Chapter 2, Problem 2.3PA

Recording Transactions (in a Journal and T-Accounts); Preparing and Interpreting the Balance Sheet

Ethan Allen Interiors Inc. is a leading manufacturer and retailer of home furnishings in the United States and abroad, The following is adapted from Ethan Allen's September 30, 2013, trial balance. (The amounts shown represent millions of dollars.)

Assume that the following events occurred in the following quarter.

1. a. Paid $30 cash for additional inventory.
2. b. Issued additional shares of common stock for $20 in cash.
3. c. Purchased equipment for $170; paid $80 in cash and signed a note to pay the remaining $90 in two years.
4. d. Signed a short-term note to borrow $ 10 cash.
5. e. Conducted negotiations to purchase a sawmill, which is expected to cost $36.

Required:

1. 1. Analyze transactions (a)-(e) to determine their effects on the accounting equation. Use the format shown in the demonstration case on page 69.
2. 2. Record the transaction effects determined in requirement 1 using journal entries.
3. 3. Using the September 30, 2013, ending balances as the beginning balances for the October- December 2013 quarter, summarize the journal entry effects from requirement 2. Use T-accounts if this requirement is being completed manually; if you are using the GL tool in Connect, the journal entries will have been posted automatically to general ledger accounts that are similar in appearance to Exhibit 2.9.
4. 4. Explain your response to event (e).
5. 5. Prepare a classified balance sheet at December 31. 2013.
6. 6. As of December 31, 2013, has the financing for Ethan Allen’s investment in assets primarily come from liabilities or stockholders’ equity?
7. 7. Calculate Ethan Allen’s current ratio at September 30, 2013, prior to the transactions listed above. (Using the September 30 balances will prevent any errors in your answers to requirements 1-5 from affecting your answer to this requirement.) Based on this calculation and the analysis of Linkedln’s current ratio in the chapter, indicate which company was in a better position to pay liabilities as they come due in the next year.

To determine

To analyze: The given transaction, and explain their effect on the accounting equation.

Explanation of Solution

Accounting equation:

Accounting equation is an accounting tool expressed in the form of equation, by creating a relationship between the resources or assets of a company, and claims on the resources by the creditors and the owners. Accounting equation is expressed as shown below:

$\boxed{\text{Assets = Liabilities + Stockholder's Equity}}$

Accounting equation for each transaction is as follows:

Figure (1)

Therefore, the total assets are equal to the liabilities and stockholder’s equity.

To determine

To record: The journal entries based on requirement 1.

Explanation of Solution

Journal:

Journal is the method of recording monetary business transactions in chronological order. It records the debit and credit aspects of each transaction to abide by the double-entry system.

Rules of Debit and Credit:

Following rules are followed for debiting and crediting different accounts while they occur in business transactions:

• Debit, all increase in assets, expenses and dividends, all decrease in liabilities, revenues and stockholders’ equities.
• Credit, all increase in liabilities, revenues, and stockholders’ equities, all decrease in assets, expenses.

Journal entries of Company E are as follows ($ in millions):

a. Inventories purchased in cash:

Date	Accounts title and explanation	Ref.	Debit ($)	Credit ($)
	Inventories (+A)		30
	Cash (-A)			30
	(To record purchase of supplies in cash)

Table (1)

• Inventories are an assets account and it increased the value of asset by $30. Hence, debit the inventories account for $30.
• Cash is an assets account and it decreased the value of asset by $30. Hence, credit the cash account for $30.

b. Issuance of common stock:

Date	Accounts title and explanation	Ref.	Debit ($)	Credit ($)
	Cash (+A)		20
	Common stock (+SE)			20
	(To record the issuance of common stock)

Table (2)

• Cash is an assets account and it increased the value of asset by $20. Hence, debit the cash account for $20.
• Common stock is a component of stockholder’s equity and it increased the value of stockholder’s equity by $20, Hence, credit the common stock for $20.

c. Equipment purchased on account and in cash:

Date	Accounts title and explanation	Ref.	Debit ($)	Credit ($)
	Equipment (+A)		170
	Cash (-A)			80
	Notes payable (+L)			90
	(To record purchase of equipment on account and in cash)

Table (3)

