Nature
Definition
A trial balance is a list of all the closing debit and credit balances from each ledger account in the general ledger.
It lists all the debit and credit balances on the individual ledger accounts.
Generally, it is to be expected that:
There is no prescribed order in which the balances are listed. Businesses will adopt whatever is most convenient. For example:
Information on all business transactions travels through the accounting system to form the trial balance used to prepare financial statements.
Purpose of a Trial Balance
The trial balance is a list of all the closing balances of the individual general ledgers. A trial balance is prepared for several purposes:
Used as a starting point for preparing the financial statements
The financial statements are the end product of the accounting process. The Trial Balance extracted will help identify if double entries have been correctly posted. This makes the preparation of the final accounts more efficient.
Limitations of a Trial Balance
A trial balance will not identify error corrections.
An error identified in a trial balance merely indicates the existence of an error. It does not inform the cause of the problem and how to correct it. The trial balance is only the starting point for investigating errors in the general ledger.
Preparing a Trial Balance
Process of Preparing Trial Balance and Financial Statements
To create the trial balance, the following steps are made:
Prepare Initial Trial Balance
Prepare a Final Trial Balance
The remaining closing balances in the statement of financial position for the current year become the opening balances for next year.
DEAD CLIC
A trial balance is a list of all the closing balances from the ledger accounts in the general ledger. Debit or credit balances will be determined from the category of each ledger account (DEAD CLIC mnemonic).
DEBIT
Examples:
CREDIT
Expense
Telephone Bill
Rental
Sales Returns
Purchases
Liabilities
Loans
Trade Payables
Output Sales Tax
Bank overdraft
Assets
Motor Vehicles
Bank balance
Inventories
Trade Receivables
Input Sales Tax
Income
Sales
Purchase Returns
Bank Interest received
Discounts received
Drawings
Capital
Capital investment
Activity 1
From the balances of the general ledger, prepare the opening trial balance by selecting where the balance should appear: Debit or Credit column.
Once the trial balance has been completed, all necessary reconciliations have been made, and all balances verified, it will be the basis of the opening trial balance for the next accounting period.
Types of Errors
After extracting the initial trial balance, the business will identify any errors and make adjustments to correct them. Errors can be categorised into:
A suspense account is created to automatically balance the differences between the debit and credit amounts in the trial balance. Without it, the trial balance would not balance. The suspense account is temporary and is reversed when the business identifies and makes the necessary error corrections.
Examples of such errors that affect the trial balance are:
An error of partial omission occurs when only one side of the entry (either debit or credit) is posted in the general ledger.
For example, a depreciation expense is calculated at year-end for office computers and equipment and is correctly debited to the Depreciation expense account, but no credit entry is made.
An error of posting occurs when either the debit or credit entry is posted with an incorrect value or different incorrect values are posted in both the debit and credit accounts.
For example, in error, the double entry made for an irrecoverable debt write-off worth $1,200 is DR Irrecoverable Debt Expense $120 and CR Trade Receivables $1,200. The debit entry is posted with an incorrect amount.
Exam advice
With the advent of computerised systems, differences due to unbalanced double entries are automatically posted to the suspense account.
Modern accounting systems may also have embedded controls that prevent unbalanced double entries from being posted.
Businesses may also deliberately post an entry into the suspense account due to uncertainty about the correct account to use.
For example, the proceeds from a sale of a non-current asset have been recorded by debiting cash. However, the bookkeeper is unsure of the corresponding ledger account to make the credit entry.
Therefore, the amount is posted by crediting the suspense account. The correct ledger account is subsequently identified, which is the disposal account. A correction is made by debiting the suspense account (to remove its balance) and crediting the disposal account.
Errors that Do Not Affect the Trial Balance
Errors can arise that do not affect the trial balance (it balances but is incorrect). These errors are caused by double entries that have debit and credit amounts that balance. These errors are usually due to posting to incorrect accounts or wrong values used for debit and credit.
Examples of such errors are:
An error of commission occurs when a transaction has been posted to the wrong account of the same ‘type’ with the correct value. Accounts of the same type are expenses, assets, income, and liability.
