Chapter 15

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Chapter 15 Closing the Books

CHAPTER 15 - CLOSING THE BOOKS

Closing the Books X X X X

Closing Entries Net Income Summary Year-End Trial Balance Year-End Summary

Closing Entries Throughout a year in business you will maintain the books and use the information from the financial statements to measure the state of the business. At the end of an accounting period (in this case one year) you must complete the full year accounting cycle. What you are doing is finalizing the financial statements so that you can measure the business activities for the period. In order to close the books for this accounting period, you must perform certain functions. Each function is designed to clear out revenue, expense and withdrawal accounts (known as temporary accounts) to start a fresh accounting period. Since the income statement reports net income (profit or loss) for a single accounting period (shows revenue less expenses for that period only) you need to begin the next accounting period with zero balances. REMINDER NOTE: The account balances on the Balance Sheet are PERMANENT. This means that Balance Sheet accounts (Assets, Liabilities, Owner’s Equity) are ongoing, with the closing balances at the end of one accounting period carried forward to the next accounting period. The account balances on the Income Statement are TEMPORARY. This means that Income Statement accounts (revenue and expenses) accumulate throughout the accounting period but are cleared at the end of the period. The accounts are cleared using closing entries.

Once the income statement has been finalized at the end of the accounting period (the year) a new accounting period starts. First the balances from the income statement accounts (revenue and expenses) which have accumulated for the entire period are transferred to Owner's Equity. The profit (or loss) made in this accounting period now belongs to the owner of the business. The income statement will then start fresh for the new accounting period. All of the revenue and expenses of a business actually belong to the owner. The owner has the benefit of the revenue and is responsible for the expenses. When the revenue and expense accounts are closed for the year, it is confirmation that a review of the accounts is complete and the amounts are ready to transfer to the Owner’s Equity account. In order to do this, there is one temporary step: transfer all of the account balances to a Net Income Summary account and then transfer the balance of this account to Owner’s Equity.

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The reason for this temporary Net Income Summary account is so that you can easily identify how much was added to Owner’s Equity during the year by the profits the business generated. (Distinguishing between any increase in Owner’s Equity from money put in the business versus an increase from profits.) This is an optional step in closing the books - it is not mandatory. This summary is simply a very efficient method of identifying how much of the increase in Owner’s Equity was due to profits. The first step is to enter the year-to-date amount of the revenue or expense account as a minus item on each account (clear the accounts) and put the same amount as a plus item on the Owner’s Equity account. You are then ready to start seeing what income is being generated for the next accounting period (for the next year). The steps to take in clearing out the revenue and expense accounts are as follows: 1.

Close the Revenue accounts - transfer to the Net Income Summary account

2.

Close the Expense accounts - transfer to the Net Income Summary account

3.

Close the Income Summary account to Owner’s Equity account

4.

Close the Drawings account to Owner’s Equity account

Steps 1 to 3 are performed in order to determine the profit (or loss) generated for the year to be transferred (or given) to the owner - who may now either leave it in the business or take it out of the business for personal use. Step 4 simply recognizes the amounts withdrawn during the year, which also reduces the equity in the business.

Net Income Summary In order to move the revenue and expense accounts to Owner’s Equity and find out what the profit or loss is, as part of the process, accountants use a “net income summary”. (This account may also be called a “profit & loss account”, an “income summary”, etc. The name of the account may be different, depending on the preference of the person setting up the account, but the principle remains the same.) The balances of the revenue accounts (credit balances) are moved to the net income summary and placed in the CREDIT column. The balances of the expense accounts (debit balances) are moved to the net income summary and placed in the DEBIT column. At this point, the balance in the net income summary tells you whether you have a profit or a loss. A credit balance means that there were more revenues than expenses - a profit. A debit balance in the account means that there was a loss. After you verify that the profit or loss amount is correct, you can then move the total balance from the net income summary account to Owner’s Equity.

