Using a Worksheet

A worksheet is a multiple-column form used in the adjustment process and in preparing financial statements. As its name suggests, the worksheet is a working tool. It is not a permanent accounting record; it is neither a journal nor a part of the general ledger. The worksheet is merely a device used in preparing adjusting entries and the financial statements. Companies generally computerize worksheets using an electronic spreadsheet program such as Excel.

Illustration 4-1 shows the basic form of a worksheet and the five steps for preparing it. Each step is performed in sequence. The use of a worksheet is optional. When a company chooses to use one, it prepares financial statements from the worksheet. It enters the adjustments in the worksheet columns and then journalizes and posts the adjustments after it has prepared the financial statements. Thus, worksheets make it possible to provide the financial statements to management and other interested parties at an earlier date.

Illustration 4-1 Form and procedure for a worksheet

Steps in Preparing a Worksheet

We will use the October 31 trial balance and adjustment data of Pioneer Advertising Agency Inc., from Chapter 3, to illustrate how to prepare a worksheet. We describe each step of the process and demonstrate these steps in Illustration 4-2 (page 160) and transparencies 4-3A, B, C, and D.

STEP 1. PREPARE A TRIAL BALANCE ON THE WORKSHEET

Enter all ledger accounts with balances in the account titles space. Enter debit and credit amounts from the ledger in the trial balance columns. Illustration 4-2 shows the worksheet trial balance for Pioneer Advertising Agency Inc. This trial balance is the same one that appears in Illustration 2-32 (page 71) and Illustration 3-3 (page 101).

STEP 2. ENTER THE ADJUSTMENTS IN THE ADJUSTMENTS COLUMNS

Turn over the first transparency, Illustration 4-3A. When using a worksheet, enter all adjustments in the adjustments columns. In entering the adjustments, use applicable trial balance accounts. If additional accounts are needed, insert them on the lines immediately below the trial balance totals. A different letter identifies the debit and credit for each adjusting entry. The term used to describe this process is keying. Companies do not journalize the adjustments until after they complete the worksheet and prepare the financial statements.

The adjustments for Pioneer Advertising Agency Inc. are the same as the adjustments in Illustration 3-23 (page 115). They are keyed in the adjustments columns of the worksheet as follows.

(a) Pioneer debits an additional account, Supplies Expense, 1,500 for the cost of supplies used, and credits Supplies 1,500.

(b) Pioneer debits an additional account, Insurance Expense, 50 for the insurance that has expired, and credits Prepaid Insurance 50.

(c) The company needs two additional depreciation accounts. It debits Depreciation Expense 40 for the month's depreciation, and credits Accumulated Depreciation—Equipment 40.

(d) Pioneer debits Unearned Service Revenue 400 for services provided, and credits Service Revenue 400.

(e) Pioneer debits an additional account, Accounts Receivable, 200 for services provided but not billed, and credits Service Revenue 200.

(f) The company needs two additional accounts relating to interest. It debits Interest Expense 50 for accrued interest, and credits Interest Payable 50.

(g) Pioneer debits Salaries and Wages Expense 1,200 for accrued salaries, and credits an additional account, Salaries and Wages Payable, 1,200.

After Pioneer has entered all the adjustments, the adjustments columns are totaled to prove their equality.

STEP 3. ENTER ADJUSTED BALANCES IN THE ADJUSTED TRIAL BALANCE COLUMNS

(Note: Text continues on page 161, following acetate overlays.)

Turn over the second transparency, Illustration 4-3B. Pioneer determines the adjusted balance of an account by combining the amounts entered in the first four columns of the worksheet for each account. For example, the Prepaid Insurance account in the trial balance columns has a 600 debit balance and a 50 credit in the adjustments columns. The result is a 550 debit balance recorded in the adjusted trial balance columns. For each account, the amount in the adjusted trial balance columns is the balance that will appear in the ledger after journalizing and posting the adjusting entries. The balances in these columns are the same as those in the adjusted trial balance in Illustration 3-25 (page 117).

