Lecture #4: Closing the Accounts of Proprietorships, Partnerships, and Corporations

Accountants prepare numerous memoranda, analysis, and informal papers. One important example is called the worksheet. This is not given to the owner of the business or the manager. It is prepared solely for the accountant’s use and is kept by the accountant.

→ You insert one more step in the process between the trial balance sheet and recording the adjustments in the General Journal

You start off with an unadjusted trial balance sheet. This has its own columns.

• Then you have a set of columns to make the necessary adjustments.
• Then you have a set of columns for the Adjusted Trial Balance.
• Then from the Adjusted Trial Balance sheet, you transfer the information into the Income Statement columns and the Balance Sheet columns.

→ From the worksheet, you get the necessary journal entries for the adjustments and the information to prepare the financial statements.

→ The worksheet is not a financial statement. It is a tool for the accountant to organize the data.

Closing Entries

Closing entries are designed to transfer the balances in the revenue accounts, the expense accounts, and the withdrawal accounts to the balance sheet equity account. After the closing entries, the revenue, expense, and withdrawal accounts have zero balances.

Why?

When you begin a new accounting period, you do not want old information from the previous accounting period to be included in the financial statements. That is why the revenue, expense, and withdrawal accounts are set to zero.

1. Closing Revenue Accounts.

Revenue accounts have credit balances. Therefore to close revenue accounts, you must debit each revenue account and credit Income Summary.

2. Closing Expense Accounts.

Each expense account has a debit entry. To close them, you need to debit the Income Summary Account and credit each expense account.

3. Closing the Income Summary Account.

After a business’s revenue and expense accounts are closed to Income Summary, the balance in Income Summary equals the net income or loss. To close Income Summary, you transfer the balance to the capital accounts

4. Closing the Withdrawal Account.

The withdrawal account shows the decrease in the owner’s equity due to the owner’s withdrawals. The account is closed and its balance is transferred to the capital accounts.

→ All revenue, expense, and withdrawal accounts have zero balances. The net effect of the period’s revenue, expense, and withdrawal transactions are reflected in owner’s equity.

→ Revenue, expense, withdrawal, and income summary accounts are temporary accounts. These accounts are closed at the end of each accounting period. The permanent accounts are open as long as the asset, liability, or owner’s equity continue to exist.

5. Because errors may have been introduced in the process of adjusting and closing the accounts, a new trial balance is prepared. This post-closing trial balance is prepared to retest the equality of the accounts.

Partnership Accounting

Very similar to accounting for a single proprietorship. You have capital and withdrawal accounts for each partner.

• First, you close the revenue and expense accounts into the Income Summary account. When you close the Income Summary account, you have an entry that allocates to each partner of his share of the net income or loss.
• Second, you close the withdrawal accounts of each partner into his capital account.

Corporate Accounting

Accounting for a corporation is different than accounting for a proprietorship, because you have two capital accounts: Contributed Capital and Retained Earnings Accounts.

For example, five people secure a charter for a new corporation. Each person invested $10,000 in the corporation by buying 1,000 shares of stock each. Each share has a $10 par value.

During the first year, the corporation earned $20,000. Below is shown the entry to close the Income Summary account.

Since a corporation is a separate legal entity, the names of its stockholders are of little interest to readers of the balance sheet and therefore the names are not shown.

On Jan. 10 of the corporation’s second year, the board of directors met and declared a $1 per share dividend payable on Feb. 1. The dividend is the reward to the stockholders of the corporation for investing in it.

The Dividends Declared account is a temporary account that is similar to a withdrawal account for a proprietorship. To record the payment of the dividend:

This transaction lowered the stockholder’s equity. A dividend must be formally voted by a corporation’s board of directors. The stockholders have no right to a dividend until it is declared. As soon as a dividend is declared, it becomes a liability to the corporation and must be paid.

During the corporation’s second year, it suffered a $7,000 net loss. The entries to close its Incomes Summary and Dividends Declared accounts are:

Now during the third year, the corporation paid no dividend, and suffered a net loss of $14,000. The entry to close the Income Summary account.

A corporation with a negative amount of retained earnings is said to have a deficit. It is illegal for a corporation to declare dividends with a negative retained earnings, because a corporation is a separate legal person, who is responsible for its debts. If the corporation bankrupts, the creditors get paid first from the corporation’s assets. Therefore, making it illegal for a corporation to declare dividends with a negative retained earnings leaves assets for the creditors.

The Accounting Cycle

In lectures 2, 3, and 4, we discussed all the accounting procedures that must be completed each accounting period.

1. Analyzing and recording transactions in a journal.
2. Copying the debits and credits of the journal entries into the ledger accounts.
3. Preparing an unadjusted trial balance.
4. Completing the worksheet.
5. Preparing the financial statements.
6. Adjusting the ledger accounts.
7. Closing the temporary accounts.
8. Preparing a post-closing trial balance.