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The following is an illustrative example of the steps to closing the books. There are 15 expense accounts (which will have a debit balance at the end of the period) and 6 revenue accounts (which will have a credit balance at the end of the period). These need to have a zero balance in preparation for the next accounting period. You therefore need to credit all expense accounts and debit all revenue accounts (bringing them to zero). Note: We are only using a few accounts for the purpose of this illustration:

Step 2 - Close EXPENSE accounts EXPENSE Accounts

Debit

Opening Balance

8,700

Advertising Bad Debts Insurance

Credit

REVENUE Accounts

Debit

Opening Balance 6,800 500 1,400

Total Closing Balance

Step 1 - Close REVENUE accounts

26,575

Membership sales - A/R 25,900 Revenue - drop-off centre 500 Interest earned 175

8,700 0

Total

26,575

Closing Balance

NET INCOME SUMMARY 8,700

26,575

17,875

Step 3 - Close Net Income Summary OWNER'S EQUITY

WITHDRAWALS 6,000

Step 4 - Close Withdrawals

6,000

17,875

On the next few pages we will take you through the steps one at a time.

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CHAPTER 15 - CLOSING THE BOOKS

The Year-End Trial Balance Throughout the accounting period (the year) you complete financial statements at the end of each month in order to determine the profit (loss) each month. At the end of the accounting period, you must use the cumulative totals for the entire year. (Remember that the Balance Sheet is a permanent, ongoing record so the totals at year-end are the totals on December 31st.) The year-end Trial Balance is as follows: TRIAL BALANCE AS AT DECEMBER 31, 20XX #

ACCOUNT TITLES

101 Cash

DEBIT

CREDIT

10,603

105 Accounts Receivable 110 Prepaid Expenses 120 Fixed Assets - Equipment

7,100 3,624 25,188

200 Accounts Payable

2,620

205 Unearned Revenue

6,500

210 Bank Loan

0

215 Equipment Loan

5,500

300 Capital Account

8,000

305 Owner’s Investment

5,000

310 Owner’s Drawings

138,700

405 Revenue - Interest on Savings

175

410 Revenue - Discounts Received

18

500 Advertising

opening Owner’s Equity amount at January 1st

32,232

400 Revenue - Membership Sales

6,800

505 Bad Debts

500

510 Insurance

1,400

515 Maintenance

4,900

520 Miscellaneous

cumulative balances to December 31st

410

525 Office Supplies

1,030

530 Professional Fees

2,800

535 Rent

13,800

540 Salaries & Bonuses

46,400

541 Salary Benefits

1,000

545 Telephone

1,160

550 Travel

1,800

555 Depreciation

3,280

560 Interest & Bank Charges 565 Loss on disposal of equipment Totals

balances at December 31st

954 1,532 166,513 166,513

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CHAPTER 15 - CLOSING THE BOOKS

Step 1: Close the Revenue Accounts Use the general journal to close the revenue accounts. Revenue accounts are normally credit balances. When you close the revenue accounts, you want to make the balance in each revenue account zero. In order to do that, you need to debit the revenue accounts. The corresponding credit is made to the net income summary account. TRIAL BALANCE AS AT DECEMBER 31, 20XX #

ACCOUNT TITLES

101 Cash

DEBIT

105 Accounts Receivable

7,100

110 Prepaid Expenses

3,624

120 Fixed Assets - Equipment

GENERAL JOURNAL - CLOSING REVENUE ACCOUNTS

25,188

200 Accounts Payable

2,620

205 Unearned Revenue

6,500

210 Bank Loan

0

215 Equipment Loan

5,500

300 Capital Account

8,000

305 Owner’s Investment

5,000

310 Owner’s Drawings

175

410 Revenue - Discounts Received

18

500

510 Insurance

1,400

515 Maintenance

4,900 410

525 Office Supplies

1,030

530 Professional Fees

2,800

535 Rent

13,800

540 Salaries & Bonuses

46,400

541 Salary Benefits

1,000

545 Telephone

1,160

550 Travel

1,800

555 Depreciation

3,280

560 Interest & Bank Charges 565 Loss on disposal of equipment Totals

Dec 31 Revenue - Membership Sales Revenue - Interest on Savings Revenue - Discounts Received Net Income Summary To close the revenue accounts

J13

GL NO.

