Pro Tip: For optimal viewing, review Lee’s cheat sheets on a PC or Laptop rather than mobile devices.
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🔹 Basic Accounting Assumptions and Principles
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Time Period Assumption in Accounting
📌 Accounting information is reported at regular intervals (monthly, quarterly, annually) to facilitate decision making.
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Revenue Recognition Principle
📌 Revenue should be recognized in the same period it is earned, regardless of when cash is received.
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Expense Recognition Principle (Matching Principle)
📌 Expenses should be recorded in the same period that the cost has been incurred, and also “matched” to the revenues they help generate.
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Accrual Basis Accounting
📌 Revenue is recognized when earned and expenses are recognized when incurred, regardless of the timing of cash flows.
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Cash Basis Accounting
📌 Revenue is recognized when cash is received and expenses are recognized when cash is paid.
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🔹 Financial Reporting Periods
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Annual Financial Statements
📌 Financial reports covering a one-year period.
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Interim Financial Statements
📌 Financial reports covering a period less than one year, often bi-annually, quarterly, or even monthly.
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Fiscal Year
📌 A 12-month period over which a company measures its financial performance, which may not coincide with the calendar year.
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Natural Business Year
📌 A fiscal year that ends when a company's activities are at their lowest point. For example, a retailer’s may elect for their natural business year to end in January: the end of peak sales surrounding the holidays.
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🔹 The Accounting Cycle
📌 This is a systematic process used by businesses to record and organize their financial transactions during an accounting period, as well as to prepare their financial statements.
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- The cycle always starts with recording individual journal entries.
- Posting always comes directly after journal entries.
- You always see the next three items in this logical order:
- Unadjusted trial balance
- followed by adjusting entries…
- creates the adjusted trial balance
- Remember it as: Unadjusted > Adjusting Entries > Adjusted!
- Preparing financial statements comes right after preparing the adjusted trial balance.
- This is due to the fact that the financial statements are formulated from this "adjusted" data.
- The cycle always ends (i.e. closes) with closing entries, followed by the post-closing trial balance.
- Use these logical associations to your advantage for memorizing the correct order on exams!
The following are the steps in the accounting cycle:
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📌 This is the process of identifying the business transactions that have a monetary impact on the company.
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📌 Once the transactions have been identified, they are recorded in the general journal in chronological order. This record, called a journal entry, includes the date of the transaction, the accounts affected, the amounts to be debited or credited, and a brief description of the transaction.
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📌 The next step is to transfer the journal entries to the appropriate ledger accounts. This process of transferring entries is called posting. A ledger account, or T-account, provides a detailed record of all changes that have occurred in an individual account during a period.
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📌 Once all transactions have been posted to the ledger, a trial balance is prepared. This is a list of all accounts and their balances at a particular date, showing that total debits equal total credits.
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📌 At the end of the accounting period, some accounts may need to be updated with adjusting entries. These include prepayments, accruals, and estimates, to ensure the revenue recognition and matching principles are followed.
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📌 After all adjusting entries have been posted to the ledger accounts, a new trial balance is prepared to verify that total debits still equal total credits after the adjustments.
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📌 Using the adjusted trial balance, the financial statements are prepared. This typically includes the income statement, statement of retained earnings, balance sheet, and statement of cash flows.
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📌 These are journal entries made at the end of an accounting period to transfer the balances of temporary accounts (like revenues, expenses, and dividends) to a permanent equity account, such as retained earnings.
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📌 This is the last step in the accounting cycle. It involves preparing a trial balance after the closing entries have been made. This is done to ensure that all temporary accounts have a zero balance and are ready to track transactions in the next accounting period.
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🔹 Posting to the “ledger” (aka T Accounts)
📌This process of transferring entries is called posting. A ledger account, or T-account, provides a detailed record of all the debits/credits that have occurred in an individual account from journal entries during a period.
Pro Tip for ExamsUnderstanding T Accounts and Journal EntriesEnhancing readability of T-Accounts
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It's crucial to understand that the values recorded in a T Account are not arbitrary; they're directly tied to the journal entries made earlier in the accounting cycle.
This is best seen via an example:Cash T Account Example
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Compare the following "staggered" T-Account:
To the following "not-staggered" T-Account:
Which one do you find easier to read? (I’d imagine it’s the staggered one!)
- Remember, what's easier for you to read is also easier for your professor to read while grading your exams!
