Trial balances and correcting errors

1 Introduction

This chapter describes the process of extracting trial balances, investigating and correcting any errors that might be discovered, making other adjustments and setting up accruals and prepayments.

2 Recording transactions and the trial balance

The double entry system consists of:

• The cash book: this records amounts paid into and out of the bank account
  

• The petty cash book: this records small amounts of cash paid for day to day expenses, such as buying postage stamps and teas or coffee for the office.
  

• The general or nominal ledger, which records amounts such as wages, sales, purchases, electricity, travel, advertising, rent, insurance, repairs, receivables, payables and non-current assets.
  

In addition there were two detailed memoranda ledgers

• The payables ledger which details of exactly what is owed to whom are also recorded here. The sum of the amounts owing in this ledger should agree with the payables balance in the general ledger.
  

• The receivables ledger which details of exactly what is owed from whom are also recorded here. There is a separate account for each credit customer. The sum of the amounts owing in this ledger should agree with the receivables balance in the general ledger.
  

If double entry had been carried out correctly then the values of all credits made should equal the value of all debits made, and when balances on each account are worked out, the sum of the debit balances should equal the sum of the credit balances. The document showing this is the trial balance.

For example:

Trial balances should be taken out regularly (at least monthly) to see if something has gone wrong with the maintenance of double entry. It is much easier finding an error in one month’s postings than a whole year’s.

However, trial balances will not detect all errors: they only detect errors where the debit does not equal the credit entry, or where the trial balance has been taken out incorrectly.

Errors not found by trial balance can be categorised as:

Errors of commission

Example: an expense of rent was incorrectly debited to the wages account.

Example: the purchases day book had been added up to be $8,900 when the correct total was $9,800. Both purchases and the payables control account would then have $900 (ie $9,800 - $8,900) too little posted to them, but the double entry would have been maintained.

Errors of omission

Example: an invoice from a supplier is not entered into the purchases day book at all, so no entry is made for that transaction.

Compensating errors

Example: rent paid of $210 is debited to the rent account as $120 (error = $90 too little debited) and cash sales of $540 are credited to the sales account as $450 (error = $90 too little credited).

Errors of principle

Example: the expense of rent of $350 was incorrectly posted to a receivables account. This error is worse than the error of commission above because it will affect the profit of the business. Instead of adding to an expense, the value of an asset has increased.

A common cause of errors, rather than a type of error, is a transposition error, such as writing 1234 instead of 1324.

Errors of original entry

Example: an invoice for $560 is entered in the sales day book as $650. Both the debit and the credit are made at $650, so the trial balance still balances, but every figure flowing from that entry - sales, the receivables control account and the customer's own account - is $90 too high. A transposition, as above, is the most common cause.

Reversal of entries

Example: cash of $400 received from a customer is debited to the receivables control account and credited to cash - the right two accounts, the right amount, the wrong way round. Again the trial balance balances. Correcting it takes TWICE the amount: $800 credited to receivables and $800 debited to cash, because the first $400 cancels the wrong entry and the second $400 makes the right one. Doubling is the point the examiner is testing.

None of the types of error described above will cause a trial balance not to balance. The errors once found are easy to correct by journal.

If a trial balance does not balance then:

1. A one sided error must have occurred (Such as Credit cash $120, Debit Purchases $100 and forgetting about the sales tax of $20).
   

2. The production of the trial balance is incorrect. For example, leaving out an account or listing it in the wrong side of the trial balance.
   

Non-balancing trial balances often use a suspense account to indicate the amount by which the two sides differ, and as errors are found, the suspense account can be brought back to zero, indicating that the two columns of the trial balance agree.

For example: if the trial balance produced was this:

Then a suspense account would be introduced to make it balance:

This suspense account indicates that there was originally more on the credit side than on the debit side so that more debits are needed.

An investigation of the differences then needs to be carried out. Let’s say that the following errors were found:

1. Rent of $400 had been charged to wages.
   

2. Cash received of $200 had been assumed to be a customer paying an invoice in the receivables ledger. In fact it was a new sale.
   

3. Petty cash of $44 has been left out of the trial balance
   

4. A sales day book total of $820 had been debited to receivables (customers) as $280, though had been correctly posted to the sales account.
   

5. Discounts allowed to customer of $30 had been credited to the sales account rather than debited to the discounts allowed account.
   

Now look at each error and decide how to correct it. Also think carefully if it would have caused the trial balance not to balance: if so, the suspense account will be affected.

The trial balance will now be as follows:

The remaining errors are all of a one-sided nature, and as they are corrected, the suspense account can be updated. The suspense account is a real account in the general ledger: it holds the difference until the errors are found, and each correction is posted to it by journal until its balance is nil.

It is easy to make the wrong adjustments in the suspense account. The key is to think:

1. How are the accounts or trial balance to be corrected? What side is to be adjusted and by how much?
   

2. Having worked that out, the suspense account entry is always on the other side.
   

Continuing with the example;

Error 3

$44 has been left out of the trial balance. $44 needs to be introduced on the debit side of the trial balance so the suspense account will be credited $44.

Error 4

Receivables were debited by $280 when they should have been debited by $820. The size of the error is therefore $540 and this needs to be an extra debit to receivables. Therefore, credit the suspense account by $540.

Error 5

$30 had been credited to sales rather than debited to discounts allowed. The size of the error is $30 x 2 = $60. $30 has to be debited (ie come out of) to the sales account and $30 debited into the discount account.

