5

Completing the Accounting Cycle

Figure 5.1 Mark reviews the financial data from Supreme Cleaners. (credit left: modification of “Numbers and
Finance” by “reynermedia”/Flickr, CC BY 2.0; credit right: modification of “Dry cleaned clothes (Unsplash)” by
“m0851”/Wikimedia Commons, CC0)

Chapter Outline
5.1 Describe and Prepare Closing Entries for a Business

5.2 Prepare a Post-Closing Trial Balance

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

5.4 Appendix: Complete a Comprehensive Accounting Cycle for a Business

Why It Matters
As we learned in Analyzing and Recording Transactions and The Adjustment Process, Mark Summers has
started his own dry-cleaning business called Supreme Cleaners. Mark had a busy first month of operations,
including purchasing equipment and supplies, paying his employees, and providing dry-cleaning services to
customers. Because Mark had established a sound accounting system to keep track of his daily transactions,
he was able to prepare complete and accurate financial statements showing his company’s progress and
financial position.

In order to move forward, Mark needs to review how financial data from his first month of operations
transitions into his second month of operations. It is important for Mark to make a smooth transition so he
can compare the financials from month to month, and continue on the right path toward growth. It will also
assure his investors and lenders that the company is operating as expected. So what does he need to do to
prepare for next month?
286 Chapter 5 Completing the Accounting Cycle

5.1 Describe and Prepare Closing Entries for a Business

In this chapter, we complete the final steps (steps 8 and 9) of the accounting cycle, the closing process. You will
notice that we do not cover step 10, reversing entries. This is an optional step in the accounting cycle that you
will learn about in future courses. Steps 1 through 4 were covered in Analyzing and Recording Transactions
and Steps 5 through 7 were covered in The Adjustment Process.

Our discussion here begins with journalizing and posting the closing entries (Figure 5.2). These posted entries
will then translate into a post-closing trial balance, which is a trial balance that is prepared after all of the
closing entries have been recorded.

Figure 5.2 Final steps in the accounting cycle. (attribution: Copyright Rice University, OpenStax, under CC
BY-NC-SA 4.0 license)

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Chapter 5 Completing the Accounting Cycle 287

THINK IT THROUGH

Should You Compromise to Please Your Supervisor?

You are an accountant for a small event-planning business. The business has been operating for several
years but does not have the resources for accounting software. This means you are preparing all steps in
the accounting cycle by hand.

It is the end of the month, and you have completed the post-closing trial balance. You notice that there is
still a service revenue account balance listed on this trial balance. Why is it considered an error to have a
revenue account on the post-closing trial balance? How do you fix this error?

Introduction to the Closing Entries

Companies are required to close their books at the end of each fiscal year so that they can prepare their
annual financial statements and tax returns. However, most companies prepare monthly financial statements
and close their books annually, so they have a clear picture of company performance during the year, and give
users timely information to make decisions.

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, or clearing the balances, 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.

To further clarify this concept, 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. However, the 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.

For example, a store has an inventory account balance of $100,000. If the store closed at 11:59 p.m. on January
31, 2019, then the inventory balance when it reopened at 12:01 a.m. on February 1, 2019, would still be
$100,000. The balance sheet accounts, such as inventory, would carry over into the next period, in this case
February 2019.

The accounts that need to start with a clean or $0 balance going into the next accounting period are revenue,
income, and any dividends from January 2019. To determine the income (profit or loss) from the month of
January, the store needs to close the income statement information from January 2019. Zeroing January 2019
would then enable the store to calculate the income (profit or loss) for the next month (February 2019),
instead of merging it into January’s income and thus providing invalid information solely for the month of
February.

However, if the company also wanted to keep year-to-date information from month to month, a separate set
of records could be kept as the company progresses through the remaining months in the year. For our
purposes, assume that we are closing the books at the end of each month unless otherwise noted.
288 Chapter 5 Completing the Accounting Cycle

Let’s look at another example to illustrate the point. Assume you own a small landscaping business. It is the
end of the year, December 31, 2018, and you are reviewing your financials for the entire year. You see that you
earned $120,000 this year in revenue and had expenses for rent, electricity, cable, internet, gas, and food that
totaled $70,000.

You also review the following information:

The next day, January 1, 2019, you get ready for work, but before you go to the office, you decide to review
your financials for 2019. What are your year-to-date earnings? So far, you have not worked at all in the current
year. What are your total expenses for rent, electricity, cable and internet, gas, and food for the current year?
You have also not incurred any expenses yet for rent, electricity, cable, internet, gas or food. This means that
the current balance of these accounts is zero, because they were closed on December 31, 2018, to complete
the annual accounting period.

Next, you review your assets and liabilities. What is your current bank account balance? What is the current
book value of your electronics, car, and furniture? What about your credit card balances and bank loans? Are
the value of your assets and liabilities now zero because of the start of a new year? Your car, electronics, and
furniture did not suddenly lose all their value, and unfortunately, you still have outstanding debt. Therefore,
these accounts still have a balance in the new year, because they are not closed, and the balances are carried
forward from December 31 to January 1 to start the new annual accounting period.

This is no different from what will happen to a company at the end of an accounting period. A company will
see its revenue and expense accounts set back to zero, but its assets and liabilities will maintain a balance.
Stockholders’ equity accounts will also maintain their balances. In summary, the accountant resets the
temporary accounts to zero by transferring the balances to permanent accounts.

LINK TO LEARNING

Understanding the accounting cycle and preparing trial balances is a practice valued internationally. The
Philippines Center for Entrepreneurship and the government of the Philippines hold regular seminars
going over this cycle with small business owners. They are also transparent with their internal trial
balances in several key government offices. Check out this article talking about the seminars on the
accounting cycle (https://openstax.org/l/50PhilAcctSem) and this public pre-closing trial balance
(https://openstax.org/l/50PhilTrialBal) presented by the Philippines Department of Health.

Temporary and Permanent Accounts

All accounts can be classified as either permanent (real) or temporary (nominal) (Figure 5.3).

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Chapter 5 Completing the Accounting Cycle 289

Permanent (real) accounts are accounts that transfer balances to the next period and include balance sheet
accounts, such as assets, liabilities, and stockholders’ equity. These accounts will not be set back to zero at the
beginning of the next period; they will keep their balances. Permanent accounts are not part of the closing
process.

Temporary (nominal) accounts are accounts that are closed at the end of each accounting period, and
include income statement, dividends, and income summary accounts. The new account, Income Summary, will
be discussed shortly. These accounts are 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 are closed
to Income Summary, and Income Summary and Dividends are closed to the permanent account, Retained
Earnings.

Figure 5.3 Location Chart for Financial Statement Accounts. (attribution: Copyright Rice University,
OpenStax, under CC BY-NC-SA 4.0 license)

The income summary account is an intermediary between revenues and expenses, and the Retained Earnings
account. It stores all of the closing information for revenues and expenses, resulting in a “summary” of
income or loss for the period. The balance in the Income Summary account equals the net income or loss for
the period. This balance is then transferred to the Retained Earnings account.

Income summary is a nondefined account category. This means that it is not an asset, liability, stockholders’
equity, revenue, or expense account. The account has a zero balance throughout the entire accounting period
until the closing entries are prepared. Therefore, it will not appear on any trial balances, including the adjusted
trial balance, and will not appear on any of the financial statements.

You might be asking yourself, “is the Income Summary account even necessary?” Could we just close out
revenues and expenses directly into retained earnings and not have this extra temporary account? We could
do this, but by having the Income Summary account, you get a balance for net income a second time. This
gives you the balance to compare to the income statement, and allows you to double check that all income
statement accounts are closed and have correct amounts. If you put the revenues and expenses directly into
retained earnings, you will not see that check figure. No matter which way you choose to close, the same final
balance is in retained earnings.
290 Chapter 5 Completing the Accounting Cycle

YOUR TURN

Permanent versus Temporary Accounts

Following is a list of accounts. State whether each account is a permanent or temporary account.

A. rent expense
B. unearned revenue
C. accumulated depreciation, vehicle
D. common stock
E. fees revenue
F. dividends
G. prepaid insurance
H. accounts payable

Solution

A, E, and F are temporary; B, C, D, G, and H are permanent.

Let’s now look at how to prepare closing entries.

Journalizing and Posting Closing Entries

The eighth step in the accounting cycle is preparing closing entries, which includes journalizing and posting
the entries to the ledger.

Four entries occur during the closing process. The first entry closes revenue accounts to the Income Summary
account. The second entry closes expense accounts to the Income Summary account. The third entry closes
the Income Summary account to Retained Earnings. The fourth entry closes the Dividends account to Retained
Earnings. The information needed to prepare closing entries comes from the adjusted trial balance.

Let’s explore each entry in more detail using Printing Plus’s information from Analyzing and Recording
Transactions and The Adjustment Process as our example. The Printing Plus adjusted trial balance for January
31, 2019, is presented in Figure 5.4.

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Chapter 5 Completing the Accounting Cycle 291

Figure 5.4 Adjusted Trial Balance for Printing Plus. (attribution: Copyright Rice University, OpenStax, under
CC BY-NC-SA 4.0 license)

The first entry requires revenue accounts close to the Income Summary account. To get a zero balance in a
revenue account, the entry will show a debit to revenues and a credit to Income Summary. Printing Plus has
$140 of interest revenue and $10,100 of service revenue, each with a credit balance on the adjusted trial
balance. The closing entry will debit both interest revenue and service revenue, and credit Income Summary.

The T-accounts after this closing entry would look like the following.
292 Chapter 5 Completing the Accounting Cycle

Notice that the balances in interest revenue and service revenue are now zero and are ready to accumulate
revenues in the next period. The Income Summary account has a credit balance of $10,240 (the revenue sum).

The second entry requires expense accounts close to the Income Summary account. To get a zero balance in
an expense account, the entry will show a credit to expenses and a debit to Income Summary. Printing Plus
has $100 of supplies expense, $75 of depreciation expense–equipment, $5,100 of salaries expense, and $300 of
utility expense, each with a debit balance on the adjusted trial balance. The closing entry will credit Supplies
Expense, Depreciation Expense–Equipment, Salaries Expense, and Utility Expense, and debit Income Summary.

