Principles of Accounting: Financial Statements, Merchandising Operations, and Inventory

Chapter 4: Financial Statements and Closing Process

Financial Statements

Financial statements are formal records that summarize the financial activities and position of a business. They provide essential information for decision-making by internal and external users.

• Income Statement: Reports revenues and expenses to show net income or loss for a period.

• Balance Sheet: Presents assets, liabilities, and equity at a specific point in time.

• Statement of Cash Flows: Shows cash inflows and outflows from operating, investing, and financing activities.

• Statement of Retained Earnings: Explains changes in retained earnings during the period.

Classified Balance Sheet

A classified balance sheet organizes assets and liabilities into current and non-current categories, enhancing clarity for users.

• Current Assets: Expected to be converted to cash or used within one year (e.g., cash, accounts receivable, inventory).

• Non-Current Assets: Long-term resources (e.g., property, plant, equipment).

• Current Liabilities: Obligations due within one year (e.g., accounts payable, short-term loans).

• Long-Term Liabilities: Obligations due after one year (e.g., bonds payable).

Closing Entries

Closing entries transfer the balances of temporary accounts (revenues, expenses, dividends) to permanent accounts (retained earnings) at the end of the accounting period.

• Purpose: Reset temporary accounts to zero for the next period.

• Process: Close revenue accounts, expense accounts, and dividends to retained earnings.

Post-Closing Trial Balance

The post-closing trial balance lists all permanent accounts and their balances after closing entries are made, ensuring debits equal credits and that temporary accounts have zero balances.

• Purpose: Verify the equality of debits and credits after closing entries.

Chapter 5: Merchandising Operations

Merchandising Operations

Merchandising companies buy and sell goods. Their primary source of revenue is sales of merchandise, and they maintain inventory accounts.

• Inventory: Goods held for sale to customers.

• Cost of Goods Sold (COGS): The cost of inventory sold during the period.

Perpetual vs. Periodic Inventory Systems

Inventory systems determine how companies track inventory and cost of goods sold.

• Perpetual System: Continuously updates inventory records for each purchase and sale.

• Periodic System: Updates inventory records at the end of the period based on physical count.

Recording Purchases of Merchandise

• Journal Entry: Debit Inventory, Credit Accounts Payable or Cash.

• Freight Costs:

  • FOB Shipping Point: Buyer pays freight; included in inventory cost.

  • FOB Destination: Seller pays freight; recorded as delivery expense (Freight Out).

• Purchase Returns and Allowances: Reductions in cost of purchases due to returned goods or allowances for defective goods.

• Purchase Discounts: Price reductions for early payment (e.g., 2/10, n/30 means 2% discount if paid within 10 days).

Recording Sale of Merchandise

• Two Journal Entries:

  • 1. Record revenue: Debit Accounts Receivable or Cash, Credit Sales Revenue.

  • 2. Record cost: Debit Cost of Goods Sold, Credit Inventory.

• Sales Returns and Allowances: Contra-revenue accounts for returned or defective goods.

• Sales Discounts: Contra-revenue accounts for discounts given to customers for early payment.

Closing Entries in Merchandising Companies

Merchandising companies have additional temporary accounts (e.g., Sales, Sales Returns and Allowances, Sales Discounts, Cost of Goods Sold) that must be closed at period end.

• Process: Close all revenue and expense accounts, including new accounts related to merchandising operations.

Multi-Step Income Statement

The multi-step income statement separates operating revenues and expenses from non-operating items, providing detailed information about a company's profitability.

• Sections:

  • Net Sales

  • Cost of Goods Sold

  • Gross Profit

  • Operating Expenses

  • Other Revenues and Expenses

  • Net Income

Chapter 6: Inventory and Costing Methods

Principles Applying to Inventory

Inventory accounting is governed by principles that ensure accurate valuation and reporting.

• Consistency Principle: Use the same inventory method each period.

• Conservatism Principle: Report inventory at the lower of cost or market value.

• Full Disclosure Principle: Disclose inventory methods and any changes in the notes to financial statements.

Inventory Costing Methods – Perpetual Systems

Inventory costing methods determine how costs are assigned to inventory and cost of goods sold.

• FIFO (First-In, First-Out): Assumes earliest goods purchased are the first sold.

• LIFO (Last-In, First-Out): Assumes latest goods purchased are the first sold.

• Average Cost: Allocates cost based on the weighted average unit cost.

Formulas:

• Weighted Average Cost per Unit: $\text{Weighted Average Cost per Unit} = \frac{\text{Cost of Goods Available for Sale}}{\text{Total Units Available for Sale}}$

• Cost of Goods Sold (COGS): $\text{COGS} = \text{Number of Units Sold} \times \text{Cost per Unit}$

Differences in Income Statement and Balance Sheet Balances Due to Valuation Methods

The choice of inventory costing method affects reported income and asset values.

• FIFO: Higher net income and inventory values when prices are rising.

• LIFO: Lower net income and inventory values when prices are rising; may reduce taxes.

• Average Cost: Results fall between FIFO and LIFO.

Example: If prices are rising, FIFO will show higher ending inventory and net income compared to LIFO.

Test Preparation Checklist

• Read each chapter thoroughly.

• Outline each chapter to organize key concepts.

• Recopy class notes for reinforcement.

• Prepare index cards for new vocabulary and concepts.

• Redo all problems from class and homework.

• Complete end-of-chapter review problems and multiple-choice questions.

• Create a comprehensive study guide.

• Utilize Pearson study resources.

• Test yourself by solving problems without notes or textbooks.