Projekt współfinansowany ze środków Unii Europejskiej w ramach Europejskiego Funduszu Społecznego

Fundamentals of Financial Accounting

Rafał Grabowski

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Dr Rafał Grabowski
 Projekt współfinansowany ze środków Unii Europejskiej w ramach Europejskiego Funduszu Społecznego

Contents
Introduction ........................................................................................................................................... 4
CHAPTER I Business Environment and Accounting ................................................................................. 5
I.1 Information as a Basis of Wise Decisions about Allocation of Resources ........................... 5
I.2 The General Concept of Accounting.................................................................................... 7
I.2.1 The Definition and Types of Accounting ............................................................................. 7
I.2.2 The Monetary Unit Assumption (Principle) ......................................................................... 9
I.2.3 The Balance Method ........................................................................................................... 9
I.2.4 The Entity Assumption (Principle) ..................................................................................... 12
I.3 Summary............................................................................................................................ 14
I.4 Exercises ............................................................................................................................ 15
CHAPTER II Balance Sheet: the Concept and Recognizing of Assets, Liabilities and Owners’ Equity ... 18
II.1 The General Concept of Financial Statements .................................................................. 18
II.2 The General Concept of a Balance Sheet .......................................................................... 19
II.3 Recognition Criteria of Assets ........................................................................................... 22
II.4 Recognition Criteria of Owners’ Equity and Liabilities ...................................................... 25
II.5 The Actual Layout of a Balance Sheet in Accordance with the Accounting Act ................ 27
II.6 Summary............................................................................................................................ 31
II.7 Exercises ............................................................................................................................ 31
CHAPTER III Business Transactions within the Accounting System (part I)........................................... 37
III.1 Business Transactions and Their Influence on the Financial Position of an Entity ........... 37
III.2 Measurement of business transactions ............................................................................ 41
III.3 Documentation of business transactions .......................................................................... 42
III.4 Recording of business transactions ................................................................................... 44
III.5 Summary............................................................................................................................ 57
III.6 Exercises ............................................................................................................................ 57
CHAPTER IV Profit and Loss Account ..................................................................................................... 68
IV.1 The General Concept of Profit (Loss), Revenues, and Expenses ....................................... 68
IV.2 Recognition and measurement of revenues and expenses .............................................. 71
IV.3 The Division of Income ...................................................................................................... 79
IV.4 Summary............................................................................................................................ 81
IV.5 Exercises ............................................................................................................................ 83
CHAPTER V Business Transactions within the Accounting System (part II) .......................................... 90
V.1 Recording Revenues and Expenses ................................................................................... 90
V.2 Transferring Revenues and Expenses to the “Net Profit (Loss)” Account ......................... 95

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V.3 Summary............................................................................................................................ 98
V.4 Exercises ............................................................................................................................ 98

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Introduction
This manual is designed for students who are starting to learn (study) accounting. It
contains a description of the key issues that are discussed during the course "Accounting".
However, it should be noted that the manual cannot be considered as an alternative to the
lectures - it may be treated only as an addition to the lectures. The manual describes the
theory. However, it also contains examples and exercises that are helpful in understanding
described issues.
This manual was written as a part of the project “Young Teachers Prepare a
Management Course in English” implemented at the Warsaw School of Economics.
Therefore, I offer thanks to all those who initiated and pursued this project.

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CHAPTER III
Business Transactions within the Accounting System
(part I)

III.1 Business Transactions and Their Influence on the Financial

Position of an Entity
A balance sheet is prepared as at a specific point in time, the so-called balance sheet
date. Therefore in some sense a balance sheet is a picture of an entity’s assets, liabilities and
capital (called previously within this book - owners’ equity). However running a company is a
dynamic process that affects assets, liabilities, and owners’ equity. Thus “the picture” that was
taken at one point in time may be, and usually is, different than “the picture” that will be
taken at another point in time. In other words, as a result of running a company, a company’s
financial position - described in the balance sheet in terms of assets, liabilities and owners’
equity - changes.
Actions and events that affect an entity’s financial position are called business
transactions. These actions may be taken (1) by internal managers and other employees, and
(2) by external stakeholders. For example, if an employee buys raw materials on credit (on
behalf of an entity) from a supplier, then such a business transaction affects the entity’s
financial position by increasing the value of inventories and trade payables.
The financial position of an entity may be also affected be events that are independent
of internal managers, other employees, and external stakeholders. For example, let’s consider
a natural disaster which results in the damage of inventories. In such a situation the value of
inventories and owners’ equity (precisely – net profit which is a part of owners’ equity)
decreases.
Each business transaction affects financial position in a specific manner. This manner
is the result of applying of the balance method. To make it clear it is useful to refer to the
accounting equation.

