CHAPTER 3

INCOME STATEMENT: REPORTING THE RESULTS

OF OPERATING ACTIVITIES

Questions, Short Exercises, Exercises, Problems, and Cases: Answers and Solutions

3.1 See the text or the glossary at the end of the book.

3.2 Net income equals cash inflows minus cash outflows from operating, investing, and
non-owner (that is, debt servicing) financing activities. If the period were long
enough, then sales of goods and services (revenue under the accrual basis) and cash
receipts from customers (revenue under the cash basis) would both occur in the same
long-enough time period. Revenues would therefore not differ between the cash and
accrual basis. Likewise, costs incurred to generated revenues (expenses under the
accrual basis) and cash expenditures for goods and services consumed (expenses under
the cash basis) would both occur in the same period. Expenses would also not differ
between the cash and accrual basis. With the same amounts of revenues and expenses,
net income on an accrual basis would equal net income on a cash basis.

3.3 The amount of revenue recognized equals the amount of cash the firm expects to
collect from customers. The firm does not necessarily recognize the revenue,
however, at the time it receives the cash. It typically recognizes revenue at the time of
sale even though it has not yet collected cash from customers. Likewise, the amount
of expense recognized equals the cash disbursement made for equipment, materials,
labor, and so forth. However, the firm recognizes the expense when it consumes the
services of these factor inputs, not when it makes the cash expenditure.

3.4 Revenues measure the inflow of net assets from operating activities and expenses
measure the outflow of net assets consumed in the process of generating revenues.
Thus, recognizing revenues and expenses always involves a simultaneous entry in an
asset and/or liability account. Likewise, adjusting entries almost always involve an
entry in at least one income statement and one balance sheet account.

3.5 Cost is the economic sacrifice made to acquire goods or services. When the good or
service acquired has measurable future benefits to a firm, the cost is an unexpired cost,
or an asset. When the firm consumes the good or service, the cost is an expired cost,
or expense.

3-1 Solutions
3.6 Accrual accounting attempts to relate inputs with outputs to obtain a measure of the
economic value added by a firm’s operating activities. Accrual accounting recognizes
expenses in the same period as related revenues. Costs not closely related to particular
revenues become expenses in the period when the firm consumes the services of assets
in operations. Thus, expenses either match with particular revenues or with a
particular accounting period.

3.7 Current accounting practice takes the viewpoint of shareholders by reporting the
amount of net income available to shareholders after subtracting from revenues all
expenses incurred in generating the revenue by claimants (for example, employees,
lenders, governments) other than shareholders. Critics point out that funds provided
by shareholders have a cost just as much as funds provided by lenders and accounting
should subtract this cost as well in measuring net income.

3.8 Contra accounts provide disaggregated information concerning the net amount of an
asset, liability, or shareholders' equity item. For example, the account, Property, Plant
and Equipment net of Accumulated Depreciation, does not indicate separately the
acquisition cost of fixed assets and the portion of that acquisition cost written off as
depreciation since acquisition. If the firm used a contra account, it would have such
information. The alternative to using contra accounts is to debit or credit directly the
principal account involved (for example, Property, Plant and Equipment). This
alternative procedure, however, does not permit computation of disaggregated
information about the net balance in the account. Note that the use of contra accounts
does not affect the total of assets, liabilities, shareholders' equity, revenues, or
expenses, but only the balances in various accounts that comprise the totals for these
items.

3.9 (Microsoft Corporation; analyzing changes in accounts receivable.)

(Amounts in Millions)

Accounts Receivable, Beginning of Year 13............................................ $ 5,129

Plus Sales on Account during Year 13...................................................... 32,120
Less Cash Collections during Year 13...................................................... (?)
Accounts Receivable, End of Year 13...................................................... $ 5,196

Cash collections during Year 13 total $32,053 million.

3.10 (General Electric Company; analyzing changes in inventory.) (Amounts in

Millions)

Inventory, Beginning of Year 12.............................................................. $ 8,565

Plus Purchases or Production of Inventory during Year 12...................... ?
Less Cost of Goods Sold for Year 12........................................................ (63,072)
Inventory, End of Year 12......................................................................... $ 9,247

Purchases or production of inventory during Year 12 total $63,754 million.

Solutions 3-2
3.11 (Ann Taylor Stores; analyzing changes in inventory and accounts payable.)
(Amounts in Millions)

Inventory, Beginning of Year 13.............................................................. $ 180.1

Plus Purchases of Inventory during Year 13............................................. ?
Less Cost of Goods Sold for Year 13........................................................ (633.5)
Inventory, End of Year 13......................................................................... $ 185.5
Purchases during Year 13 total $638.9 million.

Accounts Payable, Beginning of Year 13................................................. $ 52.0

Plus Purchases of Inventory on Account during Year 13 from
above.................................................................................................. 638.9
Less Cash Payments to Suppliers during Year 13..................................... (?)
Accounts Payable, End of Year 13........................................................... $ 57.1
Cash payments to suppliers during Year 13 total $633.8 million.

3.12 (AMR; analyzing changes in salaries payable.) (Amounts in Millions)

Salaries Payable, Beginning of Year 12.................................................... $ 721

Plus Salary Expense for Year 12............................................................... 8,392
Less Cash Payments to Employees during Year 12.................................. (?)
Salaries Payable, End of Year 12.............................................................. $ 705
Cash payments to employees during Year 12 total $8,408 million.

3.13 (Johnson & Johnson; analyzing changes in retained earnings.) (Amounts in

Millions)

Retained Earnings, Beginning of Year 12................................................. $ 23,066

Plus Net Income for Year 12..................................................................... ?
Less Dividends Declared and Paid during Year 12................................... (3,092)
Retained Earnings, End of Year 12........................................................... $ 26,571
Net income for Year 12 totals $6,597 million.

3.14 (Gillette; computing interest expense.) (Amounts in Millions)

Interest expense for Year 12 is $3.75 million (= $250 X .06 X 3/12).

3.15 (Radio Shack; computing income tax expenses and income taxes paid.)
(Amounts in Millions)

Income Taxes Payable, Beginning of Year 13.......................................... $ 78.1

Plus Income Tax Expense for Year 13 (.38 X $424.9)............................. 161.5
Less Income Taxes Paid during Year 13................................................... (?)
Income Taxes Payable, End of Year 13.................................................... $ 60.1
Income taxes paid during Year 13 total $179.5 million.

3-3 Solutions
3.16 (Journal entry for prepaid rent.)

Prepaid Rent.............................................................................. 300

Rent Expense...................................................................... 300

Shareholders'
Assets = Liabilities + Equity (Class.)
+300 +300 IncSt  RE

The required balance in the Prepaid Rent account on December 31, Year 12, is $1,500,
which equals one-twelfth of the $18,000 payment for the period February 1, Year 12,
through January 31, Year 13. The Prepaid Rent account had a balance of $1,200 on
January 1, Year 12, and the firm made no entry affecting this account during Year 12.
Thus, the entry above increases the balance from $1,200 to $1,500. The entry made
on February 1, Year 12, decreased retained earnings (rent expense) by $18,000. Rent
expense for Year 12 should be $17,700 [= $1,200 + (11/12 X $18,000)]. The entry
above reduces the expenses (that is, increases retained earnings) from $18,000 to
$17,700.

3.17 (Journal entry to correct recording error.)

Entry Made:
Equipment Expense.................................................................. 20,000
Cash...................................................................................... 20,000

Shareholders'
Assets = Liabilities + Equity (Class.)
–20,000 –20,000 IncSt  RE

Correct Entries:
Equipment ....................................................................20,000
Cash...................................................................................... 20,000

Shareholders'
Assets = Liabilities + Equity (Class.)
–20,000
+20,000

Depreciation Expense ($20,000/5)........................................... 4,000

Accumulated Depreciation................................................... 4,000

Shareholders'
Assets = Liabilities + Equity (Class.)
–4,000 –4,000 IncSt  RE

Solutions 3-4
3.17 continued.

Correcting Entry:
Equipment ....................................................................20,000
Depreciation Expense............................................................... 4,000
Equipment Expense.............................................................. 20,000
Accumulated Depreciation................................................... 4,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+20,000 –4,000 IncSt  RE
–4,000 +20,000 IncSt  RE

3.18 (Neiman Marcus; revenue recognition.)

February March April

a. -- -- $ 800

b. -- $ 2,160 --

c. $39,200 -- --

d. -- $ 59,400 --

e. -- $ 9,000 $ 9,000

f. -- $ 9,000 $ 9,000

3.19 (Revenue recognition.)

a. No. (One might argue that receipt of the order and completion of manufacturing
are sufficient to justify recognition of revenue. However, the purchaser may
reject the T-shirts when received. Furthermore, the concert may not take place
and the purchaser would fail to pay for the T-shirts. Thus, sufficient uncertainties
remain to justify delaying revenue recognition until at least the time of delivery.)

b. Yes (the firm has provided the services).

c. No (the baseball games will not take place until next year).

d. Yes (on an accrual basis, accounting recognizes interest as time passes).

e. No (accrual accounting usually recognizes revenue when a firm sells goods or

services).

f. Yes (the agency has provided the services).

3-5 Solutions
3.20 (Sun Microsystems; expense recognition.)

June July August

a. -- $ 15,000 $ 15,000

b. $ 4,560 -- --

c. -- $ 5,800 $ 6,300

d. $ 600 $ 600 $ 600

e. -- -- --

f. -- -- $ 4,500

g. $ 6,600 -- --

3.21 (Kroger Stores; expense recognition.)

a. None (this is a September expense).

b. $200 (= $12,000/60).

c. $2,000 (= $24,000/12).

d. $12,300 (= $2,900 + $12,900 – $3,500).

e. $1,200 (the repair does not extend the life beyond that originally expected).

f. None (the firm will include the deposit in the acquisition cost of the land).

g. $10,000 (the firm includes the remaining $10,000 in prepaid rent).

3.22 (Identifying missing half of journal entries.)

a. Merchandise Inventory or Finished Goods Inventory decreases

because the firm has sold goods.

b. Sales Revenue increases because of sales.

c. Cash increases because of collections from customers.

d. Cash decreases because of payments to creditors.

e. Either an inventory account or an expense account increases because

of receipts of goods or services.

Solutions 3-6
3.22 continued.

f. Depreciation Expense increases because an adjusting entry recognizes

the expense.

g. Dividends Payable increases because of the dividend, or closing entry

for an expense or income summary account showing a loss.

h. Either Insurance Expense increases (period expense) or Work-in-

Process Inventory increases (product cost) as a result of an adjusting
entry.

i. Cash decreases because a firm pays property taxes.

j. Either Accounts Payable increases or Cash decreases because of

acquisition of inventory.

k. Revenue increases because a firm provides goods or services to

customers.

l. Assets increase for the amount of the cash or goods received from
supplier.

3.23 (Corner Grocery Stores; journal entries for notes receivable and notes payable.)

a. Year 12
Dec. 1
Cash..................................................................................... 100,000
Notes Payable................................................................. 100,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+100,000 +100,000

Dec. 31
Interest Expense ($100,000 X .06 X 30/360)...................... 500
Interest Payable.............................................................. 500

Shareholders'
Assets = Liabilities + Equity (Class.)
+500 –500 IncSt  RE

3-7 Solutions
3.23 a. continued.

Year 13
March 1
Note Payable....................................................................... 100,000
Interest Payable................................................................... 500
Interest Expense.................................................................. 1,000
Cash................................................................................ 101,500

Shareholders'
Assets = Liabilities + Equity (Class.)
–101,500 –100,000 –1,000 IncSt  RE
–500

b. Year 12
Dec. 1
Notes Receivable................................................................. 100,000
Cash................................................................................ 100,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+100,000
–100,000

Dec. 31
Interest Receivable.............................................................. 500
Interest Revenue............................................................. 500

Shareholders'
Assets = Liabilities + Equity (Class.)
+500 +500 IncSt  RE

Year 13
March 1
Cash..................................................................................... 101,500
Note Receivable.............................................................. 100,000
Interest Receivable......................................................... 500
Interest Revenue............................................................. 1,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+101,500 +1,000 IncSt  RE
–100,000
–500

Solutions 3-8
3.24 (Dollar General; journal entries for inventories.) (Amounts in Millions)

Merchandise Inventories............................................................ 4,368

Accounts Payable................................................................... 4,368

Shareholders'
Assets = Liabilities + Equity (Class.)
+4,368 +4,368

Cost of Goods Sold ($1,131 + $4,368 – $1,123)....................... 4,376

Merchandise Inventories........................................................ 4,376

Shareholders'
Assets = Liabilities + Equity (Class.)
–4,376 –4,376 IncSt  RE

Accounts Payable ($322 + $4,368 – $341)................................ 4,349

Cash........................................................................................ 4,349

Shareholders'
Assets = Liabilities + Equity (Class.)
–4,349 –4,349

3.25 (Eason Corporation; journal entries for insurance.)

September 1, Year 12
Prepaid Insurance....................................................................... 3,600
Cash........................................................................................ 3,600

Shareholders'
Assets = Liabilities + Equity (Class.)
+3,600
–3,600

December 31, Year 12

Insurance Expense...................................................................... 1,200
Prepaid Insurance................................................................... 1,200

Shareholders'
Assets = Liabilities + Equity (Class.)
–1,200 –1,200 IncSt  RE

3-9 Solutions
3.25 continued.

September 1, Year 13
Prepaid Insurance....................................................................... 4,800
Cash........................................................................................ 4,800

Shareholders'
Assets = Liabilities + Equity (Class.)
+4,800
–4,800

December 31, Year 13

Insurance Expense [($3,600 X 8/12) + ($4,800 X
4/12)]...................................................................................... 4,000
Prepaid Insurance................................................................ 4,000

Shareholders'
Assets = Liabilities + Equity (Class.)
–4,000 –4,000 IncSt  RE

3.26 (Effect of errors on financial statements.)

Shareholders'
Assets Liabilities Equity
a. U/S $ 6,000 NO U/S $ 6,000
b. NO U/S $ 1,200 O/S $ 1,200
c. U/S $ 4,600 NO U/S $ 4,600
d. O/S $ 250 NO O/S $ 250
e. NO U/S $ 1,500 O/S $ 1,500
f. NO O/S $ 11,600 U/S $ 11,600

3.27 (Forgetful Corporation; effect of recording errors on financial statements.)