For example, the purchase of a motor vehicle is recorded in the Fixture and Fittings account. The Motor Vehicle and Fixture and Fittings accounts are asset accounts and, therefore, the same type. The trial balance agrees, but the individual asset account balances are incorrect.
An error of principle occurs when a transaction has been posted to an account of a different ‘type’.
For example, a motor vehicle purchase is recorded in the Purchases account. These accounts are different types, as motor vehicles are assets while purchases are expenses. The trial balance agrees, but the individual Motor Vehicle and Purchases balances are incorrect.
An error of omission occurs when something is ‘omitted’ – left out or not posted to the accounts.
For example, a supplier (purchase) invoice is received from the supplier, and the business fails to record the invoice in its accounting system. As a result, both the Purchases account and Trade Payables are understated due to this omission.
Reversal of entry occurs when transactions are posted to the wrong sides of the accounts.
For example, an advertising payment of $50 is posted wrongly by debiting Bank $50 and crediting Advertising Expense $50 instead of the other way round.
An error of transposition occurs when two consecutive numbers are reversed in error.
For example, an accruals creation for $420 is adjusted by debiting expenses and crediting accruals with $402. The digits 2 and 0 are transposed on both sides.
However, note that if the transposition error only affects one side of the double entry (i.e. the debit or the credit entry), the system will automatically post the difference to a suspense account. In this case, the error does affect the trial balance (see 2.1.1, Error of posting).
An error of original entry occurs when a transaction has been posted with an incorrect amount. Both sides of the account are posted with the same wrong amount.
For example, a supplier (purchase) invoice received of $50 is recorded in the purchases accounting system as $100. As a result, the purchases and trade payables balance will be incorrect.
The Suspense Account
A suspense account is a temporary account in the general ledger.
It is temporary as this account is reversed with the necessary error corrections and, thus, does not appear in the financial statements.
Suspense accounts are used in two situations:
For example, the trial balance debit total is $400, but the credit total is $350. Therefore, the suspense account is credited with $50 to balance the trial balance.
For example, a bank receipt appears on the bank statement, but it is unclear what it relates to.
The bank is debited to reflect the cash inflow, and the bookkeeper will credit the suspense account while he investigates the receipt and makes the correction later.
Activity 2
From the balances of the general ledger, prepare the trial balance by selecting where the balance should appear: Debit or Credit column.
Correcting Errors in the Trial Balance
Once the errors have been identified, the business will make adjustments to correct the errors through the journal. After error corrections, the updated balance in the general ledger will form the final trial balance.
The steps to correct errors identified are:
When a business makes error corrections or a year-end adjustment, the impact on the financial statements must be considered.
Example 1
Rohan trades as a mechanic and has a mixture of individual and corporate clients. Draft financial statements for the year ended 31 December 20X8 have been produced, and these statements have reported a profit for the year of $35,840.
After performing year-end reconciliations and reviews, the following errors and adjustments have been discovered:
Rohan has treated a $900 payment for telephone service as a stationery expense.
The receipt from a credit customer of $2,000 has been credited to trade payables.
The final electricity invoice for the year arrived on 28 January 20X9. The $750 outstanding is for the quarter that ended 31 December 20X8 but has not yet been paid.
In completing the year-end bank reconciliation, it was discovered that $120 of bank interest had been received and not accounted for.
Below is the summary of corrections needed for each of the errors listed:
No
Incorrect Entry
Correct Entry
Correction
1.
DR Stationery $900
DR Telephone $900
CR Bank $900
CR Stationery $900
This is an Error of Commission. The correction entry has no impact on the profits during the year.
2.
DR Bank $2,000
DR Trade Payables $2,000
CR Trade Payables $2,000
CR Trade Receivables $2,000
This is an Error of Principle. The correction entry has no impact on the profits during the year.
3.
No entry made
DR Electricity $750
CR Accruals $750
This is not an error. The business post year-end adjustments such as this accrual. This adjustment increases expenses and hence reduces profit.
4.
DR Bank $120
CR Interest Income $120
This is an Error of Omission. The income will increase profits for the year.
The impact on the profits for the year due to the correcting adjustments/ year-end adjustment is as follows:
Example 2
Puja is the bookkeeper for Harsev’s business, preparing his accounts for the year ended 31 December 20X8. She has extracted the trial balance, but the debit side totals $130,400, whereas the credit side has a total of $124,800.
