Question:

You are an analyst. The industry you are covering is having a difficult time with over-capacity and slow growth. One of your target companies, MUSTSURVIVE (in short, MS), is trying to survive in this difficult period. MUSTSURVIVE just reported its financial statements and the results were much better than your expectation. You suspect that, however, MUSTSURVIVE manipulated its accounts aggressively to report better earnings. Specifically, you believe MUSTSURVIVE 1) increased its sales by 20,000 by selling on credit; 2) delayed necessary write-offs of goodwill (non-current assets) of 40,000; 3) changed a depreciation period assumption from 5 years to 10 years, resulting in a reduction of depreciation expense by 5,000.

Assume MUSTSURVIVEs gross profit margin is 50%, marginal tax rate is 20%, and write-offs and depreciation expense are tax deductible expenses.

Required:

Describe necessary accounting adjustments for MUSTSURVIVE to reflect its true performance for the period.

Answer:

Increase in sales by 20,000

Debit sales 20,000; credit accounts receivable 20,000

Debit inventory 10,000; credit COGS 10,000

Debit deferred tax liabilities 2,000; credit tax expense 2,000

Debit retained earnings 8,000; credit net income 8,000 (clearing)

Delayed write off of goodwill of 40,000

Debit expense 40,000; credit goodwill 40,000

Debit deferred tax liabilities 8,000; credit tax expense 8,000

Debit retained earnings 32,000; credit net income 32,000 (clearing)

Reduction in depreciation expense by 5,000

Debit depreciation expense 5,000; credit accumulated depreciation 5,000

Debit deferred tax liabilities 1,000; credit tax expense 1,000

Debit retained earnings 4,000; credit net income 4,000 (clearing) My question: I can't understand why you are meant to credit net income (clearing) to reduce the retained earnings. In my mind net income is an equity account, so crediting it would increase it? I asked a bot and it said that clearing accounts are used to balance entries, if this is the case can you explain why? Is it because net income is not an actual income account where you receive income, but just an adjustment that needs to be made? If so, can you explain the reasoning and logic behind the debit vs credit? I understand everything else regarding sales, inventory, taxes etc. It's literally just that last credit entry made while reducing the retained earnings which I am stuck on. Please explain in as much detail as possible as this one line is not clicking at all. Thank you!