Assets = Owners’ equity + Liabilities

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Since assets, owners’ equity, and liabilities are not homogenous groups, we may expend this
equation by splitting each element of the equation into particular categories. If we use
categories of assets, owners’ equity, and liabilities which are included in the simplified
balance sheet described in chapter II, then we may write the accounting equation as follows.

Exhibit III.1 The Accounting Equation Written on the Basis of the Simplified Balance
Sheet

Owners’ equity + Liabilities

+ Share capital
Assets
+ Called up share capital
+ Intangible assets + Own shares (-)
+ Tangible assets + Supplementary capital
+ Long-term receivables + Revaluation reserve
+ Long-term investments + Other reserves
+ Long-term prepayments + Retained earnings (losses)
+ Inventories + Net profit (loss)
+ Short-term receivables + Write-off on net profit during the financial year (-)
+ Short-term investments + Provisions
+ Short-term prepayments + Long-term liabilities
+ Short-term liabilities
+ Accruals

The accounting equation that is presented above may be extended by applying the real
layout of the balance sheet, however it is not necessary.
The accounting equation always exists. Regardless of a point in time, the sort of an
entity, business transactions, and other factors, assets always equal owners’ equity plus
liabilities. It means that each business transaction affects at least two variables of the
accounting equation in the manner in which the right side of the equation remains equal
left side. However, it does not mean that after recording business transaction the value
of right and left side of the accounting equation must remain unchanged.
Since each business transaction affects at least two variables in the manner in which
the right side of the equation remains equal left side, we may distinguish the following types
of business transactions.
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1. Business transactions that affect only structure of assets. The total value of assets and the
total value of owners’ equity plus liabilities do not change. For example, let us assume
that an entity purchased raw materials (PLN 1 000.00) for cash. As a result of this
business transaction the value of inventories increased by PLN 1 000.00 and the value of
cash decreased by PLN 1 000.00. The total value of assets and total value of owners’
equity plus liabilities remained unchanged.
2. Business transactions that affect only the structure of the right side of the accounting
equation (owners’ equity and liabilities). For example, let us assume that an entity
converted short-term credit (PLN 150 000.00) into long-term credit. As a result of this
business transaction the value of short-term liabilities resulting from short-term credit
decreased by PLN 150 000.00 and the value of liabilities resulting from the long-term
credit increased by PLN 150 000.00. The total value of assets and total value of owners’
equity plus liabilities remained unchanged.
3. Business transactions that affect the left side and the right side of the accounting equation.
The total value of assets and the total value of owners’ equity plus liabilities change. For
example, let’s assume that a company purchased a computer for its own use (PLN
5 000.00) on credit (the date of payment – the end of next month). In such a situation the
value of tangible assets increased by PLN 5 000.00 and the value of short-term liabilities
also increased by PLN 5 000.00. The total value of assets and the total value of owners’
equity plus liabilities increased by PLN 5 000.00.

Example III.1 The Influence of the Business Transactions on the Accounting Equation
In order to illustrate how business transactions affect the accounting equation let’s
consider the following example. Assume that on 2 January 2019 Mr Johnson established a
limited liability company – “Teachers for you”. The core business of this entity is teaching
foreign languages. Within the month of January Mr Johnson (on behalf of the company) took
5 actions. Each of them and their influence on the accounting equation are described below.
Action 1: On 10 January Mr Johnson contributed to the entity a building (PLN 200 000.00)
which was intended for the entity’s own use. On this basis we may illustrate the effect of the
business transaction on the accounting equation as follows.

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Assets = Owners’ equity + Liabilities

Tangible assets = Share capital + Liabilities
200 000.00 = 200 000.00 + 0.00

Action 2: On 12 January Mr Johnson submitted an application to a bank, and the bank

granted a credit (50 000.00) to the entity. The bank transferred money to the entity’s account.
The credit should be repaid on 31 December 2019. After this transaction the accounting
equation should be written as follows.

Assets = Owners’ equity + Liabilities

Tangible assets + Short-term investments = Share capital + Short-term liabilities
200 000.00 + 50 000.00 = 200 000.00 + 50 000.00

Since in accordance with the Accounting Act cash is a part of short-term investments, the
amount of PLN 50 000.00 was recognized as the short-term investments. On the other side of
the equation PLN 50 000.00 was recognized as a short-term liabilities.

Action 3: On 18 January 2019 a supplier delivered a computer (PLN 5 000.00) and an invoice
(date of payment - 25 January 2019). On the basis of the description we may say that the
value of tangible assets increased by PLN 5 000.00 and the value of short-term liabilities
increased also by PLN 5 000.00. Therefore after the action 3 the accounting equation should
be written as follows.

