Chapter 3, Problem 3.6CP

1.

To determine

Identify the way in which Company E prepared its income statement and to explain the accounting basis was used.

Explanation of Solution

Cash basis of accounting:

Cash basis of accounting refers to the recognition of financial transactions only when the cash is received or paid.

Accrual basis of accounting:

Accrual basis of accounting refers to recognizing the financial transactions during the period in which the event occurs, even if the cash is not exchanged.

Company E has prepared its income statement based on the Cash basis of accounting. It is identified from the following fact, income collected rather than received, expenses are paid rather than incurred and the supplies are purchased rather than used.

• Company E can use accrual basis of accounting to recognize its incomes and the expenses to the accounting period in which they are received and incurred.

2.

To determine

Reconstruct the journal entries based on the accrual basis of accounting and post the effects to T-accounts.

Explanation of Solution

Journal:

Journal is the book of original entry. Journal consists of the day-to-day financial transactions in a chronological order. The journal has two aspects; they are debit aspect and the credit aspect.

Prepare the journal entries based on the accrual basis of accounting.

a. Record the journal entry for receiving the various contributions:

Date	Accounts title and explanation	Ref.	Debit ($)	Credit ($)
	Building (+A)		21,000
	Tools and equipment (+A)		17,000
	Land (+A)		20,000
	Cash (+A)		1,000
	Common stock (+SE)			1,000
	Additional paid-in capital (+SE)			58,000
	(To record the contributions received by the company)

Table (1)

• Building, tools and equipment, land, and cash are assets. There is an increase in the assets. Hence, debit building, tools and equipment, land, and cash accounts.
• Common stock is the component of stockholders’ equity. There is an increase in the common stock which increases the stockholders’ equity. Hence, credit the common stock account.
• Additional paid-in capital is a component of stockholders’ equity. There is an increase in the additional paid-in capital which increases the stockholders’ equity. Hence, credit additional paid-in capital.

b. Record the journal entry for service fee revenue:

Date	Accounts title and explanation	Ref.	Debit ($)	Credit ($)
	Cash (+A)		55,000
	Accounts receivable (+A)		52,000
	Unearned revenue (+L)			20,000
	Service fees revenue (+R, +SE)			87,000
	(To record the service fee revenue)

Table (2)

• Cash is an asset. There is an increase in the asset. Hence, debit cash account with $55,000.
• Accounts receivable is an asset. There is an increase in the asset. Hence, debit accounts receivable account with $52,000.
• Unearned revenue is a liability. There is an increase in the liability. Hence, credit unearned revenue account with $20,000.
• Service revenue is a revenue account which is a component of stockholders’ equity. There is an increase in the revenue account which increases the stockholders’ equity. Hence, credit service revenue account with $87,000.

c. No journal entry is recorded as the stock is not owned by the Company E.

d. Record the journal entry for the payment made for the operating expenses:

Date	Accounts title and explanation	Ref.	Debit ($)	Credit ($)
	Operating expenses (+E) (-SE)		61,000
	Accounts payable (+L)			39,000
	Cash (-A)			22,000
	(To record the payment of operating expenses)

Table (3)

• Operating expenses are the expense account which is a component of stockholders’ equity. There is an increase in the expense account which decreases the stockholders’ equity. Hence, debit the operating expenses with $61,000.
• Accounts payable is a liability. There is an increase in the liability. Hence, credit accounts payable with $39,000.
• Cash is an asset. There is a decrease in the asset. Hence, credit cash account with $22,000.

e. Record the journal entry for the payment of supplies expense:

Date	Accounts title and explanation	Ref.	Debit ($)	Credit ($)
	Supplies expenses (+E) (-SE) (1)		2,500
	Supplies (+A)		700
	Cash (-A)			3,200
	(To record payment of supplies expense)

Table (4)

• Supplies expenses are an expense account which is a component of stockholders’ equity. There is an increase in the expense account which decreases the stockholders’ equity. Hence, debit supplies expenses with $2,500.
• Supplies are an asset. There is an increase in the asset. Hence, debit supplies with $700.
• Cash is an asset. There is a decrease in the asset. Hence, credit cash with $3,200.

Working note:

Calculate the amount of supplies expenses to be recorded:

$\begin{array}{c}\text{Supplies expenses}=\text{Supplies purchases}-\text{Supplies at the end of the year}\\ =\$3,200-\$700\\ =\$2,500\end{array}$ (1)

Other entries:

1. Record the journal entry for the loss from theft:

Date	Accounts title and explanation	Ref.	Debit ($)	Credit ($)
	Loss from theft (+E) (–SE)		500
	Cash (-A)			500
	(To record the entry for loss from theft)

Table (5)

• Loss from theft is an expense account which is a component of stockholders’ equity. There is an increase in the expense account which decreases the stockholders’ equity. Hence, debit loss from theft with $500.
• Cash is an asset. There is a decrease in asset. Hence, credit cash with $500.

2. Record the journal entry for the purchase of tools and equipment:

Date	Accounts title and explanation	Ref.	Debit ($)	Credit ($)
	Tools and equipment (+A)		1,000
	Cash (-A)			1,000
	(To record the purchase of tools and equipment)

Table (6)

• Tools and equipment is an asset. There is an increase in the asset. Hence, debit tools and equipment with $1,000.
• Cash is an asset. There is a decrease in the asset. Hence, credit cash with $1,000.

