The operations of a company determines the shape of its income statement, an income statement presented of a trading or merchandising company is different with the income statement of a manufacturing company. There would be raw materials, work in process and finished goods with an income statement of a manufacturing company.
To find direct material available to use, add beginning inventory of direct material with purchasing direct material. Deduct direct material available to use with ending inventory of direct material to find direct material used.
Total manufacturing cost by adding direct material used with direct labor and manufacturing overhead. To find cost of goods manufactured by adding total manufacturing cost with beginning inventory of work in process and deduct with ending inventory of work in process.
Add cost of goods manufactured with beginning inventory of finished goods and deduct with ending inventory of finished goods, to find cost of goods sold. Sales deduct with cost of goods sold to find gross profit and net income before taxes result from gross profit deduct with operating expenses.
Those steps use within an income statement of a manufacturing company. The income statement of a trading or merchandising company looks more simplier because there is no raw materials and work in process. To find cost of goods sold of a trading or a merchandising company, add beginning inventory of merchandise with net purchase of merchandise and deduct with ending inventory of merchandise. Net sales deduct with cost of goods sold to find gross profit. Net income before taxes result from gross profit deduct with operating expenses.
No matter you work with an income statement of a trading or a merchandising company nor a manufacturing company, you have to prepare the accounts for the next period’s transactions which is known as the CLOSING PROCESS.
In the closing process, all of the revenue and expense account balances are transferred to an account called INCOME SUMMARY to clear. This process is used only at the end of yearly accounting period.
On closing process, all revenues and expenses are matched in the income summary account to get the net result of this matching which represents the net income or net loss for the period. The net income or net loss then be transferred to an owners’ equity account called retained earning for a corporation and capital account for proprietorship and partnerships.
A shop with the following balances at the end of the year
Revenue of sales $560,000
Rental revenue $50,000
Interest revenue $30,000
Cost of goods sold $309,000
Selling expenses $45,000
Administrative expenses $50,000
Interest expense $15,000
Income tax expense $25,000
Those revenue accounts would be closed with debit on
revenue of sales $560,000
rental revenue $50,000
interest revenue $30,000.
Credit with income summary $640,000 ($560,000 + $50,000 + $30,000)
Cost of goods sold account and those expense accounts should be closed with debit income summary $444,000 ($309,000 + $45,000 + $50,000 + $15,000 + $25,000) and credit on
cost of goods sold $309,000
selling expenses $45,000
administrative expenses $50,000
interest expense $15,000
income tax expense $25,000
Now, you have income summary from revenue $640,000 credit and income summary from cost of goods sold and expense $444,000 debit, as a result the income summary has a credit balance $196,000 ($640,000 credit minus $444,000 debit) which is the net income. This net income then be transferred to owners’ equity by closing the income summary account with debit on income summary $196,000 and credit $196,000 on retained earnings, if it is a corporation. Debit on income summary $196,000 and credit $196,000 on capital, if it is a proprietorship or patnership.
If the dividends $10,000 were declared and distributed during the year, the closing journal entry debit retained earning $10,000 and credit dividends $10,000
After the financial statement have been prepared and the books have been closed, it is often helpful to reverse some of the adjusting entries before recording the regular transactions of the next period. It is called REVERSING ENTRIES.
A reversing entries is made at the beginning of the next accounting period and is opposite of the related adjusting entry made in the previous period.
The purpose of reversing entries is to simplify the recording of transactions in the next accounting period. The use of reversing entries does not change the amounts reported in the financial statements for the previous period.
Expenses related to reversing entries
However there are conditions whether or not reversing entries are used, the entries are same. For example on date 24th Nov, a company pays salaries $18,000 incurred between 1st Nov till 24th Nov. The journal entry on date 24th Nov debit salaries expense $18,000 and credit cash $18,000
If salaries between 25th Nov till the end of Nov will be paid on 10th Dec, the adjusting journal entry for accrued expense on date 30th Nov debit salaries expense $4,500 (6 days / 24 days x $18,000) and credit salaries payable $4,500
Suppose the closing entries is applied on date 30th Nov, debit income summary $22,500 ($18,000 + $4,500) credit salaries expense $22,500
The entries on date 24th Nov and 30th Nov still same whether or not reversing entries are used by a company.
