Chapter 4 Completing the Accounting Cycle

Chapter 4 Learning Objectives Prepare the financial statements including the classified balance sheet Use the worksheet to prepare financial statements Explain the purpose of, journalize, and post closing entries Prepare the post-closing trial balance © 2018 Pearson Education, Inc.

Chapter 4 Learning Objectives Describe the accounting cycle Use the current ratio to evaluate business performance Explain the purpose of, journalize, and post reversing entries (Appendix 4A) © 2018 Pearson Education, Inc.

© 2018 Pearson Education, Inc. Learning Objective 1 Prepare the financial statements including the classified balance sheet © 2018 Pearson Education, Inc.

HOW DO WE PREPARE FINANCIAL STATEMENTS? The financial statements: Income statement Reports revenues and expenses and calculates net income or net loss for the period Statement of retained earnings Shows how retained earnings changed during the period due to net income (or net loss) and dividends. Balance sheet Reports assets, liabilities, and stockholders’ equity as of the last day of the period. After the adjusted trial balance is prepared, it is time to prepare the financial statements. The financial statements are prepared in the following order: income statement, statement of retained earnings, and then the balance sheet. The income statement reports revenues and expenses and calculates net income or net loss for the time period. The statement of retained earnings shows how retained earnings changed during the period due to net income (or net loss) and dividends. The balance sheet reports assets, liabilities, and stockholders’ equity as of the last day of the period. © 2018 Pearson Education, Inc.

HOW DO WE PREPARE FINANCIAL STATEMENTS? The financial statements are prepared from the adjusted trial balance. The financial statements will be prepared from the adjusted trial balance. Each account on the adjusted trial balance will be used on only one financial statement, except Retained Earnings, which appears on the statement of retained earnings and the balance sheet. © 2018 Pearson Education, Inc.

Relationships Among the Financial Statements The financial statements relate to each other. Net income or net loss from the income statement flows to the statement of retained earnings. Ending Retained Earnings from the statement of retained earnings flows to the balance sheet. Net income from the income statement increases Retained Earnings. A net loss decreases Retained Earnings. Ending Retained Earnings goes to the balance sheet and makes total liabilities plus stockholders’ equity equal total assets, satisfying the accounting equation. © 2018 Pearson Education, Inc.

Exhibit 4-2 Smart Touch Learning Financial Statements (continued on next slide) Net income flows to the statement of retained earnings. We always prepare the income statement first. The net income or net loss from the income statement will flow to the statement of retained earnings. © 2018 Pearson Education, Inc.

Exhibit 4-2 Smart Touch Learning Financial Statements (continued) The second financial statement prepared is the statement of retained earnings. The net income or net loss from the income statement increases or decreases retained earnings for the period. The ending retained earnings balance flows to the balance sheet. The net income from the income statement flows to the statement of retained earnings. The ending Retained Earnings flows to the balance sheet. © 2018 Pearson Education, Inc.

Exhibit 4-2 Smart Touch Learning Financial Statements (continued) The ending value of Retained Earnings from the statement of retained earnings flows to the balance sheet. The ending value of Retained Earnings from the statement of retained earnings is reported on the balance sheet. Smart Touch Learning’s balance sheet in Exhibit 4-2 lists the assets on the left and the liabilities and the stockholders’ equity on the right in an arrangement known as the account form. © 2018 Pearson Education, Inc.

Classified Balance Sheet A classified balance sheet places each asset and each liability into a specific category. Assets are shown in order of liquidity. Liabilities are classified as current (due within one year) or long term (due after one year). Liquidity measures how quickly and easily an account can be converted to cash. A classified balance sheet is a balance sheet that places each asset and each liability into a specific category, such as current or long term. Liquidity is a measure of how quickly an item can be converted to cash (because cash is the most liquid asset). Accounts receivable are relatively liquid because receivables are collected quickly. Office supplies are less liquid, and furniture and buildings are even less so because they take longer to convert to cash or to be used up. © 2018 Pearson Education, Inc.