After Pioneer has entered all account balances in the adjusted trial balance columns, the columns are totaled to prove their equality. If the column totals do not agree, the financial statement columns will not balance and the financial statements will be incorrect.

STEP 4. EXTEND ADJUSTED TRIAL BALANCE AMOUNTS TO APPROPRIATE FINANCIAL STATEMENT COLUMNS

Turn over the third transparency, Illustration 4-3C. The fourth step is to extend adjusted trial balance amounts to the income statement and statement of financial position columns of the worksheet. Pioneer enters statement of financial position accounts in the appropriate statement of financial position debit and credit columns. For instance, it enters Cash in the statement of financial position debit column, and Notes Payable in the credit column. Pioneer extends Accumulated Depreciation—Equipment to the statement of financial position credit column; the reason is that accumulated depreciation is a contra asset account with a credit balance.

Because the worksheet does not have columns for the retained earnings statement, Pioneer extends the balance in Share Capital—Ordinary and Retained Earnings, if any, to the statement of financial position credit column. In addition, it extends the balance in Dividends to the statement of financial position debit column because it is an equity account with a debit balance.

The company enters the expense and revenue accounts such as Salaries and Wages Expense and Service Revenue in the appropriate income statement columns. Illustration 4-3C shows all of these extensions.

STEP 5. TOTAL THE STATEMENT COLUMNS, COMPUTE THE NET INCOME (OR NET LOSS), AND COMPLETE THE WORKSHEET

Turn over the fourth transparency, Illustration 4-3D. The company now must total each of the financial statement columns. The net income or loss for the period is the difference between the totals of the two income statement columns. If total credits exceed total debits, the result is net income. In such a case, as shown in Illustration 4-3D, the company inserts the words “Net Income” in the account titles space. It then enters the amount in the income statement debit column and the statement of financial position credit column. The debit amount balances the income statement columns; the credit amount balances the statement of financial position columns. In addition, the credit in the statement of financial position column indicates the increase in equity resulting from net income.

What if total debits in the income statement columns exceed total credits? In that case, the company has a net loss. It enters the amount of the net loss in the income statement credit column and the statement of financial position debit column.

After entering the net income or net loss, the company determines new column totals. The totals shown in the debit and credit income statement columns will match. So will the totals shown in the debit and credit statement of financial position columns. If either the income statement columns or the statement of financial position columns are not equal after the net income or net loss has been entered, there is an error in the worksheet. Illustration 4-3D shows the completed worksheet for Pioneer Advertising Agency Inc.

Preparing Financial Statements from a Worksheet

After a company has completed a worksheet, it has at hand all the data required for preparation of financial statements. The income statement is prepared from the income statement columns. The statement of financial position and retained earnings statement are prepared from the statement of financial position columns. Illustration 4-4 (page 162) shows the financial statements prepared from Pioneer's worksheet. At this point, the company has not journalized or posted adjusting entries. Therefore, ledger balances for some accounts are not the same as the financial statement amounts.

Illustration 4-4 Financial statements from a worksheet

The amount shown for Share Capital—Ordinary on the worksheet does not change from the beginning to the end of the period unless the company issues additional ordinary shares during the period. Because there was no balance in Pioneer's Retained Earnings, the account is not listed on the worksheet. Only after dividends and net income (or loss) are posted to retained earnings does this account have a balance at the end of the first year of the business.

Using a worksheet, companies can prepare financial statements before they journalize and post adjusting entries. However, the completed worksheet is not a substitute for formal financial statements. The format of the data in the financial statement columns of the worksheet is not the same as the format of the financial statements. A worksheet is essentially a working tool of the accountant; companies do not distribute it to management and other parties.

