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CHAPTER

4

CHAPTER 4 A systematic approach is essential for effi- cient and accurate processing of large amounts

A systematic approach is essential for effi- cient and accurate processing of large amounts of information. Whether work sheets are on paper or computerized, they help provide this structure. Proprietorships, partnerships, and corporations all use simi- lar work sheets.

The Work Sheet and the Closing Process

Paralleling Karen White and Mark Smith’s progress in the study of accounting was their continued interest in the ex- amination of the annual report of Imperial Oil Limited. They reread the “Letter to Shareholders.” On this reading they were particularly interested in the statement: “First, we in- tend to improve the sales mix by emphasizing more prof- itable products.” White and Smith have now completed the study of Chap- ter 3. They intend to use their newfound knowledge to test whether Imperial is indeed improving its profitability.

IMPERIAL OIL LIMITED Selected financial data (in millions)

 

1994

 

1993

1992

1991

1990

Net earnings (income)

 

$

359

$

279

$

195

$

162

$

256

Revenue

.

.

.

.

.

.

.

.

.

.

.

.

9,011

8,903

9,147

9,502

11,303

184

Chapter 4

LEARNING

OBJECTIVES

After studying Chapter 4, you should be able to:

1. Explain why work sheets are useful, prepare a work sheet for a service busi- ness, and prepare financial statements from the information in a work sheet.

2. Explain why the temporary accounts are closed at the end of each accounting pe- riod and prepare closing entries and a post-closing trial balance for a service business.

3. Describe each step in the accounting cycle.

4. Calculate the profit margin ratio and describe what it reveals about a com- pany’s performance.

5. Define or explain the words and phrases listed in the chapter glossary.

After studying Appendix C at the end of Chapter 4, you should be able to:

6. Explain when and why reversing entries are used and prepare reversing entries.

After studying Appendix D at the end of Chapter 4, you should be able to:

7. Explain the nature of a corporation’s retained earnings and their relationship to the declaration of dividends.

8. Prepare entries to record the declaration and payment of a dividend and to close the temporary accounts of a corporation.

This chapter continues your study of the accounting process by describing proce- dures that the accountant performs at the end of each reporting period. You learn about an optional work sheet that accountants use to draft adjusting entries and the financial statements. Studying the work sheet allows you to get an overall per- spective on the steps in the accounting cycle. The chapter also describes the clos- ing process that prepares the revenue, expense, and withdrawals accounts for the next reporting period and updates the owner’s capital account. In addition, the chap- ter describes the profit margin ratio that decision makers use to assess a company’s performance.

decision makers use to assess a company’s performance. USING WORK SHEETS AT THE END OF ACCOUNTING

USING WORK SHEETS AT THE END OF ACCOUNTING PERIODS

LO 1 Explain why work sheets are useful, prepare a work sheet for a service busi- ness, and prepare finan- cial statements from the information in a work sheet.

When organizing the information presented in formal reports to internal and ex- ternal decision makers, accountants prepare numerous analyses and informal doc- uments. These informal documents are important tools for accountants. Tradition- ally, they are called working papers. One widely used working paper is the work sheet. Normally, the work sheet is not distributed to decision makers. It is prepared and used by accountants.

Why Study the Work Sheet?

As we stated previously, preparing a work sheet is an optional procedure. When a business has only a few accounts and adjustments, preparing a work sheet is not necessary. Also, computerized accounting systems provide financial statements without first generating a work sheet. Nevertheless, there are several reasons why an understanding of work sheets is helpful:

The Work Sheet and the Closing Process

185

1. In a manual accounting system involving many accounts and adjustments, the work sheet helps the accountant avoid errors.

2. Studying the work sheet is an effective way for you to see the entire ac- counting process from beginning to end. In a sense, it gives a bird’s-eye view of the process between the occurrence of economic events and the pre- sentation of their effects in financial statements. This knowledge helps man- agers and other decision makers understand the information in the statements.

3. After a company has tentatively prepared its financial statements, the audi- tors of the statements often use a work sheet as a basis for planning and or- ganizing the audit. Also, they may use a work sheet to reflect any additional adjustments that appear necessary as a result of the audit.

4. Accountants often use work sheets to prepare interim (monthly or quarterly) financial statements.

5. A modified form of the work sheet is sometimes used to show the effects of proposed transactions.

Where Does the Work Sheet Fit into the Accounting Process?