Since the debit side is larger than the credit side by $5,600, a credit entry is made to the suspense account to tie the balance.
After investigation, she discovered the following:
On 1 November 20X8, she was unsure of the correct account to debit for one of the supplier (purchase) invoices, so she debited the cost of $50,000 to a suspense account in April.
The debit balance of $50,000 is included in the suspense account of the trial balance.
She now discovered that it was for purchasing a machine for his workshop.
The journal entry to correct this error is: DR Plant and Machinery $50,000, CR Suspense $50,000
She discovered an error in posting the cash sales in October. She correctly debited Bank but omitted to post cash sales of $5,600 to the Sales account.
The initial erroneous entry was DR Bank $5,600, CR nil. The credit entry in the suspense account results from an unbalanced trial balance. The journal entry to correct this error is: DR Suspense $5,600, CR Sales $5,600
The suspense account will be as follows after correcting the errors:
DR
Suspense Account
CR
01-Nov-X8
Balance per TB
$50,000
31-Dec-X8
To balance TB
$5,600
Plant & Machinery
0
The suspense account has been reduced to $0, and Puja can now complete the preparation of Harsev’s accounts.
Posting Year-end Adjustments
Year-end adjustments are made to the general ledger accounts at the end of the financial year. These adjustments are posted to ensure transactions comply with the applicable accounting framework. We have learned each of these adjustments in the previous chapters.
Examples of year-end adjustments that are applicable include:
Non-current asset transactions
Depreciation
Accruals, prepayments, accrued and deferred income
Allowance for irrecoverable debts
Irrecoverable debts
Provisions
Closing the ledger accounts
After the correcting errors and posting year end adjustments, the general ledger accounts should contain the correct final balances for the year, and can now be closed off, and the balances posted to the financial statements.
Accounts that contain income and expenses, are closed off by transferring the balances to a T account headed “profit or loss” account. This account is balanced and the closing balance is the profit or loss for the year. This is transferred to retained earnings. The opening balance in these accounts at the start of the next financial period will be zero.
The closing balance on accounts relating to assets and liabilities is carried forward as an opening balance for the following period.
The closing balances are also posted to the financial statements.
Example 3
The following income and expense accounts have been balanced for the year just ended:
Dr.
Wages
Cr.
Cash
$500
Bal c/fwd
Bal b/fwd
$4,000
$7,500
Trade receivables
$3,500
$3,000
Trade payables
$2,800
$5,800
The balances are closed off by transferring their balances to a T a/c headed “Profit or loss a/c”. This account is then balanced and the balance transferred to retained earnings.
Transfer to P or L a/c
Transfer to P or L
Profit or loss a/c
Bal – transferred to retainedearnings
$1,200
Commentary
If the balancing figure on the Profit or loss a/c is on the debit side, this represents profit (credit retained earnings). If it is on the credit side, it represents a loss.
Reason for Incomplete Records
There are many reasons for keeping complete and accurate accounting records. Some of the common reasons are:
However, records may be incomplete due to the following reasons:
Solving Incomplete Records
A sole trader may want information about profit and financial position for planning and monitoring purposes.
There are generally few legal requirements, other than for tax purposes, for the information to be produced. This means that a profit-for-the-year figure will satisfy this requirement even if there is no detail for the sole trader.
For businesses, charities and other organisations, there will be strict legal guidelines about what information should be included, when the complete financial statements should be submitted, where they should be stored and how long records should be kept. The implications of not meeting these legal guidelines can be severe and may result in penalties, but these are outside the scope of the syllabus.
In such cases, there are several techniques to derive missing figures or elements in the financial statements to construct missing accounts, such as:
Many sole trader businesses keep some accounting records, such as customer (sales)/ supplier (purchase) invoices and bank statements. Profit for the year and basic accounts can be constructed using this information.
Manipulation of Accounting Equation
When an accountant has incomplete records, the accounting equation can be manipulated to establish the profit for the year. The accounting equation is Capital = Assets – Liabilities
Capital is calculated as Opening Capital + Capital Introduced + Profits − Drawings
Key Point
The expanded Accounting Equation:
(Opening Capital + Capital Introduced + Profit − Drawings) = Assets − Liabilities
To identify the missing profit amount, the equation can be rearranged to:
Profit = Assets − Liabilities − Opening Capital − Capital Introduced + Drawings
Information on Assets, Liabilities, Opening Capital, Capital introduced, and Drawings must be known to derive the Profit amount.
