Chapter 4, Problem 4.2COMP

Recording Transactions (Including Adjusting and Closing Entries), Preparing Financial Statements, and Performing Ratio Analysis

Josh and Kelly McKay began operations of their furniture repair shop (Furniture Refinishers, Inc.) on January 1, 2016. The annual reporting period ends December 31. The trial balance on January 1, 2017. was as follows:

Account Titles	Debit	Credit
Cash	5,000
Accounts receivable	4,000
Supplies	2,000
Small tools	6,000
Equipment
Accumulated depreciation (on equipment)
Other assets (not detailed to simplify)	9,000
Accounts payable		7,000
Notes payable
Wages payable
Interest payable
Income taxes payable
Unearned revenue

To determine

Prepare T-accounts for the accounts on the trial balance and enter beginning balances.

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:

(a)The title of the account

(b)The left or debit side

(c)The right or credit side

Prepare the T-account (amounts in thousands):

Cash (A) account
Beginning Balance	5	b	18
a	20	e	28
c	5	f	3
d	56	h	11
g	8
j	3	k	10
Ending Balance	27

Accounts Receivable (A) account
Beginning Balance		4
d		14		g		8
Ending Balance		10
Supplies (A) account
Beginning Balance		2
i		10		l		8
Ending Balance		4
Small tools (A) account
Beginning Balance	6
f	3
Ending Balance	8

Equipment (A) account
Beginning Balance b	0 18
Ending Balance	18

Accumulated depreciation (xA) account
		Beginning Balance	0
		m	2
		Ending Balance	2
Other assets (A) account
Beginning Balance	9
Ending Balance	9
Accounts payable (L) account
h	11	Beginning Balance	7
		e	7
		i	10
		Ending Balance	13
Notes  payable (L) account
		Beginning Balance	0
		a	20
		Ending Balance	20
Wages payable (L) account
		Beginning Balance	0
		o	3
		Ending Balance	3

Interest payable (L) account
		Beginning Balance	0
		n	1
		Ending Balance	1
Income taxes  payable  (L) account
		Beginning Balance	0
		p	4
		Ending Balance	4

Unearned revenue  (L) account
		Beginning Balance	0
		j	3
		Ending Balance	3
Common Stock (SE) account
		Beginning Balance	6
		c	1
		Ending Balance	7
Additional paid-in capital account
		Beginning Balance	9
		c	4
		Ending Balance	13

Retained earnings (SE) account
		Beginning Balance	4
k	10
		Closing entry	16
		Ending Balance	10

Service Revenue (R) account
		Balance	0
Closing entry	70	d	70
		Ending Balance	0

Depreciation expense (E) account
Balance	0
m	2	Closing entry	2
Ending Balance	0

Income Tax Expense ( E) account
Balance	0
p	4	Closing entry	4
Ending Balance	0

Interest Expense ( E) account
Balance	0
n	1	Closing entry	1
Ending Balance	0
Remaining Expense ( E) account
Balance	0
e	35
l	9	Closing entry	44
Ending Balance	0

Wages Expense (E) account
Balance	0
o	3	Closing entry	3
Ending Balance	0

To determine

Record Journal entries for transactions (a) to (k).

Explanation of Solution

Journal entries for the transactions (a) to (k) as follows:

Date	Account Title and Explanation	Debit ($)	Credit ($)
a)	Cash (+A)	20,000
	Notes payable (Short-term) (+L)		20,000
	(To record borrowed cash on note)
b)	Equipment (+A)	18,000
	Cash (-A)		18,000
	(To record purchase of equipment)
c)	Cash (+A)	5,000
	Common Stock (+SE)		1,000
	Additional paid-in capital (+SE)		4,000
	(To record issued common stock for cash and additional paid in capital)
d)	Cash (+A)	56,000
	Accounts Receivable (+A)	14,000
	Service Revenue (+R, +SE)		70,000
	(To record service revenue earned during the year 2017)
e)	Remaining expenses (+A)	35,000
	Accounts payable (+L)		7,000
	Cash (-A)		28,000
	(To record Purchase of remaining expenses)
f)	Small tools (+A)	3,000
	Cash (-A)		3,000
	(To record other assets)
g)	Cash (+A)	8,000
	Accounts Receivable (-A)		8,000
	(To record cash collected on customer’s account)
h)	Accounts payable (-L)	11,000
	Cash (-A)		11,000
	(To record cash paid to creditors)
i)	Supplies (+A)	10,000
	Accounts payable  (+L)		10,000
	(To record supplies purchased for future use)
j)	Cash (+A)	3,000
	Unearned revenue (+L)		3,000
	(To record unearned revenue)
k)	Retained earnings (-SE)	10,000
	Cash (-A)		10,000
	(To record retained earnings)

Table (1)

To determine

Record Adjusting journal entries (l) to (p).

