Chapter 5: Recording Business Transactions and Sales Tax

1.1 Types of Business Transactions

The monetary value of business transactions is shown in financial documents, and its data is
entered into the ledger accounts using journal entries (either automatic or manual), applying
the fundamental principle of double-entry.

This chapter will discuss the recording of these business transactions:

 Cash and Credit Sales

 Sales Returns

 Cash and Credit Purchases

 Purchase Returns

 Petty Cash transactions

There is an assumption in the FA/FFA exam that businesses will be using computerised
accounting systems where the sales and purchase modules are integrated with the general
ledger. This means that the general ledger accounts will automatically be updated when
sales invoices and credit notes are produced by the sales module, or when purchase invoices
or credit notes from suppliers are entered into the purchases module. However, the bank is
not integrated with the general ledger, so bank transactions will need to be entered using
manual journal entries.

1.2 Cash and Credit Sales

1.2.1 Cash and Credit Sales

A cash sale arises from a sale to a customer for immediate payment. The double entry to
record a cash sale is:

General Ledger Account Category Explanation

DR Cash/Bank Asset Cash (Asset) increased

CR Sales Income Sales (Income) increased

A credit sale arises from a sale to a customer for future payment. At the point of sale, the
customer owes the business the sale amount. The amount is classified as trade receivables.
The journal entry to record a credit sale is:

General Ledger Account Category Explanation

DR Trade Receivables Asset Trade Receivables (Asset) increased

CR Sales Income Sales (Income) increased

These journal entries would be posted to the general ledger accounts automatically where
the sales module is integrated with the general ledger.

1.2.2 Sales Return

Sale returns are goods returned to the business by its customers due to an error on the part
of the business, such as delivering damaged or incorrect items. Credit notes are issued by
the business to reduce the value of the previously issued customer invoice.

The journal entry to record a sales return transaction is:

General Ledger Account Category Explanation

DR Sales Income Sales (Income) decreased

CR Trade Receivables Asset Trade Receivables (Asset) decreased

Some businesses may use an additional account called “sales returns”. If that is the case,
the journal entry to record a credit note becomes:

General Ledger Account Category Explanation

DR Sales returns Income Sales (Income) decreased

CR Trade Receivables Asset Trade Receivables (Asset) decreased

At the end of each financial period, the balance on the sales returns account would be
deducted from the balance in the sales account, giving the same sales value as if the credit
note had been directly debited to sales. In exam questions, if no sales returns account is
mentioned in the question, use the first of the journal entries above (i.e. the debit entry to
record a credit note should be to the sales account, rather than the sales returns account).

Journal entries relating to sales returns would be posted automatically to the general ledger
from the sales module in an integrated accounting system.

1.2.3 Receipts from Customer

At the end of the credit term, the customers should pay the business for the outstanding
balance for purchases. Since the bank is not integrated with the general ledger, a manual
journal entry is required to record receipts from credit customers. This is:

General Ledger Account Category Explanation

DR Bank/Cash Asset Bank/Cash (Asset) increased

CR Trade Receivables Asset Trade Receivables (Asset) decreased

1.3 Cash and Credit Purchases

1.3.1 Cash and Credit Purchases

Where a purchase from a supplier requires immediate payment this is known as a ‘cash
purchase’ (although it may be paid from the bank account). The journal entry to record a
cash purchase is:

General Ledger Account Category Explanation

DR Purchases Expense Purchases (Expense) increased

CR Cash/Bank Asset Cash (Asset) decreased

A credit purchase arises from a purchase from a credit supplier for future payment. At the
point of purchase, the business owes the money to the seller. Where the purchase is of
goods or services for resale, the credit side of the transaction is entered in the trade
payables ledger account. The journal entry to record a credit purchase is:

General Ledger Account Category Explanation

DR Purchases Expense Purchases (Expense) increased

CR Trade Payables Liability Trade Payables (Liability) increased

In an integrated system, the journal entry in respect of purchases would be posted to the
general ledger automatically when the purchase invoice is entered into the system.

1.3.2 Purchase Returns

Purchase returns are goods returned to the seller by the business due to an error, such as
delivering damaged or incorrect items. The seller issues credit notes to reduce the value of
the previously issued purchase invoice.

