appendix

I

ACCOUNTING FOR SOLE PROPRIETORSHIPS study objectives After studying this appendix, you should be able to: 1 Identify the differences in equity accounts between a corporation and a sole proprietorship.

3 Describe the differences between a retained earnings statement and an owner’s equity statement.

2 Understand what accounts increase and decrease owner’s equity.

4 Explain the process of closing the books for a sole proprietorship.

Chapter 1 identified three forms of business organization. Two forms, the sole proprietorship and the partnership, were discussed only briefly. Emphasis was placed on the corporate form in Chapter 1 as well as in subsequent chapters. The purpose of this appendix is to discuss and illustrate the accounting for the operations and financial condition of a sole proprietorship. The primary difference between accounting and reporting for a sole proprietorship and a corporation involves accounting for equity transactions. Because a sole proprietorship has a single owner rather than numerous stockholders, a sole proprietorship uses a permanent owner’s capital account, such as “Sally Jones, Capital,” instead of Common Stock and Retained Earnings. In a sole proprietorship there is no need to separate owner’s investments from net income retained for dividends because the sole proprietor does not declare or receive dividends. Instead, withdrawals by the owner of cash or other assets from the business for personal use are recorded in a temporary drawing account. The different equity accounts are contrasted as shown in Illustration I-1.

Corporation

Sole Proprietorship

Stockholders’ equity Common stock Retained earnings

Owner’s equity Owner’s name, capital

study objective

1

Identify the differences in equity accounts between a corporation and a sole proprietorship.

Illustration I-1 Equity section of the balance sheet—corporation vs. proprietorship

For purposes of comparing the accounting for a corporation with a sole proprietorship, the illustrations in this Appendix I assume a sole proprietorship owned by R. Neal and named Sierra Company. Except for equity transactions, we use the same accounts, amounts, and transactions as those of Sierra Corporation presented in Chapters 1 through 4.

I-1

I-2

appendix I Accounting for Sole Proprietorships

Owner’s Equity in a Sole Proprietorship study objective

2

Understand what accounts increase and decrease owner’s equity.

The ownership claim on total assets is known as owner’s equity. It is equal to total assets minus total liabilities. INCREASES IN OWNER’S EQUITY In a proprietorship, owner’s equity is increased by owner’s investments and revenues.

Investments by Owner Investments by owner are the assets the owner puts into the business. These investments increase owner’s equity.

Revenues Revenues are the gross increase in owner’s equity resulting from business activities entered into for the purpose of earning income. DECREASES IN OWNER’S EQUITY In a proprietorship, owner’s equity is decreased by owner’s drawings and expenses.

Drawings An owner may withdraw cash or other assets for personal use. These withdrawals could be recorded as a direct decrease of owner’s equity. However, it is generally considered preferable to use a separate classification called drawings to determine the total withdrawals for each accounting period. Drawings decrease owner’s equity.

Expenses Expenses are the cost of assets consumed or services used in the process of earning revenue. They are decreases in owner’s equity that result from operating the business. In summary, owner’s equity is increased by an owner’s investments and by revenues from business operations. In contrast, owner’s equity is decreased by an owner’s withdrawals of assets and by expenses. These relationships are shown in Illustration I-2. Net income results when revenues exceed expenses. A net loss occurs when expenses exceed revenues.

Illustration I-2 Increases and decreases in owner’s equity

INCREASES

DECREASES

Investments by owner

Withdrawals by owner

Owner's Equity Revenues

Expenses

Financial Statements for a Proprietorship

I-3

Recording Transactions of a Proprietorship Chapter 3 described the basic steps employed in the accounting process as follows: Analyze transactions. Record transactions in the journal. Post journal entries to the general ledger. Prepare a trial balance. These same steps apply to all forms of business. Illustration 3-3 (page 110) presented the impact of Sierra’s transactions on its accounting equation. Illustration I-3 shows how the same transactions would have been recorded for a sole proprietor. The only differences are related to the accounts used to record equity transactions. Those differences are highlighted here in red. Illustration I-3 of transactions ⴝ