Preparing Adjusting Entries from a Worksheet

A worksheet is not a journal, and it cannot be used as a basis for posting to ledger accounts. To adjust the accounts, the company must journalize the adjustments and post them to the ledger. The adjusting entries are prepared from the adjustments columns of the worksheet. The reference letters in the adjustments columns and the explanations of the adjustments at the bottom of the worksheet help identify the adjusting entries. The journalizing and posting of adjusting entries follows the preparation of financial statements when a worksheet is used. The adjusting entries on October 31 for Pioneer Advertising Agency Inc. are the same as those shown in Illustration 3-23 (page 115).

Closing the Books

At the end of the accounting period, the company makes the accounts ready for the next period. This is called closing the books. In closing the books, the company distinguishes between temporary and permanent accounts.

Temporary accounts relate only to a given accounting period. They include all income statement accounts and the Dividends account. The company closes all temporary accounts at the end of the period.

In contrast, permanent accounts relate to one or more future accounting periods. They consist of all statement of financial position accounts, including equity accounts. Permanent accounts are not closed from period to period. Instead, the company carries forward the balances of permanent accounts into the next accounting period. Illustration 4-5 identifies the accounts in each category.

Illustration 4-5 Temporary versus permanent accounts

Preparing Closing Entries

At the end of the accounting period, the company transfers temporary account balances to the permanent equity account, Retained Earnings, by means of closing entries.

Closing entries formally recognize in the ledger the transfer of net income (or net loss) and Dividends to Retained Earnings. The retained earnings statement shows the results of these entries. Closing entries also produce a zero balance in each temporary account. The temporary accounts are then ready to accumulate data in the next accounting period separate from the data of prior periods. Permanent accounts are not closed.

Journalizing and posting closing entries is a required step in the accounting cycle. (See Illustration 4-12 on page 171.) The company performs this step after it has prepared financial statements. In contrast to the steps in the cycle that you have already studied, companies generally journalize and post closing entries only at the end of the annual accounting period. Thus, all temporary accounts will contain data for the entire year.

In preparing closing entries, companies could close each income statement account directly to Retained Earnings. However, to do so would result in excessive detail in the permanent Retained Earnings account. Instead, companies close the revenue and expense accounts to another temporary account, Income Summary, and they transfer the resulting net income or net loss from this account to Retained Earnings.

Companies record closing entries in the general journal. A center caption, Closing Entries, inserted in the journal between the last adjusting entry and the first closing entry, identifies these entries. Then the company posts the closing entries to the ledger accounts.

Companies generally prepare closing entries directly from the adjusted balances in the ledger. They could prepare separate closing entries for each nominal account, but the following four entries accomplish the desired result more efficiently:

1. Debit each revenue account for its balance, and credit Income Summary for total revenues.
2. Debit Income Summary for total expenses, and credit each expense account for its balance.
3. Debit Income Summary and credit Retained Earnings for the amount of net income.
4. Debit Retained Earnings for the balance in the Dividends account, and credit Dividends for the same amount.

Illustration 4-6 presents a diagram of the closing process. In it, the boxed numbers refer to the four entries required in the closing process.

Illustration 4-6 Diagram of closing process—corporation

If there were a net loss (because expenses exceeded revenues), entry 3 in Illustration 4-6 would be reversed: There would be a credit to Income Summary and a debit to Retained Earnings.

CLOSING ENTRIES ILLUSTRATED

In practice, companies generally prepare closing entries only at the end of the annual accounting period. However, to illustrate the journalizing and posting of closing entries, we will assume that Pioneer Advertising Agency Inc. closes its books monthly. Illustration 4-7 shows the closing entries at October 31. (The numbers in parentheses before each entry correspond to the four entries diagrammed in Illustration 4-6.)

Illustration 4-7 Closing entries journalized

Note that the amounts for Income Summary in entries (1) and (2) are the totals of the income statement credit and debit columns, respectively, in the worksheet.

A couple of cautions in preparing closing entries: (1) Avoid unintentionally doubling the revenue and expense balances rather than zeroing them. (2) Do not close Dividends through the Income Summary account. Dividends are not an expense, and they are not a factor in determining net income.

