The Accounting Process (So Far)

Ch. 5: Closing Process 1

Chapter 5

Closing Process

In this chapter you will see how accounting systems are organized to keep results of different accounting periods separate from one another. The process that produces financial statements relating to separate accounting periods is the closing process.

The Accounting Process (so far)

In the first four chapters, we saw the goal of a company's financial accounting system is to provide information about the company's resources and where they came from. The information is provided in the form of financial statements. To generate information for financial statements, accounting systems are organized around the accounting equation:

The equality of the accounting equation is constantly maintained through the debits equal credits process. In brief, in order to produce information for financial statements, accounting systems:

1.organize data to be reported by using a chart of accounts and a general ledger.

2.analyze business events, or transactions, and convert them into debits and credits through the preparation of journal entries. The journal entries are recorded in the general journal.

3.post the journal entries to the general ledger.

4.verify the data in the general ledger accounts will result in a balanced accounting equation through the preparation of a trial balance.

5.review data in the trial balance for reasonableness and prepare adjusting entries to correct any unreasonable account balances.

6.post the adjusting entries to the general ledger.

7.verify the data in the general ledger accounts will result in a balanced accounting equation through the preparation of an adjusted trial balance.

Once the adjusted trial balance is prepared, it is possible to produce reasonable financial statements from the adjusted trial balance data. The work in Chapter 4 resulted in the Parks Computer Service Corporation's September financial statements, presented again in Exhibits 5-1, 5-2, and 5-3.

From the Parks Computer Service Corporation's income statement we saw management used the company's resources in September to generate $1,705 of additional resources (net income). The income statement showed management brought in resources of $3,300 (fees revenue) and used $1,595 of resources (total operating expenses of $1,170 + income taxes expense of $425).

From the Parks Computer Service Corporation's statement of retained earnings we saw of the $1,705 resources generated through management operations in September (net income), $75 were distributed to the owner (dividends). By the end of September, the company retained in the business $2,530 of the resources generated through management operations in September and prior months.

The company's balance sheet showed on September 30 the company had resources (assets) of $13,295. $765 of resources were borrowed (liabilities). $10,000 of resources were invested by the owner (common stock). $2,530 of resources were generated through management operations and retained in the company (retained earnings).

Beginning a New Reporting Period

Closing fees revenue account Now that you are familiar with how the accounting system works to provide reasonable information in the form of financial statements, the next important question is: What happens when the company continues to operate in the next reporting period? For example, if the Parks Computer Service Corporation's September income statement showed management generated $3,300 of fees revenue in September, what happens when management services customers in October? Should the $3,300 fees revenue be carried over into October?

Examine the company's general ledger fees revenue account presented below. The $3,300 balance in the fees revenue account appeared on the company's September 30 adjusted trial balance and on the September income statement.

Consider what would happen if the company provided $4,250 of additional services to customers in October, prepared the proper journal entries, and posted them to the general ledger. The October 31 general ledger fees revenue account would appear as follows.

If the Parks Computer Service Corporation were to prepare a trial balance at the end of October, the fees revenue account balance would appear as a $7,550 credit balance. If this amount were to be used on the October income statement, it would suggest management had brought in resources of $7,550 by providing services to customers in October. A brief review of the general ledger fees revenue account, however, clearly shows $7,550 of resources were not brought in by management in October. In October, the company provided customer services of $4,250 ($600 on October 2, $1,200 on the 9th, $900 on the 17th, $1,100 on the 26th, and $450 on the 31st). $3,300 of the services recorded as fees revenue had been provided by management in September. Therefore, to report fees revenue of $7,550 on the October income statement would be unreasonable. In order for the more reasonable fees revenue amount of $4,250 to appear on the October income statement, the $3,300 of September's fees revenue must be removed from the fees revenue account. This is accomplished as part of the closing process. The journal entry required to prevent September's $3,300 of fees revenue from appearing in the October fees revenue account is as follows.

Several points should be noted in the above journal entry. First, the entry was recorded at the end of September. Business is an ongoing process: once one period is over, another begins immediately. In order to properly account for this continuous process, once the financial statements for a period are prepared, closing entries for the period can be immediately prepared to eliminate that period’s effects from the general ledger accounts. As a result, in a new reporting period the accounts will reflect only the activities of the new period.

A second point to note in the journal entry is the fees revenue account was debited for $3,300. This debit is required because the fees revenue account had a $3,300 credit balance on September 30 before the closing entry was made. To eliminate or reduce a credit balance, a debit is required.

The third point to note is the credit to a new account, income summary. Remember, net income is calculated as the difference between revenues and expenses. One of the results of the closing process is net income briefly appears in an account called income summary.

If the above entry to close the fees revenue account had been recorded in the general journal and posted to the general ledger in September, the fees revenue account at the end of October would have appeared as follows.

As you can see in the general ledger, when the proper journal entry was prepared and posted to close the fees revenue account at the end of September, by the end of October the only amounts in the fees revenue account were those that resulted from October transactions. The September 30 closing entry eliminated all September fees revenue results. Thus, when the October income statement is prepared, only the $4,250 of fees revenue reported in October will appear as October fees revenue. In such a way, the closing process keeps the results of different periods separate from one another: September’s fees revenue does not appear on October’s income statement. As you probably suspect, at the end of October the fees revenue account will again be closed so the results of October's events will not appear as part of fees revenue reported in the November income statement.

