chapter
4
Completing the
Accounting Cycle
______________________________________________
OPENING COMMENTS
Chapter 4 opens with a review of the flow of accounting information. The text introduces the end-of–
period spreadsheet (work sheet) as a tool for the completion of the accounting process. The text discusses
the spreadsheet (work sheet) as optional, and it will be up to the individual instructor to determine if the
spreadsheet will be covered in the class. The end–of-period spreadsheet (work sheet) is discussed in detail
in the appendix to the chapter. The spreadsheet (work sheet) becomes the source of information used to
Chapter 4 reminds students that it is not sufficient to record adjusting entries only on the end–of-period
spreadsheet. These entries must be journalized and posted to make them a part of a company’s accounting
records. The chapter also discusses the fiscal year and the natural business year. It ends with an
explanation of how working capital demonstrates a company’s solvency and how current ratio is useful
when making company comparisons.
After studying the chapter, your students should be able to:
2. Prepare financial statements from adjusted account balances.
4. Describe the accounting cycle.
5. Illustrate the accounting cycle for one period.
7. Describe and illustrate the use of working capital and the current ratio in evaluating a company’s
financial condition.
KEY TERMS
accounting cycle
clearing account
closing entries
closing process
closing the books
current assets
current liabilities
current ratio
fiscal year
fixed (plant) assets
Income Summary
liquidity
long-term liabilities
natural business year
notes receivable
real (permanent) accounts
solvency
temporary (nominal) accounts
working capital
STUDENT FAQS
Chapter 4 Completing the Accounting Cycle 65
• What is the normal account balance of Income Summary?
• Why doesn’t Income Summary appear on any financial statement?
• Why do we close the dividends account to the retained earnings account instead of to Income
Summary? Wouldn’t it be easier to close all the temporary accounts to Income Summary and then
close Income Summary to the retained earnings account since the ending balance in the retained
earnings account will be the same either way?
• Why do we list each expense and revenue during the closing process? Wouldn’t it be easier to debit a
generic revenue account for all revenues and credit a generic expense account for all expenses?
• Who or what kind of organizations are most interested in a company’s current ratio?
• Why is proper format, dollar signs, and single and double lines important?
OBJECTIVE 1
Describe the flow of accounting information from the unadjusted trial balance into the
adjusted trial balance and financial statements.
SYNOPSIS
The flow of accounting information is reviewed. The process can be easily seen in the worksheet. The
unadjusted trial balance is completed to show that the total debit and credit balances in the general ledger
are equal. Adjustments are completed to ensure that revenues and expenses are accurate and updated.
These debit and credit balances must also be equal. The preparation of the adjusted trial balance ensures
Relevant Example Exercises and Exhibits
• Example Exercise 4-1 Flow of Accounts into Financial Statements
• Exhibit 1 – End-of-Period Spreadsheet and Flow of Accounting Data—NetSolutions
SUGGESTED APPROACH
This objective reviews the flow of accounting information. It provides an opportunity to review the
material discussed in Chapters 1–3 and explain that many of the ten steps of the accounting cycle,
discussed later in Chapter 4, have already been discussed in those first three chapters. Exhibit 1 shows an
66 Chapter 4 Completing the Accounting Cycle
WRITING EXERCISE—Benefits of the End-of-Period Spreadsheet (Work
Sheet)
Ask your students to read and answer the following case (also shown on Transparency Master [TM]
4-10).
Keith Martin is the controller for Daniels Printing Service. Keith has been putting in a lot
of overtime; therefore, Mr. Daniels has allowed Keith to hire an assistant. Keith’s assistant
1. List the account balances from the general ledger in the Trial Balance columns of the end-of–
period spreadsheet.
3. Make the adjusting entries on the spreadsheet.
5. Prepare the formal financial statements using the data from the Income Statement and
Balance Sheet columns of the spreadsheet.
6. Journalize and post the adjusting entries.
Possible response: Tasks 1 and 2 are tasks that could possibly be delegated to the assistant. With
little instruction, the assistant could copy the accounts and the balances in a trial balance format.
Adding the Debit and Credit columns are also tasks suited for the assistant. After the assistant is
comfortable with these tasks, completing the work sheet (not adjusting entries, but from the
Chapter 4 Completing the Accounting Cycle 67
OBJECTIVE 2
Prepare financial statements from adjusted account balances.
SYNOPSIS
The income statement is prepared following the format shown in Exhibit 2; revenues are always first
followed by expenses. The net income is calculated by subtracting the expenses from the revenues. If the
resulting number is positive, it is known as net income. If the result is negative, it is called net loss. Next
in order is the retained earnings statement. The net income or loss from the income statement is used in
this statement. Exhibit 2 shows that the retained earnings statement starts with the retained earnings
Key Terms and Definitions
• 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, through the normal operations of the business.
