Chapter 13 Financial Statements and Closing Procedures

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1 Chapter 13 - Financial Statements and Closing Procedures Chapter 13 Financial Statements and Closing Procedures TEACHING OBJECTIVES 13-1) Prepare a classified income statement from the worksheet. 13-2) Prepare a statement of owner s equity from the worksheet. 13-3) Prepare a classified balance sheet from the workbook. 13-4) Journalize and post the adjusting entries. 13-5) Journalize and post the closing entries. 13-6) Prepare a postclosing trial balance. 13-7) Journalize and post reversing entries. 13-8) Define the accounting terms new to the chapter. SECTIONS 1. Preparing the Financial Statements 2. Completing the Accounting Cycle CHAPTER OVERVIEW/ LEARNING OBJECTIVES Learning Link: Chapter 12 discussed accrual accounting and completion of a worksheet for a merchandising business. Chapter 13 explains how to use worksheets to prepare and record adjusting and closing entries, to prepare a post-closing trial balance, and to prepare financial statements. 13-1) This chapter explains how to prepare a classified income statement. A classified income statement for a merchandising business usually includes these sections: Operating Revenue, Cost of Goods Sold, Gross Profit on Sales, Operating Expenses, and Net Income. 13-2) The chapter explains that a statement of owner s equity is prepared to provide detailed information about the changes in the owner s financial interest during the period. The ending owner s capital balance is used to prepare the balance sheet. 13-3) In preparing a Classified Balance Sheet from the worksheet: Assets are usually presented in two groups current assets, and plant and equipment. Current assets consist of cash, items to be converted into cash within one year, and items to be used up within one year. Plant and equipment consists of property that will be used for a long time in the operations of the business. Liabilities are also divided into two groups current liabilities and long-term liabilities. Current liabilities will normally be paid within one year. Long-term liabilities are due in more than one year Copyright No reproduction or distribution without the prior written consent of McGraw-

2 Chapter 13 - Financial Statements and Closing Procedures 13-5) When the year-end worksheet and financial statements have been completed, adjusting entries are recorded in the general journal and posted to the general ledger. The data comes from the worksheet ADJUSTMENTS columns. 13-5) The chapter describes the journalizing and posting of the closing entries. The data in the INCOME STATEMENT section of the worksheet can be used to journalize the closing entries. 13-5) To confirm that the general ledger is still in balance after the adjusting and closing entries have been posted, a postclosing trial balance is prepared. 13-6) Lastly, the chapter introduces reversing entries. At the start of each new period, many firms follow the practice of reversing certain adjustments that were made in the previous period. This is an optional procedure but with reversing entries there is no need to examine each transaction to see whether a portion applies to the past period and then divide the amount of the transaction between the two periods Copyright No reproduction or distribution without the prior written consent of McGraw-

3 At the beginning of the chapter, there is a short paragraph about Whole Foods Market. Let s read this together Ask If you owned stock in Whole Foods Market, what type of financial information would be most important to you? Answer-- Students should realize information such as stock prices, dividend earnings, net income, gross profit, net sales, and changes in stockholders equity are all indicators of the financial strength of a company. FAST FACTS: Founded in 1980 in Austin, TX, Whole Foods Market is the world s leading retailer of natural and organic foods. In early 2007, Whole Foods Market entered into a merger agreement with Wild Oats, a competitor. Total sales for the year 2012 were approximately $12 billion The company operates 340 stores in the United States, Canada, and the United Kingdom Copyright No reproduction or distribution without the prior written consent of McGraw-

4 Section 1. PREPARING THE FINANCIAL STATEMENTS Financial Statements and Closing Procedures Section 1: Preparing the Financial Statements Section Objectives 13-1 Prepare a classified income statement from the worksheet Prepare a statement of owner s equity from the worksheet Prepare a classified balance sheet from the worksheet. The Classified Income Statement A classified income statement is sometimes called a multiple-step income statement. Items are divided into groups of similar accounts. There are subtotals within groups. The classification and order of information depends on the type of business and the expected use of the statement Chapter 13 Objective 13-1 Prepare a classified income statement from the worksheet. QUESTION: ANSWER: What is a single-step income statement? A single-step income statement is a format in which only one computation is needed to determine the net income. (Total Revenue Total Expenses = Net Income) 13-4 Ask, If you were looking for a job, in what part of the newspaper would you look? How about if you were looking for a used car; in what part of the newspaper would you look? Point out that the newspaper s classified section is similar to a business s classified financial statements. All of the accounts are classified into certain sections and so would appear in only those sections of the Classified Income Statement, Classified Balance Sheet or Statement of Owner s Equity. Objective 1 A. The Classified Income Statement Point out that classifying like information together on financial statements makes them easier to interpret. Explain that classification and order of information depends on the type of business and the expected use of the statement Direct students attention to Figure Trace the major sections of the income statement: I. Operating Revenue (sales section) 13-4 Copyright No reproduction or distribution without the prior written consent of McGraw-

