978-1133939283 Chapter 4 Lecture Note

Unlock access to all the studying documents.

View Full Document

Chapter 4

Completing the Accounting Cycle

Learning Objectives

1. Describe the role of closing entries in the preparation of nancial statements.

2. Prepare closing entries.

3. Prepare reversing entries

4. Prepare a work sheet.

5. Explain the importance of the work sheet and closing entries when managing a business.

Section 1: Concepts

Concepts

 Periodicity

 Accrual accounting

Lecture Outline

I. There are six steps in the accounting cycle:

A. Analyze transactions from source documents to decide which account(s) to debit

and which account(s) to credit.

B. Journalize transactions.

C. Post entries to the ledger, and prepare a trial balance.

D. Make end-of-period adjustments, and prepare an adjusted trial balance.

E. Prepare nancial statements.

F. Close the accounts, and prepare a post-closing trial balance.

II. Closing entries serve two purposes:

A. They clear all temporary accounts.

B. They transfer net income or loss to the Capital account.

1. The Income Summary account is a temporary account.

2. Its purpose is to provide a place to summarize all revenues and expenses.

3. It is used only in the closing process and never appears in the nancial

statements.

Summary

The steps in the accounting cycle are as follows:

1. Analyze business transactions from source documents.

2. Record the entries in the journal.

3. Post the entries to the ledger, and prepare a trial balance.

4. Adjust the accounts, and prepare an adjusted trial balance.

or posted to a publicly accessible website, in whole or in part.

Chapter 4: Completing the Accounting Cycle Instructor’s Manual, p. 2

5. Prepare nancial statements.

6. Close the accounts, and prepare a post-closing trial balance.

Permanent accounts are balance sheet accounts whose balances can extend past the end

of the accounting period.

Temporary accounts show the accumulation of revenues and expenses over one

accounting period. At the end of that period, the account balances are transferred to the

Income Summary account.

Closing entries serve two purposes. First, they clear revenue and expense accounts to zero

so that these accounts may begin accumulating the components of net income for the next

accounting period. Second, they summarize a period’s revenues and expenses by

transferring the balances of revenue and expense accounts to the Income Summary

account, the balance of which is transferred to the Capital account. (The Income Summary

account exists only for the preparation of closing entries and does not appear in the work

sheet or in the nancial statements.)

Relevant Examples and Exhibits

 Exhibit 1 Overview of the Closing Process

Teaching Strategy

Review the steps in the accounting cycle. Ask students to sequence the steps in Short

Exercise 2.

Review with students that nancial statements are prepared annually and the Income

Statement is a nancial statement that re<ects the activity of one accounting periond. Since

the Income Statement only re<ects accounting activity for one accounting period, these

accounts have to be brought to zero at the end of the period, so Income Statement accounts

are called “temporary” accounts. Balance Sheet accounts are called permanent accounts

because these account balances extend from one accounting period to the next. For

instance, the amount of cash at the end of the accounting period is the same amount of

cash at the beginning of the next accounting period.

Section 2: Accounting Applications

Accounting Applications

 Prepare closing entries

 Prepare reversing entries

 Prepare a work sheet

or posted to a publicly accessible website, in whole or in part.

Chapter 4: Completing the Accounting Cycle Instructor’s Manual, p. 3

Lecture Outline

I. There are four closing entries:

A. Close revenue accounts.

B. Close expense accounts.

C. Close the Income Summary account.

D. Close the Withdrawals account.

II. Reversing entry

A. A reversing entry is the opposite of an adjusting entry.

B. Reversing entries are never required.

C. Reversing entries are dated the beginning of the new accounting period.

D. Reversing entries enable the bookkeeper to continue making routine journal

entries at the beginning of the new period (show how).

E. Only accruals may be reversed.

III. A work sheet is a working paper that facilitates the preparation of nancial statements.

IV. There are ve steps in the preparation of a work sheet:

A. Enter ledger account balances into the Trial Balance columns.

B. Enter and key adjustments into the Adjustments columns.

C. Crossfoot the rst two sets of columns to produce the Adjusted Trial Balance

columns.

D. Extend account balances to either the Income Statement columns or the Balance

Sheet columns.

E. Enter net income (or loss) as a balancing gure for the Income Statement columns

and the Balance Sheet columns.