Posting Closing Entries

Illustration 4-8 shows the posting of the closing entries and the underlining (ruling) of the accounts. Note that all temporary accounts have zero balances after posting the closing entries. In addition, you should realize that the balance in Retained Earnings represents the accumulated undistributed earnings of the corporation at the end of the accounting period. This balance is shown on the statement of financial position and is the ending amount reported on the retained earnings statement, as shown in Illustration 4-4. Pioneer uses the Income Summary account only in closing. It does not journalize and post entries to this account during the year.

As part of the closing process, Pioneer totals, balances, and double-underlines its temporary accounts—revenues, expenses, and Dividends, as shown in T-account form in Illustration 4-8. It does not close its permanent accounts—assets, liabilities, and equity (Share Capital—Ordinary and Retained Earnings). Instead, Pioneer draws a single underline beneath the current-period entries for the permanent accounts. The account balance is then entered below the single rule and is carried forward to the next period (for example, see Retained Earnings).

Illustration 4-8 Posting of closing entries

Preparing a Post-Closing Trial Balance

After Pioneer has journalized and posted all closing entries, it prepares another trial balance, called a post-closing trial balance, from the ledger. The post-closing trial balance lists permanent accounts and their balances after journalizing and posting of closing entries. The purpose of the post-closing trial balance is to prove the equality of the permanent account balances carried forward into the next accounting period. Since all temporary accounts will have zero balances, the post-closing trial balance will contain only permanent—statement of financial position—accounts.

Illustration 4-9 shows the post-closing trial balance for Pioneer Advertising Agency Inc.

Illustration 4-9 Post-closing trial balance

Pioneer prepares the post-closing trial balance from the permanent accounts in the ledger. Illustration 4-10 shows the permanent accounts in Pioneer's general ledger.

Illustration 4-10 General ledger, permanent accounts

A post-closing trial balance provides evidence that the company has properly journalized and posted the closing entries. It also shows that the accounting equation is in balance at the end of the accounting period. However, like the trial balance, it does not prove that Pioneer has recorded all transactions or that the ledger is correct. For example, the post-closing trial balance still will balance even if a transaction is not journalized and posted or if a transaction is journalized and posted twice.

The remaining accounts in the general ledger are temporary accounts, shown in Illustration 4-11. After Pioneer correctly posts the closing entries, each temporary account has a zero balance. These accounts are double-underlined to finalize the closing process.

Illustration 4-11 General ledger, temporary accounts

Summary of the Accounting Cycle

Illustration 4-12 summarizes the steps in the accounting cycle. You can see that the cycle begins with the analysis of business transactions and ends with the preparation of a post-closing trial balance.

Steps 1–3 may occur daily during the accounting period. Companies perform Steps 4–7 on a periodic basis, such as monthly, quarterly, or annually. Steps 8 and 9—closing entries, and a post-closing trial balance—usually take place only at the end of a company's annual accounting period.

Illustration 4-12 Steps in the accounting cycle

There are also two optional steps in the accounting cycle. As you have seen, companies may use a worksheet in preparing adjusting entries and financial statements. In addition, they may use reversing entries, as explained below.

Reversing Entries—An Optional Step

Some accountants prefer to reverse certain adjusting entries by making a reversing entry at the beginning of the next accounting period. A reversing entry is the exact opposite of the adjusting entry made in the previous period. Use of reversing entries is an optional bookkeeping procedure; it is not a required step in the accounting cycle. Accordingly, we have chosen to cover this topic in Appendix 4A at the end of the chapter.

Correcting Entries—An Avoidable Step

Unfortunately, errors may occur in the recording process. Companies should correct errors, as soon as they discover them, by journalizing and posting correcting entries. If the accounting records are free of errors, no correcting entries are needed.

