CIMA BA3 Study Text

Fundamentals of Financial
Accounting

Chapter 5
Recording Transactions
 Chapter 5 Recording Transactions

1. Introduction
Just as ‘money makes the world go round’ in our modern consumer-
capitalist society, the concept of double entry bookkeeping keeps the
accounting system running!

Although accounting is kept logical by the double-entry process, it can be

confusing to implement and understand at times.

So far we know that transactions are initially recorded in the daybooks

before they get to the individual ledgers (e.g. sales ledger, purchases ledger,
nominal ledger).

We also know that the nominal ledger uses the principle of double-entry
bookkeeping. It’s therefore vital that accountants learn how to use double-
entry in all scenarios.

To tackle this issue, we're going to take a look at how certain kinds of
transaction are recorded in the nominal ledger accounts. Specifically,
discounts, sales tax and accruals and prepayments, employee pay and bad
and doubtful debts.

First, however, let’s recap the DEAD CLIC process of double entry and think
about the different kinds of accounts we use in the bookkeeping process as
this is vital to being able to tackle this chapter.

2. Methods of transaction
There are several different ways that transactions can be made.

Cheque

A person making out a cheque is referred to as a drawer. The drawer

makes a cheque out to a payee. So, when Business M writes a cheque to
the landlord for rent, Business M is the drawer and the landlord is the
payee.

The transaction is recorded in to the drawer’s (Business M’s) ledger right

away, whilst the cheque is sent to the payee (the landlord). Once the payee
receives the cheque, they will pay it into their bank using a paying-in
slip.

The payee's bank then makes sure there are sufficient funds in the drawer's
account before processing the transaction.

When the funds are transferred between the accounts, the cheque has
been cleared. If a cheque does not clear (due to insufficient funds) then
it may be returned as dishonoured.

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BACS (Banker's Automated Clearing System)

Rather than waiting around for a cheque to be cleared, we can use BACS to
make automated payments by providing a list of payments to be made at a
specific time. This essentially 'cuts out the middle man' and saves time by
having a bank make immediate transfers.

On the downside, this only applies to one-off transactions. So if Business M

wanted to make a regular payment of rent to the landlord using BACS, this
payment would need to be performed manually each month, which could
become bothersome.

Direct Debit or Standing Order

Similar to BACS, although the key difference here is that a direct

debit/standing order can be totally automated. So if Business M has a
regular payment such as rent, the business can arrange to have this paid
automatically on a set date every week/month/etc.

Bank-Initiated Transactions

And finally, we have bank-initiated transactions, which are the transaction a

bank will make on its own behalf for charges incurred when using their
services (such as overdraft fees, processing, account maintenance etc.).

3. Account types
The ledger runs on a system of double-entry. The concept of DEAD CLIC
helps us to decide how to record particular transactions, so that they are in-
line with the double-entry process.

We know that if a transactions shows an increase in an asset, it should be

debited to that asset account, because we always DEBIT an INCREASE in
assets.

For example, if a company makes £100 from sales, and this money goes into
the company bank, the company bank account (which is an ASSET account)
should be DEBITED with £100.

Generally, assets and liabilities are fairly easy to distinguish from one
another. But what about all of the other types of accounts mentioned in
DEADCLIC? What are expense accounts, drawings accounts, income accounts
and capital or equity accounts?

Let’s look at some simple explanations:

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 Chapter 5 Recording Transactions

Debit an increase in:

• Expense accounts. These are accounts which represent money going

out of the business to pay for operations. e.g. rent, salaries.

• Asset accounts. These are accounts which represent things that a

company owns, which hold monetary value. e.g. machinery, property.

• Drawings accounts. These are accounts which represent amounts of

money being taken from the business by its owners.

Credit an increase in:

• Liabilities accounts. These are accounts which represent money that

a company owes. e.g. bank loan, receivables.

• Income accounts. These are accounts which represent the money

coming into the business as a result of goods or services sold.

• Capital accounts. These are accounts which represent money invested

by or due to owners.

