When ledger postings are completed and accounts are balanced, the next phase in the accounting cycle is preparation of a Trial Balance. This phase helps to verify whether sum of the debit balances is equal to the sum of the credit balances. This is an essential phase before proceeding further to prepare the final accounts at the end of accounting period. However, Trial Balance is generally prepared at quarterly interval in practice to check the arithmetic accuracy of accounts.
Trial Balance is a statement of ledger balances at a particular point of time. At all points of time sum of all debit balances must be equal to sum of all credit balances.
Trial balance is prepared for the following purposes:
1. To check the arithmetic accuracy of ledger balances:
When a trial balance is tallied, i.e., when sum of all debit balances equals the sum of all credit balances, there is a prima facie evidence that ledger accounts are arithmetically correct. (However, there are certain types of errors which may remain despite of the fact that the Trial Balance has been tallied).
2. To finalize the accounts easily:
In the Trial Balance all ledger balances are arranged in accordance with their nature. This means all debit balances and credit balances are properly categorized and put together. So while finalizing accounts, the accountant can proceed with the Trial Balance without referring to voluminous ledger accounts again and again.
3. To ensure that Balance Sheet will tally:
Balance Sheet has also two panels (but remember balance sheet is not an account). The lower panel is for ‘Equity and Liabilities’ and the upper panel for ‘Assets’. You have learnt that Equity + Liabilities = Assets at all points of time. So both sides of Balance Sheet are always in balance. Trial Balance provides a first trial and ensures that Balance Sheet will balance.
Advantages of Trial Balance:
The following are the advantages of preparing a Trial Balance:
1. This helps to check arithmetic accuracy of ledger accounts.
2. This helps to detect errors.
3. This helps to identify income, expense, assets and liabilities easily since debit and credit balances are arranged separately.
4. It is a basis for preparation of final accounts.
Techniques of Preparing Trial Balance:
Preparation of Trial Balance is the Third Phase in the accounting process the first two are:
(i) Journalisation, and
(ii) Ledger posting and balancing.
A trial balance is prepared whenever it is necessary to finalize accounts. Alternatively, it is possible to have an in-built mechanism by which Trial Balance can be prepared on a daily basis.
To prepare quarterly Trial Balance all accounts are balanced at the end of the accounting period. Thereafter the balances are arranged in accordance with their nature, i.e., debit balance and credit balance.
While preparing a Trial Balance, the following steps should be followed:
1. All the ledger accounts including cash and bank are to be entered in the Trial Balance in accordance with their nature. The accounts having debit balances appear under the heading ‘Debit balances’ and the accounts having ‘credit balances’ appear under the heading ‘Credit balances’ (see Exhibit TB.1). Alternatively, all the accounts may appear under the common heading ‘Ledger balances’ (see Exhibit TB.2).
2. All ledger balances excepting debtors and creditors are scanned and entered against the respective accounts in the Trial Balance.
3. Balances of individual debtors are added together and shown as sundry debtors or simply Debtors. Balances of individual creditors are added together and shown as Sundry Creditors or simply Creditors.
4. Debit balances and credit balances are totaled separately to produce the Rough Trial Balance.
5. End of accounting period transactions and events are journalized and posted in the appropriate ledger accounts. Ledger balances are redrawn after such adjustments.
6. Ledger Balance as per the Rough Trial Balance are changed wherever necessary.
7. Debit balance and credit balance are totaled separately to produce the Final Trial Balance. This becomes a basis for the preparation of final account.
In the first alternative (Exhibit TB.1), accounts showing debit balances and credit balances are shown separately. Debit balances are shown on the left hand side while the credit balances are shown on the right hand side. In the second alternative (Exhibit TB.2), all the ledger balances are put together, only the balances are put under Dr. or Cr. Column in accordance with their nature.
It may be recapitulated that:
1. All assets accounts have debit balance.
2. All liabilities accounts including capital account have credit balance.
3. Drawing account is just opposite to the capital account. Drawing means withdrawal of capital, so it has debit balance.
4. All expense accounts have debit balance.
5. All revenue/income accounts have credit balance.
Land, Building, Plant and Machinery, Furniture and Fixtures, Deposits, Investments, Advances to employees, Advances to suppliers, Cash in hand, Cash at Bank, Sundry Debtors.
