Chapter 5 & 6

Trial Balance,
Trading and P & L account &
Balance sheet
 The Trial Balance….
In the previous chapters, we have learnt how
to record various transactions (passing entries
into journal), Classify these transactions under
various heads of account (posting to ledger)
and balancing. The next step in the process of
accounting is the preparation of a statement
to check the arithmetical accuracy of
transactions recorded so far. This statement is
known as “Trial Balance.”
 MEANING OF TRIAL BALANCE
• Trial Balance is a statement, which shows debit
balances and credit balances of all the accounts
in the ledger. The total of all debit entries must
be equal to that of all credit entries in the ledger.
– In case any difference arises, that is, the totals of
debit balances and credit balances do not tally, the
correctness of the balances brought forward from the
respective accounts must be checked by preparing
this statement.
• “Trial Balance is a statement, prepared with the
debit and credit balances of ledger accounts to
test the arithmetical accuracy of the books.”
OBJECTIVES AND SALIENT FEATURES OF TRIAL BALANCE

Objectives of a Trial Balance

 To check the arithmetical accuracy of the ledger
account,
 To locate the errors and rectify them,
 To provide basis for the preparation of final accounts,
 To serve as a ready reckoner (it provides a summary
of all transactions during an accounting period at one
place, i.e. this statement).
 Salient Features of a Trial Balance
 It is only a statement. It is not an account. It is
simply a list of balances of all accounts.
 It is prepared on a particular date.
 It may be prepared at any time during the year.
 It is one method of checking the accuracy of
transactions.
 It can be prepared only by the firms, which
adopt double entry system.
 Some errors may not be detected.
METHODS OF PREPARATION OF A TRIAL BALANCE

A Trial Balance can be prepared in the following

three ways:
1. Totals Method
2. Balances Method
3. Totals cum Balances Method
• Totals Method -Under this method, each side in
the ledger (debit and credit) is totaled. Then they
are recorded in the Trial Balance in respective
columns. The total of the debit column of Trial
Balance and the total of credit column of Trial
Balance should be equal. But this method is not
widely used.
• Balances Method - Trial Balance is prepared by
recording the balances of all ledger accounts.
Then debit column and credit column of the Trial
Balance is totaled. As the balance summarizes the
net effect of all transactions relating to a
particular account, balances are taken as a base
for preparing a Trial Balance.
• Totals Cum Balances Method -Under this
method, the Trial Balance is prepared by
combining the above methods. This method is
also not adopted widely.
Proforma of Trial Balance
Illustration – The following balances were extracted from the ledger of Mohammed on 2019 Mar 31.
Prepare a Trial Balance as on that date in the proper form.
($)
Salaries 72,640
Sales 347,000
Plant and machinery 68,600
Commission paid 3,760
Purchases 289,340
Stock on 2019Apr 01 22,200
Repairs 3,340
Sundry expenses 920
Sundry debtors 2,860
Returns inward 2,000
Returns outward 800
Discount allowed 2,300
Rent and rates 6,440
Sundry creditors 28,520
Carriage inward 480
Travelling expenses 5,260
Drawings 7,000
Investments 12,000
Capital 2019 Apr 01 125,000
Cash at Bank 2,180
Solution Keep in mind, the general rules and
classify and then enter in the Trial Balance in its
format.
Step 1:
Debit balances: Assets, Drawings, Debtors, Losses
and Expenses
Credit balances: Liabilities, Capital, Creditors,
Gains and Incomes
Each item is explained here, why it is classified as Debit
balance or Credit balance.
 1. Salaries – Nominal A/C – Expense Dr. Balance
2. Sales – Real A/C – Goods Cr. Balance
3. Plant and Machinery – Real A/C – Assets Dr. Balance
4. Commission paid – Nominal A/C – Expense Dr. Balance
5. Purchases – Real A/C – Goods Dr. Balance
6. Stock – Real A/C – Goods Dr. Balance
7. Repairs – Nominal A/C – Expense Dr. Balance
8. Sundry Expenses – Nominal A/C – Expense Dr. Balance
9. Returns Inward – Real A/C – Goods Dr. Balance
10. Returns Outward – Real A/C – Goods Cr. Balance
11. Discount allowed – Nominal A/C – Loss Dr. Balance
12. Rent and rates – Nominal A/C – Expense Dr. Balance
13. Sundry creditors – Personal A/C – Supplier Cr. Balance
14. Sundry debtors – Personal A/C – Customer Dr. Balance
15. Carriage inwards – Nominal A/C – Expenses Dr. Balance
16. Travelling expenses – Nominal A/C – Expenses Dr. Balance
17. Drawings – Personal A/C – Proprietor (owner) Dr. Balance
18. Investments – Real A/C – Asset Dr. Balance
19. Capital 2011 Apr 01 – Personal A/C – Owner Cr. Balance
20. Cash at Bank – Real A/C – Asset Dr. Balance
Step 2: For any item (of account or transaction),
apply the Rules of Debit and Credit and thereby
determine whether it is a Dr. balance or Cr.
balance.
Step 3: Now, draw the format of a Trial Balance
and record as it is classified in the columns of
debit balance and credit balance, respectively.
Step 4: Finally, total both the debit and credit
columns separately and ascertain both the
totals should tally.
Errors in Trial Balance
 Errors of Principle

