Completing the Accounting Cycle

Learning objectives

After studying this chapter, you should be able to:

• Summarize the steps in the accounting cycle.
• Prepare a work sheet for a service company.
• Prepare an income statement, statement of retained earnings, and balance sheet using information contained in the work sheet.
• Prepare adjusting and closing entries using information contained in the work sheet.
• Prepare a post-closing trial balance.
• Describe the evolution of accounting systems.
• Prepare a classified balance sheet.
• Analyze and use the financial results – the current ratio.
  

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A career in information systems

Have you ever heard the sayings "knowledge is power" or "information is money"? When people talk about accounting, what they are really talking about is information. The information used by businesses, as well as the technology that supports that information, represents some of the most valuable assets for organizations around the world. Very often, the success of a business depends on effective creation, management, and use of information.

As companies become ever more reliant on technology, the need for well-educated Management Information Systems (MIS) auditors and control professionals increases. Improved technology has the potential to dramatically improve business organizations and practices, reduce costs and exploit new business and investment opportunities. At the same time, companies face constant challenges in selecting and implementing these new technologies. Because of their high value and inherent complexity, the development, support, and auditing of information systems has become one of the fastest growing specialties in accounting.

Graduates with special interests and skills in computing and technology have expansive opportunities. In addition to traditional accounting and auditing functions, MIS professionals perform evaluations of technologies and communications protocols involving electronic data interchange, client servers, local and wide area networks, data communications, telecommunications, and integrated voice/data/video systems. In public accounting, technology has impacted the auditing profession by extending the knowledge required to draw conclusions and the skills required to audit advanced accounting and information systems.

With management consulting practices growing and information systems becoming a larger percentage of public accounting revenue, MIS professionals are in high demand. If you are considering a degree in computer or information systems, you should consider the advantages that an accounting major or minor can give you in working closely with businesses and consulting firms. A dual major in accounting and MIS is one of the most desirable undergraduate degree combinations in the workforce. This chapter explains two new steps in the accounting cycle – the preparation of the work sheet and closing entries. In addition, we briefly discuss the evolution of accounting systems and present a classified balance sheet. This balance sheet format more closely resembles actual company balance sheets. After completing this chapter, you will understand how accounting begins with source documents that are evidence of a business entity's transactions and ends with financial statements that show the solvency and profitability of the entity.

The accounting cycle summarized

In Chapter 1, you learned that when an event is a measurable business transaction, you need adequate proof of this transaction. Then, you analyze the transaction's effects on the accounting equation, Assets = Liabilities + Stockholders' equity. In Chapters 2 and 3, you performed other steps in the accounting cycle. Chapter 2 presented the eight steps in the accounting cycle as a preview of the content of Chapters 2 through 4. As a review, study the diagram of the eight steps in the accounting cycle in Exhibit 19. Remember that the first three steps occur during the accounting period and the last five occur at the end. The next section explains how to use the work sheet to facilitate the completion of the accounting cycle.

The work sheet

The work sheet is a columnar sheet of paper or a computer spreadsheet on which accountants summarize information needed to make the adjusting and closing entries and to prepare the financial statements. Usually, they save these work sheets to document the end-of-period entries. A work sheet is only an accounting tool and not part of the formal accounting records. Therefore, work sheets may vary in format; some are prepared in pencil so that errors can be corrected easily. Other work sheets are prepared on personal computers with spreadsheet software. Accountants prepare work sheets each time financial statements are needed – monthly, quarterly, or at the end of the accounting year.

This chapter illustrates a 12-column work sheet that includes sets of columns for an unadjusted trial balance, adjustments, adjusted trial balance, income statement, statement of retained earnings, and balance sheet. Each set has a debit and a credit column. (See Exhibit 20.)

Accountants use these initial steps in preparing the work sheet. The following sections describe the detailed steps for completing the work sheet.

• Enter the titles and balances of ledger accounts in the Trial Balance columns.
  
• Enter adjustments in the Adjustments columns.
  
• Enter adjusted account balances in the Adjusted Trial Balance columns.
  
• Extend adjusted balances of revenue and expense accounts from the Adjusted Trial Balance columns to the Income Statement columns.
  
• Extend any balances in the Retained Earnings and Dividends accounts to the Statement of Retained Earnings columns.
  
• Extend adjusted balances of asset, liability, and capital stock accounts from the Adjusted Trial Balance columns to the Balance Sheet columns.
  

