 |
The double entry system is well known for built in error checking. At the end of a reporting period, accountants create
a trial balance from all active accounts, to see if total Debits equals total Credits. An imbalance between totals signals an error in the system.
|
The terms trial balance and trial balance period refer to an error-checking step in the accounting cycle in companies that use a double entry system for bookkeeping and accounting. This article defines, explains, and illustrates trial balance and trial balance period with examples.
Exhibit 1 (below) shows that accountants create a trial balance after all the period's transactions have been posted to the general ledger but before account balances are transferred to the period's financial reports.
The trial balance is based on data from all the company's open general ledger accounts (nominal ledger accounts). The "trial" is simply a comparison of two sums: total debits and total credits. When double entry principles are applied correctly, total debits from all accounts must equal total credits. A mismatch between trial debit and credit sums means that one or more accounting errors have been made, such as a transaction for which a debit entry in one account was not accompanied by an equal offsetting credit entry in another account.
Exhibit 1.Trial balance in the accounting cycle. Transactions are entered into the journal when they occur as the first step in the accounting cycle. Journal entries are transferred to a ledger (a process called posting) as the second step. Thirdly, entries are checked with a trial balance and corrected if necessary. The final steps are publication of the financial statements and auditing.
The trial balance thus exercises a well known advantage of the double entry system, built in error checking.
- Note that such errors are more likely where accounting is still done entirely "by hand" or manually with pencil and paper. Where accounting is computer-based, modern accounting software uses additional layers of error checking, continuously, with every transaction, designed to help avoid these errors.
- The trial balance can still miss other kinds of accounting errors, such as the simple omission of transactions that should have been posted but were not. For more on these kinds of errors, see the section below on finding errors.
When the trial balance does not balance, accountants try to find and correct the error immediately. If the reason for the error is obscure or not easily uncovered, however, the accountant may create temporary adjustments in certain accounts (described below), which restore the debit/credit balance on a temporary basis while they search for the problem.
The period of time between final posting to the ledger and transfer of account balances to financial statements is called the trial balance period. Accountants use this time to find and correct errors revealed by the trial balance, but also to search for the kinds of errors that are not detected by the trial balance. Company management would much rather find errors themselves during the trial balance period, than have them found by external auditors after financial statements are published.
Note that the trial balance period also includes reconciliation, the process of checking account balances against other sources. Bank statements should agree with ledger balances for cash accounts, for instance, and liability accounts for bank loans should agree with the lender's account statements, and so on.
Contents
• The trial balance calculation
• The trial balance vs. the income statement and balance sheet
• Finding and fixing and adjusting for errors
– Errors revealed by the trail balance
– Errors not revealed by the trail balance
• The trial balance vs. the income statement and balance sheet
• Finding and fixing and adjusting for errors
– Errors revealed by the trail balance
– Errors not revealed by the trail balance
The trial balance calculation
The debit and credit totals in the trial balance must match, in order for the income statement and balance sheet to be completed correctly (as shown in the example below). Accounting errors responsible for the mismatch must be found and fixed before the period's statements are published and audited. Other material errors underlying the account balances must also be found and fixed during the trial balance period, as well, so as to avoid an adverse opinion from external auditors.
The trial balance calculation has in view every active account from the company's chart of accounts and general ledger (nominal ledger). The calculation attempts to determine whether total debits in all these accounts equal total credits. The calculation can be made without having to add up every debit and every credit transaction from every account. A valid trial balance calculation can be made simply by adding instead the account balances from the general ledger, as shown in this section.
Consider, for instance, just one account, "Cash on hand." Debit (DR) and credit (CR) transactions in this account for have been posted from the journal to the general ledger, summarized in the ledger in a so-called "T-account," such as that in Exhibit 2 below:
Exhibit 2. A ledger T-account for one account, cash on hand, for several days transactions. Cash on hand is an assetaccount and this means that debits increase its balance, and credits decrease its balance. This asset account, therefore, is said to carry a debit (DR) balance.
