Chapter 4: Completing the Accounting Cycle

Preparing Financial Statements

Financial statements have vital importance for the companies. By analysing the financial statements, information users drill out information about the company according to their information needs. Therefore, information given in the financial statements must be relevant, faithfully representable, comparable, verifiable, timely and understandable.

At the end of the period, companies prepare financial statements for evaluating the financial performance. After the preparation of financial statements, there comes the final step of accounting cycle which is closing the accounts. This step is for preparing the accounts for the coming year.

Adjusted trial balance is one form of trial balance that holds in-term transactions’ totals and balances as well as the end of the period transactions’ totals and balances for final checking of the accounts and preparation of financial statements. Financial statements are prepared in order;

• Income statement
• Statement of owner’s equity
• Balance sheet

Income statement is the initial financial statement that is going to be prepared. Income Statement shows the profit or loss of the company. So, how does profit or loss occur? The positive difference between revenues and expenses give profit whereas the negative difference gives the loss. Profit and loss are the rights of the owners’; and therefore, they are reported in owner’s equity section in the balance sheet.

Statement of owner’s equity reports the changes in the capital throughout the period caused by the owner’s capital investments or withdrawals, net profit or loss. Balance sheet reports the assets, liabilities and the owner’s equity in a specific date.

Classified Balance Sheet

Classified balance sheet reports each asset, liability and owner’s equity in specific sections. There are five sections in the classified balance sheet. Assets are divided into two sections: current assets and non-current assets. Liabilities are also divided into two sections: current liabilities and non-current (long-term) liabilities. There is one more section in the classified balance sheet and, that is for the owner’s equity. Liquidity is the measure of how quickly and easily an account can be converted into cash.

Current assets include the assets that will be converted into cash, sold, consumed or received within 12 months or within the business’s operating cycle, and the cash and cash equivalents. Non-current assets include the assets acquired to be used in business ‘s operations for more than 12 months and receivables of which due dates are more than 12 months.

Companies have two finance sources for their assets. They are liabilities and owner’s equity. Sources are classified according to their maturity dates on the balance sheet: from short-term maturity dates to owner’s equity which has an indefinite maturity date. Liabilities are the existing debts of the company. They are classified as current liabilities and non-current liabilities. Current liabilities are the short term liabilities. It means that the company has to pay the liability either with cash of by handling goods or services within one year or in an operating cycle. Companies benefit from current liabilities for financing its current assets.

Owner’s equity is the owners’ claims on the assets. In the balance sheet, owner’s equity shows the owners’ investments, profit and loss of the period. Capital account shows the investments done to the company or drawings from the company by the owners.

Closing Process and Closing the Accounts

Owner’s equity shows the investments done by the owner/owners and the result of the operations of the company which is either profit or loss. Profit increases the owner’s equity whereas the loss decreases. If so, it is possible to record revenues into the credit side of the Capital account because revenues increase the claims of the owners on assets and also it is possible to record expenses into the debit side of the Capital account. Transferring the balances of the revenue and expense accounts to Income summary account, and transferring Income Summary account’s balance to Capital account are called the “Closing Entries”.

If the company has a profit at the end of the period, the credit balance of the Income Summary account is transferred to the credit side of Capital account, because profit increases the Capital. If there is a loss, the debit balance of the Income Summary account is transferred to the debit side of Capital account, because loss decreases the Capital.

Closing Entries for Revenue Accounts

Revenue accounts have credit balances or have no balances at the end of the term. In order to close revenue accounts, the revenue account must be debited with the same amount equal to its credit balance.

Closing Entries for Expense Accounts

Expense accounts have debit balances or have no balances at the end of the period. In order to close the expense accounts, the expense accounts must be credited with the same amount equal to its debit balance.

Closing The Income Summary Account

Now that the revenue accounts and expense accounts are closed and their balances were transferred to Income Summary account, the company may easily calculate its profit or loss. If credit side of Income Summary account which holds the totals for revenues is bigger than the debit side of the account that holds the totals for expenses, then profit will occur. If it is vice versa, loss occurs. Whether profit or loss occurs, the balance of the Income Summary account will be transferred to Capital account. Because both profit and loss are the rights of the owner/owners.

Post-Closing Trial Balance

After closing of revenue accounts, expense accounts and Income Summary account, it is time to prepare postclosing trial balance as the ending step in the accounting cycle. Post-closing trial balance shows the accounts with only balances. As the revenue accounts, expense accounts and Income Summary accounts were closed, it means that they have no balances. So, in the post-closing trial balance those type of accounts will not take place. Assets, liabilities and Capital accounts are the only accounts that have balances left at the end of the period.

Accounting Cycle

Accounting cycle can be defined as the process by which companies produce their financial statements for a specific period of time.

As briefly mentioned, accounting cycle includes three main stages of activities;

• beginning of the period activities
• during the period activities
• end of the period activities

Beginning of the period activities deal with the opening transactions of the company. After the closing entries done for the previous term, the accounts have to be opened for the new fiscal year. The opening of the accounts is based on the opening balance sheet which is also the closing balance sheet of the ended period.

During the period, the company makes tens of thousands of financial transactions. The company purchases raw materials, produces goods, sells them, pays for the vendors, collects receivables, and pays for labour, taxes, etc.

As the end of the period comes, adjusting entries are made to ensure the assets, liabilities and owner’s equity. After the adjustment transactions, adjusted trial balance is prepared, and financial statements are prepared afterwards.

• Let’s summarize the steps in accounting cycles briefly:
• Opening entries based on opening balance sheet
• Posting opening entries to ledger accounts
• Analysing and journalizing daily transactions
• Posting daily transactions to accounts
• Preparing monthly trial balances
• Preparing unadjusted trial balance at the end of the period
• Adjusting entries
• Preparing adjusted trial balance
• Preparing financial statements
• Closing entries
• Preparing post-closing trial balance.