Many small businesses opt to use the cash method of accounting, where they report income in the year they receive it and deduct expenses in the year they pay them. But, if your business has any kind of inventory, you must use the accrual methods, where you report income and expenses in the year you earned or incurred them. At the end of your fiscal year, you make adjusting entries to match sales and purchases to the correct year before closing at the end of the year.
Year End Accounting Procedures
Prepare the Adjusting Entries
First, create a backup of your accounting system. Prepare an income statement and balance sheet report and gather any financial statements for your major accounts.
List all of your expenses paid in advance, where the term of the expense goes into the next accounting year. For instance, if you pay your annual web hosting fees on July 1 for $1,000 and your fiscal year ends with the calendar year on December 31, at the end of the year, you will have prepaid 6 months of coverage for next year.
Next, credit the expense account with the prepaid expense to reduce your expense for the year, and then debit the prepayments account in the balance sheet. Continuing with the sample, credit the IT account with $500, while also debiting the prepayments account with the same amount.
Repeat for all expenses you’ve paid in advance, crediting the appropriate accounts and debiting the prepayments account.
From there, you’ll move onto all the expenses the organization has incurred but hasn’t recorded or paid. For instance, your last power bill was issued at the end of October, but you won’t get another one until after January. You’ll need to estimate your electricity costs for November and December. If possible, look at last year’s usage and use that as a guide.
Debit the expense account and credit the accruals account in the balance sheet with the accrued expense. Continuing with the utility bill example, if you estimate your power bill to run $750 for two months, you’d debit the utilities account, while crediting accruals with the $750.
Repeat for all expenses you’ve incurred, but not recorded or paid, debiting the appropriate accounts and crediting the accruals account.
At this stage, you’ll list the income the business has earned but not yet billed. For instance, you may invoice customers in January for work you completed in December. This accrued revenue needs to be included in December’s income.
Credit the revenue account with that income. Debit your accounts receivable with the amount earned in December. For instance, if you have recorded $1,000 of work in December to billed in January, you’ll credit the revenue account then debit accounts receivable in your balance sheet with that same $1,000.
Now it’s time to calculate the depreciation of the organization’s fixed assets to spread the cost of the asset over its useful lifetime. For instance, if you use the straight-line method of depreciation, you depreciate your assets by an equal amount every accounting period.
Debit your depreciation expense account with the total depreciation for the year. Credit the accumulated depreciation in the balance sheet. For example, if you have determined your fleet vehicles have depreciated $1,000 and your office equipment has depreciated $500, then you’ll debit the depreciation expense account $1,500 and apply a $1500 credit to the accumulated depreciation.
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Make the Closing Entries
After you’ve prepared your adjusting entries, use it to prepare an adjusted trial balance and income statement.
Close all the income statement accounts that a credit balance. Debit them with the amount of the credit balance and posting the same amount as a credit to the temporary income summary account. For instance, if you have three income accounts with credit balances of $25,000, $10,000, and $2,500 respectively, then you’ll debit each account with the corresponding credit, and then credit your income summary account with $37,500.
Close all the income statement accounts with debit balances. Credit the account with the balance to close and debit the income summary account with the same amount. For instance, if your utility account has a debit balance of $3,000 at the year-end, credit utilities and debit the income summary account with $3,000.
From here, calculate the balance on the income summary account and close the account. Transfer the balance to the owner’s capital account for a sole proprietor, or to the retained earnings account for a corporation. For instance, if your business has made $100,000 in profit for the year, the income summary will have a credit balance of this amount. Debit the income summary account and credit the necessary owner or retained earnings account with $100,000.
Finish by transferring the owner’s drawings to the owner’s capital account or dividend accounts to the retained earnings accounts. These drawings and dividends accounts will typically have debit balances. Credit drawings or dividends then debit the owner’s capital or retained earnings account accordingly.
If you have the option to choose between the cash or accrual method of accounting, choose the one you are most comfortable with. What matters is that you use the same method year after year to keep data consistent. The IRS also expects businesses to use the same accounting method every year.
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