Note: The actual and correct entries appear below to show the effect and amount of
the errors, but are not required.

a. Actual Entry:
Cash..................................................................................... 1,400
Sales Revenue................................................................. 1,400

Shareholders'
Assets = Liabilities + Equity (Class.)
+1,400 +1,400 IncSt  RE

Solutions 3-10
3.27 a. continued.

Correct Entry:
Cash..................................................................................... 1,400
Advance from Customer................................................ 1,400

Shareholders'
Assets = Liabilities + Equity (Class.)
+1,400 +1,400

Liabilities understated by $1,400 and shareholders’ equity overstated by $1,400.

b. Actual Entry:
Cost of Goods Sold............................................................. 5,000
Cash................................................................................ 5,000

Shareholders'
Assets = Liabilities + Equity (Class.)
–5,000 –5,000 IncSt  RE

Correct Entries:
Machine............................................................................... 5,000
Cash................................................................................ 5,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+5,000
–5,000

Depreciation Expense......................................................... 500

Accumulated Depreciation............................................. 500

Shareholders'
Assets = Liabilities + Equity (Class.)
–500 –500 IncSt  RE

Assets understated by $4,500 and shareholders’ equity understated by $4,500.

c. Actual Entry:
None for accrued interest.

3-11 Solutions
3.27 c. continued.

Correct Entry:
Interest Receivable ($2,000 X .12 X 60/360)...................... 40
Interest Revenue............................................................. 40

Shareholders'
Assets = Liabilities + Equity (Class.)
+40 +40 IncSt  RE

Assets understated by $40 and shareholders’ equity understated by $40.

d. The entry is correct as recorded.

e. Actual Entry:
None for declared dividend.

Correct Entry:
Retained Earnings............................................................... 1,500
Dividend Payable........................................................... 1,500

Shareholders'
Assets = Liabilities + Equity (Class.)
+1,500 –1,500 Dividend

Liabilities understated by $1,500 and shareholders’ equity overstated by $1,500.

f. Actual Entries:
Machinery........................................................................... 50,000
Accounts Payable........................................................... 50,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+50,000 +50,000

Accounts Payable................................................................ 50,000

Cash................................................................................ 49,000
Miscellaneous Revenue.................................................. 1,000

Shareholders'
Assets = Liabilities + Equity (Class.)
–49,000 –50,000 +1,000 IncSt  RE

Solutions 3-12
3.27 f. continued.

Maintenance Expense......................................................... 4,000

Cash................................................................................ 4,000

Shareholders'
Assets = Liabilities + Equity (Class.)
–4,000 –4,000 IncSt  RE

Correct Entries:
Machinery........................................................................... 50,000
Accounts Payable........................................................... 50,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+50,000 +50,000

Accounts Payable................................................................ 50,000

Cash................................................................................ 49,000
Machinery....................................................................... 1,000

Shareholders'
Assets = Liabilities + Equity (Class.)
–49,000 –50,000
–1,000

Machinery........................................................................... 4,000
Cash................................................................................ 4,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+4,000
–4,000

Assets understated by $3,000 and shareholders’ equity understated by $3,000.

3-13 Solutions
3.28 (Ailawadi Corporation; cash versus accrual basis of accounting.)

a. and b.
a. b.
Accrual Cash
Basis Basis
Sales Revenue................................................................. $ 69,500a $ 61,200b
Less Expenses:
Cost of Merchandise Sold.......................................... $ 43,200c --
Payments on Merchandise Purchased........................ -- $ 44,800
Depreciation Expense................................................ 1,000d --
Payments on Equipment Purchased........................... -- 36,000
Utilities Expense........................................................ 1,010e 750
Salaries Expense........................................................ 4,760f 3,500
Rent Expense............................................................. 3,000 6,000
Insurance Expense..................................................... 100 1,200
Interest Expense......................................................... 200g --
Total Expenses....................................................... $ (53,270) $ (92,250)
Net Income (Loss).......................................................... $ 16,230 $ (31,050)

a$69,500 = $60,000 + $9,500.

b$61,200 = $60,000 + $1,200.
c$43,200 = $44,800 + $3,900 – $5,500.
d$1,000 = ($36,000/3)/12.
e$1,010 = $750 + $260.
f$4,760 = $3,500 + $1,260.
g$200 = (.06 X $40,000) X 30/360.

c. The accrual basis of accounting provides superior measures of operating

performance because it matches revenues generated from selling activities during
January with the costs incurred in generating that revenue. Note that the capital
contribution and bank loan do not give rise to revenue under either basis of
accounting because they represent financing, not operating, activities.

Solutions 3-14
3.29 (McKindly Consultants, Inc.; cash versus accrual basis of accounting.)

a. and b.
a. b.
Accrual Cash
Basis Basis
Consulting Revenue........................................................ $ 135,000 $ 109,000
Less Expenses:
Rental Expense........................................................... $ 7,500 $ 7,500
Depreciation Expense................................................ 2,000a --
Payments on Equipment Purchased........................... -- 24,000
Utilities Expense........................................................ 4,040b 3,460
Salaries Expense........................................................ 109,800c 98,500
Supplies Expense....................................................... 3,630d 2,790
Interest Expense......................................................... 2,000e --
Total Expenses....................................................... $ 128,970 $ 136,250
Net Income (Loss).......................................................... $ 6,030 $ (27,250)

a$2,000 = ($24,000/5) X 5/12.

b$4,040 = $3,460 + $580.
c$109,800 = $98,500 + $11,300.
d$3,630 = $2,790 + $840.
e$2,000 = ($60,000 X .08) X 5/12.

c. See the answer for Problem 3.28, Part c. above.

3.30 (Hansen Retail Store; preparing income statement and balance sheet using accrual
basis.)

a. HANSEN RETAIL STORE

Income Statement
For the Year Ended December 31, Year 8

Sales ($52,900 + $116,100)............................................................ $ 169,000

Cost of Goods Sold ($125,000 – $15,400)..................................... (109,600)
Salary Expense ($34,200 + $2,400)................................................ (36,600)
Utility Expense ($2,600 + $180).................................................... (2,780)
Depreciation Expense ($60,000/30)............................................... (2,000)
Interest Expense (.10 X $40,000).................................................... (4,000)
Net Income before Income Taxes................................................... $ 14,020
Income Taxes at 40 Percent............................................................ (5,608)
Net Income...................................................................................... $ 8,412

3-15 Solutions
3.30 continued.

b. HANSEN RETAIL STORE

Balance Sheet
December 31, Year 8

Assets

Cash ($50,000 + $40,000 – $60,000 – $97,400 + $52,900

+ $54,800 – $34,200 – $2,600).................................................. $ 3,500
Accounts Receivable ($116,100 – $54,800)................................... 61,300
Inventories....................................................................................... 15,400
Total Current Assets.............................................................. $ 80,200
Building ($60,000 – $2,000)........................................................... 58,000
Total Assets............................................................................ $ 138,200

Liabilities and Shareholders' Equity

Accounts Payable ($125,000 – $97,400)........................................ $ 27,600

Salaries Payable.............................................................................. 2,400
Utilities Payable.............................................................................. 180
Income Taxes Payable.................................................................... 5,608
Interest Payable............................................................................... 4,000
Loan Payable................................................................................... 40,000
Total Current Liabilities........................................................ $ 79,788
Common Stock............................................................................... $ 50,000
Retained Earnings........................................................................... 8,412
Total Shareholders' Equity..................................................... $ 58,412
Total Liabilities and Shareholders' Equity............................. $ 138,200

3.31 (Miscellaneous transactions and adjusting entries.)

a. (1) Accounts Payable....................................................... 6,000

Notes Payable........................................................ 6,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+6,000
–6,000

(2) Interest Expense [$6,000 X .10 X (30/360)].............. 50

Interest Payable..................................................... 50

Shareholders'
Assets = Liabilities + Equity (Class.)
+50 –50 IncSt  RE

Solutions 3-16
3.31 continued.

b. (1) Cash............................................................................ 18,000

Advances from Customers.................................... 18,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+18,000 +18,000

(2) Advances from Customers ($18,000 X 4/24)............ 3,000

Insurance Revenue................................................. 3,000

Shareholders'
Assets = Liabilities + Equity (Class.)
–3,000 +3,000 IncSt  RE

c. (1) Equipment.................................................................. 40,000

Cash ...................................................................... 40,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+40,000
–40,000

(2) Depreciation Expense [.25($40,000 –

$4,000)/4].............................................................. 2,250
Accumulated Depreciation................................ 2,250

Shareholders'
Assets = Liabilities + Equity (Class.)
–2,250 –2,250 IncSt  RE

d. (1) Automobile................................................................ 24,000

Cash ...................................................................... 24,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+24,000
–24,000

(2) Depreciation Expense [.5 X {($24,000 –

$3,000)/3}]............................................................ 3,500
Accumulated Depreciation................................ 3,500

Shareholders'
Assets = Liabilities + Equity (Class.)
–3,500 –3,500 IncSt  RE

3-17 Solutions
3.31 continued.

e. (1) Prepaid Rent............................................................... 12,000

Cash ...................................................................... 12,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+12,000
–12,000

(2) Rent Expense.............................................................. 4,000

Prepaid Rent.......................................................... 4,000

Shareholders'
Assets = Liabilities + Equity (Class.)
–4,000 –4,000 IncSt  RE

f. (1) Office Supplies Inventory.......................................... 7,000

Accounts Payable.................................................. 7,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+7,000 +7,000

(1) Accounts Payable....................................................... 5,000

Cash ...................................................................... 5,000

Shareholders'
Assets = Liabilities + Equity (Class.)
–5,000 –5,000

(2) Office Supplies Expense ($7,000 – $1,500).............. 5,500

Office Supplies Inventory..................................... 5,500

Shareholders'
Assets = Liabilities + Equity (Class.)
–5,500 –5,500 IncSt  RE

3.32 (Miscellaneous transactions and adjusting entries.)

a. (1) Cash............................................................................ 48,000

Rental Fees Received in Advance......................... 48,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+48,000 +48,000

Solutions 3-18
3.32 a. continued.

(2) Rental Fees Received in Advance.............................. 12,000

Rent Revenue......................................................... 12,000

Shareholders'
Assets = Liabilities + Equity (Class.)
–12,000 +12,000 IncSt  RE

b. (1) Notes Receivable........................................................ 10,000

Accounts Receivable............................................. 10,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+10,000
–10,000

(2) Interest Receivable ($10,000 X .06 X

30/360)................................................................... 50
Interest Revenue................................................ 50

Shareholders'
Assets = Liabilities + Equity (Class.)
+50 +50 IncSt  RE

c. (1) Prepaid Insurance....................................................... 6,600

Cash ...................................................................... 6,600

Shareholders'
Assets = Liabilities + Equity (Class.)
+6,600
–6,600

(2) Insurance Expense [$500 + ($6,600 X

10/24)]................................................................... 3,250
Prepaid Insurance.............................................. 3,250

Shareholders'
Assets = Liabilities + Equity (Class.)
–3,250 –3,250 IncSt  RE

3-19 Solutions
3.32 c. continued.

Alternate entries for Part c. are:

(1) Insurance Expense ..................................................... 500

Prepaid Insurance ($6,600 – $500)............................ 6,100
Cash ...................................................................... 6,600

Shareholders'
Assets = Liabilities + Equity (Class.)
+6,100 –500 IncSt  RE
–6,600

(2) Insurance Expense ($6,600 X 10/24)......................... 2,750

Prepaid Insurance.................................................. 2,750

Shareholders'
Assets = Liabilities + Equity (Class.)
–2,750 –2,750 IncSt  RE

d. (1) Repair Expense.......................................................... 14,900

Cash ...................................................................... 14,900

Shareholders'
Assets = Liabilities + Equity (Class.)
–14,900 –14,900 IncSt  RE

(2) Repair Expense.......................................................... 200

Repair Parts Inventory........................................... 200

Shareholders'
Assets = Liabilities + Equity (Class.)
–200 –200 IncSt  RE

e. (1) Equipment.................................................................. 200,000

Cash ...................................................................... 200,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+200,000
–200,000

Solutions 3-20
3.32 e. continued.

(2) Depreciation Expense [($200,000 – $20,000)

X .5/10].................................................................. 9,000
Accumulated Depreciation................................ 9,000

Shareholders'
Assets = Liabilities + Equity (Class.)
–9,000 –9,000 IncSt  RE

f. (1) Property Tax Expense................................................ 12,000

Cash ...................................................................... 12,000

Shareholders'
Assets = Liabilities + Equity (Class.)
–12,000 –12,000 IncSt  RE

(2) No adjusting entry required because the full amount paid is an expense for
Year 3.

3.33 (Moulton Corporation; analysis of transactions and preparation of income statement

and balance sheet.)

a. T-accounts.

Cash (A) Accounts Receivable (A)

√ 343,000 √ 0
(4) 1,400,000 950,000 (5) (2) 2,000,000 1,400,000 (4)
625,000 (6)
82,400 (7)
√ 85,600 √ 600,000

Inventory (A) Prepaid Insurance (A)

√ 275,000 √ 12,000
(1) 1,100,000 1,200,000 (3) 12,000 (9)
√ 175,000 √ 0

Land (A) Building (A)

√ 50,000 √ 450,000

√ 50,000 √ 450,000

3-21 Solutions
3.33 a. continued.

Equipment (A) Accumulated Depreciation (XA)

√ 80,000 0 √
34,000 (10)
√ 80,000 34,000 √

Accounts Payable (L) Note Payable (L)

30,000 √ 80,000 √
(5) 950,000 1,100,000 (1) (7) 80,000
180,000 √ 0 √

Interest Payable (L) Income Tax Payable (L)

0 √ 0 √
24,000 (8) 41,040 (11)
24,000 √ 41,040 √

Loan Payable (L) Common Stock (SE)

300,000 √ 800,000 √

300,000 √ 800,000 √

Retained Earnings (SE) Sales Revenue (SE)

0 √ (12) 2,000,000 2,000,000 (2)
61,560 (12)
61,560 √

Selling and
Cost of Goods Sold (SE) Administrative Expense (SE)
(3) 1,200,000 1,200,000 (12) (6) 625,000 625,000 (12)

Interest Expense (SE) Insurance Expense (SE)

(7) 2,400 (9) 12,000 12,000 (12)
(8) 24,000 26,400 (12)

Solutions 3-22
3.33 a. continued.

