Chapter 15: Financial Statements and Year-End Accounting for a Merchandising Business

Lecture Notes I. The Income Statement

A. Single-step income statement 1. Lists all revenue items and their total first, followed by all expense items

and their total. 2. The difference, which is either net income or net loss, is then calculated.

B. Multiple-step income statement 1. Commonly used for merchandising businesses. 2. The final net income or net loss calculated on a step-by-step basis.

3. Gross sales is shown first, less sales returns and allowances and sales discounts. This difference is called net sales. This is what is considered 100% when analysis is made.

4. Purchases less purchases returns and allowances equals net purchases. 5. The beginning inventory plus net purchases plus freight-in less ending

inventory equals cost of goods sold. 6. Net sales less cost of goods sold equals gross profit (also called gross

margin). 7. Operating expenses are then listed and subtracted from the gross profit to

compute income from operations (sometimes called operating income). Some companies divide operating expenses into the following subcategories: a) Selling expenses are directly associated with selling activities.

Examples include: (1) Sales Salaries Expense (2) Sales Commissions Expense (3) Delivery Expense (4) Advertising Expense (5) Bank Credit Card Expense (6) Depreciation Expense⎯Store Equipment and Fixtures

b) General expenses are associated with administrative, office, or general operating activities. Examples include: (1) Office Salaries Expense (2) Office Supplies Expense (3) Rent Expense (4) Telephone Expense (5) Insurance Expense (6) Utilities Expense (7) Depreciation Expense—Office Equipment

c) Operating expenses are arranged in the order given in the chart of accounts or by descending amounts, with Miscellaneous Expense last.

8. Other revenues are added and other expenses are subtracted to arrive at net income (or net loss). a) Examples of other revenues and other expenses are interest

earned (if the company's primary business is not lending - e.g., it is not a financial institution), interest expense (e.g., the company borrows money to buy equipment). Interest expense is a much

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more common "other" item than interest revenue since most companies borrow but not many lend.

II. The Statement of Owner’s Equity The Statement of Owner’s Equity is the same for service and merchandising businesses.

A. Summarizes all changes in the owner’s equity during the period. 1. Includes the net income or loss and any additional investments or

withdrawals by the owner. B. The balances shown on this statement also appear in the owner’s equity section

of the balance sheet.

III. Balance Sheet A. Current Assets

1. 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.

2. The operating cycle is the length of time generally required for a business to buy inventory, sell it, and collect the cash.

3. In a merchandising business, the current assets usually include: a) Cash b) Receivables (such as accounts receivable and notes receivable) c) Merchandise inventory d) Prepaid expenses

4. Current assets are listed on the balance sheet from the most liquid to least liquid.

5. Liquidity refers to the speed with which an asset can be converted into cash.

B. Property, Plant, and Equipment 1. Include assets that are expected to be used for more than one year in the

operations of a business. 2. Types of property, plant, and equipment

a) Land b) Buildings c) Office equipment d) Store equipment e) Delivery equipment

3. Assets with longer useful lives are listed first. 4. Land is NOT depreciated. 5. Accumulated depreciation amounts are shown as deductions from the

original cost of depreciable assets to provide book value (also called undepreciated cost and carrying value–i.e., carried on the books). In future periods, book value less salvage value is written off as depreciation expense.

C. Current Liabilities 1. 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.

2. Types of current liabilities a) Notes Payable b) Accounts Payable c) Wages Payable d) Taxes Payable (includes sales tax)

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e) Unearned Subscriptions Revenue f) Mortgage Payable (current portion)

The current portion of long-term debt, the amount due within one year, is reported as a current liability. The remainder is reported under long-term liabilities.

D. Long-Term Liabilities 1. Include those obligations that will extend beyond one year or the normal

operating cycle, whichever is longer. 2. A mortgage is a written agreement specifying that if a borrower fails to

repay a debt, the lender has the right to force the sale of the property mortgaged to satisfy the debt.

3. Mortgage Payable is an account used to reflect an obligation that is secured by a mortgage on certain property.

E. Owner’s Equity 1. The permanent owner’s equity accounts reported on the balance sheet

are determined by the type of organization. 2. The balance of this account is taken from the statement of owner’s equity.

IV. Financial Statement Analysis A. Balance Sheet Analysis

1. Working capital, current assets minus current liabilities, represents the amount of capital the business has available for current operations.

2. Current ratio, the ratio of current assets to current liabilities, is a measure of the firm’s ability to pay its current liabilities. a) 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.

3. Quick ratio (or acid-test ratio), the ratio of quick assets (cash, accounts receivable, and temporary investments these are not shown above, and tend to be between cash and accounts receivable) to current liabilities, is a second measure of a firm’s ability to pay its current liabilities. a) 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.

B. Interstatement Analysis 1. Provides a comparison of the relationships between selected income

statement and balance sheet amounts. 2. Return on owner’s equity is the ratio of net income to average owner’s

equity in the business (beginning equity plus ending equity divided by 2). a) Compared to prior years or to other similar businesses. 3. Accounts receivable turnover

a) This is the ratio of net credit sales for the period to average accounts receivable (beginning accounts receivable plus ending accounts receivable divided by 2).

b) Computes the number of times accounts receivables “turned over,” or were collected during the accounting period. (1) A higher number indicates that cash is collected more

quickly. c) The average collection period is calculated by dividing the

number of days in the year (365) by the rate of turnover to

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determine the number of days credit customers take to pay for their purchases.

d) Comparing the average collection period with a business’s credit terms offers an indication of whether customers are paying within the terms.

4. Inventory turnover a) This is the ratio of cost of goods sold for the period divided by

average inventory (beginning inventory plus ending inventory divided by 2).

b) Computes the number of times the merchandise inventory ‘turned over’, or was sold, during the accounting period.

c) The number of days in a year (365) divided by the number of times inventory turned over equals average days to sell inventory.

d) The higher the rate of inventory turnover, the smaller the profit required on each dollar of sales to produce a satisfactory gross profit.

It is important to compare ratios with past performance and with other firms in the same industry. Information on industry averages is available in various publications from Dun & Bradstreet, Standard & Poor’s, and Moody’s.

V. Closing Entries A. Steps used to prepare closing entries for a merchandising firm:

1. All income statement accounts with credit balances are debited, with an offsetting credit to Income Summary.

2. All income statement accounts with debit balances are credited, with an offsetting debit to Income Summary.

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.

4. The balance in the owner’s drawing account is transferred to the owner’s capital account.

B. Post-Closing Trial Balance 1. Prepared after the temporary owner’s equity accounts have been closed. 2. 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.

3. It should also confirm that all temporary accounts have zero balances. The post-closing trial balance must be prepared by taking the balances from

the general ledger accounts. Do not use the balances reported on the work sheet, since this defeats the purpose of making sure that all adjusting and closing entries were entered and posted correctly.

VI. Reversing Entries A. A reversing entry is the opposite of an adjusting entry. B. Reduces the likelihood of error, especially in large businesses. C. Except for the first year of operations, reverse all adjusting entries that increase

an asset or liability account from a zero balance.

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