Trading Accounts
The first section of trading and profit and loss accounts is
called trading account. The aim of preparing trading account is to find out
gross profit or gross loss while that of second section is to find out net profit
or net loss.
Preparation of Trading Account
Trading account is prepared mainly to know the profitability
of the goods bought (or manufactured) sold by the businessman. The difference
between selling price and cost of goods sold is the, gross earning of the
businessman. Thus in order to calculate the gross earning, it is necessary to
know: cost of goods sold and sales. Total sales can be ascertained from the
sales ledger. The cost of goods sold is, however calculated, in order to
calculate the cost of sales it is necessary to know its meaning. The 'cost of
goods' includes the purchase price of the goods plus expenses relating to
purchase of goods and bringing the goods to the place of business. In order to
calculate the cost of goods " we should deduct from the total cost of
goods purchased the cost of goods in hand. We can study this phenomenon with
the help of following formula:
Opening stock + cost of purchases - closing stock = cost of
sales.
As already discussed,
the purpose of preparing trading account is to calculate the gross profit of
the business. It can be described as excess of amount of 'Sales' over 'Cost of
Sales'. This definition can be explained in terms of the equation:
Gross Profit = Sales-Cost of goods sold or (Sales + Closing
Stock) - (Stock in the beginning + Purchases + Direct Expenses).
The opening stock and purchases along with buying and
bringing expenses (direct exp.) are recorded on the debit side whereas sales
and closing stock is recorded on the credit side. If credit side is greater
than the debit side the difference is written on the debit side as gross
profit, which is ultimately recorded on the credit side of profit and loss
account. When the debit side exceeds the credit side, the difference is gross
loss, which is recorded at credit side and ultimately shown on the debit side
of profit & loss account. Usual Items in a Trading Account:
A) Debit Side Opening Stock, purchases, buying expenses,
manufacturing expenses,
B) Credit Side Sales, Closing Stock,
Profit and Loss Account
The profit and loss account is opened by recording the gross
profit (on credit side) or gross loss (debit side). For earning net profit, a
businessman has to incur many more expenses in addition to the direct expenses.
Those expenses are deducted from profit (or added to gross loss); the resultant
figure will be net profit or net loss. The expenses, which are recorded in
Profit and loss account, are called indirect expenses.
Journals
According to Larson Wild Chiappetta the process of journalizing
transactions, require an understanding of a journal. While a company can use
various journals, every company use general journal, which shows the debit and
credit of each transactions. It can record any transaction. A general journal
entry include the following
i.
Date of action
ii.
Title of effects
iii.
Amount of each debit and credit
iv.
Explanation of the transaction as can be seen
below.
Ledger Accounts
The next step of processing
transaction is to post journal entries to ledger accounts. To ensure that the
ledger accounts are up to date entries are posted as soon as possible. This
might be daily, weekly, monthly or when time permits. All entries must be
posted to the ledger by the end of the reporting period. This is necessary so
accounts balances are current when financial statements are prepared. When
entries are posted to the ledger, the debit in journal entries occupy into the
ledger accounts as debit, and credit are occupy into the ledger accounts as
credits as can be seen in the above. The following shows 4 steps to post a
journal entry
•
Identify debit account ledger, enter date,
journal page amount and balance
•
Enter the debit accounts number from the in the
Page Reference(PR) column of the journal
•
Identify credit accounts in ledger, enter date,
journal page, amount and balance
•
Enter the credit accounts number from the ledger
in the PR column of the journal. The posting process creates a link between the
ledger and the journal entry. This link is a useful cross reference for tracing
an amount from one record to another
The
Trial Balance
The preparation of trial balance involve three steps
•
List each account title and its amount (from
ledger) in the trial balance
•
Compute the total of debit balance and the total
of credit balance
•
Verify (prove) the total debit balance equal
total credit balances.
The total of debit balance equals the total credit balance
for the trial balance as in above. If these totals were not equal, then one or
more errors exist. However, the equality of these two totals does not guarantee
that no errors were occurred. These errors post many difficulties on the small scale
businesses in which we refer to in our studies as challenges. These errors can
be put into two; those that affect the agreement of the trial balance totals
and those that do not affect the agreement of the trial balance totals.
Balance Sheet
The purpose of balance sheet is to show the financial
position of a given business entity at a specific date. Every business prepares
a balance sheet at the end of the months and most companies prepare one at the
end of each month. A balance sheet consists of listing of assets, liabilities
and owners’ equity of a business. The balance sheet date is important as the
financial position of a business may change quickly. A balance sheet is most
useful if it is relatively recent. A Balance Sheet is a statement of the
financial position of a business which states the assets, liabilities, and
owners' equity at a particular point in time. In other words, the Balance Sheet
illustrates your business's net worth. (Ward, 2012) Assets are economic
resources that are owned by a business and are expected to benefits future
operations.
