ACC100 Introduction to Accounting
Week 6 Closing entries and preparing financial statements Chapter 4 (p148-162); and Chapter 5 Completing the accounting cycle closing and reversing entries. Study Group Australia Pty Limited, SGA1286-F2/10/12 2
Learning Outcomes On completion of this week s study, you should be able to: Prepare financial statements from Adjusted Trial Balance Identify temporary and permanent accounts. Perform the closing process for a service entity on the last day of the accounting period utilizing the Profit & Loss Summary account. Prepare a post-closing trial balance after the closing process is completed. Explain the need for reversing entries on the first day of the next accounting period 3
Preparation Of Financial Statements Income Statement Prepared first to determine profit or loss for period Reflects entity s financial performance Statement of Changes in Equity Shows details of movements in equity Profit (loss) must be added to (subtracted from) equity New equity balance is reported in balance sheet Balance Sheet Reflects entities financial position including new equity balance derived in statement of changes in equity Users find further classification of Assets & Liabilities useful 4
Balance Sheet Assets Liabilities Current Assets Current Liabilities Non-Current Assets Non-Current Liabilities Investments Property, Plant & Equip. Intangible Assets Other Assets 5
Current vs. Non-current Current assets/liabilities will be used up/paid off within a single operating cycle (usually 12 months). Examples include: ASSETS Cash at Bank Accounts Receivable Inventory Prepaid Expenses LIABILITIES Bank Overdraft Accounts Payable Unearned Revenue Accrued Expenses
Current vs. Non-current Non- Current assets/liabilities that will not be used up/paid off within a single operating cycle (usually 12 months). Examples include: ASSETS Land Buildings Equipment Vehicles LIABILITIES Mortgage Long Term Borrowings
Classification Of Balance Sheet ASSETS Current assets Cash Receivables Prepayments Inventories Non-current assets Investments Property, plant and equipment Intangible assets Other assets LIABILITIES Current liabilities Payables Unearned revenues Non-current or long-term liabilities Mortgages N.B. These lists are not exhaustive just common examples 8
The Worksheet Assembles all information needed to adjust the accounts and prepare financial statements. Aids in the preparation of interim financial statements when adjusting and closing entries are not required. Contains information needed to close off profit and loss accounts for the period (closing entries next week). 9
Preparation Of The Worksheet 1. Enter ledger account titles and balances in the account title and unadjusted trial balance columns 2. Enter the adjustments in the adjustment column 3. Prepare an adjusted trial balance 4. Extend adjusted balances to the financial statements columns ( 2 columns for P&L; 2 columns for Balance Sheet) 10
Preparation Of The Worksheet 5. Difference between the two income columns represents the profit or loss for the period. This balance is transferred to the balance sheet column to balance totals. Financial statements can then be prepared 11
Financial Statements And Decision Making Financial statements are the final output of the accounting cycle They are not an ends in themselves They allow users to make decisions Questions might include Has the business been profitable? Is the business solvent? Should more capital be invested? 12
Closing Entries Closing entries are performed at the end of the accounting cycle to: Clearly record the profit or loss of an entity for the current period (income minus expenses) Transfer these profits (or losses) to equity, and Prepare the accounts ready to begin the next accounting cycle
Closing Entries Identify temporary and permanent accounts Perform the closing process for a service entity at the end of the accounting cycle utilising the Profit and Loss Summary Account (N.B. Retail entities covered next week) Prepare a Post-closing Trial Balance Prepare a set of Financial Statements Understand the need for reversing entries and how to complete them, on the first day of the next period
The Complete Accounting Cycle 1. Recognise and record transactions Source documents 2. Journalise transactions General journal 3. Post to ledger accounts General ledger 4. Prepare unadjusted trial balance of GL Trial balance (unadjusted) Continued next slide 15
