Introduction to Inventories and the Classified Income Statement

Exhibit 40 shows a work sheet for a merchandising company. Lyons Company is a small sporting goods firm. The illustration for Lyons Company focuses on merchandise-related accounts. Thus, we do not show the fixed assets (land, building, and equipment). Except for the merchandise-related accounts, the work sheet for a merchandising company is the same as for a service company. Recall that use of a work sheet assists in the preparation of the adjusting and closing entries. The work sheet also contains all the information needed for the preparation of the financial statements.

To further simplify this illustration, assume Lyons needs no adjusting entries at month-end. The trial balance is from the ledger accounts at 2010 December 31. The USD 7,000 merchandise inventory in the trial balance is the beginning inventory. The sales and sales-related accounts and the purchases and purchases-related accounts summarize the merchandising activity for December 2010.

Lyons carries any revenue accounts (Sales) and contra purchases accounts (Purchase Discounts, Purchase Returns, and Allowances) in the Adjusted Trial Balance credit columns of the work sheet to the Income Statement credit column. It carries beginning inventory, contra revenue accounts (Sales Discounts, Sales Returns, and Allowances), Purchases, Transportation-In, and expense accounts (Selling Expenses, Administrative Expenses) in the Adjusted Trial Balance debit column to the Income Statement debit column.

Assume that ending inventory is USD 8,000. Lyons enters this amount in the Income Statement credit column because it is deducted from cost of goods available for sale (beginning inventory plus net cost of purchases) in determining cost of goods sold. It also enters the ending inventory in the Balance Sheet debit column to establish the proper balance in the Merchandise Inventory account. The beginning and ending inventories are on the Income Statement because Lyons uses both to calculate cost of goods sold in the income statement. Net income of USD 5,843 for the period balances the Income Statement columns. The firm carries the net income to the Statement of Retained Earnings credit column. Retained earnings of USD 18,843 balances the Statement of Retained Earnings columns. Lyons Company carries the retained earnings to the Balance Sheet credit column.

Lyons carries all other asset account balances (Cash, Accounts Receivable, and ending Merchandise

Inventory) to the Balance Sheet debit column. It also carries the liability (Accounts Payable) and Capital Stock account balances to the Balance Sheet credit column. The balance sheet columns total to USD 29,543.

Once the work sheet has been completed, Lyons prepares the financial statements. After entering any adjusting and closing entries in the journal, the firm posts them to the ledger. This process clears the records for the next accounting period. Finally, it prepares a post-closing trial balance.

Income statement Exhibit 41 shows the income statement Lyons prepared from its work sheet in Exhibit 40. The focus in this income statement is on determining the cost of goods sold.

Statement of retained earnings The statement of retained earnings, as you recall, is a financial statement that summarizes the transactions affecting the Retained Earnings account balance. In Exhibit 42, the statement of retained earnings shows an increase in equity resulting from net income and a decrease in equity resulting from dividends.

 

LYONS COMPANY
Worksheet
For the Month Ended 2010 December 31

		Trial Balance		Adjustments		Adjusted Trial Balance		Income Statement		Statement of Retained Earnings		Balance Sheet
Acct. no.	Account Titles	Debit	Credit	Debit	Credit	Debit	Credit	Debit	Credit	Debit	Credit	Debit
100	Cash	19,663				19,663						19,653
103	Accounts Receivable	1,380				1,880						1,880
105	Merchandise Inventory, December 1	7,000				7,000		7,000	8,000			8,000
200	Accounts Payable		700				700
300	Capital Stock		10,000				10,000
310	Retained Earnings, Decernber 1		15,000				15,000				15,000
320	Dividends	2,000				2,000				2,000
410	Sales		14,600				14,600		14,600
411	Sales Discounts	44				44		44
412	Sales Returns and Allowances	20				20		20
500	Purchases	6,000				6,000		6,000
SOI	Purchases Discounts		82				82		32
502	Purchase Returns and Allowances		100				100		100
503	Transportation-In	75				75		75
557	Miscellaneous Selling Expenses	2,650				2,650
567	Miscellaneous Administrative Expenses	1,150				1,150		1,150
		40,482				40,432	40,482	16,939	22,782
		1,150
	Net Income							5,843		5,343
	Retained Earnings, December 31							22,732	22,782	2,000	20,343	29,543
										18.543
										20,843	20,843	29,543

 

