Essential Concepts in Accounting

Essential Concepts in Accounting

In this lesson, you’re expected to learn about:
– nominal, purchase, and sales ledgers
– debits and credits
– value added tax
Accounting vs. Bookkeeping

Bookkeeping is usually described as the process of recording all the daily transactions of a company.

Accounting, on the other hand, is the process of taking the book-keeper’s work and turning it into a set of accounts.
How often should you do your accounts? 
It is recommended that everyone does their accounts at least quarterly and preferably monthly.

[Optional] Bookkeeping
Check out this article to learn more:
Nominal Ledger and Nominal Accounts

Each of the items that make up the balance sheet is called a nominal account.

Instead of just one nominal account, accountants typically have a nominal account for each different type of asset.

The sum of all these assets would add up to the total assets of that particular category (e.g. fixed assets can be broken up into many smaller components). This makes it easy to derive the P&L from the balance sheet.

A large company may have hundreds of nominal accounts to help track its revenues and expenses.

All the nominal accounts make up the nominal ledger – this contains details of each of the nominal accounts.

Purchase and Sales Ledgers

Purchase ledgers are used for companies to keep detailed records of all transactions with suppliers.

They are linked to the nominal ledger so that whenever a change is made to the purchase ledger, the relevant nominal accounts in the nominal ledger are automatically updated.

Similarly, companies have thousands of customers and it is essential to keep a record of all transactions with them. This is what the sales ledger is used for.

Keep in mind that the nominal ledger is the most important of the three. The sales and purchase ledgers are very useful but are not the essence of the accounting system.

Source Documents

When you buy goods from a supplier, there are many documents involved:

• Purchase Order: this records the fact that the goods have been ordered.

• Delivery Note: this is enclosed with the goods to indicate what is included in the delivery.

• Invoice: this lists the goods purchased, the tax point date (the official date of the sale and purchase for VAT purposes), the amount charged for the goods and any applicable VAT.

• Statements: the supplier sometimes issues statements to its customers, itemizing all the invoices that are still unpaid.

For accounting purposes, the only document that we’re concerned with is the invoice.

This is the official record of the transaction to buy the goods and it is what we use to make entries into the accounting system.

When you buy something in a shop, you might just be given a receipt from the till. While this does not match an invoice in terms of the amount of information provided, it is still the source document for that purchase.

Journal Entry

A journal entry is a change you make to the balance sheet that is made directly to the nominal ledger. It is often an end of period adjustment.

[Optional] What is a journal entry?
What are Debits & Credits?
All the nominal accounts on the assets bar are debit balances. When you increase one of these nominal accounts, you are debiting the account. When you decrease one, you are crediting it.

All the nominal accounts on the claims bar have credit balances. When you increase one of these, you are crediting the account and when you decrease one, you are debiting it.

From the Bank’s Point of View

The bank is looking at your bank account from the point of view of its balance sheet. If you deposit money with your bank, it owes you that money – you have a claim over their assets. From its point of view, your bank account appears on the claims side of its balance sheet and is thus a credit balance.

On your balance sheet, that cash is an asset and thus a debit balance.

Transaction 1 
Sarah invested £10,000 cash into the company in return for shares.

This resulted in the cash nominal account going up by £10,000 and the share capital nominal account going up by £10,000.

We can describe this transaction as follows:
Debit: Cash £10,000
Credit: Share capital £10,000

Transaction 3
Sarah bought a car for £9,000 in cash.

The car became a fixed asset of the company. Thus the cash nominal account went down by £9,000 and the fixed assets nominal account went up by £9,000.

We can describe this transaction as follows:
Credit: Cash £9,000
Debit: Fixed assets £9,000

Transaction 6 
Company A sold £6,000 worth of stock for £12,000 cash

In this case, three nominal accounts changed – stock, cash, and retained profit.

We can describe this transaction as follows:

NOTE: To make things easier, debits are always listed in the left-hand column and credits in the right-hand column.
Trial Balance

A trial balance (TB) is just a list of all the nominal accounts in the nominal ledger showing the balance in each at a point in time. Each balance takes into account every transaction and adjustment the company has ever made up to that point.

Importance of the TB 

• It is the end of the process of getting all our transactions and adjustments into the accounting system.

• It is also the starting point for the process of producing our balance sheet , P&L – both of which are derived from the TB.

[Optional] Trial Balance
Chart of Accounts

A chart of accounts allows you to summarize your data by grouping nominal accounts together. This also allows you to see the cumulative effect of every transaction that’s ever been carried out by a company.

Chart of accounts identifies: 
• which of the nominal accounts are part of retained profit.
• which nominal accounts should be listed under each of the categories on the balance sheet.

[Optional] Chart of Accounts
What does ‘value added’ mean?
Value added is the difference between the outputs and inputs of a company. In other words, it is the amount of value that the employees add to the inputs.

Value Added Tax (VAT) is a tax on the value added in products and services. Most products and services are subject to VAT.

Companies fall into two groups as far as VAT is concerned – those that are VAT registered and those that are not.

VAT in the EU & UK

The EU has standard rules on VAT however these may be applied differently in each European country.

In the UK, you register for VAT if your annual sales are more than a certain figure. Thus, you have to add VAT to the amount you charge for your products or services.

Check out this link to see the rules and rates for different countries:
[Optional] 2017 Worldwide VAT, GST and Sales Tax Guide
Check out this list compiled by EY to see how VAT varies in 120 different countries:–gst-and-sales-tax-guide—rates
How does VAT work in a double-entry system?

The rate of VAT is different in most countries and is subject to change every once in a while.

Let’s assume that the VAT is 20% and you sell some consulting work that you charge €1,000 for. You would have to add 20% to that, making the total charge to the customer €1,200.

The customer owes you the VAT but the liability of that VAT is not on you so it does not affect retained profit.

Similarly, when you make purchases, you will be charged VAT but this also does not affect retained profit.

[Optional] Cross-Border VAT in the EU
The official website of the European Union explains the rules that apply if you buy or sell goods/services from or to other countries:
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