4-1
chapter
4
Completing the Accounting Cycle
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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 Appendix 1 to this chapter. The spreadsheet (work sheet) becomes the source of information used to prepare formal financial statements. The classified balance sheet is introduced. The closing process, including the post-closing trial balance, is explained. The chapter continues by listing and then illustrating in detail the 10 steps in the accounting cycle. Reversing entries are presented in Appendix 2 to this chapter. This presentation provides a solid foundation for financial accounting.
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 the current ratio is useful when making company comparisons.
After studying the chapter, your students should be able to:
1. Describe the flow of accounting information from the unadjusted trial balance into the adjusted trial balance and financial statements.
2. Prepare financial statements from adjusted account balances.
3. Prepare closing entries.
4. Describe the accounting cycle.
5. Illustrate the accounting cycle for one period.
6. Explain what is meant by the fiscal year and the natural business year.
7. Describe and illustrate the use of working capital and the current ratio in evaluating a company’s financial condition.
KEY TERMS
accounting cycle closing entries closing process closing the books current assets current liabilities current ratio first closing entry fiscal year
fixed (plant) assets liquidity
long-term liabilities natural business year notes receivable
real (permanent) accounts reversing entries
second closing entry solvency
temporary (nominal) accounts working capital
STUDENT FAQS
Does anyone make manual entries anymore or even keep a manual set of books?
Is there a need for manual work sheets since computerized accounting packages bypass them and allow the financial reports all to be printed out after adjusting and closing entries are recorded and posted?
Why do the steps in the accounting cycle have to be done in order?
Can I skip or combine any of the steps in the accounting cycle?
Why is Drawing not in the income statement?
Chapter 4 Completing the Accounting Cycle 4-3
Why don’t we close all the accounts at year-end?
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 are 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 work sheet. 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 that the post adjustment balances are equal. From these adjusted balances, the financial statements can be prepared. The income statement is prepared first, because the net income becomes part of the new owner’s equity. After the income statement, the owner’s statement is prepared. Using the new balance in the owner’s equity account, the balance sheet for the end of the period can be completed. The financial statements must be prepared in this order so the next statement can use information provided by the previous statement.
Relevant Example Exercise and Exhibit
Exhibit 1 – End-of-Period Spreadsheet and Flow of Accounting Data—NetSolutions
Example Exercise 4-1 – Flow of Accounts into Financial Statements
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 10 steps of the accounting cycle, discussed later in Chapter 4, have already been discussed in those first three chapters. Exhibit 1 shows an end-of-period spreadsheet (work sheet), and the text discusses the end-of-period spreadsheet (work sheet) as an optional tool to assist the accountant in the completion of accounting cycle. Some instructors may choose to skip the end-of-period spreadsheet due to automation of the process through computerized accounting software packages that automatically complete this process. The end-of-period spreadsheet, regardless of its usefulness in the real world, provides the student with an insight to the process that is required to complete the accounting cycle. The spreadsheet also provides a valuable visual overview of the process from unadjusted trial balance, through the adjusting process, to adjusted trial balance and to the preparation of financial statements. This knowledge of what actually goes into completing the accounting cycle is invaluable to the students’ understanding of the entire accounting cycle. Should you
choose to include the end-of-period spreadsheet (work sheet) as part of the learning process, you may want to move to Appendix 1 and cover the detailed material included there for the completion of the spreadsheet.
WRITING EXERCISE—Benefits of the End-of-Period Spreadsheet (Work Sheet)
Ask your students to read and answer the following case (also shown on Handout 4-1).
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 is a bright, high school graduate, but he has never taken an accounting class. Keith is trying to decide which accounting activities could be delegated to his assistant. Keith is willing to give the assistant a few simple instructions on how to complete each task, but he doesn’t have time to teach the assistant to be an accountant.
For each task listed, state whether Keith should continue to do the work or delegate the task to his assistant. Explain each answer.
1. List the account balances from the general ledger in the Trial Balance columns of the end-of- period spreadsheet.
2. Add the Debit and Credit columns of the trial balance.
3. Make the adjusting entries on the spreadsheet.
4. Complete the spreadsheet.
5. Type 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 explanation: 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 adjusted trial balance to the Income Statement and Balance Sheet columns) could be trusted to an assistant with some training and supervision. Since final accuracy and completion of all tasks resides with the controller, close supervision is recommended.
Chapter 4 Completing the Accounting Cycle 4-5
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 statement of owner’s equity. The net income or loss from the income statement is used in this statement. Exhibit 2 shows that the statement starts with the owner’s equity at the beginning of the year. Additional investments by the owner are listed next, followed by the net income (loss), and any withdrawals by the owner are listed. A determination is made of whether the owner’s equity has increased or decreased, and the owner’s equity as of the end of the period is calculated. The balance sheet is prepared from the asset and liability accounts listed in the adjusted trial balance. The owner’s equity account is taken from the new owner’s equity statement. The balance sheet shown in Exhibit 2 is a classified balance sheet; assets and liabilities are divided into current and long-term items. The owner’s equity is listed below the liabilities, and its total combined with the total liabilities must equal the total assets.
