Chapter 3, Problem 2E

Exercise 3-2 Comparing a merchandising company with a service company

The following information is available for two different types of businesses for the 2018 accounting year. Hopkins CPAs is a service business that provides accounting services to small businesses. Sports Clothing is a merchandising business that sells sports clothing to college students.

Data for Hopkins CPAs

1. Borrowed $90,000 from the bank to start the business.

2. Provided $60,000 of services to clients and collected $50,000 cash.

3. Paid salary expense of $32,000.

Data for Sports Clothing

1. Borrowed $90,000 from the bank to start the business.

2. Purchased $60,000 inventory for cash.

3. Inventory costing $26,000 was sold for $50,000 cash.

4. Paid $8,000 cash for operating expenses.

Required

a. Prepare an income statement, balance sheet, and statement of cash flows for each of the companies.

b. Which of the two businesses would have product costs? Why?

c. Why does Hopkins CPAs not compute gross margin on its income statement?

d. Compare the assets of both companies. What assets do they have in common? What assets are different? Why?

To determine

Prepare an income statement, balance sheet and statement of cash flows for each of the companies.

Explanation of Solution

Income statement: This statement reports revenues and expenses from business operations and the result of those operations as net income or net loss. Net income is the positive difference between revenues and expenses. If the difference between revenues and expenses is negative, it results in net loss.

Prepare income statement for H CPAs:

H CPAs
Income Statement
For the Year Ended December 31, 2018
Particulars	Amount
Revenue
Service Revenue	$60,000
Expenses
Salaries Expense	($32,000)
Net Income	$28,000

Table (1)

Prepare income statement for S Clothing:

S Clothing
Income Statement
For the Year Ended December 31, 2018
Particulars	Amount
Net Sales Revenue	$50,000
Less: Cost of goods sold	($26,000)
Gross margin	$24,000
Expenses:
Operating expenses	($8,000)
Net Income	$16,000

Table (2)

Balance sheet: This financial statement reports a company’s resources (assets) and claims of creditors (liabilities) and stockholders (stockholders’ equity) over those resources, on a specific date. The resources of the company are assets which include money contributed by stockholders and creditors. Hence, the main elements of the balance sheet are assets, liabilities, and stockholders’ equity.

Prepare balance sheet for H CPAs:

H CPAs
Balance Sheet
As of December 31, 2018
Assets
Cash (1)	$118,000
Total Assets		$118,000
Liabilities
Notes Payable	$90,000
Total Liabilities		$90,000
Stockholders’ Equity
Retained Earnings	$28,000
Total Stockholders’ Equity		$28,000
Total Liabilities and Stockholders’ Equity		$118,000

Table (3)

Prepare balance sheet for S Clothing:

S Clothing
Balance Sheet
As of December 31, 2018
Assets
Cash (2)	$72,000
Merchandised Inventory (1)	$34,000
Total Assets		$106,000
Liabilities
Notes Payable	$90,000
Total Liabilities		$90,000
Stockholders’ Equity
Retained Earnings	$16,000
Total Stockholders’ Equity		$16,000
Total Liabilities and Stockholders’ Equity		$106,000

Table (4)

Working note:

(1) Calculate the amount of cash account for H CPAs:

$\begin{array}{c}\text{Cash account = }\left[\left(\begin{array}{l}\text{Borrowed amount + }\\ \text{Collected amount of cash}\end{array}\right)-\text{Paid amount of salaries}\right]\\ \text{= }\left[\left(\text{\$90,000 + \$60,000}\right)-\text{\$32,000}\right]\\ =\$150,000-\$32,000\\ =\$118,000\end{array}$

(2) Calculate the amount of cash account for S Clothing:

$\begin{array}{c}\text{Cash account = }\left[\left(\begin{array}{l}\text{Borrowed amount + }\\ \text{Sold inventory for cash}-\\ \text{Paid amount of operating expenses}-\\ \text{Purchased inventory for cash}\end{array}\right)\right]\\ \text{=}\left(\$90,000+50,000-\$8,000-\$60,000\right)\\ =\$72,000\end{array}$

(3) Calculate the amount of merchandised account for S Clothing:

$\begin{array}{c}\text{Merchandised account = }\left(\begin{array}{l}\text{Sold amount of inventory}\\ -\text{Cost of inventory}\end{array}\right)\\ =\left(\$60,000-\$26,000\right)\\ =\$34,000\end{array}$

Statement of cash flows: Statement of cash flows reports all the cash transactions which are responsible for inflow and outflow of cash and result of these transactions is reported as ending balance of cash at the end of reported period. Statement of cash flows includes the changes in cash balance due to operating, investing, and financing activities.

Prepare statement of cash flows for H CPAs:

H CPAs
Statement of Cash Flows
For Year Ended December 31, 2018
Cash Flows From Operating Activities:
Cash Inflow from Clients	$50,000
Cash Outflow for Salaries	($32,000)
Net Cash Flow from Operating Activities		$18,000
Cash Flows From Investing Activities		$0
Cash Flows From Financing Activities:
Cash Inflow  from Loan	$90,000
Net Cash Flow from Financing Activities		$90,000
Net Increase in Cash		$108,000
Add: Beginning Cash Balance		$0
Ending Cash Balance		$108,000

Table (5)

Prepare statement of cash flows for S Clothing:

S Clothing
Statement of Cash Flows
For Year Ended December 31, 2018
Cash Flows From Operating Activities:
Cash Inflow from Customers	$50,000
Cash Outflow for Inventory	($60,000)
Cash Outflow for Expenses	($8,000)
Net Cash Used for Operating Activities		($18,000)
Cash Flows From Investing Activities		$0
Cash Flows From Financing Activities:
Cash Inflow  from Loan	$90,000
Net Cash Flow from Financing Activities		$90,000
Net Increase in Cash		$72,000
Add: Beginning Cash Balance		$0
Ending Cash Balance		$72,000

Table (6)

To determine

Determine which business have product cost.

Explanation of Solution

Product costs: The costs are incurred to acquire the merchandise, ship the stock, prepare the merchandise for sale, and store the inventory are collectively referred to as product costs or inventory costs.

S Clothing business is considered as a merchandising business because it has inventory and the goods are sold. Hence, S Clothing business has product cost. However, H CPAs is a service oriented business and that firm does not have product costs.

To determine

Determine the why H CPAs does not compute gross margin on its income statement.

Explanation of Solution

H CPAs is a service oriented business and that firm does not have product costs. Hence, H CPAs does not require computing gross margin on its income statement. However, it only has selling and administrative expense (period expense).

To determine

Compare the assets of both the companies and explain the common assets and different asset of both the companies.

Explanation of Solution

Comparison of the common assets and different asset of given the companies:

• The common asset for both companies is Cash.
• Cash is the only asset that H CPAs hold it.
• S Clothing has cash plus inventory as an asset.
• H CPAs not having any inventory and does not sell.
• S Clothing sells products and must carry inventory available for sale to customers.