V. A work sheet is used to perform three principal tasks:

A. Record the adjusting entries in the general journal.

B. Record the closing entries in the general journal.

C. Prepare the nancial statements.

Summary

There are four closing entries:

1. Income statement accounts with credit balances are closed. This is accomplished by a

simple compound entry that debits each revenue account for the amount required to

give it a zero balance and credits Income Summary for the total.

2. Income statement accounts with debit balances are closed. This is accomplished by a

compound entry that credits each expense account for the amount required to give it a

zero balance and debits Income Summary for the total.

3. The Income Summary account is closed. After revenue and expenses have been closed,

the Income Summary account has either a debit balance or a credit balance. If a credit

balance exists, Income Summary must be debited for the amount required to give it a

zero balance, and the owner’s Capital account is credited for the same amount. The

reverse is done when Income Summary has a debit balance.

4. The Withdrawals account is closed. This is accomplished by crediting Withdrawals by

the amount required to give the account a zero balance and debiting the owner’s

Capital account by the same amount. Note that the Income Summary account is not

involved in this closing entry.

or posted to a publicly accessible website, in whole or in part.

Chapter 4: Completing the Accounting Cycle Instructor’s Manual, p. 4

The following closing journal entries are introduced in this section:

Design Revenue XX (current credit balance)

Income Summary XX (sum of revenue amounts)

To close the credit balance accounts

Income Summary XX (sum of expense amounts)

Wages Expense XX (current debit balance)

Utilities Expense XX (current debit balance)

Rent Expense XX (current debit balance)

ODce Supplies Expense XX (current debit balance)

Depreciation Expense—ODce Equipment XX (current debit balance)

To close the debit balance accounts

Income Summary XX (current credit balance)

J. Blue, Capital XX (net income amount)

To close the Income Summary account

J. Blue, Capital XX (withdrawals for period)

J. Blue, Withdrawals XX (withdrawals for period)

To close the Withdrawals account

At the end of each accounting period, the accountant makes adjusting entries to record

accrued revenues and expenses. Many of the adjusting entries are followed in the next

period by the receipt or payment of cash. Thus, it is necessary in the next period to make a

special entry apportioning amounts between the two periods. To avoid this inconvenience,

the accountant can make a reversing entry (dated the beginning of the new period), which

allows a routine bookkeeping entry when cash eventually changes hands.

Not all adjusting entries can be reversed. In the system we use, only adjustments for

accruals, not those for deferrals, can be reversed.

The following journal entries illustrate two alternatives for handling the accrual and payment

of wages:

End of period accrual:

Wages Expense XX (amount incurred)

Wages Payable XX (amount to be paid)

Accrued unrecorded wages

Alternative 1: No reversing entry:

Wages Payable XX (amount previously accrued)

Wages Expense XX (amount earned this period)

Cash XX (amount paid)

Paid wages (entry above was not

reversed)

Alternative 2: Reversal of accrual:

Wages Payable XX (amount to be paid)

Wages Expense XX (amount returned)

Reversing entry for rst entry above

(assume that Wages Expense

was closed at end of period)

Wages Expense XX (amount paid)

Cash XX (amount paid)

Paid wages (rst entry above was

or posted to a publicly accessible website, in whole or in part.

Chapter 4: Completing the Accounting Cycle Instructor’s Manual, p. 5

reversed)

The following additional journal entry was introduced for Learning Objective 3:

Design Revenue XX (amount accrued)

Accounts Receivable XX (amount accrued)

Reversed the adjusting entry for accrued

revenue earned

Accountants use working papers to help them organize their work and to provide evidence

in support of the nancial statements. The work sheet is one such working paper. It

reduces the chance of overlooking an adjustment, provides a check on the arithmetical

accuracy of the accounts, and facilitates the preparation of nancial statements. Although

the work sheet is never published, it is a useful accounting tool.

The ve steps in the preparation of the work sheet are as follows:

1. Enter and total the account balances (debit or credit) in the Trial Balance columns.

2. Enter and total the adjustments in the Adjustments columns.

3. Enter and total the adjusted account balances in the Adjusted Trial Balance columns (by

means of crossfooting).

4. Extend (transfer) the account balances from the Adjusted Trial Balance columns to the

Income Statement columns or the Balance Sheet columns.

5. Total the Income Statement columns and the Balance Sheet columns. Enter the net

income or net loss in both pairs of columns as a balancing gure, and recompute the

column totals.

