Classification and Rectification of Errors- Accounting and Finance for Bankers

Classification and Rectification of Errors- Accounting and Finance for Bankers

Introduction:

  • Tallying of the trial balance is not conclusive proof of the accuracy of accounts. This is because there are certain categories of errors which, even though has taken place, are not visible prima facie. For example, an amount of Rs 2000 paid as salaries recorded as rent paid. Here the net effect on trial balance will be nil but the balances in the salary and rent account are not true. Hence such errors are classified into certain types and after locating them, an adjusted trial balance is prepared.
  • Errors of Commission: Errors which are clerical in nature - wrong posting of transactions, wrong totalling or balancing the accounts, incorrect amount recorded in the journal. Example: In our above example, cash has been paid to Khalid Retail Rs. 500 against purchases made at an earlier date. While recording it in the cash book, the amount has been recorded as Rs. 5000. Most of these errors affect the trial balance directly.
  • Errors of Omission: Committed either at the time of posting it in the books of original entry or while posting in the ledger account. Example: Salaries paid in cash Rs 2000, in our above example, not recorded in the Journal.
  • Errors of Principle: Accounting entries are made as per the Generally Accepted Accounting Principles (GAAP). If these are ignored while preparation of accounts, violations arise called as errors of principles. Incorrect classification of expenditure or income as capital or revenue in nature belong to this category. Expenditure, which are revenue in nature, but recorded as capital expenditure, will lead to overstating assets and understating liabilities, thereby not giving a fair view of accounts. These do not affect the trial balance. Example: A business has a building as an asset. An additional floor is constructed in it. This is in the nature of capital expenditure which will increase the asset value. However if the same is recorded as repairs and maintenance expenses, it will reduce our profit and also understate our asset value.
  • Compensating Errors: If multiple errors are committed in a way that the net effect on the total of debit and credit balances of the trial balance is nil, it is called compensating errors. Example: Amount of salaries paid Rs. 2000, in our example above, recorded as rent paid. This will not affect the trial balance, because the debit side will show Rent as an expense in place of salary.

Rectification of Errors

  • When errors are identified, they need rectification to show the correct view of the accounts of the enterprise. There are two categories here:
    1. Errors not affecting trial balance: This happens when errors affect two accounts and can be easily corrected via a journal entry
    2. Errors affecting trial balance: This happens when errors affect one account and therefore, a journal cannot rectify the same. It needs an opening of a Suspense Account.

(A) Errors not affecting the trial balance

  • These are two-sided errors which can be rectified through a journal entry by giving the correct debit and credit amounts to the concerned accounts. These arise due to errors of Omission, few errors of commission and errors of principle.
    • If there is an error of omission, say in the books of original entry, then recording the usual entry will rectify the error.
    • If there is an error of commission, say the wrong amount recorded. Eg: Sales to Khan Brothers of Rs 12000 recorded as 2000. Here is a shortfall to the tune of Rs. 10000. Either the original entry of Rs 2000 can be reversed and the correct entry for Rs 12000 can be passed or an entry similar to the original entry can be passed again for Rs. 10000.
    • Similarly, if there is excess debit, then a reverse entry compared to the original entry can be passed with the difference between the true amount and amount recorded.
    • If there is an error of principle: Say, rent paid in cash debited to landlords account instead of rent account. Here, revenue expense has been recorded as capital expense i.e. nominal account has been substituted with a personal account, but the cash account has been correctly treated by debiting it. Hence we can credit the landlord account to nullify the earlier debit while debiting the rent account.

Journal Entries for the above examples.

a)      Error of Omission: Transaction not recorded in the books of original entry.
Amount of Rs. 7000 withdrawn for personal use has not been recorded.
Entry Prior to Rectification
Rectified Entry
No Entry
Drawings A/c……...Dr       7000
  To, Cash A/c                                 7000
 --
 --
b)     Sales to Khan Brothers of Rs 12000 recorded as 2000.
Entry Prior to Rectification
Rectified Entry
Khan Brothers A/c……Dr      2000
  To, Sales A/c                                          2000
Alternative 1:
Sales A/c…………...Dr. 2000
  To, Khan Brothers A/c            2000

Khan Brothers A/c ...Dr 12000
  To, Sales A/c                               12000

Alternative 2:
Khan Brothers A/c……..Dr. 10000
  To, Sales A/c                                  10000
 --
 --
c)      Rent paid in cash debited to landlords account
Landlords A/c…………….Dr
  To, Cash A/c
Correct Entry should have been:
Rent A/c………………..Dr.
  To, Cash A/c

Rectification entry:
Rent A/c………………...Dr.
  To, Landlords A/c.

(B) Errors Affecting Trial Balance

  • When one-sided errors are made while recording in a journal, or posting in a ledger or transferring balances to trial balances, the trial balance will not tally. However, until the errors are located the rest of the accounting work has to go on. Till then, a temporary arrangement is made in the name of Suspense Account against which the shortfall or the difference in the debit and credit total of the trial balance is recorded.
  • Such errors can be errors in carrying forward, the error of balancing, error of posting to correct account but with the wrong amount, error of posting to correct account but on the wrong side omitting to show an account in the trial balance. Example: Credit sales to Khan Brothers of Rs. 12000 posted to their account as Rs 10000.
Solution: Here the Journal Entry passed is:

Khan Brothers Account………...Dr. 10000
 To, Sales A/c 12000
  • Thus we see, while the amount in sales account is correctly recorded, the same in Khan Brothers account is not. While preparing the trial balance, the debit side will reflect a deficit of Rs. 2000 (shortfall in Khan Brother’s Account) and as a temporary measure, a suspense account will be opened and the amount of Rs. 2000 will be recorded on the debit side against it.
  • When the error is identified, the amount from the Suspense account will be transferred to the correct account. In this case:
Khan Brothers A/c…………Dr 2000
To, Suspense A/c 2000
(suspense account with a debit balance earlier now nullified)

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