It’s important to understand the theory behind bookkeeping to be able to process in the most accurate manner. Below is our ultimate guide to double entry bookkeeping, chart of accounts, and journals. We hope it will provide insight into why bookkeeping is so important and give definition to terms you may have heard but not fully understood.
Simple double entry principles
There are many ways of remembering debits and credits. Here is one example:
The Balance Sheet
The balance sheet provides information relating to money owed out and money owed in (or items of value).
- Debit = a debtor (customer, also known as Accounts Receivable) or something of value ie a fixed asset or stock. Also known as Accounts Receivable.
- Credit = a creditor (supplier, also known as Accounts Payable) or someone you owe money to such as a bank or loan company
The Balance Sheet is made up of the following sections:-
Fixed Assets
Items bought of significant value that are expected to remain in the business for more than one year. For example, property, vehicles, office equipment, fixtures and fitting, machines etc.
Current Assets
- Money owed to you typically from customers
- Money you have at your disposal – bank balance; petty cash
- Items of value that can be turned into cash such as stock
- Prepayments – money paid, or invoices received in advance of a service.
Current Liabilities
- Money owed by you – for example suppliers and HMRC
- Short term loans (a year or less) or this year’s expected payments from a longer term debt
- Accruals – expected costs that have not been invoiced or paid
Long term Liabilities
The value of loans covering more than one year. For example on the first day a 5 year loan, 4 years value will be shown here. The first year’s liability will be shown in the current liabilities.
Capital and Reserves (also referred to as Financed By or Equity)
For all companies, the company’s profit/loss from the beginning of trading until the point you prepare the balance sheet will be shown here. Prior years’ profits/losses are often referred to as “retained earnings”.
For a sole trader or a partnership, your “Drawings” will be shown here. This includes money you have taken from the business and money you have put back into the business.
For a limited company, including a limited liability company, the value of the company shares will be shown here.
The Profit and Loss
The Profit & Loss gives information relating to the income and expenditure of the company. It represents the day to day trading of the company.
- Debit = expense
- Credit = income
As a minimum, a Profit and Loss should contain an income section and an expenditure section.
You may also want to consider splitting the expenditure into the following:-
- Cost of Sales – items you buy to sell on
- Direct Costs – the cost of selling the goods ie carriage; advertising
- Overheads – costs which don’t have any direct relationship to sales such as premises running costs; bookkeeping
The Bank
The bank account can often be confusing because during bookkeeping, money paid into the bank is entered as a debit and money paid out will show as a credit.
This is because, when we pay money into the bank, the bank becomes our debtor – they are holding our money and therefore owe it to us.
When we draw money from the bank, the bank becomes our creditor because we owe the money.
When the bank sends a paper statement or you look at your online bank statement, they are showing an extract from their books. When you pay money into your account it will credit the bank’s books because you are their creditor and they owe you the money. So in effect, an extract of the bank’s books shows the debits and credit the opposite way around to your books. If you owe the bank money, in your books you will show as a creditor (credit) and in their books, they will show as a debtor (debit).
So in your books:-
- Money out = Credit
- Money in = Debit
Bank accounts belong to the Balance Sheet so therefore a credit is something owed by you and a debit is something of value.
Debtors’/Creditors’ Control Account also known as Accounts Receivables and Payables
Debtors’ control account = Accounts Receivable
Items entered here have firstly been entered into the sales ledger. Transactions you find in this account include sales invoices, sales credits notes, invoice payments and payments on account – the same transactions you find in the sales ledger.
Creditors’ control account = Accounts Payable
Items entered here have firstly been entered into the purchase ledger (or ‘bills’ depending on your software). Transactions you find in this account include purchase invoices, purchase credit notes, invoice payments and payments on account – the same transactions you find in the purchase ledger.
- The Debtors’ Control Account (or Accounts Receivable) is an exact monetary reflection
of the Sales Ledger. - The Creditors’ Control Account (or Accounts Payable) is an exact monetary reflection of the Purchase Ledger (or bills, depending on your software).
Journal Entries
Many transactions are posted automatically into the nominal ledger by the software. In particular, transactions entered through the Sales Ledger (Customers); the Bank and the Purchase Ledger (Bills or Purchases) are updated automatically into the Nominal Ledger.
Your software is pre-programmed with where to post the Gross Value and the VAT of a transaction arising from these ledgers. The user defines where the net value is posted and the transaction may be split across any number of nominal codes. Your software is also programmed to know whether the nominal transaction(s) should be a debit or a credit.
Posting directly to the Nominal Ledger
Transactions can be posted (or entered) directly into the nominal ledger. These are called “Journals”. There must always be a debit and a credit of equal value in a journal – your software will not allow you to save the transaction unless the total debits equal the total credits.
