Tag: Double Entry

Accounting Equation is a fundamental concept in accounting that serves as the foundation for the double-entry bookkeeping system. It reflects the relationship between a company’s assets, liabilities, and equity. The equation is expressed as:

Assets = Liabilities + Equity

This equation must always balance, meaning that the value of a company’s resources (assets) is always equal to the claims against those resources (liabilities and equity). It provides a snapshot of a company’s financial health at a specific point in time and forms the basis for the structure of financial statements, such as the balance sheet.

1. Assets:

Assets are the resources owned by a business that are expected to bring future economic benefits. They include both tangible and intangible items that the company controls as a result of past transactions. Examples of assets are:

• Cash: The most liquid asset, representing money available for immediate use.
• Accounts Receivable: Amounts owed to the company by customers for goods or services delivered.
• Inventory: Goods that are held for sale in the normal course of business.
• Equipment and Machinery: Physical assets used in the production or operations of the business.
• Intangible Assets: Non-physical assets such as patents, trademarks, and goodwill.

Assets can be classified as current or non-current based on their liquidity or how soon they can be converted into cash.

2. Liabilities:

Liabilities are the obligations or debts that a business owes to outside parties. They represent claims on the company’s assets by creditors, suppliers, and lenders. Liabilities arise from borrowing funds, purchasing goods or services on credit, or other financial commitments. Examples:

• Accounts Payable: Money owed to suppliers for purchases made on credit.
• Loans Payable: Debts that the company must repay, typically to banks or other financial institutions.
• Unearned Revenue: Money received from customers for services or goods to be delivered in the future.

Liabilities are classified as current (due within one year) or long-term (due after one year).

3. Equity:

Equity represents the owners’ claims on the company’s assets after all liabilities have been settled. It can be thought of as the residual interest in the assets of the business. Equity is also referred to as owners’ equity or shareholders’ equity in the case of corporations.

• Contributed Capital: The money that shareholders or owners invest in the business.
• Retained Earnings: The accumulated profits that the business has earned over time, minus any distributions (dividends or withdrawals) to the owners.

In a sole proprietorship or partnership, equity is usually referred to as owner’s capital, whereas in a corporation, it includes stock (common or preferred) and retained earnings.

Importance of the Accounting Equation

The accounting equation plays a critical role in maintaining the integrity of a company’s financial records. Every financial transaction that a business undertakes affects at least two accounts, and the equation ensures that these transactions keep the balance intact. For example:

• If a business takes out a loan, assets (cash) increase, but liabilities (loans payable) also increase, keeping the equation balanced.
• If a company purchases inventory with cash, one asset (inventory) increases while another asset (cash) decreases, which also balances the equation.

Double-Entry System

The accounting equation is central to the double-entry accounting system, which requires that every financial transaction affects at least two accounts to keep the equation in balance. For every debit entry made to one account, a corresponding credit entry must be made to another account. This ensures that total debits always equal total credits, maintaining the equality of assets with liabilities and equity.

Relationship with Financial Statements

The accounting equation is directly related to the preparation of the balance sheet, which is structured to reflect the equation. The balance sheet lists a company’s assets on one side and liabilities and equity on the other side. The accounting equation ensures that the balance sheet is always balanced, providing users with a clear view of the financial position of the business at a particular time.

Trial Balance is a summary of all the general ledger accounts of a business at a specific point in time. It lists the balances of each account, separating them into debit and credit columns. The primary purpose of preparing a trial balance is to check the mathematical accuracy of the bookkeeping system, ensuring that total debits equal total credits. If the trial balance is balanced, it indicates that the double-entry accounting system has been followed correctly. However, a balanced trial balance does not guarantee the absence of errors, as some types of mistakes may not affect the overall balance.

Functions of Trial Balance:

1. Verification of Mathematical Accuracy

The main function of a trial balance is to ensure that the double-entry accounting system has been followed correctly. In this system, every transaction affects two or more accounts, with debits equaling credits. The trial balance checks the mathematical accuracy of these entries by listing all debit and credit balances. If the total debits equal the total credits, the bookkeeping entries are presumed correct.

