Financial Statements and Year-End Accounting for a Merchandising Business woot was originally a truncated expression commonly used by players

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1 Chapter 15 COURTESY OF WOOT.COM LEARNING OBJECTIVES Careful study of this chapter should enable you to: LO1 Prepare a single-step and multiple-step income statement for a merchandising business. LO2 Prepare a statement of owner s equity. LO3 Prepare a classified balance sheet. LO4 Compute standard financial ratios. LO5 Prepare closing entries for a merchandising business. LO6 Prepare reversing entries. Financial Statements and Year-End Accounting for a Merchandising Business woot was originally a truncated expression commonly used by players of Dungeons and Dragons for Wow, loot! Woot, Inc., is an online store, founded in 2003, that focuses on selling cool stuff cheap. The company is known for its honest item descriptions and limited customer service. For example, the Web site explains that the company doesn t take calls because its 100 employees are busy finding new products and shipping orders. Further, don t try to return something until all other options have been exhausted. If you want cheap prices, don t expect great service. This candor is refreshing, but we suspect they will help you out if you need it. The company claims profitability is anticipated by By then we should be retired; someone smarter might take over and jack up the prices. Clever, but with revenues increasing from $2.3 million to $117.4 million over a recent three-year period, we suspect the company is doing just fine. Probably the most unique characteristic of this merchandiser is that it sells only one product each day. It is available from 12:00 A.M. until sold out, or 11:59 P.M., when a different product is posted. Missed a cool product? Too bad. You can t buy yesterday s item. Though clearly unique, this business must perform year-end accounting in the same manner as other retailers. In this chapter, you will learn how Woot and other merchandising firms prepare financial statements, compute financial ratios to evaluate performance, and prepare closing and reversing entries. No matter how unique, businesses must follow similar accounting procedures so that profitability and financial health can be compared across years and with other companies.

2 The first six chapters of this text illustrated the accounting cycle for a service business. In this chapter, we complete the accounting cycle for a merchandising business. In Chapter 14, we prepared the year-end work sheet and adjusting entries for Northern Micro. In this chapter, we will prepare financial statements, look briefly at financial statement analysis, and demonstrate closing and reversing entries. THE INCOME STATEMENT LO1 Prepare a single-step and multiple-step income statement for a merchandising business. As you know, a primary purpose of the work sheet is to serve as an aid in preparing the financial statements. Figure 15-1 shows the completed work sheet for Northern Micro. We will use it to prepare financial statements. The purpose of an income statement is to summarize the results of operations during an accounting period. The income statement shows the sources of revenue, types of expenses, and the amount of the net income or net loss for the period. Two forms of the income statement commonly used are the single step and the multiple step. The single-step income statement lists all revenue items and their total first, followed by all expense items and their total. The difference, which is either net income or net loss, is then calculated. A single-step income statement for Northern Micro is illustrated in Figure The use of the work sheet to prepare a multiple-step income statement is illustrated in Figure This type of income statement is commonly used for merchandising businesses. The term multiple-step is used because the final net income is calculated on a step-by-step basis. Gross sales is shown first, less sales returns and allowances and sales discounts. This difference is called net sales. (Many published income statements begin with the amount of net sales.) Cost of goods sold is subtracted next to arrive at gross profit (sometimes called gross margin). Operating expenses are then listed and subtracted from the gross profit to compute income from operations (sometimes called operating income). Operating expenses are directly associated with providing the primary goods and services of the business. Some companies divide operating expenses into the following subcategories. Selling expenses. These expenses are directly associated with selling activities. Examples include: Sales Salaries Expense Sales Commissions Expense Advertising Expense Bank Credit Card Expense Delivery Expense Depreciation Expense Store Equipment and Fixtures Chapter 15 Financial Statements and Year-End Accounting for a Merchandising Business 567

3 568 PART 3 Accounting for a Merchandising Business FIGURE 15-1 Northern Micro Work Sheet Northern Micro Work Sheet For Year Ended December 31, ACCOUNT TITLE TRIAL BALANCE ADJUSTMENTS ADJUSTED TRIAL BALANCE INCOME STATEMENT BALANCE SHEET DEBIT CREDIT DEBIT CREDIT DEBIT CREDIT DEBIT CREDIT DEBIT CREDIT 1 Cash Accounts Receivable Merchandise Inventory (b) (a) Supplies (c) Prepaid Insurance (d) Land Building Accum. Depr. Building (e) Store Equipment Accum. Depr. Store Equipment (f) Notes Payable Accounts Payable Wages Payable (g) Sales Tax Payable Unearned Subscriptions Revenue (h) Mortgage Payable Gary L. Fishel, Capital Gary L. Fishel, Drawing Income Summary (a) (b) Sales Sales Returns and Allowances Interest Revenue Rent Revenue Subscriptions Revenue (h) Purchases Purchases Returns and Allowances Purchases Discounts Freight-In Wages Expense (g) Advertising Expense Bank Credit Card Expense Rent Expense Supplies Expense (c) Telephone Expense Utilities Expense Insurance Expense (d) Depr. Expense Building (e) Depr. Expense Store Equipment (f) Miscellaneous Expense Interest Expense Net Income

