Introduction to Financial Accounting
Completing the Accounting Cycle (Chapter 4)
February 20th, 2013
by Professor Victoria Chiu
The lecture begins with an overview of the accounting cycle. We start with the beginning account balances and analyze / journalize transactions as they happen, posting them to T-accounts. We also enter the trial balance and complete the worksheet and use it to prepare the financial statements. Lastly, we journalize closing entries before preparing the post-closing trial balance.
The closing of accounts occurs at the end of every period. In this process, we zero out revenue, expenses, and dividends accounts - essentially, we close out all temporary accounts. Note that the term "zero-ing" out does NOT mean we make the accounts equal to zero. Rather, we transfer their balances to retained earnings. It gets our accounts ready for the next period, updating retained earnings to the proper ending balance (since it wasn't up to date until then).
Temporary accounts are closed at the end of the period (revenues, expenses, dividends) and begins the next period with a zero-balance. Permanent accounts are not closed at the end of the period (assets, liabilities, common stock, retained earnings), and the ending balance transfers over to the next period.
The closing process consists of four steps: (1) Close revenues (debit) to income summary (credit). (2) Close expenses (credit) to income summary (debit). (3) Close income summary (debit) to retained earnings (credit). (4) Close dividends (credit) into retained earnings (debit). The income summary account is best thought of as a temporary "holding tank" (opened and used solely for the closing of accounts) that shows the amount of net income / loss of the current period. Its balance is then transferred (closed) into the retained earnings account.
The post-closing trial balance is an optional step in the accounting cycle. It lists permanent accounts (no temporary accounts) after posting closing entries, no temporary accounts. It has the same accounts as those on the balance sheet.
Liquidity measures how quickly an asset can be turned into cash. Assets and liabilities are classified as either current or long-term to show their relative liquidity. The classified balance sheet lists assets based on their liquidity. For example, cash would be the most liquid since it is already cash. Accounts receivable would probably be the second most liquid item (sometimes considered a cash equivalent) since in many occasions, the money they are owed can be quickly collected.
Current assets will be converted into cash, sold, or used within the next 12 months (although in some cases, the business cycle for a given company may be longer than a year). Current assets would include cash, accounts receivable, supplies, prepaid expenses, and inventory.
Long-term assets can be used for more than a year and will not be converted to cash within the current year (or business cycle). This includes accounts such as land, building, furniture, equipment, and long-term investments. It should also be noted that accumulated depreciation is a long-term asset account as well given it represents the value that has been used up from plant assets (there is usually an accumulated depreciation account for each plant asset).
Current liabilities must be paid with cash (or cash equivalents / goods) within an operating cycle. This includes accounts payable, notes payable, salary payable, interest payable, and unearned revenue. Our internet, cell phone, electric, and water bills are all current liabilities since we have to pay for them on a monthly basis.
Long-term liabilities are not due within the current year or operating cycle. This includes notes payable (similar to accounts receivable except it has a maturity date over an entire year) and mortgages. For example, if you buy a car, you usually have to sign up for several years of car payments (assuming you don't purchase the car at once). This can be thought of as a long-term liability.
Current ratio and debt ratios are discussed last.
Video begins with review of previous lecture
(Steps in the Accounting Cycle)
Concept of Closing the Accounts: 5:40
Temporary and Permanent Accounts: 9:34
Process of Closing Accounts: 13:10
Demonstration of Closing Accounts: 23:44
Chart of the Four Step Closing Process: 27:50
Exercise E4-18 - (Preparing Closing Entries from a Partial Worksheet): 28:55
Post-Closing Trial Balance: 40:53
Current Assets: 44:30
Long-term Assets: 48:07
Current Liabilities: 52:13
Long-term Liabilities: 54:05
Classified Balance Sheet - Account Form: 55:39
Exercise S4-9 - (Classifying Assets & Liabilities as Current or Long-term): 57:42
Accounting Ratios: 1:02:48
Current Ratio: 1:04:34
Debt Ratio: 1:07:01
Exercise S4-11 - (Computing the Current and Debt Ratios): 1:10:24