From Trial Balance to Balance Sheet
- The starting trial balance
- The six adjustments
- What a trial balance cannot catch
- Working the adjustments systematically
- The profit and loss account
- The balance sheet
- Why the two statements connect
- Three that catch people
- Where this fits
A trial balance proves only that debits equal credits. It does not prove the figures are right, and it is not a financial statement. Between the trial balance and a set of accounts sit the adjusting entries, and that is where the actual work of a period end lives.
This walks one small business, a proprietorship, through the whole journey, with every adjustment shown.
The starting trial balance
Sharma Traders, 31 March, before adjustments. Figures in ₹.
| Account | Debit | Credit |
|---|---|---|
| Capital | 8,00,000 | |
| Drawings | 1,20,000 | |
| Plant and machinery | 6,00,000 | |
| Accumulated depreciation, plant | 1,50,000 | |
| Inventory, 1 April | 2,40,000 | |
| Trade receivables | 3,80,000 | |
| Cash and bank | 1,10,000 | |
| Trade payables | 2,60,000 | |
| Bank loan | 3,00,000 | |
| Sales | 24,00,000 | |
| Purchases | 15,60,000 | |
| Salaries | 4,20,000 | |
| Rent | 2,40,000 | |
| Insurance | 72,000 | |
| Other expenses | 1,68,000 | |
| Total | 39,10,000 | 39,10,000 |
It balances. It is also wrong in six places, all of them ordinary.
The six adjustments
1. Closing inventory is ₹2,95,000. The trial balance carries only opening stock. Closing stock has to enter both statements: as a deduction from cost of goods sold, and as a current asset.
Dr Inventory (balance sheet) ₹2,95,000 · Cr Closing stock (profit and loss) ₹2,95,000
2. Depreciation on plant at 10% straight line on cost, ₹60,000. The asset has been used for a year; the trial balance does not know that yet. The depreciation calculator works out the charge for other rates and methods.
Dr Depreciation ₹60,000 · Cr Accumulated depreciation ₹60,000
3. Salaries for March, ₹35,000, unpaid at the year end. The cost belongs to this year regardless of when it is paid.
Dr Salaries ₹35,000 · Cr Outstanding salaries ₹35,000
4. Insurance of ₹72,000 was paid on 1 October for twelve months. Half of it, ₹36,000, covers the next financial year.
Dr Prepaid insurance ₹36,000 · Cr Insurance ₹36,000
5. A customer owing ₹40,000 has become irrecoverable.
Dr Bad debts ₹40,000 · Cr Trade receivables ₹40,000
6. Interest on the bank loan for the last quarter, ₹27,000, is accrued and unpaid.
Dr Interest ₹27,000 · Cr Outstanding interest ₹27,000
Five of these six exist for one reason: the cash moved in a different period from the event. That is the whole of accrual accounting, and it is why the bank statement never equals the profit.
What a trial balance cannot catch
It is worth being precise about how little the agreement of a trial balance proves, because the reassurance it gives is out of proportion to the evidence.
A trial balance will still balance if a transaction was omitted entirely, because neither side was recorded. It will balance if a transaction was posted to the wrong account of the right type, so a repair charged to plant and machinery passes unnoticed. It will balance if both sides were recorded at the same wrong amount, which is exactly what happens when a figure is misread off an invoice. And it will balance if two separate errors happen to be equal and opposite, which is rarer but does occur in a busy ledger.
What it does catch is a one-sided posting, a transposed figure on one side only, and an addition error. Useful, and much narrower than most people assume. This is why the adjustments above are found by asking questions about the business rather than by staring at the ledger.
Working the adjustments systematically
The six adjustments in this example were not discovered by inspection. They come from running the same short list every period, and the list is shorter than the anxiety around it suggests.
What did we consume but not pay for? Salaries for the final month, interest since the last instalment, electricity billed in arrears, professional fees for work already done. Each one is an accrual.
What did we pay for but not consume? Insurance, annual subscriptions, advance rent, prepaid licences. Each one is a prepayment and belongs partly in the next year.
What do we own that has lost value? Fixed assets need depreciation. Receivables need reviewing for recoverability. Stock needs checking against what it can actually be sold for.
What did we count? Closing inventory comes from a physical count, not from the ledger. If nobody counted, the figure is an estimate and should be described as one.
Four questions, asked in that order, catch the great majority of what a small business needs. The discipline is asking them every period rather than only at year end, because an adjustment found in April is a five-minute entry and the same adjustment found the following March is an archaeology exercise.
The profit and loss account
| Line | ₹ |
|---|---|
| Sales | 24,00,000 |
| Opening inventory | 2,40,000 |
| Add: purchases | 15,60,000 |
| Less: closing inventory | (2,95,000) |
| Cost of goods sold | 15,05,000 |
| Gross profit | 8,95,000 |
| Salaries (4,20,000 + 35,000) | 4,55,000 |
| Rent | 2,40,000 |
| Insurance (72,000 − 36,000) | 36,000 |
| Other expenses | 1,68,000 |
| Depreciation | 60,000 |
| Bad debts | 40,000 |
| Interest | 27,000 |
| Total expenses | 10,26,000 |
| Net loss for the year | (1,31,000) |
Before adjustments the trial balance pointed to a loss of ₹3,00,000, mainly because it charged opening stock with no credit for closing stock. After the adjustments the loss is ₹1,31,000. Nothing about the trading changed; the adjustments simply put costs and stock in the year they belong to.
The balance sheet
| Line | ₹ |
|---|---|
| Plant and machinery, at cost | 6,00,000 |
| Less: accumulated depreciation (1,50,000 + 60,000) | (2,10,000) |
| Net block | 3,90,000 |
| Inventory | 2,95,000 |
| Trade receivables (3,80,000 − 40,000) | 3,40,000 |
| Prepaid insurance | 36,000 |
| Cash and bank | 1,10,000 |
| Total assets | 11,71,000 |
| Capital | 8,00,000 |
| Less: drawings | (1,20,000) |
| Less: loss for the year | (1,31,000) |
| Owner’s equity | 5,49,000 |
| Bank loan | 3,00,000 |
| Trade payables | 2,60,000 |
| Outstanding salaries | 35,000 |
| Outstanding interest | 27,000 |
| Total equity and liabilities | 11,71,000 |
It balances, and this time the balancing means something. Assets of ₹11,71,000 are funded by ₹5,49,000 of owner’s money and ₹6,22,000 of other people’s.
Why the two statements connect
The loss of ₹1,31,000 does not sit in a drawer. It reduces owner’s equity by exactly that amount. Every profit or loss in every period lands in the balance sheet, which is why the two statements cannot be prepared independently and why a balance sheet that will not balance is almost always a profit figure that has not been carried across.
Drawings do the same thing from a different direction. They are not an expense and never touch the profit and loss account; they reduce equity directly.
Three that catch people
Closing stock appears twice. Once reducing cost of goods sold, once as an asset. It looks like double counting and is not: one is the flow, the other the balance.
Prepaid expenses are assets. Insurance paid for next year is a right to cover, not a cost yet.
Accumulated depreciation is a credit balance sitting under assets. It is not a liability. It reduces the asset it relates to.
If your balance sheet is out by an amount, halve it. If the halved figure is a number you recognise, an entry has gone the wrong way round rather than being missing.
Where this fits
- The rule underneath every entry above: debits and credits
- The lesson version: trial balance
- Reading the finished article: how to read a balance sheet
- The third statement: how to read a cash flow statement
- Doing this monthly: month-end close checklist