{m}.{s}.1The figures from the trial balance are used to prepare the profit and loss account and balance sheet. Therefore if there is something wrong in the trial balance, there must be correspondingly something wrong with either the profit and loss account or balance sheet (or both).

 

BALANCE SHEET
 
CORRECT
INCORRECT
ACCOUNT DEBIT CREDIT DEBIT CREDIT
Sales   2,725   2,725
Cost of sales 1,500   1,500  
Wages 50   50  
Rent 400   400  
Heat and light 340   0  
Post, tel, stat 25   365  
Fittings 1,000   1,000  
Stock 0   3,375  
Debtors 2,050   2,050  
Bank 3,185   3,185  
Loan   2,000   2,000
Creditors   840   840
Capital   6,360   6,360
  11,925 11,925 11,925 11,925
         

[{m}.{s}a]

Now let's see how the figures change if the bill for £340 was entered as Postage, telephone and stationery instead of Heat and light (this misposting could easily be made in a manual or computer system).

The two accounts affected are both expense accounts which belong in the profit and loss. We will compare the profit and loss accounts prepared from the correct and incorrect trial balances.

We can see that total expenses are unchanged and the profit figure is therefore correct.

Profit and loss account: CORRECT
Sales   2,725
Less Cost of sales   1,500
Gross profit   1,225
Less Expenses    
    Wages 50  
    Rent 400  
    Heat and light 340  
    Post, tel, stat 25  
    815
NET PROFIT   410
     
[{m}.{s}b]

 

Profit and loss account: INCORRECT
Sales   2,725
Less Cost of sales   1,500
Gross profit   1,225
Less Expenses    
    Wages 50  
    Rent 400  
    Heat and light -  
    Post, tel, stat 365  
    815
NET PROFIT   410
     
[{m}.{s}c]

The use of the profit and loss account, however, is not simply to calculate the profit but also to show how it has been derived. In that the expenses figures are now showing incorrectly, Mr Allen is getting the wrong information from the profit and loss account. He may now be trying to cut down on the use of the telephone etc... unnecessarily.

{m}.{s}.2TB error: Profit incorrect

Let us now consider the result of a different misposting. Instead of debiting the £25 to Postage, telephone and stationery, it was debited to Fittings.

Profit and loss account: CORRECT
Sales   2,725
Less Cost of sales   1,500
Gross profit   1,225
Less Expenses    
    Wages 50  
    Rent 400  
    Heat and light 340  
    Post, tel, stat 25  
    815
NET PROFIT   410
     
[{m}.{s}d]

 

 

 

Profit and loss account: INCORRECT
Sales   2,725
Less Cost of sales   1,500
Gross profit   1,225
Less Expenses    
Wages 50  
Rent 400  
Heat and light 340  
Post, tel, stat --  
    790
NET PROFIT   435
     
[{m}.{s}e]
BALANCE SHEET
 
CORRECT
INCORRECT
ACCOUNT DEBIT CREDIT DEBIT CREDIT
Sales   2,725   2,725
Cost of sales 1,500   1,500  
Wages 50   50  
Rent 400   400  
Heat and light 340   340  
Post, tel, stat 25   0  
Fittings 1,000   1,025  
Stock 3,375   3,375  
Debtors 2,050   2,050  
Bank 3,185   3,185  
Loan   2,000   2,000
Creditors   840   840
Capital   6,360   6,360
  11,925 11,925 11,925 11,925
         
[{m}.{s}f]

The total expenses, and therefore also the net profit, showing in the profit and loss account are now incorrect. The profit figure is higher than it should be - the business looks more profitable than it really is.

This is a particularly bad type of error - getting the distinction between capital expenditure and revenue expenditure wrong thus producing the wrong figure for profit.

Note that the balance sheet will still balance as two figures are incorrect:

  • Fittings is overstated by £25.
  • Capital will also be overstated by £25 (as profit is £25 too high).

We will now look at the difference between capital expenditure and revenue expenditure.

{m}.{s}.3Capital expenditure

  • Expenditure to purchase or improve fixed assets
    (includes such things as delivery and installation costs).
  • Belongs in the balance sheet.

Delivery

{m}.{s}.4Revenue expenditure

  • Expenditure for running the business on a day-to-day basis (this will include the cost of repairing and maintaining fixed assets).
  • Belongs in the profit and loss account.

Maintenance

Open/Close{m}.{s}.Q1