Journals are not required often as most day to day transactions are entered via the Sales Ledger, the Purchase Ledger or the bank. Journals are most often used to move values from one nominal code to another such as year end adjustments by the Accountant.
A common journal is the ‘Payroll journal’ where the liability created by calculating your wages is entered into your accounts.
Sage 50/Xero/Quickbooks Users – payroll journal
Note that if you use Sage 50 payroll to calculate your wages, a journal may not required as the payroll has an optional link to the Accounts. You may wish to customize the nominal codes it uses.
If you use Xero or Quickbooks for your payroll, the journal is automatically entered for you when you finalise the payrun. You can customize the nominal codes they use.
To post a journal
Sage 50
Xero
Accounting > Manual Journals
QuickBooks Online
New > Journal Entry
Reversing Journals using a different date
Some journals need to be reversed for accounting reasons. This is because different values need to be posted within different periods.
Here is an example of using a reversing journal:-
A subcontractor invoices £1,000 every month but he was late with his invoicing in January and it came in dated 1st February. His February invoice arrives dated 29th February. When we look at the P&L, we have no cost in January and we have £2,000 cost in February.
Journal
Date 31st January
P&L Subcontractor nominal code Dr £1,000
Balance sheet accruals code Cr £1,000
Reverse at 1st February
This adds £1,000 cost into January and takes £1,000 out of February.
Using the Autoreverse date facility means you only have to enter one journal but the system will process two journals. The system will enter the first journal as you have typed it in dated 31st January and then enter a second journal, reversing the debits and credits dated 1st February. It’s a time saving feature.
The Chart of Accounts – Specific to Xero
To access Nominal Ledger codes or “Account Codes”, click on the company name at the top left and select Settings. Then select the link “Looking for Advanced Settings?” followed by Chart of Accounts.
Tip: Click on the star next to Chart of Accounts. Next time you want to open the Chart of Accounts, you will find it under the Accounting Menu.
Account Records
Each account has several options:-
- Account Type – the location within the balance sheet or profit and loss
- Code – a short code to assist with designing your nominal structure. Not very important in Xero but a required field.
- Name – a short name to describe the account
- Description – optional but can be useful to explain how and when the code should be used. This description is not shown when posting transactions and so it’s questionable whether it’s worth completing it.
- Tax – The default tax code to be used when this code is selected. This can be overwritten when entering transactions.
- (Tick box) Show on dashboard watchlist – When ticked, the balance of this account will show when you first log in to Xero
- (Tick box) Show in expense claims – When entering an expense in either the web-based software or the app, only those accounts with this box ticked will show as an option.
- (Tick box) Enable payments to this account – Useful for Directors’ Loan accounts and petty cash accounts. When ticked, this account will show in the list of bank accounts when making payments.
Changing an Account
From the Chart of Accounts, click on the account to be changed. You can change the account type, the code, the name, the description and the tick box options.
To Add a New Account
Click Add Account from the top left of the Chart of Accounts and complete as required.
Default VAT Codes
A VAT code is assigned to each account, this can be changed by opening an account, making the change then saving the account. To change the VAT code for multiple accounts, from the Chart of Accounts, select the ones to be changed by clicking into the tick box to the left of each account. Then select Change Tax Rate, select the code and save.
Exporting and Importing the Chart of Accounts
If there is considerable work to be done on the Chart of Accounts, such as multiple tax code changes, different tick box options, new accounts, deletion of accounts etc, you may want to consider exporting the Chart of Accounts. This is much quicker than changing each individual account.
By clicking Export from the Chart of Accounts, the complete Chart of Accounts is exported to Excel where changes can be made quickly and easily. Once the changes have been made, click Import from the Chart of Accounts and the changes will be applied instantly. This system works even if you have been using the chart of accounts and there are balances within the codes.
Journals – Specific to Xero
Journals are found in the Advanced Settings and are used to make adjustments to your accounts that do not affect your sales ledger, your purchase ledger or your banks.
Typically journals are used for the following:-
- Year end adjustments
- Accruals and prepayments
- Payroll liability
Journals are found in Advanced Settings:-
- Click on the company name at the top left
- Select Settings then “Looking for Advanced Setting”
- Manual Journals
Tip: Click on the star next to Journals. Next time you want to open Journals, you will find it under the Accounting Menu.
Journals can be created, drafted, copied, repeated, amended and voided.
To create or draft a journal, select the New Journal option. To create a repeating journal, click on New Repeating Journal.
Journals can also be reversed automatically on a specified date.
To copy, amend or void a journal, open an existing journal and select options at the top right.
Comments