Example 4
Hannah runs a restaurant selling hot food to customers. He does not keep detailed accounting records but has supplied the following year-end balances:
Year-end balances:
$
Motor van for transporting stall and supplies
3,000
Market stall including cooking facilities
2,000
Inventory of food stuff
500
Bank and cash balance
850
Amounts outstanding to suppliers
250
Capital at the end of the last year
5,000
Capital introduced this year
Nil
Drawings taken
8,000
Hannah’s profit for the year based on the above information is as follows:
Profit
=
−
Opening Capital
Capital introduced
+
9,100
3,000 + 2,000 + 500 + 8506,350
Activity 7
Milos started his business on 1 January with $10,000 in cash. He bought a kiosk for $9,000 and inventory for $1,000.
He did not introduce any further capital into the business during the year.
He withdrew $100 weekly, except for the first two weeks when he drew nothing.
At the end of the year, on 31 December, he had the following assets and liabilities:
Kiosk
–
Estimated useful life is another two years
$950
Trade payables (wholesaler)
$1,650
$550
$370
Calculate Milos’ profit for the year.
Derive Missing Figures from Ledger Accounts
Missing figures can be derived using the ledger accounts. The three main accounts used are Trade Receivables, Trade Payables, and Bank/ Cash.
Trade Receivables Account
The Trade receivables account can derive the total sales or cash received from customers.
Trade receivables account
Balance b/d
X
Cash from customers
Total sales
Balance c/d
XX
The below pro forma template provides the same outcome:
Cash received from customers
Add closing customer balances outstanding(receivables)
Less opening customer balances outstanding(receivables)
(x)
Credit sales in the year
x
Example 5
Naima runs a florist business. She makes cash sales to customers who come into her shop and supplies floral arrangements to local hotels on credit terms. The hotels settle their balances in cash at her shop when the customer (sales) invoices become due. She banks all cash remaining each day in her business bank account.
Naima works alone and has no time to maintain a complete set of accounting records. However, she does have all her bank statements for the year. She also has a list of balances outstanding from her hotel customers at the start and end of her accounting year, 31 December 20X9. Total cash received during the year $183,400.
1 January 20X9
31 December 20X9
Hotel customer balances outstanding
$38,600
$29,900
Naima can derive the total sales amount for the year using the trade Receivables account as follows:
Date
Narrative
38,600
183,400
174,700
29,900
213,300
The value of the sales that Naima has made during the year is $174,700.
Activity 8
Hiroto has an air-conditioning business. He makes sales mainly on credit, issuing customer (sales) invoices for every sale.
As his business has grown, he has not kept track of the amounts owed to him by customers at the end of his current accounting year, 31 December 20X9.
However, he kept the bank statements that recorded all receipts from his credit customers and all customer (sales) invoices for the year.
Total cash received from credit customers during the year $136,800. Total credit customer (sales) invoices $162,400.
Customer balances outstanding
$27,200
?
How much money is Hiroto owed from his customers at 31 December 20X9?
*Please use the notes feature in the toolbar to help formulate your answer.
Trade Payables Account
The Trade Payables Account can derive the Total Purchase or Cash paid to suppliers.
Cash to suppliers
Total Purchases
Cash paid to suppliers
Add closing outstanding balances to suppliers(payables)
Less opening outstanding balances to suppliers(payables)
Credit purchases in the year
Example 6
All purchases made by Naima are made over the telephone to a supplier with whom she has a credit account. The flowers and plants are delivered directly to her shop. She then pays for the delivery using a direct bank transfer.
Total bank transfers during the year $124,600.
Balances outstanding to suppliers
$19,800
$20,300
Naima can derive the total purchases amount for the year using the Trade payables account as follows:
124,600
19,800
125,100
20,300
144,900
For example, Naima spent $125,100 on flowers and plants during the year.
