The Accounting Cycle for a Service Business: Closing Entries and the PostClosing Trial Balance

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Chapter 5

• The Accounting Cycle for a Service Business
  Closing Entries and the Post-Closing Trial Balance

2
Remember

• End-of-Period Procedures
• Step 5. Determine needed adjustments.
• Step 6. Prepare a work sheet.
• Step 7. Prepare financial statements from a
  completed work sheet.
• Step 8. Journalize and post adjusting entries.

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Completing the Accounting Cycle

• Step 9. Journalize and post closing entries.
• Step 10. Prepare a post-closing trial balance.

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The Closing Process

• Definition The process of transferring the
  balances of temporary accounts to the owners
  capital account at the end of the accounting
  period.

5
Remember

• The revenue and expense accounts and the owners
  drawing account are temporary accounts used to
  record changes in owners equity during a single
  accounting period.

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Closing Entries

• Reduce the balances of the temporary owners
  equity accounts to zero so these accounts will be
  ready for entries in the next accounting period.
• Update the balance of the owners capital account
  so it will reflect the net income or net loss for
  the accounting period that has just ended.

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The Income Summary Account

• A clearing account used to summarize the balances
  of the revenue and expense accounts.
• A temporary owners equity account that is opened
  and closed during the closing process.

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The Closing Process

• Step 1. Close the balance of each revenue account
  into the Income Summary account.
• Step 2. Close the balance of each expense account
  into the Income Summary account.

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The Closing Process

• Step 3. Close the balance of the Income Summary
  account into the owners capital account.
• Step 4. Close the balance of the owners drawing
  account into the owners capital account.

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The Closing ProcessExample

• The information for the closing entries comes
  from the Income Statement and Balance Sheet
  sections of the work sheet.

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The Closing ProcessExample

• The example will use the work sheet of Hill
  Advertising for the month ended January 31,
  although closing entries are normally made at the
  end of a 12-month accounting period.
• The example will use T accounts to illustrate the
  closing entries, although in practice entries
  must be journalized and posted to the ledger
  accounts.

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Closing the Revenue Accounts

• Hill Advertisings work sheet shows just one
  revenue account in the Income Statement
  sectionAdvertising Fees Earnedwith a Cr.
  balance of 21,000.
• The first closing entry reduces the balance of
  the revenue account to zero.

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Closing the Revenue Accounts

• Because the revenue account has a credit balance,
  it is debited to close it.
• The corresponding credit is made to the Income
  Summary account.

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Closing the Revenue Accounts

• Advertising Fees Earned
• 1/31 Cl. 21,000 1/31 Bal. 21,000
• 
  0

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Closing the Revenue Accounts

• Income Summary
• 1/31 Cl. 21,000

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Closing the Expense Accounts

• Hill Advertisings work sheet shows six expense
  accounts in the Income Statement section.
• The second closing entry reduces the balances of
  the expense accounts to zero.

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Closing the Expense Accounts

• A compound entry is made to close the expense
  accounts.
• Because the expense accounts have debit balances,
  each of the accounts must be credited to close.
• The total of all the balances of the expense
  accounts is debited to the Income Summary
  account.

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Closing the Expense Accounts

• On January 31, the expense account at Hill
  Advertising showed the following Dr. balances.
• Rent Expense 3,100
• Salaries Expense 11,500
• Insurance Expense 40
• Office Supplies Expense 200
• Depr. ExpenseOffice Equipment 100
• Depr. ExpenseOffice Furniture 60
• 15,000

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Closing the Expense Accounts

• Each expense account is credited for the amount
  of its balance.
• Example
• Rent Expense is credited for 3,100. The Income
  Summary account is debited for the total of all
  the balances of the expense accounts (15,000).

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Closing the Expense Accounts

• Rent Expense
• 1/31 Bal. 3,100 1/31 Cl. 3,100
• 0

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Closing the Expense Accounts

• Income Summary
• 1/31 Cl. 15,000 1/31 Cl. 21,000

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Income Summary AccountThe Balance

• After the balances of the revenue and expense
  accounts are closed into the Income Summary
  account, the balance of that account is the net
  income or net loss for the period.
• In this case, the Income Summary account has a
  Cr. balance of 6,000, indicating a net income of
  6,000.