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
Exhibit 2 – Financial Statements, NetSolutions
Example Exercise 4-2 – Statements of Owner’s Equity
Example Exercise 4-3 – Classified Balance Sheet
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 long-term liabilities. Use the Group Learning Activity to demonstrate financial statement preparation with this expanded format. This will be the second time for students to prepare financial statements.
Depending on the depth of the discussion and their understanding of Chapter 1, the time dedicated to this demonstration may vary.
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.
Next, explain the following account classifications:
Current assets
Property, plant, and equipment Current liabilities
Long-term liabilities
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 adjusted trial balance in Handout 4-2, ask the students to prepare formal financial statements. You may want to show your students Handout 4-3 to guide them through the process of preparing financial statements. The completed financial statements are displayed on Handout 4-4, Part 1 and Part 2. If time allows, compare these financial statements to the real-world financial statements found in Appendix D of the text.
It is helpful to emphasize the following points regarding the statement of owner’s equity:
1. In preparing the statement of owner’s equity, it is necessary to examine the owner’s capital account to determine whether any additional investments have been made during the period.
2. The ending capital balance of the owner’s capital account does not appear on the end-of-period spreadsheet. The ending capital balance is determined by preparing the statement of owner’s equity.
Students need to be reminded that writing adjusting entries on the end-of-period spreadsheet does not make the entries a part of the company’s accounting records. The only way to get adjustments “on the books” is to journalize and post these entries.
Chapter 4 Completing the Accounting Cycle 4-7
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.
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 owner’s drawing 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 two steps. The revenue accounts and the expense accounts are closed to the owner’s capital account. The second step transfers the drawing account to the owner’s equity account. After these transactions are posted, all temporary accounts in the general ledger will have a zero balance. Exhibits 4 and 5 show how the closing process works. After the closing process is complete, a post-closing trial balance is prepared. Only permanent accounts are listed on the post-closing trial balance.
Key Terms and Definitions
Closing Entries - The entries that transfer the balances of the revenue, expense, and drawing accounts to the owner’s capital account.
Closing Process - The transfer process of converting temporary account balances to zero by transferring the revenue and expense account balances to the owner’s capital account, and transferring the owner’s drawing account to the owner’s capital account.
Closing the Books - The process of transferring temporary accounts balances to permanent accounts at the end of the accounting period.
First Closing Entry - The first journal entry in the closing process that transfers revenue and the expense account balances to the owner’s capital account as either a net income or a net loss..
Real (Permanent) Accounts - Term for balance sheet accounts because they are relatively permanent and carried forward from year to year.
Second Closing Entry - The second journal entry of the closing process that transfers the owner’s drawing account balance to the owner’s capital account.
Temporary (Nominal) Accounts - Accounts that report amounts for only one period.
Relevant Example Exercise and Exhibits
Exhibit 3 – The Closing Process
Exhibit 4 – Flowchart of Closing Entries for NetSolutions
Exhibit 5 – Closing Entries, NetSolutions
Exhibit 6 – Ledger, NetSolutions
Example Exercise 4-4 – Closing Entries
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 accounting cycle. As a result, the instructor may want to introduce this topic with a few attention-getting exercises that attempt to explain why closing entries are prepared. As a next step, try a group learning activity that allows students to discover the mechanics of preparing closing entries. End the class with a short writing exercise to summarize why and how closing entries are prepared.
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 4-5, 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 papers, it was important to time each row separately and reset the stopwatch after each row performed the task. In business, we want to know how much income a business earns during the course of one accounting period. Therefore, we record revenues and expenses for the accounting period and prepare an income statement. Before we begin recording revenues and expenses for the second accounting period, however, we must reset each of the revenue and expense accounts to a zero balance, just as the stopwatch was reset. The drawing account is also reset to a zero balance. The process of getting these accounts to a zero balance is accomplished through closing entries.
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 drawing 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 drawing accounts to the owner’s capital account. Remind students that in Chapter 1, all revenue, expense, and
Chapter 4 Completing the Accounting Cycle 4-9
Be sure your students can identify temporary and real (or permanent) accounts. Ask them to turn to the completed end-of-period spreadsheet (work sheet) (Exhibit 1) in the textbook. From that exhibit, quiz students on which accounts will be closed at the end of the accounting period and which will be left open.
Ask your students to break into groups of three or four and, using Handout 4-5, prepare entries that will zero-out the revenue, expense, and drawing accounts and move their balances to the capital account.
Remind students that they must keep debits and credits equal in all entries. If some groups finish early, ask them to practice preparing financial statements by constructing an income statement and a statement of owner’s equity for this company.
Review the exercise with the class, using Handout 4-6. Show your students that the account balance equals the ending capital balance shown on a statement of owner’s equity (Handout 4-7). After completing T account entries, you may want to ask your students to prepare these same entries in journal entry format.
Review with students that like adjusting entries, closing entries are journalized and posted to the general ledger to assure the account balances are correct prior to starting a new financial period.
LECTURE AID—Closing Entries
You can also illustrate closing entries with a visual example using four cups and paper clips. Label each of the four cups with one of the following titles: Revenues, Expenses, Drawing, and Capital. Styrofoam cups work well because you can write on them with an ink pen. Next, place a few paper clips in each cup.
