Learning objectives

By the end of this chapter, you should be able to:

• Explain why source documents are essential evidence for recording transactions and creating an audit trail.
• Select the correct book of prime entry for common business transactions and explain why each book is used.
• Apply debit/credit logic to post from books of prime entry to ledger accounts, including VAT where relevant.
• Prepare receivables and payables control accounts from period totals and reconcile them to lists of balances and supporting evidence.
• Prepare a bank reconciliation by updating the cash book for bank-only items and explaining timing differences.
• Identify and correct common misclassifications (cash vs credit, VAT, discounts, returns, and dishonoured receipts).

Overview & key concepts

A simple process map (how evidence becomes financial statements)

Source document → Book of prime entry → Ledger accounts → Trial balance → Financial statements

• The source document provides evidence.
• The book of prime entry records the transaction in the correct “bucket”.
• Ledger accounts collect and summarise the effect by account.
• The trial balance checks that double-entry has been applied consistently.
• Financial statements present performance and position.

Why source documents matter

A source document is the original proof that a transaction occurred and the details are correct (date, amount, parties, terms, tax). Examples include sales invoices, supplier invoices, credit notes, receipts, remittance advices, till rolls, bank statements, payroll summaries, petty cash vouchers, and goods received notes.

Together, the documents and the accounting entries form an audit trail—a chain that allows a user to trace a figure in the accounts back to evidence (and trace the evidence forward into the accounts).

The accounting equation and transaction logic

Every entry must keep the accounting equation in balance:

Assets = Liabilities + Equity

Income and expenses are recorded during the period and ultimately affect equity:

• Income increases equity(through profit).
• Expenses decrease equity(through profit).

Debits and credits (practical rules)

Focus on what increases and what decreases:

Assets

• Increase:Debit
• Decrease:Credit

Liabilities

• Increase:Credit
• Decrease:Debit

Equity

• Increase:Credit
• Decrease:Debit

Income

• Increase:Credit
• Decrease:Debit

Expenses

• Increase:Debit
• Decrease:Credit

“Cash” vs “credit” (what the words really mean)

In bookkeeping, cash usually means immediate settlement to cash or bank (including card receipts that settle directly to the bank). It does not necessarily mean notes and coins.
A credit transaction creates a receivable or payable first; cash/bank moves later when it is settled.

Core theory and frameworks

Source documents: three practical checks

Source documents help you check three practical things:

1. Reality: the transaction genuinely took place and relates to the business.
2. Measurement: quantities, prices, and tax have been calculated correctly.
3. Recording: it has been posted to the correct account and the correct period.

Books of prime entry (BPE): where transactions are first recorded

Books of prime entry organise transactions so they can be posted efficiently to ledgers.

Common books and what they capture:

• Sales day book: credit sales invoices only (not cash/card sales).
• Sales returns day book: customer credit notes (returns/allowances).
• Purchases day book: credit purchase invoices only.
• Purchases returns day book: supplier credit notes.
• Cash book: money in and out of bank (and sometimes a separate cash column for notes/coins).
• General journal: items not suited to the day books (opening entries, accruals, depreciation, bad debts/allowances, corrections, transfers).

Posting to ledger accounts

After recording in the books of prime entry:

• Totals from day books are posted to thegeneral ledger(for example, total credit sales to revenue).
• Individual customer/supplier entries are posted to thereceivablesandpayablesledgers.

VAT handling

Net, VAT, and gross

When VAT applies:

• Sales invoices typically shownet + VAT = gross.
• Purchases invoices typically shownet + VAT = gross.

The accounting records usually keep VAT separate:

• Output VAT on sales: liability (until paid to the tax authority)
• Input VAT on purchases: recoverable (or offsets output VAT)

VAT fraction (for VAT-inclusive figures)

If an amount is VAT-inclusive, extract VAT using the fraction:

VAT fraction = rate / (100 + rate)

Example at 10% VAT:

• VAT = gross × 10/110
• Net = gross × 100/110

Common transaction patterns and correct journal entries

Credit sale (invoice issued)

• Dr Trade receivables (gross)
• Cr Sales revenue (net)
• Cr VAT payable (output VAT)

Cash/card sale (immediate settlement)

• Dr Bank/Cash (gross)
• Cr Sales revenue (net)
• Cr VAT payable (output VAT)

Credit purchase (inventory or expense)

• Dr Inventory (or expense) (net)
• Dr VAT receivable (input VAT)
• Cr Trade payables (gross)

Sales returns (customer credit note)

• Dr Sales returns / Revenue reduction (net)
• Dr VAT payable (output VAT reduction)
• Cr Trade receivables (gross)

Dishonoured cheques (customer receipt reversed by bank)

Two effects are common:

1. The bank reverses the receipt:
   • Dr Trade receivables
   • Cr Bank
2. The bank charges a fee:
   • Dr Bank charges expense
   • Cr Bank

Settlement discounts (discounts taken on payment)

Settlement discounts are recorded only when payment is made and the discount is actually taken.

