5.5: 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 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.

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