2. Detecting Errors

The trial balance helps in identifying certain types of errors in the accounting records. For example, if debits and credits do not match, it indicates that there has been a mistake in the recording process. Errors such as omission, reversal of entries, or incorrect postings can be traced and corrected through the trial balance. However, it’s important to note that it won’t detect all types of errors, like compensating errors or incorrect amounts in both debit and credit sides.

3. Facilitating the Preparation of Financial Statements

One of the critical functions of the trial balance is to simplify the preparation of financial statements such as the balance sheet and income statement. Once the trial balance is complete and balanced, accountants can use the information to prepare these financial reports, ensuring the financial position and performance of the business are accurately reflected.

4. Summarizing Financial Data

The trial balance acts as a summary of all the financial data for a specific period. It compiles the ending balances of all the ledger accounts, providing a snapshot of the company’s financial standing. This summary allows management and auditors to review the overall status of the accounts in one place.

5. Checking for Completeness

By listing all the balances from the general ledger, a trial balance helps to check if any accounts have been omitted during the posting process. This function ensures that all financial transactions have been properly accounted for and included in the company’s records.

6. Simplifying Adjustments

Trial balances are typically prepared before making adjusting entries at the end of the accounting period. It helps in identifying which accounts require adjustments, such as accruals, depreciation, or prepaid expenses. Once the necessary adjustments are made, a new trial balance, known as the adjusted trial balance, is prepared.

7. Monitoring Financial Health

A well-maintained trial balance helps monitor the financial health of a business. By reviewing the balances in various accounts, management can assess liquidity, solvency, profitability, and other key financial metrics. The trial balance also highlights the balances of assets, liabilities, and equity accounts, offering insights into the overall financial condition of the company.

8. Supporting Auditing

The trial balance is an important tool for auditors during the auditing process. It provides a basis for auditors to verify the accuracy of financial records, trace transactions back to their original entries, and assess the reliability of the company’s financial statements. It also helps in ensuring that financial statements are prepared according to accounting standards and regulations.

Components of Trial Balance:

Trial Balance consists of several key components that help summarize the financial data of a business at a specific point in time. These components ensure that the double-entry accounting system has been followed correctly, and they aid in the preparation of financial statements.

1. Account Title

• This is the name of each account in the general ledger. It includes all types of accounts such as assets, liabilities, equity, revenues, and expenses.
• Examples of account titles are “Cash,” “Accounts Receivable,” “Inventory,” “Sales Revenue,” and “Salaries Expense.”

2. Debit Column

• The debit column lists all the amounts that have been debited to the various accounts.
• It includes the total debits recorded during the accounting period, and it helps track the value of transactions that increase assets or expenses.
• For example, cash receipts and expenses like rent or utilities are recorded on the debit side.

3. Credit Column

• The credit column contains all the amounts credited to the various accounts.
• It represents the transactions that reduce assets or expenses or increase liabilities, equity, and revenues.
• For example, income from sales and amounts owed to suppliers are typically recorded in the credit column.

4. Account Balances

• The trial balance includes the closing balances of each account from the general ledger.
• Each account will have either a debit or a credit balance depending on its nature (e.g., assets normally have debit balances, while liabilities have credit balances).
• The trial balance displays these balances in the respective debit and credit columns.

5. Total of Debit and Credit Columns

• At the bottom of the trial balance, the total of all debit and credit columns is shown.
• The total debits and total credits should match (be equal), ensuring that the accounting records are mathematically correct and balanced.

6. Date

• The trial balance is usually prepared at the end of an accounting period (monthly, quarterly, or annually).
• The date helps to define the period for which the financial data is summarized, making it clear which transactions are included in the trial balance.