DEBIT

400 405 410 315

138,700 175 18

6,800

505 Bad Debts

520 Miscellaneous

ACCOUNT TITLE AND EXPLANATION

138,700

405 Revenue - Interest on Savings

500 Advertising

DATE: 20XX

32,232

400 Revenue - Membership Sales

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CREDIT

10,603

Income Summary 138,893

954 1,532 166,513 166,513

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CREDIT

138,893

CHAPTER 15 - CLOSING THE BOOKS

Step 2: Close the Expense Accounts In a fashion similar to closing the temporary revenue accounts, you also need to close the expense accounts. Since expense accounts are normally debit balances, you need to credit the expense accounts in order to reduce them to a zero balance. The corresponding entry is a debit to the summary. TRIAL BALANCE AS AT DECEMBER 31, 20XX #

ACCOUNT TITLES

DEBIT

101 Cash

CREDIT

10,603

105 Accounts Receivable

7,100

110 Prepaid Expenses

3,624

120 Fixed Assets - Equipment

GENERAL JOURNAL - CLOSING EXPENSE ACCOUNTS DATE: 20XX

25,188

200 Accounts Payable

2,620

205 Unearned Revenue

6,500

210 Bank Loan

0

215 Equipment Loan

5,500

300 Capital Account

8,000

305 Owner’s Investment

5,000

310 Owner’s Drawings

32,232

400 Revenue - Membership Sales

138,700

405 Revenue - Interest on Savings

175

410 Revenue - Discounts Received

18

500 Advertising

6,800

505 Bad Debts

500

510 Insurance

1,400

515 Maintenance

4,900

520 Miscellaneous

GL NO.

DEBIT

315 500 505 510 515 520 525 530 535 540 541 545 550 555 560 565

87,766

Dec 31 Net Income Summary Advertising Bad Debts Insurance Maintenance Miscellaneous Office Supplies Professional Fees Rent Salaries & Bonuses Salary Benefits Telephone Travel Depreciation Interest & Bank Charges Loss on disposal of equipment To close the expense accounts

CREDIT

6,800 500 1,400 4,900 410 1,030 2,800 13,800 46,400 1,000 1,160 1,800 3,280 954 1,532

410

525 Office Supplies

1,030

530 Professional Fees

2,800

535 Rent

13,800

540 Salaries & Bonuses

46,400

541 Salary Benefits

1,000

545 Telephone

1,160

550 Travel

1,800

555 Depreciation

3,280

560 Interest & Bank Charges 565 Loss on disposal of equipment Totals

ACCOUNT TITLE AND EXPLANATION

J13

954 1,532

Net Income Summary 87,766

138,893

166,513 166,513

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Step 3: Close the Income Summary account to Owner’s Capital account You will now move the net income for the year to Owner’s Equity because these funds belong to the owner. The funds have not been put directly to Owner’s Equity during the year in order to monitor how the business was doing. Once you have finalized the business activities for the year, you can move these funds to the place they really belong - the Owner’s Equity account - and you can start monitoring the detailed operations for the next year on a fresh income statement (starting with zero balances). In order to make this transfer, you will close the net income summary account by recording the journal entry that reduces the balance of the Income Summary to a zero balance. Check first, however, to make sure that the balance of the Income Summary agrees with your income statement from January 1st to December 31st. Income Summary

GENERAL JOURNAL - CLOSING INCOME SUMMARY ACCOUNT

87,766

DATE: 20XX

138,893

ACCOUNT TITLE AND EXPLANATION

GL NO. DEBIT

December 31 Income summary Capital Account To close income summary account

51,127

J13

315 300

51,127

CREDIT

51,127

Capital Account 51,127

Step 4: Close the Drawings Account The final step in the closing process is to close the Drawings account. The Drawings account, like revenue and expenses, is a temporary account used so that you can conveniently see withdrawals by the owner during the year. GENERAL JOURNAL - CLOSING DRAWINGS ACCOUNT TRIAL BALANCE AS AT DECEMBER 31, 20XX

#

ACCOUNT TITLES

101 Cash

DEBIT 10,603

105 Accounts Receivable

7,100

110 Prepaid Expenses

3,624

120 Fixed Assets - Equipment

ACCOUNT TITLE AND EXPLANATION

GL NO.