ⴙ Owner’s Equity Unearned R. Neal, Prepaid Notes Accounts Service ⴙ Supplies ⴙ Insurance ⴙ Equipment ⴝ Payable ⴙ Payable ⴙ Revenue ⴙ Capital Assets

Cash

Summary

(1) ⫹$10,000 (2) ⫹5,000

⫽

5,000

⫽

5,000

5,000

⫽

5,000

⫹

1,200

⫹

10,000 ⫹10,000 Service Revenue

⫹

5,000

⫽

5,000

⫹

1,200

⫹

20,000 ⫺900 Rent Expense

⫹

5,000

⫽

5,000

⫹

1,200

⫹

19,100

⫹

5,000

⫽

5,000

⫹

1,200

⫹

19,100

15,000 ⫺5,000 10,000 ⫹1,200

⫹

5,000

(4)

11,200 (5) ⫹10,000

⫹

(6)

21,200 ⫺900

(7)

20,300 ⫺600

⫹$5,000

⫹

19,700

600

⫹$1,200

⫹$2,500

(8)

⫹$10,000 Investment by owner

⫹$5,000

⫽

(3)

⫹$600

Liabilities

⫹

10,000

⫹

10,000

⫹$2,500 ⫹

5,000

⫽

5,000 ⫹

2,500 ⫹

1,200

⫹

19,100 ⫺500 Drawings

19,200 ⫹ ⫺4,000

2,500 ⫹

600

⫹

5,000

⫽

5,000 ⫹

2,500 ⫹

1,200

⫹

(11)

18,600 ⫺4,000 Salaries Expense

$15,200 ⫹

$2,500 ⫹

$600

⫹

$5,000

⫽

$5,000 ⫹

$2,500 ⫹

$1,200

⫹

$14,600

$23,300

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

2,500 ⫹ ⫹

⎧ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩

19,700 ⫹ ⫺500

600

(10)

$23,300

Financial Statements for a Proprietorship Chapter 4 described accounting for adjusting entries. A sole proprietor makes the same types of adjustments as a corporation. After recording and posting all of the adjustments, an adjusted trial balance is prepared. Illustrations I-4 (page I-4) and I-5 (page I-5) show how the adjusted trial balance is used to prepare a sole proprietor’s financial statements. The primary differences between these statements and those of a corporation (presented in Illustrations 4-27 and 4-28, pages 184 and 185) relate to the way equity is reported. A sole proprietor prepares an owner’s equity statement rather than a retained earnings statement and uses different titles for the equity items shown on the balance sheet.

study objective

3

Describe the differences between a retained earnings statement and an owner’s equity statement.

I-4

appendix I Accounting for Sole Proprietorships

SIERRA COMPANY Adjusted Trial Balance October 31, 2012 Account

Debit

Cash Accounts Receivable Supplies Prepaid Insurance Equipment Accumulated Depreciation— Equipment Notes Payable Accounts Payable Interest Payable Unearned Service Revenue Salaries Payable R. Neal, Capital Drawing Service Revenue Salaries Expense Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense

$15,200 200 1,000 550 5,000

SIERRA COMPANY Income Statement For the Month Ended October 31, 2012

Credit

Revenues Service revenue

$

40 5,000 2,500 50 800 1,200 10,000

500

Expenses Salaries expense Supplies expense Rent expense Insurance expense Interest expense Depreciation expense

$10,600

$5,200 1,500 900 50 50 40

Total expenses

7,740

Net income

$ 2,860

10,600 5,200 1,500 900 50 50 40 $30,190

$30,190

SIERRA COMPANY Owner’s Equity Statement For the Month Ended October 31, 2012 R. Neal, Capital, October 1 Add: Investments by owner R. Neal, Capital Net income

$

–0– 10,000 10,000 2,860 12,860

Less: Drawings R. Neal, Capital, October 31

500 $12,360

To balance sheet

Illustration I-4 Preparation of the income statement and owner’s equity statement from the adjusted trial balance

Closing the Books of a Proprietorship study objective Explain the process of closing the books for a sole proprietorship.