Assets = Owners’ equity + Liabilities

Tangible assets + Short-term investments = Share capital + Short-term liabilities
205 000.00 + 50 000.00 = 200 000.00 + 55 000.00

Action 4: On 25 January Mr Johnson paid the entity’s liability (PLN 5 000.00) to the supplier
who delivered the computer. The payment was made by a bank transfer. As a result of the
transaction the value of short-term investments decreased by PLN 5 000.00 and the value of
short-term liabilities decreased by PLN 5 000.00 as well.

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Assets = Owners’ equity + Liabilities

Tangible assets + Short-term investments = Share capital + Short-term liabilities
205 000.00 + 45 000.00 = 200 000.00 + 50 000.00

Action 5: On 16 January 2019 Mr Johnson (on behalf of the entity) placed an order for office
supplies for PLN 7 000.00. In this case we may say that the action which was taken by Mr
Johnson did not influence the accounting equation. This is not a business transaction, because
it does not influence on either resources (assets) or sources of assets funding (owners’ equity
and liabilities). Therefore after this action the accounting equation remains unchanged as
compared to the equation before the action 5 was taken.

Assets = Owners’ equity + Liabilities

Tangible assets + Short-term investments = Share capital + Short-term liabilities
205 000.00 + 45 000.00 = 200 000.00 + 50 000.00

III.2 Measurement of business transactions

Business transactions affect a company’s financial position which is communicated
through the financial statements. Therefore these transactions must be collected, accumulated,
and processed within the accounting system. To do so we need to answer the following
questions.
1. How to measure financial results of business transactions?
2. How to document business transactions?
3. How to record business transactions?
As to measurement, we should apply two rules. The first one – well known at this
stage since it was explained in the chapter I – is the monetary unit principle which requires
that we should measure the results of business transactions in terms of money. The second
rule refers to the manner of assessing the financial results of business transactions. That
second rule is called cost principle and holds that the value of acquired assets and services
should be initially assessed at their actual cost which is also called historical cost. In the case

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of purchases, historical cost equals actual (real) price paid for purchased assets and services.
Even though the manager or another employee may believe that the price paid is a bargain,
and usual price is much higher, the value of acquired assets or services should be assessed at
the actual price that was paid.

III.3 Documentation of business transactions

Another step, that we should take in order to find out how to record business
transactions within the accounting system, refers to documentation. Every business
transaction should be documented in the form of the so-called source documents. In fact,
preparation of source documents is the first formal stage of collecting, accumulating, and
processing information within the accounting system. Source documents are evidence of
business transactions and contain input (information) that is entered into the accounting
system. Examples of source documents are: invoices, bank statements, cash register files,
employee earnings records.
In accordance with the Accounting Act there are following sorts of source
documents6:
1. third party external source documents - received from contractors, for example bank
statements, purchase invoices;
2. own external source documents (originals) - prepared by an entity and in the case of which
copies are submitted to contractors; they include especially sales invoices;
3. internal source documents - are prepared by an entity and relate to internal transactions in
the case of which the only party that is involved is the entity.
Entries into the accounting system may also be based on the following types of source
documents prepared by an entity7:
1. aggregated documents – used to make summary entries in respect of a set of source
documents which should be mentioned separately in a related aggregated document;
2. documents correcting previous entries;
3. substitute documents – which may be used in the case of a justifiable inability to obtain
third party external source document; however it is not allowed to use substitute

6
The Accounting Act of 29 September 1994, article 20.
7
The Accounting Act of 29 September 1994, article 20.

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documents in respect of business transaction which are subject to the Value Added Tax
and to business transactions which involve purchases of non-ferrous scrap metal from
individuals;
4. settlement documents – which allocate existing entries according with new classification
criteria.
Nowadays source documents can be prepared in either hard copy or in electronic form. To
apply appropriate sort and form of document it is crucial do proceed in accordance with
accounting regulations and other provisions, especially devoted to documentation of
transactions which are subject to Value Added Tax.
Within literature devoted to information systems exists the opinion that is called
“garbage in – garbage out” (GIGO). This opinion states that if we enter incorrect input
(information) into a system, we will obtain output (results) that will be also incorrect. Since
source documents contain input (information) that is entered into the accounting system, we
may conclude that the output – which appears in the form of financial statements – depends to
a great extent on source documents. Therefore to expend probability that the output (the
financial statements) will be reliable and useful, source documents should include specified
data and characteristics.
A source document should contain at least8:
1. “a description of the the type (for example: invoice) of document and its identification
number;
2. names and addresses of the parties involved in a business transaction;
3. a description of the transaction and its value, specified also in volume units, if it is
possible (since value depends on volume);
4. a transaction date;
5. a date when the document was prepared if it is different from the transaction date;
6. a signature of the person who made out the document and of the person who received or
delivered a given item of assets;
7. a statement that the document was verified and approved for recording in the accounting
system (in the books of accounts which will be explained in the next part of this chapter)