© 2018 Pearson Education, Inc. Assets Current assets will be converted to cash, sold, or used up during the next 12 months or within the business’s operating cycle if the cycle is longer than a year. The operating cycle is the time span when Cash is used to acquire goods and services. These goods and services are sold to customers. The business collects cash from customers. A current asset is an asset that is expected to be converted to cash, sold, or used up within the next 12 months or within the business’s normal operating cycle if the cycle is longer than a year. The operating cycle is the time span during which cash is paid for goods and services, which are then sold to customers, from whom the business collects cash. © 2018 Pearson Education, Inc.

© 2018 Pearson Education, Inc. Assets Long-term assets are all the assets that will not be converted to cash or used up within the business’s operating cycle or one year, whichever is greater. Long-term Investments are investments in bonds or stocks that the company intends to hold for longer than one year. Property, Plant, and Equipment are long-lived, tangible assets, used in the operation of a business. Intangible Assets are assets with no physical form that are valuable because of the special rights carried. Long-term assets are assets that will not be converted to cash or used up within the business’s operating cycle or one year, whichever is greater. A long-term investment is an investment in bonds (debt securities) or stocks (equity securities) in which the company intends to hold the investment for longer than one year. Plant assets are long-lived, tangible assets, such as land, buildings, and equipment used in the operations of a business. An intangible asset is an asset with no physical form that is valuable because of the special right it carries. © 2018 Pearson Education, Inc.

© 2018 Pearson Education, Inc. Liabilities Current liabilities must be paid either with cash or with goods and services within one year or within the entity’s operating cycle. Examples: Accounts Payable Salaries Payable Unearned Revenue Long-term liabilities are liabilities that do not need to be paid within one year or within the operating cycle. A current liability is a liability that must be paid with cash or with goods and services within one year or within the entity’s operating cycle if the cycle is longer than a year. A long-term liability is a liability that does not need to be paid within one year or within the entity’s operating cycle, whichever is longer. © 2018 Pearson Education, Inc.

© 2018 Pearson Education, Inc. Stockholders’ Equity Stockholders’ equity represents the stockholders’ claims to the assets of the business. Reflects the stockholders’ contributions through common stock Represents the amount of assets left over after the corporation has paid its liabilities Stockholders’ equity represents the stockholders’ claims to the assets of the business. The stockholders’ equity section reported on the balance sheet is in part transferred from the ending Retained Earnings balance on the statement of retained earnings. The equity balance also reflects the stockholders’ contributions through common stock. It represents the amount of assets left over after the corporation has paid its liabilities. © 2018 Pearson Education, Inc.

© 2018 Pearson Education, Inc. The classified balance sheet includes categories for current assets, long-term assets, current liabilities, and long-term liabilities. The balance sheet in Exhibit 4-3 is being presented in the report form, which lists the assets at the top and liabilities and stockholders’ equity below. The report form is more popular in practice than the account form shown in Exhibit 4-2. © 2018 Pearson Education, Inc.

© 2018 Pearson Education, Inc. Learning Objective 2 Use the worksheet to prepare financial statements © 2018 Pearson Education, Inc.

HOW COULD A WORKSHEET HELP IN PREPARING FINANCIAL STATEMENTS? The first four sections of the worksheet (see Chapter 3) helped determine the adjusted trial balance, from which we prepare financial statements. Section 5—Income Statement Includes only revenue and expense accounts Section 6—Balance Sheet Includes asset, liability, and equity accounts except revenues and expenses Section 7—Determine Net Income or Net Loss The balancing amount for the income statement and balance sheet sections (will be the same amount) The income statement section includes only revenue and expense accounts. The revenues and expenses from the adjusted trial balance section will be transferred into the appropriate column in the income statement section. The balance statement section includes the asset and liability accounts and all equity accounts except revenues and expenses. The balance of each of these accounts will be transferred from the adjusted trial balance section of the worksheet to the appropriate column in the balance sheet section. Compute net income or net loss as total revenues minus total expense. Enter net income (loss) as the balancing amount in the income statement and balance sheet sections. If net income exists, the balance will be entered in the debit column of the income statement section and the credit column of the balance sheet section. If net loss exists, the balance will be entered in the credit column of the income statement section and the debit column of the balance sheet section. © 2018 Pearson Education, Inc.