The Complete Accounting Cycle 5. Determine adjusting entries and/or journalise General journal 6. Post adjusting entries to general ledger General ledger (accounts adjusted) 7. Prepare adjusted trial balance of GL (adjusted) Trial balance (adjusted) 8. Journalise closing entries General journal Continued next slide 16
The Complete Accounting Cycle 9. Post closing entries to GL GL temporary accounts closed 10. Prepare post closing trial balance Trial balance (post closing) 11. Prepare financial statements work sheet Financial statements 12. Journalise reversing entries first day of next period 13. Post reversing entries to GL first day of next period General journal GL temporary accounts opened 17
Identifying Temporary And Permanent Accounts Temporary accounts: Accounts that are reduced to zero at the end of an accounting period (income, expense and drawings accounts) Permanent accounts: Accounts reported in the Balance Sheet (Statement of Financial Position) and therefore rolled over from one period to the next (assets, liabilities and updated equity balances)
Closing Temporary Accounts Income and expense accounts must be closed at the end of each period to determine the profit or loss for the period That is, they begin and end each accounting period with zero balances Profit and loss summary account is used to facilitate closing process and determination of profit 19
Using The Worksheet From last week: Gathers information together in one place Enables preparation of interim financial statements Adjusting entries easily reflected And new to this week: Facilitates closing journal preparation 20
Recording Adjusting Entries From worksheet formal adjusting entries are entered in general journal (or vice versa) Entries are dated the last day of the accounting period Data for determining the entity s closing entries for the period are found in income statement columns of worksheet which contain temporary income and expense accounts ( these worksheets were prepared in Week 3) 21
The Closing Process 1. Income accounts closed to P & L Summary One journal entry combining the following: Debit each income account ( ie multiple entries if more than one income type ) Credit P & L Summary (total income) ( one entry for total amount) 2. Expense accounts closed to P & L Summary One journal entry combining the following: Debit P & L Summary (total expenses) ( one entry for total amount) Credit each expense account ( ie multiple entries if more than one expense type ) 22
The Closing Process 3. Profit & Loss Summary balances to determine profit/loss then closed to capital Debit P & L Summary (assuming a profit) - (i.e. Total Income minus Total Expenses) Credit capital account 4. Drawings closed to capital Debit capital account Credit drawings account 23
The Closing Process: An Example Assume a business has the following: 1. Revenues: a. $12,000 b. $7,500 total $28,500 c. $9,000 2. Expenses: a. Salaries of $3,300 b. Rent of $800 total $4,450 c. Supplies of $350 3. Drawings of $2,500 by the owner
The Closing Process In the Journal: 1. Jun 30 Incomes* 28 500 P&L Summary 28 500 (To close income accounts at end of period) 2. Jun 30 P&L Summary 4 450 Salaries expense 3 300 Rent expense 800 Supplies expense 350 (To close expense accounts at end of period) *NOTE: The income accounts should be closed as individual accounts rather than an aggregated amount the aggregation is done for simplicity in this example
The Closing Process 3. Jun 30 P&L Summary 24 050 Capital 24 050 (To close profits to the capital account at end of period) 4. Jun 30 Capital 2 500 Drawings 2 500 (To close drawings account to the capital account at end of period)
The Closing Process Posting to T-Accounts INCOME P & L SUMMARY 28,500 12,000 ACCOUNTS) 4,450 28,500 7,500 9,000 SALARY EXP 1,500 1,800 3,300 RENT EXP (1. CLOSE INCOME ACCOUNT) (2. CLOSE EXPENSE 24,050 (3. CLOSE P & L SUMMARY) 2,500 24,050 CAPITAL ACCOUNT 24,050 800 800 SUPPLIES EXP 350 350 DRAWINGS 2,500 2,500 (4. CLOSE DRAWINGS ACCOUNT) 27
Account Balances After The Closing Process All income accounts have nil balances All expense accounts have nil balances The drawings account has a nil balance The capital account has been increased by profit or decreased by loss and it has been decreased by any drawings 28
