BackPrinciples of Accounting: Financial Statements, Merchandising Operations, and Inventory
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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.
Key Financial Statements:
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: Organizes assets and liabilities into current and non-current categories for clarity.
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 accounts to zero for the next period.
Process:
Close all revenue accounts to Income Summary.
Close all expense accounts to Income Summary.
Close Income Summary to Retained Earnings.
Close Dividends to Retained Earnings (if applicable).
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: Verifies the equality of debits and credits in the ledger after closing entries.
Chapter 5: Merchandising Operations
Merchandising Operations Overview
Merchandising companies buy and sell goods rather than services. Their accounting systems track inventory and cost of goods sold.
Inventory: Goods held for resale to customers.
Cost of Goods Sold (COGS): The cost of inventory sold during the period.
Inventory Systems: Perpetual vs. Periodic
Perpetual Inventory System: Continuously updates inventory records for each purchase and sale.
Periodic Inventory System: Updates inventory records at the end of the period based on a physical count.
Recording Purchases of Merchandise
Journal Entry Example (Perpetual System):
Debit: Inventory
Credit: Accounts Payable or Cash
Freight Costs:
FOB Shipping Point: Buyer pays freight; cost added to inventory.
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, net due in 30 days).
Recording Sale of Merchandise
Two Journal Entries (Perpetual System):
Record the sale:
Debit: Accounts Receivable or Cash
Credit: Sales Revenue
Record the cost of goods sold:
Debit: Cost of Goods Sold
Credit: Inventory
Sales Returns and Allowances: Contra-revenue accounts for returned goods or allowances granted to customers.
Sales Discounts: Contra-revenue accounts for discounts given to customers for early payment.
Closing Entries for Merchandising Companies
Include new revenue and expense accounts related to sales, cost of goods sold, and related contra accounts.
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.
Key Sections:
Gross Profit = Net Sales - Cost of Goods Sold
Operating Income = Gross Profit - Operating Expenses
Net Income = Operating Income ± Non-operating Items
Chapter 6: Inventory Principles 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: Tracks the actual cost of each specific item sold.
Inventory Costing Methods (Perpetual Systems)
FIFO (First-In, First-Out): Assumes earliest goods purchased are the first to be sold.
Ending inventory consists of the most recently purchased items.
LIFO (Last-In, First-Out): Assumes latest goods purchased are the first to be sold.
Ending inventory consists of the oldest items.
Average Cost: Allocates cost based on the weighted average cost per unit.
Weighted Average Cost per Unit =
Differences in Financial Statements Due to Valuation Methods
Income Statement Effects:
FIFO: Lower cost of goods sold and higher net income when prices are rising.
LIFO: Higher cost of goods sold and lower net income when prices are rising.
Balance Sheet Effects:
FIFO: Inventory reflects recent (higher) costs in periods of rising prices.
LIFO: Inventory reflects older (lower) costs in periods of rising prices.
Example Table: Comparison of Inventory Methods
Method | COGS (Rising Prices) | Net Income (Rising Prices) | Ending Inventory (Rising Prices) |
|---|---|---|---|
FIFO | Lower | Higher | Higher |
LIFO | Higher | Lower | Lower |
Average Cost | Middle | Middle | Middle |
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.
Make your own study guide and use available study resources.
Test yourself by solving problems without notes or textbooks.
Additional info: Active study and practice are essential for mastering accounting concepts and performing well on exams.
