitled to receive from them).

2. The VAT on Transactions Account - This account will usually show a credit (the VAT Authorities are "entitled" to receive the VAT from you that you have collected from them. The money is not yours and it is only temporarily in your possession until the due date for the payment of VAT.

3. The VAT Debit and Credit account. This is the account to which the 2 first accounts are posted. The account balance may show a credit, when the periodic report to the VAT is for a payment to be made, or it may show a debit when the periodic report shows that that money is to be returned.

4. A simple example: 30.1.xx - The total purchases that you made amount to $ 1,000 plus $ 150 VAT on inputs. 30.1.xx - The total sales you made amount to $ 4,000 plus $ 600 VAT on transactions. 15.2.xx - You paid the balance to that VAT authorities that was owing to them. 5. The bookkeeping records will look as follows:

1. Purchases VAT on transactions Current account at bank

Debi Cred t it 1,00 0 150 1,500

(30.1.xx) Purchases recorded for January

2. Current account at bank

4,60 0

Sales VAT on transactions

4,000 600

(30.1.xx) Sales recorded for January

3. VAT on transactions VAT on inputs VAT debit and credit account

600 150 450

19 (30.1.xx) Transfer of surplus to debit & credit account 4. VAT debit and credit account Current account at bank (15.2.xx)Payment of VAT reported for January

450 450

Trial Balance After transferring the records to the Journal (Journal Entries) and from there to the account in the Nominal Ledger, the balance for each account is found (by hand or by using a computerized system). We will organize all the transactions and balance in every account in the nominal ledger into a table. This arrangement is called the Trial Balance.

Account Name Cash Owners Equity City Central current account Fixed assets Rental expenses Electricity expenses Purchase of goods Sales of Goods Income from interest TOTAL TOTAL

Debit Credit Debit Transactio Transaction Balance n 10,000 5,600 4,400

Credit Balance -

-

10,000

-

10,000

10,100

4,900

5,200

-

1,300

-

1,300

-

600

-

600

-

400

-

400

-

4,200

-

4,200

-

-

6,000

-

6,000

-

100

-

100

26,600 26,600 ======= ======= 16,100 16,100 ====== ====== = =

The expression 'Trial Balance' comes, as is shown in the table, from the fact the debit and credit columns must balance (hence the word balance). Moreover the above table constitutes a trial (check) that the records in the journal have been properly transferred to

20 the nominal ledger. It is important to point out that the fact that the Trial Balance (flow or balances) balances is not necessarily proof that the entries in the journal were recorded correctly. However, this subject is not under discussion just now. We will be content with pointing out the following main facts:

Trial Balance (Flow) In addition to the fact that the "Debit Transaction" column is identical to the "credit transaction" column, both columns must be equal to the sum in the journal (in the example before you, the journal total was $ 26,600 as well.

The Trial Balance (Balances)

This is in fact the more important of the two Trial Balances. In the Trial Balance (balances), the "Total Debit Balances" column must be identical to the "Total Credit Balances" column. Nevertheless, the column total (in our example, $ 16,100) will always be less than the journal total or the "Trial Balance (Flow)" column. As has been mentioned, the more important Trial Balance is the Trial Balance "(Balances)" as the balances are transferred directly from it to the two main statements that are prepared at the end of the year. The two statements are: A. The Profit and Loss Statement. B. The Balance Sheet. The two statements are known as the Annual Statements.

A journal entry

Up until now we have seen that each single business transaction is recorded in a journal entry which is comprised of 2 components, a debit and a credit. A complete journal entry is comprised of the following components: 1. The account that is debited. 2. The account that is credited. 3. A row of particulars - including date, the type of transaction and the number of the document that is used as a reference for the transaction (receipt, invoice, check and so forth). Care should be taken to see that the credit line is always recorded a little to the right of the debit line. The function of the Journal entry is very simple, the immediate recording, as close as possible to the date on which the transaction is carried out, of all economic activities that occur in a business in chronological order (with the recording being made in the new language we have learned, bookkeeping language, that records each single transaction twice, once as a debit and once as a credit).

