CHAPTER 4 COMPLETING THE ACCOUNTING CYCLE Related Assignment Materials Student Learning Objectives Questions Conceptual objectives: C1. Explain why temporary 1, 2, 4, 5 accounts are closed each period. C2. Identify steps in the accounting 8 cycle. C3. Explain and prepare a classified 9, 10, 11, balance sheet. 14, 15 Analytical objectives: A1. Compute the current ratio and describe what it reveals about a company’s financial condition. Procedural objectives: P1. Prepare a work sheet and 6, 7 explain its usefulness. Quick Studies* Exercises* Problems* Beyond the Numbers 4-1 4-3 4-2 RIA, CIP 4-2 4-5 4-2 EC, HTR 4-3, 4-4 4-4 4-1, 4-3, 4-4, 4-5 BW, ED 4-4 4-6, 4-7 4-1, 4-2, 4-3 CA, TTN, 4-4 BW, ED, GD 4-5, 4-6, 4-7, 4-8 4-5 TIA 4-2, 4-3 4-4, 4-5 RIA, CIP, TIA, ED 4-6 P2. Describe and prepare closing entries. 2, 3, 4,5,6 4-1, 4-9 P3. Explain and prepare a postclosing trial balance. P4. Prepare reversing entries and explain their purpose. (Appendix 4A) 4 4-3 4-8, 4-9, 4-10, 4-11, 4-12 4-1, 4-2, 4-3, 4-4, 4-11, 4-12 4-2, 4-3 12, 13 4-11 4-13, 4-14 4-2, 4-3 *See additional information on next page that pertains to these quick studies, exercises and problems. Instructor’s Resource Manual, Chapter 4 ©The McGraw-Hill Companies, Inc., 2005 81 Additional information on Related Assignment Material Corresponding problems in set B (in text) and set C (on book’s website), also relate to learning objectives identified in grid on previous page. The Serial Problem for Success Systems continues in this chapter. Problems 4-2A and 4-3A can be completed using Excel. Problem 4-3A, 4-4A and the Serial Problem can be completed with Peachtree or Carol Yatch General Ledger Software. Homework Manager (on book’s website) repeats all numerical Quick Studies all Exercises and Problems 4-5A, 4-6A. Homework Manager provides new numbers each time the Quick Study, Exercise or Problem is worked. It can be used in practice, homework, or exam mode. Synopsis of Chapter Revision Premier Snowskate NEW opener Streamlined discussion of accounting work sheet Revised Excel screen captures with acetates for work sheet Shortened section on closing process Reduced presentation on operating cycles Active Learning Activities Found in STUDENT LEARNING TOOLS Activity Topic(s) Description Class Activity # 11 SLT pp.# 66-70 The Closing Process Class Activity # 12 71 The Accounting Cycle Class Activity # 13 72-78 Balance sheet classifications, current ratio, and working capital ratio. Class Activity # 14 79-81 Classified Balance Sheet Writing Assignment # 4 240 Loan Application Analysis Uses team observation and collaboration and writing to learn techniques to engage students in discovering the objectives of the closing process and required entries. Uses think-square-share and writing to learn to reinforce the objectives and relationships of the steps in a complete accounting cycle. Assumes the use of a work sheet in the cycle. Uses observation & comparison and team collaboration to introduce the need for and categories of balance sheet classifications Requires deductive reasoning. Uses classified information for analysis Uses think-square-share and challenges students to use critical thinking skills to discover errors in statement presentation. Students generally find this activity especially enjoyable. Requires students to prepare a memo evaluating two loan applications based on two classified balance sheets provided. ©The McGraw-Hill Companies, Inc., 2005 82 Fundamental Accounting Principles, 17/e Chapter Outline I. II. Notes Work Sheet as a Tool A. The work sheet is an internal document that serves as a useful tool for organizing accounting information. It is not a required report. B. Benefits include: aids the preparation of financial statements, reduces possibility of errors, captures links accounts and adjustments to their impacts in financial statements, assists in planning and organizing an audit of financial statements, helps in preparing interim (monthly and quarterly) financial statements, and shows the effect of proposed or “what if” transactions. C. Steps to prepare a work sheet: 1. Enter the unadjusted trial balance in the first two columns. 2. Enter the adjustments in the third and fourth columns. Total columns to verify debit adjustments equal credit adjustments. 3. Prepare the Adjusted Trial Balance. This is done by combining the unadjusted trial balance and adjustment columns. Total Adjusted Trial Balance columns to verify debits equal credits. 4. Sort the adjusted trial balance amounts to the appropriate financial statement columns. 5. Total statement columns, compute net income or loss and balance the columns by adding net income or loss. D. Work Sheet Applications and Analysis—it does not substitute for financial statements. The financial statement columns yield pro forma financial statements because they show the statements as if the proposed transactions occurred. Closing Process—The closing process is an important step at end of the accounting period after financial statements have been completed. A Steps in closing process: 1. Identify accounts for closing. 2. Record and post closing entries. 3. Preparing a post-closing trial balance. B. Purpose of closing process: 1. To reset revenues, expenses, and withdrawals account to zero at the end of every period to prepare these accounts to proper measurement in the next period. 2. To summarize a period's revenues and expenses. C. Temporary and Permanent Accounts 1. Temporary (or nominal) accounts accumulate data related to one accounting period. (All income statement accounts, withdrawals accounts, and the Income Summary.) Instructor’s Resource Manual, Chapter 4 ©The McGraw-Hill Companies, Inc., 2005 83 Chapter Outline Notes 2. Permanent (or real) accounts report on activities related to one or more future accounting periods. They are all balance sheet accounts that are not closed. D. Recording Closing Entries—the purpose is to transfer the end-ofperiod balances in revenues, expense, and withdrawals accounts to the permanent capital account. 