CHAPTER 4
Completing the Accounting Cycle
Chapter Overview
This chapter explains how the last major step in the accounting cycle, closing the books, prepares the accounts for use in the next accounting period. The chapter begins with an overview of the accounting cycle and leads into the work sheet as a tool to move data from the trial balance to the financial statements. Students follow the preparation of the work sheet from the trial balance, through adjustments, to extending account balances to the proper columns, and finally to computing net income or net loss. A mid-chapter summary problem offers practice in preparing a work sheet.
The text then discusses how a work sheet may be used to prepare the financial statements. The adjusting entries are journalized with data taken from the work sheet, and then posted to the ledger. Closing entries, also prepared from the work sheet, adjust the balances in all temporary (nominal) accounts to zero but never affect the balances in the real (permanent) accounts. The authors explain the use of Income Summary in the closing process and how closing entries transfer revenue, expense, and withdrawals accounts into the capital account. The postclosing trial balance is illustrated.
Assets and liabilities are classified as current or long-term. Assets are listed based on liquidity. The report format and the account format of the balance sheet are illustrated. The current ratio and the debt ratio are presented, along with a discussion about using ratios for financial statement analysis and decision making. Decision guidelines summarize the completion of the accounting cycle. The final summary problem is a continuation of the mid-chapter problem, providing practice with adjusting and closing entries and preparation of financial statements.
An appendix to Chapter 4 explains the use of reversing entries as an optional step in the accounting cycle.
Learning Objectives
After studying Chapter 4, your students should be able to:
1. Prepare an accounting work sheet
2. Use the work sheet to complete the accounting cycle
3. Close the revenue, expense, and withdrawal accounts
4. Classify assets and liabilities as current or long-term
5. Use the current and debt ratios to evaluate a business’s ability to pay its debts
Chapter Outline
Objective 1: Prepare an accounting work sheet
A. The accounting cycle, the process by which an accountant prepares financial statements for an entity, consists of a number of steps. Exhibit 4-1 illustrates those steps, from the beginning of the period through the work sheet and preparation of the financial statements.
1. For a new business, begin by setting up ledger accounts; for an existing business, begin with account balances carried over from the previous period.
2. During the period:
a. Analyze and journalize transactions (based on various source documents) for the current period.
b. Post transactions from the journal to the ledger.
3. End of the period:
a. Calculate the balance of each account in the ledger.
b. Enter the trial balance on the work sheet and complete the worksheet (optional).
c. Using the adjusted trial balance, prepare financial statements.
e. Prepare the post-closing trial balance.
B. Exhibits 4-2 through 4-6 illustrate the following steps in preparing the work sheet. It is an optional tool that may be used for the convenience of the accountant in the adjusting and closing process. Note that each pair of columns must be in balance.
1. Begin by listing the account titles, then enter the trial balance directly into the first two columns of the work sheet. Total the columns.
2. Enter adjusting entries in the next two columns. Total the columns.
3. Combine the amounts in the Trial Balance columns with the amounts in the Adjustments columns; write the total of each account in the Adjusted Trial Balance columns. Total the columns.
4. Extend these adjusted balances to the Income Statement or Balance Sheet columns. Debits on the Adjusted Trial Balance columns remain as debits and credits remain as credits.
5. The amount required to balance the Income Statement and Balance Sheet columns represents net income or net loss.
a. Net income is entered in the debit column of the Income Statement and in the credit column of the Balance Sheet.
b. Net loss is entered in the credit column of the Income Statement and in the debit column of the Balance Sheet.
Objective 2: Use the work sheet to complete the accounting cycle
A. After the work sheet is completed, it may be used to prepare the financial statements, adjusting entries, and closing entries. Preparation of the postclosing trial balance completes the accounting cycle.
B. From the data on the work sheet, prepare financial statements, always in this order as illustrated in Exhibit 4-7: income statement, statement of owner’s equity, and balance sheet.
C. Copy adjusting entries from the work sheet into the journal and post to the ledger. (Refer to Exhibit 4-8.)
Objective 3: Close the revenue, expense, and withdrawal accounts
B. Closing entries transfer revenues, expenses, and withdrawals to the Capital account. These accounts relate to a particular accounting period and must be closed at the end of the period. They are called temporary or nominal accounts.
1. Revenue and expense accounts are closed to Income Summary, an account used only at closing. Close revenue accounts:
Revenue XX
Income Summary XX
2. Close expense accounts:
Income Summary XX
Expense XX
3. Close Income Summary. The balance of Income Summary equals net income or net loss and must be transferred to the capital account.
Income Summary XX
Capital XX
To close net income.
Income Summary XX
To close net loss.
4. Close Withdrawals directly to Capital. Withdrawals are not closed to Income Summary because Withdrawals is not an expense account.
Capital XX
Withdrawals XX
5. After the closing entries are posted, all temporary accounts will have a zero balance.
C. Never close permanent (real) accounts.
2. Balances of permanent accounts carry over to the next period.
D. A postclosing trial balance (Exhibit 4-10) proves the accuracy of the journalizing and posting of closing entries. It lists the account balances after closing entries.
1. The postclosing trial balance is similar to the balance sheet in that it contains the balances of only permanent (real) accounts.
2. If any temporary accounts appear on the postclosing trial balance, one or more errors have been made. Revenues, expenses, withdrawals, and income summary should never be among the accounts listed.
E. Reversing entries are optional; they are discussed in the Appendix to Chapter 4.