Depreciation Expense (SE) Income Tax Expense (SE)

(10) 34,000 34,000 (12) (11) 41,040 41,040 (12)

See the following page for the transactions spreadsheet.

b. MOULTON CORPORATION
Income Statement
For Year 13

Sales Revenue.............................................................................. $ 2,000,000

Expenses:
Cost of Goods Sold................................................................. $ 1,200,000
Selling and Administrative Expenses...................................... 625,000
Insurance................................................................................. 12,000
Depreciation............................................................................ 34,000
Interest ($2,400 + $24,000)..................................................... 26,400
Total Expenses.................................................................... $ 1,897,400
Net Income before Income Taxes................................................ $ 102,600
Income Tax Expense at 40 Percent.............................................. (41,040)
Net Income................................................................................... $ 61,560

3-23 Solutions
3.33 a. continued.
Transactions spreadsheet.
Balance Sheet Accounts Transactions, By Number and Description

Balance: Acquire Sell Recog. Collect Pay Pay S&A Repay Recog. Recog. Recog. Recog. Balance:
Beginning Inventory Inventory COGS Accts. Accts. Expenses Note Int. on Insur. Depre. Inc. Tax End of
of Period on on Rec. Pay. Payable Bank Expired Exp. Period
Account Account Loan
1 2 3 4 5 6 7 8 9 10 11
ASSETS
Current Assets:
Cash 343,000 1,400,000 -950,000 -625,000 -82,400 85,600
Accounts Receivable 2,000,000 -1,400,000 600,000
Inventory 275,000 1,100,000 -1,200,000 175,000
Prepaid Insurance 12,000 -12,000 0
Total Current Assets 630,000 860,600
Noncurrent Assets:
Land 50,000 50,000
Building 450,000 450,000
Equipment 80,000 80,000
Accumulated
Depreciation -34,000 (34,000)
Total Noncurrent Assets 580,000 546,000
Total Assets 1,210,000 1,406,600

LIABILITIES AND SHARE-

HOLDERS' EQUITY
Current Liabilities:
Accounts Payable 30,000 1,100,000 -950,000 180,000
Note Payable 80,000 -80,000 -
Interest Payable 24,000 24,000
Income Tax Payable 41,040 41,040
Total Current Liabilities 110,000 245,040
Noncurrent Liabilities:
Loan Payable 300,000 300,000
Total Noncurrent
Liabilities 300,000 300,000
Total Liabilities 410,000 545,040
Shareholders' Equity:
Common Stock 800,000 800,000
Retained Earnings 2,000,000 -1,200,000 -625,000 -2,400 -24,000 -12,000 -34,000 -41,040 61,560
Total Shareholders'
Equity 800,000 861,560
Total Liabilities and 1,210,00
Shareholders' Equity 0 1,406,600

Imbalance, if Any - - - - - - - - - - - - -

Income Statement Sales COGS S&A Exp. Int. Exp. Int. Insur. Depre. Inc Tax
Accounts Rev. Exp. Exp. Exp. Exp.

Solutions 3-24
3.33 continued.

c. MOULTON CORPORATION
Comparative Balance Sheet

December 31, December 31,

Year 12 Year 13
Assets

Cash...................................................................... $ 343,000 $ 85,600

Accounts Receivable............................................ 0 600,000
Inventories............................................................ 275,000 175,000
Prepaid Insurance................................................. 12,000 0
Total Current Assets........................................ $ 630,000 $ 860,600
Land (at Cost)...................................................... $ 50,000 $ 50,000
Building................................................................ 450,000 450,000
Equipment............................................................ 80,000 80,000
Less Accumulated Depreciation.......................... 0 (34,000)
Land, Building, and Equipment (Net)................. $ 580,000 $ 546,000
Total Assets..................................................... $ 1,210,000 $ 1,406,600

Liabilities and Shareholders' Equity

Accounts Payable................................................. $ 30,000 $ 180,000

Notes Payable....................................................... 80,000 0
Interest Payable.................................................... 0 24,000
Income Tax Payable............................................. 0 41,040
Total Current Liabilities.................................. $ 110,000 $ 245,040
Loan Payable........................................................ 300,000 300,000
Total Liabilities............................................... $ 410,000 $ 545,040
Common Stock.................................................... $ 800,000 $ 800,000
Retained Earnings................................................ 0 61,560
Total Shareholders' Equity.............................. $ 800,000 $ 861,560
Total Liabilities and Shareholders'
Equity.......................................................... $ 1,210,000 $ 1,406,600

3.34 (Regaldo Department Stores; analysis of transactions and preparation of income

statement and balance sheet.)

a. T-accounts.

Cash (A) Accounts Receivable (A)

√ 247,200 √ 0
(3a) 62,900 32,400 (4) (3a) 194,600 84,600 (6)
(6) 84,600 2,700 (5)
205,800 (7a)
29,000 (7b)
√ 124,800 √ 110,000

3-25 Solutions
Solutions 3-26
3.34 a. continued.

Inventory (A) Prepaid Rent (A)

√ 188,800 √ 60,000
(2) 217,900 162,400 (3b)
4,200 (7a) 30,000 (11)
√ 240,100 √ 30,000

Prepaid Insurance (A) Equipment (A)

√ 12,000 1,000 (12) √ 0
(1) 90,000
√ 11,000 √ 90,000

Accumulated Depreciation (XA) Patent (A)

0 √ √ 24,000
1,500 (10) 400 (13)
1,500 √ √ 23,600

Accounts Payable (L) Note Payable (L)

32,000 √ 0 √
(7a) 210,000 217,900 (2)
(7b) 29,000 90,000 (1)
10,900 √ 90,000 √

Compensation Payable (L) Utilities Payable (L)

0 √ 0 √
6,700 (8) 800 (9)
6,700 √ 800 √

Interest Payable (L) Income Tax Payable (L)

0 √ 0 √
900 (14) 5,610 (15)
900 √ 5,610 √

Common Stock (SE) Retained Earnings (SE)

500,000 √ 0 √
13,090 (16)
500,000 √ 13,090 √

3-27 Solutions
3.34 a. continued.

Sales Revenue (SE) Cost of Goods Sold (SE)

(16) 257,500 257,500 (3a) (3b) 162,400 162,400 (16)

Compensation Expense (SE) Utilities Expense (SE)

(4) 32,400 (5) 2,700
(8) 6,700 39,100 (16) (9) 800 3,500 (16)

Depreciation Expense (SE) Rent Expense (SE)

(10) 1,500 1,500 (16) (11) 30,000 30,000 (16)

Patent
Insurance Expense (SE) Amortization Expense (SE)
(12) 1,000 1,000 (16) (13) 400 400 (16)

Interest Expense (SE) Income Tax Expense (SE)

(14) 900 900 (16) (15) 5,610 5,610 (16)

Solutions 3-28
3.34 a. continued.
Transactions spreadsheet.
Balance Sheet Transactions, By Number and Description
Accounts
Balance: Purchase Acquire Sell Recog. Paid Paid Collects Pay Pay Recog. Recog. Recog. Recog. Recog. Recog. Recog. Recog. Balance:
Begin- Equip. Merchan. Mer. For COGS Compen. Utilities Accts. Accts. Accts. Unpaid Unpaid Depre. Rent Insur. Patent Int. Exp. Inc. Tax End of
ning of with Loan On Acct. Cash & To Emp. Rec. Pay. Pay. Comp. Util. Exp. Exp. Exp. Exp. Amort. Exp. Period
Period on Acct. With W/O Exp.
Discount Discount
1 2 3a 3b 4 5 6 7a 7b 8 9 10 11 12 13 14 15
ASSETS
Current Assets:
Cash 247,200 62,900 -32,400 -2,700 84,600 -205,800 -29,000 124,800
Accounts Receivable 194,600 -84,600 110,000
Merchandise
Inventories 188,800 217,900 -162,400 -4,200 240,100
Prepaid Rent 60,000 -30,000 30,000
Prepaid Insurance 12,000 -1,000 11,000
Total Current Assets 508,000 515,900
Noncurrent Assets:
Equipment 90,000 90,000
Accumulated
Depreciation -1,500 (1,500)
Patent 24,000 -400 23,600
Total Noncurrent
Assets 24,000 112,100
Total Assets 532,000 628,000

LIABILITIES AND SHARE-

HOLDERS' EQUITY
Current Liabilities:
Accounts Payable 32,000 217,900 -210,000 -29,000 10,900
Note Payable 90,000 90,000
Compensation Payable 6,700 6,700
Utilities Payable 800 800
Interest Payable 900 900
Income Tax Payable 5,610 5,610
Total Current Liabilities 32,000 114,910
Noncurrent Liabilities:
Total Noncurrent
Liabilities - -
Total Liabilities 32,000 114,910
Shareholders' Equity:
Common Stock 500,000 500,000
Retained Earnings 257,500 -162,400 -32,400 -2,700 -6,700 -800 -1,500 -30,000 -1,000 -400 -900 -5,610 13,090
Total Shareholders'
Equity 500,000 513,090
Total Liabilities and
Shareholders' Equity 532,000 628,000

Imbalance, if Any - - - - - - - - - - - - - - - - - -
-

Income Statement Sales COGS Comp. Utility Comp. Utility Depre. Rent Insur. Amort. Int. Income
Accounts Rev. Exp. Exp. Exp. Exp. Exp. Exp. Exp. Exp. Exp. Tax Exp.

3-29 Solutions
3.34 continued.

b. REGALDO DEPARTMENT STORES

Income Statement
For the Month of February Year 8

Sales Revenue................................................................................. Ps 257,500

Expenses:
Cost of Goods Sold.................................................................... Ps 162,400
Compensation (Ps32,400 + Ps6,700)......................................... 39,100
Utilities (Ps2,700 + Ps800)........................................................ 3,500
Depreciation............................................................................... 1,500
Rent ........................................................................................... 30,000
Insurance.................................................................................... 1,000
Patent Amortization.................................................................... 400
Interest........................................................................................ 900
Total Expenses....................................................................... Ps 238,800
Net Income before Income Taxes................................................... Ps 18,700
Income Tax Expense at 30 Percent................................................. (5,610)
Net Income...................................................................................... Ps 13,090

Solutions 3-30
3.34 continued.

c. REGALDO DEPARTMENT STORES

Comparative Balance Sheet

January 31, February 28,

Year 8 Year 8
Assets
Cash...................................................................... Ps 247,200 Ps 124,800
Accounts Receivable............................................ 0 110,000
Inventories............................................................ 188,800 240,100
Prepaid Rent......................................................... 60,000 30,000
Prepaid Insurance................................................. 12,000 11,000
Total Current Assets........................................ Ps 508,000 Ps 515,900
Equipment (at Cost)............................................. Ps 0 Ps 90,000
Less Accumulated Depreciation.......................... 0 (1,500)
Equipment (Net).................................................. Ps 0 Ps 88,500
Patent ................................................................ 24,000 23,600
Total Noncurrent Assets.................................. Ps 24,000 Ps 112,100
Total Assets..................................................... Ps 532,000 Ps 628,000

Liabilities and Shareholders' Equity

Accounts Payable................................................. Ps 32,000 Ps 10,900

Notes Payable....................................................... 0 90,000
Compensation Payable......................................... 0 6,700
Utilities Payable................................................... 0 800
Interest Payable.................................................... 0 900
Income Tax Payable............................................. 0 5,610
Total Liabilities............................................... Ps 32,000 Ps 114,910
Common Stock.................................................... Ps 500,000 Ps 500,000
Retained Earnings................................................ 0 13,090
Total Shareholders' Equity.............................. Ps 500,000 Ps 513,090
Total Liabilities and Shareholders'
Equity.......................................................... Ps 532,000 Ps 628,000

3.35 (Patterson Corporation; analysis of transactions and preparation of income statement

and balance sheet.)

a. T-accounts.

Cash (A) Marketable Securities (A)

√ 47,150 √ 95,000
(6) 1,206,000 2,400 (1)
235,000 (5)
710,000 (7)
√ 305,750 √ 95,000

3-31 Solutions
Solutions 3-32
3.35 a. continued.

Accounts Receivable (A) Receivable from Supplier (A)

√ 0 √ 1,455
(3) 1,495,500 1,206,000 (6) 1,455 (2)
√ 289,500 √ 0

Merchandise Inventory (A) Prepaid Rent (A)

√ 70,945 √ 1,400
(2) 1,050,000 950,000 (4) 1,400 (8)
√ 170,945 √ 0

Prepaid Insurance (A) Land (A)

√ 0 √ 80,000
(1) 2,400 100 (11)
√ 2,300 √ 80,000

Building (A) Equipment (A)

√ 280,000 √ 97,750

√ 280,000 √ 97,750

Accumulated Depreciation (XA) Patent (A)

0 √ √ 28,000
2,500 (9) 450 (10)
2,500 √ √ 27,550

Accounts Payable (L) Advance from Customer (L)

14,200 √ 4,500 √
(7) 710,000 1,048,545 (2) (3) 4,500
352,745 √ 0 √

Interest Payable (L) Income Tax Payable (L)

0 √ 0 √
265 (12) 124,114 (13)
265 √ 124,114 √

3-33 Solutions
3.35 a. continued.

