appendix

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 owners equity. 3 Describe the differences between a retained earnings statement and an owners 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 owners capital account, such as Sally Jones, Capital, instead of Common Stock and Retained Earnings. In a sole proprietorship there is no need to separate owners 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

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

Corporation Stockholders equity Common stock Retained earnings

Sole Proprietorship Owners equity Owners name, capital

Illustration F-1 Equity section of the balance sheetcorporation 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

F-2

appendix F Accounting for Sole Proprietorships

Owners Equity in a Sole Proprietorship

study objective

Understand what accounts increase and decrease owners equity.

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

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

Revenues
Revenues are the gross increase in owners equity resulting from business activities entered into for the purpose of earning income. DECREASES IN OWNERS EQUITY In a proprietorship, owners equity is decreased by owners 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 owners 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 owners equity.

Expenses
Expenses are the cost of assets consumed or services used in the process of earning revenue. They are decreases in owners equity that result from operating the business. In summary, owners equity is increased by an owners investments and by revenues from business operations. In contrast, owners equity is decreased by an owners 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 owners equity

INCREASES
Investments by owner

DECREASES
Withdrawals by owner

Owner's Equity
Revenues Expenses

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 Sierras 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 Owners Equity Prepaid Office Notes Accounts Unearned R. Neal, Supplies Insurance Equipment Payable Payable Revenue Capital $5,000 5,000 5,000 $1,200 5,000 5,000 5,000 5,000 $2,500 600 600 $600 5,000 5,000 $5,000 5,000 5,000 $5,000 2,500 2,500 $2,500 1,200 1,200 $1,200 19,100 500 Drawings 18,600 4,000 Salaries Expense $14,600 1,200 1,200 1,200 1,200 $10,000 Investment by owner 10,000 10,000 10,000 10,000 Service Revenue 20,000 900 Rent Expense 19,100 19,100

Cash (1) $10,000 (2) 5,000 (3) (4) 15,000 5,000 10,000 1,200

$5,000 5,000 5,000 5,000 5,000 5,000

11,200 (5) 10,000 (6) (7) (8) (10) (11) 19,700 500 19,200 4,000 $15,200 21,200 900 20,300 600 19,700 $2,500 2,500 2,500 $2,500 $600 600

$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 proprietors 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 owners equity statement rather than a retained earnings statement and uses different titles for the equity items shown on the balance sheet.
study objective

$23,300

Describe the differences between a retained earnings statement and an owners equity statement.

F-4

appendix F Accounting for Sole Proprietorships

SIERRA COMPANY Adjusted Trial Balance October 31, 2010 Account Debit Credit

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 $10,600

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

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

$5,200 1,500 900 50 50 40 7,740 $ 2,860

$30,190

SIERRA COMPANY Owners Equity Statement For the Month Ended October 31, 2010
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
To balance sheet

500 $12,360

Illustration F-4 Preparation of the income statement and owners 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.

At the end of the accounting period, the temporary account balances are transferred to the permanent owners equity account, Owners 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 owners drawing to owners capital. The results of these entries are shown in the owners 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 owners capital. However, to do so would result in excessive detail in the permanent owners 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 Owners Capital.

Closing the Books of a Proprietorship

F-5

SIERRA COMPANY Adjusted Trial Balance October 31, 2010 Account Debit Credit

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

Cash $15,200 Accounts Receivable 200 Advertising Supplies 1,000 Prepaid Insurance 550 Office Equipment 5,000 Accumulated Depreciation Office 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 Advertising Supplies Expense 900 Rent Expense 50 Insurance Expense 50 Interest Expense 40 Depreciation Expense $30,190

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

Liabilities and Owners Equity

Liabilities Notes payable Accounts payable Interest payable Unearned revenue Salaries payable Total liabilities Owners equity R. Neal, Capital Total liabilities and owners equity
Capital Balance at Oct. 31 from Owners Equity Statement in Illustration F-4

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

$30,190

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 owners 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 Owners Capital for the amount of net income. 4. Debit Owners Capital for the balance in the Owners Drawing account, and credit Owners Drawing for the same amount. 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 Owners Capital.