In practice, the work sheet is an optional step in the accounting process that can simplify the accountant’s efforts in preparing financial statements. When a work sheet is used, it is prepared before making the adjusting entries at the end of the reporting period. The work sheet gathers information about the accounts, the needed adjustments, and the financial statements. When it is finished, the work sheet contains information that is recorded in the journal and then presented in the statements.

Illustration 4–1 shows a blank work sheet. Notice that it has five sets of double columns for the

1. Unadjusted trial balance.

sets of double columns for the 1. Unadjusted trial balance. PREPARING THE WORK SHEET 2. Adjustments.

PREPARING

THE WORK

SHEET

2. Adjustments.

3. Adjusted trial balance.

4. Income statement.

5. Statement of changes in owner’s equity and the balance sheet.

Note that a separate set of double columns is not provided for the statement of changes in owner’s equity. Because that statement includes only a few items, they are simply listed with the balance sheet items. A work sheet can be completed manually or with a computer. In fact, the format is well-suited for using a spread- sheet program.

Step 1—Enter the Unadjusted Trial Balance

Turn the first transparency over to create Illustration 4–2. This illustration shows how the accountant starts preparing the work sheet by listing the number and title of every account expected to appear on the company’s financial statements. Then, the unadjusted debit or credit balances of the accounts are found in the ledger and

Illustration 4–1

Preparing the Work Sheet at the End of the Accounting Period

 

CLEAR COPY CO. Work Sheet For Month Ended December 31, 19X1

COPY CO. Work Sheet For Month Ended December 31, 19X1 The heading should identify the entity,

The heading should identify the entity, the document, and the time period.

 

Unadjusted

 

Adjusted

 

Income

Statement of Changes in Owner’s Equity and Balance Sheet

Account

Trial Balance

Adjustments

Trial Balance

Statement

No.

Title

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.

Dr.

Cr.

The work sheet can be prepared manually or with a computer spreadsheet program.

The worksheet collects and summarizes the information used to prepare financial statements, adjusting entries, and closing entries.

Illustration 4–2

Step One: Enter the Unadjusted Trial Balance

CLEAR COPY CO. Work Sheet For Month Ended December 31, 19X1

101

Cash

7,950

106

Accounts receivable

125

Store supplies

3,720

128

Prepaid insurance

2,400

167

Copy equipment

26,000

168

Accumulated depreciation, copy equipment

201

Accounts payable

6,200

209

Salaries payable

236

Unearned copy services revenue

3,000

301

Terry Dow, capital

30,000

302

Terry Dow, withdrawals

400

403

Copy services revenue

3,900

614

Depreciation expense, copy equipment

622

Salaries expense

1,400

637

Insurance expense

641

Rent expense

1,000

651

Store supplies expense

690

Utilities expense Totals

230

43,100

43,100

When entering the unadjusted trial balances, include all accounts that have balances or that are
When entering the unadjusted trial balances, include all accounts that have balances or that are
When entering the unadjusted trial balances, include all accounts that have balances or that are
When entering the unadjusted trial balances, include all accounts that have balances or that are

When entering the unadjusted trial balances, include all accounts that have balances or that are expected to have balances after adjustments.

These two columns should show equal totals.
These two
columns
should show
equal
totals.

Illustration 4–3

Step Two: Enter the Adjustments and Prepare the Adjusted Trial Balance

Enter the Adjustments and Prepare the Adjusted Trial Balance   7,950 (f) 1,800 1,800   (b)
 

7,950

(f)

1,800

1,800

 

(b)

1,050

2,670

(a)

100

2,300

 

26,000

 

(c)

375

375

 

6,200

 

(e)

210

210

(d)

250

2,750

 

30,000

 

400

 

(d)

250

(f)

1,800

5,950

(c)

375

375

(e)

210

1,610

(a)

100

100

 

1,000

(b)

1,050

1,050

 

230

 

3,785

3,785

45,485

45,485

These two columns should show equal totals. columns should show equal totals.

These two columns should show equal totals. These two columns should show equal totals.

These two columns should show equal totals. columns should show equal totals.

These two columns should show equal totals. These two columns should show equal totals.

llustration 4–4

Step Three: Extend the Adjusted Trial Balance Amounts to the Financial Statement Columns

Trial Balance Amounts to the Financial Statement Columns   7,950 1,800 2,670 2,300 26,000
 

7,950

1,800

2,670

2,300

26,000

 

375

6,200

210

2,750

30,000

 

400

 

5,950

375

1,610

100

1,000

1,050

230

4,365

5,950

41,120

39,535

Extend all revenue and expense amounts to the Income Statement columns. Extend all asset, liability,
Extend all revenue and expense amounts to the Income Statement columns.
Extend all
revenue and
expense amounts
to the Income
Statement
columns.
Extend all asset, liability, and owner’s equity amounts to these columns.
Extend all
asset, liability,
and owner’s
equity amounts
to these
columns.

