Trial Balance (B.Com Hons) Notes ||UNIT 2||

Unit-II : Trial Balance

Definition of Trial Balance

A Trial Balance is defined as:

“A statement that lists all the balances of the ledger accounts at a specific date, prepared to check the mathematical accuracy of the accounts and as a preliminary step to the preparation of final accounts.”

Features of Trial Balance

1. Prepared from Ledger Accounts: It includes all ledger account balances.
2. Two Columns: It has two columns, one for debit and one for credit.
3. Prepared at a Specific Date: It is created as of a particular date.
4. Helps in Error Detection: If the totals of both columns match, it indicates that the accounting entries are arithmetically correct.

Limitations of Trial Balance

1. Cannot detect all types of errors (e.g., compensating errors or errors of omission).
2. Only verifies the mathematical accuracy, not the correctness of transactions.
3. A balanced trial balance does not ensure the absence of fraud or misrepresentation.

Rectification of errors

Rectification of errors is the process of identifying mistakes made during the preparation or recording of financial transactions and taking corrective actions to ensure that the accounts accurately reflect the financial position and performance of the business.

Types of Errors

Errors can be broadly classified into the following categories:

1. Errors of Omission: When a transaction is completely or partially omitted from the books.

   • Example: A sales invoice of ₹5,000 is not recorded.

2. Errors of Commission: When an entry is made but incorrectly in terms of amount, account, or classification.

   • Example: Recording ₹4,000 instead of ₹40,000.

3. Errors of Principle: When a transaction is recorded in violation of fundamental accounting principles.

   • Example: Recording a capital expense as revenue expense.

4. Compensating Errors: When two or more errors cancel each other out in their net effect.

   • Example: Overstating purchases and understating expenses by the same amount.

5. Errors of Duplication: When a transaction is recorded more than once.

Methods of Rectification

• Before the Preparation of Trial Balance: Errors are rectified directly in the ledger accounts.
• After the Preparation of Trial Balance: Suspense accounts are used to temporarily hold differences caused by errors, which are then resolved.

Final Accounts

Final Accounts are the financial statements prepared at the end of an accounting period to provide a summary of a business's financial performance and position. These accounts help stakeholders assess the profitability and financial health of the organization.

Objectives of Final Accounts

1. To ascertain the financial performance (profitability) during the period.
2. To determine the financial position (assets, liabilities, and capital) at the end of the period.
3. To comply with statutory requirements and provide transparency to stakeholders.

Key Components

1. Trading Account:

   • Debit side: Opening stock, purchases, direct expenses.
   • Credit side: Sales, closing stock.
   • Result: Gross profit or loss.

2. Profit and Loss Account:

   • Debit side: Indirect expenses (e.g., salaries, rent, depreciation).
   • Credit side: Indirect incomes (e.g., commission, interest received).
   • Result: Net profit or loss.

3. Balance Sheet:

   • Assets: Fixed assets, current assets.
   • Liabilities: Current liabilities, long-term liabilities.
   • Capital: Owner's equity and reserves.

Provisions

A Provision is a liability of uncertain amount or timing that is created to cover anticipated future expenses or losses. Provisions are made to ensure that expenses or losses are recognized in the financial period to which they relate, even if the exact amount or timing is unknown.

Key Features of Provisions:

• Created to cover specific anticipated liabilities (e.g., bad debts, depreciation, repairs).
• Mandatory as per the principle of prudence in accounting.
• Reduces the profit for the period in which it is created.
• Shown as a liability or deducted from related assets in the balance sheet.

Example: Provision for doubtful debts, provision for taxation.

Reserves

A Reserve is a portion of the profit retained by a business to strengthen its financial position, meet future uncertainties, or fund specific projects. Unlike provisions, reserves are created out of profits and are not meant to cover specific liabilities.

Key Features of Reserves:

• Created from net profit after tax.
• Not mandatory (except for legal reserves in certain cases).
• Does not reduce profit but is appropriated from profit.
• Shown as part of shareholders’ equity in the balance sheet.

Types of Reserves:

1. Revenue Reserve: Created from operational profits (e.g., General Reserve, Dividend Equalization Reserve).
2. Capital Reserve: Created from non-operational profits (e.g., profit on sale of assets, revaluation surplus).

Example: General reserve, capital redemption reserve.

Methods of Depreciation

Depreciation refers to the systematic allocation of the cost of a tangible asset over its useful life. It is the reduction in the value of an asset due to wear and tear, obsolescence, or passage of time. Depreciation ensures that the cost of an asset is matched with the revenue it generates.

Methods of Depreciation

There are several methods to calculate depreciation, with the most common ones listed below:

1. Straight Line Method (SLM)

• Definition: Under this method, depreciation is charged evenly over the useful life of the asset. The same amount is written off every year.
• Formula:$$\text{<span style="background-color: white;"><span style="font-size: large;">Depreciation</span></span>}<span\; style="background-color:\; white;"><span\; style="font-size:\; large;">=</span></span>\frac{\text{<span style="background-color: white;"><span style="font-size: large;">Cost of Asset</span></span>}<span\; style="background-color:\; white;"><span\; style="font-size:\; large;">-</span></span>\text{<span style="background-color: white;"><span style="font-size: large;">Residual Value</span></span>}}{\text{<span style="background-color: white;"><span style="font-size: large;">Useful Life of Asset</span></span>}}$$
• Example: A machine costing ₹1,00,000 with a residual value of ₹10,000 and a useful life of 10 years would have an annual depreciation of ₹9,000.

