Chapter 5: Completion of the Accounting Cycle for a Service Business

Objectives:

a. To provide reliable financial information about a business firm's economic

resources (assets) and obligations (liabilities).

b. To provide information about the company's earning potential

c. To provide accurate information about changes in resources and obligations

resulting from business activities.

d. To disclose the various accounting policies followed in preparing the financial

statements to its various user groups.

e. To the greatest extent possible, disclose other financial statement-related

information relevant to the users' needs.

Introduction

Financial statements are the result of the accounting process that reveals the
financial results of the specified period and the financial position as of date. It is the most
fundamental and formal annual report through which a company communicates financial
information to its various user groups.

Characteristics of Ideal Financial Statement

1. Relevancy

2. Reliability -

3. Understandability

4. Comparability

Importance of Financial Statement

1. Importance to Management

2. Importance to Creditors

1|Page
FUNDAMENTALS OF ACCOUNTING 1
 3. Importance to Bankers

4. Importance to Investors

5. Importance to Government

Limitation of Financial Statement

1. Provide only interim reports.

2. Aggregate information

3. No qualitative information

4. Personal biasness

5. Historical Cost

Components of Financial Statements

1. Statement of Financial Position or Balance Sheet

2. Statement of Financial Performance or Income Statement

3. Statement of Changes in Owner's Equity

4. Statement of Cash Flow

5. Notes to the Financial Statements

Preparation of Balance Sheet

a. Understand the basic idea of the balance sheet.

b. Determine the value of the assets.

c. Write all the information on the paper.

d. Determine the liabilities.

e. Make a record of the liabilities.

f. Subtract the liabilities from the assets.

2|Page
FUNDAMENTALS OF ACCOUNTING 1
 g. Expand on shareholder's Equity.

Formats of Balance Sheet

A horizontal balance sheet includes additional columns to present more information

about a company's assets, liabilities, and equity. This balance sheet format is laid out as
follows:

1. The first column lists all of the asset line items with ending balances.

2. The second column contains the numbers associated with those assets.

3. The third column lists all the liability line items and then the equity line
items for ending balances.

4. The fourth column states the numbers associated with these liabilities and
equity items.

The total for all the assets in the second column should match the total for all the
liabilities and equity items in the fourth column.

A vertical balance sheet is one in which the balance sheet presentation format
is a single column of numbers, starting with asset line items, then liability line items, and

3|Page
FUNDAMENTALS OF ACCOUNTING 1
finally shareholders' equity line items. Line items are presented in decreasing order of
liquidity within each of these categories. Thus, the presentation within the topmost block
of line items (for assets) begins with cash and usually ends with fixed assets (which are
much less liquid than cash) or goodwill. Similarly, the liabilities section begins with
accounts payable and usually ends with long-term debt for the same reason.

The intent of a vertical balance sheet is for the reader to make comparisons between the
numbers on the balance sheet for a single period.

Preparation of Income Statement

a. Start with net sales.

b. Less Cost of Goods Sold

c. Calculate Gross profit

d. List the Company's operating expenses.

4|Page
FUNDAMENTALS OF ACCOUNTING 1
 e. Find the Net Income

f. Write out Non-operating Expenses.

g. Layout the Income statement

Preparation in Changes in Owner's Equity

a. Net profit or loss during the accounting period attributes to shareholders.

b. Increase or decrease in share capital reserves.

c. Dividend payments to shareholders

d. Gains and losses recognized directly in equity.

5|Page
FUNDAMENTALS OF ACCOUNTING 1
Preparation of Cash Flow

a. Start cash flows statement from operating activities.

b. Calculate cash flow in the rest of the operations.

c. Calculate cash flows from investing activities.

d. Calculate cash available from financing activities.

e. Layout, a statement of cash, flows from all the activities.

6|Page
FUNDAMENTALS OF ACCOUNTING 1
Notes to the Financial Statements

Financial statement notes are the supplemental notes that are added to the published
financial statements of a company. The notes are used to explain further the numbers
included in the financial statements and the accounting policies adopted by the company.
They help different users, such as financial analysts and investors, interpret all the
numbers added to the financial statements.

Also referred to as footnotes. These are an essential part of the financial

statements because they provide additional information about a company's operations
and financial position. The entire disclosure principle requires the notes.

Closing Entries

• These are end-of-period journal entries prepared to "empty" the temporary

accounts of their balances and prepare them for the next accounting period.

7|Page
FUNDAMENTALS OF ACCOUNTING 1
 • The Income and Expense Summary account is a sole proprietorship account used
to close temporary or nominal accounts.

• Temporary or nominal accounts have balances that relate to a specific accounting

period. These are revenue and expense accounts or income statement accounts.

• Preparation of closing entries is a required step in the accounting cycle. The

closing journal entries are posted so that all nominal accounts should have zero
balances at the start of the next accounting period.

Two Methods in Closing Accounts:

1. Direct Method. - The net income or loss and drawing accounts are closed directly
to the capital account using the direct method.

2. Indirect Method. - The net income or loss is transferred to the Drawing account,
then transferred to the Capital Account.

3.

Steps in the Closing Process (under the Indirect Method)

1. Debit all nominal accounts with credit balances and credit Income and Expense
Summary

2. Debit Income and Expense Summary and credit all nominal accounts with debit
balances.

3. Compute the balance of the Income and Expense Summary account (Step 1 and
2). Close its balance against the Drawing account.

4. Compute the updated balance of the Drawing account and close the amount
against the capital account.

5. Compute the balance of the Capital account and prepare Post-Closing Trial
Balance.

8|Page
FUNDAMENTALS OF ACCOUNTING 1
Post-Closing Trial Balance

a. It is a list of permanent accounts and their balances after posting the closing
entries.

b. Balances come from the ledger.

c. Total debits and credits must be equal.

d. Duplicate accounts as on the Balance Sheet

e. Revenues, expenses, and drawing accounts should NOT appear on Post-Closing

Trial Balance since they should have been closed.

9|Page
FUNDAMENTALS OF ACCOUNTING 1
Video Presentation

Please click the link below:

Preparing Financial Statements and Closing Accounts -

https://info.percipio.com/courses/2502e5b1-e4b1-11e6-a792-
0242c0a80b09/videos/57cdfac0-290d-11e7-b2c9-0242c0a80909

10 | P a g e
FUNDAMENTALS OF ACCOUNTING 1