The T-accounts after this closing entry would look like the following.

Notice that the balances in the expense accounts are now zero and are ready to accumulate expenses in the
next period. The Income Summary account has a new credit balance of $4,665, which is the difference between
revenues and expenses (Figure 5.5). The balance in Income Summary is the same figure as what is reported on
Printing Plus’s Income Statement.

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Chapter 5 Completing the Accounting Cycle 293

Figure 5.5 Income Statement for Printing Plus. (attribution: Copyright Rice University, OpenStax, under CC
BY-NC-SA 4.0 license)

Why are these two figures the same? The income statement summarizes your income, as does income
summary. If both summarize your income in the same period, then they must be equal. If they do not match,
then you have an error.

The third entry requires Income Summary to close to the Retained Earnings account. To get a zero balance in
the Income Summary account, there are guidelines to consider.

• If the balance in Income Summary before closing is a credit balance, you will debit Income Summary and
credit Retained Earnings in the closing entry. This situation occurs when a company has a net income.
• If the balance in Income Summary before closing is a debit balance, you will credit Income Summary and
debit Retained Earnings in the closing entry. This situation occurs when a company has a net loss.

Remember that net income will increase retained earnings, and a net loss will decrease retained earnings. The
Retained Earnings account increases on the credit side and decreases on the debit side.

Printing Plus has a $4,665 credit balance in its Income Summary account before closing, so it will debit Income
Summary and credit Retained Earnings.

The T-accounts after this closing entry would look like the following.

Notice that the Income Summary account is now zero and is ready for use in the next period. The Retained
Earnings account balance is currently a credit of $4,665.
294 Chapter 5 Completing the Accounting Cycle

The fourth entry requires Dividends to close to the Retained Earnings account. Remember from your past
studies that dividends are not expenses, such as salaries paid to your employees or staff. Instead, declaring
and paying dividends is a method utilized by corporations to return part of the profits generated by the
company to the owners of the company—in this case, its shareholders.

If dividends were not declared, closing entries would cease at this point. If dividends are declared, to get a zero
balance in the Dividends account, the entry will show a credit to Dividends and a debit to Retained Earnings. As
you will learn in Corporation Accounting, there are three components to the declaration and payment of
dividends. The first part is the date of declaration, which creates the obligation or liability to pay the dividend.
The second part is the date of record that determines who receives the dividends, and the third part is the date
of payment, which is the date that payments are made. Printing Plus has $100 of dividends with a debit
balance on the adjusted trial balance. The closing entry will credit Dividends and debit Retained Earnings.

The T-accounts after this closing entry would look like the following.

Why was income summary not used in the dividends closing entry? Dividends are not an income statement
account. Only income statement accounts help us summarize income, so only income statement accounts
should go into income summary.

Remember, dividends are a contra stockholders’ equity account. It is contra to retained earnings. If we pay out
dividends, it means retained earnings decreases. Retained earnings decreases on the debit side. The
remaining balance in Retained Earnings is $4,565 (Figure 5.6). This is the same figure found on the statement
of retained earnings.

Figure 5.6 Statement of Retained Earnings for Printing Plus. (attribution: Copyright Rice University,
OpenStax, under CC BY-NC-SA 4.0 license)

The statement of retained earnings shows the period-ending retained earnings after the closing entries have
been posted. When you compare the retained earnings ledger (T-account) to the statement of retained
earnings, the figures must match. It is important to understand retained earnings is not closed out, it is only
updated. Retained Earnings is the only account that appears in the closing entries that does not close. You

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Chapter 5 Completing the Accounting Cycle 295

should recall from your previous material that retained earnings are the earnings retained by the company
over time—not cash flow but earnings. Now that we have closed the temporary accounts, let’s review what the
post-closing ledger (T-accounts) looks like for Printing Plus.

T-Account Summary
The T-account summary for Printing Plus after closing entries are journalized is presented in Figure 5.7.
296 Chapter 5 Completing the Accounting Cycle

Figure 5.7 T-Account Summary. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0
license)

Notice that revenues, expenses, dividends, and income summary all have zero balances. Retained earnings
maintains a $4,565 credit balance. The post-closing T-accounts will be transferred to the post-closing trial

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Chapter 5 Completing the Accounting Cycle 297

balance, which is step 9 in the accounting cycle.

THINK IT THROUGH

Closing Entries
A company has revenue of $48,000 and total expenses of $52,000. What would the third closing entry be?
Why?

YOUR TURN

Frasker Corp. Closing Entries

Prepare the closing entries for Frasker Corp. using the adjusted trial balance provided.

Solution
298 Chapter 5 Completing the Accounting Cycle

5.2 Prepare a Post-Closing Trial Balance

The ninth, and typically final, step of the process is to prepare a post-closing trial balance. The word “post” in
this instance means “after.” You are preparing a trial balance after the closing entries are complete.

Like all trial balances, the post-closing trial balance has the job of verifying that the debit and credit totals are
equal. The post-closing trial balance has one additional job that the other trial balances do not have. The post-
closing trial balance is also used to double-check that the only accounts with balances after the closing entries
are permanent accounts. If there are any temporary accounts on this trial balance, you would know that there
was an error in the closing process. This error must be fixed before starting the new period.

The process of preparing the post-closing trial balance is the same as you have done when preparing the
unadjusted trial balance and adjusted trial balance. Only permanent account balances should appear on the
post-closing trial balance. These balances in post-closing T-accounts are transferred over to either the debit or
credit column on the post-closing trial balance. When all accounts have been recorded, total each column and
verify the columns equal each other.

The post-closing trial balance for Printing Plus is shown in Figure 5.8.

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Chapter 5 Completing the Accounting Cycle 299

Figure 5.8 Printing Plus’s Post-Closing Trial Balance. (attribution: Copyright Rice University, OpenStax, under
CC BY-NC-SA 4.0 license)

Notice that only permanent accounts are included. All temporary accounts with zero balances were left out of
this statement. Unlike previous trial balances, the retained earnings figure is included, which was obtained
through the closing process.

At this point, the accounting cycle is complete, and the company can begin a new cycle in the next period. In
essence, the company’s business is always in operation, while the accounting cycle utilizes the cutoff of
month-end to provide financial information to assist and review the operations.

It is worth mentioning that there is one step in the process that a company may or may not include, step 10,
reversing entries. Reversing entries reverse an adjusting entry made in a prior period at the start of a new
period. We do not cover reversing entries in this chapter, but you might approach the subject in future
accounting courses.

Now that we have completed the accounting cycle, let’s take a look at another way the adjusted trial balance
assists users of information with financial decision-making.

LINK TO LEARNING

If you like quizzes, crossword puzzles, fill-in-the-blank, matching exercise, and word scrambles to help
you learn the material in this course, go to My Accounting Course (https://openstax.org/l/
50MyAcctCourse) for more. This website covers a variety of accounting topics including financial
accounting basics, accounting principles, the accounting cycle, and financial statements, all topics
introduced in the early part of this course.
300 Chapter 5 Completing the Accounting Cycle

CONCEPTS IN PRACTICE

The Importance of Understanding How to Complete the Accounting Cycle

Many students who enroll in an introductory accounting course do not plan to become accountants.
They will work in a variety of jobs in the business field, including managers, sales, and finance. In a real
company, most of the mundane work is done by computers. Accounting software can perform such tasks
as posting the journal entries recorded, preparing trial balances, and preparing financial statements.
Students often ask why they need to do all of these steps by hand in their introductory class, particularly
if they are never going to be an accountant. It is very important to understand that no matter what your
position, if you work in business you need to be able to read financial statements, interpret them, and
know how to use that information to better your business. If you have never followed the full process
from beginning to end, you will never understand how one of your decisions can impact the final
numbers that appear on your financial statements. You will not understand how your decisions can
affect the outcome of your company.

As mentioned previously, once you understand the effect your decisions will have on the bottom line on
your income statement and the balances in your balance sheet, you can use accounting software to do
all of the mundane, repetitive steps and use your time to evaluate the company based on what the
financial statements show. Your stockholders, creditors, and other outside professionals will use your
financial statements to evaluate your performance. If you evaluate your numbers as often as monthly,
you will be able to identify your strengths and weaknesses before any outsiders see them and make any
necessary changes to your plan in the following month.

5.3Apply the Results from the Adjusted Trial Balance to Compute Current
Ratio and Working Capital Balance, and Explain How These Measures
Represent Liquidity
In The Adjustment Process, we were introduced to the idea of accrual-basis accounting, where revenues and
expenses must be recorded in the accounting period in which they were earned or incurred, no matter when
cash receipts or outlays occur. We also discussed cash-basis accounting, where income and expenses are
recognized when receipts and disbursements occur. In this chapter, we go into more depth about why a
company may choose accrual-basis accounting as opposed to cash-basis accounting.

LINK TO LEARNING

Go to the Internal Revenue Service’s website, and look at the most recently updated Pub 334 Tax Guide
for Small Business (https://openstax.org/l/50IRSPub334) to learn more about the rules for income tax
preparation for a small business.

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Chapter 5 Completing the Accounting Cycle 301

Cash Basis versus Accrual Basis Accounting

There are several reasons accrual-basis accounting is preferred to cash-basis accounting. Accrual-basis
accounting is required by US generally accepted accounting principles (GAAP), as it typically provides a better
sense of the financial well-being of a company. Accrual-based accounting information allows management to
analyze a company’s progress, and management can use that information to improve their business. Accrual
accounting is also used to assist companies in securing financing, because banks will typically require a
company to provide accrual-basis financial income statements. The Internal Revenue Service might also
require businesses to report using accrual basis information when preparing tax returns. In addition,
companies with inventory must use accrual-based accounting for income tax purposes, though there are
exceptions to the general rule.

