Accounting (9706) | The accounting system

Welcome to Chapter 1.2: The Accounting System

Hello future accountants! This chapter is where we build the essential foundation for everything else you will study in AS Level Accounting. Don't worry if terms like 'debit' and 'credit' seem confusing right now—they are just simple rules for organizing information.

Understanding the accounting system is like learning the grammar rules of a new language: it tells you how to record transactions so that they make sense and can be used to prepare accurate financial statements. Let's dive into the fundamental engine of accounting!

1. The Core Engine: Double Entry and the Accounting Equation

1.1 The Principle of Double Entry

The entire structure of accounting rests on the principle of Duality (we’ll look at this concept later). Every single business transaction affects at least two accounts. This is the Double Entry System.

Imagine you buy a textbook for $50 cash.

• Your Cash Account goes down.
• Your Stationery Expense Account goes up.

Because every transaction has two sides, the entire accounting system remains perpetually in balance.

How Debits and Credits Work

In Accounting, we use two simple terms: Debit (DR) and Credit (CR). These are not synonyms for "good" and "bad" or "increase" and "decrease." They simply represent the left and right sides of an account.

To know whether to debit or credit an account, use the following rules based on the type of account:

The DEAD CLIC Mnemonic
This is a super helpful memory tool to remember when to debit or credit an account type when it increases:

D E A D: Accounts that Increase with a Debit.
(Drawings, Expenses, Assets, Debtors/Receivables)

C L I C: Accounts that Increase with a Credit.
(Creditors/Payables, Liabilities, Income/Revenue, Capital)

If an account decreases, you do the opposite!

1.2 The Accounting Equation

The double entry system ensures that the Accounting Equation always holds true. This equation summarizes the financial position of the business at any given moment:

$$ \text{Assets} = \text{Capital} + \text{Liabilities} $$

Where:

• Assets: What the business owns (e.g., cash, non-current assets, trade receivables).
• Liabilities: What the business owes to external parties (e.g., loans, trade payables).
• Capital: The owner's residual claim; the money or resources the owner has invested in the business.

Did you know? If Assets exceed Liabilities, the remainder must belong to the owner (Capital). If your calculation doesn't balance, you know immediately that an error has occurred in recording the double entry.

Key Takeaway (Section 1)

Accounting is systematic. The Double Entry principle ensures that the Accounting Equation remains balanced, forming the backbone of all financial records.

2. The Journey of Data: Prime Entry and Ledgers

When a transaction occurs (like a sale or a purchase), it is first recorded in a specific book called a Book of Prime Entry. These books act as the source records before the data is moved into the main accounts (the Ledgers).

2.1 Books of Prime Entry (Journals)

These are often called journals. They are summaries used for efficiency, especially when dealing with many similar transactions (e.g., all credit sales).

(a) Sales Journal (Sales Day Book)

Records all credit sales (sales where the customer buys now and pays later).
Source Document: Sales Invoice issued to the customer.

(b) Sales Returns Journal (Returns Inwards Book)

Records goods returned by customers.
Source Document: Credit Note issued to the customer.

(c) Purchases Journal (Purchases Day Book)

Records all credit purchases (purchases where the business buys now and pays later).
Source Document: Purchases Invoice received from the supplier.

(d) Purchases Returns Journal (Returns Outwards Book)

Records goods returned to suppliers.
Source Document: Debit Note or Credit Note received from the supplier.

(e) Cash Book

Records all transactions involving cash (physical notes/coins) or bank (cheques, bank transfers).

Important: The Cash Book is special! It acts as both a book of prime entry AND a ledger account (Cash Account and Bank Account).

(f) General Journal (or simply 'Journal')

This is the "catch-all" book. It records transactions that don't fit into any other specialized journal, such as:

• The purchase/sale of non-current assets (e.g., buying machinery).
• Opening entries (setting up the books).
• Year-end adjustments (e.g., depreciation, accruals).
• Correction of errors (using the rules of double entry).

