1. Completing the Accounting Cycle
Chapter 4
Chapter 4 depicts the completion of the accounting cycle.

2. Copyright © 2009 Prentice Hall. All rights reserved
The Accounting Cycle
Process by which companies produce their financial statements
Use of a work sheet summarizes needed data in one place
The accounting cycle is the process by which companies produce their financial statements. Work sheets help by summarizing lots of data in one place.
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3. Accounting Cycle Journalize Transaction Post to Accounts
Adjust Accounts
Prepare
Financial Statements
Close Accounts
During the period
End of the period
The accounting cycle starts with the beginning asset, liability, and owner’s equity account balances left over from the preceding period. During the period, transactions are journalized and then posted to the accounts. At the end of the period, accounts are adjusted, financial statements are prepared and then, the accounts are closed.
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4. Learning Objective 1 Prepare an accounting work sheet
The first learning objective is to prepare an accounting work sheet.
Prepare an accounting work sheet
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5. Work Sheet Internal summary device NOT:
A journal
A ledger
A financial statement
Computerized spreadsheets work well
Accountants often use a work sheet—a document with several columns—to summarize data for the financial statements. The work sheet is not a journal, a ledger, nor a financial statement. It is merely a summary device that helps identify the accounts that need adjustment. A spreadsheet works well for preparing an accounting work sheet. Note that the work sheet is an internal document. It is not meant to be given to outsiders. A step-by-step description of the work sheet follows.
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6. Work Sheet Steps
Enter account titles and their unadjusted balances in the Trial Balance columns
Total the amounts
Enter the account titles and their unadjusted balances in the Trial Balance columns of the work sheet, and total the amounts. Data come from the ledger accounts before any adjustments. Accounts are listed in proper order (Cash first, Accounts receivable second, and so on). Total debits must equal total credits.
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7. Work Sheet Steps
Enter the adjusting entries in the Adjustments columns
Total the amounts
Enter the adjusting entries in the Adjustments columns, and total the amounts. Letters are used to identify which debit belongs with which credit.
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8. Work Sheet Steps
Compute each account’s adjusted balance by combining the trial balance and adjustment figures
Enter each account’s adjusted amount in the Adjusted trial balance columns
See following slide
Compute each account’s adjusted balance by combining the trial balance and adjustment figures. Enter each account’s adjusted amount in the Adjusted Trial Balance columns.
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9. Work Sheet Steps
Here is the work sheet with the adjusted trial balance completed. For example, Cash is never adjusted. Accounts receivable’s adjusted balance of $2,500 is computed by adding the unadjusted amount of $2,200 to the $300 adjustment. For Supplies, we subtract the $500 credit adjustment from the unadjusted debit balance of $700. Note that an account may receive more than one adjustment. For example Service revenue has two adjustments(c and d). The adjusted balance of $6,500 is computed by taking the unadjusted balance of $6000 and adding the credit adjustments of $300 and $200 to arrive at the $6,500 adjusted balance. As on the trial balance, total debits must equal total credits on the adjusted trial balance.
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10. Work Sheet Steps
Draw an imaginary line above the first revenue account
Every account above goes to the Balance sheet columns
Every account below goes to the Income Statement columns
Draw an imaginary line above the first revenue account (in this case, Service revenue). Every account above that line (assets, liabilities, equity accounts) is copied from the Adjusted trial balance to the Balance sheet columns. Every account below the line (revenues and expense) is copied from the Adjusted trial balance to the Income statement columns.
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11. Each account’s balance should appear in only one column set -either the Income statement or the Balance sheet column set, as shown here.
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12. Work Sheet Steps On the income statement, compute net income
Revenues minus expenses
Enter net income as the balancing amount
On the income statement, compute net income or net loss as total revenues minus total expenses. Enter net income as the balancing amount on the income statement. In this case, net income equals $3600 (6500 – 2900).
Net Income
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13. Work Sheet Steps
Also enter net income as a balancing amount on the balance sheet
Also enter net income as the balancing amount on the balance sheet. Then total the financial statement columns.
Net Income
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14. Here is the completed work sheet in its entirety.
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15. Learning Objective 2
Use the work sheet to prepare financial statements
The second learning objective is to use the work sheet to prepare financial statements.
