Chapter 4, Problem 8CP

1.

To determine

Record the adjusting entries in the books of Corporation ZM required on December 31, 2020.

Explanation of Solution

Record the adjusting entries in the books of Corporation ZM required on December 31, 2020.

Date		Account Title and Explanation	Debit ($)	Credit ($)
	a.	Supplies Expense (+E, –SE) $(\$4,000-\$1,800)$	2,200
		Supplies (–A)		2,200
		(Record supplies expenses)
	b.	Insurance Expense (+E, –SE) $\left(\frac{\text{\$6,000}}{\text{2 years}}\right)$	3,000
		Prepaid Insurance (–A)		3,000
		(Record insurance expense)
	c.	Depreciation Expense (+E, –SE)	8,000
		Accumulated Depreciation (+XA, –A)		8,000
		(Record accumulated depreciation)
	d.	Salaries Expense (+E, –SE)	3,200
		Salaries Payable (+L)		3,200
		(Record payment of salaries)
	e.	Transportation Revenue (–R, –SE)	7,000
		Unearned Transportation Revenue (+L)		7,000
		(Record part of unearned transportation revenue earned)
	f.	Income Tax Expense (+E, –SE)	3,650
		Income Tax Payable (+L)		3,650
		(Record income tax expense)

Table (1)

Working Notes:

Calculate pretax income.

$\begin{array}{c}\text{Pretax income = Transportation revenues }-\text{Expenses}\\ \text{=}\left[\begin{array}{l}\left(\text{\$85,000}-\$7,000\right)-(\$47,000+\$2,200+\\ \$3,000+\$8,000+\$3,200)\end{array}\right]\\ =\left[\$78,000-\$63,400\right]\\ =\$14,600\end{array}$

Calculate income tax expense.

$\begin{array}{c}\text{Income tax expense = Pretax income }\times \text{Income tax rate}\\ \text{=\$14,600}\times 2\text{5\%}\\ \text{=\$3,650}\end{array}$

2.

To determine

Prepare the income statement and balance sheet after considering the adjusting entries.

Explanation of Solution

Prepare the income statement after considering the adjusting entries.

Corporation ZM
Corrections to 2020 Income Statements
2020 Income Statement:	Amounts Reported ($)	Changes			Corrected Amounts ($)
			Debit	Credit
Revenue:
Transportation revenue	$85,000	e	7,000		$78,000
Expenses:
Salaries expense	17,000	d	3,200		20,200
Supplies expense	12,000	a	2,200		14,200
Other expenses	18,000				18,000
Insurance expense	0	b	3,000		3,000
Depreciation expense	0	c	8,000		8,000
Income tax expense	0	f	3,650		3,650
Total expenses	47,000				67,050
Net income	$38,000		$27,050		$10,950

Table (2)

Prepare the balance sheet after considering the adjusting entries.

Corporation ZM
Corrections to 2020 balance Sheet
December 31, 2020, Balance Sheet	Amounts Reported		Changes		Corrected Amounts
			Debit	Credit
Assets:
Current Assets:
Cash	$2,000				$2,000
Receivables	3,000				3,000
Supplies	4,000	a		2,200	1,800
Prepaid insurance	6,000	b		3,000	3,000
Total current assets	15,000				9,800
Equipment	40,000				40,000
Less:  Accumulated depreciation	0	c		8,000
Other assets	27,000				27,000
Total assets	82,000				68,800
Liabilities:
Current Liabilities:
Accounts payable	9,000				9,000
Salaries payable	0	d		3,200	3,200
Unearned transportation revenue	0	e		7,000	7,000
Income tax payable	0	f		3,650	3,650
Total current liabilities	9,000				22,850
Stockholders' Equity:
Common stock	30,000				30,000
Retained earnings	43,000		27,050		15,950
Total stockholders' equity	73,000				45,950
Total liabilities and stockholders' equity	82,000				68,800

Table (3)

3.

To determine

Fill the blanks with the omitted amounts of the adjusting entries.

Explanation of Solution

Fill the blanks with the omitted amounts of the adjusting entries.

Omission of the adjusting entries caused:

1. (a)  Net income to be overstated by $27,050.
2. (b)  Total assets to be overstated by $13,200.
3. (c)  Total liabilities to be understated by $13,850.

4.

To determine

Ascertain (a) earnings per share and (b) total asset turnover ratio for both unadjusted and adjusted balances, explain the causes of the differences, and mention the impact of the changes on financial analysis.

Explanation of Solution

Calculate earnings per share.

For Unadjusted balance:

$\begin{array}{c}\text{Earnings}\text{per}\text{share = }\frac{\text{Net}\text{income}}{\text{Average number of shares of stock outstanding during the period}}\\ =\frac{\$38,000}{10,000\text{shares}}\\ =\$3.80\text{per share}\end{array}$

For adjusted balance:

$\begin{array}{c}\text{Earnings}\text{per}\text{share = }\frac{\text{Net}\text{income}}{\text{Average number of shares of stock outstanding during the period}}\\ =\frac{\$10,050}{10,000\text{shares}}\\ =\$1.10\text{per share}\end{array}$

Calculate total asset turnover.

For Unadjusted balance:

$\begin{array}{c}\text{Total asset turnover ratio }=\frac{\text{Sales}\text{revenues}}{\text{Average total assets}}\\ =\frac{\$85,000}{\frac{\$46,400+\$82,000}{2}}\\ =\frac{\$85,000}{\$64,200}\\ =1.32\end{array}$

For Adjusted balance:

$\begin{array}{c}\text{Total asset turnover ratio }=\frac{\text{Sales}\text{revenues}}{\text{Average total assets}}\\ =\frac{\$78,000}{\frac{\$46,400+\$68,800}{2}}\\ =\frac{\$78,000}{\$57,600}\\ =1.35\end{array}$

Causes of the differences and its impact of the changes on financial analysis:

• Both ratios were affected by the adjustments included in net income, revenue, and assets decreasing. 
• The decrease in net income and no change in denominator resulted in a lower earnings per share.
• The decrease in sales revenue and decrease in average total assets resulted an increase in the total asset turnover ratio. 

5.

To determine

Write a letter to the company explaining the results of the adjustments regarding analysis and decision about the loan.

Explanation of Solution

To,

The Stockholders of Corporation ZM,

We regret to inform you that your plea for the requested loan has been disapproved.

Our analysis showed that the adjustments were required adjust the original unadjusted set of financial statements.  The unadjusted financial statements that were provided showed an overstated net income of $27,050$\left(\$38,000-\$10,950\right)$. This was because a $7,000 revenue collected in advance which was not earned in 2020 was included as revenue in 2020 financial statements. The overstatement of net income was also due to understated expenses and exclusion of income tax expense.

Total assets amounting to $13,200 $\left(\$82,000-\$68,800\right)$ were also overstated. Supplies worth $2,200, prepaid insurance amounting to $3,000, and the net book value of the equipment amounting to $8,000 were also overstated because the annual depreciation expense was not recognized appropriately.  The total liabilities were also understated by $13,850.

An assessment of key financial ratios shows that the adjustments adversely affected the earnings per share, even though the total asset turnover increased from 1.32 to 1.35. However, the adjusted ratios should be compared with the other similar companies that are operating the same industry.

As per bank rules a substantial security should be pledged for the approval of the loan.  The equipment should have a current market value which would be worth to provide security for the loan. The personal investments would be counted as collateral if the companies agree to pledge the assets as security for the loan. So, kindly provide the details of current market of the assets for further processing of the loan.

Regards,

Ms J