Instead of preparing a separate trial balance as we did in Chapter 2, accountants use the Trial Balance columns on a work sheet. Look at Exhibit 20 and note that the numbers and titles of the ledger accounts of MicroTrain Company are on the left portion of the work sheet. Usually, only those accounts with balances as of the end of the accounting period are listed. (Some accountants do list the entire chart of accounts, even those with zero balances.) Assume you are MicroTrain's accountant. You list the Retained Earnings account in the trial balance even though it has a zero balance to (1) show its relative position among the accounts and (2) indicate that December 2010 is the first month of operations for this company. Next, you enter the balances of the ledger accounts in the Trial Balance columns. The accounts are in the order in which they appear in the general ledger: assets, liabilities, stockholders' equity, dividends, revenues, and expenses. Then, total the columns. If the debit and credit column totals are not equal, an error exists that must be corrected before you proceed with the work sheet.

As you learned in Chapter 3, adjustments bring the accounts to their proper balances before accountants prepare the income statement, statement of retained earnings, and balance sheet. You enter these adjustments in the Adjustments columns of the work sheet. Also, you cross-reference the debits and credits of the entries by placing a key number or letter to the left of the amounts. This key number facilitates the actual journalizing of the adjusting entries later because you do not have to rethink the adjustments to record them. For example, the number (1) identifies the adjustment debiting Insurance Expense and crediting Prepaid Insurance. Note in the Account Titles column that

the Insurance Expense account title is below the trial balance totals because the Insurance Expense account did not have a balance before the adjustment and, therefore, did not appear in the trial balance.

Work sheet preparers often provide brief explanations at the bottom for the keyed entries as in Exhibit 20. Although these explanations are optional, they provide valuable information for those who review the work sheet later.

The adjustments (which were discussed and illustrated in Chapter 3) for MicroTrain Company are:

Exhibit 19: Steps in the accounting cycle

• Entry (1) records the expiration of USD 200 of prepaid insurance in December.
  
• Entry (2) records the expiration of USD 400 of prepaid rent in December.
  
• Entry (3) records the using up of USD 500 of supplies during the month.
  
• Entry (4) records USD 750 depreciation expense on the trucks for the month. MicroTrain acquired the trucks at the beginning of December.
  
• Entry (5) records the earning of USD 1,500 of the USD 4,500 in the Unearned Service Fees account.
  
• Entry (6) records USD 600 of interest earned in December.
  
• Entry (7) records USD 1,000 of unbilled training services performed in December.
  
• Entry (8) records the USD 180 accrual of salaries expense at the end of the month.
  

Often it is difficult to discover all the adjusting entries that should be made. The following steps are helpful:

• Examine adjusting entries made at the end of the preceding accounting period. The same types of entries often are necessary period after period.
  
• Examine the account titles in the trial balance. For example, if the company has an account titled Trucks, an entry must be made for depreciation.
  
• Examine various business documents (such as bills for services received or rendered) to discover other assets, liabilities, revenues, and expenses that have not yet been recorded.
  
• Ask the manager or other personnel specific questions regarding adjustments that may be necessary. For example: "Were any services performed during the month that have not yet been billed?"
  

MICROTRAIN COMPANY Work Sheet For the Month Ended 2010 December 31

Acct. Account Titles

Exhibit 20: Completed worksheet

(1) To record insurance expenses for December.

(2) To record rent expenses for December.

(3) To record supplies expenses for December.

(4) To record depreciation expenses for December.

(5) To transfer fees for service provided in December from the liability account to the revenue account.

(6) To record one month's interest revenue.

(7) To record unbilled training services performed in December.

(8) To accrue one day's salaries that were earned but are unpaid.

After all the adjusting entries are entered in the Adjustments columns, total the two columns. The totals of these two columns should be equal when all debits and credits are entered properly.

After MicroTrain's adjustments, compute the adjusted balance of each account and enter these in the Adjusted Trial Balance columns. For example, Supplies on Hand (Account No. 107) had an unadjusted balance of USD 1,400. Adjusting entry (3) credited the account for USD 500, leaving a debit balance of USD 900. This amount is a debit in the Adjusted Trial Balance columns.

Next, extend all accounts having balances to the Adjusted Trial Balance columns. Note carefully how the rules of debit and credit apply in determining whether an adjustment increases or decreases the account balance. For example, Salaries Expense (Account No. 507) has a USD 3,600 debit balance in the Trial Balance columns. A USD 180 debit adjustment increases this account, which has a USD 3,780 debit balance in the Adjusted Trial Balance columns.

Some account balances remain the same because no adjustments have affected them. For example, the balance in Accounts Payable (Account No. 200) does not change and is simply extended to the Adjusted Trial Balance columns.

Now, total the Adjusted Trial Balance debit and credit columns. The totals must be equal before taking the next step in completing the work sheet. When the Trial Balance and Adjustments columns both balance but the Adjusted Trial Balance columns do not, the most probable cause is a math error or an error in extension. The Adjusted Trial Balance columns make the next step of sorting the amounts to the Income Statement, the Statement of Retained Earnings, and the Balance Sheet columns much easier.

