Chapter 8, Problem 7AE

a.

To determine

Record the events in general journal format and post to T-accounts.

Explanation of Solution

Journal entry:

Journal entry is a set of economic events which can be measured in monetary terms. These are recorded chronologically and systematically.

Accounting rules for Journal entries:

• To record increase balance of account: Debit assets, expenses, losses and credit liabilities, capital, revenue and gains.
• To record decrease balance of account: Credit assets, expenses, losses and debit liabilities, capital, revenue and gains.

T-account:

T-account is the form of the ledger account, where the journal entries are posted to this account. It is referred to as the T-account, because the alignment of the components of the account resembles the capital letter ‘T’.

The components of the T-account are as follows:

a)      The title of the account

b)      The left or debit side

c)      The right or credit side

Straight-line Depreciation:

Under the straight-line method of depreciation, the same amount of depreciation is allocated every year over the estimated useful life of an asset. The formula to calculate the depreciation cost of the asset using the residual value is shown as below:

$\text{Depreciation = }\frac{\left(\text{Cost of the asset}-\text{Residual value}\right)}{\text{Estimated useful life of the asset}}$

Record the events in general journal format.

Event	Account title and Explanation	Post ref	Debit  (in $)	Credit (in $)
1.	Cash		60,000
	Common Stock			60,000
	(To record the issue of the common stock)
2.	Equipment–Cooktop		40,000
	Cash			40,000
	(To record the purchase of equipment)
3.	Cash		72,000
	Sales Revenue			72,000
	(To record  the sales revenue)
4.	Salaries Expense		25,000
	Cash			25,000
	(To record salaries expense)
5.	Depreciation Expense		586
	Accumulated Depreciation  (1)			158
	(To record depreciation expense )

Table (1)

Working note:

Calculate the depreciation expense on cooktop.

$\begin{array}{c}\text{Depreciation expense = }\frac{\left(\text{Cost of the asset}-\text{Residual value}\right)}{\text{Estimated useful life of the asset}}\\ =\frac{\left(\$40,000-\$4,000\right)}{4\text{years}}\\ =\frac{\$36,000}{4}\\ =\$9,000\end{array}$ (1)

Post the events to T-accounts as follows:

Cash
1.	60,000	2.	40,000
3.	72,000	4.	25,000
Balance              67,000

Equipment–Cooktop
2.	40,000
Balance              40,000

Accumulated Depreciation
		5.	9,000
		Balance           9,000

Common Stock
		1.	60,000
		Balance         60,000

Service Revenue
		3.	72,000
		Balance         72,000

Salaries Expense
4.	25,000
Balance              25,000

Depreciation Expense
5.	9,000
Balance                9,000

b.

To determine

Prepare a balance sheet and a statement of cash flows for the Year 1 accounting period.

Explanation of Solution

Balance sheet:

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

Statement of cash flows:

This statement reports all the cash transactions which are responsible for inflow and outflow of cash, and result of these transactions is reported as ending balance of cash at the end of reported period. Statement of cash flows includes the changes in cash balance due to operating, investing, and financing activities.

Prepare a balance sheet of Company GS for the Year 1 accounting period.

Company GS
Balance Sheet
As of December 31, Year 1
	Amount (in $)	Amount (in $)
Assets:
Cash		67,000
Property and Equipment, at cost	40,000
Less: Accumulated Depreciation	9,000	31,000
Total Assets		$98,000
Liabilities:
Liabilities		0
Stockholders’ Equity:
Common Stock	60,000
Retained Earnings	38,000
Total Stockholders’ Equity		98,000
Total Liabilities and Stockholders’ Equity		$98,000

Table (2)

Prepare a statement of cash flows of Company GS for the Year 1 accounting period.

Company GS
Statement of Cash Flows
For the Year Ended December 31, Year 1
Cash flows from operating activities:
Cash receipts from revenue	$72,000
Cash payments for salaries	(25,000)
Net cash flows used for operating activities		$47,000
Cash flows from investing activities:
Cash outflow for Cooktop	$(40,000)
Net cash flows used for investing activities		$(40,000)
Cash flows from financing activities:
Cash receipts from issue of stock	$60,000
Net cash flows from financing activities		$60,000
Net change in cash		$67,000
Beginning cash balance		0
Ending Cash Balance		$67,000

Table (3)

c.

To determine

Determine the net income for Year 1.

Explanation of Solution

Determine the net income for Year 1.

Particulars	Amount (in $)
Revenue	72,000
Less: Salaries Expense	25,000
Depreciation expense	9,000
Net Income	$38,000

Table (4)

Hence, the net income for Year 1 is $38,000.

d.

To determine

Determine the amount of depreciation expense that Company GS would report on the Year 2 income statement.

Explanation of Solution

Straight-line Depreciation:

Under the straight-line method of depreciation, the same amount of depreciation is allocated every year over the estimated useful life of an asset. The formula to calculate the depreciation cost of the asset using the residual value is shown as below:

$\text{Depreciation = }\frac{\left(\text{Cost of the asset}-\text{Residual value}\right)}{\text{Estimated useful life of the asset}}$

Calculate the depreciation expense on cooktop.

$\begin{array}{c}\text{Depreciation expense = }\frac{\left(\text{Cost of the asset}-\text{Residual value}\right)}{\text{Estimated useful life of the asset}}\\ =\frac{\left(\$40,000-\$4,000\right)}{4\text{years}}\\ =\frac{\$36,000}{4}\\ =\$9,000\end{array}$

Hence, the amount of depreciation expense that Company GS would report on the Year 2 income statement is $9,000.

e.

To determine

Determine the amount of accumulated depreciation that Company GS would report on the December 31, Year 2, balance sheet.

Explanation of Solution

Accumulated depreciation:

The total amount of depreciation expense deducted, from the time asset acquired till date, as reported in the account as on a particular date, is referred to as accumulated depreciation.

Formula for accumulated depreciation:

$\text{Accumulated depreciation = }\left\{\begin{array}{l}\text{Depreciation expense in the previous years+}\\ \text{Depreciation in current year}\end{array}\right\}$

Calculate the accumulated depreciation on December 31, Year 2.

$\begin{array}{c}\text{Accumulated depreciation = }\left\{\begin{array}{l}\text{Depreciation expense in Year 1+}\\ \text{Depreciation in Year 2}\end{array}\right\}\\ =\$9,000+\$9,000\\ =\$18,000\end{array}$

Hence, the amount of accumulated depreciation that Company GS would report on the December 31, Year 2, balance sheet is $18,000.

f.

To determine

Identify whether the cash flow from operating activities would be affected by depreciation in Year 2.

Answer to Problem 7AE

No, the cash flow from operating activities would not be affected by depreciation in Year 2.

Explanation of Solution

Cash flows from operating activities:

These refer to the cash received or cash paid in day-to-day operating activities of a company.  In the direct method, cash flow from operating activities is computed by using all cash receipts and cash payments during the year. In the indirect method, some amounts are to be adjusted from the Net Income to calculate the net cash provided from operating activities.

Depreciation is a non-cash expense. It is added to net income while preparing the statement of cash flows under the indirect method. During the preparation of net income, the depreciation is not considered as an expense but as a non-cash expense. That is, each year when depreciation expense is recorded in the financial statements, no cash payment is made actually. Therefore, it is again added back to the net income in the preparation of cash flows under the indirect method.