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1 C H A P T E R Completing the Accounting Cycle AP Photo/Gregory Bull E L E C T R O N I C A R T S I N C. Most of us have had to file a personal tax return. At the beginning of the year, you estimate your upcoming income and decide whether you need to increase your payroll tax withholdings or perhaps pay estimated taxes. During the year, you earn income and enter into taxrelated transactions, such as making charitable contributions. At the end of the year, your employer sends you a tax withholding information form (W-) form, and you collect the tax records needed for completing your yearly tax forms. As the next year begins, you start the cycle all over again. Businesses also go through a cycle of activities. For example, Electronic Arts Inc., the world s largest developer and marketer of electronic game software, begins its cycle by developing new or revised game titles, such as Madden NFL Football, Need for Speed, Tiger Woods PGA Tour, The Sims, and The Lord of the Rings. These games are marketed and sold throughout the year. During the year, operating transactions of the business are recorded. For Electronic Arts, such transactions include the salaries for game developers, advertising expenditures, costs for producing and packaging games, and game revenues. At the end of the year, financial statements are prepared that summarize the operating activities for the year. Electronic Arts publishes these statements on its Web site at investor.ea.com. Finally, before the start of the next year, the accounts are readied for recording the operations of the next year. As we saw in Chapter,the initial cycle for NetSolutions began with Chris Clark s investment in the business on November, 009. The cycle continued with recording NetSolutions transactions for November and December, as we discussed and illustrated in Chapters and. In Chapter, the cycle continued when the adjusting entries for the two months ending December, 009, were recorded. In this chapter, we complete the cycle for NetSolutions by preparing financial statements and getting the accounts ready for recording transactions of the next period.

2 Chapter Completing the Accounting Cycle After studying this chapter, you should be able to: Describe the flow of accounting information from the unadjusted trial balance into the adjusted trial balance and financial statements. 5 6 Prepare financial statements from adjusted account balances. Prepare closing entries. Describe the accounting cycle. Illustrate the accounting cycle for one period. Explain what is meant by the fiscal year and the natural business year. Flow of Accounting Information EE - (page 6) Financial Statements Income Statement EE - (page 6) Closing Entries Accounting Cycle EE -6 (page 56) Illustration of the Accounting Cycle Fiscal Year Statement of Owner s Equity EE - (page 8) Journalizing and Posting Closing Entries EE -5 (page 5) Post-Closing Trial Sheet EE - (page 9) At a Glance Menu Turn to pg 70 Describe the flow of accounting information from the unadjusted trial balance into the adjusted trial balance and financial statements. Many companies use Microsoft s Excel software to prepare end-of-period spreadsheets (work sheets). Flow of Accounting Information The end-of-period process by which accounts are adjusted and the financial statements are prepared is one of the most important in accounting. Using our illustration of NetSolutions from Chapters, this process is summarized in spreadsheet form in Exhibit. Exhibit begins with the unadjusted trial balance as of the end of the period. The unadjusted trial balance verifies that the total of the debit balances equals the total of the credit balances. If the trial balance totals are unequal, an error has occurred. Any error must be found and corrected before the end-of-period process can continue. The adjustments for NetSolutions from Chapter are shown in the Adjustments columns of Exhibit. Cross-referencing (by letters) the debit and credit of each adjustment is useful in reviewing the impact of the adjustments on the unadjusted account balances. The adjustments are normally entered in the order in which the data are assembled. If the titles of the accounts to be adjusted do not appear in the unadjusted trial balance, the accounts are inserted in their proper order in the Account Title column. The total of the Adjustments columns verifies that the debits equals the credits for the adjustment data and adjusting entries. The total of the column must equal the total of the column. The adjustment data are added to or subtracted from the amounts in the Unadjusted Trial columns to arrive at the Adjusted Trial columns. In this way, the Adjusted Trial columns of Exhibit illustrate the impact of the adjusting entries on the unadjusted accounts. The totals of the Adjusted Trial columns verify the equality of the totals of the debit and credit balances after adjustment.

3 Chapter Completing the Accounting Cycle 5 Exhibit Exhibit also illustrates the flow of accounts from the adjusted trial balance into the financial statements as follows:. The revenue and expense accounts are extended to (flow into) the Income Statement columns.. At the bottom of the Income Statement columns, the net income or net loss for the period is the difference between the total Column (revenues) and the total column (expenses). If the Income Statement column total (revenues) is greater than the Income Statement column total (expenses), the difference is the net income. If the Income Statement column total is greater than the Income Statement column total, the difference is a net loss. Exhibit shows that NetSolutions had net income of $7,05 for the period.. The assets, liabilities, owner s capital, and drawing accounts are extended (flow into) to the Sheet columns.. At the bottom of the Sheet column, the net income or net loss for the period is the difference between the total column and the total column. Since net income increases owner s capital, NetSolutions net income of $7,05 is shown in the Sheet column. To summarize, Exhibit illustrates the end-of-period process by which accounts are adjusted. In addition, Exhibit illustrates how the adjusted accounts flow into the financial statements. The financial statements for NetSolutions can be prepared directly from Exhibit. The spreadsheet in Exhibit is not a required part of the accounting process. However, many accountants prepare such a spreadsheet, often called a work sheet, in End-of-Period Spreadsheet (Work Sheet) Cash Accounts Receivable Supplies Prepaid Insurance Land Office Equipment Accumulated Depreciation Accounts Payable Wages Payable Unearned Rent Chris Clark, Capital Chris Clark, Drawing Fees Earned Rent Revenue Wages Expense Rent Expense Depreciation Expense Utilities Expense Supplies Expense Insurance Expense Miscellaneous Expense Net income A B C D E F G H I J K NetSolutions End-of-Period Spreadsheet (Work Sheet) For the Two Months Ended December, 009 Unadjusted Adjusted Trial Adjustments Trial Income Statement Sheet Account Title Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.,065,0,000,00 0,000,800,000,75, ,600 6,0,600 (d) 500 (f) (e) ,000 (c) 0 (e) 50 (f) 50 (a),0 (b) 00,60 (a),0 (b) 00 (d) 500 (c) 0,60,065,70 760,00 0,000,800,000,55, , , ,000 6,80 0,00,55, , ,855 7,05 6,960 6,80 0 6,960 6,960,065,70 760,00 0,000,800,000,55, ,000 6,0 7,05,55