Explanation of Solution

Prepare adjusting journal entries (l) to (p):

Date	Account Title and Explanation	Debit ($)	Credit ($)
l.	Remaining  expense (+E, -SE)	9,000
	Supplies(-A) $(\$12,000-\$4,000)$		8,000
	Small tools (-A) $(\$9,000-\$8,000)$		1,000
	(To record the use of supplies and small tools)
m.	Depreciation expense (+E, -SE)	2,000
	Accumulated depreciation – (+xA, -A)		2,000
	(To record adjusting entry for depreciation expense)
n.	Interest expense (+E, -SE) $(\$20,000\times \frac{10}{100}\times \frac{6}{12})$	1,000
	Interest payable(+L)		1,000
	(To record the adjusting entry for interest expense)
o.	Wages expense (+E, -SE)	3,000
	Wages payable (+L)		3,000
	(To record the adjusting entry for wages expenses)
p.	Income tax expense(+E, -SE)	4,000
	Income tax payable(+L)		4,000
	(To record the adjusting entry for income tax expense)

Table (2)

l.

• Remaining expense is an expense account which is a component of stockholders equity. There is an increase in the expense which decreases the stock holders’ equity. Hence, debit remaining expense with $9,000.
• Supplies are asset. There is a decrease in the asset. Hence, credit asset with $8,000.
• Small tools are asset. There is a decrease in the asset. Hence, credit asset with $1,000.

m.

• Depreciation expense is an expense account which is a component of stockholders’ equity. There is an increase in expense account which decreases the stockholders’ equity. Hence, debit depreciation expense with $2,000.
• Accumulated depreciation is a contra-asset. There is a decrease in the asset. Hence, credit accumulated depreciation with $2,000.

n.

• Interest expense 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 interest expense with $1,000.
• Interest payable is a liability. There is an increase in the liability. Hence, credit wages with $1,000.

o.

• Wages expense is an expense account which is a component of stockholders equity. There is an increase in the expense which decreases the stock holders’ equity. Hence, debit wages expense with $3,000.
• Wages payable is a liability. There is an increase in the liability. Hence, credit wages payable with $3,000.

p.

• Income tax expense is an expense account which is a component of stock holders’ equity. There is an increase in the expense account which decreases the stockholders’ equity. Hence, debit interest expense with $4,000.
• Income tax payable is a liability. There is an increase in the liability. Hence, credit, interest payable with $4,000.

To determine

Prepare an income statement, Statement of stockholders’ equity and balance sheet.

Explanation of Solution

Prepare an income statement for the year ended December 31, 2017:

Incorporation FR
Income statement
For the year ended December 31, 2017
Particulars	Amount ($)
Revenues:
Service revenue	70,000
Total revenues	70,000
Less: Expenses
Depreciation expense	2,000
Wages expense	3,000
Remaining expense	44,000
Total operating expenses	21,000
Operating income	53,000
Less: Other item
Interest expense	1,000
Pretax income	20,000
Less: Income tax expense	4,000
Net income	16,000
Earnings per share$(\frac{\$16,000}{70,000\text{shares}})$	$0.23

Table (3)

Incorporation FR net income is $16,000.

Prepare a statement of Stockholders’ equity:

Incorporation FR
Statement of stockholders’ equity
For the year ended December 31, 2017
Particulars	Common Stock	Additional Paid-in Capital	Retained earnings	Total Stockholders' Equity
Balance, January 1, 2017	$6,000	$9,000	$4,000	$19,000
Additional stock issuance	1,000	4,000		5,000
Net income			16,000	16,000
Dividends declared			(10,000)	(10,000)
Balance, December 31, 2017	$7,000	$13,000	$10,000	$30,000

Table (4)

Prepare a balance sheet for the year December 31, 2017:

Incorporation FR
Balance Sheet
At December 31, 2017
Assets	Amount ($)	Liabilities and Stockholders’ Equity	Amount ($)
Current Assets:		Current Liabilities:
Cash	27,000	Accounts payable	13,000
Accounts receivable	10,000	Notes payable	20,000
Supplies	4,000	Interest payable	1,000
Small tools	8,000	Wages payable	3,000
		Income taxes payable	4,000
		Unearned revenue	3,000
Total current assets	49,000	Total current liabilities	44,000
Land	13,000	Stockholders' Equity:
Equipment	18,000	Common stock	7,000
Less: Accumulated depreciation	(2,000)	Additional paid-in capital	13,000
Net book value	16,000	Retained earnings	10,000
Other assets	9,000	Total stockholders' equity	30,000
Total assets	74,000	Total liabilities and stockholders' equity	74,000

Table (5)

The balance sheet agrees with the $74,000 of both assets and liabilities columns.

