In 2014 ABC Company reported net income of $100,000. What would be the effect on retained earnings on ABC Company's balance sheet and on its 2015 income statement if it didn't record a closing entry?
To determine the effect on retained earnings on ABC Company's balance sheet and its 2015 income statement if it didn't record a closing entry, you need to understand the purpose of a closing entry and its impact on financial statements.
Closing entries are made at the end of an accounting period to transfer net income or net loss to the retained earnings account on the balance sheet. The purpose of closing entries is to reset the temporary accounts (revenue, expense, and dividend accounts) to zero for the new accounting period.
In this case, if ABC Company didn't record a closing entry for 2014, the effect on the balance sheet and the income statement in 2015 would be as follows:
1. Balance Sheet:
Retained Earnings: The net income of $100,000 from 2014 would not be transferred to retained earnings, resulting in an understated retained earnings balance on the balance sheet for 2014.
The effect on the balance sheet in 2015 would be no impact since the retained earnings balance at the end of 2014 would carry forward and continue to be reported as the beginning balance for 2015.
2. Income Statement:
The net income of $100,000 from 2014, which should have been closed to retained earnings, would remain in the revenue and expense accounts on the income statement, causing an overstatement of net income for 2015.
This overstatement would affect the calculation of taxes, dividends, and other financial ratios based on net income.
In summary, failing to record a closing entry for 2014 would result in an understated retained earnings balance on the balance sheet for 2014 and an overstated net income on the income statement for 2015.