Understanding and Managing Finance Presentation 3 Lecture Version

Objectives for This week After studying this week’s work, you should: Understand the principles behind double entry bookkeeping Be able to record transactions in a simple system Begin to understand how these transactions can contribute to more formal financial statements such as Balance Sheets and profit & Loss Accounts.

The Wealth of a Company As we have seen, the main purpose of a Balance Sheet is to show the total wealth of a business at a single point in time We show the Assets and the Claims To work effectively, a Balance Sheet should Balance, that is what the business owns should exactly match what the business owes In other words, the net worth is zero.

Balance Sheet Example Lemonade Stall (From Last Week) Assets: Cash: £ 65 Stock: £ 20 (100 x 20p) Total: £ 85 On Day 2 of the Lemonade Stall (Last week) we had: Total business assets: £85 Total claims on the business: £85 Net worth of business £0 Claims: Loan outstanding: £ 20 Retained profits: £ 65 Total: £ 85

Double Entry Bookkeeping Double Entry Bookkeeping is an important underlying financial practice which has a long history, and has been used since the Middle Ages. A ‘book’ or ‘ledger’ consists of a number of pages in which are recorded all the business transactions with dates and amounts. Each page is divided into two halves: on the left is the ‘debit’ side; one the right is the ‘credit’ side.

Double Entry Bookkeeping Here are two pages: CASH STOCK On each page we show Debits on the left; Credits on the right.

Double Entry – Duality Principle The Duality principle says that every business transaction will be recorded on two different pages of the book: Once on the Debit Side Once on the Credit side.

Double Entry Bookkeeping EXAMPLE: Stock is bought for a cash payment of £600 This is entered once as a credit and once as a debit:

Double Entry – Balancing Principle The Balancing Principle says that every business transaction has precisely two effects: One which serves to increase the wealth of the business One which serves to decrease the wealth of the business The Net result of these effects is zero.

Double Entry: Example 1 Suppose in the lemonade stall we buy 200 cans of lemonade for 20p per can (£40) We have increased our stock of lemonade by £40; We have reduced our cash by £40 Bookkeeping rules would require two entries, one which increases assets by £40 (credit stock) and one which reduces assets by £40 (debit cash) Net change is zero.

Balance Sheet Example Lemonade Stall Decrease by £40 Assets: Cash: £ 25 Stock: £ 60 Total: £ 85 We still have Total business assets: £85 Total claims on the business: £85 Net worth of business £0 Claims: Loan outstanding: £ 20 Retained profits: £ 65 Total: £ 85 Increase by £40

Double Entry: Example 2 Suppose in the lemonade stall we pay the outstanding loan of £20. We reduce our cash by £20; We reduce our loan by £20 Bookkeeping rules would require two entries, one which decreases assets by £20 (cash) and one which decreases claims by £20 (loan) Net change is zero.

Balance Sheet Example Lemonade Stall Decrease by £20 Decrease by £20 Assets: Cash: £ 5 Stock: £ 60 Total: £ 65 We now have Total business assets: £65 Total claims on the business: £65 Net worth of business £0 Claims: Loan outstanding: £ 0 Retained profits: £ 65 Total: £ 65

Accounts The following pages are typical of those found in a Double Entry Accounting system: Cash Stock Capital Trade Creditors Trade Debtors Cost of Sales Sales

Bookkeeping Pages: Left & Right Each page shows a separate Account OUT IN On the Left is shown the money which has come into that account. On the Right is shown the money which has gone out of that account.

Bookkeeping Pages Transaction Examples These are shown as Debits and Credits £5000 comes into the Cash Account; its partner transaction will be found in the the Capital Account, which will be debited by £5000. £600 goes out of the Cash Account; its partner transaction will be found in the the Stock Account, which will be credited by £600.

Bookkeeping Pages Example of Double Entry Stock is bought for a cash payment of £600 We reduce Cash by £600; this is shown on the right in the Cash Account, as it is money going out of the account. The money goes to Stock, so we Credit stock by £600 We increase Stock by £600; this is shown on the left in the Stock Account, as it is money coming into the account. The money comes from Cash, so we Debit stock by £600

Selling for Cash A More Complex Example When we sell something for Cash, we have two different Double Entries to make. This is because we have two different amounts: The amount we sell for The amount we originally bought it for. Each of these requires two entries to balance it. Original Purchase Price This is entered in Cost of Sales and Stock Selling Price This is entered in Sales and Cash

Sales Example : Recording the Selling price We sell goods for Cash to the value of £800, which we originally bought for £750. The entries are recorded as follows: Cash Page: Cash of £800 comes in (left hand side) Reads as “Debit Sales by £800” Sales Page: Sales of £800 goes out (right hand side) Reads as “Credit Cash by £800”

Sales Example : Recording the Purchase Price We sell goods for Cash to the value of £900, which we originally bought for £750. The entries are recorded as follows: Cost of Sales: Cost of Sales increased by £750 (left hand side) Reads as “Debit Stock by £750” Stock: Stock of value £800 goes out (right hand side) Reads as “Credit Cost of Sales by £750”

Cash Book This activity practises and develops some of the skills necessary to understand the principles behind double entry bookkeeping. The material all comes from M & A Appendix A pp 546-558, and you should begin by reading this. Next you should download the Word Document: CashBook Activity. This will take you through the Activity step-by-step. You may find that you will need to refer to M & A from time to time.

Cash Book Next, from the Website, Download the CashBook spreadsheet. When you try to open this, you will normally get a message telling you that the spreadsheet contains Macros. Click on Enable Macros.

CashBook Spreadsheet The details of how the Spreadsheet works are given in the CashBook Activity document. You will find that there are several features (buttons & lists) which will help you complete the activity

Seminar Preparation Cash Book Activity takes you through the full set of tasks to preparing a balance sheet for January . For the next Seminar, you should come prepared with the full details of how you dealt with the February Transactions. These are given at the end of Cash Book Activity.