"Completing the Accounting Cycle", Part III

Completing the Accounting Cycle: Part 3

Review of the Accounting Cycle

• Step 1: Analyze Business Transactions
  • Review source documents to determine when to record transactions.
• Step 2: Journalize Business Transactions
  • Record transactions in the journal (the diary of the business).
  • Format:
    • Date first.
    • Debit entries (left side) first.
    • Credit entries (right side) second.
  • Simple entry: One debit and one credit.
  • Compound entry: Three or more accounts.
• Step 3: Post to the General Ledger
  • Transfer information from the journal to the ledger.
• Step 4: Prepare an Unadjusted Trial Balance
  • Purpose: Verify the equality of debits and credits.
  • Equality doesn't guarantee 100% accuracy (e.g., omitted transactions, incorrect accounts).
• Step 5: Journalize and Post Adjusting Entries
  • Two categories:
    • Deferrals: Postponements
      • Cash paid/received in advance of expense/revenue recognition.
      • Expense/Revenue recognition is deferred until incurred/earned.
    • Accruals:
      • Accrual of revenues and expenses that occur daily.
      • Require adjustments to update the books.
  • Every adjusting entry needs an income statement and a balance sheet account.
  • Cash is never used in adjusting entries.
• Step 6: Prepare an Adjusted Trial Balance
  • Verify the equality of debits and credits after adjustments.
• Step 7: Prepare Financial Statements
  • Four statements in a specific order:
    1. Income Statement:
       • For a period of time.
       • Communicates profitability.
       • Lists revenues and expenses.
    2. Statement of Owner's Equity:
       • Shows changes to the owner's claim.
    3. Balance Sheet:
       • A single date (point in time).
       • Proves the accounting equation is in balance.
       • Communicates financial health and position.
    4. Statement of Cash Flows:
       • Shows sources and uses of cash.
       • Grouped into three business activities: operating, investing, and financing.
• Step 8: Journalize and Post Closing Entries
• Step 9: Prepare a Post-Closing Trial Balance

This cycle repeats every accounting period.

Closing the Books

• Closing Analogy: Closing a bank account means reducing the balance to zero.
• Closing the books means zeroing out specific accounts to prepare for the next fiscal year.
• Closing Entries: Journal entries that prepare the books for the next fiscal year by clearing out specific accounts.
• Specifically, Revenue, Expense, and Drawings accounts.
• Closing entries reset the balances in these accounts to zero.

Categories of Accounts

• Temporary Accounts

  • Also known as nominal accounts.

  • Closed at the end of the fiscal year (made zero).

  • Balances do not carry forward.

  • Include revenues, expenses, and drawings.

  • All accounts on the income statement, plus the drawings account.

  • Start the next accounting period with a zero balance.

  • Easy way to remember: spell "RED" (Revenues, Expenses, Drawings).

  • Revenue and Expense Recognition

    • Revenue is recognized in the period it's earned.
    • Expenses are recognized in the period they're incurred and matched to their revenue.

• Permanent Accounts

  • Also called real accounts.
  • Not closed; balances carry over to the next fiscal year.
  • All accounts found on the balance sheet.
  • Include assets, liabilities, and owner's equity.

Income Summary Account

• Special, temporary account used only in the closing process.
• Reports amounts for only one period.
• Revenue and expense accounts are transferred into the income summary.
• The income summary balance represents net income or net loss.
• In a sole proprietorship, the owner gets the income or loss.
• At the end of the year, information from the income summary transfers to the owner's capital account.
• Temporary account with no normal balance.
• Increased on both the left (debit) and right (credit) sides.
• Not found on any financial statements.

Steps to Close the Books

1. Close Credit Balances in Revenue Accounts to the Income Summary
2. Close Debit Balances in Expense Accounts to the Income Summary
3. Close the Income Summary to the Owner's Capital Account
   • Transfer the income or loss to the owner's capital account.
4. Close the Drawing Account Balance to the Owner's Capital Account

• The income summary does not involve the drawings account.
• The closing process is complete when all temporary accounts have a zero balance.
• Closing entries effectively journalize a statement of owner's equity.
• Updates the owner's capital account.

Visual Representation of Closing Process:

1. Debit revenue accounts and credit the income summary.
2. Credit expense accounts and debit the income summary.
3. Close the income summary to the capital account.
4. Close the drawings to the owner's capital account.

Example with Account Balances:

Two revenue accounts exist and must be closed individually by debiting each account to make its balance zero, with the total transferred to the income summary.

Each revenue account is treated as a separate account and must be closed individually.

Close the debit balances in our expense accounts, transfer the total to the income summary.

Revenues less expenses equals net income (net\ income = revenues - expenses).

Income summary's balance should be closed to the capital account.

If there's a net loss, it still closes to capital, but it would decrease the capital account.

The third closing entry is to transfer net income to capital.

To get the ending capital balance: Beginning balance + Net income - Drawings = Ending Balance.

Ending\ Balance = Beginning\ Balance + Net\ Income - Drawings

The close debit balance of the drawings account directly to the capital.

Journal Entries for Closing Process

Step 1: Closing Revenues

• Debit each revenue account and credit the income summary.
• Can be done in a compound entry.

Step 2: Closing Expenses

• Credit each expense account and debit the income summary.
• Can be done in a compound entry.

Step 3: Closing Income Summary

• Close the income summary to the owner's capital account, representing net income.

Step 4: Closing Drawings

• Close out the drawing account directly to the capital account.
• All temporary accounts now have zero balances.

Post-Closing Trial Balance

• Lists only balance sheet (real/permanent) accounts.
• Remaining accounts with balances that carry over to the next fiscal year.
• No temporary accounts are listed.
• Verifies that debits equal credits.