4

At the end of the accounting period, the temporary account balances are transferred to the permanent owner’s equity account, Owner’s Capital, through the preparation of closing entries. Closing entries for a proprietorship formally recognize in the ledger the transfer of net income (or net loss) and owner’s drawing to owner’s capital. The results of these entries are shown in the owner’s equity statement. Journalizing and posting closing entries is a required step in the accounting cycle. (See Illustration 4-31 on page 188 for Sierra Corporation.) In preparing closing entries for a proprietorship, each income statement account could be closed directly to owner’s capital. However, to do so would result in excessive detail in the permanent owner’s capital account. Instead, the revenue and expense accounts are closed, in the same manner as for a corporation, to another temporary account, Income Summary. Only the net income or net loss is transferred from this account to Owner’s Capital.

Closing the Books of a Proprietorship

SIERRA COMPANY Balance Sheet October 31, 2012

SIERRA COMPANY Adjusted Trial Balance October 31, 2012 Account

Debit

Cash $15,200 Accounts Receivable 200 Supplies 1,000 Prepaid Insurance 550 Equipment 5,000 Accumulated Depreciation— Equipment Notes Payable Accounts Payable Interest Payable Unearned Service Revenue Salaries Payable R. Neal, Capital 500 R. Neal, Drawing Service Revenue 5,200 Salaries Expense 1,500 Supplies Expense 900 Rent Expense 50 Insurance Expense 50 Interest Expense 40 Depreciation Expense $30,190

I-5

Credit

$

40 5,000 2,500 50 800 1,200 10,000 10,600

$30,190

Assets Cash Accounts receivable Supplies Prepaid insurance Equipment $5,000 Less: Accumulated depreciation— equipment 40 Total assets

$15,200 200 1,000 550 4,960 $21,910

Liabilities and Owner’s Equity Liabilities Notes payable Accounts payable Interest payable Unearned service revenue Salaries payable Total liabilities Owner’s equity R. Neal, Capital Total liabilities and owner’s equity

$ 5,000 2,500 50 800 1,200 9,550 12,360 $21,910

Capital Balance at Oct. 31 from Owner’s Equity Statement in Illustration I-4

Illustration I-5 Preparation of the balance sheet from the adjusted trial balance

Closing entries for a proprietorship may be prepared directly from the adjusted balances in the ledger, from the income statement and balance sheet columns of the work sheet, or from the income and owner’s equity statements. Separate closing entries could be prepared for each nominal account, but the following four entries accomplish the desired result more efficiently: 1. Debit each revenue account for its balance, and credit Income Summary for total revenues. 2. Debit Income Summary for total expenses, and credit each expense account for its balance. 3. Debit Income Summary and credit Owner’s Capital for the amount of net income. 4. Debit Owner’s Capital for the balance in the Owner’s Drawing account, and credit Owner’s Drawing for the same amount. The four entries are referenced in the diagram of the closing process shown in Illustration I-6 and in the journal entries in Illustration I-7, both on page I-6. The posting of closing entries is shown in Illustration I-8 (page I-7). If there were a net loss because expenses exceeded revenues, entry 3 in Illustration I-6 would be reversed: Credit Income Summary and debit Owner’s Capital.

Helpful Hint Owner’s Drawing is closed directly to Capital and not to Income Summary because Owner’s Drawing is not an expense.

(Individual) Expenses

(Individual) Revenues

1

2 Income Summary

3 Owner’s Capital

Owner’s Capital is a permanent account; all other accounts are temporary accounts.

4

Key: 1 Close Revenues to Income Summary. 2 Close Expenses to Income Summary. 3 Close Income Summary to Owner’s Capital. 4 Close Owner’s Drawing to Owner’s Capital.