• Equipment is an assets account and it increased the value of asset by $170. Hence, debit the equipment account for $170.
• Cash is an assets account and it decreased the value of asset by $80. Hence, credit the cash account for $80.
• Notes payable is a liability account, and it increased the value of liabilities by $90. Hence, credit the notes payable for $90.

d. Cash borrowed from bank (short term)

Date	Accounts title and explanation	Ref.	Debit ($)	Credit ($)
	Cash (+A)		10
	Notes payable (+L)			10
	(To record cash borrowed from bank)

Table (4)

• Cash is an assets account and it increased the value of asset by $10. Hence, debit the cash account for $10.
• Notes payable is a liability account, and it increased the value of liabilities by $10. Hence, credit the notes payable for $10.

e. Conducted negotiations to purchase a saw mill:

In this case, no entry required, because it is not a business transaction.

To determine

To prepare: T-account for each account listed in the requirement 2.

Explanation of Solution

T-account:

T-account refers to an individual account, where the increasesor decreases in the value of specific asset, liability, stockholder’s equity, revenue, and expenditure items are recorded.

This account is referred to as the T-account, because the alignment of the components of the account resembles the capital letter ‘T’.’ An account consists of the three main components which are as follows:

1. (a) The title of the account
2. (b) The left or debit side
3. (c) The right or credit side

T-accounts of company E are as follows:

Cash (A)
Beg.	106
(b)	20	30	(a)
(d)	10	80	(c)
End.	26

Accounts Receivable (A)
Beg.	13
End.	13
Inventory (A)
Beg.		142
(a)		30
End.		172

Short-term Investments (A)
Beg.	13
End.	13

Equipment (A)
Beg.	290
(c)	170
End.	460

Software (A)
Beg.	50
End.	50

Prepaid Rent (A)
Beg.	23
End.	23

Accounts Payable (L)
			121	Beg.
			121	End.

Salaries and Wages Payable (L)
		23	Beg.
		23	End.

Notes Payable (short-term) (L)
		1	Beg.
		10	(d)
		11	End.

Notes Payable (long-term) (L)
		150	Beg.
		90	(c)
		240	End.

Common Stock (SE)
		21	Beg.
		20	(b)
		41	End.

Retained Earnings (SE)
		321	Beg.
		321	End.

To determine

To explain: The response for event (e).

Explanation of Solution

Business transaction:

Business transaction is a record of any economic activity, resulting in the change in the value of the assets, the liabilities, and the stockholder’s equities, of a business. Business transaction is also referred to as financial transaction.

In this case, conducting negotiation to purchase a saw mill is not creating any impact on assets, liabilities and stockholder’s equity of the business, because it is not a business transaction.

To determine

To prepare: The classified balance sheet of Company E at December 31, 2013.

Explanation of Solution

Classified balance sheet:

This is the financial statement of a company which shows the grouping of similar assets and liabilities under subheadings.

Classified balance sheet of Company E is as follows ($ in millions):

Figure (2)

Therefore, the total assets of Company E are$757 million, and the total liabilities and stockholders’ equity is$757 million.

To determine

Whether the assets amount of Company E is primarily come from liabilities or stockholders’ equity.

Explanation of Solution

The invested amount of assets are primarily come from liabilities (current and non-current) of Company E, because liabilities financed $395 million of the Company E’s total assets, and stockholder’s equity (common stock) financed $362 million.

To determine

The current ratio of Company E and compare with Company L’s current ratio.

Explanation of Solution

Current Ratio:

A part of liquidity ratios, current ratio reflects the ability to oblige the short term debts of a company. It is calculated based on the current assets and current liabilities; a company has in an accounting period. A current ratio is a useful tool for analysis of financials of a company.

Calculate the current ratio of Company E as follows:

Here,

Current assets = $297 millions

Current liabilities= $145 millions

$\begin{array}{c}\text{Current ratio=}\frac{\text{Current assets}}{\text{Current liabilities}}\\ \text{=}\frac{\text{\$297 millions}}{\text{\$145 millions}}\\ =2.05\end{array}$

Therefore, the current ratio of Company E is 2.05.

Current ratio of Company E is 2.05 and Company L is 4.73, so Company E has less current ratio than Company L and it indicates Company L has better position to repay the liabilities.