Lesson 4: Completion of the Accounting Cycle

Chapter 4 demonstrates the final steps in the accounting cycle, primarily those involving creation of the financial statements, preparing the closing entries, and proving that the General Ledger is ready for the following accounting period. The accounting period may be a year, a quarter (three months) or one month. We think of the accounting cycle as a set of steps that will be completed in the accounting period.

A Summary of the Accounting Cycle

Here is the full list of the steps in the Accounting Cycle:

1. Analyze each transaction as it occurs.

2. Journalize each transaction by date.

3. Post each transaction to the appropriate accounts.

4. Prepare the trial balance.

5. Journalize and post the adjustments.

6. Prepare an adjusted trial balance.

7. Prepare the financial statements (Income Statement, OE Statement, Balance Sheet and Cash Flow Statement).

8. Journalize and post the closing entries.

9. Prepare the post closing trial balance.

A worksheet, optional at Step 5 above, provides an overview of the end-of-period activities. A worksheet allows the accountant to begin at the trial balance stage of the accounting cycle, and, armed with the adjustment information, model the resulting financial statements, and journalize/post the closing entries. Why should you learn about worksheets? Here are several reasons:

1.     The financial statements may have to be published before the journalizing/posting of the adjustments and closing entries can be completed;

2.     You may be delegating some accounting tasks, and the worksheet provides check figures that should reconcile with those of your subordinates;

3.     A worksheet is a fundamental tool for an accountant, and is useful for modeling any financial problem or project. Additionally, the development of spreadsheet programs such as Microsoft Excel enhances the usefulness of worksheets for financial or managerial accounting purposes.

If you read through the steps in the accounting cycle, you will note that of the nine steps, there are three instances of journalizing: journalize the regular transactions, journalize the adjustments, and journalize the closing entries. All three types of entries must go through the journal in order to get to the ledger.

Additionally, there are three instances of preparing trial balances--the unadjusted trial balance, the adjusted trial balance, and the post-closing trial balance. We cannot go forward in the accounting cycle if at any point there is a disparity between debits and credits.

Closing Entries

At the end of the accounting period, we must perform the closing process. Closing consists of bringing all revenues, expenses, and drawing accounts to zero, and moving the net income to the owner's capital account. No assets get closed. No liabilities get closed. All closing happens in the owner's equity section of the ledger.

What does it mean to close an account? The term "close" means to bring an account to a zero balance.

 

ACCOUNT X

 

2,000

 

 


Here is an unknown account, Account X, with a $2,000 credit balance. What would it take to close it? (Answer: a debit of $2000). What would it take to close Acct Y below?

ACCOUNT Y

3,000

 

 

 

(Answer: a credit of $3,000.)

Not all accounts get closed at the end of the accounting period. Which ones do get closed? Answer: the ones that get closed are the temporary Owner's Equity Accounts. In other words, Revenue accounts, Expense accounts, and the Drawing Account.

There is one new account that is added to the ledger -- the Income Summary account. The account title is appropriate -- Income Summary does indeed summarize the net income. The total revenues will end up on the right side of Income Summary; the total expenses will end up on the left side, and the balance of Income Summary will equal the net income. The Income Summary account gets closed to the Capital account.

Here is a summary of the closing process. There are four steps:

1.     Close all Revenue accounts into Income Summary.

2.     Close all Expense accounts into Income Summary.

3.     Close Income Summary into the Capital Account.

4.     Close Drawings into the Capital Account.

Note the use of the word " into" in the four closing steps. If you take a few moments looking at the closing process, you will conclude that we are transferring balances from one place to another. For example, when we close the revenue account into income summary, we are moving the credit balance in the revenue account to the credit side of income summary.


Example: Suppose, at the end of January, the balances in the General Ledger appear as follows. (Assets and Liabilities are not detailed here; only the Owner's Equity accounts).

Jones Drawing

 

Jones Capital

1,000

 

 

 

 

 

 

 

 

 

 

Telephone Expense

 

Service Revenue

1,000

 

 

 

8,000

 

 

 

 

 

 

Rent Expense

 

Income Summary

2,000

 

 

 

 

 

 

 

 

 

 

Salaries Expense

3,000

 

 

 

I suggest that you copy the diagram shown above to your notebook and execute the steps as discussed below.