Let’s have a look at some examples:

Type of account Examples

Bank fees, cost of goods sold, advertising, office

Expense
supplies, asset losses

Accounts receivable (due from customers), bank, cash,

Asset inventory, land and buildings (often known as PPE –
Plant, Property, Equipment)

Drawings Drawings

Accounts payable (to suppliers), bank loan, credit

Liability
card, mortgage

Income Sales, interest, investment income

Capital Net Income (Retained Earnings), equity paid into the

business

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So, if the transaction shows an increase in money coming INTO either an

expense account, an assets account or a drawings account, it should be
DEBITED to that account.
On the reverse of this, if the transaction shows an increase in money coming
INTO a liability account, an income account or a capital account, it should
be CREDITED to that account.

4. Discounts
Now, let’s look at how we account for discounts.

A discount is a reduction in the price of a product or service. It’s likely

you’re familiar with the concept of discounts; most people will have
purchased items from stores or online retailers at a discounted price before.

A business can issue and receive discounts, which fall into the following
categories:

Trade discounts

This is a discount which is intended to be used on products sold to people

who will then sell them on again (e.g. if you own a corner shop and buy
newspapers from a wholesaler).

It is the net value of the product after its discount that is recorded in the
ledger.

Example

Let's say John buys a bicycle for his bicycle shop from an online company,
OBC. The bicycle has a listed price of £400, subject to a trade discount of
25%. This makes the value of the discount £100, which is subtracted from
the listed price, leaving the net value of the bicycle at £300.

John's nominal ledger: In John's ledger, the purchase expenses account is

debited with £300.

Purchasing inventory or stock is a cost involved in running John’s business. It

is therefore an Expense which is a Debit using the DEAD CLIC rule.

He will now owe this money to OBC though, a Liability which is a Credit
using DEAD CLIC.

Dr Purchase expenses £300

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Cr Payables (OBC) £300

Note how it is the net value of the product after its discount that is
recorded in the ledger.

OBC's nominal ledger: Meanwhile, in OBC’s books, their sales account is

Credited with the £300 they will receive from John because this is Income to
them (DEAD CLIC).

On the other side of the double entry they are owed money from John (a
receivable). Increasing an Asset is a Debit (DeAD clic).

Dr Receivables (John) £300

Cr Sales £300

Cash discounts

Cash discounts are discounts which apply for a limited time. They are
used to encourage trade customers to pay for goods in cash at the time of
(or soon after) a sale (rather than the credit this is traditionally offered to
trade customers).

The problem with cash discounts is that they are often taken after the
original transaction is booked. e.g. Book a purchase of £100 on the purchase
date, but then receive the discount a day or two later – another transaction
which also needs to be recorded. Let's see how this works.

Example

The Online Bike Company, OBC, sell goods on credit (meaning customers can
buy now, pay later). They offer a cash discount of 10% for payments made
within 5 days of purchase, on top of their trade discount.

At the time of his purchase, John isn't sure if he can afford to make the
payment within the cash discount time frame, and so he records the price of
the bike in his purchases and OBC's payable accounts as the list price of
£300.

He fills out his accounts using the same method as we saw previously for a
credit purchase:

Purchase expense
01st Jan Payables (OBC) 300

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Payables (OBC)
01st Jan Purchase exp. 300

However, the next day, John finds that he can afford to make the payment
in time to receive the discount, and so pays OBC the discounted sum of
£270.

Firstly let's record the £270 payment. Paying out of the bank is reducing an
asset and so it is a credit to the bank ledger. This will look like this:

Bank
02nd Jan Payables (OBC) 270

On the other side of the transaction John reduces the amount owed to OBC
as he's now paid them.

Payables (OBC)
nd
02 Jan Bank 270 01st Jan Purchase exp. 300

However, notice now that we've still got £30 left as owed to OBC. That's
obviously wrong as John has taken the discount so does not owe them
anything!

A final adjusting entry is required. The £30 discount John has received from
OBC is classed as income in his accounts. We credit this increase in income
(dead ClIc) into a discounts received account. This account shows the
discounts John has received from suppliers.

