BUSA 100 ON-LINE COURSE MR.

. FARINA LECTURE NOTES Chapter 13: Financial Statements and Closing Procedures NOTE: Much thanks to Professor Debra Schmidt, whose chapter summary on the multiple-step income statement is incorporated as a significant portion of these notes. We are almost finished learning the accounting cycle for a merchandising enterprise. We have learned how to record purchasing and sales transactions in a general journal. We prepared a bank reconciliation, and learned the basics of payroll. We have reviewed the adjustment process and learned several new adjusting entries. We then learned prepared a worksheet for a merchandising company. This brings us to the summarizing process of the accounting function. This chapter will introduce you the financial statements for a merchandiser and how to prepare the closing entries for a merchandiser. It will also introduce you to reversing entries. The chapter has four major objectives: 1. Learn to prepare a multiple-step income statement; 2. Learn to prepare a classified balance sheet. 3. Learn to compute and analyze the current ratio, inventory turnover ratio, and gross profit percentage. 4. Prepare the four closing entries for a merchandising company. Financial Statements The same three financial statements that we learned for a service-oriented company will also be used for a merchandiser. However, they will look different. The main challenge will be to prepare a multiple-step income statement. See the separate handout of the skeleton based multi-step income statement for additional help. To refresh your memory, the three financial statements that you will need to prepare are:

The Income Statement The Statement of Owners Equity The Balance Sheet

As you will recall, they need to be prepared in this prescribed order, because the contents of one follows the next.
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The Multiple-Step Income Statement Unless given, the source for the numbers on income statement is from the worksheet columns. As discussed previously, a vast majority of merchandising companies use the multiple-step format of an income statement. The Cost of Good Sold will be the most challenging part of this worksheet. An example of a completed multiple-step income statement is on page 457. There is much more information given on this income statement than on others we prepared in this course. The main difference is the use of many subtotals that are not accounts in the general ledger, such as Net Sales, Cost of Goods Sold, Gross Profit on Sales, and other. Preparing the multiple-step income statement will be much easier if we can learn the accounts that are added or subtracted to arrive at these subtotals. The major subtotals on a multiple-step income statement are: Net Sales Less: Cost of Goods Sold Gross Profit on Sales Less: Operating Expenses Net Income from Operations +\- Other Income or Other Expense Net Income

Each major subtotal is arrived by adding or subtracting various general ledger accounts. The accounts added or subtracted are detailed below.

Net Sales = Sales - Sales Discounts - Sales Returns and Allowances Cost of Goods Sold = Beginning Inventory + Net Purchases + Freight In Ending Inventory Cost of Goods Sold, in detail: Merchandise Inventory, January 1 Add: Net Purchases: Purchases Add: Freight In Delivered Cost of Purchases Less Purch Ret/Allow Less Purch Discounts XXX X XXX (xx) (xx) XX XXXX XXX XXX XXX -

Net Delivered Cost of Purchases Total Merchandise Available for Sale Less Merchandise Inventory, December 31 Cost of Goods Sold

Gross Profit =

Net Sales

Cost of Goods Sold

Operating Expenses = Selling Expenses & General and Administrative Expenses

Selling Expenses are those directly related to the sales or marketing functions. They include any sales salaries, commissions, advertising, depreciation of store equipment, and others. The General and Administrative expenses are all the other day-to-day operating expenses not related to the sales function and include the salaries of clerical workers, accounting/finance people, rent, utilities, general office supplies, business insurance, and rent. Net Income from Operations: Gross Profit Total Operating Expenses Other Income: Other income is any other revenue besides sales. This will include rental income, dividend income, or any gains on sale of assets, such as equipment. Other Expenses: These include non-operating costs, such as interest expense or losses on sale of assets. Net Income: Net Income from Operations + Other Income Other Expenses As stated previously, you MUST KNOW HOW TO PREPARE this multistep income statement. You need to practice, practice, and practice. You will also prepare this many times over in your next accounting class, BUSA 101.

Statement of Owners Equity The statement of owners equity has not changed. As a review, this is the format:

Capital, January 1 Add: Additional investments, if any Subtotal Add: Net Income Less: Withdrawals Increase in capital Capital, December 31 XXX (XXX)

XXX XXX XXX

XXX XXX

Preparing a classified balance sheet is discussed on the next page.

The Balance Sheet The Balance sheet looks very much the same. The only change is now you will be required to classify your balance sheet. (Almost all companies even service enterprises do this. This text waited until Chapter 13 to introduce this new format.) The following summarizes the classification criteria in the new balance sheet:
Account Category Assets Classifications Current Assets Definition Assets that will be converted to cash, or "used up," within one year from the date of the balance sheet. Assets that (1) are tangible, (2) have long useful lives, usually exceeding 3 years, and (3) are used in business operations. Examples of Accounts Included Cash, Accounts Receivable, Merchandise Inventory, Prepaid Insurance, Prepaid Rent, Supplies

Property and Equipment

Land, Equipment, Building, Machinery, Furniture and Fixtures. Also includes the Accumulated Depreciation accounts as contra-assets (except Land, which is not depreciated). Accounts Payable, Wages Payable, Unearned Revenue, and Notes Payablecurrent portion.

Liabilities

Current liabilities

Liabilities that are expected to be paid, or otherwise terminated, within one year from the date of the balance sheet. Liabilities that are expected to be paid, or otherwise terminated, after one year from the date of the balance sheet.

Long-term liabilities

Notes Payable, due after one year.

Owners Equity

No sub-classifications.

The owner's capital balance at the end of the year, after closing entries.

Owner, Capital. The amount comes from the statement of owners equity.

Why bother with these new statement formats? Well, there are several good reasons to learn these: 1) To pass the next test, 2) because thats what financial statements in the real world look like, 3) because many common financial ratios and analyses will use components from these statements, and 4) because you will have money to invest someday and need to learn what some key ratios mean so you can make an informed investment choice.

Some common financial analysis

Working Capital and the Current Ratio Working Capital is a very basic financial statement analysis tool. Working Capital = Current Assets Current Liabilities. This is why analysts need to see a classified balance sheet. The amount of working capital is of key concern to management and to lenders and creditors. Another way to view the companys liquidity is called the current ratio. The current ratio is calculated as follows: Current Ratio = Current Assets */* Current Liabilities Bankers and other creditors will calculate a firms current ratio, and compare it to the industry average. The Inventory Turnover Ratio The inventory turnover shows the number of times inventory is replaced during the accounting period. It is an indicator of how fast the company is selling its merchandise inventory. This is of great interest to bankers and other creditors, as sales of merchandise inventory give the company its cash to repay debt. The Inventory turnover ratio is calculated as:

Cost of Goods Sold */* Average Inventory Average inventory is calculated as: (Beginning inventory + Ending Inventory)*/* 2 The Gross Profit Percentage The gross profit percentage reveals the amount of gross profit kept from each sales dollar. It is calculated as follows: Gross Profit */* Net Sales Closing Entries Remember why we need closing entries:

To close out nominal accounts in order to be ready for the next new fiscal year To transfer net income and drawing to the owners capital account.

The purpose of doing the closing entries has not changed. We just need to tweak the process a little.

For Service Business Close revenues

For Merchandisers Close Income Stmt accounts with credit balances (i.e., Sales, Purchases Discounts) Close Income Stmt accounts with debit balances (i.e., Rent Expense, Sales Discounts) Close Income Summary *** Close Drawing

Close expenses

Close Income Summary Close Drawing

***Dont forget to make a t-account because this account has some balances from the inventory adjustments discussed in Chapter 12.