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16. Preparing Financial Statements from a Work Sheet
Both work sheet and financial statements have the same account balances and the same net income(or loss)
Work sheet is an internal document
Financial statements are for external users
Adjusting entries from work sheet need to be recorded in journal and posted
The work sheet shows the amount of net income or net loss for the period, but it is an internal document. We still must prepare the financial statements for external decision makers. The formal financial statements and the work sheet financial statement columns both show the same income(or loss) number and the same account balances. So why do we need to do both a Work sheet and a formal document, such as an Income Statement? The answer is the decision makers. The Work sheet is going to be used mainly by internal decision makers. The formal financial statements, on the other hand, may be used by external decision makers. Adjusting the accounts requires journalizing entries and posting to the accounts. The adjustments that are journalized after they are entered on the work sheet are exactly the same adjusting journal entries
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17. Work Sheet Financial Statement Net Income Any Company Income Statement
Month ended May 31, 2010
Revenue:
Service revenue
$ 6,500
Expenses:
Salary expense
$1,000
Depreciation expense
1,000
Supplies expense
500
Utilities expense
400
Total expenses
2,900
Net Income
$ 3,600
Using the worksheet on previous slides, let’s look at how it compares to the financial statements. The income statement columns from the work sheet are on the left and the Income statement is on the right. The same accounts and amounts appear, only in a different format.
Net Income
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18. Statement of Owner’s Equity
Any Company
Statement of Owner’s Equity
Month ended May 31, 2010
Josie Smith, Capital May 1, 2010
$13,200
Add: Net Income
3,600
16,800
Less: Withdrawals
(1,000)
Josie Smith, Capital, May 31, 2010
$15,800
The work sheet does not have columns for the Statement of Owner’s Equity. The beginning balance of Capital and the Withdrawals come from the work sheet. The net income number can be found either on the work sheet or the Income Statement. The ending balance of Capital is the only amount on the financial statements that does not appear on the work sheet.
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19. On this slide, we have the balance sheet columns from the work sheet on the left and the financial statement on the right. Every number except capital is the same. The Capital value on the Balance Sheet comes from the Statement of owner’s equity we just prepared. The balance sheet also has useful subtotals for the users.
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20. Learning Objective 3
Close the revenue, expense, and withdrawal accounts
The third learning objective is to close the revenue, expense and wtihdrawal accounts.
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21. Closing the Accounts Occurs at the end of the period
Gets accounts ready for next period
Zeroes out revenue and expense accounts
Closing the accounts occurs at the end of the period. Closing consists of journalizing and posting the closing entries in order to get the accounts ready for the next period. The closing process zeroes out all the revenues and all the expenses in order to measure each period’s net income separately from all other periods.
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22. Temporary and Permanent Accounts
Closed at the end of the period
Revenues
Expenses
Withdrawals
Start next period with a zero balance
Permanent
Not closed at the end of the period
Assets
Liabilities
Capital
Ending balance carries forward to next period
Recall that the income statement reports net income for a specific period. For example, a business’s net income for 2010 relates exclusively to For this reason, revenues and expenses are called temporary accounts. The Withdrawals account is also temporary and must be closed at the end of the period because it measures the withdrawals for only that one period. All temporary accounts (withdrawals, revenues, and expenses) are closed (zeroed). By contrast, the permanent accounts—the assets, liabilities, capital—are not closed at the end of the period because their balances are not used to measure income. Another way to remember which accounts are permanent is to recall that all accounts on the balance sheet are permanent accounts because they are part of the accounting equation.
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23. Closing Entries Transfer temporary accounts to Capital
Income summary account used in closing process
Summarizes net income
Temporary holding tank
Closed into Capital
Closing entries transfer the revenue, expense, and withdrawals balances to the Capital account. As an intermediate step the revenues and the expenses may be transferred first to an account titled Income Summary. Income summary summarizes the net income (or net loss) for the period by collecting the sum of all the revenues (a credit) and the sum of all the expenses (a debit). The Income summary account is like a temporary “holding tank” that shows the amount of net income or net loss of the current period. Its balance—net income or net loss—is then transferred (closed) to Capital.
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24. Four Closing Entries 1. Close revenues 2. Close expenses
Make the revenue accounts equal zero via the Income summary account. This closing entry transfers total revenues to the credit side of Income summary.
Make expense accounts equal zero via the Income summary account. This closing entry transfers total expenses to the debit side of Income summary.

25. Income Summary Service Revenue Expenses Income summary
6,500
6,500
2,900
2,900 #2 #1
Income summary
When the first two closing entries are posted to Income summary, the resulting balance is $3600 – net income.
2,900
6,500
Bal. 3,600
Revenues – Expenses =
Net Income
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26. Four Closing Entries 3. Close Income summary 4. Close Withdrawals
In step 3, make the Income summary account equal zero via the Capital account. This closing entry transfers net income (or net loss) to Capital. In step 4, make the withdrawals account equal zero via the Capital account. This entry transfers the withdrawals to the debit side of Capital.
