Chapter 5, Problem 3AP

a.

To determine

Prepare an income statement, statement of retained earnings and balance sheet of Incorporation M for the year ended December 31, current year.

Answer to Problem 3AP

• Prepare the income statement of Incorporation M as on December 31, current year as follows:

Incorporation M
Income Statement
For the Year Ended December 31, Current Year
Particulars	$	$
Revenues:
revenue earned		52,000
Less: Expenses:
Insurance expense	$6,000
Office rent expense	9,000
Supplies expense	440
Salary expense	48,000
Depreciation expense of furniture & fixtures	1,400
Office and telephone expense	3,000
Internet service expense	4,900
Legal expense	1,500
Interest expense	4,000
Miscellaneous expense	5,000	83,240
Net Loss		31,240

Table (1)

• Prepare the statement of retained earnings of Incorporation M as on December 31, current year as follows:

Incorporation M
Statement of retained earnings
For the Year Ended December 31, Current Year
Particulars	$
Retained earnings as on January 1, Current Year	2,600
Less: Net Loss	31,240
Retained earnings as on December 31, Current Year	$28,640

Table (2)

• Prepare the Balance Sheet of Incorporation M as on December 31, current year as follows:

Incorporation M
Balance Sheet
December 31, Current Year
Assets	$	$
Cash		$960
Accounts receivable		300
Unexpired insurance		2,000
Prepaid rent		1,500
Supplies		200
Furniture & fixtures	8,400
Less: Accumulated depreciation of Furniture & fixtures	5,200	3,200
Total Assets		8,160
Liabilities
Accounts payable	$6,540
Notes payable	24,000
Salaries payable	1,700
Interest payable	360
Unearned revenue	200
Total Liabilities		32,800
Stockholders' Equity
Capital stock	4,000
Retained earnings -deficit	(28,640)
Total Stockholders' Equity		24,640
Total Liabilities and Stockholders' Equity		8,160

Table (3)

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.

Statement of retained earnings:

This statement reports the beginning retained earnings and all the changes which led to ending retained earnings. Net income from income statement is added to and dividends are deducted from beginning retained earnings to arrive at the end result, ending retained earnings.

Balance sheet:

This financial statement reports a company’s resources (assets) and claims of creditors (liabilities) and stockholders (stockholders’ equity) over those resources. 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.

b.

To determine

Prepare the year-end closing entries of Incorporation M.

Answer to Problem 3AP

Prepare the year-end closing entries of Incorporation M as follows:

Date	Accounts title and Explanation	Post Ref.	Debit ($)	Credit ($)
December 31	Client revenue Earned		52,000
	Income Summary			52,000
	(To record the closure of revenues account )
December 31	Income Summary		83,240
	Insurance Expense			6,000
	Office Rent Expense			9,000
	Supplies Expense			440
	Salaries Expense			48,000
	Depreciation Expense of Furniture & fixtures			1,400
	Office & Telephone Expense			3,000
	Internet Service Expense			4,900
	Legal Expense			1,500
	Interest Expense			4,000
	Miscellaneous Expense			5,000
	(To record the closure of expense account to income summary)
December31	Retained earnings		31,240
	Income Summary			31,240
	(To record the closure of net income from income summary to retained earnings)

Table (4)

Explanation of Solution

• Revenue Earned are the revenue account. Since the amount of revenue is closed, and transferred to retained earnings account, they are debited.
• Insurance Expense, Office Rent Expense, Supplies expense, Salaries Expense, Depreciation Expense, Office & Telephone Expense, Internet Service Expense, Legal Expense, Interest Expense, Miscellaneous Expense are the expense accounts. Since the amounts of expenses are closed to retained earnings account, they are credited.
• Since Retained Earnings account’s amount has decreased due to closing of Income Summary account to Retained Earnings account, stockholders’ equity amount has decreased. Therefore, debit Retained Earnings account with $31,240.
• Income Summary is a clearing account or temporary account used to close revenues and expenses to Retained Earnings account. Since Income Summary account has a debit balance, it is transferred to Retained Earnings account by crediting it. Therefore, credit Income Summary account with $31,240.

c.

To determine

Prepare an after-closing trial balance of Incorporation M.

Answer to Problem 3AP

Prepare an after-closing trial balance of Incorporation M as follows:

Incorporation M
After-Closing Trial Balance
December 31, Current Year
Particulars	$	$
Cash	$960
Accounts receivable	300
Unexpired insurance	2,000
Prepaid rent	1,500
Supplies	200
Furniture & fixtures	8,400
Accumulated depreciation of Furniture & fixtures		$5,200
Accounts payable		6,540
Notes payable		24,000
Salaries payable		1,700
Interest payable		360
Unearned client revenue		200
Capital stock		4,000
Retained earnings	28,640
Totals	42,000	42,000

Table (5)

Explanation of Solution

Post-Closing Trial Balance:

After passing all the journal entries and the closing entries of the permanent accounts and then further posting them to each of the respective accounts, a post-closing trial balance is prepared which consists of a list of all the permanent accounts. A post-closing trial balance serves as an evidence to prove that the balance of the permanent accounts is equal.

d.

To determine

Evaluate the performance of the company, using the financial statements prepared in requirement (a).

Explanation of Solution

• For $52,000 sales, the company has incurred a net loss of $31,240 for the year ended December 31. This indicates that the net loss has been incurred for 60% $\left(\frac{\text{\$31,240}}{\text{\$52,000}}\times \text{100}\right)$  of the total sales and also this indicates a deficit balance in stockholders’ equity, makes an interpretation that the return on equity is impossible. Therefore, the company appears to be extremely unprofitable.
• On the other hand, the balance sheet of the company reports cash and accounts receivable for $1,260. However the liabilities of the company report $32,800. Thus, this indicates the company may not currently be liquid even if the amount of note payable reported in the balance sheet is not due in the near future. Thus the company faces extreme shortfall with respect to its ability to make good on its current obligations.

e.

To determine

Identify the information that the company is apt to disclose in the notes that accompany the financial statements prepared in requirement (a).

Explanation of Solution

The company must inspect the following primary issues in the notes to the financial statements:

• Ability of the company (or)
• Lack thereof,
• To remain a going concern

In other words, the company should disclose how long it can stay afloat even in its desperate financial condition. The information regarding the note payable amount of $24,000 should also be disclosed. The information about the maker of the note and its due date and whether the note is secured by company assets everything must be disclosed.  Similarly, the company has to disclose information regarding the legal problems it faces.  The legal expenses that are reported in the income statement could suggest that one or more lawsuits are currently pending.