Illustrate closing entries by pouring the paper clips from the Revenues cup into the Capital cup.
Emphasize that the Revenues cup is now closed (empty) because its contents were transferred to the Capital cup. Repeat the same process for the Expenses cup. Now, explain to your students that the analogy is not perfect because the revenue paper clips are “positive” clips and the expense paper clips are
“negative.” But, in effect, the Capital cup now holds the net income.
Finally, pour the paper clips from the Drawing cup into the Capital cup. Emphasize that all the cups except Capital are now empty (closed). You can also reinforce that the capital account is not closed—the contents of all the other cups were transferred there.
Reinforce the fact that the revenue, expense, and drawing accounts are temporary accounts that get zeroed out in the closing process, while the capital account is a permanent account that resides on the balance sheet and the balance is updated as part of the closing process.
Net income and the drawing amount for the year are transferred to the capital account and reflect the statement of owner’s equity. Ending capital per the statement of owner’s equity and the balance of the capital 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.
1. Why are closing entries prepared?
2. Why are closing entries prepared after financial statements?
3. What are some examples of temporary accounts that would be closed for a physician?
Possible answers:
1. Closing entries are prepared to reset the temporary account balances to zero. This “reset” will assure that the upcoming financial period will accurately reflect the activity of the period and not erroneously report revenue or expenses that actually occur in previous accounting periods. It facilitates adherence to the matching principle.
2. If the income statement accounts (temporary or nominal accounts) are closed prior to financial statements, then no revenue or expense accounts would have a balance and therefore no net income would be reported.
3. 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 physician’s drawing 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, expenses, and drawing.
2. What accounts will appear on a post-closing trial balance? Answer: assets, liabilities, and capital.
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 owner’s capital account would not agree with the amount shown on the balance sheet.
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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 10 steps of the cycle are listed in Exhibit 8.
Keys Term and Definition
Accounting Cycle -The process that begins with analyzing and journalizing transactions and ends with the post-closing trial balance.
Relevant Example Exercise and Exhibits
Exhibit 7 – Post-Closing Trial Balance, NetSolutions
Example Exercise 4-5 – Accounting Cycle
Exhibit 8 – Accounting Cycle
SUGGESTED APPROACH
Rather than simply memorizing the 10 steps in their proper order, it is helpful if students understand the relationships between the steps in the accounting cycle. Students will not make the mistake of listing
“Financial statements prepared” before completing the end-of-period spreadsheet (work sheet) or adjusted trial balance if they understand that the spreadsheet or adjusted trial balance provides the data necessary to prepare financial statements. Therefore, you may want to use the activities described below after covering the end-of-period spreadsheet or adjusted trial balance and closing entries (Objectives 1 through 3 and/or Appendix 1).
Emphasize that the accounting cycle is the same for all businesses, no matter how complex or how simple. The accounting cycle is repeated each period in which financial statements are prepared.
GROUP LEARNING ACTIVITY—Accounting Cycle
Show your class Handout 4-8, which lists the steps in the accounting cycle in random order. Ask students to put the steps in the proper order. You can ask them to work individually or in small groups. Handout 4-9 lists the steps in the accounting cycle in the correct order.
WRITING EXERCISE—Accounting Cycle
Write the 10 steps of the accounting cycle on the board or display Handout 4-9. Ask your students to record what information is needed as an input to each step in the accounting cycle. For example, source documents are needed in order to analyze transactions and record them in journals (Step 1). Completed journal entries are needed to post transactions to the ledger (Step 2).
After giving the students a few minutes to write, review the inputs needed for each step. Show students that knowing what information is needed to complete each step in the accounting cycle will make it easy to put the steps in the proper order.
Possible answers:
1. and 2. Provided above.
3. The unadjusted trial balance requires that Steps 1 and 2 are completed and the account names and balances are obtained from the general ledger.
4. Although adjustment data for the student are provided, the accountant would need to examine the various accounts to determine which ones require adjustments and the amount to be adjusted. Once the adjustment accounts have been identified, these tend to repeat in subsequent financial periods.
5. The optional spreadsheet requires data from the unadjusted trial balance and the adjustment data in order to start and complete the spreadsheet.
6. Step 6 requires the input from Step 4 to complete. If the end-of-period spreadsheet is completed, the adjusting data can be taken from the spreadsheet in order to journalize the adjustments. The posting of the adjustments is a required step.
7. The adjusted trial balance requires that Step 6 be completed. The data are then obtained from the general ledger once the adjusting data have been posted to update the account balances. If the optional end-of-period spreadsheet is completed, this step maybe skipped since the spreadsheet contains an adjusted trial balance as part of the completion process.
8. Financial statements are prepared using the data from the adjusted trial balance or the optional spreadsheet.
9. Closing data are obtained from the general ledger, trial balance, or spreadsheet. Temporary accounts are closed in the process described earlier.
10. A post-closing trial balance is completed once the closing process is finalized. The accounts and their balances can be found in the general ledger once all closing entries are posted. All temporary accounts should have zero balances. Only permanent (balance sheet) accounts will have a positive balance; therefore, the post-closing trial balance will include only asset, liability, and owner’s capital accounts.
