1. Chapter 4 Completing the Accounting Cycle

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Learning Objectives
Prepare the financial statements including the classified balance sheet
Use the worksheet to prepare financial statements
Explain the purpose of, journalize, and post closing entries
Prepare the post-closing trial balance
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Learning Objectives
Describe the accounting cycle
Use the current ratio to evaluate business performance
Explain the purpose of, journalize, and post reversing entries (Appendix 4A)
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Learning Objective 1
Prepare the financial statements including the classified balance sheet
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5. How Do We Prepare Financial Statements?
The financial statements:
Income statement:
Reports revenues and expenses and calculates net income or loss for the period
Statement of retained earnings:
Shows how retained earnings changed during the period
Balance sheet:
Reports assets, liabilities, and stockholders’ equity as of the last day of the period
After the adjusted trial balance is prepared, it is time to prepare the financial statements. The financial statements are prepared in the following order: income statement, statement of retained earnings, and then the balance sheet. The income statement reports revenues and expenses and calculates net income or net loss for the time period. The statement of retained earnings shows how retained earnings changed during the period due to net income (or net loss) and dividends. The balance sheet reports assets, liabilities, and stockholders’ equity as of the last day of the period.
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The financial statements are prepared from the adjusted trial balance.
The financial statements will be prepared from the adjusted trial balance. Each account on the adjusted trial balance will be used on only one financial statement, except Retained Earnings, which appears on the statement of retained earnings and the balance sheet.
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7. Relationships Among the Financial Statements
The financial statements relate to each other.
Net income or net loss from the income statement flows to the statement of retained earnings.
Ending Retained Earnings from the statement of retained earnings flows to the balance sheet.
Net income from the income statement increases Retained Earnings. A net loss decreases Retained Earnings. Ending Retained Earnings goes to the balance sheet and makes total liabilities plus stockholders’ equity equal total assets, satisfying the accounting equation.
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8. Exhibit 4-2 Smart Touch Learning Financial Statements
Net income flows to the statement of retained earnings.
We always prepare the income statement first. The net income or net loss from the income statement will flow to the statement of retained earnings.

9. Exhibit 4-2 Smart Touch Learning Financial Statements
The net income from the income statement flows to the statement of retained earnings.
The second financial statement prepared is the statement of retained earnings. The net income or net loss from the income statement increases or decreases retained earnings for the period. The ending retained earnings balance flows to the balance sheet.
The ending Retained Earnings flows to the balance sheet.

10. Exhibit 4-2 Smart Touch Learning Financial Statements
The ending value of Retained Earnings from the statement of retained earnings flows to the balance sheet.
The ending value of Retained Earnings from the statement of retained earnings is reported on the balance sheet.

11. Classified Balance Sheet
A classified balance sheet places each asset and each liability into a specific category.
Assets are shown in order of liquidity.
Liabilities are classified as current (due within one year) or long term (due after one year).
Liquidity measures how quickly and easily an account can be converted to cash.
A classified balance sheet is a balance sheet that places each asset and each liability into a specific category, such as current or long term. Liquidity is a measure of how quickly an item can be converted to cash (because cash is the most liquid asset). Accounts receivable are relatively liquid because receivables are collected quickly. Office supplies are less liquid, and furniture and buildings are even less so because they take longer to convert to cash or to be used up.
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Assets
Current assets
Converted to cash or used within 12 months or within the operating cycle.
Long-term assets
Not converted to cash or used up within the operating cycle or one year.
Long-term investments
Plant assets
Intangible assets
A current asset is an asset that is expected to be converted to cash, sold, or used up within the next 12 months or within the business’s normal operating cycle if the cycle is longer than a year. The operating cycle is the time span during which cash is paid for goods and services, which are then sold to customers, from whom the business collects cash.
Long-term assets are assets that will not be converted to cash or used up within the business’s operating cycle or one year, whichever is greater. A long-term investment is an investment in bonds (debt securities) or stocks (equity securities) in which the company intends to hold the investment for longer than one year. Plant assets are long-lived, tangible assets, such as land, buildings, and equipment used in the operations of a business. An intangible asset is an asset with no physical form that is valuable because of the special right it carries.
The operating cycle is the time span during which cash is paid for goods and services, which are then sold to customers, from whom the business collects cash.
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Liabilities
Current liabilities must be paid either with cash or with goods and services within one year or within the entity’s operating cycle.
Examples:
Accounts Payable
Salaries Payable
Unearned Revenue
Long-term liabilities are all liabilities that do not need to be paid within one year or within the operating cycle.
A current liability is a liability that must be paid 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. A long-term liability is a liability that does not need to be paid within one year or within the entity’s operating cycle, whichever is longer.
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Stockholders’ Equity
Stockholders’ equity represents the stockholders’ claims to the assets of the business.