8
The Accounting Act, article 21.

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by indicating the month and the so-called posting (to be explained later), as well as a
signature of the person responsible for such these statements”.
The Accounting Act includes provisions which simplify source documents if some conditions
are held. However there are also provisions which require containing more pieces of
information than it was listed above. Those provisions refer to documents expressed in
foreign currencies.
Source documents should also include specified characteristics9. Firstly, they
should be reliable. It means that they should be consistent with the actual courses of business
transactions. Secondly, they should contain data specified in provisions devoted to them – the
required set of data was listed above. Thirdly, they should be free from arithmetical errors.

III.4 Recording of business transactions

The part of the accounting system which is responsible for recording business
transactions, on the basis of source documents, is called bookkeeping. Within the accounting
system information is accumulated and processed in the so-called books of accounts, which
include: (1) a journal, (2) a general ledger and subsidiaries ledgers, (3) a trial balance, and (4)
lists of assets, owners’ equity and liabilities.

Exhibit III.2 The Structure of the Books of Accounts in Accordance with the
Accounting Act

2. A general
ledger and
1. A journal
subsidiary
ledgers

4. A list of
3. A trial assets, owner's
balance equity and
liabilities

9
The Accounting Act of 29 September 1994, Article 22.

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In order to record business transactions an account is used. The concept of an account

is applied within: (1) a journal, (2) a general ledger and subsidiary ledgers, and (3) within a
trial balance. Therefore, to discuss these items (1-3) it is necessary to explain the idea of an
account.
Many authors refer to an account as a basic tool or device. However, it seems to be
much more precisely to say that an account is a manner in which we record values and its
changes of assets, owners’ equity, liabilities, and – to be explained later – revenues and
expenses.
Each account should be used to record the value and its changes for one exactly
specified category of assets, owners’ equity, liabilities, revenues, and expenses. Therefore,
each account should be marked in order to indicate the category for which the account is
held. In reality names and identification numbers (also called account codes) are used to mark
accounts. However, in this book we use only names.
An account consists of two sides. The left side of an account is called the Debit
(abbreviated Dr), and the right side is called the Credit (abbreviated Cr10). One of them is
used to record increases of value and the other to record decreases. In theory an account is
illustrated by the symbol which is similar to capital letter T. Therefore it is called T-account.

Exhibit III.3 The T-account

Debit (Dr) Name and identification number Credit (Cr)

of an account

In order to explain which side is used for increases and which for decreases of assets, owners’
equity, and liabilities it is necessary to divide accounts as follows.

10
These abbreviations (Dr and Cr) derive from words: debitor and creditor, which were used in recordkeeping
practices in the 18th century instead of debit and credit.

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Exhibit III.4 The rules of entering increases and decreases in accounts

Accounts

Accounts used for the purpose of Accounts used for the purpose of
recording values of assets and their recording values of owners’ equity
changes and liabilities and their changes

Debit (Dr) Credit (Cr) Debit (Dr) Credit (Cr)

+ - - +
Increases Decreases Decreases Increases

Recording business transactions within the accounting system we should remember

that for each transaction the total value of entries on the debit side always equals the
total value of entries on the credit side. To explain this statement it would be useful to write
the accounting equation applying accounts.

Exhibit III.5 The Accounting Equation Written by Applying Accounts

Assets = Owners’ equity + Liabilities

+ - - + - +

Since the total value of assets always equals the total value of owners’ equity plus
liabilities, we may conclude that the total value of entries on the debit side always equals the
total value of entries on the credit side. It means also that this equality, which always exists,
requires recording each business transaction in the manner in which:
1. the total value of an entry on the debit side always equals the total value of its opposite
entry on the credit side
2. each business transaction is recorded twice – on the debit side and on the credit side

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For this reason this system of recording of business transactions is called the double entry
book-keeping. An illustration of recording of business transactions is included in the
example III.2.