So why might a company use cash-basis accounting? Companies that do not sell stock publicly can use cash-
basis instead of accrual-basis accounting for internal-management purposes and externally, as long as the
Internal Revenue Service does not prevent them from doing so, and they have no other reasons such as
agreements per a bank loan. Cash-basis accounting is a simpler accounting system to use than an accrual-
basis accounting system when tracking real-time revenues and expenses.

Let’s take a look at one example illustrating why accrual-basis accounting might be preferred to cash-basis
accounting.

In the current year, a company had the following transactions:

January to March Transactions

Date Transaction

Jan. 1 Annual insurance policy purchased for $6,000 cash

Jan. 8 Sent payment for December’s electricity bill, $135

Jan. 15 Performed services worth $2,500; customer asked to be billed

Jan. 31 Electricity used during January is estimated at $110

Feb. 16 Realized you forgot to pay January’s rent, so sent two months’ rent, $2,000

Feb. 20 Performed services worth $2,400; customer asked to be billed

Feb. 28 Electricity used during February is estimated at $150

Mar. 2 Paid March rent, $1,000

Mar. 10 Received all money owed from services performed in January and February

Mar. 14 Performed services worth $2,450. Received $1,800 cash

Mar. 30 Electricity used during March is estimated at $145

Table 5.1
302 Chapter 5 Completing the Accounting Cycle

IFRS CONNECTION

Issues in Comparing Closing Procedures

Regardless of whether a company uses US GAAP or International Financial Reporting Standards (IFRS),
the closing and post-closing processes are the same. However, the results generated by these processes
are not the same. These differences can be seen most easily in the ratios formulated from the financial
statement information and used to assess various financial qualities of a company.

You have learned about the current ratio, which is used to assess a company’s ability to pay debts as they
come due. How could the use of IFRS versus US GAAP affect this ratio? US GAAP and IFRS most
frequently differ on how certain transactions are measured, or on the timing of measuring and reporting
that transaction. You will later learn about this in more detail, but for now we use a difference in
inventory measurement to illustrate the effect of the two different sets of standards on the current ratio.

US GAAP allows for three different ways to measure ending inventory balances: first-in, first-out (FIFO);
last-in, first-out (LIFO); and weighted average. IFRS only allows for FIFO and weighted average. If the
prices of inventory being purchased are rising, the FIFO method will result in a higher value of ending
inventory on the Balance Sheet than would the LIFO method.

Think about this in the context of the current ratio. Inventory is one component of current assets: the
numerator of the ratio. The higher the current assets (numerator), the higher is the current ratio.
Therefore, if you calculated the current ratio for a company that applied US GAAP, and then recalculated
the ratio assuming the company used IFRS, you would get not only different numbers for inventory (and
other accounts) in the financial statements, but also different numbers for the ratios.

This idea illustrates the impact the application of an accounting standard can have on the results of a
company’s financial statements and related ratios. Different standards produce different results.
Throughout the remainder of this course, you will learn more details about the similarities and
differences between US GAAP and IFRS, and how these differences impact financial reporting.

Remember, in a cash-basis system you will record the revenue when the money is received no matter when
the service is performed. There was no money received from customers in January or February, so the
company, under a cash-basis system, would not show any revenue in those months. In March they received
the $2,500 customers owed from January sales, $2,400 from customers for February sales, and $1,800 from
cash sales in March. This is a total of $6,700 cash received from customers in March. Since the cash was
received in March, the cash-basis system would record revenue in March.

In accrual accounting, we record the revenue as it is earned. There was $2,500 worth of service performed in
January, so that will show as revenue in January. The $2,400 earned in February is recorded in February, and
the $2,450 earned in March is recorded as revenue in March. Remember, it does not matter whether or not the
cash came in.

For expenses, the cash-basis system is going to record an expense the day the payment leaves company
hands. In January, the company purchased an insurance policy. The insurance policy is for the entire year, but
since the cash went to the insurance company in January, the company will record the entire amount as an
expense in January. The company paid the December electric bill in January. Even though the electricity was
used to earn revenue in December, the company will record it as an expense in January. Electricity used in

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Chapter 5 Completing the Accounting Cycle 303

January, February, and March to help earn revenue in those months will show no expense because the bill has
not been paid. The company forgot to pay January’s rent in January, so no rent expense is recorded in January.
However, in February there is $2,000 worth of rent expense because the company paid for the two months in
February.

Under accrual accounting, expenses are recorded when they are incurred and not when paid. Electricity used
in a month to help earn revenue is recorded as an expense in that month whether the bill is paid or not. The
same is true for rent expense. Insurance expense is spread out over 12 months, and each month 1/12 of the
total insurance cost is expensed. The comparison of cash-basis and accrual-basis income statements is
presented in Figure 5.9.

Figure 5.9 Cash Basis versus Accrual Basis Accounting. (attribution: Copyright Rice University, OpenStax,
under CC BY-NC-SA 4.0 license)

CONCEPTS IN PRACTICE

Fundamentals of Financial Ratios

One method used by everyone who evaluates financial statements is to calculate financial ratios.
Financial ratios take numbers from your income statements and/or your balance sheet to evaluate
important financial outcomes that will impact user decisions.

There are ratios to evaluate your liquidity, solvency, profitability, and efficiency. Liquidity ratios look at
your ability to pay the debts that you owe in the near future. Solvency will show if you can pay your bills
not only in the short term but also in the long term. Profitability ratios are calculated to see how much
profit is being generated from a company’s sales. Efficiency ratios will be calculated to see how efficient a
company is using its assets in running its business. You will be introduced to these ratios and how to
interpret them throughout this course.

Compare the two sets of income statements. The cash-basis system looks as though no revenue was earned in
the first two months, and expenses were excessive. Then in March it looks like the company earned a lot of
revenue. How realistic is this picture? Now look at the accrual basis figures. Here you see a better picture of
what really happened over the three months. Revenues and expenses stayed relatively even across periods.

This comparison can show the dangers of reporting in a cash-basis system. In a cash-basis system, the timing
of cash flows can make the business look very profitable one month and not profitable the next. If your
company was having a bad year and you do not want to report a loss, just do not pay the bills for the last
month of the year and you can suddenly show a profit in a cash-basis system. In an accrual-basis system, it
304 Chapter 5 Completing the Accounting Cycle

does not matter if you do not pay the bills, you still need to record the expenses and present an income
statement that accurately portrays what is happening in your company. The accrual-basis system lends itself
to more transparency and detail in reporting. This detail is carried over into what is known as a classified
balance sheet.

The Classified Balance Sheet

A classified balance sheet presents information on your balance sheet in a more informative structure, where
asset and liability categories are divided into smaller, more detailed sections. Classified balance sheets show
more about the makeup of our assets and liabilities, allowing us to better analyze the current health of our
company and make future strategic plans.

Assets can be categorized as current; property, plant, and equipment; long-term investments; intangibles;
and, if necessary, other assets. As you learned in Introduction to Financial Statements, a current asset (also
known as a short-term asset) is any asset that will be converted to cash, sold, or used up within one year, or one
operating cycle, whichever is longer. 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 (Figure 5.10). For a merchandising
firm that sells inventory, an operating cycle is the time it takes for the firm to use its cash to purchase
inventory, sell the inventory, and get its cash back from its customers.

Figure 5.10 Operating Cycle. (credit left: modification of “All Sales Final” by Dan Keck/Flickr, Public Domain;
credit center: modification of “Money Wallet Finance” by “Goumbik”/Pixabay, CC0; credit right: modification of
“Inventory for Seasonal Decoration” by Mirko Tobias Schäfer/Flickr, CC BY 2.0)

LINK TO LEARNING

Newport News Shipbuilding is an American shipbuilder located in Newport News, Virginia. According to

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Chapter 5 Completing the Accounting Cycle 305

information provided by the company, the company has designed and built 30 aircraft carriers in the past
75 years. That is 30 carriers in 75 years. Newport News constructed the USS Gerald R. Ford. It took the
company eight years to build the carrier, christening it in 2013. The ship then underwent rigorous testing
until it was finally delivered to its home port, Naval Station Norfolk in 2017. That is 12 years after work
commenced on the project.

With large shipbuilding projects that take many years to complete, the operating cycle for this type of
company could expand beyond a year mark, and Newport News would use this longer operating cycle
when dividing current and long-term assets and liabilities.

Learn more about Newport News and its parent company Huntington Ingalls Industries
(https://openstax.org/l/50IngallsShip) and see a time-lapse video of the construction of the carrier
(https://openstax.org/l/50ShipBuilding) . You can easily tell the passage of time if you watch the snow
come and go in the video.

If an asset does not meet the requirements of a current asset, then it is classified as a long-term asset. It can
be further defined as property, plant, and equipment; a long-term investment; or an intangible asset
(Figure 5.11). Property, plant, and equipment are tangible assets (those that have a physical presence) held
for more than one operating cycle or one year, whichever is longer. A long-term investment is stocks, bonds,
or other types of investments that management intends to hold for more than one operating cycle or one
year, whichever is longer. Intangible assets do not have a physical presence but give the company a long-
term future benefit. Some examples include patents, copyrights, and trademarks.

Liabilities are classified as either current liabilities or long-term liabilities. Liabilities also use the one year, or
one operating cycle, for the cut-off between current and noncurrent. As we first discussed in Introduction to
Financial Statements, if the debt is due within one year or one operating cycle, whichever is longer, the liability
is a current liability. If the debt is settled outside one year or one operating cycle, whichever is longer, the
liability is a long-term liability.
306 Chapter 5 Completing the Accounting Cycle

Figure 5.11 Asset Classification Flowchart. A flowchart for asset classification can assist with financial
reporting. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

YOUR TURN

How to Classify Assets

Classify each of the following assets as current asset; property, plant, and equipment; long-term
investment; or intangible asset.