• 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.
• Fixed Assets (or Plant Assets) – Long-term or relatively permanent tangible assets such as
equipment, machinery, and buildings that are used in the normal business operations and that
depreciate over time.
• Long-Term Liabilities – Liabilities that usually will not be due for more than one year.
• Notes Receivable – A customer’s written promise to pay an amount and possibly interest at an
agreed-upon rate.
Relevant Example Exercises and Exhibits
• Example Exercise 4-2 Retained Earnings Statement
• Example Exercise 4-3 Classified Balance Sheet
• Exhibit 2 – Financial Statements—NetSolutions
SUGGESTED APPROACH
Objective 2 revisits the financial statement preparation introduced in Chapter 1. The Balance Sheet is
expanded to include categories for Current Assets, Property Plant and Equipment, Current Liabilities, and
68 Chapter 4 Completing the Accounting Cycle
Optional discussion: International Financial Reporting Standards (IFRSs). You may want to mention
that while financial statements prepared for companies from different countries may appear different from
those prepared for U.S. companies the basic principles underlying the accounting equation are the same.
GROUP LEARNING ACTIVITY—Preparing Financial Statements
To complete this activity, you can either break the class into small groups or ask each student to work
individually. Ask the students to list all the asset and liability accounts they can think of. Give the
students two to three minutes to complete their lists.
Ask the students to call out the accounts on their lists as you write them on the board.
Instruct your students to go back to the accounts on their lists and indicate where each account would be
classified on a balance sheet: current assets; property, plant, and equipment; current liabilities; or long–
term liabilities. After giving the students a minute or two to work, list the proper classification for each
account on the board.
Next, using the end-of-period spreadsheet (work sheet) from the appendix or an adjusted trial balance, ask
the students to prepare formal financial statements. You may want to show your students TM 4-7 to guide
them through the process of preparing financial statements. The completed financial statements are
displayed on TMs 4-8 and 4-9. If time allows, compare these financial statements to the real-world
financial statements found in Appendix C of the text. It may be helpful to emphasize that the ending
GROUP LEARNING ACTIVITY—Journalizing Adjusting Entries
At this point, the students will have a completed end-of-period spreadsheet (work sheet). Ask the students
to break into groups and record the adjusting entries in journal format. If the end–of-period spreadsheet
approach is not included, the students must still understand that adjusting entries need to be journalized
and posted prior to the completion of financial statements.
Chapter 4 Completing the Accounting Cycle 69
OBJECTIVE 3
Prepare closing entries.
SYNOPSIS
Closing entries are recorded only for the temporary accounts. The permanent accounts, such as those
listed on the balance sheet, are not closed. The balances of the revenue and expenses accounts listed on
the income statement are not carried forward from year to year. These temporary accounts, which also
include the dividends account, are closed at the end of the period. Closing entries transfer the balances of
these accounts to the permanent accounts. The closing process has four steps. The revenue accounts are
transferred to the income summary account, and then the expense accounts are closed to the same
account. Third, the income summary account balance is transferred to the retained earnings account.
Key Terms and Definitions
• Clearing Account – Another name for the income summary account because it has the effect of
clearing the revenue and expense accounts of their balances.
• Closing Entries – The entries that transfer the balances of the revenue, expense, and dividends
accounts to the retained earnings account.
• Closing Process – The transfer process of converting temporary account balances to zero by
transferring the revenue and expense account balances to Income Summary, transferring the
income summary account balance to the retained earnings account, and transferring the dividends
account balance to the retained earnings account.
Relevant Example Exercises and Exhibits
• Example Exercise 4-4 Closing Entries
• Exhibit 3 – The Closing Process
70 Chapter 4 Completing the Accounting Cycle
SUGGESTED APPROACH
Understanding closing entries tends to be a real struggle for students. All too frequently, students resort to
memorizing the mechanics of closing entries without understanding the purpose of this step in the
LECTURE AID—Purpose of Closing Entries
Bring a stopwatch to class. Ask for a student volunteer who knows how to run a stopwatch. Instruct your
volunteer to time a few students completing a simple activity. For example, you may want to time how
long it takes the first row in your classroom to pass out Handout 4-2, which will be used in the next group
learning activity, to all the students in that row. Then time the next row in your class. Ask the student
volunteer to write the time for each row on the board.
Next, ask the student volunteer to explain how he or she timed each row. As part of that student’s
explanation, he or she should mention that after timing each row, the stopwatch had to be reset to zero.