DEBIT

300 310

32,232

25,188 2,620

205 Unearned Revenue

6,500

Capital Account

0

215 Equipment Loan

5,500

300 Capital Account

36,692

305 Owner’s Investment 310 Owner’s Drawings

DATE: 20XX

Dec 31 Capital Account Owner’s Drawings To close drawings account

200 Accounts Payable 210 Bank Loan

378

CREDIT

J13

32,232

5,000 32,232

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CREDIT

32,232

CHAPTER 15 - CLOSING THE BOOKS

The completed General Journal is as follows: GENERAL JOURNAL DATE: 20XX

GL NO.

DEBIT

Revenue - Membership Sales Interest on Savings Discounts Received Net Income Summary To close the revenue accounts

400 405 410 315

138,700 175 18

December 31

Net Income Summary Advertising Bad Debts Insurance Maintenance Miscellaneous Office Supplies Professional Fees Rent Salaries & Bonuses Salary Benefits Telephone Travel Depreciation Interest & Bank Charges Loss on disposal of equipment To close the expense accounts

315 500 505 510 515 520 525 530 535 540 541 545 550 555 560 565

87,766

December 31

Net Income Summary Capital Account To close the Income Summary account

315 300

51,127

December 31

Capital Account Owner’s Drawings To close the drawings account

300 310

32,232

December 31

Capital Account Owner’s Investment To close the investment account

300 305

5,000

December 31

ACCOUNT TITLE AND EXPLANATION

J13 CREDIT

138,893

6,800 500 1,400 4,900 410 1,030 2,800 13,800 46,400 1,000 1,160 1,800 3,280 954 1,532

51,127

32,232

5,000

For this particular Chart of Accounts, the Owner’s Investment for the year is recorded in account 305 in order to highlight the amount for management purposes. Not all charts of account will include an account like this. If this is the case, the investment would be recorded directly in the Owner’s Equity account.

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The following is an example of what your ledgers (the accounts) will look like upon closing. We have selected only four accounts to use as a demonstration:

ACCOUNT:

Capital Account

DATE 20XX

DESCRIPTION

NO. REF.

DEBIT

BALANCE (DR OR CR)

CREDIT

OPENING BALANCE Dec 31 Closing income summary

J13

Dec 31 Closing drawings account

J13

ACCOUNT:

51 1 32 2

3

7

2

DESCRIPTION

REF.

DEBIT

0

CR

59

1

2

7

CR

26

8 9

5

CR

138 8 9 3

Dec 31 Closingexpense accounts

J13

87 7

6 6

Dec 31 Closing income summary

J13

51

2

1

138 8 9 51

1

2

7

3

CR

7

CR

0

Revenue - Membership Sales

DATE 20XX

DESCRIPTION

NO. REF.

DEBIT

138 7 J13

138 7

0

0 0

0

CR

0

Rent

NO. DESCRIPTION

REF.

DEBIT

13 J13

535

BALANCE (DR OR CR)

CREDIT

OPENING BALANCE Dec 31 Closing entry

400

BALANCE (DR OR CR)

CREDIT

OPENING BALANCE Dec 31 Closing entry

315

BALANCE (DR OR CR)

CREDIT

J13

DATE 20XX

0 0

NO.

Dec 31 Closing revenue account

ACCOUNT:

8

Income Summary Account

DATE 20XX

ACCOUNT:

2

300

8 0

13 8 0 0

0

DR

0

You would proceed to close EACH and EVERY revenue and expense account as shown above.

