Accounting Closing Entries for Merchandisers

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Questions and Answers

What is the journal entry for recognizing a price reduction related to defective goods?

Debit cash, credit sales returns and allowances

Debit income summary, credit sales

Debit sales returns and allowances, credit cash (correct)

Debit sales, credit cash

Which of the following accounts may be closed to the income summary at the end of the accounting period?

Net sales

Accounts receivable

Sales returns and allowances (correct)

Cash

In a multiple-step income statement, what follows the net sales?

General and administrative expenses

Income from operations

Selling expenses

Cost of goods sold (correct)

What is the correct sequence for closing temporary accounts?

Close sales, close expenses, close income summary Signup and view all the answers

Which of the following is typically included in the operating expenses section of an income statement?

Sales salaries expense Signup and view all the answers

Which accounts get debited when closing dividend accounts?

Retained earnings Signup and view all the answers

Which of the following items would not be closed to the income summary?

Cash Signup and view all the answers

What should be done after closing the income summary?

Credit dividends Signup and view all the answers

What is the primary reason grocery stores use the FIFO method?

To ensure the oldest products are sold first Signup and view all the answers

Which inventory cost flow assumption results in the cost of goods sold reflecting the newest costs?

LIFO Signup and view all the answers

What inventory method does a gas station utilize according to the typical practices outlined?

Weighted average Signup and view all the answers

What is a disadvantage of using the LIFO method in grocery stores?

It may cause the newest products to spoil. Signup and view all the answers

How does the inventory valuation change under the FIFO method?

Cost of goods sold is the oldest cost. Signup and view all the answers

Which of the following is a characteristic of the weighted average method?

It smooths out price changes Signup and view all the answers

In a periodic system, which financial statement reflects the ending inventory amount?

Balance sheet Signup and view all the answers

Why do most companies prefer the weighted average method?

It provides significant tax benefits. Signup and view all the answers

What happens to the cost amounts assigned by inventory methods due to price changes?

They change with different inventory methods. Signup and view all the answers

Which of the following is true regarding the LIFO conformity rule?

LIFO must be applied to both tax and financial reporting once chosen. Signup and view all the answers

How must inventory be reported when market value is lower than cost?

At market value according to conservatism principles. Signup and view all the answers

What impact does overstating inventory in one year have on future financial statements?

It results in an overstatement for the next year. Signup and view all the answers

Which of the following methods can be applied for determining the lower of cost or market inventory?

To major categories of assets or the whole inventory. Signup and view all the answers

What does inventory turnover indicate?

How many times inventory is turned over during a period. Signup and view all the answers

What is the formula for calculating average inventory?

Beginning inventory + Ending inventory / 2 Signup and view all the answers

Which calculation correctly represents inventory turnover?

Cost of goods sold / average inventory. Signup and view all the answers

How is days sales in inventory calculated?

Ending inventory / Cost of goods sold x 365 Signup and view all the answers

What ethical consideration must be kept in mind when reporting inventory?

It is unethical to overstate inventory. Signup and view all the answers

What consequence can occur from having a high inventory turnover?

Stock outs due to fast selling items Signup and view all the answers

What is one of the purposes of an internal control system?

Protect assets Signup and view all the answers

What does the Sarbanes-Oxley Act (SOX) require of public companies?

To document and certify the system of internal controls Signup and view all the answers

What type of penalties might violators of the Sarbanes-Oxley Act face?

Harsh penalties including imprisonment up to 25 years Signup and view all the answers

What is a known cost of implementing internal controls under SOX?

1.24 billion for Section 404 alone Signup and view all the answers

Which of the following companies typically has high inventory turnover?

McDonald's Signup and view all the answers

What are the three basic guidelines for an effective internal control system protecting cash and cash equivalents?

Handling cash is separated from record keeping, cash receipts are promptly deposited, and cash payments are made electronically. Signup and view all the answers

Which component is NOT part of the fraud triangle?

Management oversight Signup and view all the answers

How should cash equivalents be characterized?

Short-term investments easily convertible to cash with a close maturity date. Signup and view all the answers

Which of the following is a goal of effective cash management?

Plan cash receipts to meet cash payments when due. Signup and view all the answers

What is a limitation of internal control related to human factors?

Human error and fraud can both undermine internal controls. Signup and view all the answers

Which of the following best describes 'cash' in financial reporting?

Includes currency, bank deposits, checks, and certificates. Signup and view all the answers

Which action enhances effective cash management?

Planning expenditures strategically to maintain liquidity. Signup and view all the answers

What is an example of cash fraud prevention in cash receipts by mail?