The journal entry to record a purchase return is:

General Ledger Account Category Explanation

DR Trade Payables Liability Trade payables (Liability) decreased

CR Purchases/Expense Expense Purchase (Expense) decreased

As with sales returns, some businesses may use a purchase returns account which is credited
when a credit note is received from a supplier, rather than crediting directly to the purchases
or expense account. If that is the case, the balance on the purchase returns account would
be deducted from the balance on the purchases account at the end of the year.

1.3.3 Payments to Suppliers

At the end of the credit term, the business should pay the supplier for the purchased items.
There is an assumption in FA/FFA that the bank is not integrated with the general ledger, so
bank transactions must be entered manually. The manual journal entry to record a payment
made to a supplier is:

General Ledger Account Category Explanation

DR Trade Payables Liability Trade Payables (Liability) decreased

CR Bank/Cash Asset Cash (Asset) decreased

1.4 Petty Cash Transactions

Petty cash refers to small amounts of money kept on business premises for small-value
purchases. The petty cash ledger account records when cash is used to make sundry small
payments such as postage stamps, coffee and taxi fares.

The petty cash will be kept securely in a locked cash box. The amount of money typically
held in the petty cash box is known as a float.

The two sources of petty cash are:

 Small Receipts

A business may make petty cash sales on small-value items on the business premises. For
example, a business client comes to the office for a meeting and uses the office photocopier
to print some documents. They may pay a small fee due in cash. This would be placed in the
cash float.

 Imprest System

The business decides how much float it would like to keep in the cash box by employing an
imprest system. Periodically, cash is withdrawn from the bank account to maintain the
amount of the float.

1.4.1 Methods of Replenishing

An imprest system of replenishing is where a fixed sum is maintained in the petty cash tin.
As cash is paid out, it must be replaced by petty cash vouchers, so that the value of cash
plus petty cash vouchers in the tin is always equal to the fixed sum. When the cash in the tin
is replenished, it is exchanged for petty cash vouchers with a value equal to the cash paid
into the tin.

Key Point

Imprest Amount = Balance in the Petty Cash tin + Petty Cash Vouchers
 Example 1

In a week, the petty cash tin had the following transactions:

$ $

Imprest balance at the beginning of 10

the week 0

Less: Paid during the week

Stationery 9

1
Tea and coffee 4

Telephone 2

Taxi 4

3
Auditor’s lunch 9

68

Petty cash-in-hand at the end of the

week 32

At the end of the week, $68 of cash will be drawn from the bank to reimburse the petty
cash tin to top it up to the imprest balance of $100.

A non-imprest system is any method of replenishing petty cash other than an imprest
system. An amount added into the petty cash tin, regardless of the petty cash taken out
during the week, is a non-imprest system.

 For example, a business decides to replenish a fixed amount of $30 each week,
regardless of the amount taken out.

The petty cash tin is reimbursed by transferring money from the business bank account. The
manual journal entry to record petty cash replenishment is:

General Ledger Account Category Explanation

DR Petty Cash Asset Petty Cash (Asset) increased

CR Bank Asset Cash in Bank (Asset) decreased

1.4.2 Need for a Record

The petty cash ledger account is maintained, and relevant transactions are recorded to
establish internal controls.

The record of petty cash transactions helps minimise the risk of theft and fraud (expenses
must have documentary support).

 Every payment out of the petty cash tin is supported with a voucher. The cashier will
authorise the voucher.

 At the end of each month, the petty cash book is totalled, and the expense totals are
posted to the general ledger accounts.

The record of petty cash transactions in the general ledger accounts also collects information
valuable to the manager’s operations. If the petty cash expenses are high in a period, the
petty cash ledger can provide the transaction documentation to support any issues.

2.1 General Principles

Key Point

A sales tax is an indirect tax imposed by tax authorities or governments. A percentage

is charged on goods sold.

An indirect tax is a tax charged on goods and services rather than on the profits made by a
business. Indirect tax is therefore charged on transactions.

Sales tax is an example of an indirect tax.

Businesses must register with the tax authorities in their country to become sales tax
collecting agents for the government. Businesses charge tax on sales (output tax) and
reclaim tax on purchases (input tax).

A business must be registered to collect or reclaim sales tax.

 Output tax is the sales tax charged on sales to customers.

 Input tax is the sales tax paid on purchases of goods and services.

