Before accounting software, people had to do all of their accounting manually, using something called the accounting cycle.
The most important part of the accounting cycle is the trial balance, a magical document that lets you see all (and we mean all) of your business’ financial information in one place, create financial statements, and automatically detect any mistakes in your accounting.
Here we’ll go over what exactly this miraculous document is, how to create one, and why it’s such an important part of accounting.
What is a trial balance?
The trial balance is a list of all your business’ ledger accounts, and how much each of those accounts changed over a particular period of time.
Here’s the unadjusted trial balance (more on what that means below) for the fictional company Pepper’s Inc., for the period ending December 31, 2018:
|Unearned consulting revenue||-||1,000|
|Mr. Pepper, capital||-||20,320|
|Mr. Pepper, withdrawals||300||-|
The trial balance is at the heart of the accounting cycle—a multi-step process that takes in all of your business’ financial transactions, organizes them, and turns them into readable financial statements. If you’ve ever wondered how accountants turn your raw financial data into readable financial statements, the trial balance is how.
The trial balance isn’t a financial statement itself, but all of the information that you need to create the three major financial statements—the balance sheet, the cash flow statement and the income statement—comes directly from the trial balance.
It’s hard to understand exactly what a trial balance is without understanding double-entry accounting jargon like “debits” and “credits,” so let’s go over that next.
A quick primer on double-entry accounting
Double-entry accounting tracks where your money comes from and where it’s going.
It does this by recording every transaction your business makes twice. Once as a “debit” to describe when money is flowing into an account, and again as a “credit” when money is flowing out of an account.
Let’s say your business buys a brand new $3,000 MacBook Pro.
Under double-entry accounting, you make two entries: one to record the decrease in your cash account (credit) and one to record the increase in your laptops account (debit):
Run your business long enough, and you’ll accumulate a long list of debits and credits in your company’s ledger, which is a chronological list of all your business’s transactions.
Journal entries are usually posted to the ledger on a continuous basis, as soon as business transactions occur, to make sure that the company’s books are always up to date.
Further reading: A Visual Guide to Debits and Credits
What is the accounting cycle?
At some point, you’ll want to make sense of all those financial transactions you’ve recorded in your ledger. That’s where the accounting cycle comes in.
The accounting cycle is a multi-step process designed to convert all of your company’s raw financial information into usable financial statements.
Accounting software handles most of the accounting cycle automatically these days. But if you’re doing it manually, you’ll spend most of your time on three steps:
preparing an unadjusted trial balance
making adjusting entries to it
preparing an adjusted trial balance
What is an unadjusted trial balance?
An unadjusted trial balance is what you get when you calculate account balances for each individual account in your books over a particular period of time.
Let’s look at the first line of the unadjusted trial balance we looked at above:
This means that for this accounting period, there was a total inflow (debit) of $11,670 into the cash account. Pepper’s Inc. totalled up all of the debits and credits from their general ledger account involving cash, and they added up to a $11,670 debit.
According to the rules of double-entry accounting, a company’s total debit balance must equal its total credit balance.
If the sum of the debit entries in a trial balance (in this case, $36,660) doesn’t equal the sum of the credits (also $36,660), that means there’s been an error in either the recording of the journal entries.
If you use accounting software, this usually means you’ve made a mistake inputting information into the system.
Searching for and fixing these errors is called making correcting entries.
For example, let’s imagine that after Pepper’s Inc. does a bank reconciliation, it notices that it’s $500 short in cash, and realizes that it recorded $500 too much in unearned consulting revenue.
To fix that mistake, they would make the following correcting entry:
|Unearned consulting revenue||$500|
What does it mean to “adjust” a trial balance?
Once you’ve double checked that you’ve recorded and added up all of your transactions properly, it’s time to make adjusting entries.
Adjusting entries are all about making sure that your financial statements only contain information that is relevant to the particular period of time you’re interested in.
There are four main types of adjustments you can make to your trial balance:
Deferrals remove transactions that do not belong to the period you’re creating a financial statement for (e.g. an advanced payment from a customer).
Accruals make sure that the financial statements you’re preparing now take into account any future payments and expenses (e.g. rent you owe a landlord and haven’t paid yet).
Missing transaction adjustments account for the transactions you forgot about while bookkeeping (e.g. a business purchase on your personal credit card).
For example, let’s say that Pepper’s Inc. paid $200 in January 2019 insurance fees in December.
To make sure that the trial balance contains only insurance fees that apply to the period ending December 31, 2018 (the period we’re focused on here), Pepper’s Inc. should make the following adjusting entry (a deferral):
This decreases the insurance payable account by $200, increases the insurance expense account by $200 and ensures that the trial balance only contains information about insurance paid in the period ending December 31, 2018, and not after.
Applying all of these adjusting entries turns your unadjusted trial balance into an adjusted trial balance.
What is an adjusted trial balance?
The adjusted trial balance is what you get when you take all of the adjusting entries from the previous step and apply them to the unadjusted trial balance. It should look exactly like your unadjusted trial balance, save for any deferrals, accruals, missing transaction or tax adjustments you made.
Just like in an unadjusted trial balance, the total debits and credits in an adjusted trial balance must equal. If they don’t, you’ve made a mistake somewhere.
How does an adjusted trial balance get turned into financial statements?
At this point you might be wondering what the big deal is with trial balances. Did we really go through all that trouble just to make sure that all of the debits and credits in your books balance? Not quite. You’re now set up to make financial statements, which is a big deal.
Once you have a completed, adjusted trial balance in front of you, creating the three major financial statements—the balance sheet, the cash flow statement and the income statement—is fairly straightforward.
Using information from the revenue and expense account sections of the trial balance, you can create an income statement.
Using information from the asset, liability and equity accounts in the trial balance, you can prepare a balance sheet.
Finally, you can prepare a statement of cash flows using information found in any of the accounts that interacts with the cash accounts in the trial balance.
If you’re doing your accounting by hand, the trial balance is the keystone of your accounting operation. All of your raw financial information flows into it, and useful financial information flows out of it.
This sounds like a lot of work
Understanding the trial balance is crucial if you handle your business’ accounting system manually. But if you’d rather leave that work to an expert, consider using a service like Bench. Our bookkeepers will import your bank statements, categorize your transactions and prepare your financial statements for you every month. Give us a call to learn more and start a free trial.