Assets may have definite physical form such as building,
machinery or an inventory of merchandise. On the other hand, some asset exists
not in physical or tangibly forms but in the form of valuable legal claims or
rights; examples are amount due from customers, investment in government bonds
and patent rights.
Liabilities; the person or organizations to which the debt
is owed is called creditor. All businesses have liabilities; even the largest companies
often purchase merchandise, supplies and service on accounts. The liabilities
arising from such purchases are called accounts payables.
Owners’ Equity; the owners’ equity in a corporation is
called stockholders equity. In this discussion, we will use the broader term
“owner’s equity” because the concepts being presented are equally applicable to
the ownership equity in corporations, partnerships, and sole proprietorships.
Owners’ equity represents the owners’ claims to the assets of the business. Because
creditors’ claims have legal priority over those of the owners, owner’s equity
is a residual amount. Owners are entitled to what is left after the claims of
creditors have been satisfy in full. Therefore owners’ equity is always equal
to total assets minus total liabilities
Challenges of Accounting Practices in Small
Scale Businesses
Challenges have been defined by Cambridge advance learners
dictionary as (the situation of being faced with) something needing great
mental or physical effort in other to be done successfully and which therefore
test a person's ability or a questioning of whether something is true or false.
It can also be said to be the violation of the accounting conventions and rules
in the recording and posting of accounting transaction. This can affect or not
affect the agreements of the trial balance; hence, it may affect or not affect
the preparation of the final accounts. Mukhaerjee (2003) put it that, a trial
balance only checks the sum of debits against the sum of credits. That is why
it does not guarantee that there are no errors. The following are the main
classes of error that are not detected by the trial balance
Challenges That Do Not Affect the Trial
Balance
Mukherjee (2003) mention the following as the errors that do
not affect the trial balance agreement
•
An error of original entry: This is when
both sides of a transaction include the wrong amount. For example, if a
purchase invoice for N21 is entered as N12, this will result in an incorrect
debit entry (to purchases), and an incorrect credit entry (to the relevant
creditor account), both for N9 less, so the total of both columns will be N9
less, and will thus balance.
•
An error
of omission: This is when a transaction is completely omitted from the
accounting records. As the debits and credits for the transaction would
balance, omitting it would still leave the totals balanced. A variation of this
error is omitting one of the ledger account totals from the trial balance.
•
An error
of reversal: This is when entries are made to the correct amount, but with
debits instead of credits, and vice versa. For example, if a cash sale for N100
is debited to the Sales account, and credited to the Cash account. Such an error
will not affect the totals.
•
An error of commission is when the entries
are made at the correct amount, and the appropriate side (debit or credit), but
one or more entries are made to the wrong account of the correct type. For
example, if fuel costs are incorrectly debited to the postage account (both
expense accounts). This will not affect the totals.
•
An error of principle is when the entries
are made to the correct amount, and the appropriate side (debit or credit), as
with an error of commission, but the wrong type of account is used. For
example, if fuel costs (an expense account), are debited to stock (an asset
account). This will not affect the totals.
•
Compensating
errors are multiple unrelated errors that would individually lead to an
imbalance, but together cancel each other out.
•
A transposition error is an error
caused by switching the position of two adjacent digits. Since the resulting
error is always divisible by 9, accountants use this fact to locate the miss
entered number. For example, a total is off by 72, dividing it by 9 gives 8,
which indicates that one of the switched digits, is either more, or less, by 8
than the other digit. Hence, the error was caused by switching the digits 8 and
0 or 1 and 9. This will also not affect the totals.
Challenges That Affect the Trial Balance
(Type 1 Error) Mtewa (2011) states that, a group of errors
that affect the balancing of the trial balance are known as type one errors.
The trial balance can be used as an internal control tool as it helps in
ensuring that the total debit balances and the total credit balances in the
general ledger or nominal ledger are equal. However, there are instances when
there are disparities between the debit balances and the credit balances, and
this is due to errors made in the accounting process. The main reasons why type
1 errors occur are:
•
The debit
entry entered on the ledger is not equal to credit entry for the corresponding
entry. For example, in a transaction involving a credit purchase of stock of
N550; stock is debited by N550 but creditors are credited by N55 instead of N550.
•
When two debit entries or two credit entries are
simultaneously made for the same transaction. The imbalance will be caused
because double entry rules will not have been applied correctly. A double entry
system dictates that every transaction creates both a debit entry and a credit
entry and not two debit or credit entries simultaneously.