Bank Loan, Overdraft, Cash Credit, Term Loan, Sundry Creditors.
Purchases of goods and services, Wages and salaries, Carriages, Stationery, Electricity and telephone charges, Discount allowed, Commission paid, Interest paid, Travelling Expenses, Advertisement.
Sale of goods and services, Fees received, Commission received, Discount received, Interest or Dividend on investment.
From the following ledger balances, prepare a Trial Balance of M/s. Arunav Traders as on 31-3-2009.
Capital Rs.7,24,000, Sales Rs.11,23,000, Sales Return Rs.17,100, Purchases Rs.6,27,000, Purchases Return Rs.12,300, Discount (Dr.) Rs.1,100, Discount (Cr.) Rs.1,450, Wages Rs.1,54,300, Commission Rs.87,200, Travelling Expenses Rs.67,200, Carriages Rs.27,200, Insurance Rs.13,200, Rent Rs.14,800, Electricity Rs.12,000, Telephone Charges Rs.12,000, Advertisement Rs.25,000, Sales Tax Rs.1,54,000, Debtors Rs.1,54,000, Creditors Rs.74,000, Bills Receivable Rs.27,000, Bills Payable Rs.12,000, Bank Loan Rs.1,40,000, Deposits with Delhi Vidyut Board (DVB) Rs.20,000, Deposits with Delhi Mahanagar Telephone Nigam (MTNL) Rs.8,000, Security Deposit with Government as per agency agreement Rs.12,000, Cash in hand Rs.3,650, Cash at Bank Rs.3,00,000, Furniture Rs.1,50,000, Investment in units of the Unit Trust of India Rs.2,00,000.
Accountant of Girish Software Ltd. provides the following ledger balances as on 31-3-2009.
He wants to know whether the accounts are in order:
Since the Trial Balance is tallied, it ensures arithmetic accuracy. But certain types of mistakes may still be there. Examples, compensating errors- wrong debit in one transaction is exactly compensated by wrong credit in another transaction. Error of principle is a special type of error in which accounting principles are wrongly applied.
The following account balances are arranged in alphabetic order.
Prepare Trial Balance (Figures are in Rs. million) as on 31.12.2008:
Accounts payables 3000 ; Accounts Receivables 5000 ; Accumulated Depreciation 2000; Administrative Expenses 3000; Bank Loans 5000 (10°6 interest p.a.); Equity Share Capital 8000; Employee Benefit Expenses 6000; Factory Expenses 2000; General Reserve 18000 (as on 1.1.2008); Held for Trading Financial Assets 2000; Interest 400; Interest in Joint Ventures 2000; Investments in Associates 500; Investment Property 600; Inventories (as on 1.1.2008): Raw materials 2000, Work In Process 500, Finished Goods 4000; Land and Building 5000; Plant and machinery 12000; Furniture and equipment 2000; Patent Right 1000; Purchases of raw materials 9000; Sales 23000; Selling and distribution expenses 2500; Dividend from joint venture and associates 700, Cash and bank balances 200.
End of Accounting Period Adjustments:
An entity is required to adjust for the accruals, deferrals and inventories at the end of the accounting period.
Accruals are the income and expense that have accrued but not accounted for. Under accrual principle income is recognised when it is earned and expense is recognised when it is incurred. It is necessary to check if all items of expenditure which are incurred during the accounting period are recognised. Normally many items accrue on expiry of time – examples are rent, electricity expense, insurance, telephone expenses, wages and salaries and items of employee benefits, interest etc. They are accounted for accruals. To the extent they are not paid, they are accounted for as expense as well as outstanding’s (liability) – remember unpaid expense creates a liability.
At the year end of 2008 (31 December 2008), X Ltd. checked that the following expenses remains unpaid:
i. Electricity bill for November – December 2008 Rs.20,00,000
ii. Telephone bill for December 2008 Rs.12,00,000
iii. Interest for September – December 2008 Rs.8,00,000
How do you journalise the above transactions? The company classifies electricity and telephone bills as general expenses.
