What Is the Financial Statement Closing Process?

The financial statement closing process is the sequence of accounting activities performed at the end of a period to finalize the books and prepare financial reports. This procedure is done at regular intervals, such as monthly or annually, to verify and adjust account balances. The resulting statements are used by management to make informed business decisions, by investors to assess performance, and by lenders to evaluate creditworthiness. A systematic close also ensures a company meets compliance obligations, including tax filings and regulatory requirements like the Sarbanes-Oxley Act (SOX).

Initial Data Compilation and Reconciliation

The first phase of the closing process ensures all financial data for the period has been captured correctly. All customer invoices, vendor bills, cash receipts, and payments must be entered into the general ledger, which is the central repository for all financial data.

A detailed review of accounts receivable and accounts payable is performed. The accounts receivable aging report is analyzed to identify potential collection problems and estimate an allowance for doubtful accounts. Simultaneously, accounts payable records are reviewed to confirm that all obligations to vendors have been recorded by matching purchase orders to vendor invoices.

Bank and credit card reconciliations are another check. This procedure involves comparing the company’s recorded transactions against statements from financial institutions. Each transaction is matched to identify discrepancies, such as outstanding checks, deposits in transit, bank service fees, or unrecorded electronic payments.

The final preparatory step is the reconciliation of sub-ledgers to their corresponding general ledger control accounts. Sub-ledgers provide detailed transactional data for accounts like inventory and accounts receivable. For example, the total balance of all individual customer accounts in the accounts receivable sub-ledger must match the single accounts receivable balance in the general ledger.

Calculating and Posting Adjusting Journal Entries

After all transactions are recorded and accounts reconciled, the next phase involves making adjusting journal entries. These are entries made in the general ledger to properly account for revenue and expenses under the accrual basis of accounting.

Common types of adjustments include:

• Accrued expenses: These are expenses the company has incurred but has not yet paid for by the end of the period. An example is employee wages; if a pay period ends after the close of the month, the company must record an entry for the wages earned.
• Accrued revenue: This is revenue that has been earned but not yet invoiced or collected. For instance, a consulting firm that completes a project on the last day of the month must record the earned revenue, even if it plans to send the invoice in the following month.
• Prepaid expenses: This occurs when a company pays for a future expense in advance, creating an asset. For a 12-month insurance policy paid upfront, each month the company must recognize one month’s worth of the expense by making an entry to reduce the prepaid asset.
• Unearned revenue: This represents cash received from a customer for goods or services that have not yet been delivered. If a software company receives an annual subscription fee, it initially records this as unearned revenue and makes monthly entries to recognize the revenue as it is earned.
• Depreciation and amortization: Depreciation is the process of allocating the cost of tangible assets, like buildings and equipment, over their useful lives. Amortization is the similar process for intangible assets. For a machine with a five-year useful life, the company would record depreciation expense each month.

Finalizing the Close and Generating Reports

Once all adjusting journal entries are posted, the next step is to prepare an adjusted trial balance. This internal document lists every account in the general ledger and its final balance. Its purpose is to serve as a final check that the total debits equal the total credits.

With the accounts confirmed to be in balance, the next step is to post closing entries. This prepares the books for the next accounting period by closing all temporary accounts, which include revenue, expense, and dividend accounts. The net balance is transferred to Retained Earnings, a permanent equity account.

The final output is the generation of the company’s formal financial statements. These reports provide a comprehensive view of the company’s financial performance and position and include:

• The Income Statement, showing revenues, expenses, and resulting net income or loss.
• The Balance Sheet, presenting a snapshot of assets, liabilities, and equity.
• The Statement of Retained Earnings, detailing changes in the retained earnings account.
• The Statement of Cash Flows, summarizing cash inflows and outflows.