Example III.2 Increases and Decreases in Accounts

To illustrate how business transactions should be entered in accounts, we will
reconsider the particular actions from the example III.1.
Action 1: On 10 January Mr Johnson contributed to the entity a building (PLN 200 000.00)
which was intended for the entity’s own use. As a result of the transaction the value of
tangible assets and owners’ equity increased by PLN 200 000.00. The increase in the value of
the tangible assets was recorded on the debit side of the “Tangible assets – buildings”
account. The increase in owners’ equity was recorded on the credit side of the “Owners’
equity” account.
Action 2: On 12 January Mr Johnson submitted an application to a bank, and the bank
granted the credit (50 000.00) to the entity. The bank transferred money to the entity’s
account. The credit should be repaid on 31 December 2012. The transaction affected assets
(money in a bank which is a part of short-term investments) and short-term liabilities. The
increase in money was recorded by debit. The increase in short-term liabilities was recorded
by credit.
Action 3: On 18 January Mr Johnson acquired a computer for PLN 5 000.00 (the date of
payment – (25 January 2019). On the basis of the description we may say that the value of the
tangible assets increased by PLN 5 000.00 and the value of the short-term liabilities increased
also by PLN 5 000.00. The increase in the tangible assets was debited to the “Tangible assets
– machinery and equipment” account. The increase in the short-term liabilities was credited to
the “Short-term liabilities – credits and loans” account.
Action 4: On 25 January Mr Johnson paid the entity’s liability (PLN 5 000.00) to the supplier
who delivered the computer. The payment was made by a bank transfer. As a result of the
transaction the value of money in a bank decreased by PLN 5 000.00 and the value of the
short-term liabilities decreased by PLN 5 000.00 as well. The decrease in money was entered
on the credit side of “Short-term investments – money in a bank” account. The decrease in the
short-term liabilities was recorded on the debit side of the “Short-term liabilities” account.

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Action 5: On 16 January 2019, Mr Johnson on behalf of the company placed an order for a
computer for PLN 5 000.00. In this case we may say that the action which was taken by Mr
Johnson did not influence the accounting equation. This is not a business transaction, because
it does not influence on either resources (assets) or sources of assets funding (owners’ equity
and liabilities). Therefore this action was not recorded within the accounts.

Assets Owners’ equity and liabilities

Tangible assets –
buildings Share capital
1) 200 000 200 000 (1

Short-term
investments – money Short-term liabilities –
in a bank credits and loans
2) 50 000 5 000 (4 50 000 (2

Tangible assets –
machinery and Short-term payables -
equipment other
3) 5 000 4) 5 000 5 000 (3

At the end of reporting period, after recording business transactions, each account has
a balance, the so-called closing balance. This amount is a difference between total debits and
total credits of an account. If the sum of debits is greater than the sum of credits, the account
has the debit balance. If the sum of credits exceeds sum of debits, the account has the credit
balance. If the sum of debits equals the sum of credits, the account has a zero balance. In the
manual accounting systems the balances are computed as it is shown in the Exhibit III.6.
Nowadays most accounting systems are computerized. Therefore we do not need to
follow the rules indicated in the Exhibit III.6 to compute total debits, total credits, and
balances. “Pressing a key” we are able to generate them for any given account and at any
given point in time.

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Exhibit III.6 The Steps of Computing Balances in the Manual Accounting Systems

Dr Cr Dr Cr
2 300 700 Step 1 Underline all debits and credits and 100 1 500
1 200 300 summarize them. 300 500
500 200
4 000 1 000 Step 2 Determine which sum is greater – debits or 600 2 000
3 000 CB credits. CB 1 400
4 000 4 000 2 000 2 000
If sum of debits exceeds sum of credits, the
account has a debit balance. Such a balance should
be written on the credit side.

If sum of credits exceeds sum of debits, the

account has a credit balance. Such a balance
should be written on the debit side.

Step 3 Underline account one more time. Check

out whether the sums of numbers under the first
line are the same on both sides. Write down these
sums under the second line.

Example III.3 Computing of closing balances of accounts

To illustrate how to compute balances of accounts, we will reconsider the accounts
and the entries in them from the example III.2.

Assets Owners’ equity and liabilities

Tangible assets –
buildings Share capital
1) 200 000 200 000 (1
200.000 0 0 200 000
200 000 CB CB 200 000

Short-term
investments – money Short-term liabilities –
in a bank credits and loans
2) 50 000 5 000 (4 50 000 (2
50 000 5 000 0 50 000
45 000 CB CB 50 000

Tangible assets –
machinery and Short-term payables -
equipment other
3) 5 000 4) 5 000 5 000 (3
5 000 0 0 0
5 000 CB - -

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At this stage it should be accented that the sum of all debit balances always equals the
sum of all credit balances. This statement is always true because the accounting equation
always exists.
As a result of the consistency principle11, the value of a closing balance which was
computed at the end of one reporting period for an account should be used as the value of
opening balance at the beginning of consecutive reporting period for the same account. This
rule is included in the Accounting Act. In accordance with the Act, “balances of assets,
liabilities, and equity recognized in the books of accounts as at their closing date must be
recognized in the same amounts in the books of accounts opened for the following financial
year.”12

Example III.4 Opening of accounts13

During the year 2019 Miss Y. Lee established a joint-stock company “Young
Teachers”. In the course of the financial year 2019 six business transactions took place. Mrs
Y. Lee entered these transactions and closed accounts, which are presented below. On this
basis we will open accounts for the next financial year 2020.