1. Use a new temporary account called Income Summary. The four closing entries are: a. Close credit balances in revenue (and gain) accounts by debiting the accounts and crediting Income Summary. This transfers revenue balances to the credit side Income Summary. b. Close debit balances in expense (and loss) accounts by crediting the accounts and debiting Income Summary. This transfers the expense balances to the debit side of Income Summary. c. Close the Income Summary account to the owner’s capital account. Note: The Income Summary account, prior to closing, will have a credit balance equal to net income or a debit balance equal to net loss. Therefore this entry will credit capital for the amount of net income (or debit capital for a net loss). d. Close withdrawals account by crediting the account and debiting the owner's capital account. 2. After all closing entries are posted, all temporary accounts have a zero balance and capital is up to date. C. Post-Closing Trial Balance—a list of permanent accounts and their balances taken from the ledger. 1. Prepared after closing entries are journalized and posted. 2. Verifies that total debits equal total credits for permanent accounts and all temporary accounts have zero balances. ©The McGraw-Hill Companies, Inc., 2005 84 Fundamental Accounting Principles, 17/e Chapter Outline III. Notes D. The Accounting Cycle--steps can vary if a worksheet is used (see Visual 7) The ten steps repeated each accounting cycle are as follows: 1. Analyze transactions 2. Journalize 3. Post 4. Prepare unadjusted trial balance 5. Adjust 6. Prepare an adjusted trial balance 7. Prepare statements 8. Close 9. Prepare a post-closing trial balance. 10. Reverse (optional) Classified Balance Sheet—organizes assets and liabilities into important subgroups and provides more information for decision makers. A. Classification Structure 1. One of the more important classifications is the separation between current and noncurrent assets and liabilities. 2. Current items are expected to come due (both collected and owed) within the longer of one year or the company’s operating cycle. 3. Operating cycle is the time span from when cash is used to acquire goods and services until cash is received from the sale of those goods and services. B. Classification Categories 1. Current assets—cash or other resources that are expected to be sold, collected, or used within one year or the operating cycle, whichever is longer. Examples: cash, short-term investments, accounts receivable, notes receivable, merchandise inventory, and prepaid expenses. 2. Long-Term Investments—assets held for more than one year, that are not used in business operations. Examples: stocks, bonds, promissory notes, and land held for future expansion. 3. Plant Assets—tangible, long-lived assets that are used to produce or sell goods and services. Examples: equipment, buildings, land. 4. Intangible assets—long-term resources that benefit business operation. They lack physical form. Their value comes from the privileges or rights that are granted to or held by the owner. Examples: goodwill, patents, trademarks, franchises, copyrights. Instructor’s Resource Manual, Chapter 4 ©The McGraw-Hill Companies, Inc., 2005 85 IV. V. 5. Current liabilities—obligations due to be paid or settled within the longer of one year or the operating cycle. Examples: accounts payable, notes payable, wages payable, taxes payable, interest payable, unearned revenues, current portions of long-term liabilities. 6. Long-term liabilities—obligations that are not due to be paid within one year or the operating cycle of the business. Examples: notes payable, mortgage payable, bonds payable. 7. Equity—Owner’s claim on assets. For a proprietorship it is reported in this section as the owner's capital account. In a corporation , equity is divided into two main subsections: capital stock and retained earnings. Decision Analysis—Current Ratio A. Assesses a company’s ability to pay its debts in the near future. B. Calculated as total current assets divided by total current liabilities. Appendix 4A—Reversing Entries A. Accounting with reversing Entries 1. An optional step. 2. Linked to asset and liability account balances that arose from the accrual of revenues and expenses. 3. Purpose is to simplify recordkeeping. 4. They are prepared after closing entries and dated the first day of the new period. 5. Procedure is to transfer accrued asset and liability account balances to related revenue and expense accounts creating an abnormal balance in these accounts 6. The full subsequent cash receipts (and payments) are recorded as increases in revenue (and expense) accounts creating a net balance equal to the amount earned or incurred in that period. B. Accounting without reversing entries 1. To construct proper entries when the cash receipt/payment occurs in the new accounting period, the related accrual or deferral adjustment must be recalled and considered. 2. Accounting with or without reversing entries must yield the same result. ©The McGraw-Hill Companies, Inc., 2005 86 Fundamental Accounting Principles, 17/e VISUAL #7 THE ACCOUNTING CYCLE 1. 2. 3. 4. 5. 6. 