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🔹 Adjusting Entries
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Purpose of Adjusting Entries
📌 Adjusting entries are made at the end of an accounting period to ensure that all revenues and expenses from that period are accurately recorded. This aligns with the revenue and expense recognition principles which state that transactions should be recognized in the period they occur.
- Therefore, adjusting entries, typically done on the year-end date (e.g., 12/31), provide the final opportunity to ensure these revenues and expenses are appropriately accounted for within the current accounting period.
- Consider the place of adjusting entries within the accounting cycle: they occur immediately after the preparation of the unadjusted trial balance and just before the preparation of the adjusted trial balance and subsequent financial statements.
- Therefore, adjusting entries can be viewed as a final review of all account balances, providing an opportunity for necessary "adjustments" to be made before producing the most accurate and up-to-date financial statements. To grasp these concepts more firmly, it is highly recommended to work through practice problems and exercises.
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Deferral Adjusting Entries
📌 Deferral adjusting entries are adjusting previously recorded transactions, where the recognition of revenues or expenses was deferred. These adjusting entries ensure that the income statement, statement of retained earnings, and balance sheet accurately reflect all relevant transactions for the specified period.
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Examples of Deferrals
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Prepaid Expenses
📌 Prepaid expenses are payments made in advance for goods or services that are expected to be consumed in the future. Common examples include prepaid insurance, rent, supplies, and advertising
- Initially, the transaction is recorded by debiting the Prepaid Expenses account (an asset) and crediting the Cash account.
- As these prepaid items are consumed or used, an adjusting entry is made by debiting the appropriate Expense account and crediting the Prepaid Expenses account, decreasing it for the amount that was consumed.
- Note: Even though 'Expense' is in the term, Prepaid Expenses are classified as assets on the balance sheet until they are consumed or used.
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Unearned Revenue
📌 Unearned Revenue, also known as deferred revenue, represents cash received in advance for a product or service that has not yet been delivered or rendered.
- When cash is received, an entry is made debiting the Cash account and crediting the Unearned Revenue account (a liability).
- When the service is provided or the product is delivered, an adjusting entry is made to debit the Unearned Revenue account and credit a Revenue account—effectively transforming Unearned Revenue into Earned Revenue.
Misconceptions about Unearned vs. Earned Revenue frequently causes students to lose points on exams!
Misunderstanding Unearned Revenue“Revenue is about receiving cash, right?”
See Common Mistakes below:
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📌 What is Unearned Revenue? This is for cash received in advance for products or services yet to be provided. It is considered a liability because, despite already being paid upfront, the company still owes the goods or services.
- You might be asking yourself, 'How can receiving cash become a liability, suggesting we owe something?' Though this seems counterintuitive, understanding the revenue recognition principle clarifies it.
- The principle asserts that revenue is only recognized when earned, i.e., when the service is delivered. Therefore, money received for a service not yet provided is 'unearned revenue' until we actually deliver the service.
- Consider this another way: you've received upfront cash, but the service remains undelivered. What if the service isn't provided, or the customer cancels the contract?
- In that case, you might need to refund the money! Given these uncertainties, can we truly claim we've 'earned' that cash?
- Isn't it logical to set up a liability account to earmark these funds until we genuinely earn them?
- That's exactly our strategy. At the year end, we'll evaluate how much of our unearned revenue has been earned (i.e., the proportion of the service actually delivered and what remains outstanding).
- Following this, we'll record an adjusting entry to effectively convert unearned revenue into earned revenue.
- We’ll expand much deeper on Unearned Revenue adjusting entries in Chapter 3. With practice, it'll become second nature to you.
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⚠️ CAUTION ⚠️ Often, students confuse revenue to only refer to receiving cash. This is not always the case!
- Example #1: When we provide services on credit, the customer pays later, but the revenue is recognized as soon as the services are delivered, as per the revenue recognition principle.
- Example #2: If we receive cash in advance for services we will provide later, this is recorded as Unearned Revenue — a prime example that receiving cash doesn’t always equate to generating revenue!
- Example #3: What if we receive cash immediately upon providing services — is this reveune? Yes, this is considered revenue.
- Nevertheless, it's important to understand that revenue is attributed to the services rendered, not the cash received. The cash received does not trigger the revenue; it is the completion of the services that does.
- Refer back to example #1, where revenue is generated without any cash received yet. It's revenue because the services are delivered!