You should recognize several differences between correcting entries and adjusting entries. First, adjusting entries are an integral part of the accounting cycle. Correcting entries, on the other hand, are unnecessary if the records are error-free. Second, companies journalize and post adjustments only at the end of an accounting period. In contrast, companies make correcting entries whenever they discover an error. Finally, adjusting entries always affect at least one statement of financial position account and one income statement account. In contrast, correcting entries may involve any combination of accounts in need of correction. Correcting entries must be posted before closing entries.

To determine the correcting entry, it is useful to compare the incorrect entry with the correct entry. Doing so helps identify the accounts and amounts that should—and should not—be corrected. After comparison, the accountant makes an entry to correct the accounts. The following two cases for Mercato Co. illustrate this approach.

CASE 1

On May 10, Mercato Co. journalized and posted a $50 cash collection on account from a customer as a debit to Cash $50 and a credit to Service Revenue $50. The company discovered the error on May 20, when the customer paid the remaining balance in full.

Illustration 4-13 Comparison of entries

Comparison of the incorrect entry with the correct entry reveals that the debit to Cash $50 is correct. However, the $50 credit to Service Revenue should have been credited to Accounts Receivable. As a result, both Service Revenue and Accounts Receivable are overstated in the ledger. Mercato makes the following correcting entry.

Illustration 4-14 Correcting entry

CASE 2

On May 18, Mercato purchased on account equipment costing $450. The transaction was journalized and posted as a debit to Equipment $45 and a credit to Accounts Payable $45. The error was discovered on June 3, when Mercato received the monthly statement for May from the creditor.

Illustration 4-15 Comparison of entries

Comparison of the two entries shows that two accounts are incorrect. Equipment is understated $405, and Accounts Payable is understated $405. Mercato makes the following correcting entry.

Illustration 4-16 Correcting entry

Instead of preparing a correcting entry, it is possible to reverse the incorrect entry and then prepare the correct entry. This approach will result in more entries and postings than a correcting entry, but it will accomplish the desired result.

The Classified Statement of Financial Position

The statement of financial position presents a snapshot of a company's financial position at a point in time. To improve users' understanding of a company's financial position, companies often use a classified statement of financial position. A classified statement of financial position groups together similar assets and similar liabilities, using a number of standard classifications and sections. This is useful because items within a group have similar economic characteristics. A classified statement of financial position generally contains the standard classifications listed in Illustration 4-17.

Illustration 4-17 Standard statement of financial position classifications

These groupings help financial statement readers determine such things as (1) the claims of long- and short-term creditors on the company's total assets, and (2) whether the company has enough assets to pay its debts as they come due. Many of these groupings can be seen in the statement of financial position of Cheng Corporation shown in Illustration 4-18 below. In the sections that follow, we explain each of these groupings.

Illustration 4-18 Classified statement of financial position

Intangible Assets

Many companies have long-lived assets that do not have physical substance yet often are very valuable. We call these assets intangible assets. One significant intangible asset is goodwill. Others include patents, copyright, and trademarks or trade names that give the company exclusive right of use for a specified period of time. In Illustration 4-18, Cheng Corporation reported intangible assets of NT$3,100,000.

Illustration 4-19 shows the intangible assets of Nokia (FIN).

Illustration 4-19 Intangible assets section

Property, Plant, and Equipment

Property, plant, and equipment are assets with relatively long useful lives that a company is currently using in operating the business. This category (sometimes called fixed assets) includes land, buildings, machinery and equipment, delivery equipment, and furniture. In Illustration 4-18, Cheng Corporation reported property, plant, and equipment of NT$29,000,000.

Depreciation is the practice of allocating the cost of assets to a number of years. Companies do this by systematically assigning a portion of an asset's cost as an expense each year (rather than expensing the full purchase price in the year of purchase). The assets that the company depreciates are reported on the statement of financial position at cost less accumulated depreciation. The accumulated depreciation account shows the total amount of depreciation that the company has expensed thus far in the asset's life. In Illustration 4-18, Cheng Corporation reported accumulated depreciation of NT$5,000,000.

