Both beginning and ending inventory amounts are crucial figures that affect a number of other financial metrics. To make sure these values are as accurate as possible, adjusting entries for closing inventory may be needed.
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Last Days of the Accounting Period
Mellany Baring, the accountant of Febros Trading Company, one of the biggest trading companies in Farlandville City, is busy with the final details of the financial reports that are to be submitted to the board of directors for additional information. The adjusting entries for accruals and deferrals are already submitted by the accounting staff so it is time to work on the closing entries and on the post-closing trial balance. Miss Baring understands that her work as an accountant does not end after the preparation of the financial statements. While the information relative to the performance or results of business operations and financial conditions are already relayed to the owner and other potential users, she still has to make a compliance of an accounting requirement - the 'closing of the books of accounts' - signalling the end of an accounting period and the preparation of the "post-closing trial balance." Her job is to ensure the arithmetical accuracy and correctness of the balances of accounts after the closing entry work has been done and to facilitate the preparation of the next accounting period. The closing of books of accounts at the end of the calendar year is also a governmental requirement for income tax and renewal of business taxes and permits purposes. We will take a look at her adjusting entries for closing inventory.
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Let Us Gaze into Some Previous Topics in Basic Accounting
Transactions are recorded by using the assigned account titles for Income Statement and Balance Sheet. The accounts in the Income Statement are called nominal accounts closed at the end of the accounting period. In large-scale business firms, however, adjusting and closing entries are prepared at the end of each month. Sometimes, adjusting entries are prepared on a monthly basis while closing entries are done at the end of the year. The Balance Sheet is composed of real accounts which are held open until such time that the business is closed.
By closing, this means that a nominal account which has an open balance will be reduced to "zero" balance.
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What is the Objective of Closing the Nominal Accounts and How Do We Close Them?
The inventory account comes in two forms: Beginning and Ending inventory. The beginning inventory figure is the amount of goods that were left unsold during the previous accounting period. This amount is added to the amount of purchases during the current accounting period in order to know the amount of goods available or open for sale to the public. The ending inventory figure, on the other hand, is the amount of goods left during the current period, counted physically by authorized personnel.
It is the beginning inventory that is closed at the end of the current year. In other words, the effect of closing the beginning inventory along with the other nominal accounts and the setting up of the ending inventory is the establishment of the gross margin for the period.
Let us look at the selected figures of the Febros Trading Company:
As a guide for closing the figures above, let us remember that the individual account has two sides - left and right. Left side is often called DEBIT and the right side is often called CREDIT. Closing the accounts means bringing the account balances to ZERO.
The following accounts have normal debit balances:
Sales Discounts $4,000
Sales Returns and Allowances $3,000
Merchandise Inventory, beginning $180,000
Freight In $1,000
Operating Expenses $69,660
And the following accounts have normal credit balances:
Purchase Discount $12,000
Purchase Returns and Discount $3,000
To close the revenue accounts:
Sales, Sales Returns & Allowances, and Sales Discount:
To close Sales is placing the amount of $270,000 at its left side. The Sales Discounts of $4,000 and Sales Returns and Allowances of $3,000 are placed at their respective right sides. The closing of these accounts results in the setting-up of the Income and Expense Summary placed at its left side with a corresponding amount of $263,000 computed as: $270,000 minus $4,000 and $3,000.
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Adjusting Entries for Closing Inventory
To continue with the adjusting entries for closing inventory, the next accounts to be closed are the accounts that compose the Cost of Sales: Purchases, Purchase Discounts, Purchase Returns & Allowances and Freight in.
The stated amounts of Purchases and Freight In with debits, or placed at their respective left sides, are placed at their respective right sides to bring these amounts to zero. The amounts of the Purchase Discounts and Purchase Returns & Allowances with credits, or placed at their respective right sides, are placed on their respective left sides to bring their amounts also to zero. As an additional step, the amount of the inventory counted physically at the end of the period totaling $253,000 is also placed at its left side. The result of these series of steps is the creation of the Income and Expense Summary amounting to $181,000. To clarify the corresponding computations, together this time with the amounts, they are computed as: Merchandise Beginning, $180,000; added to Purchases, $268,000; and Freight In, $1,000. So $180,000 plus $268,000 plus $1,000 equals $449,000. Merchandise Inventory, End, $253,000; Purchase Discounts, $12,000; and Purchase Returns & Allowances of $3,000 are deducted from $449,000, which will give us an amount of $181,000, representing the Income and Expense Summary account.
To compute the net profit and closing this amount to the owner's capital account, let us now focus on the Income and Expense Summary account. Based on the above discussion, we already have placed $181,000 and $263,000 at the Income and Expense Summary account's left side and right side, respectively. We will now place the amount of the operating expenses, $69,660, at the left side to compute how much is the ending balance. The amount of $12,340 is obtained by deducting $181,000 and $69,660 from $263,000. The amount of $12,340 is the net profit of the company, which is closed to the owner's capital account. If the capital has an existing balance of $897,400, its updated amount will now be $909,740, because if there is a net profit, the capital account is increased.
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Summary and Conclusion: What is the Effect of Closing the Inventory Account at the End of the Accounting Period?
The ultimate goal in preparing the income statement and balance sheet at the end of the accounting period is to know the results of operations for that period and the financial standing of the company. In obtaining the net profit at the end of the period, the setting up of adjusted balances is not enough. The accountant must close the nominal accounts or the income statement accounts to establish the following: Ending Inventory, which is forwarded to the balance sheet; Net Profit for the period; and the updated owner's capital account.
The closing of the inventory account is essential in the computation of the net profit.
Book and Image Credits:
Fundamentals of Accounting by Rafael M. Lopez, Jr. 2009-2010