Lecture: Completing the Accounting Cycle
Lecture script · about 15–20 minutes spoken · Week 5
Opening
Picture three people at the end of a stretch of work. One grooms dogs and has reached the end of the year with a drawer full of receipts. One runs a stall at a farmers' market and has finished a first season. And one is a founder of our bicycle shop, standing at the counter on the last day of Month 1. All three want the same things. How much did we earn? What do we own, and what do we owe? And how do we start the next stretch with a clean slate? This lecture answers all three for the shop.
Let me remind you where we are. In Week 2 you walked the shop's 12 Month 1 transactions through the accounting equation. In Week 3 you journalized and posted them and proved the unadjusted trial balance at $36,800 on each side. In Week 4 you made six adjusting entries and proved the adjusted trial balance at $37,650 on each side. Every balance is up to date now. But a trial balance is a list, not a report. A founder can't read it and see the month's profit.
Here's the plan. We'll take the three statements in their order: the income statement, the statement of retained earnings, and the balance sheet. We'll sort the balance sheet into groups. Then we'll sort the accounts into two kinds, close the books, check them one last time, and step back to see the whole cycle. Next week, in Merchandising Operations, the shop starts buying and reselling bicycles.
1. Why the statements come in order
Start with something from a kitchen. If you're building a layer cake, you bake the bottom layer before you stack the next one on it. You can't frost the top first, because there's nothing to hold it up. Each layer rests on the one below.
The financial statements work the same way. They're the reports a business prepares for outside readers from the adjusted trial balance, and they're prepared in order, because each one uses a figure from the one before it. The income statement comes first and finds net income. The statement of retained earnings takes that net income and finds ending retained earnings. The balance sheet takes that ending retained earnings and puts it in the equity section.
Here's how that plays out for the shop. The income statement will find $1,400 of net income. The statement of retained earnings will turn that into $900 of ending Retained Earnings. And the balance sheet will carry the $900 into stockholders' equity. Every other number comes straight off Week 4's adjusted trial balance.
Pause and try this. Why can't the shop prepare its balance sheet first, before the other two statements?
Think about which number the balance sheet is missing.
Here's the answer. The balance sheet needs the ending Retained Earnings of $900, and that figure doesn't exist until the income statement and the statement of retained earnings produce it. The adjusted trial balance shows no Retained Earnings balance at all, because the shop is brand new.
2. The income statement and net income
Now picture the dog groomer adding up a year of grooming fees, then subtracting the rent, the wages, and the shampoo. Whatever is left is the year's profit. That's the whole idea of an income statement.
The income statement reports a business's revenues and expenses for a period. When revenues are larger, the result is net income: a period's revenues minus its expenses. Net income is a measure of what the business earned, not the cash it has.
For the shop's Month 1, there's one revenue, Service Revenue, at $5,850. There are five expenses: Wages Expense at $2,000, Rent Expense at $1,500, Supplies Expense at $550, Insurance Expense at $200, and Depreciation Expense at $200. Together the expenses come to $4,450. Take $4,450 away from $5,850 and you get net income of $1,400.
In one plain sentence: the shop earned $1,400 in Month 1, because the repair work it did was worth more than the resources it used to do that work.
Pause and try this. The shop's Cash account holds $17,100. Its net income is $1,400. Does that mean the shop's work brought in $17,100 of cash this month?
Give yourself a moment on where the cash came from.
Here's the answer. No. Most of the $17,100 traces back to the founders' $30,000 investment, which is not revenue at all, and some of the $5,850 of revenue hasn't been collected yet. Net income answers "what did we earn?" and Cash answers "what's in the bank?"
3. The statement of retained earnings
Think about a savings jar on a kitchen shelf. It starts the month with some amount. The month's earnings go in. Anything handed out to the family comes out. What's left at the end depends on all three.
The statement of retained earnings shows how retained earnings changed during the period. It starts with the beginning balance, adds net income, and subtracts dividends. Retained earnings is the part of equity the business has earned and kept.