Mortgage Payable (L) Common Stock (SE)

53,000 √ 450,000 √

53,000 √ 450,000 √

Additional Paid-in Capital (SE) Retained Earnings (SE)

180,000 √ 0 √
186,171 (14)
180,000 √ 186,171 √

Sales Revenue (SE) Cost-of-Goods Sold (SE)

(14) 1,500,000 1,500,000 (3) (4) 950,000 950,000 (14)

Selling and
Administrative Expense (SE) Rent Expense (SE)
(5) 235,000 235,000 (14) (8) 1,400 1,400 (14)

Depreciation Expense (SE) Amortization Expense (SE)

(9) 2,500 2,500 (14) (10) 450 450 (14)

Insurance Expense (SE) Interest Expense (SE)

(11) 100 100 (14) (12) 265 265 (14)

Income Tax Expense (SE)

(13) 124,114 124,114 (14)

Solutions 3-34
3.35 a. continued.
Transactions spreadsheet.
Balance Sheet Accounts Transactions, By Number and Description

Balance: Pays Acquire Sell Mer. Recog. Pays Collect Pays Recog. Recog. Recog. Recog. Recog. Recog. Balance:
Begin- Insur. Mer. Inv. Inv. On COGS S&A Cash from Sup. For Rent Depre. Patent Insur. Int. Exp. Inc. Tax End of
ning of Premium On Acct. Acct. Exp. Cust. Pur. On Exp. Exp. Amort. Exp. Exp. Period
Period Acct.
1 2 3 4 5 6 7 8 9 10 11 12 13
ASSETS
Current Assets:
Cash 47,150 -2,400 -235,000 1,206,000 -710,000 305,750
Marketable Securities 95,000 95,000
Accounts Receivable 1,495,500 -1,206,000 289,500
Receivable from Supplier 1,455 -1,455 -
Merchandise Inventories 70,945 1,050,000 -950,000 170,945
Prepaid Rent 1,400 -1,400 -
Prepaid Insurance 2,400 -100 2,300
Total Current Assets 215,950 863,495
Noncurrent Assets:
Land 80,000 80,000
Building 280,000 280,000
Equipment 97,750 97,750
Accumulated Depreciation -2,500 (2,500)
Patent 28,000 -450 27,550
Total Noncurrent Assets 485,750 482,800
Total Assets 701,700 1,346,295

LIABILITIES AND SHARE-

HOLDERS’ EQUITY
Current Liabilities:
Accounts Payable 14,200 1,048,545 -710,000 352,745
Advance from Customer 4,500 -4,500 -
Interest Payable 265 265
Income Tax Payable 124,114 124,114
Total Current Liabilities 18,700 477,124
Noncurrent Liabilities:
Mortgage Payable 53,000 53,000
Total Noncurrent 53,00 53,00
Liabilities 0 0
Total Liabilities 71,700 530,124
Shareholders' Equity:
Common Stock 450,000 450,000
Additional Paid-in Capital 180,000 180,000
Retained Earnings 1,500,000 -950,000 -235,000 -1,400 -2,500 -450 -100 -265 -124,114 186,171
[Insert Rows as Needed] -
Total Shareholders' 630,00 816,17
Equity 0 1
Total Liabilities and 701,70 1,346,295
Shareholders' Equity 0

Imbalance, if Any - - - - - - - - -
- - - - -

Income Statement Sales COGS S&A Rent Depre Amort. Insur. Int. Exp. Inc. Tax
Accounts Rev. Exp. Exp. Exp. Exp. Exp. Exp.

3-35 Solutions
3.35 continued.

b. PATTERSON CORPORATION
Income Statement
For the Month of February, Year 13

Sales Revenue.............................................................................. $ 1,500,000

Expenses:
Cost of Goods Sold................................................................. $ 950,000
Selling and Administrative Expenses...................................... 235,000
Rent ........................................................................................ 1,400
Depreciation............................................................................ 2,500
Amortization............................................................................ 450
Insurance................................................................................. 100
Interest..................................................................................... 265
Total Expenses.................................................................... $ 1,189,715
Net Income before Income Taxes................................................ $ 310,285
Income Tax Expense at 40 Percent.............................................. (124,114)
Net Income................................................................................... $ 186,171

Solutions 3-36
3.35 continued.

c. PATTERSON CORPORATION
Comparative Balance Sheet

January 31, February 28,

Year 13 Year 13
Assets

Cash...................................................................... $ 47,150 $ 305,750

Marketable Securities........................................... 95,000 95,000
Accounts Receivable............................................ 0 289,500
Receivable from Supplier.................................... 1,455 0
Merchandise Inventories...................................... 70,945 170,945
Prepaid Rent......................................................... 1,400 0
Prepaid Insurance................................................. 0 2,300
Total Current Assets........................................ $ 215,950 $ 863,495
Land (at Cost)...................................................... $ 80,000 $ 80,000
Building (at Cost)................................................. 280,000 280,000
Equipment (at Cost)............................................. 97,750 97,750
Less Accumulated Depreciation.......................... 0 (2,500)
Land, Building, and Equipment (Net)................. $ 457,750 $ 455,250
Patent (Net).......................................................... 28,000 27,550
Total Noncurrent Assets.................................. $ 485,750 $ 482,800
Total Assets..................................................... $ 701,700 $ 1,346,295

Liabilities and Shareholders' Equity

Accounts Payable................................................. $ 14,200 $ 352,745

Advance from Customers.................................... 4,500 0
Interest Payable.................................................... 0 265
Income Tax Payable............................................. 0 124,114
Total Current Liabilities.................................. $ 18,700 $ 477,124
Mortgage Payable................................................ 53,000 53,000
Total Liabilities............................................... $ 71,700 $ 530,124
Common Stock.................................................... $ 450,000 $ 450,000
Additional Paid-In Capital................................... 180,000 180,000
Retained Earnings................................................ 0 186,171
Total Shareholders' Equity.............................. $ 630,000 $ 816,171
Total Liabilities and Shareholders'
Equity.......................................................... $ 701,700 $ 1,346,295

3-37 Solutions
3.36 (Zealock Bookstore; analysis of transactions and preparation of income statement and
balance sheet.)

a. T-accounts.

Cash (A) Accounts Receivable (A)

(1) 25,000 20,000 (3) (8) 148,200 142,400 (10)
(2) 30,000 4,000 (4)
(8) 24,600 10,000 (5)
(10) 142,400 8,000 (6)
(13) 850 16,700 (11)
139,800 (12)
24,350 5,800

Merchandise Inventory (A) Prepaid Rent (A)

(7) 160,000 140,000 (8) (3) 20,000 10,000 (15)
14,600 (9)
5,400 10,000

Deposit with Suppliers (A) Equipment (A)

(6) 8,000 (4) 4,000
(5) 10,000
8,000 14,000

Accumulated Depreciation (XA) Note Payable (L)

400 (16) 30,000 (2)
1,500 (17)
1,900 30,000

Accounts Payable (L) Advances from Customers (L)

(9) 14,600 160,000 (7) 850 (13)
(12) 139,800
5,600 850

Interest Payable (L) Income Tax Payable (L)

900 (14) 1,320 (19)

900 1,320

Solutions 3-38
3.36 a. continued.

Common Stock (SE) Retained Earnings (SE)

25,000 (1) 1,980 (20)

25,000 1,980

Sales Revenue (SE) Cost of Goods Sold (SE)

(20) 172,800 172,800 (8) (8) 140,000 140,000 (20)

Compensation Expense (SE) Interest Expense (SE)

(11) 16,700 16,700 (20) (14) 900 900 (20)

Rent Expense (SE) Depreciation Expense (SE)

(15) 10,000 10,000 (20) (16) 400 1,900 (20)
(17) 1,500

Income Tax Expense (SE)

(19) 1,320 1,320 (20)

3-39 Solutions
 3.36 a. continued.
Transactions spreadsheet.
Balance Sheet Transactions, By Number and Description
Accounts
Balance: Issue Obtain Pay Rent Acquire Acquire Make Pur. Sell Recog. Return Collect Pay Pay Sup. Receive Recog. Recog. Recog. Recog. Recog. Balance:
Begin- Common Bank in Book- Compu- Deposit Books Books COGS Unsold Cash Compen- For Pur. Adv. Int. Exp. Rent Depre. Depre. On Inc. Tax End of
ning of Stock for Loan Advance shelves ters for with on Acct. for Cash Books from sation to On Acct. From Exp. On Comp. Exp. Period
Period Cash for Cash Cash Supplier and on Credit Emp. Cust. Book-
Acct. Sales shelves
1 2 3 4 5 6 7 8a 8b 9 10 11 12 13 14 15 16 17 18
ASSETS
Current Assets:
Cash 25,000 30,000 -20,000 -4,000 -10,000 -8,000 24,600 142,400 -16,700 -139,800 850 24,350
Accounts Receivable 148,200 -142,400 5,800
Merchandise
Inventories 160,000 -140,000 -14,600 5,400
Prepaid Rent 20,000 -10,000 10,000
Deposit with Suppliers 8,000 8,000
Total Current Assets - 53,550
Noncurrent Assets:
Equipment 4,000 10,000 14,000
Accumulated
Depreciation -400 -1,500 (1,900)
Total Noncurrent
Assets - 12,100
Total Assets - 65,650

LIABILITIES AND SHARE-

HOLDERS' EQUITY
Current Liabilities:
Accounts Payable 160,000 -14,600 -139,800 5,600
Note Payable 30,000 30,000
Advances from
Customers 850 850
Interest Payable 900 900
Income Tax Payable 1,320 1,320
Total Current Liabilities - 38,670
Noncurrent Liabilities:
Total Noncurrent
Liabilities - -
Total Liabilities - 38,670
Shareholders' Equity:
Common Stock 25,000 25,000
Retained Earnings 172,800 -140,000 -16,700 -900 -10,000 -400 -1,500 -1,320 1,980
Total Shareholders'
Equity - 26,980
Total Liabilities and
Shareholders' Equity - 65,650

Imbalance, if Any - - - - - - - - - - - - - - - - - - - - -

Income Statement Sales COGS - Comp. Int. Rent Depre. Depre. Inc. Tax
Accounts Rev. Exp. Exp. Exp. Exp. Exp. Exp.

Solutions 3-40
3.36 continued.

b. ZEALOCK BOOKSTORE
Income Statement
For the Six Months Ending December 31, Year 10

Sales Revenue................................................................................... $ 172,800

Less Expenses:
Cost of Goods Sold...................................................................... $ 140,000
Compensation Expense................................................................ 16,700
Interest Expense........................................................................... 900
Rent Expense............................................................................... 10,000
Depreciation Expense.................................................................. 1,900
Income Tax Expense.................................................................... 1,320
Total Expenses........................................................................ $ 170,820
Net Income....................................................................................... $ 1,980

c. ZEALOCK BOOKSTORE
Balance Sheet
December 31, Year 10

Assets

Current Assets:
Cash........................................................................................ $ 24,350
Accounts Receivable.............................................................. 5,800
Merchandise Inventories........................................................ 5,400
Prepaid Rent........................................................................... 10,000
Deposit with Suppliers........................................................... 8,000
Total Current Assets.......................................................... $ 53,550
Equipment.............................................................................. $ 14,000
Less Accumulated Depreciation............................................ (1,900)
Equipment (Net).................................................................... $ 12,100
Total Assets....................................................................... $ 65,650

3-41 Solutions
3.36 c. continued.

Liabilities and Shareholders' Equity

Current Liabilities:
Accounts Payable................................................................... $ 5,600
Note Payable.......................................................................... 30,000
Advances from Customers..................................................... 850
Interest Payable...................................................................... 900
Income Tax Payable............................................................... 1,320
Total Current Liabilities.................................................... $ 38,670
Shareholders' Equity:
Common Stock...................................................................... $ 25,000
Retained Earnings.................................................................. 1,980
Total Shareholders' Equity................................................ $ 26,980
Total Liabilities and Shareholders' Equity........................ $ 65,650

d. Net income was positive, which is unusual for a new business in its first year.
The profit margin, however, is only 1.1 percent (= $1,980/$172,800). This small
margin does not leave much room for unexpected events. Current Assets exceed
Current Liabilities by a comfortable margin. The firm sells its inventory quickly
and collects its accounts receivable soon after sale. It must also pay its suppliers
quickly.

3.37 (Zealock Bookstore; analysis of transactions and preparation of comparative income

statements and balance sheet.)

a. T-accounts.

Cash (A) Accounts Receivable (A)

√ 24,350 √ 5,800
(3) 75,000 1,320 (1) (7) 327,950 320,600 (9)
(4) 8,000 31,800 (2)
(7) 24,900 20,000 (5)
(9) 320,600 29,400 (10)
281,100 (11)
4,000 (12)
√ 85,230 √ 13,150

Solutions 3-42
3.37 a. continued.

Merchandise Inventory (A) Prepaid Rent (A)

√ 5,400 √ 10,000
(6) 310,000 286,400 (7) (5) 20,000 20,000 (13)
22,700 (8)
√ 6,300 √ 10,000

Deposit with Suppliers (A) Equipment (A)

√ 8,000 √ 14,000
8,000 (4)
√ 0 √ 14,000

Accumulated Depreciation (XA) Note Payable (L)

1,900 √ 30,000 √
800 (14) (2) 30,000 75,000 (3)
3,000 (15)
5,700 √ 75,000 √

Accounts Payable (L) Advance from Customers (L)

5,600 √ 850 √
(8) 22,700 310,000 (6) (7) 850
(11) 281,100
11,800 √ 0 √

Interest Payable (L) Income Tax Payable (L)

900 √ 1,320 √
(2) 900 3,000 (16) (1) 1,320 4,080 (17)
3,000 √ 4,080 √

Common Stock (SE) Retained Earnings (SE)

25,000 √ 1,980 √
(12) 4,000 6,120 (18)
25,000 √ 4,100 √

Sales Revenue (SE) Cost of Goods Sold (SE)

(18) 353,700 353,700 (7) (7) 286,400 286,400 (18)

3-43 Solutions
3.37 a. continued.