21

We will take another step forward. Let us assume that in the above example there were not 5 records but 500. The question is whether we are able to obtain an immediate answer from the journal to the question, "What is the cash balance?" - It is clear that the answer is negative. For this purpose, we must go over 500 journal entries (1000 rows), and from these rows, sort out all the events in which a reference is made to the words 'Cash Account'. For this purpose, another system exists in bookkeeping that is known as the "Nominal ledger".

THE DEBIT AND CREDIT RULES Type of To Debit the Account Account When the person whose in whose name the 1. Personal account is kept is in debt to us When the account 2. Real received money/the equivalent Any account that ends Profit 3. with the words 'Expense and Loss Accounts'.

To Credit the Account When the person in whose name the account is kept is in credit with us When the account gives us money/the equivalent Any account that ends with the words 'Revenue Account'

Comprehensive Example: 1. 2. 3. 4. 5.

1.1.xx 2.1.xx 3.1.xx 4.1.xx 5,1,xx

We We We We We

bought goods from Waterman for an overall sum of $ 1,000 (Invoice No. 123). sold part of the goods for $ 600 cash (Receipt No. 1950) paid $ 200 cash for electricity expenses (Expense Voucher 001). bought a store from Max for $ 20,000 (Invoice No. 953). rented the store out for $ 700 cash (Invoice No.001)

We will practice making the bookkeeping records that are the subject of the above table (Comment: In the first part of the solution, the records will be presented in the form of a T account, and they will be presented textually in the second part. This will be explained more fully later on.

T ACCOUNTS

22

Goods Debit (1) 1,000

Cash Debit (2) 600 (5) 700

Store Debit

Account

Waterman Account

Credit

Debit

Credit

600 (2)

Account

1,000 (1)

Electricity Expenses Account

Credit 200 (3)

Debit

Credit

(3) 200

Account

Max

Credit

Debit

(4) 20,000

Account Credit 20,000 (4)

Store Rental Account Debit

Credit 700 (5)

Textual Records (Journal Entries)

Debit (1) Debit Goods Account Credit: Waterman Account 1.1.xx Purchase on credit Invoice 123 (2) Debit: Cash Account Credit: Goods Account 2.1.xx Cash Sale, Receipt 1950 (3) Debit: Electricity Expenses Credit: Cash 3.1.xx Cash payment, Expenses Voucher 001 (4) Debit: Store Account Credit: Max Account 4.1.xx Purchase of Store, Account 953

1,000

600

200

Credi t

1,000

600

200

20,00 20,00 0 0

23

(5) Debit: Cash Credit: Income from Rental 5.1.xx Cash Rental Account 001

700

700

22,50 22,50 0 0

Let's go over the entries together:

Event 1: The Goods Account (a real account) is debited - because an account was received (Rule 1 in the table). The Waterman Account, (a personal account) is credited - as it is due to receive money (Rule 2 in the table).

Event 2: The Cash Account (a real account) is debited - because the cash was received (Rule 2 in the table) The Goods Account (a real account) is credited - because the warehouse issued goods (Rule 2 in the table).

Event 3: The Electricity Expenses - (A profit and loss account) is debited - as every expense account is debited (Rule 3 in the table).

Event 4: The Store Account (a real account) is debited - the transaction received a monetary value (Rule 2 in the table). The Max Account (a personal account) is credited - according to Rules 1 or 2.

Event 5: The Income from the Rental Account (a profit and loss account) is a credit - as all receipts are a credit (Rule 3 in the table). The Cash Account is debited - according to Rule 2 in the table. Comment: It is easy to remember that every expense account is debited (the expense is a

24 negative matter from an economic point of view and it is a debt of the business).Similarly, all receipts are a credit (a credit is something positive from an economic point of view and it is to the credit of the business). An additional stage that should be emphasized is that the first part (the T - Accounts) in fact serve us as a draft for the purpose of illustrating the records. In actual fact, the bookkeeping records are only inwords, the professional term for each record being a "Journal Entry: (or a "journal voucher").

The Balance Sheet Structure The Balance Sheet logic is completely consistent with the two basic rules (the rules of debit/credit) that were demonstrated at the beginning of the tutorial.