Illustration 4-20 presents the property, plant, and equipment of the LG Group (KOR).

Illustration 4-20 Property, plant, and equipment section

Long-Term Investments

Long-term investments are generally, (1) investments in ordinary shares and bonds of other companies that are normally held for many years, and (2) non-current assets such as land or buildings that a company is not using in its operating activities. In Illustration 4-18, Cheng Corporation reported total long-term investments of NT$7,200,000 on its statement of financial position.

Weinberger AG (AUT) reported long-term investments in its statement of financial position as shown in Illustration 4-21 (page 176).

Illustration 4-21 Long-term investments section

Current Assets

Current assets are assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer. In Illustration 4-18, Cheng Corporation had current assets of NT$22,100,000. For most businesses, the cutoff for classification as current assets is one year from the statement of financial position date. For example, accounts receivable are current assets because the company will collect them and convert them to cash within one year. Supplies is a current asset because the company expects to use it up in operations within one year.

Some companies use a period longer than one year to classify assets and liabilities as current because they have an operating cycle longer than one year. The operating cycle of a company is the average time that it takes to purchase inventory, sell it on account, and then collect cash from customers. For most businesses, this cycle takes less than a year, so they use a one-year cutoff. But, for some businesses, such as vineyards or airplane manufacturers, this period may be longer than a year. Except where noted, we will assume that companies use one year to determine whether an asset or liability is current or non-current.

Common types of current assets are (1) prepaid expenses (insurance and supplies), (2) inventories, (3) receivables (notes receivable, accounts receivable, and interest receivable), (4) short-term investments (such as short-term U.S. government securities), and (5) cash. On the statement of financial position, companies usually list these items in the reverse order in which they expect to convert them into cash.

Illustration 4-22 presents the current assets of Tesco (GBR).

Illustration 4-22 Current assets section

As explained later in the chapter, a company's current assets are important in assessing its short-term debt-paying ability.

Equity

The content of the equity section varies with the form of business organization. In a proprietorship, there is one capital account. In a partnership, there is a capital account for each partner. Corporations divide equity into two accounts—Share Capital—Ordinary and Retained Earnings. Corporations record shareholders' investments in the company by debiting an asset account and crediting the Share Capital—Ordinary account. They record in the Retained Earnings account income retained for use in the business. Corporations combine the Share Capital—Ordinary and Retained Earnings accounts and report them on the statement of financial position as equity. (We'll learn more about these corporation accounts in later chapters.) Unilever Group (GBR and NLD) recently reported its equity section as follows.

Illustration 4-23 Equity section

Non-Current Liabilities

Non-current liabilities are obligations that a company expects to pay after one year. Liabilities in this category include bonds payable, mortgages payable, long-term notes payable, lease liabilities, and pension liabilities. Many companies report long-term debt maturing after one year as a single amount in the statement of financial position and show the details of the debt in notes that accompany the financial statements. Others list the various types of non-current liabilities. In Illustration 4-18, Cheng Corporation reported non-current liabilities of NT$11,300,000.

Illustration 4-24 shows the non-current liabilities that Siemens (DEU) reported in its statement of financial position.

Illustration 4-24 Non-current liabilities section

Current Liabilities

Current liabilities generally are obligations that the company is to pay within the coming year or its operating cycle, whichever is longer. Common examples are accounts payable, wages payable, bank loans payable, interest payable, and taxes payable. Also included as current liabilities are current maturities of long-term obligations—payments to be made within the next year on long-term obligations. In Illustration 4-18, Cheng Corporation reported five different types of current liabilities, for a total of NT$16,050,000.

Within the current liabilities section, companies usually list notes payable first, followed by accounts payable. Other items then follow in the order of their magnitude. In your homework, you should present notes payable first, followed by accounts payable.

Illustration 4-25 shows the current liabilities section adapted from the statement of financial position of Siemens (DEU).

