Accounting for. Sole Proprietorship. 1 Identify the differences in equity accounts between a corporation and a sole proprietorship.

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1 appendix F 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. 2 Understand what accounts increase and decrease owner s equity. 3 Describe the differences between a retained earnings statement and an owner s equity statement. 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 F-1. study objective 1 Identify the differences in equity accounts between a corporation and a sole proprietorship. Corporation Stockholders equity Common stock Retained earnings Sole Proprietorship Owner s equity Owner s name, capital Illustration F-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 F 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. F-1

2 F-2 appendix F 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 F-2. Net income results when revenues exceed expenses. A net loss occurs when expenses exceed revenues. Illustration F-2 Increases and decreases in owner s equity INCREASES DECREASES Investments by owner Revenues Owner's Equity Withdrawals by owner Expenses

3 Financial Statements for a Proprietorship F-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 3-2 (page 104) presented the impact of Sierra s transactions on its accounting equation. Illustration F-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 F-3 Summary of transactions Assets Liabilities Owner s Equity Prepaid Office Notes Accounts Unearned R. Neal, Cash Supplies Insurance Equipment Payable Payable Revenue Capital (1) $10,000 $10,000 Investment by owner 5,000 $5,000 15,000 5,000 10,000 (3) 5,000 $5,000 10,000 5,000 5,000 10,000 (4) 1,200 $1,200 11,200 5,000 5,000 1,200 10,000 (5) 10,000 10,000 Service Revenue 21,200 5,000 5,000 1,200 20,000 (6) Rent Expense 20,300 5,000 5,000 1,200 19,100 (7) 600 $600 19, ,000 5,000 1,200 19,100 (8) $2,0 $2,0 19,700 2, ,000 5,000 2,0 1,200 19,100 (10) 0 0 Drawings 19,200 2, ,000 5,000 2,0 1,200 18,600 (11) 4,000 4,000 Salaries Expense $15,200 $2,0 $600 $5,000 $5,000 $2,0 $1,200 $14,600 $23,300 $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 F-4 (page F-4) and F-5 (page F-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 4-23 and 4-24, page 179) 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.

4 F-4 appendix F Accounting for Sole Proprietorships SIERRA COMPANY Adjusted Trial Balance October 31, 2010 Account Cash Accounts Receivable Advertising Supplies Prepaid Insurance Office Equipment Accumulated Depreciation Office Equipment Notes Payable Accounts Payable Interest Payable Unearned Service Revenue Salaries Payable R. Neal, Capital Drawing Service Revenue Salaries Expense Advertising Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense Debit $15, , , ,200 1, Credit $ 40 5,000 2, ,200 10,000 $30,190 $30,190 SIERRA COMPANY Income Statement For the Month Ended October 31, 2010 Revenues Service Revenue Expenses Salaries expense Advertising supplies expense Rent expense Insurance expense Interest expense Depreciation expense Total expenses Net income $5,200 1, $ 7,740 $ 2,860 SIERRA COMPANY Owner s Equity Statement For the Month Ended October 31, 2010 R. Neal, Capital, October 1 Add: Investments by owner R. Neal, Capital Net income Less: Drawings R. Neal, Capital, October 31 $ 0 10,000 10,000 2,860 12,860 0 $12,360 To balance sheet Illustration F-4 Preparation of the income statement and owner s equity statement from the adjusted trial balance study objective Explain the process of closing the books for a sole proprietorship. 4 Closing the Books of a Proprietorship 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 4-27 on page 182 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.

5 Closing the Books of a Proprietorship F-5 SIERRA COMPANY Adjusted Trial Balance October 31, 2010 Account Debit Credit Cash Accounts Receivable Advertising Supplies Prepaid Insurance Office Equipment Accumulated Depreciation Office Equipment Notes Payable Accounts Payable Interest Payable Unearned Service Revenue Salaries Payable R. Neal, Capital R. Neal, Drawing Service Revenue Salaries Expense Advertising Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense $15, , ,000 0 $ 40 5,000 2, ,200 10,000 5,200 1, $30,190 $30,190 SIERRA COMPANY Balance Sheet October 31, 2010 Assets Cash Accounts receivable Advertising supplies Prepaid insurance Office equipment $5,000 Less: Accumulated depreciation 40 Total assets Liabilities and Owner s Equity Liabilities Notes payable Accounts payable Interest payable Unearned revenue Salaries payable Total liabilities Owner s equity R. Neal, Capital Total liabilities and owner s equity Capital Balance at Oct. 31 from Owner s Equity Statement in Illustration F-4 $15, , ,960 $21,910 $ 5,000 2, ,200 9,5 12,360 $21,910 Illustration F-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. Helpful Hint Owner s Drawing is closed directly to Capital and not to Income Summary because Owner s Drawing is not an expense. The four entries are referenced in the diagram of the closing process shown in Illustration F-6 and in the journal entries in Illustration F-7, both on page F-6. The posting of closing entries is shown in Illustration F-8 (page F-7). If there were a net loss because expenses exceeded revenues, entry 3 in Illustration F-6 would be reversed: Credit Income Summary and debit Owner s Capital.