Compensation Expense (SE) Interest Expense (SE)

(10) 29,400 29,400 (18) (2) 900
(16) 3,000 3,900 (18)

Rent Expense (SE) Depreciation Expense (SE)

(13) 20,000 20,000 (18) (14) 800
(15) 3,000 3,800 (18)

Income Tax Expense (SE)

(17) 4,080 4,080 (18)

Solutions 3-44
3.37 a. continued.
Transactions spreadsheet.
Balance Sheet Transactions, By Number and Description
Accounts
Balance: Pay Yr. Repay Obtain Rec. Pay Pur. Sells Recog. Return Collect Pay Pay Sup. Dec. Rec. Int. Recog. Recog. Recog. Recog. Balance:
Begin- 10 Inc. Bank Bank Refund Annual Books Books COGS Unsold Cash Emp. and Exp. Rent Depre. Depre. Inc. Tax End of
ning of Tax Loan Loan of Sec. Rent on Acct. for Cash Books from Compen. Pay Exp. On On Exp. Period
Period with Int. Dep. and on Credit Div. Book- Comp.
Acct. Sales shelves
1 2 3 4 5 6 7a 7b 8 9 10 11 12 13 14 15 16 17
ASSETS
Current Assets:
Cash 24,350 -1,320 -31,800 75,000 8,000 -20,000 24,900 320,600 -29,400 -281,100 -4,000 85,230
Accounts Receivable 5,800 327,950 -320,600 13,150
Merchandise Inventories 5,400 310,000 -286,400 -22,700 6,300
Prepaid Rent 10,000 20,000 -20,000 10,000
Deposit with Suppliers 8,000 -8,000
-
Total Current Assets 53,550 114,680
Noncurrent Assets:
Equipment 14,000 14,000
Accumulated
Depreciation -1,900 -800 -3,000 (5,700
)
Total Noncurrent Assets 12,100 8,300
Total Assets 65,650 122,980

LIABILITIES AND SHARE-

HOLDERS' EQUITY
Current Liabilities:
Accounts Payable 5,600 310,000 -22,700 -281,100 11,800
Note Payable 30,000 -30,000 75,000 75,000
Advances from
Customers 850 -850 -
Interest Payable 900 -900 3,000 3,000
Income Tax Payable 1,320 -1,320 4,080 4,080
Total Current Liabilities 38,670 93,880
Noncurrent Liabilities:
Total Noncurrent
Liabilities - -
Total Liabilities 38,670 93,880
Shareholders' Equity:
Common Stock 25,000 25,000
Retained Earnings 1,980 -900 353,700 -286,400 -29,400 -4,000 -3,000 -20,000 -800 -3,000 -4,080 4,100
Total Shareholders'
Equity 26,980 29,100
Total Liabilities and
Shareholders' Equity 65,650 122,980

Imbalance, if Any - - - - - - - - - - - - - - - - - -
- -

Income Statement Int. Exp. Sales COGS Comp. Int. Exp. Rent Depre. Depre. Inc. Tax
Accounts Rev. Exp. Exp. Exp. Exp. Exp.

3-45 Solutions
3.37 continued.

b. ZEALOCK BOOKSTORE
Comparative Income Statement
For Year 10 and Year 11

Year 10 Year 11
Sales Revenue......................................................... $ 172,800 $ 353,700
Less Expenses:
Cost of Goods Sold............................................ $ 140,000 $ 286,400
Compensation Expense...................................... 16,700 29,400
Interest Expense................................................. 900 3,900
Rent Expense...................................................... 10,000 20,000
Depreciation Expense......................................... 1,900 3,800
Income Tax Expense.......................................... 1,320 4,080
Total Expenses............................................... $ 170,820 $ 347,580
Net Income.............................................................. $ 1,980 $ 6,120

c. ZEALOCK BOOKSTORE
Comparative Balance Sheet
December 31, Year 10 and Year 11

Year 10 Year 11
Assets

Current Assets:
Cash.................................................................... $ 24,350 $ 85,230
Accounts Receivable.......................................... 5,800 13,150
Merchandise Inventories.................................... 5,400 6,300
Prepaid Rent....................................................... 10,000 10,000
Deposit with Suppliers....................................... 8,000 --
Total Current Assets...................................... $ 53,550 $ 114,680
Noncurrent Assets:
Equipment.......................................................... $ 14,000 $ 14,000
Less Accumulated Depreciation......................... (1,900) (5,700)
Equipment (Net)................................................. $ 12,100 $ 8,300
Total Assets.................................................... $ 65,650 $ 122,980

Solutions 3-46
3.37 c. continued.

Liabilities and Shareholders' Equity

Current Liabilities:
Accounts Payable............................................... $ 5,600 $ 11,800
Note Payable....................................................... 30,000 75,000
Advances from Customers................................. 850 --
Interest Payable.................................................. 900 3,000
Income Tax Payable........................................... 1,320 4,080
Total Current Liabilities................................ $ 38,670 $ 93,880
Shareholders' Equity:
Common Stock................................................... $ 25,000 $ 25,000
Retained Earnings............................................... 1,980 4,100
Total Shareholders' Equity............................. $ 26,980 $ 29,100
Total Liabilities and Shareholders'
Equity........................................................ $ 65,650 $ 122,980

d. Schedule 1 of this solution presents selected financial ratios for Zealock

Bookstore. The profit margin percentage increased slightly. The principal driver
was a decrease in the compensation expense to sales percentage. The bookstore
must have employees operating the store regardless of the number of books sold.
Sales more than doubled between the six-month period in Year 10 and the 12-
month period in Year 11. Compensation did not increase proportionally,
suggesting the benefits of spreading relatively fixed costs over a larger sales base.
The interest expense to revenues percentage increased because of the larger
amount of debt and larger interest rate. The income tax expense to sales
percentage increased because of higher pre-tax profitability. The income tax rate
was 40 percent in both years.
The current ratio declined, although it is still at a healthy level. The
proportion of liabilities in the capital structure increased significantly. It appears
that Zealock Bookstore may have taken on more short-term borrowing than it
needed. Inventories did not increase as fast as sales. Thus, the firm collected
cash more quickly in Year 11 than in Year 10 and may not have needed as much
financing as it obtained.

3-47 Solutions
3.37 d. continued.

SCHEDULE 1
Financial Ratios for Zealock Bookstore

Year 10 Year 11
Sales................................................................................ 100.0% 100.0%
Cost of Goods Sold........................................................ (81.0) (81.0)
Compensation Expense.................................................. (9.7) (8.3)
Interest Expense............................................................. (.5) (1.1)
Rent Expense.................................................................. (5.8) (5.7)
Depreciation Expense..................................................... (1.1) (1.1)
Income Tax Expense...................................................... (.8) (1.1)
Net Income..................................................................... 1.1% 1.7%

Current Assets/Current Liabilities.................................. 1.4 1.2

Liabilities/(Liabilities + Shareholders’ Equity)............. 58.9% 76.3%

3.38 (Prima Company; working backwards to balance sheet at beginning of the period.)

A T-account method for deriving the solution appears below and on the following
page. The end-of-year balance appears at the bottom of the T-account. The derived
starting balance appears at the top. “p” indicates plug; “c” closing entry.

Cash Marketable Securities

(p) 11,700 (p) 12,000
(1) 47,000 128,000 (3) (8) 8,000
(2) 150,000 49,000 (4)
7,500 (5)
1,200 (6)
5,000 (7)
8,000 (8)
Bal. 10,000 Bal. 20,000

Accounts Receivable Merchandise Inventory

(p) 22,000 (p) 33,000
(10) 153,000 150,000 (2) (9) 127,000 130,000 (11)
Bal. 25,000 Bal. 30,000

Prepayments for Land, Buildings, and

Miscellaneous Services Equipment
(p) 1,700 (p) 40,000
(4) 49,000 47,700 (14)
Bal. 3,000 Bal. 40,000

Solutions 3-48
3.38 continued.

Accounts Payable
(for Merchandise) Interest Payable
26,000 (p) 300 (p)
(3) 128,000 127,000 (9) (6) 1,200 1,200 (15)
25,000 Bal. 300 Bal.

Taxes Payable Note Payable

3,500 (p) 20,000 (p)
(5) 7,500 8,000 (13)
4,000 Bal. 20,000 Bal.

Accumulated Depreciation Common Stock

12,000 (p) 50,000 (p)
4,000 (12)
16,000 Bal. 50,000 Bal.

Retained Earnings Sales

8,600 (p) 47,000 (1)
(7) 5,000 9,100 (16c) (16c) 200,000 153,000 (10)
12,700 Bal.

Cost of Goods Sold Depreciation Expense

(11) 130,000 130,000 (16c) (12) 4,000 4,000 (16c)

Tax Expense Other Operating Expense

(13) 8,000 8,000 (16c) (14) 47,700 47,700 (16c)

Interest Expense
(15) 1,200 1,200 (16c)

3-49 Solutions
3.38 continued.
Transactions spreadsheet.
Balance Sheet Transactions, By Number and Description
Accounts
Balance: Recog. Acct. Recog. Recog. Recog. Recog. Recog. Recog. Recog. Recog. Recog. Recog. Recog. Record Balance:
Begin- Sales Rec. Pur. Of COGS Cash Depre. Tax Exp. Tax Paid Prepay. Oper. Int. Exp. Int. Paid Div. Dec. Mkt. End of
ning of Rev. Collected Merchn. Pay. To Exp. Made Exp. and Paid Sec. Pur. Period
Period Supp.
1 2 3 4 5 6 7 8 9 10 11 12 13 14
ASSETS
Current Assets:
Cash 11,700 47,000 150,000 -128,000 -7,500 -49,000 -1,200 -5,000 -8,000 10,000
Marketable Securities 12,000 8,000 20,000
Accounts Receivable 22,000 153,000 -150,000 25,000
Merchandise Inventory 33,000 127,000 -130,000 30,000
Prepayments for
Miscellaneous Ser. 1,700 49,000 -47,700 3,000
Total Current Assets 80,400 88,000
Noncurrent Assets:
Land, Building, & Equip. 40,000 40,000
Accumulated (16,000
Depreciation -12,000 -4,000 )
Total Noncurrent
Assets 28,000 24,000
Total Assets 108,400 112,000

LIABILITIES AND SHARE-

HOLDERS' EQUITY
Current Liabilities:
Accounts Payable 26,000 127,000 -128,000 25,000
Interest Payable 300 1,200 -1,200 300
Taxes Payable 3,500 8,000 -7,500 4,000
Total Current Liabilities 29,800 29,300
Noncurrent Liabilities:
Note Payable 20,000 20,000
Total Noncurrent
Liabilities 20,000 20,000
Total Liabilities 49,800 49,300
Shareholders' Equity:
Common Stock 50,000 50,000
Retained Earnings 8,600 200,000 -130,000 -4,000 -8,000 -47,700 -1,200 -5,000 12,700
Total Shareholders'
Equity 58,600 62,700
Total Liabilities and
Shareholders' Equity 108,400 112,000

Imbalance, if Any - - - - - - - - - - - - - - -

Income Statement Sales COGS Depre. Tax Exp. Ot. Op. Int. Exp.
Accounts Rev. Exp. Exp.

Solutions 3-50
3.38 continued.

PRIMA COMPANY
Balance Sheet
As of January 1, Year 2

Assets
Cash................................................................................ $ 11,700
Marketable Securities..................................................... 12,000
Accounts Receivable...................................................... 22,000
Merchandise Inventory................................................... 33,000
Prepayments................................................................... 1,700
Total Current Assets............................................... $ 80,400
Land, Buildings, and Equipment.................................... $ 40,000
Less Accumulated Depreciation..................................... (12,000) 28,000
Total Assets............................................................. $ 108,400

Liabilities and Shareholders’ Equity

Accounts Payable........................................................... $ 26,000
Interest Payable.............................................................. 300
Taxes Payable................................................................. 3,500
Total Current Liabilities......................................... $ 29,800
Notes Payable (6 Percent).............................................. 20,000
Total Liabilities....................................................... $ 49,800
Common Stock............................................................... $ 50,000
Retained Earnings........................................................... 8,600
Total Shareholders’ Equity..................................... $ 58,600
Total Liabilities and Shareholders’ Equity............. $ 108,400

3.39 (The Secunda Company; working backwards to cash receipts and disbursements.)

A T-account method for deriving the solution appears on the following two pages.
After Entry (6), we have explained all revenue and expense account changes.
Plugging for the unknown amounts determines the remaining, unexplained changes in
balance sheet accounts. A “p” next to the entry number designates these entries. Note
that the revenue and expense accounts are not yet closed to retained earnings, so
dividends account for the decrease in the Retained Earnings account during the year of
$10,000.

3-51 Solutions
3.39 continued.

Cash Accounts Receivable

Bal. 20,000 Bal. 36,000
(7) 85,000 (1) 100,000 85,000 (7p)
2,000 (9)
81,000 (10)
3,000 (11)
10,000 (12)
Bal. 9,000 Bal. 51,000

Merchandise Inventory Prepayments

Bal. 45,000 Bal. 2,000
(8p) 65,000 50,000 (2) 1,000 (5)
Bal. 60,000 Bal. 1,000

Land, Buildings, and

Equipment Cost of Goods Sold
Bal. 40,000 Bal. 0
(2) 50,000
Bal. 40,000 Bal. 50,000

Interest Expense Other Operating Expenses

Bal. 0 Bal. 0
(3) 3,000 (4) 2,000
(5) 1,000
(6p) 26,000
Bal. 3,000 Bal. 29,000

Accumulated Depreciation Interest Payable

16,000 Bal. 1,000 Bal.
2,000 (4) (9p) 2,000 3,000 (3)
18,000 Bal. 2,000 Bal.

Accounts Payable Mortgage Payable

30,000 Bal. 20,000 Bal.
(10p) 81,000 26,000 (6) (11p) 3,000
65,000 (8)
40,000 Bal. 17,000 Bal.

Solutions 3-52
3.39 continued.

Common Stock Retained Earnings

50,000 Bal. 26,000 Bal.
(12p) 10,000
50,000 Bal. 16,000 Bal.

Sales
0 Bal.
100,000 (1)
100,000 Bal.

