CHAPTER 5

ACCOUNTING CYCLE OF A SERVICE PROVIDER:

Closing Entries, Post-Closing Trial Balance
and Reversing Entries

Learning Outcomes

After reading this chapter, the learners should be able to

1. Explain the relevance of closing the books;

2. Record closing entries;
3. Prepare post-closing trial balance;
4. Explain the importance of reversing entries; and
5. Prepare reversing entries.

CLOSING ENTRIES

In the previous chapter, we discussed that accounts are classified

into two: real accounts and nominal accounts. Per definition, real
accounts are the accounts that are not closed or “zeroed in” at the end of
the accounting period and their balances are carried over to the next
accounting period and become the beginning balances. On the other hand,
nominal accounts are accounts that are closed every year. Meaning, their
balances are “zeroed in” or “reset” at the end of the period.

The process if “zeroing in” or “resetting” the balances of the

nominal accounts, specifically the income expense accounts and the
drawing account, is called “closing procedure”. The nominal accounts are
closed by transferring their balances to the capital account. The entry that
records the transfer of nominal accounts is called closing entry.
Chapter 5 – Accounting Cycle of Service Provider

Income and expense accounts are not directly closed to the capital
account. They are first closed a summary account called income
summary. The steps followed in closing the nominal accounts are the
following:

1. Close the income accounts to income summary. To close the

income accounts, the accounts are debited since the normal balance of
income accounts is credit.
2. Close the expense accounts to income summary. To close the
expense accounts, the accounts are credited since the normal balance
of expense accounts is debit.
3. Close the income summary account to the capital account. If the
working balance of the income summary account is credit, it means
that the total income is higher than the total expense. Hence, the
closing entry is to debit the income summary account. If the working
balance of the income summary account is debit, it means that the
total expense is higher than the total income. Hence, the closing entry
is to credit the income summary account.
4. Close the drawing account to the capital account. The normal
balance of drawing account is debit, hence it is closed by a credit.

The pro-forma of the closing entries are as follows:

To close the income accounts To close the expense accounts

Service income xx Income summary xx

Income summary xx Expenses xx

To close the income summary account To close the drawing account

Income summary xx Owner's drawing xx

Owner's capital xx Owner's capital xx

or
Owner's capital xx
Income summary xx

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Continuing the illustration in Chapter 4 for Iladia Vedasto

Appraisers, Inc., the closing entries are prepared as follows:

Service income 830,000

Income summary 830,000

Income summary 467,300

Interest expense 3,000
Advertising expense 20,000
Salaries expense 180,000
Lease expense 80,000
Insurance expense – equipment 40,000

Utilities expense 49,000

Impairment loss 4,500
Supplies expense 3,800
Depreciation expense 90,000

Vedasto, Capital 4,000

Vedasto, Drawing 4,000

Income summary 359,700

Vedasto, Capital 359,700

POST-CLOSING TRIAL BALANCE

The last step in the accounting cycle is the preparation of post-

closing trial balance. Post-closing trial balance presents the list of all
accounts and their balances after all the closing entries have been
journalized and posted. Therefore, only real accounts are included in the
post-closing trial balance since the nominal accounts were already closed.

Using the illustration for Iladia Vedasto Appraisers, Inc.,, the post-
closing trial balance at December 31, 2018 will appear as follows:

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Chapter 5 – Accounting Cycle of Service Provider

Iladia Vedasto Appraisers, Inc.

Post-Closing Trial Balance
December 31, 2018

Cash 300,000
Accounts receivable 125,000
Allowance for impairment loss 12,500
Prepaid advertising 10,000
Prepaid lease 40,000
Prepaid insurance 20,000
Office supplies 1,200
Equipment 900,000
Accumulated depreciation - equipment 270,000
Accounts payable 80,000
Interest payable 3,000
Utilities payable 4,000
Unearned service income 80,000
Notes payable 200,000
Vedastor, Capital 746,700
Totals 1,396,200 1,396,200

