Chapter 5, Problem 5.1CON

Evaluating the Impact of Transactions on Statement Categories and Ratios

After completing her first year of operations. Penny Cassidy used a number of ratios to evaluate the performance of Penny's Pool Service & Supply. Inc., She was particularly interested in the effects of the following transactions from the last quarter;

1. a. Paid herself a dividend of $10,000 as the sole stockholder.
2. b. Recorded advance payments from customers of $2,000.
3. c. Paid the current month's rent in cash. $500.
4. d. Purchased a new truck for $14,000 and signed a note payable for the whole amount. The truck was not placed in service until January 2015.
5. e. Recorded depreciation expense on office equipment of $600.
6. f. Accrued interest expense on the note payable to the bank was $400.

Required:

(Hint: Construct the journal entry for each transaction before evaluating itseffect.)

I. Complete the following table, indicating the effects of each transaction on each financial statement category listed. Indicate the amount and use + for increase, − for decrease, and NE for no effect.

Transaction	Gross Profit	Operating Income (I.oss)	Current /Assets
a.
etc.

2. Complete the following table, indicating the sign of the effects of each transaction on the financial ratio listed. Use + for increase, −for decrease, and NE for no effect.

Transaction	Net Profit Margin	Total /Asset Turnover	Return on Assets
a.
etc.

To determine

Complete the tabulation by indicating (+ for increase, -for decrease and NE for no effect), for the effect of the transactions on gross profit, operating income, and return on assets.

Answer to Problem 5.1CON

Preparation of a table showing the effects of transaction on gross profit, operating income and current assets as given below:

Effects of transaction on the listed category of financial statement
Transaction	Gross Profit	Operating income	Current assets
a. Paid herself a dividend of $10,000 as the sole stockholder.	NE	NE	($10,000)
b. Recorded advance payments from customers of $10,000.	NE	NE	$2,000
c. Paid the current month’s rent in cash, $500.	NE	($500)	($500)
d. Purchased a new truck for $14,000 and signed a note payable for the whole amount. The truck was not placed in service until January 2015.	NE	NE	NE
e. Recorded depreciation expense on office equipment of $600.	NE	($600)	NE
f. Accrued interest expense on the note payable to the bank was $400.	NE	NE	NE

Table (1)

Explanation of Solution

Current asset: Current asset are those assets which can be easily converted into cash. These assets should be consumed within a year or operating cycles whichever is less.

Gross Profit or Gross Margin: Gross Profit is the difference between the net sales, and the cost of goods sold. Gross profit usually appears on the income statement of the company.

Operating income: Operating income refers to the income generated from the operation of business, or the revenue generated from the services offered by the company. Operating income is also known as Income before tax.

The effects on the transaction can be explained as follows:

a. Paid herself a dividend of $10,000 as the sole stockholder.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Retained earnings (−SE)		$10,000
	Cash (−A)			$10,000
	( To record the payment of dividend)

Table (2)

• Retained earnings are a component of stockholders’ equity. Payment of dividend decreases the balance of retained earnings. Thus, it is debited with $10,000.
• Cash is a current asset. Payment of cash dividend decreases the cash account by $10,000. Thus, cash is credited with $10,000.

b. Recorded advance payments from customers of $2,000.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Cash (+A)		$2,000
	Deferred revenue (+L)			$2,000
	( To record the cash received from customers as advance payment)

Table (3)

• Cash is a current asset. Receipt of advance payment from the customers increase the cash account by $2,000. Thus, cash is credited with $2,000.
• Deferred revenue is a liability. Advance payment of cash from customers increases the liabilities. Hence, it is credited with $2,000.

c. Paid the current month’s rent in cash, $500.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Rent expense (+E, −SE)		$500
	Cash (−A)			$500
	( To record the payment of rent expense for the current month)

Table (4)

• Rent expense is a component of income statement that decreases the net income by $500. Thus, rent expense is debited with $500.
• Cash is a current asset. Payment of cash decreases the balance of cash account. Hence, it is credited with $500.

d. Purchased a new truck for $14,000 and signed a note payable for the whole amount. The truck was not placed in service until January 2015.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Equipment (Truck) (+A)		$14,000
	Note payable (+L)			$14,000
	( To record the payment of rent expense)

Table (5)

• Equipment (Truck) is an asset. Purchase of equipment (truck) increases the asset by $14,000. Thus, it is debited with $14,000.
• Note payable is a liability. Purchase of equipment (truck) through the issuance of note payable increases the liability by $14,000. Hence, it is credited with $14,000.

e. Recorded depreciation expense on office equipment of $600.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Depreciation expense (+E, −SE)		$600
	Accumulate depreciation (−A)			$600
	( To record the payment of depreciation expense)

Table (6)

• Depreciation expense is a component of income statement that decreases the net income by $600. Thus, depreciation expense is debited with $600.
• Accumulated depreciation is a contra asset. There is an increase in accumulated depreciation that decreases the value of asset. Hence, it is credited with $600.

f. Accrued interest expense on the note payable to the bank was $400.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Interest expense (+E, −SE)		$400
	Interest payable (+L)			$400
	( To record the accrued interest expense on note payable)

Table (7)

• Interest expense is a component of income statement that decreases the net income by $400. Thus, interest expense is debited with $400.
• Interest payable is a current liability. There is an increase in the liability and hence, it is credited with $400.

