Chapter 10: The Trial Balance and Financial Statements

Question 1

• A TRIAL BALANCE is a list of all the closing debit and credit balances from each ledger account in the general ledger

Answer 1

Information on all business transactions travels through the accounting system to form the trial balance used to prepare financial statements

Business transactions [sales, purchases, payroll] ->
Financial documents [sales invoice, credit notes]->
General ledger accounts->
Trial Balance ->
Financial Statements (S of Profit or Loss, S of F Position)

Question 2

Purpose of a Trial Balance
The trial balance is a list of all the closing balances of the individual general ledgers; it is prepared for several purposes:

Answer 2

• To ensure double entries are correctly posted
  The concept of double entry in the general ledger states that the debit entry must equal the credit entry. An imbalanced trial balance indicates imbalanced double entries have been input
• Used as a starting point for preparing the financial statements
  The financial statements are the end product of the accounting process. The trial balance helps check if double entries have been correctly posted, making preparing the final accounts more efficient

Question 3

Limitations of a Trial Balance

• A trial balance may not identify all errors in the general ledger.
  It only gives evidence of whether the total debits and credits balances or not. Although debits and credits agree in the trial balance, there could still be errors

Answer 3

• A trial balance will not identify error corrections.
  Examining the trial balance may identify the existence of an error. However, it may not clearly show the cause of the problem or its correction.
  The trial balance is only the starting point for investigating errors in the general ledger.

Question 4

Process of Preparing Trial Balance and Financial Statements
7 steps

Answer 4

1. Close off each ledger account
   - each ledger account (t-account) is closed off, and the balance c/d is identified
2. Prepare an initial trial balance
   - each ledger account balance is summarised and collected to form the initial trial balance
3. Correcting errors
   - the initial trial balance is analysed for any errors, and appropriate corrections are made for the errors using the journal
4. Record any year-end adjustments
   Year-end adjustments such as irrecoverable debt, accruals and provisions are identified and adjusted in their relevant general ledger account
5. Prepare a final trial balance
   The balances of ledger accounts are updated to reflect error corrections and year-end adjustments. The trial balance is updated to form the final trial balance
6. Prepare the financial statements
   - Each ledger account in the final trail balance is categorised and classified into either the statement of profit or loss or the statement of financial position

Question 5

Elements in the Capital Account

Capitals are the amounts owed to the owner of the business. The closing balance in a Capital account is made up of the following:

Answer 5

Total Capital Invested (opening + introduced during the year)
[The total capital invested is money the owner has paid into the business. capital invested is shown as the credit balance]

Add: Profits to date
[The profit of the business belongs to the owner. At the end of each year, the profit generated will be transferred to the capital account.]

Less: Drawings
[Money taken out of the business for the owner’s personal use is known as drawings and is shown as a debit balance.]

Question 6

Extracting the Initial Trial Balance

Answer 6

The initial trial balance is prepared by entering each ledger balance into the correct debit or credit column.
Errors, including the balance in the Suspense account, should be investigated and corrected.

Question 7

Types of errors

Answer 7

• errors that affect the trial balance
• errors that do not affect the trial balance

Question 8

Errors that Affect the Trial Balance
-> double entries that are unbalanced. Unbalanced entries are made where the debit amount does not equal the credit amount.

Answer 8

A SUSPENSE ACCOUNT is created to balance the differences between the debit and credit amounts in the trial balance. The Suspense account is temporary and will be closed after the business makes the necessary error corrections.

Question 9

Examples of such errors that affect the trial balance are:
- Error of partial omission
when only one side of the entry (either debit or credit) is posted in the general ledger.

For example, a depreciation expense is calculated for office computers and equipment at year-end. The depreciation charge is correctly debited to the Depreciation expense account, but no credit entry is made.

Answer 9

• Error of Posting
  when the value of one or both sides of a double-entry is incorrect.

For example, the double entry made for an irrecoverable debt write-off worth $1,200 is DR Irrecoverable Expense $2,100 and CR Trade Receivables $1,200. The debit entry is posted with an incorrect amount.

Question 10

Exam advice - With the advent of computerised systems, errors due to unbalanced double entries are eliminated.

Modern accounting systems have embedded controls that prevent these errors from occurring. However, it is still useful to learn the nature of these errors.

