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How to Calculate Amortization Expense

The following is an excerpt from Accounting Made Simple: Accounting Explained in 100 Pages or Less.

Intangible assets are real, identifiable assets that are not physical objects. Common intangible assets include patents, copyrights, and trademarks.

Amortization is the process—very analogous to depreciation—in which an intangible asset’s cost is spread out over the asset’s life. Generally, intangible assets are amortized using the straight-line method over the shorter of:

  • The asset’s expected useful life, or
  • The asset’s legal life.

Example: Kurt runs a business making components for wireless routers. In 2008, he spends $60,000 obtaining a patent for a new method of production that he has recently developed. The patent will expire in 2022.

Even though the patent’s legal life is 14 years, its useful life is likely to be much shorter, as it’s a near certainty that this method will become obsolete in well under 14 years, given the rapid rate of innovation in the technology industry. As such, Kurt will amortize the patent over what he projects to be its useful life: four years.

Each year, the following entry will be made:

Amortization Expense 15,000
Accumulated Amortization 15,000

Simple Summary

  • Amortization is the process in which an intangible asset’s cost is spread out over the asset’s life.
  • The time period used for amortizing an intangible asset is generally the lesser of the asset’s legal life or expected useful life.

To Learn More, Check Out the Book:

Book6FrontCoverTiltedBlue

Accounting Made Simple: Accounting Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to read and prepare financial statements
  • Preparing journal entries with debits and credits
  • Cash method vs. accrual method
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"A quick tour of the ins and outs of accounting. Great introduction on the basics and keeps it simple. Short enough to be read in a day. I highly recommend this to any one looking for a crash course in accounting. "

How to Calculate Depreciation Expense

The following is an excerpt from Accounting Made Simple: Accounting Explained in 100 Pages or Less.

When a company buys an asset that will probably last for greater than one year, the cost of that asset is not counted as an immediate expense. Rather, the cost is spread out over several years in a process known as depreciation.

Straight-Line Depreciation

The most basic form of depreciation is known as straight-line depreciation. Using this method, the cost of the asset is spread out equally over the expected life of the asset.

Example: Daniel spends $5,000 on a new piece of equipment for his carpentry business. He expects the equipment to last for 5 years, by which point it will likely be of no substantial value. Each year, $1,000 of the equipment’s cost will be counted as an expense.

When Daniel first purchases the equipment, he would make the following journal entry:

DR. Equipment 5,000
CR. Cash 5,000

Then, each year, Daniel would make the following entry to record Depreciation Expense for the equipment:

Depreciation Expense 1,000
Accumulated Depreciation 1,000

Accumulated Depreciation is what’s known as a “contra account,” or more specifically, a “contra-asset account.” Contra accounts are used to offset other accounts. In this case, Accumulated Depreciation is used to offset Equipment.

At any given point, the net of the debit balance in Equipment, and the credit balance in Accumulated Depreciation gives us the net Equipment balance—sometimes referred to as “net book value.” In the example above, after the first year of depreciation expense, we would say that Equipment has a net book value of 4,000. (5,000 original cost, minus 1,000 Accumulated Depreciation.)

We make the credit entries to Accumulated Depreciation rather than directly to Equipment so that we:

  1. Have a record of how much the asset originally cost, and
  2. Have a record of how much depreciation has been charged against the asset already.

Example (continued): Eventually, after 5 years, Accumulated Depreciation will have a credit balance of 5,000 (the original cost of the asset). At this point—once the asset has zero net book value—Daniel will make the following entry to “write off” the asset:

Accumulated Depreciation 5,000
Equipment 5,000

After making this entry, there will no longer be any balance in Equipment or Accumulated Depreciation.

Salvage Value

What if a business plans to use an asset for a few years, and then sell it before it becomes entirely worthless? In these cases, we use what is called “salvage value.” Salvage value (sometimes referred to as residual value) is the value that the asset is expected to have after the planned number of years of use.

Example:
Lydia spends $11,000 on office furniture, which she plans to use for the next ten years, after which she believes it will have a value of approximately $2,000. The furniture’s original cost, minus its expected salvage value is known as its depreciable cost—in this case, $9,000.

