Introduction to Accounting
1.7 Closing the books. Permanent and temporary accounts
At the end of a period, all accounts are prepared for the next period. It is important to distinguish between permanent and temporary accounts. Balance sheet accounts (i.e., assets, liabilities, and equity) have a continuing nature; thus, they are not closed after each period and that's why they are called permanent accounts.
Permanent accounts are balance sheet accounts. They are not closed each period. Their balances are carried forward into the next period. Permanent accounts are also called real accounts.
In contrast, revenue, expense, and distribution accounts are used to collect information about a single accounting period. At the end of a period, amounts in revenue, expense, and distribution accounts are transferred to Retained Earnings. Accordingly, the revenue, expense, and distribution accounts must have zero balances at the end of one accounting period (after closing the books) and at the beginning of the following period.
Temporary accounts are closed at the end of each period. These are mostly income statement accounts, except for a distribution account that is equity statement account. Temporary accounts are also called nominal accounts.
The process of transferring the balances from the temporary accounts to the permanent account, Retained Earnings, is referred to as closing the accounts or closing the books.
1.8 Financial statements description
Based on the five transactions described above, we can now prepare the financial statements for the period. Recall that there are four general-purpose financial statements:
- Income Statement
- Statement of Changes in Equity
- Balance Sheet
- Statement of Cash Flows
1.8.1 Presentation of the income statement
The income statement is presented below. We do not intend to go through the preparation of financial statements process at this point. That will be covered in other chapters. The purpose of showing the financial statements below is just to understand how they are look like.
Illustration 1-9: Income statement for Friends Company
Friends
Company |
|
|
|
Revenue (i.e., assets increase) |
3,000 |
Expenses (i.e., assets decrease) |
(1,000) |
Net Income (i.e., change in net assets) |
$ 2,000 |
The income statement measures the change in net assets or the difference between assets increases and assets decreases. The asset increases from the operating activities were labeled revenues. The asset decreases were called expenses. The difference between revenues and expenses is called net income (if revenue is greater than expenses) or a net loss (if vice versa).
Net income is the excess of asset increases (revenues) and asset decreases (expenses) for a period. Note that distributions do not fall under expenses caption and thus are not used in calculating the net income.
Net loss is the opposite of net income. Net loss results from the excess of asset decreases (expenses) over asset increases (revenues) for a period.
1.8.2 Presentation of the statement of changes in equity
The statement of changes in equity has the following format:
Illustration 1-10: Statement of changes in equity for Friends Company
Friends
Company |
|
|
|
Beginning Contributed Capital |
$0 |
Plus: Capital Acquisition |
5,000 |
Ending Contributed Capital |
5,000 |
|
|
Beginning Retained Earnings |
$0 |
Plus: Net Income |
2,000 |
Less: Distribution |
(500) |
Ending Retained Earnings |
1,500 |
|
|
Total Equity |
$ 6,500 |
The statement of changes in equity explains the effects of transactions on owner's equity during an accounting period. The statement includes the beginning and ending balances of contributed capital and reflects any new capital acquisitions made during the accounting period. The statement also shows the portion of net earnings retained in the business.
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