4 Chapter 15 Financial Statements and Year-End Accounting for a Merchandising Business 569 FIGURE 15-2 Single-Step Income Statement Northern Micro Income Statement For Year Ended December 31, Revenues: Net sales $ Interest revenue Rent revenue Subscriptions revenue Total revenues $ Expenses: Cost of goods sold $ Wages expense Advertising expense Bank credit card expense Rent expense Supplies expense Telephone expense Utilities expense Insurance expense Depreciation expense building Depreciation expense store equipment Miscellaneous expense Interest expense Total expenses Net income $ LEARNING KEY Although the formats for the single-step and multiple-step income statements are different, the reported net income is the same. By showing other revenues and other expenses separately, it is possible to show income from operations. This makes it easier for the reader to see how the business is doing in its main activity. General expenses. These expenses are associated with administrative, office, or general operating activities. Examples include: Rent Expense Office Salaries Expense Office Supplies Expense Telephone Expense Utilities Expense Insurance Expense Depreciation Expense Office Equipment Finally, other revenues are added and other expenses are subtracted to arrive at net income (or net loss). Note that the operating expenses are arranged according to the order given in the chart of accounts. They could also be listed by descending amount, with Miscellaneous Expense last.

5 570 PART 3 Accounting for a Merchandising Business FIGURE 15-3 Using a Work Sheet to Prepare a Multiple-Step Income Statement Northern Micro Work Sheet (Partial) For Year Ended December 31, ACCOUNT TITLE INCOME STATEMENT DEBIT CREDIT 1 Cash 2 Accounts Receivable 3 Merchandise Inventory 4 Supplies 5 Prepaid Insurance 6 Land 7 Building 8 Accum. Depr. Building 9 Store Equipment 10 Accum. Depr. Store Equipment 11 Notes Payable 12 Accounts Payable 13 Wages Payable 14 Sales Tax Payable 15 Unearned Subscriptions Revenue 16 Mortgage Payable 17 Gary L. Fishel, Capital 18 Gary L. Fishel, Drawing 19 Income Summary Sales Sales Returns and Allowances Interest Revenue Rent Revenue Subscriptions Revenue Purchases Purchases Returns and Allowances Purchases Discounts Freight-In Wages Expense Advertising Expense Bank Credit Card Expense Rent Expense Supplies Expense Telephone Expense Utilities Expense Insurance Expense Depr. Expense Building Depr. Expense Store Equipment Miscellaneous Expense Interest Expense Net Income Northern Micro Income Statement For Year Ended December 31, Revenue from sales: Sales $ Less sales returns and allowances Net sales $ Cost of goods sold: Merchandise inventory, January 1, 20-- $ Purchases $ Less: Purchases returns and allowances $ Purchases discounts Net purchases $ Add freight-in Cost of goods purchased Goods available for sale $ Less merchandise inventory, December 31, Cost of goods sold Gross profit $ Operating expenses: Wages expense $ Advertising expense Bank credit card expense Rent expense Supplies expense Telephone expense Utilities expense Insurance expense Depreciation expense building Depreciation expense store equipment Miscellaneous expense Total operating expenses Income from operations $ Other revenues: Interest revenue $ Rent revenue Subscriptions revenue Total other revenues Other expenses: Interest expense Net income $ U REVU Complete U REVU-1 on page 592 to test your basic understanding of LO1. THE STATEMENT OF OWNER S EQUITY LO2 Prepare a statement of owner s equity. The statement of owner s equity summarizes all changes in the owner s equity during the period. It includes the net income or loss and any additional investments or withdrawals by the owner. These changes result in the end-of-period balance shown on this statement and the balance sheet.

