Chapter 2, Problem 2.1CON

Accounting for the Establishment of a New Business (the Accounting Cycle)

Penny Cassidy has decided to start her business. Penny’s Pool Service & Supply, Inc. (PPSS). There is much to do when starting a new business. Here are some transactions that have occurred in the business in March.

1. a. Received $25,000 cash and a large delivery van with a value of $36,000 from Penny, who was given 4,000 shares of $0.05 par value common stock in exchange.
2. b. Purchased land with a small office and warehouse by paying $10,000 cash and signing a 10-year mortgage note payable to the local bank for $80,000. The land has a value of $18,000 and the building’s value is $72,000. Use separate accounts for land and buildings.
3. c. Purchased a new computer from Dell for $2,500 cash and office furniture for $4,000, signing a short-term note payable in six months.
4. d. Hired a receptionist for the office at a salary of $1,500 per month, starting in April.
5. e. Paid $1,000 on the note payable to the bank at the end of March (ignore interest).
6. f. Purchased short-term investments in the stock of other companies for $5,000 cash.
7. g. Ordered $10,000 in inventory from Pool Corporation, Inc., a pool supply wholesaler, to be received in April.

Required:

1. 1. For each of the events (a) through (g), prepare journal entries if a transaction of the business exists, checking that debits equal credits. If a transaction does not exist, explain why there is no transaction for the business.
2. 2. Create T-accounts, and post each of the transactions to determine balances at March 31. Because this is a new business, beginning balances are $0.
3. 3. Prepare a trial balance on March 31 to check that debits equal credits after the transactions are posted to the T-accounts.
4. 4. From the trial balance, prepare a classified balance sheet (with current assets and current liabilities sections) at March 31 (before the beginning of operations in April).
5. 5. For each of the events (a) through (g), indicate if it is an investing activity (I) or financing activity (F), and the direction (+ for increases; − for decreases) and amount of the effect on cash flows using the following structure. Write NE if there is no effect on cash flows.

	Type of Activity (I, F, or NE)	Effect on Cash flows (+ or − and amount)
(a)
(b) etc.

1. 6. Calculate the current ratio at March 31. What does this ratio indicate about the ability of PPSS to pay its current liabilities?

To determine

Prepare the journal entries for the given events.

Explanation of Solution

Journal:

Journal is the method of recording monetary business transactions in chronological order. It records the debit and credit aspects of each transaction to abide by the double-entry system.

Rules of Debit and Credit:

Following rules are followed for debiting and crediting different accounts while they occur in business transactions:

• Debit, all increase in assets, expenses and dividends, all decrease in liabilities, revenues and stockholders’ equities.
• Credit, all increase in liabilities, revenues, and stockholders’ equities, all decrease in assets, expenses.

Journal entries of Company P are as follows:

a. Issuance of common stock:

Date	Accounts title and explanation	Ref.	Debit ($)	Credit ($)
	Cash (+A)		25,000
	Equipment (+A)		36,000
	Common stock (+SE) (1)			200
	Additional paid-in capital (+SE) (2)			60,800
	(To record the issuance of common stock)

Table (1)

• Cash is an assets account and it increased the value of asset by $25,000. Hence, debit the cash account for $25,000.
• Equipment is an assets account and it increased the value of asset by $36,000. Hence, debit the equipment account for $36,000.
• Common stock is a component of stockholder’s equity and it increased the value of stockholder’s equity by $200. Hence, credit the common stock for $200.
• Additional paid-in capital is a component of stockholder’s equity and it increased the value of stockholder’s equity by $60,800. Hence, credit the additional paid-in capital for $60,800.

Working note:

Calculate the value of common stock

$\begin{array}{c}\text{Common stock =}\left(\text{ Number of share}\times \text{Par value per share}\right)\\ \text{=4,000 shares}\times \text{\$0}\text{.05}\\ \text{=\$200}\end{array}$ (1)

Calculate the value of additional paid in capital

$\begin{array}{c}\text{Additional paid-in capital = }\left(\begin{array}{l}\text{Total cash received}-\\ \text{Common stock value (1)}\end{array}\right)\\ =\left(\$61,000-\$200\right)\\ =\$60,800\end{array}$ (2)

b. Purchase of building and land on notes and in cash:

Date	Accounts title and explanation	Ref.	Debit ($)	Credit ($)
	Land (+A
	Building (+A)		18,000
	Cash (-A)		72,000	10,000
	Mortgage notes payable (+L)			80,000
	(To record purchase of land and building on note and in cash)

