FINANCIAL ACCOUNTING 1 CHAPTER TWO Accounting process: Preparation of journal, Ledger and Trail balance Lecturer: Abdirahman Awil (MBA, BA in Finance & Accounting) 11:06 PM 1 2.4 MEANING AND FORMAT OF A JOURNAL Journal is a historical record of business transactions or events. The word journal comes from the French word "Jour" meaning "day". It is a book of original or prime entry written up from the various source documents. Journal is a primary book for recording the day to day transactions in a chronological order i.e. in the order in which they occur. The journal is a form of diary for business transactions. This is also called the book of first entry since every transaction is recorded firstly in the journal. The format of a journal is shown as follows: Date 11:06 PM Particulars Debit Credit 2 Advantages of Journal 1. 2. 3. 4. 5. 6. 7. 8. The transactions are recorded in journal as and when they occur so the chances of error is minimized. It help in preparation of ledger. Any transfer from one account to another account is made through Journal. The entry recorded in journal are self-explanatory as it includes narration also. It can record any such transaction which cannot be entered in any other books of account. Every transaction is recorded in chronological order (date wise) so the chances of manipulations are reduced. Journal shows all information in respect of a transaction at one place. The closing balances of previous year of accounts related to assets and liabilities can be brought forward to the next year by passing journal entry in journal. 11:06 PM 3 Illustration 1 • State with reasons whether the following events are transactions or not to Mr. Nikhil, Proprietor, Delhi Computers 1. Mr. Khalil started business with capital (brought in cash) $ 40,000. 2. Paid salaries to staff $ 5,000. 3. Purchased machinery for $ 20,000 in cash. 4. Placed an order with Sen & Co. for goods for $ 5,000. 5. Opened a Bank account by depositing $ 4,000. 6. Received pass book from bank. 7. Appointed Sahal as Manager on a salary of $ 4,000 per month. 8. Received interest from bank $ 500. 9. Received a price list from Asma. 11:06 PM 4 Example 1 Mr. Mohamed started a business to be known as “Mohamed Super market”. He performed following transactions during the first month of operations: 1. Mr. Mohamed invested a capital of $15,000 into his business. 2. He purchased furniture for $1,500 cash for business use. 3. He purchased inventory for $3,000 cash. 4. He sold inventory for $1,000 cash 5. He purchased inventory for $2,000 on credit. 6. He sold inventory for $800 on credit 7. He paid $1,000 cash to his payables. 8. He collected $800 cash from his receivables. 9. Mr. Mohamed paid $150 cash for telephone bill. 10. He borrowed money amounting to $5,000 from City Bank for business purpose. Instruction • Prepare accounting equation (show your computations) 11:06 PM 5 Example 2 Show that the accounting equation is satisfied after taking into consideration each of the following transactions in the books of Mr. Mohamed 1. Started business with capital 1,00,000 2. Bought furniture 25,000 3. Bought goods for cash 20,000 4. Bought goods on Credit 5,000 5. Sold goods for cash for 15,000 6. Sold goods on credit 8,000 7. Paid cash to creditor 4,000 8. Received cash from his receivables 5,000 9. Paid Cash into Bank 25,000 10. Withdrawn from bank 10,000 11:06 PM 6 Example 3 Following are the accounting transactions relating to Mr. Khadar business. Use the accounting equation to show their effect on his assets, liabilities and capital. 1. Commenced business with a Capital of 50,000 2. Bought Machinery for cash 10,000 3. Purchased goods for cash 15,000 4. Purchased goods on credit 5,000 5. Sold goods for cash 10,000 6. Paid to his creditor 2,000 7. Sold goods on credit 3,000 8. Paid into Bank 6,000 9. Paid to his payables by check1,000 10. Received from his receivables a check for 2,000 11:06 PM 7 Example 4 Mr. Yusuf has the following transactions in the month of June. 1. Started business with a capital of 100,000 2. Purchased goods on credit for 20,000 3. Purchased Goods for Cash 15,000 4. Sold goods worth 15,000 on credit 5. Sold goods for cash 20,000 6. Paid 1000 to a creditor 7. Purchased supplies for cash 45,000 8. Bought computer from Intel Computers for 25,000 9. Purchased furniture for 10,000 10. Collected 19000 cash from debtors 11. Owner withdrew of worth $ 2,000 for personal use. 12. Paid Salaries Expense $ 2,000 Required 11:06 PM • Prepare journal entries 8 LEDGER • Journal is a daily record of all business transactions. • In the journal all transactions relating to persons, expenses, assets, liabilities and incomes are recorded. Journal does not give a complete picture of the fundamental elements of book keeping i.e. properties, • Relationship between Journal and Ledger • Journal and Ledger are the most useful books kept by a business entity. The points of distinction between the two are given below : 1. The journal is a book of original entry where as the ledger is the main book of account. 2. In the journal business transactions are recorded as and when they occur i.e. date-wise. However posting from the journal is done periodically, may be weekly, 11:06 PM fortnightly as per the convenience of the business. 9 3. The journal does not disclose the complete position of an account. On the other hand, the ledger indicates the position of each account debit wise or credit wise, as the case may be. In this way, the net position of each account is known immediately. 4. The record of transactions in the journal is in the form of journal entries whereas the record in the ledger is in the form of an account. Utility of a Ledger The main utilities of a ledger are summarized as under : a) It provides complete information about all accounts in one book. b) It enables the ascertainment of the main items of revenues and expenses c) It enables the ascertainment of the value of assets and liabilities. d) It facilitates the preparation of Final Accounts. 