Exhibit 40: Work sheet for a merchandising company

 

LYONS COMPANY
Income Statement
For the Month Ended 2010 December 31

Operating revenues:
Gross sales				$14,600
Less: Sales discounts			$44
Sales return and allowances			20	64
Net sales				$14,536
Cost of goods sold:
Merchandise inventory, 2010 January 1			$ 7,000
Purchases		$ 6,000
Less: Purchase discount	$82
Purchase returns and allowances	100	182
Net purchases		$5,818
Add: Transportation-in		75
Net cost of purchases			5,893
Cost of goods available for sale			$12,893
Less: Merchandise inventory, 2010 December 31			8,000
Cost of goods sold				4,893
Gross Margin				$ 9,643
Operating expenses:
Miscellaneous selling expense			$2,650
Miscellaneous administrative expense			1,150
Total operating expenses				3,800
Net income				$ 5,843

 

Exhibit 41: Income statement for a merchandising company

 

LYONS COMPANY
Statement of Retained Earnings
For the Month Ended 2010 December 31

 

Retained earnings, 2010 December 1	$15,000
Add: Net income for the month	5,843
Total	$20,843
Deduct: Dividends	2,000
Retained earnings, 2010 December 31	$18,843

 

Exhibit 42: Statement of retained earnings

 

LYONS COMPANY
Balance Sheet 2010 December 31

Assets
Cash		$19,663
Accounts receivable		1,880
Merchandise inventory		$8,000
Total assets		$29,543
Liabilities and Stockholders' Equity
Liabilities:
Accounts payable		$700
Stockholders' equity:
Capital stock	$10,000
Retained earnings	18,843
Total stockholders' equity Total liabilities and		28,843
stockholders' equity		$29,543

 

Exhibit 43: Balance sheet for a merchandising company

 

Balance sheet The balance sheet, Exhibit 43, contains the assets, liabilities, and stockholders' equity items taken from the work sheet. Note the USD 8,000 ending inventory is a current asset. The Retained Earnings account balance comes from the statement of retained earnings.

Recall from Chapter 4 that the closing process normally takes place after the accountant has prepared the financial statements for the period. The closing process closes revenue and expense accounts by transferring their balances to a clearing account called Income Summary and then to Retained Earnings. The closing process reduces the revenue and expense account balances to zero so that information for each accounting period may be accumulated separately.

Lyons's accountant would prepare closing entries directly from the work sheet in Exhibit 40 using the same procedure presented in Chapter 4. The closing entries for Lyons Company follow.

The first journal entry debits all items appearing in the Income Statement credit column of the work sheet and credits Income Summary for the total of the column, USD 22,782.

• 1^st Entry

2010 Dec. 31	Merchandise Inventory (ending)	8,000
	Sales	14,600
	Purchase Discounts	82
	Purchase Returns and Allowances	100
	Income Summary		22,782
	To close accounts with a credit balance in the Income
	Statement columns and to establish ending merchandise inventory.

 

The second entry credits all items appearing in the Income Statement debit column and debits Income Summary for the total of that column, USD 16,939.

• 2^nd entry

2010 Dec. 31	Income Summary	16,939	7,000
	Merchandise Inventory (beginning)		44
	Sales Discounts		20
	Sales Returns and Allowance
	Purchases		6,000
	Transportation-In		75
	Miscellaneous Selling Expenses		2,650
	Miscellaneous Administrative Expenses		1,150
	To close accounts with a debit balance in the Income
	Statement columns.

  

The third entry closes the credit balance in the Income Summary account of USD 5,843 to the Retained Earnings account.

2010 Dec. 31	Income Summary	5,843
	Retained Earnings		5,843
	To close the Income Summary account to the Retained Earnings

 

The fourth entry closes the Dividends account balance of $2,000 to the Retained Earnings account by debiting Retained Earnings and crediting Dividends.

2010 Dec. 31	Retained Earnings	2,000
	Dividends		2,000
	To close the Dividends account to the Retained Earnings account.

 

Note how the first three closing entries tie into the totals in the Income Statement columns of the work sheet in Exhibit 40. In the first closing journal entry, the credit to the Income Summary account is equal to the total of the Income Statement credit column. In the second entry, the debit to the Income Summary account is equal to the subtotal of the Income Statement debit column. The difference between the totals of the two Income Statement columns (USD 5,843) represents net income and is the amount of the third closing entry.