5 II. Cost of Goods Sold section III. Operating Expenses section IV. Other Income and Other Expense section Operating Revenue Net sales for Whiteside Antiques Three elements are needed to compute the cost of goods sold: Beginning inventory Net delivered cost of purchases Ending inventory Cost of Goods Sold The Cost of Goods Sold section contains information about the cost of the merchandise that was sold during the period. Point out that a classified income statement is sometimes called a multiple-step income statement because it has multiple subtractions. A single step income statement, is where total revenues - total expenses = net income. (i.e. only one subtraction.) Operating Revenue Explain that the first section of a classified income statement contains the operating revenue or normal revenue of a business. Net Delivered Cost of Purchases Purchases Freight In (Purchases Returns and Allowances) (Purchases Discounts) Net Delivered Cost of Purchases 13-7 Total Merchandise Available for Sale Beginning Merchandise Inventory + Net Delivered Cost of Purchases Total Merchandise Available for Sale 13-8 Ask, What would be the normal revenue of a merchandiser? Of a bakery? How about an attorney? Refer to Figure13-1 Point out that because Whiteside Antiques is a retailer, its operating revenue section would contain: Sales (Sales Returns and Allowances) (Sales Discounts) Net Sales 13-5 Copyright No reproduction or distribution without the prior written consent of McGraw-

6 Cost of Goods Sold Cost of Goods Sold Beginning Merchandise Inventory Plus Net Delivered Cost of Purchases Cost of Goods Available for Sale Less Ending Inventory Cost of Goods Sold 13-9 Merchandise Inventory Account Merchandise Inventory is the one account that appears on both the income statement and the balance sheet. Refer to Figure 13-1 and review this section. Indicate that the Cost of Goods Sold section contains information about the cost of the merchandise that was sold during the period. Beginning and ending merchandise inventory balances appear on the income statement. Ending merchandise inventory also appears on the balance sheet in the Assets section. Gross Profit on Sales Cost of Goods Sold Explain that the gross profit on sales is the difference between the net sales and the cost of goods sold. Merchandise available for sale Cost of goods sold Point out that gross profit is what is left to cover operating expenses and provide a profit. Gross Profit on Sales For Whiteside Antiques, net sales is the revenue earned from selling antique items. Cost of goods sold is what Whiteside Antiques paid for the antiques that were sold during the fiscal period. Operating Expenses Gross profit is what is left to cover operating expenses and provide a profit. Gross profit is the difference between the net sales and the cost of goods sold. Refer to Figure 13-1 and review this section Gross profit on sales for Whiteside Antiques Point out that operating expenses are expenses that arise from normal business activities Operating Expenses Explain that they are separated into two categories: (1) Selling Expenses & (2) General and Administrative Expenses. Salaries for salespersons and advertising are examples of selling expenses Net Income or Net Loss from Operations Point out that keeping operating and nonoperating income separate helps financial statement users learn about the operating efficiency of the firm: 13-6 Copyright No reproduction or distribution without the prior written consent of McGraw-

7 Operating Expenses Gross Profit on Sales - Total Operating Expenses = Net Income (or Net Loss) from Operations Rent, utilities, and salaries for office employees are examples of general and administrative expenses Other Income and Other Expenses Other Income and Other Expenses Explain that income that is earned from sources unrelated to the normal business activity is classified as other income and would appear in the Other Income section. Point out that expenses which are incurred but not directly connected with business operations appear in the Other Expenses section. (ex. Interest expense.) Net Income or Net Loss Net income from operations Ask, Can anyone tell me the definition of Net income? How about Net Loss? Objective 13-2 Prepare a statement of owner s equity from the worksheet. The statement of owner's equity reports the changes that occurred in the owner's financial interest during the period. The ending capital balance for Bill Whiteside, $84,576.80, is used to prepare the balance sheet. Objective 2 B. The Statement of Owner s Equity Emphasize that the Statement of Owner s Equity reflects changes that have occurred in the owner s financial interest during the reporting period. Refer students to Figure 13-2, Statement of Owner s Equity 13-7 Copyright No reproduction or distribution without the prior written consent of McGraw-

