Financial Accounting / Chapter 7

Trial Balance

Overview
Definition and general summary
Benefits and limitations of Trial Balances
Passing Adjusting Entries
Types of Adjusting Entries
Closing Summary

Overview

At the end of each accounting period, a trialbalance is prepared from all the recorded ledger entires. This chapter explores how & why trial balances are prepared along with its use in financial statements.

Trial Balance – Definition and general summary

A trial balance is a list of all the accounts of an entity along with their balances at a given period of time.

A company usually prepares its trial balance at the end of an accounting period which is typically either a financial year or a financial quarter. Usually, all the accounts are listed in the order in which they appear in the general ledger along with their balances. Debits and credits are separated by listing debits in the left-hand side columns and credits in the right-hand side column. Every financial transaction has two offsetting ledger entries under double entry form of bookkeeping as we had learned in earlier chapters, the total of credits and debits should be equal.

As an example, consider the simple ledger of ABC Co Pvt. Ltd. considered in the earlier chapter (with a small modification):

General Ledger

ABC Co Pvt. Ltd.

Jan 1, 2022 - March 31, 2022

Cash Account
Debits	Credits

General Ledger

ABC Co Pvt. Ltd.

Jan 1, 2022 - March 31, 2022

Cash Account
Reference	Due Date	Amount	Reference	Due Date	Amount
Balance B/f	Jan 1, 2022	25,000	Salary	March 31, 2022	10,000
Sales	March 31, 2022	5,000	...	...	...

Salary Expense Account
Debits	Credits
Reference	Due Date	Amount	Reference	Due Date	Amount
Balance B/f	Jan 1, 2022	0	...	...	...
Cash	March 31, 2022	10,000	...	...	...

Sales Account
Debits	Credits
Reference	Due Date	Amount	Reference	Due Date	Amount
...	...	...	Balance B/f	Jan 1, 2022	0

First, let us find the balances in each of the ledger accounts at the end of the period. In our case, as of 31st March 2022.

General Ledger

ABC Co Pvt. Ltd.

Jan 1, 2022 - March 31, 2022

Cash Account
Reference	Due Date	Amount	Reference	Due Date	Amount
Balance B/f	Jan 1, 2022	25,000	Salary	March 31, 2022	10,000
Sales	March 31, 2022	5,000	...	...	...
Balance	...	20,000	...	...	...

Salary Expense Account
Debits	Credits
Reference	Due Date	Amount	Reference	Due Date	Amount
Balance B/f	Jan 1, 2022	0	...	...	...
Cash	March 31, 2022	10,000	...	...	...
Balance	...	10,000	...	...	...

Sales Account
Debits	Credits
Reference	Due Date	Amount	Reference	Due Date	Amount
...	...	...	Balance B/f	Jan 1, 2022	0
...	...	...	Sales	March 31, 2022	5,000
Balance	...	...	...	...	5,000

Common Equity Account
Debits	Credits
Reference	Due Date	Amount	Reference	Due Date	Amount
...	...	...	Balance B/f	Jan 1, 2022	25,000
Balance	...	...	...	...	25,000

A simplified trial balance prepared for ABC Co Pvt. Ltd. which has only these ledgers would look soothing like:

ABC Co Pvt. Ltd.

Trial Balance

March 31, 2022

Cash Account
...	Debit	Credit
Cash	20,000	...
Salary	10,000	...
Sales	...	5,000
Common Equity	...	25,000
...	30,000	30,000

Note that the debits and credits have an equal total balance, Rs. 30,000. If you compare the ledger presented here with the one in the previous chapter, you will notice that there’s an added common equity account with a balance of Rs. 25,000. Can you guess why adding this was necessary?

Hint: Try to prepare the trial balance for the previous period ending Dec 31, 2021.

Benefits and limitations of Trial Balances

The trial balance helps uncover errors in journalizing and posting.

Let’s consider the example discussed in chapter 6 of a business that pays salaries worth Rs. 15000 for the month of March in cash on the 31st of March. Remember that the ledger entry posting for the transaction involved a credit of Rs. 10000 in the cash account and a debit of the same amount in the salary expense account. While posting to the ledger, suppose the accountant only posted to the salary account and forgot to credit the cash account. When the trial balance is prepared, the total debits would be higher than the total credits by Rs. 10000 causing error. What would happen if the accountant had debited the cash account instead of crediting it? The final trial balance would reflect the total debits to be higher than the total credits by Rs. 20000 uncovering the error.

