What is a trial balance, and how does a trial balance work?
Let me show you an example of what a trial balance looks like, and explain why a trial
balance is a useful accounting tool that has already been in use for centuries!
Let’s start off with identifying how trial balances fit into the accounting process.
The first step is to identify the transactions that need to be recorded.
You then record the journal entries, and prepare T-accounts.
The trial balance is the next step, right in between preparing the T-accounts and preparing
the financial statements.
A trial balance allows you to check for mathematical errors (is the sum of the debits equal to
the sum of the credits), and check account balances versus expectations (if you usually
have a balance of around $100,000 in Accounts Receivable, and now you have $10 million,
you want to check the journal entries making up that balance).
Not everything that happens in a company is a transaction that needs to be recorded.
For example, saying good morning to the managing director, or taking customers on a tour of
the site, might be useful things to do, but don’t need a journal entry.
An example of an event that does need to be recorded
is purchasing goods from a supplier on credit.
The journal entry for this is debit inventory, credit accounts payable.
Or if you want to visualize that, put the debit amount on the left of the inventory
T-account and put the credit on the right of the accounts payable T-account.
A trial balance is a listing of all ledger accounts along with their respective debit
or credit balances for the period.
Let’s take the journal entries from the “income statement versus balance sheet”
video (that I encourage you to watch first by clicking on the link) to prepare a trial balance.
A trial balance covers a certain accounting period, in this case year 1 of a brand new
company, and lists the ledger accounts with their respective debit or credit balance.
Accountants usually start a trial balance with assets.
In this example, four asset accounts (cash, accounts receivable, inventory and plant and
equipment) have one or more journal entries posted to them.
Add up the debits posted from journal entries, and add up the credits posted from journal entries.
For the cash account, the sum of the debits is 200, and the sum of the credits is 140,
so the balance for the cash account that we enter on the trial balance is debit 60.
Accounts receivable 200. Inventory 0.
Plant & equipment (or “fixed assets”) 100 debit minus 20 credit is a debit balance of 80.
Next, we do the same for liabilities and equity.
100 credit balance in accounts payable, 100 credit balance in debt,
100 credit balance in equity.
Finally, we determine the balances for the income statement, or profit and loss, accounts.
Revenue has a credit balance of 200, cost of goods sold a debit balance of 100, compensation
and benefits expense has a debit balance of 20, depreciation expense debit 20, interest
expense debit balance 10, and tax expense has a debit balance of 10.
A trial balance is not the same as a balance sheet.
A trial balance lists balance sheet as well as income statement accounts.
Now add up all amounts on the debit side, add up all amounts on the credit side, and
we get to the same number of 500 on each side.
Our trial balance is balancing!
As you can see, net income itself is not a trial balance amount, it is represented here
by the individual income statement accounts.
Net income is added to retained earnings (in equity) at a later stage, once we prepare
the financial statements.
What can we conclude now that our trial balance is balancing?
Well… if the trial balance fails to balance,
then we know that an error has occurred and must be located.
If the trial balance is balancing, then either no error has occurred
or an error has occurred that is more difficult to detect.
For example, maybe the debit and the credit in a journal entry were swapped.
Or a journal entry may have been posted to the wrong account.
Or a transaction has not been recorded altogether.
Or a journal entry was posted for incorrect amounts.
Or a journal entry was posted to the wrong account type.
Careful review of the trial balance, checking for example whether all asset and expense
accounts have debit balances, and all liabilities, equity and revenue accounts have credit balances,
could help you detect some of these.
We have moved from the days of manually writing our journal entries into large ledger books,
to electronic posting of journal entries into large databases.
Every accounting system that I have ever used has a validation rule that checks whether
a journal entry is balanced, so the need to check whether a trial balance is balancing
between debits and credits has decreased.
It’s still worthwhile to know how a trial balance works, as it can help you detect errors
in an early stage.
The trial balance: a listing of all ledger accounts along with their respective debit
or credit balances for the period.
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Thank you.