Example of Trial Balance:

Here is an example of a trial balance in table format:

Account Title	Debit ($)	Credit ($)
Cash	10,000
Accounts Receivable	5,000
Inventory	7,500
Equipment	15,000
Accounts Payable		3,500
Notes Payable		12,000
Capital		10,000
Sales Revenue		25,000
Salaries Expense	8,000
Rent Expense	2,000
Utilities Expense	1,000
Total	48,500	48,500

Explanation:

• Debit Column:

This lists all the accounts with debit balances, such as assets (Cash, Accounts Receivable, Inventory, Equipment) and expenses (Salaries Expense, Rent Expense, Utilities Expense).

• Credit Column:

This lists all the accounts with credit balances, such as liabilities (Accounts Payable, Notes Payable), owner’s equity (Capital), and revenues (Sales Revenue).

• Total:

The total of the debit and credit columns must be equal (48,500), confirming that the ledger is balanced.

The reporting information will not be accurate unless we take into consideration the adjustment entries. The treatment of various common adjustments such as closing stock, outstanding expenses, accrued incomes, prepaid expenses, incomes received in advance, bad debts, reserve for bad and doubtful debts, reserve for discount on debtors, reserve for discount on creditors, interest on capital, interest on drawings, depreciation, etc., the knowledge of which should be made use of while preparing final accounts.

Special Items of Adjustments:

1. Goods Distributed as Free Samples

In order to promote a product, free samples are supplied to experts in the field. For example, free samples of books to professors, free samples of medicine to doctors.

Therefore the adjusting entry is as follows:

Particulars	Dr	Cr
Advertising A/c                Dr To Purchasing A/c or To Trading A/c	****	**** ****

The transfer entry is as follows:

Particulars	Dr	Cr
Profit and Loss A/c        Dr To Advertisement A/c	****	****

The net effect would be reduction in purchases and charge to profit and loss account as promotional expense.

2. Goods Sold on Sale or Approval Basis

In order to gain confidence of the customers on quality of the goods, sometimes goods are sold on approval basis. If the customer approves it, then it becomes a sale. If the customer does not approve it, then the sale is not complete and hence cannot be treated as sales. Suppose at the end of the financial year certain goods sent on approval basis are with the customers, then there is a need to pass necessary entries for adjustment.

The adjusting entries are as follows:

Particulars	Dr	Cr
Sales A/c                        Dr To Debtors A/c (at sales price of the goods)	****	****
Particulars	Dr	Cr
Stock A/c                        Dr To Trading A/c (at cost price of the goods)	****	****

The treatment is as follows:

(a) As a deduction from sales at sales price on credit side of trading account and as an addition to closing stock at cost price.

(h) As a deduction from sundry debtors on the assets side and the total stock to be shown at cost price (closing stock at cost + stock with the customers on approval) on the assets side of the balance sheet.

3. Goods Sent on Consignment

Since consignment transaction is not a sale transaction it does not affect the trading and profit and loss accounts directly. A separate consignment account is opened and the goods sent on consignment are debited to consignment account. When the account sale is received, it is treated as consignment sales and credited to consignment account and debited to consignees account.

Any consignment stock remaining with the consignee will be credited to consignment account and profit on consignment is ascertained after charging the expenses on consignment, consignee’s commission, etc. However, closing stock of consignment will be shown on the balance sheet’s assets side and the profit on consignment is credited to profit and loss account (the entry will be reversed if there is loss on consignment).

The transfer entry for profit or loss on consignment is as follows:

• If it is a Profit

Particulars	Dr	Cr
Consignment A/c                Dr To Profit and loss A/c	****	****

• If it is Loss

Particulars	Dr	Cr
To profit and loss A/c       Dr           Consignment A/c	****	****

Note: (i) The above transfer entry becomes necessary only where the consignor is also running a trading business

(ii) The working of consignment account is almost similar to trading account which is not shown here.

