chapter 4—completion of the accounting...

Chapter 4—Completion of the Accounting Cycle

Study Objectives:1. Prepare a work sheet.2. Explain the process of closing the books.3. Describe the content and purpose of a post-closing trial balance.4. State the required steps in the accounting cycle.5. Explain the approaches to preparing correcting entries.6. Identify the sections of a classified balance sheet

I. USING A WORK SHEETA. WORK SHEET FORM AND PROCEDURE: the 10-column

Work Sheet (an informal working paper used by the accountant to organize data for the financial statements and lessen the possibility of overlooking an adjustment) has 5 steps to prepare it where each step must be performed in the prescribed sequence. The first two columns show the Trial Balance. When a Work Sheet is used, it is not necessary to prepare a separate trial balance to test the equality of the debits and the credits of the ledger account balances because this is done on the first two columns of the work sheet. Once the accounts are all presented in the work sheet format, it makes it easier to determine what accounts need to be adjusted. Note the columns shown on the work sheet as follows:

Name of the CompanyWork Sheet

For the Period Ended Month, Day, YearAccount

TitlesTrial Balance Adjustments Adj. Trial Balance Income Statement Balance Sheet

Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit

B. Note the characteristics and purposes of a work sheet:1. A work sheet is a multiple-column form that may be used in

the adjustment process, in preparing financial statements, and in the closing of the books process.

2. It is a working tool for the accountant and not a permanent accounting record. The work sheet is not a formal statement, but is a working paper (a tool) for the accountant (no one other than the accountant usually sees it). Therefore it is OK to abbreviate words as long as the full names for accounts are used and capitalization does not matter.

3. Use of a work sheet should make the preparation of adjusting entries and financial statements easier. The work sheet is a useful tool for organizing data and collecting one’s thoughts as to what accounts need to be adjusted (to lessen the possibility of overlooking an adjustment). Since the accounts are all presented on the work sheet it makes it easier to go down through the list of accounts to determine which ones need adjusted or brought up-to-date.

4. The use of a work sheet is optional. Preparation of the work sheet is not mandatory. It is simply something done to make end-of-period

1

work easier and provide an arithmetical check on the accuracy of work. It makes it easier to see the adjustments needed and the balance of the accounts after the adjustment as a check once the entries have been journalized and then posted to the accounts.

5. When one is used, financial statements are prepared from the worksheet. After the work sheet is completed, it summarizes all the information necessary to prepare the financial statements and complete the accounting cycle.

6. Adjustments are journalized and posted from the work sheet after financial statements are prepared. The work sheet is a useful tool as well to journalize the closing entries.

C. Steps in Preparing a Work Sheet.1. Some textbooks use overlays to show the preparation process.

First note the heading of the work sheet:a) First line answers the question Who: Name of the

Company.b) Second line answers the question What: Name of the

report (Work Sheet).c) Third line gives the When: Period of time which the

Work Sheet covers. There is a misconception that since the first columns of the Work Sheet are showing a Trial “Balance” and an Adjusted Trial “Balance” that the “when” would be a single date in time. But that is not correct as the bottom line of the Work Sheet is going to disclose the amount of net income or not loss that the company has generated over the accounting period. Remember that a net income or a net loss is shown on the income statement stating a period of time for which it covers. Think of this that is someone asked, “How much did you make?” The question is not complete until you add the time period: last month, last week, last year, etc. Since the bottom line is intended to disclose the net income or the net loss, then a period of time must be shown.

2. Step 1: Prepare a Trial Balance on the Work Sheet. There are actually 2 formats for preparing a work sheet. The textbook shows the first format but the format that works the best for spreadsheet applications is the second format below as works better when using formulas on work sheets.a) Format #1: All ledger accounts with balances are

entered in the account titles space. 1) Trial balance amounts are taken directly from

ledger accounts.2) If additional accounts are needed for the

adjusting entries, they are inserted on the lines immediately below the trial balance totals.

b) Format #2: Refer to Pioneer Advertising Agency below to show the second format:

2

1) All accounts should be listed in the trial balance, even those with a zero balance. Notice on the work sheet below that there are accounts with zero balances listed on the trial balance. These are the accounts that will be used in the adjusting process and they are listed by their classification which makes it easier to determine how the adjustment will affect the account.

2) Since the first two columns of a work sheet contain a trial balance which will prove the equality of the debit and credit entries in the ledger accounts’ a separate trial balance will not be necessary. So these columns are added at this point and if they do not balance, the same procedures outlined in Chapter 2 need to be used to determine the error and correct it before going any further.

3) The amount in the account with a zero balance can show a zero or have a line drawn straight through the account that shows it does not have a balance. The first step in the preparation of a work sheet is accomplished under Format #2:

Pioneer Advertising AgencyWork Sheet

For the Month Ended October 31, 20--Account

TitlesTrial Balance Adjustments Adj. Trial Balance Income Statement Balance Sheet

Debit Credit Debit Credit Debit Credit Debit Credit Debit CreditCash 15,200AcctsRec. 0AdvertSup 2,500Prepd Ins. 600Off.Equip 5,000A/D OffEq 0Notes Pay. 5,000Accts.Pay. 2,500Interest Pay 0UnearnRev 1,200Sal. Pay. 0CRB, Cap.. 10,000CRB, Draw 500Ser.Rev. 10,000Sal. Exp. 4,000Rent.Exp. 900Adv,SupExp. 0Ins.Exp. 0DepEx. OE 0Interest Exp 0 Totals 28,700 28,700

4) Note the bold line that was drawn (NOT done on an actual work sheet) that shows the separation of the balance sheet accounts (as well as owner’s equity) from the income statement accounts. This is an advantage of Format #2 as the accounts needed for the various financial statements appear together which helps not to forget any when preparing them.