4 6 Chapter Completing the Accounting Cycle Example Exercise - manual or electronic form, as part of their normal end-of-period process. The primary advantage in doing so is that it allows managers and accountants to see the impact of the adjustments on the financial statements. This is especially useful for adjustments that depend upon estimates. We discuss such estimates and their impact on the financial statements in later chapters. Flow of Accounts into Financial Statements The balances for the accounts listed below appear in the Adjusted Trial columns of the end-ofperiod spreadsheet (work sheet). Indicate whether each balance should be extended to (a) an Income Statement column or (b) a Sheet column.. Amber Bablock, Drawing 5. Fees Earned. Utilities Expense 6. Accounts Payable. Accumulated Depreciation Equipment 7. Rent Revenue. Unearned Rent 8. Supplies Follow My Example -. Sheet column 5. Income Statement column. Income Statement column 6. Sheet column. Sheet column 7. Income Statement column. Sheet column 8. Sheet column For Practice: PE -A, PE -B Prepare financial statements from adjusted account balances. Financial Statements Using Exhibit, the financial statements for NetSolutions can be prepared. The income statement, the statement of owner s equity, and the balance sheet are shown in Exhibit. Income Statement The income statement is prepared directly from the Income Statement or Adjusted Trial columns of Exhibit beginning with fees earned of $6,80. The expenses in the income statement in Exhibit are listed in order of size, beginning with the larger items. Miscellaneous expense is the last item, regardless of its amount. Example Exercise - Determining Net Income from End-of-Period Spreadsheet In the Sheet columns of the end-of-period spreadsheet (work sheet) for Dimple Consulting Co. for the current year, the column total is $678,50, and the column total is $599,750 before the amount for net income or net loss has been included. In preparing the income statement from the end-of-period spreadsheet (work sheet), what is the amount of net income or net loss? Follow My Example - A net income of $78,700 ($678,50 $599,750) would be reported. When the column of the Sheet columns is more than the column, net income is reported. If the column exceeds the column, a net loss is reported. For Practice: PE -A, PE -B The appendix to this chapter describes and illustrates how to prepare the end-of-period spreadsheet (work sheet) shown in Exhibit.

5 Chapter Completing the Accounting Cycle 7 Exhibit Financial Statements Prepared from Work Sheet NetSolutions Income Statement For the Two Months Ended December, 009 Fees earned Rent revenue Total revenues Expenses: Wages expense Supplies expense Rent expense Utilities expense Insurance expense Depreciation expense Miscellaneous expense Total expenses Net income $6,80 0 $,55,00, $6,960 9,855 $ 7,05 NetSolutions Statement of Owner s Equity For the Two Months Ended December, 009 Chris Clark, capital, November, 009 Investment on November, 009 Net income for November and December Less withdrawals Increase in owner s equity Chris Clark, capital, December, 009 $5,000 7,05 $,05,000 $ 0 8,05 $8,05 NetSolutions Sheet December, 009 Assets Liabilities Current assets: Cash Accounts receivable Supplies Prepaid insurance Total current assets Property, plant, and equipment: Land Office equipment Less accum. depreciation Total property, plant, and equipment Total assets $, $,065,70 760,00 $0,000,750 $ 7,75,750 $9,95 Current liabilities: Accounts payable Wages payable Unearned rent Total liabilities Chris Clark, capital Total liabilities and owner s equity Owner s Equity $ $,90 8,05 $9,95

6 8 Chapter Completing the Accounting Cycle THE ROUND TRIP A common type of fraud involves artificially inflating revenue. One fraudulent method of inflating revenue is called round tripping. Under this scheme, a selling company (S) lends money to a customer company (C). The money is then used by C to purchase a product from S. Thus, S sells product to C and is paid with the money just loaned to C! This looks like a sale in the accounting records, but in reality, S is shipping free product. The fraud is exposed when it is determined that there was no intent to repay the original loan. Statement of Owner s Equity The first item presented on the statement of owner s equity is the balance of the owner s capital account at the beginning of the period. The amount listed as owner s capital in the spreadsheet, however, is not always the account balance at the beginning of the period. The owner may have invested additional assets in the business during the period. Thus, for the beginning balance and any additional investments, it is necessary to refer to the owner s capital account in the ledger. These amounts, along with the net income (or net loss) and the drawing account balance, are used to determine the ending owner s capital account balance. The basic form of the statement of owner s equity is shown in Exhibit. For NetSolutions, the amount of drawings by the owner was less than the net income. If the owner s withdrawals had exceeded the net income, the order of the net income and the withdrawals would have been reversed. The difference between the two items would then be deducted from the beginning capital account balance. Other factors, such as additional investments or a net loss, also require some change in the form, as shown below. Allan Johnson, capital, January, 009 $9,000 Additional investment during the year 6,000 Total $5,000 Net loss for the year $ 5,600 Withdrawals 9,500 Decrease in owner s equity 5,00 Allan Johnson, capital, December, 009 $9,900 Example Exercise - Statement of Owner s Equity Zack Gaddis owns and operates Gaddis Employment Services. On January, 009, Zack Gaddis, Capital had a balance of $86,000. During the year, Zack invested an additional $0,000 and withdrew $5,000. For the year ended December, 009, Gaddis Employment Services reported a net income of $8,750. Prepare a statement of owner s equity for the year ended December, 009. Follow My Example - GADDIS EMPLOYMENT SERVICES STATEMENT OF OWNER S EQUITY For the Year Ended December, 009 Zack Gaddis, capital, January, $86,000 Additional investment during ,000 Total $6,000 Withdrawals $ 5,000 Less net income ,750 Decrease in owner s equity ,50 Zack Gaddis, capital, December, $9,750 For Practice: PE -A, PE -B