Notice that only real accounts are included in the post-

closing trial balance. Another thing that you should notice is that the totals
of the debit and credit columns are not the same with the total assets and
total liabilities and equity in the statement of financial position. This is
because post-closing trial balance are prepared using the normal balances
of the accounts. Whereas the statement of financial position is prepared
using the groupings of the elements (assets, liabilities and equity). In the
statement of financial position, allowance for impairment loss and
accumulated depreciation are reported as contra-asset accounts in the asset

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section. In the post-closing trial balance, these accounts are included in the
credit columns.
REVERSING ENTRIES

Reversing entries are so called because they reverse the adjusting

entries made at end of the accounting period to facilitate the recording of
the journal entries in the following accounting period. For example, the
adjusting entry pertaining to accrued expense at the end of the accounting
period means there is an unpaid expense. In the following accounting
period, the entry to record the total payment, including the unpaid expense
in the prior year, is simplified if the adjusting entry in the prior year is
reversed in the following year before the entry for the payment is
recorded. Reversing entries are recorded on the first day of the accounting
year.

To illustrate, let us use the adjusting entry made in the records of

Iladia Vedasto Appraisers, Inc. to accrue interest (adjusting entry “e”).

Without reversing entry With reversing entry

To accrue interest 2
0
Interest expense 3,000 Interest expense 3,000 1
Interest payable 3,000 Interest payable 3,000 8

To reverse accrual entry

Interest payable 3,000
none
Interest expense 3,000 2
0
Payment of interest on due date 1
9
Interest expense 3,000 Interest expense 12,000
Interest payable 9,000 Cash 12,000
Cash 12000

Notice that the journal entry to record the payment of interest in

2019 is a lot easier and simpler because the determination of cash payment
is straight-forward, that is, for a total of 12 months or one year, although

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Chapter 5 – Accounting Cycle of Service Provider

the interest incurred in the year of payment is only for nine months
(January 2019 to September 2019).
Another illustration: Let us use the transaction Iladia Vedasto Appraisers,
Inc. affecting the advertising expense.
Asset method - without reversing entry Asset method - with reversing entry

Payment of advertising
Advertising expense 30,000 Prepaid advertising 30,000
2
Cash 30,000 Cash 30,000
0
1
Adjusting entry 8
Prepaid advertising 10,000 Advertising expense 20,000
Advertising expense 10,000 Prepaid advertising 20,000

Reversing entry
Prepaid advertising 20,000
2
Advertising expense 20,000
0
1
Expiration of the prepaid amount 9
Advertising expense 30,000 Advertising expense 20,000
Prepaid advertising 30,000 Prepaid advertising 20,000

As you can notice, if a reversing entry is made at the start of 2019,

there is no need to prepare an entry to show that the prepaid insurance
expired after one month because the reversing entry already showed that
the prepaid advertising has expired already (the account is credited) with
the recognition of the related insurance expense (the account is debited).

Which adjusting entries are to be reversed?

Take note that not all adjusting entries are to be reversed on day
one of the accounting year. Only the following adjusting entries need
reversing entries:

1. accrued income;
2. accrued expense
3. deferred income using the income method; and
4. deferred expense using the expense method.

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Adjusting entries for deferred expense using the asset method and
deferral income using the liability method need not be reversed because it
will result to misstated opening balances of the related asset and liability
accounts.

Using the information above, assuming Iladia Vedasto Appraisers,

Inc. used the asset method in recording prepaid advertising, the journal
entries are the following:

Asset method - without reversing entry Asset method - with reversing entry

Payment of advertising
Advertising expense 30,000 Prepaid advertising 30,000
2
Cash 30,000 Cash 30,000
0
1
Adjusting entry 8
Prepaid advertising 10,000 Advertising expense 20,000
Advertising expense 10,000 Prepaid advertising 20,000

Reversing entry
Prepaid advertising 20,000
2
Advertising expense 20,000
0
1
Expiration of the prepaid amount 9
Advertising expense 30,000 Advertising expense 20,000
Prepaid advertising 30,000 Prepaid advertising 20,000

Notice that the reversing entry resulted to recognition of prepaid

adverting of P20,000 at the start of the accounting year. This amount is
overstated by P10,000 because the correct amount of prepayment is only
P10,000 (January 2019). Additionally, the entry made on the expiration of
the prepaid amount is erroneous because it showed a P20,000 insurance
expense when the correct amount of expense is only P10,000.