11:06 PM 10 • Format of a Ledger Account • A ledger account can be prepared in any one of the following two forms: 11:06 PM 11 Posting • Posting refers to the process of transferring debit and credit amounts from the Journal or subsidiary books to the respective heads of accounts in the ledger. 11:06 PM 12 Trial Balance: A Trial Balance is a statement of debit and credit balances extracted from all the ledgers with a view to ascertain arithmetical accuracy of posting of all transactions into the respective ledgers OBJECTIVES OF PREPARING TRIAL BALANCE The following are the main objectives of preparing the trial balance: 1. To check the arithmetical accuracy of books of accounts 2. Helpful in preparing final accounts 3. To serve as an aid to the management 11:06 PM 13 Limitations of trial balance • The following are the main limitations of the Trial Balance: 1. Trial Balance can be prepared only in those concerns where double entry system of accounting is adopted. 2. Though trial balance gives arithmetic accuracy of the books of accounts but there are certain errors, which are not disclosed by the trial balance. That is why it is said that trial balance is not a conclusive proof of the accuracy of the books of accounts. 3. If trial balance is not prepared correctly then the final accounts prepared will not reflect the true and fair view of the state of affairs of the business. Whatever conclusions and decisions are made by the various groups of persons will not be correct and will mislead such persons. 11:06 PM 14 Methods of preparation of trial balance • A trial balance can be prepared by the following two methods: 1. Total method: In this method, the debit and credit totals of each account are shown in the two amount columns (one for the debit total and the other for the credit total). 2. Balance Method: In this method, the difference of each amount is extracted. If debit side of an account is bigger in amount than the credit side, the difference is put in the debit column of the Trial Balance and if the credit side is bigger, the difference is written in the credit column of the Trial Balance. 11:06 PM 15 Trial balance format 11:06 PM 16 ACCOUNTING ERRORS • If the two sides of a trial balance agree it is a prima facie evidence of the arithmetical accuracy of the entries made in the Ledger. But even if the trial balance agrees, it does not necessarily mean that the accounting records are free from all errors, because there are certain types of errors, which are not revealed by a Trial Balance. Therefore a Trial Balance should not be regarded as a conclusive proof of accuracy of accounts. • These errors can be classified as follows: 1. Clerical errors 2. Errors of Principle 11:06 PM 17 • A brief description of the above errors is given below: 1. Clerical errors • Clerical errors are those errors, which are committed by the clerical staff during the course of recording business transactions in the books of accounts. These errors are: • 1. Errors of omission • 2. Errors of commission • 3. Compensating errors • 4. Errors of duplication 11:06 PM 18 A. Errors of omission: • When business transaction is either completely or partly omitted to be recorded in the books of prime entry it is called an ‘error of omission’. • When a business transaction is omitted completely, it is called a ‘complete error of omission”, and when a business transaction is partly omitted, it is called a “partial error of omission”. B. Error of commission: • Such errors are generally committed by the clerical staff due to their negligence during the course of recording business transactions in the books of accounts. Though, the rules of debit and credit are followed properly yet some mistakes are committed. • These mistakes may be due to wrong posting of a business transaction either to a wrong account or on the wrong side of an account, or due to wrong casting (addition) i.e. overcasting or under-casting or due to wrong balancing of the accounts in the ledger. 11:06 PM 19 C. Compensating errors: • Compensating errors are those errors, which cancel or compensate themselves. These errors arise when an error is either compensated or counter-balanced by another error or errors so that of the other on the debit or credit side neutralizes the adverse effect of one on credit side or debit side. • For example, over posting on one side may be compensated by under posting of an equal amount on the same side of the same account or over posting of one side of an account may be compensated by an equal overprinting on the opposite side of some other account. But these errors do not affect the trial balance. D. Errors of duplication: • When a business transaction is recorded twice in the prime books and posted in the Ledger in the respective accounts twice, the error is known as the ‘Error of Duplication’. These errors do not affect the trial balance. 11:06 PM 20 2. Errors of principle • When a business transaction is recorded in the books of original entries by violating the basic/fundamental principles of accountancy it is called an error of principle. Some examples of these errors are: I. When revenue expenditure is treated as capital expenditure or vice-versa, e.g. building purchased is debited to the purchase account instead of the building account. II. Revenue expenses debited to the personal account instead of the expenses account, e.g. salary paid to Mr. Ashok, a clerk, for the month of June, debited to Ashok’s account instead of salary account. These errors do not affect the Trial Balance. 11:06 PM 21