6 Chapter 15 Financial Statements and Year-End Accounting for a Merchandising Business 571 To prepare the statement of owner s equity for Northern Micro, two sources of information are needed: (1) the work sheet, and (2) Gary Fishel s capital account (no. 311) in the general ledger. The work sheet (Figure 15-1) shows net income of $22,650 and withdrawals of $20,000 during the year. Fishel s capital account (Figure 15-4) shows a beginning balance of $104,400. An additional $10,000 was invested in the business in February of the current year. The statement of owner s equity for Northern Micro for the year ended December 31, 20--, is shown in Figure FIGURE 15-4 Capital Account for Gary L. Fishel ACCOUNT: Gary L. Fishel, Capital ACCOUNT NO. 311 DATE ITEM POST. REF. DEBIT CREDIT BALANCE DEBIT CREDIT 20-- Jan. 1 Balance Feb. 12 CR FIGURE 15-5 Statement of Owner s Equity The statement of owner s equity is the same for service and merchandising businesses. Northern Micro Statement of Owner s Equity For Year Ended December 31, Gary L. Fishel, capital, January 1, $ Add additional investments Total investment $ Net income for the year $ Less withdrawals for the year Increase in capital Gary L. Fishel, capital, December 31, $ U REVU Complete U REVU-2 on page 592 to test your basic understanding of LO2. BALANCE SHEET LO3 Prepare a classified balance sheet. LEARNING KEY Note the use of the ending balance for merchandise inventory. It is reported on the income statement as part of the calculation of cost of goods sold. It also is reported on the balance sheet as a current asset. The use of the work sheet to prepare a report form classified balance sheet is illustrated in Figure The balance sheet classifications used by Northern Micro are explained below. CURRENT ASSETS Current assets include cash and all other assets expected to be converted into cash or consumed within one year or the normal operating cycle of the business, whichever is longer. The operating cycle is the length of time generally required for a business to buy inventory, sell it, and collect the cash. This time period is generally less than a year. Thus, most firms use one year for classifying current assets. In a merchandising business, the current assets usually include cash, receivables (such as accounts receivable and notes receivable), and merchandise inventory. Since prepaid expenses, such as unused supplies and unexpired insurance, are likely to be consumed within a year, they also are reported as current assets.

7 572 PART 3 Accounting for a Merchandising Business FIGURE 15-6 Using a Work Sheet to Prepare a Report Form Classified Balance Sheet Northern Micro Work Sheet (Partial) For Year Ended December 31, BALANCE SHEET ACCOUNT TITLE DEBIT CREDIT 1 Cash Accounts Receivable Merchandise Inventory Supplies Prepaid Insurance Land Building Accum. Depr. Building Store Equipment Accum. Depr. Store Equipment Notes Payable Accounts Payable Wages Payable Sales Tax Payable Unearned Subscriptions Revenue Mortgage Payable Gary L. Fishel, Capital Gary L. Fishel, Drawing Income Summary 20 Sales 21 Sales Returns and Allowances 22 Interest Revenue 23 Rent Revenue 24 Subscriptions Revenue 25 Purchases 26 Purchases Returns and Allowances 27 Purchases Discounts 28 Freight-In 29 Wages Expense 30 Advertising Expense 31 Bank Credit Card Expense 32 Rent Expense 33 Supplies Expense 34 Telephone Expense 35 Utilities Expense 36 Insurance Expense 37 Depr. Expense Building 38 Depr. Expense Store Equipment 39 Miscellaneous Expense 40 Interest Expense Net Income Assets Northern Micro Balance Sheet December 31, Current assets: Cash $ Accounts receivable Merchandise inventory Supplies Prepaid insurance Total current assets $ Property, plant, and equipment: Land $ Building $ Less accum. depr. building Store equipment $ Less accum. depr. store equip Total property, plant, and equipment Total assets $ Liabilities Current liabilities: Notes payable $ Accounts payable Wages payable Sales tax payable Unearned subscriptions revenue Mortgage payable (current portion) Total current liabilities $ Long-term liabilities: Mortgage payable $ Less current portion Total liabilities $ Owner s Equity Gary L. Fishel, capital * Total liabilities and owner s equity $ *From statement of owner s equity. Current assets are listed on the balance sheet from the most liquid to least liquid. Liquidity refers to the speed with which the company can convert the asset to cash. Cash is the most liquid asset and is always listed first. Notes Receivable, Accounts Receivable, and Merchandise Inventory often follow it on the balance sheet. PROPERTY, PLANT, AND EQUIPMENT Assets that are expected to be used for more than one year in the operation of a business are called property, plant, and equipment. Examples include land, buildings, office equipment, store equipment, and delivery equipment. Of these assets, only land is

8 Chapter 15 Financial Statements and Year-End Accounting for a Merchandising Business 573 permanent; however, all of these assets have useful lives that are comparatively long. Typically, assets with longer useful lives are listed first. The balance sheet of Northern Micro shows Land, Building, and Store Equipment. Land is not depreciated. Accumulated depreciation amounts are shown as deductions from the costs of the building and store equipment. The difference represents the undepreciated cost, or book value, of the assets. This amount less any salvage value will be written off as depreciation expense in future periods. The current portion of longterm debt, the amount due within one year, is reported as a current liability. The remainder is reported under long-term liabilities. CURRENT LIABILITIES Current liabilities include those obligations that are due within one year or the normal operating cycle of the business, whichever is longer, and will require the use of current assets. As of December 31, the current liabilities of Northern Micro consist of Notes Payable, Accounts Payable, Wages Payable, Sales Tax Payable, Unearned Subscriptions Revenue, and the portion of Mortgage Payable that is due within the next year. LONG-TERM LIABILITIES Long-term liabilities include those obligations that will extend beyond one year or the normal operating cycle, whichever is longer. A common long-term liability is a mortgage payable. A mortgage is a written agreement specifying that if the borrower does not repay a debt, the lender has the right to take over specific property to satisfy the debt. When the debt is paid, the mortgage becomes void. Mortgage Payable is an account that is used to reflect an obligation that is secured by a mortgage on certain property. OWNER S EQUITY The permanent owner s equity accounts reported on the balance sheet are determined by the type of organization. The accounts for a sole proprietorship, a partnership, and a corporation differ. Northern Micro is a sole proprietorship and reports one owner s equity account, Gary L. Fishel, Capital. The balance of this account is taken from the statement of owner s equity. Partnerships are illustrated in Chapter 19 and corporations are discussed in Chapters 20 and 21. U REVU Complete U REVU-3 on page 592 to test your basic understanding of LO3. FINANCIAL STATEMENT ANALYSIS LO4 Compute standard financial ratios. Both management and creditors are interested in using the financial statements to evaluate the financial condition and profitability of the firm. This can be done by making a few simple calculations. BALANCE SHEET ANALYSIS Recall the following: 1. Current assets include cash, items that will be converted to cash, and items that will be consumed within one year. 2. Current liabilities are obligations that will require the use of current assets. Thus, the difference between current assets and current liabilities represents the amount of capital the business has available for current operations. This is called working capital. Working Capital = Current Assets Current Liabilities

