Study: Closing Entries: Analyze, Record, Post, Prepare Post-Closing Trial Balance
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Slides 1-4 (2m:01s)
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Slide 1
Welcome to Introduction to Accounting Preparing for a User’s Perspective
Closing Entries: Analyze, record & post. Prepare Post-Closing Trial Balance
Slide 2
We’re now ready to finish up the full accounting cycle by recording the closing entries and preparing the post-closing trial balance.
In the prior video, you learned how to identify which accounts needed to be closed. Those are the temporary accounts, also known as nominal accounts.
In this video, we will analyze those accounts, determine how to record the closing entries, record them, post the entries to the ledger accounts so that all temporary accounts are zero and their balances are transferred into retained earnings and then we will prepare the post-closing trial balance which will only include balances for permanent (i.e. real accounts) that appear on the balance sheet.
Slide 3
In the prior video, we talked about identifying those temporary accounts. Now we will analyze, record, post and prepare the post-closing trial balance.
Slide 4
Before continuing, you should make sure that you know the difference between temporary, also known as nominal accounts, and permanent, also known as real accounts.
The temporary accounts are all those accounts that do not appear on the balance sheet. Those are the things on the income statement or dividends.
Permanent accounts are all those accounts that do appear on the balance sheet and they carry their balances forward from one year to the next.
You should also know why temporary accounts are closed into retained earnings each year.
One reason is to avoid double-counting of net income and dividends. Since all revenues and expenses which create net income are closed every year and dividends are closed every year, when the new year starts, it’s like a new football game, you start with zeros and you keep track of how you did in that year. It’s like each year is a game and each year begins with zero.
It allows you to start fresh each year to account for the net income and dividends just for that year.
If you need a refresher on what accounts are temporary [i.e. nominal] and which ones are permanent [i.e. real] please watch this 7 minute 30 second video on YouTube
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Slides 5-7 (6m:13s)
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Slide 5
I’ve created a simple example to step you through the concept of closing entries. This is the adjusted trial balance for ABC Co. for the year ended December 31, X1. You can see we have permanent accounts up through retained earnings and we have temporary accounts.
Revenues and expenses are temporary accounts that appear on the income statement and are used to compute net income. The credit for revenues shows it has a positive balance in revenues; therefore, it’s added to net income. The debit in expenses shows it has a positive balance in the expense account because expenses are increased on the debit side. So, we have $55 in expenses which are deducted from revenues to arrive at net income.
Then we prepare the statement of retained earnings. The beginning retained earnings will come from the adjusted trial balance, but retained earnings is the only account that really hasn’t been adjusted yet, because retained earnings are adjusted by dividends, revenues and expenses. Therefore, this $25 [credit in retained earnings] is actually the January 1st, X1 balance because these [temporary] accounts have not been closed into it. Through the closing process we will make sure all these [temporary] accounts get closed into this retained earnings but just remember that the beginning retained earnings to be used on the statement of retained earnings comes from the adjusted trial balance. The way you know that these accounts have not been closed yet is because [the] temporary accounts still have balances.
The beginning retained earnings then goes onto the statement of retained earnings, then the net income computed from the income statement goes onto the statement of retained earnings, and dividends are deducted from the statement of retained earnings. That gets us to the ending retained earnings balance. So after the closing process, this retained earnings amount needs to be a credit of $50.
That credit of $50 appears on the balance sheet, so one of the goals will be to make sure that all the accounts have been updated to exactly agree with the balance sheet and since none of the temporary accounts appear on the balance sheet, they all need to be zero.
All temporary accounts, and you can use the acronym to remember them REID, must be closed to match this ending balance sheet.
• R standing for Revenues.
• E standing for Expenses.
• I standing for Income Summary, and
• D standing for Dividends
Slide 6
Visually you can think of the closing process in this manner.
In this blue box we have all the permanent accounts and in the red box below we have all the temporary accounts. The closing process will take these temporary accounts and put them into retained earnings and zero them out.
All I’ve done is I’ve taken the adjusted trial balance from the prior page and I put their balance into their respective ledger account.
What we are now going to do is go through the R E I D acronym to close all temporary accounts into retained earnings.
R: Revenues currently is a credit balance of $90. How do we get revenues to go down to $0. The only way to do that would be to debit revenues $90. By recording this journal entry, a debit of $90 and posting it to the ledger account, revenues are now $0 like they should be. But that journal entry does not balance yet. We can see from this diagram that revenues need to be closed into the income summary account; therefore, we will credit income summary.
The key point you need to see is that this credit of revenues was transferred into net income, but the way you had to do that is you had to debit revenues to zero it out and then credit the income summary account.
Let’s see if you can think what you do to close the expenses account. It currently has a debit of $55. How would we close this debit? The only way, since the debits increase expenses and the credits decrease expenses, we would have to credit it $55. Posting that to the ledger account, expenses are now $0, but to balance this journal entry out, we need to debit income summary.
By posting that to the income summary account, you can now see that revenues have been credited to income and expenses have been debited to income.