3. Step 2: Enter the Adjustments in the Adjustments Columns.

3

a) Enter adjustment amounts in appropriate columns, and use letters to cross reference the debit and credit adjustments. . Letters are used to show which account is debited and which account is credited for each adjustment. Notice how the adjustments for the (a) supplies used; (b) insurance expired, (c) depreciation of office equipment (d) unearned revenue that now has been earned are handled; and for the (e) service revenue accrued, (f) interest accrued, and (g) salaries accrued but not received or paid as yet are handled in the adjustments columns.

b) Total adjustments columns and check for equality. After the adjustments are entered, the adjustments columns need to be added to determine at this point if there is an equal amount of debits and credits:


For the Month Ended October 31, 20--Account Titles Trial Balance Adjustments Adj. Trial

BalanceIncome

StatementBalance Sheet

Debit Credit Debit Credit Debit Credit Debit Credit Debit CreditCash 15,200AcctsRec. 0 (e) 200AdvertSup 2,500 (a)1500Prepd Ins. 600 (b) 50Off.Equip 5,000A/D OffEq 0 (c ) 40Notes Pay. 5,000Accts.Pay. 2,500Interest Pay 0 (f) 50UnearnRev 1,200 (d) 400Sal. Pay. 0 (g)1200CRB, Cap.. 10,000CRB, Draw 500Service.Revenue. 10,000 (d)(e)

600Sal. Exp. 4,000 (g)1200Rent.Exp. 900Adv,SupExp. 0 (a)1500Ins.Exp. 0 (b) 50DepEx. OE 0 (c ) 40Interest Exp 0 (f) 50 Totals 28,700 28,700 3,440 3,440

4. Step 3: Enter the Adjusted Balances in the Adjusted Trial Balance.a) Combine trial balance amounts with adjustment amounts

to obtain the adjusted trial balance. To complete the adjusted trial balance, the original trial balance total needs to reflect the debit or credit that was made with the adjusting entry if there is one. The assets which have a debit balance would add any entries in the debit column of the adjustments column and subtract any credits to the adjustments column. The contra asset accounts (those with credit balances) would add the

4

amounts in the credit column under the adjustments as those would increase those accounts; the liability accounts would add any credit entries in the credit column of the adjustment and subtract any debit entries there; the capital and drawing accounts should not be adjusted so the amounts would carry over to the adjusted trial balance; the revenue accounts would add any credit and deduct any debits under the adjustments columns and the expenses would add any entries in the debit adjustments columns and subtract any credits in the adjustments column

b) Total adjusted trial balance columns and check for equality. Again the equality of the debits and credits are proven by adding up the column totals:



TitlesTrial Balance Adjustments Adj. Trial

BalanceIncome Statement Balance Sheet

Debit Credit Debit Credit Debit Credit Debit Credit Debit CreditCash 15,200 → → → 15,200AcctsRec. 0 → (e) 200 → 200AdvertSup 2,500 → → (a)1500 1,000Prepd Ins. 600 → → (b) 50 550Off.Equip 5,000 → → → 5,000A/D OffEq 0 → (c ) 40 → 40Notes Pay. 5,000 → → → 5,000Accts.Pay. 2,500 → → → 2,500Interest Pay 0 → (f) 50 → 50UnearnRev 1,200 (d) 400 → → 800Sal. Pay. 0 → (g)1200 → 1,200CRB, Cap.. 10,000 → → → 10,000CRB, Draw 500 → → → 500Ser.Rev. 10,000 → (d)(e)

600→ 10,600

Sal. Exp. 4,000 → (g)1200 → 5,200Rent.Exp. 900 → → → 900Adv,SupExp. 0 → (a)1500 → 1,500Ins.Exp. 0 → (b) 50 → 50DepEx. OE 0 → (c ) 40 → 40Interest Exp 0 → (f) 50 → 50 Totals 28,700 28,700 3,440 3,440 30,190 30,190

5. Step 4: Extend the Adjusted Trial Balance Amounts to the Appropriate Financial Statements. a) Extend all revenue and expense account balances to the

income statement columns. Follow the arrows to see how the accounts moves across the page to either end up on the balance sheet OR the income statement The income statement has only revenue and expense accounts.

b) Extend all asset and liability account balances, as well as owner’s capital and drawing account balances, to the balance sheet columns. Follow the arrows to see how the accounts moves across the page to either end up on the balance sheet OR the income statement.

5

The OR is emphasized as from the adjusted trial balance, a number will end up on the BALANCE SHEET OR on the INCOME STATEMENT. There should NOT be any numbers on both the balance sheet and the income statement. The heavy line after the owner’s drawing account is show the dividing line between the numbers that end on the Balance Sheet and those that end up on the income statement. The balance sheet has the assets, the liabilities, and the owner’s equity including owner’s capital, and owner’s drawing accounts.

c) The columns are totaled but NOTE at this point they do NOT BALANCE. Total the income statement columns and the balance sheet columns. Both the income statement columns and the balance sheet columns should be out of balance by the same amount. See example above that the difference between the income statement columns is $2,860 and the difference between he balance sheet totals is $2,860.





Debit Credit Debit Credit Debit Credit Debit Credit Debit CreditCash 15,200 → → → 15,200 → → → 15,200AcctsRec. 0 → (e) 200 → 200 → → → 200AdvertSup 2,500 → → (a)1500 1,000 → → → 1,000Prepd Ins. 600 → → (b) 50 550 → → → 550Off.Equip 5,000 → → → 5,000 → → → 5,000A/D OffEq 0 → (c ) 40 → 40 → → → 40Notes Pay. 5,000 → → → 5,000 → → → 5,000Accts.Pay. 2,500 → → → 2,500 → → → 2,500Interest Pay 0 → (f) 50 → 50 → → → 50UnearnRev 1,200 (d) 400 → → 800 → → → 800Sal. Pay. 0 → (g)1200 → 1,200 → → → 1,200CRB, Cap.. 10,000 → → → 10,000 → → → 10,000CRB, Draw 500 → → → 500 → → → 500Ser.Rev. 10,000 → (d)(e)

