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Accounting: The Language of Business - Vol. 2 (Intermediate: Part 34)

For a hot-shot CEO taking over a troubled company, mass firings are the ultimate quick fix, the accounting equivalent of crack: cheap, easy to score, instantly gratifying, and highly addictive.

Arianna Huffington

A Review of the Accounting Cycle (Part K)

by

Charles Lamson

Step 8: Close Temporary Accounts

The next step in the accounting cycle (continued from part part 33) requires closing all temporary accounts, which are all income statement accounts and dividends that must be reduced to a zero balance in order to report net income (or net loss) and dividends for the next accounting period. The temporary accounts begin the next period with a zero balance to ensure that prior period revenues and expenses are not included in the computation of the next year's net income or loss. Closing is the process of bringing all temporary accounts to a zero balance.

In contrast to the income statement temporary accounts, the balance sheet consists of permanent accounts, which are accounts with cumulative balances carried forward period after period. Permanent accounts are not closed at the end of the period.

Closing each revenue and expense temporary account to retained earnings would involve a significant amount of detail flowing through the retained earnings account. To avoid the excessive detail and retained earnings, companies use another temporary account, income summary, to accumulate revenues and expenses and transfer the net value of the income summary to retained earnings in a single journal entry.

Four closing entries are required to close the temporary accounts.

1. Close out revenue and gain accounts: Debit all revenue and gain accounts and credit income summary for the total of the accounts debited.

2. Close out expense and loss accounts: Debit income summary for total expenses and losses and credit each expense and loss account for its balance.

3. Close out income summary account: Debit income summary and credit earnings for the amount of net income; conversely, credit income summary and debit retained earnings in the event of a loss.

4. Close out the dividends account: Debit retained earnings and credit the dividends account for the year. 

EXAMPLE 4.12 Closing Entries

PROBLEM: Consider Plush Service Corporation from the prior examples in the preceding parts of this volume. Prepare the closing entries for Plush Service Corporation.

SOLUTION: We record each of the four closing entries. First, we debit the service revenue account and credit income summary. Second, we credit each of the expense accounts and debit the total amount to income summary. At this point, income summary will have a credit balance because revenues are greater than expenses and represent net income for the period. Third, we debit income summary for its balance (which, in this case, is net income as opposed to net loss) and credit retained earnings. Finally, we credit the dividends account for its balance and debit retained earnings. The closing entries on December 31 are presented here: 

*GORDON,RAEDY,SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 117-118*

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Accounting: The Language of Business - Vol. 2 (Intermediate: Part 33)

If you look at the Forbes 400, they are paying a lower rate, accounting payroll taxes, than their secretary or - whomever around their office.

Warren Buffett

Review of the Accounting Cycle (part J)

by

Charles Lamson

Step 7: Prepare Financial Statements

After completing the adjusted trial balance (part 32), the company can prepare financial statements, a process we will explore in depth in subsequent posts. First, It prepares the statement of net income, which presents the financial results of operations, using the revenue and expense accounts. We will not consider the statement of comprehensive income in this post. We will cover comprehensive income in depth in a later post.

Accountants occasionally use a worksheet to facilitate the preparation of the adjusting entries in financial statements (discussed in a future post). Accountants may also use reversing entries as part of the accounting cycle (also discussed in a future post).

Exhibit 4.15 presents the sequence of financial statement preparation.

EXHIBIT 4.15 Sequence of Preparation of Financial Statements

Example 4.11 Financial Statements 

PROBLEMS: Using the adjusted trial balance for Plush Service Corporation in Example 4.10 from part 32, prepare a statement of net income, a statement of stockholders' equity, and a balance sheet.

SOLUTION: the financial statements are presented here. We first identify the income statement accounts and include them on the statement of net income. Net income is completed as revenues less expenses.

Net income is needed to prepare the statement of stockholders equity.

Note that the ending retained earnings balance is $131,500. We use this balance in the balance sheet as follows. The other accounts are obtained directly from the adjusted trial balance from part 32.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 115-117*

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Accounting: The Language of Business - Vol. 2 (Intermediate: Part 32)

You have wondered, perhaps, why all real accountants wear hats? They are today's cowboys. As will you be. Riding the American range. Riding herd on the unending torrent of financial data. The eddies, cataracts, arranged variations, fractious minutiae. You order the data, shepherd it, direct its flow, lead it where it's needed ... You deal in facts, gentlemen, for which there has been a market since man first crept from the primeval slurry.