Begin by extending all of MicroTrain's revenue and expense account balances in the Adjusted Trial Balance columns to the Income Statement columns. Since revenues carry credit balances, extend them to the credit column. After extending expenses to the debit column, subtotal each column. MicroTrain's total expenses are USD 6,510 and total revenues are USD 13,800. Thus, net income for the period is USD 7,290 (USD 13,800 – USD 6,510). Enter this USD 7,290 income in the debit column to make the two column totals balance. You would record a net loss in the opposite manner; expenses (debits) would have been larger than revenues (credits) so a net loss would be entered in the credit column to make the columns balance.

Next, complete the Statement of Retained Earnings columns. Enter the USD 7,290 net income amount for December in the credit Statement of Retained Earnings column. Thus, this net income amount is the balancing figure for the Income Statement columns and is also in the credit Statement of Retained Earnings column. Net income appears in the Statement of Retained Earnings credit column because it causes an increase in retained earnings. Add the USD 7,290 net income to the beginning retained earnings balance of USD 0, and deduct the dividends of USD 3,000. As a result, the ending balance of the Retained Earnings account is USD 4,290.

Now extend the assets, liabilities, and capital stock accounts in the Adjusted Trial Balance columns to the Balance Sheet columns. Extend asset amounts as debits and liability and capital stock amounts as credits.

Note that the ending retained earnings amount determined in the Statement of Retained Earnings columns appears again as a credit in the Balance Sheet columns. The ending retained earnings amount is a debit in the Statement of Retained Earnings columns to balance the Statement of Retained Earnings columns. The ending retained earnings is a credit in the Balance Sheet columns because it increases stockholders' equity, and increases in stockholders' equity are credits. (Retained earnings would have a debit ending balance only if cumulative losses and dividends exceed cumulative earnings.) With the inclusion of the ending retained earnings amount, the Balance Sheet columns balance.

When the Balance Sheet column totals do not agree on the first attempt, work backward through the process used in preparing the work sheet. Specifically, take the following steps until you discover the error:

MICROTRAIN COMPANY

Income Statement For the Month Ended 2010 December 31

Exhibit 21: Income statement

• Re-total the two Balance Sheet columns to see if you made an error in addition. If the column totals do not agree, check to see if you did not extend a balance sheet item or if you made an incorrect extension from the Adjusted Trial Balance columns.
  
• Re-total the Statement of Retained Earnings columns and determine whether you entered the correct amount of retained earnings in the appropriate Statement of Retained Earnings and Balance Sheet columns.
  
• Re-total the Income Statement columns and determine whether you entered the correct amount of net income or net loss for the period in the appropriate Income Statement and Statement of Retained Earnings columns.
  

Preparing financial statements from the work sheet

When the work sheet is completed, all the necessary information to prepare the income statement, statement of retained earnings, and balance sheet is readily available. Now, you need only recast the information into the appropriate financial statement format.

The information you need to prepare the income statement in Exhibit 21 is in the work sheet's Income Statement columns in Exhibit 20.

The information you need to prepare the statement of retained earnings is taken from the Statement of Retained Earnings columns in the work sheet. Look at Exhibit 22, MicroTrain Company's statement of retained earnings for the month ended 2010 December 31. To prepare this statement, use the beginning Retained Earnings account balance (Account No. 310), add the net income (or deduct the net loss), and then subtract the Dividends (Account No. 320). Carry the ending Retained Earnings balance forward to the balance sheet. Remember that the statement of retained earnings helps to relate income statement information to balance sheet information. It does this by indicating how net income on the income statement relates to retained earnings on the balance sheet.

MICROTRAIN COMPANY

Statement of Retained Earnings

For the Month Ended 2010 December 31,

Exhibit 22: Statement of retained earnings

MICROTRAIN COMPANY

Balance Sheet

2010 December 31

Assets

Liabilities and Stockholders' Equity

Exhibit 23: Balance sheet

The information needed to prepare a balance sheet comes from the Balance Sheet columns of MicroTrain's work sheet (Exhibit 20). As stated earlier, the correct amount for the ending retained earnings appears on the statement of retained earnings. See the completed balance sheet for MicroTrain in Exhibit 23.

Journalizing adjusting entries

After completing MicroTrain's financial statements from the work sheet, you should enter the adjusting entries in the general journal and post them to the appropriate ledger accounts. You would prepare these adjusting entries as you learned in Chapter 3, except that the work sheet is now your source for making the entries. The preparation of a work sheet does not eliminate the need to prepare and post adjusting entries because the work sheet is only an informal accounting tool and is not part of the formal accounting records.