600→ 10,600 → 10,600

Sal. Exp. 4,000 → (g)1200 → 5,200 → 5,200Rent.Exp. 900 → → → 900 → 900Adv,SupExp. 0 → (a)1500 → 1,500 → 1,500Ins.Exp. 0 → (b) 50 → 50 → 50DepEx. OE 0 → (c ) 40 → 40 → 40Interest Exp 0 → (f) 50 → 50 → 50 Totals 28,700 28,700 3,440 3,440 30,190 30,190 7,740 10,600 22,450 19,590

6. Step 5: Total the Statement Columns, Compute the Net Income (or Net Loss), and Complete the Work Sheet:a) The difference between the totals of the two income

statement columns determines net income or net loss. Determine the difference between both sets of totals. Actually find the difference in the income statement and determine if that balance will complete the balance sheet so that it will balance. You subtract the smaller total from the

6

larger total and the difference goes on the shortest side of the income statement.

b) Net income is extended to the credit column of the balance sheet columns. (Net loss would be extended to the debit column): You subtract the smaller total from the larger total and the difference goes on the shortest side of the income statement and then take it to the balance sheet shortest side to see if it will balance the balance sheet. This is a check figure when it balances that the numbers have been carried across to the right areas with the right amounts.

c) Record the net income or loss figure, Add the columns down, and rule them. As you can see, a net income figure appears on the debit column of the income statement and the credit column of the balance sheet. The reason it shows on the credit column of the balance sheet is that a net income increases owner’s capital and owner’s capital increases on the credit side. Note that owner’s capital is bolded to emphasize why the net income appears on the credit side of the balance sheet columns. A net income example below:





Debit Credit Debit Credit Debit Credit Debit Credit Debit CreditCash 15,200 → → → 15,200 → → → 15,200AcctsRec. 0 → (e) 200 → 200 → → → 200AdvertSup 2,500 → → (a)1500 1,000 → → → 1,000Prepd Ins. 600 → → (b) 50 550 → → → 550Off.Equip 5,000 → → → 5,000 → → → 5,000A/D OffEq 0 → (c ) 40 → 40 → → → 40Notes Pay. 5,000 → → → 5,000 → → → 5,000Accts.Pay. 2,500 → → → 2,500 → → → 2,500Interest Pay 0 → (f) 50 → 50 → → → 50UnearnRev 1,200 (d) 400 → → 800 → → → 800Sal. Pay. 0 → (g)1200 → 1,200 → → → 1,200CRB, Cap.. 10,000 → → → 10,000 → → → 10,000CRB, Draw 500 → → → 500 → → → 500Ser.Rev. 10,000 → (d)(e)

600→ 10,600 → 10,600

Sal. Exp. 4,000 → (g)1200 → 5,200 → 5,200Rent.Exp. 900 → → → 900 → 900Adv,SupExp. 0 → (a)1500 → 1,500 → 1,500Ins.Exp. 0 → (b) 50 → 50 → 50DepEx. OE 0 → (c ) 40 → 40 → 40Interest Exp 0 → (f) 50 → 50 → 50 Totals 28,700 28,700 3,440 3,440 30,190 30,190 7,740 10,600 22,450 19,590Net Income → → → → → → 2,860 2,860

10,600 10,600 22,450 22,450

For a work sheet showing a net loss example, you would add the columns down, and rule them. A net loss figure appears on the credit column of the income statement and the debit column of the balance sheet. The reason it shows on the debit column of the

7

balance sheet is that a net loss decreases owner’s capital and owner’s capital decreases on the debit side.

The work sheet can be computerized using an electronic spreadsheet program (Excel, for example) where formulas can be entered that will speed up the process of preparing a work sheet to just a few minutes. A tremendous advantage of an electronic work sheet is the ability to change data easily. When preparing an electronic work sheet using formulas, the formulas are entered in the template and then the template can be copied over and over for later use for each period’s preparation of a new work sheet.

D. Preparing Financial Statements from a Work Sheet. All figures for the financial statements are on the work sheet. Using a work sheet, financial statements can be prepared before adjusting entries are journalized and posted. However, the completed work sheet is not a substitute for formal financial statements. Data in the financial statement columns of the work sheet are not properly arranged for statement purposes. A work sheet is essentially a working tool of the accountant; it is not distributed to management or other parties.1. Income Statement --use the figures from the income

statement columns of the work sheet:a) Heading: shows Who (name of the company; What (name

of the statement); and When (period of time) which is stated: “For the Period (Month, Quarter, Year, etc.) Ended Month, Day, Year.”

b) Only capitalize the first word on a line. Note that there is an error on the handout example as the word, “revenue,” after the word, “Service,” should NOT be capitalized as shown in the text example.

c) Individual revenue and expense items are indented (use the increase indent button and click once) after the word “Revenue:” and “Expenses:” with a colon is entered to indicate to look what follows.

d) Remember that revenues (if more than one) and expenses are listed in the order of magnitude (largest to smallest).

e) Note that there are no abbreviations on the statement.f) Words must be spelled correctly (use Excel’s spell

checker feature) for full points on the statement.

2. Owner’s Equity or Statement of Retained Earnings:a) Heading: shows Who (name of the company; What (name

of the statement); and When (period of time). .b) Only the first word on a line is capitalized unless it is a

proper noun and note that no abbreviations are used.c) The beginning capital or retained earnings shows the

date at the beginning of the period (month, day, year). The amount shown for owner’s capital or retained earnings on the work sheet is the account balance before considering drawings (dividends) and net income (or loss).

8

d) The net income or net loss figure is brought it from the Income Statement to be added (net income) or subtracted (net loss) from the beginning capital or retained earnings.

e) “Less: Drawings “or “Less: Dividends” shows the amount from the owner’s drawing account or the dividends account.

f) The ending capital is indicated by listing the owner’s name as given or retained earnings and the date at the end of the period (month, day, year).

