1. Completing the Accounting Cycle
Chapter 4
Completing the Accounting Cycle
This chapter emphasizes the final steps in the accounting process and reviews the entire accounting cycle. We explain the closing process, including accounting procedures and the use of the post-closing trial balance. We show how a work sheet aids in preparing financial statements.

2. Conceptual Chapter Objectives
C1: Explain why temporary accounts are closed each period
C2: Identify steps in the accounting cycle
C3: Explain and prepare a classified balance sheet
In this chapter, you will learn the following conceptual objectives:
C1: Explain why temporary accounts are closed each period
C2: Identify steps in the accounting cycle
C3: Explain and prepare a classified balance sheet

3. Analytical Chapter Objectives
A1: Compute the current ratio and describe what it reveals about a company’s financial condition
In this chapter, you will learn the following analytical objectives:
A1: Compute the current ratio and describe what it reveals about a company’s financial condition

4. Procedural Chapter Objectives
P1: Prepare a worksheet and explain its usefulness
P2: Describe and prepare closing entries
P3: Explain and prepare a post-closing trial balance
P4: Appendix 4A: Prepare reversing entries and explain their purpose
In this chapter, you will learn the following procedural objectives:
P1: Prepare a worksheet and explain its usefulness
P2: Describe and prepare closing entries
P3: Explain and prepare a post-closing trial balance
P4: Appendix 4A: Prepare reversing entries and explain their purpose

5. Benefits of a Work SheetP1
Aids the preparation of financial statements.
Assists in planning and organizing an audit.
Not a required report.
Reduces possibility of errors.
Helps in preparing interim financial statements.
Using an electronic spreadsheet helps reduce the number of errors we may encounter. The spreadsheet is an excellent way to organize your work and review information prior to recording the adjusting journal entries. The spreadsheet is merely a tool we use; not a formal requirement of the double-entry process.
Links accounts and their adjustments.
Shows the effects of proposed transactions.

6. First, enter the unadjusted amounts to the worksheet.
FastForward Work Sheet
For Month Ended December 31, 2007 P1
First, enter the unadjusted amounts to the worksheet.
Here is the spreadsheet we will use for FastForward. We have a set of two columns for the trial balance information prior to making adjustments. We often refer to this as the unadjusted trial balance. The unadjusted trial balance will be combined with our adjustments to arrive at the adjusted trial balance. 43

7. Next, enter the adjustments.
FastForward Work Sheet
For Month Ended December 31, 2007 P1
Next, enter the adjustments.
The adjustments have been entered on the worksheet in the appropriate columns. Let’s look at adjustment A. This adjustment is made to record the expiration of prepaid insurance during the month. The entry is to debit, or increase, insurance expense, and to credit, or decrease, prepaid insurance. You may want to go over the other adjustments.
Notice that the total debits and total credits are equal in the unadjusted trial balance and the adjustments columns. We can now combine the balances on the unadjusted trial balance with the adjustments we prepared. 44

8. Prepare adjusted trial balance.
FastForward Work Sheet
For Month Ended December 31, 2007 P1
Prepare adjusted trial balance.
The result of the combination is the adjusted trial balance. You can see that the prepaid insurance account balance was reduced from twenty-four hundred dollars to twenty-three hundred. The insurance expense account went from zero to one hundred dollars.
We have to be careful and combine the amounts properly or an error will result.
The adjusted trial balance shows that the books are still in balance. 45

9. Sort adjusted trial balance amounts to financial statements.
FastForward Work Sheet
For Month Ended December 31, 2007 P1
We have added four more columns to our spreadsheet.
We take the information from the adjusted trial balance and prepare the income statement.
Once the income statement has been completed, we can prepare the balance sheet.
Notice that we have added two rows to the bottom of our spreadsheet.
Let’s see how we prepare the income statement and balance sheet. 45

10. Total statement columns, compute income or loss, and balance columns.
FastForward Work Sheet
For Month Ended December 31, 2007 P1
First, we subtract total expenses of four thousand three hundred and sixty-five dollars from total revenues of eighty-one hundred and fifty dollars to determine net income of thirty-seven hundred and eighty-five dollars.
We move the income to the debit column so that our column totals will be the same. We are not implying that income has a debit balance but simply that when we put it in the debit column, we get the totals straight. You know that income will be in the owner’s equity account on the balance sheet. To make sure it appears in the proper side of the balance sheet, we place net income on the credit side of the balance columns. By doing this you can see that our balance sheet is in balance.
Using an electronic spreadsheet saves us a great deal of time and effort. The math is automatically recalculated and we can make sure the books remain in balance. We encourage you to use this type of spreadsheet, where appropriate, to complete your homework assignments. 45

11. Prepare the Financial Statements
Prepare the Income
Statement.
A work sheet does not substitute for financial statements.
After the work sheet is complete, we can prepare the formal financial statement.
All of the amounts on FastForward’s income statement are taken from the income statement columns on the work sheet.