The totals for the columns are not equal because the debit and the credit balances in the revenue and expense accounts are not equal.

the columns are not equal because the debit and the credit balances in the revenue and
the columns are not equal because the debit and the credit balances in the revenue and
the columns are not equal because the debit and the credit balances in the revenue and
the columns are not equal because the debit and the credit balances in the revenue and
the columns are not equal because the debit and the credit balances in the revenue and

llustration 4–5

Step Four: Enter the Net Income (or Loss) and Balance the Financial Statement Columns

Income (or Loss) and Balance the Financial Statement Columns Net income 1,585 1,585 Totals 5,950 5,950
Net income 1,585 1,585 Totals 5,950 5,950 41,120 41,120 Add two new lines for the
Net income
1,585
1,585
Totals
5,950
5,950
41,120
41,120
Add two new lines for the net
income (or loss) and the totals
Enter the net income
amount as the
difference between
the debits and the
credits in the Income
Statement columns.
Also enter the net
income amount in
the credit column
to include all
changes in
owner’s equity.

The Work Sheet and the Closing Process

CLEAR COPY Income Statement For Month Ended December 31, 1996

Revenues:

Copy services revenue Operating expenses:

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

$5,950

Amortization expense, copy equipment

 

$

375

Salaries expense

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

1,610

Insurance expense

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

100

. Store supplies expense

Rent expense

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

1,000

1,050

. Total operating expenses

Utilities expense

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

230

4,365

Net income

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

$1,585

CLEAR COPY Statement of Changes in Owner’s Equity For Month Ended December 31, 1996

 

Terry Dow, Capital, November 30, 1996 Plus:

 

$

0

Investments by owner

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

$30,000

 

Net income

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

1,585

31,585

Total

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

$31,585

Less withdrawals by owner

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

400

Terry Dow, capital, December 31, 1996

 

$31,185

CLEAR COPY Balance Sheet December 31, 1996

 
 

Assets

 

Cash

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

$ 7,950

Accounts receivable

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

1,800

Store supplies

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

2,670

Prepaid insurance

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

2,300

. Accumulated amortization, copy equipment

Copy equipment

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

$26,000

(375)

 

25,625

Total assets

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

$40,345

Liabilities

 

Accounts payable

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

$ 6,200

. Unearned copy services revenue

Salaries payable

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

210

2,750

Total liabilities

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

$ 9,160

Owner’s Equity

 

Terry Dow, capital

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

31,185

Total liabilities and owner’s equity

 

$40,345

Illustration 4–6 Step Five: Prepare the Financial Statements from the Work Sheet Information

186

Chapter 4

recorded in the first two columns. Because these columns serve as the unadjusted trial balance, the totals of the columns should be equal. Illustration 4–2 uses the information for Clear Copy from Chapter 2 to show step 1. The account balances include the effects of December’s external transac- tions. They do not reflect any of the adjustments described in Chapter 3. In some cases, the accountant determines later that additional accounts need to be inserted on the work sheet. If the work sheet is completed manually, the addi- tional accounts are inserted below the initial list. If a computer spreadsheet pro- gram is used, the new lines are easily inserted between existing lines. Because a later phase in the example requires two lines for the Copy Services Revenue account, Illustration 4–2 includes an extra blank line below that account. If this need is not anticipated when the work sheet is being prepared manually, the accountant can squeeze two entries on one line.

Step 2—Enter the Adjustments and Prepare the Adjusted Trial Balance

Turn the next overlay page to create Illustration 4–3. The work sheet now appears as it would after step 2 is completed. Step 2 begins by entering adjustments for economic events that were not external transactions. These include adjustments for prepaid expenses, amortization, unearned revenues, accrued expenses, and accrued revenues. The illustration shows the six adjustments for Clear Copy that were explained in Chapter 3:

a. Expiration of $100 of prepaid insurance.

b. Consumption of $1,050 of store supplies.

c. Amortization of copy equipment by $375.

d. Earning of $250 of previously unearned revenue.

e. Accrual of $210 of salaries owed to the employee.

f. Accrual of $1,800 of revenue owed by a customer.

