Chapter 5 Closing Entries and the Post-Closing Trial Balance

We are now starting the last steps of the Accounting Cycle: Steps 8 and 9
Lets review the steps we have completed of the Accounting Cycle:
o Step 1: Analysis of Business Transactions and Journal Entries
o Step 2: Post the journal entries to the General Ledger Accounts
o Step 3: Prepare the Trial Balance
o Step 4: Record the adjusting entries on the worksheet
o Step 5: Complete the worksheet
o Step 6: Journalize and post adjusting entries from the worksheet
o Step 7: Prepare the financial statements from the worksheet.

Step 8: Journalize and post the closing entries

Closing entries are used to close out the balance of certain accounts. We want to bring
their beginning balance in the next accounting period to zero.
The reason we want to zero these accounts out is that their balances only apply for one
accounting period.
Real or Permanent Accounts do not get closed out. These are Assets, Liabilities, and
Capital accounts. Their balances are carried over from year to year.
Nominal or Temporary Accounts are closed out. These are Revenues, Expenses, and
Owners Withdrawal accounts. These are the accounts that you want to start the next
account period with zero balances.
We will use a new account as we do the closing entries. The account is called the
Income Summary account. It is a temporary account which is only used for the purpose
of balancing debits and credits during the closing process. Income Summary will always
have a zero balance both before and after closing entries are done.
There are four steps to Closing Entries (see the middle of page 225):
1. Close all the Revenue Accounts to Income Summary.
2. Close all the Expense Accounts to Income Summary.
3. Close Income Summary to the Capital Account.
4. Close the Owners Withdrawal Account(s) to the Capital Account(s).
In Step 2: Close all the Expense Accounts to Income Summary, to get the amount for
Income Summary it will equal the total of all the expenses. The total should be the same
as on the Worksheet.
In Step 3: Close Income Summary to the Capital Account, the amount in Income
Summary at this point should equal the total of the companys Net Income or Net Loss.
Each time you do the steps the journal entries will look the same except for Step 3. This
step depends on whether or not the company has Net Income or Net Loss. Net Income
will be Credited to Capital and a Net Loss will be Debited to Capital.
1

Hint: To determine if you should debit or credit the Capital account in Step 3 draw you a
T Account for Income Summary and enter the amounts from Steps 1 and 2. You have to
zero out Income Summary in Step 3 and the opposite has to go into Capital.
Look at an example of Closing Entries in Figure 3 on page 228.
Closing entries must also be posted to the accounts (see page 231).

Step 9: Post-Closing Trial Balance

The purpose of the Post-Closing Trial Balance is to verify that all the debits and credits
balance. It also lets you be sure that all of the accounts were closed correctly during the
closing process.
The only accounts that should have balances and be included on the Post-Closing Trial
Balance are Assets, Liabilities, and Capital. These are the Real or Permanent accounts.
These accounts and their balances are carried forward to the next accounting period or
fiscal year.

Cash versus Accrual Accounting

Businesses must use the same method of accounting from year to year. The method has a
direct effect on the businesss net income and taxes.
The two methods are Cash and Accrual Based Accounting.
Accrual Accounting, revenues are recorded when they are earned, and expenses are
recorded when they are incurred. It does not matter if you collect the revenues at the time
of the services or pay for the expenses when you receive them.
Example of Revenue under Accrual Accounting: When you go to the Doctors Office
and you do not pay. The doctor has done a service so he has earned revenue. He will do
an entry at the time of the service for Revenue and Accounts Receivable. Accounts
Receivable to receive in the future.
Example of Expense under Accrual Accounting: Your business buys supplies over the
telephone. You receive the supplies and will receive the bill to pay in 30 days. You
record this when you receive the supplies as an Expense and Accounts Payable.
Accounts Payable to pay in the future.
Cash Accounting, revenue is recorded when it is received, not when it is earned.
Expenses are generally recorded when they are paid rather than when they are incurred or
are billed.
Some expenses may be recorded even though they are paid at a different time (and
adjustments must be made). Example: Adjustments for depreciation and adjustment for
insurance expired.
Example of Revenue under Cash Accounting: When you go to the Doctors Office and
you do not pay. The doctor has done a service so he has earned revenue. He will not do
any type of journal entry until he actually receives the money from you, no matter how
long it takes to collect his fees.
2

Example of Expense under Cash Accounting: Your business buys supplies over the
telephone. You receive the supplies and will receive the bill to pay in 30 days. You will
not record the expense until you actually pay the bill in 30 days.
Many businesses actually use a combination of accrual and cash accounting. However
they have to select one method when they are doing their tax returns and inventory.

Interim Statements

These are statements that are prepared for less than a 12 month period.
Owners and managers do not want, or need, to wait 12 month to see what is going on
with their company so they prepare interim statements.
Interim statements can be prepared as often as management wants them, however the
most common periods of time are monthly and quarterly.