Note that total debits and total credits to a single account are not necessarily equal, either for the period or for the account's entire history. The difference between debit and credit totals across the account's history represents the current account balance. Exhibit 3, below, shows that two of the five major account types, Asset accounts and Expense category accounts show debit balances, whereas the other three types, Liability accounts, Equity accounts, and Revenue accounts, show credit balances. The trial balance comparison will actual compare the total debit balance with the total credit balance.
| ||||||||||||||||||||||||
| Exhibit 3. The five major kinds of accounts. A positive balance in an Asset category account or Expense account is a debit balance. A positive balance in a Liability account, Equity account, or a Revenue account, is a Credit balance. |
Now consider the current balances at end of period (after all the period's transactions have been posted to the ledger T-accounts), as in all the general ledger open accounts, as represented by Exhibit 4 below:
| Acct. No | Aerofirma Corporation Accounts Fiscal Year 20XX | Debit Balance | Credit Balance |
| Asset Accounts - Current Assets | |||
| 101 | Cash on hand | 12,700 | |
| 110 | Accounts receivable | 2,890 | |
| 139 | Finished goods inventory | 3,830 | |
| 163 | Factory manufacturing equipment | 10,560 | |
| Liability Accounts - Current Liabilities | |||
| 200 | Accounts payable | 2,320 | |
| 234 | Payroll payable | 3,720 | |
| 235 | Accrued fees | 310 | |
| 260 | Bonds payable | 1,400 | |
| 280 | Bank loans payable | 3,100 | |
| Equity Accounts | |||
| 320 | Owner capital | 9,400 | |
| 350 | Retained earnings | 7,400 | |
| Revenue Accounts | |||
| 410 | Product sales revenues | 13,000 | |
| 420 | Services sales | 5,030 | |
| 430 | Rental property revenues | 1,200 | |
| 450 | Interest earned revenues | 300 | |
| Expense Accounts - Cost of Goods Sold | |||
| 520 | Raw materials costs | 5,100 | |
| 530 | Direct labor costs | 5,490 | |
| 540 | Indirect labor costs | 3,730 | |
| 550 | Manufacturing plant costs | 2,780 | |
| 800 | Other expenses | 100 | |
| Total | 47,180 | 47,180 | |
| Exhibit 4. General ledger account balances for a company at the end of the reporting period. The trial balance test is simply a comparison of total debit balances and total credit balances. In this case, the totals match and the trial balance therefore does not reveal any accounting errors. (Note that for simplicity, this list of accounts is unrealistically short. Also for the sake of simplicity, the accounts shown do not include contra accounts, drawing accounts, depreciation expenses, or taxes.) | |||
The trial sums in this example balance, that is, the total of debit balances equals the total of credit balances. The mathematics behind this result also mean that the sum of individual debit transactions equals the sum of individual credit transactions.
A successful trial balance notwithstanding, accountants will still check careful for the other kinds of accounting errors that do not impact a trail balance. Once all errors have been corrected, the account balances are reading for publication in the period financial accounting reports (see the final section in this article).
The trial balance figures vs. the income statement and balance sheet
For the most part, line items on the period's balance sheet and income statement are nothing more than account names, such as those in Exhibit 4 above, while the figures reported for each item are simply the account balances. In fact, when the trail balance balances, and when accountants are satisfied that the account balances are error-free, the balance sheet and income statement can be built directly from the list of accounts and their balances, as shown inExhibit 4.
Consider first the revenue category accounts and expense category accounts. These are also known as "income statement accounts" and they do indeed make up the income statement contents. In the case of this very simple example, using account balance figures from the trial balance exercise in Exhibit 4 above, the company's income statement appears as follows:
| Aerofirma Corporation Income Statement for Fiscal Year 20XX | ||
| Revenues | ||
| Product sales revenues | 13,000 | |
| Services sales revenues | 5,030 | |
| Rental property revenues | 1,200 | |
| Interest earned revenues | 300 | |
| Total revenues | 19,530 | |
| Expenses | ||
| Raw materials costs | 5,100 | |
| Direct labor costs | 5,490 | |
| Indirect labor costs | 3,730 | |
| Manufacturing plant costs | 2,880 | |
| Total expenses | 17,200 | |
| Net income | 2,330 | |
The remaining account categories (Asset, Liability, and Equity accounts) are called "balance sheet accounts." These accounts and their balances do indeed make up the company's end-of-period balance sheet:
| Aerofirma Corporation Balance Sheet at the end of Fiscal Year 20XX | ||
| Assets | ||
| Cash on hand | 12,700 | |
| Accounts receivable | 2,890 | |
| Finished goods inventory | 3,830 | |
| Factory manufacturing equip. | 10,560 | |
| Total assets | 29,980 | |
| Liabilities | ||
| Accounts payable | 2,320 | |
| Payroll payable | 3,720 | |
| Accrued fees | 310 | |
| Bonds payable | 1,400 | |
| Bank loans payable | 3,100 | |
| Total liabilities | 10,850 | |
| Owners Equity | ||
| Owner capital | 9,400 | |
| Retained earnings | 7,400 | |
| NET INCOME | 2,330 | |
| Total owners equity plus inc | 19,130 | |
| Total liabilities plus equity | 29,980 | |
Notice here that the "Net income" result from the income statement was inserted into the current balance sheet under "Owners Equity." When the balance sheet is finalized, the net income value will indeed appear here, either as retained earnings, and/or as dividends.