The numerical notations in the Adjustments columns and the adjustments explanations at the bottom of the work sheet identify each adjusting entry. The Adjustments columns show each entry with its appropriate debit and credit. MicroTrain's adjusting entries as they would appear in the general journal after posting are:

MICROTRAIN COMPANY

General Journal

The closing process

In Chapter 2, you learned that revenue, expense, and dividends accounts are nominal (temporary) accounts that are merely subclassifications of a real (permanent) account, Retained Earnings. You also learned that we prepare financial statements for certain accounting periods. The closing process transfers (1) the balances in the revenue and expense accounts to a clearing account called Income Summary and then to Retained Earnings and (2) the balance in the Dividends account to the Retained Earnings account. The closing process reduces revenue, expense, and Dividends account balances to zero so they are ready to receive data for the next accounting period. Accountants may perform the closing process monthly or annually.

The Income Summary account is a clearing account used only at the end of an accounting period to summarize revenues and expenses for the period. After transferring all revenue and expense account balances to Income Summary, the balance in the Income Summary account represents the net income or net loss for the period. Closing or transferring the balance in the Income Summary account to the Retained Earnings account results in a zero balance in Income Summary.

Also closed at the end of the accounting period is the Dividends account containing the dividends declared by the board of directors to the stockholders. We close the Dividends account directly to the Retained Earnings account and not to Income Summary because dividends have no effect on income or loss for the period.

In accounting, we often refer to the process of closing as closing the books. Remember that only revenue, expense, and Dividend accounts are closed – not asset, liability, Capital Stock, or Retained Earnings accounts. The four basic steps in the closing process are:

• Closing the revenue accounts – transferring the balances in the revenue accounts to a clearing account called Income Summary.
  
• Closing the expense accounts – transferring the balances in the expense accounts to a clearing account called Income Summary.
  
• Closing the Income Summary account – transferring the balance of the Income Summary account to the Retained Earnings account.
  
• Closing the Dividends account – transferring the balance of the Dividends account to the Retained Earnings account.
  

Revenues appear in the Income Statement credit column of the work sheet. The two revenue accounts in the Income Statement credit column for MicroTrain Company are service revenue of USD 13,200 and interest revenue of USD 600 (Exhibit 20). Because revenue accounts have credit balances, you must debit them for an amount equal to their balance to bring them to a zero balance. When you debit Service Revenue and Interest Revenue, credit Income Summary (Account No. 600). Enter the account numbers in the Posting Reference column when the journal entry has been posted to the ledger. Do this for all other closing journal entries.

MICROTRAIN COMPANY

General Journal

After the closing entries have been posted, the Service Revenue and Interest Revenue accounts (in T-account format) of MicroTrain appear as follows. Note that the accounts now have zero balances.

Service Revenue

Interest Revenue

As a result of the previous entry, you would credit the Income Summary account for USD 13,800. We show the Income Summary account in Step 3.

Expenses appear in the Income Statement debit column of the work sheet. MicroTrain Company has eight expenses in the Income Statement debit column. As shown by the column subtotal, these expenses add up to USD 6,510. Since expense accounts have debit balances, credit each account to bring it to a zero balance. Then, make the debit in the closing entry to the Income Summary account for USD 6,510. Thus, to close the expense accounts, MicroTrain makes the following entry:

MICROTRAIN COMPANY

General Journal

The debit of USD 6,510 to the Income Summary account agrees with the Income Statement debit column subtotal in the work sheet. This comparison with the work sheet serves as a check that all revenue and expense items have been listed and closed. If the debit in the preceding entry was made for a different amount than the column subtotal, the company would have an error in the closing entry for expenses.

After they have been closed, MicroTrain's expense accounts appear as follows. Note that each account has a zero balance after closing.

Advertising Expense

Gas and Oil Expense

Salaries Expense

Utilities Expense

Insurance Expense

Rent Expense

Supplies Expense

Depreciation Expense-Trucks

The expense accounts could be closed before the revenue accounts; the end result is the same.

As the result of closing the revenues and expenses of MicroTrain, the total revenues and expenses have been transferred to the Income Summary account.

Income Summary

MicroTrain's Income Summary account now has a credit balance of USD 7,290, the company's net income for December.