1. Debit Side- Describes either assets that belong to the business (property, a real account, according to Rule No. 2 an asset is always a debit) or debts owed by customers to us. Customers according to Rule No. 1 - are a personal account that must be a debit (the accounting entity must have a "debt" to the business).

2. Credit Side- Describes the obligations of the business to either of two factors as follows: 1. External agencies (suppliers, lenders and so forth).

2. The owner of the business (Capital Account or accumulated profits). In either case, according to Rule 1 either the external agencies or the owner of the business are eligible to be "credited" with money from the business and therefore they are in credit.

Why does the Balance Sheet balance? In principle, there are two explanations for why the Balance Sheet must balance. 1. A Logical Explanation. The Balance Sheet is in fact made up of two parts while:

The total assets of the business (the debit side) = The total obligations to external agencies (the credit side) + the total obligations to the owner of the business. 2. An accounting explanation The Balance Sheet is made up directly from the Trial Balance (Balances) which is itself a Balance Sheet. It is clear, therefore, that if we went from a Trial Balance to a Balance Sheet, then the final result (a Balance Sheet), that also takes account of the balance in the Profit and Loss Statement, will be balanced.

Summary

25

In a graphic format, the accounting system looks like this

Survey of The Accounting System (Locating Irregularities) At this stage, now that the subject of the Profit and Loss Statement and the is quite clear, during the year, you can easily survey the Nominal Ledger and locate balances which would appear to be unreasonable. The logical test will be carried out according to the model in the following chart: Below is an example of unreasonable balances that need to be clarified with the bookkeepers:

Personal Account Loan received Loan granted Goods purchases Goods sold ....Expenses ....Receipts

Debi Credi t t + + + + + +

26

Vehicles Real Estate Customers Suppliers

+ + + +

Annual Statements At the end of each year, the bookkeeping system produces two statements (directly from the Trial Balance). Let us assume that we are concerned with the year ending on December 12, xx. The two statements will be: Statement 1 - The Profit and Loss Statement for the year ending December 31, xx. Statement 2 - The Balance Sheet as on December 31, xx. The Profit and Loss Statement In principle, it is important in the normal T account, when the debit side organizes all the accounts that end with the words "….Expense Account" while the credit side organizes all the accounts that end with the words "…. Receipts Account" and it is indeed logical that the Financial Statement is the total of all the receipts less the total expenses (Take care, as the Profit and Loss Accounts refers to a period of a year and not to the last day of the year. In other words. The Profit and Loss Statements is for the year ending on December 31, xx and does not show what the profit/loss was on the last day only, but for the entire year ending on December 31, xx) Balance Sheet In principle go back to the normal T account where the debit side shows what assets belonged to the business while the credit side shows the obligations that the business has to other agencies. Take care, as distinct from the Profit and Loss Statement that refers to the "Year ending December 31,xx" the Balance Sheet shows a photograph of the situation on the last day only. Transfer from the Trial Balance We will go back to the Trial Balance (Balances) on the previous pages. Every balance will be transferred to the Profit and Loss Statement (if an expenses/receipts account is concerned) or to the Balance Sheet, while an iron rule that must be strictly observed is - "a balance cannot change its character" (in other words, a debit balance in the Trial Balance must be transferred to the debit side, whether on the Profit and Loss Statement or on the Balance Sheet, similarly a credit balance in the Trial Balance must appear only on the credit side, whether on the Profit and Loss Statement or on the Balance Sheet.

Profit & Loss Statement for the Year... Debit Rent Expenses

Credit 600

Balance Sheet as at 31.12.xx Debit

Go 6,000 Cash od s

Credit 4,400 Owners

10,000

27 Elec.Expense s Goods Purchsd

400 4,200

_________

sal e

Bank current a/c

I nt er est re cd

Fixed Assets 100

5,200

equity

1,300 _________ 10,900 ____________

---------- ----------->

5,200

10,000

_____ _____ __

Profit for year

900 10,900

6,100 Cr edi t Ba lan ce (Pr ofi t)

900

The Development of Bookkeeping. In each area of life, techniques are developed and inventions made to answer the problems that arise therein. Thus, for example, the invention of the "airplane" provided an answer to the problem of reducing travel time between distant cities. The discovery of "canned foods" on the other hand gave an answer to the need to keep food fresh for long periods. This is similar to what happened with bookkeeping, in that it answered the severe problems that arose in managing modern commerce. It is important to remember that we are in fact talking in a new language that you have yet to learn, as you had to learn any foreign language when young. Before we go into the structure of the language, we will try to see which problems are answered by bookkeeping.

