Chapter 5 Lecture and Notes

Describe and Prepare Closing Entries for a Business

Closing entries prepare a company for the next accounting period by clearing any outstanding balances in certain accounts that should not transfer over to the next period. 

• Closing means returning the account to a zero balance.
  • Having a zero balance in these accounts is important so a company can compare performance across periods, particularly with income.
  • It also helps the company keep thorough records of account balances affecting retained earnings.
  • Revenue, expense, and dividend accounts affect retained earnings and are closed so they can accumulate new balances in the next period, which is an application of the time period assumption.
• Balances are closed to assure all revenues and expenses are recorded in the proper period and then start over the following period.
  • The revenue and expense accounts should start at zero each period, because we are measuring how much revenue is earned and expenses incurred during the period.
  • Cash balances, as well as the other balance sheet accounts, are carried over from the end of a current period to the beginning of the next period.

Temporary and Permanent Accounts

All accounts can be classified as either permanent (real) or temporary (nominal).

Permanent (real) accounts

• Accounts that transfer balances to the next period
• Include balance sheet accounts, such as assets, liabilities, and stockholders’ equity
• Are not part of the closing process

Temporary (nominal) accounts

• Accounts that are closed at the end of each accounting period
• Include income statement, dividends, and income summary accounts
• Temporary because they keep their balances during the current accounting period and are set back to zero when the period ends
• Revenue and expense accounts closed to Income Summary
• Income Summary and Dividends closed to the permanent account, Retained Earnings

Prepare a Post-Closing Trial Balance

Apply the Results from the Adjusted Trial Balance to Compute Current Ratio and Working Capital Balance, and Explain How These Measures Represent Liquidity

An operating cycle is the amount of time it takes a company to use its cash to provide a product or service and collect payment from the customer.

Liquidity is a company's ability to convert assets into cash in order to meet short-term cash needs, so it is very important for a company to remain liquid. 

Working capital is one measure of liquidity and indicates the value of current assets that would be remaining after paying off current debts.

The current ratio (also known as the working capital ratio), tells a company how many times over company current assets can cover current liabilities. It is found by dividing current assets by current liabilities and is calculated as follows:

Reversing Entries 

While the book does not cover reversing entries, the optional 10th step in the accounting cycle, I want you to have a brief understanding of this optional step. 

Before we use reversing entries as an additional step, it is useful to understand what a reverse entry is. The following video talks about reverse entries as a way to fix a mistake. However, that process is the same at the end of a period

Sometimes it is helpful to reverse some of the adjusting entries before recording the regular transactions of the next period.

• Companies make a reversing entry at the beginning of the next accounting period to bring the balances back to before the closing of the accounts as if no closing entries had happened.
• Reversing entries are used to make it easier for the accounting department under certain circumstances.
• Each reversing entry is the exact opposite of the adjusting entry made in the previous period.
• The use of reversing entries does not change the amounts reported in the financial statements.
• The use of reversing entries is not necessary, but optional.

• Closing entries: Closing entries prepare a company for the next period and zero out balance in temporary accounts.
• Purpose of closing entries: Closing entries are necessary because they help a company review income accumulation during a period, and verify data figures found on the adjusted trial balance.
• Permanent accounts: Permanent accounts do not close and are accounts that transfer balances to the next period. They include balance sheet accounts, such as assets, liabilities, and stockholder’s equity.
• Temporary accounts: Temporary accounts are closed at the end of each accounting period and include income statement, dividends, and income summary accounts.
• Income Summary: The Income Summary account is an intermediary between revenues and expenses, and the Retained Earnings account. It stores all the closing information for revenues and expenses, resulting in a “summary” of income or loss for the period.
• Recording closing entries: There are four closing entries; closing revenues to income summary, closing expenses to income summary, closing income summary to retained earnings, and close dividends to retained earnings.
• Posting closing entries: Once all closing entries are complete, the information is transferred to the general ledger T-accounts. Balances in temporary accounts will show a zero balance.
• Post-closing trial balance: The post-closing trial balance is prepared after closing entries have been posted to the ledger. This trial balance only includes permanent accounts.
• Cash-basis versus accrual-basis system: The cash-basis system delays revenue and expense recognition until cash is collected, which can mislead investors about the daily operations of a business. The accrual-basis system recognizes revenues and expenses in the period in which they were earned or incurred, allowing for an even distribution of income and a more accurate business of daily operations.
• Classified balance sheet: The classified balance sheet breaks down assets and liabilities into subcategories focusing on current and long-term classifications. This allows investors to see company position in both the short term and long term.
• Liquidity: Liquidity means a business has enough cash available to pay bills as they come due. Being too liquid can mean that a company is not using its assets efficiently.
• Working capital: Working capital shows how efficiently a company operates. The formula is current assets minus current liabilities.
• Current ratio: The current ratio shows how many times over a company can cover its liabilities. It is found by dividing current assets by current liabilities.