2.2 Preparation of Ledger Accounts

The Ledger Accounts (often called T-accounts because of their shape) are where the double entry is completed. They classify all the information by account type (e.g., rent, sales, cash).

The process is: Transaction → Source Document → Book of Prime Entry → Ledger Accounts.
For example, the total of the Sales Journal for the month is posted as a debit to Trade Receivables Control Account and a credit to the Sales Account.

Key Takeaway (Section 2)

Books of Prime Entry are initial chronological lists of similar transactions, while Ledger Accounts are where those transactions are summarized and classified according to the double entry rules.

3. The Checkpoint: The Trial Balance

3.1 Purpose of a Trial Balance

A Trial Balance is a list of all the balances remaining in the ledger accounts (both debit balances and credit balances) at a specific date.

Its main purpose is to verify the arithmetical accuracy of the double entry postings. If the total of the Debit balances equals the total of the Credit balances, the Trial Balance "agrees."

3.2 Advantages and Disadvantages of Maintaining Full Accounting Records

Maintaining full, systematic records (using the full system above) is essential, but it has costs.

Advantages of Full Records:

• Accuracy Check: Allows the preparation of a trial balance to check for errors.
• Decision Making: Provides detailed, reliable information for managers to plan and control the business.
• Legal/Tax Requirements: Necessary for calculating tax and satisfying legal obligations.
• Comparison: Allows for easy comparison of performance across different periods.

Disadvantages of Full Records:

• Costly and Time-Consuming: Requires skilled staff and significant effort.
• Complexity: Small businesses may find the detailed system overly complex.

Benefits and Limitations of a Trial Balance

While a trial balance is crucial, remember it only confirms that DR = CR. It doesn't mean the accounts are perfectly correct!

Limitation: A Trial Balance will NOT detect errors that do not upset the balance between total debits and total credits.

3.3 Errors that DO NOT Affect the Trial Balance Agreement

These are the common pitfalls! You must know these six types of errors:

1. Error of Omission: A transaction is completely missed (e.g., failing to record a sale altogether). DR and CR were both missed, so the totals remain equal.
2. Error of Commission: A transaction is recorded in the correct type of account (e.g., an asset account) but in the wrong specific ledger account (e.g., debiting the Motor Vehicles account instead of the Machinery account).
3. Error of Principle: A transaction is recorded in the wrong class of account (e.g., treating a capital expenditure, like buying a new machine, as a revenue expense, like paying for repairs).
4. Error of Original Entry: The amount recorded in the books is incorrect, but the double entry is completed using the wrong figure in both accounts (e.g., $100 recorded as $10 in both DR and CR).
5. Reversal of Entries: The correct accounts are used, but the debit and credit sides are swapped (e.g., debiting Sales and crediting Cash, instead of the opposite).
6. Compensating Errors: Two unrelated errors cancel each other out (e.g., Rent is overstated by $50 (DR error) and Sales is also overstated by $50 (CR error)).

Key Takeaway (Section 3)

The Trial Balance is a fundamental check, but it is not a guarantee of error-free accounting. Knowing the six errors that bypass the Trial Balance check is vital.

4. The Rulebook: Accounting Concepts

Accounting rules are governed by internationally accepted practices and theories. These Accounting Concepts underpin why we prepare accounts the way we do. You must understand how these concepts apply when preparing financial statements.

4.1 Fundamental Accounting Concepts

Business Entity Concept

The business is treated as completely separate from its owner(s). The finances of the business must not be mixed with the personal finances of the owner.

Analogy: A company wallet versus your personal wallet. They must never be swapped.

Historic Cost Concept

Assets are recorded at their original purchase price (the price paid when they were acquired).

Limitation: This price may not reflect the current market value (inflation).

Money Measurement Concept

Only transactions that can be expressed in monetary terms are recorded in the accounts.

Example: The high morale of staff or the skill of the manager cannot be measured in money, so they are not recorded as assets.

