Chapter 5

The
Accounting
Cycle:
Reporting
Financial
Results

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 Adjusted Trial Balance
From the adjusted trial balance, we can
prepare the following:
1. Income statement
2. Statement of retained earnings
3. Balance sheet

KEY POINT
At this time, we are not including the statement of cash flows, as an
in-depth discussion of the statement of cash flows is the primary focus
of Chapter 13.

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Adjusted Trial Balance Example

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Income Statement
1. The income statement is prepared first because
it determines the amount of net income to be
reported in the statement of retained earnings.
2. Alternative titles for the income statement
include:
a. Earnings statement
b. Statement of operations
c. Profit and loss statement (P&L)

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Income Statement (concluded)
3. The income statement summarizes operating
results by matching revenue earned with the
expenses incurred to generate the revenue.
4. Limitations of the income statement:
a. Accounting estimates and assumptions.
b. Only reports those events which have been
evidenced by actual business transactions.

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Income Statement Example

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Statement of Retained Earnings
1. Retained earnings is that portion of
stockholders’ (owners’) equity created by
earning net income and retaining the related
resources in the business.
2. The statement of retained earnings summarizes
the increases and decreases in retained
earnings resulting from business operations
during the period.
a. Increases result from earning net income.
b. Decreases result from net losses and the
declaration of dividends.

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Computing Retained Earnings
The following formula is used to compute
Retained Earnings at the end of an accounting
period:

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Statement of Retained Earnings
Example

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Balance Sheet
1. The balance sheet lists:
a. Assets
b. Liabilities
c. Owners’ equity (also called stockholders’
equity)
2. May be presented with assets on the left side
and liabilities and equity on the right side.
3. May also be presented in report form with
assets at the top and liabilities and equity
below.

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Balance Sheet Example

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Classified Balance Sheet
1. A classified balance sheet provides separate
totals for assets and liabilities considered to be
current.
2. Current assets include:
a. Cash.
b. Assets capable of being converted to cash
within a short time (usually one year).
c. Assets that will be used up within a short
time (i.e. prepaid expenses).

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Classified Balance Sheet (concluded)
3. Current liabilities include:
a. Debt that a company expects to satisfy
relatively soon using current assets.
b. Unearned revenue.

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Relationship among Financial
Statements
The relationship among the financial statements is
emphasized by the arrows in the right-hand
margin of Exhibit 5–2 in the textbook.
 Net income from the income statement is used
to compute the ending retained earnings
balance.
 The ending retained earnings balance is used
in the equity section of the balance sheet.

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Drafting Financial Statement Notes
1. The principle of adequate disclosure means that
financial statements should be accompanied by any
information necessary for the statements to be
interpreted properly.
2. Most disclosures appear within the many pages of
notes that follow the financial statements.
3. Drafting the notes is a challenging task as it requires
an in-depth understanding of the company and its
operations, of accounting principles, and of how
accounting information is interpreted by users of
financial statements.

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Content of Notes
1. The first financial statement footnote typically
details a company’s significant accounting
methods and policies.
2. There is no comprehensive list of all
information that should be disclosed in
financial statements. The adequacy of
disclosure is based on a combination of
a. Official rules
b. Tradition
c. Accountant’s professional judgment

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Common Disclosures
As a general rule, a company should disclose any facts that
an informed user would consider necessary for the
statements to be interpreted properly. Thus, businesses
often disclose such things as:
 Lawsuits pending against the business.
 Scheduled plant closings.
 Significant events occurring after the balance sheet date
but before the financial statements are actually issued.
 Customers that account for 10 percent or more of the
company’s revenues.
 Unusual transactions or conflicts of interest between the
company and its key officers.
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Temporary Accounts
Temporary Accounts
Also called nominal accounts.
Accumulate the transactions of only one
accounting period.
Balances are transferred to retained earnings at
the end of the accounting period.
Includes revenue, expenses, and dividend
accounts.
Balance at the beginning of the next accounting
period should be zero.

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Permanent Accounts
Permanent Accounts
Also called real accounts.
Balances continue to exist beyond the current
accounting period.
Includes asset, liability, and equity accounts.

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Closing Process
Transferring the balances of the temporary
accounts into the Retained Earnings account is
called the closing process.
The journal entries made for the purpose of
closing the temporary accounts are called
closing entries.
Revenue and expense accounts are closed at the
end of each accounting period by transferring
their balances to an account called the Income
Summary.

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Income Summary
After the credit balances of the revenue accounts
and the debit balances of the expense accounts
have all been transferred to the Income
Summary account, its balance will be the net
income or net loss for the period.
If revenues (credit balances) exceed expenses
(debit balances), the Income Summary account
will have a credit balance representing net
income.

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Income Summary (cont.)
Ifexpenses exceed revenues, the Income
Summary account will have a debit balance
representing a net loss.
This is consistent with the rule that increases in
owners’ equity are recorded by credits and
decreases are recorded by debits.

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Closing Entries
Closing entries are usually made once per year
and include the following steps:
1. Closing all revenue accounts to the Income
Summary.
2. Closing all expense accounts to the Income
Summary.
3. Closing the Income Summary to Retained
Earnings.
4. Closing the Dividends account to Retained
Earnings.

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Closing Revenue Accounts
Closing a revenue account means transferring its
credit balance to the Income Summary account.
This transfer is accomplished by a journal entry
debiting the revenue account in an amount equal
to its credit balance, with an offsetting credit to
the Income Summary account.
The debit portion of this closing entry returns
the balance of the revenue account to zero.

