Workshop 4 Closing entries and accounting for inventory in Retail PDF

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Workshop 4: Closing Entries and Accounting for Inventory in Retail Set readings for this topic Please also visit the following websites for more understanding on this chapter https://smallbusiness.chron.com/retail-accounting-vs-cost-accounting-23729.html https://www.accountingtools.com/articles/what-are-closing-entries.html https://www.investopedia.com/terms/j/jit.asp http://www.business.vic.gov.au/money-profit-and-accounting/financial-processes-and-procedures/set-upa-stock-control-process https://www.aasb.gov.au/admin/file/content105/c9/AASB102_07-15.pdf th

The following has been extracted from Financial Accounting by Hoggett 10 edition - Chapter 5 & 6

CHAPTER 5 Completing the accounting cycle — closing and reversing entries 5.1 The complete accounting cycle The accounting cycle, that sequence of events or steps which leads from source documents to the final production of the financial statements, is usually completed once a year. The accounting cycle developed in the chapter on adjusting the accounts and preparing financial statements is completed in this chapter by including the journalising and posting of closing entries, and the journalising and posting of reversing entries when they are required. From the worksheet, financial statements can be prepared without journalising, adjusting and closing entries and posting these to general ledger accounts. Nevertheless, it is still quite common for accountants to prepare a worksheet even at the end of the financial year accounting period to help organise their work and minimise errors. 5.2 Closing temporary accounts The income statement reports income and expenses for a single accounting period. Data needed to prepare the statement are accumulated in the individual income and expense accounts. To help in the preparation of this statement for the next accounting period, all income and expense account balances are closed or cleared (reduced to a zero balance) by transferring their balances to another account in order to calculate profit. (Recall from the chapter on adjusting the accounts and preparing financial statements, that because income and expense accounts are closed each period, they are called temporary or nominal accounts.) This step in the accounting cycle is referred to as the closing process, and journal entries made to close the temporary accounts are called closing entries. The closing process results in each income and expense account beginning the next period with a zero balance, which prepares them for accumulating information for that period’s

income statement. In addition, income increases and expenses decrease equity. Because they are recorded in separate temporary accounts rather than directly in the Capital account, journal entries are needed to transfer the net change in equity during the period to the Capital account. In the closing process, a new temporary account called the Profit or Loss Summary account is established to summarise the balances in the income and expense accounts and to calculate profit (loss). This is the only time in the accounting process that this account is used. Closing entries are generally made as follows. 1. The balance in each income account is transferred to the Profit or Loss Summary account. 2. The balance in each expense account is transferred to the Profit or Loss Summary account. 3. The balance in the Profit or Loss Summary account is transferred to the Capital account. 4. The Drawings account is transferred to the Capital account. 5.4 The closing process The closing process involves closing each income and expense account to the Profit or Loss Summary account, and the balance of this account (profit or loss) is then closed off to the Capital account. Any drawings made by the owner during the year are reflected in the Drawings account, which is also closed off to the Capital account. The closing of all temporary accounts is done by making compound general journal entries, and then posting to the relevant accounts. Closing entries are not shown on a worksheet, but the information necessary to make the general journal entries is available from the worksheet. Closing the income (including revenue) accounts An income account normally contains a credit balance. Hence, to close the account, it must be debited for an amount equal to its credit balance. The offsetting credit is made to the Profit or Loss Summary account. The compound journal entry needed to close the income accounts is as follows. General Journal Date Particulars 2019 Closing entries June 30 Management Services Revenue Appraisal Fees Revenue (1) Marketing Services Revenue Profit or Loss Summary (Closing the income accounts)

Post Ref 400 401 402 600

Debit

Page 4 Credit

19 200 500 800 20 500

In the journal, the adjusting entries are separated from the closing entries by the heading ‘Closing entries’. For posting purposes, it is assumed that the closing entries are entered

on page 4 of the general journal. Also, account numbers are entered in the posting reference column when the entry is posted to the ledger. Closing the expense accounts Expense accounts normally have debit balances. In order to close the expense accounts, each account is therefore credited for an amount equal to its balance, and the Profit or Loss Summary account is debited for the sum of the individual balances. The compound journal entry is entered on page 4 of the journal (underneath closing entry (1) shown earlier) as below. June 30 (2)

