Accounting Principles Second Canadian Edition Prepared by: Carole Bowman, Sheridan College Weygandt · Kieso · Kimmel · Trenholm

COMPLETION OF THE ACCOUNTING CYCLE CHAPTER 4

A work sheet is a multiple-column form that may be used in the adjustment process and in preparing financial statements. It is a working tool or a supplementary device for the accountant and not a permanent accounting record. Use of a work sheet should make the preparation of adjusting entries and financial statements easier. WORK SHEET

ILLUSTRATION 4-1 WORK SHEET 1. Prepare trial balance on the worksheet. 2. Enter adjustment data. 3. Enter adjusted balances 4. Extend adjusted balance to appropriate columns. 5. Calculate income/loss and complete the worksheet.

PURPOSE OF CLOSING ENTRIES 1. Updates the owner’s capital account in the ledger by transferring net income (loss) and owner’s drawings to owner’s capital. 2. Prepares the temporary accounts (revenue, expense, drawings) for the next period’s postings by reducing their balances to zero.

ILLUSTRATION 4-2 TEMPORARY VERSUS PERMANENT ACCOUNTS TEMPORARY (NOMINAL) PERMANENT (REAL) These accounts are closed These accounts are not closed All revenue accounts All asset accounts All expense accounts All liability accounts Owner’s drawings Owner’s capital account (Balance Sheet Accounts) (Income Statement / Drawings Accounts)

ILLUSTRATION 4-3 DIAGRAM OF CLOSING PROCESS 1 1 Debit each revenue account for its balance, and credit the owner’s capital account for total revenues. 2 Debit the owner’s capital account for total expenses, and credit each expense account for its balance. 1 Debit each revenue account for its balance, and credit the owner’s capital account for total revenues. 2 Debit the owner’s capital account for total expenses, and credit each expense account for its balance. (INDIVIDUAL) EXPENSES Normal Dr. Balance Normal Cr. Balance Cr. to close Dr. to close Expenses Revenues Opening Balance 2

ILLUSTRATION 4-3 DIAGRAM OF CLOSING PROCESS 3 3 Debit owner’s capital for the balance in the owner’s drawings account and credit owner’s drawings for the same amount. OWNER’S DRAWINGS Normal Dr. Balance Cr. to close Expenses Revenues Opening Balance Drawings Ending Balance

CLOSING ENTRIES STOP AND CHECK 1.Does the balance in your Owner’s Capital account equal the ending capital balance reported in the Balance Sheet and Statement of Owner’s Equity? 2. Are all of your temporary account balances zero?

POST-CLOSING TRIAL BALANCE After all closing entries have been journalized and posted, a post-closing trial balance is prepared. The purpose of this trial balance is to prove the equality of the permanent (balance sheet) account balances that are carried forward into the next accounting period.

ILLUSTRATION 4-8 POST-CLOSING TRIAL BALANCE The post-closing trial balance is prepared from the permanent accounts in the ledger. The post-closing trial balance provides evidence that the journalizing and posting of closing entries has been properly completed.

1. Analyse transactions 2. Journalize the transactions 3. Post to ledger accounts 4. Prepare a trial balance 5. Journalize and post adjusting entries 6. Prepare adjusted trial balance 7. Prepare financial statements 8. Journalize and post closing entries 9. Prepare post-closing trial balance STEPS IN THE ACCOUNTING CYCLE

A reversing entry is made at the beginning of the next accounting period. A reversing entry reverses certain adjusting entries made in the previous period. Opening balances can then be ignored when preparing year-end adjusting entries. This topic is illustrated in Appendix 4A. REVERSING ENTRIES (OPTIONAL STEP)

CORRECTING ENTRIES Errors that occur in recording transactions should be corrected as soon as they are discovered by preparing correcting entries. Correcting entries are unnecessary if the records are free of errors; they can be journalized and posted whenever an error is discovered. They involve any combination of balance sheet and income statement accounts.

ILLUSTRATION 4-10 STANDARD BALANCE SHEET CLASSIFICATIONS Assets Liabilities and Equity Financial statements become more useful when the elements are classified into significant subgroups. A classified balance sheet generally has the following standard classifications: Current Assets Current Liabilities Long-Term Investments Long-Term Liabilities Capital Assets Owner’s/ Partners’/ Shareholders’ Equity

Current assets are cash and other resources that are reasonably expected to be realized in cash or sold or consumed in the business within one year of the balance sheet date or the company’s operating cycle, whichever is longer. Listed in the order of liquidity. Examples of current assets are cash, temporary investments, accounts receivable, inventory, and prepaids. CURRENT ASSETS

100 XYZ shares LONG-TERM INVESTMENTS Long-term investments are resources that can be realized in cash, but the conversion into cash is not expected within one year or the operating cycle, whichever is longer. Examples include investments in shares or bonds of another company or investment in land held for resale.

CAPITAL ASSETS Tangible resources of a relatively permanent nature that are used in the business and not intended for sale are classified as (1) property, plant, and equipment and (2) natural resources. (1)Examples of property, plant, and equipment include land, buildings, and machinery. (2)Examples of natural resources include tracts of timber, oil and gas reserves, and mineral deposits.

Intangible assets are noncurrent resources that do not have physical substance. Examples include patents, copyrights, trademarks, or trade names that give the holder exclusive right of use for a specified period of time. CAPITAL ASSETS

Current liabilities are obligations that are reasonably expected to be paid from existing current assets or through the creation of other current liabilities within one year or the operating cycle, whichever is longer. Examples include accounts payable, unearned revenue, interest payable, and current maturities of long-term debt. CURRENT LIABILITIES

Obligations expected to be paid after one year are classified as long-term liabilities. Examples include long-term notes payable, bonds payable, mortgages payable, and lease liabilities. LONG-TERM LIABILITIES

The content of the equity section varies with the form of business organization. In a proprietorship, there is a single owner’s equity account called (Owner’s Name), Capital. In a partnership, there are separate capital accounts for each partner. For a corporation, owners’ equity is called shareholders’ equity, and it consists of two accounts: Share Capital and Retained Earnings. EQUITYEQUITY

ILLUSTRATION 4-17 CLASSIFIED BALANCE SHEET IN REPORT FORM A classified balance sheet helps the financial statement user determine: The availability of assets to meet debts as they come due, and The claims of short- and long-term creditors on total assets. A classified balance sheet helps the financial statement user determine: The availability of assets to meet debts as they come due, and The claims of short- and long-term creditors on total assets. The balance sheet is most often presented in the report form, with the assets shown above the liabilities and owner’s equity.

LIQUIDITY Liquidity measures ability to pay short- term obligations when they come due. Working capital is one important measure of liquidity. WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES

CURRENT RATIO The current ratio (working capital ratio) is a widely used measure for evaluating a company’s liquidity and short-term debt- paying ability. It is calculated by dividing current assets by current liabilities and is a more dependable indicator of liquidity than working capital. CURRENT ASSETS CURRENT RATIO = ——————————— CURRENT LIABILITIES

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