At this stage we can move on to closing the income summary account into retained earnings. Currently income summary has a credit balance of $35, which is what our net income was. We use an income summary account so that when we finish closing revenues and expenses we can verify that the balance matches our net income. If the balance in income summary, before closing it [into retained earnings] is a credit, that means you had net income because your revenues were greater than your expenses. However, if these were reversed, if you had $90 of expenses and $55 of revenues, you would have a net loss of $35, which net loss would be debited to retained earnings.
Now how would we close this income summary account? Since it is currently a credit, we would have to debit income summary. We post that debit into the income summary account, income summary is now $0, but this journal entry needs to balance, so we need a credit of $35 and that $35 will appear as a credit in retained earnings and that makes sense. Net income increases retained earnings.
Finally, we need to close our dividends account. It currently has a debit balance of $10. To close that we would need to credit it $10. By posting that, our dividends are now $0.
To balance out the entry, we need to debit retained earnings, which will reduce retained earnings by $10 and our ending retained earnings are now $50, which is exactly the ending retained earnings which we computed on the statement of retained earnings.
We’ve just finished the closing process for that simple ABC Company trial balance.
Slide 7
Looking at it from the big picture again, we took all the temporary accounts and we closed them into retained earnings causing retained earnings to go from a credit of $25 to a credit of $50.
After all the temporary accounts have been closed into retained earnings, only permanent accounts will carry amounts forward to next year and will appear on the post-closing trial balance.
All temporary accounts are now $0 and are ready to capture new data for the New Year.
Slide 8
Now let’s look back at the Suepervantastic Toy Company that we’ve been working with in this full accounting cycle video series.
On that, it was a brand-new company, so the beginning retained earnings was $0. We had net income of $71,696 and then declared $5,940 in dividends resulting in an ending retained earnings balance of $65,756.
To do the closing entry process for Suepervantastic Toy Company we need to take all these temporary accounts and close them into retained earnings.
Slide 9
This is the full adjusted trial balance. It starts from cash and goes all the way down to income tax expense and debits do equal credits.
In order to do the closing entry process correctly, we need to identify all permanent accounts which we will not close and all temporary accounts which we will close. Those temporary accounts appear on the income statement and dividends which appears on the statement of retained earnings.
It’s these accounts that we are going to close and put into retained earnings.
Why doesn’t the retained earnings account appear on this adjusted trial balance?
In this case, it doesn’t appear because it’s a zero balance because it’s a brand-new company and therefore began the year with zero, so we didn’t bother to put it on. If this company had been around for a while, we would have had a retained earnings opening balance into which all these temporary accounts would be closed into.
Slide 10
Here’s the [portion of the] adjusted trial balance that includes all temporary accounts. We’re first going to start with the R, Revenue accounts. All revenue accounts normally have a credit balance because that is their increase side. To close sales revenue we would have to debit it $200,000. To close interest revenue, we have to debit it $600 and to close dividend income we’d have to debit it $200. To balance this journal entry out we would have to credit income summary $200,800.
Slide 11
This is the income summary account. If we were to post that closing entry, you would see that we would credit all the revenues into income summary $200,800.
Slide 12
Moving on to the expenses. All the expenses are currently debits so the only way to close a debit is to credit them. The sum of all those expenses is $129,104, which needs to be closed into the income summary account by debiting it.
Slide 13
The income summary account had the credit for revenues and now it has the debit for all the expenses, we can now compute the balance in income summary which should match the net income on our income statement of $71,796.
After all the expenses have been closed into the income summary account, the balance in the income summary account should be equal to net income. If it’s a credit balance you know had net income because revenues exceeded expenses. If it’s a debit balance, you know you had a net loss because expenses exceeded revenues.
Therefore, the balance in the income summary account represents net income, if it’s a credit, or net loss, which is a debit and they will be closed into retained earnings.
Slide 14
Now that we know what the net income is in the income summary account, we need to close it. The only way we close a credit is to debit it $71,796.
What account do we close income summary into? Retained earnings.
So we just increased retained earnings by crediting it $71,796.
Slide 15
Looking at the income summary account, we needed to close this credit and we did so by recording a debit entry $71,796 and income summary is now a $0 balance. It [income summary] should always end the closing process with a $0.
Income summary is a very temporary, temporary account that only exists during the closing process.
Slide 16
Finally, we are going to close the dividends. It’s currently are a debit so we have to credit dividends $5,940 and we are going to reduce retained earnings by debiting it $5,940.
Slide 17
The big picture is we took all these temporary accounts and we closed them into retained earnings. The post-closing trial balance now only has permanent accounts all the accounts below that were temporary and have been closed into retained earnings so a new year can be started with zero balances in those accounts.
Slide 18
Effectively what we did is we took all these temporary accounts and put them into the permanent account called retained earnings and this is the balance that will carry forward and keep the balance sheet in balance at the end of the year.
Slide 19
Now let’s verify that the retained earnings ledger account matches what we already showed on our completed statement of retained earnings. Our ending retained earnings balance should be $65,756.
We started with $0 retained earnings. We then added net income of $71,796.
We then reduced retained earnings because we declared the dividend $5,940, thus arriving at an ending retained earnings balance of $65,756 and this shows that our ledger account now agrees with the financial statements that we already prepared.
Slide 20
I hope you have a solid understanding of the full accounting cycle now. We’ve just wrapped it all up and we have a post-closing trial balance with which to start the new year and keep track of our results in that year. Good luck.