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FAM III

Trial Balance and Adjustments


Trial Balance

Debits = Credits

Trial balance is not an accounting record


Trial Balance
• Trial Balance contains two amount columns: Debit column and
Credit column.
• Since the journal entries are made following double entry
principles, the Trial Balance will tally. In other words, the sum
of Debit column must be equal to the sum of Credit column.
• A Trial Balance consists of all the five financial elements-
assets, liabilities, equity, income and expenses.
• A Trial Balance is not a part of books of accounts. It is prepared
as a separate statement and is used as the basic document to
prepare financial statements viz, Balance Sheet and Profit &
Loss Account.
Purpose of Trial Balance

• To check the airthmetic accuracy of


ledger balances
• To finalise the Accounts easily
• To ensure that Balance sheet will tally
Advantage of Trial Balance
• This helps to detect error
• Helps to identify income, expenses,
assets and liability
• It is basis of preparation of Final
Accounts
Difference in Trial Balance
• Indication that the accounts have not been made or
posted properly
• If not rectified, balance sheet will also not tally and there
will be always be a difference between the total of the
assets side and the liabilities side
• The trial balance is not a conclusive proof of accuracy
that no errors have been committed
• It is only a prima facie evidence that the accounts are in
order
• Possible errors even when trial balance matches includes
issues such as (a) wrong posting; (b) wrong entry; (c)
error of principle; (d) compensating errors (in a series)
Trial Balance and Errors
• There are certain accounting errors which are detected easily
while preparing Trial Balance. For example, balancing error,
posting error (posting of a wrong amount or on the wrong side
of an account). These errors get rectified at the time of
preparation of Trial Balance.
• There are certain errors which go undetected while preparing
Trial Balance. Such errors are vital and these need to be
detected and rectified before preparing financial statements.
Steps for Locating Differences
• Check the total on both the side of a trial balance.
• Check whether all the balances have been taken to
the trial balance
• Check the balancing of individual accounts properly
• For very large differences, compare the figures with
those of the previous year
• If error is yet undetected, check the posting of
subsidiary books first and then, the other accounts
are to be checked in detail
Rectification of Errors
• Accounting errors can be detected at three stages:
• Stage I: Before preparation of Trial Balance
• Stage II: After preparation of Trial Balance but before final
accounts (i.e., financial statements) are prepared.
• Stage III: After the final accounts i.e., detected next year.
Stage I Errors
• Ledger balances are not drawn and hence accounts are not yet
closed.
• There are two kinds of Stage I errors:
• Errors for whose rectification no journal entry is possible
(e.g., sales account is undercast by Rs.20,000)
• Errors which can be rectified with the help of a journal
entry.
Stage I Errors: Examples

Goods returned by a customer, Mr. X, worth Rs.


5,650 has been posted in the Return Inward
Account as Rs.5,560 and in Mr. X Account as
Rs.6,550
• In this case, the correct entry should have been:
• Return Inward Account Debit Rs.5,650
• X Account Credit Rs.5,650
• Hence, Return Inward Account is debited less by Rs.90 (5650-
5560) and X Account is credited more by Rs.900 (6550-5650).
• Rectification entries would therefore be:
• Return Inward Account Debit Rs.90
• X Account Debit Rs.900
• Since both entries are on the debit side of the affected accounts,
no journal entry is required to be passed and instead necessary
rectifications are to be carried out in the respective accounts
directly.
Stage I Errors: Examples

Salary paid Rs.6000 has been posted to Rent Account.