Each step in the process depends on the previous step in order to obtain the necessary information to complete the subsequent step. The optional spreadsheet can consolidate and simplify the process;
however, it does not eliminate the requirements of recording and updating the general ledger using the journalizing and posting process.
Chapter 4 Completing the Accounting Cycle 4-13
OBJECTIVE 5
Illustrate the accounting cycle for one period.
SYNOPSIS
This objective shows the complete accounting cycle for a new business known as Kelly Consulting. A total of 30 transactions are listed. Each transaction is analyzed and recorded in the journal. Exhibit 10 shows each journal entry. Each journal entry is posted, and then the unadjusted trial balance is prepared.
Adjustment data are analyzed, journalized, and posted. An adjusted trial balance is prepared. Financial statements are prepared in order. Next, the closing entries are journalized and posted. The post-closing trial balance is the last step in the accounting cycle.
Relevant Exhibits
Exhibit 9 – Chart of Accounts for Kelly Consulting
Exhibit 10 – Journal Entries for April, Kelly Consulting
Exhibit 11 – Unadjusted Trial Balance, Kelly Consulting
Exhibit 12 – End-of-Period Spreadsheet, Kelly Consulting
Exhibit 13 – Adjusting Entries, Kelly Consulting
Exhibit 14 – Adjusted Trial Balance, Kelly Consulting
Exhibit 15 – Financial Statements, Kelly Consulting
Exhibit 16 – Closing Entries, Kelly Consulting
Exhibit 17 – Post-Closing Trial Balance, Kelly Consulting
Exhibit 18 – Ledger, Kelly Consulting
SUGGESTED APPROACH
After defining and working with the accounting cycle in Objective 4, you may wish to select PR 4-5A or PR 4-5B and work it through using the Excel templates provided in the instructor resources. This will allow the student to see the entire accounting cycle demonstrated at one time. A word of caution: This problem is rather lengthy and could take an entire class period to complete. Nevertheless, it is a valuable review to demonstrate to the students all the foundation materials that have been covered in Chapters 1–4.
OBJECTIVE 6
Explain what is meant by the fiscal year and the natural business year.
SYNOPSIS
The fiscal year for a business usually begins on January 1 and ends on December 31. However, a business can choose to start its fiscal year in another month and its fiscal year-end will then be the 31st of the following twelfth month. If a business’s fiscal year follows its natural business cycle, it is called the natural business year. The financial history of a business may be shown by a series of income statements and balance sheets.
Keys Terms and Definitions
Fiscal Year - The annual accounting period adopted by a business.
Natural Business Year - A fiscal year that ends when business activities have reached the lowest point in an annual operating cycle.
Relevant Exhibit
Exhibit 19 – Financial History of a Business
SUGGESTED APPROACH
Objective 6 asks students to understand the definitions of fiscal year and natural business year, not just to memorize these definitions. Therefore, the instructor must help the student to internalize these concepts.
LECTURE AID—Fiscal Year
To begin this exercise, explain the definitions of fiscal year and natural business year. Then ask students who work either full or part time to raise their hands. Call on one of these students and ask where he or she works.
Next, ask the student at what time of the year the company is at the end of its natural business year (e.g., when stocks are lowest; prices are normal; the company is not buying heavily). Ask the student whether he or she knows when the company closes its fiscal year. If the student doesn’t know, ask when the company takes a physical inventory count. That may provide a clue.
Repeat the same exercise with several other students.
Use the following examples to help students understand why the fiscal business year may vary from the calendar year. First, ask students if they would like to be taking inventory and working through the accounting cycle financial statements closing process the week of Christmas. For retail stores, this is typically a high volume sales time with after-Christmas sales, returns, and exchanges. Explain that a retail store will typically choose the slowest time of the year, when inventory levels are low and sales are slow, to complete this process.
A second example for demonstration purposes is a ski resort. Ski resorts’ busy season is in the winter, when there is snow. A secondary busy season might be summer for hiking and fishing. Ski resorts’ slow time is typically in the spring, when snow is melting and the slopes are a muddy mess. This is the time a ski resort would choose to complete the accounting cycle.
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OBJECTIVE 7
Describe and illustrate the use of working capital and the current ratio in evaluating a company’s financial condition.
SYNOPSIS
Financial statements can also be used to analyze a business in another way. Using numbers obtained from the financial statements, a business’s liquidity and solvency can be determined. Working capital is defined as follows: Working Capital = Current Assets – Current Liabilities. Current assets are usually those that can be converted to cash within one year of operation. A positive working capital is necessary for a company to pay its current liabilities. The current ratio uses the same two numbers from the balance sheet. The current ratio is computed as follows: Current Ratio = Current Assets/Current Liabilities. The current ratio is useful to make comparisons with other companies or industries.
Keys Terms and Definitions
Current Ratio - A financial ratio that is computed by dividing current assets by current liabilities.
Liquidity - The ability to convert assets into cash.
Solvency - The ability of a firm to pay its debts as they come due.
Working Capital - The excess of the current assets of a business over its current liabilities.