© 2018 Pearson Education, Inc. Exhibit 4-4 shows the net income adjustment in the debit column of the income statement section and the adjustment in the balance sheet section as a credit. © 2018 Pearson Education, Inc.

© 2018 Pearson Education, Inc. Learning Objective 3 Explain the purpose of, journalize, and post closing entries © 2018 Pearson Education, Inc.

WHAT IS THE CLOSING PROCESS, AND HOW DO WE CLOSE THE ACCOUNTS? The closing process zeroes out all revenue and expense accounts in order to measure each period’s net income separately from all other periods. Temporary accounts relate to a particular accounting period and are closed at the end of that period Revenues, Expenses, Income Summary, and Dividends accounts. Permanent accounts are not closed at the end of the period Asset, Liability, Common Stock, and Retained Earnings accounts. In order to measure each period’s net income separately from income of all other periods, revenues and expenses are closed. The closing process is a step in the accounting cycle that occurs at the end of the period. The closing process consists of journalizing and posting the closing entries to set the balances of the revenues, expenses, Income Summary, and Dividends accounts to zero for the next period. A temporary account is an account that relates to a particular accounting period and is closed at the end of that period—the revenues, expenses, Income Summary, and Dividend accounts. By contrast, a permanent account is an account that is not closed at the end of the period—the asset, liability, Common Stock, and Retained Earnings accounts. © 2018 Pearson Education, Inc.

WHAT IS THE CLOSING PROCESS, AND HOW DO WE CLOSE THE ACCOUNTS? Closing entries transfer revenues, expenses, and Dividends to Retained Earnings. Revenues and expenses may be transferred first to an account titled Income Summary. Income Summary is a temporary account that summarizes the net income (or net loss) for the period. Closing entries are entries that transfer revenues, expenses, and Dividend balances to the Retained Earnings account to prepare the company’s books for the next period. This transfer to Retained Earnings also causes the Retained Earnings ledger account to now equal its balance reported on the balance sheet. As an intermediate step, the revenues and the expenses may be transferred first to an account titled Income Summary. The Income Summary is a temporary account into which revenues and expenses are transferred prior to their final transfer into the Retained Earnings account. This account summarizes net income (or net loss) for the period. © 2018 Pearson Education, Inc.

WHAT IS THE CLOSING PROCESS, AND HOW DO WE CLOSE THE ACCOUNTS? Closing entries transfer the revenues, expenses, and Dividend balances to the Retained Earnings account to prepare the company’s books for the next period. The Income Summary is a temporary account into which revenues and expenses are transferred prior to their final transfer into the Retained Earnings account. It summarizes net income (or net loss) for the period. Closing the revenue accounts requires that a debit be entered into the revenue account in an amount equal to the existing balance. The matching credit is entered into the Income Summary account. Next, each expense account receives a credit entry in an amount equal to the debit balance in each expense account. A matching debit is entered into the Income Summary account. At this point, all of the revenue accounts and expense accounts will show a zero balance. The Income Summary account, when balanced, will have a balance equal to net income (or net loss). The Income Summary account is then closed to the Retained Earnings account. The Dividends account has a debit balance and is closed with a credit entry equal to the balance in the account. The matching debit is entered into the Retained Earnings account. © 2018 Pearson Education, Inc.

Closing Temporary Accounts—Net Income for the Period Step 1: Make the revenue accounts equal zero via the Income Summary account. Example: Smart Touch Learning has a $17,500 credit balance in Service Revenue. The closing entry would be: In the case of Smart Touch Learning, the Service Revenue account showed a credit balance of $17,500. A closing entry is prepared to debit Service Revenue for $17,500 and a credit Income Summary for $17,500. © 2018 Pearson Education, Inc.