1. The problem of human memory - In a commercial business, even in the smallest business, hundreds and thousands of transactions are carried out over a year. It is obvious that without proper records, it would be difficult for you to reconstruct past transactions relying on your memory alone.

2. Determining the annual profit - Determining the precise annual profit is of the utmost importance, both to you as the owner of the business and to the Tax Authorities (Income Tax, V.A.T. and Social Security). Bookkeeping is in fact the raw material used as a basis for determining the profit.

3. Current Control - By means of up-to-date bookkeeping, it is possible to obtain current data in real time. Thus for example, you are able to use bookkeeping to obtain answers to questions of the sort: 'What is the cash balance?' 'What is the balance at the bank?' 'What credit is available to any particular supplier?', and more.

4. Business analysis - It is reasonable to assume that you will ask yourself how to increase the profits of the business. Is it possible to reduce any particular class of expense and so on It is obvious that the main tool to assist you in an analysis of this type, is the bookkeeping system.

28

We will go on to the technical part which is, in fact, the structure of the language known as "bookkeeping". As with any other language, this stage resembles learning the alphabet and basic rules of grammar and it is, naturally enough, fairly boring. Try not to skip this stage as it is actually the basis for bookkeeping language.

BOOKKEEPING CONVENTIONS Bookkeeping language is based on 2 basic conventions:

1. The Convention of the Common Monetary Denominator Try to add the following two data: Let us assume that you are deal in textiles. On the 15th of the month, you bought 13 kilogram of fabric and 17 meters of material. It is clear that adding the 2 numbers (13 and 17) amounts to 30 but it lacks all significance as the base is different (a kilogram - a unit of weight as compared to a meter - a unit of length). However, if we add the following data to the example, we will reach a logical result. Let us assume that the material is $ 1,000 a kilo or $ 50 a meter, you can state in monetary terms that you bought goods with a value of $13,850/(13 x $ 1000 = $ 13,000 plus 17 x $ 50 = $ 850, Total $ 13,850) It is clear, therefore, that the common basis for every bookkeeping record is the monetary value.

2. The "Dual Aspect" Convention. This convention is in fact at the very heart of a bookkeeping system. Let us take an example of an economic transaction done in the Middle Ages. Jo brings a kg. of fish to the market and in exchange he buys a pair of shoes from Jake. Each of the parties to the transaction "received" a certain economic value and "gave" an identical value.

3. At this stage, you are of course wondering why we have taken an example from the Middle Ages for commercial life in the 21st century. I am sorry to disappoint you but the situation is very similar today. Let's alter the previous example to suit our times. Let's assume that Jo buys a pair of shows from Jake for $ 80. We can see here as well that although we are concerned with a single commercial transaction (from Jo's point of view - buying shoes for cash, from Jake's point of view - selling shoes for cash). We are still left with the "dual aspect" convention as follows:

4.

In other words, the language of bookkeeping tends to record a single transaction in dual manner. Once, what the tradesman "received", and the second time, what that same trader "gave".

29

Jo - "received": a pair of shoes and "gave" a kilo of fish

Jake - "received" a kilo of fish and "gave" a pair of shoes

5. At this stage, you are of course wondering why we have taken an example from the Middle Ages for commercial life in the 21st century. I am sorry to disappoint you but the situation is very similar today. Let's alter the previous example to suit our times. Let's assume that Jo buys a pair of shows from Jake for $ 80. We can see here as well that although we are concerned with a single commercial transaction (from Jo's point of view - buying shoes for cash, from Jake's point of view - selling shoes for cash). We are still left with the "dual aspect" convention as follows:

6.