A. machine
B. patent
C. supplies

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Chapter 5 Completing the Accounting Cycle 307

D. building
E. investment in bonds with intent to hold until maturity in 10 years
F. copyright
G. land being held for future office
H. prepaid insurance
I. accounts receivable
J. investment in stock that will be held for six months

Solution

A. property, plant, and equipment. B. intangible asset. C. current asset. D. property, plant, and
equipment. E. long-term investment. F. intangible asset. G. long-term investment. H. current asset. I.
current asset. J. current asset.

The land is considered a long-term investment, because it is not land being used currently by the
company to earn revenue. Buying real estate is an investment. If the company decided in the future that
it was not going to build the new office, it could sell the land and would probably be able to sell the land
for more than it was purchased for, because the value of real estate tends to go up over time. But like
any investment, there is the risk that the land might actually go down in value.

The investment in stock that we only plan to hold for six months will be called a marketable security in
the current asset section of the balance sheet.

As an example, the balance sheet in Figure 5.12 is classified.

308 Chapter 5 Completing the Accounting Cycle

Figure 5.12 Classified Balance Sheet for Magnificent Landscaping Service. (attribution: Copyright Rice
University, OpenStax, under CC BY-NC-SA 4.0 license)

C O N T I N U I N G A P P L I C AT I O N AT W O R K

Interim Reporting in the Grocery Industry

Interim reporting helps determine how well a company is performing at a given time during the year.
Some companies revise their earnings estimates depending on how profitable the company has been up
until a certain point in time. The grocery industry, which includes both private and publicly traded
companies, performs the same exercise.

However, grocery companies use such information to inform other important business decisions.
Consider the last time you walked through the grocery store and purchased your favorite brand but
found another item out of stock. What if the next time you shop, the product you loved is no longer
carried, but the out-of-stock item is available?

Grocery store profitably is based on small margins of revenue on a multitude of products. The bar codes
scanned at checkout not only provide the price of a product but also track how much inventory has been
sold. The grocery store analyzes such information to determine how quickly the product turns over,

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Chapter 5 Completing the Accounting Cycle 309

which drives profit on small margins. If a product sells well, the store might stock it all of the time, but if a
product does not sell quickly enough, it could be discontinued.

Using Classified Balance Sheets to Evaluate Liquidity

Categorizing assets and liabilities on a balance sheet helps a company evaluate its business. One way a
company can evaluate its business is with financial statement ratios. We consider two measures of liquidity,
working capital, and the current ratio. Let’s first explore this idea of liquidity.

We first described liquidity in Introduction to Financial Statements as the ability to convert assets into cash.
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. A critical piece of information to remember at this point is that most
companies use the accrual accounting method to determine and maintain their accounting records. This fact
means that even with a positive income position, as reflected by its income statement, a company can go
bankrupt due to poor cash flow. It is also important to note that even if a company has a lot of cash, it may still
be in bankruptcy trouble if all or much of that cash is borrowed. According to an article published in Money
[1]
magazine, one in four small businesses fail because of cash flow issues. They are making a profit and seem
financially healthy but do not have cash when needed.

Companies should analyze liquidity constantly to avoid cash shortages that may result in a need for a short-
term loan. Intermittently taking out a short-term loan is often expected, but a company cannot keep coming
up short on cash every year if it is going to remain liquid. A seasonal business, such as a specialized holiday
retailer, may require a short-term loan to continue its operations during slower revenue-generating periods.
Companies will use numbers from their classified balance sheet to test for liquidity. They want to make sure
they have enough current assets to pay their current liabilities. Only cash is used to directly pay liabilities, but
other current assets, such as accounts receivable or short-term investments, might be sold for cash, converted
to cash, or used to bring in cash to pay liabilities.

E T H I C A L C O N S I D E R AT I O N S

Liquidity Is as Important as Net Worth

How does a company like Lehman Brothers Holdings, with over $639 billion in assets and $613 billion in
liabilities, go bankrupt? That question still confuses many, but it comes down to the fact that having
assets recorded on the books at their purchase price is not the same as the immediate value of the
assets. Lehman Brothers had a liquidity crisis that led to a solvency crisis, because Lehman Brothers
could not sell the assets on its books at book value to cover its short-term cash demands. Matt Johnston,
in an article for the online publication Coinmonks, puts it simply: “Liquidity is all about being able to
access cash when it’s needed. If you can settle your current obligations with ease, you’ve got liquidity. If
you’ve got debts coming due and you don’t have the cash to settle them, then you’ve got a liquidity
[2]
crisis.” Continuing this Coinmonks discussion, the inability to timely pay debts leads to a business entity

1 Elaine Pofeldt. “5 Ways to Tackle the Problem That Kills One of Every Four Small Businesses.” Money. May 19, 2015. http://time.com/money/
3888448/cash-flow-small-business-startups/
310 Chapter 5 Completing the Accounting Cycle

becoming insolvent because bills cannot be paid on time and assets need to be written down. When
Lehman Brothers could not timely pay their bills in 2008, it went bankrupt, sending a shock throughout
the entire banking system. Accountants need to understand the differences between net worth, equity,
liquidity, and solvency, and be able to inform stakeholders of their organization’s actual financial
position, not just the recorded numbers on the balance sheet.

Two calculations a company might use to test for liquidity are working capital and the current ratio. Working
capital, which was first described in Introduction to Financial Statements, is found by taking the difference
between current assets and current liabilities.

A positive outcome means the company has enough current assets available to pay its current liabilities or
current debts. A negative outcome means the company does not have enough current assets to cover its
current liabilities and may have to arrange short-term financing. Though a positive working capital is
preferred, a company needs to make sure that there is not too much of a difference between current assets
and current liabilities. A company that has a high working capital might have too much money in current
assets that could be used for other company investments. Things such as industry and size of a company will
dictate what type of margin is best.

Let’s consider Printing Plus and its working capital (Figure 5.13).

2 Matt Johnson. “Revisiting the Lehman Brothers Collapse, the Business of Banking and Its Inherent Crises.” Coinmonks. February 1, 2018.
https://medium.com/coinmonks/revisiting-the-lehman-brothers-collapse-fb18769d6cf8

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Chapter 5 Completing the Accounting Cycle 311

Figure 5.13 Balance Sheet for Printing Plus. (attribution: Copyright Rice University, OpenStax, under CC BY-
NC-SA 4.0 license)

Printing Plus’s current assets include cash, accounts receivable, interest receivable, and supplies. Their current
liabilities include accounts payable, salaries payable, and unearned revenue. The following is the computation
of working capital:
Working capital = $26,540 – $5,400 = $21,140

This means that you have more than enough working capital to pay the current liabilities your company has
recorded. This figure may seem high, but remember that this is the company’s first month of operations and
this much cash may need to be available for larger, long-term asset purchases. However, there is also the
possibility that the company might choose to identify long-term financing options for the acquisition of
expensive, long-term assets, assuming that it can qualify for the increased debt.

Notice that part of the current liability calculation is unearned revenue. If a company has a surplus of
unearned revenue, it can sometimes get away with less working capital, as it will need less cash to pay its bills.
However, the company must be careful, since the cash was recorded before providing the services or products
associated with the unearned revenue. This relationship is why the unearned revenue was initially created, and
there often will be necessary cash outflows associated with meeting the terms of the unearned revenue
creation.

Companies with inventory will usually need a higher working capital than a service company, as inventory can
tie up a large amount of a company’s cash with less cash available to pay its bills. Also, small companies will
normally need a higher working capital than larger companies, because it is harder for smaller companies to
get loans, and they usually pay a higher interest rate.
312 Chapter 5 Completing the Accounting Cycle

LINK TO LEARNING

PricewaterhouseCoopers (PwC) released its 2015 Annual Global Working Capital Survey
(https://openstax.org/l/50PwC2015WorCap) which is a detailed study on working capital. Though the
report does not show the working capital calculation you just learned, there is very interesting
information about working capital in different industries, business sizes, and locations. Take a few
minutes and peruse this document.

The current ratio (also known as the working capital ratio), which was first described in Introduction to
Financial Statements, 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:

For example, if a company has current assets of $20,000 and current liabilities of $10,000, its current ratio is
$20,000/$10,000 = two times. This means the company has enough current assets to cover its current liabilities
twice. Ideally, many companies would like to maintain a 1.5:2 times current assets over current liabilities ratio.
However, depending on the company’s function or purpose, an optimal ratio could be lower or higher than
the previous recommendation. For example, many utilities do not have large fluctuations in anticipated
seasonal current ratios, so they might decide to maintain a current ratio of 1.25:1.5 times current assets over
current liabilities ratio, while a high-tech startup might want to maintain a ratio of 2.5:3 times current assets
over current liabilities ratio.

The current ratio for Printing Plus is $26,540/$5,400 = 4.91 times. That is a very high current ratio, but since the
business was just started, having more cash might allow the company to make larger purchases while still
paying its liabilities. However, this ratio might be a result of short-term conditions, so the company is advised
to still plan on maintaining a ratio that is considered both rational and not too risky.

Using ratios for a single year does not provide a broad picture. A company will get much better information if
it compares the working capital and current ratio numbers for several years so it can see increases, decreases,
and where numbers remain fairly consistent. Companies can also benefit from comparing this financial data to
that of other companies in the industry.

E T H I C A L C O N S I D E R AT I O N S

Computers Still Use Debits and Credits: Check behind the Dashboard for Fraud
Newly hired accountants are often sat at a computer to work off of a dashboard, which is a computer
screen where entries are made into the accounting system. New accountants working with modern
accounting software may not be aware that their software uses the debit and credit system you learned
about, and that the system may automatically close the books without the accountant’s review of closing
entries. Manually closing the books gives accountants a chance to review the balances of different

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Chapter 5 Completing the Accounting Cycle 313

accounts; if accountants do not review the entries, they will not know what is occurring in the accounting
system or in their organization’s financial statements.

Many accounting systems automatically close the books if the command is made in the system. While
debits and credits are being entered and may not have been reviewed, the system can be instructed to
close out the revenue and expense accounts and create an Income Statement.

A knowledgeable accountant can review entries within the software’s audit function. The accountant will
be able to look at every entry, its description, both sides of the entry (debit and credit), and any changes
made in the entry. This review is important in determining if any incorrect entry was either a mistake or
fraud. The accountant can see who made the entry and how the entry occurred in the accounting system.

