At this point in the accounting cycle, we have prepared the financial statements. Now we do the last part, the closing entries. The videos in the adjusting entry section gave you a preview into this process but we will discuss it in more detail.
|1. Analyze Transactions||5. Prepare Adjusting Journal Entries||9. Prepare Closing Entries|
|2. Prepare Journal Entries||6. Post Adjusting Journal Entries||10. Post Closing Entries|
|3. Post journal Entries||7. Prepare Adjusted Trial Balance||11. Prepare Post-Closing Trial Balance|
|4. Prepare Unadjusted Trial Balance||8. Prepare Financial Statements|
The closing entries will be a review as the process for closing does not change for a merchandising company. Do you remember why we do closing entries? They are the journal entry version of the statement of retained earnings to ensure the balance we report on the statement of retained earnings and the balance sheet matches the ending balance of retained earnings in our general ledger. Closing entries also set the balances of all temporary accounts (revenues, expenses, dividends) to zero for the next period.
If the process is the same, why do we need to review it? We have many new accounts learned for a merchandiser and we want to see how they fit into the closing process. The new accounts remaining for a merchandiser after adjusting entries are:
|Sales Returns and Allowances*||Revenue|
|Cost of Goods Sold||Expense|
Revenue accounts typically have normal credit balances (credit to increase, debit to decrease) but Sales Discounts and Sales Returns and Allowances are contra-accounts because they are revenue accounts but have normal debit balances (debit to increase, credit to decrease). Expenses have normal debit balances.
The four basic steps in the closing process are modified slightly:
- Closing the revenue accounts with credit balances—transferring the credit balances in the revenue accounts to a clearing account called Income Summary.
- Closing the expense accounts and contra-revenue accounts—transferring the debit balances in the expense accounts and contra-revenue accounts to a clearing account called Income Summary.
- Closing the Income Summary account—transferring the balance of the Income Summary account to the Retained Earnings account (this should always equal net income or loss from the income statement).
- Closing the Dividends account—transferring the debit balance of the Dividends account to the Retained Earnings account.
To illustrate, let’s look at the adjusted trial balance from Hanlon from the previous section:
|Adjusted Trial Balance||Debit||Credit|
|Sales returns and allowances*||1,000|
|Cost of goods sold||159,000|
|Sales Salaries expense||20,000|
|Rent expense – sales||12,000|
|Rent expense – office||12,000|
|Office Salaries expense||40,000|
We will prepare the closing entries for Hanlon. Remember to close means to make the balance zero. To do this, we will do the opposite of the balance in the adjusted trial balance in a journal entry and use Income Summary to balance the entry.
1. Close the revenue accounts with credit balances. We have 2 revenue accounts with a credit balance, Sales Revenue (or Sales) and Interest Revenue.
|To close revenue accounts with credit balances.|
2. Close contra-revenue accounts and expense accounts with debit balances. We will close sales discounts, sales returns and allowances, cost of goods sold, and all other operating and nonoperating expenses.
|Sales Returns and Allowances||1,000|
|Cost of Goods Sold||159,000|
|Sales Salaries Expense||20,000|
|Rent Expense – Sales||12,000|
|Rent Expense – Office||12,000|
|Office Salaries Expense||40,000|
|To close contra-revenue and expense accounts.|
3. Close income summary into retained earnings. We will take the difference between income summary in step 1 $275,150 and subtract the income summary balance in step 2 $268,050 to get the adjustment amount of $7,100. This should always match net income calculated on the income statement.
|Income Summary (275,150 – 268,050)||7,100|
|To close net income into retained earnings.|
4. Close the debit balance of dividends into retained earnings. Remember, dividends are earnings of the company given back to the owner and will reduce retained earnings. Retained earnings is an equity account and is decreased with a debit. Dividends is a contra-account because it is an equity account but has a normal debit balance. Do not use the retained earnings balance in this entry!
|To close dividends into retained earnings.|
To check our work, the Statement of Retained Earnings would look like this:
|Hanlon Food Store|
|Statement of Retained Earnings|
|For Year Ended December 31|
|Retained Earnings, January 1||25,000|
|Add: Net Income||7,100|
|Retained Earnings, December 31||24,100|
When we post the closing entries to the general ledger, the revenues, expenses and dividends accounts are all zero. The retained earnings ledger card would look like:
|Account: Retained Earnings||Debit||Credit||Balance|
|(3) Close income summary||7,100||32,100|
|(4) Close dividends||8,000||24,100|
The final step in the merchandising accounting cycle would be to prepare a post-closing trial balance. The post closing trial balance will contain assets, liabilities, common stock and the new ending balance calculated for retained earnings.