In other words, the language of bookkeeping tends to record a single transaction in dual manner. Once, what the tradesman "received", and the second time, what that same trader "gave".

Jo - "received" goods (shoes) and "gave" money

Jake - "received" money and "gave" goods (shoes)

7.

In other words, the language of bookkeeping tends to record a single transaction in dual manner. Once, what the tradesman "received", and the second time, what that same trader "gave".

The Double Entry Convention

In bookkeeping, each single" commercial transaction is recorded twice. On the "Received" side and then again on the "Gave" side

1. DIVIDING THE TRANSACTION INTO SUBSIDIARY COMPONENTS Bookkeeping Does not refer to a business as a single unit but as a body that contains a number of subsidiary units with a particular person being responsible for each

30 subsidiary unit. In order to organize the business activities, we will take a separate sheet of paper that will organize all the activities that are connected to the person in charge. So for example, the Cash Page - will describe everything connected with the cashier, the Goods Page - will describe everything that is connected with the warehouseman, while the Bank Page - will coordinate all that is connected with the person that deals with the banks. Event 1 - We bought goods for $100 cash. Event 2 - We transferred $60 in cash to our bank account. Event 3 - We bought goods from a supplier for $30 that we took out of cash. The bookkeeping records are as follows: Event 1:

Goods Page Received

100 (1)

Warehouse man Gave

Cash Page Received

Cashier Gave

100 (1)

The explanation is very simple: The Goods Page - that describes the events from the point of view of the warehouseman - received an economic value of $ 100. The Cash Page - that describes the event from the point of view of the cashier - gave $ 100. Comment - The decision that the left side of the page reflects "Received" while the right side shows "Gave" has no logical explanation and it is a convention adopted for the sake of uniformity only (rather like the rule that all vehicles travel in the right lane on the roads in most countries, a safety regulation that affects everyone in principle (uniformity). Further Comment: The professional expression for each bookkeeping page is not the "Goods Page" and/or the "Cash Page" but ACCOUNT (as distinct from an account submitted to a supplier for goods or services he :gave" or a tax invoice), somewhat similar to the expression "Report". From this stage on, we will use the expressions "Goods Account" and Cash Account" and so on. Event 2: Let's sketch "Accounts" (pages). It is obvious that the relevant accounts are: the "Bank Account that describes what happened in the transaction from the point of

31 view of the person in charge of the account with the bank and the "Bank Account". The record will look as follows:

Goods Page Received

Warehouse man Gave

Cash Page Received

60 (2)

Cashier Gave

60 (2)

Event 3: The record will look like this:

Goods Page Received

30 (3)

Warehouse man Gave

Cash Page Received

Cashier Gave

30 (3)

In actual practice, the account looks somewhat different. The three sides are removed from the original account and the resulting format resembles the letter 'T'. In fact, the custom is to call accounts by the name 'T Accounts'.

Bookkeeping Course: TYPES OF ACCOUNTS

32 1. PERSONAL ACCOUNT - Any account that bears the name of a particular person (including, of course, names of companies, suppliers, customers and so forth). For instance, the Walters Account, the Mortimer Account, the Calvin Motors Ltd. Account, and more.

2. REAL ACCOUNT - Any account for which that recorded on the account can be really verified. For instance, the Cash Account (if the Cash Account shows that we received $ 80, then we can check physically to see if we have $ 80 in cash). Another example is the Goods Account. If the Account shows that we received goods worth $ 100, then goods to that value should be physically present in the warehouse.

3. PROFIT AND LOSS ACCOUNT- Any account that describes an expense or receipts (the name of the account will always be followed by the words ' ... Expense Account' or '... Receipts Account'}. Until now we have learned that the left hand side of the account is called 'Received' and the right hand side is called 'Gave'. The correct expressions that are used in the profession are: The left hand side (the 'Received' side)- the Debit Side. The right hand side (the 'Gave' side)- the Credit Side. Moreover, there are clear rules as to when to debit the account (that is to say, to enter the record on the left hand side) and when to credit the account (that is to say, to enter the record in the right hand side). We shall use the following tables and the example that follows it to help us understand more fully: