What is a trial balance?

What is a trial balance in accounting?

A trial balance is a fundamental accounting process that ensures the accuracy and completeness of a business’s financial records over a period of time. It’s a basic check-up to ensure a company’s financial books are balanced before diving into more detailed reports. A trial balance essentially summarises the ending balances of all general ledger accounts.

Think of it like a balancing scale. On one side, you list the total debits (money going out) from all accounts, and on the other side, you list the total credits (money coming in) from all accounts. Ideally, for the scale to be balanced, both sides should have the same total amount.

The importance of a trial balance

Trial balances are important because it gives businesses a chance to detect errors.

If the debits and credits don’t balance, it indicates a potential error in the accounting records. This prompts the accountant to investigate and align the accounts. A trial balance verifies that all transactions have been properly recorded in the general ledger and ensures double-entry bookkeeping has been followed correctly.

These reviews serve as a foundation for comprehensive financial statements like a balance sheet or income statement.

Types of trial balances

There are three main types of trial balances used in accounting, each serving a specific purpose in the accounting cycle. To understand them, remember the following principles:

• The unadjusted trial balance is the first step, providing a basic overview.
• The adjusted trial balance refines the picture with necessary adjustments.
• The post-closing trial balance is the final check after closing entries, ready for the next period.

Unadjusted trial balance

This is the initial trial balance prepared after all transactions for a period (month, quarter, year) have been recorded in the general ledger. It simply lists the ending balances of all accounts without any adjustments. Think of it as a preliminary snapshot of the company’s financial position before accounting for any outstanding events or accruals.

Adjusted trial balance

An adjusted trial balance is prepared after making necessary adjustments to the financial statements. These adjustments account for factors like depreciation (wear and tear on assets), accrued expenses (expenses incurred but not yet paid), and prepaid expenses (expenses paid for but not yet used).

The adjusted trial balance reflects a more accurate picture of the company’s financial performance and position by incorporating these adjustments. Imagine it as a refined version of the unadjusted trial balance, taking into account additional details to provide a clearer view.

Post-closing trial balance

The post-closing trial balance is the final trial balance prepared after closing entries have been posted to the general ledger. It typically includes only balance sheet accounts (assets, liabilities, and equity) with zero balances in all revenue and expense accounts.

Closing entries are a technical accounting procedure used to temporarily remove revenue and expense accounts from the books and transfer the net income (or loss) to the retained earnings account.

pen_spark

Retained Earnings = Net Income – Net Loss – Dividends

Retained earnings are calculated by subtracting dividends and any net losses from the company’s net income. This value determines how much of the company’s profits it has kept and reinvested in the business rather than distributing it to shareholders.

For example, let’s say a company has a net income of $500,000 for the year. It pays out dividends of $50,000 to shareholders and reports a net loss of $20,000 from a previous year. To calculate retained earnings, you would start with the net income of $500,000 and subtract the dividends of $50,000 and the net loss of $20,000, resulting in retained earnings of $430,000.

Retained Earnings = $500,000 – $20,000 – $50,000 = $430,000

Pros & cons of retained earnings

There are several pros and cons associated with retained earnings that businesses should consider:

Pros

• Fuels growth to invest in new projects
• Safety net for unforeseen threats, such as economic downturns
• Funding flexibility

One of the main advantages of retaining earnings is that it allows businesses to reinvest in their operations and fund future growth opportunities. By retaining earnings, you can finance projects, expand product lines, or make strategic investments without seeking external financing. This can help businesses remain competitive and continue to grow over time.

Additionally, retained earnings can also provide a cushion for a business in times of economic downturn or financial difficulty. By building up a strong reserve of retained earnings, a company can better weather periods of instability or uncertainty without resorting to drastic cost-cutting measures or taking on additional debt.

Cons

• Shareholder dissatisfaction over dividends amount
• Operational inefficiencies

One potential downside is that by holding onto profits, businesses may miss out on opportunities to provide returns to shareholders. Shareholders may become impatient if they do not see a return on their investment in the form of dividends, which could lead to a decrease in share prices or shareholder dissatisfaction.

Another disadvantage of retaining earnings is that it can lead to a buildup of excess cash within a company. This excess cash may not be used efficiently or effectively and could be wasted on low-return projects or investments.