8 Prepare a classified balance Objective 13-3 sheet from the worksheet QUESTION: ANSWER: What are current assets? Current assets are assets consisting of cash, items that normally will be converted into cash within one year, and items that will be used up within one year Current Assets Current assets for Whiteside Antiques Ask, Can anyone explain to me in plain language what the Statement of Owner s Equity reports? Emphasize that many students fail to notice that the first line of the statement is dated with the first day of the period and the last line is dated as of the last day of the period. Objective 3 C. The Classified Balance Sheet Point out that a Classified Balance Sheet is very similar to the Balance Sheets they have already prepared in the past except the assets and liabilities are classified into separate categories. Current Assets Explain that current assets consist of cash, items that will normally be converted into cash within one year, and items that will be used within one year. (Cash, accounts receivables, merchandise inventory, etc.) Point out that current assets are usually listed in the order of liquidity. Emphasize that current assets are vital to the survival of a business because they provide the funds needed to pay bills and meet expenses Copyright No reproduction or distribution without the prior written consent of McGraw-

9 Plant and Equipment Explain that plant and equipment is property that will be used over a long period of time to conduct business operations. Plant and Equipment Noncurrent assets are called long-term assets. An important category of long-term assets is plant and equipment. For many businesses plant and equipment represents a sizable investment. They are non-current (long-term) assets because they have a life greater than one year Point out that any accumulated depreciation accounts are shown below their respective accounts. Ask, Can anyone tell me what the second number to the right of the accumulated depreciation accounts represent? (book value of the asset) Current Liabilities Whiteside Antiques Partial Balance Sheet December 31, 2016 Assets Prepaid Interest , Total Current Assets 98, Total Plant and Equipment 31, Total Assets 130, Total current liabilities Liabilities and Owner s Equity Current Liabilities Notes Payable-Trade 2, Notes Payable-Bank 9, Accounts Payable 24, Interest Payable Social Security Tax Payable 1, Medicare Tax Payable Employee Income Tax Payable Fed. Unemployment Tax Pay State Unemployment Tax Pay Salaries Payable 1, Sales Tax Payable 7, Total Current Liabilities 46, Current Liabilities Point out that liabilities are classified in only two categories. Those debts which must be paid off within one year are current liabilities. Long-Term Liabilities Although repayment of long-term liabilities might not be due for several years, management must make sure that periodic interest is paid promptly. Long-term liabilities include mortgages, notes payable, and loans payable. Long-Term Liabilities Debts that are not due to be paid within a year are classified as long-term liabilities Owner s Equity The ending balance from the Statement of Owner s Equity is transferred to the Owner s Equity section of the Balance Sheet Copyright No reproduction or distribution without the prior written consent of McGraw-

10 Financial Statements and Closing Procedures Section 2: Completing the Accounting Cycle Section Objectives 13-4 Journalize and post the adjusting entries Journalize and post the closing entries Prepare a postclosing trial balance Journalize and post reversing entries. Objective 13-4 Journalize and post the adjusting entries Chapter 13 All adjustments are shown on the worksheet. After the financial statements have been prepared, the adjustments are made a permanent part of the accounting records. They are recorded in the general journal as adjusting journal entries and are posted to the general ledger. Type of Adjustment Adjusting Entries Worksheet Reference Purpose Inventory (a b) Removes beginning inventory and adds ending inventory to the accounting records. Expense (c e) Matches expense to revenue for the period; the credit is to a contra asset account. Accrued Expense (f i) Matches expense to revenue for the period; the credit is to a liability account. Prepaid Expense (j l) Matches expense to revenue for the period; the credit is to an asset account. Accrued Interest (m) Recognizes interest earned in the period. The debit is to an asset account, (interest receivable) and the credit is to a revenue account. Section 2. COMPLETING THE ACCOUNTING CYCLE Remind students that the complete accounting cycle for a business was covered in chapter 6. Point out that the accounting cycle is reviewed again in this chapter except we are working with a retailer instead of a service business. Objective 4 A. Journalizing and Posting the Adjusting Entries Remind students that all of the adjustments listed on the worksheet still need to be journalized in the general journal and posted to the general ledger accounts. Journalizing the Adjusting Entries Tell students to refer to Figure 13-4 to see the adjusting journal entries made using the information off of the worksheet. Remind students that Adjusting Entries should be written on the journal page right above the first adjusting entry. Tell your students that good explanations are a vital part of a business s financial record. Ask, Why are journal entry explanations so important? Copyright No reproduction or distribution without the prior written consent of McGraw-

