Calculating an adjusted trial balance is a critical step in the accounting cycle, involving the compilation of all general ledger account balances after applying necessary adjustments that adhere to the accrual basis of accounting. This internal report ensures that all revenues and expenses are recognized in the period they are earned or incurred, regardless of when cash changes hands, providing a true financial picture before the preparation of formal financial statements.
The Step-by-Step Process for Calculating an Adjusted Trial Balance
The process of calculating an adjusted trial balance systematically transforms raw transaction data into a refined financial summary.
Step 1: Record All Transactions
The first step involves meticulously recording all financial transactions throughout an accounting period. This includes sales, purchases, payments, and receipts. Each transaction is initially entered into the general journal as a journal entry, adhering to the double-entry accounting system where every debit has a corresponding credit. These entries are then posted to their respective accounts in the general ledger.
Step 2: Run an Unadjusted Trial Balance
After all routine transactions have been journalized and posted to the general ledger, an unadjusted trial balance is prepared. This preliminary list compiles every general ledger account and its current balance (debit or credit). The primary purpose of this step is to verify that the total of all debit balances equals the total of all credit balances. If they do not match, it indicates an error in recording or posting transactions that must be identified and corrected before proceeding.
Step 3: Make Adjustments to the Balance
This is the most crucial step where the "adjusted" part of the adjusted trial balance comes into play. Adjusting entries are special journal entries made at the end of an accounting period to record revenues earned and expenses incurred that have not yet been recorded. They are vital for compliance with the accrual basis of accounting, ensuring that financial statements accurately reflect a company's financial performance and position. These adjustments modify the balances of existing accounts.
Common Types of Adjusting Entries:
- Accrued Revenues: Revenues that have been earned but for which cash has not yet been received. For example, interest earned on a note receivable or services performed on credit but not yet billed.
- Entry: Debit Accounts Receivable, Credit Revenue Account.
- Accrued Expenses: Expenses that have been incurred but not yet paid or recorded. Common examples include salaries payable, utilities consumed, or interest owed on a loan.
- Entry: Debit Expense Account, Credit Payable Account.
- Deferred Revenues (Unearned Revenue): Cash received in advance for goods or services that have not yet been delivered or performed. As the revenue is earned over time, an adjustment is made.
- Entry: Debit Unearned Revenue, Credit Revenue Account.
- Deferred Expenses (Prepaid Expenses): Payments made in advance for expenses that will be incurred in the future, such as prepaid insurance or rent. As the benefit is consumed, the expense is recognized.
- Entry: Debit Expense Account, Credit Prepaid Expense Account.
- Depreciation Expense: The systematic allocation of the cost of a tangible asset (like equipment or buildings) over its useful life. This recognizes the consumption of the asset's economic benefits.
- Entry: Debit Depreciation Expense, Credit Accumulated Depreciation (a contra-asset account).
Each of these adjusting entries directly impacts the account balances that appeared on the unadjusted trial balance, leading to their "adjustment."
Step 4: Run Your Adjusted Trial Balance
Once all necessary adjusting entries have been journalized and posted to the general ledger accounts, a new trial balance is prepared. This is the adjusted trial balance. It lists all accounts and their balances after the adjustments have been applied. Similar to the unadjusted trial balance, the total debits must equal the total credits. If they do not, it signifies an error in the adjusting entries or their posting. The adjusted trial balance serves as the foundation for preparing the primary financial statements, including the income statement and the balance sheet.
Here's a conceptual example of what an adjusted trial balance might look like:
Account Name | Debit Balance | Credit Balance |
---|---|---|
Cash | $15,000 | |
Accounts Receivable | $3,000 | |
Prepaid Rent | $1,000 | |
Equipment | $20,000 | |
Accumulated Deprec. | $4,000 | |
Accounts Payable | $2,000 | |
Unearned Revenue | $500 | |
Notes Payable | $10,000 | |
Common Stock | $20,000 | |
Retained Earnings | $1,500 | |
Service Revenue | $10,000 | |
Salaries Expense | $3,000 | |
Rent Expense | $1,000 | |
Utilities Expense | $500 | |
Depreciation Expense | $1,000 | |
Total | $44,500 | $44,500 |
Step 5: Post Your Closing Entries
While not directly part of calculating the adjusted trial balance itself, posting closing entries is the subsequent step in the accounting cycle. After the adjusted trial balance confirms the accuracy of account balances for the period, temporary (nominal) accounts—revenues, expenses, and dividends—are closed out to retained earnings. This prepares these accounts for the next accounting period, allowing them to start with a zero balance.
Importance and Benefits
The adjusted trial balance is indispensable because it:
- Ensures Accuracy: It ensures that financial statements accurately reflect the company's financial performance and position by incorporating all revenues earned and expenses incurred during the period.
- Complies with Accrual Accounting: It upholds the accrual basis of accounting, which is required by Generally Accepted Accounting Principles (GAAP).
- Facilitates Financial Reporting: It provides the finalized figures necessary for the preparation of reliable income statements, balance sheets, and statements of cash flows, offering true insights to stakeholders.