12. Prepare the Statement of Owner’s Equity.
After completing the income statement, we prepare the statement of owner’s equity.
Once again, we add the net income and investment amounts together and subtract any withdrawals to arrive at the ending capital balance of thirty-three thousand five hundred and eighty-five dollars.
We are now ready to prepare the balance sheet.

13. Prepare the Balance Sheet.
The balance in Chuck Taylor’s capital account appears on the balance sheet in owner’s equity. The assets and liabilities are taken directly from our worksheet.
The balance for total assets and total liabilities plus owner’s equity do not equal the balance that appears on the work sheet. This is because we show the accumulated depreciation, a credit balance account, as a reduction in equipment, a debit balance account.

14. Closing Process C1
Identify accounts for closing.
Resets revenue, expense and withdrawal account balances to zero at the end of the period.
Helps summarize a period’s revenues and expenses in the Income Summary account.
Record and post closing entries.
Once the formal financial statements have been prepared we may begin the process of closing the books and getting ready for the next accounting period.
Income is earned over a period of time. At the end of the time period, we start over and calculate income for the next period. The closing process has as its goal to reset all revenue, expense and withdrawal accounts to a zero balance at the end of the period. By doing this we can start the next accounting period fresh.
We will use a temporary account called income summary to facilitate the closing process. The account will never appear on any financial statement and will have a zero balance when the closing process is complete.
Prepare post-closing trial balance.

15. Temporary and Permanent Accounts
Temporary Accounts
Revenues
Income Summary
Expenses
Withdrawals
Permanent Accounts
Assets
Liabilities
Owner’s Capital
All accounts that will be closed are known as temporary accounts. Temporary accounts include revenues, expenses, withdrawals, and the income summary. These accounts should all have a zero balance at the end of the period.
Permanent accounts include assets, liabilities and owner’s capital. These accounts are permanent in nature because they are carried forward from one accounting period to the next.
The closing process applies only to temporary accounts.

16. Recording Closing EntriesP2
Close Revenue accounts to Income Summary.
Close Expense accounts to Income Summary.
Close Income Summary account to Owner’s Capital.
Close Withdrawals to Owner’s Capital.
Let’s see how the closing process works!
Here are the four steps we always follow in the closing process.
First, we close all revenue accounts to the income summary. We move the balance in all revenue accounts from the account to the income summary. This process will cause all revenue accounts to have a zero balance. Remember that revenue accounts normally have a credit balance.
Next, we close all expense accounts to the income summary. This will zero out all our expense accounts. Expense accounts normally have a debit balance.
Next, the income summary will show revenues and expense, or net income. We must close the income summary, which contains net income, to owner’s capital. This process zeroes out the income summary.
The final closing entry will be to move the owner’s withdrawals to the owner’s capital account. This will cause the withdrawal account to have a zero balance.
Let’s see how this process works. To prevent confusion when you first try to make closing entries, it is an excellent idea to follow these four steps exactly.

17. Balances before closing.
Closing Process P2
To illustrate the closing process we will assume that the company has only one expense account and only one revenue account. The beginning credit balance in owner’s capital account is thirty thousand dollars, and the withdrawal account has a debit balance of five thousand dollars.
The first step in the closing process is to transfer all revenues to the income summary. Let’s do this now.
Balances before closing.

18. Close Revenue accounts to Income Summary.
Closing Process P2
Close Revenue accounts to Income Summary.
You can see that the closing entry requires a debit to the revenue account. The revenue account now has a zero balance. The credit portion of the entry is made to income summary. Revenues have been transferred from the revenue account to the income summary.
The next step is to close all expense accounts.
Let’s get started with that entry.

