CHAPTER 4
Completing the Accounting Cycle
Chapter Outline
Learning Objective 1: Prepare an accounting work sheet
A.
The accounting cycle, the process by which an accountant prepares financial statements for an
entity, consists of a number of steps. Exhibit 4-1 illustrates those steps, from beginning of
the period through the work sheet and preparation of the financial statements.
During the period:
1.
For a new business, begin by setting up ledger accounts; for an existing business, begin
with account balances carried over from the previous period.
2.
Analyze and journalize transactions (based on various source documents) for the current
period.
3.
Post transactions from the journal to the ledger.
End of the period:
4.
Compute the unadjusted balance of each account in the ledger. Prepare the trial balance.
5.
Journalize and post adjusting entries, and create the adjusted trial balance. Complete a
work sheet (optional).
6.
Prepare the financial statements.
7.
Journalize and post the closing entries.
8.
Prepare the postclosing trial balance.
B.
Exhibits 4-2 through 4-6 illustrate the following steps in preparing the work sheet. It is an
optional tool The work sheet may be used for the convenience of the accountant in the adjusting
and closing process. Note that each pair of columns must be in balance.
1.
Begin by listing the account titles, then enter the trial balance directly into the first
columns of the work sheet.
2.
Enter adjusting entries in the next two columns.
3.
Calculate the total of each account in the Adjusted Trial Balance columns.
4.
Extend these adjusted balances to the Income Statement or Balance Sheet columns.
Debits on the Adjusted Trial Balance columns remain as debits and credits remain as
credits.
5.
The amount required to balance the Income Statement and Balance Sheet columns
represents net income or net loss.
a.
Net income is entered in the debit column of the Income Statement and in the
credit column of the Balance Sheet.
b.
Net loss is entered in the credit column of the Income Statement and in the debit
column of the Balance Sheet.
Learning Objective 2: Use the work sheet to complete the accounting cycle
A.
One of the benefits of the work sheet is the financial statements can be prepared directly from
the data on the work sheet before the adjusting entries are recorded. Financial statements are
always prepared in the order illustrated in Exhibit 4-7―income statement, statement of owner’s
equity, and balance sheet―no matter if the financial statements are prepared from an adjusted
trial balance or a work sheet.
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B.
Adjusting entries are not considered recorded until they are recorded in the journal. To do this,
copy adjusting entries from the work sheet into the journal and post to the ledger. (Refer to
Exhibit 4-8.)
Learning Objective 3: Close the revenue, expense, and withdrawal accounts
A.
Closing the accounts is the process by which certain accounts are prepared for recording
transactions of the next period. Exhibit 4-9 shows the overall flow of the closing process and
Exhibit 4-10 illustrates the journalizing and posting of closing entries. Note that closing entries
may be prepared directly from the work sheet.
B.
Close temporary (nominal) accounts. Temporary or nominal accounts relate to a particular
accounting period and must be closed at the end of the period.
1.
Revenue and expense accounts are closed to Income Summary, an account used only at
closing. Close revenue accounts:
Revenues
XX
Income Summary
XX
2.
Close expense accounts:
Income Summary
Expenses
3.
XX
XX
Close Income Summary. The balance of Income Summary equals net income or net loss
and must be transferred to the capital account.
Income Summary
XX
Capital
XX
Entry if there is net income.
Capital
XX
Income Summary
Entry if there is net loss.
C.
D.
XX
4.
Close Withdrawals directly to Capital:
Capital
XX
Withdrawals XX
5.
Closing entries must leave a zero balance in all temporary accounts.
Never close permanent (real) accounts.
1.
Permanent accounts include assets, liabilities, and owner’s equity accounts.
2.
Balances of permanent accounts carry over to the next period.
A postclosing trial balance (Exhibit 4-11) proves that all debits and credits of the adjusting, and
closing journal entries are balanced and were posted correctly. It lists the account balances after
closing entries.
1.
The postclosing trial balance is similar to the balance sheet in that it contains the
balances of only permanent (real) accounts.
2.
If any temporary accounts appear on the postclosing trial balance, one or more errors
have been made. Revenues, expenses, withdrawals, and income summary should never
be among the accounts listed.
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Learning Objective 4: Correct typical accounting errors
A.
