DETAILS Chapter 11a: How to Prepare the Worksheet The Big Picture

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1 2008 by Mark Krilanovich Mark Krilanovich November 22, 2008 ACCT 110 DETAILS Chapter 11a: How to Prepare the Worksheet The Big Picture 1. Chapters 9 and 10 introduced ten new accounts (see p. Ch. 9b and Ch. 10b). Chapter 11 now shows us how to adjust them onto a Worksheet, and introduces using that Worksheet to produce Financial Statements. 2. Chapter 11 mentions several payroll accounts covered in Chapters 7 and 8. (Don't worry about them.) 3. Pages of Chapter 10 introduced the new accounts "Merchandise Inventory" and "Cost of Goods Sold." Chapter 11 now delves deeply into them, from the simpler perspective of the "Periodic Inventory System." (Definitions of the Periodic and Perpetual Systems are on the bottom of p. 404.) 4. The text almost implies that "Beginning (Merchandise) Inventory" and "Ending (Merchandise) Inventory" are two separate accounts. In truth, the only account is "Merchandise Inventory." "Beginning Inventory" and "Ending Inventory" are the balances of that account at the beginning and ending of the accounting period. 5. In a few places, the text talks about the beginning and ending of the month, but most places more correctly talk about the beginning and end of the year. 6. The title of Chapter 11 includes the term "Merchandise Company," and the text often talks about "Art's Wholesale Clothing Co.," which is simply the name of a wholesale merchandise company. 7. Chapter 10 often viewed one transaction from the perspective of two companies: the buyer and the seller of the same item. Chapter 11 considers only one company, which buys goods and later sells them. 8. Chapter 12 will tie together many ideas we've studied separately. These are some new concepts (you must memorize these formulas): 1. "Cost of Goods Sold" ("CoGS") means "The cost to us of merchandise we purchased from our supplier, and we later sold to our customers." (I.e., the word "Cost" applies to the time we purchased from our supplier, but the word "Sold" applies to the time we sold to our customer.) 2. "Unearned Revenue" is money that we haven't yet earned, but will. It's money paid us in advance of goods or services, like a deposit. It is a Liabillity. 3. Net Purchases = (gross) Purchases - Purchases Returns & Allowances - Purchase Discounts. 4. Cost of Goods Available for Sale = Beginning Inventory + Net Purchases + Freight-In. 5. Cost of Goods Sold = Beginning Inventory + Net Purchases + Freight-In - Ending Inventory. 6. Net Sales = (gross) Sales - Sales Returns & Allowances - Sales Discounts. 7. Gross Profit = Net Sales - Cost of Goods Sold. 8. Net Income = Gross Profit - Operating Expenses. Memorize either these formulas, or the diagrams on page 3. needed for the Income Statement

2 Chapter 11b: The New Accounts ACCT 110, Chapter 11, page 2 Definitions and Characteristics of the New Accounts: account name category normal balance when and how this account is used Unearned Rent Liability credit Rental Income Revenue credit This is one kind of "Unearned Revenue" (revenue we will earn, but haven't yet). When we rent space to a customer and they give us their "Prepaid Rent" (p. 121), we hold their deposit in this account. This is our liability, because we owe them that much occupancy. As their rent comes due, we move one month's rent to our "Rental Income" account. Revenue we earn by renting space to customers. This account increases when a customer's rent comes due, coming from our Unearned Rent. Mortgage Payable Liability credit The amount we owe on mortgage(s). Chapter 12 will cover this. Interest Expense other Expense debit The cost of our borrowing money. Chapter 12 will cover this more. Petty Cash Asset debit Chapter 6 covered this. Payroll liabilities Liability credit Chapters 7 and 8 covered this. Payroll Tax Expense Expense debit Chapter 8 (p. 279) covered this. Merchandise Inventory Asset debit Beginning Inventory Ending Inventory This is the value of all our merchandise. This account doesn't change during the accounting period, only at the end of the accounting period. This is the balance of the Merchandise Inventory account at the beginning of the accounting period. At the end of the accounting period, we take a physical count of our merchandise on hand, which we haven't sold. We compute its collective original cost to us (p. 390), and that's our Ending Inventory balance. As part of adjusting journal entries at the end of the accounting period, we move Beginning Inventory out of the Mechandise Inventory account into Income Summary, and move Ending Inventory into the Merchandise Inventory account to begin the next accounting period. Note: Table 11.1 on page 395 gives more information about all new account titles by Mark Krilanovich