- This can be confusing, but it's a vital distinction to grasp. For determining revenue under accrual accounting, the key factor isn't whether we've received cash, but rather if we've completed the work. Understanding this is best achieved through practicing problems!
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Depreciation
📌 Depreciation is the process of spreading out the cost of a tangible asset over its anticipated useful life.
- Consider that when we acquire an asset, such as a building, we initially record the cost as a debit to an asset account, not an expense account. The expense associated with this asset isn't recognized immediately but instead is incrementally acknowledged throughout the asset's useful life via depreciation.
- An adjusting entry for depreciation involves a debit to Depreciation Expense and a credit to Accumulated Depreciation. Note that Accumulated Depreciation is a contra-asset account, and it reduces the book value of the asset on the balance sheet.
- This technique enables us to distribute the cost of the asset over the period it contributes to revenue generation, not just the period it was acquired.
- There are several methods for calculating annual depreciation, with the Straight Line Method being the simplest and often tested on your first exam. I’ll provide a high-level overview of it below, but the remaining depreciation methods will be discussed in much more detail in Chapter 8.
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Accrual Adjusting Entries
Accrual adjusting entries are recording transactions that have not yet been documented. This involves recognizing revenues that have been earned or expenses that have been incurred but not yet recorded. These adjusting entries ensure that the income statement, statement of retained earnings, and balance sheet accurately reflect all relevant transactions for the specified period, even if cash has not yet been exchanged. This reflects the essence of 'accrual' accounting, where the financial impact of transactions is recognized when they occur, not necessarily when cash is exchanged.
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Examples of Accruals
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Accruing Revenue
📌 Accrued revenues represent the revenue that a company has earned from providing goods or services but hasn't billed or received cash for yet.
- Initially, when revenue is recognized but cash has not been received, an adjusting entry is made debiting a Receivable account (an asset) and crediting the Revenue account.
- Later, when the cash is received, an entry is made debiting the Cash account and crediting the Receivable account, thereby reducing it for the amount received.
- Remember, the nature of accruals implies that the actual payment or receipt of cash will happen at a future date. Until that happens, the accruals are either recognized as assets (like Receivables) or liabilities (like Payables) on the balance sheet.
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Accruing Interest Revenue
📌 Accrued interest revenue refers to the interest income earned on an investment or loan but not yet received
- When interest revenue is recognized but not received, an adjusting entry is made debiting Interest Receivable (an asset) and crediting Interest Revenue.
- Later, when the company receives the interest, an entry is made debiting the Cash account, to reflect the increase in cash, and crediting the Interest Receivable account, reducing the asset.
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Accruing Wages Expense
📌 Accrued wages represent salaries or wages that employees have earned for their work but haven't been paid yet.
- When the wage expense is incurred but cash hasn't been paid, an adjusting entry is made debiting the Wages Expense account and crediting Wages Payable (a liability).
- When the company eventually pays its employees, an entry is made debiting the Wages Payable account, reducing the liability, and crediting the Cash account to reflect the cash paid.
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Accruing Interest Expense
📌 Accrued interest expense represents the interest cost that has been incurred but not yet paid on borrowed money.
- When interest expense is incurred but not paid, an adjusting entry is made debiting Interest Expense and crediting Interest Payable (a liability).
- When the company later pays the interest, an entry is made debiting the Interest Payable account, reducing the liability, and crediting the Cash account, to reflect the cash paid.
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Accruing Income Tax Expense
📌 Accrued taxes represent a company's tax liability that has been incurred but not yet paid to the tax authorities.
- When a company recognizes it has incurred a tax liability but hasn't paid it yet, an adjusting entry is made by debiting Income Tax Expense and crediting Income Taxes Payable (a liability).
- Later, when the company pays its taxes, an entry is made by debiting Income Taxes Payable, reducing the liability, and crediting Cash to reflect the payment made.
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Accruing Utilities Expense
📌 Accrued utilities represent a company's utility expenses that have been incurred but not yet paid.
- When a company consumes utilities such as electricity, water, and gas but hasn't received the bill or paid for these utilities yet, an adjusting entry is made by debiting Utilities Expense and crediting Utilities Payable (a liability).
- When the company later pays its utility bill, an entry is made by debiting Utilities Payable, reducing the liability, and crediting Cash to reflect the payment made.
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Accruing Sales Commission Expense
📌 Accrued sales commission represents a company's commission expense that has been incurred but not yet paid to the salespersons.
