Chapter 3

Recording Transactions
 Trial Balance
• Once all transactions have been posted to the
ledger, a trial balance is prepared.

• Trial balance - a list of all of the accounts with their

balances

The purposes of the trial balance:

– To help check on accuracy of posting by proving whether
the total debits equal the total credits

– To establish a convenient summary of balances in all

accounts for the preparation of formal financial statements
 Preparing the Trial Balance
• The trial balance is usually prepared with the balance sheet accounts
first, followed by the income statement accounts.

• Order is : Current Assets

Fixed Assets
Current Liabilities
Long term Liabilities
Paid in Capital
Retained Income
Sales Revenue
COGS
Expenses
TOTAL
 Deriving Financial Statements from
the Trial Balance
• The trial balance is the starting point for the
preparation of the balance sheet and the income
statement.

– The income statement accounts are summarized

later in a single account called Net Income, which
becomes part of Retained Income in the balance
sheet.
 Preparing the Trial Balance

*If a Retained Earnings balance existed at the start of the accounting period, it
would appear here.
Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.
 Disadvantage of the Trial Balance
• Note that a trial balance may balance even when
errors were made in recording or posting.

– A transaction may be recorded in different

amounts
– A transaction may be recorded in a wrong
account.
• In both situations, the total debits will still equal total
credits on the trial balance.

Dr. = Cr.
 Closing the Accounts
• Once the financial statements are prepared,
the ledger accounts must be prepared to
record the next period’s transactions. This
process is called closing the books.

– The balances in all “temporary” stockholders’

equity accounts are transferred to a Retained
Income Account via a temporary Income
Summary account.

– The revenue and expense accounts are “reset” to

zero and the current net income is transferred to
Retained Income.
 Closing the Accounts
There are three closing entries:
C1: Close all revenue accounts
C2: Close all expense accounts
C3: Close the Income Summary account

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.

 Capital Vs Revenue
• The items of expenses and income, are termed as
Revenue by accountants- they are short lived and
closed by transferring to Income Summary Account

• The credit and debit balances in Trial Balance which

remain unclosed (not transferred to Income Summary
Account) are called Capital- They survive and move
to the next year as opening balances

- All Asset accounts, Liability accounts, Paid up Capital and

Retained Earnings account are called Capital
 Effects of Errors
• When a journal entry contains an error, it can be
erased or crossed out only if the error is detected
before the entry is posted to the ledgers.

• If the error is detected after posting, a correcting

entry must be made.
– The correcting entry counteracts the incorrect
entry and assures that the correct account is
debited or credited for the proper amount.
 Effect of Errors
• Some errors may be Temporary while some errors
persist till corrected.

1. Temporary Errors

- Some errors, which remain undetected by

accountants, can affect a variety of items including
revenue and expenses for a given period.

- However, they get automatically corrected in the

next period- they have a counterbalancing effect in
two accounting periods which nullifies their effect
 Effect of Errors
• E.g.- Rent paid in advance, Rs.100 on 1st
December 2022 for the month of January
2023, wrongly recorded as Rent Expense
Incorrect Entry Correct Entry Correct Entry
On 1st Dec 2022 On 1st Dec 2022 On 31st Jan 2023
Rent Exp………100 Prepaid Rent…100 Rent Exp………100
Cash……… 100 Cash………….. 100 Prepaid Rent….100

Effect in 1st year (2022) Effect in 2nd year(2023)

-Rent Expense will be -Rent expense understated
overstated by 100 by 100

-Pre tax Income will be -Pre tax Income overstated

understated by 100 by 100

-Assets understated by 100 -No effect

2. Errors that are not counterbalanced

• Errors that are not counterbalanced will keep the

balance sheet incorrect until correcting entries are
made.

e.g.: Overlooking a depreciation expense by Rs.500 in

year 1

Effect:
Year 1: Overstated Pretax income, Assets and Retained
Income
Subsequent Years: Overstated Asset and RI
 Incomplete Records
• Accountants must sometimes “fill in the blanks” when
accounting records are lost, stolen, or destroyed.

– T-accounts can help to recreate and calculate

unknown amounts.
• The accountant must understand the account
and the amounts that flow through it in order to
determine unknown amounts.

– This process can become extremely complicated

when many accounts are used.
 Incomplete Records
• You need to help a store owner in calculating the
sales for the year 2022 as he has lost the records.
The following information has been provided by
him:

• List of customers who owe money-

- On December 31st, 2021= Rs.14,000
- On December 31st, 2022= Rs.28,000
- Cash receipts from customers during 2022 = Rs.4,00,000
(Assume all sales were on credit)