Transactions are recorded as per Generally Accepted

Accounting Principles (GAAP). In case, the principles are
violated or ignored, errors of principle take place in such
transactions, which will not affect the Trial Balance.
 
Example: Credit sale of land (asset) recorded in Sales
Book.
This is an error of principle because credit sale of assets
is not recorded in subsidiary book. It has to be recorded
in Journal Proper. Amount spent on additions to fixed
assets has to be treated as capital expenditure and not
of revenue nature.
 Clerical Errors

These errors occur due to mistakes made by the

concerned accounting clerks, which can be
further classified into the following categories:
Errors of Omission
Errors of Commission
Compensating Errors
 
 Errors of Omission
When a transaction is omitted in the books of
account, this type of error occurs. This may be
further classified as:
•Error of Complete Omission: When a
transaction is totally omitted for recording in the
books of accounts, this type of error arises.
–Example: Credit sale of `10,000 to Adam. If this
transaction is omitted entirely, such error is called
error of complete omission. This error will not affect
the Trial Balance.
• Error of Partial Omission: When only one
aspect of the transaction is recorded, this type
of error arises. In the above example, one
aspect, credit sales, is recorded duly in Sales
A/C, but the aspect, Adam’s Account, is
omitted while recording, this error of partial
omission arises. This will affect the Trial
Balance.
 Errors of Commission
This type of error occurs due to various factors such as wrong recording,
wrong posting, wrong balancing and the like. This may further be classified
as follows:
• Error of Recording: This error arises when a transaction is wrongly
recorded in the books of original entry. This does not affect the trial
balance, as both debit and credit are wrongly recorded. Example: Credit
purchase of goods from Remo for `17,500 recorded in the books as `15,700.
•Error of Posting: This error occurs when information recorded in the books
of original entry is entered wrongly in the ledger. This error may arise due
to:
–Recording the right amount in the wrong side of correct account.
–Recording the right amount in the right side of wrong account.
–Entering the wrong amount in the right side of correct account.
–Entering the wrong amount in the wrong side of correct account.
–Entering the wrong amount in the right side of wrong account.
–Entering wrong amount in the wrong side of wrong account.
•  
Error of Casting: When a mistake is committed while totaling in a
subsidiary book, this error arises.
Example: If the total is `11,000 in a subsidiary book, it may be
wrongly totaled and entered as `16,000.
This is an error of over casting. If it is wrongly totaled as `10,000, it
is an error of under casting.
 
Error of Carrying Forward: When a total of one page is written
wrongly on the next page, this error occurs.
 