Closing Temporary Accounts—Net Income for the Period Step 2: Make expense accounts equal zero via the Income Summary account. Example: Smart Touch Learning has a $3,000 debit balance in Rent Expense account. It will be closed with a credit to Rent Expense: Step 2: Make expense accounts equal zero via the Income Summary account. Example: Smart Touch Learning has a $3,000 debit balance in Rent Expense account. It will be closed with a credit to Rent Expense. © 2018 Pearson Education, Inc.

Closing Temporary Accounts—Net Income for the Period In a compound closing entry, each individual expense account is credited and the Income Summary account is debited for the total amount of expenses: We prepare a closing entry for expenses by crediting each expense account and making a debit entry to Income Summary for the amount of the total expense balances. © 2018 Pearson Education, Inc.

Closing Temporary Accounts—Net Income for the Period The Income Summary T-account after closing revenues and expenses is: We prepare a closing entry for expenses by crediting each expense account and making a debit entry to Income Summary for the amount of the total expense balances. © 2018 Pearson Education, Inc.

Closing Temporary Accounts—Net Income for the Period Step 3: Make the Income Summary account equal zero via the Retained Earnings account. Example: Smart Touch Learning’s $8,550 credit balance in the Income Summary account will be closed to Retained Earnings: After closing the revenue and expense accounts, the Income Summary account now has a credit balance of $8,550. By debiting Income Summary for $8,550 and crediting Retained Earnings for $8,550, we have effectively updated the Retained Earnings account for the amount of Net Income earned by Smart Touch Learning during the year. © 2018 Pearson Education, Inc.

Closing Temporary Accounts—Net Income for the Period Step 4: Make the Dividends account equal zero via the Retained Earnings account. Example: Smart Touch Learning’s $5,000 debit balance in the Dividends account will be closed to Retained Earnings: Step 4: Make the Dividends account equal zero via the Retained Earnings account. Example: Smart Touch Learning’s $5,000 debit balance in the Dividends account will be closed to Retained Earnings. © 2018 Pearson Education, Inc.

Closing Temporary Accounts—Net Income for the Period Smart Touch Learning’s $5,000 debit balance in the Dividends account will be closed to Retained Earnings: Smart Touch Learning’s $5,000 debit balance in the Dividends account will be closed with a debit to Retained Earnings and a credit to Dividends. © 2018 Pearson Education, Inc.

Closing Temporary Accounts—Net Loss for the Period If a business had a net loss for the period, the closing entry to close the Income Summary account would be different. Example: If a business had a net loss of $2,000: If a business had a net loss for the period, closing entries 1, 2, and 4 would be similar to those completed for net income. However, the closing entry to close the Income Summary account would be different. Consider this example. Suppose a business had a net loss of $2,000. The Income Summary T-account would hold a debit balance instead of a credit balance. Therefore, the closing entry to close Income Summary would be a debit to Retained Earnings and a credit to Income Summary. The effect of this closing entry decreases Retained Earnings. © 2018 Pearson Education, Inc.

Closing Temporary Accounts—Summary Exhibit 4-6 shows the complete closing process for Smart Touch Learning. Panel A gives the closing entries. © 2018 Pearson Education, Inc.

Exhibit 4-6 Journalizing and Posting Closing Entries (continued) Exhibit 4-6 shows the complete closing process for Smart Touch Learning. Panel B shows the accounts after posting. © 2018 Pearson Education, Inc.

© 2018 Pearson Education, Inc. Learning Objective 4 Prepare the post-closing trial balance © 2018 Pearson Education, Inc.

