College
Accounting,
by Heintz and Parry
Chapter 15:
Financial Statements and
Year-End Accounting for a
Merchandising Business
Eddie was fired up about doing the year-end accounting
for The CD Side of Town. Now that the work sheet was done, he
decided to prepare the income statement under two formats to
see which one Nick liked better. A single-step income statement
would be simple, looking much like the ones Eddie did for Eddie
and the Losers.
The CD Side of Town
Income Statement
For Year Ended Dec. 31, 2000
Revenues:
Sales
Rent Revenue
Interest Revenue
Total Revenues
Expenses:
Cost of Goods Sold
Wage Expense
Depn. Exp.-Bldg.
Supply Exp.
Advertising Expense
Insurance Exp.
Bank Credit Card Exp.
Utilities Expense
Miscellaneous Exp.
Interest Expense
Total Expenses
Net Income
$365,876
500
368
$213,675
74,160
6,490
835
7,230
920
4,369
1,853
1,238
2,386
$366,744
313,156
$ 53,588
The other format, one frequently used by merchandising
businesses, is the multiple-step income statement. More
detailed, it shows important subtotals like gross profit. Here is
the top half of the statement for The CD Side of Town:
The CD Side of Town
Income Statement
For Year Ended Dec. 31, 2000
Revenue from Sales:
Sales
Less Sales Returns & Allow.
Net Sales
Cost of Goods Sold:
Mdse. Inventory, Jan. 1, 2000
Purchases
Less: Purch. Ret. & Allow.
Purch. Discounts
Net purchases
Add freight-in
Cost of goods purchased
Goods available for sale
Less mdse. Inv., Dec. 31, 2000
Cost of Goods Sold
Gross Profit
$367,121
1,245
$387
212
$215,276
599
214,677
1,533
$365,876
7,683
216,210
223,893
10,218
213,675
$152,201
Another difference in this format is that it includes many
of the extra accounts used by a merchandising business: Sales
Returns and Allowances, Purchase Returns and Allowances,
Purchase Discounts, and Freight In.
The CD Side of Town
Income Statement
For Year Ended Dec. 31, 2000
Revenue from Sales:
Sales
Less Sales Returns & Allow.
Net Sales
Cost of Goods Sold:
Mdse. Inventory, Jan. 1, 2000
Purchases
Less: Purch. Ret. & Allow.
Purch. Discounts
Net purchases
Add freight-in
Cost of goods purchased
Goods available for sale
Less mdse. Inv., Dec. 31, 2000
Cost of Goods Sold
Gross Profit
$367,121
1,245
$387
212
$215,276
599
214,677
1,533
$365,876
7,683
216,210
223,893
10,218
213,675
$152,201
The bottom half of a multiple-step income statement lists
operating expenses next. Some companies divide these
expenses into two categories: selling expenses (like advertising
expense and bank credit card expense) and administrative
expenses (like insurance expense and utilities expense).
The CD Side of Town
Income Statement
For Year Ended Dec. 31, 2000
Operating expenses:
Wage Expense
Depn. Expense-Bldg.
Supply Expense
Advertising Expense
Insurance Expense
Bank Credit Card Expense
Utilities Expense
Miscellaneous Expense
Total Operating Expenses
Income from operations
Other revenues:
Rent Revenue
Interest Revenue
Total other revenues
Other expenses:
Interest expense
Net Income
74,160
6,490
835
7,230
920
4,369
1,853
1,238
97,095
55,106
500
368
868
2,386
(1,518)
$ 53,588
The bottom half of a multiple-step income statement lists
the subtotal Income from operations next. This number
represents how well the store did in its main business, before
adding in unrelated income sources (Rent Revenue) or accounts
that reflect the sources of financing (Interest Expense) or the
ability to invest excess cash (Interest Revenue).
The CD Side of Town
Income Statement
For Year Ended Dec. 31, 2000
Operating expenses:
Wage Expense
Depn. Expense-Bldg.
Supply Expense
Advertising Expense
Insurance Expense
Bank Credit Card Expense
Utilities Expense
Miscellaneous Expense
Total Operating Expenses
Income from operations
Other revenues:
Rent Revenue
Interest Revenue
Total other revenues
Other expenses:
Interest expense
Net Income
74,160
6,490
835
7,230
920
4,369
1,853
1,238
97,095
55,106
500
368
868
2,386
(1,518)
$ 53,588
Eddie did the store’s Statement of Owner’s Equity
next. The sentence that helps you remember the format
is Connie and Tom need less ice cream.