To be sure that equal debits and credits are entered, the components of each ad- justment are identified on the work sheet with a letter. Some accountants explain the adjustments with a list at the bottom of the work sheet or on a separate page. 1 To test for accuracy, they add the totals of the two columns to confirm that they are equal. After the adjustments are entered on the work sheet, the adjusted trial balance is prepared by combining the adjustments with the unadjusted balances. Debits and credits are combined just as they would be in determining an account’s balance. For example, the Prepaid Insurance account in Illustration 4–3 has a $2,400 debit bal- ance in the unadjusted trial balance. This is combined with the $100 credit entry (a) in the Adjustments columns to give the account a $2,300 debit balance in the ad- justed trial balance. Salaries Expense has a $1,400 balance in the unadjusted trial balance and is combined with the $210 debit entry (e) in the Adjustments columns. When the debit balance is combined with the debit from the adjustment, the account

1 Auditors’ work sheets cross-reference each adjustment to a detailed analysis and other supporting evi- dence.

The Work Sheet and the Closing Process

187

has a $1,610 debit balance in the adjusted trial balance. The totals of the Adjusted Trial Balance columns should confirm that debits equal credits.

Step 3—Extend the Adjusted Trial Balance Amounts to the Financial Statement Columns

Turn the third transparency over to create Illustration 4–4 and to see the effects of step 3. In this step, the accountant assigns each adjusted account balance to its fi- nancial statement. This is done by extending each amount to the appropriate col- umn across the page. The revenue and expense balances are extended to the Income Statement columns. The asset, liability, and owner’s capital and withdrawals account balances are extended to the Statement of Changes in Owner’s Equity and Balance Sheet columns. Accounts with debit balances in the adjusted trial balance are ex- tended to the Debit columns and accounts with credit balances are extended to the Credit columns. Next, the columns are totaled. Notice that the paired column totals are not equal. This occurs because the sum of the expenses debit balances does not equal the sum of the revenue credit balances. This also creates an equal and opposite imbalance in the Statement of Changes in Owner’s Equity and Balance Sheet columns. Step 4 deals with this imbalance.

Step 4—Enter the Net Income (or Loss) and Balance the Financial Statement Columns

To see the completed work sheet, turn the final transparent overlay to create Illus- tration 4–5. Step 4 begins by entering Net income and Totals on the next two lines in the account title column. Next, the accountant computes the net income by find- ing the excess of the Income Statement Credit column total over the Debit column total. This amount is inserted on the net income line in the Debit column, and a new total is computed for each column. (If the initial total of the debits is greater than the initial total credits, the expenses exceed the revenues and the company has incurred a net loss. If so, the difference is entered in the Credit column instead of the Debit column.) The total debits and total credits in the Income Statement columns are now equal. The accountant next enters the net income in the last Credit column of the work sheet. (If there is a net loss, it is entered in the last Debit column.) Notice that this entry causes the total debits in the last two columns to equal the total credits. Even if all five pairs of columns balance, the work sheet may not be free of er- rors. For example, if the accountant incorrectly extends an asset account’s balance to the Income Statement Debit column, the columns balance but net income is un- derstated. Or, if an expense is extended to the Statement of Changes in Owner’s Equity and Balance Sheet Debit column, the columns balance but the net income is overstated. Although these errors may not be immediately obvious, they are dis- covered when the accountant begins to actually prepare the financial statements. For example, it would be apparent that an asset does not belong on the income statement or that an expense does not belong on the balance sheet. At this point, the work sheet is complete. If the accountant discovers new in- formation or an error, the change can easily be included in the work sheet, espe- cially if it is being prepared with a computer spreadsheet.

188

Chapter 4

1 8 8 Chapter 4 PREPARING ADJUSTING ENTRIES FROM THE WORK SHEET PREPARING FINANCIAL STATEMENTS FROM

PREPARING ADJUSTING ENTRIES FROM THE WORK SHEET

Chapter 4 PREPARING ADJUSTING ENTRIES FROM THE WORK SHEET PREPARING FINANCIAL STATEMENTS FROM THE WORK SHEET

PREPARING FINANCIAL STATEMENTS FROM THE WORK SHEET

SHEET PREPARING FINANCIAL STATEMENTS FROM THE WORK SHEET WHY USE A WORK SHEET? Entering the adjustments

WHY USE A WORK SHEET?

Entering the adjustments in the Adjustments columns of a work sheet does not get these adjustments into the ledger accounts. Therefore, after completing the work sheet, adjusting entries like the ones described in Chapter 3 must be entered in the General Journal and posted to the accounts in the ledger. The work sheet makes this easy because its Adjustments columns provide the information for these en- tries. If adjusting entries are prepared from the information in Illustration 4–3, you will see that they are the same adjusting entries we discussed in the last chapter.