Discount allowed (given to customer):

• Dr Bank (amount received)
• Dr Discount allowed (expense)
• Cr Trade receivables (amount cleared)

Discount received (from supplier):

• Dr Trade payables (amount cleared)
• Cr Bank (amount paid)
• Cr Discount received (income)
• (Alternatively, discount received may be presented as a reduction of related costs, depending on policy and materiality.)

VAT and settlement discounts (exam technique)
Follow the question instruction. Some questions require VAT to be reduced in proportion to the settlement discount; others tell you to ignore VAT on settlement discounts.

Optional illustration (VAT-adjustment variant)
A supplier invoice is gross 1,100 at 10% VAT (net 1,000, VAT 100). A 2% settlement discount applies to the gross amount (discount 22). VAT reduces by 2 (10% of net discount 20), and the remaining 20 is discount received.

On payment (VAT-adjustment variant):

• Dr Trade payables 1,100
• Cr Bank 1,078
• Cr VAT receivable 2
• Cr Discount received 20

Control accounts

A control account is a summary account representing the total of many individual customer or supplier accounts. It provides a check that postings are complete and accurate by comparing:

• the control account balance, and
• the total of individual balances from the receivables/payables listings.

Cash book and bank reconciliation

Two-stage approach

1. Update the cash bookfor items on the bank statement not yet recorded internally (bank charges, interest, standing orders/direct debits, dishonoured items, bank errors).
2. Reconcilethe updated cash book balance to the bank statement balance using timing differences (outstanding lodgements and unpresented payments).

Only stage 1 changes the ledger balance. Stage 2 explains differences.

Petty cash imprest (controlled small payments)

Under an imprest system:

• A fixed float is set.
• Small payments are supported by vouchers.
• At replenishment, the float is topped back up to the fixed amount.

Payroll documents (gross pay, deductions, net pay)

Payroll records usually show:

• Gross pay(wages expense)
• Employee deductions(amounts owed to authorities/other parties)
• Net pay(cash paid to employees)

A simple set of entries:

• Dr Wages expense (gross)
• Cr Payroll liabilities (deductions)
• Cr Bank (net pay)

Drawings of goods (owner withdrawals)

Goods taken by the owner are not an expense. They are a withdrawal of value by the owner and reduce equity. In some bookkeeping systems (especially where purchases are accumulated during the year), drawings of goods may be recorded by reducing purchases; the key outcome is that profit is not understated and equity is reduced.

Worked example

Narrative scenario

ABC Retail is an unincorporated retail business. During December, the opening balances were:

• Trade receivables:USD 50,000
• Trade payables:USD 30,000

VAT is charged at 10%.

The following transactions occurred during the month:

1. Sold goods on credit forUSD 20,000 (net)plus VAT.
2. Received a customer cheque forUSD 15,000, which was later dishonoured by the bank.
3. Purchased inventory on credit forUSD 10,000 (net)plus VAT.
4. Settled a supplier invoice with agross balance of USD 5,000and received a2% settlement discount(cash paidUSD 4,900). Assume VAT isnotadjusted for the settlement discount.
5. Recorded sales ofUSD 8,000 (VAT-inclusive), made up of:
   • Cash takings USD 4,000 (VAT-inclusive), and
   • Card sales USD 4,000 (VAT-inclusive).
6. BankedUSD 3,500of the cash takings;USD 500was retained as a cash float.
7. The card provider settled thegross card receipts (USD 4,000)into the bank. Merchant fees ofUSD 1,000were charged separately.
8. Issued a customer credit note for returned goods ofUSD 2,000 (net)plus VAT.
9. Paid wages ofUSD 3,000; employee deductions wereUSD 500.
10. Reimbursed petty cash expenses ofUSD 200from the bank.
11. Recorded drawings of goods at cost ofUSD 500.
12. The bank statement included a bank charge ofUSD 50not yet recorded in the cash book.