11 Posting the Adjusting Entries Remind students that the posting process is the same as covered in Chapter 5. Note that the words Adjusting entry is recorded in the Description column of the general ledger account. Objective 13-5 Journalize and Post the Closing Entries. At the end of the period, the temporary accounts are closed. The temporary accounts are: Revenue accounts Cost of goods sold Expense accounts Drawing account There are four steps in the closing process: 1. Close revenue accounts and cost of goods sold accounts with credit balances to Income Summary. 2. Close expense accounts, cost of goods sold accounts with debit balances, and any contra revenue accounts with debit balances to Income Summary. 3. Close Income Summary, which now reflects the net income or loss for the period, to owner's capital. 4. Close the drawing account to owner's capital Explain that after all adjusting entries have been posted, the balances of the general ledger accounts should match the ADJUSTED TRIAL BALANCE section of the worksheet. Objective 5 B. Journalizing and Posting the Closing Entries Remind students that the closing process is where all the temporary accounts are closed to $0 so that: (1) The business can start fresh in the next accounting period and (2) So that the changes in the temporary owner equity accounts can be transferred to the permanent owner s capital account. Journalizing the Closing Entries Indicate that the INCOME STATEMENT section of the worksheet in Figure 12-2 (of the last chapter) provides the data needed to prepare the closing entries Copyright No reproduction or distribution without the prior written consent of McGraw-

12 Point out that the words closing entries should be written on the journal page right before the first closing entry. Step 1: Closing the Revenue Accounts and the Cost of Goods Sold Accounts with credit balances. GENERAL JOURNAL PAGE 28 DESCRIPTION POST. DEBIT CREDIT DATE REF Closing Entries Dec. 31 Sales 561, Interest Income Miscellaneous Income Purchases Returns and Allowances 3, Purchases Discounts 3, Income Summary 568, When viewing the work sheet, debit each account, except Income Summary, for its balance. Credit Income Summary for the total Indicate that the temporary Income Summary account is also used in the closing process of a merchandiser. Step 1: Closing the Revenue Accounts and the Cost of Goods Sold Accounts with Credit Balances. Tell students to refer to the illustration of the first closing entry in the book. Remind them that this first closing entry closes the revenue accounts and other temporary income statement accounts with credit balances. Step 2: When looking at the worksheet, close the expense accounts and the Cost of Goods Sold Accounts with debit Balances, as well as any contra revenue accounts with debit balances, to Income Summary. Credit each account, except Income Summary, for its balance. Debit Income Summary for the total Step 2: Closing the Expense Accounts and the Cost of Goods Sold Accounts with Debit Balances Tell students to refer to the illustration of the second closing entry in the book. Remind them that this second closing entry closes the expense accounts and other temporary income statement accounts with debit balances Copyright No reproduction or distribution without the prior written consent of McGraw-

13 Step 3: Closing the Income Summary Account The third closing entry transfers the Income Summary balance to the owner's capital account. This closes the Income Summary account, which remains closed until it is used in the end-of-period process for the next year. For Whiteside Antiques, the third closing entry is as follows: Income Summary Adjusting Entries (a-b) 12/31 52, /31 47, /31 568, Closing Entries 12/31 512, , , , Bal. JOURNAL PAGE GENERAL 28 POST. DEBIT CREDIT DATE DESCRIPTION REF. Dec. Income Summary 50, Bill Whiteside, Capital 50, Step 3: Closing the Income Summary Account Remind students that after the first two closing entries have been posted, the balance of the Income Summary account is net income or net loss for the period. This third closing entry will transfer the net income or net loss into the owner s capital account. Step 4: Closing the Drawing account This entry closes the drawing account and updates the capital account GENERAL JOURNAL PAGE 28 POST. DEBIT CREDIT DATE DESCRIPTION REF. Dec. 31 Bill Whiteside, Capital 27, Bill Whiteside, Drawing 27, Posting the Closing Entries The closing entries are posted from the general journal to the general ledger. This process brings the temporary account balances to zero. The word Closing is entered in the Description column. Objective Preparing a Postclosing Trial Balance Prepare a postclosing trial balance to confirm that the general ledger is in balance. Only the accounts that have balances the asset, liability and owner's capital accounts appear on the postclosing trial balance. The postclosing trial balance matches the amounts reported on the balance sheet. To verify this, compare the postclosing trial balance with the balance sheet. Revenue Expenses Only the accounts that have balances the asset, liability and owner's capital accounts appear on the postclosing trial balance Temporary accounts do not appear on the postclosing trial balance Cost of Goods Sold Withdrawals Step 4: Closing the Drawing Account This entry closes the drawing account into the capital account. Point out that the Income Summary is not used in this last closing entry. Posting the Closing Entries Remind students that the posting process is the same as covered in Chapter 6. Note that the words Closing entry is recorded in the Description column of the general ledger account when the entry is posted. Objective 6 C. Preparing a Post-closing Trial Balance Remind students that we prepare a postclosing trial balance to confirm that the general ledger is in balance Copyright No reproduction or distribution without the prior written consent of McGraw-