Table (2)

• Land is an assets account and it increased the value of asset by $18,000. Hence, debit the land account for $18,000.
• Building is an assets account and it increased the value of asset by $72,000. Hence, debit the building account for $72,000.
• Cash is an assets account and it decreased the value of asset by $10,000. Hence, credit the cash account for $10,000.
•  Mortgage notes payable is a liability account, and it increased the value of liabilities by $80,000. Hence, credit the mortgage notes payable for $80,000.

c. Purchase of equipment on notes and cash:

Date	Accounts title and explanation	Ref.	Debit ($)	Credit ($)
	Equipment (+A)		6,500
	Cash (-A)			2,500
	Short-term notes payable (+L)			4,000
	(To record purchase of equipment on account and in cash)

Table (3)

• Equipment is an assets account and it increased the value of asset by $6,500. Hence, debit the equipment account for $6,500.
• Cash is an assets account and it decreased the value of asset by $2,500. Hence, credit the cash account for $2,500.
• Short-term notes payable is a liability account, and it increased the value of liabilities by $4,000. Hence, credit the notes payable for $4,000.

d. Hiring of new employee:

In this case, journal entry is not required, because it is not a business transaction.

e. Cash paid to bank:

Date	Accounts title and explanation	Ref.	Debit ($)	Credit ($)
	Mortgage notes payable (+L)		1,000
	Cash (+A)			1,000
	(To record cash paid to creditors)

Table (4)

• Mortgage notes payable is a liability account, and it decreased the value of liabilities by $1,000. Hence, debit the mortgage notes payable for $1,000.
• Cash is an assets account and it decreased the value of asset by $1,000. Hence, credit the cash account for $1,000.

f. Purchase of short-term investment:

Date	Accounts title and explanation	Ref.	Debit ($)	Credit ($)
	Short-term investments (A+)		5,000
	Cash (-A)			5,000
	(To record purchase of short-term investment)

Table (6)

• Short-term investment is an assets account and it increased the value of asset by $5,000. Hence, debit the short-term investment account for $5,000.
• Cash is an assets account and it decreased the value of asset by $5,000. Hence, credit the cash account for $5,000.

g. Ordered inventory from Company PC:

In this case, journal entry is not required, because it is not a business transaction.

To determine

Prepare T-account for the given transaction.

Explanation of Solution

T-account:

T-account refers to an individual account, where the increases or decreases in the value of specific asset, liability, stockholder’s equity, revenue, and expenditure items are recorded.

This account is referred to as the T-account, because the alignment of the components of the account resembles the capital letter ‘T’.’ An account consists of the three main components which are as follows:

1. (a) The title of the account
2. (b) The left or debit side
3. (c) The right or credit side

T-accounts of company P are as follows:

Cash
Beg.	0
(a)	25,000	10,000	(b)
		2,500	(c)
		1,000	(e)
		5,000	(f)
	6,500

Short-term Investments
Beg.	0
(f)	5,000
	5,000

Equipment
Beg.	0
(a)	36,000
(c)	6,500

Land
Beg.	0
(b)	18,000
	18,000

Buildings
Beg.	0
(b)	72,000
	72,000

Short-term Notes Payable
		0	Beg.
		4,000	(c)
		4,000

Mortgage Notes Payable
		0	Beg.
(e)	1,000	80,000	(b)
		79,000

Common Stock
		0	Beg.
		200	(a)
		200

Additional Paid-in Capital
		0	Beg.
		60,800	(a)
		60,800

To determine

Prepare the trial balance of Company P on March, 31.

Explanation of Solution

Trial balance:

Trial balance is the summary of accounts, and their debit and credit balances at a given time. It is usually prepared at end of the accounting period.  Debit balances are listed in left column and credit balances are listed in right column.  The totals of debit and credit column should be equal.  Trial balance is useful in the preparation of the financial statements.

Trial balance of Company P is as follows:

Company P
Trial Balance
March, 31
Particulars	Debit ($)	Credit ($)
Cash	$6,500
Short-term investments	5,000
Equipment	42,500
Land	18,000
Buildings	72,000
Short-term notes payable		$4,000
Mortgage notes payable		79,000
Common stock		200
Additional paid-in capital		60,800
Totals	$144,000	$144,000

Table (7)

Therefore, the total of debit, and credit columns of trial balance is $144,000 and agree.

To determine

Prepare the classified balance sheet of Company P.

