Chapter 5, Problem 5BP

The following unadjusted trial balance is prepared at fiscal year-end for Foster Products Company. Foster Products Company uses a perpetual inventory system. It categorizes the following accounts as selling expenses; Depreciation Expense—Store Equipment, Sales Salaries Expense, Rent Expense—Selling Space, Store Supplies Expense, and Advertising Expense. It categorizes the remaining expenses as general and administrative.

Required

1. 1. Prepare adjusting journal entries to reflect each of the following:
   1. a. Store supplies still available at fiscal year-end amount to $3,700.
   2. b. Expired insurance, an administrative expense, for the fiscal year is $2,800.
   3. c. Depreciation expense on store equipment, a selling expense, is $3,000 for the fiscal year.
   4. d. To estimate shrinkage, a physical count of ending merchandise inventory is taken. It shows $21,300 of inventory is still available at fiscal year-end.
2. 2. Prepare a multiple-step income statement for the year ended October 31 that begins with gross sales and includes separate categories for net sales, cost of goods sold, selling expenses, and general and administrative expenses.
3. 3. Prepare a single-step income statement for the year ended October 31.
4. 4. Compute the current ratio, acid-test ratio, and gross margin ratio as of October 31. (Round ratios to two decimals.)

To determine

Journalize adjusting entries of Company FP.

Explanation of Solution

Journal entry: Journal entry is a set of economic events which can be measured in monetary terms. These are recorded chronologically and systematically.

Adjusting entries: Adjusting entries are those entries which are recorded at the end of the year, to update the income statement accounts (revenue and expenses) and balance sheet accounts (assets, liabilities, and stockholders’ equity) to maintain the records according to accrual basis principle.

Record the adjusting entries of Company FP.

Date	Accounts title and explanation	Post Ref.	Debit ($)	Credit ($)
a.	Store supplies expense (1)		6,000
	Store supplies			6,000
	(To record store supplies expense)
b.	Insurance expenses		2,800
	Prepaid expenses			2,800
	(To record prepaid selling expenses)
c.	Depreciation expense - Store equipment		3,000
	Accumulated Depreciation - Store equipment			3,000
	(To record depreciation expenses)
d.	Cost of goods sold		2,700
	Merchandise inventory (2)			2,700
	(To record the inventory shrinkage)

Table (1)

a. To record store supplies expense:

• Store supplies expense is an expense account and it is increased. Therefore, debit office supplies expense with $6,000.
• Store supplies are an asset account and it is decreased. Therefore, credit office supplies with $6,000.

b. To record prepaid insurance expenses:

• Insurance expense is an expense account and it is increased. Therefore, it is debited with $2,800.
• Prepaid expense is an asset account and it is decreased. Therefore, credit prepaid selling expense with $2,800.

c. To record depreciation expenses:

• Depreciation expense is an expense account and it is increased. Therefore, it is debited with $3,000.
• Prepaid expense is an asset account and it is decreased. Therefore, credit prepaid selling expense with $3,000.

d. To record the shrinkage of inventory:

• Cost of goods sold is an expense and they are increased. Thus, it is debited with $2,700.
• Inventory is an asset account, and they are increased. Hence, debit the inventory returns estimated account by $2,700.

Working Note:

Compute the Store supplies expense.

…… (1)

Compute the shrinkage of inventory.

…… (2)

To determine

Prepare the multi- step income statement of Company FP for the year ended October 31.

Explanation of Solution

Multi-step income statement: The income statement represented in multi-steps with several subtotals, to report the income from principal operations, and separate the other expenses and revenues which affect net income, is referred to as multi-step income statement.

Prepare the income statement of Company FP for the year ended October 31.

Company FP
Statement of Income
For the year ended October 31
Particulars	Amount	Amount
Sales		$227,100
Less:  Sales discounts	$1,000
Sales returns and allowances	$5,000	($6,000)
Net sales		$221,100
Less: Cost of goods sold (2)		($78,500)
Gross profit		$142,600
Expenses
Selling expenses
Depreciation expense—Store equipment	$3,000
Sales salaries expense $\left(\$63,000\times 1/2\right)$	$31,500
Rent expense—Selling space $\left(\$26,000\times 1/2\right)$	$13,000
Store supplies expense (1)	$6,000
Advertising expense	$17,800
Total selling expenses	$71,300
General and administrative expenses
Insurance expense	$2,800
Office salaries expense $\left(\$63,000\times 1/2\right)$	$31,500
Rent expense—Office space $\left(\$26,000\times 1/2\right)$	$13,000
Total general and administrative expenses	$47,300
Total expenses		($118,600)
Net income		$24,000

Table (2)

Thus, the net income of Company FP for the year ended October 31 is $24,000.

To determine

Prepare the single-step income statement of Company FP for the year ended October 31.

Explanation of Solution

Single-step income statement:  This statement displays the total revenues as one line item from which the total expenses including cost of goods sold is subtracted to arrive at the net profit /net loss for the period.

Prepare the income statement of Company FP for the year ended October 31.

Company FP
Statement of Income
For the year ended October 31
Particulars	Amount	Amount
Net sales		$221,100
Less: Expenses
Cost of goods sold (2)	$78,500
Selling expenses (Refer Table (2))	$71,300
General and administrative expense (Refer Table (2))	$47,300
Total expenses		($197,100)
Net income		$24,000

Table (3)

Thus, the net income of Company FP for the year ended October 31 is $24,000.

To determine

Compute current ratio, acid-test ratio and gross margin ratio.

Explanation of Solution

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. Current ratio is calculated by using the formula:

  $\text{Current ratio}=\frac{\text{Current Assets}}{\text{Current Liabilities}}$

Acid test ratio: It is a ratio used to determine a company’s ability to pay back its current liabilities by liquid assets that are current assets except inventory and prepaid expenses.

  $\text{Acid test ratio}=\frac{\text{Quick Assets}}{\text{Current Liabilities}}$

Gross margin ratio: The percentage of gross profit generated by every dollar of net sales is referred to as gross margin ratio. This ratio measures the profitability of a company by quantifying the amount of income earned from sales revenue generated after cost of goods sold are paid. The higher the ratio, the more ability to cover operating expenses. It is calculated by using the formula:

$\text{Gross margin ratio}=\frac{\text{Net sales}-\text{Cost of goods sold}}{\text{Net sales}}$

Compute current ratio, acid test ratio and gross margin ratio of Company FP.

Computation of ratios
Particulars	Amount
Cash	$7,400
Merchandise inventory (2)	$21,300
Store supplies (1)	$3,700
Prepaid insurance	$3,800
Total current assets (A)	$36,200
Current liabilities (B)	$18,000
Current ratio $\left(\text{A}\right)÷\left(\text{B}\right)$	2.01
Quick assets (Cash) (C)	$7,400
Current liabilities (D)	$18,000
Acid-test ratio $\left(\text{C}\right)÷\left(\text{D}\right)$	0.41
Net Sales (E)	$221,100
Less: Cost of Goods Sold (2)	($78,500)
Gross margin (F)	$142,600
Gross margin ratio $\left(\text{F}\right)÷\left(\text{E}\right)$	0.64 or 64%

Table (4)

The current ratio, acid- test ratio and gross margin ratio of Company FP is 2.01, 0.41 and 0.64 or 64% respectively.