Detecting and correcting accounting errors are necessary in order to present accurate financial
statements.
B.
The “error” may be any combination of errors, including posting errors, transpositions, slides, and
so on. Incorrect journal entries may be corrected as soon as made, or, if detected after posting,
then will require a correcting journal entry.
C.
Two alternatives are presented: 1) Reverse the original incorrect entry and record the correct
entry or 2) Create a journal entry that changes only the affected accounts.
Learning Objective 5: Classify assets and liabilities as current or long-term, and prepare a classified
balance sheet
A.
Assets and liabilities are classified as either current or long-term based on their liquidity.
Liquidity is the measure of how quickly the item may be converted to cash.
B.
Assets include:
C.
D.
1.
Current assets (also can be referred to as short-term assets) include cash or other assets
that will be converted to cash, sold, or consumed, in one year or one operating cycle,
whichever is longer.
a.
The operating cycle is the length of time during which (1) cash is used to
acquire goods or services; (2) these goods or services are sold to customers, who
(3) pay for their goods or services with cash.
b.
Current assets include cash, accounts and notes receivable due in less than one
year, prepaid expenses, and inventory.
2.
Long-term assets include all other assets used in the business, such as property, plant,
and equipment, and investments that mature in more than one year.
Liabilities include:
1.
Current liabilities are debts or obligations due within one year or one operating cycle,
whichever is longer. Included are accounts and notes payable due in less than one year,
salary and other accrued payables, and unearned revenue.
2.
Long-term liabilities are all other debts due in longer than one year. Many notes payable
and bonds payable are long-term.
The classified balance sheet groups assets and liabilities as current and long-term, as illustrated
in Exhibits 4-13 (account format) and 4-14 (report format). Both formats are acceptable
1.
The account format reports assets on the left side and liabilities and owner’s equity on t
he right, similar to the accounting equation, A = L + O/E.
2.
The report format of the balance sheet lists assets first, then liabilities, and finally
owner’s equity.
Learning Objective 6: Use the current ratio and the debt ratio to evaluate a company
A.
Accounting ratios are useful in financial statement analysis and decision making.
B.
The current ratio compares current assets to current liabilities. It helps the financial statement
user assess the company’s ability to pay current liabilities with current assets.
Current ratio = Total current assets / Total current liabilities
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C.
The debt ratio compares total liabilities to total assets. It shows how much of the company’s
assets are financed with debt. The debt ratio helps the financial statement user assess the
company’s long-term and short-term debt-paying ability.
Debt ratio = Total liabilities / Total assets
D.
Generally, a high current ratio is preferable to a low current ratio. A low debt ratio is
preferable to a high debt ratio.
E.
Financial ratio analysis is most helpful when performed for a series of periods and when many
different ratios are included.
Learning Objective 7: Describe the accounting-cycle and financial-reporting implications of
international financial reporting standards (IFRS)
A.
The accounting cycle is the same under IFRS and ASPE.
B.
The presentation of information may be quite different, as follows:
Under ASPE, companies provide the following
financial statements:
Balance sheet*
Income statement
Statement of owner's equity
(Statement of retained earnings for a
corporation)
Cash flow statement
Under IFRS, companies must provide the
following financial statements:
Statement of financial position
or Balance sheet
Statement of comprehensive income
or Income statement
Statement of changes in equity
or Statement of retained earnings
Statement of cash flows
or Cash flow statement
Companies reporting under either method must also provide notes to the financial statements, which
include significant accounting policies and explanatory information
* Focus of this chapter. The balance sheet in this chapter follows ASPE.
C.
Canadian companies reporting under IFRS have a choice between the following two options:
1.
Present balance sheet information in a different order. On the asset side, long-term assets
are listed first, followed by current assets. On the liability and equity side, the equity
section is presented first, followed by long-term liabilities and then current liabilities.
2.
Present balance sheet in the traditional order as described in this chapter.
Chapter 4 Appendix
Learning Objective A1: Describe and prepare reversing entries
Although not required by ASPE, reversing entries are sometimes used for convenience and to save time.
Reversing entries are primarily used for accrual adjusting entries, such as salary expense. The text walks
through an example using HEC’s accrual for salary expense. Exhibit 4A-1 compares the two ways of
recording accruals – with no reversals and with reversals.