A work sheet is not a substitute for the financial statements. The work sheet is

nothing more than a supporting tool that the accountant uses at the end of an ac- counting period to help organize the data. However, as soon as it is completed, the accountant uses the work sheet to prepare the financial statements. The sequence is the same as we have seen before. The income statement is com- pleted first. The net income is then combined with the owner’s investments, with- drawals, and beginning capital balance on the statement of changes in owner’s eq- uity. In doing this, the accountant analyzes the owner’s capital account to separate the beginning balance from any new investments made during the reporting period. Finally, the balance sheet is completed by using the ending balance of owner’s eq- uity from the statement of changes in owner’s equity.

At this point, it should be clear that we ended up with exactly the same financial statements and adjusting entries that we developed in Chapter 3 without using a work sheet. So, why prepare a work sheet? First, the example in this chapter is greatly simplified. Real companies have many more adjusting entries and accounts than Clear Copy. A work sheet makes

it easier to organize all the additional information. As we mentioned earlier in the chapter, auditors often use work sheets to plan and organize their work. In fact, they may request that a company provide a work sheet showing the adjustments made prior to the audit. Second, the work sheet can be used to prepare interim financial statements with- out recording the adjusting entries in the journal and ledger. Thus, a company can prepare statements each month or quarter and avoid taking the time to formally journalize and post the adjustments except once at the end of each year. All large companies with publicly traded ownership prepare interim financial reports, usu- ally on a quarterly basis. Some of them also include summaries of the past year’s quarterly data in their annual reports. Also, companies may use a work sheet format to show the effects of proposed transactions. In doing this, they enter their adjusted financial statements amounts

in the first two columns, arranging them to appear in the form of financial state-

ments. Then, the proposed transactions are inserted in the second two columns. The extended amounts in the last columns show the effects of the proposed trans- actions on the financial statements. These final columns are called pro forma state- ments, because they show the statements as if the proposed transactions had already occurred.

The Work Sheet and the Closing Process

Because the work sheet is an informal working paper, its format is not dictated by generally accepted accounting principles. For example, some accountants omit the Adjusted Trial Balance columns. Others use different work sheet columns to draft the closing entries described later in the chapter. Some work sheets have separate columns for the statement of changes in owner’s equity and the balance sheet. The decision about which format is preferred rests with the accountant who creates the work sheet.

189

rests with the accountant who creates the work sheet. 189 ALTERNATE FORMATS OF THE WORK SHEET

ALTERNATE

FORMATS OF

THE WORK

SHEET

Progress Check

(Answers to Progress Checks are provided at the end of the chapter.)

4–1

On a work sheet, the $99,400 salaries expense balance was incorrectly extended from the Adjusted Trial Balance column to the Statement of Changes in Owner’s Eq- uity and Balance Sheet Debit column. As a result of this error, (a) the Adjusted Trial Balance columns will not balance; (b) revenues on the work sheet will be un- derstated; (c) net income on the work sheet will be overstated.

4–2

Where does the accountant obtain the amounts entered in the Unadjusted Trial Bal- ance columns of the work sheet?

4–3

What is the advantage of using a work sheet to prepare adjusting entries?

4–4

From a 10-column work sheet, the accountant prepares the financial statements in what order?

After the financial statements are completed and the adjusting entries are recorded, the next step in the accounting cycle is to journalize and post closing entries. Clos- ing entries are designed to transfer the end-of-period balances in the revenue, ex- pense, and withdrawals accounts to the owner’s capital account. These entries are necessary because:

1. Revenues increase owner’s equity, while expenses and withdrawals decrease owner’s equity.

2. During an accounting period, these increases and decreases are temporarily accumulated in the revenue, expense, and withdrawals accounts rather than in the owner’s capital account.

3. By transferring the effects of revenues, expenses, and withdrawals from the revenue, expense, and withdrawals accounts to the owner’s capital account, closing entries install the correct end-of-period balance in the owner’s capi- tal account.

4. Closing entries also cause the revenue, expense, and withdrawals accounts to begin each new accounting period with zero balances.

Remember that an income statement reports the revenues earned and expenses incurred during one accounting period and is prepared from information recorded in the revenue and expense accounts. Also, the statement of changes in owner’s eq- uity reports the changes in the owner’s capital account during one period and uses the information accumulated in the withdrawals account. Because the revenue, ex- pense, and withdrawals accounts accumulate information for only one period and then must be ready to do the same thing the next period, they must start each period with zero balances.

next period, they must start each period with zero balances. CLOSING ENTRIES LO 2 Explain why

CLOSING

ENTRIES

LO 2 Explain why the tempo- rary accounts are closed at the end of each ac- counting period and pre- pare closing entries and a post-closing trial balance for a service business.

