Other examples include the purchase of land for cash, and the sale of land for cash or on credit. | | |d. |The investment of cash in the business by the owners will cause an increase in an asset (cash) and an increase in the | | | |owners’ equity. | | |e. |The purchase of an automobile (or other asset) paying part of the cost in cash and promising to pay the remainder at a | | | |later time would cause an increase in one asset (automobile), a decrease in another asset (cash), and an increase in a | | | |liability by the amount of the unpaid portion. | |Ex. 2–8 |a. (1) |Owner’s equity: | | | | | |Johanna Small, capital |\$390,000 | | | | |*\$850,000 in assets ( \$460,000 in liabilities | | | |(2) |Partners’ equity: | | | | | |Johanna Small, capital |\$240,000 | | | | | |Mikki Yato, capital |? 150,000 | | | | | | |Total partners’ equity |\$390,000 | | | | |*Yato’s capital = \$390,000 ( Small’s capital, \$240,000 | | | |(3) |Stockholders’ equity: | | | | | |Capital stock |\$250,000 | | | | | |Retained earnings |? 40,000 | | | | | | |Total stockholders’ equity |\$390,000 | | | | |*Capital stock = 25 ( \$10,000. Retained earnings = \$390,000 ( capital stock. | | |b. |Yes; the form of Fellingham’s organization is relevant to a lender. If the company is not incorporated, the owner or | | | |owners are personally liable for the debts of the business organization. Thus, if the business is organized as a sole | | | |proprietorship, it is actually Small’s personal debt-paying ability that determines the collectibility of loans to the | | | |business.

If the business is a partnership, all of the partners are personally liable for the company’s debts. | | | |If Fellingham Software is organized as a corporation, however, a lender may look only to the corporate entity for payment. | |Note to instructor: You may wish to point out that some lenders would not make sizable loans to a small corporation unless one or more of the | |stockholders personally guaranteed the loan. This is accomplished by having the stockholder(s) cosign the note. | |Ex. 2–9 |a. |Cash is the most liquid of all assets. In fact, companies must use cash in paying most bills. Therefore, cash contributes | | | |more to a company’s liquidity than any other asset does. | | |b. Accounts payable is a liability that requires payment, usually in the near future. Thus, existing accounts payable detract| | | |from liquidity. | | |c. |Accounts receivable are assets that will shortly convert into cash. Therefore, they contribute toward the company’s | | | |liquidity. | | |d. |The capital stock account is the owners’ equity of the business. It represents amounts originally invested in the business| | | |by the owner, but says nothing about the form in which the company now holds these resources—nor even whether the | | | |resources are still on hand.

Thus, the capital stock account has no direct effect upon liquidity. On the other hand, the | | | |amount of the owners’ equity, related to the amount of the liabilities is an important factor in evaluating liquidity. | |Ex. 2–10 |a. |The situations encountered in the practice of accounting and auditing are too complex and too varied for all specific | | | |answers to be set forth in a body of official rules. Therefore, individual accountants must resolve many situations, based| | | |upon their general knowledge of accounting, their experience, and their ethical standards—in short, their professional | | | |judgment. | | |b. Accountants must rely upon their professional judgment in such matters as determining (three required) (1) how to record | | | |an unusual transaction that is not discussed in accounting literature, (2) whether or not a specific situation requires | | | |disclosure, (3) what information will be most useful to specific decision makers, (4) how an accounting system should be | | | |designed to operate most efficiently, (5) the audit procedures necessary in a given situation, (6) what constitutes a fair| | | |presentation, (7) whether specific actions are ethical and are in keeping with the accountants’ responsibilities to serve | | | |the public’s interests. | |Ex. –11 |GARDIAL Company | | |Statement of Cash Flows | | |For the Month Ended October 31, 2005 | | |Cash flows from operating activities: | | | |Cash received from revenues | \$ 10,000 | | | | |Cash paid for expenses | (7,200) | | | | |Net cash provided by operating activities | | | | | |\$2,800 | | |Cash flows from investing activities: | | | |Cash paid for equipment |(2,500) | |Cash flows from financing activities: | | | |Cash received from sale of capital stock | \$ 6,000 | | | | |Cash used to repay bank loans | (2,000) | | | | |Net cash provided by financing activities | 4,000 | | |Increase in cash | \$ 4,300 | | |Cash balance, October 1, 2005 | 7,450 | | |Cash balance, October 31, 2005 | \$11,750 | |Ex. 2–12 |HERNANDEZ, Inc. | |Income Statement | | |For the Month Ended March 31, 2005 | | |Revenues |\$9,500 | | |Expenses |? 5,465 | | |Net income |\$4,035 | | |The cash received from bank loans is a positive cash flow—financing activity—in the statement of cash flows, but is not included| | |in the income statement.

Dividends paid to stockholders are a negative cash flow—financing activity—in the statement of cash | | |flows, but are not included in the income statement. | |Ex. 2–13 |YARNELL Company | | |Income Statement | | |For the Month Ended August 31, 2005 | | |Service revenues |\$15,000 | | |Expenses |?? ,500 | | |Net income |\$? 7,500 | | |The following four items represent cash flows, but are not revenues or expenses that should be included in the income statement:| | |Investment by stockholders | | |Loan from bank | | |Payments to long-term creditors | | |Purchase of land | |Ex. –14 |YARNELL Company | | |Statement of Cash Flows | | |For the Month Ended August 31, 2005 | | |Cash flows from operating activities: | | | |Cash received from revenues | \$ 15,000 | | | | |Cash paid for expenses | (7,500) | | | | |Net cash provided by operating activities | \$ 7,500 | | |Cash flows from investing activities: | | | |Cash paid for purchase of land | (16,000) | | |Cash flows from financing activities: | | | |Cash received from bank loan | \$ 15,000 | | | | |Cash received from investment by stockholders | 5,000 | | | | |Cash paid to long-term creditors | (12,000) | | | | |Net cash provided by financing activities | 8,000 | | |Decrease in cash | \$ (500) | | |Cash balance, August 1, 2005 | 7,200 | | |Cash balance, August 31, 2005 | \$ 6,700 | |Ex. –15 |John Franklin, owner’s equity: | | | |Balance, January 1, 2005 |\$50,000 | | | |Add: |Investment during 2005 |10,000 | | | | |Net income for 2005 |? 25,000 | | | |Balance, December 31, 2005 |\$85,000 | | |The end-of-year balance of owner’s equity in the balance sheet is \$85,000. This amount articulates with the amount of net income| | |in the income statement because net income is added to the amount of beginning owner’s equity, plus additional investment, to | | |determine the ending balance that appears in the December 31, balance sheet.

The accounting equation stays in balance because | | |the amount of net income is reflected in changes in the balances of various assets and liabilities that are also presented in | | |the balance sheet. | |Ex. 2–16 |Note to instructor: Many examples of steps to improve the financial statements could be cited. The ones listed below are those | | |that the authors believe are most likely to be identified by students. | | |Steps to Window Dress | |Impact on Financial Statements* | | |Delay cash payment of expenses at year-end (assume expense | BS—Higher cash balance | | |already incurred) | |IS—No impact | | | | |SCF—Higher cash from operating activities | | |Accelerate payment of liabilities at | |BS—Reduced cash and liability balances | | |year-end | |IS—No impact | | | | |SCF—Lower cash balance | | |Delay purchase of equipment (or other noncurrent asset) | |BS—Higher cash balance | | | | |IS—No impact | | | | |SCF—Lower cash used in investing activities | | |Year-end investment by owner | |BS—Higher cash and owners’ equity balances | | | | |IS—No impact | | | | |SCF—Higher cash flow from financing activities | | |Year-end borrowing | |BS—Higher cash and liability balances | | | | |IS—No impact | | | | |SCF—Higher cash flow from financing activities | | |Acceleration of credit sales at year-end | |BS—Higher receivables and owners’ equity balances | | | | |IS—Higher sales and net income | | | | |SCF—No impact (assuming receivables not | | | | |collected) | | |*BS = Balance sheet; IS = Income statement; SCF = Statement of cash flows | |Ex. 2–17 |a. |The company has a net income (earnings) of \$66,388 thousand for the year ended December 31, 2002. | | |b. |Cash balances at the beginning and end of the year were: | | | |End |\$105,507 thousand | | | |Beginning |? 06,532 thousand | | | |Decrease |\$    1,025 thousand | | | |Major causes of the decrease in the amount of cash are the purchases of investments and capital expenditures, all of which| | | |are investing activities. Financing activities also caused cash to decrease, primarily due to the repurchase and | | | |retirement of capital stock. | | |c. |The largest asset is machinery and equipment (\$196,706 thousand before depreciation). The largest liability is accrued | | | |liabilities (expenses) (\$35,825 thousand). | |Ex. –18 |Net income stated as a percentage of revenue for each year is as follows: | | |2000: \$10,535/\$33,726 = 31% | | |2001: \$1,291/\$26,539 = 5% | | |2002: \$3,117/\$26,764 = 12% | The trend is basically negative, although 2002 is higher than 2001. Both sales and net income were the highest in 2000 of the three years 2000-2002. Between 2000 and 2001, both sales and net income dropped dramatically. Net income as a percentage of sales dropped from a high of 31% in 2000 to a low of 5% in 2001. 002 can be described as a “rebounding year” in which net income increased significantly, though not to the 2000 level, and sales increased slightly. As a percentage of sales, net income in 2002 rose to 12%, a clear improvement over 2001 but not nearly as positive as in 2000. solutions to problems |15 Minutes, Easy |Problem 2–1 | | |Smokey mountain lodge | [pic] |b. |The balance sheet indicates that Smokey Mountain Lodge is in a weak financial position.