A final point to note about the September 30 closing of the fees revenue account is total resources and total sources of resources did not change as a result of the closing entry. Both the fees revenue account and the income summary account are part of stockholders' equity. Thus, the closing entry decreased and then increased sources of resources by the same dollar amount, $3,300. This is reasonable because the company did not receive or use up any resources simply by transferring dollar amounts from one stockholders' equity account to another.

Closing supplies expense account Similar to the preceding discussion of fees revenue, consider the supplies expense to be reported on the Parks Computer Service Corporation’s October income statement. At the end of September, the company’s supplies account and supplies expense account in the general ledger were as follows.

Suppose the Parks Computer Service Corporation did not purchase any additional supplies in October and a review of supplies at the end of October revealed only $200 of supplies were on hand. Since the general ledger supplies account reports $320 of supplies, but only $200 were still on hand at the end of October, $120 of supplies must have been used in October ($320 - $200 = $120). The adjusting entry to properly record the October supplies expense is as follows.

After the supplies adjusting entry was posted to the general ledger, the supplies and supplies expense accounts appear as follows.

If the Parks Computer Service Corporation were to prepare a trial balance at the end of October, the supplies account balance would appear as a $200 debit balance and the supplies expense account would show as a $290 debit balance.

Remember, the October 31 examination of supplies revealed $200 of supplies were on hand. Thus, the supplies account $200 debit balance in the general ledger on October 31 is reasonable. It would be reasonable for this $200 to appear as an asset on the company’s October 31 balance sheet.

However, what about the $290 debit balance in the supplies expense account on October 31? The October 31 examination of supplies revealed $120 of supplies had been used in October, not $290. Thus, October’s income statement should report a supplies expense of $120, not $290. An examination of the supplies expense account in the general ledger shows of the $290 balance in the account, only $120 related to October, while the other $170 related to September’s operations. Clearly, reporting supplies expense of $290 on October’s income statement would be unreasonable.

In order for the more reasonable supplies expense amount of $120 to appear on the October income statement, the $170 of September's supplies expense must be removed from the supplies expense account. This is accomplished as part of the closing process. The journal entry required to prevent September's supplies expense from appearing in the October supplies expense account is as follows.

Several points should be noted in the above journal entry. First, the entry was recorded at the end of September. In order to properly account for the continuous business process, once the financial statements for a period are prepared, closing entries for the period can be immediately prepared to eliminate that period’s effects from the general ledger accounts.

A second point to note in the journal entry is the supplies expense account was credited for $170. This credit was required because the supplies expense account had a $170 debit balance on September 30 before the entry was made. To eliminate or reduce a debit balance, a credit is required.

The third point to note is the debit to the account, income summary. Remember, net income is calculated as the difference between revenues and expenses. One of the results of the closing process is net income briefly appears in an account called income summary.

If the above entry to close the supplies expense account had been recorded in the general journal and posted to the general ledger in September, the supplies expense account at the end of October would have appeared as follows.

As you can see in the general ledger, when the proper journal entry was prepared and posted to close the supplies expense account at the end of September, by the end of October the only amount in the supplies expense account resulted from October transactions. The closing entry eliminated all September supplies expense results. Thus, when the October income statement is prepared, only the $120 of supplies used in October will appear as October supplies expense. In such a way, the closing process keeps the results of different periods separate from one another: September’s supplies expense does not appear on October’s income statement. At the end of October the supplies expense account will again be closed so the results of October events will not appear as part of supplies expense reported in the November income statement.

As was the case with the closing of the fees revenue account, the closing of the supplies expense account did not change total resources and total sources of resources. Both the supplies expense account and the income summary account are part of stockholders' equity. Thus, the closing entry decreased and then increased sources of resources by the same dollar amount, $170. This is reasonable because the company did not receive or use up any resources simply by transferring dollar amounts from one stockholders' equity account to another.

Closing other expense accounts Similar to the preceding discussion of closing the supplies expense account at the end of a reporting period, all other expense accounts will be closed. In order to keep the September expenses separate from the October expenses, the Parks Computer Service Corporation would prepare the following entries to close its other expense accounts at the end of September. It is important to note that it is not necessary to close each expense account in a separate entry. In most accounting systems, all expenses are closed in one compound journal entry in which income summary is debited for the total of all expenses while individual expense accounts are credited for their separate amounts.

Closing income summary account Once the fees revenue account and all expense accounts are closed, their account balances are zero and the dollar amounts previously in them have been transferred to the income summary account. The Parks Computer Service Corporation’s income summary account would appear as follows after the September revenue and expense accounts closing entries were posted.

After all revenue and expense accounts have been closed and the dollar amounts posted to the income summary account, the balance in the income summary account is the net income of the Parks Computer Service Corporation for September. You can confirm this by comparing the $1,705 income summary balance to the $1,705 net income shown on the income statement in Exhibit 5-1. At this point it should be fairly clear how the income summary account got its name. The income summary account summarizes the company's revenues and expenses for a given time period. Since net income is calculated as the difference between revenues and expenses, income summary is a logical name for the account summarizing revenues and expenses.