3. Balance sheet: a) Assets and liabilities are listed in the appropriate

column.b) The first column is used to show the long-term assets.c) Accumulated depreciation is shown as a deduction from

the related asset and is under the asset. d) The book value (original cost minus accumulated

depreciation) of the long-term asset is listed with the other assets in the appropriate column.

e) “Total assets” is shown in the appropriate column.f) The new capital figure is taken from the owner’s equity

statement (or retained earnings from the Statement of Retained Earnings) is listed in the appropriate column.

g) Total liabilities and owner’s (stockholders’) equity appears in the appropriate column.

h) Only the first word on a line is capitalized and there are no abbreviations on the balance sheet.

E. Preparing Adjusting Entries from a Work Sheet. The entries have already been worked out while preparing the work sheet. So it is just a matter of transferring the numbers from the adjustment columns of the work sheet to a general journal. A work sheet is not a journal, and it cannot be used as a basis for posting to ledger accounts. The adjusting entries are prepared from the adjustments columns of the work sheet. The numbers are taken in order so that none are left out beginning with the (a) and continuing until all the adjustments have been entered into the journal.

II. CLOSING THE BOOKS—the process of transferring the balances of temporary accounts to the owner’s capital account or retained earnings, a permanent account.A.

1. Define temporary accounts. Revenue, expense, and drawing accounts are temporary accounts used to show changes in owner’s equity during a single fiscal period. When that period is over, the balances of all temporary accounts are summarized, and the information is transferred to the owner’s capital account. Temporary accounts are also called nominal accounts.

9

2. The permanent or real accounts are assets, liabilities, and owner’s capital because their balances will be carried into the next accounting period.

3. Below are the T-accounts for Pioneer Advertising Agency with the balances in the accounts with after adjusting entries have been posted to helping understanding the closing process. Below the temporary accounts have been highlighted that need to be closed at the end of the accounting period:

Assets = Liabilities + Owner’s Equity + Revenues - Expenses+ - - + - + - + + -

Cash Notes Payable C. R. Byrd, Capital ServiceRev Adv. Sup. Exp.15,200 3,000 10,000 10,600 1,500

Accts.Rec. Accts. Payable C.R. Byrd Drawing Depr. Exp.200 210 500 40

Int. PayableAdver. Sup. Insur. Exp.1,000 Unearn. Rev. 50

Prepd Ins. Salar. Payable Salaries Exp.550 5,200

Off. Equip. Rent Exp. 5,000 900A/D-Off. Eq.

40 Interest Exp.

50

B. Describe the objectives of the closing process. 1. To reduce the balances of the temporary owner’s equity accounts to

zero and thus make the accounts ready for entries in the next accounting period. The normal accounting period is one year because tax returns need to be prepared ever year. Therefore, the amounts are there for the tax return for the current year and then these temporary accounts are reduced to zero so are ready to accumulate amounts for the next year for the next year’s tax return. Also the accounts are zero to follow the matching principle of accounting so that revenues and expenses are reported in the same accounting period so do not want to mix accounting period together.

2. To update the balance of the owner’s capital or retained earnings account. The owner’s capital and the retained earnings are permanent accounts that show the owner’s right or claims to the assets and will be carried forward to the new year.

10

C. Describe the Income Summary account—a clearing account used to summarize the balances of revenue and expense accounts (Hence, the name Income summary). A clearing account is an account used to summarize (clear out) the balances of other accounts. The Income Summary account is used only at the end of the period and is opened and closed during the process. Note that the Income Summary below in located in the Owner’s (Stockholders’) Equity section of the accounting equation to emphasize that this account will be closed to the owner’s capital or retained earnings account which are permanent owner’s equity accounts Some points that should be noted about the Income Summary account are:1. It does not have a “normal” balance as other accounts do. It is just a

clearing account used to close the balances of revenue and expense accounts.

2. The use of the Income Summary account avoids the unnecessary detail of closing revenue and expense accounts directly into the owner’s capital account.

3. Income Summary will never appear on the financial statements.

D. Identify the four steps in the closing process, and describe the entries needed to accomplish them. The acronym REID (pronounced read) will be used to help remember the 4-step closing process. To close an account so that it will end up with a zero balance, you do the exact opposite of what is in the account. To close an account with a credit balance, you make an equal debit; to close an account with a debit balance, you make an equal credit.1. Close the balance of each Revenue account to the Income Summary

account. Debit each revenue account; credit the Income Summary account for the total of all the revenue accounts. Note that since Pioneer Advertising Agency has only one revenue account, there is only one debit amount for service revenue and the credit to Income Summary. But if there were more than one revenue account, then a compound entry would be made with a debit to each revenue account and one credit to income summary for the total of the revenue accounts. Below the entry is shown in the T-accounts with the numbers in bold and highlighted which reduces the revenue account to zero where a line in both the debit and credit balance columns indicates that there is now not a debit or a credit balance:


Cash Notes Payable C. R. Byrd, Capital ServiceRev Adv. Sup. Exp.

15,200 3,000 10,000 10,600 10,600 1,500

-- --

Accts.Rec. Accts. Payable C.R. Byrd Drawing Depr. Exp.200 210 500 40

Int. PayableAdver. Sup. Income Summary Insur. Exp.

11

1,000 Unearn. Rev. 10,600 50

Prepd Ins. Salar. Payable Salaries Exp.550 5,200

Off. Equip. Rent Exp. 5,000 900A/D-Off. Eq.

40 Interest Exp.

50

2. Close the balance of each Expense account to the Income Summary account. Debit the Income Summary account for the total of all the expense account balances; credit each expense account. Below the entry is shown in the T-accounts with the numbers in bold and highlighted which reduces the expense accounts to zero where a line in both the debit and credit balance columns indicates that there is now not a debit or a credit balance: Note how the Income Summary account is debited for the total 7,740 (1,500 + 40 + 50 + 5,200 + 900 + 50) of all the expense accounts.