HOW DO WE PREPARE A POST-CLOSING TRIAL BALANCE? The accounting cycle ends with a post-closing trial balance: A list of the accounts and their balances at the end of the period, after journalizing and posting the closing entries Includes only permanent accounts After closing entries are recorded and posted, the accounting cycle ends with a post-closing trial balance. The post-closing trial balance is a list of the accounts and their balances at the end of the period, after journalizing and posting the closing entries. It should include only permanent accounts. © 2018 Pearson Education, Inc.

HOW DO WE PREPARE A POST-CLOSING TRIAL BALANCE? At this point, since all the revenue, expense, and dividend accounts have been closed, they will all have a zero balance. The resulting post-closing trial balance lists only permanent accounts and shows the debits are equal to the credits. Notice that the Adjusted Trial Balance for Smart Touch Learning (Exhibit 4-1) and the Post-Closing Trial Balance (Exhibit 4-7) are similar. An easy way to make sure that you didn’t make an error in the closing process is to compare the Adjusted Trial Balance to the Post-Closing Trial Balance to ensure that: (1) account balances above Retained Earnings are the same; (2) account balances below Retained Earnings are zero and, therefore, not included; and (3) the Retained Earnings account balance matches Retained Earnings on the balance sheet. © 2018 Pearson Education, Inc.

© 2018 Pearson Education, Inc. Learning Objective 5 Describe the accounting cycle © 2018 Pearson Education, Inc.

WHAT IS THE ACCOUNTING CYCLE? The accounting cycle is the process by which companies produce their financial statements for a specific period. It is the steps that are followed throughout the time period. It starts with the beginning asset, liability, and stockholders’ equity account balances left over from the preceding period. The accounting cycle is the process by which companies produce their financial statements for a specific period. It is the steps that are followed throughout the time period. It starts with the beginning asset, liability, and stockholders’ equity account balances left over from the preceding period. © 2018 Pearson Education, Inc.

© 2018 Pearson Education, Inc. Exhibit 4-8 outlines the complete accounting cycle of Smart Touch Learning and every other business. Start with Step 1 and move clockwise. Accounting takes place at two different times: • During the period (Steps 1 through 3)—Journalizing transactions and posting to the accounts • End of the period (Steps 4 through 10)—Adjusting the accounts, preparing the financial statements, and closing the accounts © 2018 Pearson Education, Inc.

© 2018 Pearson Education, Inc. Learning Objective 6 Use the current ratio to evaluate business performance © 2018 Pearson Education, Inc.

HOW DO WE USE THE CURRENT RATIO TO EVALUATE BUSINESS PERFORMANCE? The current ratio measures a company’s ability to pay its current liabilities with its current assets. The ratio is computed as follows: A company prefers to have a high current ratio. Increases in current ratio indicates improvement in ability to pay debts. The current ratio measures a company’s ability to pay its current liabilities with its current assets. A company prefers to have a high current ratio because that means it has plenty of current assets to pay its current liabilities. A strong current ratio is 1.50, which indicates that the business has $1.50 in current assets for every $1.00 in current liabilities. A current ratio of 1.00 is considered low and somewhat risky. © 2018 Pearson Education, Inc.

HOW DO WE USE THE CURRENT RATIO TO EVALUATE BUSINESS PERFORMANCE? Kohl’s had the following total current assets and current liabilities, found on the balance sheet. January 30, 2015: January 30, 2016: Given that the current ratio is above 1.5 for both years, Kohl’s Corporation would be considered a less risky investment than another business with a lower current ratio. Similarly, creditors would be more willing to extend credit to Kohl’s Corporation than another company with a lower current ratio. The decrease in current ratio from 2015 to 2016 indicates Kohl’s has deteriorated slightly in ability to pay current debts. © 2018 Pearson Education, Inc.

© 2018 Pearson Education, Inc. Learning Objective 7 Explain the purpose of, journalize, and post reversing entries (Appendix 4A) © 2018 Pearson Education, Inc.