Next, close MicroTrain's Income Summary account to its Retained Earnings account. The journal entry to do this is:

MICROTRAIN COMPANY

General Journal

After its Income Summary account is closed, the company's Income Summary and Retained Earnings accounts appear as follows:

Income Summary

Retained Earnings

The last closing entry closes MicroTrain's Dividends account. This account has a debit balance before closing. To close the account, credit the Dividends account and debit the Retained Earnings account. The Dividends account is not closed to the Income Summary because it is not an expense and does not enter into income determination. The journal entry to close MicroTrain's Dividends account is:

MICROTRAIN COMPANY

General Journal

After this closing entry is posted, the company's Dividends and Retained Earnings accounts appear as follows:

Dividends

Retained Earnings

After you have completed the closing process, the only accounts in the general ledger that have not been closed are the permanent balance sheet accounts. Because these accounts contain the opening balances for the coming accounting period, debit balance totals must equal credit balance totals. The preparation of a post-closing trial balance serves as a check on the accuracy of the closing process and ensures that the books are in balance at the start of the new accounting period. The post-closing trial balance differs from the adjusted trial balance in only two important respects: (1) it excludes all temporary accounts since they have been closed; and (2) it updates the Retained Earnings account to its proper ending balance.

A post-closing trial balance is a trial balance taken after the closing entries have been posted.

The only accounts that should be open are assets, liabilities, capital stock, and Retained Earnings accounts. List all the account balances in the debit and credit columns and total them to make sure debits and credits are equal.

Look at Exhibit 24, a post-closing trial balance for MicroTrain Company as of 2010 December 31.

The amounts in the post-closing trial balance are from the ledger after the closing entries have been posted.

The next section briefly describes the evolution of accounting systems from the one-journal, one-ledger manual system you have been studying to computerized systems. Then, we discuss the role of an accounting system.

Accounting systems: From manual to computerized

The manual accounting system with only one general journal and one general ledger has been in use for hundreds of years and is still used by some very small companies. Gradually, some manual systems evolved to include multiple journals and ledgers for increased efficiency. For instance, a manual system with multiple journals and ledgers often includes: a sales journal to record all credit sales, a purchases journal to record all credit purchases, a cash receipts journal to record all cash receipts, and a cash disbursements journal to record all cash payments. Still recorded in the general journal are adjusting and closing entries and any other entries that do not fit in one of the special journals. Besides the general ledger, such a system normally has subsidiary ledgers for accounts receivable and accounts payable showing how much each customer owes and how much is owed to each supplier. The general ledger shows the total amount of accounts receivable and accounts payable, but the details in the subsidiary ledgers allow companies to send bills to customers and pay bills to suppliers.

Another innovation in manual systems was the "one write" or pegboard system. By creating one document and aligning other records under it on a pegboard, companies could record transactions more efficiently. These systems permit the writing of a check and the simultaneous recording of the check in the cash disbursements journal. Even though some of these systems are still in use today, computers make them obsolete.

During the 1950s, companies also used bookkeeping machines to supplement manual systems.

These machines recorded recurring transactions such as sales on account. They posted transactions to the general ledger and subsidiary ledger accounts and computed new balances. With the development of computers, bookkeeping machines became obsolete. They were quite expensive, and computers easily outperformed them. In the mid-1950s, large companies began using mainframe computers. Early accounting applications were in payroll, accounts receivable, accounts payable, and inventory. Within a few years, programs existed for all phases of accounting, including manufacturing operations and the total integration of other accounting programs with the general ledger. Until the 1980s, small and medium-sized companies either continued with a manual system, rented time on another company's computer, or hired a service bureau to perform at least some accounting functions.

MICROTRAIN COMPANY

Trial Balance

2010 December 31

Exhibit 24: Post closing trial balance

The development of the personal computer (PC) in 1976 and its widespread use a decade later drastically changed the accounting systems of small and medium-sized businesses. The number and quality of accounting software packages for PCs and the power of PCs quickly increased. Soon small and medium-sized businesses could maintain all accounting functions on a PC. By the 1990s, the cost of PCs and accounting software packages had decreased significantly, accounting software packages had become more user-friendly, and computer literacy had increased so much that many very small businesses converted from manual to computerized systems. However, some small business owners still use manual systems because they are familiar and meet their needs, and the persons keeping the records may not be computer literate.

Your knowledge of the basic manual accounting system described in these first four chapters enables you to better understand a computerized accounting system. The computer automatically performs some of the steps in the accounting cycle, such as posting journal entries to the ledger accounts, closing the books, and preparing the financial statements. However, if you understand all of the steps in the accounting cycle, you will better understand how to use the resulting data in decision making.

As we show in Exhibit 25, an accounting system is a set of records and the procedures and equipment used to perform the accounting functions. Manual systems consist of journals and ledgers on paper. Computerized accounting systems consist of accounting software, computer files, computers, and related peripheral equipment such as printers.