9 574 PART 3 Accounting for a Merchandising Business The balance sheet in Figure 15-6 shows that Northern Micro has current assets of $54,000 and current liabilities of $19,450. Thus, the working capital at year end is $34,550 ($54,000 $19,450). This amount should be more than adequate to satisfy current operating requirements. Two measures of the firm s ability to pay its current liabilities are the current ratio and quick ratio. The formulas for calculating these ratios are as follows: LEARNING KEY Ratio analysis is most informative when the ratios are compared with past performance and with those of similar businesses. Information on industry averages is available in various publications from Dun & Bradstreet, Standard & Poor s, and Moody s. Current Ratio Quick Ratio = = Northern Micro Current Assets $54,000 = = 2.8 to 1 Current Liabilities $19,450 Quick Assets $35,000 = Current Liabilities $19,450 = 1.8 to 1 Northern Micro s current ratio of 2.8 to 1 is quite high, which indicates a favorable financial position. The traditional rule of thumb has been that a current ratio should be about 2 to 1, but many businesses operate successfully on a current ratio of 1.5 to 1. Although a rule of thumb is helpful, it is better to compare an individual company to industry averages, which are available in most public libraries or on the Internet. Quick assets include cash and all other current assets that can be converted into cash quickly, such as accounts receivable and temporary investments. Temporary investments are discussed in more advanced textbooks. The balance sheet in Figure 15-6 shows total quick assets of $35,000 ($20,000 in cash + $15,000 in accounts receivable). This produces a quick ratio of 1.8 to 1. Quick assets appear to be more than adequate to meet current obligations. The traditional rule of thumb has been that a quick ratio should be about 1 to 1, but many businesses operate successfully on a quick ratio of 0.6 to 1. INTERSTATEMENT ANALYSIS Interstatement analysis provides a comparison of the relationships between selected income statement and balance sheet amounts. A good example of interstatement analysis is the ratio of net income to owner s equity in the business. This ratio is known as return on owner s equity. Northern Micro Return on Net Income $22,650 = = Owner s Equity Average Owner s Equity ($104,400 + $117,050) 2 = = $22,650 $110, % The statement of owner s equity in Figure 15-5 shows that the owner s equity of Northern Micro was $104,400 on January 1 and $117,050 on December 31. The net income for the year of $22,650 is 20.5% of the average owner s equity. A comparison of this ratio with the return on owner s equity in prior years should be of interest to the owner. It may also be of interest to compare the return on owner s equity of Northern Micro with the same ratio for other businesses of comparable nature and size. A second ratio involving both income statement and balance sheet accounts is a measure of the time required to collect cash from credit customers. This financial measure is often computed in two ways. The accounts receivable turnover is the number of times the accounts receivable turned over, or were collected, during the accounting period. Of course, a higher number indicates that cash is collected more quickly. This ratio is calculated as follows:

10 Chapter 15 Financial Statements and Year-End Accounting for a Merchandising Business 575 Accounts Receivable Turnover = Net Credit Sales for the Period Average Accounts Receivable Net credit sales is generally not reported in the financial statements. Use net sales, instead. As long as the proportion of cash and credit sales is reasonably stable over time, this ratio will provide a reasonable measure of the business s ability to collect receivables in a timely manner from year to year. The accounts receivable turnover for Northern Micro for the year ended December 31 is computed as follows: Net credit sales for the year (determined from the accounting records) $110,000 Accounts receivable balance, January 1, 20-- (taken from last year s balance sheet) 10,000 Accounts receivable balance, December 31, ,000 Northern Micro Average Accounts Beginning Balance + Ending Balance $10,000 + $15,000 = = Receivable 2 2 = $12,500 Accounts Receivable Net Credit Sales for the Period $110,000 = = Turnover Average Accounts Receivable $12,500 = 8.8 The average collection period is calculated by dividing the number of days in the year (365) by the rate of turnover to determine the number of days credit customers take to pay for their purchases. Northern Micro s customers are taking about 42 days. 365 days 8.8 = 41.5 days Comparing the average collection period with a business s credit terms offers an indication of whether customers are paying within the terms. If Northern Micro allows credit terms of n/45, an average collection period of 41.5 days would suggest that customers are paying on a timely basis. A third ratio involving both income statement and balance sheet accounts is the rate of inventory turnover. This is the number of times the merchandise inventory turned over, or was sold, during the accounting period. This ratio is calculated as follows: Inventory Turnover = Cost of Goods Sold for the Period Average Inventory If inventory is taken only at the end of each accounting period, the average inventory for the period can be calculated by adding the beginning and ending inventories and dividing their sum by two. Northern Micro s turnover for the year ended December 31 is computed as follows: Cost of goods sold for the period $111,500 Beginning inventory 26,000 Ending inventory 18,000 Northern Micro Average Beginning Inventory + Ending Inventory $26,000 + $18,000 = = Inventory 2 2 = $22,000 Inventory Cost of Goods Sold for the Period $111,500 = = Turnover Average Inventory $22,000 = 5.1

11 576 PART 3 Accounting for a Merchandising Business The average days to sell inventory can be computed by dividing the number of days in the year (365) by the inventory turnover. For Northern Micro, it takes about two months. 365 days 5.1 = 71.6 days The higher the rate of inventory turnover, the smaller the profit required on each dollar of sales to produce a satisfactory gross profit. This is because the increase in the number of units sold offsets the smaller amount of gross profit earned per unit. For example, grocery stores have a very small gross profit on each item sold, but make up for this with a rapid inventory turnover. Other types of businesses, jewelers for example, need a high gross profit on each item because their inventory turnover is quite slow. Evaluations of Northern Micro s rate of inventory turnover would require comparison with prior years, other companies, or its industry. U REVU Complete U REVU-4 on pages to test your basic understanding of LO4. CLOSING ENTRIES LO5 Prepare closing entries for a merchandising business. Closing entries for a service business were illustrated in Chapter 6. The process is essentially the same for a merchandising business. All revenues and expenses reported on the income statement must be closed to Income Summary. Then, the income summary and drawing accounts are closed to the owner s capital account. Keep in mind, however, that a few new accounts were needed for a merchandising business. These include Sales Returns and Allowances, Sales Discounts, Purchases Returns and Allowances, and Purchases Discounts. Since these are temporary accounts reported on the income statement, they also must be closed. The easiest way to complete the closing process is by using the work sheet to prepare the closing entries in four basic steps, as illustrated in Figures 15-7 and FIGURE 15-7 The Closing Process THE CLOSING PROCESS FOR A MERCHANDISING BUSINESS STEP 1 All income statement accounts with credit balances are debited, with an offsetting credit to Income Summary. STEP 2 All income statement accounts with debit balances are credited, with an offsetting debit to Income Summary. STEP 3 The resulting balance in Income Summary, which is the net income or loss for the period, is transferred to the owner s capital account. ACCOUNT: Income Summary ACCOUNT NO. 331 DATE ITEM POST. REF. DEBIT CREDIT BALANCE DEBIT CREDIT 20-- Dec. 31 Adjusting J Adjusting J Closing J Closing J Closing J Adjustments to: Remove Beg. Inventory Enter End. Inventory Closing step 1 Closing step 2 Closing step 3 STEP 4 The balance in the owner s drawing account is transferred to the owner s capital account.

12 Chapter 15 Financial Statements and Year-End Accounting for a Merchandising Business 577 FIGURE 15-8 Closing Entries for a Merchandising Business Northern Micro Work Sheet (Partial) For Year Ended December 31, ACCOUNT TITLE INCOME STATEMENT BALANCE SHEET DEBIT CREDIT DEBIT CREDIT 17 Gary L. Fishel, Capital Gary L. Fishel, Drawing Income Summary Sales Sales Returns and Allowances Interest Revenue Rent Revenue Subscriptions Revenue Purchases Purchases Returns and Allow Purchases Discounts Freight-In Wages Expense Advertising Expense Bank Credit Card Expense Rent Expense Supplies Expense Telephone Expense Utilities Expense Insurance Expense Depr. Expense Building Depr. Expense Store Equip Miscellaneous Expense Interest Expense Net Income GENERAL JOURNAL PAGE 6 DATE DESCRIPTION POST. REF. DEBIT CREDIT Closing Entries 1 2 Dec. 31 Sales Interest Revenue Rent Revenue Subscriptions Revenue Purchases Returns and Allowances Purchases Discounts Income Summary Income Summary Sales Returns and Allowances Purchases Freight-In Wages Expense Advertising Expense Bank Credit Card Expense Rent Expense Supplies Expense Telephone Expense Utilities Expense Insurance Expense Depreciation Exp. Building Depreciation Exp. Store Equip Miscellaneous Expense Interest Expense Income Summary Gary L. Fishel, Capital Gary L. Fishel, Capital Gary L. Fishel, Drawing