Two people are assigned to open the mail with separate responsibilities. Signup and view all the answers

Study Notes

Buyer Allowance for Defective Goods

When merchandise is defective, and the buyer keeps the merchandise, a sales return and allowance entry is debited, and cash is credited.

Closing Entries for Merchandisers

Temporary accounts are closed to the income summary account.
- Debit Sales: This closes the credit balance in the Sales account.
- Credit Income Summary: This increases the Income Summary account balance.
Temporary accounts that have a debit balance are also closed to the income summary account.
- Debit Income Summary: This decreases the Income Summary account balance.
- Credit Sales Discount, Returns and Allowances, Cost of Goods Sold, Depreciation Expense, Salaries Expense, Insurance Expense, Rent Expense, Supplies Expense, Advertising Expense: This closes the debit balance in the temporary account.
The income summary account is closed to retained earnings.
- Debit Income Summary: This closes the Income Summary account.
- Credit Retained Earnings: This increases the Retained Earnings account balance.
Dividends are closed to retained earnings.
- Debit Retained Earnings: This decreases the Retained Earnings account balance.
- Credit Dividends: This closes out the Dividends account.

Multi-Step Income Statement

Sales: This includes both credit sales and debit sales, and it subtracts sales discounts and returns to obtain net sales.
Cost of Goods Sold: This is subtracted from net sales to determine the gross profit.
Operating Expenses: These are further categorized by type.
- Selling Expenses: These are directly related to the sale of goods, such as depreciation expenses, sales salaries expense, rent expense for selling space, storage supplies expense, and advertising expenses.
- General and Administrative Expenses: These are all other expenses, such as depreciation expense of office equipment, office salaries expense, insurance expense, rent expense for office space, and office supplies expense.
Income from Operations: This represents the company's operating profit.
Other Revenues and Gains: Includes revenue and gain items that are not related to the company's primary operating activities, such as interest revenue, gain on the sale of a building, and interest expense.
Total Other Revenues and Gains: This gives a summary of all non-operating revenue and gain amounts.

Inventory Cost Flow Assumptions

Inventory cost flow assumptions determine how the cost of goods sold is calculated.
- FIFO (First In, First Out): The oldest inventory is assumed to be sold first. This method is commonly used by grocery stores to ensure freshness. The Cost of Goods Sold is based on the oldest costs, and the ending inventory approximates current cost. This means that ending inventory is valued at the most recent cost.
- LIFO (Last In, First Out): The newest inventory is assumed to be sold first. This method is not typically used by grocery stores, but it can be beneficial for industries that sell products with a long shelf life, like wine distributors, and for products like mulch or coal from a large pile, where the oldest and newest inventory is mixed. The Cost of Goods Sold is based on the newest costs, and the ending inventory is valued at the oldest costs.
- Weighted Average: A single average cost is calculated for all inventory units. This method is commonly used when inventory is homogeneous, like gas stations, as it is not practical to track different prices for gasoline purchased on different dates. The Cost of Goods Sold is based on the average cost, and the ending inventory is also valued at the average cost.

### Inventory Costing Illustrations

Periodic System: This method uses a physical count of inventory to determine the cost of goods sold.
- Specific Identification: Items are identified with their specific purchase cost when they're sold. This is used for unique inventory.
- FIFO: The oldest inventory is assumed to be sold first.
- LIFO: The newest inventory is assumed to be sold first.
- Weighted Average: All inventory items sold are assigned the weighted average cost.
Perpetual System: This system keeps a continuous record of inventory on hand and tracks the cost of goods sold.

Financial Statement Effects of Inventory Costing Methods

Financial Statements: Inventory costing methods can have significant effects on income statements and balance sheets, especially during periods of inflation.
Tax Effects: The IRS requires that if LIFO is used for tax reporting, it must also be used for financial reporting. This is known as the LIFO conformity rule.

Lower of Cost or Market

Companies must report inventory at the lower of cost or market. This is done to avoid overstating the value of inventory on the balance sheet.
The market value is defined as the current replacement cost, not the selling price.
This principle is consistent with the conservatism principle in accounting.
There are three ways to apply the lower of cost or market:
- Separately to each individual item: This is the most precise method, but it is usually not practical.
- To major categories of assets: This is a common practice and usually sufficient for providing a fair value of inventory.
- To the whole inventory: This is the least specific but is the simplest to apply.

