ACCT 211 Week 8 Individual Learning Project Example

From Adjusted Trial Balance to Financial Statements: A Worked Individual Learning Project for a Small Retailer

Adjusted Balances Provided

The composite company, Harbor Outfitters, sells outdoor equipment. After adjusting entries, its accounts show sales of $1,250,000, sales returns and allowances of $25,000, cost of goods sold of $735,000, salaries of $180,000, rent of $48,000, depreciation of $30,000, utilities of $22,000, advertising of $35,000, insurance of $12,000, interest expense of $13,000 and income tax expense of $31,500. Beginning retained earnings were $210,000, and dividends declared were $40,000.

Multiple-Step Income Statement

Statement of Retained Earnings

Classified Balance Sheet

How the Statements Link

The three statements are connected in a fixed order, which is why preparing them in sequence prevents errors. Net income from the income statement is the only operating figure that enters retained earnings, so any error in revenue or expenses changes retained earnings and therefore the balance sheet. Dividends reduce retained earnings but never appear on the income statement, because they are distributions to owners rather than expenses. On the balance sheet, accumulated depreciation and the allowance for doubtful accounts are deducted from the assets they relate to, which is why equipment appears at $210,000 rather than $300,000. Accrued items such as wages, interest and income tax payable record obligations for costs already included on the income statement, so omitting an adjusting entry would understate both expenses and liabilities at once.

Reading the Statements

The statements balance, and a few ratios show what they mean. The current ratio is 3.39 ($324,000 / $95,500), so the company can comfortably meet short-term obligations. The debt ratio is 36.6% ($195,500 / $534,000), a moderate reliance on borrowing. Gross margin is 40.0% and profit margin 9.7%, and return on total assets is about 22.2% using year-end assets. Inventory represents about 70 days of cost of goods sold ($140,000 / $735,000 x 365), which deserves watching in a seasonal business, since winter gear bought in autumn ties up cash for months. Nissim and Penman (2001) show that ratios like these can be organized to explain how profitability is produced, separating margins from the efficiency with which assets are used. Ratios also carry predictive value: Altman (1968) found that a combination of liquidity, profitability, debt, solvency and activity ratios correctly classified most manufacturers that went bankrupt a year before failure, and Piotroski (2000) found that simple signals from financial statements separated stronger from weaker firms among value stocks. A balance sheet that balances proves the arithmetic; the ratios are what tell you whether the business is healthy.

Checklist Before Submitting

Before submitting, confirm that net income on the income statement matches the amount added in retained earnings, that ending retained earnings matches the balance sheet, that contra accounts are subtracted, that every current item truly turns over within a year and that total assets equal total liabilities and equity. Recomputing one or two totals by hand often catches a transposed digit that Connect would mark wrong.

References

Altman, E. I. (1968). Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. The Journal of Finance, 23(4), 589-609. https://doi.org/10.1111/j.1540-6261.1968.tb00843.x

Nissim, D., & Penman, S. H. (2001). Ratio analysis and equity valuation: From research to practice. Review of Accounting Studies, 6(1), 109-154. https://doi.org/10.1023/A:1011338221623

Piotroski, J. D. (2000). Value investing: The use of historical financial statement information to separate winners from losers. Journal of Accounting Research, 38, 1-41. https://doi.org/10.2307/2672906