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Prepare a Post-Closing Trial Balance "Post" is a Latin word that means "after". So … a Post-closing trial balance is a trial balance that is prepared after the closing process has been completed. Since the closing process involves reducing all revenue to zero, reducing all expenses to zero, making the balance in the income summary account a zero balance, and eliminating the drawings account, what is left? Assets, Liabilities and Owners' Equity are the only accounts remaining. If you have correctly completed the closing process, your post closing trial balance will show only Assets, Liabilities and Owners' Equity.

POST-CLOSING TRIAL BALANCE AT JANUARY 1, 20XX ACCOUNT TITLES Cash Accounts Receivable Prepaid Expenses Fixed Assets - Equipment Accounts Payable Unearned Revenue Bank Loan Equipment Loan Owner’s Equity (including Owner’s Investment) Totals

DEBIT

CREDIT

10,603 7,100 3,624 25,188

46,515

2,620 6,500 0 5,500 31,895 46,515

Note: The balance in the Owner’s Equity account (Capital Account) is the opening balance at January 1st ($8,000 + Owner’s Investment of $5,000) less the total Drawings for the period ($32,232) plus the net income (profit) upon closing all accounts ($51,127): $13,000

Owner’s Investments

-

32,232

Drawings

+

51,127

Net Profit

$31,895

Closing Owner’s Equity

The post-closing trial balance is a snapshot of all of the Assets, Liabilities and Owner's Equity at the start of the first day of the next accounting period. You will note that on all the balance sheet accounts, the value on December 31st before closing and the value at January 1st after closing are identical. In other words, any assets or liabilities you owned or owed at midnight on December 31st would still be owned or owed by you at 12:01 a.m. on January 1st. The income statement accounts are all at zero as you are starting a new accounting year. All income and expenses on December 31st have been transferred to the Owner’s Equity account.

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CHAPTER 15 - CLOSING THE BOOKS

Year-End Summary Here is a summary of the steps to be taken in completing the accounting cycle:

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Exercises: Chapter 15

CHAPTER 15 - EXERCISES

Exercise #1 CLOSING THE BOOKS Please circle the correct answer. 1. In order to close the books you must clear out the following accounts (circle the correct accounts): a. Revenue b. Expense c. Asset d. Liability e. Withdrawal 2. Income statement accounts are temporary and are cleared out at the end of an accounting period. a. True b. False 3. What a. b. c.

is the “Net Income Summary” account used for? To identify the increase in Owner’s Equity due to profits. To record the balances of all balance sheet accounts. To summarize all the transactions for the past month.

4. The Net Income Summary account is optional when closing the books. a. True b. False 5. Which of the following procedures are required when closing the books at year end? a. Close the revenue accounts b. Close the expense accounts c. Close the income summary account to the owner’s capital account d. Close the drawings account 6. In order to clear the expense account (to bring the account to zero) the entry would (generally) be a: a. Debit b. Credit 7. The total of all expense accounts is recorded on the Net Income Summary as a: a. Debit b. Credit 8. The closing balance in the revenue account is (generally) a: a. Debit b. Credit

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CHAPTER 15 - EXERCISES

9. The total of the revenue account is recorded on the Net Income Summary as a: a. Debit b. Credit 10. Closing the books means: a. that you simply start a new year and write zero balances on all GL accounts b. that you simply close the books and open them again in the new year c. that the income statement starts again in the new year with zero balances 11. The term ‘fiscal year’ has the same meaning as a ‘calendar year’: a. True b. False 12. Different businesses may have different year ends. a. True b. False 13. The total annual profit is made up of the same profit amount each month. a. True b. False 14. Profits represent the same amount as cash in the bank at the end of the year. a. True b. False 15. What does "post" mean in the Latin Language? a. Mail letters b. Before c. After d. An amount of money that you owe 16. A Post-Closing Trial Balance is a trial balance that is prepared after the closing entries are prepared. a. True b. False 17. What is the purpose of a trial balance? a. To ensure that every debit has a corresponding credit b. To ensure that every debit has a corresponding debit c. To ensure that every credit has a corresponding credit d. To see if you made a profit e. To check if the balance sheet balances 18. If you have correctly completed the closing process, the trial balance will only show Assets, Liabilities and Equity, without Revenue and Expenses. a. True b. False

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