Prepare the T-accounts:

T-account:

T-account is the form of the ledger account, where the journal entries are posted to this account. It is referred to as the T-account, because the alignment of the components of the account resembles the capital letter ‘T’.

The components of the T-account are as follows:

a) The title of the account

b) The left or debit side

c) The right or credit side

Cash account:

Cash account
Beginning balance	$0	(d)	$22,000
(a)	$1,000	(e)	$3,200
(b)	$55,000	(1)	$500
		(2)	$1,000
Ending balance	$29,300

Accounts receivable account

Accounts receivable account
Beginning balance	$0
(b)	$52,000
Ending balance	$52,000

Supplies account:

Supplies account
Beginning balance	$0
(e)	$700
Ending balance	$700

Building account:

Building account
Beginning balance	$0
(a)	$21,000
Ending balance	$21,000

Land account:

Land account
Beginning balance	$0
(a)	$20,000
Ending balance	$20,000

Tools and equipment account:

Tools and equipment account
Beginning balance	$0
(a)	$17,000
(2)	$1,000
Ending balance	$18,000

Accounts payable account:

Accounts payable account
		Beginning balance	$0
		(d)	$39,000
		Ending balance	$39,000

Unearned revenue account:

Unearned revenue account
		Beginning balance	$0
		(b)	$20,000
		Ending balance	$20,000

Common stock account:

Common stock account
		Beginning balance	$0
		(a)	$1,000
		Ending balance	$1,000

Additional paid-in capital account:

Accounts payable account
		Beginning balance	$0
		(a)	$58,000
		Ending balance	$58,000

Retained earnings account:

Retained earnings account
		Beginning balance	$0
		Ending balance	$0

Service fees revenue account:

Service fees revenue account
		Beginning balance	$0
		(b)	$87,000
		Ending balance	$87,000

Operating expenses account:

Operating expenses account
Beginning balance	$0
(d)	$61,000
Ending balance	$61,000

Supplies expense account:

Supplies expense account
Beginning balance	$0
(e)	$2,500
Ending balance	$2,500

Loss from theft account:

Loss from theft account
Beginning balance	$0
(1)	$500
Ending balance	$500

Hence, the T-accounts are prepared.

3.

To determine

Prepare an income statement on the accrual basis of accounting and explain the reason for each change using the footnote.

Explanation of Solution

Income statement:

The financial statement which reports revenues and expenses from business operations and the result of those operations as net income or net loss for a particular time period is referred to as income statement.

Prepare the income statement on the accrual basis of accounting:

Company E
(a) Income Statement
(b) For the Year Ended 31st December
Particulars	Amount ($)	Amount ($)
(c) Revenues:
(d) Service fees revenue	87,000
(e) Total revenues		87,000
(f) Costs and expenses:
(g) Operating expenses	61,000
(h) Supplies expense	2,500
(i) Loss from theft	500
(j)Total costs and expenses		64,000
(k) Net Income		23,000

Table (7)

Explanation for the change made in the income statement:

a. Give the standard title for the statement that is prepared (Income statement).

b. Give the date to indicate the time and the period that is covered in the statement that is prepared (For the year ended 31^st December).

c. Give the suitable title (Revenues).

d. Revenues earned rather than cash received should be identified.

e. Total of revenues should be calculated.

f. Give the suitable title (Costs and expenses).

g. Expenses incurred but the payment of cash is not made should be identified.

h. Supplies expenses that are used $2,500.

i. The amount that is lost during the theft should be recorded as the loss from theft as the amount is not covered under the insurance.

j. Give the suitable title (Total costs and expenses).

k. Net income is calculated.

4.

To determine

Explain the additional information that is to be assisted in formulating the decision regarding the loan to Person J.

Explanation of Solution

• In the above statement, Company E has not yet recorded the various adjustments that are to be made at the year-end which includes the depreciation and income taxes.
• Adjustment for the income tax should be made to know the effect for the future cash flows.
• The current market value of the land, building, and tools and equipment should be recorded for the purpose of making the loan decision.
• The stocks of ABC industrial are owned by the Person J and that is not owned by the company. Hence, those stocks can be used as the security for the purpose of taking loan.
• Personal assets also can be pledged for the purpose of loan.

5.

To determine

Write a memo to Person J.

Explanation of Solution

Memo

From,

XYZ

To,

Person J

Company E.

Dear Sir,

Sub: Decision that is made regarding the loan.

This is to inform you that your loan amount of $100,000 has been rejected based on the below criteria:

The current business seems to be profitable and there is an adequate cash to maintain its operation even if there is any additional expense that can be managed by the company. But looking into the financial statement of the company, the expected incomes, expenses and the various cash flows of the business that is expanded would be wanted to measure the future capability of the company.

There is no sufficient security is pledged against the loan. Present market values of the various assets are insufficient for accepting it as the security for the loan. If the additional information regarding the tools and equipment are provided, then that can be accepted as the security for the loan. The investments that are made personally can be used as the security for the loan. These are some of the common requirement for starting up the small business.

If the additional information regarding the current market value of the assets and the correct financial statements are provided, then the application can be reconsidered.

Regards,

XYZ

Loan application department,

Bank E.