Relevant Example Exercise
Example Exercise 4-6 – Working Capital and Current Ratio
SUGGESTED APPROACH
To help students understand these terms, make it personal.
For example, for liquidity, ask them to imagine being offered the “deal of a lifetime” but the opportunity is available only for the next hour. What is the first item they possess that comes to mind that would be easiest to use to pay for “the deal”? For those who have cash in the bank, a quick trip to the ATM would seal the deal or selling something very popular among their peers could work. Which items would take more time to sell and thus convert to cash? Probably more expensive items.
Tie solvency to working capital by asking students if they could pay their current obligations in a timely manner if it were necessary. They should think about their current sources of cash (job, allowance from parents, etc.) and their current bills (rent, utilities, school supplies, etc.).
Ask students to consider why the current ratio is more indicative of how a company’s ability to meet its current obligations compares to its industry average than only knowing the value of its current assets and liabilities.
APPENDIX 1—End-of-Period Spreadsheet
If you elect to include the end-of-period spreadsheet (work sheet) in the curriculum, you may want to include this discussion early in the chapter material.
GROUP LEARNING ACTIVITY—Preparing an End-of-Period Spreadsheet (Work Sheet)
Handout 4-10 presents information that can be used in explaining the purpose of the end-of-period spreadsheet (work sheet). After reviewing this material, use Handout 4-11 to explain how to complete the columns of the spreadsheet (work sheet). You may want to instruct your students to turn to the end-of- period spreadsheet illustrated in the text while you review this information. Point out that it is not necessary to prepare a separate trial balance if an end-of-period spreadsheet is used. You may also want to emphasize that the Adjusted Trial Balance columns are a check on the mathematical accuracy of the spreadsheet.
It is helpful to allow your students to practice completing an end-of-period spreadsheet. This Group Learning Activity will assist in accomplishing this goal.
Handout 4-12 is an end-of-period spreadsheet (work sheet) for Dixie Machinery. The Unadjusted Trial Balance columns have been completed using account balances from the company’s ledger. Make copies of this handout for each of your students. Divide the class into small groups and instruct them to enter the adjusting entries from Handout 4-13 on the spreadsheet. Also ask them to complete the Adjusted Trial Balance columns.
At this point, display Handout 4-14, which shows the first three columns of the completed spreadsheet.
After your students have checked their work, instruct them to complete the Income Statement and Balance Sheet columns by sorting the account balances to the proper financial statement. Handout 4-15 shows the Adjusted Trial Balance, Income Statement, and Balance Sheet columns. The net income is not illustrated on this handout. This gives you the opportunity to complete that step for your students on the handout. Fill in these columns as follows:
Income Statement Balance Sheet Debit Credit Debit Credit Total of accounts 11,290 15,140 7,400 3,550
Net income 3,850 3,850
15,140 15,140 7,400 7,400
Check your students’ understanding of using the end-of-period spreadsheet to compute net income by asking the following questions:
Chapter 4 Completing the Accounting Cycle 4-17
2. If the totals of the Balance Sheet columns of a spreadsheet are Debit, $1,250 and Credit, $1,110, what is the net income or net loss? Answer: Net income, $140.
Once the spreadsheet is completed, it may be beneficial to have students complete financial statements from the data on the spreadsheet. This will help them understand that the purpose of the spreadsheet is to provide a tool that will assist the preparer in getting from an unadjusted trial balance to producing financial statements in a very efficient manner. Remind them that using the spreadsheet does not excuse the requirement to journalize and post adjusting entries in order to make sure the general ledger account balances are accurate. The financial statements are available on Handouts 4-16 and 4-17.
APPENDIX 2—Reversing Entries
SYNOPSIS
Some companies prepare reversing entries on the first day of the next period to cancel the effect of some of the adjusting entries from the previous period. These entries are the opposite (or reversal) of the related adjusting entries from the end of the previous period. These reversing entries eliminate the need to identify what part, if any, of a particular payment or receipt made or received in the beginning of the new period relates to the previous period. Reversing entries are most often used with adjusting entries that are accruals.
Key Term and Definition
Reversing Entries - Journal entries made the first day of the period that are the exact opposite of the related adjusting entries of the prior period.
Relevant Exhibits
Exhibit 25 – Accrued Wages
Exhibit 26 – Wages Expense and Wages Payable
Exhibit 27 – Wages Expense and Wages Payable
SUGGESTED APPROACH
Some entries, such as entries for wages, occur often and are somewhat routine. But those entries are different when there was a related adjusting entry at the end of the previous period. When reversing entries are not made, the accountant needs to remember last period adjusting entries and account for any expense/revenue previously recognized relating to current period payments or receipts. Some students may have difficulty with the concept of crediting an expense account. Using Exhibit 27, continue the example, demonstrating that Wages Expense will have a normal debit balance when the first entry of January is prepared and posted. Point out that the reversing entry brings Wages Payable to a zero balance so that the first entry in January can be a routine entry for wages: debit to Wages Expense and credit to Cash.