If output tax exceeds input tax = tax payable to authorities (Current Liability)

If input tax exceeds output tax = tax reclaimable from authorities (Current Asset)

The settlement of collected sales tax to the authorities is made regularly (either monthly or
quarterly). The business submits a sales tax return, which shows the calculation of the
amount of sales tax due, along with the payment.

When a business is registered for sales tax, the tax authorities generally require the business
to maintain sales tax-related documentation and records and to follow administrative rule.
The legislation will vary between countries, but the basic principles will be the same.
 Example 2

Hassan is the owner of a stationery shop and is registered for sales tax.

1. Hassan purchases several boxes of pencils from a supplier. The sales tax paid for
the purchases is the input tax. Hassan will record the sales tax in the sales tax
ledger account on the debit side (Asset) as the input tax can be reclaimed from
tax authorities.

2. Hassan sells some pencils to a local shop and charges sales tax. The sales tax
collected from the local shop is the output tax. Hassan will record the sales tax
collected in the sales tax ledger on the credit side (Liability), as the output tax is
payable to the tax authorities.

3. At each period-end, the total output tax and the total input tax for the period are
calculated in the sales tax ledger account. The output and input tax figures are
included on the sales tax return. The sales tax collection period can be monthly or
every three months.

If the business is in a net credit position, payment must be made to the tax authorities.
If the business is in a net debit position, it can reclaim the amount from them.

2.2 Sales Tax Calculation

The rates of sales tax that apply to sales and purchases will vary from country to country.
Sales tax can be calculated based on either the gross or net amount of the transaction.

Key Point

The net amount is the sale or purchase price before sales tax and is always 100%.

The gross amount is the sale or purchase price, including sales tax. The gross figure is
always 100% + sales tax %.

Gross amount: the sale or purchase price, including sales tax.

Net amount: the sale or purchase price, excluding sales tax.

Example 3

Hanna is a sole trader selling furniture from her shop. The sales tax rate in Hanna's
country is 20%. This example illustrates her sale of a table.

1. If the net price of the table is $250, the sales tax is:

Net Sales Tax Gross

Amount Amount
 Example 3

$250 $50 $300

($250 × ($250 +
20/100) $50)

Or $250 ×
20%

Always 20% 120%

100%

2. If the gross price of the table is $300, the sales tax is:

Net Sales Tax Gross

Amount Amount

$250 $50 $300

($300 - ($300 ×
$50) 20/120)

Always 20% 120%

100%

3.
2.3 Accounting for Sales Tax

Sales tax may be relevant to several transactions, such as:

 Cash and credit sales

 Cash and credit purchases

 Payment/ receipt of sales tax to authorities

2.3.1 Cash and Credit Sales

The journal entries for cash and credit sales were described above in section 2. Where there
is sales tax, the journal entry changes slightly:

General Ledger Catego Explanation

Account ry

DR Cash/Trade Asset Trade receivable/Cash (asset) increased with the

Receivable gross value of the invoice
 CR Sales Income Sales (income) net of sales tax increases

CR Sales tax Liability A liability to the tax authorities for the collection of
sales tax has increased.

In a computerised accounting system where the sales module is integrated with the
accounting system, this journal entry would be posted automatically when the invoice is
issued by the sales system.

2.3.2 Sales returns

As explained in section 1 above, sales returns occur when goods are returned to the business
by the customers due to an error on the part of the business, such as delivering damaged or
incorrect items. If the original customer invoice included sales tax, the sales return should
also include a refund of the sales tax element.

The journal entry for recording a sales return with sales tax is:

General Catego Explanation

Ledger ry
Account

DR Sales (or sales Income Reducing sales

returns)

DR Sales tax Liability A refund of the sales tax on the sale represents a
reduction of the business’s liability to the tax
authorities

CR Trade Asset Trade receivables decreases with the gross value of

receivables the return

2.3.3 Cash and Credit Purchase

For credit purchases incorporating sales tax, the amount attributable to sales tax is recorded
as input tax in the sales tax account.

The journal entry that would be recorded in respect of cash or credit purchases of goods or
services for resale, with sales tax is:

 DR Purchases (expense) with the net amount of the invoice

 DR Sales tax (asset) with the sales tax

 CR Cash/ Trade Payables (reduce asset/ increase liability) with the gross value of the
invoice

2.3.4 Credit notes in respect of purchases

The journal entry to record purchase returns with sales tax is:
  DR Trade payables (reduce liability)

 CR Sales tax (reduce asset)

 CR Purchase returns (reduce expense)

3.1 Trade Discounts

A discount is a reduction in the price of goods, or services, below the price at which they
would typically be sold to customers. The two types of discounts that a business may
encounter are trade and prompt payment (or settlement) discounts.