3-53 Solutions
3.39 continued.
Transactions spreadsheet.
Balance Sheet Transactions, By Number and Description
Accounts
Balance: Recog. Cash Recog. Pur. Of Cash Recog. Int. Paid Recog. Recog. Cash Recog. Recog. Check on Balance:
Begin- Sales on Collect. COGS Mer. On Pay. For Int. Exp. Depre. Of Oper. Paid for Mort. Div. Dec. Ending End of
ning of Acct. From Acct. Merchn. Exp. Exp. Prepay. Paid & Paid Bal. Sheet Period
Period Cus. Amts.
1 2 3 4 5 6 7 8 8 9 10 11 12
ASSETS
Current Assets:
Cash 20,000 85,000 -55,000 -2,000 -26,000 -3,000 -10,000 9,000 9,000
Accounts Receivable 36,000 100,000 -85,000 51,000 51,000
Merchandise Inventory 45,000 -50,000 65,000 60,000 60,000
Prepayments 2,000 -27,000 26,000 1,000 1,000
Total Current Assets 103,000 121,000 121,000
Noncurrent Assets:
Land, Buildings, &
Equip. 40,000 40,000 40,000
Accumulated
Depreciation -16,000 -2,000 -18,000 (18,000)
Total Noncurrent
Assets 24,000 22,000 22,000
Total Assets 127,000 143,000 143,000

LIABILITIES AND SHARE-

HOLDERS' EQUITY
Current Liabilities:
Interest Payable 1,000 3,000 -2,000 2,000 2,000
Accounts Payable 30,000 65,000 -55,000 40,000 40,000
Total Current Liabilities 31,000 42,000 42,000
Noncurrent Liabilities:
Mortgage Payable 20,000 -3,000 17,000 17,000
Total Noncurrent
Liabilities 20,000 17,000 17,000
Total Liabilities 51,000 59,000 59,000
Shareholders' Equity:
Common Stock 50,000 50,000 50,000
Retained Earnings 26,000 100,000 -50,000 -3,000 -2,000 -27,000 -10,000 34,000 34,000
Total Shareholders'
Equity 76,000 84,000 84,000
Total Liabilities and
Shareholders' Equity 127,000 143,000 143,000

Imbalance, if Any - - - - - - - - - - - - - - -

Income Statement Sales COGS Int. Exp. Ot. Oper. Ot. Oper.
Accounts Rev. Exp. Exp.

Solutions 3-54
3.39 continued.

SECUNDA COMPANY
Cash Receipts and Disbursements Schedule

Receipts:
Collections from Customers................................... $ 85,000
Disbursements:
Suppliers of Merchandise and Other Ser-
vices.................................................................... $ 81,000
Mortgage................................................................. 3,000
Dividends................................................................ 10,000
Interest ................................................................... 2,000
Total Disbursements........................................... 96,000
Decrease in Cash............................................................ $ 11,000
Cash Balance, January 1................................................. 20,000
Cash Balance, December 31........................................... $ 9,000

3.40 (Tertia Company; working backwards to income statements.)

A T-account method for deriving the solution appears below and on the following two
pages. Transactions (1)—(9) correspond to the numbered cash transactions
information. In Transactions (10)—(25), “p” indicates that the figure was derived by
a “plug” and “c” indicates a closing entry. The final check is that the debit to close
Income Summary in Transaction (25) matches the plug in the Retained Earnings
account.

Accounts and
Cash Notes Receivable
Bal. 40,000 Bal. 36,000
(1) 144,000 114,000 (4) (10p) 149,000 144,000 (1)
(2) 63,000 5,000 (5)
(3) 1,000 500 (6)
57,500 (7)
1,200 (8)
2,000 (9)
Bal. 67,800 Bal. 41,000

3-55 Solutions
3.40 continued.

Merchandise Inventory Interest Receivable

Bal. 55,000 Bal. 1,000
(14) 121,000 126,500 (15p) (11p) 700 1,000 (3)
Bal. 49,500 Bal. 700

Building, Machinery,
Prepaid Miscellaneous Services and Equipment
Bal. 4,000 Bal. 47,000
(7) 57,500 56,300 (12p)
Bal. 5,200 Bal. 47,000

Accounts Payable Accounts Payable

(Miscellaneous Services) (Merchandise)
2,000 Bal. 34,000 Bal.
500 (13p) (4) 114,000 121,000 (14p)
2,500 Bal. 41,000 Bal.

Property Tax Payable Accumulated Depreciation

1,000 Bal. 10,000 Bal.
(8) 1,200 1,700 (16p) 2,000 (17p)
1,500 Bal. 12,000 Bal.

Mortgage Payable Common Stock

35,000 Bal. 25,000 Bal.
(5) 5,000
30,000 Bal. 25,000 Bal.

Retained Earnings Sales

76,000 Bal. 63,000 (2)
(9) 2,000 25,200 (18p) (18c) 212,000 149,000 (10)
99,200 Bal.

Cost of Goods Sold Interest Expense

(15) 126,500 126,500 (18c) (6) 500 500 (18c)

Solutions 3-56
3.40 continued.

Interest Revenue Miscellaneous Expenses

(18c) 700 700 (11) (12) 56,300
(13) 500 56,800 (18c)

Property Tax Expense Depreciation Expense

(16) 1,700 1,700 (18c) (17) 2,000 2,000 (18c)

3-57 Solutions
 3.40 continued.
Transactions spreadsheet.
Balance Sheet Transactions, By Number and Description
Accounts
Balance: Collect. Recog. Collect. Recog. Pay. To Pur. Of Recog. Repay. Pay. Of Pay. For Acq. Of Pay. For Recog. Dec. Recog. Check on Balance:
Begin- From Sales Of Int. Rev. Sup. Of Merchn. COGS Of Mort. Int. Misc. Misc. Prop. Prop. Tax and Depre. Ending End of
ning of Credit Rev. Interest Merchn. Ser. Ser. Taxes Exp. Pay. Exp. Bal. Sheet Period
Period Cust. Div. Amts.
1 2 3a 3b 4 5 6 7 8 9 10 11 12 13 14 15
ASSETS
Current Assets:
Cash 40,000 144,000 63,000 1,000 -114,000 -5,000 -500 -57,500 -1,200 -2,000 67,800 67,800
Accounts & Notes Rec. 36,000 -144,000 149,000 41,000 41,000
Merchandise Inventory 55,000 121,000 -126,500 49,500 49,500
Interest Receivable 1,000 -1,000 700 700 700
Prepaid Misc. Services 4,000 1,200 5,200 5,200
Total Current Assets 136,000 164,200 164,200
Noncurrent Assets:
Bldg., Mach., &
Equipment 47,000 47,000 47,000
Accumulated
Depreciation -10,000 -2,000 -12,000 (12,000)
Total Noncurrent
Assets 37,000 35,000 35,000
Total Assets 173,000 199,200 199,200

LIABILITIES AND SHARE-

HOLDERS' EQUITY
Current Liabilities:
Accounts Pay.
(miscellaneous ser.) 2,000 -56,300 56,800 2,500 2,500
Accounts Pay.
(mer. pur.) 34,000 -114,000 121,000 41,000 41,000
Property Taxes Payable 1,000 -1,200 1,700 1,500 1,500
Total Current Liabilities 37,000 45,000 45,000
Noncurrent Liabilities:
Mortgage Payable 35,000 -5,000 30,000 30,000
Total Noncurrent
Liabilities 35,000 30,000 30,000
Total Liabilities 72,000 75,000 75,000
Shareholders' Equity:
Common Stock 25,000 25,000 25,000
Retained Earnings 76,000 212,000 700 -126,500 -500 -56,800 -1,700 -2,000 -2,000 99,200 99,200
Total Shareholders'
Equity 101,000 124,200
Total Liabilities and
Shareholders' Equity 173,000 199,200

Imbalance, if Any - - - - - - - - - - - - - - - - -
-

Income Statement Sales Int. Rev. COGS Int. Mis. Ser. Prop. Tax Depre.
Accounts Rev. Exp. Exp. Exp. Exp.

Solutions 3-58
3.40 continued.

TERTIA COMPANY
Statement of Income and Retained Earnings

Revenues:
Sales ......................................................................$ 212,000
Interest Revenue...................................................... 700
Total Revenues................................................... $ 212,700
Expenses:
Cost of Goods Sold................................................. $ 126,500
Property Tax Expense............................................. 1,700
Depreciation Expense............................................. 2,000
Interest Expense...................................................... 500
Miscellaneous Expenses......................................... 56,800
Total Expenses................................................... 187,500
Net Income..................................................................... $ 25,200
Less Dividends............................................................... (2,000)
Increase in Retained Earnings........................................ $ 23,200
Retained Earnings, Beginning of Year........................... 76,000
Retained Earnings, End of Year..................................... $ 99,200

3.41 (Portobello Co.; reconstructing the income statement and balance sheet.)

T-accounts to derive the amounts in the income statement and balance sheet appear
below.

Cash Accounts Receivable

√ 18,600 √ 33,000
(4) 10,900 4,800 (3) (15) 228,000 210,000 (14)
(14) 210,000 115,000 (5)
3,000 (10)
85,000 (17)
27,000 (19)
√ 4,700 √ 51,000

Notes Receivable Interest Receivable

√ 10,000 √ 600
10,000 (4) 600 (4)
√ 0 √ 0

3-59 Solutions
3.41 continued.

Merchandise Inventory Prepaid Insurance

√ 22,000 √ 4,500
(6) 95,000 88,000 (8) 3,000 (1)
(7) 11,000
√ 40,000 √ 1,500

Advances to Employees Prepaid Taxes

√ 0 √ 0
(17) 4,000 (19) 3,000
√ 4,000 √ 3,000

Accumulated Depreciation—
Computer System (at Cost) Computer System
√ 78,000 26,000 √
13,000 (13)
√ 78,000 39,000 √

Accumulated Depreciation—
Delivery Trucks Delivery Trucks
√ 0 0 √
(9) 60,000 4,500 (12)
√ 60,000 4,500 √

Accounts Payable Notes Payable

36,000 √ 0 √
(5) 115,000 95,000 (6) 60,000 (9)
16,000 √ 60,000 √

Interest Payable Dividend Payable

0 √ 1,800 √
2,000 (11) (3) 4,800 6,000 (2)
2,000 √ 3,000 √

Salaries Payable Taxes Payable

6,500 √ 10,000 √
(17) 6,500 (19) 10,000 4,000 (20)
1,300 (18)
1,300 √ 4,000 √

Solutions 3-60
3.41 continued.

Consulting Fee Payable Advances from Customers

0 √ 600 √
4,800 (21) (16) 600 1,400 (15)
4,800 √ 1,400 √

Common Stock Retained Earnings

40,000 √ 45,800 √
11,000 (7) (2) 6,000 15,400 (22)
51,000 √ 55,200 √

Sales Revenue Interest Revenue

226,600 (15) (22) 300 300 (4)
(22) 227,200 600 (16)

Cost of Goods Sold Depreciation Expense

(8) 88,000 88,000 (22) (12) 4,500
(13) 13,000 17,500 (22)

Salary Expense Tax Expense

(17) 74,500 (19) 14,000
(18) 1,300 75,800 (22) (20) 4,000 18,000 (22)

Insurance Expense Consulting Expense

(1) 3,000 3,000 (22) (21) 4,800 4,800 (22)

Interest Expense
(10) 3,000
(11) 2,000 5,000 (22)

3-61 Solutions
 3.41 continued.
Transactions spreadsheet.
Balance Sheet Transactions, By Number and Description
Accounts
Balance: Recog. Pay Yr. 9 Dec. and Rec. Issue Pay Pur. Of Recog. Acquire Recog. Recog. Recog. Cash Record Recog. Cash Recog. Cash Recog. Recog. Balance:
Begin- Insur. Dividend Pay. Yr. Repay. Com- Merch. Merch. COGS Del. Int. Exp. Dep. Dep. Col. Sales Sales on Paid to Unpaid Paid for Unpaid Unpaid End of
ning of Exp. 10 Div. Of Note mon Suppliers On Trucks On Note Exp. On Exp. On From from Acct. Emp. Sal. Exp. Taxes Taxes Consult. Period
Period & Int. Stock for Acct. Pay. Del. Comp. Cust. Cus. Ser. Exp.
Merch. Equip. System Adv.
1 2a 2b 3 4a 4b 4c 4d 5a 5b 5c 6 7a 7b 7c 8a 8b 9a 9b 10
ASSETS
Current Assets:
Cash 18,600 -1,800 -3,000 10,900 -115,000 -3,000 210,000 -85,000 -27,000 4,700
Accounts Receivable 33,000 -208,600 226,600 51,000
Notes Receivable 10,000 -10,000 -
Interest Receivable 600 -600 -
Merchandise Inventory 22,000 11,000 95,000 -88,000 40,000
Prepaid Insurance 4,500 -3,000 1,500
Advances to Employees 4,000 4,000
Prepaid Property Taxes 3,000 3,000
Total Current Assets 88,700 104,200
Noncurrent Assets:
Computer System 78,000 78,000
Delivery Trucks 60,000 60,000
Accum. Depre.:
Comp. Sys. -26,000 -13,000 (39,000)
Accum. Depre.:
Del. Trucks -4,500 (4,500)
Total Noncurrent
Assets 52,000 94,500
Total Assets 140,700 198,700

LIABILITIES AND SHARE-

HOLDERS’ EQUITY
Current Liabilities:
Accounts Payable 36,000 -115,000 95,000 16,000
Dividend Payable 1,800 -1,800 3,000 3,000
Salaries Payable 6,500 -6,500 1,300 1,300
Taxes Payable 10,000 -10,000 4,000 4,000
Advances from
Customers 600 1,400 -600 1,400
Interest Payable 2,000 2,000
Consulting Services
Pay. 4,800 4,800
Total Current Liabilities 54,900 32,500
Noncurrent Liabilities:
Note Payable 60,000 60,000
Total Noncurrent
Liabilities - 60,000
Total Liabilities 54,900 92,500
Shareholders' Equity:
Common Stock 40,000 11,000 51,000
Retained Earnings 45,800 -3,000 -6,000 300 -88,000 -5,000 -4,500 -13,000 600 226,600 -74,500 -1,300 -14,000 -4,000 -4,800 55,200
Total Shareholders'
Equity 85,800 106,200
Total Liabilities and
Shareholders' Equity 140,700 198,700

Imbalance, if Any - - - - - - - - - - - - - - - - - - - - - -

Income Statement Insur. Int. Rev. COGS Int. Exp. Depre. Depre. Sales Sales Sal. Exp. Sal. Exp. Tax Exp. Tax Exp. Consul.
Accounts Exp. Exp. Exp. Rev. Rev. Exp.

Solutions 3-62
3.41 continued.