Discounts received
02nd Jan Payables (OBC) 30

The corresponding double entry is a debit entry in the payables account.

This reduces the amount the John owes to OBC.

Payables (OBC)
02nd Jan Bank 270 01st Jan Purchase exp. 300
02nd Jan Discounts received 30

So the payables account is now zero, as it should be as nothing is owed to

OBC by John.

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 Chapter 5 Recording Transactions

In OBC’s books, the discount allowed to John is debited as an expense (DEad

clic) in a discounts allowed account, with a corresponding credit entry in
the receivables account to reduce the amount John owes to the company.

5. Sales tax
What is sales tax?

Almost all items that are sold have sales tax attached to them. Therefore,
if you have ever purchased an item before, it is very likely that you have
paid sales tax.

In the UK this tax is called Value Added Tax (VAT) and is typically included in
the price of the item, if it applies to that item. But in other countries, such
as the USA, sales tax is not usually included in the price of the item, and is
added to the bill when a transaction is made.

Who pays sales tax?

Businesses and individuals pay sales tax when they purchase items. A
business will pay sales tax on the items it purchases from suppliers, and will
receive sales tax on the goods it sells to customers.

However, the sales tax that a business receives from customers does not
belong to the business – it is a taxation amount that goes to a taxation
authority, and it ultimately paid to the government.

For example, let’s say Mr T purchases an item for £500 from Company O.
Let’s say there's 25% of sales tax included in that payment.

So how much tax was paid? Your initial instinct might be to say well, it's 25%
of £500 which is £125. But you'd be wrong!

Tax is paid on the before tax amount. In this case the sales amount was
£400, and the tax rate of 25% means that there's £100 (£400 x 25%) of tax.

This can be shown as follows:

Final amount paid after tax = Sales value before tax x (1 + tax rate)
= £400 x (1 + 0.25)
= £500

Rearranging this formula, if we are given the final amount we can always
work out the original amount as follows:

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Final amount after tax

Sales value before tax =
(1 + tax rate)
£500
=
(1 + 0.25)
= £400

So, for this purchase from Mr T, Company O owes £100 to the tax
authorities.

The amount a business 'receives' in sales tax from customers does not
affect the revenue of that business, since sales tax goes straight from the
business to the taxation authority.

£400 in revenue from this sale to Mr T, and £100 in tax liabilities (the
amount is a liability since they owe it to an external party).

Tax reclaimable on purchases

Equally, a business will pay sales tax on goods that it purchases.

If the business is a registered business, the sales tax amount will be able to
be reclaimed from the tax authorities. By this we mean that the amount of
sales tax a business has paid to other companies will be deducted from
the amount of sales tax they owe to the tax authorities.

So, let’s say when Company O buys stock from their supplier for a total of
£400 and there is a 25% sales tax. Let's calculate the original amount:

Final amount after tax

Sales value before tax =
(1 + tax rate)
£400
=
(1 + 0.25)
= £320

£80 was sales tax. That means, this £80 will be able to be claimed back from
the tax authorities.

So, remember that when Company O sold Mr T some goods, they received an
£100 payment of sales tax from him. They now owe this to the tax
authorities.

But, since Company O is also owed £80 from the tax authorities for the
purchases it made, we can offset these two amounts against each other:

£100 - £80 = £20

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So because of these two transactions, Company O only owe the tax

authorities £20.

So, as we have seen, during the course of trading, a business will both pay
and receive sales tax. A business will keep track of all the tax they have
paid to suppliers and all the tax they have been paid by customers, and
offset these two amounts against each other to get an overall amount of
sales tax owed to them, or that they owe to the authorities.

Output vs input tax

Now another thing to note is that the tax a company receives from its
customers is called ‘output tax’ and the tax that they pay to their
suppliers is called ‘input tax’.

Let’s revisit Company O. The £100 that they owe to the tax authorities from
their sale of goods to Mr T, is their output tax.

The £80 that they are owed from the tax authorities is their input tax.

Think of it like this: sales tax received from customers is paid on goods
going OUT of the company and is therefore output tax, and sales tax paid on
purchases is paid on goods coming IN to the company and is therefore input
tax.