14 Preparing a Postclosing Trial Balance Point out that only permanent accounts will exist on this trial balance because all temporary accounts were closed. Review with students the difference between a trial balance, an adjusted trial balance and the post-closing trial balance D. Interpreting the Financial Statements Review the basic procedure for calculating a ratio. (One number is divided by another number. The result is the ratio of the numerator, or top number, to the denominator, or bottom number.) Teaching Tip: Poll students and write on the chalkboard the number of students who are (1) male, (2) female, (3) like pepperoni pizza, (4) don t like pepperoni pizza, (5) like scary movies, (6) don t like scary movies, (7) married, and (8) single. Then have students calculate the ratios of the following: (1) males to females (2) students who like pepperoni pizza to students who don t like pepperoni pizza (3) students who like scary movies to students who don t like scary movies; and (4) married students to single students. Have students draw conclusions about the ratios. Point out that businesses also use ratios to draw conclusions about their operations Copyright No reproduction or distribution without the prior written consent of McGraw-

15 Review with students the three ratios (gross profit percentage, current ratio, and inventory turnover). Then direct students attention to Figures 13-1 and 13-3 in order to point out the locations of the numbers used for each of the three ratios. Explain that ratios alone are not as meaningful as current ratios compared to past ratios and to ratios of other similar companies. These comparisons show how well a company is operating in relation to its past and to other companies. L1 Objective 13-7 QUESTION: Journalize and post reversing entries What are reversing entries? ANSWER: Reversing entries are journal entries made to reverse the effect of certain adjusting entries involving accrued income or accrued expenses. Step 1 Analyze transactions The Accounting Cycle Step 2 Journalize the data about transactions Step 9 Interpret the financial information Step 8 Prepare a postclosing trial balance Step 3 Post the data about transactions Step 7 Journalize and post closing entries Step 4 Prepare a worksheet Step 5 Prepare financial statements Step 6 Journalize and post adjusting entries Objective 7 E. Journalizing and Posting Reversing Entries Explain that reversing entries are made to reverse the effect of certain adjustments. This helps prevent errors in recording payments or cash receipts in the new accounting period. Identifying Items for Reversal Explain that reversing entries are journal entries made at the beginning of an accounting period that are the opposite of certain adjusting entries, particularly those for accrued expenses and income. Point out that normally the adjustments requiring reversal are: Copyright No reproduction or distribution without the prior written consent of McGraw-

16 1. accrued expense items that will involve future payments of cash. 2. accrued future items that will involve future receipts of cash. 3. prepaid expense items that were initially treated as expenses, the endof-period adjustments for those items must be reversed. Journalizing Reversing Entries Review the reversing journal entries for Whiteside Antiques using a calendar time-line to illustrate the events. Note that the reversing entries involve cash that will be paid or received in the future. Point out that not all companies use reversing entries. In many small companies, accounting records are simple and accountants can easily recall adjustments made in the prior period Copyright No reproduction or distribution without the prior written consent of McGraw-

17 Flow of Financial Data through an Accounting System F. Review of the Accounting Cycle Emphasize that, regardless of the type of business organization (merchandising or service), there is a flow of data that takes place in the accounting system. Also, the same basic nine steps that make up the accounting cycle must be performed: 1. Analyze transactions. 2. Journalize the data about transactions. 3. Post the data about transactions to the General Ledger. 4. Prepare a worksheet. 5. Prepare financial statements. 6. Journalize and post adjusting entries. 7. Journalize and post closing entries. 8. Prepare a post-closing trial balance. 9. Interpret the financial information. Managerial Implications: Ask, How can managers use financial statements to learn about a company s operating efficiency? Answer Managers can use financial statements to learn about a company s operating efficiency by using ratios and measurements to analyze the financial statement results and compare them to those measurements of prior periods and to similar businesses in the same industry Copyright No reproduction or distribution without the prior written consent of McGraw-

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