Accounting Cycle Lecture PDF

Completing the Accounting Cycle Concepts Underlying Closing Entries Closing entries are journal entries at the end of the accounting period. They have two purposes: 1 Setting the stage for the next accounting period Closing entries clear revenue, expense, and withdrawals accounts of the...

Completing the Accounting Cycle Concepts Underlying Closing Entries Closing entries are journal entries at the end of the accounting period. They have two purposes: 1 Setting the stage for the next accounting period Closing entries clear revenue, expense, and withdrawals accounts of their balances so that they can start over with a zero balance in the next accounting period. 2 Summarizing a period’s revenues and expenses The Income Summary account is a temporary account that summarizes all revenues and expenses for the period. It is used only in the closing process, and its balance equals the net income or loss. The net income or loss is transferred from the Income Summary account to the owner’s Capital account. Overview of the Closing Entries Concepts Underlying Closing Entries Closing entries help achieve periodicity by dividing the life of the business into equal time periods. Definition of Periodicity: estimating a business’s net income in terms of accounting periods It is important to understand the concepts of permanent and temporary accounts. o Balance sheet accounts are permanent accounts (or real accounts) because they carry their end- of- period balances into the next accounting period. o Equipment, Land, Accounts Receivable, Cash, Capital etc. o Revenue and expense accounts are temporary accounts (or nominal accounts) because they are cleared by means of the closing entries. o Service Revenue, Interest Income, Rent Expense, Insurance Expense, Depreciation Expense etc. Preparing Closing Entries The steps involved in making closing entries: o 1. Close the credit balances on the income statement accounts to Income Summary. o 2. Close the debit balances on the income statement accounts to Income Summary. o 3. Close the Income Summary account balance to the owner’s Capital account. o 4. Close the Withdrawals account balance to the owner’s Capital account. The adjusted trial balance provides all the data needed to record the closing entries. Preparing Closing Entries from the Adjusted Trial Balance Preparing Closing Entries from the Adjusted Trial Balance Step 1: Closing the Credit Balances (Closing the Revenue Account) Accounts On July 31, Design Revenue of $ 13,600 credit balance is closed to Income Summary. Analysis The journal entry to close Revenue decreases the owner’s equity account Design Revenue with a debit increases the owner’s equity account Income Summary with a credit Preparing Closing Entries from the Adjusted Trial Balance Step 1: Closing the Credit Balances (Closing the Revenue Account) Design Revenue Income Summary $13,600 End of alance $13,600 B Closing Entries $13,600 Closing Entry $0 $0 Comment Design Revenue now has a zero balance in preparation for the next accounting period and Income Summary reflects revenue for the period. The next slide shows Design Revenue and Income Summary ledger accounts at this point in the closing process. Preparing Closing Entries from the Adjusted Trial Balance Step 1: Closing the Credit Balances (Closing the Revenue Account) Preparing Closing Entries from the Adjusted Trial Balance Step 2: Closing the Debit Balances (Closing the Expense Accounts) Accounts On July 31, expenses accounts shown in the trial balance in Exhibit 2 are closed to Income Summary. Analysis The journal entry to close the expense accounts decreases the owner’s equity account Income Summary with a debit decreases the owner’s equity expense with a credit Preparing Closing Entries from the Adjusted Trial Balance Step 2: Closing the Debit Balances (Closing the Expense Accounts)  Preparing Closing Entries from the Adjusted Trial Balance Step 2: Closing the Debit Balances (Closing the Expense Accounts) Wages Expense Utilities Expense Rent Expense Supplies Expense Depreciation Expense $5,520 $5,520 $680 $680 $ 1,600 $ $1,540 $1,540 $300 $300 End of Closing End of Closing End of 1,600 End of Closing End of Closing Balance Entry Balance Entry Balance Closing Balance Entry Balance Entry Entry $0 $0 $0 $0 $0 $0 $0 $0 $0 Comment All accounts $0 balances in expense nowfor the preparation $5,520 next accounting period, haveand Income Summary $680 Income Summary zero reflects $1,600 revenue and expenses for the $1,540 period. The next slide shows all $300 expense ledger accounts and Closing Entries the Income Summary ledger account at this point in the accounting cycle. Preparing Closing Entries from the Adjusted Trial Balance Step 3: Closing the Income Summary Account Accounts On July 31, Income Summary account balance of $3,960 credit is closed to J. Blue, Capital. Analysis The journal entry to close Income Summary decreases the owner’s equity account Income Summary with a debit increases the owner’s equity account J. Blue, Capital with a credit Preparing Closing Entries from the Adjusted Trial Balance Step 3: Closing the Income Summary Account Income J. Blue Summary Capital $5,520 $13,600 $3,960 Comment $680 Closing Revenue Closing Income Summary now has a $1,600 Income zero balance in preparation for $1,540 Summary the next accounting