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Closing Revenue: Example
Overnight uses two revenue accounts: (1) Repair Service Revenue,
which had a credit balance of $172,000 at December 31, 2018, and
(2) Rent Revenue Earned, which had a credit balance of $3,000 at
December 31, 2018. Two separate journal entries could be made to
close these accounts, but the use of one compound journal entry is
an easier, time-saving method of closing more than one account.

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Revenue Account Balances
After this closing entry has been posted, the two revenue accounts
each have zero balances, whereas Income Summary has a credit
balance of $175,000.

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Closing Expense Accounts
Closing an expense account means transferring
its debit balance to the Income Summary
account.
The journal entry to close an expense, therefore,
consists of a credit to the expense account in an
amount equal to its debit balance, with an
offsetting debit to the Income Summary
account.
The credit portion of this closing entry returns
the balance of the expense account to zero.

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Closing Expenses: Example
There are nine expense accounts in Overnight’s ledger (see the
adjusted trial balance in Exhibit 5–1). Again, a compound journal
entry is used to close each of these accounts.

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Expense and Income Summary
Account Balances
After this closing entry has been posted, the Income Summary account
has a credit balance of $39,942 ($175,000 credit posted minus the
$135,058 debit posted), and the nine expense accounts each have zero
balances.

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Closing the Income Summary
The net income of $39,942 earned during the year causes an increase
in Overnight’s owners’ equity. Thus, the $39,942 credit balance of the
Income Summary account is transferred to the Retained Earnings
account by the closing entry.

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Income Summary Balance
After this closing entry has been posted, the Income Summary account
has a zero balance, and the net income for the year ended December
31, 2018, appears as an increase (or credit entry) in the Retained
Earnings account.

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Closing the Dividends Account
Dividends to stockholders are not considered an expense of the
business; therefore, they are not taken into account in determining
net income for the period. Since dividends are not an expense, the
Dividends account is not closed to the Income Summary account.
Instead, it is closed directly to the Retained Earnings account.

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Retained Earnings Balance
After this closing entry has been posted, the Dividends account will
have a zero balance, and the Retained Earnings account will have an
ending credit balance of $25,942.

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Summary of the Closing Process
In summary, the closing process involves four simple
steps.
1. Closing the various revenue accounts and transferring
their balances to the Income Summary account.
2. Closing the various expense accounts and transferring
their balances to the Income Summary account.
3. Closing the Income Summary account and transferring
its balance to the Retained Earnings account.
4. Closing the Dividends account and transferring its
balance to the Retained Earnings account.

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Flowchart of the Closing Process

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After-Closing Trial Balance

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Interim Financial Statements
Interim Financial Statements:
◦ Cover a time period other than the company’s
fiscal year.
◦ May be prepared monthly, quarterly, or on a
year-to-date basis.
◦ Can be prepared using a company’s adjusted
trial balance.

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Accounting Cycle Summary
We have now completed the entire accounting cycle, the
eight steps of which include:
1. Journalize (record) transactions. Enter all transactions
in the journal, thus creating a chronological record of
events.
2. Post to ledger accounts. Post debits and credits from
the journal to the proper ledger accounts, thus creating
a record classified by accounts.
3. Prepare a trial balance. Prove the equality of debits
and credits in the ledger.
4. Make end-of-period adjustments. Make adjusting
entries in the general journal and post to ledger
accounts.
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Accounting Cycle Summary (cont.)
5. Prepare an adjusted trial balance. Prove again the
equality of debits and credits in the ledger. (Note:
These are the amounts used in the preparation of
financial statements.)
6. Prepare financial statements and appropriate
disclosures. An income statement shows the results of
operation for the period. A statement of retained
earnings shows changes in retained earnings during
the period. A balance sheet shows the financial
position of the business at the end of the period.
Financial statements should be accompanied by notes
disclosing facts necessary for the proper interpretation
of those statements.
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Accounting Cycle Summary
(concluded)
7. Journalize and post the closing entries. The closing
entries “zero” the revenue, expense, and dividends
accounts, making them ready for recording the events
of the next accounting period. These entries also bring
the balance in the Retained Earnings account up-to-
date.
8. Prepare an after-closing trial balance. This step
ensures that the ledger remains in balance after the
posting of the closing entries.

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Benefits of Using Computer Software
When using computerized accounting
software:
Accountants only enter the adjustments.
The system automatically computes
totals.
The system can generate a worksheet
and/or trial balance.

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Learning Objective Summary LO5-1
LO5-1: Prepare an income statement, a statement of retained
earnings, and a balance sheet. The financial statements are
prepared directly from the adjusted trial balance. The income
statement is prepared by reporting all revenue earned during the
period, less all expenses incurred in generating the related
revenue. The retained earnings statement reports any increase to
Retained Earnings resulting from net income earned for the
period, as well as any decreases to Retained Earnings resulting
from dividends declared or a net loss incurred for the period. The
balance sheet reveals the company’s financial position by
reporting its economic resources (assets) and the claims against
those resources (liabilities and owners’ equity).

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Learning Objective Summary LO5-3
LO5-3: Explain the concept of adequate disclosure. Adequate
disclosure is the generally accepted accounting principle that
financial statements should include any information that an
informed user needs to interpret the statements properly. The
appropriate disclosures usually are contained in several pages of
notes that accompany the statements.

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End of Chapter 5

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