3 Chapter 11c: The New Accounts ACCT 110, Chapter 11, page 3 Making Year-End Adjustments on the Worksheet with the New Accounts: Unearned Rent; when we receive advance payment from a customer for their future rent, we do this: Debit Cash for the amount of money our rental customer gave us. Credit Unearned Rent for the same amount. Rental Income; when our customer's rent comes due (e.g., on the last day of the month), we do this: Debit Unearned Rent by the amount of one month of our customer's rent. Credit Rental Income by the same amount. Merchandise Inventory; at the end of the accounting period, we do these two transactions: 1. Credit Merchandise Inventory by the amount in the Merchandise Inventory account (out with the old inventory). Debit Income Summary by the same amount. 2. Debit Merchandise Inventory by the amount on the Ending Inventory sheet (in with the new inventory). Credit Income Summary by the same amount. Note: The above debit and credit to Income Summary remain separate across the worksheet; we don't combine them, because we'll need them separate in Chapter 12 to prepare the formal Income Statement. Be patient to see why. Diagrams that Illustrate Formulas for the Income Statement: Beginning Inventory Gross Purchases Gross Sales Net Sales Gross Profit - Ending Inventory + Net Purch - Purch Ret. - Sales Ret. - COGS - Operating Expenses - Purch Disc. - Sales Disc. = COGS + Freight-In = Net Purch = Net Sales = Gross Profit = Net Income Cost Of Goods Sold ("COGS") = Begin Inven - End Inven + Net Purch + Freight-In Net Purchases = Gross Purch - Purch Returns - Purch Discounts Net Sales = Gross Sales - Sales Returns - Sales Discounts Gross Profit = Net Sales - COGS Net Income = Gross Profit - Op Expense I'm a colorful guy. (c)2008 by Mark Krilanovich

4 ACCT 110, Chapter 11, page 4 Chapter 11d: How to Adjust Merchandise Inventory Using the "Income Summary" Account Assume our merchandise business has an accounting period from Jan. 1 through Dec. 31. On Jan. 1 (a holiday when our store is closed), we have a Merchandise Inventory of $19,000. This is how our T-accounts look: Merchandise Inventory BB Jan. 1; $19,000 Income Summary Doesn't exist now, because it's a temporary account, and lived only long enough for us to do last years' year-end adjustments and closing. On Dec. 31, we close our store and take a hand count of the merchandise in it. We find that we own $4000 worth of merchandise. Now our T-accounts (for the moment) look like this: Merchandise Inventory BB Jan. 1; $19,000 Income Summary Doesn't exist. EB Dec. 31; $4,000 How can we get from the first pair of T-accounts to the second? By the unique two-step process of crediting out the old Inventory balance, and then debiting in the new balance, like below left. Of course, we must match that credit and debit with an equal debit and credit somewhere else. We do those in the Income Summary account, because the beginning and ending Merchandise Inventory balances will later help us compute our income. Thus, our T-accounts now look like this: Merchandise Inventory Income Summary BB Jan. 1; $19,000 $19,000 Out In $4,000 matches Out $19,000 $4,000 matches In EB Dec. 31; $4,000 After we complete the year-end closing process, Dec. 31's ending balance of $4000 will, the next day, be the beginning balance on Jan. 1 of the new year by Mark Krilanovich