Illustration I-6 Diagram of closing process

Owner’s Drawing

GENERAL JOURNAL Date

Account Titles and Explanation

Debit

Credit

Closing Entries 2012 Oct. 31

31 Illustration I-7 Closing entries journalized

Helpful Hint Income Summary is a very descriptive title: Total revenues are closed to Income Summary, total expenses are closed to Income Summary, and the balance in the Income Summary is a net income or net loss. I-6

31

31

(1) Service Revenue Income Summary (To close revenue account) (2) Income Summary Salaries Expense Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense (To close expense accounts) (3) Income Summary R. Neal, Capital (To close net income to owner’s capital) (4) R. Neal, Capital R. Neal, Drawing (To close drawings to owner’s capital)

10,600 10,600

7,740 5,200 1,500 900 50 50 40

2,860 2,860

500 500

Summary of Study Objectives

Supplies Expense 1,500

(2)

Depreciation Expense 40

(2)

I-7

Service Revenue

631

(1)

1,500

2

10,600

10,000 400 200

10,600

10,600

1

711

40 Income Summary

Insurance Expense 50

(2)

Salaries Expense 4,000 1,200

(2)

5,200

50

(2)

7,740 2,860

(1)

10,600

10,600

10,600

3

726

5,200

R. Neal, Capital

5,200

Rent Expense 900

(2) (3)

722

(4)

500

2

(3)

10,000 2,860

Bal.

12,360

729

900 4

Interest Expense

905

50

50

(2)

R. Neal, Drawing 500

(4)

500

Preparing a Post-Closing Trial Balance for a Proprietorship

Illustration I-8 Posting of closing entries

After all closing entries are journalized and posted, the post-closing trial balance is prepared from the ledger. A post-closing trial balance is a list of all permanent accounts and their balances after closing entries are journalized and posted. As with a corporation, the purpose of a proprietorship post-closing trial balance is to prove the equality of the permanent account balances that are carried forward into the next accounting period. Since all temporary accounts will have zero balances, the post-closing trial balance will contain only permanent—balance sheet—accounts.

Summary of Study Objectives 1

Identify the differences in equity accounts between a corporation and a sole proprietorship. A sole proprietorship uses a permanent owner’s equity Capital account instead of Common Stock and Retained Earn-

ings. Withdrawals of cash or other assets by the owner for personal use are recorded in a temporary Drawing account.

I-8

appendix I Accounting for Sole Proprietorships

2

Understand what account transactions increase and decrease owner’s equity. Investments by the owner and revenue increase owner’s equity. Owner’s drawings and expenses decrease owner’s equity.

3

Describe the differences between a retained earnings statement and an owner’s equity statement. A sole proprietor prepares an owner’s equity statement rather than a retained earnings statement. The owner’s equity statement shows the beginning balance in the owner’s capital account (instead of retained earnings,

as shown in the retained earnings statement), plus any investments made by the owner, less any drawings (in place of dividends, shown in the retained earnings statement).

4

Explain the process of closing the books for a sole proprietorship. In closing the books for a sole proprietorship, separate entries are made to close revenues and expenses to Income Summary, Income Summary to Owner’s Capital, and Owner’s Drawing to Owner’s Capital.

Glossary Drawings (p. I-2) Withdrawal of cash or other assets from a sole proprietorship for the personal use of the owner. Investments by owner (p. I-2) The assets put into the business by a sole proprietor.

Owner’s equity (p. I-2) The ownership claim on the total assets of a sole proprietorship. Owner’s equity statement (p. I-3) The financial statement prepared for a sole proprietorship to summarize the changes in owner’s equity for a specific period of time.

Self-Test, Brief Exercises, Exercises, Problem Set A, and many more resources are available for practice in WileyPLUS

Questions 1. What is the basic accounting equation for a sole proprietorship?

cash revenues. Is this treatment appropriate? Why or why not?

2. What are the differences in the equity accounts of a sole proprietorship versus those of a corporation?

5. What are the steps in preparing an owner’s equity statement?

3. What items affect owner’s equity, and in what direction?

6. Identify the account(s) debited and credited in each of the required closing entries for a sole proprietorship, assuming the company has net income for the year.

4. In February 2012, Jim Grant invested an additional $10,000 in his business, Grant’s Pharmacy, which is organized as a proprietorship. Grant’s accountant, Ronny Jones, recorded this receipt as an increase in

Brief Exercises Determine effect of transactions on basic accounting equation.

(SO 2), C

Determine effect of transactions on owner’s equity.

(SO 2), C

Indicate debit and credit effects and normal balance.