- When a company recognizes that its salespersons have made sales that earn them commission but the company hasn't paid these commissions yet, an adjusting entry is made by debiting Sales Commission Expense and crediting Sales Commission Payable (a liability).
- When the company later pays its sales commissions, an entry is made by debiting Sales Commission Payable, reducing the liability, and crediting Cash to reflect the payment made.
- As with other types of accruals, the cash payment related to the sales commission expense is not until a later period. The liability for the sales commission is recognized on the balance sheet until the payment is made.
Hang in there!
I know this may feel overwhelming, but remember that the underlying objective of these varied examples is to continually reinforce the key pattern of Accrual adjusting entries:
REVENUE/EXPENSE RECOGNIZED FIRST,
CASH RECEIVED/PAID LATER!
Your professor should guide you on which specific Accruals you need to focus on for your exam - usually, it's only a couple of them. So, don't feel overwhelmed!
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🔹 Trial Balances & Financial Statements
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What is a Trial Balance?
📌 A trial balance is a financial report that lists the balances of all ledger accounts of a business at a specific point in time. It ensures that the total debits equal the total credits, demonstrating the consistency of all recorded transactions.
- All your Trial balance does is list all of your accounts (A = L + E, Revenues, Expenses, any contra accounts) and their current ending debit or credit balance from the T Accounts from the Posting process.
- If debits and credits don’t equal in your trial balance, this indicates that there was an error if your journal entries or during posting.
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Unadjusted Trial Balance vs. Adjusted Trial Balance
📌 An unadjusted trial balance is prepared before any adjusting entries are made in the ledger accounts, while an adjusted trial balance is prepared after all adjusting entries have been made. The adjusted trial balance verifies that the total debits equal the total credits after adjustments.
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Preparing a Trial Balance
📌 A trial balance is straightforward to prepare. It involves listing all your accounts (Assets = Liabilities + Equity, Revenues, Expenses, Contra Accounts) alongside their current ending debit OR credit balance, which is derived from the posting process.Please refer to the example below for clarity.
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Preparing Financial Statements
📌 This involves summarizing the financial activity of a business during an accounting period. The typical financial statements prepared include the income statement, statement of retained earnings, balance sheet, and statement of cash flows. These statements are derived from the adjusted trial balance.
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🔹 Closing Entries
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Closing Entries
📌 Closing entries are made at the end of an accounting period to reset the balances of temporary accounts (revenues, expenses, and dividends) to zero, transferring their balances to a permanent equity account (usually retained earnings).
Pro Tips for ExamsClosing EntriesClosing Revenue Accounts using R.E.I.D.Wondering why there are three revenue accounts?Closing Expense Accounts using R.E.I.D.Wondering why there are four expense accounts?Closing Income Summary (Net Income) using R.E.I.D.Closing Income Summary (Net Loss) using R.E.I.D.Closing Dividends using R.E.I.D.Why is Retained Earnings debited when closing Dividends?
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Use the R.E.I.D acronym to easily recall the accounts closed at the end of each period!
- Revenues
- Expenses
- Income Summary
- Dividends
Closing Revenue Accounts
With a solid understanding of debits & credits for each account type, closing entries become very straightforward. Let's reference the following framework from Chapter 2 for debits & credits: Assets = Liabilities + Equity Revenues / Expenses (+/-) (-/+) (-/+) (-/+) (+/-)
- Revenues operate on a (-/+) basis, meaning to close (i.e., reduce to zero), we must DEBIT THEM.
- Then, we total the closed revenue accounts, and “dump” them into the Income Summary on the other side of the entry — ensuring debits are equal to credits.
Revenue #1 50,000
Revenue #2 20,000
Revenue #3 30,000
Income Summary 100,000
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- This is simply a hypothetical scenario.
- Depending on your exam, you may have only one revenue account to close (e.g. Fees Earned), or multiple revenue accounts needing closing (Fees Earned, Consulting Revenue, Rent Revenue, Sales, etc.).
- In essence, the point I’m trying to illustrate is that, whatever revenues you see on the income statement — they will ALL need to be closed!
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Use the R.E.I.D acronym to easily recall the accounts closed at the end of each period!
