Accounting Cycle IV

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Lecture Outline
 Closing Entries
 Defined
 Closing Revenue Accounts
 Closing Expense Accounts

 Allocation of Profit/Loss (Partnership)

 Fixed Capital Balance Method
 Refer to page 600 of Hoggett & Edwards 5th Edition.

 Closing Drawings Account

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The Problem
Period A Period B Period C
Rev. = 2,000 2,000 + 5,000 = 7,000 7,000 + 8,000 = 15,000

Ex. = 800 800 + 700 = 1,500 1,500 + 900 = 2,400

Profit = 1,200 Profit = 6,500 Profit = 12,600

 Revenue ($2,000) and expense ($800) from Period A has been carried forward to
Period B. The calculation of profit in Period B will therefore include revenues earnt
and expenses incurred in Period A. This violates accrual accounting principles (i.e.
Only revenue earnt and expenses incurred in the current period should be included
in the calculation of the current periods profit.

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Closing Entries
 At the end of each new accounting period the
balances within the revenue and expense accounts
at the end of the old accounting period must be
“closed off”.

“Closing Off the accounts”

 Simply means that accounts are returned to a zero
balance.


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Problem Solved
Period A Period B Period C

Rev. = 2,000 0 + 5,000 = 5,000 0 + 8,000 = 8,000

Ex. = 800 0 + 700 = 700 0 + 900 = 900

Profit = 1,200 Profit = 4,300 Profit = 7,100

 Revenue and expense accounts are closed off to ensure that only
revenues earnt and expenses incurred within a period are included
within the Income Statement.

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Closing Revenue Accounts
 Revenue accounts are closed by debiting the revenue
account by the amount of the closing balance and then
crediting the P&L Summary account by the same amount.

Example
 “Novel Sports” sells $60,000 worth of goods in the period.
The sales revenue account would be debited by $60,000
and the P&L Summary account would be credited by
$60,000.

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Closing Revenue Accounts
General Journal Entry
Debit
Credit
Sales Revenue 60,000
P&L Summary 60,000

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Closing Expense Accounts
 Expense accounts are closed by crediting the
expense account by the amount of the closing
balance and then debiting the P&L Summary
account by the same amount.

Example
 The wages expense for “Novel Sports” is $10,000.
The wages account needs to be credited by $10,000
and the P&L Summary account debited by $10,000.

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Closing Expense Accounts
General Journal Entry
Debit
Credit
P&L Summary 10,000
Wages Expense 10,000

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Closing the P&L Summary
 The P&L Summary is a temporary
account. It is closed off to the Profit
Distribution account at the end of the
accounting period.

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Closing the P&L Summary
Example
 “Novel Sports” has made a $50,000 profit
(i.e. $60,000 – 10,000) then the P&L
Summary will have a $50,000 credit
balance. This needs to be closed off to
the profit distribution account

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Closing the P&L Summary

Debit
Credit
P&L Summary 50,000
Profit Distribution 50,000

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Allocation of Profit/Loss
 Three methods for allocating profit are as
follows:
 Fixed ratio
 Ratio based on capital balances
 Fixed ratio after deducting interest on partners capital
and salaries paid to partners.

 The manner in which profits are to be allocated

should be outlined in the partnership agreement.

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Example
 Matt and Justin are partners in “Novel
Sports”.

 Capital Investments are as follows:

 Justin $200,000
 Matt $150,000

 Profit for the year is $50,000.

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1. Fixed Ratio
 The partnership agreement specifies that net
profit is to be allocated on the following basis
(50% Justin, 50% Matt).

Debit
Credit
Profit Distribution 50,000
Retained Profits - Justin 25,000
Retained Profits - Matt 25,000

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Balance Sheet (Extract)
Equity
Equity
Capital - Justin 200,000
Capital - Matt 150,000
Retained Profits- Justin 25,000
Retained Profits - Matt 25,000
Total Equity 400,000

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2. Ratio Based on Capital
Balances
 Justin and Matt agree to share profit
based on opening capital balances.

 In this way, the partner that has invested

more money into the business receives a
greater proportion of any profit or loss.

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2. Ratio Based on Capital
Balances
Justin: 200/350 x 50,000 = 28,571
Matt: 150/350 x 50,000 = 21,429

Debit
Credit
Profit Distribution 50,000
Retained Profits - Justin 28,571
Retained Profits - Matt 21,429
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Balance Sheet (Extract)
Equity
Equity
Capital – Justin 200,000
Capital - Matt 150,000
Retained Profits- Justin 28,571
Retained Profits - Matt 21,429
Total Equity 400,000

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3. Fixed Ratio after Interest on
Capital and Salaries
 Partners may specify within the partnership
agreement that each partner is to receive the
following:
 Interest on Opening Capital
 Salary

 Interest and Salaries to partners are paid out of

the profit (i.e. they are not expenses of the
business).

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3. Fixed Ratio after Interest on
Capital and Salaries
 Matt and Justin agree that 10% interest on
opening capital should be paid each year.

 Interest allocated to each partner from

profit
Justin: 10% x 200,000 = 20,000
Matt: 10% x 150,000 = 15,000

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Profit Distribution

$50,000

Justin Matt
$20,000 15,000

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3. Fixed Ratio after Interest on
Capital and Salaries
 The partners agree that Justin should
receive a salary of $7,000 and Matt a
salary of $3,000.

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Profit Distribution

$50,000

Justin Matt
$20,000 $15,000

$7,000 $3,000

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3. Fixed Ratio after Interest on
Capital and Salaries
 The remaining profit ($5,000) is then allocated
according to fixed ratio as follows:
 Justin60%
 Matt 40%

 Profit allocated to each partner from profit

Justin: 60% x $5,000 = 3,000
Matt: 40% x $5,000 = 2,000

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 $50,000

Justin Matt
$20,000 $15,000

$7,000 $3,000

$3,000 $2,000

Total Total
$30,000 $20,000
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Distribution of Profit
Debit
Credit
Profit Distribution 50,000
Retained Profits - Justin
30,000
Retained Profits - Matt
20,000

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Balance Sheet (Extract)
Equity
Equity
Capital - Justin 200,000
Capital - Matt 150,000
Retained Profits- Justin 30,000
Retained Profits - Matt 20,000
Total Equity 400,000

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Closing Drawings
 At the end of the period any drawings by
partners are closed off to the respective
partners retained profit account.

 Drawings by each partner during the period

Justin: 9,000
Matt: 6,000

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Closing Drawings
Debit
Credit
Retained Profits - Justin 9,000
Retained Profits – Matt 6,000
Drawings - Justin 9,000
Drawings – Matt 6,000

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Balance Sheet (Extract)
Equity
Equity
Capital – Justin 200,000
Capital - Matt 150,000
Retained Profits- Justin 21,000 1
Retained Profits - Matt 14,000 2
Total Equity 385,000
Note
1. Share of profit, $30,000, less drawings $9,000.
2. Share of profit, $20,000, less drawings $6,000.

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