Accounting for sales tax

When it comes to accounting for sales tax, the value of goods must be
recorded separately from the sales tax. This is because we use the value
and cost of goods to calculate the net profit for a business in a given period,
and this should not be affected by the amount of tax paid or received.

Example

Let's return to Company O. Company O sell bicycles in their shop to many

different customers. Company O also often purchase bikes from the same
online bicycle retailer that we looked at earlier, OBC.

Below is a list of transactions in which Company O have been recently

involved (figures are before sales tax):

01st November: Company O purchases £800 worth of helmets from OBC for
cash, with a 25% trade discount.

03rd November: Company O makes sales on helmets of £60 to Alan Barker

(AB) for cash. These originally cost O £30.

Each transaction is subject to the standard sales tax of 20% which is not
included in the figures above.

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Solution

With regards to the first transaction, we know that Company O made of

£600 from OBC. The original price for the items was £800, but Company O
received a 25% discount, giving us:

£800 x 0.75 = £600

Company O will have had to pay sales tax on this transaction. We know that
sales tax is not included in the amounts shown and is charged at 20%, so:

£600 x 1.20 = £720

Therefore, the total amount Company O paid for the goods was £720
including sales tax. We know that the sales tax and the purchase price have
to be recorded separately:

• £600 purchase price

• £120 sales tax

Now, the total amount that has left the bank account as a result of this
transaction is £720, so this amount needs to be credited to the bank
account, since the bank account is an asset account and a decrease in assets
is always credited.

So the bank account will look like this:

Bank
01st Nov Inventory 600
01st Nov Sales tax 120

Now we also have to enter these transactions into the inventory account (to
recognise the asset – note increasing an asset is a debit) and the sales tax
account.

Inventory
01st Nov Bank 600

Sales tax
01st Nov Bank 120

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The sales tax account is an asset account (as it's money owed from the tax
authorities), and an increase in assets is also always debited (DeAd clic).

Now, let’s try the same process with the sale of goods to AB. As the table
shows us, the amount that AB paid for the goods was £60, and on top of this
he paid £12 sales tax, making the total £72:

£60 x 1.2 = £72

Therefore, the whole £72 amount needs to be accounted for.

Because this is a sale made by company O, the money received goes INTO
the bank. Because the bank account is an assets account, an increase is
debited (DeAd clic). Therefore £72 is debited into the bank account:

Bank
03rd Nov Sales 60
rd
03 Nov Sales tax 12

The sales account is an income account, and an increase in income is always

credited (dead ClIc):

Sales
03rd Nov Bank 60

The other £12 is recorded in the sales tax account. The sales tax account is
an asset account, a decrease in assets is always credited:

Sales tax
01st Nov Bank 120 03rd Nov Bank 12

And just like that, the sale of goods to AB is also accounted for.

However we also need to take account of the fact that that sale also means
that inventory has been sold so there's a reduction of an asset (credit). The
asset cost £30, and this become an increase in an expense (DEad clic)

Inventory
st
01 Nov Bank 600 03rd Nov Expenses 30

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Expenses
rd
03 Nov Inventory 30

Note therefore that the total profit gained on this transaction was £60
(sales) less £30 (expenses) = £30.

Summary – sales tax

As we have seen, once both transactions have been accounted for, the sales
tax account looks like this:

Sales tax
01st Nov Bank £120 03rd Nov Bank £12

From these two transactions there is a debit balance (an asset) of £108. If
there were no other transactions this could be reclaimed from the tax
authorities.

Non-current assets and expenses

Just like the purchasing of current assets (assets which can be used up in
the short term such as money and inventory), when a company purchases
non-current assets (long-term assets such as buildings, machinery and
land), they are ordinarily able to reclaim any sales tax paid on these
items back from the tax authorities.

There are some exceptions as to what kinds of sales tax expenditure can be
claimed back, however. The specific rules around this vary depending on the
country in which the business is trading.

