Completing the cycle: financial statements and closing entries

With the adjusted trial balance in hand, the accountant can prepare the financial statements and then close the books for the period. This lesson prepares Birchwood Bikes' May income statement, statement of changes in equity and classified balance sheet; explains how a worksheet organizes the work; shows the closing entries that reset revenue, expense and dividend accounts to zero; and prepares the post-closing trial balance. It ends by putting the whole accounting cycle together. The statement of cash flows, the fourth statement, is prepared in lesson 12 because it needs comparative balance sheets.

The order of preparation

The statements are prepared in a set order because each feeds the next. The income statement comes first, because its net income is needed for the statement of changes in equity. That statement comes second, because its ending retained earnings are needed for the balance sheet. The balance sheet comes third. The cash flow statement uses information from all three.

The income statement

The income statement lists revenues and expenses for the period and reports net income or net loss. For a service business like Birchwood Bikes in May, a single-step format, which lists all revenues and then all expenses, is clear. Merchandising businesses usually use a multiple-step format that shows gross profit first (lesson 8). Under IFRS the statement may be titled the statement of profit or loss; under ASPE and US GAAP, income statement or statement of operations are common. Expenses may be classified by nature (wages, rent, depreciation) or by function (cost of sales, selling, administrative); small businesses usually present by nature.

The statement of changes in equity

The statement of stockholders' equity shows each component of equity at the start of the period, the changes during the period, and the balance at the end. Many small companies present a simpler statement of retained earnings, with changes in contributed capital disclosed in the notes. A sole proprietorship prepares a statement of owner's equity: opening capital, plus investments and net income, less withdrawals, equals ending capital.

The classified balance sheet

A classified balance sheet groups assets and liabilities into current and non-current categories, which helps users judge liquidity. Current assets are cash and other assets expected to be converted to cash, sold or used up within one year or the operating cycle, whichever is longer: receivables, inventory, supplies, prepaid expenses and short-term investments. Non-current assets include property, plant and equipment, intangible assets and long-term investments. Current liabilities are obligations due within one year: accounts payable, wages payable, interest payable, unearned revenue, sales taxes payable and the current portion of long-term debt. Non-current liabilities include long-term loans, bonds and lease obligations due after more than a year.

US companies almost always list current assets first and liabilities before stockholders' equity, in order of liquidity. Companies reporting under IFRS, including many Canadian and European companies, sometimes list non-current assets first and equity before liabilities. The content is the same; only the order changes.

Two quick measures come straight from the classified balance sheet. Working capital is current assets minus current liabilities: $44,200 − $1,370 = $42,830. The current ratio is current assets divided by current liabilities: 44,200 ÷ 1,370 ≈ 32.3. A ratio that high is typical of a business that has just raised cash and not yet spent it; most established businesses have current ratios between about 1 and 3. Lesson 12 interprets ratios properly.

The worksheet

Before software, accountants used a worksheet, a large spreadsheet with columns for the unadjusted trial balance, adjustments, adjusted trial balance, income statement and balance sheet, to organize end-of-period work and catch errors before entries were journalized. Accountants still build worksheets in spreadsheet software for complex closes, for year-end working papers, and when they need to test proposed adjustments before posting them. The worksheet is a tool, not a statement; adjustments shown on it must still be journalized and posted.

Closing entries

Revenue, expense and dividend accounts are temporary accounts. They collect amounts for one period only, so that the income statement shows that period's results. At the end of the period their balances are transferred to retained earnings and they are reset to zero, ready to start the next period. Asset, liability and equity accounts other than dividends are permanent accounts; their balances carry forward. The entries that transfer temporary balances are closing entries.

Closing is often done in four steps through a temporary Income summary account, which makes the net income figure visible in the ledger. Step 1: debit each revenue account and credit Income summary for total revenues. Step 2: debit Income summary for total expenses and credit each expense account. Income summary now has a credit balance equal to net income. Step 3: debit Income summary and credit Retained earnings for net income (reverse for a loss). Step 4: debit Retained earnings and credit Dividends. Many businesses, and accounting software, close revenues and expenses directly to retained earnings without an Income summary account; the result is identical.

For a sole proprietorship, steps 3 and 4 close Income summary and the owner's Withdrawals account to the owner's Capital account instead of Retained earnings. For a partnership, net income is divided among the partners' capital accounts according to their agreement.

# Closing entries and the post-closing trial balance (illustrative)
adjusted = {"Cash": 37800, "Accounts receivable": 2200, "Supplies": 900,
            "Prepaid insurance": 3300, "Equipment": 18000,
            "Accumulated depreciation": -300,      # credit balance shown negative
            "Accounts payable": -850, "Wages payable": -420,
            "Interest payable": -100, "Note payable": -20000,
            "Share capital": -40000, "Retained earnings": 0,
            "Dividends": 500, "Service revenue": -8200,
            "Rent expense": 2000, "Wages expense": 3520,
            "Utilities expense": 350, "Insurance expense": 300,
            "Supplies expense": 600, "Depreciation expense": 300,
            "Interest expense": 100}
temporary = [k for k in adjusted if "revenue" in k or "expense" in k]

income_summary = 0
for acct in temporary:                # steps 1 and 2
    income_summary += adjusted[acct]  # revenues are negative (credits)
    adjusted[acct] = 0
net_income = -income_summary
adjusted["Retained earnings"] -= net_income          # step 3 (credit RE)
adjusted["Retained earnings"] += adjusted["Dividends"]  # step 4 (debit RE)
adjusted["Dividends"] = 0

print("Net income closed:", net_income)
post = {k: v for k, v in adjusted.items() if v != 0}
for k, v in post.items():
    print(f"{k:<26}{v if v > 0 else '':>8}{-v if v < 0 else '':>8}")
print("Debits", sum(v for v in post.values() if v > 0),
      "Credits", -sum(v for v in post.values() if v < 0))

Net income closed: 1030
Cash                         37800        
Accounts receivable           2200        
Supplies                       900        
Prepaid insurance             3300        
Equipment                    18000        
Accumulated depreciation               300
Accounts payable                       850
Wages payable                          420
Interest payable                       100
Note payable                         20000
Share capital                        40000
Retained earnings                      530
Debits 62200 Credits 62200

The post-closing trial balance

After closing, a post-closing trial balance lists only permanent accounts. It confirms that the ledger is in balance at the start of the new period and that every temporary account is zero. For Birchwood Bikes, debits and credits each total $62,200: total assets of $61,900 plus the $300 of accumulated depreciation, which appears on the credit side rather than as a deduction. Retained earnings now shows $530, matching the statement of changes in equity.

The accounting cycle

The steps covered in lessons 2 to 7 make up the accounting cycle, repeated every period: analyze transactions from source documents; journalize; post to the ledger; prepare an unadjusted trial balance; journalize and post adjusting entries; prepare an adjusted trial balance; prepare the financial statements; journalize and post closing entries; prepare a post-closing trial balance; and, optionally, record reversing entries at the start of the next period. Most businesses close monthly for management reporting and formally once a year, when the books are locked and, for many, audited or reviewed.