7 Chapter Completing the Accounting Cycle 9 Sheet The balance sheet is prepared directly from the Sheet or Adjusted Trial columns of Exhibit beginning with Cash of $,065. The balance sheet in Exhibit shows subsections for assets and liabilities. Such a balance sheet is a classified balance sheet. We describe these subsections next. Assets Assets are commonly divided into two sections on the balance sheet: () current assets and () property, plant, and equipment. Two common classes of assets are Current Assets Cash and other assets that are expected to be converted to cash or sold or used up usually within one year or less, current assets and property, plant, and equipment. through the normal operations of the business, are called current assets. In addition to cash, the current assets may include notes receivable, accounts receivable, supplies, and other prepaid expenses. Notes receivable are amounts that customers owe. They are written promises to pay the amount of the note and interest. Accounts receivable are also amounts customers owe, but they are less formal than notes. Accounts receivable normally result from providing services or selling merchandise on account. Notes receivable and accounts receivable are current assets because they are usually converted to cash within one year or less. Property, Plant, and Equipment The property, plant, and equipment section may also be described as fixed assets or plant assets. These assets include equipment, machinery, buildings, and land. With the exception of land, as we discussed in Chapter, fixed assets depreciate over a period of time. The cost, accumulated depreciation, and book value of each major type of fixed asset are normally reported on the balance sheet or in the notes to the financial statements. Two common classes of liabilities are current liabilities and long-term liabilities. Example Exercise - Liabilities Liabilities are the amounts the business owes to creditors. Liabilities are commonly divided into two sections on the balance sheet: () current liabilities and () long-term liabilities. Current Liabilities Liabilities that will be due within a short time (usually one year or less) and that are to be paid out of current assets are called current liabilities. The most common liabilities in this group are notes payable and accounts payable. Other current liabilities may include Wages Payable, Interest Payable, Taxes Payable, and Unearned Fees. Long-Term Liabilities Liabilities that will not be due for a long time (usually more than one year) are called long-term liabilities. If NetSolutions had long-term liabilities, they would be reported below the current liabilities. As long-term liabilities come due and are to be paid within one year, they are reported as current liabilities. If they are to be renewed rather than paid, they would continue to be reported as long term. When an asset is pledged as security for a liability, the obligation may be called a mortgage note payable or a mortgage payable. Owner s Equity The owner s right to the assets of the business is presented on the balance sheet below the liabilities section. The owner s equity is added to the total liabilities, and this total must be equal to the total assets. Classified Sheet The following accounts appear in an adjusted trial balance of Hindsight Consulting. Indicate whether each account would be reported in the (a) current asset; (b) property, plant, and equipment; (c) current liability; (d) long-term liability; or (e) owner s equity section of the December, 009, balance sheet of Hindsight Consulting.. Jason Corbin, Capital 5. Cash. Notes Receivable (due in 6 months) 6. Unearned Rent ( months). Notes Payable (due in 0) 7. Accumulated Depreciation Equipment. Land 8. Accounts Payable (continued)

8 50 Chapter Completing the Accounting Cycle Follow My Example -. Owner s equity 5. Current asset. Current asset 6. Current liability. Long-term liability 7. Property, plant, and equipment. Property, plant, and equipment 8. Current liability For Practice: PE -A, PE -B INTERNATIONAL DIFFERENCES Financial statements prepared under accounting practices in other countries often differ from those prepared under generally accepted accounting principles in the United States. This is to be expected, since cultures and market structures differ from country to country. To illustrate, BMW Group prepares its financial statements under International Financial Reporting Standards as adopted by the European Union. In doing so, BMW s balance sheet reports fixed assets first, followed by current assets. It also reports owner s equity before the liabilities. In contrast, balance sheets prepared under U.S. accounting principles report current assets followed by fixed assets and current liabilities followed by long-term liabilities and owner s equity. The U.S. form of balance sheet is organized to emphasize creditor interpretation and analysis. For example, current assets and current liabilities are presented first to facilitate their interpretation and analysis by creditors. Likewise, to emphasize their importance, liabilities are reported before owner s equity. Regardless of these differences, the basic principles underlying the accounting equation and the double-entry accounting system are the same in Germany and the United States. Even though differences in recording and reporting exist, the accounting equation holds true: the total assets still equal the total liabilities and owner s equity. Prepare closing entries. Closing entries transfer the balances of temporary accounts to the owner s capital account. Closing Entries As discussed in Chapter, the adjusting entries are recorded in the journal at the end of the accounting period. For NetSolutions, the adjusting entries are shown in Exhibit 7 of Chapter. After the adjusting entries are posted to NetSolutions ledger, shown in Exhibit 6 (on pages 5 55), the ledger agrees with the data reported on the financial statements. The balances of the accounts reported on the balance sheet are carried forward from year to year. Because they are relatively permanent, these accounts are called permanent accounts or real accounts. For example, Cash, Accounts Receivable, Equipment, Accumulated Depreciation, Accounts Payable, and Owner s Capital are all permanent accounts. The balances of the accounts reported on the income statement are not carried forward from year to year. Also, the balance of the owner s drawing account, which is reported on the statement of owner s equity, is not carried forward. Because these accounts report amounts for only one period, they are called temporary accounts or nominal accounts. Temporary accounts are not carried forward because they relate only to one period. For example, the Fees Earned of $6,80 and Wages Expense of $,55 for NetSolutions shown in Exhibit are for the two months ending December, 009, and should not be carried forward to 00. At the beginning of the next period, temporary accounts should have zero balances. To achieve this, temporary account balances are transferred to permanent accounts at the end of the accounting period. The entries that transfer these balances are called closing entries. The transfer process is called the closing process and is sometimes referred to as closing the books.