Required

• Compute the VAT payable for the period.
• Prepare the trade receivables control account.
• Prepare the trade payables control account.
• Reconcile the cash book with the bank statement (updating the cash book for bank-only items).
• Identify and correct any misclassifications in the draft records.
• Describe the impact on the financial statements.

Solution

1) VAT payable for the period

Output VAT (sales)

Credit sale (net stated):

• Output VAT = 20,000 × 10% =2,000.00

Total retail sales (VAT-inclusive):

• Output VAT = 8,000 × 10/110 =727.27
• Net retail sales = 8,000 × 100/110 =7,272.73

Sales return (credit note, net stated):

• Output VAT reduction = 2,000 × 10% =200.00

Input VAT (purchases)

Credit purchase of inventory (net stated):

• Input VAT = 10,000 × 10% =1,000.00

Net VAT payable

VAT payable = Output VAT − Input VAT
= (2,000.00 + 727.27 − 200.00) − 1,000.00
= 1,527.27

VAT payable (liability): USD 1,527.27

2) Trade receivables control account (running balance format)

Closing trade receivables: USD 69,800

3) Trade payables control account (running balance format)

Closing trade payables: USD 36,000

4) Cash book update and bank reconciliation

Stage 1: Update the cash book for bank-only items

The bank charge of USD 50 appears on the bank statement but was not yet recorded.

Entry to update the cash book:

• Dr Bank charges expense50
• Cr Bank50

Stage 2: Updated bank (cash book) position for the month

Bank receipts

• Customer cheque received:15,000
• Cash banked:3,500
• Card receipts settled to bank (gross):4,000

Total receipts = 22,500

Bank payments

• Dishonoured cheque (bank reversal):15,000
• Supplier payment:4,900
• Merchant fees:1,000
• Wages paid (net):3,000
• Petty cash reimbursement:200
• Bank charge:50

Total payments = 24,150

Closing bank balance (overdraft) = 22,500 − 24,150 = (1,650)

So, the updated cash book shows a bank overdraft of USD 1,650.

Bank reconciliation statement (what can be concluded from the information given)

With no bank statement closing balance and no timing differences provided (such as outstanding lodgements or unpresented payments), the focus here is the cash book update and the correct treatment of bank-only items. In a full question, you would compare the updated cash book balance to the bank statement balance given and list any timing differences needed to reconcile the two.

Cash in hand
The cash float retained is USD 500, which remains as cash-in-hand (an asset) and is separate from the bank balance.

5) Misclassifications and corrections (high-impact checks)

• VAT on VAT-inclusive sales: VAT must be extracted using the VAT fraction (rate ÷ (100 + rate)), not calculated as a simple percentage of the gross.
• Dishonoured cheque: a dishonour reinstates the receivable and reverses the bank receipt; it is not a “deduction” from receivables in the period totals.
• Cash vs bank movement: cash banking is a transfer from cash-in-hand to bank. It does not create additional sales.
• Settlement discount clearing: a supplier balance of USD 5,000 gross is cleared by USD 4,900 cash plus USD 100 discount received (and VAT treatment follows the question instruction).

6) Impact on the financial statements (high level)

Profit or loss (performance)

• Revenue includes:
  1. Credit sales (net)20,000
  2. Retail sales (net)7,272.73
  3. Less returns (net)2,000
• Expenses include:
  1. Wages (gross)3,500(net paid 3,000 plus deductions payable 500)
  2. Merchant fees1,000
  3. Bank charges50
  4. Petty cash expenses200(assuming supported by vouchers)
• Discount received100is recorded as other income (or as a reduction of related costs, depending on presentation policy).
• Drawings of goods500are not an expense; they reduce equity.

Financial position (statement of financial position)

• Trade receivables close at69,800(gross).
• Trade payables close at36,000(gross).
• VAT payable is1,527.27(liability).
• Bank is an overdraft of1,650(liability if presented as overdraft).
• Payroll deductions500create a liability until paid.
• Cash-in-hand includes theUSD 500float (asset).