Relevant Examples and Exhibits

 Exhibit 2 Preparing Closing Entries from the Adjusted Trial Balance

 Exhibit 3 Preparing the Closing Entry of a Credit Balance Account to the Income

Summary Account

 Exhibit 4 Posting the Closing Entry of Debit Balance Accounts to the Income Summary

Account

 Exhibit 5 Posting the Closing Entry of the Income Summary Account Balance to the

Owner’s Equity Account

 Exhibit 6 Posting the Closing Entry of the Withdrawals Account Balance to the

Owner’s Capital Account

 Exhibit 7 Post-Closing Trial Balance

 Exhibit 8 The Work Sheet

 Exhibit 9 Adjustments from the Work Sheet Entered in the General Journal

 Exhibit 10 The EJect of Closing Entries on the Financial Statements

Teaching Strategy

This is an opportunity to discuss temporary accounts and the periodicity issue. Use Exhibit 2

to give students a visual picture of how numbers <ow through the accounts in the closing

process. Point out that the Capital account is now being updated for the eJects of revenues,

expenses, and withdrawals throughout the accounting period. Explain that this is why in

preparing the transaction analysis charts in Chapter 1, transactions involving revenues,

expenses, or withdrawals were placed in the Owner’s Equity column. Students may initially

be confused about the purpose behind closing versus adjusting entries.

or posted to a publicly accessible website, in whole or in part.

Chapter 4: Completing the Accounting Cycle Instructor’s Manual, p. 6

Students may also be confused about why the balances of some accounts are carried to the

next accounting period, whereas others are brought to zero. The concept of temporary and

permanent accounts can be illustrated with the following analogy. Suppose that on a daily

basis, you put all the pennies you receive in a piggy bank. At the end of the year, you empty

your piggy bank and count all the pennies you have accumulated for the year. You then take

those pennies to the bank and deposit them in your bank account. Your bank account

balance is a cumulative total that represents all deposits and withdrawals made since you

opened the account (like owner’s equity). The piggy bank is now empty and will be used to

accumulate pennies during the next year (like revenue and expense accounts).

Enumerate the four closing entries required to complete the journal entries. Emphasize that

there are only four closing entries. Introduce students to these compound entries.

Demonstrate the eDciency of the compound entries over closing each account to the

Income Summary account individually.

Emphasize that the information for the closing entries comes from the adjusted trial balance.

Refer to the illustrations in the text that present the closing entries. Review the signicance

of the balance in the Income Summary account. Students often make errors in closing the

Income Summary account. Recommend that students draw a T account for Income

Summary and post the rst two closing entries before closing the Income Summary account.

Point out that Withdrawals is not closed to Income Summary because it is not a component

of net income. Unlike revenues and expenses, Withdrawals is closed directly to the owner’s

Capital account.

Discuss the eJect of posting the closing entries to the ledger accounts. Referring to the

exhibits in the text that illustrate the posting process helps students visualize bringing the

accounting period to an end.

Explain how closing entries are handled in a computerized system. Students are often

amazed at how simple it is, which whets their appetite for computerized accounting

applications.

Short Exercises 3 through 6 and Exercises 1A and 8A allow for a brief review of closing

entries.

Explain typical reversing entries and their purpose. Emphasize that reversing entries are the

rst entries of the new accounting period and help make the accounts ready for data to be

posted later in the period.

Emphasize that reversing entries are optional and demonstrate that if proper entries follow,

the accounting information is not altered by the decision to use or not to use reversing

entries. Short Exercises 8 and 9 and Exercise 6A can be eJective in illustrating how

reversing entries are made and their eJects.

At this point in the course, it may be helpful to give an exam that requires students to

complete the accounting cycle from preparation of a work sheet through the post-closing

trial balance.

Having just recently learned how to prepare a trial balance, students are at rst reluctant to

see the convenience of the work sheet. Stress that the work sheet is not an added step in

the accounting cycle but an eDcient tool for organizing the end-of–period processes.

Reiterate that the work sheet Trial Balance columns replace the trial balance discussed in

Chapter 2.

Several attempts at completing the work sheet are needed before students are comfortable

with it. Until now, all entries have been entered rst in a book of original entry. To minimize

confusion, show that the adjustment columns are a preliminary “scratch sheet” for

organizing what will be adjusting entries in the general journal. Students may hesitate to

enter the new account titles required by the adjusting process. Conrm that the work sheet

or posted to a publicly accessible website, in whole or in part.