Explanation of Solution

Classified balance sheet:

This is the financial statement of a company which shows the grouping of similar assets and liabilities under subheadings.

Classified balance sheet of Company P on January, 31 is as follows:

Company P
Balance Sheet
On March 31
Assets	$	$
Current Assets:
Cash	6,500
Short-term investments	5,000
Total current assets		11,500
Equipment		42,500
Land		18,000
Buildings		72,000
Total assets		144,000
Liabilities and Stockholder’s Equity
Current Liabilities:
Short-term notes payable	4,000
Total current liabilities		4,000
Mortgage notes payable		79,000
Total liabilities		83,000
Stockholder’s Equity:
Common stock ($0.05 par value)		200
Additional paid-in capital		60,800
Total stockholder’s equity		61,000
Total liabilities and stockholder’s equity		144,000

Table (8)

Therefore, the total assets of Company P are $144,000, and the total liabilities and stockholders’ equity is $144,000.

To determine

Indicate whether each of given item is an investing (I) or financing (F), also indicate effect on the cash flow (+ for increase, – for decrease and NE for no effect).

Explanation of Solution

Statement of cash flows: Statement of cash flow is a financial statement that shows the cash and cash equivalents of a company for a particular period of time. It shows the net changes in cash, by reporting the sources and uses of cash as a result of operating, investing, and financing activities of a company.

Transaction	Type of Activity	Effect on Cash
(a) Issuance of common stock	Financing activity	Increased by $25,000
(b) Purchase of land and buildings	Investing activity	Decreased by $3,400
(c) Purchase of new equipment and office furniture	Investing activity	Decreased by $2,500
(d) Hiring of new employee	No effect	No effect
(e) Cash paid to bank on notes playable	Financing activity	Decreased by $1,000
(f) Purchase of short-term investment	Investing activity	Decreased by $5,000
(g) Ordered inventory from Company P	No effect	No effect

Table (9)

(a) Issuance of common stock: In this transaction, issuance of common stock is the finance source of the company, and it is cash inflow of the company. So, issuance common stock is reported under financing activity section of cash flow statement and it increased the value of cash by $25,000.

(b) Purchase of land and buildings: In this transaction, company purchased land and building for investing purpose, and it decreased the value of cash. So, purchase of land and building is reported under investing activity section of cash flow statement, and it decreased the value of cash by $10,000.

(c) Purchase of new equipment and office furniture: In this transaction, company purchased new equipment and office furniture for investing purpose, and it decreased the value of cash. So, purchase of equipment is reported under investing activity section of cash flow statement, and it decreased the value of cash by $2,500.

(d) Hiring of new employee: In this case, ordered wood and raw materials is not creating any impact on assets, liabilities and stockholder’s equity of the business, because it is not a business transaction.

(e) Cash paid to bank on notes playable: In this transaction, company paid loan amount to bank for financing purpose, and it is cash outflow of the company. So, cash paid to bank is reported under financing activity section of cash flow statement and it decreased the value of cash by $1,000

(f) Purchase of short-term investment: In this transaction, company purchased short-term investment for investing purpose, and it decreased the value of cash. So, purchase of short-term investment is reported under investing activity section of statement of cash flow, and it decreased the value of cash by $5,000.

(g) Ordered inventory from Company P: In this case, ordered inventory is not creating any impact on assets, liabilities and stockholder’s equity of the business, because it is not a business transaction.

To determine

Calculate the current ratio of Company P and evaluate the ratio.

Explanation of Solution

Current Ratio:

A part of liquidity ratios, current ratio reflects the ability to oblige the short term debts of a company. It is calculated based on the current assets and current liabilities; a company has in an accounting period. A current ratio is a useful tool for analysis of financials of a company.

Calculate the current ratio of Company P as follows:

Here,

Current assets = $11,500 (3)

Current liabilities= $4,000 (short-term notes payable)

$\begin{array}{c}\text{Current ratio=}\frac{\text{Current assets}}{\text{Current liabilities}}\\ \text{=}\frac{\text{ \$11,500}}{\text{\$4,000}}\\ \text{=2}\text{.875}\end{array}$

Therefore, the current ration of Company P is 2.875

In this case, Company P has more current assets than current liabilities. Therefore, Company P has better position to repay the current liabilities.

Working note:

Calculate the value of current assets

$\begin{array}{c}\text{Total current assets = }\left(\text{Cash+Short-term investment}\right)\\ =\left(\$6,500+\$5,000\right)\\ =\$11,500\end{array}$ (3)