11
The consistency principle states that a business entity should use the same methods and rules within the
consecutive reporting periods.
12
The Accounting Act of 29th September 1994, article 5.
13
This example is designed only for the purpose of illustrating rules of opening accounts. That is way the
example is very simplified. However the rules that are illustrated in the example should be applied in reality,
even if a business entity holds several thousand accounts.

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The accounts closed as at 31 December, 2019

Money in a bank Owners’ equity

1) 500 000 200 000 (2 500 000 (1
5) 7 000 6 000 (4 0 500 000
500 (6 CB 500 000 -
507 000 206 500 500 000 500 000
- 300 500 CB
507 000 507 000

Buildings Trade payables

2) 200 000 4) 6 000 8 000 (3
200 000 0 6 000 8 000
- 200 000 CB CB 2 000 -
200 000 200 000 8 000 8 000

Long-term liabilities –
Office supplies credits and loans
3) 8 000 6) 500 7 000 (5
8 000 0 500 7 000
8 000 CB CB 6 500
8 000 8 000 7 000 7 000

The accounts opened as at 1 January, 2020

Money in a bank Owners’ equity

OB 300 500 500 000 OB

Buildings Trade payables

OB 200 000 2 000 OB

Long-term liabilities –
Office supplies credits and loans
OB 8 000 6 500 OB

The Accounting Act includes the list of situations in which books of accounts should
be opened and closed. The most common in reality and the most important at this stage are
two situations relating to the beginning and to the end of financial year. In accordance with
the Act books of accounts are opened (among others) as at the beginning of each subsequent

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Dr Rafał Grabowski
 Projekt współfinansowany ze środków Unii Europejskiej w ramach Europejskiego Funduszu Społecznego

financial year; books of accounts are closed (among others) as at the last day of a financial
year14.
Since each account should be used only for one category of assets, liabilities, owners’
equity, revenues and costs, there are many categories of accounts. In fact every entity needs
many accounts. We can open (create) as many accounts as it is necessary. The division of
accounts should be as detailed as it is necessary to guarantee appropriate information for the
preparation of financial statements and the fulfilment of other entity’s obligations. For
example, since in reality in a balance sheet we should present inventories divided into five
categories, we should hold at least following accounts:
1. the materials account;
2. the semi-finished products and work in progress account;
3. the finished products account;
4. the goods for resale account;
5. the advances on supplies account.
The complete list of the entity’s accounts is called the chart of accounts.
At first sight it appears that recording business transactions only in accounts is enough.
However, it is not because in reality we need a possibility to “come back” to a business
transaction and check out what and how accounts were affected by it. Performing this task by
searching whole set of accounts and entries in them would be very difficult and time-
consuming. In reality large entities hold even hundreds accounts. Besides, in the course of one
reporting period occur even thousands business transactions. And that is why, linking debit(s)
and credit(s) for a particular transaction would be “mission impossible” in accounting,
especially in a large corporation. Therefore, apart from accounts and entries in them, we need
also a set of data that shows - in chronological order - the complete effect of business
transactions. Such a set of data is called a journal. In accordance with the Accounting Act a
journal should contain chronologically recorded business transactions which took place in a
given reporting period. All journal entries should be made in such a manner which enables to
correlate particular entries with their source documents. The example of a simplified journal
is shown in Exhibit III.7.

14
The Accounting Act of 29 September 1994, article 12.

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Dr Rafał Grabowski
 Projekt współfinansowany ze środków Unii Europejskiej w ramach Europejskiego Funduszu Społecznego

Exhibit III.7 The Simplified Example of a Journal

Date Document Description Name (or Dr Cr
type and identification
number number) of
account
02.01.2012 Invoice Purchase of materials on Inventories - 1 000 -
01/2012 credit materials
Trade payables - 1 000
03.01.2012 Bank statement Payment of liabilities Trade payables 200 -
001 Money in bank - 200

In principle, a business transaction should be entered into a journal and then should be
transferred into appropriate accounts, as it is illustrated in Exhibit III.8.