Answer 10

Although errors that affect the trial balance (unbalanced double entries) are rare in a business where computerised systems are used, Suspense accounts are still needed.

• The Suspense account still exists as businesses may deliberately post an entry into the Suspense account due to uncertainty on which ledger to post to.
  For example, the proceeds from a sale of a non-current asset have been recorded by debiting cash. The bookkeeper is unsure of the ledger account in which to make the corresponding credit entry.

Therefore, the amount is initially 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.

Question 11

Errors that Do Not affect the Trial Balance
Double entries causing these errors have balanced debit and credit amounts. These errors are usually due to incorrect accounts or wrong values.

Answer 11

• ERRORS OF COMMISSION
  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, a motor vehicle purchase is recorded in the Fixture and Fittings account. 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.

Question 12

ERRORS OF PRINCIPLE

Answer 12

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 as motor vehicles are assets, whereas purchases are expenses. The trial balance agrees, but the individual Motor Vehicle and Purchases balances are incorrect.

Question 13

ERRORS OF OMISSION

Answer 13

when something is ‘omitted’ – left out or not posted to the accounts.

For example, a purchase invoice is received from the supplier, and the business fails to record the invoice in its accounting system. Both the Purchases account and Trade Payables are understated due to this omission.

Question 14

ERRORS OF REVERSAL ENTRY

Answer 14

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.

Question 15

ERRORS OF TRANSPOSITION

Answer 15

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).

Question 16

ERRORS OF ORIGINAL ENTRY

Answer 16

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 wrong amount.

For example, a purchase invoice received of $50 is recorded in the purchases accounting system as $100. The Purchases and Trade Payables balance will be incorrect.

Question 17

Exam - It is common to be examined the different types of errors, their impact on the trial balance, the corrections required, and the effect of these corrections on the financial statements.

Answer 17

Apart from the trial balance, businesses can identify errors in the general ledger accounts from:

• Respective ledger accounts (T-accounts) – Errors in sales, purchases, trade receivables and trade payables transactions can often be identified from their ledger accounts.
• Reconciliations – Errors relating to trade payables or bank transactions can be identified by performing Supplier Statement Reconciliations and Bank Statement Reconciliations.
• Reviewing ledger balances – Errors in other accounts can be highlighted by reviewing the balances to ensure there are no unusual transactions or discrepancies.

Question 18

A SUSPENSE ACCOUNT is a temporary account in the general ledger. it is temporary as this account is closed with the necessary error corrections and does not appear in the financial statements

• will not appear in the final trial balance and financial statements. It deals with uncertainty over which accounting ledger to post transactions to.

The Suspense account should have a nil balance after making corrections for errors.

Answer 18

Suspense accounts are used in two situations:

• If the initial trial balance does not show the same debit and credit balance, the differences are entered into the suspense account to balance the trial balance.
  Since modern accounting systems do not allow for unbalanced double entries to be processed, suspense accounts are no longer created from such situations.
  However, transactions posted manually into the accounting systems can still cause a difference between the debit and credit balances. Unusual and one-off transactions are posted manually using the journal.
• If there is uncertainty over which account to record a specific transaction, a bookkeeper may temporarily post part of the entry into the suspense account and investigate the correct account.

Question 19

Correcting Errors in the Trial Balance

Answer 19

Once the errors have been identified, the business will make adjustments to correct the errors using journal entries. After error corrections, the updated balances in the general ledger will be used to form the final trial balance.

The steps to correct errors identified are:

1. Establish the correct double entry for the transaction.
2. Identify the actual double entry made in error.
3. Determine the accounting entry required to correct the error (from what was posted to what should be posted) and make the adjustments using journal entries.

Question 20

What are Year-End Adjustments?

Answer 20

Year-end adjustments are adjustments 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:
- inventories
- non-current asset transactions
- depreciation
- accruals, prepayments, accrued and deferred income
- allowance for receivables
- irrecoverable debts
- provisions

Question 21

Inventories
-> the value of goods a business holds for sale to its customers

Answer 21

The inventory to be recorded at the year-end is physically counted at that date, and these quantities are then valued to arrive at a figure for the closing inventory.

The final inventory amount is the value of the closing inventory calculated at year-end.