Activity 9
Hiroto makes purchases for his business using both cash and credit transactions. He keeps a record of the payments made to his suppliers, but he does not specify whether they are cash purchases or for the payment of supplier (purchase) invoices. He does, however, keep all supplier (purchase) invoices.
Total cash paid to suppliers $122,800. Total supplier (purchase) invoices $117,300.
$19,500
How much does Hiroto owe his suppliers at 31 December 20X9?
Bank Ledger Account
The Bank account can be used to derive cash received from customers, cash paid to suppliers, drawings taken by the owner and money paid for other expenses.
Bank and cash account
Balance b/d (deposit balance)
Balance b/d (overdraft balance)
Balance c/d (overdraft balance)
Other expenses paid
Balance c/d (deposit balance)
Example 7
Continuation from Examples 5 and 6.
Naima has kept all her bank statements for the year. From examples 4 and 5, the total cash received during the year has been identified as $183,400, and bank transfers to suppliers were $124,600.
Naima banks all cash at the end of each day after subtracting her personal expenses (drawings) and paying small business expenses totalling $8,840 for the year. The bank statements show that she has paid other business expenses such as rent and electricity totalling $18,650. These bills have been paid by bank transfer.
Bank statement balance
$1,380
$6,720
Naima can derive the total amount taken as drawings using the Bank account as follows:
Bank account
$124,600
$183,400
$25,970
Other expenses paid($8,840 + $18,650)
$27,490
$184,780
Naima has taken $25,970 in drawings in total.
Mark-Up and Margin Cost Structure
For any business to continue trading, it needs to make a profit.
Most businesses will use a standard formula to calculate the selling price of goods or services based on the cost of producing them.
The cost structure, or profit percentage, is how a business includes profit in its selling price. There are two types of cost structures:
Mark-up
Margin
Markup Cost Structure
A markup cost structure is based on cost.
The cost amount represents 100% of the cost structure.
For example, a business with a mark-up of 20% will have the following cost structure:
Trading Account
%
120
Cost of Goods Sold
(100)
Gross Profit
20
Example 8
Femi ensures he makes a profit on top of the cost of the motorbikes that he sells by applying a 25% markup to all goods sold.
The total sales figure for the year is $250,000.
The cost structure of the motorbike Femi sells is as follows:
250,000
(100 + 25) = 125
Cost of goods sold
(200,000)
always 100
Gross profit
50,000
25
Cost of goods sold = $250,000 × (100/125) = $200,000
Gross profit = $250,000 × (25/125) = $50,000 or
Gross profit = $250,000 − $200,000 = $50,000
Margin Cost Structure
A Margin cost structure is based on Sales.
The sale amount represents 100% of the cost structure.
For example, a business with a margin of 20% will have the following cost structure:
100
(80)
Example 9
Shreya has a luxury boat business. She ensures her business will profit by applying a margin of 25% to all goods sold.
She has kept all supplier (purchase) invoices, giving a total cost of goods sold for the year of $225,000.
The cost structure of Shreya’s goods sold is as follows:
300,000
(225,000)
(100 − 25) = 75
75,000
Sales = $225,000 × (100/75) = $300,000
Gross profit = $225,000 × (25/75) = $75,000 or
Gross profit = $300,000 − $225,000 = $75,000
Identifying Inventory figures using Cost Structures
Inventory management is vital in identifying the amount wasted each year and the inventory turnover (before inventory is sold). In addition, such information may lead to the business ordering future inventory more efficiently.
Example 10
SJQ Co is a soft drinks business. It applies a markup of 25% to all goods sold. It kept all supplier (purchase) invoices, which total $200,000. SJQ Co had an opening inventory of $30,000 and total sales for the year of $280,000.
What is the closing inventory?
As before, we start by inputting the figures that we have into the trading account:
280,000
125
Cost of goods sold:
Opening inventory
30,000
purchases
200,000
Less: closing inventory
(224,000)
56,000
Total Cost of Goods Sold = $280,000 × 100/125 = $224,000
Total Gross Profit = $280,000 × 25/125 = $56,000
Therefore, the closing inventory amount is:
Cost of Goods Sold:
Opening Inventory
Less: Closing Inventory
(6,000)
224,000
The closing inventory is $6,000 ($30,000 +$200,000 − $224,000).