Profit or Loss Summary Salaries Expense Telephone Expense Advertising Expense Insurance Expense Office Supplies Expense Depreciation Expense — Office Equipment Depreciation Expense — Building Interest Expense Electricity Expense (Closing the expense accounts)

600 500 510 520 521 530 540 541 560 570

14 940 11 580 160 240 80 160 200 500 1 600 420

As shown in figure 5.7, the entry reduces the expense accounts to a zero balance and transfers the total of $14 940 as a debit to the Profit or Loss Summary account. Closing the Profit or Loss Summary account After the first two closing entries are posted, the balances formerly reported in the individual income and expense accounts are summarised in the Profit or Loss Summary account. If income exceeds expenses, a profit is recognised and the Profit or Loss Summary account will contain a credit balance. If expenses exceed income, a loss is indicated and the account will have a debit balance. In either case, the balance is transferred to the Capital account. Intellect Management Services earned a profit during June. The credit balance of $5560 in the Profit or Loss Summary account is closed by recording the entry on page 4 of the journal (underneath closing entry (2) shown previously) as follows. June 30 Profit or Loss Summary M. Mooney, Capital (3) (Closing the Profit or Loss Summary account)

600 300

5 560 5 560

This entry is posted to the accounts as shown in figure 5.8. The effect of this entry is to recognise that the net assets (assets minus liabilities) increased this period owing to profitable operations, and this increase in net assets adds to the owner’s interest in the business. If a loss

is reported, the Profit or Loss Summary account is credited to reduce the account to a zero balance and the Capital account is debited to reflect a decrease in equity.

Closing the Drawings account The debit balance in the Drawings account reflects the decrease in the owner’s interest during the period resulting from the withdrawal of cash and/or other assets for personal use. Note that the Drawings account is not closed to the Profit or Loss Summary account because the withdrawal of assets by the owner is not an expense of doing business. The balance in the account is transferred directly to the Capital account by the following entry (again recorded on page 4 of the journal after closing entry (3) shown above). June 30 M. Mooney, Capital 300 1 200 M. Mooney, Drawings 310 1 200 (4) (Closing the Drawings account) After the entry is posted, the Drawings account will have a zero balance, as shown in figure 5.8. Account balances after the closing process The detailed accounts for Intellect Management Services, after both the adjusting and closing entries have been posted, are presented in figure 5.9. Note that the income (revenue), expense and drawings accounts all have zero balances and are ready for recording transactions in the next period. The balances in the asset, liability and equity accounts are carried forward to the next period and are the only accounts that have balances. These balances are then reported in the balance sheet (also called the statement of financial position)

Reversing entries Reversal of accrual entries An alternative approach to the treatment of accrual entries in subsequent periods, as discussed in the previous section, is the preparation of reversing entries. This involves adding another step to the accounting cycle after the closing entries have been posted to the ledger (see step 12 in figure 5.1). Reversing entries are dated as of the first day of the next accounting period and are so called because they reverse the effects of certain adjusting entries that were made on the last day of the preceding accounting period. Reversing entries are an accounting technique made to simplify the recording of regular transactions in the next period. To illustrate reversing entries, we will continue with the accrued salaries adjustment for Intellect Management Services. Recall that $7600 in salaries was paid during June and that $3980 was accrued on 30 June. Salaries earned for the period 23 June to 6 July for the

amount of $7400 are to be paid on 6 July. Throughout an accounting period, the normal entry to record the payment of salaries is to debit Salaries Expense and credit Cash at Bank. (Wages and salaries are exempt from GST.) At the end of June, accrued salaries were recorded in the following adjusting entry (e). June (e)