To determine

Identify the type of transaction for (a) to (k) for the statement of cash flows and the direction and the amount of the effect.

Explanation of Solution

Identify the type of transaction for (a) to (k) for the statement of cash flows and the direction and the amount of the effect:

Transaction	Type of Effect on Cash Flows	Direction and Amount of Effect
a.	F	+20,000
b.	I	-18,000
c.	F	+5,000
d.	O	+56,000
e.	O	-28,000
f.	O	-3,000
g.	O	+8,000
h.	O	-11,000
i.	NE	NE
j.	O	+3,000
k.	F	-10,000

Table (6)

Statement of cash flow:

A statement that shows the inflows and outflows of cash or cash equivalents is known as a cash flow statement. A cash flow statement includes the following three components.

1. 1. Cash flows from operating activities:

These are the cash produced by the normal business operations.

The following amounts are to be adjusted from the Net Income to calculate the cash flows from the operating activities.

• Deduct increase in current assets.
• Deduct decrease in current liabilities.
• Add decrease in current assets.
• Add the increase in current liability.
• Add depreciation expense.
• Add loss on sale of plant assets.
• Less gain on sale of plant assets.

1. 2. Cash flows from investing activities:

These are the amount of cash used for the purchase of any fixed assets, and any cash receives from the sale of fixed assets.

• Deduct the amount of cash used to purchase any fixed assets from cash flows from investing activities to calculate the net cash provided or used for investing activities.
• Add the amount of cash received from the sale of any fixed assets to cash flows from investing activities to calculate the net cash provided or used from investing activities.

1. 3. Cash flows from financing activities:

These are the sources of finance of the business.

• Add the amount of cash received from any source of finance like amount from stockholders, debenture holders, or from any fixed liability to the cash flows from financing activities to calculate the net cash used or provided by the financing activities.
• Deduct the payment of dividend and interest from the cash flows from financing activities to calculate the net cash used or provided by the financing activities.
• Deduct the amount of cash paid to purchase the treasury stocks from the cash flows from financing activities to calculate the net cash used or provided by the financing activities.

Note:

I refer to investing activity.

F refers to financing activity.

O refers to operating activity.

NE refers to no effect.

To determine

Prepare the closing entry for Incorporation FR on December 31, 2017.

Explanation of Solution

Prepare closing entries for Incorporation FR on December 31, 2017:

Date	Account Title and Explanation	Debit ($)	Credit ($)
December 31, 2017	Service revenue(-R)	70,000
	Retained earnings(+SE)		16,000
	Depreciation expense(-E)		2,000
	Interest expense (-E)		1,000
	Income tax expense(-E)		4,000
	Wages expense(-E)		3,000
	Remaining expense(-E)		44,000
	(To record the closing entries for Incorporation FR)

Table (7)

For closing of temporary accounts, the balances of revenues, expenses, and dividend accounts will be transferred to retained earnings in order to bring zero balance for expenses and revenues accounts.

To determine

Compute Current ratio, Total asset turnover and net profit margin and explain the results to suggest about the Company FR.

Explanation of Solution

1. (a) Calculation of current ratio:

$\begin{array}{c}\text{Current ratio=}\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$49,000}{\$44,000}\\ =1.11:1\end{array}$

The current ratio is 1.11:1.

For Incorporation FR, suggests that their current ratio is having sufficient current assets to pay current liabilities.

1. (b) Calculation of total asset turnover:

$\begin{array}{c}\text{Total asset turnover ratio }=\frac{\text{Sales}\text{revenues}}{\text{Average total assets}}\\ =\frac{\$70,000}{(\frac{\$26,000+\$74,000}{2})}\\ =\frac{\$70,000}{\$50,000}\\ =1.40\end{array}$

For Incorporation FR, suggests that the total asset turnover ratio has generated $1.40 for every dollar of assets.

1. (c) Calculation of net profit margin:

$\begin{array}{c}\text{Net profit margin = }\frac{\text{Net income }}{\text{Sales}}\\ =\frac{\$16,000}{\$70,000}\\ =0.23\end{array}$

For Incorporation FR, suggests that the net profit margin earns $0.23 for every dollar in sales that it generates.