Cash Notes Payable C. R. Byrd, Capital Service Rev Adv. Sup. Exp.15,200 3,000 10,000 10,600 10,600 1,500 1,500

-- -- -- --Accts.Rec. Accts. Payable C.R. Byrd Drawing Depr. Exp.200 210 500 40 40

Int. Payable -- --Adver. Sup. Income Summary Insur. Exp.1,000 Unearn. Rev. 7,740 10,600 50 50

-- --Prepd Ins. Salar. Payable Salaries Exp.550 5,200 5,200

-- --Off. Equip. Rent Exp. 5,000 900 900A/D-Off. Eq. -- --

40 Interest Exp.

50 50-- --

3. Close the balance of the Income Summary account to the owner’s capital or retained earnings account. The balance of the Income Summary account is the net income or loss. Debit the Income Summary account and credit the capital account or retained earnings; reverse if a net loss. First, you must determine the balance in the income

12

summary account. Since Pioneer Advertising Agency have a net income, income summary has a credit balance of 2860. To CONFIRM that all the revenue and expense accounts were properly closed, compare the balance of the income summary account to the net income or net loss amount on the Income Statement that was prepared for the company. Below the entry is shown in the T-accounts with the numbers in bold and highlighted which reduces the income summary account to zero where a line in both the debit and credit balance columns indicates that there is now not a debit or a credit balance.


Cash Notes Payable C. R. Byrd, Capital Service Rev Adv. Sup. Exp.15,200 3,000 10,000 10,600 10,600 1,500 1,500

2,860 -- -- -- --Accts.Rec. Accts. Payable C.R. Byrd Drawing Depr. Exp.200 210 500 40 40


Clo. 2,860 2,860 Bal. -- --Prepd Ins. Salar. Payable -- -- Salaries Exp.550 5,200 5,200

-- --Off. Equip. Rent Exp. 5,000 900 900A/D-Off. Eq. -- --

40 Interest Exp.

50 50-- --

4. Close the balance of the owner’s Drawing or Dividends account to the owner’s capital or retained earnings account. Debit the capital or retained earnings account; credit the drawing or dividend account. The balance of the capital or retained earnings account now agrees with the final figure on the statement of owner’s equity or the statement of retained earnings. Below the entry is shown in the T-accounts with the numbers in bold and highlighted which reduces the drawing account to zero where a line in both the debit and credit balance columns indicates that there is now not a debit or a credit balance. After the last closing entry, the balance of the capital account is calculated. NOTE that the capital or retained earnings account is not zero as these accounts are permanent accounts and will carry this balance forward into the new year. Also NOTE that none of the assets or liabilities were closed during the closing process as these accounts are permanent accounts that will carry their balances forward into the new year.

13


Cash Notes Payable C. R. Byrd, Capital Service Rev Adv. Sup. Exp.15,200 3,000 500 10,000 10,600 10,600 1,500 1,500

2,860 -- -- -- --12,360

Accts.Rec. Accts. Payable C.R. Byrd Drawing Depr. Exp.200 210 500 500 40 40


2,860 2,860 -- --Prepd Ins. Salar. Payable -- -- Salaries Exp.550 5,200 5,200

-- --Off. Equip. Rent Exp. 5,000 900 900A/D-Off. Eq. --

40 Interest Exp.

50 50-- --

E. Keep in mind that closing the income summary account depends on whether the business has a net income or a net loss. If the company has a net income, income summary will be debited and the owner’s capital or retained earnings will be credited. But if the company has a net loss, the income summary will be credited and owner’s capital or retained earnings will be debited.

F. Closing Entries Illustrated1. Journalizing the closing entries from a work sheet.

a) The Work Sheet is very useful when preparing closing entries, because up-to-date balances of all temporary accounts are clearly shown together in one place. Refer to page 144 with the last overlay (Illustration 4-3D) of the textbook and the last 4 columns of the work sheet shown below. Only the last 4 columns are referred to as those are the columns that contain the numbers needed for the closing entries. Again use the acronym REID to remember the 4-steps in the closing process:

b) Step 1—Close the balance of each Revenue account to the Income Summary account. To locate all the revenue accounts, you look at all the numbers in the credit column of the Income Statement columns on the work sheet. Below is the partial work sheet with the journal entry below showing how entered into there:

PIONEER ADVERTISING AGENCY

14

Work SheetFor the Month Ended October 31, 20--

Income Statement Balance SheetAccount Name Debit Credit Debit Credit

Cash 15,200Accts. Receivable. 200Advert. Supplies 1,000Prepaid Insurance. 550Office Equip. 5,000Accum. Depr. Off. Eq 40Notes Payable 5,000Accts. Payable 2,500Interest Payable 50Unearned Revenue 800Salaries Payable 1,200C.R. Byrd, Capital 10,000C.R. Byrd, Drawing 500Service Revenue 10,600Salaries Expense 5,200Rent Expense 900Advert. Sup. Expense 1,500Insurance Expense 50Depr. Exp. Off. Eq. 40Interest Expense 50

Totals 7,740 10,600 22,450 19,590Net Income 2,860 2,860

10,600 10,600 22,450 22,450

Note: the words, “Closing Entries,” head the closing entries where explanations are not needed but optional when you distinguish these type of entries:

General Journal Page 3Date Account Title P.R. Debit Credit20-- Closing Entries

Oct. 31 Service Revenue 10,600 Income Summary 10,600

c) Step 2—Close the balance of each Expense account to the Income Summary account. To locate all the expense accounts, you look at all the numbers in the debit column of the Income Statement columns on the work sheet. . Below is the partial work sheet with the journal entry below showing how entered into there and note that the expenses are entered in the journal in the order that they are appear on the work sheet to prevent omitting any accounts:

PIONEER ADVERTISING AGENCYWork Sheet

For the Month Ended October 31, 20--Income Statement Balance Sheet

Account Name Debit Credit Debit CreditCash 15,200

15

Accts. Receivable. 200Advert. Supplies 1,000Prepaid Insurance. 550Office Equip. 5,000Accum. Depr. Off. Eq 40Notes Payable 5,000Accts. Payable 2,500Interest Payable 50Unearned Revenue 800Salaries Payable 1,200C.R. Byrd, Capital 10,000C.R. Byrd, Drawing 500Service Revenue 10,600Salaries Expense 5,200Rent Expense 900Advert. Sup. Expense 1,500Insurance Expense 50Depr. Exp. Off. Eq. 40Interest Expense 50