Each year, Lydia will record $900 of depreciation as follows:

Depreciation Expense 900
Accumulated Depreciation 900

After ten years, Accumulated Depreciation will have a $9,000 credit balance. If, at that point, Lydia does in fact sell the furniture for $2,000, she’ll need to record the inflow of cash, and write off the Office Furniture and Accumulated Depreciation balances:

Accumulated Depreciation 9,000
Cash 2,000
Office Furniture 11,000

Gain or Loss on Sale

Of course, it’s pretty unlikely that somebody can predict exactly what an asset’s salvage value will be several years from the date she bought the asset. When an asset is sold, if the amount of cash received is greater than the asset’s net book value, a gain must be recorded on the sale. (Gains work like revenue in that they have credit balances, and increase owners’ equity.)

If, however, the asset is sold for less than its net book value, a loss must be recorded. (Losses work like expenses: They have debit balances, and they decrease owners’ equity.)

Determining whether to make a gain entry or a loss entry is never too difficult: Just figure out whether an additional debit or credit is needed to make the journal entry balance.

Example (continued): If, after ten years, Lydia had sold the furniture for $3,000 rather than $2,000, she would record the transaction as follows:

Cash 3,000
Accumulated Depreciation 9,000
Office Furniture 11,000
Gain on Sale of Furniture 1,000

Example (continued): If, however, Lydia had sold the furniture for only $500, she would make the following entry:

Cash 500
Accumulated Depreciation 9,000
Loss on Sale of Furniture 1,500
Office Furniture 11,000

Other Depreciation Methods

In addition to straight-line, there are a handful of other (more complicated) methods of depreciation that are also GAAP-approved. For example, the double declining balance method consists of multiplying the remaining net book value by a given percentage every year. The percentage used is equal to double the percentage that would be used in the first year of straight-line depreciation.

Example:
Randy purchases $10,000 of equipment, which he plans to depreciate over five years. Using straight-line, Randy would be depreciating 20% of the value (100% ÷ five years) in the first year. Therefore, the double declining balance method will use 40% depreciation every year (2 x 20%). The depreciation for each of the first four years would be as follows:

Year Net Book Value Depreciation Expense
1 $10,000 x40% = $4,000
2 $6,000 x40% = $2,400
3 $3,600 x40% = $1,440
4 $2,160 x40% = $864

Example (continued): Because the equipment is being depreciated over five years, Randy would record $1,296 (that is, 2,160 – 864) of depreciation expense in the fifth year in order to reduce the asset’s net book value to zero.

Another GAAP-accepted method of depreciation is the units of production method. Under the units of production method, the rate at which an asset is depreciated is not a function of time, but rather a function of how much the asset is used.

Example: Bruce runs a business making leather jackets. He spends $50,000 on a piece of equipment that is expected to last through the production of 5,000 jackets. Using the units of production method of depreciation, Bruce would depreciate the equipment each period based upon how many jackets were produced (at a rate of $10 depreciation per jacket).

If, in a given month, Bruce’s business used the equipment to produce 150 jackets, the following entry would be used to record depreciation:

Depreciation Expense 1,500
Accumulated Depreciation 1,500

Immaterial Asset Purchases

The concept of materiality plays a big role in how some assets are accounted for. For example, consider the case of a $15 wastebasket. Given the fact that a wastebasket is almost certain to last for greater than one year, it should, theoretically, be depreciated over its expected useful life.

However—in terms of the impact on the company’s financial statements—the difference between depreciating the wastebasket and expensing the entire cost right away is clearly negligible. The benefit of the additional accounting accuracy is far outweighed by the hassle involved in making insignificant depreciation journal entries year after year. As a result, assets of this nature are generally expensed immediately upon purchase rather than depreciated over multiple years. Such a purchase would ordinarily be recorded as follows:

Office Administrative Expense 15.00
Cash (or Accounts Payable) 15.00

Simple Summary

  • Straight-line depreciation is the simplest depreciation method. Using straight-line, an asset’s cost is depreciated over its expected useful life, with an equal amount of depreciation being recorded each month.
  • Accumulated depreciation—a contra-asset account—is used to keep track of how much depreciation has been recorded against an asset so far.
  • An asset’s net book value is equal to its original cost, less the amount of accumulated depreciation that has been recorded against the asset.
  • If an asset is sold for more than its net book value, a gain must be recorded. If it’s sold for less than net book value, a loss is recorded.
  • Immaterial asset purchases tend to be expensed immediately rather than being depreciated.

