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Every business – from the solo freelance graphic artist to the Fortune 500 global company – relies on the same basics for tracking their finances.
Two pieces of that foundation are the trial balance and the balance sheet. Understanding what they are and how they relate is a significant step towards understanding money flow through a company.
Let’s dig in.
What Is a Trial Balance vs. Balance Sheet?
The trial balance is a listing of a company’s financial accounts and their balances, while the balance sheet is a report that shows a company’s net worth.
The trial balance and the balance sheet are different stages in the accounting process:
Journal Entry → General Ledger → Trial Balance → Financial Statements
First, financial transactions are recorded as journal entries. Those journal entries are collected in the general ledger. General ledger transactions are aggregated by account to create the trial balance. Finally, ledger accounts in the trial balance are aggregated by category to make the financial statements:
The trial balance is an internal document used as the first step in creating financial statements. It lists all the financial accounts and their ledger balances on a specific date. That date may be the end of the financial year, the end of a quarter, or the last day of the month, depending on the period that is being reported on.
By convention, debit balances and credit balances are listed in different columns. By adding up the total of debits and the total of credits, it’s easy to see if all transactions balance: Debits must equal credits.
If debits equal credits, the accounts and balances are further aggregated to create the financial statements. Accounts in the trial balance are split between balance sheet accounts and income statement accounts. The balance sheet accounts and their balances are sorted into assets, liabilities, and owner’s equity to create the balance sheet.
The balance sheet, along with the income statement and the statement of cash flows, can be used internally for management reporting or externally for reporting to investors, creditors, and other stakeholders. External users most commonly use the year-end financial statements for their decision-making.
In the centuries before bookkeeping was performed on computers using accounting software, compiling the data to create the trial balance and financial statements was a tedious, time-consuming, and error-prone manual process performed with paper and pen. Because of the time required to compile these, trial balances and balance sheets were created only as needed at the end of a quarter or a year. Today, these can be created in most accounting systems nearly instantly with a few clicks.
What Is a Trial Balance?
A trial balance is an internal report that lists all financial accounts and their ending balances on a specific date. These balances arise from double-entry accounting, which means that debits should equal credits. Using accounting software makes it nearly impossible to record transactions out of balance, so the historical purpose of creating a trial balance – to verify that debits equal credits – is a trivial matter. However, it’s still helpful to scan the trial balance for any obvious bookkeeping errors that may appear as odd account balances. For example, accounts payable should have a credit balance, and accounts receivable should have a debit balance.
Here’s an example of a trial balance for XYZ Co. as of December 31, 202X. By convention, the debit column is on the left, and the credit column is on the right.
AccountDR.CR.Cash94,000Accounts Receivable11,000Building150,000Land50,000Equipment20,000Accumulated Depreciation1,000Accounts Payable 20,000Notes Payable200,000Shareholders’ Equity100,000Revenue20,000Wage and Salary Expense11,000Utility Expense3,000Depreciation Expense1,000Supplies Expense500Legal Expense500Totals341,000341,000
Besides correcting apparent errors, other adjustments may be needed as part of the accounting cycle to ensure that the numbers comply with accounting principles. As part of the closing process at the end of an accounting period, balance sheet accounts must be reconciled, and adjusting entries must be posted. Companies that carry inventory need to count their closing stock so that the Cost of Goods Sold can be calculated appropriately.
Once the balance sheet accounts are tied out, the adjusted trial balance can create the income statement and balance sheet. The income statement tracks the results of operations over time, while the balance sheet tracks the cumulative impacts of operations on assets, liabilities, and stockholder’s equity.
What Is the Balance Sheet?
The balance sheet shows the financial condition of a company at a given point in time. Another name for a balance sheet is the statement of financial position. A balance sheet is divided into sections:
Assets: This is anything the company owns that has inherent value. Examples include cash, amounts owed to the company by customers (accounts receivable), buildings, furniture, and equipment. Assets may also be intangible, such as patents or trademarks.
Liabilities: This is what the company owes to other parties. They are legal obligations to pay a certain amount of money to another person or entity. These may be in the form of bills that have not yet been paid (accounts payable), bank loans, or notes payable.
Owner’s Equity: Owner’s equity is also known as shareholders’ equity or stockholders’ equity. This represents the company’s residual value after all debts have been paid. Equity comes from two primary sources: Money or other resources invested in the company by owners and earnings that have been retained by the company for future needs.
The balance sheet is defined by the accounting equation:
Assets = Liabilities + Shareholders’ Equity
According to this equation, an organization’s assets must be balanced by the sum of its liabilities plus shareholders’ equity. A balance sheet that doesn’t balance is a sign of errors in accounting records.
Balance sheets are used for internal purposes to support strategic decisions. External users use balance sheets to assess a company’s financial status and liquidity. Both sets of users may rely on ratios to compare the company’s financial position to benchmarks.
Here’s the balance sheet for the trial balance above:
Balance Sheet of XYZ Co.
As of December 31, 202X
Assets Cash 94,000Accounts Receivable 11.000Property, Plant and Equipment, Net 219,000Total Assets 324,000Liabilities Accounts Payable 20,000Notes Payable 200,000Total Liabilities 220,000Shareholders’ Equity Beginning Balance 100,000Net Income 4,000Total Shareholders’ Equity 104,000Total Liabilities plus Shareholders’ Equity 324,000
Depending on the intended users of a balance sheet, the categories of assets, liabilities, and equity may be shown in summary form or include a detailed listing of all general ledger accounts in each category. For example, managers or a firm’s auditors will likely want to see a detailed listing of all the asset accounts, while executives and external users may only need to see current and non-current assets. Existing assets are items that are already in the form of cash or will likely be converted to cash within a year. Non-current assets are items that are not likely to be converted to cash in the short term.
Trial Balance vs. Balance Sheet (Comparison Table)
Here are the main differences between a trial balance and a balance sheet:
Trial BalanceBalance SheetDefinitionA listing of financial accounts and their balances on a specific dateA summary of a company’s financial position at a specific point in timeFunctionTo test whether debits equal creditsTo determine the financial position of a companyPart of Financial Statements?NoYes, along with income statement and statement of cash flowsFrequency of PreparationAs neededMonthly, quarterly, or annually, depending on a company’s reporting requirementsPrimary UsersInternal onlyInternal and ExternalSourceGeneral LedgerTrial BalanceEquity ValueBeginning BalanceClosing BalanceWhich accounts?All of a company’s financial accounts are includedBalance sheet accounts only. Revenue and expenses are reported as net income for a particular periodLevel of AggregationAggregates transactions by account Aggregates accounts by categories of assets, liabilities and equityAccounting StandardsNo standards mandate presentation or formatPresentation and general format must comply with relevant accounting standards
Understand Your Numbers To Grow Your Business
Understanding how information flows through your accounting system can help you see where the numbers in your financial statements come from. The trial balance and balance sheet are just two components of that understanding. A deeper understanding of your numbers and how they interact can give you insights to grow your business.