13 578 PART 3 Accounting for a Merchandising Business POST-CLOSING TRIAL BALANCE A trial balance of the general ledger accounts taken after the temporary owner s equity accounts have been closed is called a post-closing trial balance. The purpose of the post-closing trial balance is to prove that the general ledger is in balance at the beginning of a new accounting period, before any transactions for the new accounting period are entered. It should also confirm that all temporary accounts have zero balances. Figure 15-9 shows a post-closing trial balance for Northern Micro. FIGURE 15-9 Post-Closing Trial Balance The post-closing trial balance must be prepared by taking the balances from the general ledger accounts. It should not be prepared from the balances on the work sheet. Using the general ledger accounts makes sure that all adjusting and closing entries were entered and posted correctly. Northern Micro Post-Closing Trial Balance December 31, ACCOUNT TITLE ACCOUNT NO. DEBIT BALANCE CREDIT BALANCE Cash Accounts Receivable Merchandise Inventory Supplies Prepaid Insurance Land Building Accumulated Depreciation Building Store Equipment Accumulated Depreciation Store Equipment Notes Payable Accounts Payable Wages Payable Sales Tax Payable Unearned Subscriptions Revenue Mortgage Payable Gary L. Fishel, Capital A BROADER VIEW LESTER LEFKOWITZ/GETTY IMAGES Who Cares About Tracking Financial Ratios? Tracking a business s average collection period for receivables can help investors avoid making poor investments. Take the case of Kendall Square, a supercomputer maker. In an effort to increase sales and profits, Kendall Square recognized large amounts of revenues that had not actually been earned. Since no cash was received for these sales, accounts receivable increased dramatically (by 57%). Similarly, the average collection period increased to 157 days. Large increases in the average collection period should warn potential investors that something might be wrong. What happened at Kendall Square? Over $10 million of sales on account was never collected. This was equal to almost half of the revenues reported for the year. When eventually discovered, Kendall Square s stock price fell from $24.25 to $2.28 a share.

14 Chapter 15 Financial Statements and Year-End Accounting for a Merchandising Business 579 U REVU Complete U REVU-5 on page 594 to test your basic understanding of LO5. REVERSING ENTRIES LO6 Prepare reversing entries. ADJUSTING ENTRY REVERSING ENTRY (OPPOSITE) LEARNING KEY Reverse all adjusting entries that increase an asset or liability account from a zero balance. Numerous adjusting entries are needed at the end of the accounting period to bring the account balances up to date for presentation in the financial statements. Although not required, some of these adjusting entries should be reversed at the beginning of the next accounting period. This is done to simplify the recording of transactions in the new accounting period. As its name implies, a reversing entry is the reverse or opposite of the adjusting entry. 4 Dec. 31 Wages Expense Wages Payable Jan. 1 Wages Payable Wages Expense To see the advantage of using reversing entries, let s consider the effect of reversing Northern Micro s adjusting entry for wages earned, but not paid, at the end of the year. Figure shows that accrued wages on December 31 were $450. These wages are for work performed by the employees on the last three days of the accounting period ($150 3 = $450). The employees will be paid on Friday, January 2, the normal payday. Note that the adjusting and closing entries are the same, regardless of whether a reversing entry is made. However, the reversing entry on January 1 has an impact on the entry made when the employees are paid. Without a reversing entry, the payment on January 2, 20-2, must be split between reduction of the wages payable account for wages earned in 20-1 and Wages Expense for wages earned in With a reversing entry, the bookkeeper simply debits Wages Expense and credits Cash, as is done on every other payday. Thus, the likelihood of error is reduced. Reversing entries are particularly important in large businesses where the individual recording the entry for wages may not even know what adjusting entries were made. Not all adjusting entries should be reversed. To determine which adjusting entries to reverse, follow this rule: Except for the first year of operations, reverse all adjusting entries that increase an asset or liability account from a zero balance. Except for the first year of operation, merchandise inventory, and contra-assets like accumulated depreciation, will have existing balances. Thus, they should never be reversed. The adjusting entries for Northern Micro are shown in Figure Note that only the adjustment for accrued wages is reversed in Figure