Businesses will also calculate the Cost of Goods sold during year-end.

Cost of Goods Sold = Opening Inventory + Purchases − Closing Inventory

Question 22

Non-Current Asset Transactions

Answer 22

A business may also decide to sell or dispose of an asset before it has reached the end of its useful life.

To account for the disposal of a non-current asset, the Cost and Accumulated Depreciation account of the disposed asset should be removed. The sales proceeds and the gain/loss on disposal should also be accounted for.

Question 23

Non-Current Asset Depreciation

Answer 23

Asset depreciation spreads the depreciable amount of the non-current asset over its useful life. The depreciation cost is recorded as an expense in the Statement of Profit or Loss.

At year-end, businesses will calculate the depreciation charge for each category of non-current asset it owns.

Question 24

Accruals, Prepayments, Accrued and Deferred Income

Answer 24

Accruals and prepayments are liabilities and assets recognised during year-end due to EXPENSE payments in arrears or in advance.

Accrued and deferred (prepaid) incomes are assets and liabilities recognised during year-end due to INCOME receipts in arrears or in advance.

[see table!]

Question 25

Irrecoverable Debt and Allowance for Receivables

Answer 25

At the end of each year, businesses will review all customer accounts in the receivables ledger and identify if an allowance needs to be made for the balance owed that may not be settled. The outcome of the review includes:

• The business identifies customers where there is evidence that they will not pay. These customer balances should be written off as IRRECOVERABLE DEBTS.
• The business identifies customers with evidence to suggest they might not pay. An ALLOWANCE FOR RECEIVABLES is set for these account balances.

Question 26

Provisions
A provision is a liability of uncertain timing or amount. To recognise a provision liability, these criteria need to be met:

Answer 26

• The entity has a PRESENT OBLIGATION to make future payments due to past events
• It is PROBABLE that a transfer of economic benefit is required to settle the obligation
• a RELIABLE ESTIMATE of the provision can be determined

Question 27

Updating the Trial Balance

Answer 27

Once all errors have been corrected and year-end adjustments have been posted using journal entries, the balances of the affected ledger accounts are updated and summarised to form the Final Trial Balance.

The final closing balance is the sum of the opening balance, error corrections, and year-end adjustments.

Question 28

Process of Preparing Financial Statements
From the final trial balance, a distinction is made between ledger accounts that affect the Statement of Profit or Loss and those that affect the Statement of Financial Position.

Answer 28

Statement of Profit or Loss (SPL) shows the business’s financial performance in the accounting year. This includes the INCOME and EXPENSES of a business.
- Income and expense accounts must be closed off by transferring any balance to the Profit or Loss ledger account.
- This account is created at the year-end and records the profit or loss to be reflected in the statement of profit or loss for the current year.

• Statement of Financial Position (SFP) highlights the financial position of a business at a point in time. This includes ASSETS owned, LIABILITIES owed and the CAPITAL balance of the business.
• Asset and liability accounts will be left with a balance c/d which is the opening balance for the next accounting period.
  For example, the closing bank balance at the end of this year becomes the opening bank balance at the beginning of next year.

The Capital account is calculated as Opening Capital + Capital Introduced + Profits/(Losses) – Drawings

(see table)

Question 29

Statement of Profit or Loss
is a primary financial statement that shows the financial performance of a business in terms of its income and expenses for the year.

For a sole trader, the Statement of Profit or Loss contains two elements:

Answer 29

• Trading accounts which focus on the trading activities of the business, such as sales and purchases
• Other income and expenses of the business, such as rental income and the day-to-day running expenses

A Statement of Profit or Loss (SPL) shows the business’s financial performance in the accounting year. This includes the INCOME and EXPENSES of a business.

• Income and Expense accounts need to be closed off to zero by transferring any balance to a ledger account called the Profit or Loss ledger account.

Question 30

Closing off Income and Expense Accounts
Each income and expense ledger account balance is closed off and transferred to the Profit or Loss ledger account.

Answer 30

When all the Income and Expense ledger accounts are closed off, their balance will be nil,

Question 31

Preparing the Statement of Profit Or Loss

Answer 31

The individual balance of the Income and Expense ledger is transferred and presented in the Statement of Profit or Loss. The Statement of Profit or Loss is the final product of the accounting system.