•
When a single-sided transaction is posted in the
ledger. The double entry rules require two entries to be posted or be made for
each transaction. Therefore, there will be an imbalance on the ledger, because
one leg of the double entry has been posted instead of both legs; a debit and
credit entry must be posted for each transaction.
•
Under casting or over casting of individual
general ledger or nominal ledger accounts. It is important to note that over
casting or under casting errors, two simultaneous posted debit or credit
entries and one-sided transactions occur mostly in manual accounting systems.
Most computerized accounting systems have internal controls that are embedded
in the accounting system that make it impossible to post transactions with
these errors.
A computerized system will decline or refuse to post
journals with the above errors. In a manual accounting system, it usually takes
time to identify type 1 errors because bookkeepers and accountants use trial
and error to identify the ledger accounts that contain the error or errors. To
ensure that the error identification and correction process does not hold back
or undermine the ability to prepare management accounts or annual accounts a
temporary holding account is created. This temporary holding account is known
as the “Suspense” account, it is created to artificially allow the debit
balances, and the credit balances on a trial balance to agree or to balance. If
the balance on the suspense is a debit balance it can be treated as either an
asset or expense, however prudent companies usually treat them as expenses. If
the balance on the suspense account is a credit balance, it is recommendable
that the business treats the error as a liability rather than as income.
Treatment as income may lead to write-offs of future income if it turns out the
reason of the disparity between the debit and credit balances was because of
errors in accounting of liabilities in the nominal ledger accounts.
The Impact of Accounting Practices Challenges
on the Operations of Small Scale Businesses
•
failure
to meet profit motive
•
hinders the acquisition of loan facility
•
wrong reflection of its operations
•
loss of potential investors
•
inability to separate business from own
properties
Measures Adopted to Solve accounting practice
Challenges
Addressing the challenges of accounting practices and how
they influence small-scale enterprise depend on the type of error committed.
However, the specific tool or measure adopted by most businesses is the system
of internal control, which covers almost all aspect of their businesses
operations. Internal control is a laid down procedures through which every
transaction must pass in the protection of the business resources. Walter B.
Meigs and Robert F (1987) defined internal control system as all measures taken
by organizations for the purpose of: protecting its resources against waste,
fraud and inefficiencies, ensuring accuracy and reliability in accounting and
operating data, securing compliance with firm policy, and evaluating the
performance in all division of the economy. Internal Control structure or
system is an amalgamation of the policies and procedures that a small business
implements to ensure that each of its goals is achieved. It ensures that each
employee follows directives implemented by the senior management team. It also
ensures that every financial statement is accurate. In addition, an internal
control structure ensures that the organization remains compliant with any laws
or other legal regulations that police the industry. The Committee of
Sponsoring Organizations of the Tread way Commission recognizes five essential
components to this system: the control environment, risk assessment, control
activities, information, and communication and monitoring.
•
Control
Environment: The control environment, also called the internal control
environment, referred to value that the senior management team of a small business
attaches to the importance of the audit and risk management function to the
firm. In addition, this component addresses the methods and style in which
internal control initiatives are implemented. Some organizations, for example,
maintain an incredibly lax control environment in which few policies are put
into practice and employees are given free reign. This is often the case in
unregulated industries. In heavily regulated industries, such as financial
services, the control environment is often incredibly formal. Various
departments, including legal, compliance, and human resources, enforce many
guidelines to minimize legal and financial risk to the firm.
•
Risk
Assessment: The component of risk assessment is the actions taken by a
small business to determine any situations that may pose legal or financial
risk to the firm. For example, a team of legal professionals may audit a
business’ employment records to ensure that all files are compliant with the
policies of the Country. Likewise, an
accountant may audit the financial records of the business to ensure that all
accounting practices are sound.
•
Control
Activities: The control activities component describes every policy,
procedure and best practice a small business put in place to minimize risk. For
example, the firm’s senior management may mandate that an external accountant
review the organization’s books on an annual basis to ensure that the internal
accounting team is performing effectively. Likewise, a business may create a
policy stating that the legal department before delivery must review all
outgoing correspondence.
•
Information
and Communication: Information and communication are the methods used to
train the employee population of the control activities. A small business may
implement this component in a variety of ways. Some control activities may be
spelled out in an employee handbook. Alternatively, the human resources
department may deliver classroom training to the workers, educating them on all
risk management policies.
•
Monitoring:
The monitoring component of the internal control structure describes a small
business’ practices of self-auditing its risk management systems, ensuring that
all employees are compliant with the internal policies. This may be carried out
through a few ways. An internal compliance department may be created
specifically to audit the organization. Alternatively, the company may engage
the services of an external auditing firm, to provide an independent assessment
of the organization’s internal control success.