To determine

Complete the tabulation by indicating (+ for increase, -for decrease and NE for no effect), for the effect of the transactions on financial ratios.

Answer to Problem 5.1CON

Preparation of a table showing the effects of transaction on the undermentioned ratios as given below:

Effects of transaction on ratios
Transaction	Net profit margin	Total asset turnover	Return on assets
a. Paid herself a dividend of $10,000 as the sole stockholder.	NE	Increase	Increase
b. Recorded advance payments from customers of $10,000.	NE	Decrease	Decrease
c. Paid the current month’s rent in cash, $500.	Decrease	Increase	Decrease
d. Purchased a new truck for $14,000 and signed a note payable for the whole amount. The truck was not placed in service until January 2015.	NE	Decrease	Decrease
e. Recorded depreciation expense on office equipment of $600.	Decrease	Increase	Decrease
f. Accrued interest expense on the note payable to the bank was $400.	Decrease	NE	Decrease

Table (8)

Explanation of Solution

Net profit margin ratio: Net profit is the financial ratio that shows the relationship between the net profit and net sales (Operating revenue). Net profit is the difference between total operating revenue and total operating expenses. It can be calculated by dividing net profit and operating revenue. Net profit margin ratio can be calculated by using the following formula:

$\text{Net profit margin}=\frac{\text{Net income}}{\text{Net sales}}$

Total Asset turnover: Total asset turnover is a ratio that measures the productive capacity of the total assets to generate the sales revenue for the company. Thus, it shows the relationship between the net sales and the average total asset.

$\text{Total asset turnover}=\frac{\text{Net sales}}{\text{Average total assets}}$

Return on assets: Return on assets is the financial ratio which determines the amount of net income earned by the business with the use of total assets owned by it. It indicates the magnitude of the company’s earnings relative to its total assets. The formula is stated below:

$\text{Return on assets}=\frac{\text{Net income}}{\text{Average total assets}}$

The effects on the transaction can be explained as follows:

a. Paid herself a dividend of $10,000 as the sole stockholder.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Retained earnings (−SE)		$10,000
	Cash (−A)			$10,000
	( To record the payment of dividend)

Table (9)

• Retained earnings are a component of stockholders’ equity. Payment of dividend decreases the balance of retained earnings. Thus, it is debited with $10,000.
• Cash is a current asset. Payment of cash dividend decreases the cash account by $10,000. Thus, cash is credited with $10,000.

b. Recorded advance payments from customers of $2,000.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Cash (+A)		$2,000
	Deferred revenue (+L)			$2,000
	( To record the cash received from customers as advance payment)

Table (10)

• Cash is a current asset. Receipt of advance payment from the customers increase the cash account by $2,000. Thus, cash is credited with $2,000.
• Deferred revenue is a liability. Advance payment of cash from customers increases the liabilities. Hence, it is credited with $2,000.

c. Paid the current month’s rent in cash, $500.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Rent expense (+E, −SE)		$500
	Cash (−A)			$500
	( To record the payment of rent expense for the current month)

Table (11)

• Rent expense is a component of income statement that decreases the net income by $500. Thus, rent expense is debited with $500.
• Cash is a current asset. Payment of cash decreases the balance of cash account. Hence, it is credited with $500.

d. Purchased a new truck for $14,000 and signed a note payable for the whole amount. The truck was not placed in service until January 2015.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Equipment (Truck) (+A)		$14,000
	Note payable (+L)			$14,000
	( To record the payment of rent expense)

Table (12)

• Equipment (Truck) is an asset. Purchase of equipment (truck) increases the asset by $14,000. Thus, it is debited with $14,000.
• Note payable is a liability. Purchase of equipment (truck) through the issuance of note payable increases the liability by $14,000. Hence, it is credited with $14,000.

e. Recorded depreciation expense on office equipment of $600.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Depreciation expense (+E, −SE)		$600
	Accumulate depreciation (+XA, −A)			$600
	( To record the payment of depreciation expense)

Table (13)

• Depreciation expense is a component of income statement that decreases the net income by $600. Thus, depreciation expense is debited with $600.
• Accumulated depreciation is a contra asset. There is an increase in accumulated depreciation that decreases the value of asset. Hence, it is credited with $600.

f. Accrued interest expense on the note payable to the bank was $400.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Interest expense (+E, −SE)		$400
	Interest payable (+L)			$400
	( To record the accrued interest expense on note payable)

Table (14)

• Interest expense is a component of income statement that decreases the net income by $400. Thus, interest expense is debited with $400.
• Interest payable is a current liability. There is an increase in the liability and hence, it is credited with $400.