ACCOUNTING – YEAR 9

NOTES FOR STUDENTS

UNIT 4.0 - PROVING THE LEDGER AND PREPARING THE FINANCIAL STATEMENTS

Introduction

Is there a way of checking to see that the entries have been recorded accurately in the ledger?  Yes, a proof is made to verify (check) the equality of the ledger at the end of each accounting period.  Proving the equality of the ledger is the fourth step in the accounting cycle.  Then the financial statements are prepared.  This is the fifth step in the cycle.

4.1 The Trial Balance

A trial balance is a proof that the ledger is mathematically accurate.  (The term proof means “a test to show that something is true.”)  As you learned earlier, the total debit balances in the ledger must always equal the total credit balances.  A trial balance is a test to make sure that this equality exists in the ledger.

a. Determining Account Balances

Before a trial balance can be prepared, the balance of each account must be determined.

An account balance is the difference between the total debits and the total credits in an account.  If all the entries are on one side of the account, the total  of those entries is the account balance.  If the entries appear  on both sides of the account, the difference between  the total of each side is the account balance.  The illustration below shows how an account balance is obtained when the account has entries on both sides.

1. Total the debits in the Debit column.  Record the total in small pencil figures directly under the last amount.  This penciled total is called pencil footing.  Writing the footing in small pencil figures distinguishes it from a regular entry and permits using the line below for an entry.  Moreover, using a pencil makes it possible to erase the footing in case of an error.
2. Total the credits in the Credit column.  Pencil-foot the total directly under the last amount.
3. Subtract the smaller total from the larger total.  The difference is the account balance.  Record the balance in small pencil figures in the Particulars column of the side that has the larger total.  Since the Cash account has a larger total on the debit side, it has a debit balance.  Therefore, the balance is entered on the debit side.  The pencil figures for the balance are written to the left of the pencil footing of the total debits.  In accounts with credit balances, the balance is entered on the credit side to the left of the total credits.  Then the balancing double entry is completed by recording the balance “carried down” and the balance “bought  down” on the relevant sides.

Pencil footings are used in accounts to show the results of adding and subtracting.  The pencil footings may be omitted when no computation is needed.  For example, if an account has only one entry, no computation is required because the amount of the entry is the total of that side of the account and also the balance of the account.  It is not necessary in this case to record a pencil footing before the account balance is recorded.  If an account has several entries but they are all on one side, the pencil-footed total of the money column is also the balance of the account.  Thus it is not necessary to show an account balance in pencil.

The type of balance an account has depends on the account itself.  One of the rules for debiting and crediting given earlier is stated as follows. The balance of an account normally appears on the same side as it is shown in the accounting equation.

 TYPE OF ACCOUNT NORMAL BALANCE Asset accounts Debit balance Liability accounts Credit balance Capital accounts Credit balance Revenue accounts Credit balance Expense accounts Debit balance

The process of determining the balances of the ledger accounts is referred to as balancing the accounts.  The remaining accounts in the ledger of the OSC are balanced for October as shown below.

Remember expense accounts have debit balances because they decrease owner’s equity.

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b. Preparing a Trial Balance

After each account has been balanced in the ledger, a check is made to see that the total of the debit balances equals to total of the credit balances.  These totals should agree because the debits equal the credits for each transaction.  The proof of the ledger balances is the trial balance.  A formal trial balance is a listing of the titles of the accounts and their balances.  The accounts are listed in the order in which the accounts appear in the ledger.  The trial balance prepared for the OSC on 31 October is shown below.

A trial balance may be prepared any time to ensure that the ledger is in balance.  Generally, a trial balance is prepared at the end of each month.  One must be prepared at the end of each accounting period.

The procedure for preparing a trial balance is as follows:

Heading:  Centre the heading at the top of the trial balance.  The heading answers these questions: WHO? (the name of the company), WHAT? (the name of the listing), and WHEN? (the date).

Account Balances:  List the accounts in order, just as they appear in the ledger.  Write the account title in the first column, and the account balance in either the Debit column or the Credit column.  Only accounts with balances need to be shown on the trial balance.

Ruling and Totaling:  After all the account balances have been entered, total and pencil-foot the money columns.  If the total debits equal the total credits, do the following:

1. Draw a single rule in ink across both money columns.
2. Record the totals.
3. Draw a double rule across both money columns beneath the totals.  The double rules indicate that the trial balance is completed.

If the total debits do not equal the total credits, then there is an error.  All errors must be located before the trial balance totals are recorded and the rules drawn.

c. Locating Trial Balance Errors

When the debit and credit totals agree, a trial balance is said to be in balance.  There are times, however, when a trial balance is out of balance.  That is, the totals do not agree.  To locate the error or errors, start with the last in preparing a trial balance.  Then work back, step by step, until the error or errors are found.

