Chapter 4: Completing the accounting cycle

With the adjusted trial balance in hand, the accounting cycle can be completed: the financial statements are prepared, the temporary accounts are closed and a post-closing trial balance is drawn up. This chapter also introduces the classified balance sheet and the current ratio, and, through the case Puzzles Ltd, shows how the income statement, balance sheet and statement of cash flows of a real company fit together so tightly that missing numbers can be reconstructed.

Preparing the financial statements

The statements are prepared from the adjusted trial balance, in this order:

1. Income statement: revenues and expenses, giving net income or net loss for the period.
2. Statement of retained earnings: beginning retained earnings + net income (or − net loss) − dividends = ending retained earnings.
3. Balance sheet: assets, liabilities and stockholders' equity on the last day of the period, with ending retained earnings from step 2.

The classified balance sheet

A classified balance sheet places each asset and liability in a category, so readers can judge liquidity. Liquidity is how quickly and easily an item can be turned into cash; assets are listed in order of liquidity.

• Current assets will be converted to cash, sold or used up within twelve months or within the operating cycle if that is longer. The operating cycle is the time from spending cash on goods and services, to selling them, to collecting the cash. Examples: cash, accounts receivable, inventory, supplies, prepaid expenses.
• Long-term assets: long-term investments (bonds or stocks held for more than a year), property, plant and equipment (shown at book value), and intangible assets (no physical form, valuable because of the rights they carry).
• Current liabilities must be paid within one year or the operating cycle: accounts payable, salaries payable, interest payable, unearned revenue. Long-term liabilities are due later, such as long-term notes payable.
• Stockholders' equity: common stock and retained earnings, the residual claim after the liabilities.

A balance sheet in report form lists assets above liabilities and equity; account form puts them side by side.

The closing process

Revenues, expenses and dividends measure one period only. At the end of the period they are set to zero so the next period starts fresh; their net effect is moved to retained earnings. This is the closing process.

• Temporary accounts are closed: revenues, expenses, dividends and the Income summary account.
• Permanent accounts are not closed: assets, liabilities, common stock and retained earnings. Their balances carry over to the next period.

The four closing entries (using a temporary Income summary account):

1. Debit each revenue account for its balance, credit Income summary.
2. Debit Income summary for total expenses, credit each expense account.
3. Close Income summary to Retained earnings. With a net income: Dr Income summary, Cr Retained earnings. With a net loss the reverse: Dr Retained earnings, Cr Income summary.
4. Close Dividends directly to Retained earnings: Dr Retained earnings, Cr Dividends. Dividends never pass through Income summary, because they are not part of net income.

For Smart Touch Learning, revenue of $17,500 is closed, expenses are closed, the remaining $8,550 credit in Income summary (the net income) goes to retained earnings, and the $5,000 of dividends is closed to retained earnings.

After closing, a post-closing trial balance is prepared. It lists only permanent accounts and checks that debits still equal credits before the new period starts.

The accounting cycle

The accounting cycle is the process by which a company produces its statements for a period. It starts with the balances carried over from the previous period:

1. Start with the beginning balances of the permanent accounts.
2. Analyse and journalize transactions as they occur.
3. Post the journal entries to the ledger.
4. Prepare the unadjusted trial balance.
5. Journalize and post the adjusting entries.
6. Prepare the adjusted trial balance.
7. Prepare the financial statements.
8. Journalize and post the closing entries.
9. Prepare the post-closing trial balance.

The current ratio

It measures the ability to pay current liabilities with current assets. A higher ratio is safer, and an increase means improvement. Kohl's had current assets of $4,835 million and current liabilities of $2,730 million at the end of 2018, a current ratio of 1.77, compared with 5,380 / 2,709 = 1.99 a year earlier: liquidity weakened a little.

The statement of cash flows

The statement of cash flows explains why cash changed. It has three sections:

• Operating activities: cash effects of the day-to-day business (customers, suppliers, employees, interest, taxes).
• Investing activities: buying and selling long-term assets and investments (purchase of property and equipment, acquisitions).
• Financing activities: cash from and to owners and lenders (issuing or repurchasing stock, borrowing and repaying, dividends).

Large companies usually present operating cash flow with the indirect method: start with net income, add back expenses that did not use cash (such as depreciation and amortisation) and correct for changes in working capital. An increase in a current asset such as inventory used cash, so it is subtracted; an increase in a current liability such as accounts payable means cash was not yet paid, so it is added. Net income and operating cash flow are therefore different numbers, which is why both statements are needed.

Case: Puzzles Ltd

Puzzles Ltd, an international puzzle maker (modelled on a real listed company), was about to file its annual statements when a computer virus deleted some numbers. Your job is to reconstruct them using the links between the statements (amounts in € thousands):

A check: operating 1,389,108 − investing 427,891 − financing 844,987 − exchange rate effect 6,876 = 109,354, exactly the increase in cash from 1,150,517 to 1,259,871. The case shows the message of the course: the statements form one system, and an accountant who understands the links can find errors and missing pieces.

The closing slide of the case quotes an executive of the insurer AIG in 2008, just before the crisis: be a critical accounting student and do not take numbers at face value.