The suspense account would therefore be:

The trial balance would be:

3 The effect of the corrections on profit and net assets

Getting the trial balance to balance is only half of what the exam asks. You also have to be able to say what the corrections did to the reported profit and to the statement of financial position. Take the five errors just corrected:

The way to think about it: an error that moves a figure between two expense accounts, or between two asset accounts, changes nothing that is reported. An error that moves a figure BETWEEN the statement of profit or loss and the statement of financial position - or that creates or destroys one - changes the profit. And because profit is added to capital, whatever happens to profit happens to capital too.

Net assets did not move by the same $140 as profit here because errors 3 and 4 were errors in extracting the trial balance itself: the assets were always there, they were just listed wrongly, so correcting them changes the reported net assets without ever having affected profit.

4 Extending the trial balance

The trial balance lists all accounts in the general ledger plus the cash book and petty cash book balances. Each account will either end up on the statement of profit or loss (incomes and expense accounts) or the statement of financial position (assets, liabilities and capital accounts).

However, before the accounts are finalised some adjustments might be needed. These include:

• Inventory adjustments - bringing in closing inventory and clearing opening inventory

• Non-current asset transactions - acquisitions and disposals not yet posted

• Depreciation charges for the year

• Writing off irrecoverable debts, and creating or adjusting the allowance for irrecoverable debts

• Accrued and prepaid expenses

• Accrued income and deferred income

• Provisions - creating a new one, or adjusting an existing one to the year-end estimate

In addition, accruals and prepayments might need to be set up:

Accruals:   increase the expenses recorded in the expenses ‘T’ accounts and also feature as liabilities (amounts still owed in respect of the expense)

Prepayments:   decrease the expenses recorded in the expenses ‘T’ accounts and also feature as assets (amounts paid in advance to suppliers).

All these matters can be incorporated in an extended trial balance:

Where the totals go: Total accruals → statement of financial position, Cr column. Total prepayments → statement of financial position, Dr column. Profit (the balancing figure in the statement of profit or loss columns) → statement of financial position, Cr column, added to capital.

The extended trial balance works as follows:

1. Start with the initial, balancing trial balance. There’s no point going on unless this balances as there must be an error.
   

2. The adjustments columns are journal entries and these must balance. So, to put through depreciation of $3,000 on office equipment, $3,000 would be placed in the Debit column at the depreciation expense row, and $3,000 also in the Credit column in the Office Equipment Accumulated Depreciation row. The sum of the DR and Cr columns must be equal.
   

3. If rent of $1,000 had to be accrued, then $1,000 would be placed in the Accrual column at the Rent Account row. If a prepayment were needed it would be placed in the appropriate row in the Prepayments column. The sum of the Accruals and Prepayments columns do not need to balance. However, the totals of these columns are carried across to the Statement of Financial Position – but they ‘change column’. Thus the rent accrual that started in the left hand column of the Accruals and Prepayments pair will end up in the Cr column (right hand) of the SOFP. This recognises that an accrual is a liability on the SOFP. Similarly, the total of the prepayments column will be carried to the debit side of the SOFP, representing an asset.
   

4. The first three pairs of columns are added across adding to end up with the final figures after adjustments, accruals and prepayments. Each account ends up either in the statement of profit or loss or the Statement of Financial Position. Any profit made will be carried across to the credit side of the SOFP, to be added to capital.

A word on the adjustments the extended trial balance in Example 4 does not happen to show, because every one of them is examinable in the same two columns:

• Inventory. The closing inventory goes in TWICE: Dr Inventory (the asset row) and Cr Cost of sales, both in the Adjustments columns. The opening inventory already sits in the initial trial balance and is cleared the other way - Dr Cost of sales, Cr Inventory - so the Inventory row ends at the closing figure and cost of sales ends correct.

• A disposal. Dr Disposals with the cost, Cr the asset cost account; Dr the accumulated depreciation account, Cr Disposals; the balance on Disposals goes to the statement of profit or loss columns as a profit or a loss.

• An allowance for irrecoverable debts. Dr Irrecoverable debts expense, Cr Allowance for irrecoverable debts - with the MOVEMENT only. The allowance row then carries across to the credit side of the statement of financial position, where it is netted against receivables.

• A provision. Dr the relevant expense, Cr Provisions - again with the movement only. The provision row carries across to the credit side of the statement of financial position, within current liabilities unless it will be settled after more than a year.

• Accrued income and deferred income. These use the Accruals and Prepayments pair in the same way as their expense equivalents, but on the income rows: accrued income behaves like a prepayment (it ends up a debit, an asset), deferred income like an accrual (a credit, a liability).

5 The opening trial balance for the next period

Once the financial statements are done, the books are closed and a new trial balance is struck at the start of the next period. It is much shorter than the one you have just worked with, and you need to know why.

• Income and expense accounts have all been transferred to the statement of profit or loss. They are closed and start the new year at nil. Sales, purchases, wages, rent, depreciation expense, discounts, irrecoverable debts - none of them appears on the opening trial balance.

• Asset, liability and capital accounts are not closed. Their balances are carried down and brought down into the new period. Cash, petty cash, non-current asset cost, accumulated depreciation, inventory, receivables, the allowance for irrecoverable debts, payables, accruals, prepayments, provisions and capital all appear.

• Capital has already absorbed the profit for the year and the drawings, so the opening capital figure is last year's closing capital.

So the opening trial balance for the period after Example 4 would be:

Every figure comes straight off the closing statement of financial position, which is the check: if the opening trial balance does not agree with the statement of financial position you have just prepared, one of them is wrong.