GROUP LEARNING ACTIVITY—Reversing Entries
To complete this activity, you can either break the class into small groups or ask each student to work individually. Pass out or project Handout 4-18, Part 1. This handout assumes four pay periods but ignores dates. The purpose is to demonstrate the routine nature of some journal entries. Now pass out or project Handout 4-18, Part 2. In this handout, the students are asked to prepare the entries for June 30 through July 2 under two scenarios: (a) assumes no reversing entry is made or (b) a reversing entry is made on July 1. Ask the students to post the entries to the T account for Wages Expense below the journal.
The solution to Handout 4-18, Part 2 is provided in Handout 4-19. Point out to students that when a reversing entry is made, the journal entry to record payroll is always a debit to Wages Expense and a credit to Cash, regardless of when it occurs.
Use the T account to demonstrate that the balance in Wages Expense on July 2 is the same and is accurate: 6 employees × $100 × 3 days in July = $1,800. You can also use this opportunity to discuss the normal balance of accounts. Point out that after the reversing entry, Wages Expense leaves the account with a credit balance. The normal balance of an expense account is a debit, but this balance will become normal again after the first payroll is recorded in July.
Handout 4-1
WRITING EXERCISE
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 is a bright high school graduate, but he has never taken an accounting class. Keith is trying to decide which accounting activities could be delegated to his assistant.
Keith is willing to give the assistant a few simple instructions on how to complete each task, but he doesn’t have time to teach the assistant to be an accountant.
For each task listed, state whether Keith should continue to do the work or delegate the task to his assistant. Explain each answer.
1. List the account balances from the general ledger in the Trial Balance columns of the end-of-period spreadsheet.
2. Add the Debit and Credit columns of the trial balance.
3. Make the adjusting entries on the spreadsheet.
4. Complete the spreadsheet.
5. Type 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.
Handout 4-2
Thiago Company Adjusted Trial Balance
December 31, 20Y1 Acct.
No.
Debit Balances
Credit Balances
Cash 11 2,600
Accounts Receivable 12 1,200
Supplies 14 275
Prepaid Insurance 15 1,200
Equipment 18 7,500
Accum. Depr.—Equipment 19 1,600
Accounts Payable 21 675
Wages Payable 22 450
Unearned Revenue 23 280
James Thiago, Capital 31 2,500
James Thiago, Drawing 32 6,800
Fees Earned 41 29,750
Wages Expense 51 9,755
Rent Expense 52 2,400
Supplies Expense 53 325
Insurance Expense 54 2,400
Depreciation Expense 58 800
35,255 35,255
Handout 4-3
Income Statement
Revenues (from the work sheet) – Expenses (from the work sheet) Net Income
Statement of Owner’s Equity
Beginning Capital Balance (from the work sheet or owner’s capital account in the ledger)
+ Investments (from the owner’s capital account in the ledger)
+ Net Income (from the income statement)
– Drawing (from the work sheet or
owner’s drawing account in the ledger)
Ending Capital Balance
Balance Sheet
Current Assets (from the work sheet) + Property, Plant, & Equip. (from the work sheet) Total Assets
Current Liabilities (from the work sheet) + Long-Term Liabilities (from the work sheet) Total Liabilities
+ Capital Balance (from statement of owner's equity)
Total Liabilities and Owner’s Equity
Handout 4-4, Part 1
Thiago Company Income Statement
For the Year Ended December 31, 20Y1
Fees earned $29,750
Expenses:
Wages expense $9,755
Rent expense 2,400
Insurance expense 2,400
Depreciation expense 800
Supplies expense 325
Total expenses 15,680
Net income $14,070
Thiago Company
Statement of Owner’s Equity For the Year Ended December 31, 20Y1
James Thiago, capital, January 1 $2,500
Net income $14,070
Withdrawals (6,800)
Increase in owner’s equity 7,270
James Thiago, capital, December 31 $9,770
Handout 4-4, Part 2
Thiago Company Balance Sheet December 31, 20Y1
Assets Current assets:
Cash $2,600
Accounts receivable 1,200
Supplies 275
Prepaid insurance 1,200
Total current assets $ 5,275
Property, plant, and equipment:
Equipment $7,500
Less accumulated depreciation 1,600
Total property, plant, and equipment 5,900
Total assets $11,175
Liabilities Current liabilities:
Accounts payable $ 675
Wages payable 450
Unearned revenue 280
Total liabilities $ 1,405
Owner’s Equity
James Thiago, capital 9,770
Total liabilities and owner’s equity $11,175
Handout 4-5
CLOSING ENTRIES
Prepare the two closing entries in the format used by accountants. After you have completed your entries, compute the balance of the capital account.
Service Revenue 3,500
J. Jones, Drawing 1,200
Salaries Expense 1,400
Rent Expense 600
J. Jones, Capital
10,000
Handout 4-6
CLOSING ENTRIES
Service Revenue
3,500 Bal. 3,500
Bal. 0
Salaries Expense Rent Expense
Bal. 1,400 1,400 Bal. 600 600
Bal. 0 Bal. 0
J. Jones, Drawing J. Jones, Capital
Bal. 1,200 1,200 1,400 Bal. 10,000
600 3,500
1,200
Bal. 0 Bal. 10,300
Handout 4-7
J. Jones Company Income Statement
For the Year Ended December 31, 20Y1
Service revenue ... $3,500 Expenses:
Salaries expense ... $1,400 Rent expense ... 600
Total expenses ... 2,000 Net income ... $1,500
J. Jones Company
Statement of Owner’s Equity
For the Year Ended December 31, 20Y1
J. Jones, capital, January 1 ... $10,000 Net income ... $1,500
Withdrawals ... 1,200
Increase in owner’s equity ... 300
J. Jones, capital, December 31 ... $10,300
Handout 4-8
STEPS IN THE ACCOUNTING CYCLE Instructions: List the following steps in the correct order.
