Question & Answer: C1. Explain why temporary accounts are closed each period……

C1. Explain why temporary accounts are closed each period.
C2. Identify steps in the accounting cycle.
C3. Explain and prepare a classified balance sheet.
Analytical objectives:
A1. Compute the current ratio and describe what it reveals about a company’s financial condition.

Expert Answer


C1. Explain why temporary accounts are closed each period:-

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The closing entries are recorded after the financial statements for the accounting year are prepared. The reason for the closing entries is to ensure that each revenue and expense account will begin the next accounting year with a zero balance.

The closing entries require that a debit be entered into each of the temporary accounts having a credit balance. The debit entered must be exactly the amount of the credit balance prior to the closing entry. The objective is to get the account balance to be zero.

The closing entries also require that a credit be entered into each of the temporary accounts having a debit balance. The credit amount that is entered must be exactly the amount of the debit balance prior to the closing entry.

The net amount of the debits and credits in the closing entries for the income statement accounts is the amount of the income or loss. This net amount will end up in the balance sheet account Retained Earnings (part of stockholders’ equity of a corporation) or in the owner’s capital account (part of owner’s equity in a sole proprietorship). In manual systems, there is often an Income Summary account before the entry into the equity account.

With some accounting software the closing entries are prepared and posted by selecting “closing entries.” With other accounting software, formal closing entries are not used. Instead, the user specifies the beginning and ending dates of the information needed.

C2. Identify steps in the accounting cycle:-

The accounting cycle, also commonly referred to as accounting process, is a series of procedures in the collection, processing, and communication of financial information.

As defined in earlier lessons, accounting involves recording, classifying, summarizing, and interpreting financial information.

Financial information is presented in reports called financial statements. But before they can be prepared, accountants need to gather information about business transactions, record and collate them to come up with the values to be presented in the reports.

The cycle does not end with the presentation of financial statements. Several steps are needed to be done to prepare the accounting system for the next cycle.

Accounting Cycle Steps:-

Question & Answer: C1. Explain why temporary accounts are closed each period...... 1

1. Identifying and Analyzing Business Transactions

The accounting process starts with identifying and analyzing business transactions and events. Not all transactions and events are entered into the accounting system. Only those that pertain to the business entity are included in the process.

For example, a personal loan made by the owner that does not have anything to do with the business entity is not accounted for.

The transactions identified are then analyzed to determine the accounts affected and the amounts to be recorded.

The first step includes the preparation of business documents, or source documents. A business document serves as basis for recording a transaction.

2. Recording in the Journals

A journal is a book – paper or electronic – in which transactions are recorded. Business transactions are recorded using the double-entry bookkeeping system. They are recorded in journal entries containing at least two accounts (one debited and one credited).

To simplify the recording process, special journals are often used for transactions that recur frequently such as sales, purchases, cash receipts, and cash disbursements. A general journal is used to record those that cannot be entered in the special books.

Transactions are recorded in chronological order and as they occur.

Journals are also known as Books of Original Entry.

3. Posting to the Ledger

Also known as Books of Final Entry, the ledger is a collection of accounts that shows the changes made to each account as a result of past transactions, and their current balances.

After the posting all transactions to the ledger, the balances of each account can now be determined.

For example, all journal entry debits and credits made to Cash would be transferred into the Cash account in the ledger. We will be able to calculate the increases and decreases in cash; thus, the ending balance of Cash can be determined.

4. Unadjusted Trial Balance

A trial balance is prepared to test the equality of the debits and credits. All account balances are extracted from the ledger and arranged in one report. Afterwards, all debit balances are added. All credit balances are also added. Total debits should be equal to total credits.

When errors are discovered, correcting entries are made to rectify them or reverse their effect. Take note however that the purpose of a trial balance is only test the equality of total debits and total credits and not to determine the correctness of accounting records.

Some errors could exist even if debits are equal to credits, such as double posting or failure to record a transaction.

5. Adjusting Entries

Adjusting entries are prepared as an application of the accrual basis of accounting. At the end of the accounting period, some expenses may have been incurred but not yet recorded in the journals. Some income may have been earned but not entered in the books.

Adjusting entries are prepared to update the accounts before they are summarized in the financial statements.

Adjusting entries are made for accrual of income, accrual of expenses, deferrals (income method or liability method), prepayments (asset method or expense method), depreciation, and allowances.

6. Adjusted Trial Balance

An adjusted trial balance may be prepared after adjusting entries are made and before the financial statements are prepared. This is to test if the debits are equal to credits after adjusting entries are made.

7. Financial Statements

When the accounts are already up-to-date and equality between the debits and credits have been tested, the financial statements can now be prepared. The financial statements are the end-products of an accounting system.

A complete set of financial statements is made up of: (1) Statement of Comprehensive Income (Income Statement and Other Comprehensive Income), (2) Statement of Changes in Equity, (3) Statement of Financial Position or Balance Sheet, (4) Statement of Cash Flows, and (5) Notes to Financial Statements.

