Welcome to week 6
Week 5: Task answer Trial Balance
| Account | Debit | Credit |
| Sales | 3500 | |
| Bank | 440 | |
| Debtors | 2000 | |
| Consultancy | 300 | |
| Fuel | 60 | |
| Credit Card | 400 | |
| Equipment | 1000 | |
| Deposit Account | 700 | |
| Creditors | 200 | |
| Stationery | 200 | |
| Totals | 4400 | 4400 |
If you did the task correctly, your debits will equal your credits, and both will add up to 4400. The four new accounts appear at the bottom.
Transactions Recap
Let’s take another look at transactions. But just before we do, let’s get one myth out of the way. There are no different types of transaction! Yes, that’s right. All transactions are the same. They move money from one account to another. And as we said at the beginning, there are no special types of account either. They all record money coming from and going to them.
It is really important that you understand the last paragraph. It will really help your confidence in the future. If you know these two things; all accounts are the same; all transactions are the same, you will never have to worry if you missed some important concept when handling tricky looking transactions.
Patterns
The other vital thing to understand is that there are patterns in accounting. You have already encountered the first. The idea of money flowing from (credit) one account to (debit) another. Another pattern we have already seen is balancing credits and debits. If you want to see the balance of an account, all you do is total the two columns and subtract the lesser balance from the greater. If you then add that balance to the lesser total, you make the two columns balance. You then carry that balance down to the opposite column to get the real balance of the account ready to add more transactions.
The Trial Balance (commonly referred to as the abbreviation TB) includes part of the last pattern. The act of balancing both columns. It is called Trial because that is what it is, you are testing the balances. Do they equal each other. What happens if the TB columns do not equal each other? It means you have made a fundamental mistake somewhere. That mistake can be one of the following:
- One side of the TB has been wrongly added up
- Both sides of the TB have been wrongly added up (rare)
- One part of a transaction has a wrongly posted amount
- One part of a transaction has been missed out altogether
- One part of a transaction has been posted on the wrong side
The TB balances. Does that mean it is correct?
No! It just means that the debits equal the credits. It does not prove the following:
- A complete transaction or more has been omitted (Omissions)
- An error on one side cancels an error on the other (Commission)
- Amounts misposted to the wrong account or accounts (Commission or Principle)
- Amount entered wrongly (but the same wrong amount) on both sides (Commission or Compensating)
- Amounts entered on the side of both accounts (Principle)
Here are the definitions of the types of error (in brackets above):
- Original: Errors in original books
- Omission: Completely missing transaction (or 2 separate compensating sides missed)
- Commission: Wrongly copying something
- Compensating: Two wrongs making a right!
- Principle: Placing an account in the wrong place (eg. expense as capital)
Correcting a balancing TB but with errors of the above types
Where the accounts (and if relevant the amounts) are wrong:
- Copy the original transaction but reverse the accounts involved (thus zeroing the transaction)
- Make a new correct transaction
Where the accounts are correct but the amount is wrong:
- Make a transaction compensating for the difference
Correcting an Imbalancing Trial Balance
- For each wrong entry make a reversing entry
- For each reversing entry make the correct entry (except if the reversing entry is the correction)
If there is an amount that you cannot find or correct. Open a suspense account and post it there. A suspense account, like all accounts, is nothing special. It is just a means of temporarily balancing the books. Place the suspense account in current assets or liabilities depending on its balance. Once the correct account is known, it can be zeroed by posting its balance to the correct account.
Profit and Loss Account
Let’s move on to what many people assume is a report, some assume is a special kind of account, and those ‘in the know’ understand is just another account: the Profit and Loss (P&L) account. To see how this can be, let’s forget every other account and place our sales and expense transactions directly in the P&L account. Suppose we have two sales, the first for 100, the second for 40, and three expenses; 25, 45 and 69.
Before we show the P&L account, let’s look at the five transactions, so we can understand their debits and credits. As you know, every transaction involves two accounts. We know that one side of all these transactions will be the P&L. For now, we will assume the other side is Bank.
- From Sales To Bank 100
- From Sales To Bank 40
- From Bank To Expenses 25
- From Bank To Expenses 45
- From Bank To Expenses 69
You can see how easy it is to transpose From instead of Credit and To instead of Debit. It dramatically shows the flow of money. When you first start, think in terms of From and To, then transpose them to Credit and Debit. You will ‘get it’ really fast this way. And better still, you will be able to work out credits and debits with logic.
Top Tip
Alphabetically, Credit is before Debit and From is before To. Credit = From, Debit = To.