For example, if a business in the UK pays for a company party for customers,
the sales tax incurred on paying for the party is not refundable because
there is no exemption from sales tax on entertainment expenses in the UK.

Tax returns

A tax return is the document on which a summary of the tax position over
a period of time is shown. This is then submitted to the tax authorities. It
is usually necessary to list taxes paid and taxes received separately and
so a business will usually have separate accounts for input sales tax and
output sales tax (and not combine them as we did in the Company O
example.)

Non-registered businesses

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If a business is particularly small, or the nature of the product or service

they provide is of a certain kind, they will not have to charge sales tax to
their customers and thus are known as non-registered businesses.

This also means that they cannot claim back sales tax on their purchases.
In this case, the non-registered company will not have a sales tax account
and will instead include the sales tax in the price of the product.

Zero-rated and exempt supplies

The sale of some goods and services are charged at a rate of 0%, and we call
these goods zero-rated products (e.g. in the UK, books are one example).
Businesses that supply these goods or services are able to put zero sales
tax on their outputs, and can still claim tax refunds on their inputs.

It is also possible for the sale of certain goods and services to be exempt
from sales tax altogether (e.g. In the UK, private healthcare). In some
cases, a business that is exempt from sales tax altogether may be at a
disadvantage because they are unable to claim a refund on the taxes they
pay when making purchases. This will affect the overall profit, since the
sales tax will be added to their cost of sales making it more expensive. This
will serve to bring down profit.

6. Corporation tax
Corporation tax in the financial statements

Corporate entities pay tax on their taxable profits called corporation tax.

Unlike sole traders, for whom tax is a personal expense, companies need to
show their tax in the financial statements. This is done via the creation of a
taxation expense account and a taxation liability account. Let’s explore
these in some more detail.

Tax estimates

As with many other payments by a company, taxation payments do not

necessarily relate to the accounting period in which they are made. At
the time of preparing the financial statements, the final taxation liability
for the period is not yet known. Confirmation of the final value must await
the submission of the corporate tax return and any enquiries made by the
tax authorities. This can take a while, particularly if the authorities do not
agree!

Due to these necessary time delays, an estimate of the corporation tax

payable for the period is made at the time of preparation of the financial
statements and included within them. This means that the taxation figure in
the statements in each year is usually subject to some adjustments.

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This means that there are generally two elements to the tax charge in
the accounts for any period:

• Tax payable for the current accounting period - This will be the tax
estimate that we mentioned a moment ago, since tax for the current
period will only ever be confirmed by the authorities in a later
period.

• Adjustments to the tax charge for previous accounting periods -

These will be any changes required to the tax charge based on
differences between the estimated tax and the final amount that was
paid.

Tax accounting

The corporation tax is debited to a tax expense account based on the

estimated tax payable for the year.

The balance on this account is shown on the statement of financial position

(balance sheet) at the accounting year end as a taxation credit or debit,
depending on whether we owe tax, or are owed a refund:

For example:

Dr Taxation expense £11,150

Cr Tax liability £11,150

Here, we have a simple example where we debit a current taxation charge

of £11,150 in the profit and loss account and credit a tax liability of the
same amount in the statement of financial position (balance sheet).
Remember though, this figure is our estimate, and it may change once the
tax authorities have reviewed it.

Making adjustments

Okay, so let's say we submit our tax computation for this first year (let's call
it Year 1), but it isn't until the following year (Year 2) that the tax
authorities get back to us and decide that our final tax liability for Year 1
should have been £12,000. We take a look at their calculations and decide
that they are correct and agree on £12,000 as the tax liability for Year 1.

In addition, we have now come to the end of Year 2 and have calculated a
new tax liability of £13,500 for the year.

So now what? How to we make the adjustment? Let's summarise:

Year 1 (£) Year 2 (£)

Current tax estimate 11,150 13,500

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Final tax payable 12,000 -

Tax adjustment required 850 -

For Year 2, we are going to charge current tax of £13,500 as usual, but we
are also going to include an adjustment of £850 in respect of Year 1. This
means the taxation liability for Year 2 is £13,500 + £850 = £14,350.

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