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Financial Accounting Unit 4: Closing the Books and the Financial Statements

This unit finishes the accounting cycle: preparing the four financial statements, classifying the balance sheet, and closing temporary accounts so the next period starts fresh.

Covers: Preparing the financial statements, Classified balance sheet, Temporary and permanent accounts, Closing entries and Income Summary, Post-closing trial balance, The full accounting cycle, Working capital and current ratio

Study guide

After adjustments, the adjusted trial balance supplies every number needed for the statements, which are prepared in a set order. The income statement comes first: revenues minus expenses equals net income for the period. Net income flows into the statement of retained earnings: beginning retained earnings plus net income minus dividends equals ending retained earnings. Ending retained earnings then flows into the balance sheet, which lists assets, liabilities and equity at the period-end date. The statement of cash flows, covered later, explains the change in cash. This chain of links is called articulation, and it is why an error in one statement often shows up in another.

A classified balance sheet groups items to help users judge liquidity and solvency. Current assets, such as cash, short-term investments, receivables, inventory and prepaid expenses, are expected to be turned into cash or used up within one year or the operating cycle, whichever is longer. Long-term investments, property, plant and equipment (shown net of accumulated depreciation) and intangible assets such as patents follow. Current liabilities, including accounts payable, wages payable, unearned revenue, accrued interest and the current portion of long-term debt, are due within the same window; the rest of the debt is long-term. Stockholders' equity shows common stock and retained earnings.

Closing entries reset temporary accounts to zero so they can measure the next period. Revenues, expenses and dividends are temporary; balance sheet accounts are permanent and carry their balances forward. Many textbooks use four entries with an Income Summary account: debit revenues and credit Income Summary; debit Income Summary and credit each expense; close the Income Summary balance (net income or loss) to Retained Earnings; and debit Retained Earnings and credit Dividends. Some companies skip Income Summary and close revenues and expenses directly into Retained Earnings. Either way, dividends never pass through Income Summary, because they are not part of net income.

After closing, a post-closing trial balance lists only the permanent accounts and confirms debits still equal credits. The full accounting cycle is: analyze transactions, journalize, post, prepare a trial balance, adjust, prepare an adjusted trial balance, prepare statements, close, and prepare a post-closing trial balance. Some firms use a worksheet, a spreadsheet that organizes these steps, and some record reversing entries at the start of the next period to simplify accruals. When errors are discovered, correcting entries fix the accounts; the most efficient approach compares the wrong entry with the right one and records only the difference.

The classified balance sheet makes basic ratios possible. Working capital equals current assets minus current liabilities and measures the cushion available to pay short-term debts. The current ratio, current assets divided by current liabilities, expresses the same idea as a ratio; a value above 1 means current assets exceed current liabilities. Transactions affect these measures differently. Paying a payable with cash leaves working capital unchanged but raises a current ratio that is above 1. Buying inventory on credit adds equal amounts to both sides and pulls the ratio toward 1. Debt ratios, covered later, use total liabilities to judge long-term solvency.

Key ideas

• Statements are prepared in order: income statement, retained earnings statement, balance sheet.
• Revenues, expenses and dividends are temporary accounts closed at period end; balance sheet accounts are permanent.
• Closing transfers net income and dividends into Retained Earnings.
• Dividends close directly to Retained Earnings and never go through Income Summary.
• Current items are those expected within one year or the operating cycle, whichever is longer.
• The post-closing trial balance contains only permanent accounts.
• Working capital and the current ratio measure short-term liquidity.

Formulas and rules

Common mistakes

• Closing dividends into Income Summary, which wrongly treats them as an expense.
• Putting beginning instead of ending retained earnings on the balance sheet.
• Listing the full balance of a long-term note as long-term, ignoring the current portion.
• Treating Accumulated Depreciation as temporary and closing it.
• Assuming any transaction that keeps working capital constant also keeps the current ratio constant.

Before the test, make sure you can

• Prepare an income statement, retained earnings statement and balance sheet from an adjusted trial balance.
• Classify accounts into current assets, long-term assets, current liabilities, long-term liabilities and equity.
• Identify temporary and permanent accounts.
• Journalize closing entries with and without an Income Summary account.
• Solve for missing revenues, net income or dividends from retained earnings changes.
• Calculate working capital and the current ratio and predict how transactions change them.
• List the steps of the accounting cycle in order.

Words to know

Income statement

Reports revenues, expenses and net income or loss for a period of time.

Statement of retained earnings

Shows beginning retained earnings, plus net income, minus dividends, equals ending retained earnings.

Balance sheet

Reports assets, liabilities and stockholders' equity at a specific date.

Classified balance sheet

A balance sheet that groups items into categories such as current assets, PP&E and current liabilities.

Current assets

Assets expected to be converted to cash or used within one year or the operating cycle, whichever is longer.

Current liabilities

Obligations expected to be paid within one year or the operating cycle, whichever is longer.

Operating cycle

The average time to spend cash on inventory or services, sell, and collect cash from customers.

Temporary accounts

Revenue, expense and dividend accounts that are closed to zero at the end of each period.

Permanent accounts

Balance sheet accounts whose balances carry forward to the next period.

Closing entries

Entries that transfer temporary account balances into Retained Earnings at period end.

Income Summary

A temporary clearing account used during closing; its balance equals net income or net loss.

Post-closing trial balance

A trial balance prepared after closing that lists only permanent accounts.

Working capital

Current assets minus current liabilities.

Current ratio

Current assets divided by current liabilities, a measure of short-term liquidity.

Current portion of long-term debt

The part of a long-term obligation due within the next year, reported as a current liability.

Correcting entry

An entry made to fix an error found in previously recorded transactions.

Reversing entry

An optional entry at the start of a period that reverses an accrual adjustment to simplify later recording.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.