period, and $300 J. Blue, Capital reflects the Closing Expenses income for the period. The next $3,960 $3,960 slide shows Income Summary Closing End Balance and J. Blue, Capital ledger Income accounts at this point in the Summary closing process. $0 $0 Preparing Closing Entries from the Adjusted Trial Balance Step 3: Closing the Income Summary Account Preparing Closing Entries from the Adjusted Trial Balance Step 4: Closing the Withdrawals Account Accounts On July 31, Withdrawals in the amount of $2,800 debit is closed to J. Blue, Capital. Analysis The journal entry to close Withdrawals decreases the owner’s equity account J. Blue, Capital with a debit decreases the owner’s equity account Withdrawals with a credit Preparing Closing Entries from the Adjusted Trial Balance Step 4: Closing the Withdrawals Account Withdrawals J. Blue Capital $2,800 $2,800 $2,800 $40,000 End Balance Closing Entry Beg. Bal. Closing Withdrawal $3,960 Closing $0 $0 Income Summary $41,160 Comment Withdrawals now has a zero balance in preparation for the next accounting period, and J. Blue, Capital reflects the income minus the withdrawals for the period. The next slide shows J. Blue, Withdrawals and J. Blue, Capital ledger accounts at this point in the closing process. Preparing Closing Entries from the Adjusted Trial Balance Step 4: Closing the Withdrawals Account Preparing Closing Entries from the Adjusted Trial Balance Summary Preparing Closing Entries from the Adjusted Trial Balance Summary The Accounts After Closing After all closing entries have been posted, everything is ready for the next accounting period. * The revenue, expense, and withdrawals accounts (temporary accounts) have zero balances. * The owner’s Capital account has been increased or decreased to reflect net income or net loss and has been decreased for withdrawals. *The balance sheet accounts (permanent accounts) show the correct balances, which are carried forward to the next period, as shown in the post-closing trial balance, on the next slide. Post-Closing Trial Balance Exercise Refer to the following partial adjusted trial balance for Fountas Recreational Park. (Except for K. Fountas, Capital, balance sheet accounts have been omitted.) 1. Prepare the necessary closing entries. 2. Compute the ending balance of the owner’s Capital account. Solution Prepare the necessary closing entries June Campsite Rentals (Revenue) 88,20 30 Income Summary 0 88,20 To close the credit 0 balance account June30 Income Summary 36,754 Wages Expense 23,850 Insurance Expense 3,784 Utilities Expense 1,800 Supplies Expense 1,320 Depreciation Expense – Building 6,000 To close the debit balance accounts Solution Prepare the necessary closing entries June Income Summary 51,44 30 K. Fountas, Capital 6 51,44 To close the Income Summary account 6 $88,200 − $36,754 = $51,446 June K. Fountas, Capital 36,00 30 K. Fountas, Withdrawals 0 36,00 To close the Withdrawals account 0 Solution Compute the ending balance of the owner’s Capital account Reversing Entries: An Optional First Step A reversing entry is an optional journal entry made on the first day of an accounting period. An accounting adjustment made at the beginning of a new accounting period to cancel out an adjusting entry that was made in the previous period. It has the opposite effect of an adjusting entry made at the end of the previous period: It debits the credits and credits the debits of an earlier adjusting entry. The sole purpose of reversing entries is to simplify routine bookkeeping procedures, and they apply only to certain adjusting entries, such as accruals. As illustrated on the next five slides, reversing entries solve the problem of applying revenues and expenses to the correct accounting period. Adjusting Entry to Accrue Wages Expense at the End of the Accounting Period Payment of Wages, Part of Which Accrued in the Previous Accounting Period Payment of Wages, Part of Which Accrued in the Previous Accounting Period To make the entry on the previous slide, the accountant had to determine how much of the $2,400 in wages applied to the current period and how much applied to the previous period. In a company with many employees, this would be very difficult and time-consuming. Using a reversing entry solves this problem: The Effect of Using a Reversing Entry on the Wages Expense Account Entry 1 adjusted Wages Expense to accrue $720 in the July accounting period. Entry 2 closed the $5,520 in Wages Expense for July to Income Summary, leaving a zero balance. Entry 3, the reversing entry, set up a credit balance of $720 on August 1 in Wages Expense, which is the expense recognized through the adjusting entry in July (and also reduced the liability account Wages Payable to a zero balance). The reversing entry always sets up an abnormal balance in the income statement account and produces a zero balance in the balance sheet account. Entry 4 recorded the $2,400 payment of wages as a debit to Wages Expense, automatically leaving a balance of $1,680, which represents the correct wages expense to date in August. The reversing entry simplified the process of making the payment entry on August 9. Reversing Entry for Accrued Revenue Reversing entries apply to any accrued expenses or revenues. An adjusting entry for Blue Design Studio’s accrued revenue would require the reversing entry below.