After an amount or entry is checked for an error, a check mark (Ö ) is placed at the right of the amount or entry.  The check mark shows that this item has been verified.  If the item must be checked again, a line is made through the check mark ( x ).  Here is a sequence used for tracing errors.

1. Check the addition of both money columns of the trial balance.   If there is no error, go to the next check point and any others if necessary.
2. Compare the balance of each ledger account with the amount entered for that account on the trial balance.  An account balance may have been copied incorrectly or entered in the wrong column.  An account balance may have been omitted or added more than once.
3. Verify the balance of each ledger account by checking the subtraction of the smaller total from the larger total.
4. Verify the total debits and the total credits in each ledger account by checking the addition.
5. Compute the difference between the two totals on the trial balance.  Search the ledger accounts for entries of this amount. Check each of these entries to see whether it has been recorded correctly.  For example, a debit entry for \$50 recorded twice to Cash  would make the debit total of the trial balance \$50 greater than the credit total.  The debit total would also be \$50 greater if a credit entry for \$50 had not been recorded.
6. Take the difference between the two totals on the trial balance, and divide it by 2.  Search the ledger accounts for an entry of this amount.  If a difference of \$60 divided by 2 is \$30, a debit entry for \$30 posted as a credit entry would throw off the trial balance by \$60.  The debit total would be \$30 less than it should be, and the credit total would be \$30 more.
7. Divide the trial balance difference by 9.  If the difference can be divided evenly by 9, two digits in an amount may have been transposed.  For example, if \$132 were posted as \$123, there would be a difference of \$9 on the trial balance.  If \$164 were posted as \$146, there would be a difference of \$18.  Each of these differences can be evenly divided by 9.  This principle of dividing by 9 is an excellent way to uncover the possibility of transposed digits.

A correction must be made for each error that is found.  The only erasures in the accounting record, however, should be pencil figures.  To correct an error in an amount, first draw a single line through the entire amount.  Then write the complete correct amount above it.

d. Errors Not Revealed by A Trial Balance

The fact that a trial balance is “in balance” does not mean that the accounting records are completely accurate.  The trial balance merely checks the mathematical accuracy of the ledger.  It proves that the totals of the debit and credit balances in the ledger accounts are equal.  A trial balance does not reveal the following types of errors.  These errors do not create a difference between the totals of the debit balances and the credit balances.

1. A transaction that is completely omitted from the ledger.
2. A transaction that is recorded more than once.
3. A transaction that has been posted to the wrong account.  For example, a debit to the Furniture account that has been posted in error as a debit to the Office Equipment account.
4. A transaction where a wrong amount is debited and credited.  For example, a transaction for \$50 has been posted as \$5.
5. Two errors for the same amount that cancel each other out.  For example, a debit account balance that is \$100 too much and a credit account that is \$100 too much.

These errors emphasize the need for accuracy at all times in recording data, in analyzing transactions, and in posting.  Time is lost if a person must look for errors.

e. Functions of the Trial Balance

The trial balance serves two functions.

1. It proves the equality of the debit and credit balances in the ledger accounts.
2. It provides the data needed  to  prepare an income statement and a balance sheet.  (This function will be discussed later.)

If you simply want to prove that the ledger is in balance, you may take a quick trial balance on a calculator.

4.2 Financial Statements

Are the amounts for the income statement and the balance sheet obtained directly from the ledger accounts?  No, the trial balance provides the data for the financial statements.  The accounts on the trial balance are in order as they are written in the ledger.  They contain asset accounts, liability accounts, owner’s equity, revenue, and expense accounts.

Thus the accounts on the trial balance can easily be divided into two groups: the income statement accounts, and balance sheet accounts.  Those accounts that appear on the income statement are called income statement accounts.  Those that appear on the balance sheet are called balance sheet accounts.

a. The Income Statement

An income statement is prepared before a balance sheet because the net income (or net loss) amount must be reported on the balance sheet.  The types and amounts of the revenue and expenses are obtained from the trial balance.  The income statement prepared for the OSC for the month ended 31 October is shown below.  It shows revenue of \$3,000; expenses of \$1,600; and a net income of \$1,400 (\$3,000 - \$1,600).

b. The Balance Sheet

The amount of each asset and liability is taken from the trial balance.  For the owner’s equity, the balance of the capital account is taken from the trial balance.  The net income or net loss is taken from the income statement.   The Owner’s Equity section of the balance sheet is completed by computing the total owner’s equity.

The balance sheet prepared for the OSC as at 31 October is shown above.  The balance sheet shows total assets of \$22 450, total liabilities of \$1,050 and total owner’s equity of \$21,400.  The total of the assets, \$22,450, equals the total of the liabilities and owner’s equity, \$22,450.

c. The Accounting Cycle

The preparation of the financial statements is the fifth step in the accounting cycle.  The steps discussed up to this point are as follows:

1. Record original data on source documents.
2. Classify and file the source documents.
3. Record entries in ledger accounts.
4. Prove the ledger by extracting trial balance.