EFFECT OF RECTIFYING ENTRIES ON PROFITS

  9.6 EFFECT OF RECTIFYING ENTRIES ON PROFITS

You have seen that the creation of Suspense Account helps in tallying the Trial Balance and avoiding delay in the preparation of final accounts. The errors still remain to be detected and rectified so, the' Profit and Loss Account prepared from such Trial Balance is subject to the undetected errors. The profit thus arrived at may be more or less than the actual profits. Similarly, when the errors are detected and rectified during the next year, the rectifying entries will have their effect on the profit of the next year.

The profit is affected only if the errors involve accounts which usually appear in the Trading and Profit and Loss Account (nominal account$) and not those which appear in the Balance Sheet (real and personal accounts).

Let us understand it with the help of an example. Suppose Rs 24,000 paid for salaries during 1986 was posted to the Salaries Account as Rs. 20,400. This error has resulted in short debit of Rs. 3600 to Salaries Account and so the salaries charged to Profit and has Account are short by Rs. 3,600. This would overstate the profits of 1986. When this error ‘will be decked in 1987 and the rectifying entry passed, Rs. 3,600 will be added to salaries of 1987 and so the profit of 1987 will be decreased by Rs. 3,600.Thus, the errors, as well 4s the rectifying entries affect the profit. Of course, the effect of-rectifying entry will talk most the reverse of the effect of errors.

Look at illustration 5. It shows rectifying entries and their effect on profits.  

Illustration 5

A Businessman finds that he could tally his Trial Balance of 1986 only by opening a Suspense Account. During 1987, he discovered the Flowing errors.'

1.     The Discount Allowed column of the Cash Book was overcast by Rs. 25.

2.      Sale of old machinery amounting to Rs. 550 had been credited to Sales Nc.

3.     A sale of Rs. 780 to Ahmed had been debited to his account as Rs. 870.

4.     The total of Bills Payable Book Amounting to Rs. 4,000 for the month of June was not posted into the ledger.  

Rectify the above errors and prepare the Suspense Nc. Also explain. The effect of rectifying the errors on the profits of 1987

Profit and loss Adjustment Account: In the above illustration you observed that errors were committed during 1986 and the rectifying entries were passed in the books of 1987. This unnecessarily affected the profits of 1987. In order that the profits of the year in which rectifying entries are passed is not affected, a new account celled Profit and Loss Adjustment Account is opened. ?'hen, dl amounts whish are to be debited  or credited to nominal account in the rectifying entries may be debited or credited to  the Profit and Loss Adjustment Account. The balance of the Profit and Loss Adjustment Account is directly adjusted in the capital. Thus, the profit of the year in which the rectifying entries are made remains unaffected. The rectifying entries 1 and 2 of Illustration 5 which involve debit and credit to nominal account can now be shown as follows: 

9.7 LET US SUM UP

When the Trial Balance does not tally, it means there are errors in books of amount. These may be the errors of principle, errors of omission, errors of commission or compensating errors. Some of these errors affect the agreement of 'Trial Balance while some do not. The errors which do not affect the Trial Balance are difficult to Iwate but those which affect it are easily located by following a series of steps. Errors thus located inquest be rectified before preparing the final accounts.

One-sided errors which affect only one account are rectified by means of a suitable note on the relevant side in the concerned amount. Two-sided errors involving two or more accounts are rectified by weans sf journal entries. If the Trial Balance does not tally even after the detected errors have been rectified, it means that there are still some errors which have not been detected. In such a situation, the difference in trial Balance is put against a Suspense Account to avoid delay in preparing the final accounts. Later, when these errors are discovered, they can be rectified through journal entries and the Suspense Account may be closed.

When errors are rectified during the next accounting par, the rectification entries involving nominal accounts affect the profits of the next year. 'To avoid such effect, a, Profit and Loss Adjustment Account can be opened and its balance directly adjusted in capital.

9.8 WORD KEY

Audit: Checking the books of account by auditors for detection and prevention of errors and frauds.

Compensating errors: A group of errors wherein the effect of one error is counter-balance (compensated) by the effect of the other errors.

Errors of commission: A clerical error committed while recording or posting the uansaction or while totaling, balancing, ete.

Errors of Complete omission: An errors committed by completely omitting to record a, transaction in books.

Errors of Partial Omission: An error committed in omitting to post one aspect of an entry in the ledger.

Errors of Principal: An errors Committed by ignoring or misapplying some principles of accounting while recording a transaction in books.

One side error: An error which affects the debit or credit side of on account only,

Profit and loss Adjustment Amount: An account opened for avoiding the effect of testifying entries in respect of the previous year's errors on the profits of the current year. 

Rectifying Entries: Entries made in books of account for correction of errors.

Suspense Account:An account opened to tally the Trial Balance temporarily. It represents the net effect of undetected one-sided errors.

Two-sided: An error which involves two or more accounts and effect both the debit and credit aspects.