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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CHAPTER 15 - CLOSING THE BOOKS
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
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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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