30

Salaries Expense Salaries Payable (Unpaid salaries at the end of June)

500 210

3 980 3 980

At the end of the period, the balance of $11 580 in the Salaries Expense account is closed to the Profit or Loss Summary account and the Salaries Payable balance of $3980 is reported as a current liability in the balance sheet. If the adjusting entry is not reversed, the following entry is made on 6 July to record payment (as illustrated in the previous section). July

6 Salaries Payable Salaries Expense Cash at Bank (Payment of salaries for the period 23 June to 6 July)

210 500 100

3 980 3 420 7 400

Note that this entry requires two debits, a variation from the normal entry of one debit to the Salaries Expense account. Thus, a change from the normal procedures is necessary and requires that the adjusting entry or the Salaries Expense account in the general ledger for the previous period be referred to in order to divide the payment between the two accounts. If the adjusting entry is reversed on 1 July, this will simplify the 6 July entry. The reversing entry is as follows. July

1 Salaries Payable Salaries Expense (Reversing the adjusting entry to accrue unpaid salaries at the end of the previous period)

210 3 980 500 3 980

Compare this reversing entry with the adjusting entry on 30 June. Observe that the debit and credit amounts are the same in both entries, but the account debited (Salaries Expense) in the adjusting entry is credited in the reversing entry, and the account credited (Salaries Payable) in the adjusting entry is debited in the reversing entry. In other words, the reversing entry is the opposite of the adjusting entry. The debit in the reversing entry transfers the liability to the expense account. This produces a temporary credit balance of $3980 in the expense account since it had a zero balance before the reversing entry as a result of the closing process. The business can now make the normal

entry to record the payment on 6 July as follows, without having to refer to the previous period to find any accruals of salaries: July

6 Salaries Expense Cash at Bank (Payment of salaries for the period 23 June to 6 July)

500 100

7 400 7 400

The debit of $7400 is partially offset by the credit of $3980 made in the reversing entry, leaving a debit balance of $3420 in the Salaries Expense account, which is the expense for July. Reversing entries are also useful in relation to accrued income (revenue) items which have resulted in adjusting entries. For example, a bank may have thousands of outstanding loans. At the end of the period, interest earned but not received must be accrued in order to report correctly interest revenue and interest receivable in the financial statements. If a reversing entry is not made, each time an interest payment is received in the next period an employee must refer back to the list of accruals in order to divide the amount of the payment between the reduction in the receivable balance and the interest earned in the current period. Reversal of deferral entries In relation to deferrals, adjusting entries are made for prepaid expenses and unearned or precollected revenue, as illustrated in figure 4.2. The need for reversing entries to reverse the effects of any adjusting entries depends on whether the initial recording of a transaction occurs in a permanent account, i.e. asset or liability. To illustrate, consider the purchase on 3 June of a 24-month fire and business liability insurance policy for $1920 plus $192 GST by Intellect Management Services. The entry to record this purchase was made to a permanent asset account, Prepaid Insurance, as follows. June 3 Prepaid Insurance 110 1 920 GST Receivable 120 192 Cash at Bank 100 2 112 (Purchase of a 24-month fire and business liability insurance policy) The adjusting entry (a) at 30 June for the expiration of 1 month’s insurance was recorded as follows. June (a)

30

Insurance Expense Prepaid Insurance (Adjusting entry to record expiration of 1 month’s insurance)

521 110

80 80

In this circumstance, where the adjusting entry is merely recording the gradual expiration of the asset as time goes by, there is no need for any reversal of the adjusting entry in the new

accounting period in order to facilitate the accounting procedure. All that needs to be done is to gradually reduce the value of the asset at the end of each accounting period by way of adjusting entries. Similarly, there is no need for reversing entries in relation to adjustments for supplies used or for depreciation expense, where the initial entry for purchase of the asset is placed in an asset account. However, some entities, on initial purchase of an asset, make a debit entry to an expense account. For example, Intellect Management Services could have recorded the purchase of its insurance policy in the following entry, as discussed in the chapter on adjusting the accounts and preparing financial statements. June 3 Insurance Expense 521 1 920 GST Receivable 120 192 Cash at Bank 100 2 112 (Purchase of a 24-month fire and business liability insurance policy) If this initial entry is made, the adjusting entry (aa) at 30 June to record the portion of insurance premium unexpired is as follows: June (aa)