4. Loss of Stock by Fire

If the stock is destroyed by fire, then the loss incurred will be treated differently under the following three possible situations:

(a) If the stock is not insured: The entire value of the stock destroyed by fire will be treated as loss, with an entry:

Particulars	Dr	Cr
To profit and loss A/c       Dr           To trading A/c	****	****

Note: (i) The value of stock destroyed is credited to trading account as “stock destroyed” (had it not been destroyed, it would have appeared as closing stock).

(ii) Entire value of the stock destroyed is treated as loss and charged to profit and loss account.

(b) If stock is fully insured: When the stock which is fully insured is destroyed, the enterprise has a claim on the insurance company for the recovery of loss incurred due to goods being destroyed by fire. Therefore, the claim is preferred with an entry –

Particulars	Dr	Cr
Insurance Co. A/c             Dr           To Trading A/c	****	****

In effect, the claim on the insurance company is treated as ‘debtors’ and shown in the balance sheet assets side as due from the insurance company.

If the insurance company settles the dues, then the entry will be as follows:

Particulars	Dr	Cr
Cash/Bank A/c       Dr           To insurance A/c	****	****

In effect, the cash/bank balance in the balance sheet will increase to the extent of the claims settled and therefore, insurance company account will not appear in the balance sheet.

(c) If the stock is partly insured: In this case the total value of the stock destroyed is credited to trading account, and that part of the claim to be settled by the insurance company is debited to insurance company account and the difference between stock destroyed and insurance claim accepted is debited to profit and loss account as loss. The entry is as follows:

Particulars	Dr	Cr
Insurance Co. A/c             Dr           (part of the claim accepted) Profit and loss A/C             Dr (loss which connot be recovered) To trading A/c	****   ****	****

5. Deferred Revenue Expenditure

Huge expenditure of revenue nature incurred at the initial stages of the business enterprise with the belief of deriving benefit from such expenditure during the subsequent years is regarded as deferred revenue expenditure provided the charging of such expenses is spread over the number of years during which the benefit is expected to be derived.

A part of such expenditure is charged as revenue in each year and the rest is capitalized based on matching concept. For example, huge expenditure on ‘advertisement’ is incurred in the initial years of business to derive the benefit over an estimated term of ten years. Then, each year one-tenth of that expenditure is charged to revenue over the term of ten years. The catch here is that the expenditure that is not charged to revenue is capitalized and shown as fictitious assets on the balance sheet.

Suppose, the advertisement expenditure incurred Rs.2,00,000 is able to yield benefit over five-year term. Then, one-fifth of 2,00,000, i.e., Rs.40,000 is charged to revenue in the first year and the rest Rs.1,60,000 is shown as fictitious assets. In the second year Rs.40,000 is charged to revenue and the balance 1,20,000 is shown as fictitious assets. This process goes on for five years till the complete expenditure is written off. The entries to be passed during the first year are as follows:

Particulars	Dr	Cr
Advertisement A/c       Dr            To Bank A/c (For Advertisement Expenditure)	2,00,000	2,00,000
Particulars	Dr	Cr
Profit and loss A/c                  Dr           Deferred Revenue expenditure A/c  Dr   To Advertisement A/c (For charging 1/5th of advertising expense to revenue and treating the rest as deferred revenue expenditure.)	40,000 1,60,000	2,00,000

6. Creation of a Reserve Fund

To strengthen the financial position of the enterprise, a part of the net profit may be transferred to reserve fund account by means of appropriation. The entry for creating a reserve fund is as follows:

Particulars	Dr	Cr
To profit and loss Appropriation A/c           Dr           To Reserve fund A/c	****	****

Note: (i) Reserve fund will appear on the liabilities side of the balance sheet.

(ii) In the case of sole trading and partnership organizations, it is customary to change this directly to profit and loss account instead of profit and loss appropriation account.

7. Manager’s Commission

Business enterprises sometimes offer profit incentive to managers in the form of commission to motivate the person to increase the profits of the business. This commission is given as a percentage on the net profits. There are two ways of offering this percentage on net profits.