19. Closing Process Close Expense accounts to Income Summary.
We close the expense account with a credit to that account and a debit to the income summary. The expense account now has a zero balance and the expenses appear on the debit side of the income summary. The balance in the income summary is fifteen thousand dollars. This amount is the difference between revenue and expense, or net income. We know it is net income because revenues are greater than expenses.
Notice that all revenue and expense accounts now have a zero balance so we accomplished part of our goal.
The third step is to close the income summary to owner’s capital.
Let’s do that now.
The balance in Income Summary equals net income.

20. Close Income Summary to Owner’s Capital.
Closing Process P2
Close Income Summary to Owner’s Capital.
In the case of a net income, the third closing entry is a debit to the income summary and a credit to the owner’s capital. (If we had a net loss, this entry would be reversed and we would debit the owner’s capital and credit the income summary.) The income summary has served its purpose and now has a zero balance. We will use the income summary again at the end of the next accounting period. Net income is now added to the beginning balance of owner’s capital.
The final closing entry is to close the withdrawal account to the owner’s capital account.

21. Close Withdrawals account to Owner’s Capital.
Closing Process P2
We complete this closing entry with a debit, or reduction, in the owner’s capital account and a credit to the withdrawal account. The balance in the withdrawal account is now zero. The ending balance in owner’s capital is forty thousand dollars and will appear on the balance sheet.
We are now ready to start accumulating revenues, expenses and withdrawals for the next accounting period.
Close Withdrawals account to Owner’s Capital.

22. P2
Using the adjusted trial balance, let’s prepare the closing entries for FastForward.
Let’s use the adjusted trial balance for FastForward and prepare the necessary closing entries. We will follow our four-step approach.

23. Close Revenue accounts to Income Summary.P2
Close Revenue accounts to Income Summary.
Our first step is to close the two revenue accounts. Since they have a credit balance, we will debit the accounts to zero out the balance.
Let’s look at the closing entry in the journal.

24. Close Revenue Accounts to Income SummaryP2
Now, let’s look at the ledger accounts after posting this closing entry.
To close the accounts, we debit consulting revenue for seventy-eight hundred fifty dollars and debit rental revenue for three hundred dollars. The credit to income summary is for the total of eighty-one hundred fifty dollars.
Let’s see what the ledger will look like after the closing entry is posted.

25. Close Revenue Accounts to Income SummaryP2
The balance in both revenue accounts is now zero and all revenue has been transferred to the credit side of the income summary.

26. Close Expense accounts to Income Summary.
Our second step is to close all expense accounts to the income summary.
Let’s make the journal entry.

27. Close Expense Accounts to Income Summary
We credit each expense account for its adjusted balance and debit the income summary for the total of forty-three hundred sixty-five dollars.
Let’s look at the ledger accounts after posting this entry.
Now, let’s look at the ledger accounts after posting this closing entry.

28. Close Expense Accounts to Income Summary
We have a zero balance in each expense account and have transferred total expenses of forty-three hundred sixty-five dollars to the debit side of the income summary.
The difference between revenues and expenses is income of thirty-seven hundred eighty-five dollars.
Next, we close the income summary to owner’s equity.
Net Income

29. Close Income Summary to Owner’s Capital.
Our goal is to update the balance in Chuck Taylor’s capital account for the income earning during the period.
Let’s make the next closing entry.

30. Close Income Summary to Owner’s Capital
Now, let’s look at the ledger accounts after posting this closing entry.
We debit the income summary for thirty-seven hundred eighty-five dollars and credit C. Taylor, capital for the same amount.
Now we have increased owner’s capital for income earned during the period.

31. Close Income Summary to Owner’s Capital
We can see that the balance in the income summary is zero and the balance in the capital account has been updated.

32. Close Withdrawals to Owner’s Capital.
The final closing entry is to close withdrawals to owner’s capital.
Let’s take a look at the journal entry.

33. Close Withdrawals to Owner’s Capital
Now, let’s look at the ledger accounts after posting this closing entry.
We debit, or reduce, owner’s capital by two hundred dollars and credit the withdrawal account for the same amount.

34. Close Withdrawals to Owner’s Capital
The withdrawal account now has a zero balance and once again the owner’s capital has been updated to the balance of thirty-three thousand five hundred eighty-five dollars. This balance appears on the balance sheet of FastForward.

35. Post-Closing Trial Balance
List of permanent accounts and their balances after posting closing entries.
Total debits and credits must be equal.
Let’s look at FastForward’s post-closing trial balance.
After all four of our closing entries have been made, we prepare a post-closing trial balance. This trial balance should show only permanent accounts, that is assets, liabilities, and the capital account. All the revenues, expenses, and withdrawals have been reduced to zero balances.