9 Chapter Completing the Accounting Cycle 5 The closing process involves the following four steps:. Revenue account balances are transferred to an account called Income Summary.. Expense account balances are transferred to an account called Income Summary.. The balance of Income Summary (net income or net loss) is transferred to the owner s capital account.. The balance of the owner s drawing account is transferred to the owner s capital account. Exhibit diagrams the closing process. Exhibit The Closing Process Expenses are transferred to Income Summary INCOME SUMMARY Revenues are transferred to Income Summary.... Net Income or Net Loss is transferred to Owner s Capital.... Owner's Capital Drawings are transferred to Owner s Capital Income Summary is a temporary account that is only used during the closing process. At the beginning of the closing process, The income summary account Income Summary has no balance. During the closing process, does not appear on the financial Income Summary will be debited and credited for various statements. amounts. At the end of the closing process, Income Summary will again have no balance. Because Income Summary has the effect of clearing the revenue and expense accounts of their balances, it is sometimes called a clearing account. Other titles used for this account include Revenue and Expense Summary, Profit and Loss Summary, and Income and Expense Summary. The four closing entries required in the closing process are as follows:. each revenue account for its balance and credit Income Summary for the total revenue.. each expense account for its balance and debit Income Summary for the total expenses.. Income Summary for its balance and credit the owner s capital account.. the owner s capital account for the balance of the drawing account and credit the drawing account. In the case of a net loss, Income Summary will have a debit balance after the first two closing entries. In this case, credit Income Summary for the amount of its balance and debit the owner s capital account for the amount of the net loss. Closing entries are recorded in the journal and are dated as of the last day of the accounting period. In the journal, closing entries are recorded immediately following the adjusting entries. The caption, Closing Entries, is often inserted above the closing entries to separate them from the adjusting entries.

10 5 Chapter Completing the Accounting Cycle Exhibit It is possible to close the temporary revenue and expense accounts without using a clearing account such as Income Summary. In this case, the balances of the revenue and expense accounts are closed directly to the owner s capital account. This process may be used in a computerized accounting system. In a manual system, the use of an income summary account aids in detecting and correcting errors. Journalizing and Posting Closing Entries A flowchart of the four closing entries for NetSolutions is shown in Exhibit. The balances in the accounts are those shown in the Adjusted Trial columns of the end-of-period spreadsheet shown in Exhibit. Flowchart of Closing Entries for NetSolutions Owner s Equity Wages Expense Bal.,55,55 Rent Expense Bal.,600,600 Income Summary 9,855 7,05 6,960 Fees Earned 6,80 Bal. 6,80 Rent Revenue 0 Bal. 0 Depreciation Expense Bal Utilities Expense Bal Chris Clark, Capital Supplies Expense Bal.,00,00 Insurance Expense Bal Miscellaneous Expense Bal ,000 Bal. 5,000 7,05. each revenue account for its balance, and credit Income Summary for the total revenue.. Income Summary for the total expenses, and credit each expense account for its balance.. Income Summary for the amount of its balance (net income), and credit the capital account. (The accounts debited and credited are reversed if there is a net loss.). the capital account for the balance of the drawing account, and credit the drawing account. Chris Clark, Drawing Bal.,000,000 The closing entries for NetSolutions are shown in Exhibit 5. The account titles and balances for the these entries may be obtained from the end-of-period spreadsheet, the adjusted trial balance, the income statement, the statement of owner s equity, or the ledger. The closing entries are posted to NetSolutions ledger as shown in Exhibit 6 (pages 5 55). Income Summary has been added to NetSolutions ledger in Exhibit 6 as account number. After the closing entries are posted, NetSolutions ledger has the following characteristics:. The balance of Chris Clark, Capital of $8,05 agrees with the amount reported on the statement of owner s equity and the balance sheet.. The revenue, expense, and drawing accounts will have zero balances. As shown in Exhibit 6, the closing entries are normally identified in the ledger as Closing. In addition, a line is often inserted in both balance columns after a closing entry is posted. This separates next period s revenue, expense, and withdrawal transactions from those of the current period. Next period s transactions will be posted directly below the closing entry.

11 Chapter Completing the Accounting Cycle 5 Exhibit 5 Closing Entries for NetSolutions Description Journal Page Dec. Closing Entries Fees Earned Rent Revenue 6,80 0 Income Summary 6,960 Income Summary 9,855 Wages Expense 5,55 Rent Expense 5,600 Depreciation Expense 5 50 Utilities Expense Supplies Expense 55,00 Insurance Expense Miscellaneous Expense Income Summary 7,05 Chris Clark, Capital 7,05 Chris Clark, Capital,000 Chris Clark, Drawing,000 Example Exercise -5 Closing Entries After the accounts have been adjusted at July, the end of the fiscal year, the following balances are taken from the ledger of Cabriolet Services Co.: Terry Lambert, Capital $65,850 Terry Lambert, Drawing 5,000 Fees Earned 80,50 Wages Expense 50,000 Rent Expense 65,000 Supplies Expense 8,50 Miscellaneous Expense 6,00 Journalize the four entries required to close the accounts. Follow My Example -5 July Fees Earned 80,50 Income Summary 80,50 Income Summary 9,50 Wages Expense 50,000 Rent Expense 65,000 Supplies Expense 8,50 Miscellaneous Expense 6,00 Income Summary,000 Terry Lambert, Capital,000 Terry Lambert, Capital 5,000 Terry Lambert, Drawing 5,000 For Practice: PE -5A, PE -5B

