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 Owner's Equity: Shows changes in owner's equity during the period.

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

Classified Balance Sheet

A classified balance sheet organizes assets and liabilities into current and non-current categories, providing clearer information about liquidity and financial flexibility.

• 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 are journal entries made at the end of an accounting period to transfer balances from temporary accounts to permanent accounts.

• Purpose: Reset revenue, expense, and dividend/drawing accounts to zero for the next period.

• Process: Transfer net income (or loss) to owner's equity.

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.

Chapter 5: Merchandising Operations

Merchandising Operations Overview

Merchandising companies buy and sell goods rather than provide services. Their accounting systems track inventory and cost of goods sold.

• Inventory: Goods held for resale.

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

Perpetual vs. Periodic Inventory Systems

• 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 (Perpetual): Debit Inventory, Credit Cash/Accounts Payable.

• 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 or damaged 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 (Perpetual):

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

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

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

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

Closing Entries in Merchandising Companies

• Include new revenue and expense accounts such as Sales Revenue, Sales Returns and Allowances, Sales Discounts, and Cost of Goods Sold.

Multi-Step Income Statement

The multi-step income statement separates operating revenues and expenses from non-operating items, providing more detail about profitability.

• Gross Profit: $Gross\ Profit = Net\ Sales - Cost\ of\ Goods\ Sold$

• Operating Income: $Operating\ Income = Gross\ Profit - Operating\ Expenses$

• Net Income: $Net\ Income = Operating\ Income + Non\text{-}Operating\ Items$

Chapter 6: Inventory and Costing Methods

Principles Applying to Inventory

• Consistency Principle: Use the same accounting methods from period to period.

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

• Specific Identification: Track actual cost of each item (used for unique, high-value items).

Inventory Costing Methods (Perpetual Systems)

• 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 weighted average cost per unit.

Weighted Average Cost Formula:

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

Differences in Financial Statements Due to Valuation Methods

• Income Statement: COGS and net income vary depending on the inventory method used, especially during periods of changing prices.

• Balance Sheet: Ending inventory values differ, affecting total assets and equity.

Example: In periods of rising prices, FIFO results in lower COGS and higher net income, while LIFO results in higher COGS and lower net income.

Test Preparation Checklist

• Read and outline each chapter thoroughly.

• 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 and multiple-choice questions.

• Create your own study guide and use available study resources.

• Test yourself by solving problems without notes or textbooks.