Common pitfalls and misunderstandings

• Treating VAT as part of revenue/expense rather than separating it into VAT control accounts.
• Calculating VAT incorrectly on VAT-inclusive figures (forgetting to use the VAT fraction).
• Recording a dishonoured cheque as a receipt reduction without reversing the bank entry and reinstating the receivable.
• Confusing cash-in-hand with bank: banking cash is a movement between assets, not income.
• Posting credit sales into the cash book (credit sales belong in the sales day book and receivables ledger).
• Omitting settlement discounts or posting them to the wrong side (discount allowed is an expense; discount received is income or cost reduction).
• Mixing up returns: credit notes reduce the customer balance and reduce revenue (and output VAT).
• Building control accounts from individual invoices instead of using period totals and then reconciling to listings.
• Performing a bank reconciliation without first updating the cash book for bank-only items.
• Recording wages using net pay only (gross expense and deductions liabilities must be recognised).
• Treating drawings as an expense rather than as a reduction of equity.
• Forgetting that receipts in advance are liabilities until the goods/services are provided.

Summary and further reading

Accurate bookkeeping starts with reliable evidence. Source documents support each transaction and create a clear audit trail. Books of prime entry organise transactions efficiently before posting to ledgers. Control accounts provide an accuracy check over receivables and payables, while bank reconciliation ensures bank balances in the records match external evidence once cash book updates and timing differences are properly handled.

To strengthen exam performance, practise:

• identifying the correct book of prime entry from a set of documents,
• extracting VAT from VAT-inclusive amounts,
• preparing control accounts from period totals, and
• updating the cash book before reconciling to the bank statement.

FAQ

What is the role of source documents in accounting?

They provide evidence for each transaction and support accurate recording. They also make it possible to trace amounts in the records back to what actually happened.

How do books of prime entry differ from ledger accounts?

Books of prime entry record transactions first in grouped form (for example, all credit sales invoices). Ledger accounts then collect postings by account to show totals and balances.

What is the importance of control accounts?

They summarise receivables or payables and provide a check that postings to individual accounts are complete and accurate by comparing the control balance to the total of individual balances.

How is a bank reconciliation performed?

First update the cash book for bank-only items not yet recorded. Then compare the updated cash book balance with the bank statement balance and list timing differences that explain any remaining difference.

What are settlement discounts and how are they recorded?

They are reductions for early payment and are recorded only when taken. Discount allowed is an expense; discount received is income (or a reduction of related costs). If the question requires it, VAT may also be adjusted proportionately when the discount is taken.

What is deferred income and why is it shown as a liability?

If you receive money before you deliver the goods or service, you haven’t earned it yet. Until you supply what was promised, the amount represents an obligation to the customer, so it is shown as a liability. When delivery happens, you move it from the liability to revenue.

How are dishonoured cheques handled?

A dishonour reverses the bank receipt and reinstates the receivable. Any bank charges are recorded as expenses.

Summary (Recap)

This chapter explained how source documents feed into books of prime entry, then into ledger accounts, before producing a trial balance and financial statements. It reinforced debit/credit logic using the accounting equation, clarified cash versus credit transactions, and showed how VAT is separated from revenue and expenses (including how to extract VAT from VAT-inclusive amounts). It also covered control accounts as a completeness check and bank reconciliation as a two-stage process: update the cash book for bank-only items, then reconcile using timing differences. The worked example integrated these techniques by calculating VAT payable, preparing control accounts in a clear running-balance format, and aligning bank movements with cash and card sales.

Glossary

Source documents
Original evidence of a transaction’s details (date, amount, parties, terms, tax), used to support entries and create a traceable record.

Audit trail
A traceable link from source evidence through books and ledgers to reported figures (and back again).

Books of prime entry
First-stage records that collect similar transactions before posting to ledgers.

Ledger accounts
Records that accumulate transactions by account to show totals and balances.

Control account
A summary account representing the total of many individual balances, used to check completeness and accuracy.

Bank reconciliation
A statement that explains the difference between the updated cash book balance and the bank statement balance, usually due to timing differences.

Settlement discount
A reduction granted for early payment. Recorded when taken; VAT treatment follows the question instruction.

Dishonoured cheque
A receipt reversed by the bank; it reinstates the receivable and may create bank charges.

VAT (Value Added Tax)
A transaction tax recorded separately: output VAT arises on sales, input VAT arises on purchases; the net is payable or recoverable.

Petty cash imprest
A controlled system where a fixed petty cash float is maintained and replenished based on vouchers.

Deferred income
Cash received before goods/services are supplied; recorded as a liability until earned.

Drawings
Owner withdrawals (cash or goods) that reduce equity rather than being treated as an expense.

Merchant fees
Charges by payment processors for handling card receipts, recorded as an expense and typically paid from the bank.