Problem 32 - Accounting

Question

On October 31, 2008, the balances of the accounts appearing in the ledger of Kavanaugh Company, a furniture wholesaler, are as follows: \(\begin{array}{lrlr}\text { Accumulated Dep. -Building } & \$ 152,300 & \text { Notes Payable } & \$ 120,000 \\ \text { Administrative Expenses } & 326,500 & \text { Salaries Payable } & 3,400 \\ \text { Building } & 278,400 & \text { Sales } & 1,567,700 \\ \text { Cash } & 44,200 & \text { Sales Discounts } & 90,000 \\ \text { Cost of Merchandise Sold } & 940,000 & \text { Sales Returns and Allow. } & 60,000 \\ \text { Interest Expense } & 9,600 & \text { Sales Tax Payable } & 24,500 \\ \text { Lillian Kavanaugh, Capital } & 705,775 & \text { Selling Expenses } & 620,000 \\ \text { Lillian Kavanaugh, Drawing } & 39,750 & \text { Store Supplies } & 22,900 \\ \text { Merchandise Inventory } & 130,000 & \text { Store Supplies Exp. } & 12,325\end{array}\) Prepare the October 31, 2008, closing entries for Kavanaugh Company.

Step-by-Step Solution

Answer

Close revenue, expense, Income Summary, and Drawing accounts to reset for the next period.

Step 1: Identify Revenue Accounts

Close all revenue accounts to the Income Summary account. In this case, the revenue account is Sales, which has a balance of \(1,567,700\). Prepare the closing entry by debiting Sales and crediting Income Summary.

Step 2: Identify Expense Accounts

Close all expense accounts to the Income Summary account. The expense accounts are Administrative Expenses (\(326,500\)), Cost of Merchandise Sold (\(940,000\)), Interest Expense (\(9,600\)), Selling Expenses (\(620,000\)), and Store Supplies Expense (\(12,325\)). Prepare the closing entry by debiting Income Summary and crediting each expense account.

Step 3: Calculate Net Income or Loss

Calculate the net income or loss by finding the difference between total revenues and total expenses. Revenues are \(1,657,700\) (considering Sales, Sales Discounts, and Sales Returns) and expenses are the total of the amounts from Step 2. The income summary will show the net effect.

Step 4: Close Income Summary to Capital

Close the Income Summary account to Lillian Kavanaugh, Capital. If the company has net income, credit Lillian Kavanaugh, Capital and debit Income Summary. If there's a net loss, reverse the entry.

Step 5: Close Drawing to Capital

Close the Lillian Kavanaugh, Drawing account to Lillian Kavanaugh, Capital. Prepare the closing entry by crediting Drawing and debiting Capital for the amount of \(39,750\).

Key Concepts

Revenue Accounts

Revenue accounts are where a business records its sales activities. In the case of Kavanaugh Company, the primary revenue account is labeled as 'Sales'. This account reflects the total revenue generated by the company from selling its products or services. For the closing process, it is crucial to transition these revenues out of the temporary revenue account into a more permanent one, such as the Income Summary account. By doing so, the revenues are effectively "closed" at the end of an accounting period.

To close the revenue account, you would typically debit the Sales account to bring its balance to zero. This credit is then transferred into the Income Summary account. For Kavanaugh Company, the corresponding entry is prepared by debiting the 'Sales' account by its balance of $1,567,700 and crediting the 'Income Summary' account by the same amount.

To sum it up, the main goal of closing a revenue account is to start the new period without remnants of past revenues, capturing a fresh start for the new cycle.

Expense Accounts

Expense accounts are crucial as they record the costs incurred during a period to earn revenues. At Kavanaugh Company, multiple expense categories such as Administrative Expenses, Cost of Merchandise Sold, and others reflect these costs. Expense accounts, just like revenue accounts, are temporary and need to be zeroed out at the end of each period.

To close expense accounts, each one must be credited for the balance it carries, which transfers the cost information into the Income Summary account. This process ensures that all recorded expenses are summed up, providing a holistic view of the total costs the business undertook to generate revenue.

For example, if Administrative Expenses for Kavanaugh Company amounted to $326,500, you would credit this account and debit the Income Summary account accordingly. By closing these expense accounts, Kavanaugh Company prepares them for the upcoming period while painting a precise picture of its expenditures in the closing period.

Income Summary

The Income Summary account acts as a unique intermediary that helps transition information from temporary accounts to permanent ones. It paves the way from monthly operations to summarizing financial outcomes like net income or loss. After closing all revenue and expense accounts into it, the Income Summary serves as a calculation hub for determining the financial performance for the period.

Once revenues and expenses have been carried over, the balance in the Income Summary reveals the net effect—net income or loss. This figure is pivotal as it indicates whether the business was profitable or not over the period. For Kavanaugh Company, calculating this involves compiling entries from both revenue and credits and various debited expenses.

After this calculation, the balance in the Income Summary needs to be transferred to the owner’s capital account, further solidifying its role in summarizing the business's operations.

Net Income or Loss

The concept of net income or loss is critical for gauging how well the business performed financially over the accounting period. It is derived from subtracting total expenses from total revenues. If Kavanaugh Company's total revenues exceed its total expenses, it will result in a net income. Conversely, if expenses outweigh revenues, the company faces a net loss.

This figure is not just a number; it tells the story of the company's profitability within that timeframe. In the closing entries, the calculated net income is transferred from the Income Summary to the Capital account, increasing the owner’s equity, while a net loss would do the opposite.

For Kavanaugh Company, this process involves evaluating the amounts collected in the Income Summary following all revenue and expense transfers. Adjusting the Capital account according to this result ensures that financial statements reflect an accurate position of the company's operations.