2. Diminishing Balance Method (Reducing Balance Method)

• Definition: Depreciation is calculated as a fixed percentage on the book value (written-down value) of the asset at the beginning of each year. This results in higher depreciation in the earlier years and lower in later years.
• Formula:$$\text{<span style="background-color: white;"><span style="font-size: large;">Depreciation</span></span>}<span\; style="background-color:\; white;"><span\; style="font-size:\; large;">=</span></span>\text{<span style="background-color: white;"><span style="font-size: large;">Opening Book Value</span></span>}<span\; style="background-color:\; white;"><span\; style="font-size:\; large;">\times </span></span>\text{<span style="background-color: white;"><span style="font-size: large;">Rate of Depreciation</span></span>}$$

• Example: If the initial value of an asset is ₹1,00,000 with a 20% depreciation rate, the depreciation for the first year is ₹20,000, and for the second year, it is ₹16,000.

3. Sum-of-Years-Digits Method

• Definition: This method uses a fraction of the total life years to determine the depreciation amount. Higher depreciation is charged in earlier years, and it decreases over time.

Formula:$$\text{<span style="background-color: white;"><span style="font-size: large;">Depreciation</span></span>}<span\; style="background-color:\; white;"><span\; style="font-size:\; large;">=</span></span>\frac{\text{<span style="background-color: white;"><span style="font-size: large;">Remaining Life of Asset</span></span>}}{\text{<span style="background-color: white;"><span style="font-size: large;">Sum of Useful Life Years</span></span>}}<span\; style="background-color:\; white;"><span\; style="font-size:\; large;">\times </span></span>\text{<span style="background-color: white;"><span style="font-size: large;">(Cost - Residual Value)</span></span>}$$                                       ×(Cost - Residual Value)

• Example: If the useful life is 5 years, the sum of years will be $5+4+3+2+1=15$.

4. Units of Production Method

• Definition: Depreciation is based on the actual usage or output of the asset rather than time.
• Formula:$$\text{<span style="background-color: white;"><span style="font-size: large;">Depreciation per Unit</span></span>}<span\; style="background-color:\; white;"><span\; style="font-size:\; large;">=</span></span>\frac{\text{<span style="background-color: white;"><span style="font-size: large;">Cost - Residual Value</span></span>}}{\text{<span style="background-color: white;"><span style="font-size: large;">Total Estimated Output</span></span>}}$$
• Example: If a machine costs ₹1,00,000, has a residual value of ₹10,000, and produces 10,000 units over its life, depreciation per unit is ₹9.

5. Double Declining Balance Method

• Definition: This is an accelerated depreciation method where double the straight-line rate is applied to the diminishing book value.
• Formula:$$\text{<span style="background-color: white;"><span style="font-size: large;">Depreciation</span></span>}<span\; style="background-color:\; white;"><span\; style="font-size:\; large;">=</span></span>\mathrm{<span\; style="background-color:\; white;"><span\; style="font-size:\; large;">2</span></span>}<span\; style="background-color:\; white;"><span\; style="font-size:\; large;">\times </span></span>\text{<span style="background-color: white;"><span style="font-size: large;">Straight-Line Rate</span></span>}<span\; style="background-color:\; white;"><span\; style="font-size:\; large;">\times </span></span>\text{<span style="background-color: white;"><span style="font-size: large;">Book Value at Beginning of Year</span></span>}$$

6. Annuity Method

• Definition: Depreciation is calculated based on the asset’s cost and a fixed rate of return, similar to an annuity.
• Formula:$$\text{<span style="background-color: white;"><span style="font-size: large;">Depreciation</span></span>}<span\; style="background-color:\; white;"><span\; style="font-size:\; large;">=</span></span>\text{<span style="background-color: white;"><span style="font-size: large;">(Initial Cost + Interest)</span></span>}<span\; style="background-color:\; white;"><span\; style="font-size:\; large;">-</span></span>\text{<span style="background-color: white;"><span style="font-size: large;">Residual Value</span></span>}$$

7. Machine Hour Rate Method

• Definition: Depreciation is calculated based on the total working hours of a machine.
• Formula:$$\text{<span style="background-color: white;"><span style="font-size: large;">Depreciation per Hour</span></span>}<span\; style="background-color:\; white;"><span\; style="font-size:\; large;">=</span></span>\frac{\text{<span style="background-color: white;"><span style="font-size: large;">Cost - Residual Value</span></span>}}{\text{<span style="background-color: white;"><span style="font-size: large;">Total Estimated Machine Hours</span></span>}}$$

Choosing the Right Method

The choice of depreciation method depends on:

1. Nature of the asset.
2. Pattern of usage.
3. Financial policies.
4. Tax regulations.