The Post Closing Trial Balance Reflects all accounts with balances after the closing process Assets Liabilities i.e. Balance Sheet accounts Equity Is prepared to verify equality of debits and credits Confirms that only permanent accounts have balances 29
Accrual Entries In Subsequent Periods Adjusting entries are made at the end of the accounting period to record accruals (as seen in Week 3 material ) Cash received or paid in subsequent periods for accruals must be analysed to correctly apportion amount between the two periods e.g. payment for salaries. On the next slides we will continue the example used in Week 3 lecture. 30
Example: Accrued Salaries 31
Accrual Entries In Subsequent Periods Adjusting entry (30 June last day of current period) Jun 30 Salary Expense 1 990 Salary Payable 1 990 (To accrue salaries owing to 30 June. Per Week 3 lecture slides) Normal entry (6 July in subsequent period) Method 1 Jul 6 Salary Payable 1 990 Salary Expense 1 710 Cash at Bank 3 700 (To record payment of salaries from 23 June to 6 July) 32
Reversing Entries (The Alternative Method : Method 2) Reversal of accrual entries Dated the first day of the subsequent accounting period Exactly reverse certain adjusting entries An accounting technique used to simplify the recording of regular transactions in the next period Reversals ( Method 2) are optional in an accounting system 33
Reversing Entries Adjusting entry (last day of current period) Jun 30 Salary Expense 1 990 Salary Payable 1 990 (To accrue salaries owing to 30 June) Reversing entry (first day of next period) Jul 1 Salary Payable 1 990 Salary Expense 1 990 (To reverse the adjusting entry which recorded unpaid salaries at end of previous month) July 6 entry (subsequent entry) Jul 6 Salary Expense 3 700 Cash at Bank 3 700 (Payment of salaries for period 27 June to 6 July) 34
Reversing Entries We will now draw up T-Accounts to show that the end result is the same whether we use the first method 1( on slide 22) or the reversing entries method 2 (slide 23) to record subsequent transactions We just need to be consistent
Reversing Entries Not required for all adjusting entries Only used where adjustment is temporary Accrued expenses (payables) Accrued income (receivables) Prepayments originally recorded as expenses (i.e. in temporary account)* Unearned income originally recorded as income (i.e. in temporary account)* * this method is not favoured by the authors of the text as noted on page 204 of text. 36
Reversing Entries It is therefore good practice to: Record prepayments as assets (and not as an expense) in the first place and expense them as they are used up Record unearned income as a liability (and not as a revenue) in the first place and then record the revenue as it is earned This removes any need for reversing these types of adjusting entries in subsequent periods 37
Accounting For A Company Owners are referred to as shareholders Owner s interests are called share capital (at inception of company, the amount original shareholders had invested in the company) Not all profits/losses are distributed to shareholders distributed amounts are called dividends. Retained amounts are called retained earnings or retained profits Over time, total equity will be represented by retained profits (or accumulated losses) + original investment + reserves 38
Accounting For A Company Profits added to retained earnings and part distributed as dividends INTELLECT MANAGEMENT SERVICES LTD Statement of Changes in Equity For the year ended 31 December 2013 Share Capital, 1 January 2013 $240 000 Share Capital, 31 December 2013 240 000 Retained earnings, 1 January 2013 -- Add: Profit for the year 50 000 50 000 Less: Cash dividends for the year 24 000 Retained earnings, 31 December 2013 $26 000 39
Accounting For A Company Extract from Equity section of Balance Sheet INTELLECT MANAGEMENT SERVICES LTD Balance Sheet (extract) as at 31 December 2013 Share capital (240 000 shares issued for $1) $240 000 Retained earnings 26 000 Total equity $266 000 40
WORKSHOP To illustrate closing process, post-closing trial balance and statements Exercise 5.10 is on page 211 of the textbook You have been provided with a customised workshop answer template. Please print this and use it to complete this exercise in class. As an additional requirement, Part D will be to produce a Post-closing Trial Balance The exercise is similar to Problem 5.4 which you will be required to complete in tutorials or your own time 41