7. This Cycle Assumes a Worksheet is Used STEPS PURPOSE Journalizing To record the daily transactions Posting To transfer the amounts from journal entries to the individual accounts affected by the recorded transaction Work sheet To summarize the balances of ledger accounts and test the accuracy of journalizing and posting and the computation of account balances (unadjusted trial balance columns) To plan the adjusting entries and the income statement and balance sheet numbers To prove the mathematical accuracy of net income To provide information for closing entries Preparing the To report financial information statements Journalizing and To bring the ledger accounts to posting of adjusted balances adjusting entries Journalizing and To bring all temporary accounts to posting of zero and the capital account up-toclosing entries date Post-closing To prove the accuracy of the trial balance adjusting and closing procedures Instructor’s Resource Manual, Chapter 4 TIMING During the period During the period End of period End of period End of year End of year End of year ©The McGraw-Hill Companies, Inc., 2005 87 ©The McGraw-Hill Companies, Inc., 2005 88 Fundamental Accounting Principles, 17/e VISUAL #8 MUSIC WORLD BALANCE SHEET DECEMBER 31, 20XX Assets Current Assets Cash Short-Term Investments Notes Receivable Accounts Receivable Merchandise Inventory Prepaid Insurance Supplies Total Current Assets Investments Land Held for Future Use Property, Plant, and Equipment Land Building Less Accumulated Depreciation Office Equipment Less Accumulated Depreciation Total Property, Plant, and Equipment Intangible Assets Trademark Total Assets $30,360 2,000 8,000 35,300 60,400 6,600 1,696 $144,356 13,950 $ 4,500 $20,650 8,640 $ 8,600 5,000 12,010 3,600 20,110 500 $178,916 Liabilities Current Liabilities Notes Payable Accounts Payable Salaries Payable Mortgage Payable Total Current Liabilities Long-Term Liabilities Mortgage Payable Total Liabilities $15,000 25,683 2,000 10,200 $52,883 27,600 $ 80,483 Owner’s Equity Joy Melody, Capital Total Liabilities and Owner’s Equity Instructor’s Resource Manual, Chapter 4 98,433 $178,916 ©The McGraw-Hill Companies, Inc., 2005 89 ©The McGraw-Hill Companies, Inc., 2005 90 Fundamental Accounting Principles, 17/e Alternate Demo Problem Four The trial balance of Large Company, Inc. at the end of its annual accounting period is as follows: LARGE COMPANY, INC. Trial Balance December 31, 2004 Cash .......................................................................... Prepaid Insurance ................................................... Supplies .................................................................. Equipment ............................................................... Accumulated depreciation equipment .................. C. Large, Capital ..................................................... C. Large, Withdrawals ............................................. Revenue ................................................................... Salaries expense ..................................................... Rent expense .......................................................... Totals ........................................................................ $ 4,000 1,600 2,100 20,000 $ 2,000 19,000 2,000 33,000 18,300 6,000 $54,000 ______ $54,000 Additional information: 1. Expired insurance, $600. 2. Unused supplies, per inventory, $800. 3. Estimated depreciation, $1,000. 4. Earned but unpaid salaries, $700. 5. Earned but unpaid salaries, $700. Required 1. Prepare adjusting entries. 2. Prepare closing entries. 3. Prepare a post-closing trial balance. Instructor’s Resource Manual, Chapter 4 ©The McGraw-Hill Companies, Inc., 2005 91 Solution: Alternate Demo Problem Four 1. Insurance Expense ........................................... 600 Prepaid Insurance ...................................... Supplies Expense ............................................. 600 1,300 Supplies ...................................................... Depreciation Expense Equip. .......................... 1,300 1,000 Accumulated Depreciation Equip. ............ Salaries Expense .............................................. 1,000 700 Salaries Payable ......................................... 2. Revenue ............................................................. 700 33,000 Income Summary ....................................... Income Summary .............................................. 33,000 27,900 Salaries Expense ........................................ 19,000 Rent Expense.............................................. 6,000 Insurance Expense..................................... 600 Supplies Expense....................................... 1,300 Depreciation Expense ................................ 1,000 Income Summary .............................................. 5,100 C. Large, Capital ......................................... C. Large, Capital ............................................... C. Large, Withdrawal .................................. 5,100 2,000 2,000 Solution continued next page ©The McGraw-Hill Companies, Inc., 2005 92 Fundamental Accounting Principles, 17/e 3. LARGE COMPANY, INC. Post-Closing Trial Balance December 31, 2004 Dr. Cash ................................................................... $4,000 Prepaid Insurance ............................................. 1,000 Supplies ............................................................. 800 Equipment ......................................................... 20,000 Cr. Accumulated depreciation, equipment ........... $ 3,000 Salaries payable ................................................ 700 C. Large, Capital ............................................... ______ 22,100 Totals ................................................................. $25,800 $25,800 Instructor’s Resource Manual, Chapter 4 ©The McGraw-Hill Companies, Inc., 2005 93 ©The McGraw-Hill Companies, Inc., 2005 94 Fundamental Accounting Principles, 17/e