Illustration 4-25 Current liabilities section

Users of financial statements look closely at the relationship between current assets and current liabilities. This relationship is important in evaluating a company's liquidity—its ability to pay obligations expected to be due within the next year. When current assets exceed current liabilities, the likelihood for paying the liabilities is favorable. When the reverse is true, short-term creditors may not be paid, and the company may ultimately be forced into bankruptcy.

SUMMARY OF LEARNING OBJECTIVES

1 Prepare a worksheet. The steps in preparing a worksheet are as follows. (a) Prepare a trial balance on the worksheet. (b) Enter the adjustments in the adjustments columns. (c) Enter adjusted balances in the adjusted trial balance columns. (d) Extend adjusted trial balance amounts to appropriate financial statement columns. (e) Total the statement columns, compute net income (or net loss), and complete the worksheet.

2 Explain the process of closing the books. Closing the books occurs at the end of an accounting period. The process is to journalize and post closing entries and then underline and balance all accounts. In closing the books, companies make separate entries to close revenues and expenses to Income Summary, Income Summary to Retained Earnings, and Dividends to Retained Earnings. Only temporary accounts are closed.

3 Describe the content and purpose of a post-closing trial balance. A post-closing trial balance contains the balances in permanent accounts that are carried forward to the next accounting period. The purpose of this trial balance is to prove the equality of these balances.

4 State the required steps in the accounting cycle. The required steps in the accounting cycle are (1) analyze business transactions, (2) journalize the transactions, (3) post to ledger accounts, (4) prepare a trial balance, (5) journalize and post adjusting entries, (6) prepare an adjusted trial balance, (7) prepare financial statements, (8) journalize and post closing entries, and (9) prepare a post-closing trial balance.

5 Explain the approaches to preparing correcting entries. One way to determine the correcting entry is to compare the incorrect entry with the correct entry. After comparison, the company makes a correcting entry to correct the accounts. An alternative to a correcting entry is to reverse the incorrect entry and then prepare the correct entry.

6 Identify the sections of a classified statement of financial position. A classified statement of financial position categorizes assets as intangibles; property, plant, and equipment; long-term investments; and current assets. Liabilities are classified as either current or non-current. There is also an equity section, which varies with the form of business organization.

GLOSSARY

Classified statement of financial position A statement of financial position that contains standard classifications or sections. (p. 173).

Closing entries Entries made at the end of an accounting period to transfer the balances of temporary accounts to a permanent equity account, Retained Earnings. (p. 164).

Correcting entries Entries to correct errors made in recording transactions. (p. 171).

Current assets Assets that a company expects to convert to cash or use up within one year. (p. 176).

Current liabilities Obligations that a company expects to pay after one year. (p. 178).

Equity The combination of Share Capital—Ordinary and Retained Earnings accounts. Often referred to as the ownership claim of shareholders on total assets. It is to a corporation what owner's equity is to a proprietorship. (p. 178).

Income summary A temporary account used in closing revenue and expense accounts. (p. 164).

Intangible assets Non-current assets that do not have physical substance. (p. 174).

Liquidity The ability of a company to pay obligations expected to be due within the next year. (p. 179).

Long-term investments Generally, (1) investments in shares and bonds of other companies that companies normally hold for many years, and (2) non-current assets, such as land and buildings, not currently being used in operations. (p. 175).

Non-current liabilities Obligations that a company expects to pay after one year. (p. 178).

Operating cycle The average time that it takes to purchase inventory, sell it on account, and then collect cash from customers. (p. 176).

Permanent (real) accounts Accounts that relate to one or more accounting periods. Consist of all statement of financial position accounts. Balances are carried forward into the next accounting period. (p. 164).

Post-closing trial balance A list of permanent accounts and their balances after a company has journalized and posted closing entries. (p. 168).

Property, plant, and equipment Assets with relatively long useful lives and currently being used in operations. (p. 175).