The CD Side of Town
Statement of Owner’s Equity
For Year Ended Dec. 31, 2000
N. Flannery, Cap., Jan. 1
$90,000
Additional Investment
5,000
Total
95,000
Net Income
$53,588
Less Withdrawals
37,000
Increase in Capital
16,588
N. Flannery, Cap, Dec. 31
$111,588
The store’s balance sheet was pretty
straightforward. The assets looked like this:
The CD Side of Town
Balance Sheet
Dec. 31, 2000
Assets
Current Assets:
Cash
$8,383
Accounts Receivable
1,329
Merchandise Inventory
10,218
Supplies
225
Prepaid Insurance
320
Total Current Assets
$20,475
Prop., Plant, & Equip.:
Land
$ 24,000
Building
$114,380
Less Accum. Dep’n.
6,490 107,890
Total P P & E
131,890
Total Assets
$152,365
Eddie’s current liabilities include his deferred
(unearned) rent revenue and a portion of his 15-year
mortgage liability, because any principal to be repaid
during the year 2001 fits the definition of a current
liability (an obligation due within one year).
The CD Side of Town
Balance Sheet
Dec. 31, 2000
Liabilities
Current Liabilities:
Accounts Payable
Wages Payable
Deferred Rent Revenue
Mortgage Pay.(current portion)
Tot. Curr. Liabilities
Long-term Liabilities
Mortgage Payable
Less current portion
Total liabilities
Owner’s Equity
Nick Flannery, Capital
Tot. Liab. & Own. Equity
$4,360
867
1,000
1,723
$34,550
1,723
$7,950
32,827
$ 40,777
111,588
$152,365
One reason Eddie was anxious to complete the
financial statements is that he wanted to impress Nick with his
ability to do financial statement analysis: calculating
relationships between financial statement amounts to learn
information about how well the business is operating.
The first thing Eddie did was calculate the store’s working
capital. The calculation is:
Current Assets - Current Liabilities = Working Capital
or 20,475 7,950
= 12,525
This amount represents the assets the business would have left
for day-to-day operations if it paid all of its current liabilities
today.
Eddie knew that Nick would want to compare any
financial results with The Pound of Music, a chain of record
stores with five locations around town. It’s pretty meaningless
to compare the working capital of companies that are very
different in size, so Eddie also calculated the current ratio, a
number that takes out size as a factor by computing the relative
size of a company’s current assets and current liabilities. The
calculation was:
Current Assets / Current Liabilities = Current Ratio
or 20,475 /
7,950
= 2.58 to 1
This means that The CD Side of Town has $2.58 in current
assets for every $1.00 of current liabilities.
Question: What number do you think most companies
try to maintain as a current ratio?
Answer:
two to one.
Most companies want a current ratio of at least
Eddie also calculated the store’s quick ratio, which compares
the company’s quick assets, the assets that should be easily
convertible into cash in 30 days, with the current liabilities (most
of which are usually due within 30 days). The quick assets are:
1) cash, 2) temporary investments (safe financial instruments
that the company expects to sell soon), and 3) accounts
receivable. The quick ratio for the CD Side of Town is:
Quick Assets
/
Curr. Liabilities = Quick Ratio
(8,383 Cash + 1,329 A/R) / 7,950
= 1.22 to 1
This means that The CD Side of Town has $1.22 in quick assets
for every $1.00 of current liabilities.
Question: What number do you think most companies
try to maintain as a quick ratio?
Answer:
one to one.
Most companies want a quick ratio of at least
To try to determine whether the store was a good investment of
Nick’s money, Eddie calculated the store’s return on owner’s
equity. The formula is:
Net Income
Average Owner’s Equity = Return on Owner’s Equity
A simple way to estimate average owner’s equity is to take an
average of beginning owner’s equity and ending owner’s equity:
($90,000 beginning capital + $111,588 ending capital)/2
This answer of $100,794 goes into the calculation as follows:
53,588 / 100,794 = 53.2%
This means that a dollar invested into The CD Side of Town grew
at a rate of 53% per year during the year 2000, an impressive
performance!
