This may seem unimportant to the business owner, but this report is a tool to deliver quality information to the readers of financial statements. The following sections describe the historical use of the report and how the report is used in the modern technology based accounting systems. Finally I’ll finish up by explaining how even the more novice business owner can interpret the information presented in this report.
Historical Use of the Trial Balance
Accounting relies on what is referred to as ‘dual entry’ transactions to maintain balance in the books of record. This means that debits and credits, terms used in accounting referring to financial transactions, must always equal each other. Therefore, when all the debits are combined from the respective accounts and all the credits are added together from their respective ledgers, the two sums will equal each other. Below is a simple illustration of a basic trial balance. It shows two columns, the one on the left are debits and the one on the right, credits.
XYZ Construction Company
Accounts Receivable 1,100
Work in Process 4,850
Fixed Assets 7,600
Accumulated Depreciation 4,100
Accounts Payable 700
Job Progress Billings 3,700
Long-Term Debt 2,250
Capital Paid in Excess 1,000
Retained Earnings 5,000
Distributions/Dividends 1,700 – 0 –
Totals 17,750 17,750
Before technology kicked in for accounting, books were kept in logs. In general, there was a log (in accounting we use the term ledger) for each account. When a transaction was recorded, you literally took the ledger for that particular account and recorded your debit or credit and then took the ledger for dual account (the other account in the dual entry system) and entered the opposite. As an example, suppose the customer owing the contractor paid $600 on his account. The cash log would be pulled and an entry of $600 as a debit would be recorded and then the accounts receivable log would be pulled and the credit would be applied for $600. The new balances are cash at $3,000 and accounts receivable would be reduced to $500 ($1,100 minus $600). At the end of the month, the logs would be footed, that is added up. Then a balance existed for that ledger. That balance would be manually inserted into the trial balance and the trial balance would be footed for all the debits and credits. If they equaled each other, then all the data was entered with equal amounts of debits and credits throughout the accounting period. But, if there was an error, each of the logs would be investigated more thoroughly to determine the source of the error. The trial balance served as an accountant’s check mechanism to make sure all the respective ledgers were correct.
This whole ideal behind the trial balance was to confirm that there were no human errors in the books of record. Again, remember this was all done by hand and errors existed due to transposition issues, miscalculations, and just flat out forgetting to enter the other side of the entry. All the ledgers had a column labeled ‘Split Account’ which identified the other ledger used for the other side of the dual entry. Using the example above in reference to the cash payment by the customer, in the cash ledger, the split column would state – ‘Accounts Receivable’. To confirm that the dual entry worked, the accountant would go over to the accounts receivable ledger and confirm that on the same day, an entry existed for the same dollar amount and its split column would state – ‘Cash’.
With modern-day accounting software, the information is recorded exactly the same way. Technology allows for faster work as the accountant enters the data, both sides of the dual entry are created instantly and your trial balance would always be in balance. However, I have learned that this is not necessarily true.
Trial Balance with Modern Technology
Modern day small business accounting software like QuickBooks or Sage (read more about choosing the right accounting software here: Choose the Right Accounting Software) provide some form of a fail-safe assurance that the entry has equal debits and credits. Thus, the trial balance is always in balance. Well back in the late 90’s when I was using Peachtree’s Dos Version of the software (the precursor software to the modern-day Sage) I found out you could enter a one-sided entry. That is because the underlying software codes didn’t provide assurance of the other side of the entry. Peachtree easily corrected this bug by early 2000 but, I discovered that a power surge or power loss to the computer would indeed save a one-sided entry. Again, the only way to spot it was via the trial balance.
As technology progressed, this power surge issue was resolved, but now in 2014, I have learned software importing of data via a bridge (an account to an account transfer) from external software to the accounting software will allow a one-sided transaction to be recorded. I discovered this issue with QuickBooks. The only way to identify this is via the trial balance. I spotted this last month when closing the books for an apartment complex. The software used to record tenant charges and payments transferred the data without totaling the debits and the credits and ensuring they are equal. Fortunately, QuickBooks uses a verify data check mechanism and a rebuild function to fix the issue. However, it’s not automatic; you have to do the fix manually after discovering the problem via the trial balance.
Although modern accounting software may seem to have resolved the need for the trial balance, there are still many other uses of the trial balance and following section describes those respective uses.
Interpreting a Trial Balance
Once an accountant has confirmed the debits and credits are equal via the trial balance (s)he can use the report for other purposes.
Obvious Balance Issues
The trial balance’s layout is similar to the chart of accounts layout. It starts out with the assets section of the balance sheet in the traditional order of cash accounts, investments, inventory, receivables, fixed assets and other assets. From there the list continues with the current liabilities section, long-term liabilities and into the equity section of the balance sheet. But it doesn’t stop here, the list proceeds to the revenue section, cost of goods sold, and expenses. There is no profit account or a current earnings account up in the equity section of the trial balance.