• Rent Account is debited excess by Rs.6,000 and Salary
Account is debited less by the same amount.
• Hence, the rectification entry will be:
• Salary Account Debit Rs.6,000
• Rent Account Credit Rs.6,000
• The above rectification is possible with the help of a
complete journal entry.
Stage II Errors

• Sources of stage II errors are Compensating errors, errors of


commission, errors of omission, and errors of (accounting)
principles.
• Since the Trial Balance is already prepared, ledger balances
are drawn.
• Hence, such errors can only be rectified with journal entries.
Stage II Errors: Examples
• Example 1( Error of Omission): Bank charges of Rs.150 not
recorded in the books of accounts.
• This is an error of omission as the transaction has not at
all been recorded in the Primary Books.
• Following ground accounting rules, the rectification entry
will be:
• Bank Charges Account Debit Rs.150
• Bank Account Credit Rs.150
Stage II Errors: Examples
• Example 2(Error of Commission): Cash of Rs.10,000 received
from Mr. X wrongly posted to Mr. Y Account.
• This is called an error of commission where an amount is
wrongly entered in another account( but in correct side of
the account).
• Rectification entry:
• Y Account Debit Rs.10,000
• X Account Credit Rs.10,000
Stage II Errors: Examples
• Example 3(Compensating Error): Interest expenses of
Rs.1,000 was wrongly posted as Rs.100 and a cash sales of
Rs.2,100 was wrongly posted to Sales Account as Rs.1,200.
• You can observe that the effect of one error (interest
expenses debited less by Rs.900) was compensated by
another error( sales account credited less by Rs.900). One
error compensates the other error in such a way that Trial
Balance still tallies.
• Rectification entry:
• Interest Expenses Account Debit Rs.900
• Sales Account Credit Rs.900
Stage II Errors: Examples
• Example 4(Error of Principles): Travelling expenses of
Rs.12,000 incurred in connection with purchase of a heavy
equipment was debited to Travelling Expenses Account.
• Accounting principles recommend that expenses incurred in
connection with construction/purchase of an asset can be
added to the cost of the asset till the asset is ready for use.
Hence, this is an error of accounting principles.
• Rectification entry
• Equipment Account Debit Rs.12,000
• Travelling Expenses Account Credit Rs.12,000
Suspense Account
• If Trial Balance does not tally, one may temporarily put the
difference in an artificial account, called the Suspense
Account, to tally the Trial Balance for the time being. The
objective is to dig out the errors later and once all errors are
dug out, the Suspense Account will be automatically squared
off.
• Hence, the presence of Suspense Account in the Trial Balance
indicates existence of undetected errors.
Stage II Errors: Examples
• Example 5 (Use of Suspense Account) Cash received from Ram
Rs.650 was debited to his account.
• This is a posting error (i.e., posting on the wrong side of the
account). Hence, the affected account is only Ram Account. To
complete double entry, we need at least two accounts. Had this
error been detected before the preparation of Trial Balance, Ram
Account could have been rectified without passing any journal
entry. Since Trial Balance has already been prepared, this error
has to be rectified using a journal entry.
• Suspense Account takes care of the unknown side of the entry.
• Rectification entry:
• Suspense Account Debit Rs.1,300
• Ram Account Credit Rs.1,300
• It may be noted that Ram Account is credited by double the
amount- one for setting off the error and the other for making the
correct entry.
Stage III Errors
• These errors are detected after the preparation of financial
statements. Hence, these errors are detected in the next
accounting year.
• These are called prior period items.
Year-end adjustments
1. Calculation of cost of goods sold
2. Adjustments for accruals and deferrals
3. Charging annual depreciation
4. Updating provisions
5. Reviewing assets for potential
impairment
Cost of goods sold
• Opening raw material inventory + raw
material purchased – closing raw material
inventory = Raw material consumed
• Trading Entity:
Opening Stock + Purchases – Closing stock
= Cost of goods Sold
Events Often Requiring
Adjustments
Adjustment Required Debit A/c Credit A/c
Asset increase as a result of revenue recognition not Income or Particular income
previously recorded. revenue or revenue a/c
Example – Interest receivable. receivable
Expenses and liabilities not recorded. Respective Unpaid expense
Example – Rent expense due but not paid expense account account
Asset decreases and expenses not previously Respective Respective asset
recognized. expense account account
Example – Depreciation on fixed assets. decreases
Asset and liabilities not recorded. Usually arises in
case of transactions around closing period, which
could not be formally recorded due to non-receipt of
documents etc. The accounting record takes the
form of normal transaction only.
Accruals
• Accruals are the income and expense that
have accrued but not accounted for. Under
accrual principle income is recognised
when it is earned and expenses is
recognised when it is incurred.
Deferrals
• Defferals are expenses paid in advance
for subsequent accounting periods.
Sometimes an entity pay expenses in
advance before they become due for the
payment.
Depreciation
• Depreciation charge is another important
end of accounting period adjustments. It is
charge for reduction in the value of an
asset as a result of wear and tear, age or
obsolescence.
• Straight line method
• Written down method
Provisions
• Provision are special type of liability. An
entity may have claims against it which
cannot be estimated with certainty, for
example, possible liability in a law suit
against the entity.Example: Tax provision,
provision for retirement benefits of
employees.
Accounting for Bad Debts