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27. Four Closing Entries Income summary Josie Smith, W/D
2,900
6,500
1,000
1,000 #4
3,600
Bal. 3,600 #3
Josie Smith, Capital
When the third closing entry is posted, Income summary is zeroed out and Capital increases by $3600 – net income. The last closing entry zeroes out withdrawals and decreases capital by $1000.
13,200 Beginning balance
1,000
3,600
15, Ending balance
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28. Statement of Owner’s Equity
Any Company
Statement of Owner’s Equity
Month ended May 31, 2010
Josie Smith, Capital, May 1, 2010
$13,200
Add: Net income
3,600
16,800
Less: Withdrawals
(1,000)
Josie Smith, Capital, May 31, 2010
$15,800
Josie Smith, Capital
After the closing entries, Capital ends with a balance of $15,800. Trace this balance to the statement of owner’s equity.
13,200 Beginning balance
1,000
3,600
15, Ending balance
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29. Exercise 4-20 Service revenue 110,900 Income summary To close revenues
GENERAL JOURNAL
DATE
DESCRIPTION
REF
DEBIT
CREDIT
Service revenue
110,900
Income summary
To close revenues
Exercise 4-20 provides practice in preparing closing entries. The first closing entry for the company is to close revenue. Oceanside’s revenue account is Service revenue, which is debited to zero its balance of $110,900 ($108,000 + $2,900). The credit is to Income summary.
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30. Exercise 4-20 Income Summary 35,000 Salary expense 26,100
GENERAL JOURNAL
DATE
DESCRIPTION
REF
DEBIT
CREDIT
Income Summary
35,000
Salary expense
26,100
Supplies expense
2,500
Depreciation exp. – furniture
900
Depreciation exp. - building
5,500
To close expenses
The second closing entry is to close expenses. Each expense account is closed individually by crediting its balance. The total of the expenses is debited to Income summary. This zeros out each individual expense account.
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31. Exercise 4-20 Service Revenue Expenses Income summary
110,900
110,900
35,000
35,000 #2 #1
Income summary
When the first two closing entries are posted to Income summary, the resulting balance is $75,900 credit—revenues are greater than expenses so, the $75,900 is net income.
35,000
110,900
Bal. 75,900
Revenues – Expenses =
Net Income
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32. Exercise 4-20 Income summary 75,900 C. Pipeline, Capital
GENERAL JOURNAL
DATE
DESCRIPTION
REF
DEBIT
CREDIT
Income summary
75,900
C. Pipeline, Capital
To close Income summary
The third closing entry closes Income summary to Capital. After the first two entries, Income summary has a credit balance of $75,900, which is the net income for the period. Income summary is debited and Capital is credited. This zeroes out Income summary and increases Capital by the amount of net income.
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33. Exercise 4-20 C. Pipeline, Capital 59,000 C. Pipeline, W/D
GENERAL JOURNAL
DATE
DESCRIPTION
REF
DEBIT
CREDIT
C. Pipeline, Capital
59,000
C. Pipeline, W/D
To close withdrawals
The last closing entry is to close withdrawals. Capital is debited, which reduces equity. Withdrawals is credited, which zeroes out the account.
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34. Exercise 4-20 Income summary C. Pipeline, W/D C. Pipeline, Capital
35,000
100,900
59,000
59,000 #4
75,900
Bal. 75,900 #3
C. Pipeline, Capital
After the last two closing entries are posted, Capital has a balance of $62,900. The account was increased by net income (closing entry #3) and decreased by withdrawals (closing entry #4).
46,000 Beginning balance
59,000
75,900
62, Ending balance
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35. Learning Objective 4 Prepare postclosing trial balance
The fourth learning objective is to prepare a postclosing trial balance.
Prepare postclosing trial balance
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36. Post-Closing Trial Balance
List of permanent accounts and their balances after posting closing entries
Total debits and credits must be equal
Same accounts as on the Balance Sheet
The accounting cycle can end with a postclosing trial balance. This optional step lists the accounts and their adjusted balances after closing. Only assets, liabilities, and capital accounts appear on the postclosing trial balance. No temporary accounts—revenues, expenses, or withdrawals—are included because they’ve been closed. The ledger is now up-to-date and ready for the next period. The postclosing trial balance contains the same accounts that the balance sheet contains—assets, liabilities, and capital. Presented is the postclosing trial balance for Any Company – the company used in the worksheet and closing entries examples.
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37. Learning Objective 5
The fifth learning objective is to classify assets and liabilities as current or long-term.
Classify assets and liabilities as current or long-term
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38. Liquidity Measure of how quickly an item can be converted into cash
A classified balance sheet lists assets in order of their liquidity
Assets and liabilities are classified as either current or long-term to show their relative liquidity - a measure of how quickly and easily an account can be converted to cash, because cash is the most liquid asset. Accounts receivable are relatively liquid because receivables are collected quickly. Supplies are less liquid, and furniture and buildings are even less so because of their long lives. A classified balance sheet lists assets in the order of their liquidity.