Effects of Inventory Errors

Income Statement: An overstated inventory in one period will lead to an understated inventory in the next period. These errors will correct themselves over two years, but they can significantly impact income statement results and make it difficult to properly assess the company’s financial performance.
Retained Earnings: Companies that have to restate their retained earnings due to inventory errors usually face dropped stock prices, demonstrating the importance of accurate inventory accounting.

Inventory Management

Inventory Turnover: A measure of how efficiently a company is managing its inventory.
- Formula: Inventory Turnover = Cost of Goods Sold / Average Inventory
- A higher inventory turnover indicates that the company is selling its inventory quickly and is more efficient in managing its inventory.
Days Sales of Inventory: This measures how many days a company's average inventory on hand is holding sales.
- Formula: Days Sales in Inventory = Ending Inventory/Cost of Goods Sold x 365
- A lower Days Sales in Inventory figure indicates that inventory is moving quickly and the company is managing its inventory well.

Internal Controls System

Purpose of Internal Controls:
- Protect Assets: Ensure that company assets are protected from theft, misuse, or damage.
- Ensure Reliable Accounting: Help to ensure that the company's financial records are complete, accurate, and reliable.
- Uphold Company Policies: Promote compliance with company policies and procedures.
- Promote Efficient Operations: Improve operational efficiency and reduce unnecessary costs.
Sarbanes-Oxley Act (SOX): Requires that public companies have a documented and tested system of internal controls. The act established criminal penalties for executives and auditors who knowingly sign off on false financial statements or who fail to comply with the act's requirements.
Committee of Sponsoring Organizations (COSO): They focus on testing the effectiveness of companies' internal controls, including blockchain processes and technology.

Limitations of Internal Controls

Human Error: Carelessness, misjudgement, or confusion
Human Fraud: Intentional deceit to gain personal benefit.
- The fraud triangle: To commit fraud, a person must have the opportunity, the pressure, and the rationalization to justify the fraud.
Cost-Benefit Constraint: The cost of implementing and maintaining an internal control system should not exceed the expected benefits.

Cash and Cash Equivalents

Cash is the most liquid of all assets, including currency, coins, and bank deposits.
Cash Equivalents are short-term, highly liquid investments that are readily convertible to a known cash amount.
In order to be considered a cash equivalent, an investment must mature within three months or less of the purchase date and be subject to minimal risk of changing value.

Cash Management Strategies

Encourage Collection of Receivables: Collect cash from customers quickly to improve cash flow.
Delay Payments of Liabilities: Delay payments to vendors and suppliers until the due date to maintain cash on hand.
Keep Necessary Assets: Avoid investing in unnecessary assets or inventory. Avoid keeping too much cash that may not be put to good use.
Plan Expenditures: Plan and budget expenses to avoid unexpected cash shortages.
Invest Excess Cash: Invest excess cash to earn a return on the investment. This helps maintain a healthy cash flow.

### Control of Cash

Separation of Duties: Individuals who handle cash should be different from those responsible for recording cash receipts and disbursements.
Prompt Deposit of Cash: Deposit cash receipts as quickly as possible following receipt to minimize risk of theft.
Make Payments by Check or EFT: Avoid using cash for payments to reduce the risk of theft, loss, or mishandling.

Internal Controls for Cash Receipts

Mail Receipts: Two people, ideally from different departments, should open the mail to ensure proper control over cash receipts. The cashier deposits the cash and the record keeper records the transactions.
Cash Register: A cash register is a common control for cash receipts in retail businesses and ensures that the transactions are recorded and tracked.

Internal Controls for Cash Payments

Check Disbursement: A company should only pay bills by check or EFT. This provides a written record of each disbursement.
Approvals: All cash payments should be authorized by multiple individuals to ensure that payments are made accurately and appropriately.
Petty Cash: This is a small fund of cash used for minor expenses. A custodian is responsible for maintaining the petty cash fund and replenishing it when needed.
Prenumbered Documents: Checks, purchase orders, receiving reports, and other documents related to cash disbursements should be prenumbered to help track the documents.

Bank Reconciliation

A bank reconciliation is a document that compares the company's cash balance to its balance according to bank records.
It is essential to recognize that the book balance and the bank balance will rarely agree because of timing differences or errors in recording.
Reconciling the bank balance to the book balance involves identifying the differences in amount and the reasons for them and making adjustments to each balance. The bank reconciliation helps to reconcile the two balances and ensure accuracy of cash records.

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Description

This quiz focuses on the accounting principles related to closing entries for merchandisers, including how to handle sales returns and allowances. It explores the process of closing temporary accounts and the impact on the income summary and retained earnings. Test your knowledge of these key accounting concepts!