Regardless of the system, the functions of accountants include: (1) observing, identifying, and measuring economic events; (2) recording, classifying, and summarizing measurements; and (3) reporting economic events and interpreting financial statements. Both internal and external users tell accountants their information needs. The accounting system enables a company's accounting staff to supply relevant accounting information to meet those needs. As internal and external users make decisions that become economic events, the cycle of information, decisions, and economic events begins again.

The primary focus of the first four chapters has been on how you can use an accounting system to prepare financial statements. However, we also discussed how to use that information in making decisions. Later chapters also show how to prepare information and how that information helps users to make informed decisions. We have not eliminated the preparation aspects because we believe that the most informed users are ones who also understand how the information was prepared. These users understand not only the limitations of the information but also its relevance for decision making.

The next section discusses and illustrates the classified balance sheet, which aids in the analysis of the financial position of companies. One example of this analysis is the current ratio and its use in analyzing the short-term debt-paying ability of a company.

Exhibit 25: The role of an accounting system

A classified balance sheet

The balance sheets we presented so far have been unclassified balance sheets. As shown in Exhibit 23, an unclassified balance sheet has three major categories: assets, liabilities, and stockholders' equity. A classified balance sheet contains the same three major categories and subdivides them to provide useful information for interpretation and analysis by users of financial statements.

Exhibit 26, shows a slightly revised classified balance sheet for The Home Depot, Inc., and subsidiaries. Note that The Home Depot classified balance sheet is in a vertical format (assets appearing above liabilities and stockholders' equity) rather than the horizontal format (assets on the left and liabilities and stockholders' equity on the right). The two formats are equally acceptable.

The Home Depot classified balance sheet subdivides two of its three major categories. The Home Depot subdivides its assets into current assets, property and equipment, long-term investments, long- term notes receivable, intangible assets (cost in excess of the fair value of net assets acquired), and other assets. The company subdivides its liabilities into current liabilities and long-term liabilities (including deferred income taxes). A later chapter describes minority interest. Stockholders' equity is the same in a classified balance sheet as in an unclassified balance sheet. Later chapters describe further subdivisions of the stockholders' equity section.

We discuss the individual items in the classified balance sheet later in the text. Our only purpose here is to briefly describe the items that can be listed under each category. Some of these items are not in The Home Depot's balance sheet.

THE HOME DEPOT, INC. AND SUBSIDIARIES

Consolidated Balance Sheet

2001 January 28

(amounts in millions, except share data)

Exhibit 26: A classified balance sheet

Current assets are cash and other assets that a business can convert to cash or uses up in a relatively short period – one year or one operating cycle, whichever is longer. An operating cycle is the time it takes to start with cash, buy necessary items to produce revenues (such as materials, supplies, labor, and/or finished goods), sell services or goods, and receive cash by collecting the resulting receivables. Companies in service industries and merchandising industries generally have operating cycles shorter than one year. Companies in some manufacturing industries, such as distilling and lumber, have operating cycles longer than one year. However, since most operating cycles are shorter than one year, the one-year period is usually used in identifying current assets and current liabilities. Common current assets in a service business include cash, marketable securities, accounts receivable, notes receivable, interest receivable, and prepaid expenses. Note that on a balance sheet, current assets are in order of how easily they are convertible to cash, from most liquid to least liquid.

Cash includes deposits in banks available for current operations at the balance sheet date plus cash on hand consisting of currency, undeposited checks, drafts, and money orders. Cash is the first current asset to appear on a balance sheet. The term cash normally includes cash equivalents.

Cash equivalents are highly liquid, short-term investments acquired with temporarily idle cash and easily convertible into a known cash amount. Examples are Treasury bills, short-term notes maturing within 90 days, certificates of deposit, and money market funds

Marketable securities are temporary investments such as short-term ownership of stocks and bonds of other companies. Such investments do not qualify as cash equivalents. These investments earn additional money on cash that the business does not need at present but will probably need within one year.

Accounts receivable (also called trade accounts receivable) are amounts owed to a business by customers. An account receivable arises when a company performs a service or sells merchandise on credit. Customers normally provide no written evidence of indebtedness on sales invoices or delivery tickets except their signatures. Notice the term net in the balance sheet of The Home Depot (Exhibit 26). This term indicates the possibility that the company may not collect some of its accounts receivable. In the balance sheet, the accounts receivable amount is the sum of the individual accounts receivable from customers shown in a subsidiary ledger or file.

Merchandise inventories are goods held for sale. Chapter 6 begins our discussion of merchandise inventories.

A note is an unconditional written promise to pay another party the amount owed either when demanded or at a certain specified date, usually with interest (a charge made for use of the money) at a specified rate. A note receivable appears on the balance sheet of the company to which the note is given. A note receivable arises (1) when a company makes a sale and receives a note from the customer, (2) when a customer gives a note for an amount due on an account receivable, or (3) when a company loans money and receives a note in return. Chapter 9 discusses notes at length.