190

Chapter 4

To close the revenue and expense accounts, the accountant transfers their bal- ances first to a summary account called Income Summary. Then, the Income Sum- mary balance, which is the net income or loss, is transferred to the owner’s capital account. Finally, the accountant transfers the owner’s withdrawals account balance to the owner’s capital account. After the closing entries are posted, the revenue, ex- pense, Income Summary, and withdrawals accounts have zero balances. Thus, these accounts are said to be closed or cleared. Illustration 4–7 diagrams the four entries that close the revenue, expense, In- come Summary, and withdrawals accounts of Clear Copy on December 31, 1996. The preclosing balances of the accounts in the illustration are taken from the ad- justed trial balance in Illustration 4–5.

Entry 1.

The first closing entry transfers the credit balances in the revenue ac-

counts to the Income Summary account. In general journal form, the entry is:

Dec. 31 Copy Services Revenue Income Summary . . . . . . . .
Dec.
31
Copy Services Revenue
Income Summary
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
5,950.00
.
To close the revenue account and create the Income
Summary account.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
5,950.00
Note that this entry closes the revenue account by giving it a zero balance. If the
company had several different revenue accounts, this entry would be a compound
entry that included a debit to each of them. This clearing of the accounts allows
them to be used to record new revenues in the upcoming year.
The Income Summary account is created especially for the closing process and
is used only during that process. The $5,950 credit balance in Income Summary
equals the total revenues for the year.
Entry 2. The second closing entry transfers the debit balances in the expense
accounts to the Income Summary account. This step concentrates all the ex-
pense account debit balances in the Income Summary account. It also closes each
expense account by giving it a zero balance. That allows it to be used to record
new expenses in the upcoming year. The second closing entry for Clear Copy is:
Dec.
31
Income Summary
.
Amortization Expense, Copy Equipment
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
4,365.00
.
.
.
.
.
.
.
375.00
Salaries Expense
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
1,610.00
Insurance Expense
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
100.00
Rent Expense
Store Supplies Expense
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
1,000.00
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
1,050.00
.
To close the expense accounts.
Utilities Expense
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
230.00

Illustration 4–7 shows that posting this entry gives each expense account a zero balance and prepares it to accept entries for expenses in 1997. The entry also makes the balance of the Income Summary account equal to December’s net income of

lllustration 4–7 Closing Entries for Clear Copy

The Work Sheet and the Closing Process

191

Expense Accounts

Amortization Expense, Copy Equipment

Balance

375

375

Salaries Expense

Balance 1,610

1,610

Insurance Expense

Balance

100

100

Rent Expense

Balance 1,000

1,000

Store Supplies Expense

Balance 1,050

1,050

Utilities Expense

Balance

230

230

Terry Dow, Withdrawals

Balance

400

400

Revenue Accounts

Copy Services Revenue

5,950 Balance 5,950 2 1 Income Summary 4,365 5,950 4,365 Balance 1,585 1,585 3 Terry
5,950
Balance 5,950
2
1
Income Summary
4,365
5,950
4,365
Balance
1,585
1,585
3
Terry Dow, Capital
Balance
30,000
400
1,585
4
400
31,585
400
Balance 31,185

The Four Closing Entries

1. Close the revenue accounts

2. Close the expense accounts

3. Close the Income Summary account

4. Close the withdrawals account

$1,585. In effect, all the debit and credit balances of the expense and revenue ac- counts have now been concentrated in the Income Summary account.

Entry 3. The third closing entry transfers the balance of the Income Summary account to the owner’s capital account. This entry closes the Income Summary ac- count and adds the company’s net income to the owner’s capital account:

192

Chapter 4

Dec. 31 Income Summary . Terry Dow, Capital . . . . . . .
Dec.
31
Income Summary
.
Terry Dow, Capital
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
1,585.00
.
To close the Income Summary account and add the
net income to the capital account.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
1,585.00

After this entry is posted, the Income Summary account has a zero balance. It will continue to have a zero balance until the closing process occurs at the end of the next year. The owner’s capital account has been increased by the amount of the net income, but still does not include the effects of the withdrawal that occurred in December.

The final closing entry transfers the debit balance of the withdrawals

Entry 4.

account to the capital account. This entry for Clear Copy is: Dec. 31 Terry Dow,
account to the capital account. This entry for Clear Copy is:
Dec.
31
Terry Dow, Capital
.
Terry Dow, Withdrawals
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
400.00
.
To close the withdrawals account and reduce the
balance of the capital account.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
400.00
. . . . . . . . . . . . . . . .

