Chapter 5, Problem 5.4AP

1.

To determine

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

Answer to Problem 5.4AP

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

Effects of transaction on gross profit, operating income and return on assets
Transaction	Operating income (loss)	Net income	Return on  assets
a. Recorded and received additional interest income of $7.	NE	Increase	Increase
b. Purchased $80 of additional inventory on open account.	NE	NE	Decrease
c. Recorded and paid additional advertising expense of $16.	Decrease	Decrease	Decrease
d. Issued additional shares of common stock for $40 cash.	NE	NE	Decrease

Table (1)

Explanation of Solution

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.

Net income: Net income is the excess amount of revenue which arises after deducting all the expenses of a company. In simple terms, it is the difference between total revenue and total expenses of the company.

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. Recorded and received additional interest income of $7.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Cash (+A)		$7
	Interest income (+R)			$7
	( To record the receipt of interest income)

Table (2)

• Cash is a current asset. Receipt of interest income increases the balance of cash. Thus, it is debited with $7.
• Interest income is a component of stockholders’ equity. Interest income increases the stockholders’ equity by $7. Thus, it is credited with $7.

b. Purchased $80 of additional inventory on open account.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Inventory (+A)		$80
	Accounts payable (+L)			$80
	( To record the purchase of inventory on account)

Table (3)

• Inventory is a current asset. Purchase of inventory increases the asset account by $80. Thus, it is credited with $80.
• Accounts payable is a current liability. Purchase of inventory on account increases the liability account. Hence, it is credited with $80.

c. Recorded and paid additional advertising expense of $16.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Advertising expense (+E, −SE)		$16
	Cash (−A)			$16
	( To record the payment of rent expense for the current month)

Table (4)

• Advertising expense is a component of income statement that decreases the net income by $16. Thus, rent expense is debited with $16.
• Cash is a current asset. Payment of advertisement expense decreases the balance of cash account. Hence, it is credited with $16.

d. Issued additional shares of common stock for $40 cash.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Cash  (+A)		$40
	Common stock and additional paid-in capital  (+SE)			$40
	( To record the issuance of additional shares of common stock )

Table (5)

• Cash is a current asset. There is an increase in the balance of cash and hence, it is debited with $40.
• Common stock and additional paid-in capital is a component of stockholders’ equity. Issue of common stock and additional paid-in capital increases the balance of stockholders’ equity. Hence, it is credited $40.

2.

To determine

Explain the reasons if total assets increase by 5 percent, whether Incorporation A’s ROA of the next period be higher, lower, or the same as in the current period assuming that in the next period, Incorporation A does not pay any dividends, does not issue or retire stock, and earns 20 percent more than during the current period.

Answer to Problem 5.4AP

Preparation of table comparing the ROA of current year and next year as shown below:

Return on assets	Current Period	Future Period
$\text{Return on assets}=\frac{\text{Net income}}{\text{Average total assets}}$	$\begin{array}{l}=\frac{\text{\$514}}{\$7,804.5\left(1\right)}\\ =0.065\end{array}$	$\begin{array}{l}=\frac{\text{\$617}\left(2\right)}{\$7,928.5\left(4\right)}\\ =0.077\end{array}$

Table (6)

Working Note:

Determine the average total assets for the current period.

$\begin{array}{c}\text{Average total assets}=\frac{\left(\begin{array}{l}\text{Beginning }\\ \text{total assets}\end{array}\right)+\left(\begin{array}{l}\text{Ending }\\ \text{total assets}\end{array}\right)}{\text{2}}\\ =\frac{\$7,874+\$7,735}{2}\\ =\frac{\$15,609}{2}\\ =\$7,804.5\end{array}$ (1)

Determine the net income for the current period when the net income increases by 20%.

$\begin{array}{c}\begin{array}{l}\text{Net income for }\\ \text{the next period}\end{array}\}=\text{Net income }\times \left(1+\text{Rate of increase}\right)\\ =\$514\times \left(1+\frac{20}{100}\right)\\ =\$514\times 1.2\\ =\$617\end{array}$ (2)

Determine the ending total assets for the next period when the total assets increase by 5%.

$\begin{array}{c}\text{Total assets}=\text{Ending total assets }\times \left(1+\text{Rate of increase}\right)\\ =\$7,735\times \left(1+\frac{5}{100}\right)\\ =\$7,735\times 1.05\\ =\$8,122\end{array}$ (3)

Determine the average total assets for the future period.

$\begin{array}{c}\text{Average total assets}=\frac{\left(\begin{array}{l}\text{Beginning }\\ \text{total assets}\end{array}\right)+\left(\begin{array}{l}\text{Ending }\\ \text{total assets}\end{array}\right)}{\text{2}}\\ =\frac{\$7,735+\$8,122\left(3\right)}{2}\\ =\frac{\$15,857}{2}\\ =\$7,928.5\end{array}$ (4)

Explanation of Solution

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:

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

From Table (6), Incorporation A’s ROA would increase over the ROA that has earned in the current period because both the numerator and denominator would be increased by 20% and 5% respectively. In this situation, the net income is increasing at a higher rate than average total assets which results higher ROA in the next period.