Chapter 6: Accounting Cycle Statements and Closing Entries

Preparing the Financial Statements from the Adjusted Trial Balance

  • The Final Steps of the Accounting Cycle: Once the adjusted trial balance is completed, the final three steps of the accounting cycle are performed:

    • Step 7: Prepare the financial statements.

    • Step 8: Prepare and post closing entries.

    • Step 9: Prepare the post-closing trial balance.

  • Timing of Steps: Steps 1, 2, and 3 are repeated many times throughout the accounting period. In contrast, Steps 4 through 9 are only completed at the end of the period.

  • The Adjusted Trial Balance Tool: Use the accounts and balances from the adjusted trial balance to compile the financial statements. The worksheet used to derive these balances is an internal document for accountants and is not intended for external users of financial information.

  • MP Consulting Worksheet Example (at January 31, 2022):

    • Cash: $3,800\$3,800

    • Accounts Receivable: $4,000\$4,000

    • Prepaid Insurance: $1,100\$1,100

    • Equipment: $8,300\$8,300

    • Accumulated Depreciation—Equipment: (CR) $150\$150

    • Accounts Payable: (CR) $1,250\$1,250

    • Interest Payable: (CR) $25\$25

    • Unearned Revenue: (CR) $1,800\$1,800

    • Bank Loan: (CR) $2,500\$2,500

    • Parish, Capital: (CR) $10,300\$10,300

    • Parish, Withdrawals: (DR) $2,000\$2,000

    • Service Revenue: (CR) $4,500\$4,500

    • Depreciation Expense: $150\$150

    • Insurance Expense: $100\$100

    • Interest Expense: $25\$25

    • Rent Expense: $800\$800

    • Telephone Expense: $250\$250

    • Total (Debits and Credits): $20,525\$20,525

The Income Statement

  • Purpose and Format: The income statement organizes values from the adjusted trial balance to show the net income or net loss for a period ended (e.g., "For the Month Ended January 31, 2022").

  • Integration with Other Statements: Net income (labeled as item a) is calculated here and transferred to the statement of owner’s equity.

  • MP Consulting Income Statement Calculation:

    • Revenues:

      • Service Revenue: $4,500\$4,500

    • Expenses:

      • Depreciation Expense: $150\$150

      • Insurance Expense: $100\$100

      • Interest Expense: $25\$25

      • Rent Expense: $800\$800

      • Telephone Expense: $250\$250

      • Total Expenses: ($1,325)(\$1,325)

    • Net Income: $3,175\$3,175

The Statement of Owner’s Equity

  • Purpose: This statement reports changes in owner’s equity during the reporting period, covering a period of time similar to the income statement.

  • Components of Change:

    • Increases: Additional investments by the owner or business profit (net income).

    • Decreases: Owner withdrawals for personal use or business losses (net loss).

  • Calculation Formula for Ending Balance:

    • Owner’s Equity=Beginning Owner’s Capital+Additional Owner Investments+Net Income (Loss)−Owner’s Withdrawals\text{Owner's Equity} = \text{Beginning Owner's Capital} + \text{Additional Owner Investments} + \text{Net Income (Loss)} - \text{Owner's Withdrawals}

  • Transfers: The final closing balance of the capital account (item b) is transferred to the owner’s equity section of the balance sheet.

  • MP Consulting Statement of Owner’s Equity (Month Ended January 31, 2022):

    • Parish, Capital at Jan 1: $5,300\$5,300

    • Add: Additional Investment: $5,000\$5,000

    • Add: Net Income: $3,175\$3,175

    • Subtotal: $13,475\$13,475

    • Less: Parish, Withdrawals: ($2,000)(\$2,000)

    • Parish, Capital at Jan 31: $11,475\$11,475

The Balance Sheet

  • Snapshot Concept: The balance sheet represents a company's financial position at a single point in time ("As at January 31, 2022").

  • Data Sources: Prepared using asset and liability accounts from the adjusted trial balance; however, the owner’s equity amount is sourced from the statement of owner’s equity (item b).

  • Presentation Styles:

    • Horizontal: Assets on the left, liabilities and equity on the right.

    • Vertical: Assets listed first, followed by liabilities and equity listed directly below.