To ensure the integrity of the system, each person working in the system must have a unique user
identification, and no users may know others’ passwords. If there is an entry or updated entry, the
accountant will be able to see the entry in the audit function of the software. If an employee has changed
expense items to pay his or her personal bills, the accountant can see the change. Similarly, changes in
transaction dates can be reviewed to determine whether they are fraudulent. Professional accountants
know what goes on in their organization’s accounting system.

5.4 Appendix: Complete a Comprehensive Accounting Cycle for a Business

We have gone through the entire accounting cycle for Printing Plus with the steps spread over three chapters.
Let’s go through the complete accounting cycle for another company here. The full accounting cycle diagram
is presented in Figure 5.14.
314 Chapter 5 Completing the Accounting Cycle

Figure 5.14 The Accounting Cycle. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0
license)

We next take a look at a comprehensive example that works through the entire accounting cycle for Clip’em
Cliff. Clifford Girard retired from the US Marine Corps after 20 years of active duty. Cliff decides it would be fun
to become a barber and open his own shop called “Clip’em Cliff.” He will run the barber shop out of his home
for the first couple of months while he identifies a new location for his shop.

Since his Marines career included several years of logistics, he is also going to operate a consulting practice
where he will help budding barbers create a barbering practice. He will charge a flat fee or a per hour charge.
His consulting practice will be recognized as service revenue and will provide additional revenue while he
develops his barbering practice.

He obtains a barber’s license after the required training and is ready to open his shop on August 1. Table 5.2
shows his transactions from the first month of business.

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Chapter 5 Completing the Accounting Cycle 315

Transactions for August

Date Transaction

Aug. 1 Cliff issues $70,000 shares of common stock for cash.

Aug. 3 Cliff purchases barbering equipment for $45,000; $37,500 was paid immediately with cash, and
the remaining $7,500 was billed to Cliff with payment due in 30 days. He decided to buy used
equipment, because he was not sure if he truly wanted to run a barber shop. He assumed that
he will replace the used equipment with new equipment within a couple of years.

Aug. 6 Cliff purchases supplies for $300 cash.

Aug. 10 Cliff provides $4,000 in services to a customer who asks to be billed for the services.

Aug. 13 Cliff pays a $75 utility bill with cash.

Aug. 14 Cliff receives $3,200 cash in advance from a customer for services not yet rendered.

Aug. 16 Cliff distributed $150 cash in dividends to stockholders.

Aug. 17 Cliff receives $5,200 cash from a customer for services rendered.

Aug. 19 Cliff paid $2,000 toward the outstanding liability from the August 3 transaction.

Aug. 22 Cliff paid $4,600 cash in salaries expense to employees.

Aug. 28 The customer from the August 10 transaction pays $1,500 cash toward Cliff’s account.

Table 5.2

Transaction 1: On August 1, 2019, Cliff issues $70,000 shares of common stock for cash.

Analysis:

• Clip’em Cliff now has more cash. Cash is an asset, which is increasing on the debit side.
• When the company issues stock, this yields a higher common stock figure than before issuance. The
common stock account is increasing on the credit side.

Transaction 2: On August 3, 2019, Cliff purchases barbering equipment for $45,000; $37,500 was paid
immediately with cash, and the remaining $7,500 was billed to Cliff with payment due in 30 days.
316 Chapter 5 Completing the Accounting Cycle

Analysis:

• Clip’em Cliff now has more equipment than before. Equipment is an asset, which is increasing on the
debit side for $45,000.
• Cash is used to pay for $37,500. Cash is an asset, decreasing on the credit side.
• Cliff asked to be billed, which means he did not pay cash immediately for $7,500 of the equipment.
Accounts Payable is used to signal this short-term liability. Accounts payable is increasing on the credit
side.

Transaction 3: On August 6, 2019, Cliff purchases supplies for $300 cash.

Analysis:

• Clip’em Cliff now has less cash. Cash is an asset, which is decreasing on the credit side.
• Supplies, an asset account, is increasing on the debit side.

Transaction 4: On August 10, 2019, provides $4,000 in services to a customer who asks to be billed for the
services.

Analysis:

• Clip’em Cliff provided service, thus earning revenue. Revenue impacts equity, and increases on the credit
side.
• The customer did not pay immediately for the service and owes Cliff payment. This is an Accounts
Receivable for Cliff. Accounts Receivable is an asset that is increasing on the debit side.

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Chapter 5 Completing the Accounting Cycle 317

Transaction 5: On August 13, 2019, Cliff pays a $75 utility bill with cash.

Analysis:

• Clip’em Cliff now has less cash than before. Cash is an asset that is decreasing on the credit side.
• Utility payments are billed expenses. Utility Expense negatively impacts equity, and increases on the debit
side.

Transaction 6: On August 14, 2019, Cliff receives $3,200 cash in advance from a customer for services to be
rendered.

Analysis:

• Clip’em Cliff now has more cash. Cash is an asset, which is increasing on the debit side.
• The customer has not yet received services but already paid the company. This means the company owes
the customer the service. This creates a liability to the customer, and revenue cannot yet be recognized.
Unearned Revenue is the liability account, which is increasing on the credit side.
318 Chapter 5 Completing the Accounting Cycle

Transaction 7: On August 16, 2019, Cliff distributed $150 cash in dividends to stockholders.

Analysis:

• Clip’em Cliff now has less cash. Cash is an asset, which is decreasing on the credit side.
• When the company pays out dividends, this decreases equity and increases the dividends account.
Dividends increases on the debit side.

Transaction 8: On August 17, 2019, Cliff receives $5,200 cash from a customer for services rendered.

Analysis:

• Clip’em Cliff now has more cash than before. Cash is an asset, which is increasing on the debit side.
• Service was provided, which means revenue can be recognized. Service Revenue increases equity. Service
Revenue is increasing on the credit side.

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Chapter 5 Completing the Accounting Cycle 319

Transaction 9: On August 19, 2019, Cliff paid $2,000 toward the outstanding liability from the August 3
transaction.

Analysis:

• Clip’em Cliff now has less cash. Cash is an asset, which is decreasing on the credit side.
• Accounts Payable is a liability account, decreasing on the debit side.

Transaction 10: On August 22, 2019, Cliff paid $4,600 cash in salaries expense to employees.

Analysis:

• Clip’em Cliff now has less cash. Cash is an asset, which is decreasing on the credit side.
• When the company pays salaries, this is an expense to the business. Salaries Expense reduces equity by
increasing on the debit side.
320 Chapter 5 Completing the Accounting Cycle

Transaction 11: On August 28, 2019, the customer from the August 10 transaction pays $1,500 cash toward
Cliff’s account.

Analysis:

• The customer made a partial payment on their outstanding account. This reduces Accounts Receivable.
Accounts Receivable is an asset account decreasing on the credit side.
• Cash is an asset, increasing on the debit side.

The complete journal for August is presented in Figure 5.15.

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Chapter 5 Completing the Accounting Cycle 321

Figure 5.15 Journal Entries for August. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA
4.0 license)

Once all journal entries have been created, the next step in the accounting cycle is to post journal information
to the ledger. The ledger is visually represented by T-accounts. Cliff will go through each transaction and
transfer the account information into the debit or credit side of that ledger account. Any account that has
more than one transaction needs to have a final balance calculated. This happens by taking the difference
between the debits and credits in an account.

Clip’em Cliff’s ledger represented by T-accounts is presented in Figure 5.16.

322 Chapter 5 Completing the Accounting Cycle

Figure 5.16 T-Accounts for August. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0
license)

You will notice that the sum of the asset account balances in Cliff’s ledger equals the sum of the liability and
equity account balances at $83,075. The final debit or credit balance in each account is transferred to the
unadjusted trial balance in the corresponding debit or credit column as illustrated in Figure 5.17.

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Chapter 5 Completing the Accounting Cycle 323

Figure 5.17 Unadjusted Trial Balance for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax,
under CC BY-NC-SA 4.0 license)

Once all of the account balances are transferred to the correct columns, each column is totaled. The total in
the debit column must match the total in the credit column to remain balanced. The unadjusted trial balance
for Clip’em Cliff appears in Figure 5.18.

Figure 5.18 Unadjusted Trial Balance for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax,
under CC BY-NC-SA 4.0 license)

The unadjusted trial balance shows a debit and credit balance of $87,900. Remember, the unadjusted trial
balance is prepared before any period-end adjustments are made.

On August 31, Cliff has the transactions shown in Table 5.3 requiring adjustment.
324 Chapter 5 Completing the Accounting Cycle

August 31 Transactions

Date Transaction

Aug. 31 Cliff took an inventory of supplies and discovered that $250 of supplies remain unused at the
end of the month.

Aug. 31 The equipment purchased on August 3 depreciated $2,500 during the month of August.

Aug. 31 Clip’em Cliff performed $1,100 of services during August for the customer from the August 14
transaction.

Aug. 31 Reviewing the company bank statement, Clip’em Cliff discovers $350 of interest earned during
the month of August that was previously uncollected and unrecorded. As a new customer for
the bank, the interest was paid by a bank that offered an above-market-average interest rate.

Aug. 31 Unpaid and previously unrecorded income taxes for the month are $3,400. The tax payment was
to cover his federal quarterly estimated income taxes. He lives in a state that does not have an
individual income tax

Table 5.3

Adjusting Transaction 1: Cliff took an inventory of supplies and discovered that $250 of supplies remain
unused at the end of the month.

Analysis:

• $250 of supplies remain at the end of August. The company began the month with $300 worth of supplies.
Therefore, $50 of supplies were used during the month and must be recorded (300 – 250). Supplies is an
asset that is decreasing (credit).
• Supplies is a type of prepaid expense, that when used, becomes an expense. Supplies Expense would
increase (debit) for the $50 of supplies used during August.

Adjusting Transaction 2: The equipment purchased on August 3 depreciated $2,500 during the month of
August.