Here is how the closing entries would be journalized (numbers refer to steps outlined above):
1.  Close Revenue account(s) to Income Summary account:

Service Revenue

8,000

 

Income Summary

 

8,000

 

2.  Close Expense accounts to the Income Summary account:

Income Summary

6,000

 

Telephone Expense

 

1,000

Rent Expense

 

2,000

Salaries Expense

 

3,000



After you have penciled in the first two closing entries, pause and reflect. Note that the Income Summary account does indeed summarize the income for the period, with the revenue total on the credit side and the expense total on the debit side. And, of course, the difference between the two sides is the net income for the period. Now the final two entries.

4.     Close the net income into the Capital account:

Income Summary

2,000

 

Jones Capital

 

2,000

 

4.  Close the Drawing account into the Capital account:

Jones Capital

1,000

 

Jones Drawing

 

1,000

 

Note that every closing entry must be journalized, then posted, in order to have the desired effect on the ledger. If you looked through the journal for one month's time (January, let's say), what would you find? You would find the regular journal entries from January 1 through 31; immediately after those entries, you'd find the adjusting entries, all with a date of January 31; and finally, the four closing entries, all dated January 31.

As you will note after penciling in the closing entries:

1.     Revenues, Expenses and Income Summary are now at 0 balance;

2.     Drawings are at 0 balance;

3.     The net income has been transferred to the Owner's Capital account;

4.     The only open account in Owner's Equity is the Owner's Capital account.

Note too, that every one of the four closing entries took place strictly in the owner's equity area; no assets or liabilities were affected.

Post Closing Trial Balance

To finish the Accounting Cycle, you would take a Post-Closing Trial Balance, consisting of the Asset and Liability balances, as well as the Owner's Capital account.

As you would expect, the post closing trial balance will have no revenue account balances, no expense account balances, and no Drawing account balance.

In most Accounting textbooks, the authors try to encourage you to memorize the steps in the Accounting Cycle. I encourage you to do so, as it provides the big-picture view of accounting.

Classified Balance Sheet

Another topic in Chapter 4 is the classified balance sheet. A classified balance sheet is one in which the Assets and Liabilities are further subclassified. The typical categories for assets consist of:

Current Assets -- those that will be used up or converted to cash within one year. You should memorize the following list of current assets.

Cash
Marketable Securities (securities such as stocks and bonds, that are held for less than a year).
Notes Receivable
Accounts Receivable
Merchandise Inventory
Supplies
Prepaid Insurance

Investments -- in stocks or bonds, with the intent of holding those investments indefinitely.
Property, Plant and Equipment -- Land, Buildings, Equipment. Accumulated Depreciation must be subtracted from buildings and equipment accounts.
Natural Resources, such as an oil well or stand of timber
Intangibles -- Certain rights like patents and copyrights that may produce revenue.

For liabilities, there are two main categories:
Current Liabilities -- Accounts Payable and short term Notes Payable, payroll liabilities and other debts expected to be paid from current assets, and with maturities of less than one year. Also include Unearned Revenues
Long Term Liabilities -- debts that have maturities that stretch past one year. These would include mortgages, leases and bonds payable.

It is permissible to format the Balance Sheet in a left to right manner (account form) or top to bottom (report form). A concept that you will learn in a finance class is that short term assets are financed by short term liabilities. For example, if we purchase inventory, supplies or other current assets, we purchase them using short-term debt--such as accounts payable and notes payable. On the other hand, long term assets like buildings and equipment are financed using long term notes payable, bonds payable or issuance of stock.

Two Accounting Ratios

The text presents two ratios that can be used to evaluate the credit worthiness or liquidity of a company. First, the current ratio, measures the relationship between current assets and current liabilities. The calculation is very simple: divide the current assets by the current liabilities. If the ratio worked out to 1.0, this would indicate that the current assets are exactly sufficient to pay off the current liabilities. This may be illusory, as current assets are usually not just cash, but a mixture of cash, receivables, inventories and prepaid expenses. Thus, your text suggests that the current ratio should be somewhat higher than 1.0--for example, a current ratio of 1.5 might be sufficient to conclude that the company can meet its short term debt obligations.

The second ratio is the debt ratio, which is equal to total liabilities divided by total assets. It measures the portion of assets financed by debt. A high debt ratio indicates that the company is taking the risk that it might not be able to pay its debts as they come due.