Chapter 3, Problem 8AP

1.

To determine

Prepare the income statement and the statement of retained earnings for the calendar year 2015 and the classified balance sheet at December 31, 2015.

Explanation of Solution

Income statement:

Income statement is a financial statement that shows the net income or net loss by deducting the expenses from the revenues and vice versa.

Prepare the income statement for the year ended 31^st December 2015.

Construction T
Income statement
For the year ended December 31, 2015
Particulars	Amount ($)	Amount ($)
Revenues
Professional fees earned	97,000
Rent earned	14,000
Dividends earned	2,000
Interest earned	2,100
Total revenue		115,100
Expenses
Depreciation expense, Building	11,000
Depreciation expense, Equipment	6,000
Wages expense	32,000
Interest expense	5,100
Insurance expense	10,000
Rent expense	13,400
Supplies expense	7,400
Postage expense	4,200
Property taxes expense	5,000
Repairs expense	8,900
Telephone expense	3,200
Utilities expense	4,600
Total Expenses		110,800
Net income		$4,300

Table (1)

Statement of Retained Earnings:

Statement of retained earnings shows, the changes in the retained earnings, and the income left in the company after payment of the dividends, for the accounting period.

Prepare the statement of retained earnings for the year ended 31^st December 2015.

Construction T
Statement of Retained Earnings
For the year ended 31st December 2015
Particulars	Amount ($)	Amount ($)
Retained earnings, Beginning	121,400
Add: Net income	4,300
Subtotal	125,700
Less: Dividends	13,000
Retained earnings, Ending		$112,700

Table (2)

Balance sheet:

This financial statement reports a company’s resources (assets) and claims of creditors (liabilities) and stockholders (stockholders’ equity) over those resources. The resources of the company are assets which include money contributed by stockholders and creditors. Hence, the main elements of the balance sheet are assets, liabilities, and stockholders’ equity.

Prepare the balance sheet as on 31^st December 2015.

Construction T
Balance Sheet
As an December 31, 2015
Particulars	Amount($)	Amount($)
ASSETS
Current Assets:
Cash	5,000
Short-term investment	23,000
Supplies	8,100
Prepaid insurance	7,000
Total Current Assets		43,100
Equipment	40,000
Less: Accumulated depreciation, Equipment	20,000	20,000
Building	150,000
Accumulated depreciation, Building	50,000	100,000
Land		55,000
Total plant and Assets		175,000
Total assets		$218,100
LIABILITIES
Current Liabilities:
Accounts payable	16,500
Interest payable	2,500
Rent payable	3,500
Wages payable	2,500
Property tax payable	900
Unearned professional fees	7,500
Current portion of long-term note payable	7,000
Total current liabilities		40,400
Long-liabilities:
Long-term notes payable $\left(\$67,000-\$7,000\right)$		60,000
Total liabilities		100,400
Stockholders’ equity
Paid-in capital
Common stock	5,000
Retained earnings	112,700
Total Stockholders’ Equity		117,700
Total liabilities and Stockholders’ Equity		$218,100

Table (3)

2.

To determine

Prepare the closing entries at December 31, 2015.

Explanation of Solution

Closing entries: The journal entries prepared to close the temporary accounts to Retained Earnings account are referred to as closing entries. The revenue, expense, and dividends accounts are referred to as temporary accounts because the information and figures in these accounts is held temporarily and consequently transferred to permanent account at the end of accounting year.

Prepare the closing entry for revenue accounts.

Date	Accounts title and explanation	Post Ref.	Debit ($)	Credit ($)
December 31	Professional fee earned		97,000
	Rent earned		14,000
	Dividends earned		2,000
	Interest earned		2,100
	Income summary			115,100
	(To close the revenues account)

Table (4)

In this closing entry, revenue accounts are closed by transferring the amount of revenue accounts to the income summary account in order to bring the revenue account balance to zero. Hence, debit the revenue accounts and credit income summary account.

Prepare the closing entry for expenses account.