WHAT ARE REVERSING ENTRIES? Reversing entries are special journal entries that ease the burden of accounting for transactions in a later period. The opposite of adjusting entries Not required by GAAP Used for convenience and to save time Normally, when we record accruals, we record a expense/revenue and a corresponding payable/receivable. In the next period, when payment is made/received, the cash flow is recorded, the payable/receivable is satisfied, and the difference is shown as an additional expense/revenue. This requires referring back to the original accruals from the previous period. This process is inconvenient and potentially time-consuming. Later, when the cash flow related to the accrual finally occurs, the full amount of the cash flow is recorded to the related expense/revenue account. © 2018 Pearson Education, Inc.

Accounting for Accrued Expenses To record accrued salaries of $1,200, Smart Touch Learning recorded the following adjusting entry: After posting: Smart Touch Learning makes an adjusting entry at December 31 to show it still owes its employees an additional $1,200 for the last half of the month. © 2018 Pearson Education, Inc.

Accounting for Accrued Expenses After the adjusting entry, the following are noted: The income statement reports Salaries Expense of $4,800. The balance sheet reports Salaries Payable of $1,200. The $4,800 debit balance of Salaries Expense is closed at December 31, 2018, with the following closing entry: The $4,800 debit balance of Salaries Expense is closed at December 31, 2018, with a debit to Income Summary and a credit to Salaries Expense. © 2018 Pearson Education, Inc.

Accounting for Accrued Expenses After posting the closing entry, Salaries Expense has a zero balance as follows: After posting the closing entry, Salaries Expense has a zero balance. © 2018 Pearson Education, Inc.

Accounting Without a Reversing Entry Assume that Smart Touch Learning will pay its employees the second half of December’s salaries along with the first half of January on January 15, 2019. On January 15, the company would record the following journal entry: Assume that Smart Touch Learning will pay its employees the second half of December’s salaries along with the first half of January’s on January 15, 2017. On January 15, the company would record the journal entry to record a debit to the Salaries Payable of $1,200 and Salaries Expense of $1,200 and a credit to Cash of $2,400. © 2018 Pearson Education, Inc.

Accounting Without a Reversing Entry After posting the cash payment, the Salaries Payable and Salaries Expense accounts are as follows: This method of recording the cash payment is correct. However, it wastes time because the business must refer back to the December 31 adjustments. Otherwise, the business does not know the amount of the debit to Salaries Payable (in this example $1,200). Searching December’s adjusting entries wastes time and money. To save time, accountants can use reversing entries. © 2018 Pearson Education, Inc.

Accounting With a Reversing Entry A reversing entry switches the debit and the credit of a previous entry. It is the exact opposite of a prior adjusting entry. The reversing entry is dated the first day of the new period. © 2018 Pearson Education, Inc.

Accounting With a Reversing Entry To illustrate: Recall that on December 31 Smart Touch Learning made the following adjusting entry: The reversing entry: The reversing entry is dated the first day of the new period. It is the exact opposite of the adjusting entry. Ordinarily, the accountant who makes the adjusting entries will also prepare reversing entries at the same time. Smart Touch Learning dates the reversing entry as of January 1 so that it affects only the new period. © 2018 Pearson Education, Inc.

Accounting With a Reversing Entry The accounts after the accounting clerk posts the reversing entry: The arrow between the T-accounts shows the transfer of the $1,200 from Salaries Payable to Salaries Expense. This credit in Salaries Expense does not mean that the entity has negative salaries expense, as you might think. Instead, the odd credit balance in the Salaries Expense account is merely a temporary result of the reversing entry. © 2018 Pearson Education, Inc.

Accounting With a Reversing Entry The credit balance in Salaries Expense is eliminated on January 15: After posting: Salaries Expense has a debit balance of $1,200, which is correct and represents only the January salaries. The payment of salaries covered two periods: $1,200 related to 2018 and $1,200 related to 2019. The Salaries Expense account should only contain the amount that relates to 2019. © 2018 Pearson Education, Inc.

© 2018 Pearson Education, Inc.