Chapter 5 ACC

Chapter 5: Adjusting Accounts for Financial Statements

Learning Objectives

Conceptual

• C1: Describe merchandising activities and cost flows, including the significance of managing inventory effectively and recognizing the various costs associated with merchandise purchases.

Analytical

• A1: Compute and analyze the acid-test ratio and gross margin ratio, understanding their importance as indicators of a company's financial health and operational efficiency.

Procedural

• P1: Analyze and record transactions for merchandise purchases using a perpetual system, which requires continuous tracking of inventory levels and related expenses.

• P2: Analyze and record transactions for merchandise sales using a perpetual system, documenting both the revenue from sales and the cost associated with the sold inventory to maintain accurate financial records.

• P3: Prepare adjustments and close accounts for a merchandising company, ensuring that discrepancies such as shrinkage and errors are recorded appropriately.

• P4: Define and prepare multiple-step and single-step income statements, understanding how each format emphasizes different aspects of financial performance.

• P5: Record and compare merchandising transactions using both periodic and perpetual inventory systems (Appendix 5A), discussing the advantages and disadvantages of each method in terms of accuracy and efficiency.

• P6: Prepare adjustments for discounts, returns, and allowances per revenue recognition rules (Appendix 5B), emphasizing the implications for revenue reporting and customer relations.

• P7: Record and compare merchandising transactions using the gross method and net method (Appendix 5C), discussing the respective impacts on financial reports and decision-making processes.

Understanding Merchandising Activities

Service Companies vs. Merchandising Companies

• Service Companies

  • Examples: Accounting firms, law firms.

  • Revenue Generation: Primarily earned by providing time and services, with little focus on inventory.

  • Reliance on Expertise: Success hinges on the skills and expertise of the professionals involved.

• Merchandising Companies

  • Examples: Sporting goods stores, clothing retailers.

  • Revenue Generation: Revenue is generated through the sale of physical products. Products are often sourced from suppliers or manufacturers.

  • Importance of Inventory Management: Effective inventory control is crucial for optimizing sales and minimizing holding costs.

Operating Cycle for a Merchandiser

• The operating cycle begins with the purchase of merchandise, which is then stored until sold.

• The cycle culminates in the collection of cash from customers after sales are made, emphasizing the need for efficient cash flow management.

Inventory Systems

• Perpetual Systems

  • Continuously updates records for purchases and sales of inventory, enabling real-time inventory tracking and management.

  • Facilitates detailed insights into inventory costs and sales performance, allowing for timely decisions.

• Periodic Systems

  • Updates records at the end of an accounting period, relying on physical counts to assess inventory levels.

  • Involves greater estimation and potential discrepancies, making accurate reporting more challenging.

Analyzing and Recording Merchandise Purchases

Purchases without Cash Discounts

• Example: Z-Mart purchases $500 in inventory for cash.

  • Journal Entry:

    • Merchandise Inventory $500

    • Cash $500

Credit Terms

• Sellers often offer cash discounts to encourage early payment, such as a notation like 2/10, n/30, indicating a 2% discount if paid within 10 days; otherwise, the net amount is due in 30 days.

Purchase Discounts

• The discount is usually available for a limited time. Companies must effectively manage these discounts to realize cost savings, which can significantly impact the bottom line.

Expenses Related to Purchases

Transportation Costs

• Costs incurred depend on shipping terms:

  • FOB Shipping Point: Buyer pays for transportation and the cost is added to inventory.

  • FOB Destination: Seller pays for transportation until goods reach the buyer.

• Example: Z-Mart pays $75 freight on purchased goods.

  • Journal Entry:

    • Merchandise Inventory $75

    • Cash $75

Analyzing and Recording Merchandise Sales

Revenue from Sales

• Upon selling merchandise, two entries must be recorded:

  1. Record the sale as revenue.

  2. Record the associated cost of the sold inventory to affect the Cost of Goods Sold (COGS) appropriately.

Sales Discounts and Returns

• Sales discounts incentivize timely payments from customers, while sales returns relate to customers returning unsatisfactory merchandise.

• Accurate journal entries are essential to reflect these transactions, ensuring financial statements present a true and fair view of the company's position.

Preparing Adjustments and Closing Accounts

Adjustments

• Adjustments for shrinkage or discrepancies must be recorded to maintain accurate financial records:

  • Example: $250 shrinkage adjustment.

  • Journal Entry:

    • Cost of Goods Sold $250

    • Merchandise Inventory $250

Closing Entries

• Closing involves transferring balances from temporary accounts (like revenue and expenses) to permanent accounts (like retained earnings), paving the way for a new accounting period and allowing for performance comparison over time.

Preparing Financial Statements

Multiple-Step Income Statement

• Divided into sections detailing:

  • Sales

  • Cost of Goods Sold

  • Operating Expenses

  • Other Revenues/Gains

• This format provides detailed insights into gross profit and net income, useful for stakeholders assessing financial performance.

Single-Step Income Statement

• A simplified format that aggregates revenues and expenses to arrive at net income. It emphasizes overall profit without delving into the sources of revenues or types of expenses.

Financial Ratios

Acid-Test Ratio

• Measures short-term liquidity. A recommended value is 1.0 or greater, indicating the company's ability to meet its short-term liabilities using its most liquid assets.

Gross Margin Ratio

• Represents the percentage of sales exceeding the cost of goods sold, indicating the efficiency of a company in managing its production costs relative to sales. A higher ratio suggests better financial health.

Appendix Highlights

Comparison of Periodic vs. Perpetual Inventory Systems

• Discusses the conditions under which each system operates, emphasizing their respective efficiencies and challenges in tracking inventory and financial reporting.

Discounts, Returns, and Allowances

• Proper management and recording of these financial elements are crucial for accurate financial reporting, aiding in the assessment of profitability and customer satisfaction.