10,600 10,600 22,450 22,450



31 Income Summary 7,740 Salaries Expense 5,200 Rent Expense 900

Advert. Supplies Expense 1,500 Insurance Expense 50 Depr. Expense—Office Equip. 40 Interest Expense 50

d) Step 3—Close the balance of the Income Summary account to the owner’s capital account. To locate the balance in the Income Summary account, you look at the net income (2,860 for Pioneer Advertising Agency) or net loss amount that is at the bottom of the income statement columns of the work sheet before the final totals. Actually the T-account for the income summary account is actually shown on the income statement columns because the total debit column (7,740) is the debit entry into the income summary account and the total credit column (10,600) is the credit entry into the income summary account. Therefore, the balance at this point in the Income Summary account is the difference between the credit

16

of $10,600 and the debit of $7,749 which is the net income figure of $2,860 as a credit balance in the Income Summary account. To close, then, the Income Summary account requires a debit of $2,860. Below is the partial work sheet with the journal entry below showing how entered into there:



Account Name Debit Credit Debit CreditCash 15,200Accts. Receivable. 200Advert. Supplies 1,000Prepaid Insurance. 550Office Equip. 5,000Accum. Depr. Off. Eq 40Notes Payable 5,000Accts. Payable 2,500Interest Payable 50Unearned Revenue 800Salaries Payable 1,200C.R. Byrd, Capital 10,000C.R. Byrd, Drawing 500Service Revenue 10,600Salaries Expense 5,200Rent Expense 900Advert. Sup. Expense 1,500Insurance Expense 50Depr. Exp. Off. Eq. 40Interest Expense 50


10,600 10,600 22,450 22,450





31 Income Summary 2,860 C.R. Byrd, Capital 2,860

17

e) Step 4—Close the balance of the owner’s Drawing account to the owner’s capital account. To locate the balance in the drawing account, you look for the amount on the debit column of the Balance Sheet columns of the work sheet. Below is the partial work sheet with the journal entry below showing how entered into there:



Account Name Debit Credit Debit CreditCash 15,200Accts. Receivable. 200Advert. Supplies 1,000Prepaid Insurance. 550Office Equip. 5,000Accum. Depr. Off. Eq 40Notes Payable 5,000Accts. Payable 2,500Interest Payable 50Unearned Revenue 800Salaries Payable 1,200C.R. Byrd, Capital 10,000C.R. Byrd, Drawing 500Service Revenue 10,600Salaries Expense 5,200Rent Expense 900Advert. Sup. Expense 1,500Insurance Expense 50Depr. Exp. Off. Eq. 40Interest Expense 50


10,600 10,600 22,450 22,450





18


31 C.R. Byrd, Capital 500C.R. Byrd, Drawing 500

Below is an example of a company with a net loss (Taylor and Associates) which would be journalized below the partial work sheet illustrating that the difference is Step 3 of the closing process because Income Summary will have a debit balance of $555 prior to closing and therefore it will require that that the Income Summary account is credited to close and the capital account will be debited as a net loss decreases owner’s equity illustrated as follows:

Taylor and AssociatesWork Sheet

For the Month Ended December 31, 20--Income Statement Balance Sheet

Account Name Debit Credit Debit CreditCash 5,485Accts. Receivable. 300Office Supplies 230Prepaid Insurance. 220Office Equip. 3,000Accum. Depr. Off. Eq 50Off ice Furniture 2,000Acc.Depr. Office Furn. 30Accts. Payable 3,000Salaries Payable 210W. Taylor, Capital 10,000W. Taylor, Drawing 1,500Service Revenue 1,700Rent Expense 800Repairs Expense 50Salaries Expense 1,260Office Sup Expense 45Insur. .Expense 20Depr. Exp. Off. Eq. 50Depr. .Exp. Off. Furn. 30

Totals 2,255 1,700 12,735 13,290Net Loss 555 555

2,255 2,255 13,290 13,290


Dec. 31 Service Revenue 1,700 Income Summary 1,700

31 Income Summary 2,255 Rent Expense 800 Repairs Expense 50

19

Salaries Expense 1,260 Office Supplies Expense 45 Insurance Expense 20 Depr. Expense—Office Equip. 50 Depr. Expense—Office Furn. 30

31 William Taylor, Capital 555 Income Summary 555

31 William Taylor, Capital 1,500 William Taylor, Drawing 1,500

Below shows Pioneer Advertising Agency Adjusting Entries (Chapter 3) journalized from the adjustments columns of the work sheet by letter entered with the Closing Entries (Chapter 4) journalized from the income statement and balance sheet columns of the work sheet illustrating that these entries can all be entered on the same journal page with the respective titles for each section.

General Journal Page 3Date Account Title P.R. Debit Credit20-- Adjusting Entries

Oct. 31 Advert. Supplies Expense 1,500 Advert. Supplies 1,500

31 Insurance Expense 50 Prepaid Insurance 50

31 Depr. Expense—Office Equip. 40 Accum. Depr.—Office Equip. 40

31 Unearned Revenue 400 Service Revenue 400

31 Accounts Receivable 200 Service Revenue 200

31 Interest Expense 50 Interest Payable 50

31 Salaries Expense 1,200 Salaries Payable 1,200

Closing Entries31 Service Revenue 10,600

Income Summary 10,600

20




31 C.R. Byrd, Capital 500 C.R. Byrd, Drawing 500

NOTE: The 4 steps (REID) in the closing process produce only 4 journal entries. A typical student misconception is that every separate revenue and every separate expense require a separate journal entry to close rather than making one compound journal entry for all revenues and one compound journal entry for all expenses. Doing separate entries defeats the purpose of having an income summary account. Another typical error when closing more than one revenue and closing the expense accounts is to just enter the word, “Revenues,” as a debit to close the total revenues into the journal for the first entry and enter the word, “Expenses,” as the credit to close all the expenses for the second entry. Remember all the accounts need to be posted to the general ledger to form an audit trail so all accounts must be listed in the general journal and posted to the general ledger as shown in the post reference column of the journal and the ledger.