(a) Percentage of commission on net profits before charging such commission.

(b) Percentage of commission on net profits after charging such commission.

Whenever an error occurs, it should be rectified through proper rectification. Otherwise the books of accounts cannot exhibit the true and correct view of the state of affairs of a business and its financial results.

So it is very important that we identify and rectify all material errors in the books of accounts.

POINTS OF TIME AT WHICH ERRORS CAN BE DETECTED

1. Before preparation of the trial balance;
2. After preparation of the trial balance but before preparation of final accounts; and
3. After preparation of final accounts.

The rectification of the errors will be guided by

• the nature and effect of the errors and
• the point of time at which the errors have been detected.

TYPES OF ERRORS

A. ON THE BASIS OF NATURE

1. ERROR OF OMISSION:

It results from a complete or partial omission of recording a transaction.

For example, a transaction may be recorded in the subsidiary book but omitted to be posted to any of the ledger accounts.  This is a case of partial omission.

However, if a transaction is totally omitted to be entered in the books then it is a case of complete omission.

A complete omission will not affect the agreement of the trial balance but a partial omission will affect the agreement of a trial balance.

2. ERROR OF COMMISSION:

It results from an act of commission i.e. entries wrongly made in the journal or ledger.  It may be an

• error of posting,
• error of casting,
• entering wrong amounts,
• entering a transaction in a wrong subsidiary book etc.  

Unless the effects of errors of commission counterbalance each other, the agreement of the trial balance becomes affected.

3. ERROR OF PRINCIPLE:

It Is an error occurring due to wrong application of basic Accounting Principles.  The main reason behind such an error is incorrect classification of capital and revenue items.

For example, purchase of an Asset may be recorded through the Purchase day book instead of debiting the Asset account.  Or wages paid for the installation of an asset may be debited to the wages account instead of debiting the asset account with the amount of wages.

An error of principle will not affect the agreement of a trial balance. However, it will result in misrepresentation of the state of affairs and operational results of a business.

4. COMPENSATING ERRORS:

If the effect of an error is counterbalanced or cancelled out by the effect of another error or errors then such errors are known as compensating errors.  Since the compensating errors as a whole cancel out the effect of each other, the agreement of trial balance is not affected. Thus, it becomes difficult to detect such errors.

B. ON THE BASIS OF EFFECTS:

1. ONE SIDED ERRORS:

One sided error is an error whose effect falls on only one account.  It may arise due to

• Wrong casting of any day book;
• Posting made to the Wrong side of the relevant account;
• Duplicate posting of the same amount in an account.

One Sided errors cause a disagreement of the trial balance and hence are easy to detect.

2. TWO SIDED ERRORS:

A Two-sided error maybe

• Affecting two accounts at the same direction and not affecting the agreement of the trial balance.  For example Mr A’s account credited instead of Mr B account for an amount received from Mr B.
• Affecting two accounts at opposite direction and affecting the agreement of the trial balance.  For example, Mr A’s account debited instead of Mr B account being credited for an amount received from Mr B.

3. MORE THAN TWO SIDED ERRORS:

An error which affects more than two accounts simultaneously falls in this category.  This may or may not affect the agreement of a trial balance depending on the situation in each case.

EFFECTS OF ERRORS ON TRIAL BALANCE

Depending on its effect on the trial balance, the errors may be divided into two categories-

1. Errors affecting the agreement of trial balance; and
2. Errors not affecting the agreement of trial balance.

Errors affecting the agreement of Trial Balance (TB will not agree)	Errors not affecting the agreement of Trial Balance (TB will agree)
1. An error of Partial Omission	1. An error of complete omission
2. An error of commission whose effect is not cancelled out by a compensating error	2. Compensating Errors
3. Error in balancing an account or casting a subsidiary book	3. Error of Principles
4. An error of wrong posting unless the correct amount is posted to the right side of a wrong account.	4. An error of wrong posting of the correct amount to the right side of a wrong account.