Other current assets might include interest receivable and prepaid expenses. Interest receivable arises when a company has earned but not collected interest by the balance sheet date. Usually, the amount is not due until later. Prepaid expenses include rent, insurance, and supplies that have been paid for but all the benefits have not yet been realized (or consumed) from these expenses. If prepaid expenses had not been paid for in advance, they would require the future disbursement of cash. Furthermore, prepaid expenses are considered assets because they have service potential.

Long-term assets are assets that a business has on hand or uses for a relatively long time. Examples include property, plant, and equipment; long-term investments; and intangible assets.

Property, plant, and equipment are assets with useful lives of more than one year; a company acquires them for use in the business rather than for resale. (These assets are called property and equipment in The Home Depot's balance sheet.) The terms plant assets or fixed assets are also used for property, plant, and equipment. To agree with the order in the heading, balance sheets generally list property first, plant next, and equipment last. These items are fixed assets because the company uses them for long-term purposes. We describe several types of property, plant, and equipment next.

Land is ground the company uses for business operations; this includes ground on which the company locates its business buildings and that is used for outside storage space or parking. Land owned for investment is not a plant asset because it is a long-term investment.

Buildings are structures the company uses to carry on its business. Again, the buildings that a company owns as investments are not plant assets.

Office furniture includes file cabinets, desks, chairs, and shelves.

Office equipment includes computers, copiers, FAX machines, and phone answering machines.

Leasehold improvements are any physical alterations made by the lessee to the leased property when these benefits are expected to last beyond the current accounting period. An example is when the lessee builds room partitions in a leased building. (The lessee is the one obtaining the rights to possess and use the property.)

Construction in progress represents the partially completed stores or other buildings that a company such as The Home Depot plans to occupy when completed.

Accumulated depreciation is a contra asset account to depreciable assets such as buildings, machinery, and equipment. This account shows the total depreciation taken for the depreciable assets. On the balance sheet, companies deduct the accumulated depreciation (as a contra asset) from its related asset.

Long-term investments A long-term investment usually consists of securities of another company held with the intention of (1) obtaining control of another company, (2) securing a permanent source of income for the investor, or (3) establishing friendly business relations. The long-term investment classification in the balance sheet does not include those securities purchased for short- term purposes. For most businesses, long-term investments may be stocks or bonds of other corporations. Occasionally, long-term investments include funds accumulated for specific purposes, rental properties, and plant sites for future use.

Intangible assets Intangible assets consist of the noncurrent, nonmonetary, nonphysical assets of a business. Companies must charge the costs of intangible assets to expense over the period benefited. Among the intangible assets are rights granted by governmental bodies, such as patents and copyrights. Other intangible assets include leaseholds and goodwill.

A patent is a right granted by the federal government; it gives the owner of an invention the authority to manufacture a product or to use a process for a specified time.

A copyright granted by the federal government gives the owner the exclusive privilege of publishing written material for a specified time.

Leaseholds are rights to use rented properties, usually for several years.

Goodwill is an intangible value attached to a business, evidenced by the ability to earn larger net income per dollar of investment than that earned by competitors in the same industry. The ability to produce superior profits is a valuable resource of a business. Normally, companies record goodwill only at the time of purchase and then only at the price paid for it. The Home Depot has labeled its goodwill "cost in excess of the fair value of net assets acquired".

Accumulated amortization is a contra asset account to intangible assets. This account shows the total amortization taken on the intangible assets.

Current liabilities are debts due within one year or one operating cycle, whichever is longer. The payment of current liabilities normally requires the use of current assets. Balance sheets list current liabilities in the order they must be paid; the sooner a liability must be paid, the earlier it is listed. Examples of current liabilities follow.

Accounts payable are amounts owed to suppliers for goods or services purchased on credit. Accounts payable are generally due in 30 or 60 days and do not bear interest. In the balance sheet, the accounts payable amount is the sum of the individual accounts payable to suppliers shown in a subsidiary ledger or file.

Notes payable are unconditional written promises by the company to pay a specific sum of money at a certain future date. The notes may arise from borrowing money from a bank, from the purchase of assets, or from the giving of a note in settlement of an account payable. Generally, only notes payable due in one year or less are included as current liabilities.

Salaries payable are amounts owed to employees for services rendered. The company has not paid these salaries by the balance sheet date because they are not due until later.

Sales taxes payable are the taxes a company has collected from customers but not yet remitted to the taxing authority, usually the state.