Example: Total of Cash Book in page number 151 of the ledger is
`1,01,000. While carrying forward to the next page 152, if it is
recorded as `1,10,000, this error of carrying forward arises.
These errors may affect the trial balance, as only one side is
wrongly recorded.
 Compensating Errors
• When two or more errors are committed in such
a way that the net effect of these errors on the
debits and credits of accounts is NIL, these errors
arise, which are called “Compensating Errors.”
– Example: If purchases book is overcast, say, by
`6,000, which results in excess debit of `6,000 in
Purchases Account and if the Sales Returns Book is
under cast by the same amount of `6,000, which
results in shortage of debit in Sales Returns Account.
These type of errors compensate each other. One
excess of `6000 is set off by the other deficit (of the
same amount `6,000). The net effect is nil.
CLASSIFICATION OF ERRORS (BASED ON THE IMPACT OF ERRORS ON TRIAL BALANCE)
Rectification of Errors Which do not Affect the Trial Balance

• As these errors are committed in two more accounts, they can

be rectified by recording a journal entry by way of giving the
correct debit and credit to the concerned accounts.
Illustration (Rectification by Journal Entry)
Credit Sales to Rahman `1,05,000 were not recorded in the Sales
Book. Rectify the error.
 
Solution
This is an error of complete omission. That means this transaction
is not at all recorded.
Rectification → Now the entry will have to be made as `
Rahman’s A/C Dr. 1,05,000
To Sales A/C `1,05,000
(Being Credit Sales to Rahman, now recorded)
Rectification of Errors Affecting Trial Balance

• The errors that affect only one aspect of

account can be rectified by recording a journal
entry with an additional entry under the
caption “Suspense Account.” Creation of
Suspense Account is a stop-gap arrangement
till the error is detected and rectified.
The following procedure is adopted when we use
Suspense Account to rectify errors (one sided):
Step 1: The account affected due to error is identified.
Step 2: The difference amount (excess or shortage) in
the affected account is determined.
Step 3: In case, the difference arises due to “excess
debit” or “short credit,” credit the account with the
difference.
Step 4: In case, the difference arises due “excess credit”
or “short debit,” debit the account with the difference
amount (resulted in excess credit or short debit).
Step 5: Journal entry is to be completed with the debit
or credit of Suspense Account.
 MEANING OF SUSPENSE ACCOUNT AND ITS ACCOUNTING
TREATMENT

• Before preparing final accounts, if it is not possible to

detect the errors, the difference in Trial Balance is
transferred to a new account called “Suspense
Account.” Thereby, the Trial Balance is tallied.
– This account has been introduced to avoid delay in the
preparation of final accounts.
• When errors are located, they will be rectified through
the Suspense Account and the same will be eliminated.
– The Suspense Account is recorded without double entry
effect because Suspense Account is not a Personal Account,
not a Real Account and not even a Nominal Account
TRADING AND PROFIT AND LOSS ACCOUNT AND BALANCE SHEET

• The final phase – preparation of final accounts

from Trial Balance – is discussed in detail in
the following sections. The final accounts are
to be prepared to ascertain the net profit or
loss for a period (Trading and Profit and Loss
Account) and the financial position of the
business entities on the last date of a period
(Balance Sheet).
 TRADING ACCOUNT
• Trading account is the first constituent of financial
statements in case of trading firms. In practice, it is
treated along with Trading and Profit and Loss
Account, as one account and one unit.
• Trading Account is prepared to know whether a
business enterprise has earned profit or suffered
loss. Here profit or loss represents only gross
profit or gross loss. Gross profit means the excess
of operating revenues over direct operating
expenses. To put in other words, gross profit is the
excess of net sales revenue over cost of goods
sold.
 Profit and Loss Account: Meaning and Features

• Profit and Loss Account is prepared to ascertain the net

profit earned or net loss suffered by a business enterprise
during an accounting period.
– This account starts with gross profit on the credit side much which
is brought forward from the Trading Account.
• It is followed by any other item of revenue income.
• It is important to mention here that only items of revenue
incomes and revenue losses will be recorded in this account.
– But profit or loss on sale of capital items is recorded here.
• On the debit side it starts with gross loss, in case of gross
loss brought forward from Trading Account.
– It is followed by items relating to revenue expenses. (Items that
are not recorded in Trading Account will have to be recorded in
this account.)
  