This is how you remember which is a credit and which is a debit. We have all learnt our alphabet, so the hard bit is done for you. Let’s transpose those five transactions:
- Credit Sales Debit Bank 100
- Credit Sales Debit Bank 40
- Credit Bank Debit Expenses 25
- Credit Bank Debit Expenses 45
- Credit Bank Debit Expenses 69
And now let’s write them straight into the P&L account. The date will be the date you compiled this:
| Profit and Loss Account | |||||
| Date | Details | Debit (to) | Date | Details | Credit (from) |
| xx.xx.xxxx | Expenses | 25 | xx.xx.xxxx | Sales | 100 |
| xx.xx.xxxx | Expenses | 45 | xx.xx.xxxx | Sales | 40 |
| xx.xx.xxxx | Expenses | 69 | |||
| Balance C/D | 1 | ||||
| 140 | 140 | ||||
| xx.xx.xxxx | Balance B/D | 1 | |||
And finally let’s balance the account. As you can see we end up with a credit balance of 1. What does that mean? Let’s translate it into English. More money has come FROM Sales than has gone TO Expenses. We have received more money from sales. Therefore we have made a profit.
If you learnt this any other way, you would need to understand that a credit balance in the P&L account (or indeed in any sales account) meant that we were making money from sales. Let’s look at that from another point of view. Suppose the last expense was 71 instead of 69. We would now have a debit balance. And that would mean that More money had gone TO Expenses than we had received FROM Sales. Or in other words, a loss.
So, how would we compile a P&L account without entering transactions directly in there. Well it is actually extremely easy. We are going to reduce the balances of all our sales and expense accounts to zero and transfer those balances to the P&L account. And how are we going to do that? With more transactions! The point being that there are accounts, and there are transactions. And that is it.
We don’t have to work out how to enter these transactions as all the work is already there. We are going to use the same pattern we used when balancing an account. To keep this simple, we will use just a single Sales account and a single sales transaction for 100 (which goes to the Bank). Here’s the balanced sales account:
| SALES | |||||
| Date | Details | Debit | Date | Details | Credit |
| Balance C/D | 100 | xx.xx.xxxx | Bank | 100 | |
| 100 | 100 | ||||
| xx.xx.xxxx | Balance B/D | 100 | |||
But to make this simpler let’s just show the ‘unbalanced’ account. As there is only a single entry, you should see the logic immediately. We are going to remove all the other columns too so you can concentrate on only the accounts and the amounts. Here’s the actual transaction: Debit Bank 100 Credit Sales 100
| SALES | |
| Debit | Credit |
| 100 | |
How do we zero the balance? We add a 100 debit, right? The balance will then be zero. Here’s half the transaction: Debit Sales 100
| SALES | |
| Debit | Credit |
| 100 | 100 |
So, we have put in the debit to zero Sales, but where does the other half of this transaction go (the credit)? Direct to the P&L account! Credit P&L 100.
| Profit and Loss | |
| Debit | Credit |
| 100 | |
So the transaction was Debit Sales Credit P&L. If you study this, you can see all we have done is move the balance from Sales to the P&L account. At the start the Sales account had a credit balance of 100. At the end the P&L account has a credit balance of 100 and the Sales balance is zero. Three accounts were involved
- Bank (with a debit balance of 100)
- Sales (with a zero balance)
- Profit and Loss (with a credit balance of 100)
You can see without any effort that a trial balance would show that the books balance (zero balancing accounts are not normally shown in a trial balance by the way).
| Trial Balance | Debit | Credit |
| Bank | 100 | |
| Sales | 0 | |
| Profit and Loss | 100 | |
| Totals | 100 | 100 |
One important caveat here. No one traditionally will include the P&L account in a TB. The idea of a TB is to check all the individual accounts, rather than accounts that consist of other accounts. This is to catch mistakes before they have any chance of being compounded further. But you have learnt an important principle here about accounts and what you can do with them.
Read this section a few times. Although it looks like we are doing something special, the reality is we are not. We are just transferring money between two accounts, the same as always. In this example the money is transferred From (Credit) the P&L To (Debit) the Sales account in order to zero it.
There is one question left. Why would we want to zero the Sales account? The answer is that the P&L consists of all the balances in the sales and expense accounts. We do not want to duplicate those balances, so we make transfers like this to ensure that we do not.
If you wanted to see how your business was doing on a monthly basis, you would do this every month. That is how monthly management reports are made.
Many accountants and bookkeepers will not zero the sales and expense accounts until year end, instead preferring to produce a P&L report based on the sales and expense accounts.
But this is still an important lesson on how accounts work. Later sections go into great detail into what happens at the end of the year. You will see that we will also be zeroing the P&L account in that process so that all our revenue accounts are ready for the new year.
That ends the free edition of Accounting for Everyone. If you’d like to go further, you can become a member. This opens up weeks 7 to 12, the Accounting for Everyone basic bookkeeping certification, more quizzes, and a whole bunch more to help you on your journey to becoming a qualified bookkeeper or accountant.