solutions to exercises |Ex. 2–1 |a. |Assets are economic resources owned by the business entity. | | | |1. |Among the assets of American Airlines we might expect to find investments, accounts receivable (say, from travel | | | | |agents), fuel (in storage), maintenance supplies, aircraft, and various types of equipment. The company also owns | | | | |land and buildings—as, for example, its corporate headquarters. | | | |2. Among the assets of a professional sports team are investments (in stocks and bonds), notes receivable (often from | | | | |players), training equipment, supplies, and office furniture. (The balance sheet of a professional sports team | | | | |usually does not include land or buildings, as they generally do not own the stadiums in which they play. ) | |Note to instructor: You may wish to expand this solution to include intangible assets, such as the team’s league franchise, and player | |contracts, the right to receive the future services of a given player. Player contracts only appear as an asset if they have a cost—that is, | |if they were purchased from other teams. Advance payments to players usually are shown as prepaid expenses. ) We address intangible assets in | |Chapter 9, but the concept is consistent with the discussion of assets in Chapter 2. | | |b. |Liabilities are existing debts and other obligations of the entity. | | | |1. Among the liabilities of American Airlines, we might expect to find accounts payable, notes payable (or mortgages or | | | | |bonds payable) stemming from purchases of aircraft, salaries payable, interest payable, rent payable (for space in | | | | |airports), and income taxes payable. | | | |2. |The balance sheet of a professional sports team might include accounts payable, rent payable (for the stadium), | | | | |salaries payable, interest payable, and income taxes payable. |Note to instructor: In a classroom discussion, you might want to point out that both an airline and a professional sports team may have | |liabilities for unearned revenue. The airline sells many tickets in advance, thus incurring an obligation to render services (flights) or to | |refund the customers’ money. A sports team has a similar obligation with respect to advance sales of season tickets. We discuss unearned | |revenue in Chapter 4, but the concept can be introduced earlier at the instructor’s discretion. | |Ex. –2 |DIXIE TRANSPORTATION SERVICE | | |Balance Sheet | | |February 28, 2005 | | |Assets | |Liabilities & Owners’ Equity | | |Cash | $ 69,000 | |Liabilities: | | | |Accounts receivable | 70,000 | | |Notes payable | $ 288,000 | | |Supplies | 14,000 | | |Accounts payable | 26,000 | | |Land | 70,000 | | | |Total liabilities | $ 314,000 | | |Building | 80,000 | |Owners’ equity: | | | |Automobiles | 165,000 | | Capital stock |92,000 | | |Total | $ 468,000 | | |Retained earnings | 62,000 | | | | | |Total | $ 468,000 | |Ex. 2–3 |MERCER COMPANY | | Balance Sheet | | |December 31, 2005 | | |Assets | |Liabilities & Owners’ Equity | | |Cash | $ 36,300 | |Liabilities: | | | |Accounts receivable | 56,700 | | |Notes payable |$207,000 | | |Land | 90,000 | | |Accounts payable | 43,800 | | |Building | 210,000 | | | |Total liabilities |$250,800 | | |Office equipment | 12,400 | |Owners’ equity: | | | | | | | Capital stock |75,000 | | | | | | |Retained earnings | 79,600 | | |Total |$405,400 | |Total |$405,400 | | |The amount of retained earnings is calculated as the difference between total assets and liabilities plus capital stock: | | |$405,400 – ($250,800 + $75,000) = $79,600 | |Ex. 2–4 |a. |The supplies should be presented at $1,700 in World-Wide’s balance sheet. Presenting the supplies at their estimated | | | |liquidation value violates the assumption that World-Wide is a going concern, and will use these supplies in business | | | |operations, rather than sell them on the open market. The $500 amount also violates the objectivity principle, as it is | | | |largely a matter of personal opinion, and also the cost principle. | | |b. |The presentation of the two land parcels at a combined value of 320,000 conforms to generally accepted accounting | | | |principles. This treatment illustrates both the cost principle and the stable-dollar assumption. | | |c. |The presentation of the computer system at $14,000 in the December 31 balance sheet conforms to generally accepted | | | |accounting principles, as this is the cost of the system, and at the balance sheet date, it was an asset owned by the | | | |company. The retail value of $20,000 is not presented in the balance sheet, as this amount is not the cost incurred by the| | | |entity, nor is it an objective measurement. | | |However, the company’s failure to disclose the loss of the equipment subsequent to the balance sheet date may violate the | | | |principle of adequate disclosure. To properly interpret the company’s balance sheet, users may need to be aware that this | | | |asset no longer exists. Several issues must be considered in deciding whether or not disclosure of the burglary loss is | | | |necessary. For example, was the asset insured? And is a $14,000 asset significant (material) in relation to the assets and| | | |operations of this business? Is this amount large enough that it might impact investors’ and creditors’ decisions | | | |regarding the company? | |Ex. 2–5 |a. $236,000: Assets $578,000 ( liabilities $342,000 = owners’ equity $236,000 | | |b. |$1,132,500: Liabilities $562,500 + owners’ equity $570,000 = assets $1,132,500 | | |c. |$120,300: Assets $307,500 ( owners’ equity $187,200 = liabilities $120,300 | |Ex. 2–6 |Transaction | |Assets |= |Liabilities |+ |Owners’ Equity | | |a | |I | |I | |NE | | |b | |NE* | |NE |NE | | |c | |D | |D | |NE | | |d | |D | |D | |NE | | |e | |I | |NE | |I | | |f | |I | |I | |NE | | |g | |I | |NE | |I | | |h | |NE* | |NE | |NE | | |i | |NE* | |NE | |NE | | |*Could be I/D offsetting | |Ex. 2–7 |Note to instructor: These are examples, but many others exist. | | |a. |The purchase of office equipment (or any other asset) on credit will cause an increase in the asset (office equipment) and| | | |an increase in a liability. | | |b. |The cash payment of an account payable or note payable will cause a decrease in the asset cash and a decrease in the | | | |liability paid. | | |c. |The collection of an account receivable will cause an increase in one asset (cash) and a decrease in another asset | | | |(accounts receivable).