- Revenues
- Expenses
- Income Summary
- Dividends
Closing Expense Accounts
With a solid understanding of debits & credits for each account type, closing entries become very straightforward. Let's reference the following framework from Chapter 2 for debits & credits: Assets = Liabilities + Equity Revenues / Expenses (+/-) (-/+) (-/+) (-/+) (+/-)
- Expenses work the opposite of revenues, like (+/-), which means to close, i.e. reduce them to zero, — we must CREDIT THEM.
- Then, we total the closed expense accounts, and “dump” them into the Income Summary on the other side of the entry — ensuring debits are equal to credits.
Income Summary 75,000
Expense #1 5,000
Expense #2 15,000
Expense #3 25000
Expense #4 30,000
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- This is simply a hypothetical scenario.
- Depending on your exam, you may have only one expense account to close (e.g. Cost of Goods Sold), or multiple expense accounts needing closing (Depreciation Expense, Wages Expense, Rent Expense, Advertising Expense, etc.).
- In essence, the point I’m trying to illustrate is that, whatever expenses you see on the income statement — they will ALL need to be closed!
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Use the R.E.I.D acronym to easily recall the accounts closed at the end of each period!
- Revenues
- Expenses
- Income Summary
- Dividends
- Closing the Income Summary Account (Net Income Scenario)
- Closing this account depends on whether we had a net income (Revenues > Expenses) or a net loss (Revenues < Expenses) for a given period.
- This is best illustrated by using a T Account for Income Summary, which includes entries from the previous steps of closing revenues and expenses (R.E.I.D).
- Refer to the example below, drawing on prior examples of closing entries — which lead to Net Income:
- Simply put, the "Income Summary" account is a summarization of the Net Income or loss.
- Therefore, in this example, context, the $25,000 debit balance in Income Summary represents Net Income!
- This ending balance is derived from the debit to Income Summary of $100,000 (closing revenues) minus the credit to Income Summary of $75,000 (closing expenses),
- Since Revenues were greater than Expenses, this results in our Net Income of $25,000.
- This aligns with the Net Income calculation in an income statement:
- Revenues Equals Net Income or Loss
- Making sense?
- In my opinion, this understanding of how the Income Summary account functions is crucial — as it provides a much deeper comprehension than simply memorizing the closing entry.
- Remembering the closing entry for Income Summary, in a Net Income scenario, becomes way easier when we focus on why Retained Earnings, an equity account (-/+), is credited.
- Recall that crediting an equity account (-/+), like Retained Earnings, will INCREASE that account.
- If we have Net Income, why should we increase Retained Earnings when closing Income Summary?
- Because Net Income for the period does exactly that—it gets added to the Retained Earnings account!
- To illustrate this, reflect on the Statement of Retained Earnings formula from previous chapters:
- PLUS NET INCOME*
- Seeing it?
- Notice that when closing the Income Summary account under a Net Income scenario — we need to increase Retained Earnings by crediting it, since we know that Net Income is added to Retained Earnings!
- If you remember this, you'll automatically know that the opposite side, the debit, goes to Income Summary.
Here's the entry to close Income Summary under a NET INCOME scenario:
Income Summary 25,000
R. Earnings 25,000
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Less Expenses
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Income Summary 25,000
R. Earnings 25,000
Beginning R/E
Minus Dividends
Equals Ending R/E
Income Summary 25,000
R. Earnings 25,000
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Use the R.E.I.D acronym to easily recall the accounts closed at the end of each period!
- Revenues
- Expenses
- Income Summary
- Dividends
- Closing the Income Summary Account (Net Loss Scenario)
- Revenues
- Expenses
- Income Summary
- Dividends
- Closing the Income Summary Account (Net Loss Scenario)
- Closing this account depends on whether we had a net income (Revenues > Expenses) or a net loss (Revenues < Expenses) for a given period.
- This is best illustrated by using a T Account for Income Summary, which includes entries from the previous steps of closing revenues and expenses (R.E.I.D).
- Refer to the example below, drawing on hypothetical examples of closing entries — which lead to a Net Loss:
- Simply put, the "Income Summary" account is a summarization of the Net Income or loss.
- Therefore, in this example, context, the $25,000 credit balance in Income Summary represents a Net Loss!
- This ending balance is derived from the debit to Income Summary of $75,000 (closing revenues) minus the credit to Income Summary of $100,000 (closing expenses),
- Since Expenses were greater than Revenues, this results in our Net Loss of $25,000.
- This aligns with the Net Income calculation in an income statement:
- Revenues Equals Net Income or Loss
- Making sense?