Analysis:

• Equipment cost of $2,500 was allocated during August. This depreciation will affect the Accumulated
Depreciation–Equipment account and the Depreciation Expense–Equipment account. While we are not

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Chapter 5 Completing the Accounting Cycle 325

doing depreciation calculations here, you will come across more complex calculations, such as
depreciation in Long-Term Assets.
• Accumulated Depreciation–Equipment is a contra asset account (contrary to Equipment) and increases
(credit) for $2,500.
• Depreciation Expense–Equipment is an expense account that is increasing (debit) for $2,500.

Adjusting Transaction 3: Clip’em Cliff performed $1,100 of services during August for the customer from the
August 14 transaction.

Analysis:

• The customer from the August 14 transaction gave the company $3,200 in advanced payment for services.
By the end of August the company had earned $1,100 of the advanced payment. This means that the
company still has yet to provide $2,100 in services to that customer.
• Since some of the unearned revenue is now earned, Unearned Revenue would decrease. Unearned
Revenue is a liability account and decreases on the debit side.
• The company can now recognize the $1,100 as earned revenue. Service Revenue increases (credit) for
$1,100.

Adjusting Transaction 4: Reviewing the company bank statement, Clip’em Cliff identifies $350 of interest
earned during the month of August that was previously unrecorded.

Analysis:

• Interest is revenue for the company on money kept in a money market account at the bank. The company
only sees the bank statement at the end of the month and needs to record as received interest revenue
reflected on the bank statement.
326 Chapter 5 Completing the Accounting Cycle

• Interest Revenue is a revenue account that increases (credit) for $350.

• Since Clip’em Cliff has yet to collect this interest revenue, it is considered a receivable. Interest Receivable
increases (debit) for $350.

Adjusting Transaction 5: Unpaid and previously unrecorded income taxes for the month are $3,400.

Analysis:

• Income taxes are an expense to the business that accumulate during the period but are only paid at
predetermined times throughout the year. This period did not require payment but did accumulate
income tax.
• Income Tax Expense is an expense account that negatively affects equity. Income Tax Expense increases
on the debit side.
• The company owes the tax money but has not yet paid, signaling a liability. Income Tax Payable is a
liability that is increasing on the credit side.

The summary of adjusting journal entries for Clip’em Cliff is presented in Figure 5.19.

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Chapter 5 Completing the Accounting Cycle 327

Figure 5.19 Adjusting Journal Entries for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax,
under CC BY-NC-SA 4.0 license)

Now that all of the adjusting entries are journalized, they must be posted to the ledger. Posting adjusting
entries is the same process as posting the general journal entries. Each journalized account figure will transfer
to the corresponding ledger account on either the debit or credit side as illustrated in Figure 5.20.

Figure 5.20 Posting Ledger Entries for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax, under
CC BY-NC-SA 4.0 license)

We would normally use a general ledger, but for illustrative purposes, we are using T-accounts to represent
the ledgers. The T-accounts after the adjusting entries are posted are presented in Figure 5.21.
328 Chapter 5 Completing the Accounting Cycle

Figure 5.21 Ledger Entries (in T-Accounts) for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax,
under CC BY-NC-SA 4.0 license)

You will notice that the sum of the asset account balances equals the sum of the liability and equity account
balances at $80,875. The final debit or credit balance in each account is transferred to the adjusted trial
balance, the same way the general ledger transferred to the unadjusted trial balance.

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Chapter 5 Completing the Accounting Cycle 329

The next step in the cycle is to prepare the adjusted trial balance. Clip’em Cliff’s adjusted trial balance is shown
in Figure 5.22.

Figure 5.22 Adjusted Trial Balance for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax, under
CC BY-NC-SA 4.0 license)

The adjusted trial balance shows a debit and credit balance of $94,150. Once the adjusted trial balance is
prepared, Cliff can prepare his financial statements (step 7 in the cycle). We only prepare the income
statement, statement of retained earnings, and the balance sheet. The statement of cash flows is discussed in
detail in Statement of Cash Flows.

To prepare your financial statements, you want to work with your adjusted trial balance.

Remember, revenues and expenses go on an income statement. Dividends, net income (loss), and retained
earnings balances go on the statement of retained earnings. On a balance sheet you find assets, contra assets,
liabilities, and stockholders’ equity accounts.

The income statement for Clip’em Cliff is shown in Figure 5.23.

330 Chapter 5 Completing the Accounting Cycle

Figure 5.23 Income Statement for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax, under CC
BY-NC-SA 4.0 license)

Note that expenses were only $25 less than revenues. For the first month of operations, Cliff welcomes any
income. Cliff will want to increase income in the next period to show growth for investors and lenders.

Next, Cliff prepares the following statement of retained earnings (Figure 5.24).

Figure 5.24 Statement of Retained Earnings for Clip’em Cliff. (attribution: Copyright Rice University,
OpenStax, under CC BY-NC-SA 4.0 license)

The beginning retained earnings balance is zero because Cliff just began operations and does not have a
balance to carry over to a future period. The ending retained earnings balance is –$125. You probably never
want to have a negative value on your retained earnings statement, but this situation is not totally unusual for
an organization in its initial operations. Cliff will want to improve this outcome going forward. It might make
sense for Cliff to not pay dividends until he increases his net income.

Cliff then prepares the balance sheet for Clip’em Cliff as shown in Figure 5.25.

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Chapter 5 Completing the Accounting Cycle 331

Figure 5.25 Balance Sheet for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax, under CC BY-
NC-SA 4.0 license)

The balance sheet shows total assets of $80,875, which equals total liabilities and equity. Now that the financial
statements are complete, Cliff will go to the next step in the accounting cycle, preparing and posting closing
entries. To do this, Cliff needs his adjusted trial balance information.

Cliff will only close temporary accounts, which include revenues, expenses, income summary, and dividends.
The first entry closes revenue accounts to income summary. To close revenues, Cliff will debit revenue
accounts and credit income summary.

The second entry closes expense accounts to income summary. To close expenses, Cliff will credit expense
accounts and debit income summary.
332 Chapter 5 Completing the Accounting Cycle

The third entry closes income summary to retained earnings. To find the balance, take the difference between
the income summary amount in the first and second entries (10,650 – 10,625). To close income summary, Cliff
would debit Income Summary and credit Retained Earnings.

The fourth closing entry closes dividends to retained earnings. To close dividends, Cliff will credit Dividends,
and debit Retained Earnings.

Once all of the closing entries are journalized, Cliff will post this information to the ledger. The closed accounts
with their final balances, as well as Retained Earnings, are presented in Figure 5.26.

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Chapter 5 Completing the Accounting Cycle 333

Figure 5.26 Closed Accounts with Final Balances for Clip’em Cliff. (attribution: Copyright Rice University,
OpenStax, under CC BY-NC-SA 4.0 license)

Now that the temporary accounts are closed, they are ready for accumulation in the next period.

The last step for the month of August is step 9, preparing the post-closing trial balance. The post-closing trial
balance should only contain permanent account information. No temporary accounts should appear on this
trial balance. Clip’em Cliff’s post-closing trial balance is presented in Figure 5.27.
334 Chapter 5 Completing the Accounting Cycle

Figure 5.27 Post-Closing Trial Balance for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax,
under CC BY-NC-SA 4.0 license)

At this point, Cliff has completed the accounting cycle for August. He is now ready to begin the process again
for September, and future periods.

CONCEPTS IN PRACTICE

Reversing Entries
One step in the accounting cycle that we did not cover is reversing entries. Reversing entries can be
made at the beginning of a new period to certain accruals. The company will reverse adjusting entries
made in the prior period to the revenue and expense accruals.

It can be difficult to keep track of accruals from prior periods, as support documentation may not be
readily available in current or future periods. This requires an accountant to remember when these
accruals came from. By reversing these accruals, there is a reduced risk for counting revenues and
expenses twice. The support documentation received in the current or future period for an accrual will
be easier to match to prior revenues and expenses with the reversal.

LINK TO LEARNING

As we have learned, the current ratio shows how well a company can cover short-term debt with short-
term assets. Look through the balance sheet in the 2017 Annual Report for Target (https://openstax.org/
l/50Target2017Bal) and calculate the current ratio. What does the outcome mean for Target?

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Chapter 5 Completing the Accounting Cycle 335

THINK IT THROUGH

Using Liquidity Ratios to Evaluate Financial Performance

You own a landscaping business that has just begun operations. You made several expensive equipment
purchases in your first month to get your business started. These purchases very much reduced your
cash-on-hand, and in turn your liquidity suffered in the following months with a low working capital and
current ratio.

Your business is now in its eighth month of operation, and while you are starting to see a growth in sales,
you are not seeing a significant change in your working capital or current ratio from the low numbers in
your early months. What could you attribute to this stagnancy in liquidity? Is there anything you can do
as a business owner to better these liquidity measurements? What will happen if you cannot change
your liquidity or it gets worse?
336 Chapter 5 Completing the Accounting Cycle

Key Terms
classified balance sheet presents information on your balance sheet in a more informative structure, where
asset and liability categories are divided into smaller, more detailed sections
closing returning the account to a zero balance
closing entry prepares a company for the next accounting period by clearing any outstanding balances in
certain accounts that should not transfer over to the next period
current ratio current assets divided by current liabilities; used to determine a company’s liquidity (ability to
meet short-term obligations)
income summary intermediary between revenues and expenses, and the Retained Earnings account,
storing all the closing information for revenues and expenses, resulting in a “summary” of income or loss
for the period
intangible asset asset with financial value but no physical presence; examples include copyrights, patents,
goodwill, and trademarks
liquidity ability to convert assets into cash in order to meet primarily short-term cash needs or emergencies
long-term investment stocks, bonds, or other types of investments held for more than one operating cycle
or one year, whichever is longer
long-term liability debt settled outside one year or one operating cycle, whichever is longer
operating cycle amount of time it takes a company to use its cash to provide a product or service and collect
payment from the customer
permanent (real) account account that transfers balances to the next period, and includes balance sheet
accounts, such as assets, liabilities, and stockholder’s equity
post-closing trial balance trial balance that is prepared after all the closing entries have been recorded
property, plant, and equipment tangible assets (those that have a physical presence) held for more than
one operating cycle or one year, whichever is longer
temporary (nominal) account account that is closed at the end of each accounting period, and includes
income statement, dividends, and income summary accounts
working capital current assets less current liabilities; sometimes used as a measure of liquidity

Summary
5.1 Describe and Prepare Closing Entries for a Business
• 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

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Chapter 5 Completing the Accounting Cycle 337

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.