  • MP Consulting Vertical Balance Sheet (As at January 31, 2022):

    • Assets: Cash ($3,800\$3,800), Accounts Receivable ($4,000\$4,000), Prepaid Insurance ($1,100\$1,100), Equipment ($8,300\$8,300) minus Accumulated Depreciation—Equipment ($150\$150) = Net Equipment ($8,150\$8,150). Total Assets: $17,050\$17,050.

    • Liabilities: Accounts Payable ($1,250\$1,250), Interest Payable ($25\$25), Unearned Revenue ($1,800\$1,800), Bank Loan ($2,500\$2,500). Total Liabilities: $5,575\$5,575.

    • Owner’s Equity: Parish, Capital: $11,475\$11,475.

    • Total Liabilities and Owner's Equity: $17,050\$17,050.

Closing Entries: Temporary and Permanent Accounts

  • The Purpose of Closing: "Closing the books" updates the owner’s capital account in the general ledger and resets income statement accounts to zero to start a new period.

  • Temporary Accounts: These relate only to a specific accounting period. They are closed (reset to zero) at period end.

    • Examples: All income statement accounts (Revenue, Expenses) and the owner’s withdrawals account.

  • Permanent Accounts: These are balance sheet items where balances are carried forward to the next period. They are NOT closed.

    • Examples: Cash, Accounts Receivable, Equipment, Accounts Payable, Bank Loan, and Owner’s Capital.

  • Closing Mechanisms:

    • Revenue: Normally a credit balance; close by debiting revenue.

    • Expenses: Normally a debit balance; close by crediting expenses.

    • Withdrawals: Normally a debit balance; close by crediting withdrawals.

Methods for Preparing Closing Entries

  • Method 1: The Direct Method: Temporary accounts are closed directly to the owner’s capital account.

    • Step A: Debit Revenue, Credit Owner’s Capital.

    • Step B: Debit Owner’s Capital for total expenses, Credit individual Expense accounts.

    • Step C: Debit Owner’s Capital, Credit Owner’s Withdrawals.

  • Method 2: The Income Summary Method (Common Practice): Uses a temporary intermediary account called "Income Summary" to close revenues and expenses.

    • Step A: Close Revenue accounts to Income Summary (Debit Revenue, Credit Income Summary).

    • Step B: Close Expense accounts to Income Summary (Debit Income Summary, Credit Expenses).

    • Step C: Close Income Summary to Owner’s Capital (The balance of Income Summary represents net income or loss).

    • Note: Owner’s Withdrawals are still closed directly to Owner’s Capital, not through Income Summary.

The Post-Closing Trial Balance

  • Purpose: To prove that the general ledger is in balance after closing entries are posted and before the next cycle begins.

  • Content: Contains only permanent (balance sheet) accounts. Temporary accounts must show a zero balance.

  • MP Consulting Post-Closing Trial Balance (January 31, 2022):

    • Cash: $3,800\$3,800

    • Accounts Receivable: $4,000\$4,000

    • Prepaid Insurance: $1,100\$1,100

    • Equipment: $8,300\$8,300

    • Accumulated Depreciation—Equipment: (CR) $150\$150

    • Accounts Payable: (CR) $1,250\$1,250

    • Interest Payable: (CR) $25\$25

    • Unearned Revenue: (CR) $1,800\$1,800

    • Bank Loan: (CR) $2,500\$2,500

    • Parish, Capital (updated): (CR) $11,475\$11,475

    • Total (DR/CR): $17,200\$17,200

Classified Balance Sheet

  • Purpose: Groups similar assets and liabilities to help users better understand the company's financial position.

  • Current Assets: Assets expected to be converted to cash or used within 12 months or the operating cycle (whichever is longer).

    • Examples: Cash, Accounts Receivable, Inventory, Prepaid Expenses. Organized from most liquid to least liquid.

  • Long-Term Assets: Assets used to operate the business, not expected to be converted to cash within 12 months.

    • Examples: Property, Plant & Equipment (PPE), fixed assets, long-term investments, intangible assets.

  • Current Liabilities: Obligations due within the next 12 months.

    • Examples: Accounts Payable, Wages Payable, Interest Payable, Unearned Revenue.

  • Long-Term Liabilities: Obligations due after 12 months.