To Learn More, Check Out the Book:

Book6FrontCoverTiltedBlue

Accounting Made Simple: Accounting Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to read and prepare financial statements
  • Preparing journal entries with debits and credits
  • Cash method vs. accrual method
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"A quick tour of the ins and outs of accounting. Great introduction on the basics and keeps it simple. Short enough to be read in a day. I highly recommend this to any one looking for a crash course in accounting. "

How to Calculate Cost of Goods Sold (CoGS)

The following is an excerpt from Accounting Made Simple: Accounting Explained in 100 Pages or Less.

When using the periodic method of inventory, Cost of Goods Sold is calculated using the following equation:

Beginning Inventory + Inventory Purchases – End Inventory = Cost of Goods Sold

This equation makes perfect sense when you look at it piece by piece.

Beginning inventory, plus the amount of inventory purchased over the period gives you the total amount of inventory that could have been sold (sometimes known, understandably, as Cost of Goods Available for Sale).

We then assume that, if an item isn’t in inventory at the end of the period, it must have been sold. (And conversely, if an item is in ending inventory, it obviously wasn’t sold, hence the subtraction of the ending inventory balance when calculating CoGS).

EXAMPLE: Corina has a business selling books on eBay. An inventory count at the beginning of November shows that she has $800 worth of inventory on hand. Over the month, she purchases another $2,400 worth of books. Her inventory count at the end of November shows that she has $600 of inventory on hand.

Using the equation above, we learn that Corina’s Cost of Goods Sold for November is $2600, calculated as follows:

Beginning Inventory + Purchases Ending Inventory = Cost of Goods Sold
800 + 2400 600 = 2600

Granted, this equation isn’t perfect. For instance, it doesn’t keep track of the cost of inventory theft. Any stolen items will accidentally get bundled up into CoGS, because:

  1. They aren’t in inventory at the end of the period, and
  2. There is no way to know which items were stolen as opposed to sold, because inventory isn’t being tracked item-by-item.

Assumptions Used in Calculating CoGS under the Periodic Method

Of course, the calculation of CoGS is a bit more complex out in the real world. For example, if a business is dealing with changing per-unit inventory costs, assumptions have to be made as to which ones were sold (the cheaper units or the more expensive units).

EXAMPLE: Maggie has a business selling t-shirts online. She gets all of her inventory from a single vendor. In the middle of April, the vendor raises its prices from $3 per shirt to $3.50 per shirt. If Maggie sells 100 shirts during April—and she has no way of knowing which of those shirts were purchased at which price—should her CoGS be $300, $350, or somewhere in between?

The answer depends upon which inventory-valuation method is used. The three most used methods are known as FIFO, LIFO, and Average Cost. Under GAAP, a business can use any of the three.

First-In, First-Out (FIFO)

Under the “First-In, First-Out” method of calculating CoGS, we assume that the oldest units of inventory are always sold first. So in the above example, we’d assume that Maggie sold all of her $3 shirts before selling any of her $3.50 shirts.

Last-In, First-Out (LIFO)

Under the “Last-In, First-Out” method, the opposite assumption is made. That is, we assume that all of the newest inventory is sold before any older units of inventory are sold. So, in the above example, we’d assume that Maggie sold all of her $3.50 shirts before selling any of her $3 shirts.

EXAMPLE (CONTINUED): At the beginning of April, Maggie’s inventory consisted of 50 shirts—all of which had been purchased at $3 per shirt. Over the month, she purchased 100 shirts, 60 at $3 per shirt, and 40 at $3.50 per shirt. In total, Maggie’s Goods Available for Sale for April consists of 110 shirts at $3 per shirt, and 40 shirts at $3.50 per shirt.

If Maggie were to use the FIFO method of calculating her CoGS for the 100 shirts she sold in April, her CoGS would be $300. (She had 110 shirts that cost $3, and FIFO assumes that all of the older units are sold before any newer units are sold.)

100 x 3 = 300

If Maggie were to use the LIFO method of calculating her CoGS for the 100 shirts she sold in April, her CoGS would be $320. (LIFO assumes that all 40 of the newer, $3.50 shirts would have been sold, and the other 60 must have been $3 shirts.)