A company which does not use reversing entries need not to make any entry on date 1st Dec however on 10th Dec when a company pays the salaries, a company has to make journal entry debit salaries payable $4,500 and salaries expense for salaries incurred between 1st Dec till 10th Dec $7,500 (10 days / 24 days x $18,000). Credit cash $12,000 ($4,500 + $7,500)
If a company uses reversing entries, the journal entry on date 1st Dec as a reversing entry debit salaries payable $4,500 and credit salaries expense $4,500
Since a company uses reversing entries, the journal entry on 10th Dec debit salaries expense $12,000 ($4,500 + $7,500) credit cash $12,000
Prepayments related to reversing entries
The situation differs when a company buys some office supplies $25,000 on 10th Dec in cash, the journal entry whether or not using reversing entries are debit office supplies $25,000 and credit cash $25,000
On 31st Dec when office supplies on hand $10,000 the journal adjusting entry for a company without reversing entries are debit office supplies expense $15,000 ($25,000 – $10,000) and credit office supplies $15,000 to record the use of office supplies.
If a company use reversing entries, the adjusting journal debit office supplies $10,000 to record the rest of office supplies on hand, credit office supplies expense $10,000
Suppose the closing entries is applied on date 31st Dec, whether or not using reversing entries, the jounal for closing entries debit income summary $15,000 ($25,000 – $10,000) credit office supplies expense $15,000
A company which does not use reversing entries need not to make any entry on date 1st Jan however for a company which use reversing entries has to make journal reversing entry on date 1st Jan with debit office supplies expense $10,000 and credit office supplies $10,000 to reverse adjusting journal entry which is done on 31st Dec before closing entries.
Sometimes this practice is followed for items such as supplies and parts inventories that need to be apportioned over several periods. For items that do not follow this regular pattern and that may or may not involve two or more periods are ordinarily entered in revenue accounts or expense accounts. The revenue accounts and expense accounts may not require adjusting and systematically closed to Income Summary.
As guidelines for reversing entries
- All accrued items should be reversed.
- All prepaid items for which the cash was debited or credited to an expense account or revenue account should be reversed.
- Adjusting entries for depreciation and bad debts are not reversed.
You may know that some accountants avoid to use these reversing entries because the reversing entries do not have to be used.
Accrual basis of accounting
Most of companies use accrual basis to recognizing revenue when it is earned and recognizing expenses in the period incurred without regard to the time of receipt or payment of cash.
Cash basis of accounting
Some small enterprises and individual taxpayer use Modified Cash Basis Approach. Under cash basis, revenue is recorded when the cash is received and expenses are recorded when the cash is paid. The determination of income on cash basis rests upon the collection of revenue and the payment of expenses. Revenue recognition and the matching principle are ignored in cash basis. As a result, cash basis financial statement are not in conformity with General Accepted Accounting Principles (GAAP).
Today’s economy is lubricated by credit than by cash, accrual basis recognizes all aspects of the credit phenomenon. Investors, creditors and others seek timely information about enterprise’s future cash flows. Accrual basis provides this information by reporting cash inflows and outflows associated with earnings activities as soon as the cash flows can be estimated with an acceptable degree of certainty. Accrual basis aids in predicting future cash flows rather than when the cash is received and paid.
Modified Cash Basis Approach
The modified cash basis approach is a mixture of cash basis and accrual basis. This method often uses by service enterprises such as lawyers, doctors, architects, advertising agencies and public accountants. With this approach, expenditures having economic life of more than one year are capitalized as assets and depreciated over future years. Prepayments of expenses are deferred and deducted only in the year to which they apply, expenses paid after the year of incurrence or accrued expenses are deducted only in the year paid. Revenue is reported in the year of receipt, for tax purposes, individuals and personal businesses may use modified cash basis but this approach is prohibited to be used by corporations and any business in which inventory is a significant factor.
Any business in which inventory is a significant factor must use accrual basis accounting in reporting revenue from sales and cost of goods sold.
The aim of writing about income statement, process of closing and reversing entries to tell us that accounting is a recording process that must follow on specific rules and basis which is often using in an accounting processs report.
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