Although the store makes few sales on account, Eddie
calculated the accounts receivable turnover to make sure that
they were collecting the money on time. The formula is:
Net Credit Sales for the Period
Average Accounts Receivable = Accts. Rec. Turnover
A simple way to estimate average accounts receivable is to take
an average of beginning accts. rec. and ending accts. rec.
(Eddie used accounts receivable at March 31, the end of the
month that the store opened, as his beginning accts. rec.):
($105 beginning accts. rec. + $1,329 ending accts. rec.)/2
The average accts. rec. is $717. Next, Eddie used the Sales
Journals (and the sales returns and allowances in the General
Journal) to add up the year’s net credit sales and got $5,236.
Since the store opened in March, he estimated that net credit
sales for the year would have been $7,322.
Question: What is the accounts receivable turnover for the
store, and is it a “good” number?
Answer:
The store’s accounts receivable turnover is:
$7,322 / $717 = 10.2 times
To determine whether this is a good number, it helps to calculate
the average collection period using this formula:
365 (days) / accounts receivable turnover
or
365
/ 10.2
=
36 days
This means that the typical credit customer is paying 36 days
after the sale was made. Since the store offers payment terms
of net 30 days, this means that customers aren’t always paying
on time. The store may want to change their collection
procedures or stop granting credit to certain customers.
The final ratio Eddie calculated is called inventory
turnover. It measures how long it takes a business to sell
inventory after it buys it. The formula for this ratio is:
Cost of Goods Sold for the Year
Average Inventory
= Inventory Turnover
To estimate average inventory, he took an average of beginning
inventory and ending inventory:
($7,683 beginning inv. + $10,218 ending inv.) / 2
The average inventory is $8,950.5. Eddie took the cost of goods
sold of $213,675 and estimated that 12 full months of sales
would have equaled $268,012.
Question: What is the inventory turnover for the store, and is
it a “good” number?
Answer:
The store’s inventory turnover is:
$268,012 / $8,950.50 = 29.9 times
To determine whether this is a good number, it helps to calculate
the average days to sell inventory using this formula:
365 (days) / inventory turnover
or
365
/ 29.9
=
12.2 days
This means that the typical CD is being sold 12 days after it is
purchased by the store. This number is best judged by
comparing it to prior years (which is impossible in this case) or
industry averages, which can be found at most major libraries.
To have a number as low as 12 days for this type of inventory,
The CD Side of Town must be stocking only the most popular
titles or offering terrific prices at a terrific location (or both).
If one is majoring in accounting or a
related field, it is worthwhile to memorize some of the
most common ratios.
Questions: 1) What is the formula for current ratio?
2) What is the formula for return on owner’s equity?
3) What is the formula for receivables turnover?
Answers: 1) The formula for current ratio is:
Current Assets / Current Liabilities
2) The formula for return on owner’s equity is:
Net Income / Average Owner’s Equity
3) The formula for accounts receivable turnover is:
Net Credit Sales for the Period / Avg. Accts. Receivable
Eddie made a note to himself that one of
his adjusting entries would need a reversing entry on Jan. 1 of
the year 2001. As shown below, a reversing entry is just an
adjusting entry with the debit and credit flipped. A reversing
entry can make things easier when the adjusting entry puts a
balance into an asset or liability account that had none.
Date
2000
Dec 31
2001
Jan. 1
Description
Adjusting Entry
Wage Expense
Wages Payable
Reversing Entry
Wages Payable
Wage Expense
P.R.
Debit
867.00
867.00
Credit
867.00
867.00
If no reversing entry is made, the first
payroll of the new year would have to look like this. Eddie
would have to remember to zero out the wages payable account
when making the entry by debiting it for $867.
Date
2001
Jan 6
Description
Wage Expense
Wages Payable
Cash
P.R.
Debit
333.00
867.00
Credit
1,200.00
If the reversing entry is made, the first
payroll of the new year would look like this. Eddie could just
make the normal payroll entry he makes every week because
wage payable is already reset to zero. In the wage expense
account, the $867 credit from the reversing entry will be
combined with this $1,200 debit to make the balance a $333
debit, which represents the portion of this payroll earned in
2001.
Date
2001
Description
Jan. 6 Wages Expense
Cash
P.R.
Debit
1200.00
Credit
1200.00