(40 x 3.5) + (60 x 3) = 320

It’s worth pointing out that the two methods result not only in different Cost of Goods Sold for the period, but in different ending inventory balances as well.

Under FIFO—because we assumed that all 100 of the sold shirts were the older, $3, shirts—it would be assumed that, at the end of April, her 50 remaining shirts would be made up of 10 shirts that were purchased at $3 each, and 40 that were purchased at $3.50 each. Grand total ending inventory balance: $170.

In contrast, the LIFO method would assume that—because all of the newer shirts were sold—the remaining shirts must be the older, $3 shirts. As such, Maggie’s ending inventory balance under LIFO is $150.

Average Cost

The average cost method is just what it sounds like. It uses the beginning inventory balance and the purchases over the period to determine an average cost per unit. That average cost per unit is then used to determine both the CoGS and the ending inventory balance.

[Beginning Inventory + Purchases (in dollars)]
÷ [Beginning Inventory + Purchases (in units)]
= Average Cost per Unit

Average Cost per Unit x Units Sold = Cost of Goods Sold

Avgerage Cost per Unit x Units in Ending Inventory = Ending Inventory Balance

EXAMPLE (CONTINUED): Under the average cost method, Maggie’s average cost per shirt for April is calculated as follows:

Beginning Inventory: 50 shirts ($3/shirt)
Purchases: 100 shirts (60 at $3/shirt and 40 at $3.50/shirt)

Her total units available for sale over the period is 150 shirts. Her total Cost of Goods Available for Sale is $470 (110 shirts at $3 each and 40 at $3.50 each).

Maggie’s average cost per shirt = $470/150 = $3.13

Using an average cost/shirt of $3.13, we can calculate the following:

  • CoGS in April = $313 (100 shirts x $3.13/shirt)
  • Ending Inventory = $157 (50 shirts x $3.13/shirt)

Simple Summary

  • The perpetual method of inventory involves tracking each individual item of inventory on a minute-to-minute basis. It can be expensive to implement, but it improves and simplifies accounting.
  • The periodic method of inventory involves doing an inventory count at the end of each period, then mathematically calculating Cost of Goods Sold.
  • FIFO (first-in, first-out) is the assumption that the oldest units of inventory are sold before the newer units.
  • LIFO (last-in, first-out) is the opposite assumption: The newest units of inventory are sold before older units are sold.
  • The average cost method is a formula for calculating CoGS and ending inventory based upon the average cost per unit of inventory available for sale over a given period.

To Learn More, Check Out the Book:

Book6FrontCoverTiltedBlue

Accounting Made Simple: Accounting Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to read and prepare financial statements
  • Preparing journal entries with debits and credits
  • Cash method vs. accrual method
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"A quick tour of the ins and outs of accounting. Great introduction on the basics and keeps it simple. Short enough to be read in a day. I highly recommend this to any one looking for a crash course in accounting. "

Example Accounting Problems

These sample problems are intended as a supplement to my book Accounting Made Simple: Accounting Explained in 100 Pages or Less.

Chapter 1: The Accounting Equation

Question 1: Define the three components of the Accounting Equation.

Question 2: If a business owns a piece of real estate worth $250,000, and they owe $180,000 on a loan for that real estate, what is owners’ equity in the property?

Answer to Question 1:

  • Assets: All the property owned by a business.
  • Liabilities: A company’s outstanding debts.
  • Owners’ Equity: The company’s ownership interests in its property after all debts have been repaid.

Answer to Question 2: $70,000

Chapter 2: The Balance Sheet

Question 1: Categorize the following accounts as to whether they’re Asset, Liability, of Owners’ Equity accounts.

  • Common Stock
  • Accounts Receivable
  • Retained Earnings
  • Cash
  • Notes Payable

Question 2: For each of the following assets or liabilities, state whether it is current or non-current:

  • Accounts Payable
  • Cash
  • Property, Plant, and Equipment
  • Note Payable
  • Inventory

Answer to Question 1:

  • Common Stock: Owners’ Equity
  • Accounts Receivable: Asset
  • Retained Earnings: Owners’ Equity
  • Cash: Asset
  • Notes Payable: Liability

Answer to Question 2:

  • Accounts Payable: current liability
  • Cash: current asset
  • Property, Plant, and Equipment: non-current asset
  • Note Payable: non-current liability (Though if a portion of the note is due within the next twelve months, that portion should be shown as a current liability.)
  • Inventory: current asset

Chapter 3: The Income Statement

Question 1: Given the following information, calculate ABC Corp’s Net Income:

  • Sales: $260,000
  • Cost of Goods Sold: $100,000
  • Salaries and Wages: $20,000
  • Rent Expense: $15,000
  • Advertising Expense: $35,000
  • Cost of repairs resulting from fire: $50,000

Question 2: Using the above information, calculate ABC Corp’s Operating Income.