The shop is brand new, so its beginning Retained Earnings is $0. Add the $1,400 of net income. Subtract the $500 dividend the shop paid its owners on Day 30. The shop ends Month 1 with $900 of Retained Earnings.
Pause and try this. The $500 dividend reduces retained earnings, the same way an expense does. So why isn't it on the income statement?
Think about what a dividend helps the shop do.
Here's the answer. A dividend is a distribution to the owners, not an expense. It doesn't help the shop earn any revenue, so it stays off the income statement and appears here instead, on the statement of retained earnings.
4. The classified balance sheet
Picture the market stall again, at the end of its first season. The owner has cash in a lockbox, a booth fee paid ahead for next season, and a folding canopy that should last several seasons. There's a bill from a seed supplier due next month and a small loan due in three years. A banker wants those sorted by time: what turns into cash or comes due soon, and what stretches out over years.
That's a classified balance sheet: a balance sheet that sorts assets and liabilities into groups, separating current items from long-term ones. Current assets are cash and the items a business expects to turn into cash or use up within one year or the operating cycle. The operating cycle is the time it takes a business to spend cash on what it sells, sell it, and collect the cash from its customers. Property, plant, and equipment is the long-term group of assets a business uses for years. On the other side, current liabilities are the obligations due within one year or the operating cycle, and long-term liabilities are the ones due later.
Now the shop. Its current assets are Cash, Accounts Receivable, Supplies, and Prepaid Insurance, which add up to $20,700. Its property, plant, and equipment is the $12,000 of Equipment less $200 of Accumulated Depreciation, or $11,800. Total assets come to $32,500. Its current liabilities are Accounts Payable, Wages Payable, and Unearned Revenue, for $1,600. The shop has no long-term liabilities yet. Stockholders' equity is $30,000 of Common Stock plus the $900 of Retained Earnings, or $30,900. And $1,600 plus $30,900 is $32,500. The equation holds.
Pause and try this. Unearned Revenue has the word "revenue" in its name. Where does its $900 belong on the shop's classified balance sheet?
Picture what the shop still owes the cycling club.
Here's the answer. It's a current liability. The $900 is tune-ups the shop still owes the club, so it sits with Accounts Payable and Wages Payable, not with the revenues. And Accumulated Depreciation isn't a liability either; it's subtracted from Equipment.
5. Temporary and permanent accounts
Think about a car's dashboard. The odometer never resets. It carries the car's whole history. The trip meter measures one trip, and you reset it to zero before the next. Accounts come in those same two kinds.
Temporary accounts are the revenue, expense, and dividend accounts. They measure one period, and they're closed so that each starts the next period at zero. Permanent accounts are the asset, liability, and stockholders' equity accounts. Their balances carry forward from one period to the next, and they're never closed.
For the shop, the temporary accounts are Service Revenue, the five expenses, and Dividends. Everything else is permanent, including Retained Earnings and Accumulated Depreciation. Here's a pair worth slowing down on. Supplies is permanent: it's the $350 of supplies still on the shelf, ready for Month 2. Supplies Expense is temporary: it's the $550 used up in Month 1, and Month 2 has to measure its own use from zero.
Pause and try this. Is Dividends a temporary account or a permanent one?
Ask yourself whether it measures one period or carries a history.
Here's the answer. Dividends is temporary. It measures what the shop paid its owners in one period, so it starts each period at zero, even though it's tied to equity.
6. The closing entries
Back to the trip meter. Before the next trip, you write down how far you drove, and then you reset the meter to zero. Closing entries do both jobs at once.
Closing entries are the entries made at the end of a period that move the balances of the revenue, expense, and dividend accounts into Retained Earnings, leaving those accounts at zero. Many businesses close through Income Summary, a temporary account used only during closing. It receives the revenues and the expenses, holds the net income for a moment, and then passes it to Retained Earnings.