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Income Summary AccountThe Balance

• Income Summary
• (Expenses) 15,000 (Revenue) 21,000
• Credit amount 21,000
• Debit amount 15,000
• Balance 6,000 (Net Income)

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Closing the Income Summary Account

• After closing the revenue and expense accounts,
  the balance of the Income Summary account is
  closed into the owners capital account.
• This entry transfers the net income or net loss
  for the period to the capital account.

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Closing the Income Summary Account

• If the Income Summary account has a credit
  balance, it is debited to close it.
• The owners capital account is credited for the
  same amount.

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Closing the Income Summary Account

• Income Summary
• 1/31 Cl. 15,000 1/31 Cl. 21,000
• 1/31 Cl. 6,000
• 
  0

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Closing the Income Summary Account

• Gary Hill, Capital
• 1/1
  Bal. 12,000
• 1/15
  8,500
• 1/31 Cl.
  6,000

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Closing the Income Summary Account

• If there is a net loss, the Income Summary
  account will have a debit balance after the
  revenue and expense accounts are closed into it.
• An Income Summary account with a debit balance is
  closed by crediting it for its balance and
  debiting the owners capital account for the same
  amount.

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Closing the Owners Drawing Account

• Close the balance of the owners drawing account
  into the owners capital account.
• The Balance Sheet section of the work sheet
  prepared at Hill Advertising shows the owners
  drawing account has a Dr. balance of 4,000.
• This account is closed by crediting it for
  4,000.
• The owners capital account is debited for 4,000.

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Closing the Owners Drawing Account

• Gary Hill, Capital
• 1/31 Cl. 4,000 1/1 Bal. 12,000
• 1/15 8,500
• 1/31 Cl. 6,000
• 2/1
  Bal. 22,500

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Closing the Owners Drawing Account

• Gary Hill, Drawing
• 1/31 Bal. 4,000 1/31 Cl. 4,000
• 0

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The Results of the Closing Process

• The revenue and expense accounts and the owners
  drawing account have zero balances.
• They are ready to receive entries for the new
  accounting period.
• The owners capital account is up to date.
• It reflects the net income or net loss for the
  previous period and the owners withdrawals
  during the period.

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The Capital Account

• After the closing process, the owners capital
  account contains the same balance as the ending
  balance on the statement of owners equity.

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The Capital Account

• Gary Hill, Capital
• 1/31 Cl 4,000 1/1 Bal. 12,000
• 1/15 8,500
• 1/31 Cl. 6,000
• 2/1
  Bal. 22,500

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Hill AdvertisingStatement of Owners EquityFor
Month Ended January 31, 20X1

• Gary Hill, capital, Jan. 1, 20X1 12,000
• Add Additional investment 8,500
• Net income for month 6,000
• Total increases 14,500
• Less Withdrawals 4,000
• Increase in owners equity 10,500
• Gary Hill, capital, Jan. 31, 20X1 22,500

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The Closing ProcessSummary

• Step 1. Close the balances of the revenue
  accounts to Income Summary.
• Step 2. Close the balances of the expense account
  to Income Summary.

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The Closing ProcessSummary

• Step 3. Close the balance of Income Summary to
  the owners capital account.
• Step 4. Close the balance of the owners drawing
  account to the owners capital account.

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The Closing ProcessStep 1

• Revenue Accounts Income Summary
  Account
• Closing X Balance X
  Revenue X

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The Closing ProcessStep 2

• Expense Accounts Income Summary
  Account
• Balance X Closing X Expenses X
  Revenue X

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The Closing ProcessStep 3

• Income Summary Account Owners Capital
  Account
• Expenses X Revenue X
  Balance X
• 
  Net Income X
• Balance X
• (Net Income)

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The Closing ProcessStep 4

• Owners Drawing Account Owners Capital
  Account
• Balance X Closing X Withdrawals X
  Balance X
• 
  Net Income X

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Journalizing the Closing Entries

• A formal record must be made of the closing
  process.
• This record appears in the journal under the
  title Closing Entries.