Question 3:Using the above information, calculate ABC Corp’s Gross Profit.

Answer to Question 1: $40,000 (Sales of $260,000 minus $220,000 of total expenses.)

Answer to Question 2: $90,000 (Operating Income is intended to represent income from typical business operations.  As a result, expenses resulting from a fire would certainly not be included when calculating Operating Income.)

Answer to Question 3: $160,000 (Sales minus Cost of Goods Sold)

Chapter 4: The Statement of Retained Earnings

Question 1: Using the following information, calculate the ending balance in Retained Earnings:

  • Beginning Retained Earnings: $10,000
  • Net Income: $5,000
  • Dividends Paid: $4,000

Question 2: Calculate Net Income given the following information:

  • Consulting Revenue: $50,000
  • Rent Expense: $5,000
  • Software Licensing Fees: $3,000
  • Dividends Paid: $6,000
  • Advertising Expense:$20,000

Question 3: Using the following information, calculate how much was paid out in dividends during the year:

  • Beginning Retained Earnings: $40,000
  • Net Income: $15,000
  • Ending Retained Earnings: $30,000

Answer to Question 1: $11,000

Answer to Question 2: $22,000 (Remember, dividends are not an expense! They are a distribution of net income rather than a reduction of net income.)

Answer to Question 3: $25,000

Chapter 5: The Cash Flow Statement

Question 1: Calculate cash flow from operating activities using the following information:

  • Cash sales: $10,000
  • Credit sales: $15,000
  • Cash received from prior credit sales: $8,000
  • Rent paid: $3,000
  • Inventory purchased: $6,000
  • Wages paid:$5,000

Question 2: Categorize the following cash flows as to whether they are operating, investing, or financing activities:

  • Taxes paid
  • Dividends paid to shareholders
  • Interest paid on loans
  • Dividends received on investments
  • Cash sales
  • Purchase of new office furniture

Answer to Question 1: Net cash inflow of $4,000. (Remember not to include the $15,000 of credit sales when calculating cash flow.)

Answer to Question 2:

  • Taxes paid: Operating Activities
  • Dividends paid to shareholders: Financing Activities
  • Interest paid on loans: Operating Activities (Note: Principal paid on loans is a financing activity.)
  • Dividends received on investments: Operating Activities
  • Cash sales: Operating Activities
  • Purchase of new office furniture: Investing Activities

Chapter 6: Financial Ratios

Questions 1-3: Use the following income statement and balance sheet to answer the following questions.

Income Statement
Sales 130,000
Cost of Goods Sold 26,000
Profit Margin 104,000
Salaries and Wages 15,000
Rent Expense 5,000
Licensing Expenses 20,000
Advertising Expense 4,000
Total Expenses 44,000
Net Income
60,000
Balance Sheet
Assets
Cash 10,000
Inventory 15,000
Property, Plant, and Equipment 250,000
Accounts Receivable 5,000
Total Assets 280,000
Liabilities
Accounts Payable 20,000
Notes Payable 40,000
Total Liabilities 60,000
Owners’ Equity
Common Stock 120,000
Retained Earnings 100,000
Total Owners’ Equity 220,000

Question 1: Calculate the company’s current ratio and quick ratio.

Question 2: Calculate the company’s return on assets and return on equity.

Question 3: Calculate the company’s debt ratio and debt to equity ratio.

Answer to Question 1: Current ratio = 1.5 (30,000 current assets ÷ 20,000 current liabilities). Quick ratio = 0.75 (15,000 non-inventory current assets ÷ 20,000 current liabilities).

Answer to Question 2: Return on assets = 21.4% (60,000 net income ÷ 280,000 total assets). Return on equity = 27.3% (60,000 net income ÷ 220,000 shareholders’ equity)

Answer to Question 3: Debt ratio = 21.4% (60,000 liabilities ÷ 280,000 assets). Debt to equity ratio = 27.3% (60,000 liabilities ÷ 220,000 shareholders’ equity).