Definition

A trade discount reduces the cost of goods or services bought or sold on the basis
that the customer will buy a certain quantity. It is given on either cash or credit
transactions.

A trade discount offered to a customer is a guaranteed discount, agreed with a customer in

advance, to reward them for buying a certain volume of a product or service.

3.1.1 Accounting for Trade Discounts

Trade discounts are excluded from the accounting records.

The sale or purchase transaction is always recorded after the deduction of the trade discount
i.e. the discount is not recorded in the ledger accounts.

Example 5

Maple Leaf is a wholesaler and retailer of medicines, cosmetics and perfumes. It has an
extensive catalogue of products.

1. The list price of a new fragrance is $40 a bottle. Maple Leaf offers Kirby, a retail
shop owner, a 25% discount on ten bottles. Kirby takes advantage of the discount
price offered. What are the accounting entries in Maple Leaf's ledger accounts if
Kirby:

1. pays immediately in cash:

Maple Leaf has made a cash sale of $300 ($40 × 10 bottles − trade discount 25%). The
journal entry to record this is DR Cash $300 and CR Sales $300.

2. is given 30 days in which to pay:

Maple Leaf has made a credit sale of $300. The journal entry to record this is DR Trade
Receivables $300 and CR Sales $300.

2. Maple Leaf purchases five boxes of eye cream primer at a list price of $150 per
box from ForEyever. Purchases of three boxes and above entitle the customer to a
 Example 5

discount of 10% on the entire purchase. What are the accounting entries in Maple
Leaf’s ledger accounts if it:

1. pays immediately in cash:

Maple Leaf has made a cash purchase of $675 (5 boxes × $150 − trade discount 10%).
The journal entry to record this is DR Purchases $675 and CR Cash $675.

2. is given one month in which to pay:

Maple Leaf has made a credit purchase of $675. The journal entry to record this is DR
Purchases $675 and CR Trade Payables $675.

The sale and purchase transactions are both recorded after the deduction of the trade
discount.

3.2 Settlement Discounts

Definition

A settlement discount (or prompt payment discount) is a discount offered to

customers or given by suppliers for payment made within a specific timeframe. It is
offered only in credit transactions.

A settlement discount encourages the customers to pay outstanding balances to the

business earlier than the standard credit agreement term (credit period).

3.2.1 IFRS 15 Revenue from Contracts with Customers

Offering settlement discounts to credit customers to encourage prompt payment can help a
business's cash flow. However, whether the customer will take advantage of the discount at
the point of sale is unknown.

Per IFRS 15, settlement discounts are recognised only when a business expects that
customers will accept the discount by making the payment within the settlement window.

When recording the initial credit sale, the business must consider the probability of the
discount being taken using judgement and considering its experience with each customer.
The business must determine the amount of consideration (money) it expects from the sale
per the criteria of IFRS 15.

If the supplier expects the customer to take advantage of the settlement discount, sales are
recorded at the net amount after deducting settlement discounts. This is the same
treatment as for trade discounts.

Exam advice

Where a question requires you to deal with a transaction from the seller’s perspective
 Exam advice

(i.e. a customer (sales) invoice is issued), the question will state whether or not the
credit customer is expected to take advantage of prompt payment discount terms.

Example 6 (expects to take up settlement discount)

Simon sells Arthur $500 of goods on credit and offers him a 5% discount for payment
within seven days. Simon expects Arthur to take advantage of the discount offered.
What are the accounting entries in Simon's ledger accounts if Arthur:

1. Takes the discount

2. Does not take the discount

Solution:

Simon expects Arthur to take up the settlement discount at the initial sale entry.
Therefore, the amount to be recognised as sales is net of the settlement discount: $500
− settlement discount $25 ($500 x 5%) = $475

The journal entry to record the sale is DR Trade receivables $475 and CR Sales $475.

1. If Arthur takes up the discount by paying within seven days, Simon will record the
cash receipt: DR Cash $475 and CR Trade receivables $475.

