Chapter 4: Completing the Accounting Cycle

Work sheet

This is a tool used by accountants to assist them in the preparation of the financial statements. Once the work sheet is completed the financial statements can be prepared.

Financial Statements

The financial statements include:

Income Statement: Report revenue and expenses here to determine net income or loss.

Revenue - Expenses = Net Income or Net Loss

Statement of Owner's Equity: This statement is prepared to show the changes in the owner's capital over a period of time. (Note: The net income from the income statement is listed here.)

Balance Sheet: This statement reflects the owner's assets, liabilities and owner's equity. It is prepared on a specific date.

Closing the Books

This is the end-of-period process of preparing the accounts for the next period's transactions. You close three different types of accounts:

These three accounts are sometimes referred to as temporary or nominal accounts. You will be transferring their balances into owner's equity through an account called Income Summary. This account is used in the closing process to transfer net income or net loss into Capital.

Closing involves four steps:

  1. Close Revenue accounts into Income Summary
  2. Close Expense accounts into Income Summary
  3. Close the Income Summary account into Capital
  4. Close the Withdrawals account into Capital

Hint: The Capital balance in the company's ledger must agree with the ending balance shown on the owner's equity statement and balance sheet. Do you remember the three items that affect the company's owner's equity?

Postclosing Trial Balance

This is a trial balance prepared after closing to prove the equality of the debits and credits in the general ledger. This trial balance will show assets, liabilities, and the Capital account. These accounts are called real, or permanent, accounts.

Revenue, expenses, and withdrawals will not be shown because they are temporary accounts. They have been closed.

Accounting Ratios

To measure a company's financial position, decision makers use ratios derived from the company's financial statements. Two common ones are:

The current ratio measures a company's ability to pay current liabilities. The formula is:

Current ratio =
Total current assets
  Total current liabilities

A higher number is preferred since it indicates more current assets to cover current liabilities.

The debt ratio measures overall ability to pay debts. The formula is:

Debt ratio =
Total liabilities
  Total assets

A lower number is better since low liabilities means low required payments.