36. Post-Closing Trial Balance
Take a close look at our post-closing trial balance and be sure that we have only permanent accounts. Our books are still in balance after the closing process. The owner’s capital account is shown with its updated balance of thirty-three thousand five hundred eighty-five dollars.
We are now ready to move into the next accounting period.

37. Let’s discuss the components of a classified balance sheet.
Let’s complete the chapter by looking at how to construct a classified balance sheet.

38. Classified Balance Sheet
A classified balance sheet is the most popular format used by business. On the asset side of the balance sheet we group assets as current or noncurrent. A current asset is one that is expected to be converted into cash in one year or the company’s normal operating cycle, whichever is longer.
The operating cycle of a company is the time it takes to acquire inventory, sell the inventory, and collect cash. For many companies the operating is less than one year. These companies would classify an asset as current as long as that asset is expected to be converted into cash within one year.
On the liabilities plus equity side of the balance sheet, we divide liabilities between current and noncurrent. A current liability is one we expect to be paid out of current assets of the company.
Let’s see how new classifications appear on the balance sheet.
Current items are those expected to come due (both collected and owed) within the longer of one year or the company’s normal operating cycle.

39. C3
Current assets are expected to be sold, collected, or used within one year or the company’s operating cycle.
Current assets normally include cash, short-term investments, accounts receivable, merchandise inventory, office supplies, and prepaid expenses.
Short-term investments are expected to be sold within one year or the normal operating cycle, whichever is longer.
Merchandise inventory contains inventory items we expect to sell to customers in the normal course of business. For a service business, like an attorney, we would not expect to find a merchandise inventory account.

40. C3
Long-term investments are expected to be held for more than one year or the operating cycle.
The next major section of the classified balance sheet includes long-term investments, meaning those we expect to hold for more than one year. Some common long-term investments includes notes receivable, investments in the stock or bonds of another company, and land that a company is holding for a future plant site. Companies often purchase stock of another company in order to control or own the other company.

41. C3
Plant assets are tangible long-lived assets used to produce or sell products and services.
The third section of the classified balance sheets shows our property, plant and equipment. This section includes productive assets of the company along with any land containing structures such as buildings.
Productive assets include machinery, equipment, furniture and fixtures, and buildings. Productive assets are normally depreciated over their useful life.
The cost of the asset less any accumulated depreciation is called book value.
We do not depreciate land.

42. C3
Intangible assets are long-term resources used to produce or sell products and services and that lack physical form.
The final category of assets on the classified balance sheet include intangible assets. Intangibles include long-term resources that lack physical form—accounts like patents, copyrights, trademarks, and goodwill. In general, it is very difficult to properly value intangible assets.
In summary, we have current assets, and noncurrent assets that are divided among long-term investments, plant assets, and intangible assets.

43. C3
Current liabilities normally include accounts payable, wages payable, short-term notes payable, and the current portion of long-term liabilities.
Current liabilities are obligations due within the longer of one year or the company’s operating cycle.

44. C3
Long-term liabilities include long-term notes payable (net of current amounts due), mortgages payable, and bonds payable.
We will look at the accounting for long-term liabilities later in the text.
Long-term liabilities are obligations not due within the longer of one year or the company’s operating cycle.

45. Equity is the owner’s claim on the assets.
As we have seen, the equity section of the classified balance sheet includes the updated owner’s capital account.
Remember that almost all companies publish a classified balance sheet.
Equity is the owner’s claim on the assets.

46. Helps assess the company’s ability to pay its debts in the near future
Current Ratio A1
Helps assess the company’s ability to pay its debts in the near future
The current ratio of a company gives us a good indication of the company’s ability to pay its debts when they fall due. The current ratio is calculated by dividing current assets by current liabilities.
Let’s look at a quick example.
Suppose we have a company that has two hundred thousand dollars in current assets and one hundred thousand dollars in current liabilities. The current ratio is two to one, that is, two hundred thousand divided by one hundred thousand. A two to one current ratio means that for each dollar of current liabilities falling due in the next year, we expect to have two dollars of current assets to pay the liabilities.

47. End of Chapter 4
This completes our discussion of chapter four. We have introduced many new concepts and procedures. Your homework assignments will help reinforce most of what we have covered in our presentation. If you have difficulty with your homework assignments, you may want to review this presentation again. Good luck.