The shop makes four closing entries, and you close a balance by putting the same amount on its opposite side. First, debit Service Revenue $5,850 and credit Income Summary $5,850. Second, debit Income Summary $4,450 and credit each of the five expenses for its balance. Income Summary now holds a $1,400 credit, which is the net income. Third, debit Income Summary $1,400 and credit Retained Earnings $1,400, and Income Summary reads zero. Fourth, debit Retained Earnings $500 and credit Dividends $500. Retained Earnings ends at $900, the same figure the statement of retained earnings reported.
Pause and try this. In the fourth closing entry, why does Dividends go straight to Retained Earnings instead of through Income Summary?
Remember what Income Summary is holding.
Here's the answer. Income Summary holds the net income, and a dividend is not part of net income. Running Dividends through Income Summary would treat a distribution to owners like an expense. And notice what closing never touches: Cash, Equipment, and the other balance sheet accounts keep their balances.
7. The post-closing trial balance
A careful shop owner who has reset the register for the next morning still counts the drawer one last time before locking the door. You do the same after closing.
The post-closing trial balance is a list of the ledger's balances after the closing entries are posted, checking that total debits equal total credits. Only permanent accounts appear on it, because every temporary account now reads zero.
For the shop, the debits are Cash, Accounts Receivable, Supplies, Prepaid Insurance, and Equipment, and they total $32,700. The credits are Accumulated Depreciation, Accounts Payable, Wages Payable, Unearned Revenue, Common Stock, and Retained Earnings, and they also total $32,700. The books balance after closing.
Pause and try this. Total assets on the balance sheet are $32,500. Why is the post-closing trial balance $32,700 on each side instead?
Think about where Accumulated Depreciation sits in each one.
Here's the answer. On the balance sheet, the $200 of Accumulated Depreciation is subtracted from Equipment. On the trial balance, it sits in the credit column instead, so the debit column keeps the full $12,000 of Equipment. Add the $200 back to $32,500 and you get $32,700.
One honest warning carries over from Week 3. If you forgot the fourth closing entry, both columns would grow by the same $500 and still match. So a balanced post-closing trial balance proves the columns agree, not that every closing entry was made. Check that no revenue, expense, or dividend account is still on the list.
8. The whole accounting cycle
Think about a recipe you've made so often that you could do it without the card. The steps come in the same order every time, and each one gets the next one ready.
The accounting cycle is the steps an accountant performs each period, in order. Analyze transactions. Journalize. Post. Prepare a trial balance. Journalize and post adjusting entries. Prepare an adjusted trial balance. Prepare the financial statements. Journalize and post closing entries. And prepare a post-closing trial balance.
You've now done every step for the shop's Month 1. Week 2 analyzed the 12 transactions. Week 3 journalized, posted, and proved the trial balance at $36,800. Week 4 adjusted and proved $37,650. This week you prepared the statements, closed the books, and proved $32,700. Month 2 starts back at step one, with the permanent balances carried forward.
Pause and try this. Suppose someone made the closing entries before preparing the statements. What would the income statement show?
Think about what closing does to every revenue and expense account.
Here's the answer. It would show no revenue and no expenses, because closing sets every one of those accounts to zero. That's why the statements always come before the closing entries.
Closing
Let me pull it together in the order we built it. The statements come in order, because each one hands a figure to the next. The income statement found $1,400 of net income, and net income isn't cash. The statement of retained earnings added that $1,400 and took away the $500 dividend, for $900. The classified balance sheet sorted current from long-term and balanced at $32,500. Temporary accounts close; permanent accounts carry forward. Four closing entries moved the month into Retained Earnings through Income Summary, with Dividends going straight to Retained Earnings. The post-closing trial balance proved $32,700 on each side. And the accounting cycle took one month of the shop from its first transaction to closed books.
Next in this module, read the Readings & Resources page, then work the lecture tutorial and the practice set before the quiz, the discussion, and the assignment. Next week, in Merchandising Operations, the shop starts selling bicycles, and you'll meet cost of goods sold.
Built with The Course Maker · samples.thecoursemaker.com