Reversing entry An entry, made at the beginning of the next accounting period, that is the exact opposite of the adjusting entry made in the previous period. (p. 171).

Temporary (nominal) accounts Accounts that relate only to a given accounting period. Consist of all income statement accounts and the Dividends account. All temporary accounts are closed at the end of the accounting period. (p. 164).

Worksheet A multiple-column form that may be used in making adjusting entries and in preparing financial statements. (p. 158).

APPENDIX 4A REVERSING ENTRIES

After preparing the financial statements and closing the books, it is often helpful to reverse some of the adjusting entries before recording the regular transactions of the next period. Such entries are reversing entries. Companies make a reversing entry at the beginning of the next accounting period. Each reversing entry is the exact opposite of the adjusting entry made in the previous period. The recording of reversing entries is an optional step in the accounting cycle.

The purpose of reversing entries is to simplify the recording of a subsequent transaction related to an adjusting entry. For example, in Chapter 3 (page 113), the payment of salaries after an adjusting entry resulted in two debits: one to Salaries and Wages Payable and the other to Salaries and Wages Expense. With reversing entries, the company can debit the entire subsequent payment to Salaries and Wages Expense. The use of reversing entries does not change the amounts reported in the financial statements. What it does is simplify the recording of subsequent transactions.

Reversing Entries Example

Companies most often use reversing entries to reverse two types of adjusting entries: accrued revenues and accrued expenses. To illustrate the optional use of reversing entries for accrued expenses, we will use the salaries expense transactions for Pioneer Advertising Agency Inc. as illustrated in Chapters 2, 3, and 4. The transaction and adjustment data are as follows.

1. October 26 (initial salary entry): Pioneer pays 4,000 of salaries and wages earned between October 15 and October 26.
2. October 31 (adjusting entry): Salaries and wages earned between October 29 and October 31 are 1,200. The company will pay these in the November 9 payroll.
3. November 9 (subsequent salary entry): Salaries and wages paid are 4,000. Of this amount, 1,200 applied to accrued salaries and wages payable and 2,800 was earned between November 1 and November 9.

Illustration 4A-1 shows the entries with and without reversing entries.

Illustration 4A-1 Comparative entries—not reversing vs. reversing

The first three entries are the same whether or not Pioneer uses reversing entries. The last two entries are different. The November 1 reversing entry eliminates the 1,200 balance in Salaries and Wages Payable created by the October 31 adjusting entry. The reversing entry also creates a 1,200 credit balance in the Salaries and Wages Expense account. As you know, it is unusual for an expense account to have a credit balance. The balance is correct in this instance, though, because it anticipates that the entire amount of the first salaries and wages payment in the new accounting period will be debited to Salaries and Wages Expense. This debit will eliminate the credit balance. The resulting debit balance in the expense account will equal the salaries and wages expense incurred in the new accounting period (2,800 in this example).

If Pioneer makes reversing entries, it can debit all cash payments of expenses to the expense account. This means that on November 9 (and every payday) Pioneer can debit Salaries and Wages Expense for the amount paid, without regard to any accrued salaries and wages payable. Being able to make the same entry each time simplifies the recording process: The company can record subsequent transactions as if the related adjusting entry had never been made.

Illustration 4A-2 shows the posting of the entries with reversing entries.

Illustration 4A-2 Postings with reversing entries

A company can also use reversing entries for accrued revenue adjusting entries. For Pioneer Advertising Inc., the adjusting entry was Accounts Receivable (Dr.) 200 and Service Revenue (Cr.) 200. Thus, the reversing entry on November 1 is:

When Pioneer collects the accrued service revenue, it debits Cash and credits Service Revenue.

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 4A

7 Prepare reversing entries. Reversing entries are the opposite of the adjusting entries made in the preceding period. Some companies choose to make reversing entries at the beginning of a new accounting period to simplify the recording of later transactions related to the adjusting entries. In most cases, only accrued adjusting entries are reversed.