2. If Arthur does not take up the settlement discount he will pay $500 after seven
days. Since Simon expected Arthur to take it up, Simon deducted the settlement
discount amount when he recorded the sale to Arthur (of $475).

Therefore, Simon has to recognise the settlement discount as sales. The journal entry to
record this cash receipt is:

DR Cash $500 (record cash receipt)

CR Trade receivables $475 (remove trade receivables balance)

CR Sales $25 (balancing figure)

4.1 Purpose of Bank Reconciliations

Definition

A bank reconciliation is a reconciliation between the bank statement balance and the
balance on the Bank ledger account.

The statement of financial position shows all the assets, liabilities and capital of a business.
Users of this statement assess the business’s health by analysing the business cash balance.

Therefore, controls are set in place to ensure the cash balances recorded in the financial
statements are accurate. This means that the reported bank balance should reflect the
amount of cash in the bank. A control measure to ensure the accuracy of the Bank ledger
balance is regularly performing a bank reconciliation.

The bank keeps records of transactions in and out of the business's bank account.
Information on these transactions is sent to the business through a bank statement.

In the modern era of digital banking, bank statements and other banking records are easily
extracted from the bank’s internet website.

The balance on the bank statement or internet banking records received may be different
from the balance in the bank ledger account. In such cases, a bank reconciliation is prepared
to highlight the differences and calculate the correct Bank account balance.

4.2 Reasons for Differences

The bank statement balance may not necessarily agree with the bank ledger account
balance due to errors, omissions, or timing differences.

 Errors can be found in both the bank ledger accounts and the bank statement. Errors
may occur due to transactions posted twice or an incorrect amount reflected in either
of these balance statements.

 Omission of transactions could cause a difference between the two sources’ balances.
Transactions such as standing orders, direct debits, bank charges, or interest received
could be reflected in the bank statement but not in the bank ledger account or vice
versa.

o A standing order is an instruction given by a payer to its bank telling the bank to
pay a fixed amount on a predetermined date to a third party. The third party
cannot request payment from the bank or change the amount.

o A direct debit is an authority given by a payer to a third party (the payee) to

debit the payer's account on a specific date (or nearest banking day). This
authority can be a fixed amount (loan repayment) or a variable amount (phone
bill payments).

 Dishonoured cheques (bounced cheques) are cheques received from a customer

that has not been honoured by the customer’s bank due to insufficient funds or
incorrect cheque filing. Since there is no actual payment, the bank statement will not
include this receipt.

 Timing Differences are due to the following:

1. Unpresented cheques: cheque payments made to a supplier that the supplier

has not yet taken to their bank. Since there is no payment out of the bank
account, the bank statement will not reflect this transaction.

2. Outstanding lodgements: cheque payments received and taken to the bank but
has yet to be recorded in the bank statement. This could be due to cheques
cashed on the same day the bank statement is prepared.
 3. Direct credits: receipts or payments which take a few days to clear in the bank
account may also cause timing differences between the time the transactions
were made and when they appear on the bank statement.

Timing differences arise due to a delay between the business posting in the bank ledger and
the bank recognising the payments and receipts. Neither the bank ledger nor the bank
statement is incorrect. These differences will appear in the bank reconciliation at the end of
the process.

4.3 Preparing Bank Reconciliation

4.3.1 Bank Reconciliation Procedure

The bank reconciliation will align the balances in the bank statement to the balances in the
bank ledger. The bank reconciliation steps are:

1. Check that the opening balances agree (bank balance at the start of the month).

2. Compare the transactions of both balances. Record and correct any missing or
erroneous transactions in the bank ledger. A new bank ledger balance is calculated.

3. The new bank ledger balance and bank statement balance are compared again. A
Bank Reconciliation template is drawn up if they still do not agree.

 Record the bank Statement balance at the top.

 Make adjustments by deducting any uncleared payments (unpresented cheques)

and adding any uncleared receipts (outstanding lodgements).

 Correct any errors found in the bank statement.

The Bank Reconciliation template is shown as follows:

Bank Reconciliation
Statement

Bank Statement Balance X

Less: Unpresented (X)

Cheques

Add: Outstanding X
Lodgements

Add/(Less): Bank Error X/

(X)

Bank Ledger Balance X

The amended bank statement balance should then agree with the new bank ledger account
balance.