8. Closing Entries

Temporary or nominal accounts, i.e. income statement accounts, are closed to prepare the system for the next accounting period. Temporary accounts include income, expense, and withdrawal accounts. These items are measured periodically.

The accounts are closed to a summary account (usually, Income Summary) and then closed further to the appropriate capital account. Take note that closing entries are made only for temporary accounts. Real or permanent accounts, i.e. balance sheet accounts, are not closed.

9. Post-Closing Trial Balance

In the accounting cycle, the last step is to prepare a post-closing trial balance. It is prepared to test the equality of debits and credits after closing entries are made. Since temporary accounts are already closed at this point, the post-closing trial balance contains real accounts only.

10. Reversing Entries: Optional step at the beginning of the new accounting period

Reversing entries are optional. They are prepared at the beginning of the new accounting period to facilitate a smoother and more consistent recording process.

In this step, the adjusting entries made for accrual of income, accrual of expenses, deferrals under the income method, and prepayments under the expense method are simply reversed.

C3. Explain and prepare a classified balance sheet:-

A classified balance sheet presents information about an entity’s assets, liabilities, and shareholders’ equity that is aggregated (or “classified”) into subcategories of accounts. It is extremely useful to include classifications, since information is then organized into a format that is more readable than a simple listing of all the accounts that comprise a balance sheet. When information is aggregated in this manner, a balance sheet user may find that useful information can be extracted more readily than would be the case if an overwhelming number of line items were presented. The most common classifications used within a classified balance sheet are:

·         Current assets

·         Long-term investments

·         Fixed assets (or Property, Plant, and Equipment)

·         Intangible assets

·         Other assets

·         Current liabilities

·         Long-term liabilities

·         Shareholders’ equity

The sum of these classifications must match this formula (known as the accounting equation):

Total assets = Total liabilities + Shareholders’ Equity

The classifications used can be unique to certain specialized industries, and so will not necessarily match the classifications shown here. Whatever system of classification is used should be applied on a consistent basis, so that balance sheet information is comparable over multiple reporting periods.

There is no specific requirement for the classifications to be included in the balance sheet. The following items, at a minimum, are normally found in a balance sheet:

Current Assets:

·         Cash and cash equivalents

·         Trade and other receivables

·         Prepaid expenses

·         Investments

·         Inventories

·         Assets held for sale

Long-Term Investments:

·         Investments in other companies

Fixed Assets:

·         Computer hardware

·         Computer software

·         Furniture and fixtures

·         Leasehold improvements

·         Office equipment

·         Production equipment

·         Accumulated depreciation

Intangible Assets:

·         Intangible assets

·         Accumulated amortization

·         Goodwill

Current Liabilities:

·         Trade and other payables

·         Accrued expenses

·         Current tax liabilities

·         Current portion of loans payable

·         Other financial liabilities

·         Liabilities held for sale

Long-Term Liabilities:

·         Loans payable

·         Deferred tax liabilities

·         Other non-current liabilities

Shareholders’ Equity:

·         Capital stock

·         Additional paid-in capital

·         Retained earnings

Classified Balance Sheet Example

Here is an example of a classified balance sheet, where the classifications are listed in bold in the first column:

Question & Answer: C1. Explain why temporary accounts are closed each period...... 2

Question & Answer: C1. Explain why temporary accounts are closed each period...... 3

A1. Compute the current ratio and describe what it reveals about a company’s financial condition:-

The current ratio is a liquidity ratio that measures a company’s ability to pay off their short-term dues with their current assets

The current ratio helps to provide insight into a company’s ability to pay their short-term obligations back with their short-term (liquid) assets (basically, whether the company has enough cash to pay their immediate debts, if necessary).

If a company has a high ratio (anywhere above 1) then they are capable of paying their short-term obligations. The higher the ratio, the more capable the company.

On the other hand, if the company’s current ratio is below 1, this suggests that the company is not able to pay off their short-term liabilities with cash. This indicates poor financial health for a company, but does not necessarily mean they will unable to succeed.

The current ratio is (aka the liquidity ratio or cash ratio) is a simple formula:

Current assets / Current liabilities = Current ratio

Current ratio example

To see the current ratio in practice, here is an example: If a company had current assets of $100,000 and current liabilities of $50,000, then it’s current ratio would be solved by dividing the assets by the liabilities: $100,000 / $50,000 = 2.00. The company has a current ratio of 2.0, which would be considered a good ratio value in most industries.

While the value of acceptable current ratios varies from industry, a good ratio would often be between 1.5 and 2.

Why the current ratio is important

A company’s current ratio provides important insight into how liquid the company is and therefore lends data to the financial health of the business.

The current ratio is usually of interest to potential investors. It allows them to see a simple numerical value of a company that reveals important information about that company’s health.

However, there are some downsides to the current ratio. Because it typically falls within a very small range, it is often not very specific. Sometimes, much more information is needed to properly evaluate the health of business.

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