Exhibit III.8 The Theoretical Scheme of Transferring Entries from a Journal to

Accounts

Date Document Description Name (or Dr Cr

type and identification
number number) of
account
02.01.2012 Invoice Purchase of materials on Inventories - 1 000 -
01/2012 credit materials
Trade payables - 1 000

Inventories – raw
materials Trade payables
1 000 1 000

However, nowadays it is not necessary to make entries twice – into a journal and
into accounts. This is because in reality accounting systems are computerized and we enter
information into computer only once. Entering the transaction we should include15:
1. “the date of a business transaction,

15
The Accounting Act of 29 September 1994, article 23.

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Dr Rafał Grabowski
 Projekt współfinansowany ze środków Unii Europejskiej w ramach Europejskiego Funduszu Społecznego

2. the type and the identification number of a source document constituting the basis for an
entry as well as its date, if it is different from a transaction date;
3. an intelligible text, abbreviation or code describing a transaction; together with a written
explanation of contents of abbreviation or codes used;
4. the amount and date of an entry;
5. the identification of accounts.
Entries related to transactions expressed in foreign currencies should be made in a manner
allowing the determination of the amount of the transaction in both PLN and foreign currency.
Entries in a journal and general ledger accounts should be correlated in a manner which
enables verification”.
On the basis of the data specified above, accounting computer programs allocate
appropriate information within a data base in a manner in which information is assigned to a
journal and appropriate accounts. As a result of that we are able to generate a journal (or
journals) and trial balances (to be explained later).
The collection of all accounts together with all entries recorded in them is called a
general ledger (or ledger). The general ledger can be kept in the form of computer files on a
hard drive (in the case of computerized accounting systems) or as paper files (in the case of
manual accounting systems which are nowadays very rare). To some extent general ledgers of
business entities are similar, however there are also differences which result from the fact that
each entity is unique. Apart from a general ledger, books of accounts comprise also subsidiary
ledgers.
Subsidiary ledgers are sets of data which complement a general ledger. Subsidiary
ledgers may be kept in the form of accounts and in terms of money. However they may be
also kept in other forms and include other characteristics than value expressed in terms of
money. For example, subsidiary ledgers are kept for receivables; for each customer who
acquires on credit, entities keep records that comprise value of each transaction, payment date
and other characteristics which are crucial for the purpose of preparing financial statements16.

16
Subsidiary ledgers are kept also for other purposes. They are also kept in order to enable managing a
company and fulfil tax obligations. However, these topics are beyond the scope of the book.

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Dr Rafał Grabowski
 Projekt współfinansowany ze środków Unii Europejskiej w ramach Europejskiego Funduszu Społecznego

In accordance with the Accounting Act “subsidiary ledger accounts are kept in
particular for17:
1. items of property, plants, and equipment, including items of property, plant, and
equipment under construction, intangible assets as well as related amortisation and
depreciation charges;
2. trade receivables and payables;
3. employee receivables and payables, in particular remuneration record of each individual
employee which provides information in the entire period of employment;
4. sales transactions (sequentially numbered sales invoices and other documents, with
sufficient detail meet tax requirements);
5. purchase transactions (sequentially numbered purchase invoices and other documents with
sufficient detail to measure the value of assets and meet tax requirements);
6. costs and items of assets which are material to an entity;
7. cash transactions if the entity possesses cash-box”.
Another part of books of accounts is a trial balance which is prepared on the basis of
entries recorded in accounts of a general ledger. A trial balance should be prepared as at the
end of each reporting period, but at least as often as at the end of each month18. The example
of a trial balance is shown in Exhibit III.9.

Exhibit III.9 The Example of a Trial Balance

I. Randal Ltd
The trial balance for the reporting period: March, 2019
Total for the
Opening Total for the Closing
Account reporting
Name of account balance year-to-date Balance
code period
Dr Cr Dr Cr Dr Cr Dr Cr
010 Tangible assets 50 - 20 - 70 - 70 -
020 Intangible assets - - - - 30 - 30 -
100 Cash in hand 650 - - 35 650 65 585 -
130 Cash at bank 300 - 15 10 315 30 285 -
139 Credits and loans 100 10 - 30 100 - 70
801 Share capital 900 - - - 900 - 900
Total: 1 000 1 000 45 45 1095 1095 970 970

17
The Accounting Act of 29 September 1994, article 17.
18
The Accounting Act of 29 September 1994, article 18.

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Dr Rafał Grabowski
 Projekt współfinansowany ze środków Unii Europejskiej w ramach Europejskiego Funduszu Społecznego

In accordance with the Accounting Act a trial balance should include:

1. identification numbers (account codes) and names of accounts;
2. opening balances of accounts;
3. sum of all debits and all credits of each account for a given reporting period (usually
month);
4. sum of all debits and all credits of each account for a period of time from the beginning of
current financial year to the end of reporting period for which the trial balance is prepared
(year-to-date period);
5. closing balances of accounts.
The last part of books of accounts is a list of assets, owners’ equity and liabilities. In
accordance with the Accounting Act “a list of assets, liabilities and equity (an inventory)
confirmed by stocktaking should be prepared by entities which have not yet kept their books
of accounts in a manner stipulated in the Act. In other entities an inventory’s function is
performed by a trial balance of general ledger accounts and a statement of balances of
subsidiary ledger accounts prepared as at the date of closing the books of accounts”19.