Financial statements prepared.
Adjusted trial balance prepared.
Adjustment data assembled and analyzed.
Transactions posted to the ledger.
Closing entries journalized and posted to ledger.
Transactions analyzed and recorded in journal.
Unadjusted trial balance prepared.
Optional end-of-period spreadsheet prepared.
Post-closing trial balance prepared.
Adjusting entries journalized and posted to ledger.
Handout 4-9
STEPS IN THE ACCOUNTING CYCLE This is the correct order for the steps in the accounting cycle.
Transactions analyzed and recorded in journal.
Transactions posted to the ledger.
Unadjusted trial balance prepared.
Adjustment data assembled and analyzed.
Optional end-of-period spreadsheet prepared.
Adjusting entries journalized and posted to ledger.
Adjusted trial balance prepared.
Financial statements prepared.
Closing entries journalized and posted to ledger.
Post-closing trial balance prepared.
Handout 4-10
PURPOSE OF WORK SHEET 1. Tool to assist with end-of-accounting-period work
2. Information to prepare adjusting entries and financial statements on one continuous form
3. Format that is easily adapted to a computer spreadsheet program
Handout 4-11
WORK SHEET To complete the columns of a work sheet:
1. List all account balances from the ledger in the Trial Balance
columns. Total the Debit and Credit columns; they should be equal.
2. Record the adjusting entries in the Adjustments columns. Total the Debit and Credit columns; they should be equal.
3. Enter the balance of each account, after computing any changes due to adjusting entries, in the Adjusted Trial Balance columns. Total the Debit and Credit columns; they should be equal.
4. Enter the balance of all revenue and expense accounts in the Income Statement columns. Total the Debit and Credit columns; the
difference between these columns is net income.
5. Enter the balance of assets, liabilities, capital, and drawing in the
Balance Sheet columns. Total the Debit and Credit columns. Net
income must be added to the Credit column (or net loss added to the
Debit column) to make the Balance Sheet columns balance.
Handout 4-12
A B C D E F G H I J K
1 Dixie Machinery
2 End-of-Period Spreadsheet (Work Sheet) 3 For the Year Ended December 31, 20Y1
4 Unadjusted Adjusted Income Balance
5 Trial Balance Adjust. Trial Balance Statement Sheet 6 Account Title Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
7 Cash 825
8 Accounts. Rec. 300 9 Prepaid Insurance 500 10 Office Equipment 5,050 11 Acc. Depr.—Off. Equip. 180
12 Accounts Payable 250
13 Salaries Payable
14 Bill McCowan, Capital 2,370 15 Bill McCowan, Drawing 1,100 16 Repair Revenue 15,140 17 Salaries Expense 8,025 18 Rent Expense 1,500 19 Utilities Expense 640 20 Insurance Expense
21 Depr. Exp.—Off. Equip.
22 17,940 17,940
23 24 25 26 27
Handout 4-13
END-OF-PERIOD SPREADSHEET (WORK SHEET)
Enter the following adjusting entries on the end-of-period spreadsheet (work sheet) for Dixie Machinery:
1. $375 of the prepaid insurance has expired.
2. Depreciation to be recorded on the office equipment is $400.
3. $350 of salaries are owed to Dixie Machinery’s employees.
Handout 4-14
A B C D E F G
1 Dixie Machinery
2 End-of-Period Spreadsheet (Work Sheet)
3 For the Year Ended December 31, 20Y1
4 Unadjusted Adjusted
5 Trial Balance Adjustments Trial Balance
6 Account Title Dr. Cr. Dr. Cr. Dr. Cr.
7 Cash
825 8258 Accounts Rec.
300 3009 Prepaid Insurance
500 375 12510 Office Equipment
5,050 5,05011 Acc. Depr.—Off. Equip.
180 400 58012 Accounts Payable
250 25013 Salaries Payable
350 35014 Bill McCowan, Capital
2,370 2,37015 Bill McCowan, Drawing
1,100 1,10016 Repair Revenue
15,140 15,14017 Salaries Expense
8,025 350 8,37518 Rent Expense
1,500 1,50019 Utilities Expense
640 64020 Insurance Expense
375 37521 Depr. Exp.—Off. Equip.
400 40022
17,940 17,940 1,125 1,125 18,690 18,69023
24
25
26
27
Handout 4-15
A F G H I J K
1 Dixie Machinery
2 End-of-Period Spreadsheet (Work Sheet)
3 For the Year Ended December 31, 20Y1
4 Adjusted Income Balance
5 Trial Balance Statement Sheet
6 Account Title Dr. Cr. Dr. Cr. Dr. Cr.
7 Cash
825 8258 Accounts Rec.