Date	Accounts title and explanation	Post Ref.	Debit ($)	Credit ($)
December 31	Income summary		110,800
	Depreciation expense-Building			11,000
	Depreciation expense- Equipment			6,000
	Wages expense			32,000
	Interest expense			5,100
	Insurance expense			10,000
	Rent expense			13,400
	Supplies expense			7,400
	Postage expense			4,200
	Property taxes expense			5,000
	Repairs expense			8,900
	Telephone expense			3,200
	Utilities expense			4,600
	(To close the expenses account)

Table (5)

In this closing entry, expenses account is closed by transferring the amount of expenses to the income summary in order to bring the expenses account balance to zero. Hence, debit the income summary account and credit all expenses account.

Prepare closing entry for income summary account.

Date	Accounts title and explanation	Post Ref.	Debit ($)	Credit ($)
December 31	Income Summary		4,300
	Retained Earnings			4,300
	(To close the income summary account)

Table (6)

Closing entry of income summary account:

On December 31, total revenues are $115,100 and total expenses are $110,800. Close the Income Summary account to the Retained Earnings account.

$\begin{array}{c}\begin{array}{c}\text{Thus, net income on Income }\\ \text{Summary account}\end{array}\}=\text{Total Revenues}-\text{Total Expenses}\\ =\text{\$115,100}-\$110,800\\ =\$4,300\end{array}$

Therefore, credit balance of the Income Summary account of $4,300 is closed to Retained Earnings.

In this closing entry, income summary account is closed by transferring the amount of income summary (profit) to the retained earnings in order to bring the income summary account balance to zero. Hence, debit the income summary account and credit retained earnings account.

Prepare closing entry for dividend account.

Date	Accounts title and explanation	Post Ref.	Debit ($)	Credit ($)
December 31	Retained Earnings		13,000
	Dividends			13,000
	(To close the dividends account)

Table (7)

In this closing entry, dividend account is closed by transferring the amount of dividend to the retained earnings in order to bring the dividend account balance to zero. Hence, debit the retained earnings account and credit dividend account.

3.

To determine

Compute:

a. Return on assets

b. Debt ratio

c. Profit margin ratio

d. current ratio

Explanation of Solution

a. Return on asset ratio:

Return on assets indicates the company’s overall profitability by excluding specific sources of finance.  The Profitability is achieved through a high profit margin or a high turnover or a combination of both.

Formula for calculating the return on asset:

$\text{Return on assets}=\frac{\text{Net income}}{\text{Average total assets}}$

Compute the return on asset ratio:

$\begin{array}{c}\text{Return on assets}=\frac{\text{Net income}}{\text{Average total assets}}\\ =\frac{\$4,300}{\left(\frac{\$200,000+\$218,100}{2}\right)}\\ =0.021\end{array}$

Thus, the return on asset ratio is 0.021 or 2.1%.

b. Debt ratio:

Debt to asset ratio is the ratio between total asset and total liability of the company. Debt ratio reflects the finance strategy of the company. It is used to evaluate company’s ability to pay its debts. Higher debt ratio implies the higher financial risk.

Formula for calculating the debt ratio:

$\text{Debt ratio}=\frac{\text{Total assets}}{\text{Total liabilities}}$

Compute the debt ratio:

$\begin{array}{c}\text{Debt ratio}=\frac{\text{Total assets}}{\text{Total liabilities}}\\ =\frac{\$100,400}{\$218,100}\\ =0.46\end{array}$

Thus, the debt ratio is 0.46.

c. Profit margin ratio:

Net profit margin ratio:

Net profit is the financial ratio that shows the relationship between the net profit and net sales (Operating revenue). Net profit is the difference between total operating revenue and total operating expenses. It can be calculated by dividing net profit and net sales revenue.

Compute the net profit margin:

$\begin{array}{c}\text{Net profit margin ratio}=\frac{\text{Net income}}{\text{Total revenues }}\times 100\\ =\frac{\$4,300}{\$115,100}\times 100\\ =3.7\%\end{array}$

Hence, the profit margin ratio is 3.7%.

d. current ratio:

Current ratio

Current ratio is one of the liquidity ratios, which measures the capacity of the company to meet its short-term obligations using its current assets.

Calculate the current ratio:

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$43,100}{\$40,400}\\ =1.07:1\end{array}$

Thus, the current ratio is 1.07:1.