Chapter 7: What is GAAP?

Question 1: Who is required to follow GAAP?

Question 2: Who creates the rules for GAAP?

Question 3: What is the purpose of Generally Accepted Accounting Principles (GAAP)?

Answer to Question 1: Publicly-traded companies. (Governmental entities are required to follow GAAP as well, but the rules that make up GAAP for governmental entities are significantly different from the rules for publicly-traded companies.)

Answer to Question 2: The Financial Accounting Standards Board (FASB)

Answer to Question 3: To purpose of GAAP is to ensure that companies’ financial statements are prepared using a similar set of rules and assumptions. This helps to enable meaningful comparisons between the financial statements of multiple companies.

Chapter 8: Debits and Credits

Questions 1-3: Show how the following transactions would affect the Accounting Equation

Question 1: James purchases a $5,000 piece of equipment.

Question 2: James writes his monthly check for rent: $3,000.

Question 3: James takes out a $25,000 loan with his bank.

Questions 4-6: Create journal entries to record the following transactions

Question 4: James purchases a $5,000 piece of equipment.

Question 5: James writes his monthly check for rent: $3,000.

Question 6: James takes out a $25,000 loan with his bank.

Answer to Question 1:

Assets = Liabilities + Owners’ Equity
-5,000 no change no change
+5,000

Answer to Question 2:

Assets = Liabilities + Owners’ Equity
-3,000 -3,000

Answer to Question 3:

Assets = Liabilities + Owners’ Equity
+25,000 +25,000

Answer to Question 4:

Dr. Equipment 5,000
Cr. Cash 5,000

Answer to Question 5:

Dr. Rent Expense 3,000
Cr. Cash 3,000

Answer to Question 6:

Dr. Cash 25,000
Cr. Note Payable 25,000

Chapter 9: Cash vs. Accrual

Questions 1-5: Prepare journal entries to record each of the following events.

Question 1: Tom’s Tax Prep’s monthly rent is $3,500. At the end of February, they had not yet received their monthly rent invoice.

Question 2: In early March, Tom’s Tax Prep receives and pays their rent bill for February.

Question 3: Marla, a marketing consultant, performs services for a client. The agree-upon price was $10,000, due 30 days from the date the services were completed.

Question 4: ABC Hardware makes a sale (on credit) for $2,500 worth of lumber. The lumber originally cost them $1,300.

Question 5: Julie takes out a $10,000 loan for her business. Repayment is due in one year along with $1,200 interest.

Answer to Question 1:

Dr. Rent Expense 3,500
Cr. Rent Payable 3,500

Answer to Question 2:

Dr. Rent Payable 3,500
Cr. Cash 3,500

Answer to Question 3:

Accounts Receivable 10,000
Sales 10,000

Answer to Question 4:

Accounts Receivable 2,500
Sales 2,500
Cost of Goods Sold 1,300
Inventory 1,300

Answer to Question 5:

When the loan is taken out:

Cash 10,000
Note Payable 10,000

At the end of each month during the year:

Interest Expense 100
Interest Payable 100

When the loan is repaid:

Note Payable    10,000
Interest Payable    1,200
Cash    11,200

Chapter 10: The Accounting Close Process

Prepare closing journal entries for Mario’s Mobile Products, which has the following end-of-year trial balance:

Cash 40,000
Accounts Receivable 8,000
Property, Plant, and Equipment 150,000
Inventory 30,000
Accounts Payable 15,000
Wages Payable 22,000
Common Stock 50,000
Retained Earnings 60,000
Sales 380,000
Cost of Goods Sold 120,000
Rent Expense 60,000
Wages and Salary Expense 110,000
Advertising Expense 9,000

Answer:

Sales 380,000
Income Summary 380,000
Income Summary 120,000
Cost of Goods Sold 120,000
Income Summary 60,000
Rent Expense 60,000
Income Summary 110,000
Wages and Salary Expense 110,000
Income Summary 9,000
Advertising Expense 9,000

Alternatively, the above can be combined into one journal entry:

Sales 380,000
Cost of Goods Sold 120,000
Rent Expense 60,000
Wages and Salary Expense 110,000
Advertising Expense 9,000
Income Summary 81,000

In either case, the following closing journal entry is also required in order to close out the Income Summary account and transfer the balance — representing the business’s net income for the period — into Retained Earnings:

Income Summary 81,000
Retained Earnings 81,000

Chapter 11: Other GAAP Concepts and Assumptions

Question 1: Andy runs a real estate development firm. Five years ago, he purchased a piece of land for $250,000. This year, an appraiser tells Andy that the land is worth $300,000. At what value should Andy report the land on his balance sheet? Why?

