Chapter 12
1
Financial Statements,
Closing Entries, and
Reversing Entries
College Accounting
10th Edition
McQuaig
McQuaig
Bille
Bille
Nobles
PowerPoint presented by Douglas Cloud
Professor Emeritus of Accounting, Pepperdine University
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© 2011 Cengage Learning
The Income Statement
 Each of the amounts that appear in the Income
Statement columns of the work sheet will be
used in the income statement.
 The basic format of an incomes statement—
Net Sales
– Cost of Goods Sold
= Gross Profit
– Operating Expenses
= Income from Operations
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Gross Profit Contrasted
with Net Profit
Several years ago, Della Reyes bought an antique
table at a second-hand store for $800. She sold
the table for $1,850. She advertised in the daily
newspaper at a cost of $73. How much did she
clear as profit?
Sale of Table
$1,850
Less Cost of Table
– 800
Gross Profit
$1,050
Less Advertising Expense – 73
Net Income or Net Profit $ 977
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Gross Profit Contrasted
with Net Profit
 Gross Profit is the profit on the sale of the
table before any expenses have been
deducted.
 Net Income, or Net Profit, is the final or
clear profit after all expenses have been
deducted.
 Most accountants prefer Net Income.
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Revenue from Sales
 Sales Returns and Allowances and Sales
Discounts are deducted from Sales to give us
Net Sales.
 Note that we record these items in the same
order in which they appear in the ledger.
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Gross Profit Percentage
Net Sales
is the 100
percent
row
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Gross Profit Percentage
In 2010, for
every $100 in
net sales, cost
of goods
available for
sale amounted
to $59.
$294,000
$500,000
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Gross Profit Percentage
In 2011, for
every $100 in
net sales,
advertising
expense
amounted to $4.
$21,400
$528,000
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Gross Profit Percentage
In 2010, for
every $100 in
net sales, net
income
amounted to
$26.
$132,000
$500,000
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Cost of Goods Sold
The section of the income statement that
requires the greatest amount of concentration is
the Cost of Goods Sold section.
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Delivered Cost of Purchases
First, let’s look closely at the Purchases section.
To arrive at Net Purchases, we deduct the sum
of Purchases Returns and Allowances and
Purchases Discounts from Purchases. Then
we add Freight In to get Delivered Cost of
Purchases.
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Cost of Goods Sold
You might think of Cost of Goods Sold like this:
Amount we started with (beginning inventory)
+ Net amount we purchased, including freight charges
Total amount that could have been sold (available)
‒ Amount left over (ending inventory)
Cost of the goods that were actually sold
$ 67,000
87,920
$154,920
64,800
$ 90,120
Here’s the same Cost of Goods Sold expressed in proper wording:
Merchandise Inventory, January 1, 20‒‒
+ Delivered Cost of Purchases
Cost of Goods Available for Sale
‒ Merchandise Inventory, December 31, 20‒‒
Cost of Goods Sold
$ 67,000
87,920
$154,920
64,800
$ 90,120
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Operating Expenses
Selling Expenses are any expenses directly
connected with the selling activity:
 Sales Salary Expense
 Sales Commissions Expense
 Advertising Expense
 Store Supplies Expense
 Delivery Expense
 Depreciation Expense, Store Equipment
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Operating Expenses
General Expenses are any expenses related to
the office or administration, or any expense that
cannot be directly connected with a selling
activity:
 Office Salary Expense
 Property Tax Expense
 Depreciation Expense, Office Equipment
 Rent Expense
 Insurance Expense
 Office Supplies Expense
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Income from Operations
Net Sales
– Cost of Goods Sold
Gross Profit
– Operating Expenses
Income from Operations
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Other Income and Other Expenses
The Other Income classification includes any revenue
account other than Sales. Typical accounts are as
follows:
 Rent Income
 Interest Income
 Gain on Disposal of Equipment
 Miscellaneous Income
The Other Expense classification includes various
nonoperating expenses:
 Interest Expense
 Loss on Disposal of Equipment
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The Statement of Owner’s
Equity and the Balance Sheet
 Every figure in the Balance Sheet columns of the
work sheet is used in either the statement of
owner’s equity or the balance sheet.
 The income statement is prepared first, the
statement of owner’s equity second, and the
balance sheet last.
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Balance
Sheet for
Whitewater
Raft Supply
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Current Assets
 Current Assets consist of cash and any other assets or
resources that are expected to be realized in cash or to
be sold or consumed during the normal operating cycle of
the business (or one year, if the normal operating cycle is
less than twelve months).
 Examples of accounts that are current assets include
Cash, Notes Receivable, Accounts Receivable, and
Merchandise Inventory.
 Notes Receivable (current) are short-term (one year or
less) promissory notes (promise-to-pay notes) held by the
firm.