The highly liquid assets—cash and | | |receivables—total only \$42,000, but the company has \$100,300 of debts due in the near future (accounts payable, salaries payable, and | | |interest payable). | |Note to instructor: Students were asked to base their answers to part b on the balance sheet alone. Students may correctly point out that a | |balance sheet does not indicate the rate at which cash flows into a business. Perhaps the company can generate enough cash from daily | |operations to pay its debts. A recent statement of cash flows would be useful in making a more complete analysis of the company’s financial | |position. | 15 Minutes, Easy |Problem 2–2 | | |AJAX Moving Company | |Description of transactions: | |a. |Purchased equipment for cash at a cost of \$3,200. | |b. |Received \$900 cash from collection of accounts receivable. | |c. |Purchased equipment at a cost of \$13,500; paid \$3,500 cash as down payment and incurred a liability (account payable) for the remaining | | |\$10,000. | |d. |Paid \$14,500 of accounts payable. | |e. |\$15,000 cash was received from the sale of capital stock. | |f. |Purchased equipment on account for \$7,500. | 15 Minutes, Medium |Problem 2–3 | | |GOLDSTAR communications | [pic] |15 Minutes, Medium |Problem 2–4 | | |rANKIN truck rental | [pic] |20 Minutes, Medium |Problem 2–5 | | |Here come the clowns! | [pic] |* |Total liabilities and owners’ equity, \$553,080, minus total of all ther assets, \$520,560 (\$9,500 + \$7,450 + \$189,060 + \$24,630 + \$31,500| | |+ \$89,580 + \$63,000 + \$105,840). | |b. |The loss of an asset, Tents, from a fire would require a revised balance sheet that reflects a decrease in total assets. When total | | |assets are decreased, the other balance sheet total (that is, the total of liabilities and owners’ equity) must also decrease. Since | | |there is no change in liabilities as a result of the destruction of an asset, the decrease on the right-hand side of the balance sheet | | |must be in owners’ equity—specifically, the retained earnings account. The amount of the decrease in the assets Tents, in Retained | | |earnings, and in both balance sheet totals, is \$14,300. | 20 Minutes, Medium |Problem 2–6 | | |wILSON farms, iNC. | [pic] |*Total assets, \$901,470, minus total liabilities, \$422,050, less capital stock, \$290,000. | |b. |The loss of an asset, Barns and Sheds, from a tornado would cause a decrease in total assets. When total assets are decreased, the | | |balance sheet total of liabilities and owners’ equity must also decrease. Since there is no change in liabilities as a result of the | | |destruction of an asset, the decrease on the right-hand side of the balance sheet must be in the retained earnings account. The amount of| | |the decrease in Barns and Sheds, in the owners’ equity, and in both balance sheet totals, is \$13,700. | 35 Minutes, Medium |Problem 2–7 | | |The OVEN bakery | [pic] Retained earnings (\$40,700) = Total assets (\$220,700), less total liabilities (\$100,000) and capital stock (\$80,000). [pic] | |Problem 2–7 | | |The OVEN bakery (concluded) | [pic] |c. |The Oven Bakery is in a stronger financial position on August 3 than it was on August 1. | |On August 1, the highly liquid assets (cash and accounts receivable) total only \$18,200, but the company has \$25,100 in debts due in the | | |near future (accounts payable plus salaries payable). | | |On August 3, after additional infusion of cash from the sale of stock, the liquid assets total \$25,750, and debts due in the near future | | |amount to \$16,100. | |Note to instructor: The analysis of financial position strength in part c is based solely upon the balance sheets at August 1 and August 3. | |Hopefully, students will raise the issue regarding necessity of information about operations, rate at which cash flows into the business, etc. | |In this problem, the improvement in financial position results solely from the sale of capital stock. | 40 Minutes, Strong |Problem 2–8 | | |the sWEET SODA shop | [pic] |*Total assets, \$132,590, less owners’ equity, \$54,090, less accounts payable, \$8,500, equals notes payable. | [pic] [pic] | |Problem 2–8 | | |the SWEET SODA shop (concluded) | [pic] |c. |The Sweet Soda Shop is in a stronger financial position on October 6 than on September 30.