Chapter 2, Problem 28E

Exercise 2-27A Effect of accounting events on the income statement and statement of cash flows

Required

Explain how each of the following events or series of events and the related adjusting entry will affect the amount of net income and the amount of cash flow from operating activities reported on the yearend financial statements. Identify the direction of change (increase, decrease, or NA) and the amount of the change. Organize your answers according to the following table. The first event is recorded as an example. If an event does not have a related adjusting entry, record only the effects of the event.

1. a. Paid $9,000 cash on October 1 to purchase a one-year insurance policy.
2. b. Purchased $2,000 of supplies on account. Paid $500 cash on accounts payable. The ending balance in the Supplies account, after adjustment, was $300.
3. c. Provided services for $10,000 cash.
4. d. Collected $2,400 in advance for services to be performed in the future. The contract called for services to start on May 1 and to continue for one year
5. e. Accrued salaries amounting to $5,600.
6. f. Sold land that cost $3,000 for $3,000 cash.
7. g. Acquired $15,000 cash from the issue of common stock.
8. h. Earned $12,000 of revenue on account. Collected $8,000 cash from accounts receivable.
9. i. Paid cash operating expenses of $4,500.

To determine

Explain the way each of the given events or series of events and the related adjusting entry will affect the amount of net income and the amount of cash flow from operating activities reported on the year-end financial statements. Identify the direction of change (increase, decrease, or NA) and the amount of the change. If an event does not have a related adjusting entry, then record only the effects of the event.

Explanation of Solution

Net income: Net income is the excess amount of revenue which arises after deducting all the expenses of a company. In simple terms, it is the difference between total revenue and total expenses of the company.

Cash flows from operating activities: These refer to the cash received or cash paid in day-to-day operating activities of a company.

Explain the way that the given events are affecting net income and cash flows from operating activities.

1. a. Purchased one year insurance policy on October 1^st for $9,000. It decreases the cash flows from the operating activities by $9,000, because there is a cash outflow of $9,000. On December 31^st, three months amount is recognized as an expense through an adjusting entry. It decreases the net income in the income statement by $2,250 (1) (for three months).
2. b. Purchased supplies for $2,000 on account. $500 paid on accounts payable. This will decrease the cash flows from operating activities, but not affect the net income. During the year $1,700 (2) supplies are used. Adjusting the supplies account will decrease supplies account and increase supplies expense account. Increase in expense decreases the net income in the income statement.
3. c. $10,000 Services provided for cash. It increases the net income in the income statement and cash flows from the operating activities in the statement of cash flows by $10,000.
4. d. Cash collected $2,400 in advance to render a service, which starts from May 1^st and continued for one year. This increases the cash flows from operating activities, but not affected the net income.  Till the end of December 31, total 8 months services are rendered. This will increase the net income in the income statement by $1,600 (3).
5. e. Accrued salaries amounting to $5,600. This will decrease the net income by $5,600. Since there is no cash out flow, there is no change in the cash flow from operating activities.
6. f. Sold land that cost $3,000 for $3,000 cash. It does not affect the net income and cash flows from operating activities. Because land and cash are the balance sheet items and sale of land is an investing activity in the statement of cash flows.
7. g. Acquired $15,000 cash from the issue of common stock. It does not affect the net income and cash flows from operating activities. Because common stock and cash are the balance sheet items and issuing common stock is a financing activity in the statement of cash flows.
8. h. Earned $12,000 revenue on account. It increases the net income in the income statement. Collected $8,000 cash from the accounts receivable. It increases the cash flows from the operating activities.
9. i. Cash paid for operating expenses $4,500. It decreases the net income in the income statement and cash flows from operating activities.

Identify the direction of change (increase, decrease, or NA) and the amount of the change for the given events.

Event/Adjustment		Net Income		Cash Flow from Operating Activities
		Direction of Change	Amount of Change	Direction of Change	Amount of Change
a	Event Adjustment	NA Decrease	NA (1)$2,250	Decrease NA	$9,000 NA
b	Event Adjustment	NA Decrease	NA (2)1,700	Decrease NA	500 NA
c	Event No adjustment	Increase	10,000	Increase	10,000
d	Event Adjustment	NA Increase	NA (3)1,600	Increase NA	2,400 NA
e	Event No adjustment	Decrease	5,600	NA	NA
f	Event No adjustment	NA	NA	NA	NA
g	Event No adjustment	NA	NA	NA	NA
h	Event No adjustment	Increase	12,000	Increase	8,000
i	Event No adjustment	Decrease	4,500	Decrease	4,500

Table (1)

Working notes:

Calculate the adjustment amount for insurance policy (event a).

Purchased an insurance policy on October 1, and paid $9,000 cash. The year ending adjustment amount is calculated for 3 months (October 1^st to December 31^st).

$\begin{array}{c}\text{Adjustment}\text{Amount}\text{=}\text{\$9,000}\text{×}\frac{\text{3}\text{months}}{\text{12}\text{months}}\\ =\$2,250\end{array}$ (1)

Calculate the amount for supplies used during the year.

The supplies are purchased for $2,000. At the end of the year after adjustment, the balance amount of supplies is $300.

$\begin{array}{c}\text{Supplies used}\text{during}\text{the}\text{Year}\text{=}\text{Supplies}\text{Purchased}-\text{Balance After Adjustment}\\ \text{=}\text{\$2,000}\text{-}\text{\$300}\\ \text{=}\text{\$1,700}\end{array}$ (2)

Calculate the amount of services performed during the year.

Cash collected $2,400 in advance to provide the service from May 1, and continued for one year.

$\begin{array}{c}\text{Service provided}\text{during}\text{the}\text{Year}\text{=}\text{Cash}\text{collected}\text{for}\text{Service}\times \frac{\text{No of months service provided}}{12\text{months}}\\ =\$2,400\times \frac{8\text{months}}{12\text{months}}\\ \text{=}\text{\$1,600}\end{array}$ (3)