Question 2: Andy is the sole owner of his firm. In June, he moves $30,000 from his business checking account to his personal checking account. If Andy wants his financial records to be in accordance with GAAP, should he record the transaction or not? Why?

Answer to Question 1: Andy should report the land at its original cost: $250,000. Under GAAP’s “Historical Cost” assumption, assets are reported at their historical cost rather than at their current market value. This is done in order to remove subjective asset valuations from the reporting process.

Answer to Question 2: Yes, in order to be in compliance with GAAP, Andy must record the transaction. GAAP’s “Entity Assumption” considers businesses to be separate entities from their owners. As such, transactions between a business and its owners must be recorded as if they were between the business and an entirely separate party.

Chapter 12: Depreciation of Fixed Assets

Questions 1-6: Prepare journal entries to record each of the following events:

Question 1: Liliana spends $20,000 (cash) on a piece of equipment for use in her restaurant. She plans to use the straight-line method to depreciate the equipment over 5 years. She expects it to have no value at the end of the 5 years.

Question 2: After 4 years,  Liliana sells the equipment for $4,000.

Question 3: Same as question 2, except she sells the equipment for $6,000.

Question 4: Same as question 2, except she sells the equipment for $2,000.

Question 5: Oscar is a self-employed electrician. He purchases a piece of equipment for $30,000 cash. He plans to use it for 10 years, at which point he plans to sell it for approximately $4,000.He elects to use the straight-line method of depreciation.

Question 6: Sandra runs a business making embroidered linens for wedding receptions. She purchases a new piece of equipment for $15,000 in credit. She plans to use the units of production method of depreciation. The equipment is expected to produce approximately 5,000 linens, at which point it will be valueless. During the first year after buying the equipment, Sandra uses it to produce 1,500 linens.

Answer to Question 1:

To record the purchase:

Equipment 20,000
Cash 20,000

To record depreciation every year:

Depreciation Expense 4,000
Accumulated Depreciation 4,000

Answer to Question 2:

Cash 4,000
Accumulated Depreciation 16,000
Equipment 20,000

Answer to Question 3:

Cash 6,000
Accumulated Depreciation 16,000
Gain on Sale of Equipment 2,000
Equipment 20,000

Answer to Question 4:

Cash 2,000
Accumulated Depreciation 16,000
Loss on Sale of Equipment 2,000
Equipment 20,000

Answer to Question 5:

To record the purchase:

Equipment 30,000
Cash 30,000

To record depreciation every year:

Depreciation Expense 2,600
Accumulated Depreciation 2,600

(Depreciable value is $26,000. If depreciated over 10 years, that’s $2,600 depreciation per year.)

Answer to Question 6:

To record the purchase:

Equipment 15,000
Accounts Payable 15,000

When the purchase is eventually paid for:

Accounts Payable 15,000
Cash 15,000

To record depreciation for the first year:

Depreciation Expense 4,500
Accumulated Depreciation 4,500

($15,000 depreciable value ÷ 5,000 units = $3 of depreciation per unit. 1,500 units produce x $3 per unit = $4,500 depreciation expense.)

Chapter 13: Amortization of Intangible Assets

Questions 1-2: Prepare journal entries to record each of the following events.

Question 1: Trent runs a business as an engineering consultant. He invents a new system for preparing bridges to deal with extreme weather conditions. He spends $28,000 securing a 14-year patent for his invention. He expects the system to be used for the next few decades at least.

Question 2: Tina runs a business creating medical supplies for surgeries. Her team develops a new tool for assisting in heart surgery. She spends $42,000 on getting it patented. She receives a 14-year patent, but she only expects the technology to be used for about 7 years before a newer technology comes along to replace it.