• Such provisions are used to reduce the gross


accounts receivable to their estimated realizable
value

• The estimated collection loss is known as ‘provision


for bad debts’ or ‘reserve for doubtful debts’, etc.

• Two ways of accounting for bad or doubtful debts:


– writing them off
– creating a provision for bad and doubtful debts
Writing the bad debts off
• The amount of debt which is irrecoverable is treated as a loss and
is transferred as bad debts expense

• For example, Chandu, a trade debtor in the books of M/s Nandu


with an outstanding of Rs. 50,000, files a petition for bankruptcy.
The accountant of M/s Nandu make the following entry:
Bad Debt Expense (Debit) 50,000
Chandu Account (Credit) 50,000
(Being the amount receivable from Chandu transferred to the bad
debts account)

As a result of the above entry, the profit for the period is


reduced by Rs. 50,000
Bad Debt Recovery
Suppose, Chandu come back from the crisis and pays Rs. 15,000
in the next year then the following journal entries are to be passed:
Cash / Bank Account (Debit) 15,000
Bad Debts Recovered Account (Credit) 15,000
(Being the amount recovered from Chandu)
This amount will off course go to the Profit & Loss Account and
increase the firms profit
Bad Debts Recovered Account (Debit) 15,000
Profit and Loss Account (Credit) 15,000
(Being the amount of bad debt recovered transferred to the profit &
loss account for the period)
Illustration – Provision

Suppose, on 31st March 20X5, the following amounts were


doubtful of recovery: Dinesh 3,000; Mahesh 2,000; Somesh
5,000; Ramesh 10,000
The following entry is passed for the total amount of
doubtful recovery as follows:
Bad Debts Expense (Debit) 20,000
Provision for Bad & Doubtful Debt (Credit)
20,000
(Being the amount of provision made for the accounts of
Dinesh, Mahesh, Somesh and Ramesh)
Contd…
Let us further assume that the amount due on account of Dinesh and
Mahesh were paid while Ramesh and Somesh were declared insolvent
in the financial year ending 31-03-20X6. Also, an amount of Rs 8,000
due from Harish was considered doubtful.
Provision for Bad & Doubtful Debt (Debit) 15,000
Accounts Receivable Account (Credit) 15,000
(Being amount outstanding from Ramesh & Somesh written off as bad
debt on becoming insolvent)
Bad Debts Expense (Debit) 3,000
Provision for Bad & Doubtful Debt (Credit) 3,000
(Being the amount of provision for the year)
Various Ledger Original Trial Adjustments Adjusted Trial Income Summary Balance Sheet
Items Balance Balance
 Debit Credit Debit Credit Debit Credit Debit Credit Assets Liabilities
and
Equity
List all asset
ledger accounts
as per their
liquidity order
List all liability
and equity ledger
accounts as per
their liquidity
order
List all revenue
accounts
List all expense
accounts
Worksheet …

• Helps in systematically finalizing an entities financial


statement from its ledger account balances
• Serves two purposes:
– Checks for arithmetical errors
– Results in clear allocation of individual
accounts to either of the two financial
statements viz., Balance Sheet or Profit &
Loss Account

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