David Foster Wallace

Review of the Accounting Cycle (part I)

by

Charles Lamson

Companies prepare adjusted trial balances after journalizing and posting all adjusting journal entries, which we discussed in parts 29-31. Similar to the unadjusted trial balance, the adjusted trial balance lists all accounts and ending balances, including the accounts created during the adjustment process. Like the unadjusted trial balance, the adjusted trial balance ensures the equality of debits and credits after adjusting journal entries are made but cannot be used to prove the accuracy of the financial information included in the accounts. Note that the accounts included in the adjusted trial balance contain all the data needed to prepare the financial statements.

EXAMPLE 4.10 Adjusted Trial Balance

PROBLEM: Consider Plush Service Corporation from our prior examples in previous posts. Prepare t-accounts that begin with the unadjusted balances from the unadjusted trial balance. Post the adjusting journal entries to the t-accounts and determine the adjusted balances. Prepare an adjusted trial balance at December 31, 2018. 

SOLUTION:

The adjusted trial balance for Plush Service Corporation is presented below.

                     

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 113-115*

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Accounting: The Language of Business - Vol. 2 (Intermediate: Part 31)

Professional accountants should use that influence to encourage the companies they serve to think long term and integrate sustainable development goals into their accounting, such as by including a natural capital account, which I have heard is gaining ground.

Kofi Annan

Review of the Accounting Cycle (Part H)

by

Charles Lamson

 Accruals

Accruals occur when the economic event that gives rise to revenue or expenses occurs before the cash is received or paid. The two types of accruals are accrued revenues and accrued expenses.

Accrued Revenues. Accrued revenues occur when control of the good or service has passed to the customer but the seller has not yet received cash. For example, a wholesaler may deliver goods to a retailer on credit. In this case, there is an unrecorded asset (a receivable) and unrecognized revenue. So, both assets and revenues are understated until the company makes an adjusting journal entry. Exhibit 4.12 presents this asset-revenue relationship. 

EXHIBIT 4.12 Accrued Revenues

If the company does not adjust accrued revenue, then assets and revenues are both understated. The adjusting journal entry is needed to debit the asset account and credit the revenue account. Once the cash is received, the company debits cash and credits the asset (receivable) account.

EXAMPLE 4.8 Accrued Revenues

PROBLEM: On December 31, Plush Service Corporation received an invoice from a field technician indicating that service amounting to $35,000 had been provided but not yet billed to customers.

 What adjusting journal entry is needed as of the end of the accounting period? Prepare the t-accounts for accounts receivable and service revenue earned both before and after the adjusting journal entry.

SOLUTION: Without the adjusting journal entry, Plush's assets and revenues are both understated. Currently, Plush has not prepared any journal entries related to this transaction.

On December 31, an adjusting journal entry is required that will debit accounts receivable and credit service revenue.

Thus, at the end of the accounting period, the adjusted balances in these accounts are correct.

Accrued Expenses. Accrued expenses occur when a company has incurred expenses but has not paid cash. For example, companies may incur an utility expense before a bill is received at the end of the month, and that amount remains unpaid at the end of the accounting period. Other common examples of accrued expenses are salaries and interest. In these cases, there is an unrecorded liability (a payable) and an unrecognized expense. The company understates both liabilities and expenses until it makes the adjusting journal entry. Exhibit 4.13 presents this liability expense relationship.

EXHIBIT 4.13 Accrued Expenses

The adjusting journal entry debits the expense account and credits a liability account. Once cash is paid, the company debits the liability (payable) and credits cash.

.

Example 4.9 Accrued Expenses

PROBLEM: Plush Service Corporation incurs salaries of $4,000 at the end of the year. The next payroll date is January 2 of the following year.

What adjusting journal entry is needed as of the end of the accounting period on December 31? Prepare the t-accounts for salaries payable and salaries expense both before and after the adjusting journal entry.

SOLUTION: Without the adjusting journal entry, Plush's liabilities and expenses are both understated. Currently, Plush has not prepared any journal entries related to this transaction.

On December 31 an adjusting journal entry is required that will debit salaries expense and credit salaries payable.

Thus, at the end of the accounting period, the adjusted balances in these accounts are correct.

Exhibit 4.14 summarizes the different types of adjusting journal entries.

EXHIBIT 4.14 Summary of Adjusting Journal Entries 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 110-113*

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