15 580 PART 3 Accounting for a Merchandising Business FIGURE Adjusting, Closing, and Reversing Entries for Wages /29/-1 12/30/-1 12/31/-1 1/1/-2 1/2/-2 Monday Tuesday Wednesday Thursday Friday Wages Earned Wages Paid Total Earned Total Paid Accrued Wages on 12/31/ Date Without Reversing Entry With Reversing Entry 12/31/-1 Adj. Entry Wages Expense 450 Wages Payable 450 Wages Expense 450 Wages Payable /31/-1 Closing Entry Income Summary 42,450 Wages Expense 42,450 Income Summary 42,450 Wages Expense 42,450 1/1/-2 Rev. Entry No Entry Wages Payable 450 Wages Expense 450 1/2/-2 PPayment of PPayroll Wages Expense 300 Wages Payable 450 Cash 750 Wages Expense 750 Cash 750 Description Wages Expense Description Bal. 12/31/-1 Adj. 1/2/-2 Payroll 42, ,450 12/31/-1 Close Description Wages Expense Description Bal. 12/31/-1 Adj. 1/2/-2 Payroll Bal. 42, ,450 12/31/-1 Close 450 1/1/-2 Reversing Wages Payable Wages Payable 1/2/-2 Payroll /31/-1 Adj. 1/1/-2 Reverse /31/-1 Adj. Cash Cash 750 1/2/-2 Payroll 750 1/2/-2 Payroll

16 Chapter 15 Financial Statements and Year-End Accounting for a Merchandising Business 581 FIGURE Which Adjusting Entries to Reverse? DATE DESCRIPTION GENERAL JOURNAL PAGE 5 POST. REF. DEBIT CREDIT 1 Adjusting Entries Dec. 31 Income Summary Merchandise Inventory Merchandise Inventory Income Summary Supplies Expense Supplies Insurance Expense Prepaid Insurance Depr. Expense Building Accum. Depr. Building Depr. Expense Store Equipment Accum. Depr. Store Equipment Wages Expense Wages Payable Unearned Subscriptions Revenue Subscriptions Revenue SHOULD THE ADJUSTMENT BE REVERSED? Never reverse adjustments for merchandise inventory. Never reverse adjustments for merchandise inventory. No. No asset or liability with a zero balance has been increased. No. No asset or liability with a zero balance has been increased. Never reverse adjustments for depreciation. Never reverse adjustments for depreciation. Yes. A liability account with a zero balance has been increased. No. No asset or liability with a zero balance has been increased. FIGURE Reversing Entry for Northern Micro DATE DESCRIPTION GENERAL JOURNAL PAGE 7 POST. REF. DEBIT CREDIT 1 Reversing Entries Jan. 1 Wages Payable Wages Expense U REVU Complete U REVU-6 on page 594 to test your basic understanding of LO6.

17 SELF-STUDY LEARNING OBJECTIVES LO1 Prepare a single-step and multiple-step income statement for a merchandising business. Key Points to Remember The general formats, for a single-step and multiple-step income statement are shown below. Single-Step Income Statement For Year Ended December 31, 20-- Revenues: List all revenues Total revenues Expenses: Cost of goods sold List all other expenses xxx Total expenses xxx Net income Multiple-Step Income Statement For Year Ended December 31, 20-- Revenue from sales: Sales Less sales returns and allowances xxx Net sales Cost of goods sold xxx Gross profit Operating expenses: List all operating expenses Total operating expenses xxx Income from operations Other revenue: List all other revenue Total other revenue xxx Other expenses: List all other expenses Total other expenses xxx Net income LO2 Prepare a statement of owner s equity. A statement of owner s equity has the following format: Business Name Statement of Owner s Equity For Year Ended December 31, 20-- Capital, January 1, 20-- Add additional investments Total investment Net income for the year Less withdrawals xxx Increase in capital Capital, December 31, 20-- xxx xxx 582 PART 3 Accounting for a Merchandising Business

18 Chapter 15 Self-Study 583 LEARNING OBJECTIVES LO3 Prepare a classified balance sheet. Key Points to Remember A classified balance sheet has the following major headings: Assets Current assets: List all current assets Total current assets Property, plant, and equipment: List all property, plant, and equipment Business Name Balance Sheet December 31, 20-- Less accumulated depreciation (if appropriate) xxx Total property, plant, and equipment Total assets Liabilities Current liabilities: List all current liabilities Total current liabilities Long-term liabilities: List all long-term liabilities Total long-term liabilities Total liabilities Owner s Equity Owner s capital Total liabilities and owner s equity xxx xxx xxx LO4 Compute standard financial ratios. The following measures of financial condition may be computed from financial statement information: Working Capital = Current Assets Current Liabilities Current Ratio = Current Assets Current Liabilities Quick Ratio = Quick Assets Current Liabilities Return on Owner s Equity = Net Income Average Owner s Equity Accounts Receivable Turnover = Net Credit Sales for the Period Average Accounts Receivable Average Collection Period = 365 Accounts Receivable Turnover Inventory Turnover Cost of Goods Sold for the Period = Average Inventory Average Days to Sell Inventory = 365 Inventory Turnover