Chapter 4: Completing the Accounting Cycle Instructor’s Manual, p. 7

is a “working paper,” not a formal statement. The order in which the accounts are presented

on this form is not important. It is helpful to use the exhibits in the chapter that guide

students through the work sheet column set by column set.

Preparation of the Adjusted Trial Balance columns is a good opportunity to reinforce the

calculations that result when debits and/or credits are entered as adjustments to the

accounts to be updated. By now, students have been exposed to the adjusting process, so

they should be able to anticipate the eJect of adjustments.

Unless students have a clear understanding of account types and their respective placement

on nancial statements, the distribution of account balances to the nancial statement

columns is confusing. Attention to detail alleviates frustration during this step.

The relationships between totals and the net income/loss calculations that complete the

work sheet are not readily apparent. Explain the logic (why the diJerences in the sets of

columns should balance).

Once the work sheet is complete, encourage students to examine it closely. Point out that

the information for the next steps in the accounting cycle is readily available. Now that

students have been introduced to the formal presentation of the nancial statements, the

rough outlines, as they appear on the work sheet, provide the necessary information for this

next step. Students may need to be reminded that the accounts must be rearranged from

the work sheet into the proper order for presentation on the income statement.

The statement of owner’s equity is not readily outlined on the work sheet. Refer to Exhibit 2.

The order of the nancial statements should now be important to students. A discussion of

the signicance of the income statement to the reconciliation of ending owner’s Capital for

the statement of owner’s equity is helpful. Following in sequence, then, the new owner’s

Capital balance is required for the balance sheet.

Point out that although the nancial statements are complete, the ledgers have not yet been

updated with the adjusting entries. This requires journal entries and posting, the only

method allowed for entering data into the ledger accounts. Adjusting entries may be entered

in the general journal and posted to the ledger accounts before the nancial statements are

prepared but usually are not because issuing the nancial statements on a timely basis is a

high priority.

Information, including totals, is available for closing appropriate account balances

(temporary accounts) to Income Summary. The math is complete for closing Income

Summary to the owner’s Capital account.

Section 3: Business Applications

Business Applications

 Using a work sheet

or posted to a publicly accessible website, in whole or in part.

Chapter 4: Completing the Accounting Cycle Instructor’s Manual, p. 8

Lecture Outline

I. A work sheet is used to perform three principal tasks:

A. Record the adjusting entries in the general journal.

B. Record the closing entries in the general journal.

C. Prepare the nancial statements.

Summary

Once the work sheet is completed, it can be used to prepare the formal nancial statements,

record the adjusting entries in the journal, and record the closing entries in the journal, thus

preparing the records for the new period.

The income statement may be prepared from the information found in the work sheet’s

Income Statement columns. Calculations of the change in owner’s equity for the period may

be shown in a separate statement of owner’s equity. Information for this calculation is found

in the Balance Sheet columns of the work sheet (beginning owner’s equity, net income, and

withdrawals). The balance sheet may be prepared from information found in the work

sheet’s Balance Sheet columns and in the statement of owner’s equity.

Formal adjusting entries must be recorded in the journal and posted to the ledger so that the

account balances on the books agree with those on the nancial statements. This is easily

accomplished by referring to the Adjustments columns (and footnoted explanations) of the

work sheet. All accounts that need to be closed, except Withdrawals, are in the Income

Statement columns of the work sheet.

Teaching Strategy

This learning objective presents a good opportunity to introduce students to spreadsheet

software and to explain why work sheets are a good application for such software.

Exercise 4A requires students to prepare a simple work sheet. Exercise 6A has them prepare

adjusting entries from a work sheet. Exercise 8A requires them to prepare a balance sheet

from a work sheet. In Short Exercise 11, they prepare closing entries from a work sheet.

Student Engagement Tactics

1. Divide the class randomly into small groups of three or four students and assign Case 4.

2. Allow eight to ten minutes for group analysis. Emphasize that in addition to deciding

whether Thomas Odzer’s action is ethical, groups are to develop as complete a list of

alternative actions as possible.

3. Take a vote to determine if there is a consensus as to whether Odzer’s action was

unethical. Conduct a class discussion about the reasons why the action is or is not

ethical.

4. Then outline Odzer’s alternatives by asking each group in turn to suggest an alternative

action.

5. Assign a one-page paper to be handed in at the next class. In the paper, students are to

summarize Odzer’s alternatives, decide on an action, and defend the action.

or posted to a publicly accessible website, in whole or in part.