5.2 Prepare a Post-Closing Trial 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.

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

5.4 Appendix: Complete a Comprehensive Accounting Cycle for a Business

• The comprehensive accounting cycle is the process in which transactions are recorded in the accounting
records and are ultimately reflected in the ending period balances on the financial statements.
• Comprehensive accounting cycle for a business: A service business is taken through the comprehensive
accounting cycle, starting with the formation of the entity, recording all necessary journal entries for its
transactions, making all required adjusting and closing journal entries, and culminating in the preparation
of all requisite financial statements

Multiple Choice
1. 5.1 Which of the following accounts is considered a temporary or nominal account?
A. Fees Earned Revenue
B. Prepaid Advertising
C. Unearned Service Revenue
D. Prepaid Insurance

2. 5.1 Which of the following accounts is considered a permanent or real account?

A. Interest Revenue
B. Prepaid Insurance
C. Insurance Expense
D. Supplies Expense
338 Chapter 5 Completing the Accounting Cycle

3. 5.1 If a journal entry includes a debit or credit to the Cash account, it is most likely which of the
following?
A. a closing entry
B. an adjusting entry
C. an ordinary transaction entry
D. outside of the accounting cycle

4. 5.1 If a journal entry includes a debit or credit to the Retained Earnings account, it is most likely which of
the following?
A. a closing entry
B. an adjusting entry
C. an ordinary transaction entry
D. outside of the accounting cycle

5. 5.1 Which of these accounts would be present in the closing entries?

A. Dividends
B. Accounts Receivable
C. Unearned Service Revenue
D. Sales Tax Payable

6. 5.1 Which of these accounts would not be present in the closing entries?
A. Utilities Expense
B. Fees Earned Revenue
C. Insurance Expense
D. Dividends Payable

7. 5.1 Which of these accounts is never closed?

A. Dividends
B. Retained Earnings
C. Service Fee Revenue
D. Income Summary

8. 5.1 Which of these accounts is never closed?

A. Prepaid Rent
B. Income Summary
C. Rent Revenue
D. Rent Expense

9. 5.1 Which account would be credited when closing the account for fees earned for the year?
A. Accounts Receivable
B. Fees Earned Revenue
C. Unearned Fee Revenue
D. Income Summary

10. 5.1 Which account would be credited when closing the account for rent expense for the year?
A. Prepaid Rent
B. Rent Expense
C. Rent Revenue
D. Unearned Rent Revenue

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Chapter 5 Completing the Accounting Cycle 339

11. 5.2 Which of these accounts is included in the post-closing trial balance?
A. Sales Revenue
B. Salaries Expense
C. Retained Earnings
D. Dividends

12. 5.2 Which of these accounts is not included in the post-closing trial balance?
A. Land
B. Notes Payable
C. Retained Earnings
D. Dividends

13. 5.2 On which of the following would the year-end Retained Earnings balance be stated correctly?
A. Unadjusted Trial Balance
B. Adjusted Trial Balance
C. Post-Closing Trial Balance
D. The Worksheet

14. 5.2 Which of these accounts is included in the post-closing trial balance?
A. Supplies Expense
B. Accounts Payable
C. Sales Revenue
D. Insurance Expense

15. 5.3 If current assets are $112,000 and current liabilities are $56,000, what is the current ratio?
A. 200 percent
B. 50 percent
C. 2.0
D. $50,000

16. 5.3 If current assets are $100,000 and current liabilities are $42,000, what is the working capital?
A. 200 percent
B. 50 percent
C. 2.0
D. $58,000

Questions
1. 5.1 Explain what is meant by the term real accounts (also known as permanent accounts).

2. 5.1 Explain what is meant by the term nominal accounts (also known as temporary accounts).

3. 5.1 What is the purpose of the closing entries?

4. 5.1 What would happen if the company failed to make closing entries at the end of the year?

5. 5.1 Which of these account types (Assets, Liabilities, Equity, Revenue, Expense, Dividend) are credited in
the closing entries? Why?
340 Chapter 5 Completing the Accounting Cycle

6. 5.1 Which of these account types (Assets, Liabilities, Equity, Revenue, Expense, Dividend) are debited in
the closing entries? Why?

7. 5.1 The account called Income Summary is often used in the closing entries. Explain this account’s
purpose and how it is used.

8. 5.1 What are the four entries required for closing, assuming that the Income Summary account is used?

9. 5.1 After the first two closing entries are made, Income Summary has a credit balance of $125,500. What
does this indicate about the company’s net income or loss?

10. 5.1 After the first two closing entries are made, Income Summary has a debit balance of $22,750. What
does this indicate about the company’s net income or loss?

11. 5.2 What account types are included in a post-closing trial balance?

12. 5.2 Which of the basic financial statements can be directly tied to the post-closing trial balance? Why is
this so?

13. 5.3 Describe the calculation required to compute working capital. Explain the significance.

14. 5.3 Describe the calculation required to compute the current ratio. Explain the significance.

15. 5.4 Describe the progression of the three trial balances that a company would have during the period,
and explain the difference between the three.

Exercise Set A
EA1. 5.1 Identify whether each of the following accounts is nominal/temporary or real/permanent.
A. Accounts Receivable
B. Fees Earned Revenue
C. Utility Expense
D. Prepaid Rent

EA2. 5.1 For each of the following accounts, identify whether it is nominal/temporary or real/permanent,
and whether it is reported on the Balance Sheet or the Income Statement.
A. Interest Expense
B. Buildings
C. Interest Payable
D. Unearned Rent Revenue

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Chapter 5 Completing the Accounting Cycle 341

EA3. 5.1 For each of the following accounts, identify whether it would be closed at year-end (yes or no) and
on which financial statement the account would be reported (Balance Sheet, Income Statement, or Retained
Earnings Statement).
A. Accounts Payable
B. Accounts Receivable
C. Cash
D. Dividends
E. Fees Earned Revenue
F. Insurance Expense
G. Prepaid Insurance
H. Supplies

EA4. 5.1 The following accounts and normal balances existed at year-end. Make the four journal entries
required to close the books:

EA5. 5.1 The following accounts and normal balances existed at year-end. Make the four journal entries
required to close the books:

EA6. 5.1 Use the following excerpts from the year-end Adjusted Trial Balance to prepare the four journal
entries required to close the books:
342 Chapter 5 Completing the Accounting Cycle

EA7. 5.1 Use the following T-accounts to prepare the four journal entries required to close the books:

EA8. 5.1 Use the following T-accounts to prepare the four journal entries required to close the books:

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Chapter 5 Completing the Accounting Cycle 343

EA9. 5.2 Identify whether each of the following accounts would be listed in the company’s Post-Closing
Trial Balance.
A. Accounts Payable
B. Advertising Expense
C. Dividends
D. Fees Earned Revenue
E. Prepaid Advertising
F. Supplies
G. Supplies Expense
H. Unearned Fee Revenue

EA10. 5.2 Identify which of the following accounts would not be listed on the company’s Post-Closing Trial
Balance.

EA11. 5.3 For each of the following accounts, identify in which section of the classified balance sheet it
would be presented: current assets, property, intangibles, other assets, current liabilities, long-term liabilities,
or stockholder’s equity.
A. Accounts Payable
B. Accounts Receivable
C. Cash
D. Equipment
E. Land
F. Notes Payable (due two years later)
G. Prepaid Insurance
H. Supplies

EA12. 5.3 Using the following Balance Sheet summary information, calculate for the two years presented:
A. working capital
B. current ratio
344 Chapter 5 Completing the Accounting Cycle

EA13. 5.3 Using the following account balances, calculate for the two years presented:
A. working capital
B. current ratio

EA14. 5.3 Using the following Balance Sheet summary information, calculate for the two companies
presented:
A. working capital
B. current ratio

Then:

A. evaluate which company’s liquidity position appears stronger, and why.

EA15. 5.3 Using the following account balances, calculate:

A. working capital
B. current ratio

B
Exercise Set B
EB1. 5.1 Identify whether each of the following accounts are nominal/temporary or real/permanent.
A. Rent Expense
B. Unearned Service Fee Revenue
C. Interest Revenue
D. Accounts Payable

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Chapter 5 Completing the Accounting Cycle 345

EB2. 5.1 For each of the following accounts, identify whether it is nominal/temporary or real/permanent,
and whether it is reported on the Balance Sheet or the Income Statement.
A. Salaries Payable
B. Sales Revenue
C. Salaries Expense
D. Prepaid Insurance

EB3. 5.1 For each of the following accounts, identify whether it would be closed at year-end (yes or no) and
on which financial statement the account would be reported (Balance Sheet, Income Statement, or Retained
Earnings Statement).
A. Retained Earnings
B. Prepaid Rent
C. Rent Expense
D. Rent Revenue
E. Salaries Expense
F. Salaries Payable
G. Supplies Expense
H. Unearned Rent Revenue

EB4. 5.1 The following accounts and normal balances existed at year-end. Make the four journal entries
required to close the books:

EB5. 5.1 The following accounts and normal balances existed at year-end. Make the four journal entries
required to close the books:

EB6. 5.1 Use the following excerpts from the year-end Adjusted Trial Balance to prepare the four journal
entries required to close the books:
346 Chapter 5 Completing the Accounting Cycle

EB7. 5.1 Use the following T-accounts to prepare the four journal entries required to close the books:

EB8. 5.1 Use the following T-accounts to prepare the four journal entries required to close the books:

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Chapter 5 Completing the Accounting Cycle 347

EB9. 5.2 Identify which of the following accounts would be listed on the company’s Post-Closing Trial
Balance.
A. Accounts Receivable
B. Accumulated Depreciation
C. Cash
D. Office Expense
E. Note Payable
F. Rent Revenue
G. Retained Earnings
H. Unearned Rent Revenue

EB10. 5.2 Identify which of the following accounts would not be listed on the company’s Post-Closing Trial
Balance.