As an accountant we are trained to expect certain types of balances in the respective accounts. I should see debit balances in cash accounts and pretty much all asset accounts. Any liabilities or debt accounts should carry credit amounts. The following is a short list of types of balances in the respective groups of accounts:
Cash/Current Assets Debits
Fixed Assets Debits
Accumulated Depreciation/Amortization Credits
Other Assets Debits
Current Liabilities Credits
Long-Term Liabilities Credits
Retained Earnings Credits (This is normal which indicates the company is making money; debits indicate historical losses)
Cost of Goods Sold Debits
Other Income/Expenses Debits or Credits (Depends on the nature of the item, if interest income, the balance would be a credit)
When the dollar value for a particular type of account isn’t in the proper column, it is a key sign of a possible error. Any abnormality is investigated further to confirm proper entry related to that account.
A perfect example is finding a credit balance in a bank account. This would mean the bank account is overdrawn and not only should this be investigated, it should be addressed immediately.
Proper Grouping of Types of Accounts
Just like the obvious balance issues, accountants look for incorrect types of accounts. I’ve seen cash accounts coded as other assets and thus a reclassification is required to move the account into the proper area of the trial balance. The most common error occurs with the income statement account section of the trial balance. Often business owners classify an expense item as a cost of goods sold type of account or the other way around. To assist in better understanding of the information, it is wise to set the account type to the proper grouping of accounts. This way reports are easily understandable and the reader can quickly find any problems with the financial information.
Working Trial Balance
For accountants, this is the most often used format for a trial balance. We use the trial balance to convert our books from one format to another. What on earth is he talking about? You will often hear folks say that many companies have several sets of books. One is for GAAP (Generally Accepted Accounting Principles) and another set is for tax purposes. Yep, there are actually more! These include:
Fair Market Value
Partnership Capital Accounting
The trial balance has a set of columns inserted for the adjusting entries and a separate journal is kept to track these adjusting entries to reflect the other set of books. In effect there are three sets of columns in a working trial balance. The first set is usually the standard set of books most often in compliance with GAAP. Then a second set of columns is used to reflect the adjusting entries used to convert the first set of columns into a new third set of columns (columns of debits/credits) to achieve a modified set of books.
The most common form of this is adjusting a set of books to a cash tax basis set of books. Most taxpayers are on the cash basis with the IRS and therefore their business income needs to be adjusted to the cash basis so as to allow for the information to be reported to the IRS in accordance with the agreed upon format (most often cash presentation). This is normal with all small business operations. The following is a condensed version of a working trial balance for a contractor.
XYZ Construction Company
Working Trial Balance
GAAP Adjusting Entries Tax Basis
Debits Credits Debits Credits Debits Credits
Cash 2,400 2,400 -0-
Accounts Rcvb 1,100 1,100 -0- -0-
WIP 4,850 4,850 -0- -0-
Fixed Assets 7,600 7,600 -0-
Acc Deprec 4,100 -0- 4,100
Deposits 100 100 -0-
Accounts Payable 700 700 -0- -0-
Progress Billings 3,700 3,700 -0- -0-
Long-Term Debt 2,250 -0- 2,250
Stock 1,000 -0- 1,000
Capital Paid in Excess 1,000 -0- 1,000
Retained Earnings 5,000 -0- 5,000
Distrs/Dividends 1,700 – 0 – 1,700 -0-
Contract Income 1,100 3,700 -0- 2,600
Costs of Contract – – 4,850 700 4,150 -0-
Totals 17,750 17,750 10,350 10,350 15,950 15,950
What the above example illustrates is an adjustment from accrual accounting to a cash basis accounting for tax purposes. I had to make some assumptions to make it work correctly but the key for you is to visualize how the working trial balance is presented. The center set of columns reflects the actual cash adjustments to end up with the third column of information which is the tax basis books of record. There will be another article in the future explaining the working trial balance in more detail and how it works. This isn’t exactly what it looks like because we include source document information in the center column explaining the source location for that particular entry. For you, the traditional trial balance is only the first set of columns and the working trial balance has three sets of columns. This is merely an introduction to the term – ‘Working Trial Balance’.
Summary – Trial Balance
Although modern accounting software may have seemed to make the traditional use of the trial balance moot, the reality is that it has enhanced the report. Traditionally, the trial balance was used as accountant’s report to verify debits and credits were of equal value. In effect it helped to verify proper recording of economic transactions. Today, the trial balance has gone beyond that purpose and is used to identify obvious account discrepancies, ensure proper grouping of accounts for formatting purposes and finally the trial balance is used to generate auxiliary sets of books for other selective purposes. Act on Knowledge.