- In my opinion, this understanding of how the Income Summary account functions is crucial — as it provides a much deeper comprehension than simply memorizing the closing entry.
- Remembering the closing entry for Income Summary, in a Net Loss scenario, becomes way easier when we focus on why Retained Earnings, an equity account (-/+), is debited.
- Recall that debiting an equity account (-/+), like Retained Earnings, will DECREASE that account.
- If we have a Net Loss, why should we decrease Retained Earnings when closing Income Summary?
- Because Net Loss for the period does exactly that—it gets subtracted from the Retained Earnings account!
- To illustrate this, reflect on the Statement of Retained Earnings formula from previous chapters:
- MINUS NET LOSS*
- Seeing it?
- Notice that when closing the Income Summary account under a Net Income scenario — we need to decrease Retained Earnings by debiting it, since we know that Net Income is added to Retained Earnings!
- If you remember this, you'll automatically know that the opposite side, the credit, goes to Income Summary!
Use the R.E.I.D acronym to easily recall the accounts closed at the end of each period!
Here's the entry to close Income Summary under a NET LOSS scenario:
Retained Earnings 25,000
Income Summary 25,000
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Less Expenses
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Retained Earnings 25,000
Income Summary 25,000
Beginning R/E
Minus Dividends
Equals Ending R/E
Retained Earnings 25,000
Income Summary 25,000
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Use the R.E.I.D acronym to easily recall the accounts closed at the end of each period!
- Revenues
- Expenses
- Income Summary
- Dividends
Closing Dividends (Contra Equity)
With a solid understanding of debits & credits for each account type, closing entries become very straightforward. Let's reference the following framework from Chapter 2 for debits & credits: Assets = Liabilities + Equity Revenues / Expenses (+/-) (-/+) (-/+) (-/+) (+/-)
Contra — i.e. opposite of — Equity? (+/-)
- Dividends operates on a (+/-) basis, meaning to close (i.e., reduce to zero), we must CREDIT the account.
Retained Earnings 10,000
Dividends 10,000
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- Recall that debiting an equity account (-/+), like Retained Earnings, will DECREASE that account.
- If we’ve paid Dividends, why does this decrease Retained Earnings?
- Because Dividends for the period do exactly that—they gets subtracted from the Retained Earnings account!
- To illustrate this, reflect on the Statement of Retained Earnings formula from previous chapters:
Beginning R/E
Plus Net Income
- Minus Dividends*
Equals Ending R/E
- Seeing it?
- Connecting the closing of Dividends to the idea that Dividends are subtracted in the Statement of Retained Earnings can be a super useful memorization tool.
- If you remember that Dividends decrease Retained Earnings — it will help you recall that Retained Earnings must be debited when closing out Dividends!
Retained Earnings 10,000
Dividends 10,000
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Temporary vs. Permanent Accounts
📌 Temporary accounts (also known as nominal accounts) include revenues, expenses, and dividends accounts. They are closed at the end of each accounting period.
Pro Tips for ExamsMemorization Trick: Identifying “Temporary” Accounts
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Temporary accounts are closed at the end of each period. Use the R.E.I.D acronym to remember which accounts get closed at the end of each period:
- Revenues
- Expenses
- Income Summary
- Dividends
Keep in mind, Balance Sheet accounts (A = L + E) never get closed. Their balances persist from one period to the next.
- Also, remember: All income statement accounts are considered temporary.
- By closing these accounts at the end of each period, we ensure that the revenues and expenses reflected in an income statement pertain only to that specific period.
📌 Permanent accounts (also known as real accounts) include asset, liability, and equity accounts. They are not closed and carry their ending balance into the next accounting period.
Pro Tips for ExamsMemorization Trick: Identifying “Permanent” Accounts
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Permanent accounts do not get closed at the end of each period. Utilize the R.E.I.D acronym to remember which accounts get closed at the end of each period:
- Revenues
- Expenses
- Income Summary
- Dividends
Any account not in the R.E.I.D. acronym (like an asset such as cash or accounts receivable) is known as “permanent” — meaning it’s never closed. In particular, no Balance Sheet accounts (represented by A = L + E) are ever closed. They retain their balances from one period to the next.
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The Income Summary Account
📌 The income summary account is a temporary account that is only used during the closing process. It accumulates the balances of all revenue and expense accounts, which are then transferred to retained earnings.
