For the purposes of the FA1, FA2 and FFA/FA exams, it is assumed that every entity uses a computerised accounting system and that the sales and purchases systems are integrated into the accounting system.
This means that the sales and purchases are not recorded on a separate system and then manually input to the accounting system. Instead, whenever an entity recognises a sale or a purchase, various records will be automatically updated, simultaneously. In this article, we will explore a simple sale/purchase transaction and consider how the accounting records would be updated for each entity in the transaction.
For the purposes of this article, we will ignore sales tax and any brought forward balances that may exist due to trading in the prior year. We will also not consider how the ledger accounts are ‘balanced off’ and will, instead, focus on the initial recording of the sale/purchase and subsequent receipt/payment.
In this scenario, Farida is a sole trader who designs and manufactures accessories for pets. These include products such as collars, feeding bowls, toys and harnesses.
Farida does not sell to the public but, instead, she sells her products exclusively to other businesses such as pet shops and supermarkets.
Pierre is another sole trader. He runs a small pet shop and is one of Farida’s regular customers.
On 1 January 20X1, Pierre used Farida’s website to place an order for 100 dog collars at a cost of $5 per collar. This is Farida’s first sale of the new year but Pierre has been a longstanding customer and she allows him credit terms of 60 days.
First, we will consider the transaction from Farida’s perspective and the impact on her entity’s accounting records before we consider how Pierre would record the purchase for his entity.
The sale – Farida’s accounting records
When Farida received the order, she arranged for the goods to be posted for same-day delivery along with a delivery note which included the number of collars ordered, the date of the delivery and the address which Pierre had requested the goods be sent to.
Once the delivery was made and Pierre received the goods, Farida generated a sales invoice in her accounting system to request payment from Pierre. Through generating the sales invoice, Farida’s accounting system did two things:
1. The sales invoice
The sales invoice that Farida created may have looked something like this:
2. The accounting records
On generating the sales invoice, Farida’s accounting system will have automatically updated her accounting records to reflect that a sale was made to Pierre. The records which will have been updated are:
To update the general ledger, the following journal entry will have been recorded (by the system) on the issue of the invoice:
Dr Trade receivables $500
Cr Revenue $500
This would have the effect of updating each ledger account as follows:
This represents a debit balance of $500 in trade receivables as a result of the sale to Pierre.
The revenue account in the general ledger now shows a credit balance of $500 and this amount will be included as part of the total revenue figure in Farida’s statement of profit or loss for the year ended 31 December 20X1, when the financial statements are prepared.
Of course, although this is her first sale of the year, Farida will expect to make other sales – some of which may be to Pierre but many will be to other customers.
As Farida makes more sales, the trade receivables and revenue ledger accounts will be updated so that they will not only include sales made to Pierre but the total sales made throughout the year and the total amounts owed by all credit customers.
Therefore, so that Farida knows how much money Pierre owes her and what transactions have been made with him individually, his individual customer account will be updated automatically at the same time as the general ledger accounts are updated:
Each customer will have a separate customer account which lists out all of the individual transactions with that particular customer. These records are sometimes referred to as ‘subsidiary ledgers’ because they are separate to the main general ledger accounts where the double-entry bookkeeping takes place and which include transactions and balances related to every customer in aggregate.
It is extremely important that Farida keeps an accurate record of her revenue and trade receivables so that she knows the total sales she has made and the total amounts owed to her by all of her customers. However, it is equally important that she separately tracks how much each of her individual customers owes her – otherwise she will not be able to accurately manage her cash flow or may not be aware of any customers who are at risk of late payment.
As well as being updated for any sales made, the trade receivables account in the general ledger and the relevant individual customer account will also be reduced when customers send their payments.
For instance, if Pierre were to pay for the goods on 15 January 20X1, Farida would record the receipt in her accounting system and will be able to match the receipt to the sales invoice, indicating that the receipt was from Pierre. This will cause her general ledger to be updated (automatically) with the following journal entry:
Dr Bank $500
Cr Trade receivables $500
The general ledger accounts will then show as follows:
There is now a credit of $500 in the trade receivables ledger account referenced to ‘Bank’, which indicates that there has been a receipt from a credit customer. As the debits are now equal to the credits, this means that trade receivables is effectively showing a nil balance due from all customers.
The bank account in the general ledger now shows a $500 debit balance referenced to trade receivables, representing a positive cash balance due to a receipt from a credit customer.
As well as updating the general ledger accounts, Pierre’s individual customer account will be updated simultaneously and will now show that he has no debts outstanding:
From Farida’s perspective, this transaction was a sale. However, from Pierre’s perspective, this was a purchase of goods.
For the purposes of this article, we will assume that Pierre did not record any entries in the accounting system until he received the sales invoice from Farida. From Pierre’s perspective, the sales invoice issued by Farida would be referred to as a ‘purchase invoice’ as this is how it will be classed in his own accounting records. However, it is in fact the same document as issued by Farida.
In the same way that Farida’s accounting entries updated her general ledger accounts and Pierre’s individual customer account, Pierre’s accounting entries will update his own general ledger accounts and Farida’s individual supplier account. The individual supplier accounts are records for each of Pierre’s suppliers so that he can track and manage amounts owing to each supplier and work in a similar manner to the individual customer accounts.
When entering the details from the purchase invoice received (ie the sales invoice that Farida sent) into the accounting system, Pierre will include the fact that this was a purchase from Farida. This will mean that the accounting system will update the general ledger and Farida’s individual supplier account automatically.
The general ledger accounts which will be updated are purchases and trade payables, with the following journal entry:
Dr Purchases $500
Cr Trade payables $500
These are effectively a mirror image of Farida’s accounting entries. Instead of a debit balance in trade receivables and a credit balance in revenue, Pierre’s accounting records will show a debit balance in purchases and a credit balance in trade payables.
Farida’s individual supplier account will be updated simultaneously and will now show that he has an obligation to pay Farida $500:
The reference ‘F8421’ is the account number allocated to Farida’s individual supplier account in Pierre’s accounting system. Businesses will choose their own referencing system for customers and suppliers to help them track individual transactions.
Once Pierre makes the payment to Farida, he will update his accounting records so that the general ledger and Farida’s individual supplier account are updated to reflect the payment made:
Dr Trade payables $500
Cr Bank $500
When making this entry in the accounting system, Pierre will also ensure that he utilises the functionality of his accounting system so that the payment is allocated against Farida’s individual supplier account:
Now Pierre’s accounting records will still show total purchases of $500 but no amounts owed to Farida or any other suppliers.
In this article, we have used a very simple scenario and have not considered in detail all the events which may occur in real life. For example, we have not considered when goods are subject to sales tax, if some goods are returned to the supplier or the impact on accounting records if further purchases are made or goods are not paid for in full. However, these are simply a continuation of the principles presented in this article and will be further developed over the course of your studies.
Written by a member of the FFA/FA examining team