12 Exhibit 6 Ledger for NetSolutions Ledger Account Cash Account No. 009 Nov. 5 8 Dec Dec ,000 7,500 60,00 650,870 Account Accounts Receivable 009 Nov. 0 Dec. Adjusting Account Supplies Adjusting Adjusting,750, ,000, ,000, ,50,00 5,000 5 Account Prepaid Insurance 009 Dec. Account Land 009 Nov. 5,50, ,00 5,000 5,000,500 8,850 7,900 5,900,500,700,060,880,80,5,6,7,80,9,7,0,95,065,065 Account No. 800,0 0,000,750,00,0,70 Account No. 00,50 550, Account No. 5,00,00 Account No. 7 0,000 Account Office Equipment 009 Dec. 009 Dec.,800 Account Accumulated Depreciation 009 Nov. 0 Dec. 0 Account No. 8,800 Account No Account Accounts Payable Account No. Account Wages Payable 009 Dec. 009 Dec. Account Unearned Rent 5 Account Chris Clark, Capital 009 Nov. Dec. 009 Nov. Dec. Adjusting Adjusting Adjusting Closing Closing ,50, ,000 Account No. Account No. 60 Account Chris Clark, Drawing 5,000 7,05,000,000 Closing 6,000 Account No.,50 00,00, Account No. 5,000,05 8,05,000,000 5

13 Chapter Completing the Accounting Cycle 55 Exhibit 6 (continued) Account Income Summary Account No. Account Depreciation Expense Account No Dec. Closing Closing Closing ,855 7,05 6,960 6,960 7, Dec. Adjusting Closing Account Fees Earned 009 Nov. 8 Dec. 6 6 Account Rent Revenue 009 Dec. Adjusting Closing Adjusting Closing ,80 0 7,500,00,750,870,0 500 Account No. Account No. 7,50 0 0,600,50 5,0 6,0 6, Account Utilities Expense 009 Nov. Dec. Account Supplies Expense 009 Nov. Dec. Closing Adjusting Closing ,0 Account No ,00 Account No ,00 Account Wages Expense Account No Nov. Dec ,5 950,00 50 Adjusting Closing,55,5,075,75,55 Account Insurance Expense 009 Dec. Adjusting Closing 5 6 Account No Account Rent Expense 009 Nov. Dec. Closing ,600 Account No ,600 Account Miscellaneous Expense 009 Nov. Dec. 6 Closing Account No Post-Closing Trial A post-closing trial balance is prepared after the closing entries have been posted. The purpose of the post-closing (after closing) trial balance is to verify that the ledger is in balance at the beginning of the next period. The accounts and amounts should agree exactly with the accounts and amounts listed on the balance sheet at the end of the period. The post-closing trial balance for NetSolutions is shown in Exhibit 7.

14 56 Chapter Completing the Accounting Cycle Exhibit 7 Post-Closing Trial NetSolutions Post-Closing Trial December, 009 Cash Accounts Receivable Supplies Prepaid Insurance Land Office Equipment Accumulated Depreciation Accounts Payable Wages Payable Unearned Rent Chris Clark, Capital s,065,70 760,00 0,000,800 9,55 s ,05 9,55 Describe the accounting cycle. Example Exercise -6 Accounting Cycle The accounting process that begins with analyzing and journalizing transactions and ends with the post-closing trial balance is called the accounting cycle. The steps in the accounting cycle are as follows:. Transactions are analyzed and recorded in the journal.. Transactions are posted to the ledger.. An unadjusted trial balance is prepared.. Adjustment data are assembled and analyzed. 5. An optional end-of-period spreadsheet (work sheet) is prepared. 6. Adjusting entries are journalized and posted to the ledger. 7. An adjusted trial balance is prepared. 8. Financial statements are prepared. 9. Closing entries are journalized and posted to the ledger. 0. A post-closing trial balance is prepared. Exhibit 8 illustrates the accounting cycle in graphic form. It also illustrates how the accounting cycle begins with the source documents for a transaction and flows through the accounting system and into the financial statements. Accounting Cycle From the following list of steps in the accounting cycle, identify what two steps are missing. a. Transactions are analyzed and recorded in the journal. b. Transactions are posted to the ledger. c. Adjustment data are assembled and analyzed. d. An optional end-of-period spreadsheet (work sheet) is prepared. e. Adjusting entries are journalized and posted to the ledger. f. Financial statements are prepared. g. Closing entries are journalized and posted to the ledger. h. A post-closing trial balance is prepared. (continued) Some accountants include the journalizing and posting of reversing entries as the last step in the accounting cycle. Because reversing entries are not required, we describe and illustrate them in Appendix B at the end of the book.

15 Chapter Completing the Accounting Cycle 57 Follow My Example -6 The following two steps are missing: () the preparation of an unadjusted trial balance and () the preparation of the adjusted trial balance. The unadjusted trial balance should be prepared after step (b). The adjusted trial balance should be prepared after step (e). For Practice: PE -6A, PE -6B Exhibit 8 Accounting Cycle 5 Illustrate the accounting cycle for one period. Illustration of the Accounting Cycle In this section, we will illustate the complete accounting cycle for one period. We assume that for several years Kelly Pitney has operated a part-time consulting business from her home. As of April, 00, Kelly decided to move to rented quarters and to operate