300 3009 Prepaid Insurance
125 12510 Office Equipment
5,050 5,05011 Acc. Depr.—Off. Equip.
580 58012 Accounts Payable
250 25013 Salaries Payable
350 35014 Bill McCowan, Capital
2,370 2,37015 Bill McCowan, Drawing
1,100 1,10016 Repair Revenue
15,140 15,14017 Salaries Expense
8,375 8,37518 Rent Expense
1,500 1,50019 Utilities Expense
640 64020 Insurance Expense
375 37521 Depr. Exp.—Off. Equip.
400 40022
18,690 18,690 11,290 15,140 7,400 3,55023 Net Income 24
25
26
27
Handout 4-16
FINANCIAL STATEMENTS Dixie Machinery
Income Statement
For the Year Ended December 31, 20Y1 Revenues:
Repair revenue ... $15,140 Expenses:
Salaries expense ... $8,375 Rent expense ... 1,500 Utilities expense ... 640 Depreciation expense—office
equipment ... 400 Insurance expense ... 375
Total expenses ... 11,290 Net income ... $ 3,850
Dixie Machinery
Statement of Owner’s Equity
For the Year Ended December 31, 20Y1
Bill McCowan, capital, January 1 ... $2,370 Net income for the year ... $ 3,850
Withdrawals ... (1,100)
Increase in owner’s equity ... 2,750
Bill McCowan, capital, December 31 ... $5,120
Handout 4-17
Dixie Machinery Balance Sheet December 31, 20Y1
Assets Current assets:
Cash $ 825
Accounts receivable 300
Prepaid insurance 125
Total current assets $1,250
Property, plant, and equipment:
Office equipment $5,050
Less accumulated depreciation 580
Total property, plant, and equipment 4,470
Total assets $5,720
Liabilities Current liabilities:
Accounts payable $ 250
Salaries payable 350
Total liabilities $ 600
Owner’s Equity
Bill McCowan, capital 5,120
Total liabilities and owner’s equity $5,720
Handout 4-18, Part 1
Martinez Company has six employees that each earn $100 per day.
The payroll period ends Friday of each week, and the employees are paid cash. The accountant for Martinez Company has received the following data from the Payroll Department:
Pay Period
Total Wages
1 $ 3,000 (6 employees × $100 per day × 5 days)
2 3,000
3 3,000
4 3,000
$12,000
Ignoring dates, the journal entries for each payroll period would be prepared as follows:
Period Description Debit Credit
1 Wages Expense 3,000
Cash 3,000
2 Wages Expense 3,000
Cash 3,000
3 Wages Expense 3,000
Cash 3,000
4 Wages Expense 3,000
Cash 3,000
Handout 4-18, Part 2
Assume that the fourth pay day is July 2. The accounting period ends on Tuesday, June 30.
Date Debit Credit Date Debit Credit
6/12 3,000 6/12 3,000
3,000 3,000
6/19 3,000 6/19 3,000
3,000 3,000
6/26 3,000 6/26 3,000
3,000 3,000
6/30 6/30
7/2 7/1
7/2
6/12 3,000 6/12 3,000
6/19 3,000 6/19 3,000
6/26 3,000 6/26 3,000
Adj. Adj.
Bal. Bal.
Clos. Clos.
Description Wages Expense
Cash
Wages Expense Cash
Wages Expense Cash
Description Wages Expense
Cash
Wages Expense Cash
Prepare the adjusting entry on June 30 and the entry to record payroll on July 2 WITHOUT reversing entries.
Prepare the adjusting entry on June 30, the reversing entry on July 1, and the entry to record payroll on July 2.
Wages Expense Wages Expense
Wages Expense Cash
Handout 4-19
Date Debit Credit Date Debit Credit
6/12 3,000 6/12 3,000
3,000 3,000
6/19 3,000 6/19 3,000
3,000 3,000
6/26 3,000 6/26 3,000
3,000 3,000
6/30 1,200 6/30 1,200
1,200 1,200
7/2 1,200 7/1 1,200
1,800 1,200
3,000
7/2 3,000
3,000
6/12 3,000 6/12 3,000
6/19 3,000 6/19 3,000
6/26 3,000 6/26 3,000
Adj. 1,200 Adj. 1,200
Bal. 10,200 Bal. 10,200
Clos. 10,200 Clos. 10,200
Bal. 0 Bal. 0
7/2 1,800 Rev. 1,200
Bal. 1,800 7/2 3,000
Bal. 1,800
Wages Expense Cash
Wages Expense Wages Payable
Description Wages Expense
Cash
Wages Expense Cash
Wages Expense
Description Wages Expense
Cash
Wages Expense
Wages Expense Cash
Wages Payable Wages Payable
Wages Expense Wages Payable
Wages Expense Cash
Cash
Wages Expense Cash
Wages Expense Prepare the adjusting entry on June 30 and the
entry to record payroll on July 2 WITHOUT reversing entries.
Prepare the adjusting entry on June 30, the reversing entry on July 1, and the entry to record payroll on July 2.
Wages Expense