 Prepaid Insurance and Supplies are considered prepaid
items that will be used or will expire with the following
operating cycle or one year.
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Property and Equipment
 Property and Equipment are relatively long-lived
assets that are held for use in the production or sale of
other assets or services.
 Some accountants refer to them as fixed assets.
 Three accounts that usually appear in this category are
Land, Building, and Equipment.
 Building and Equipment are followed by their
respective Accumulated Depreciation accounts.
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Current Liabilities
 Current Liabilities are debts that will become due
within the normal operating cycle of the business,
usually within one year.
 They normally will be paid, when due, from current
assets.
 Three accounts that usually appear in this category are
Notes Payable, Wages Payable, and Interest
Payable.
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Long-Term Liabilities
 Long-Term Liabilities are debts that are payable over
a comparatively long period, usually longer than one
year.
 The current portion of notes, contracts, and loans is
shown as a current liability.
 An account that usually appears in this category is
Mortgage Payable.
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Working Capital and
Current Ratio
Working capital is the amount of capital a firm has
available to use or to work with during a normal
operating cycle
Current Assets – Current Liabilities = Working Capital
The Current ratio is useful in revealing a firm’s
ability to pay its bills. It is calculated as follows:
Current Assets (amount coming in within one year)
Current Liabilities (amount going out within one year)
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Working Capital and
Current Ratio
Two portions of Whitewater Raft Supply follow:
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Working Capital
Current Assets – Current Liabilities = Working Capital
$123,355 ‒ $43,330 = $80,025
Current Ratio
Current Assets
= Current Ratio
Current Liabilities
Whitewater Raft
$123,355
= 2.85
Supply has current
$43,330
assets available to pay
every dollar currently
due on December 31.
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Chart of Accounts
The second digit in the chart of accounts stands
for the subclassification.
Assets:
Current Assets
Property and Equipment
Liabilities
Current Liabilities
Long-Term Liabilities
Owner’s Equity
Capital
1-- Revenue
11- Revenue from Sales
Other Income
12- Cost of Goods Sold
2-Purchases
21- Expenses
22- Selling Expenses
3-General Expenses
31- Other Expenses
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Closing Entries
 At the end of the fiscal period, you close the
revenue and expense accounts so that you
can start the next fiscal period with zero
balances.
 You close the Drawing account because it,
too, applies to one fiscal period.
 Recall that these accounts are called
temporary-equity accounts, or nominal
accounts.
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Four Steps in the Closing Procedure
STEP 1:
Close the revenue accounts and the other
accounts that appear on the income
statement that have credit balances into
Income Summary.
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Four Steps in the Closing Procedure
STEP 2: Close the expense and other accounts appearing on
the income statement that have debit balances into
Income Summary. Note that you close Sales
Discounts and Sales Returns and Allowances along
with the expense accounts.
Four Steps in the Closing Procedure
STEP 3:
Close the Income Summary account into
the Capital account, transferring net
income or loss to the Capital account.
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Four Steps in the Closing Procedure
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Four Steps in the Closing Procedure
STEP 4:
Close the Drawing account into the Capital
account.
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Four Steps in the Closing Procedure
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Reversing Entries
 Reversing entries are general journal entries
that are the exact reverse of certain adjusting
entries.
 A reversing entry enables the accountant to
record routine transactions in the usual
manner, even though an adjusting entry
affecting one of the accounts involved in the
transaction has intervened.
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Reversing Entries Example
All the employees of Mason Company earn, altogether, $400 per
day for a five-day week and their payday occurs every Friday.
Their current paychecks include wages for that Friday and for the
preceding four days. The last day of the fiscal year falls on
Wednesday, December 31.
Wages Expense is debited and Cash
is credited (ignoring taxes and
deductions) $2,000.
Wages Expense is debited and
Cash is credited (ignoring taxes
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and deductions) $2,000.
Reversing Entries
The following reversing entry is made on the first day
of the following fiscal period (which is an exact reverse
of the adjusting entry):
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Reversing Entries
Now, let’s follow the T accounts to see what happens.
We begin with the adjusting entry at December 31.
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Reversing Entries
Next, we close Wages Expense (but not Wages
Payable).
Then we reverse the adjusting entry.
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Reversing Entries
Note that this gives Wages Expense a credit balance,
and closes Wages Payable.
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Reversing Entries
On the first payday of
the new fiscal period,
the accountant can
debit Wages Expense
and credit Cash for
$2,000 (just as if it was
the middle of the fiscal
year). After the payroll
entry, there will now be
a debit balance of $800
in Wages Expense,
which is the correct
amount.
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Reversing Entries
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Reversing Entries Rules
If an adjusting entry is to be reversed, it must
meet both of the following qualifications:
1. The adjusting entry increases an asset or
liability account.
2. The asset or liability account did not have a
previous balance.
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