16 58 Chapter Completing the Accounting Cycle the business on a full-time basis. The business will be known as Kelly Consulting. During April, Kelly Consulting entered into the following transactions: Apr.. The following assets were received from Kelly Pitney: cash, $,00; accounts receivable, $,000; supplies, $,00; and office equipment, $,500. There were no liabilities received.. Paid three months rent on a lease rental contract, $,800.. Paid the premiums on property and casualty insurance policies, $,800.. Received cash from clients as an advance payment for services to be provided and recorded it as unearned fees, $5, Purchased additional office equipment on account from Office Station Co., $, Received cash from clients on account, $, Paid cash for a newspaper advertisement, $0.. Paid Office Station Co. for part of the debt incurred on April 5, $,00.. Recorded services provided on account for the period April, $,00.. Paid part-time receptionist for two weeks salary, $ Recorded cash from cash clients for fees earned during the period April 6, $6, Paid cash for supplies, $ Recorded services provided on account for the period April 0, $,00.. Recorded cash from cash clients for fees earned for the period April 7, $, Received cash from clients on account, $5, Paid part-time receptionist for two weeks salary, $ Paid telephone bill for April, $.. Paid electricity bill for April, $00.. Recorded cash from cash clients for fees earned for the period April 5, $,050.. Recorded services provided on account for the remainder of April, $,500.. Kelly withdrew $6,000 for personal use. Step. Analyzing and Recording Transactions in the Journal The first step in the accounting cycle is to analyze and record transactions in the journal using the double-entry accounting system. As we illustrated in Chapter, transactions are analyzed and journalized using the following steps:. Carefully read the description of the transaction to determine whether an asset, liability, owner s equity, revenue, expense, or drawing account is affected.. For each account affected by the transaction, determine whether the account increases or decreases.. Determine whether each increase or decrease should be recorded as a debit or a credit, following the rules of debit and credit shown in Exhibit of Chapter.. Record the transaction using a journal entry. The company s chart of accounts is useful in determining which accounts are affected by the transaction. The chart of accounts for Kelly Consulting is as follows: Cash Kelly Pitney, Capital Accounts Receivable Kelly Pitney, Drawing Supplies Income Summary 5 Prepaid Rent Fees Earned 6 Prepaid Insurance 5 Salary Expense 8 Office Equipment 5 Rent Expense 9 Accumulated Depreciation 5 Supplies Expense Accounts Payable 5 Depreciation Expense Salaries Payable 55 Insurance Expense Unearned Fees 59 Miscellaneous Expense

17 Chapter Completing the Accounting Cycle 59 After analyzing each of Kelly Consulting s transactions for April, the journal entries are recorded as shown in Exhibit 9. Exhibit 9 Journal Entries for April, Kelly Consulting Step. Posting Transactions to the Ledger Periodically, the transactions recorded in the journal are posted to the accounts in the ledger. The debits and credits for each journal entry are posted to the accounts in the order in which they occur in the journal. As we illustrated in Chapters and, journal entries are posted to the accounts using the following four steps.. The date is entered in the column of the account.. The amount is entered into the or column of the account.. The journal page number is entered in the Posting Reference column.. The account number is entered in the Posting Reference ( Ref.) column in the journal. The journal entries for Kelly Consulting have been posted to the ledger shown in Exhibit 7 on pages Apr. Cash Accounts Receivable Supplies Office Equipment Kelly Pitney, Capital Description Journal Page 8,00,000,00,500,000 Prepaid Rent 5,800 Cash,800 Prepaid Insurance 6,800 Cash,800 Cash 5,000 Unearned Fees 5,000 5 Office Equipment 8,000 Accounts Payable,000 6 Cash,800 Accounts Receivable,800 0 Miscellaneous Expense 59 0 Cash 0 Accounts Payable,00 Cash,00 Accounts Receivable,00 Fees Earned,00 Salary Expense Cash 750 (continued)

18 60 Chapter Completing the Accounting Cycle Exhibit 9 Journal Entries for April, Kelly Consulting (continued) Description Journal Page 00 Apr. 7 Cash 6,50 Fees Earned 6,50 8 Supplies 800 Cash Accounts Receivable,00 Fees Earned,00 Cash,850 Fees Earned,850 6 Cash 5,600 Accounts Receivable 5,600 7 Salary Expense Cash Miscellaneous Expense 59 Cash Miscellaneous Expense Cash 00 Cash,050 Fees Earned,050 Accounts Receivable,500 Fees Earned,500 Kelly Pitney, Drawing 6,000 Cash 6,000 Step. Preparing an Unadjusted Trial An unadjusted trial balance is prepared to determine whether any errors have been made in posting the debits and credits to the ledger. The unadjusted trial balance does not provide complete proof of the accuracy of the ledger. It indicates only that the debits and the credits are equal. This proof is of value, however, because errors often affect the equality of debits and credits. If the two totals of a trial balance are not equal, an error has occurred that must be discovered and corrected. The unadjusted trial balance for Kelly Consulting is shown in Exhibit 0. The unadjusted account balances shown in Exhibit 0 were taken from Kelly Consulting s ledger shown in Exhibit 7, on pages 66 68, before any adjusting entries were recorded. Step. Assembling and Analyzing Adjustment Data Before the financial statements can be prepared, the accounts must be updated. The four types of accounts that normally require adjustment include prepaid expenses, unearned revenue, accrued revenue, and accrued expenses. In addition, depreciation

19 Chapter Completing the Accounting Cycle 6 Exhibit 0 Unadjusted Trial, Kelly Consulting Kelly Consulting Unadjusted Trial April, 00 Cash Accounts Receivable Supplies Prepaid Rent Prepaid Insurance Office Equipment Accumulated Depreciation Accounts Payable Salaries Payable Unearned Fees Kelly Pitney, Capital Kelly Pitney, Drawing Fees Earned Salary Expense Rent Expense Supplies Expense Depreciation Expense Insurance Expense Miscellaneous Expense s,00,00,00,800,800,500 6,000, ,750 s ,000,000 0,950 56,750 expense must be recorded for fixed assets other than land. The following data have been assembled on April, 00, for analysis of possible adjustments for Kelly Consulting: a. Insurance expired during April is $0. b. Supplies on hand on April are $,50. c. Depreciation of office equipment for April is $. d. Accrued receptionist salary on April is $0. e. Rent expired during April is $,600. f. Unearned fees on April are $,500. Step 5. Preparing an Optional End-of-Period Spreadsheet (Work Sheet) Although an end-of-period spreadsheet (work sheet) is not required, it is useful in showing the flow of accounting information from the unadjusted trial balance to the adjusted trial balance and financial statements. In addition, an end-of-period spreadsheet is useful in analyzing the impact of proposed adjustments on the financial statements. The end-of-period spreadsheet for Kelly Consulting is shown in Exhibit. Step 6. Journalizing and Posting Adjusting Entries Based on the adjustment data shown in step, adjusting entries for Kelly Consulting are prepared as shown in Exhibit. Each adjusting entry affects at least one income statement account and one balance sheet account. Explanations for each adjustment including any computations are normally included with each adjusting entry.