6 (Individual) Expenses (Individual) Revenues 2 1 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. Owner s Drawing Illustration F-6 Diagram of closing process GENERAL JOURNAL Illustration F-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. Date Account Titles and Explanation Debit Credit Closing Entries 2010 (1) Oct. 31 Service Revenue Income Summary (To close revenue account) 31 Income Summary 7,740 Salaries Expense 5,200 Advertising Supplies Expense 1,0 Rent Expense 900 Insurance Expense Interest Expense Depreciation Expense 40 (To close expense accounts) (3) 31 Income Summary 2,860 R. Neal, Capital 2,860 (To close net income to owner s capital) (4) 31 R. Neal, Capital 0 R. Neal, Drawing 0 (To close drawings to owner s capital) F-6

7 Summary of Study Objectives F-7 Advertising Supplies Expense 631 Service Revenue 1,0 Depreciation Expense 1, (1) 10, Income Summary Insurance Expense 722 (3) 7,740 2,860 (1) Salaries Expense ,000 1,200 5,200 R. Neal, Capital 5,200 Rent Expense 5, (4) 0 (3) 10,000 2,860 Bal. 12, Interest Expense 905 R. Neal, Drawing 0 (4) 0 Preparing a Post-Closing Trial Balance for a Proprietorship 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. Illustration F-8 Posting of closing entries 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 Earnings. Withdrawals of cash or other assets by the owner for personal use are recorded in a temporary Drawing account.

8 F-8 appendix F 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. F-2) Withdrawal of cash or other assets from a sole proprietorship for the personal use of the owner. Investments by owner (p. F-2) The assets put into the business by a sole proprietor. Owner s equity (p. F-2) The ownership claim on the total assets of a sole proprietorship. Owner s equity statement (p. F-3) The financial statement prepared for a sole proprietorship to summarize the changes in owner s equity for a specific period of time. Questions 1. What is the basic accounting equation for a sole proprietorship? 2. What are the differences in the equity accounts of a sole proprietorship versus those of a corporation? 3. What items affect owner s equity, and in what direction? 4. In February 2010, Joe Kirby invested an additional $10,000 in his business, Kirby s Pharmacy, which is organized as a proprietorship. Kirby s accountant, Lance Jones, recorded this receipt as an increase in cash revenues. Is this treatment appropriate? Why or why not? 5. What are the steps in preparing an owner s equity statement? 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. Determine effect of transactions on basic accounting equation. (SO 2) Determine effect of transactions on owner s equity. (SO 2) Indicate debit and credit effects and normal balance. (SO 2) Brief Exercises BEF-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. BEF-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 BEF-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. B. C. Jardine, Capital. 3. Service Revenue. 6. B. C. Jardine, Drawing.