Discuss the problems that would have resulted if the student had neglected to reset the stopwatch to zero.
Because the information we wanted from the exercise was how long it took each row to distribute the
GROUP LEARNING ACTIVITY—Closing Entries
Before beginning this exercise, review the purpose of closing entries. One primary concern in closing
entries is to reset the revenue, expense, and dividends accounts (the temporary or nominal accounts) to a
zero balance.
The second purpose of closing entries is to move the balance of all revenue, expense, and dividends
accounts to the retained earnings account. Remind students that in Chapter 1, all revenue, expense, and
dividend transactions were recorded in the retained earnings account because they affect stockholders’
equity. In Chapter 2, students began recording these transactions in separate accounts to make it easier to
prepare financial statements. Now it is time to move those transactions back to the retained earnings
Review the exercise with the class, using TM 4-11. Next, compute the balance of the retained earnings
account. Show your students that the account balance equals the ending balance shown on the retained
earnings statement (TM 4-12).
At this time, explain the purpose of Income Summary. When preparing closing entries, accountants first
move the balances of all revenue and expense accounts to Income Summary. If all revenue and expense
c) Make sure that the balance in the income summary account equals net income. If it doesn’t, correct
entries from a or b.
d) Close the income summary account to the retained earnings account.
e) Close the dividends account to the retained earnings account.
Review these entries using TM 4-13. Stress that the dividends account is not closed to Income Summary,
since it is not included when calculating net income. Instead, the dividends account is closed directly to
Retained Earnings. After completing T account entries, you may want to ask your students to prepare
these same entries in journal entry format.
LECTURE AID—Closing Entries
You can also illustrate closing entries with a visual example using five cups and two colors of paper clips.
Label each of the five cups with one of the following titles: Revenues, Expenses, Income Summary,
Dividends, and Retained Earnings. Styrofoam cups work well because you can write on them with an ink
pen. Next, place a few paper clips of the same color (green works well) in the Revenues cup. Finally,
place a few paper clips of the other color fired is great) in both the Expenses cup and the Dividends cup.
72 Chapter 4 Completing the Accounting Cycle
Illustrate closing entries by pouring the paper clips from the Revenues cup into the Income Summary cup.
Emphasize that the Revenues cup is now closed (empty) because its contents were transferred to the
Income Summary cup. Repeat the same process for the Expenses cup. Now, explain to your students that
account that resides on the balance sheet and the balance is updated as part of the closing process.
Net income and the dividends amount for the year are transferred to the retained earnings account and are
reported on the retained earnings statement. Ending retained earnings per the retained earnings statement
and the balance of the retained earnings account after the closing process is complete should match if the
closing process is completed correctly.
WRITING EXERCISE—Closing Entries
After discussing closing entries, ask your students to write answers to the following questions (also
shown on TM 4-14).
1. Why are closing entries prepared?
2. Why do we use Income Summary when preparing closing entries?
3. Why are closing entries prepared after financial statements?
4. What are some examples of temporary accounts that would be closed for a physician?
1. Closing entries are prepared to reset the temporary account balances to zero. This “reset” will assure
2. The income summary account is used as a clearing account and provides a balance check prior to
transferring net income to the retained earnings account. Closing revenue and expense accounts to
3. If the income statement accounts (temporary or nominal accounts) are closed prior to financial
4. Temporary revenue accounts could include office exam fees, hospital visit fees, or surgery fees.
Temporary expense accounts could include medical staff wages expense, administrative staff wages
expense, rent expense, utilities expense, and others. Don’t forget the dividends account.
LECTURE AID—Post-Closing Trial Balance
Remind your students that a post-closing trial balance is a trial balance prepared after closing entries. The
post-closing trial balance is prepared to make sure that the ledger is in balance to start the next accounting
period. You may want to refer your students to an example of a post-closing trial balance by turning to
Exhibit 7 in the text.
Pose the following questions to stimulate class discussion:
1. What three classes of accounts will not appear on a post-closing trial balance? Answer: revenues,
2. What accounts will appear on a post-closing trial balance? Answer: assets, liabilities, and
3. If a temporary account was overlooked in the closing process, would the post-closing trial balance
still balance? Answer: Yes, but the balance of the retained earnings account would not agree with the
amount shown on the balance sheet.
OBJECTIVE 4
Describe the accounting cycle.
SYNOPSIS
The accounting cycle begins with the analyzing and journalizing transactions; it ends with the post–
closing trial balance. The ten steps of the cycle are listed in Exhibit 8.
Keys Terms and Definitions
• Accounting Cycle – The process that begins with analyzing and journalizing transactions and
ends with the post-closing trial balance.