(SO 2), C

BEI-1 Presented below are three business transactions. On a sheet of paper, list the letters (a), (b), (c) with columns for assets, liabilities, and owner’s equity. For each column, indicate whether the transactions increased (⫹), decreased (⫺), or had no effect (NE) on assets, liabilities, and owner’s equity. (a) Invested cash in the business. (b) Withdrawal of cash by owner. (c) Received cash from a customer who had previously been billed for services provided. BEI-2 Presented below are three transactions. Mark each transaction as affecting owner’s investment (I), owner’s drawing (D), revenue (R), expense (E), or not affecting owner’s equity (NOE). (a) Received cash for services performed (b) Paid cash to purchase equipment (c) Paid employee salaries BEI-3 For each of the following accounts, indicate the effects of (a) a debit and (b) a credit on the accounts and (c) the normal balance of the account. 1. Accounts Payable. 4. Accounts Receivable. 2. Advertising Expense. 5. A. L. Frankum, Capital. 3. Service Revenue. 6. A. L. Frankum, Drawing.

Exercises

I-9

Exercises EI-1 An analysis of the transactions made by Gutierrez & Co., a certified public accounting firm, for the month of August is shown below. Each increase and decrease in owner’s equity is explained. Accounts Office Accounts ⴙ Receivable ⴙ Supplies ⴙ Equipment ⴝ Payable ⴙ

Cash 1. ⫹$12,000 2. ⫺2,000 3. ⫺750 4. ⫹2,600 5. ⫺1,500 6. ⫺2,000 7. ⫺650 8. ⫹450 9. ⫺2,900 10.

⫹$3,700

⫹$750

⫹$5,000

⫹$3,000 ⫺1,500

⫺450 ⫹500

Analyze transactions and compute net income.

(SO 2), AP

Owner’s Equity Gutierrez, Capital ⫹$12,000

Investment

⫹6,300

Service Revenue

⫺2,000 ⫺650

Drawings Rent Expense

⫺2,900 ⫺500

Salaries Expense Utilities Expense

Instructions (a) Describe each transaction that occurred for the month. (b) Determine how much owner’s equity increased for the month. (c) Compute the amount of net income for the month.

(b) Increase in O.E. $12,250 (c) Net income $2,250

EI-2 Presented below is information related to the sole proprietorship of John Newman, attorney.

Prepare an owner’s equity statement.

(SO 3), AP Legal service revenue—2012 Total expenses—2012 Assets, January 1, 2012 Liabilities, January 1, 2012 Assets, December 31, 2012 Liabilities, December 31, 2012 Drawings—2012

$360,000 211,000 85,000 62,000 168,000 70,000 ?

Instructions Prepare the 2012 owner’s equity statement for John Newman’s legal practice. EI-3

The adjusted trial balance of Hanlon Company at the end of its fiscal year is: HANLON COMPANY Adjusted Trial Balance July 31, 2012 No.

Account Titles

Debits

101 112 157 167 201 208 301 306 404 429 711 720 732

Cash Accounts Receivable Equipment Accumulated Depreciation Accounts Payable Unearned Rent Revenue J. D. Hanlon, Capital J. D. Hanlon, Drawing Commission Revenue Rent Revenue Depreciation Expense Salaries Expense Utilities Expense

$ 14,940 8,780 15,900

Capital, Dec. 31 $98,000 Prepare income statement, owner’s equity statement, and balance sheet.

(SO 1, 2, 3, 4), AP Credits

$

5,400 4,220 1,800 45,200

14,000 65,100 6,500 4,000 55,700 14,900 $128,220

$128,220

Instructions (a) Prepare an income statement and an owner’s equity statement for the year. Hanlon did not make any capital investments during the year. (b) Prepare a classified balance sheet at July 31.

(a) Net loss

$3,000

(b) Total assets $34,220

I-10

appendix I Accounting for Sole Proprietorships

Problems Prepare income statement, owner’s equity statement, and balance sheet.