Pro-forma of Profit and Loss A/C
 Uses of Profit and Loss A/C

(i) Determination of net income: It is very essential for any

kind of business entities to know the profit earned
periodically for which this account facilitates the task of
computing the net income with accuracy.
(ii) Capital maintenance: Capital should be maintained at an
optimum level in business organizations. The preparation of
this account extends a helping hand in determining how
much amount can be kept in capital and how much can be
earmarked for the other areas in the business firms. The
income statement plays a vital role in this aspect.
(iii) Tool of financial planning: Only after ascertaining net
profit, financial planning can be carried on without much
hindrance. The business entities can plan how much to
earmark to replace the assets and how much to keep in
reserve to meet any unforeseen eventualities which may
arise in future and the like.
(iv) Source of internal financing: It helps in maintaining the level
of retained income which will act as a source for all other
activities relating to finance within any enterprise.
(v) Basis for tax computation: This account provides accurate
basic data to calculate tax. But for this, it will not be easy to
compute tax.
(vi) Future investment decisions: Level of earnings in future can
be estimated based on the past level of earnings. This P and L
Account throws much light on this aspect by which a proper
investment decision can be made by a careful analysis of
incomes and expenses occurred in the previous years.
(vii) Managerial use: Information regarding profitability can be
had from income statement which is useful for management
to streamline the different and varied activities of the larger
enterprises.
Explanation of Some of the Terms Appearing in Profit and Loss A/C

Some of the items that frequently appearing in the preparation

of Profit and Loss Account have to be understood in the proper
context. They are as follows:
(i) Outstanding income: The amount which is due and receivable
but not yet received is referred to as “outstanding income.” A
person is entitled to receive the “outstanding income” once it
becomes due legally.
 
(ii) Accrued income: The amount which is earned but not yet
due and receivable is referred to as “Accrued Income.” This is
calculated periodically. A person is not entitled to receive the
“accrued income” legally.
 
(iii) Net profit: Excess of operating revenues over operating
expenses and losses is termed as
“Operating Profit” (Operating Profit = Gross Profit –
Operating Expenses).
Operating expenses are such expenses that form part of
normal business activities.
 
(iv) Operating loss: Excess of operating expenses over the
gross profit is known as operating loss:
Operating Loss = Operating Expenses – Gross Profit
 
(v) Non-operating profit: Non-operating profit arises from
sources other than normal activities of the business
entities.
• Solution
Notes
1. As gross profit is given, Trading Account need not be
prepared. Profit and Loss Account can be prepared straight
away.
2. Gross profit is entered on the credit side and all the
incomes of revenue nature are recorded one by one.
3. All expenses are entered (revenue nature) on the debit side.
4. Sale of machinery – only the loss on sale (`15,000 – `12,000)
(book value – sale). `3000 is
entered on the debit side. Sale amount `12,000 is not
recorded in Profit and Loss Account.
5. Reinvestment on fixed assets is capital expenditure and
hence not recorded in Profit and Loss Account
 BALANCE SHEET

• Balance Sheet is not an account but a

statement summarizing the financial position
of a business enterprise at a particular date.
• All the accounts that have not been closed by
transfer to either the Trading Account or the
Profit and Loss Account are to be recorded in
the Balance Sheet.
– It summarizes on the one side – the right hand
side – the assets of the business enterprise and on
the left hand side the liabilities of the business.
 Grouping and Marshalling of Assets and Liabilities:
Meaning of Grouping and Marshalling
• Grouping: Arranging items of a similar nature together
under a common heading is known as “grouping.”
– Examples: Creditors and Debtors.
• Marshalling: The order in which the assets and
liabilities are recorded in the Balance Sheet is referred
to as marshaling. The items in the Balance Sheet are
generally marshaled in the following two ways:
– (i) in the order of liquidity and (ii) in the order of
permanency.
 In the Order of Liquidity

(i) Assets are arranged in the order of liquidity

(liquidity means the ability to convert the asset into
cash or time taken to convert the asset into cash) –
the most liquid asset is shown first and the least is
shown last.
(ii) The liabilities are arranged in the order in which
they have to be paid off – the most emergent
amount has to be made is recorded first and other
liabilities are arranged in the order of emergency to
be paid off.
 In the Order of Permanence
Items are arranged in the order of permanence or
according to the purpose. This order is just the
reverse of the liquidity order.
The assets are arranged in the order of their
permanence – the least liquid asset is to be
recorded first and the most liquid asset is
recorded last, i.e. just the reverse order of the
liquidity order.
The liabilities (also the reverse of the liquidity
order), the least urgent payment is to be
recorded first and vice versa.
• We will consider an example of final accounts
at the time of calculating Ratios………….