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.

On September 30, the company had highly liquid| | |assets (cash and accounts receivable) of $8,650, which barely exceeded the $8,500 in liabilities (accounts payable) due in the near | | |future. On October 6, after the additional investment of cash by stockholders, the company’s cash alone exceeded its short-term | | |obligations. | | | | | |35 Minutes, Strong |Problem 2–9 | | |Berkeley playhouse | [pic] |b. (1) |The cash in Berkeley’s personal savings account is not an asset of the business entity Berkeley Playhouse. Therefore, it should not| | | |appear in the balance sheet of the business. The money on deposit in the business bank account ($15,000) and in the company safe | | | |($1,900) constitute cash owned by the business. It is not necessary to state separately in the balance sheet amounts of cash at | | | |different locations; thus, the cash owned by the business at September 30 totals $16,900. | | |(2) |Only the amount receivable from Artistic Tours ($7,200) should be included in the company’s accounts receivable as of September 30. | | |The amounts expected from future tickets sales do not relate to completed transactions and are not yet assets of the business. | | |(3) |The props and costumes should be shown in the balance sheet at their cost, $18,000, not at just the portion of the cost that was | | | |paid in cash. The $15,000 note payable is a debt of the business arising from a completed purchase transaction. Therefore, it | | | |should be included among the company’s liabilities. The date at which this liability must be paid is not relevant. | | |(4) |The theater building is not owned by Berkeley Playhouse. Therefore, it is not an asset of this business entity and should not | | | |appear in the balance sheet. | |(5) |The lighting equipment is an asset of the business and should be valued in the balance sheet at its cost, $9,400. | | |(6) |As the automobile is not used in the business, it appears to be Berkeley’s personal asset rather than an asset of the business | | | |entity. Therefore, it should not be included in the balance sheet of the business. (Note: The advertised sales price of a similar | | | |automobile would not be an appropriate valuation figure even if the automobile were to be included. ) | | |(7) |The accounts payable should be limited to the debts of the business, $3,900, and should not include Berkeley’s personal | | | |liabilities. | |Problem 2–9 | | |BERKELEY playhouse (concluded) | | |(8) |The amount owed to stagehands for work done through September 30 is the result of completed transactions and should be included | | | |among the liabilities of the business. Even if agreement has been reached with Mario Dane for him to perform in a future play, he | | | |has not yet performed and, therefore, is not yet owed any money. Thus, this $25,000 is not yet a liability of the business. | |(9) |Owner’s equity is not valued at either the original amount invested or at the estimated market value of the business. In fact, | | | |owner’s equity cannot be valued independently of the values assigned to assets and liabilities. Rather, it is a residual figure—the| | | |excess of total assets over total liabilities. (If liabilities exceed assets, owner’s equity would be a negative amount. ) Thus, the| | | |amount of Berkeley’s capital should be determined by subtracting the corrected figure for total liabilities ($23,100) from the | | | |corrected amount of total assets ($51,500). This indicates owner’s equity of $28,400. | 30 Minutes, Strong |Problem 2–10 | | |big screen scripts | [pic]* Total assets ($114,735), Less (Total Liabilities, $106,200, + Capital Stock, $5,000) |b. |(1) |The cash in Pippin’s personal savings account is not an asset of the business entity Big Screen Scripts and should not appear in | | | |the balance sheet of the business. The money on deposit in the business bank account ($3,400) and in the company safe ($540) | | | |constitute cash owned by the business. Thus, the cash owned by the business at November 30 totals $3,940. | |(2) |The years-old IOU does not qualify as a business asset for two reasons. First, it does not belong to the business entity. Second, | | | |it appears to be uncollectible. A receivable that cannot be collected is not viewed as an asset, as it represents no future | | | |economic benefit. | | |(3) |The total amount to be included in “Office furniture” for the rug is $9,400, the total cost, regardless of whether this amount was | | | |paid in cash. Consequently, “Office furniture” should be increased by $6,500. The $6,500 liability arising from the purchase of the| | | |rug came into existence prior to the balance sheet date and must be added to the “Notes payable” amount. | |(4) |The computer is no longer owned by Big Screen Scripts and therefore cannot be included in the assets. To do so would cause an | | | |overstatement of both assets and owners’ equity. The “Office furniture” amount must be reduced by $2,525. | | |(5) |The $22,400 described as “Other assets” is not an asset, because there is no valid legal claim or any reasonable expectation of | | | |recovering the income taxes paid. Also, the payment of federal income taxes by Pippin was not a business transaction by Big Screen | | | |Scripts. If a refund were obtained from the government, it would come to Pippin personally, not to the business entity. | |(6) |The proper valuation for the land is its historical cost of $39,000, the amount established by the transaction in which the land | | | |was purchased. Although the land may have a current fair value in excess of its cost, the offer by the friend to buy the land if | | | |Pippin would move the building appears to be mere conversation rather than solid, verifiable evidence of the fair value of the | | | |land. The “cost principle,” although less than perfect, produces far more reliable financial statements than would result if owners| | | |could “pull figures out of the air” in recording asset values. | | |(7) |The accounts payable should be limited to the debts of the business, $32,700, and should not include Pippin’s personal liabilities. |