- Importantly, when recording closing entries for revenues and expenses, the Income Summary account will have a different ending balance depending on whether there was Net Income or a Net Loss.
- If there is Net Income (Revenues > Expenses)…
- This will lead to an ending debit balance in Income Summary, requiring a CREDIT to close Income Summary.
- If there is Net Loss (Expenses > Revenues)…
- This will lead to an ending credit balance in Income Summary, requiring a DEBIT to close Income Summary.
Income Summary 25,000
Retained Earnings 25,000
Retained Earnings 25,000
Income Summary 25,000
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Post-closing Trial Balance
📌 A post-closing trial balance lists all remaining accounts after the closing entries have been made. This report resembles other trial balances but with all temporary (or "nominal") accounts showing zero balances. By referencing our R.E.I.D. acronym, the following should have $0 balances: - Revenues - Expenses - Income Summary - Dividends This type of trial balance is used to verify that all temporary accounts have been closed correctly and that total debits equal total credits in the permanent accounts.
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🔹 Classified Balance Sheet Components
📌 A Classified Balance Sheet categorizes a company's assets, liabilities, and equity into specific subgroups for easier analysis and understanding.
The main categories typically include:
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Current Assets
📌 Current assets are resources owned by a company that are expected to be used or converted into cash within one year. They typically include cash, accounts receivable, inventory, and prepaids.
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Long Term Assets
📌 Also known as non-current assets, these are the assets that are expected to provide value for more than one year. They are further divided into tangible assets (like property, plant, and equipment), intangible assets (like patents, trademarks, and copyrights), and long-term investments.
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Plant Assets
📌 Plant assets (also known as property, plant, and equipment or fixed assets) are tangible assets used in the operations of a business, with a useful life extending over more than one accounting period. They include machinery, buildings, land, equipment, etc.
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Long Term Investments
📌 Long-term investments are investments that a company intends to hold for more than a year. They may include bonds, stocks, or real estate investments.
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Intangible Assets
📌 Intangible assets are non-physical assets that provide long-term value to the company, such as patents, trademarks, copyrights, and goodwill.
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Current Liabilities
📌 Current liabilities are obligations that a company is expected to settle within the next year or within the business's normal operating cycle, whichever is longer. Examples include as accounts payable, short-term loans, salaries or wages payable, interest payable, and short-term loans payable, income taxes payable, unearned revenue, etc.
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Long Term Liabilities
📌 Long-term liabilities are obligations that are due in more than one year, such as long-term loans, bonds payable, mortgages payable, or lease obligations.
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Equity
📌 Equity represents the residual interest in the assets of the entity after deducting liabilities. This includes common stock, retained earnings, and other comprehensive income.
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🔹 Financial Metrics
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Profit Margin
📌 Profit margin shows how much of each dollar collected by a company as revenue translates into Net Income. It's calculated as:
(Net Profit / Revenue) x 100.
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Return on Assets (ROA)
📌 Return on Assets is a measure of how effectively a company uses its assets to generate net income. It's calculated as:
Net Income / Total Assets.
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Return on Equity (ROE)
📌 Return on Equity measures the profitability of a company in relation to stockholders' equity. It's calculated as:
Net Income / Shareholder's Equity.
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Working Capital
📌 Working capital measures a company's operational liquidity and short-term financial health. It's calculated as:
Current Assets - Current Liabilities
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Current Ratio
📌 The current ratio is a liquidity ratio that measures a company's ability to cover its short-term obligations with its short-term assets. It's calculated as:
Current Assets / Current Liabilities.
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Quick Ratio
📌 Also known as the acid-test ratio, the quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets. It's calculated as:
(Cash + Liquid Assets) / Current Liabilities
- Liquid Assets = Anything that can be quickly and easily converted into cash — this is why it’s called the Quick Ratio!
- Examples of liquid assets can range from cash in hand, bank deposits, to accounts receivable, and marketable securities.
- Illiquid Assets = Anything that can NOT be quickly and easily converted into cash.
- Common examples of such assets include prepaids and inventory.
- Another way to conceptualize the quick ratio is by modifying the formula for the current ratio, which is (Current Assets / Current Liabilities). For the quick ratio, we remove illiquid assets from the current assets in the numerator:
(Current Assets - Illiquid Assets) Current Liabilities
With this perspective, if you've memorized the current ratio, you can easily remember the quick ratio (or acid-test ratio) as a more stringent variant that only includes the most liquid assets.