Principles of Accounting I
CHAPTER 4: COMPLETING THE ACCOUNTING
CYCLE
Chapter 3 2
Learning Objectives
• LO1: Describe the flow of accounting information from the unadjusted trial
balance into the adjusted trial balance and financial statements.
• LO2: Prepare financial statements from adjusted account balances.
• LO3: Prepare closing entries.
• LO4: Describe the accounting cycle.
• LO5: Illustrate the accounting cycle for one period.
• LO6: Explain what is meant by the fiscal year and the natural business year.
• LO7: Describe and illustrate the use of working capital and the current ratio
in evaluating a company’s financial condition.
Flow of Accounting Information
End-of-Period Spreadsheet (Work Sheet)
Unadjusted Adjusted
Trial Balance Adjustments Trial Balance
Accounts Dr Cr Dr Cr Dr Cr
• Account balances are listed in the Unadjusted Trial Balance columns using
the ending balances found in the general ledger.
Flow of Accounting Information
End-of-Period Spreadsheet (Work Sheet)
Unadjusted Adjusted
Trial Balance Adjustments Trial Balance
Accounts Dr Cr Dr Cr Dr Cr
• Adjustments are entered here. Two possibilities:
– Deferrals – Existing balances are changed.
– Accruals – New information is entered
Flow of Accounting Information
End-of-Period Spreadsheet (Work Sheet)
Unadjusted Adjusted
Trial Balance Adjustments Trial Balance
Accounts Dr Cr Dr Cr Dr Cr
• Adjustments are added to or subtracted from the amounts in the
Unadjusted Trial Balance columns. Account balances are now adjusted.
Flow of Accounting Information
End-of-Period Spreadsheet (Work Sheet)
Adjusted Income Balance Sheet
Trial Balance Statement
Accounts Dr Cr Dr Cr Dr Cr
• Amounts for revenues and expenses in the Adjusted Trial Balance columns
are extended to the Income Statement columns.
Flow of Accounting Information
End-of-Period Spreadsheet (Work Sheet)
Adjusted Trial Income Balance Sheet
Balance Statement
Accounts Dr Cr Dr Cr Dr Cr
• The amounts for assets, liabilities, common stock, and dividends in the
Adjusted Trial Balance columns are extended to the Balance Sheet
columns.
End-of-Period Spreadsheet and Flow of Accounting Data
Accounting Cycle
• The steps in the accounting cycle are as follows:
– Step 1. Transactions are analyzed and recorded in the journal.
– Step 2. Transactions are posted to the ledger.
– Step 3. An unadjusted trial balance is prepared.
– Step 4. Adjustment data are assembled and analyzed.
– Step 5. An optional end-of-period spreadsheet is prepared.
– Step 6. Adjusting entries are journalized and posted to the ledger.
– Step 7. An adjusted trial balance is prepared.
– Step 8. Financial statements are prepared.
– Step 9. Closing entries are journalized and posted to the ledger.
– Step 10. A post-closing trial balance is prepared.
Permanent Accounts
• Accounts that are relatively permanent from year to year are called
permanent accounts or real accounts.
• The balances of these accounts are carried forward from year to year.
• This includes accounts reported on the balance sheet.
Temporary Accounts
• Accounts that report amounts for only one period are called temporary
accounts or nominal accounts.
• Temporary accounts are not carried forward from year to year because
they relate to only one period.
• This includes all accounts reported on the income statement as well as
the dividends account, which is reported on the retained earnings
statement.
Comparison
Permanent account Temporary account
Carried forward to the next period Not carried forward
Þ Transferring Þ Closing balance
Þ Closing of previous period = Þ Opening account = 0
Opening of current period
Balance Sheet Income statement
(Cash, Car, Account Receivable, (Fee earned, expenses, devidends)
Account Payable, so on)
Closing Entries
At the beginning of the next period, temporary accounts should have zero
balances. To achieve this, temporary account balances are transferred to
permanent accounts at the end of the accounting period. The entries that
transfer these balances are called closing entries.
Closing Entries
The closing process involves four steps:
1. Revenue account balances are transferred to an account called Income
Summary.
2. Expense account balances are transferred to an account called Income
Summary
3. The balance of Income Summary (net income or net loss) is transferred
to the Owner’s capital account.
4. The balance of the Owner’s drawing account is transferred to the
Owner’s capital account.
Financial Analysis and Interpretation:
Working Capital and Current Ratio
• The ability to convert assets into cash is called liquidity.
• The ability of a business to pay its debts is called solvency.
• Two financial measures for evaluating a business’s short-term liquidity and
solvency are working capital and the current ratio.
Working Capital = Current Assets – Current Liabilities
Current Assets
Current Ratio
Current Liabilities
=
• A positive working capital implies that the business is able to pay its
current liabilities and is solvent.
Financial Analysis and Interpretation:
Working Capital and Current Ratio
Working Capital and Current Ratio
Current assets and current liabilities for Fortson Company follow:
a. Determine the working capital and current ratio for 2016 and 2015.
b. Does the change in the current ratio from 2015 to 2016 indicate a
favorable or an unfavorable trend?