As previously stated, revenues increase owner’s equity, and expenses and withdrawals by the owner decrease owner’s equity. Ifthe only financial statement that we needed . was a balance sheet, these changes in owner’s’ equity could be recorded directly in the owner’s capital account. However, owners, managers, investors, and others need to know

amounts of specific revenues .and expenses, and the amount of net income earned in the period. Therefore, we maintain separate ledger accounts to measure each type of revenue and expense, and the owner’s drawings.

The revenue, expense, and drawing accounts are called temporary accounts, or nominal accounts, because they accumulate the transactions of only one accounting period. At the end of this accounting period, the changes in owner’s equity accumulated in these temporary accounts are transferred into the owner’s capital account. This process serves two purposes. First, it updates the balance of the owner’s capital account for changes in owner’s equity occurring during the accounting period; Second, it returns.the balances of the temporary accounts to zero, so that they are ready for measuring the revenue, expenses, and drawings of the next accounting period.

The owner’s capital account and other balance sheet accounts are called permanent or real accounts, because their balances continue to exist beyond the current accounting period. The process of transferring the balances of the temporary accounts into the owner’s capital account is called closing the accounts. 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 a summary account called Income Summary. When the credit balances of the revenue accounts and the debit balances of the expense accounts have been transferred into one summary account, the balance of this Income Summary  will be the net income or net 10$sfor the period. If the revenue (credit balances) exceeds the expenses (debit balances), the Income Summary .account will have a credit balance representing net income. Conversely, if expenses exceed revenue, the Income Summary will have a debit balance representing net loss. This is consistent with the rule that increases in owner’s equity are recorded by credits and decreases are recorde d by debits.’ . It is common practice to close the accounts only once a year, but for illustration, we will demonstrate the closing of the accounts of Overnight Auto Service at December 31 after only one month of business operations .

Closing Entries for Revenue Accounts

Revenue accounts have credit balances. Therefore, closing a revenue account means tr8DstelTingitS 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; the credit portion transfers the former balance of the revenue account into the Income Summary account. The only revenue account of Overnight Auto Service is Repair Service Revenue, which had a credit balance of $10,380 at December 31. The closing entry is as follows

Closing nwenue account

Closing nwenue account

Closing the Income Summary Account

The live expense accounts have now been closed, and the total amount of $6,480 formerly contained in these accounts appears in the debit column of the Income Summary account. The revenue of $10,380 earned during December appearsin the credit column of the Income Summary account. Since the credit entry of $10,380 representing December revenue is larger than the debit of $6,480 representing December expenses, the account has a credit balance of $3,900-the net income for December , The net income of $3.900 earned during December causes the owner’s equity to increase. The credit balance of the Income Summary account is. therefore, transferred to the owner’s equity account by the following closing entry

Net income increases the owner's equity

Net income increases the owner’s equity

After this closing entry has been posted, the Income Summary account has a zero balance, and the net income for December will appear as an increase or credit entry in the owner’s capital account, as shown on the following page

Closing the Owner’s Drawing Account

As explained earlier in this chapter, withdrawals of cash or other assets by the owner arc not considered an expense of the business and, therefore. arc not a factor in determining the net income for the period. Since drawings by the owner do not constitute an expense, the owner’s drawing account is closed not into the Income Summary account hut directly to the owner’s capital account. The following journal entry serves to close (he drawing account in the ledger of Overnight Auto Service at December 31:

T account

T account

After-Closing Trial Balance

After the revenue and expense accounts have been closed. it is desirable to prepare an after-closing trial balance. which will consist of balance sheet accounts only. There is always the possibility that an error in posting the closing entries may have upset the’ equality of debits and credits in the ledger. The-after-closing trial balance is prepared from the ledger. It gives assurance that tile accounts are in balance and ready for the recording of the transactions of the new accounting period. The after-closing trial balance of Overnight Auto Service follows:

Only the balance sheet accounts remain open

Only the balance sheet accounts remain open


The Accounting Cycle in Perspective

terms, concepts, processes, and reports. This is why we introduce it early in the course. But, please, do not confuse familiarity with this sequence of procedures with a knowledge of ‘accounting. The accounting cycle is but one accounting process-s-and a relatively simple one at that. Computers have freed accountant’> today to focus upon the more analytical aspects of their discipline. These include, for exam

• Determining the information needs of decision makers.
•Designing systems to provide the information quickly and efficiently.
•Evaluating the efficiency of operations throughout the organization.
• Assisting decision makers in interp~eting accounting information.
• Auditing (confirming. the reliability ofaccounting information).
• Forecasting the probable results of future operations.
•Tax planning

We will emphasize such topics in our remaining chapters,

But Jet us first repeat a very basic point from Chapter I: The need for some familiarity with accounting concepts and processes is not limited to individuals ‘planning carecrs in accounting. Today, an understanding of accounting information and of the business world go hand in hand. You cannot know much about one without understanding quite a bit about the other.




Posted on November 21, 2015 in The Accounting Cycle Capturing Economic Events

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