Other accrued expenses might include taxes withheld from employees, income taxes payable, and interest payable. Taxes withheld from employees include federal income taxes, state income taxes, and social security taxes withheld from employees' paychecks. The company plans to pay these amounts to the proper governmental agencies within a short period. Income taxes payable are the taxes paid to the state and federal governments by a corporation on its income. Interest payable is interest that the company has accumulated on notes or bonds but has not paid by the balance sheet date because it is not due until later.

Dividends payable, or amounts the company has declared payable to stockholders, represent a distribution of income. Since the corporation has not paid these declared dividends by the balance sheet date, they are a liability.

Unearned revenues (revenues received in advance) result when a company receives payment for goods or services before earning the revenue, such as payments for subscriptions to a magazine. These unearned revenues represent a liability to perform the agreed services or other contractual requirements or to return the assets received.

Companies report any current installment on long-term debt due within one year under current liabilities. The remaining portion continues to be reported as a long-term liability.

Long-term liabilities are debts such as a mortgage payable and bonds payable that are not due for more than one year. Companies should show maturity dates in the balance sheet for all long-term liabilities. Normally, the liabilities with the earliest due dates are listed first.

Notes payable with maturity dates at least one year beyond the balance sheet date are long-term liabilities.

Bonds payable are long-term liabilities and are evidenced by formal printed certificates sometimes secured by liens (claims) on property, such as mortgages. Maturity dates should appear on the balance sheet for all major long-term liabilities.

The deferred income taxes on The Home Depot's balance sheet result from a difference between income tax expense in the accounting records and the income tax payable on the company's tax return.

Stockholders' equity shows the owners' interest in the business. This interest is equal to the amount contributed plus the income left in the business.

The items under stockholders' equity in The Home Depot's balance sheet are paid-in capital (including common stock) and retained earnings. Paid-in capital shows the capital paid into the company as the owners' investment. Retained earnings shows the cumulative income of the company less the amounts distributed to the owners in the form of dividends. Cumulative translation adjustments result from translating foreign currencies into US dollars (a topic discussed in advanced accounting courses). The unrealized loss on investments is discussed in Chapter 14.

The next section shows how two categories on the classified balance sheet relate to each other. Together they help reveal a company's short-term debt-paying ability.

Analyzing and using the financial results – the current ratio

Understanding the learning objectives

• Analyze transactions by examining source documents.
• Journalize transactions in the journal.
• Post journal entries to the accounts in the ledger.
• Prepare a trial balance of the accounts and complete the work sheet.
• Prepare financial statements.
• Journalize and post adjusting entries.
• Journalize and post closing entries.
• Prepare a post-closing trial balance.
• The work sheet is a columnar sheet of paper on which accountants summarize information needed to make the adjusting and closing entries and to prepare the financial statements.
• Work sheets may vary in format. The work sheet illustrated in the chapter has 12 columns two each for trial balance, adjustments, adjusted trial balance, income statement, statement of retained earnings, and balance sheet.
• The information needed to prepare the income statement is in the Income Statement columns of the work sheet. Net income for the period is the amount needed to balance the two Income Statement columns in the work sheet.
• The information needed to prepare the statement of retained earnings is in the Statement of Retained Earnings columns of the work sheet. The ending Retained Earnings balance is carried forward to the balance sheet.
• The information needed to prepare the balance sheet is in the Balance Sheet columns of the work sheet.
• As explained in Chapter 3, adjusting entries are necessary to bring the accounts to their proper balances before preparing the financial statements. Closing entries are necessary to reduce the balances of revenue, expense, and Dividends accounts to zero so they are ready to receive data for the next accounting period.
• Revenue accounts are closed by debiting them and crediting the Income Summary account.
• Expense accounts are closed by crediting them and debiting the Income Summary account.
• The balance in the Income Summary account represents the net income or net loss for the period.
• To close the Income Summary account, the balance is transferred to the Retained Earnings account.
• To close the Dividends account, the balance is transferred to the Retained Earnings account.
• Only the balance sheet accounts have balances and appear on the post-closing trial balance.
• All revenue, expense, and Dividends accounts have zero balances and are not included in the post-closing trial balance.
• Manual systems and computerized systems perform the same accounting functions.
• The ease of accounting with a PC has encouraged even small companies to convert to computerized systems.
• A classified balance sheet subdivides the major categories on the balance sheet. For instance, a classified balance sheet subdivides assets into current assets; long-term investments; property, plant, and equipment; and intangible assets. It subdivides liabilities into current liabilities and long-term liabilities. Later chapters show more accounts in the stockholders' equity section, but the subdivisions remain basically the same.
• The current ratio gives some indication of the short-term debt-paying ability of a company.
• To find the current ratio, divide current assets by current liabilities.