The Adjusted Trial Balance
In the last section, adjusting entries were recorded and posted. As a result,
some account balances reported on the January 31, 2015 unadjusted trial
balance in Figure 2 have changed. Recall that an unadjusted trial balance
reports account balances before adjusting entries have been recorded and
posted. An adjusted trial balance reports account balances after adjusting
entries have been recorded and posted. Figure 3.8 shows the adjusted trial
balance for BDCC at January 31, 2015.
In Chapters 1 and 2, the preparation of financial statements was demonstrated using BDCC’s unadjusted trial balance. We now know that an adjusted trial balance must be used to prepare financial statements.
Using the Adjusted Trial Balance to Prepare Financial Statements
In the last section, we saw that the adjusted trial balance is prepared after journalizing and posting the adjusting entries. This section shows how financial statements are prepared using the adjusted trial balance.
The income statement is prepared first, followed by the statement of changes in equity as shown below.
The balance sheet can be prepared once the statement of changes in equity is complete.
Notice how accumulated depreciation is shown on the balance sheet.
The Accounting Cycle
The concept of the accounting cycle was introduced in Chapter 2. The accounting cycle consists of the steps followed each accounting period to prepare financial statements. These eight steps are:
Step 1: Transactions are analyzed and recorded in the general journal
Step 2: The journal entries in the general journal are posted to accounts in
the general ledger.
Step 3: An unadjusted trial balance is prepared to ensure total debits equal total credits.
Step 4: The unadjusted account balances are analyzed and adjusting entries are journalized in the general journal and posted to the general ledger
Step 5: An adjusted trial balance is prepared to prove the equality of debits and credits.
Step 6: The adjusted trial balance is used to prepare financial statements
Step 7: Closing entries are journalized and posted.
Step 8: Prepare a post-closing trial balance.
Steps 1 through 6 were introduced in this and the preceding chapters. Steps 7 and 8 are discussed in the next section.
The Closing Process
At the end of a fiscal year, after financial statements have been prepared, the revenue, expense, and dividend account balances must be zeroed so
that they can begin to accumulate amounts belonging to the new fiscal
year. To accomplish this, closing entries are journalized and posted. Closing entries transfer each revenue and expense account balance, as well as any balance in the Dividend account, into retained earnings. Revenues, expenses, and dividends are therefore referred to as temporary accounts because their balances are zeroed at the end of each accounting period. Balance sheet accounts, such as retained earnings, are permanent accounts
because they have a continuing balance from one fiscal year to the next.
The closing process transfers temporary account balances into a permanent account, namely retained earnings. The four entries in the closing
process are detailed below.
Entry 1: Close the revenue accounts to the income summary account
A single compound closing entry is used to transfer revenue account balances to the income summary account. The income summary is a checkpoint: once all revenue and expense account balances are transferred/closed to the income summary, the balance in the Income Summary account must be equal to the net income/loss reported on the income statement. If not, the revenues and expenses were not closed correctly.
Entry 2: Close the expense accounts to the Income Summary account
The expense accounts are closed in one compound closing journal entry to the Income Summary account. All expense accounts with a debit balance are credited to bring them to zero. Their balances are transferred to the Income Summary account as an offsetting debit.
After entries 1 and 2 above are posted to the Income Summary account, the balance in the income summary must be compared to the net income/loss reported on the income statement. If the income summary balance does not match the net income/loss reported on the income statement, the revenues and/or expenses were not closed correctly.
Entry 3: Close the income summary to retained earnings
The Income Summary account is closed to the Retained Earnings account. This procedure transfers the balance in the income summary to retained earnings. Again, the amount closed from the income summary to retained earnings must always equal the net income/loss as reported on the income statement.
Note that the Dividend account is not closed to the Income Summary account because dividends is not an income statement account. The dividend account is closed in Entry 4.
Entry 4: Close dividends to retained earnings
The Dividend account is closed to the Retained Earnings account. This results in transferring the balance in dividends, a temporary account, to retained earnings, a permanent account.
The balance in the Income Summary account is transferred to retained earnings because the net income (or net loss) belongs to the shareholders. The closing entries for Big Dog Carworks Corp. are shown in Figure 3.10.
Posting the Closing Entries to the General Ledger
When entries 1 and 2 are posted to the general ledger, the balances in all revenue and expense accounts are transferred to the Income Summary account. The transfer of these balances is shown in Figure 3.11. Notice that a zero balance results for each revenue and expense account after the closing entries are posted, and there is a $2,057 credit balance in the income summary. The income summary balance agrees to the net income reported on the income statement.
When the income summary is closed to retained earnings in the third closing entry, the $2,057 credit balance in the income summary account is transferred into retained earnings as shown in Figure 3.12. As a result, the income summary is left with a zero balance.
The Post–Closing Trial Balance
A post-closing trial balance is prepared immediately following the posting of closing entries. The purpose is to ensure that the debits and credits in the general ledger are equal and that all temporary accounts have been closed. The post-closing trial balance for Big Dog Carworks Corp. appears below.