Reflects the stockholders’ contributions through common stock
Represents the amount of assets left over after the corporation has paid its liabilities
Stockholders’ equity represents the stockholders’ claims to the assets of the business. The stockholders’ equity section reported on the balance sheet is in part transferred from the ending Retained Earnings balance on the statement of retained earnings. The equity balance also reflects the stockholders’ contributions through common stock. It represents the amount of assets left over after the corporation has paid its liabilities.
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The classified balance sheet includes categories for current assets, long-term assets, current liabilities, and long-term liabilities.
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Learning Objective 2
Use the worksheet to prepare financial statements
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17. How Could a Worksheet Help in Preparing Financial Statements?
The first four sections of the worksheet (see Chapter 3) helped determine the adjusted trial balance, from which we prepare financial statements.
Section 5—Income Statement
Includes only revenue and expense accounts
Section 6—Balance Sheet
Includes asset, liability, and equity accounts except revenues and expenses
Section 7—Determine Net Income or Net Loss
The balancing amount for the income statement and balance sheet sections (will be the same amount)
The income statement section includes only revenue and expense accounts. The revenues and expenses from the adjusted trial balance section will be transferred into the appropriate column in the income statement section.
The balance statement section includes the asset and liability accounts and all equity accounts except revenues and expenses. The balance of each of these accounts will be transferred from the adjusted trial balance section of the worksheet to the appropriate column in the balance sheet section.
Compute net income or net loss as total revenues minus total expense. Enter net income (loss) as the balancing amount in the income statement and balance sheet sections. If net income exists, the balance will be entered in the debit column of the income statement section and the credit column of the balance sheet section. If net loss exists, the balance will be entered in the credit column of the income statement section and the debit column of the balance sheet section.
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Exhibit 4-4 shows the net income adjustment in the debit column of the income statement section and the adjustment in the balance sheet section as a credit.
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Learning Objective 3
Explain the purpose of, journalize, and post closing entries
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20. What Is the Closing Process, and How Do We Close the Accounts?
Temporary Accounts
Revenues
Expenses
Dividends
Permanent Accounts
Assets
Liabilities
Equity
The closing process zeros out all revenue and expense accounts in order to measure each period’s net income separately from all other periods.
In order to measure each period’s net income separately from income of all other periods, revenues and expenses are closed. The closing process is a step in the accounting cycle that occurs at the end of the period. The closing process consists of journalizing and posting the closing entries to set the balances of the revenues, expenses, Income Summary, and Dividends accounts to zero for the next period.
A temporary account is an account that relates to a particular accounting period and is closed at the end of that period—the revenues, expenses, Income Summary, and Dividend accounts. By contrast, a permanent account is an account that is not closed at the end of the period—the asset, liability, Common Stock, and Retained Earnings accounts.
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21. What Is the Closing Process, and How Do We Close the Accounts?
Closing entries
Transfer revenues, expenses, and Dividends to Retained Earnings
Revenues and expenses may be transferred first to an account titled Income Summary.
The Income Summary account summarizes the net income (or net loss) for the period.
Closing entries are entries that transfer revenues, expenses, and Dividend balances to the Retained Earnings account to prepare the company’s books for the next period. This transfer to Retained Earnings also causes the Retained Earnings ledger account to now equal its balance reported on the balance sheet.
As an intermediate step, the revenues and the expense may be transferred first to an account titled Income Summary. The Income Summary is a temporary account into which revenues and expenses are transferred prior to their final transfer into the Retained Earnings account. This account summarizes net income (or net loss) for the period.
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22. What Is the Closing Process, and How Do We Close the Accounts?
Closing entries transfer the revenues, expenses, and Dividend balances to the Retained Earnings account to prepare the company’s books for the next period. The Income Summary is a temporary account into which revenues and expenses are transferred prior to their final transfer into the Retained Earnings account. It summarizes net income (or net loss) for the period.
Closing the revenue accounts requires that a debit be entered into the revenue account in an amount equal to the existing balance. The matching credit is entered into the Income Summary account. Next, each expense account receives a credit entry in an amount equal to the debit balance in each expense account. A matching debit is entered into the Income Summary account. At this point, all of the revenue accounts and expense accounts will show a zero balance. The Income Summary account, when balanced, will have a balance equal to net income (or net loss). The Income Summary account is then closed to the Retained Earnings account. The Dividends account has a debit balance and is closed with a credit entry equal to the balance in the account. The matching debit is entered into the Retained Earnings account.
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23. Closing Temporary Accounts—Net Income for the Period
In the case of Smart Touch Learning, the Service Revenue account showed a credit balance of $17,500. A closing entry is prepared to debit Service Revenue for $17,500 and a credit Income Summary for $17,500.
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24. Closing Temporary Accounts—Net Income for the Period
We prepare a closing entry for expenses by crediting each expense account and making a debit entry to Income Summary for the amount of the total expense balances.