EB11. 5.3 For each of the following accounts, identify in which section of the classified balance sheet it
would be presented: current assets, property, intangibles, other assets, current liabilities, long-term liabilities,
or stockholder’s equity.
A. Building
B. Cash
C. Common Stock
D. Copyright
E. Prepaid Advertising
F. Notes Payable (due six months later)
G. Taxes Payable
H. Unearned Rent Revenue

EB12. 5.3 Using the following Balance Sheet summary information, calculate for the two years presented:
A. working capital
B. current ratio
348 Chapter 5 Completing the Accounting Cycle

EB13. 5.3 Using the following account balances, calculate for the two years presented:
A. working capital
B. current ratio

EB14. 5.3 Using the following Balance Sheet summary information, calculate for the two companies
presented:
A. working capital
B. current ratio

Then:

A. evaluate which company’s liquidity position appears stronger, and why.

EB15. 5.3 From the following Company B adjusted trial balance, prepare simple financial statements, as
follows:

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Chapter 5 Completing the Accounting Cycle 349

Problem Set A
PA1. 5.1 Identify whether each of the following accounts would be considered a permanent account (yes/
no) and which financial statement it would be reported on (Balance Sheet, Income Statement, or Retained
Earnings Statement).
A. Accumulated Depreciation
B. Buildings
C. Depreciation Expense
D. Equipment
E. Fees Earned Revenue
F. Insurance Expense
G. Prepaid Insurance
H. Supplies Expense
I. Dividends

PA2. 5.1 The following selected accounts and normal balances existed at year-end. Make the four journal
entries required to close the books:

PA3. 5.1 The following selected accounts and normal balances existed at year-end. Notice that expenses
exceed revenue in this period. Make the four journal entries required to close the books:
350 Chapter 5 Completing the Accounting Cycle

PA4. 5.1 Use the following Adjusted Trial Balance to prepare the four journal entries required to close the
books:

PA5. 5.1 Use the following Adjusted Trial Balance to prepare the four journal entries required to close the
books:

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Chapter 5 Completing the Accounting Cycle 351

PA6. 5.1 Use the following T-accounts to prepare the four journal entries required to close the books:

PA7. 5.1 Assume that the first two closing entries have been made and posted. Use the T-accounts
provided as follows to:
A. complete the closing entries
B. determine the ending balance in the Retained Earnings account
352 Chapter 5 Completing the Accounting Cycle

PA8. 5.1 Correct any obvious errors in the following closing entries by providing the four corrected closing
entries. Assume all accounts held normal account balances in the Adjusted Trial Balance.
A.

B.

C.

D.

PA9. 5.2 Assuming the following Adjusted Trial Balance, create the Post-Closing Trial Balance that would
result, after all closing journal entries were made and posted:

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Chapter 5 Completing the Accounting Cycle 353

PA10. 5.2 The following Post-Closing Trial Balance contains errors. Prepare a corrected Post-Closing Trial
Balance:

PA11. 5.2 Assuming the following Adjusted Trial Balance, recreate the Post-Closing Trial Balance that would
result after all closing journal entries were made and posted:

PA12. 5.3 Use the following Adjusted Trial Balance to prepare a classified Balance Sheet:
354 Chapter 5 Completing the Accounting Cycle

PA13. 5.3 Using the following Balance Sheet summary information, for the two years presented calculate:
A. working capital
B. current ratio

PA14. 5.3 Using the following Balance Sheet summary information, calculate for the two companies
presented:
A. working capital
B. current ratio

PA15. 5.3 Using the following account balances, calculate for the two years presented:
A. working capital
B. current ratio

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Chapter 5 Completing the Accounting Cycle 355

PA16. 5.4 From the following Company R adjusted trial balance, prepare the following:
A. Income Statement
B. Retained Earnings Statement
C. Balance Sheet (simple—unclassified)
D. Closing journal entries
E. Post-Closing Trial Balance

PA17. 5.4 From the following Company T adjusted trial balance, prepare the following:
A. Income Statement
B. Retained Earnings Statement
C. Balance Sheet (simple—unclassified)
D. Closing journal entries
E. Post-Closing Trial Balance
356 Chapter 5 Completing the Accounting Cycle

B
Problem Set B
PB1. 5.1 Identify whether each of the following accounts would be considered a permanent account (yes/
no) and which financial statement it would be reported on (Balance Sheet, Income Statement, or Retained
Earnings Statement).
A. Common Stock
B. Dividends
C. Dividends Payable
D. Equipment
E. Income Tax Expense
F. Income Tax Payable
G. Service Revenue
H. Unearned Service Revenue
I. Net Income

PB2. 5.1 The following selected accounts and normal balances existed at year-end. Make the four journal
entries required to close the books:

PB3. 5.1 The following selected accounts and normal balances existed at year-end. Notice that expenses
exceed revenue in this period. Make the four journal entries required to close the books:

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Chapter 5 Completing the Accounting Cycle 357

PB4. 5.1 Use the following Adjusted Trial Balance to prepare the four journal entries required to close the
books:

PB5. 5.1 Use the following Adjusted Trial Balance to prepare the four journal entries required to close the
books:
358 Chapter 5 Completing the Accounting Cycle

PB6. 5.1 Use the following T-accounts to prepare the four journal entries required to close the books:

PB7. 5.1 Assume that the first two closing entries have been made and posted. Use the T-accounts
provided below to:
A. complete the closing entries
B. determine the ending balance in the Retained Earnings account

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Chapter 5 Completing the Accounting Cycle 359

PB8. 5.1 Correct any obvious errors in the following closing entries by providing the four corrected closing
entries. Assume all accounts held normal account balances in the Adjusted Trial Balance.
A.

B.

C.

D.

PB9. 5.2 Assuming the following Adjusted Trial Balance, create the Post-Closing Trial Balance that would
result after all closing journal entries were made and posted:
360 Chapter 5 Completing the Accounting Cycle

PB10. 5.2 The following Post-Closing Trial Balance contains errors. Prepare a corrected Post-Closing Trial
Balance:

PB11. 5.2 Assuming the following Adjusted Trial Balance, re-create the Post-Closing Trial Balance that
would result after all closing journal entries were made and posted:

PB12. 5.3 Use the following Adjusted Trial Balance to prepare a classified Balance Sheet:

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Chapter 5 Completing the Accounting Cycle 361

PB13. 5.3 Using the following Balance Sheet summary information, calculate for the two years presented:
A. working capital
B. current ratio

PB14. 5.3 Using the following Balance Sheet summary information, calculate for the two years presented:
A. working capital
B. current ratio

PB15. 5.3 Using the following account balances, calculate for the two years presented:
A. working capital
B. current ratio

PB16. 5.4 From the following Company S adjusted trial balance, prepare the following:
A. Income Statement
B. Retained Earnings Statement
C. Balance Sheet (simple—unclassified)
D. Closing journal entries
E. Post-Closing Trial Balance
362 Chapter 5 Completing the Accounting Cycle

Thought Provokers
TP1. 5.1 Assume you are the controller of a large corporation, and the chief executive officer (CEO) has
requested that you refrain from posting closing entries at 20X1 year-end, with the intention of combining the
two years’ profits in year 20X2, in an effort to make that year’s profits appear stronger.

Write a memo to the CEO, to offer your response to the request to skip the closing entries for year 20X1.

TP2. 5.1 Search the Securities and Exchange Commission website (https://www.sec.gov/edgar/
searchedgar/companysearch.html) and locate the latest Form 10-K for a company you would like to analyze.
Submit a short memo:
• State the name and ticker symbol of the company you have chosen.
• Review the company’s end-of-period Balance Sheet, Income Statement, and Statement of Retained
Earnings.
• Use the information in these financial statements to answer these questions:
A. If the company had used the income summary account for its closing entries, how much would
the company have credited the Income Summary account in the first closing entry?
B. How much would the company have debited the Income Summary account in the second
closing entry?

Provide the web link to the company’s Form 10-K, to allow accurate verification of your answers.

TP3. 5.1 Assume you are a senior accountant and have been assigned the responsibility for making the
entries to close the books for the year. You have prepared the following four entries and presented them to
your boss, the chief financial officer of the company, along with the company CEO, in the weekly staff meeting:

As the CEO was reviewing your work, he asked the question, “What do these entries mean? Can we learn
anything about the company from reviewing them?”

Provide an explanation to give to the CEO about what the entries reveal about the company’s operations this
year.

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Chapter 5 Completing the Accounting Cycle 363

TP4. 5.2 Search the US Securities and Exchange Commission website (https://www.sec.gov/edgar/
searchedgar/companysearch.html) and locate the latest Form 10-K for a company you would like to analyze.
Submit a short memo:
• State the name and ticker symbol of the company you have chosen.
• Review the company’s Balance Sheets.
• Reconstruct a Post-Closing Trial Balance for the company from the information presented in the
financial statements.

Provide the web link to the company’s Form 10-K, to allow accurate verification of your answers.

TP5. 5.3 Search the Securities and Exchange Commission website (https://www.sec.gov/edgar/
searchedgar/companysearch.html) and locate the latest Form 10-K for a company you would like to analyze.
Submit a short memo:
• State the name and ticker symbol of the company you have chosen.
• Review the company’s end-of-period Balance Sheet for the most recent annual report.
• List the amount of Current Assets and Current Liabilities for the currently reported year, and for the
previous year. Use these amounts to calculate the company’s (A) working capital and (B) current ratio.

Provide the web link to the company’s Form 10-K, to allow accurate verification of your answers.