19 584 PART 3 Accounting for a Merchandising Business LEARNING OBJECTIVES LO5 Prepare closing entries for a merchandising business. Key Points to Remember The four steps in the closing process for a merchandising business are as follows: STEP 1 All income statement accounts with credit balances are debited, with an offsetting credit to Income Summary. STEP 2 All income statement accounts with debit balances are credited, with an offsetting debit to Income Summary. STEP 3 The resulting balance in Income Summary, which is the net income or loss for the period, is transferred to the owner s capital account. STEP 4 The balance in the owner s drawing account is transferred to the owner s capital account. LO6 Prepare reversing entries. Use the following rule to determine which adjusting entries to reverse: Except for the first year of operations, reverse all adjusting entries that increase an asset or liability account from a zero balance. DEMONSTRATION PROBLEM Tom McKinney owns and operates McK s Home Electronics. He has a store where he sells and repairs televisions and stereo equipment. A completed work sheet for 20-1 is provided on page 585. McKinney made a $20,000 additional investment during The current portion of Mortgage Payable is $1,000. Net credit sales for 20-1 were $200,000, and the balance of Accounts Receivable on January 1 was $26,000. REQUIRED 1. Prepare a multiple-step income statement. 2. Prepare a statement of owner s equity. 3. Prepare a balance sheet. 4. Compute the following measures of performance and financial condition for 20-1: (a) current ratio (b) quick ratio (c) working capital (d) return on owner s equity (e) accounts receivable turnover and the average number of days required to collect receivables (f) inventory turnover and the average number of days required to sell inventory 5. Prepare adjusting entries and indicate which should be reversed and why. 6. Prepare closing entries. 7. Prepare reversing entries for the adjustments where appropriate.

20 Chapter 15 Self-Study 585 McK s Home Electronics Work Sheet For Year Ended December 31, 20-1 TRIAL BALANCE ADJUSTMENTS ADJUSTED TRIAL BALANCE INCOME STATEMENT BALANCE SHEET DEBIT CREDIT DEBIT CREDIT DEBIT CREDIT DEBIT CREDIT DEBIT CREDIT ACCOUNT TITLE 1 Cash Accounts Receivable Merchandise Inventory (b) (a) Supplies (c) Prepaid Insurance (d) Land Building Accum. Depr. Building (e) Store Equipment Accum. Depr. Store Equipment (f) Notes Payable Accounts Payable Wages Payable (g) Sales Tax Payable Unearned Repair Fees (h) Mortgage Payable Tom McKinney, Capital Tom McKinney, Drawing Income Summary (a) (b) Sales Sales Returns and Allowances Sales Discounts Repair Fees (h) Interest Revenue Purchases Purchases Returns and Allowances Purchases Discounts Freight-In Wages Expense (g) Advertising Expense Supplies Expense (c) Telephone Expense Utilities Expense Insurance Expense (d) Depr. Expense Building (e) Depr. Expense Store Equipment (f) Miscellaneous Expense Interest Expense Net Income (continued)

21 586 PART 3 Accounting for a Merchandising Business Solution 1. McK s Home Electronics Income Statement For Year Ended December 31, 20-1 Revenue from sales: Sales $ Less: Sales returns and allowances $ Sales discounts Net sales $ Cost of goods sold: Merchandise inventory, January 1, 20-1 $ Purchases $ Less: Purchases returns and allowances $ Purchases discounts Net purchases $ Add freight-in Cost of goods purchased Goods available for sale $ Less merchandise inventory, December 31, Cost of goods sold Gross profit $ Operating expenses: Wages expense $ Advertising expense Supplies expense Telephone expense Utilities expense Insurance expense Depreciation expense building Depreciation expense store equipment Miscellaneous expense Total operating expenses Income from operations $ Other revenues: Repair fees $ Interest revenue Total other revenues Other expenses: Interest expense Net income $ McK s Home Electronics Statement of Owner s Equity For Year Ended December 31, 20-1 Tom McKinney, capital, January 1, 20-1 $ Add additional investments Total investment $ Net income for the year $ Less withdrawals Increase in capital Tom McKinney, capital, December 31, 20-1 $

22 Chapter 15 Self-Study McK s Home Electronics Balance Sheet December 31, 20-1 Assets Current assets: Cash $ Accounts receivable Merchandise inventory Supplies Prepaid insurance Total current assets $ Property, plant, and equipment: Land $ Building $ Less accumulated depreciation Store equipment $ Less accumulated depreciation Total property, plant, and equipment Total assets $ Liabilities Current liabilities: Notes payable $ Accounts payable Wages payable Sales tax payable Unearned repair fees Mortgage payable (current portion) Total current liabilities $ Long-term liabilities: Mortgage payable $ Less current portion Total liabilities $ Owner s Equity Tom McKinney, capital Total liabilities and owner s equity $ (a) Current Ratio = Current Assets Current Liabilities = $79,000 $29,425 = 2.68 to 1 (b) Quick Ratio = Quick Assets Current Liabilities = $32,500 $29,425 = 1.10 to 1 (c) Working Capital = Current Assets Current Liabilities = $79,000 $29,425 = $49,575 (d) Return on Owner s Equity = Net Income Average Owner s Equity = $51,975 ($131,600 + $173,575) 2 = $51,975 $152, = 34.1% (continued)

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