PORTOBELLO CO.
Income Statement
For the Year Ended December 31, Year 10

Revenues:
Sales................................................................................................... $ 227,200
Interest................................................................................................ 300
Total Revenues.............................................................................. $ 227,500
Expenses:
Cost of Goods Sold............................................................................ $ 88,000
Depreciation....................................................................................... 17,500
Salaries............................................................................................... 75,800
Taxes.................................................................................................. 18,000
Insurance............................................................................................ 3,000
Consulting.......................................................................................... 4,800
Interest................................................................................................ 5,000
Total Expenses............................................................................... $ 212,100
Net Income ........................................................................................ $ 15,400

3-63 Solutions
3.41 continued.

PORTOBELLO CO.
Balance Sheet
December 31, Year 10

Assets

Current Assets:
Cash.................................................................... $ 4,700
Accounts Receivable.......................................... 51,000
Merchandise Inventories.................................... 40,000
Prepaid Insurance............................................... 1,500
Advances to Employees..................................... 4,000
Prepaid Property Taxes...................................... 3,000
Total Current Assets...................................... $ 104,200
Noncurrent Assets:
Computer System—at Cost................................ $ 78,000
Less Accumulated Depreciation......................... (39,000) $ 39,000
Delivery Trucks.................................................. $ 60,000
Less Accumulated Depreciation......................... (4,500) 55,500
Total Noncurrent Assets................................ $ 94,500
Total Assets.................................................... $ 198,700

Liabilities and Shareholders' Equity

Current Liabilities:
Accounts Payable............................................... $ 16,000
Interest Payable.................................................. 2,000
Dividend Payable............................................... 3,000
Salaries Payable.................................................. 1,300
Taxes Payable..................................................... 4,000
Consulting Fee Payable...................................... 4,800
Advances from Customers................................. 1,400
Total Current Liabilities................................ $ 32,500
Note Payable....................................................... 60,000
Total Liabilities.............................................. $ 92,500
Shareholders' Equity:
Common Stock................................................... $ 51,000
Retained Earnings............................................... 55,200
Total Shareholders' Equity............................. $ 106,200
Total Liabilities and Shareholders'
Equity............................................................. $ 198,700

Solutions 3-64
3.42 (Computer Needs, Inc.; reconstructing the income statement and balance sheet.)

a. T-accounts.

Cash Accounts Receivable

√ 15,600 √ 32,100
(A) 37,500 164,600 (D) (C) 159,700 151,500 (B)
(B) 151,500 21,000 (G)
3,388 (H)
4,800 (I)
6,000 (J)
√ 4,812 √ 40,300

Inventory Prepayments
√ 46,700 √ 1,500
(E) 172,100 158,100 (F) (G) 300
√ 60,700 √ 1,800

Property, Plant and Equipment Accumulated Depreciation

√ 59,700 2,800 √
(J) 6,000 3,300 (K)
√ 65,700 6,100 √

Accounts Payable—Merchandise Income Tax Payable

37,800 √ 3,388 √
(D) 164,600 172,100 (E) (H) 3,388 3,584 (L)
45,300 √ 3,584 √

Other Current Liabilities Mortgage Payable

2,900 √ 50,000 √
(G) 1,700 (I) 800
1,200 √ 49,200 √

Common Stock Retained Earnings

50,000 √ 8,712 √
9,216 (M)
50,000 √ 17,928 √

3-65 Solutions
3.42 a. continued.

Sales Cost of Goods Sold

37,500 (A) (F) 158,100 158,100 (M)
(M) 197,200 159,700 (C)

Selling and
Administrative Expense Depreciation Expense
(G) 19,000 19,000 (M) (K) 3,300 3,300 (M)

Interest Expense Income Tax Expense

(I) 4,000 4,000 (M) (L) 3,584 3,584 (M)

Solutions 3-66
3.42 a. continued.
Transactions spreadsheet.
Balance Sheet Transactions, By Number and Description
Accounts
Balance: Cash Col. Recog. Pay. To Recog. Recog. Pay Pay Recog. Pay Prin. Acq. Recog. Balance:
Begin- From Sales on Mer. Merch. COGS Emp. & Income Depre. & Int. on Equip. Inc. Tax End of
ning of Cust. Acct. Sup. Pur. On Prov. Of Taxes Exp. Mort. Exp. Period
Period Acct. S&A
Serv.
1 2 3 4 5 6 7 8 9 10 11
ASSETS
Current Assets:
Cash 15,600 189,000 -164,600 -21,000 -3,388 -4,800 -6,000 4,812
Accounts Receivable 32,100 -151,500 159,700 40,300
Inventories 46,700 172,100 -158,100 60,700
Prepayments 1,500 300 1,800
Total Current Assets 95,900 107,612
Noncurrent Assets:
Prop., Plant, &
Equipment 59,700 6,000 65,700
Accumulated
Depreciation -2,800 -3,300 (6,100)
Total Noncurrent
Assets 56,900 59,600
Total Assets 152,800 167,212

LIABILITIES AND SHARE-

HOLDERS' EQUITY
Current Liabilities:
Acct. Pay.—Merchan. 37,800 -164,600 172,100 45,300
Income Tax Payable 3,388 -3,388 3,584 3,584
Other Current
Liabilities 2,900 -1,700 1,200
Total Current
Liabilities 44,088 50,084
Noncurrent Liabilities:
Mortgage Payable 50,000 -800 49,200
Total Noncurrent
Liabilities 50,000 49,200
Total Liabilities 94,088 99,284
Shareholders' Equity:
Common Stock 50,000 50,000
Retained Earnings 8,712 37,500 159,700 -158,100 -19,000 -3,300 -4,000 -3,584 17,928
Total Shareholders'
Equity 58,712 67,928
Total Liabilities and
Shareholders' Equity 152,800 167,212

Imbalance, if Any - - - - - - - - - - - - -

Income Statement Sal. Rev. Sal. Rev. COGS S&A Depre. Int. Inc. Tax
Accounts Exp. Exp. Exp. Exp.

3-67 Solutions
3.42 a. continued.

COMPUTER NEEDS, INC.

Income Statement
For the Years Ended December 31

Year 8 Year 9
Amounts Percentages Amounts Percentages
Sales....................................... $ 152,700 100.0% $ 197,200 100.0%
Cost of Goods Sold................ (116,400) (76.2) (158,100) (80.2)
Selling and Administra-
tion Expenses..................... (17,400) (11.4) (19,000) (9.6)
Depreciation........................... (2,800) (1.9) (3,300) (1.7)
Interest.................................... (4,000) (2.6) (4,000) (2.0)
Income Taxes......................... (3,388) (2.2) (3,584) (1.8)
Net Income............................. $ 8,712 5.7% $ 9,216 4.7%

Solutions 3-68
3.42 a. continued.

COMPUTER NEEDS, INC.

Balance Sheet
December 31

Year 8 Year 9
Amounts Percentages Amounts Percentages
Assets
Cash......................................... $ 15,600 10.2% $ 4,812 2.9%
Accounts Receivable............... 32,100 21.0 40,300 24.1
Inventories............................... 46,700 30.6 60,700 36.3
Prepayments............................ 1,500 1.0 1,800 1.1
Total Current Assets........... $ 95,900 62.8% $ 107,612 64.4%
Property, Plant and
Equipment:
At Cost............................. $ 59,700 39.0% $ 65,700 39.3%
Less Accumulated
Depreciation.................. (2,800) (1.8) (6,100) (3.7)
Net.................................... $ 56,900 37.2% $ 59,600 35.6%
Total Assets......................... $ 152,800 100.0% $ 167,212 100.0%

Liabilities and Share-

holders’ Equity
Accounts Payable—
Merchandise........................ $ 37,800 24.8% $ 45,300 27.1%
Income Tax Payable................ 3,388 2.2 3,584 2.2
Other Current Liabilities......... 2,900 1.9 1,200 .7
Total Current Liabil-
ities................................... $ 44,088 28.9% $ 50,084 30.0%
Mortgage Payable.................... 50,000 32.7 49,200 29.4
Total Liabilities................... $ 94,088 61.6% $ 99,284 59.4%
Common Stock........................ $ 50,000 32.7% $ 50,000 29.9%
Retained Earnings.................... 8,712 5.7 17,928 10.7
Total Shareholders’
Equity............................... $ 58,712 38.4% $ 67,928 40.6%
Total Liabilities and
Shareholders’ Equity........ $ 152,800 100.0% $ 167,212 100.0%

3-69 Solutions
3.42 continued.

b. Although sales increased between Year 8 and Year 9, net income as a percentage
of sales declined from 5.7% to 4.7%. The decline occurs primarily as a result of
an increase in the cost of goods sold to sales percentage. The increased
percentage might suggest (1) increased competition, which forced Computer
Needs, Inc. to lower its prices, (2) increased cost of merchandise, which
Computer Needs, Inc. could not or chose not to pass on to customers, or (3) a
shift in product mix to lower margin products. The percentage is also affected by
the estimates made for the December 31, Year 9 balances in Accounts
Receivable, Inventories, and Accounts Payable. The following summarizes the
effects of an overstatement (O/S), understatement (U/S), or no effect (NO) of
each of these three accounts, assuming the other two accounts are correctly stated,
on the cost of goods sold to sales percentage.

Effect on Cost of Goods Sold

December 31, Year 9 to Sales Percentage
Balance Is: Numerator Denominator Net Effect
Accounts Receivable Overstated............ NO O/S U/S
Accounts Receivable Understated.......... NO U/S O/S
Inventories Overstated............................ U/S NO U/S
Inventories Understated.......................... O/S NO O/S
Accounts Payable Overstated................. O/S NO O/S
Accounts Payable Understated............... U/S NO U/S

Of course, there could be compounding or offsetting errors in each of these three

accounts.
The selling and administrative expense to sales percentage declined.
Compensation of employees is largely a fixed cost, so the increased sales should
permit Computer Needs, Inc. to spread this cost over the larger sales base. The
estimate of Accounts Receivable and Other Current Liabilities on December 31,
Year 9 also can affect this percentage.
The reduced expense percentage for depreciation reflects the spreading of this
fixed cost over a larger sales base. Although depreciation expense increased
between Year 8 and Year 9, sales increased by a higher percentage.
The reduced expense percentage for interest likewise results from spreading
this fixed cost over a larger sales base. Note that interest expense was the same
amount in Year 8 and Year 9. Given that the amount of the loan outstanding
decreased, the interest rate on the loan must have increased.
The decreased income tax percentage results from a lower income before
taxes to sales percentage. The income tax rate was 28 percent in both years.

Solutions 3-70
3.42 b. continued.

Year 8 Year 9
Amounts Percentages Amounts Percentages
Income before Taxes............... $ 12,100 100.0% $ 12,800 100.0%
Income Tax Expense............... (3,388) (28.0) (3,584) (28.0)
Net Income.............................. $ 8,712 72.0% $ 9,216 72.0%

The balance sheet shows a significant decline in cash and a buildup of

accounts receivable, inventories, and accounts payable. It is possible that each of
these accounts is overstated. The decline in cash, however, is consistent with the
buildup of accounts receivable. The buildup of accounts payable is consistent
with a buildup in inventories.

3.43 (The GAP and The Limited; interpreting common-size income statements.)

a. The decreasing cost of goods sold to sales percentages for both firms suggest a
common explanation. One possibility is that the economy was doing well and
both firms were able to increase selling prices and thereby their profit margins.
Another possibility is that the firms were able to purchase merchandise in larger
quantities or pay more quickly to take advantage of discounts. A third possibility
is that the firms implemented more effective inventory control systems, thereby
reducing obsolescence and the need to reduce selling prices to move their
merchandise. Another possibility is that sales grew rapidly and the firms were
able to spread their relatively fixed occupancy costs over a larger sales base.

b. The Limited relies more heavily on in-store promotions, which tend to increase
its cost of goods sold to sales percentages, whereas The GAP relies more on
advertising to stimulate sales, which The GAP includes in selling and
administrative expenses.

c. The increasing selling and administrative expenses to sales percentages for both
firms suggest a common explanation. One possibility is that the specialty
retailing industry became more competitive over this period (from new entrants
and from the Internet) and the firms had to increase marketing expenses to
compete. This explanation, however, is inconsistent with a more attractive
pricing environment suggested in Part a. above. Another possibility is that both
firms experienced increased administrative expenses as they introduced new store
concepts and opened new stores.

d. The explanation in Part b. applies here as well. The GAP includes its promotion
costs in selling and administrative expenses, whereas more of those of The
Limited appear in cost of goods sold.

3-71 Solutions
3.43 continued.

e. The interest expense to sales percentage decreased for The GAP and increased for
The Limited. One possible explanation is The GAP reduced the amount of debt
outstanding or grew it at a slower pace than that of The Limited. Another
possibility is that the market viewed The GAP as increasingly less risky,
permitting it to borrow at lower interest rates. On the other hand, the market
viewed The Limited as more risky and required it to pay a higher interest rate.
These two possibilities are not independent. Perhaps The GAP was able to
borrow at a lower rate because it reduced the amount of debt in its capital
structure. The higher interest rate for The Limited may reflect increased risk
from an increased proportion of debt in its capital structure.

f. Both firms experienced increased net income relative to sales. Both firms should
therefore experience increased income tax expense relative to sales. A more
meaningful way to interpret income taxes is to relate income tax expense to
income before income taxes. The latter is the base on which governments impose
income taxes. Consider the following:
The GAP The Limited
Year 8 Year 9 Year 10 Year 8 Year 9 Year 10
(1) Income before
Income Taxes
(plug)................. 12.4% 14.6% 16.3% 5.8% 6.5% 6.9%
(2) Income Tax
Expense............. (4.2) (5.5) (6.6) (2.0) (2.3) (2.4)
(3) Net Income......... 8.2% 9.1% 9.7% 3.8% 4.2% 4.5%

(2)/(1)....................... 33.9% 37.7% 40.5% 34.5% 35.4% 34.8%

The income tax expense to income before income taxes percentages for The GAP
continually increased while those of The Limited remained relatively stable. One
possible explanation is that The GAP expanded its operations into other countries
and perhaps experienced higher income tax rates in those countries than it
experiences in the United States.

g. The profit margins of The Limited are just slightly larger than that for Wal-Mart
in Exhibit 3.8. One would expect specialty retailers to differentiate their products
and services more than Wal-Mart and achieve a higher profit margin percentage.
The question is: How much higher? The GAP achieves profit margins similar to
those for Kellogg (branded foods) and Omnicom Group (creative marketing
services). Extensive competition characterizes specialty apparel retailing, which
dampens profit margins. However, new fashions and trends stimulate demand
and permit higher profit margins. One might, therefore, expect an average profit
margin for specialty retailers somewhere between

Solutions 3-72
3.43 g. continued.

that of The Limited and The GAP. The Limited appears to have performed worse
during this period than one might expect and The GAP performed better.