20 6 Chapter Completing the Accounting Cycle Exhibit End-of-Period Spreadsheet (Work Sheet) A B C D E F G H I J K Kelly Consulting End-of-Period Spreadsheet (Work Sheet) For the Month Ended April, 00 Unadjusted Adjusted Trial Adjustments Trial Income Statement Sheet Account Title Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Cash Accounts Receivable Supplies Prepaid Rent Prepaid Insurance Office Equipment Accum. Depreciation Accounts Payable Salaries Payable Unearned Fees Kelly Pitney, Capital Kelly Pitney, Drawing Fees Earned Salary Expense Rent Expense Supplies Expense Depreciation Expense Insurance Expense Miscellaneous Expense Net income,00,00,00,800,800,500 6,000, ,750 (c) 800 (d) 0 5,000,000 (f),500 0,950 56,750 (d) 0 (e),600 (b) 850 (c) (a) 0 5,700 (b) 850 (e),600 (a) 0 (f),500 5,700,00,00,50,00,500,500 6,000,60, , ,500,000,50 57,00,60, ,50 8,0,50,50,50,50,00,00,50,00,500,500 6,000 5,050 5, ,500,000,750 8,0 5,050 Exhibit Adjusting Entries, Kelly Consulting Journal Page 00 Apr. Adjusting Entries Insurance Expense Prepaid Insurance Expired Insurance Supplies Expense Supplies Supplies used ($,00 $,50) Depreciation Expense Accumulated Depreciation Depreciation of office equipment. 5 9 Salary Expense Salaries Payable Accrued salary Rent Expense Prepaid Rent Rent expired during April. 5 5,600,600 Unearned Fees Fees Earned Fees earned ($5,000 $,500).,500,500

21 Chapter Completing the Accounting Cycle 6 Each of the adjusting entries shown in Exhibit is posted to Kelly Consulting s ledger shown in Exhibit 7 on pages The adjusting entries are identified in the ledger as Adjusting. Step 7. Preparing an Adjusted Trial After the adjustments have been journalized and posted, an adjusted trial balance is prepared to verify the equality of the total of the debit and credit balances. This is the last step before preparing the financial statements. If the adjusted trial balance does not balance, an error has occurred and must be found and corrected. The adjusted trial balance for Kelly Consulting as of April, 00, is shown in Exhibit. Step 8. Preparing the Financial Statements The most important outcome of the accounting cycle is the financial statements. The income statement is prepared first, followed by the statement of owner s equity and then the balance sheet. The statements can be prepared directly from the adjusted trial balance, the end-of-period spreadsheet, or the ledger. The net income or net loss shown on the income statement is reported on the statement of owner s equity along with any additional investments by the owner and any withdrawals. The ending owner s capital is reported on the balance sheet and is added with total liabilities to equal total assets. The financial statements for Kelly Consulting are shown in Exhibit. Kelly Consulting earned net income of $8,0 for April. As of April, 00, Kelly Consulting has total assets of $5,70, total liabilities of $,0, and total owner s equity of $,0. Exhibit Adjusted Trial, Kelly Consulting Kelly Consulting Adjusted Trial April, 00 Cash Accounts Receivable Supplies Prepaid Rent Prepaid Insurance Office Equipment Accumulated Depreciation Accounts Payable Salaries Payable Unearned Fees Kelly Pitney, Capital Kelly Pitney, Drawing Fees Earned Salary Expense Rent Expense Supplies Expense Depreciation Expense Insurance Expense Miscellaneous Expense s,00,00,50,00,500,500 6,000,60, ,00 s 800 0,500,000,50 57,00

22 6 Chapter Completing the Accounting Cycle Exhibit Financial Statements, Kelly Consulting Kelly Consulting Income Statement For the Month Ended April, 00 Fees earned Expenses: Salary expense Rent expense Supplies expense Depreciation expense Insurance expense Miscellaneous expense Total expenses Net income $,60, $,50 5,50 $8,0 Kelly Consulting Statement of Owner s Equity For the Month Ended April, 00 Kelly Pitney, capital, April, 00 Investment during the month Net income for the month Less withdrawals Increase in owner s equity Kelly Pitney, capital, April, 00 $,000 8,0 $8,0 6,000 $ 0,0 $,0 Kelly Consulting Sheet April, 00 Assets Liabilities Current assets: Current liabilities: Cash Accounts receivable Supplies Prepaid rent Prepaid insurance Total current assets $,00,00,50,00,500 $,550 Accounts payable Salaries payable Unearned fees Total liabilities $ 800 0,500 $,0 Property, plant, and equipment: Office equipment Less accumulated depreciation Total property, plant, $,500 Kelly Pitney, capital Owner s Equity,0 and equipment,70 Total liabilities and Total assets $5,70 owner s equity $5,70