Question 32

Statement of Financial Position
highlights the assets owned by the business, liabilities owed by the business and its capital balance.

Answer 32

• • Assets are presented as either CURRENT ASSETS or NON-current assets:
    Current assets are assets that are liquid (easily converted to cash)
    Non-current assets show the cost, accumulated depreciation, and carrying amount of each asset separately
• Liabilities are presented as either CURRENT liabilities or NON-current liabilities:
• Current liabilities are due within one year
• Non-current liabilities are due after one year
• Capital balances are calculated as follows:
  Opening capital + Total capital introduced + Profit/(Loss) for the year − Drawings

Once the Statement of Financial Position is complete, the total asset amount should match the total liabilities and capital amount.

This is in line with the accounting equation: Assets = Capital + Liabilities

Question 33

Completing the Capital Account

Answer 33

The capital at year-end is the opening capital plus any capital introduced plus profits made during the year (or minus loss) minus any drawings made by the owner.
The Statement of Financial Position can be prepared now that the closing capital amount has been established.

*Closing Capital = Opening Capital + Capital Introduced + Profits/(Loss) − Drawings

Question 34

Preparing the Statement of Financial Position

Answer 34

Similar to preparing the Statement of Profit or Loss, the individual Assets, Liabilities and Capital ledger accounts from the Final Trial Balance are transferred and presented in the Statement of Financial Position.

The Statement of Financial Position is the final product of the accounting system.

Question 35

Opening Trial Balance for Next Year

Answer 35

All Statements of Profit or Loss ledger accounts (Income and Expenses) have been closed off and transferred to the Statement of Financial Position (profit for the year in the closing capital).

Therefore, only Statement of Financial Position ledger account balances (Assets, Liabilities and Capital) are carried forward to the following year.

The opening trial balance of the next accounting period is the closing balance from the current year’s Statement of Financial Position.

Question 36

Reason for Incomplete Records
occur when the information to prepare financial statements is incomplete. Incomplete records may occur due to the circumstances below:

Answer 36

• A sole trader business has no time or expertise to implement accounting policies
  
  • A sole trader in charge of implementing accounting policies may not emphasise keeping complete accounting records. Documents may be unaccounted for, leading to inconsistencies in the accounting equation.
• Data loss from accidents or fraud
  
  • Data loss occurs due to information being stolen or erased. Paper documents may also be lost due to fires or incorrect storage.

Question 37

In such cases, there are several techniques to derive missing financial statement figures or elements from the accounts, such as:

Answer 37

• manipulation of the accounting equation
• derive missing figures from ledger accounts
• Mark ups and margins cost structure

Sole traders usually keep essential accounting records such as sales/ purchase invoices and bank statements; the profit for the year and basic accounts can be derived from this information.

Question 38

Manipulation of Accounting Equation

Answer 38

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

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.

If this information is unavailable, it must be derived from the ledger accounts.

Question 39

Derive Missing Figures from Ledger Accounts

Answer 39

Missing figures can be derived using the ledger accounts. The three main accounts used are Trade Receivables, Trade Payables and Bank/Cash.

1. Trade Receivables Account
   The total sales and cash received from customers may be derived from the Trade Receivables account.

Question 40

2. Trade Payables Account

Answer 40

The Trade Payables account can be used to derive the total purchase or cash paid to suppliers.

3. Bank Ledger account
   The Bank account can be used to derive cash received from customers, paid to suppliers, taken by the owner (drawings) and paid for other expenses.

Question 41

Mark-up and Margin Cost Structure

Answer 41

Cost structures are the basis of how a business includes profit in its selling price. The cost structure can be used to calculate any missing figure in a basic trading account.

There are two types of cost structure: MARKUP and MARGINS. The profit is either related to the cost of the goods via a markup or it is related to the selling price via a margin.

When the profit markup or margin is known, this can be used to find the missing information.

The trading account is a part of the Statement of Profit or Loss, which focuses purely on the trading activities of a business:
Sales
cost of goods sold
———–
gross profit

Question 42

1. MARKUP cost structure

Answer 42

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:

Question 43

2. Margin Cost Structure

Answer 43

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:
[see table]