3.44 (The Coca-Cola Company and PepsiCo; interpreting common-size income

statements.)

a. The creation, manufacture, and distribution of beverages involve six

principal activities:

(1) Research and development to create the beverage, which generally involves
developing the formula for the syrup.

(2) Promoting the beverage through advertising and other means.

(3) Manufacturing the syrup.

(4) Mixing water with the syrup to manufacture the beverage.

(5) Placing the beverage in a container.

(6) Distributing the beverage to retail and other outlets.

Coke primarily engages in the first three activities and its independent bottlers
engage in the last three activities. PepsiCo engages more heavily in all six
activities. The lower cost of goods sold to sales percentage for Coke might
suggest that the market views the first three activities as higher value added than
the last three, permitting Coke to extract a relatively high price from its bottlers
for the syrup sold to them. PepsiCo’s cost of goods sold to sales percentage
reflects both the higher value added of the first three activities and the lower
value added of the last three activities. Another possible explanation is that Coke
dominates its bottlers and can extract a higher price because of the bottlers’
reliance on Coke for most of their purchases.

b. The beverage industry, particularly for cola beverages, is relatively

mature. The increasing selling and administrative expense to sales
percentages for Coke might reflect increased advertising to gain
market share or to introduce new beverages. Note that both firms
experienced poor sales results in Year 10. Perhaps Coke increased
advertising expenditures in Year 11 and Year 12 to stimulate sales.
The decreasing percentages are consistent with not increasing
advertising in light of the Year 10 sales results. Note that sales growth
for PepsiCo in Year 11 and Year 12 is less than the corresponding
rates for Coke, suggesting less aggressiveness on the part of PepsiCo.

3-73 Solutions
3.44 continued.

c. One possibility is that both firms reduced their levels of interest-

bearing debt, which reduced interest expense. Another possibility is
that declining interest rates permitted both firms to borrow at lower
rates.

d. Coca-Cola Company PepsiCo

Year 10 Year 11 Year 12 Year 10 Year 11 Year 12
(1) Income before
Income Taxes
(plug)................. 27.9% 32.3% 28.1% 17.5% 18.8% 20.3%
(2) Income Tax
Expense............. (10.0) (9.6) (7.8) (5.6) (6.4) (6.5)
(3) Net Income......... 17.9% 22.7% 20.3% 11.9% 12.4% 13.8%

(2)/(1)....................... 35.8% 29.7% 27.8% 32.0% 34.0% 32.0%

Coke’s tax burden by this measure is less than that of PepsiCo in Year 11 and
Year 12. The income tax is a tax on income before taxes and not on sales. Thus,
this measure more accurately reflects the income tax burden. The larger income
tax expense to sales percentages for Coke results from Coke having higher
income before taxes to sales percentages.

e. The products of Coke and PepsiCo have brand recognition. Consumers willingly
pay a higher price for branded products than non-branded products. One might
argue that little intrinsic difference exists between the products of these two
companies, so that competition between them should lower the profit margins, as
occurs for AK Steel and Wal-Mart. The two companies dominate the
nonalcoholic beverage market however. An unwritten understanding not to
compete too heavily on low prices permits both firms to realize relatively large
profit margins. The greater competition among branded food companies and
advertising companies might explain their lower profits relative to Coke and
PepsiCo. The profit margins of Coke and PepsiCo are lower than Pfizer’s,
because consumers view pharmaceutical products as necessities and insurance
companies bear some of the cost.

3.45 (Nokia; interpreting common-size income statements.)

The improved profit margin results primarily from decreases in the cost of goods sold
to sales percentage and in the selling and administrative expense to sales percentage.
One possible explanation for these decreased percentages is that either Nokia's market
dominance or the rapid growth in industry sales gave it pricing flexibility and Nokia
was able to price its products favorably relative to its costs. Another possibility is that
the rapid sales growth permitted Nokia to spread fixed manufacturing, selling, and
administrative expenses over a much larger sales base. The decreasing in-

Solutions 3-74
3.45 continued.

terest expense to sales percentage also favorably affected the profit margin. Nokia
may have reduced the amount of debt in its capital structure or replaced debt with a
higher interest rate with debt carrying a lower interest rate. It is also possible that
Nokia grew its debt but at a less rapid pace than the growth in sales, permitting the
interest expense to sales percentage to decline.
Offsetting these favorable effects on the profit margin percentage is a reduction in
the other revenues percentage. We have no information to interpret this change. The
income tax expense to sales percentage increased, the result in part of an increase in
net income before income taxes. The average income tax rate also increased, as the
following analysis shows.

Year 7 Year 8 Year 9

(1) Income before Income Taxes
(plug).................................................. 15.7% 18.3% 18.9%
(2) Income Tax Expense............................. (4.0) (5.7) (6.1)
(3) Net Income............................................ 11.7% 12.6% 12.8%

(2)/(1).......................................................... 25.5% 31.1% 32.3%

3.46 (McDonalds; interpreting common-size income statements.)

The principal reason for the declining profit margin is an increase in the cost of goods
sold to sales percentage. Increased competition in the fast food segment of the
restaurant industry led McDonalds either to reduce selling prices or not increase
selling prices in line with increases in operating expenses. Offsetting the increasing
cost of goods sold to sales percentage is a decline in income tax expense as a
percentage of income before taxes, as the following analysis shows:

Year 10 Year 11 Year 12

(1) Income before Income Taxes
(plug).................................................. 21.8% 20.3% 16.7%
(2) Income Tax Expense............................. (7.1) (6.4) (5.0)
(3) Net Income............................................ 14.7% 13.9% 11.7%

(2)/(1).......................................................... 32.6% 31.5% 29.9%

3-75 Solutions
3.47 (Identifying industries using common-size income statement percentages.)

Exhibit 3.29 indicates that two firms have relatively low profit margins, two firms
have medium profit margins, and two firms have relatively large profit margins. Low
barriers to entry, extensive competition, and commodity products characterize firms
with low profit margins. The likely candidates for Firms (1) and (2) are Kelly
Services and Kroger Stores. The office services offered by Kelly Services are clerical
in nature and not particularly unique. Kelly Services serves essentially as an
intermediary between the employee and the customer, offering relatively little value
added. Grocery products are commodities, with little, if any, differentiation between
grocery stores. Firms (1) and (2) differ primarily with respect to depreciation and
interest expense. Grocery stores require retail and warehouse space. Kelly Services
should require relatively little space, since its employees work on the customers'
premises. Thus, Firm (1) is Kroger Stores and Firm (2) is Kelly Services.
Firms with the highest profit margin should operate in industries with high
barriers to entry, relatively little competition, and differentiated products. Electric
utilities have operated until recently as regulated utilities and require extensive
amounts of capital to build capital-intensive plants. Regulation and capital serve as
barriers to entry. Gillette offers brand name products. The brand names serve as an
entry barrier. Customers also perceive its products to be differentiated. Thus, Firm
(5) and Firm (6) are likely to be Commonwealth Edison and Gillette in some order.
Firm (5) has considerably more depreciation and interest expense than Firm (6) and
Firm (6) has considerably more selling and administrative expenses than Firm (5).
Thus, Firm (5) is Commonwealth Edison and Firm (6) is Gillette.
This leaves Hewlett-Packard and Delta Airlines with medium profit margins.
Hewlett-Packard offers products that are somewhat differentiated and with some brand
name appeal. However, competition in the computer industry and rapid technological
change drive down profit margins. Delta Airlines offers a commodity product, but the
need for capital to acquire airplanes serves as a barrier to entry. Thus, these two firms
have some characteristics of firms with relatively low profit margins and some
characteristics of firms with relatively high profit margins. Firm (3) appears to have
considerably more debt in its capital structure than Firm (4). The short product life
cycles in the computer industry tend to drive down their use of debt. The aircraft of
Delta Airlines can serve as collateral for borrowing. Thus, one would expect Delta
Airlines to have a higher amount of borrowing. This clue suggests that Firm (3) is
Delta Airlines and Firm (4) is Hewlett-Packard.

3.48 (Preparing adjusting entries.)

a. The Prepaid Rent account on the year-end balance sheet should represent eight
months of prepayments. The rent per month is $2,000 (= $24,000/12), so the
balance required in the Prepaid Rent account is $16,000 (= 8 X $2,000). Rent
Expense for Year 2 is $8,000 (= 4 X $2,000 = $24,000 – $16,000).

Solutions 3-76
3.48 a. continued.

Prepaid Rent........................................................................ 16,000

Rent Expense.................................................................. 16,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+16,000 +16,000 IncSt  RE

To increase the balance in the Prepaid Rent account, reducing

the amount in the Rent Expense account.

b. The Prepaid Rent account on the balance sheet for the end of Year 3 should
represent eight months of prepayments. The rent per month is $2,500 (=
$30,000/12), so the required balance in the Prepaid Rent account is $20,000 (= 8
X $2,500). The balance in that account is already $16,000, so the adjusting entry
must increase it by $4,000 (= $20,000 – $16,000).

Prepaid Rent........................................................................ 4,000

Rent Expense.................................................................. 4,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+4,000 +4,000 IncSt  RE

To increase the balance in the Prepaid Rent account, reducing

the amount in the Rent Expense account.

The Rent Expense account will have a balance at the end of Year 3 before closing
entries of $26,000 (= $30,000 – $4,000). This amount comprises $16,000 (=
$2,000 X 8) for rent from January through August and $10,000 (= $2,500 X 4) for
rent from September through December.

c. The Prepaid Rent account on the balance sheet at the end of Year 4 should
represent two months of prepayments. The rent per month is $3,000 (=
$18,000/6), so the required balance in the Prepaid Rent account is $6,000 (= 2 X
$3,000). The balance in that account is $20,000, so the adjusting entry must
reduce it by $14,000 (= $20,000 – $6,000).

3-77 Solutions
3.48 c. continued.

Rent Expense...................................................................... 14,000

Prepaid Rent.................................................................. 14,000

Shareholders'
Assets = Liabilities + Equity (Class.)
–14,000 –14,000 IncSt  RE

To decrease the balance in the Prepaid Rent account,

increasing the amount in the Rent Expense account.

The Rent Expense account will have a balance at the end of Year 4 before closing
entries of $32,000 (= $18,000 + $14,000). This amount comprises $20,000 (=
$2,500 X 8) for rent from January through August and $12,000 (= $3,000 X 4) for
rent from September through December.

d. The Wages Payable account should have a credit balance of $4,000 at

the end of April, but it has a balance of $5,000 carried over from the
end of March. The adjusting entry must reduce the balance by $1,000,
which requires a debit to the Wages Payable account.

Wages Payable.................................................................... 1,000

Wage Expense................................................................ 1,000

Shareholders'
Assets = Liabilities + Equity (Class.)
–1,000 +1,000 IncSt  RE

To reduce the balance in the Wages Payable account, reducing

the amount in the Wage Expense account.

Wage Expense is $29,000 (= $30,000 – $1,000).

e. The Prepaid Insurance account balance of $3,000 represents four

months of coverage. Thus, the cost of insurance is $750 (= $3,000/4)
per month. The adjusting entry for a single month is as follows:

Insurance Expense.............................................................. 750

Prepaid Insurance.......................................................... 750

Shareholders'
Assets = Liabilities + Equity (Class.)
–750 –750 IncSt  RE

To recognize cost of one month’s insurance cost as expense of

the month.

Solutions 3-78
3.48 continued.

f. The Advances from Tenants account has a balance of $25,000 carried

over from the start of the year. At the end of Year 3, it should have a
balance of $30,000. Thus, the adjusting entry must increase the
balance by $5,000, which requires a credit to the liability account.

Rent Revenue...................................................................... 5,000

Advance from Tenants.................................................. 5,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+5,000 –5,000 IncSt  RE

To increase the balance in the Advances from Tenants

account, reducing the amount in the Rent Revenue account.

Rent Revenue for Year 3 is $245,000 (= $250,000 – $5,000).

g. The Depreciation Expense for the year should be $2,000 (=

$10,000/5). The balance in the Accumulated Depreciation account
should also be $2,000; thus, the firm must credit Retained Earnings
(Depreciation Expense) by $8,000 (= $10,000 – $2,000). The
adjusting entry not only reduces recorded depreciation for the period
but also sets up the asset account and its accumulated depreciation
contra account.

Equipment........................................................................... 10,000
Accumulated Depreciation............................................. 2,000
Depreciation Expense..................................................... 8,000

Shareholders'
Assets = Liabilities + Equity (Class.)
+10,000 +8,000 IncSt  RE
–2,000

To reduce the recorded amount in Depreciation Expense from

$10,000 to $2,000, setting up the asset and its contra account.

3-79 Solutions
3.49 (Ethical issues in accounting choices.)

Each of these firms received an unqualified opinion from their independent auditor,
suggesting that they applied generally accepted accounting principles properly. Each
firm disclosed sufficient information about their application of accounting principles
for the user to ascertain that UAL applied its accounting principles in more income-
enhancing ways than AMR and Delta. Thus, the remaining question is whether UAL’s
aggressiveness relative to AMR and Delta creates an ethical concern. Using an
average life of 21.1 years, the average life for Delta, results in depreciation expense of
$1,082.3 (= $22,835.5/21.1). The longer depreciable life decreases depreciation by
approximately $112.3 million (= $1,082.3 – $970.0), a 10.4 percent reduction (=
$112.3/$1,082). This reduction appears material, given the importance of
depreciable assets to airlines. The differences in the estimated uncollectible
accounts percentages seem even more material. However, most customers prepay for
their airline tickets, so accounts receivable do not represent a significant proportion of
total assets.

Solutions 3-80