30

Prepaid Insurance Insurance Expense (Adjusting entry to record portion of insurance policy unexpired)

110 1 840 521

1 840

The adjusting entry in this case needs to recognise the existence of the Prepaid Insurance asset, and leaves only $80 in the expense account, as in the first case . The entity then has two options at the beginning of the new period. 1. Leave the amount of $1840 in the Prepaid Insurance account for the coming period and make adjusting entries at the end to write down the value of the asset, in the same way that adjusting entry (a) is made. 2. Make a reversing entry on the first day of the period to reverse adjusting entry (aa). In other words, the Insurance Expense account is reopened on the first day of the new period, and a further adjusting entry is necessary at the end of the period only if part of the Insurance Expense balance is still unexpired. If option 2 is selected, then reversing entries are to be also made for all deferrals where the initial acquisition of the asset is recorded in an expense account. This particular procedure is not favoured by the authors, who believe that all assets should initially be recorded in asset accounts, as in the first case mentioned previously. If this procedure is followed, reversing entries for deferrals are unnecessary.

Applying similar reasoning, whenever precollected revenue is recorded in a liability account, e.g. subscriptions in advance, there is no need to apply reversing entries to any adjusting entries which are gradually reducing the liability over time. Nevertheless, if an entity initially records precollected revenue in an income (revenue) account, the entity may choose to use reversing entries for any adjusting entry made at the end of the period. As previously indicated, the authors favour the initial recognition of precollected revenue in a permanent account (liability), so there is no need for reversing entries in this situation. In computerised accounting systems, reversing entries can be programmed to be done automatically on the first day of the new accounting period.

If the adjusting entry is reversed, however, the receipt of cash for interest is simply recorded as a debit to Cash at Bank and a credit to Interest Revenue. In this case, reversing entries result in saving a great deal of time since an employee does not have to allocate each interest payment between two periods. As an additional example of accrued revenue where a reversing entry is useful, assume that Intellect Management Services normally receives $3200 (plus GST) on the fifteenth of each month for rent receivable in arrears on business premises in a shopping centre.

CHAPTER 6 Accounting for retailing 6.1 Inventory LEARNING OBJECTIVE 6 .1

Describe the nature of inventory and retailing operations. The term inventory is used in a retail operation to mean goods or property purchased and held for sale. Other assets held for future sale but not normally sold as part of regular business activities, such as an item of used office equipment that is no longer needed, are not included in the inventory category. Nor are stationery supplies regarded as inventory because they are not held for sale in the operating cycle of the business. Stock and stock in trade are commonly used terms for inventory. In conformity with accounting standard IAS 2/AASB 102 Inventories, the term ‘inventory’ is used in this text.

Retail business operations The operating cycle for a retail business is the average length of time it takes for the business to acquire inventory, sell that inventory to its customers and collect cash from those customers. At the time of purchase, inventory is recorded at cost. The cost of inventory available for future sale is reported in the balance sheet as a current asset. In the income statement, the cost of inventory sold during the current period is charged against the income (revenue) received from selling it. Determination of profit is a major objective of accounting for inventory. It involves determining the amount of the total inventory cost to be deducted from sales in the current period and the amount to be carried forward as an asset to be expensed in some future period. One of the major problems in accounting for inventory concerns the allocation of the costs of inventory over goods sold during a period and the goods held at the end of a period for sale in a future period. Inventory is one of the most active assets in a retail business. It is continually being acquired, sold and replaced. Inventories can also make up a significant part of a business’s total assets. The cost of sales for...