SOURCES OF CLOSING ENTRY INFORMATION

. . . . 400.00 SOURCES OF CLOSING ENTRY INFORMATION THE POST- CLOSING TRIAL BALANCE This

THE POST- CLOSING TRIAL BALANCE

This entry gives the withdrawals account a zero balance, which allows it to ac- cumulate the next year’s payments to the owner. It also reduces the capital account balance to the $31,185 amount reported on the balance sheet.

The accountant can identify the accounts to be closed and the amounts to be used in the closing entries by referring to the individual revenue and expense accounts in the ledger. However, the work sheet provides this information in a more con- venient format. To locate the information on the work sheet, look again at the in- come statement columns in Illustration 4–5. All accounts with balances in these columns are closed and the amounts in the work sheet are used in the closing en- tries. The balance of the owner’s withdrawals account appears in the last debit column in the work sheet.

The six-column table in Illustration 4–8 summarizes the effects of the closing process. The first two columns contain the adjusted trial balance from the work sheet, with two additional lines for the Income Summary account. The next two columns present the closing entries, numbered (1) through (4). The last two columns contain the post-closing trial balance, which lists the balances of the accounts that were not closed. 2 These accounts represent the company’s assets, liabilities, and owner’s equity as of the end of 1996. These items and amounts are the same as those presented in the balance sheet in Illustration 4–6.

2 Some accountants use work sheets that include these four columns instead of the financial statement columns. The financial statements are not changed by choosing one or the other.

The Work Sheet and the Closing Process

193

Illustration 4–8

The Adjusted Trial Balance, Closing Entries, and Post-Closing Trial Balance for Clear Copy

 

Adjusted Trial

 

Closing

 

Post-Closing

Balance

Entries

Trial Balance

 

Cash

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

7,950

     

7,950

 

Accounts receivable

 

1,800

1,800

Store supplies

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

2,670

2,670

Prepaid insurance

.

.

.

.

.

.

.

.

.

.

.

.

.

.

2,300

2,300

Copy equipment

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

26,000

26,000

Accumulated amortization,

 

copy equipment

.

.

.

.

.

.

.

.

.

.

.

.

.

.

375

375

Accounts payable

.

.

.

.

.

.

.

.

.

.

.

.

.

.

6,200

6,200

. Unearned copy services revenue Terry Dow, capital Terry Dow, withdrawals

.

Salaries payable

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

210

2,750

210

2,750

.

.

.

.

400

30,000

(4)

400

(3) 1,585

(4)

400

31,185

Copy services revenue Amortization expense,

 

.

.

.

.

.

.

.

.

.

.

.

5,950

(1) 5,950

copy equipment

.

.

.

.

.

.

.

.

.

.

.

.

.

.

375

(2)

375

Salaries expense

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

1,610

(2) 1,610

Insurance expense

.

.

.

.

.

.

.

.

.

.

.

.

.

.

100

(2)

100

Rent expense

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

1,000

(2) 1,000

Store supplies expense

 

1,050

(2) 1,050

Utilities expense

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

230

(2)

230

Income summary

(2) 4,365

(1) 5,950

 

(3) 1,585

 

Totals

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

45,485

45,485

12,300

 

12,300

40,720

40,720

Instead of preparing the six-column table in Illustration 4–8, the post-closing trial balance is often prepared as a separate two-column table, as in Illustration 4–9. Regardless of the format, the post-closing trial balance is the last step in the annual accounting process.

Permanent (Real) Accounts and Temporary (Nominal) Accounts

Asset, liability, and owner’s capital accounts are not closed as long as the com- pany continues to own the assets, owe the liabilities, and have owner’s equity. Be- cause these accounts are not closed, they are called permanent accounts or real accounts. These accounts are permanent because they describe real conditions that are perceived to exist. In contrast, the terms temporary accounts and nominal accounts describe the revenue, expense, Income Summary, and withdrawals accounts. These terms are used because the accounts are opened at the beginning of the year, used to record events, and then closed at the end of the year. These accounts are temporary be- cause they describe nominal events or changes that have occurred rather than real conditions that continue to exist.

