Problem 30 - Accounting

Question

From the following list, identify the accounts that should be closed to Income Summary at the end of the fiscal year under a perpetual inventory system: (a) Accounts Payable, (b) Advertising Expense, (c) Cost of Merchandise Sold, (d) Merchandise Inventory, (e) Sales, (f) Sales Discounts, (g) Sales Returns and Allowances, (h) Supplies, (i) Supplies Expense, (j) Terry Weaver, Drawing, (k) Wages Payable.

Step-by-Step Solution

Answer

Close Sales, Advertising Expense, Cost of Merchandise Sold, Sales Discounts, Sales Returns and Allowances, and Supplies Expense to Income Summary.

Step 1: Identify Revenue Accounts

Revenue accounts are typically closed to the Income Summary account at the end of the fiscal year. Among the provided options, 'Sales' (47) is a revenue account and should be closed to Income Summary.

Step 2: Identify Expense Accounts

Expense accounts are closed to the Income Summary account as they need to be cleared for the new accounting period. From the list, 'Advertising Expense' (62), 'Cost of Merchandise Sold', and 'Supplies Expense' (69) are expenses that should be closed to Income Summary.

Step 3: Identify Returns and Allowances

Sales Returns and Allowances and Sales Discounts are considered contra-revenue accounts, which means they also need to be closed to Income Summary. Therefore, both Sales Discounts and Sales Returns and Allowances should be closed.

Step 4: Exclude Permanent Accounts

Permanent accounts such as Accounts Payable, Merchandise Inventory, Supplies, and Wages Payable do not close to Income Summary. They balance forward to the next period.

Step 5: Consider Owner's Drawings

Owner's Drawings, like 'Terry Weaver, Drawing', are closed to the owner's capital account, not the Income Summary. Hence, it should not be included in the accounts to close to Income Summary.

Key Concepts

Understanding Revenue Accounts

Revenue accounts are fundamental to tracking the income generated by a business from its operational activities. At the fiscal year's end, these accounts are closed to prepare the financial records for the next period. This closure involves transferring the balances to the Income Summary account. This process clears the revenue accounts of their balances, ensuring they start fresh for the new accounting period.
Revenue accounts typically include anything that contributes to the total sales of goods or services. In the context of the original exercise, the 'Sales' account is a direct example. Once the revenue is recorded, it affects the company's net income, representing the organization's profitability. It is essential to properly manage and close these accounts to get a clear picture of the business's performance over the fiscal year.
This closing entry is a pivotal step in the accounting cycle, helping to summarize the fiscal outcomes before the next cycle begins.

Deciphering Expense Accounts

Expense accounts reflect all consistent costs incurred while running a business. They are crucial for understanding where funds are spent and how they affect the overall profit. At the end of the financial year, similar to revenue accounts, expense accounts are closed to the Income Summary account to reset the balances for the upcoming period. This closure helps in determining the net income of the business by offsetting revenues against these expenses.
In the exercise, accounts like 'Advertising Expense', 'Cost of Merchandise Sold', and 'Supplies Expense' are cited as expenses to be closed. When closed to Income Summary, these accounts allow the accurate measurement of profitability by reflecting the total costs incurred over the period. Understanding these accounts helps in identifying areas where cost management can be optimized, thus enhancing future profitability prospects.

Explaining the Perpetual Inventory System

The perpetual inventory system is a method used to continuously track inventory levels in real time via computerized systems. This approach updates inventory records with every purchase or sale, providing instant insights into stock availability.
Under a perpetual inventory system, the Cost of Merchandise Sold is continually updated, reflecting the direct link with sales activities. This system allows a more precise calculation of the cost of goods sold and inventory position at any point in time, which aids in informed decision-making and inventory management.
Implementing this system helps businesses maintain accurate stock levels, reduce the risk of overstock or stockouts, and improve overall inventory control. This method's ability to continuously update inventory records helps businesses keep track of stock more efficiently compared to the periodic inventory system.

Details About Contra-revenue Accounts

Contra-revenue accounts are unique accounts used to reduce the total revenue, ultimately affecting net income. They provide transparency by separately tracking reductions in revenue due to returns, allowances, and discounts.
In the exercise, 'Sales Discounts' and 'Sales Returns and Allowances' are identified as contra-revenue accounts that need to be closed to the Income Summary. These accounts do not represent costs in themselves but rather adjustments to the revenue figure, making it more accurate. They are closed at the end of the period because they need to be offset against revenue to determine the net sales.
Understanding contra-revenue accounts is essential for accurately calculating an organization's net income by acknowledging any deductions from gross revenue. This provides a more realistic view of the company’s revenue performance.