Depreciation charge is another important end of accounting period adjustments. It is a charge for reduction in the value of an asset as a result of wear and tear, age, or obsolescence.
At the year end of 2008 (31 December 2008), X Ltd. works out depreciation charge of Rs.20,00,000. How this should be accounted for?
Usually depreciation charge is accumulated under a separate liability head Accumulated depreciation. Refer to Example 6.3. When depreciation charge is worked out for an accounting period, it is recognised as an expense and with a corresponding credit to the Accumulated Depreciation which is a liability account – this represents a reserve.
Deferrals are expenses paid in advance for subsequent accounting periods. Sometimes an entity pay expenses in advance before they become due for payment. They deferred and treated as an expense in the appropriate accounting period. These deferrals are assets.
At the year end of 2008 (31 December 2008), X Ltd. analysed that it had paid rent upto May 2009 Rs.10,00,000 p.m. How this should be adjusted?
Expense is paid in advance is reduced by crediting the expense account. Remember that expense is debit, reduction in expense is reversal of expense recognition. So it is credit.
Capitalisation of expense:
Sometimes an entity spent for self-constructed assets. But expenses for construction of asset, which is capital expenditure is collected under the normal expense heads like employee benefit expense, general expense, etc. It becomes necessary at the end of accounting period to segregate and charge the capital expenditure to the appropriate asset account.
X Ltd. is constructing a new office building. At the year end of 2008 (31 December 2008), it analysed that:
5% of Employee Benefit Expense of Rs.80, 00,000 was for construction office building.
1% of raw material purchases Rs.800, 00,000 were for office building construction.
How should the company adjust for same? The building is still under construction.
When the asset is under construction, an entity would create an account head Capital Work in Progress and record the expenditure incurred under that account head. When the asset will be completed, the appropriate Asset account is debited and Capital Work in Progress is credited to close down.
Closing Raw Material Inventories:
An entity carries out stock taking at the end of period and records closing inventories. Raw material inventories are adjusted with raw material purchased.
Opening Raw Material Inventory
+ Raw Material Purchased
– Closing Raw Material Inventory
= Raw Material Consumed
Accordingly, an entity adds up opening stock raw material with purchases during the year and then carry out adjustment for closing stock. It creates a new account head Raw Material Consumed (which is an expense head), and transfers the opening stock and raw material purchased to this expense account.
Then it carries out adjustment for closing stock. Closing stock signifies raw material which remains unconsumed. Matching principle of accounting is applied – under matching expense is matched with revenue. To the extent raw material remains unconsumed it is not spent for revenue generation. It is an asset. So expense (raw material consumed) shall be reduced i.e. to be credited.
Y Ltd. has provided the following accounts balances:
Raw material purchased Rs.3,00,000
Opening stock of raw material Rs.50,000
At the year end it has valued the closing stock at Rs.40,000.
How should the company carry out year end adjustment for recording the closing stock?
Y Ltd. may create a new expense head titled Raw Material Consumed. It may transfer opening stock and purchases to this account. Then it will reduce the material consumed by the amount of closing stock.
Closing stock of work in progress and finished goods:
An entity maintains stock register. The opening stock and closing stock are accounted for therein. Adjustments are carried out at the stage of preparation of income statement of balance sheet for closing stock work in progress and finished goods.
Closing stock of a trading entity:
A trading entity purchases and sells finished goods. This type of entities also carry out stock taking at the end of accounting period and records closing inventories. Opening stocks are adjusted with goods purchased.
– Closing Stock
= Cost of Goods Sold
Trading entities create a new expense head cost of goods sold and carry out adjustment for closing stock.
The difference between the opening stock and closing stock of work in progress and finished goods inventory of manufacturing entity is presented in the income statement and the closing stock is presented as an asset. It is to be noted that –
If Opening Stock > Closing Stock, the difference is an expense.
If Closing Stock > Opening Stock, the difference is an income.
Take the Trial Balance given in Example 6.3. Adjust for the following end of accounting period transactions and events and show adjusted Trial Balance;
These two items may also be adjusted at the stage of preparation of financial statements:
Work in Progress – 400
Finished Goods – 3600