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25. Closing Temporary Accounts—Net Income for the Period
After closing the revenue and expense accounts, the Income Summary account now has a credit balance of $8,550. By debiting Income Summary for $8,550 and crediting Retained Earnings for $8,550, we have effectively updated the Retained Earnings account for the amount of Net Income earned by Smart Touch Learning during the year.
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26. Closing Temporary Accounts—Net Income for the Period
The Dividends account is also closed to Retained Earnings. Because Dividends has a $5,000 debit balance, it is closed by crediting Dividends and debiting Retained Earnings.
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27. Closing Temporary Accounts—Net Income for the Period
Exhibit 4-6 is a summary of the closing entries made for the revenue, expenses, and Dividend accounts. The Income Summary is closed to Retained Earnings at the end of the period as well.
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28. Closing Temporary Accounts—Net Loss for the Period
If a business had a net loss for the period, closing entries 1, 2, and 4 would be similar to those completed for net income. However, the closing entry to close the Income Summary account would be different. If a business had a net loss, the Income Summary T-account would hold a debit balance instead of a credit balance. Therefore, the closing entry to close Income Summary would be a debit to Retained Earnings and a credit to Income Summary. Notice the effect of this closing entry: it decreases Retained Earnings. This is because a net loss decreases the Retained Earnings account.
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Learning Objective 4
Prepare the post-closing trial balance
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30. How Do We Prepare a Post-Closing Trial Balance?
The accounting cycle ends with a post-closing trial balance:
A list of the accounts and their balances at the end of the period, after journalizing and posting the closing entries
Includes only permanent accounts
After closing entries are recorded and posted, the accounting cycle ends with a post-closing trial balance. The post-closing trial balance is a list of the accounts and their balances at the end of the period, after journalizing and posting the closing entries. It should include only permanent accounts.
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At this point, since all the revenue, expense, and dividend accounts have been closed, they will all have a zero balance. The resulting post-closing trial balance lists only permanent accounts and shows the debits are equal to the credits.
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Learning Objective 5
Describe the accounting cycle
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33. What Is the Accounting Cycle?
The accounting cycle is the process by which companies produce their financial statements for a specific period. It is the steps that are followed throughout the time period. The accounting cycle starts with the beginning asset, liability, and stockholders’ equity account balances left over from the preceding period.
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Learning Objective 6
Use the current ratio to evaluate business performance
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35. How Do We Use the Current Ratio to Evaluate Business Performance?
The current ratio measures a company’s ability to pay its current liabilities with its current assets.
The formula is:
The current ratio measures a company’s ability to pay its current liabilities with its current assets. A company prefers to have a high current ratio because that means it has plenty of current assets to pay its current liabilities. A strong current ratio is 1.50, which indicates that the business 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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Learning Objective 7
Explain the purpose of, journalize, and post reversing entries (Appendix 4A)
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37. What Are Reversing Entries?
Special journal entries that ease the burden of accounting for transactions in a later period
The opposite of adjusting entries
Not required by GAAP
Used for convenience and to save time
Normally, when we record accruals, we record a expense/revenue and a corresponding payable/receivable. In the next period, when payment is made/received, the cash flow is recorded, the payable/receivable is satisfied, and the difference is shown as an additional expense/revenue. This requires referring back to the original accruals from the previous period. This process is inconvenient and potentially time-consuming.
Later, when the cash flow related to the accrual finally occurs, the full amount of the cash flow is recorded to the related expense/revenue account.
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38. Accounting for Accrued Expenses
To record accrued salaries of $1,200, Smart Touch Learning recorded the following adjusting entry:
Smart Touch Learning makes an adjusting entry at December 31 to show it still owes its employees an additional $1,200 for the last half of the month.
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39. Accounting Without a Reversing Entry
To record the payment of total salaries of $2,400 on January 15 without a reversing entry, Smart Touch would:
Assume that Smart Touch Learning will pay its employees the second half of December’s salaries along with the first half of January’s on January 15, On January 15, the company would record the journal entry to record a debit to the Salaries Payable of $1,200 and Salaries Expense of $1,200 and a credit to Cash of $2,400.
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40. Accounting with a Reversing Entry
A reversing entry is a special journal entry that eases the burden of accounting for transactions in the next period.
One way to make the process more convenient and efficient is to use reversing entries. A reversing entry is a special journal entry that eases the burden of accounting for transactions in the next period. It switches the debit and the credit of a previous entry, which is exactly the opposite of a prior adjusting entry.
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41. Accounting with a Reversing Entry
The credit balance in the Salaries Expense account is eliminated on January 15, when Smart Touch Learning pays the payroll and debits Salaries Expense.
The journal entry dated January 1 leaves a credit balance in Salaries Expense, which is a temporary result of the reversing entry. The credit balance is eliminated on January 15, when Smart Touch Learning pays the payroll and debits Salaries Expense.
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