G. Posting Closing Entries1. Refer to example in the textbook showing the T-accounts used in the

closing process:a) Note that all temporary accounts (revenues, expenses, and

owner’s drawing or dividends) have zero balances after posting the closing entries.

b) All permanent accounts (assets, liabilities, and owner’s capital or retained earnings) are not closed.

c) Also, the balance is the owner’s capital account or retained earnings represents the amount shown as the ending capital on the owner’s equity statement and the owner’s capital shown on the balance sheet or the ending retained earnings on the statement of retained earnings and the retained earnings on the balance sheet.

d) The Income Summary account is used only in closing to clear out the revenue and expenses and then net income (or net loss) for the period.

2. Only the permanent accounts after closing will have balances in the general ledger:a) Note that the only words that you see in the

Explanation column (NOT for an “explanation” but only to

21

identify special types of postings) of the General Ledger are the words, “Balance, “or “Adjusting,”or “Closing”(“Adjusting” or “Closing” are needed to identify these special type of postings in the General Ledger) Below is the example of one account with an adjusting entry, closing entry, and showing how the line across the “balance” columns showing that the account is closed or the account can show a 0.

General Ledger (partial)Advertising Supplies Expense No.631

Date Explanation P.R. Debit (+) Credit (-) Balance20--

Dec. 31 Adjusting J2 1,500 1,50031 Closing J3 1,500 ---

b) The ledger account for the owner’s, capital or retained earnings has the word, “Closing” entered for entries posted into the account. Those words are entered there to alert the reader that these entries are closing entries, but the capital or retained earnings account was NOT CLOSED.

H. Preparing a Post-Closing Trial Balance. Only the permanent accounts appear on the post-closing trial balance because it is prepared after the closing entries have been posted. Its purpose:1. to prove the equality of the permanent (or balance sheet) account

balances that are carried forward into the next accounting period to make sure that the ledger will be in balance at the start of the next accounting period.

2. to provide evidence that the journalizing and posting of the closing entries have been properly completed as only permanent accounts should appear on the post-closing trial balance and if any temporary accounts are shown then all closing entries were NOT properly completed.

3. to show that the accounting equation is in balance at the end of the accounting period but does NOT prove that ALL transactions have been recorded or that the ledger is correct (as would be the case with any type of trial balance).

III. SUMMARY OF ACCOUNTING CYCLE:A. The following are steps in the accounting cycle are performed in

sequence and are repeated in each accounting period:

1. Analyze transactions form source documents;

2. Record (journalize) the transactions in a journal;

3. Post to ledger accounts;

22

4. Prepare a trial balance;

5. Determine the needed adjustments;

6. Prepare a work sheet (optional step) journalizing and posting adjusting entries (prepayments or deferrals and accruals) and preparing an adjusted trial balance

7. Prepare financial statements;

8. Journalize and post closing entries;

9. Prepare a post-closing trial balance; and10. Prepare reversing entries (optional step)—see discussion below.

B. Journalizing and posting the closing entries and preparing the post-closing trial balance are usually prepared ONLY AT THE END OF A COMPANY’S ANNUAL ACCOUNTING PERIOD.

C. Correcting Entries—an avoidable step:1. They need to be prepared when errors have been made as

soon as the errors are discovered by journalizing and posting correcting entries.

2. Differences between adjusting and correcting entries:a) Adjusting entries are an integral (necessary) part of the

accounting cycle; correcting entries only need to be made if errors have been made.

b) Adjusting entries are journalized and posted only at the end of the accounting period; correcting entries are made whenever an error is discovered.

c) Adjusting entries ALWAYS affect one balance sheet and one income statement account; correcting entries may involve any combination of accounts in need to correction. Correcting entries MUST BE POSTED BEFORE CLOSING ENTRIES.

3. To determine the correcting entry, it is useful to compare the incorrect entry with the correct entry so that only the accounts that should be corrected are involved in the correcting entry:a) The most efficient correcting entry is NOT

REVERSING the incorrect entry and then making a correct entry but 1) Comparing the incorrect entry with the correct

entry and then;2) Determining which accounts and amounts need

to be corrected; and 3) Recording only one correcting entry to correct the

amounts in just the accounts that are incorrect.

23

IV. CLASSIFIED BALANCE SHEET—a balance sheet that divides the assets and liabilities sections into standard classifications or sections as shown on handout, STANDARD CLASSIFICATIONS and will be used from now on as this format gives the user (management, creditors, potential investors, etc.) more useful information about the company and allows ratios to be computed to properly analyze the company.A. The two formats of the classified balance sheet:

1. Account form —where the assets section is placed on the left and the liabilities and owner’s equity on the right side as with the accounting equation which is why it is called the “account” form.

2. Report form —where the assets are listed above the liabilities and owner’s equity sections which is the form, most often presented as it is like reading a report from top to bottom.

B. ONLY THE FIRST WORD ON THE LINE IS CAPITALIZED UNLESS IT FOLLOWS A COLON and the rule for abbreviations is this: only abbreviate when it is necessary as the description column is shorter when there is a 3-column format so on some lines, you may have to abbreviate but if there is room on a line as is usually the case with an Excel template where columns can be increased, DO NOT ABBREVIATE).