However, the trial balance can only detect certain types of errors. Errors which affect both the credit and debit sides equally are typically not detected when the trial balance is prepared. For example, suppose the accountant forgot to enter previous transaction in the journal. During the preparation of the trial balance both the debit and credit sides would be lowered by Rs. 10000. However, the test of equality of debits and credits is still met and the error is not detected during the preparation of the trial balance. Similarly, errors where duplicate/multiple journal entries are posted, wrong accounts are used in journalizing/posting, wrong amount is entered on both credit and debit side etc. are not detected. As a mental exercise, figure out what would be the impact on the trial balance in each of these scenarios and how it deviates from the ideal trial balance and if the equality of debits and credits is affected.

Passing Adjusting Entries

Next, to get the adjusted entries we adjust trial balances. Before going into how the adjustment is done, let us consider an example to understand why adjustments are necessary. Imagine that ABC Co Pvt. Ltd. had to pay the lease for its factory building for the next five years in advance with a yearly lease of Rs. 10,000. How would the journal and ledger entries for the year look?

If we debit the entire expense of Rs. 50,000 in the current year, the profit of the current year would be severely understated and the profits of the next 4 years would be overstated given that the benefits of the lease expenses are going to be obtained over the next 5 years.

In order to avoid such distortions, we make adjusting entries. Adjusting entries ensure that revenues and expenses are recorded in the appropriate periods in which they are incurred, thereby satisfying the accrual and matching principles. The balances obtained from the trial balance may not be up to date or appropriate due to several reasons. A periodic expense such as the lease example given earlier is one of the possible reasons. Others could include transactions not recorded daily because it would be inefficient or difficult to do so (such as use of consumables) or which remain unrecorded such as interest or other expenses which may have accrued, but, not yet become due. Thus, each account is examined to determine if it is up-to-date and complete failing which adjusting entries are passed.

Types of Adjusting Entries

Adjusting entries are required for:

Prepaid expenses – For example, utilities which have been pre-paid in advance.
Unearned revenues – When customers have made payments, but, the products/services/obligations have not yet been delivered/met.
Accrued revenues – When products/services/obligations have been delivered/met, but transactions have not yet been recorded. For instance, in the case of building construction, the construction may require 5 years only post which the customer obligations are completed and payment due.
Accrued expended - For example, utilities which have been consumed during the period, but are not due for payment in the period.

Illustrative Example

For instance, consider that in the earlier example of ABC Co, the salaries due of Rs. 10,000 were payable only on say April 1, 2022, the same would not appear on the accounts. However, since the expense was incurred for the period of March 2022, an adjusting entry is necessary to satisfy the matching principle. It would look something like:

Date	Account	Debit	Credit
March 31, 2022	Salary expense	10,000	...
...	Salaries payable	...	10,000

Modifying the ledger account:

General Ledger

ABC Co Pvt. Ltd.

Jan 1, 2022 - March 31, 2022

Cash Account
Debits	Credits
Reference	Due Date	Amount	Reference	Due Date	Amount
Balance B/f	Jan 1, 2022	25,000	...	...	...
Sales	March 31, 2022	5,000	...	...	...
Balance	...	30,000	...	...	...

Salary Expense Account
Debits	Credits
Reference	Due Date	Amount	Reference	Due Date	Amount
Balance B/f	Jan 1, 2022	0	...	...	...
Cash	March 31, 2022	10,000	...	...	...
Balance	...	10,000	...	...	...

Sales Account
Debits	Credits
Reference	Due Date	Amount	Reference	Due Date	Amount
...	...	...	Balance B/f	Jan 1, 2022	0
...	...	...	Sales	March 31, 2022	5,000
Balance	...	...	...	...	5,000

Common Equity Account
Debits	Credits
Reference	Due Date	Amount	Reference	Due Date	Amount
...	...	...	Balance B/f	Jan 1, 2022	25,000
Balance	...	...	...	...	25,000

Salary Payables Account
Debits	Credits
Reference	Due Date	Amount	Reference	Due Date	Amount
...	...	...	Balance B/f	Jan 1, 2022	0
...	...	...	Salary	March 31, 2022	10,000
Balance	...	...	...	...	10,000

Updating the trial balance, we get the adjusted trial balance:

ABC Co Pvt. Ltd.

Trial Balance

March 31, 2022

Cash Account
...	Debit	Credit
Cash	30,000	...
Salary	10,000	...
Sales	...	5,000
Common Equity	...	25,000
Salary Payable	...	10,000
...	40,000	40,000

Note that each adjusting entry will involve an income statement and a balance sheet account.

Closing summary

To summarize, a trial balance is a list of all the accounts of an entity along with their balances. It is useful in identifying erroneous journal entries/ledger postings and in the preparation of financial statements. A trial balance is prepared from the ledger entries and adjustment entries are passed to ensure that the principles of matching and accrual are satisfied.