19
The Accounting Act of 29 September 1994, article 19.

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Dr Rafał Grabowski
 Projekt współfinansowany ze środków Unii Europejskiej w ramach Europejskiego Funduszu Społecznego

III.5 Summary
Actions and events that affect financial position described in terms of assets, owners’
equity, and liabilities are called business transactions. These transactions must be collected,
accumulated, and processed within the accounting system. To do so we need to answer the
following questions.
1. How to measure financial results of business transactions?
2. How to document business transactions?
3. How to record business transactions?
As to measurement, we should apply two rules. The first one – well known at this
stage since it was explained in the chapter I – is the monetary unit principle. The second rule
refers to the manner of assessing the financial results of business transactions and is cost
principle.
Every business transaction should be documented in the form of the so-called source
documents. In fact, preparation of source documents is the first formal stage of collecting,
accumulating, and processing information within the accounting system. Source documents
are evidence of business transactions and contain input (information) that is entered into
accounting system.
The part of the accounting system which is responsible for recording business
transactions, on the basis of source documents, is called bookkeeping. Within the accounting
system information is accumulated and processed in the so-called books of accounts, which
include: (1) a journal, (2) a general ledger and subsidiaries ledgers, (3) a trial balance, and (4)
lists of assets, owners’ equity and liabilities.
In order to record business transactions an account is used. The concept of an account
is applied within: (1) a journal, (2) a general ledger and subsidiary ledgers, and (3) within a
trial balance.

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 Projekt współfinansowany ze środków Unii Europejskiej w ramach Europejskiego Funduszu Społecznego

III.6 Exercises

Exercise III.1 Multiple Choice Questions

1. The company X acquired raw materials on credit. The raw materials are intended for
building a new store. As a result of this business transactions:
a) increased the value of short-term receivables and tangible assets
b) increased the value of short-term receivables and inventories
c) increased the value short-term liabilities and tangible assets
d) increased the valued of short-term liabilities and inventories
2. The left side of an account is:
a) used to record increases
b) used to record decreases
c) used to record increases or decreases, depending on the type of an account
d) called credit
e) called debit
3. The right side of an account is:
a) used to record increases
b) used to record decreases
c) used to record increases or decreases, depending on the type of an account
d) called credit
e) called debit
4. The cost principle states that:
a) we should cut costs as much as possible
b) we should compare expenses to revenues
c) the value of acquired assets and services should be initially assessed at their actual
cost which is also called historical cost

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Dr Rafał Grabowski
 Projekt współfinansowany ze środków Unii Europejskiej w ramach Europejskiego Funduszu Społecznego

5. Source documents may be:

a) External
b) Internal
c) Only external
d) Only Internal
6. Assume that your company paid trade payables by a bank transfer. This business
transaction should be entered as follows:
a) on the credit side of the “trade payables” account and on the debit side of the “Money
in a bank” account
b) on the debit side of the “trade payables” account and on the credit side of the “Money
in a bank” account
c) on the credit side of the “trade receivables” account and on the debit side of the
“Money in a bank” account
a. on the debit side of the “trade receivables” account and on the debit side of the
“Money in a bank” account
7. In the case of each business transaction:
a) the total value of an entry on the debit side always equals the total value of its opposite
entry on the credit side
b) transaction is recorded twice – on the debit side and on the credit side
c) we need to open a separate account
d) we need a source document in order to enter a business transaction
8. The system of recording of business transactions is called the double entry book-keeping
because:
a) the total value of an entry on the debit side always equals the total value of its opposite
entry on the credit side
b) each transaction is recorded twice – on the debit side and on the credit side
c) we should enter each business transaction into a journal and then in accounts

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 Projekt współfinansowany ze środków Unii Europejskiej w ramach Europejskiego Funduszu Społecznego

9. Assume that in February 2012 your company received money from a customer who
bought in January on credit. This business transaction should be entered as follows:
a) on the credit side of the “trade payables” account and on the debit side of the “Money
in a bank” account
b) on the debit side of the “trade payables” account and on the credit side of the “Money
in a bank” account
c) on the credit side of the “trade receivables” account and on the debit side of the
“Money in a bank” account
d) on the debit side of the “trade receivables” account and on the debit side of the
“Money in a bank” account
10. Assume that your company borrowed money from a bank. This business transaction
should be entered as follows:
a) on the credit side of the “short-term liabilities” account and on the debit side of the
“Money in a bank” account
b) on the debit side of the “short-term liabilities” account and on the credit side of the
“Money in a bank” account
c) on the credit side of the “short-term receivables” account and on the debit side of the
“Money in a bank” account
d) on the debit side of the “short-term receivables” account and on the debit side of the
“Money in a bank” account

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