C. The "classifications" occur in the ASSETS and LIABILITY sections as follows:

1. ASSETS are classified into the following sections.a) Current assets are resources at are cash, expected to be realized

in cash (like receivables), sold (like inventory), or consumed or used (like supplies, prepaid insurance, etc.) in within one year of the balance sheet date or the company’s operating cycle, whichever is longer. An operating cycle of a company is the average time that is required to go from cash to cash in producing revenues—to make and sell the product or service which can turn into a receivable and finally into cash.1) The common types of current assets that are customary in a

service enterprise.2) These items are listed in order of liquidity—how fast can

turn into cash or use (if not intended to turn into cash as with prepaid expenses). The prepaid expenses (prepaid insurance, supplies, etc.) are listed last and one prepaid expense is NO MORE LIQUID than another so they are usually listed how they appear in the general ledger accounts.

24

b) Long-Term Investments (not shown in the textbook)are resources not expected to be realized in cash within the next year or operating cycle and are not intended for use or consumption within the business but held for investment such as stock and bonds in other corporations.

c) Property, Plant, and Equipment (Plant Assets)are tangible resources of a relatively permanent nature (long-term), that are used in the business and not intended for sale (such as inventory).1) These assets are subject to depreciation except for land.2) These assets should be reported at cost less accumulated

depreciation (book value).d) Intangible assets (not shown in the textbook) are noncurrent

resources that do not have physical substance.1) These assets give the holder exclusive right of use for a

specified period of time. Their value to a company is generally derived from the rights or privileges granted by governmental authority.

2. LIABILITIES are classified into the following sections:a) Current liabilities are obligations (debts) that are reasonably

expected to be paid from existing current assets or through the creation of other current liabilities within the next year or operating cycle, whichever is longer.1) The arrangement of items within the current liabilities

section is usually done through custom rather than a prescribed rule. Notes payable and Accounts Payable usually are listed first in that order and the others in any order.

2) Users of the financial statements look closely at the relationship between current assets and current liabilities through the use of ratios. This relationship is important in evaluating a company’s liquidity—its ability to pay obligations that are expected to become due within the next year or operating cycle.1. When current assets are greater that current liabilities

by a certain amount (usually 2:1), this is considered favorable in ability to pay.

2. When there is not a safe cushion of current assets exceeding current liabilities or when the reverse is true, there is less of a chance that the current liabilities will be paid and the company may even be forced into bankruptcy.

b) Long-term liabilities are obligations (debts) that will be paid beyond one year. (NOTE: a debt that is paid on the monthly installment basis will be classified into both the Current liabilities section (the portion that will be paid within the

25

following year) and the Long-term liabilities section (the portion that will be paid beyond one year)).

3. OWNER’S (STOCKHOLDERS’) EQUITY section.. The content of the owner’s equity section varies with the form of organization:a) In a proprietorship, there is one capital account. The up-to-date

capital balance has been taken from the owner’s equity statement. is shown by the owner’s equity section with the owner’s name and the word, “capital.”.

b) In a partnership, there is a capital account for each partner.c) For a corporation, owner’s (stockholders’) equity is divided

into two sections—Capital or Common stock (for the sale of the corporations stock) and retained earnings (income retained for the use in the business).

V. REVERSING ENTRIES are optional entries made at the first day of the new fiscal year and are the exact opposite of the adjusting entries made in the previous period so that certain adjusting entry amounts will not be forgotten to take care of in the new accounting period. The adjusting entries that are often forgotten are the accrued entries such as accrued salaries or also called accrued wages expenses in some companies.

A. A reversing entry on the first day of the new accounting period reverses an adjusting entry that was made at the end of the prior accounting period. To explain the example, the accounting equation with T-accounts will be used with the example. Throughout the accounting period the salaries are debited to Salaries Expense and credited to Cash. With the example for Pioneer Advertising Agency, only the first month of operation is used as an example and they have only had one payment for Salaries Expense of $4,000. Then on October 31, there is an adjustment made to accrue $1,200 of salaries owed to properly match the revenues and expenses in the same accounting period leaving a balance in the account of $5,200. During the closing process the Salaries Expense account is reduced to zero to begin the new accounting period. But there is still the $1,200 credit balance in the Salaries Payable account to carry to the new period.

Assets = Liabilities + Owner's Equity + Revs. - Expenses

Cash Salaries Payable Salaries Expense

4,000 1,200 Adj. Oct. 31 Oct.26 4,000

Oct.26 Oct.31 Adj. 1,200

Bal. 5,2005,200 Close

26

----- -----B. The Salaries Payable account needs to be debited for $1,200 the first

payday of the new period, but since that is not the normal entry each time salaries are paid, it is often forgotten to do. I have asked clients when auditing their books at the end of the year what the credit number in a salaries or wages payable account represents and a typical response that I would get is, "I don't know. It's been there all year." That means the adjusting entry from the prior period into the liability account, Salaries Payable, was never shown to be paid as the normal entry to record the salaries in this example is to debit Salaries Expense and credit Cash. The correct entry for the first payroll of the new period should be to debit Salaries Payable for $1,200, debit Salaries Expense for $2,800 and credit cash for $4,000.

C. To alleviate the problem of forgetting about the amount in the Salaries Payable account, some companies do reversing entries the first day of the new accounting period. The reversing entry is the exact opposite of the adjusting entry where on November 1 as the example shows in the second column of Illustration 4A-1 page 170, there would be a debit to Salaries Payable of $1,200 and a credit to Salaries Expense of $1,200, under “Reversing Entry,” which as can be seen below leaves an unnatural (not normal) balance in the Salaries Expense account on November 1 of a credit balance of $1,200, but it does reduce the Salaries Payable account to zero. But what happens when the salaries are paid on Nov.9 of the new period, the normal entry is made to debit Salaries Expense and to credit Cash, the correct balance is now in the Salaries Expense account of $2,800 which is the portion that is an expense in the new accounting period shown in the T-accounts as follows:

Assets = Liabilities + Owner's Equity + Revenues - Expenses

Cash Salaries Payable Salaries Expense

4,000 Nov. 9

Nov.1 Rev. 1,200

1,200 Adj.

Oct.31

1200 Nov1 Reversing

----- ----- Nov. 9 4,000

Bal.Nov 92800

27

chapter 4—completion of the accounting...

Documents