Chapter 5, Problem 8P

To determine

Show the direction of effect of the following transaction on the under-mentioned ratios (+ for increase, -for decrease and NE for no effect).

Answer to Problem 8P

Prepare the effects of transaction on ratios as given below:

Effects of transaction on ratios
Transaction	Total Asset Turnover	Return on Assets	Gross Profit Percentage
a. Borrowed $3,000 on a line of credit with the bank.	Decrease	Decrease	No effect
b. Incurred salary expense of $1,000 paid for in cash.	Increase	Decrease	No effect
c. Provided $2,000 of services on account.	Increase	Increase	Increase
d. Purchased $700 of inventory on account.	Decrease	Decrease	No effect
e. Sold $500 of goods on account. The related cost of goods sold was $300. Gross profit margin was 45 percent before this sale.	Increase	Increase	Decrease

Table (1)

Explanation of Solution

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:

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

Gross Profit Percentage: Gross profit is the financial ratio that shows the relationship between the gross profit and net sales. It represents gross profit as a percentage of net sales. Gross Profit is the difference between the net sales revenue, and the cost of goods sold. It can be calculated by dividing gross profit and net sales.

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

The effects on the transaction can be explained as follows:

a. Borrowed $3,000 on a line of credit with the bank.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Cash (+A)		$3,000
	Note payable (+L)			$3,000
	( To record the borrowing on a line of credit)

Table (2)

• Cash is a current asset. Issue of note payable increases the cash account by $3,000. Thus, cash is debited with $3,000.
• Note payable is a liability. Borrowing of note payable increases the balance of cash. Thus, note payable is credited with $3,000.

b. Incurred salary expense of $1,000 paid for in cash.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Salary expense (+E, -SE)		$1,000
	Cash (-A)			$1,000
	( To record the payment of salary expense)

Table (3)

• Salary expense is a component of income statement that decreases the net income by $1,000. Thus, salary expense is debited with $1,000.
• Cash is a current asset. Payment of expenses decreases the balance of cash account. Hence, it is credited with $1,000.

c. Provided $3,000 of services on account.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Account receivable (+A)		$2,000
	Service revenue(+R, +SE)			$2,000
	( To record the services provided on account)

Table (4)

• Accounts receivable is a current asset. Service provided on account increases the balance of accounts receivable. Hence, it is debited with 2,000.
• Service revenue is a component of stockholders’ equity. Service revenue is an income that increases the balance of stockholders’ equity. Hence, it is credited with $2,000.

d. Purchased $700 of inventory on account.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Inventory (+A)		$700
	Accounts payable (+L)			$700
	( To record the purchase of inventory on account)

Table (5)

• Inventory is a current asset. Purchase of inventory increases the balance of inventory. Thus, inventory is debited with $700.
• Accounts payable is a current liability. Purchase of inventory on account increases the balance of accounts payable. Thus, accounts payable is credited with $700.

e. Sold $500 of goods on account. The related cost of goods sold was $300. Gross profit margin was 45 percent before this sale.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Accounts receivable(+A)		$500
	Sales revenue (+R, +SE)			$500
	( To record the sales on account )

Table (6)

• Accounts receivable is a current asset. Account Sales increases the balance of accounts receivable. Thus, accounts receivable is debited with $500.
• Sales revenue is a component of stockholders’ equity and it increases the stockholders’ equity or by $500. Hence, it is credited.

Date	Account title / Explanation	Post ref.	Debit	Credit
			Amount	Amount
	Cost of goods sold (+E,-SE)		$300
	Inventory(-A)			$300
	( To record the cost of goods sold )

Table (7)

• Cost of goods sold is a component of stockholders’ equity and it decreases the stockholders’ equity by $300. Hence, it is debited.
• Inventory is an asset. Sale of inventory decreases the balance of inventory. Thus, inventory is debited with $300.

Note: The net income goes up by $200 that increases the balance of ending assets by the same amount. As a result, average total assets increases by only$100$\left(\$200\times \frac{1}{2}\right)$. Hence, return on assets increases. However, the gross profit percentage on this sale was 40%$\left(\frac{\left(\$500-\$300\right)}{\$500}\right)$ and the gross profit percentage before the sale was 45%, this transaction will decrease the ratio.