(SO 1, 2, 3, 4), AP

PI-1 On May 1, Robert Neupert started Skyline Flying School, a company that provides flying lessons, by investing $45,000 cash in the business. Following are the assets and liabilities of the company on May 31, 2012, and the revenues and expenses for the month of May. Cash Accounts Receivable Equipment Lesson Revenue Advertising Expense

$ 6,500 7,200 64,000 8,600 500

Notes Payable Rent Expense Repair Expense Fuel Expense Insurance Expense Accounts Payable

$30,000 1,200 400 2,500 400 800

Robert Neupert made no additional investment in May, but he withdrew $1,700 in cash for personal use. (a) Net income $ 3,600 Owner’s equity $46,900 Total assets $ 77,700 (b) Net income $1,200 Owner’s equity $44,500 Prepare financial statements, closing entries, and postclosing trial balance.

Instructions (a) Prepare an income statement and owner’s equity statement for the month of May and a balance sheet at May 31. (b) Prepare an income statement and owner’s equity statement for May assuming that the data above need to be adjusted for the following items: (1) $900 of revenue was earned and billed but not collected at May 31, and (2) $3,300 of fuel expense was incurred but not paid. PI-2 The adjusted trial balance columns of the work sheet for Sherrick Company are as follows.

(SO 1, 2, 3, 4), AP

SHERRICK COMPANY Adjusted Trial Balance For the Year Ended December 31, 2012 Adjusted Trial Balance

Account No.

Account Titles

Dr.

101 112 126 130 151 152 200 201 212 230 301 306 400 610 631 711 722 726 905

Cash Accounts Receivable Supplies Prepaid Insurance Office Equipment Accumulated Depreciation—Office Equipment Notes Payable Accounts Payable Salaries Payable Interest Payable B. Sherrick, Capital B. Sherrick, Drawing Service Revenue Advertising Expense Supplies Expense Depreciation Expense Insurance Expense Salaries Expense Interest Expense

20,800 15,400 2,300 4,800 44,000

Totals

(a) Net income $13,300 Current assets $43,300 Current liabilities $22,000

Cr.

18,000 20,000 8,000 3,000 1,000 36,000 12,000 79,000 12,000 3,700 6,000 4,000 39,000 1,000 165,000

165,000

Instructions (a) Prepare an income statement, owner’s equity statement, and a classified balance sheet. $10,000 of the notes payable become due in 2013. B. Sherrick did not make any additional investments in the business during 2012. (b) Prepare the closing entries.

Exercises (c) Post the closing entries. Use the three-column form of account. Income summary is No. 350. (d) Prepare a post-closing trial balance. PI-3 The adjusted trial balance columns of the work sheet for Jake Mann Company, owned by Jake Mann, are as follows.

(d) Post-closing trial balance $87,300 Prepare financial statements, closing entries, and postclosing trial balance.

(SO 1, 2, 3, 4), AP

JAKE MANN COMPANY Adjusted Trial Balance For the Year Ended December 31, 2012 Adjusted Trial Balance

Account No.

Account Titles

Dr.

101 112 126 130 151 152 200 201 212 230 301 306 400 610 631 711 722 726 905

Cash Accounts Receivable Supplies Prepaid Insurance Office Equipment Accumulated Depreciation—Office Equipment Notes Payable Accounts Payable Salaries Payable Interest Payable Jake Mann, Capital Jake Mann, Drawing Service Revenue Advertising Expense Supplies Expense Depreciation Expense Insurance Expense Salaries Expense Interest Expense

13,600 15,400 1,500 2,800 34,000

Totals

Cr.

8,000 16,000 6,000 3,000 500 25,000 10,000 88,000 12,000 5,700 4,000 5,000 42,000 500 146,500

146,500

Instructions (a) Prepare an income statement, owner’s equity statement, and a classified balance sheet (Note: $10,000 of the notes payable become due in 2013.) Jake Mann did not make any additional investments in the business during the year. (b) Prepare the closing entries. Use J14 for the journal page. (c) Post the closing entries. Use the three-column form of account. Income Summary is No. 350. (d) Prepare a post-closing trial balance.

I-11

(a) Net income $18,800 Current assets $33,300 Current liabilities $19,500

(d) Post-closing trial balance $67,300