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39. Operating Cycle The operating cycle is the time span when:
Cash used to buy goods & services
Goods & services sold to customers
Business collects cash from customers
The operating cycle is the time span when:
Cash is used to acquire goods and services.
These goods and services are sold to customers.
3. The business collects cash from customers.
For most businesses the operating cycle is a few months.
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40. Current Assets
Will be converted to cash, sold or used up during the next year or operating cycle, whichever is longer
Examples:
Cash
Accounts receivable
Supplies
Prepaid expenses
Current assets will be converted to cash, sold, or used up during the next 12 months or within the business’s operating cycle if the cycle is longer than a year. Cash, Accounts receivable, Supplies, and Prepaid expenses are current assets.
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41. Long-Term Assets
Not converted to cash within the current year or operating cycle
Categories
Plant assets
Land
Building
Furniture
Equipment
Long-term investments
Other assets
Long-term assets are all the assets that will not be converted to cash within the business’s operating cycle. One category of long-term assets is plant assets (also called fixed assets or property, plant, and equipment). Land, Buildings, Furniture, and Equipment are plant assets. Other categories of long-term assets include Long-Term Investments and Other Assets (a catchall category).
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42. Current Liabilities
Must be paid either with cash or goods & services within one year or operating cycle
Examples:
Accounts payable
Notes payable due within one year
Salary payable
Interest payable
Unearned revenue
Current liabilities must be paid either with cash or with goods and services within one year, or within the entity’s operating cycle if the cycle is longer than a year. Accounts payable, Notes payable due within one year, Salary payable, Interest payable, and Unearned revenue are all current liabilities.
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43. Long-Term Liabilities
Are not due within the current year or operating cycle
Examples:
Notes payable with due dates over one year
Mortgages
All liabilities that do not have to be paid within the entity’s operating cycle are classified as long-term liabilities . Many notes payable are long-term, for example, a mortgage on a building.
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44. A classified balance sheet classifies each asset and each liability as either current or long-term. Using the previous example, the company’s classified balance sheet is shown. Note how there are headings for current assets, plant assets and current liabilities and subtotals for each. This company does not have any long-term liabilities. If it did, they would appear beneath the current liabilities.
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45. Balance Sheet Forms Account Format Side-by-side Report Format
Assets on left
Liabilities & Equity on right
Report Format
Top and bottom
Assets on top
Liabilities & Equity on bottom
There are two formats for the balance sheet. A balance sheet that lists the assets at the left and the liabilities and the equity at the right in an arrangement known as the account form. A balance sheet that lists the assets at the top and the liabilities and owner’s equity on the bottom in an arrangement known as the report form. Although either form is acceptable; the report form is more popular.
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46. Learning Objective 6
Use the current ratio and the debt ratio to evaluate a company
The sixth learning objective is to use the current and debt ratios to evaluate a company
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47. Current Ratio Current assets Current liabilities
Measures a company’s ability to pay its current liabilities
Rule of thumb
Strong current ratio is 1.5
Current assets
Current liabilities
The current ratio measures a company’s ability to pay its current liabilities. This ratio is computed as follows: current assets divided by current liabilities. A company prefers to have a high current ratio because that means it has plenty of current assets to pay its current liabilities. A current ratio that has increased from the prior period indicates improvement in a company’s ability to pay its current debts. A current ratio that has decreased from the prior period signals deterioration in the company’s ability to pay its current liabilities. The rule of thumb states that a strong current ratio is 1.50, which indicates that the company has $1.50 in current assets for every $1.00 in current liabilities. A current ratio of 1.00 is considered low and somewhat risky.
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48. Debt Ratio Total liabilities Total assets
Indicates the proportion of a business’s assets that are financed with debt
Measures business’s ability to pay its debts
Rule of thumb:
Below 60% is considered safe
A second decision aid is the debt ratio, which measures an organization’s overall ability to pay its debts. The debt ratio is computed as follows:
Total liabilities divided by total assets. The debt ratio indicates the proportion of a company’s assets that are financed with debt. A low debt ratio is safer than a high debt ratio. Why? Because a company with low liabilities usually has low required payments and is less likely to get into financial difficulty. The rule of thumb for the debt ratio is that below 60% is considered safe for most businesses, as it indicates that the company owes only 60 cents for every $1.00 in total assets. A debt ratio above 0.80, or 80%, borders on high risk.
Total liabilities
Total assets
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49. End of Chapter 4
This concludes Chapter 4.