9 Exercises F-9 Exercises EF-1 An analysis of the transactions made by Roberta Mendez & Co., a certified public accounting firm, for the month of August is shown below. Each increase and decrease in owner s equity is explained. Analyze transactions and compute net income. (SO 2) Accounts Office Accounts Owner s Equity Cash Receivable Supplies Equipment Payable R. Mendez, Capital 1. $12,000 $12,000 Investment 2. 2,000 $5,000 $3, $7 4. 2,600 $3,700 6,300 Service Revenue 5. 1,0 1,0 6. 2,000 2,000 Drawings Rent Expense ,900 2,900 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. EF-2 Presented below is information related to the sole proprietorship of Mark Garland, attorney. Legal service revenue 2010 $360,000 Total expenses ,000 Assets, January 1, ,000 Liabilities, January 1, ,000 Assets, December 31, ,000 Liabilities, December 31, ,000 Drawings 2010? Instructions Prepare the 2010 owner s equity statement for Mark Garland s legal practice. EF-3 The adjusted trial balance of Mozart Company at the end of its fiscal year is: MOZART COMPANY Adjusted Trial Balance July 31, 2010 (b) Increase in O.E. $12,2 (c) Net income $2,2 Prepare an owner s equity statement. (SO 3) Capital, Dec. 31 $98,000 Prepare income statement, owner s equity statement, and balance sheet. (SO 1, 2, 3, 4) No. Account Titles Debits Credits 101 Cash $ 14, Accounts Receivable 8, Equipment 15, Accumulated Depreciation $ 5, Accounts Payable 4, Unearned Rent Revenue 1, W.A. Mozart, Capital 45, W.A. Mozart, Drawing 14, Commission Revenue 65, Rent Revenue 6,0 711 Depreciation Expense 4, Salaries Expense 55, Utilities Expense 14,900 $128,220 $128,220 Instructions (a) Prepare an income statement and an owner s equity statement for the year. Mozart (a) Net loss $3,000 did not make any capital investments during the year. (b) Prepare a classified balance sheet at July 31. (b) Total assets $34,220

10 F-10 appendix F Accounting for Sole Proprietorships Prepare income statement, owner s equity statement, and balance sheet. (SO 1, 2, 3, 4) Problems PF-1 On May 1, Dennis Chambers 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, 2010, and the revenues and expenses for the month of May. Cash $ 6,0 Notes Payable $30,000 Accounts Receivable 7,200 Rent Expense 1,200 Equipment 64,000 Repair Expense 400 Lesson Revenue 8,600 Fuel Expense 2,0 Advertising Expense 0 Insurance Expense 400 Accounts Payable 800 Dennis Chambers 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 $44,0 Prepare financial statements, closing entries, and postclosing trial balance. (SO 1, 2, 3, 4) 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 $3,300 of fuel expense was incurred but not paid. PF-2 The adjusted trial balance columns of the work sheet for Shmi Skywalker Company are as follows. SHMI SKYWALKER COMPANY Adjusted Trial Balance For the Year Ended December 31, 2010 Adjusted Account Trial Balance No. Account Titles Dr. Cr. 101 Cash 20, Accounts Receivable 15, Supplies 2, Prepaid Insurance 4, Office Equipment 44, Accumulated Depreciation Office Equipment 18, Notes Payable 20, Accounts Payable 8, Salaries Payable 3, Interest Payable 1, S. Skywalker, Capital 36, S. Skywalker, Drawing 12, Service Revenue 79, Advertising Expense 12, Supplies Expense 3, Depreciation Expense 6, Insurance Expense 4, Salaries Expense 39, Interest Expense 1,000 Totals 165, ,000 (a) Net income $13,300 Current assets $43,300 Current liabilities $22,000 Instructions (a) Prepare an income statement, owner s equity statement, and a classified balance sheet. $10,000 of the notes payable become due in S. Skywalker did not make any additional investments in the business during (b) Prepare the closing entries.

11 Problems F-11 (c) Post the closing entries. Use the three-column form of account. Income summary is No. 3. (d) Prepare a post-closing trial balance. PF-3 The adjusted trial balance columns of the work sheet for Boss Nass Company, owned by Boss Nass, are as follows. BOSS NASS COMPANY Adjusted Trial Balance For the Year Ended December 31, 2010 (d) Post-closing trial balance $87,300 Prepare financial statements, closing entries, and postclosing trial balance. (SO 1, 2, 3, 4) Adjusted Account Trial Balance No. Account Titles Dr. Cr. 101 Cash 13, Accounts Receivable 15, Supplies 1,0 130 Prepaid Insurance 2, Office Equipment 34, Accumulated Depreciation Office Equipment 8, Notes Payable 16, Accounts Payable 6, Salaries Payable 3, Interest Payable Boss Nass, Capital 25, Boss Nass, Drawing 10, Service Revenue 88, Advertising Expense 12, Supplies Expense 5, Depreciation Expense 4, Insurance Expense 5, Salaries Expense 42, Interest Expense 0 Totals 146,0 146,0 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 2011.) Boss Nass 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. 3. (d) Prepare a post-closing trial balance. (a) Net income $18,800 Current assets $33,300 Current liabilities $19,0 (d) Post-closing trial balance $67,300

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