Answer to Question 1:

To record receiving the patent:

Patents 28,000
Cash 28,000

To record amortization expense each year:

Amortization Expense 2,000
Accumulated Amortization 2,000

Answer to Question 2:

To record receiving the patent:

Patents 42,000
Cash 42,000

To record amortization expense each year:

Amortization Expense 6,000
Accumulated Amortization 6,000

Chapter 14: Inventory and Cost of Goods Sold

Question 1: Using the following information, calculate Cost of Goods Sold:

  • Beginning Inventory: $3,000
  • Ending Inventory: $4,500
  • Purchases: $6,000

Question 2-4: Use the following information to answer questions 2-4.

  • Beginning Inventory: 1,000 units at $4/unit.
  • Purchases: 600 units at $5/unit.
  • Ending Inventory: 900 units.

Question 2: Calculate Cost of Goods Sold using First-In-First-Out (FIFO)

Question 3: Calculate Cost of Goods Sold using Last-In-First-Out (LIFO)

Question 4: Calculate Cost of Goods Sold using the Average Cost Method

Answer to Question 1: CoGS = $4,500

Answer to Question 2: CoGS = $2,800

Explanation:

The first thing to calculate is how many units were sold. In this case, 700 units must have been sold. Now we just have to figure out the cost for each unit of sold inventory.

Using FIFO, we assume that the first units purchased were the first units sold. Therefore, all 700 sold units must have been from the older ($4 per unit) inventory. 700 units x $4 per unit = $2,800

Answer to Question 3: CoGS =$3,400

Again, we know that 700 units were sold. Under LIFO, we assume that the most recently purchased units are sold first. Therefore, all 600 of the $5 units must have been sold. The remaining 100 sold units must have been from the older ($4/unit) inventory.

(600 units x $5 per unit) + (100 units x $4 per unit) = $3,400

Answer to Question 4: CoGS =$3,062.50

Using the Average Cost Method, we have to calculate the average cost per unit of inventory. We know that there were a total of 1,600 units available for sale and that–in total–they cost $7,000. That gives us an average cost per unit of $4.38 (or $4.375 to be precise).

To calculate CoGS, we multiply this average cost per unit by the number of units sold. 700 units x $4.375 per unit = $3,062.50

To Learn More, Check Out the Book:

Book6FrontCoverTiltedBlue

Accounting Made Simple: Accounting Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to read and prepare financial statements
  • Preparing journal entries with debits and credits
  • Cash method vs. accrual method
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"A quick tour of the ins and outs of accounting. Great introduction on the basics and keeps it simple. Short enough to be read in a day. I highly recommend this to any one looking for a crash course in accounting. "

Periodic vs. Perpetual Method of Inventory

The following is an excerpt from Accounting Made Simple: Accounting Explained in 100 Pages or Less.

Under GAAP, there are two primary methods of keeping track of inventory: the perpetual method and the periodic method.

Perpetual Method of Inventory

Any business that keeps real-time information on inventory levels and that tracks inventory on an item-by-item basis is using the perpetual method. For example, retail locations that use barcodes and point-of-sale scanners are utilizing the perpetual inventory method.

There are two main advantages to using the perpetual inventory system. First, it allows a business to see exactly how much inventory they have on hand at any given moment, thereby making it easier to know when to order more. Second, it improves the accuracy of the company’s financial statements because it allows very accurate recordkeeping as to the Cost of Goods Sold over a given period. (CoGS will be calculated, quite simply, as the sum of the costs of all of the particular items sold over the period.)

The primary disadvantage to using the perpetual method is, of course, the cost of implementation.

Periodic Method of Inventory

The periodic method of inventory is a system in which inventory is counted at regular intervals (at month-end, for instance). Using this method, a business will know how much inventory it has at the beginning and end of every period, but it won’t know precisely how much inventory is on hand in the middle of an accounting period.

A second drawback of the periodic method is that the business won’t be able to track inventory on an item-by-item basis, thereby requiring assumptions to be made as to which particular items of inventory were sold.

To Learn More, Check Out the Book:

Book6FrontCoverTiltedBlue

Accounting Made Simple: Accounting Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to read and prepare financial statements
  • Preparing journal entries with debits and credits
  • Cash method vs. accrual method
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"A quick tour of the ins and outs of accounting. Great introduction on the basics and keeps it simple. Short enough to be read in a day. I highly recommend this to any one looking for a crash course in accounting. "
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