When the trial balance balances as shown in the previous section, the balance sheet will also balance, and the income statement will show correct net income.
Finding and fixing errors
If the debit and credit balance totals do not match in the trial balance exercise, there is certainly an accounting error somewhere in the account balances. Errors responsible for the mismatch must be found and corrected before financial statements can be published as shown above. During the trial balance period, accountants will also search for and try to fix other kinds of accounting errors that are not revealed by the trial balance. Material errors in the account balances that are not found and fixed before financial statements are published may result in an adverse opinion from external auditors.
Errors revealed by the trial balance
A mismatch between debit and credit totals in the trial balance usually means that one or transaction postings from journal to ledger are either in error or missing. Accountants may ultimately have to examine every debit-credit pair of journal entries to find the error.
There are, however, some well known indicators for certain kinds of problems, which help reveal specific errors without having to having to resort to a complete transaction-by-transaction review. For instance:
- If an account balance is incorrectly listed as a debit balance when it should be a credit balance (or the reverse), the difference between the debit total and credit total will be twice the value of this balance, and the difference, moreover, will evenly divisible by 2. When the accountant finds a trial balance difference divisible by 2, the first step is to look for an account balance exactly half the difference. That is most likely the misplaced balance.
- When the difference between debit and credit totals is evenly divisible by 9, this is a mathematical indicator that the account balances may include a transposition error in one of the balances. A debit balance that should really be 12,578 may have been listed as something like 12,587, for instance.
- When the difference between debit and credit totals is divisible neither by 9 or by 2, it is possible that a single debit or credit balance is missing from the account lists.
Because the trial balance must balance, accountants may also make adjustments to certain accounts, to bring about a match between total debit and credit balances. Adjustments are not so much a matter of fixing errors, as they are improvements in the accuracy of accrual accounting, so that revenues and expenses are more correctly matched appropriately and reported in the appropriate period.
Adjusting entries for the purpose balancing the trial balance are typically made in two kinds of expense and asset category accounts, accrual accounts and prepayment accounts:
- Adjustments to accrual accounts (such as accrued depreciation, or accrued interest expense) are made to reflect more accurately the timing of actual expense accrual.
- Adjustments to prepayment accounts (such prepaid insurance, office supplies, or floorspace rental) are made so as to more accurately match actual timing for usage the goods or services.
Other accounting errors not revealed by the trial balance
Errors such as the following are not detected with a trial balance.
- The paired debit and credit figures for a transaction may both match but still be incorrect. Such a mistake may be accidental or it may be deliberate deception by the accountant. Either way, the trial balance is blind to the problem.
- Transactions that should have been entered in the system may have been omitted, or forgotten altogether. This is an error of omission, not visible to the trial balance.
- An account entry is made in an account as a debit when it should have a credit, and its corresponding co-transaction is then registered as a credit when it should have been a debit. This is an error of reversal. When this happens, total debits still equal total credits.
- Entries may be made in the correct kind of account (e.g., "Asset account" or "Expense account") but in the incorrect specific account within the category. The contributions to total debits and total credits will still be equal.
- Two or more errors in different accounts may be offsetting, so as to cancel each other. If, for instance, a credit transaction in one account is $100 too high, and if in another account a debit transaction is $100 too high, the trial balance will still balance.
If such errors are carried into the published financial statement, the questions for auditors and regulators then has to with materiality and intent. They will ask if the errors and their consequences are large enough and important enough to mislead decision makers and investors (i.e., Are the errors material?). They will also attempt to determine if the errors represent accidental oversights or deliberate distortion of financial results (see the encyclopedia entry materiality concept). For this reason, company management and accountants will use the trial balance period to rigorously search out and correct all accounting errors--whether they impact the trial balance or not.(source)
No comments:
Post a Comment