5 Assets Liabilities Owner's Equity Chapter 11e: Worksheet Including Adjustments for Inventory A Picture View Account Title ("ALORE" order) Worksheet for George Washington Cherry Trees, Year Ending Dec. 31, 1762 ACCT 110, Chapter 11, page 5 Trial Balance Adjustments Adjust. Trial Bal. Income Stmt. Balance Sheet Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Merchandise Inventory t t t s s * t t t * s s s s Cash o o (In) (Out) o o o o Accounts Receivable o o o o o o Always Accounts Payable o o o o o o o Salaries Payable o o o o empty. o o Owner's Capital o o o o o o o o o Owner's Withdrawals o o o Revenue Expenses Income Summary t t t s s t t t s s t t t s s Sales (gross) o o o o o o o o o Sales Returns & Allow. o o o o o o copy both copy both Sales Discounts o o o Purchases (gross) o o o o o o o o o Purchases Ret. & Allow. o o o o o o Purchases Discounts o o o o o o Office Supplies Expense o o o o o o o o o o Rent Expense o o o o o o o o o o Always empty by Mark Krilanovich totals: A A A A A A B B B B B B C C C C C C X X X E E E F F F Z Z Z We copy both the ttt and ss numbers across to the right (rather than combining them), because we'll need them individually in the Income Statement column, so that in Ch. 12 we can use them to prepare the formal Income Statement. net loss: N N N N N N totals: X X X X X X Z Z Z Z Z Z These two XXX's match, but differ from ZZZ at the right. The two NNN's match. NNN = XXX - EEE. A template of this form is on my website, These two ZZZ's match, but differ from XXX at the left. NNN is Net Income or Net Loss. NNN = ZZZ - FFF.

6 (c)2008 by Mark Krilanovich ACCT 110, Chapter 11, page 6 Chapter 11f: How to Prepare the Worksheet Step-by-Step Instructions 1. Account Titles Column: List all the accounts down the left-most column, in the order they appear in the chart of accounts (preferably "ALORE"). 2. Trial Balance Section: For each account, copy its ending balance from the general ledger (as debit or credit) into the Trial Balance Section. 3. Adjustments Section: 1. Enter the debit and credit adjustments for the familiar accounts (pp , D-G), as we learned on pp Enter the debit and credit for Unearned Rent and Rental Income as shown above in Chapter 11c. 3. On the Merchandise Inventory line, copy the original number from Merchandise Inventory in the Trial Balance Section as the credit, and enter Ending Inventory balance (from the Inventory Sheet) as the debit. (Out with the old, in with the new.) 4. On the Income Summary line, enter the same two numbers as in step #3 reversed, so that old Merchandise Inventory is the debit, and Ending Inventory balance is the credit. 4. Adjusted Trial Balance Section: 1. For the Income Summary row, copy both the debit and credit entries from the Adjustments to the Adjusted Trial Balance. 2. For every other account, combine the values in the Trial Balance Section with those in the Adjustments Section, and enter the result. as a debit or credit appropriately, in the Adjusted Trial Balance Section. 5. Income Statement Section: 1. For the Income Summary row, copy both the debit and credit entries from Adjustments to the Income Statement Section. 2. For every account (row) that relates to Income (Revenue, Expenses, and Costs, contra- and otherwise), copy the contents from the Adjusted Trial Balance Section into the Income Statement Section. (Why? See 6.1 below.) 3. Subtotal the debit half-column, and subtotal the credit half-column. 4. Subtract the smaller subtotal from the larger, yielding either Net Income or Net Loss. Place the result on the next line, below the smaller subtotal. 5. Total these last two rows, and they will match. 6. Balance Sheet Section: 1. For every account (row) in the Adjusted Trial Balance Column that you didn't copy to the Income Statement Section, copy it now to the Balance Sheet Section. (Why? It makes Income Statement and Balance Sheet Sections easier to read and total.) 2. Subtotal the debit half-column, and subtotal the credit half-column. 3. Subtract the smaller subtotal from the larger, yielding either Net Income or Net Loss. Place the result on the next line, below the smaller subtotal. This must match the Net Income calculated in step #3 in the Income Statement Section. 4. Total these last two rows, and they will match, but won't match the totals of the Income Statement Section.