CHAPTER 4
Completing the Accounting Cycle
Reviewing the Chapter
Objective 1: Describe the accounting cycle and the role of closing entries in the preparation of financial statements.
1. The steps in the accounting cycle (or the sequence of steps followed in the accounting system) are as follows:
a. Analyze business transactions from source documents.
b. Record the transactions by entering them in the general journal.
c. Post the journal entries to the ledger, and prepare a trial balance.
d. Adjust the accounts, and prepare an adjusted trial balance.
e. Prepare financial statements.
f. Close the accounts, and prepare a post-closing trial balance.
2. Balance sheet accounts are called permanent (or real) accounts because their balances can extend past the end of an accounting period. The balances are not set back to zero.
3. Revenue and expense accounts are called temporary (or nominal) accounts because of their transient nature. Their purpose is to record revenues and expenses during a particular accounting period. At the end of that period, their totals are transferred to owner’s equity (via the Income Summary account), leaving zero balances to begin the next accounting period.
4. Closing entries serve two purposes. First, they set the stage for the new accounting period by clearing revenue and expense accounts of their balances. (So that the owner’s Capital account can be updated, the Withdrawals account also is closed.) Second, they summarize the period’s revenues and expenses by transferring the balance of revenue and expense accounts to the Income Summary account. The Income Summary account exists only during the closing process and does not appear in the financial statements. Closing entries must be made at the end of each period for which financial statements are prepared (such as at the end of each quarter).
Objective 2: Prepare closing entries.
5. There are four closing entries:
a. Temporary credit balances are closed. This is accomplished with a compound entry that debits each revenue account for the amount required to give it a zero balance and credits Income Summary for the revenue total.
b. Temporary debit balances are closed. This is accomplished with a compound entry that credits each expense for the amount required to give it a zero balance and debits Income Summary for the expense total.
c. The Income Summary account is closed. After revenue and expense accounts have been closed, the Income Summary account will have either a debit balance or a credit balance. If a credit balance exists, then Income Summary must be debited for the amount required to give it a zero balance, and the owner’s Capital account is credited for the same amount. The reverse is done when Income Summary has a debit balance.
d. The Withdrawals account is closed. This is accomplished by crediting the owner’s Withdrawals account for the amount required to give it a zero balance and debiting the owner’s Capital account for the same amount. Note that the Income Summary account is not involved in this closing entry.
6. The closing process prepares the books for the next accounting period. After closing, the revenue, expense, and Withdrawals accounts (temporary accounts) have zero balances. The updated owner’s Capital account reflects withdrawals and net income or net loss for the period just ended. The balance sheet accounts (permanent accounts) show the correct balances, which are carried forward to the next period.
7. After the closing entries are posted to the ledger, a post-closing trial balance must be prepared to verify again the equality of the debits and credits in the ledger. Only balance sheet accounts appear in the post-closing trial balance because all income statement accounts and the Withdrawals account have zero balances at this point.
Objective 3: Prepare reversing entries.
8. At the end of each accounting period, the accountant makes adjusting entries to bring revenues and expenses into conformity with the matching rule. The accrual type of adjusting entry is followed in the next period by the receipt or payment of cash. Thus, it would become necessary in the next period to make a special entry dividing amounts between the two periods. To avoid this inconvenience, the accountant can make reversing entries (dated the beginning of the new period). Reversing entries, though not required, allow the bookkeeper to simply make the routine bookkeeping entry when cash finally changes hands. Not all adjusting entries may be reversed. In the system we use, only adjustments for accruals are reversed. Deferrals are not reversed because such reversals would not simplify bookkeeping in future accounting periods.
Objective 4: Prepare and use a work sheet.
9. Accountants use working papers to help organize their work and to provide evidence in support of the financial statements. The work sheet is one such working paper. It decreases the chance of overlooking an adjustment, acts as a check on the arithmetical accuracy of the accounts, provides evidence of past work so that accountants can retrace their steps, and helps in preparing financial statements. The work sheet is never published and is rarely seen by management. It is a useful tool for the accountant.
10. Preparation of a work sheet involves the following five steps:
a. Enter and total the account balances in the Trial Balance columns.
b. Enter and total the adjustments in the Adjustments columns. (A letter identifies the debit and credit for each adjustment and can act as a key to a brief explanation at the bottom of the work sheet.)
c. Enter (after crossfooting, or adding and subtracting from left to right) and total the adjusted account balances in the Adjusted Trial Balance columns.
d. Extend (transfer) the account balances from the Adjusted Trial Balance columns to the Income Statement columns or the Balance Sheet columns (depending on which type of account is involved).
e. Total the Income Statement columns and the Balance Sheet columns. Enter the net income or net loss in both pairs of columns (one will be entered in a debit column, and one will be entered in a credit column) as a balancing figure, and recompute the column totals.
11. Once the work sheet is completed, the accountant can use it (a) to record the adjusting entries in the general journal, (b) to record the closing entries in the general journal, thus preparing the records for the new period, and (c) to prepare the financial statements.
a. Formal adjusting entries must be recorded in the journal and posted to the ledger so that the account balances on the books will agree with those on the financial statements. This is easily accomplished by referring to the Adjustments columns (and footnoted explanations) of the work sheet.
b. Formal closing entries are entered into the journal and posted to the ledger, as explained in Objective 2. This is accomplished by referring to the work sheet’s Income Statement columns (for the revenue and expense accounts) and its Balance Sheet columns (for the Withdrawals account).
c. The income statement may be prepared from the information found in the work sheet’s Income Statement columns. Calculations of the change in owner’s Capital for the period are shown in the statement of owner’s equity. Information for this calculation may be found in the Balance Sheet columns of the work sheet (beginning capital, net income, and withdrawals). The balance sheet may be prepared from information found in the work sheet’s Balance Sheet columns and in the statement of owner’s equity.
Summary of Journal Entries Introduced in Chapter 4A. / (LO2) / Design Revenue / XX (current credit balance)
Income Summary / XX (sum of revenue amounts)
To close the credit balance account
B. / (LO2) / Income Summary / XX (sum of expense amounts)
Wages Expense / XX (current debit balance)
Utilities Expense / XX (current debit balance)
Rent Expense / XX (current debit balance)
Office Supplies Expense / XX (current debit balance)
Depreciation Expense—Office Equipment / XX (current debit balance)
To close the debit balance accounts
C. / (LO2) / Income Summary / XX (current credit balance)
P. Treadle, Capital / XX (net income amount)
To close the Income Summary account
(profit situation)
D. / (LO2) / P. Treadle, Capital / XX (withdrawals for period)
P. Treadle, Withdrawals / XX (withdrawals for period)
To close the Withdrawals account
E. / (LO3) / Wages Expense / XX (amount incurred)
Wages Payable / XX (amount to be paid)
To accrue unrecorded wages
F. / (LO3) / Wages Payable / XX (amount previously accrued)
Wages Expense / XX (amount incurred this period)
Cash / XX (amount paid)
Payment of wages; entry E above
was not reversed
G. / (LO3) / Wages Payable / XX (amount to be paid)
Wages Expense / XX (amount incurred)
To reverse adjusting entry for E above
(assume Wages Expense had been closed
at end of period)
H. / (LO3) / Wages Expense / XX (amount paid)
Cash / XX (amount paid)
Payment of wages; entry E above was reversed
I. / (LO3) / Design Revenue / XX (amount accrued)
Accounts Receivable / XX (amount accrued)
To reverse adjusting entry for accrued fees earned