Going Concern Concept

It is assumed that the business will continue to operate for the foreseeable future and will not be forced to close down or reduce its scale drastically.

If a business is not a going concern, assets must be valued at their immediate selling price, not historic cost.

Consistency Concept

The business must use the same accounting methods year after year.

Example: If you choose the straight-line method of depreciation, you must stick to it consistently (unless a justifiable change is needed, which must be disclosed). This allows for reliable comparison over time.

Prudence Concept (Conservatism)

Accountants should be cautious (prudent) when making estimates. Revenue/profits should only be recognized when realized (certain), but potential losses should be recognized immediately.

Analogy: Better to be safe than sorry. Do not overstate assets or profits, and do not understate liabilities or losses.

Realisation Concept

Revenue and profits are recognised and recorded only when they have been earned or legally realized (usually when ownership of goods passes to the buyer or services are rendered).

Duality Concept

This links back to Double Entry: Every transaction has a dual effect (DR and CR).

Materiality Concept

Only items that are significant enough to influence the decisions of users should be strictly reported in the accounts.

Example: A $5 ruler bought by a large corporation is technically an asset, but it is too immaterial to be depreciated over three years, so it is usually recorded immediately as an expense.

Objectivity Concept

Accounting information should be free from bias and based on verifiable facts (e.g., invoices, bank statements) rather than personal opinions or estimations.

Matching / Accruals Concept

This concept states that expenses incurred to generate revenue must be recorded in the same accounting period as that revenue.

This leads to the adjustments for Accruals (expenses owed) and Prepayments (expenses paid in advance).

Substance Over Form

Transactions should be accounted for and presented according to their economic reality (substance), not merely their legal appearance (form).

Example: If a business legally leases an asset but controls it and must purchase it at the end of the lease, the substance is a purchase (an asset), not a mere rental (an expense).

Key Takeaway (Section 4)

The 12 accounting concepts are the essential rules of the game. They ensure that accounts are reliable, comparable, and provide a true and fair view of the business's finances.

5. The Digital Era: Computerised Accounting Systems

5.1 Use of Computerised Accounting Systems

Manual accounting is detailed and time-consuming. Most modern businesses use computerised systems to record financial transactions. These systems automate many processes, from generating invoices to posting the double entry and preparing the trial balance.

Advantages of Computerised Systems:

• Speed and Efficiency: Transactions are processed almost instantly.
• Automatic Double Entry: Reduces human error in posting DR/CR entries.
• Instant Reporting: Financial reports (like the trial balance) can be generated immediately.
• Accuracy: Mathematical errors are virtually eliminated.
• Storage: Large volumes of data can be stored securely and retrieved quickly.

Disadvantages of Computerised Systems:

• Initial Cost: Software, hardware, and installation can be very expensive.
• Staff Training: Staff require training to use the new system effectively.
• System Failure: If the system crashes, all work stops (reliance on electricity/internet).
• Security Risk: Data is vulnerable to hacking or viruses if not properly protected.

5.2 Ensuring Data Security

Because computerised systems hold all critical financial data, security is paramount.

Ways to ensure the security and integrity of accounting data include:

• Regular Backups: Making copies of all data and storing them off-site or in the cloud, so data can be recovered after a disaster.
• Password Protection: Restricting access to sensitive data only to authorised users.
• Access Rights: Ensuring different staff members only have permission to view or edit the specific data they need for their job.
• Anti-Virus/Firewall Protection: Preventing external threats (hacking and malware).
• Audit Trails: The system keeps a clear log of who entered what data and when, allowing errors or fraud to be traced easily.

Note: You are expected to understand the general principles and security measures, but knowledge of specific accounting software (like QuickBooks or SAP) is not required.

Key Takeaway (Section 5)

Computerised systems revolutionize accounting by enhancing speed and accuracy, but managers must proactively protect the data through robust security measures like regular backups and access controls.