194

Chapter 4

Illustration 4–9 Separate Post-Closing Trial Balance for Clear Copy

4–9 Separate Post-Closing Trial Balance for Clear Copy THE LEDGER FOR CLEAR COPY CLOSING ENTRIES FOR

THE LEDGER

FOR CLEAR

COPY

Trial Balance for Clear Copy THE LEDGER FOR CLEAR COPY CLOSING ENTRIES FOR CORPORATIONS The Post

CLOSING ENTRIES FOR CORPORATIONS

The Post Closing Trial Balance

Cash

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

$ 7,950

Accounts receivable

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

1,800

Store supplies

 

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

2,670

Prepaid insurance

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

2,300

Copy equipment

 

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

26,000

Accumulated amortization, copy equipment

.

$

375

Accounts payable

 

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

6,200

Salaries payable

 

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

210

Unearned copy services revenue

 

2,750

Terry Dow, capital

 

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

31,185

Totals

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

$40,720

$40,720

To complete the Clear Copy example, look at Illustration 4–10, the company’s en- tire ledger as of December 31, 1996. Review the accounts and observe that the temporary accounts (the withdrawals account and all accounts with numbers greater than 400) have been closed.

Up to this point, our examples of closing entries have related to the activities and accounts of single proprietorships. However, closing entries for corporations are very similar. The first two closing entries are exactly the same. In other words, a corporation’s revenue and expense accounts are closed to the Income Summary account. The last two entries are different. Recall from Chapter 3 that a corporation’s balance sheet presents the share- holders’ equity as contributed capital and retained earnings. As a result, the third closing entry for a corporation closes the Income Summary account to the Retained Earnings account. For example, Petro-Canada reported a net income of $162 mil- lion in 1993, which means that was the credit balance in the Income Summary ac- count after the revenue and expense accounts were closed. The company’s third closing entry would have updated the Retained Earnings account as follows:

Dec. 31 Income Summary . . . . . . . . . . .
Dec.
31
Income Summary
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
162,000,000.00
.
To close the Income Summary account and
update Retained Earnings.
Retained Earnings
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
162,000,000.00

The fourth closing entry is also different because corporations use a Dividends Declared account instead of a withdrawals account. The accounting practices for dividends paid to shareholders are described in Appendix D and in Chapter 16. Coverage of corporations, at this point, is limited to closing entries. For a more complete coverage of partnership and corporation accounting refer to Appendix D at the end of this chapter and Chapters 14, 15 and 16.

IIlustration 4–10

The Work Sheet and the Closing Process

195

The Ledger for Clear Copy as of December 31, 1996 (after adjustments and closing entries have been posted)

Asset Accounts:

 

Cash

Acct. No. 101

Store Supplies

Acct. No. 125

Date

Expl.

Debit

Credit

Balance

Date

 

Expl.

Debit

Credit

Balance

1996

         

1996

         

Dec.

1

30,000

30,000

Dec.

 

2

2,500

2,500

2

2,500

27,500

6

1,100

3,600

3

20,000

7,500

26

120

3,720

10

2,200

9,700

31

1,050

2,670

12

1,000

8,700

 

12

700

8,000

22

1,700

9,700

 

24

900

8,800

Prepaid Insurance

Acct. No. 128

24

400

8,400

Date

 

Expl.

Debit

Credit

Balance

26

3,000

11,400

1996

         

26

2,400

9,000

Dec.

 

26

2,400

2,400

26

120

8,880

31

100

2,300

26

230

8,650

 

26

700

7,950

 

Copy Equipment

Acct. No. 167

 

Date

 

Expl.

Debit

Credit

Balance

1996

         
 

Accounts Receivable

Acct. No. 106

Dec.

 

3

20,000

20,000

Date

Expl.

Debit

Credit

Balance

6

6,000

26,000

1996

           

Dec.

12

1,700

1,700

22

1,700

0

Accumulated Amortization, Copy Equipment

 

31

1,800

1,800

Acct. No. 168

 

Date

 

Expl.

Debit

Credit

Balance

 

1996

         

Dec.

 

31

375

375

Liability and Equity Accounts:

 

Unearned Copy

 

Accounts Payable

Acct. No. 201

Services Revenue

Acct. No. 236

Date

Expl.

Debit

Credit

Balance

Date

 

Expl.

Debit

Credit

Balance

1996

         

1996

         

Dec.

6

7,100

7,100

Dec.

 

26

3,000

3,000

24

900

6,200

31

250

2,750

 

Salaries Payable

Acct. No. 209

Date

Expl.

Debit

Credit

Balance

1996

         

Dec.

31

210

210

196

Chapter 4

IIlustration 4–10

(concluded)

Terry Dow, Capital

Acct. No. 301

Terry Dow,

Withdrawals

Acct. No. 302