23 Chapter Completing the Accounting Cycle 65 Step 9. Journalizing and Posting Closing Entries As described earlier in this chapter, four closing entries are required at the end of an accounting period. These four closing entries are as follows:. each revenue account for its balance and credit Income Summary for the total revenue.. each expense account for its balance and debit Income Summary for the total expenses.. Income Summary for its balance and credit the owner s capital account.. the owner s capital account for the balance of the drawing account and credit the drawing account. The four closing entries for Kelly Consulting are shown in Exhibit 5. The closing entries are posted to Kelly Consulting s ledger as shown in Exhibit 7 (pages 66 68). After the closing entries are posted, Kelly Consulting s ledger has the following characteristics:. The balance of Kelly Pitney, Capital of $,0 agrees with the amount reported on the statement of owner s equity and the balance sheet.. The revenue, expense, and drawing account will have zero balances. The closing entries are normally identified in the ledger as Closing. In addition, a line is often inserted in both balance columns after a closing entry is posted. This separates next period s revenue, expense, and withdrawal transactions from those of the current period. Step 0. Preparing a Post-Closing Trial A post-closing trial balance is prepared after the closing entries have been posted. The purpose of the post-closing trial balance is to verify that the ledger is in balance at the beginning of the next period. The accounts and amounts in the post-closing trial balance Exhibit 5 Closing Entries, Kelly Consulting Description Journal Page 00 Apr. Fees Earned Income Summary Closing Entries,50,50 Income Summary Salary Expense Rent Expense Supplies Expense Depreciation Expense Insurance Expense Miscellaneous Expense ,50,60, Income Summary Kelly Pitney, Capital 8,0 8,0 Kelly Pitney, Capital Kelly Pitney, Drawing 6,000 6,000

24 66 Chapter Completing the Accounting Cycle Exhibit 6 Post-Closing Trial, Kelly Consulting Kelly Consulting Post-Closing Trial April, 00 Cash Accounts Receivable Supplies Prepaid Rent Prepaid Insurance Office Equipment Accumulated Depreciation Accounts Payable Salaries Payable Unearned Fees Kelly Pitney, Capital s,00,00,50,00,500,500 6,050 s 800 0,500,0 6,050 Exhibit 7 Ledger, Kelly Consulting should agree exactly with the accounts and amounts listed on the balance sheet at the end of the period. The post-closing trial balance for Kelly Consulting is shown in Exhibit 6. The balances shown in the post-closing trial balance are taken from the ending balances in the ledger shown in Exhibit 7. These balances agree with the amounts shown on Kelly Consulting s balance sheet in Exhibit. Ledger Account Cash Account No. 00 Apr ,00 5,000,800 6,50,850 5,600,050,800,800 0, ,000,00 8,0 6,500,500,0,80,980, 7,80 6,680 0,5 6, 5,80 5,50 5,050 8,00,00 Account Accounts Receivable 00 Apr Apr. 8 Account Supplies Adjusting,000,00,00,500, Account No.,800 5,600,000,00 5,00 7,500,900,00 Account No. 850,00,00,50

25 Chapter Completing the Accounting Cycle 67 Exhibit 7 Ledger, Kelly Consulting (continued) Account Prepaid Rent Account No. 5 Account Kelly Pitney, Capital Account No. 00 Apr. Adjusting,800,600,800,00 00 Apr. Closing Closing 6,000,000 8,0,000 8,0,0 Account Prepaid Insurance 00 Apr. Account Office Equipment 00 Apr Apr. Account Unearned Fees 00 Apr. Account Accumulated Depreciation Adjusting Adjusting Account Accounts Payable 00 Apr Apr. Adjusting Account Salaries Payable Adjusting,800,500,000,00,500, ,000 Account No. 6 0 Account No. 8,500,500 Account No. 9 Account No. Account No.,800,500 Account No., ,000,500 Account Kelly Pitney, Drawing 00 Apr. 6,000 Closing 6,000 Account Income Summary 00 Apr. 00 Apr Apr. 7 Closing Closing Closing Account Fees Earned Adjusting Closing Account Salary Expense Account Rent Expense 00 Apr. Adjusting Closing,50 5,50 8,0,50,00 6,50,00,850,050,500, Adjusting 0 Closing,60 Account No. 6,000 Account No. Account No. Account No ,500,60 Account No. 5,50 8,0,00 0,50,550 6,00 9,50 0,950,50,600,600,600 (continued)

26 68 Chapter Completing the Accounting Cycle Exhibit 7 Ledger, Kelly Consulting (concluded) Account Supplies Expense Account No. 5 Account Insurance Expense Account No Apr. Adjusting Closing Apr. Adjusting Closing Account Depreciation Expense Account No. 5 Account Miscellaneous Expense Account No Apr. Adjusting Closing 00 Apr. 0 9 Closing Explain what is meant by the fiscal year and the natural business year. Fiscal Year Percentage of Companies with Fiscal Years Ending in: January 5% July % February August March September 7 April October May November June 7 December 6 Source: Accounting Trends & Techniques, 6st edition, 007 (New York: American Institute of Certified Public Accountants). The annual accounting period adopted by a business is known as its fiscal year. Fiscal years begin with the first day of the month selected and end on the last day of the following twelfth month. The period most commonly used is the calendar year. Other periods are not unusual, especially for businesses organized as corporations. For example, a corporation may adopt a fiscal year that ends when business activities have reached the lowest point in its annual operating cycle. Such a fiscal year is called the natural business year. At the low point in its operating cycle, a business has more time to analyze the results of operations and to prepare financial statements. Because companies with fiscal years often have highly seasonal operations, investors and others should be careful in interpreting partial-year reports for such companies. That is, you should expect the results of operations for these companies to vary significantly throughout the fiscal year. The financial history of a business may be shown by a series of balance sheets and income statements for several fiscal years. If the life of a business is expressed by a line moving from left to right, the series of balance sheets and income statements may be graphed as follows: Financial History of a Business Income Statement for the year ended Dec., 008 Dec. 008 Income Statement for the year ended Dec., 009 Dec. 009 Income Statement for the year ended Dec., 00 Dec. 00 Sheet Dec., 008 Sheet Dec., 009 Sheet Dec., 00

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