Introduction to Inventories and the Classified Income Statement

Read this chapter and pay attention to the comparison of the two income statements. This chapter reviews the difference in reporting and financial presentation of information for service and merchandising operations and compares recording inventories for two separate types of businesses.

Appendix: The work sheet for a merchandising company

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.

  • 1st 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.

  • 2nd 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.