    • Examples: Long-term portion of bank loans/mortgages, bonds payable.

  • Current Portion of Long-Term Debt: If a $50,000\$50,000 bank loan is paid in 5 equal annual installments, $10,000\$10,000 (50,000÷550,000 \div 5) is classified as a current liability, and $40,000\$40,000 is a long-term liability.

Benefits of Computerized Accounting Systems

  • Automation: Automatically posts entries to the general ledger and prepares financial statements.

  • Reports: Generates management reports for budgeting and analysis.

  • Retrieval: Allows for faster and easier data retrieval compared to manual paper systems.

  • Conceptual Utility: Knowledge of manual systems is necessary to identify errors or anomalies in computerized data.

Appendix 6A: The 10-Column Worksheet

  • Structure: Adds 4 columns to the standard 6-column worksheet.

    • Columns 1-2: Unadjusted Trial Balance (DR/CR).

    • Columns 3-4: Adjustments (DR/CR).

    • Columns 5-6: Adjusted Trial Balance (DR/CR).

    • Columns 7-8: Income Statement (DR/CR).

    • Columns 9-10: Balance Sheet and Owner’s Equity (DR/CR).

  • Net Income Determination: On the worksheet, the difference between the debit and credit totals in the income statement columns is the net income or loss. The same difference must exist between the debit and credit columns of the balance sheet/equity section.

Questions & Discussion

  • LO 6-1 Question 1: Which of the following statements is true about the statement of owner’s equity?

    • Answer: a. It links the income statement to the balance sheet.

  • LO 6-1 Question 2: True or False? By analyzing the balance sheet, the revenue for the period can be observed.

    • Answer: b. False.

  • LO 6-2 Question 1: Which one of the following types of entries is required to close an expense account?

    • Answer: b. Credit the expense account.

  • LO 6-2 Question 2: Which one of the following types of entries is required to close the owner’s withdrawals account?

    • Answer: b. Debit the owner’s capital account.

  • LO 6-3 Question 1: Which accounts have zero balances in the post-closing trial balance?

    • Answer: d. All of the above (Withdrawals, Revenues, Expenses).

  • LO 6-4 Question 1: Suppose that a note payable is due within one year. What type of debt is it?

    • Answer: a. Current.

  • LO 6-4 Question 2: A company buys and sells real estate property as its main business, selling each within one year. What type of asset is the property?

    • Answer: a. Current.

Comprehensive Exercise: Green Company

  • Data (Adjusted Trial Balance, March 31, 2022):

    • Cash: $4,000\$4,000 | Prepaid Rent: $2,400\$2,400 | Equipment: $8,000\$8,000

    • Accumulated Depreciation: (CR) $120\$120 | Unearned Revenue: (CR) $600\$600 | Notes Payable: (CR) $2,000\$2,000

    • Green, Capital: (CR) $8,100\$8,100 | Green, Withdrawals: (DR) $1,500\$1,500 | Service Revenue: (CR) $6,400\$6,400

    • Advertising Expense: $300\$300 | Depreciation Expense: $120\$120 | Rent Expense: $800\$800 | Telephone Expense: $100\$100

  • Income Statement Solution:

    • Revenue: $6,400\$6,400. Expenses: $300+$120+$800+$100=$1,320\$300 + \$120 + \$800 + \$100 = \$1,320. Net Income: \$5,080**.\n* **Statement of Owner’s Equity Solution**:\n * Beg. Capital (\$8,100)+NetIncome() + Net Income (\$5,080)−Withdrawals() - Withdrawals (\$1,500)=∗∗End.Capital:) = **End. Capital:\$11,680.

  • Closing Journal Entries Solution:

    • Mar 31: Service Revenue (DR) $6,400\$6,400, Income Summary (CR) $6,400\$6,400.

    • Mar 31: Income Summary (DR) $1,320\$1,320, Ad Exp (CR) $300\$300, Depr Exp (CR) $120\$120, Rent Exp (CR) $800\$800, Tel Exp (CR) $100\$100.

    • Mar 31: Income Summary (DR) $5,080\$5,080, Green, Capital (CR) $5,080\$5,080.

    • Mar 31: Green, Capital (DR) $1,500\$1,500, Green, Withdrawals (CR) $1,500\$1,500.