Chapter 4, Problem 8CP

1.

To determine

Record the six adjusting entries required on December 31, 2015 which is based on the preceding additional information.

Answer to Problem 8CP

Record the six adjusting entries required on December 31, 2015:

Date		Account Title and Explanation	Debit ($)	Credit ($)
	a.	Supplies expense (+E, -SE) $(\$4,000-\$1,800)$	2,200
		Supplies (-A)		2,200
		(To record supplies expenses)
	b.	Insurance expense (+E, -SE) $(\frac{\$6,000}{2})$	3,000
		Prepaid insurance (-A)		3,000
		(To record insurance expense)
	c.	Depreciation expense (+E, -SE)	8,000
		Accumulated depreciation (+xA, -A)		8,000
		(To record the accumulated depreciation)
	d.	Salaries expense (+E, -SE)	3,200
		Salaries payable (+L)		3,200
		(To record the payment of salaries)
	e.	Transportation revenue (-R, -SE)	7,000
		Unearned transportation revenue (+L)		7,000
		(To record collection of unearned transportation revenue)
	f.	Income tax expense (+E, -SE)	5,110
		Income tax payable (+L)		5,110
		(To record income tax expense)

Table (1)

Explanation of Solution

Adjusting entries:

Adjusting entries are the journal entries which are recorded at the end of the accounting period to correct or adjust the revenue and expense accounts, to concede with the accrual principle of accounting.

a.

• Supplies 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 supplies expense with $2,200.
• Supplies are asset. There is a decrease in the asset. Hence, credit asset with $2,200.

b.

• Insurance 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 insurance expense with $3,000.
• Prepaid insurance is an asset. There is a decrease in the asset. Hence, credit asset with $3,000.

c.

• 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 $8,000.
• Accumulated depreciation is a contra-asset. There is a decrease in the asset. Hence, credit accumulated depreciation with $8,000.

d.

• Salaries 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 salaries expense with $3,200.
• Salaries payable is a liability. There is an increase in the liability. Hence, credit salaries payable with $3,200

e.

• Transportation revenue is revenue which is a component of stockholders’ equity. There is a decrease in the revenue account which decreases the stockholders’ equity. Hence, debit transportation revenue with $7,000.
• Unearned transportation revenue is a liability. There is an increase in the liability. Hence, credit unearned transportation revenue with $7,000

f.

• 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 $5,110.
• Income tax payable is a liability. There is an increase in the liability. Hence, credit, interest payable with $5,110.

Working notes:

Calculation of income tax expense:

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

$\begin{array}{c}\text{Income tax expense = Pretax income }\times \text{income tax rate}\\ \text{=\$14,600}\times \text{35\%}\\ \text{=\$5,110}\end{array}$

2.

To determine

Prepare the preceding statements after taking into account the adjusting entries.

Explanation of Solution

Prepare the preceding statements after taking into account the adjusting entries:

Corporation SM
Corrections to 2015 Financial Statements
			Changes
2015 Income Statement:	Amounts Reported ($)		Debit	Credit	Corrected Amounts ($)
Revenue:
Transportation revenue	85,000	e	7,000		78,000
Less: 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	5,110		5,110
Total expenses	47,000				68,510
Net income	38,000				9,490

Table (2)

Corporation SM
Corrections to 2015 Financial Statements
			Changes
December 31, 2015, Balance Sheet	Amounts Reported ($)		Debit	Credit	Corrected Amounts ($)
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
Remaining 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		5,110	5,110
Total current liabilities	9,000				24,310
Stockholders' Equity
Common stock	35,000				35,000
Retained earnings	38,000				9,490
Total stockholders' equity	73,000				44,490
Total liabilities and stockholders' equity	82,000				68,800

Table (3)

3.

To determine

Enter the amounts in the omission of the adjusting entries.

Explanation of Solution

Enter the amounts in the omission of the adjusting entries:

Omission of the adjusting entries caused:

1. (a) Net income to be overstated by $28,510.
2. (b) Total assets to be overstated by $13,200.
3. (c) Total liabilities to be understated by $15,310.

4.

To determine

Calculate earnings per share and total asset turnover ratio for both unadjusted and adjusted balances and to explain the causes of the differences and the impact of the changes on financial analysis.

Explanation of Solution

Calculation of earnings per share:

For Unadjusted:

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

For adjusted:

$\begin{array}{c}\text{Earnings}\text{per}\text{share = }\frac{\text{Net}\text{income}}{\text{Average number of shares of stock outstanding during the period}}\\ =\frac{\$9,490}{10,000\text{shares}}\\ =\$0.95\text{per share}\end{array}$

Calculation of total asset turnover:

For Unadjusted:

$\begin{array}{c}\text{Total asset turnover ratio }=\frac{\text{Sales}\text{revenues}}{\text{Average total assets}}\\ =\frac{\$85,000}{\frac{\left[0+\$82,000\right]}{2}}\\ =2.073\end{array}$

For Adjusted:

$\begin{array}{c}\text{Total asset turnover ratio }=\frac{\text{Sales}\text{revenues}}{\text{Average total assets}}\\ =\frac{\$78,000}{\frac{\left[0+\$68,800\right]}{2}}\\ =2.267\end{array}$

Explain the causes of the differences and the impact of the changes on financial analysis:

Both ratios were affected by presence of the adjustments with net income, revenue, and assets decreasing.

• For earnings per share, the numerator net income has been decreased while the denominator did not, resulting in a significantly lower figure.
• For the total asset turnover ratio, both the numerator and denominator have been decreased, but the denominator average total assets have been decreased more than the numerator revenues, causing an increase in the 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

Write a letter to the company explaining the results of the adjustments regarding analysis and decision about the loan as given below:

To

The Stockholders of Corporation SM

We regret to inform you that your plea for a $30,000 loan has been disavowed.

Our analysis showed that various adjustments were essential to the original set of financial statements provided to us.  The original financial statements overstated the net income for 2015 by $28,510$\left(\$38,000-\$9,490\right)$. This overstatement has been caused due to the erroneously including the amount $7,000 as revenue collected in advance that had not been earned in 2015. Additionally, all of the expenses incurred were also understated and income tax expense had been wrongly excluded.

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.  Though, the total liabilities were also understated by $15,310.

An assessment of key financial ratios shows that the adjustments adversely affected the earnings per share, even though the total asset turnover increased from 2.073 to 2.267. However, the adjusted ratios should be compared with the other start-up companies that are operating the same industry.

We entail that there should be sufficient collateral pledged against the loan before we can approve it.  The current market value of the equipment should be able to provide additional collateral against which the loan could be protected. Your personal investments may also be considered feasible collateral if you are agreeable to sign an agreement pledging these assets as a collateral for the loan.  This is a common requirement for similar and small start-up businesses.

If you would like us to reassess your application, kindly provide us the current market values of any assets that you would pledge as collateral.

Regards,

XYZ