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Journalizing the Closing Entries

• 20X1
• Jan. 31 Advertising Fees Earned 21,000
• Income Summary 21,000
• 31 Income Summary 15,000
• Rent Expense 3,100
• Salaries Expense 11,500
• Insurance Expense 40
• Office Supplies Expense 200
• Depr. ExpenseOffice Equipment 100
• Depr. ExpenseOffice Furniture 60

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Journalizing the Closing Entries

• 20X1
• Jan. 31 Income Summary 6,000
• Gary Hill, Capital 6,000
• 31 Gary Hill, Capital 4,000
• Gary Hill, Drawing 4,000

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Posting the Closing Entries

• The temporary owners equity accounts have zero
  balances.
• Revenue, expense, owners drawing accounts are
  ready to receive entries for the new accounting
  period.

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Posting the Closing Entries

• The balances of all the permanent accounts are
  now up to date.
• Should match the amounts reported on financial
  statements.
• Owners capital account reflects the net income
  and withdrawals for the previous accounting
  period.

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Preparing a Post-Closing Trial Balance

• Proves the equality of the Dr. and Cr. in the
  ledger accounts after the closing entries have
  been posted.
• The accounts that remain openthe permanent
  accountsare in balance before any entries for
  the new period are recorded.

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Remember

• The permanent accounts are
• Asset
• Liability
• Owners capital

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Hill AdvertisingPost-Closing Trial
BalanceJanuary 31, 20X1

• Account Title Debit Credit
• Cash 7,240
• Accounts Receivable 3,500
• Office Supplies 300
• Prepaid Insurance 440
• Office Equipment 14,000
• Accum. Depr.Office Equipment
  1,300
• Office Furniture 3,600
• Accum. Depr.Office Furniture 780
• Accounts Payable 3,000
• Salaries Payable 1,500
• Gary Hill, Capital 22,500
• Totals 29,080 29,080

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Steps Performed During the Accounting Cycle

• Step 1. Analyze transactions from source
  documents.
• Step 2. Record transactions in a journal.
• Step 3. Post from the journal to the ledger.
• Step 4. Prepare a trial balance of the ledger.

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Steps Performed at the End of the Accounting Cycle

• Step 5. Determine needed adjustments.
• Step 6. Prepare a work sheet.
• Step 7. Prepare financial statements from a
  completed work sheet.

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Steps Performed at the End of the Accounting Cycle

• Step 8. Journalize and post adjusting entries.
• Step 9. Journalize and post closing entries.
• Step 10. Prepare a post-closing trial balance.

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Fiscal Period

• Definition Any period of time covering a
  complete accounting cycle, from the analysis of
  transactions to the preparation of the
  post-closing trial balance.

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Fiscal Year

• Definition A fiscal period consisting of 12
  consecutive months.
• Businesses usually select a fiscal year that
  matches the natural flow of their operations, not
  necessarily a calendar yearJanuary 1 to December
  31.
• Often, businesses choose to end their fiscal year
  at the lowest point in their operating cycle.
  This is called a natural business year.

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Bases of Accounting

• Accrual Basis
• Cash Basis
• Modified Cash Basis

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Accrual Basis

• Revenue is recorded when it is earned, no matter
  when the related cash is received.
• Expenses are recorded when they are incurred, no
  matter when the related cash is paid out.

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Accrual Basis

• According to GAAP, the accrual basis must be used
  by businesses whose major activity is producing
  or trading goods, which are manufacturing and
  merchandising companies.

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Cash Basis

• Revenue is recorded when cash is received and
  expenses are recorded when cash is paid out.
• Used mostly by individuals for income tax
  purposes.

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Modified Cash Basis

• Revenue is recorded when cash is received and
  expenses are recorded when cash is paid out.
• Adjustments must be made for depreciation of
  long-term assets, expired insurance (when
  premiums are paid in advance), and supplies used
  (when large amounts of supplies are purchased).

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Modified Cash Basis

• A combination of the cash basis and the accrual
  basis.
• Used mostly by small service businesses,
  including professional firms.