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

(Individual) Expenses

(Individual) Revenues

2 Income Summary

3 Owners Capital

Owners Capital is a permanent account; all other accounts are temporary accounts.

Key: 1 Close Revenues to Income Summary. 2 Close Expenses to Income Summary. 3 Close Income Summary to Owners Capital. 4 Close Owners Drawing to Owners Capital.

Owners Drawing

Illustration F-6 Diagram of closing process Date 2010 Oct. 31

GENERAL JOURNAL Account Titles and Explanation Closing Entries (1) Service Revenue Income Summary (To close revenue account) (2) Income Summary Salaries Expense Advertising 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 owners capital) (4) R. Neal, Capital R. Neal, Drawing (To close drawings to owners capital) 10,600 10,600 Debit Credit

31 Illustration F-7 Closing entries journalized

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

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. F-6

31

2,860 2,860

31

500 500

Summary of Study Objectives

F-7

Advertising Supplies Expense 1,500 (2)

631

Service Revenue (1) 10,600 10,000 400 200 10,600

1,500

Depreciation Expense 40 (2)

2
711

10,600 1

40 Income Summary

Insurance Expense 50 (2)

722

(2) (3)

7,740 2,860 10,600

(1)

10,600 10,600

50

Salaries Expense 4,000 1,200 5,200 (2)

726

3 R. Neal, Capital (4) 2 500 (3) Bal. 10,000 2,860 12,360

5,200 5,200

Rent Expense 900 (2)

729

900 4

Interest Expense 50 (2)

905

R. Neal, Drawing 500 (4) 500

50

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 permanentbalance sheetaccounts.

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 owners 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.

F-8

appendix F Accounting for Sole Proprietorships

2 3

Understand what account transactions increase and decrease owners equity. Investments by the owner and revenue increase owners equity. Owners drawings and expenses decrease owners equity. Describe the differences between a retained earnings statement and an owners equity statement. A sole proprietor prepares an owners equity statement rather than a retained earnings statement. The owners equity statement shows the beginning balance in the owners 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).

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 Owners Capital, and Owners Drawing to Owners 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. Owners equity (p. F-2) The ownership claim on the total assets of a sole proprietorship. Owners equity statement (p. F-3) The financial statement prepared for a sole proprietorship to summarize the changes in owners 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 owners equity, and in what direction? 4. In February 2010, Joe Kirby invested an additional $10,000 in his business, Kirbys Pharmacy, which is organized as a proprietorship. Kirbys 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 owners 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.

Brief Exercises
Determine effect of transactions on basic accounting equation.

(SO 2)

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 owners equity. For each column, indicate whether the transactions increased (), decreased (), or had no effect (NE) on assets, liabilities, and owners 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 owners investment (I), owners drawing (D), revenue (R), expense (E), or not affecting owners 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.

Determine effect of transactions on owners equity.

(SO 2)

Indicate debit and credit effects and normal balance.

(SO 2)

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 owners equity is explained.
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. Accounts Office Accounts Receivable Supplies Equipment Payable $5,000 $3,000 1,500 Owners Equity R. Mendez, Capital $12,000 6,300 2,000 650 2,900 500 Investment Analyze transactions and compute net income.

(SO 2)

$3,700

$750

Service Revenue Drawings Rent Expense Salaries Expense Utilities Expense

450 500

Instructions (a) Describe each transaction that occurred for the month. (b) Determine how much owners 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 revenue2010 Total expenses2010 Assets, January 1, 2010 Liabilities, January 1, 2010 Assets, December 31, 2010 Liabilities, December 31, 2010 Drawings2010 $360,000 211,000 85,000 62,000 168,000 70,000 ?

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

Prepare an owners equity statement.

(SO 3)

Instructions Prepare the 2010 owners equity statement for Mark Garlands 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 No. 101 112 157 167 201 208 301 306 404 429 711 720 732 Account Titles Cash Accounts Receivable Equipment Accumulated Depreciation Accounts Payable Unearned Rent Revenue W.A. Mozart, Capital W.A. Mozart, Drawing Commission Revenue Rent Revenue Depreciation Expense Salaries Expense Utilities Expense Debits $ 14,940 8,780 15,900 $ 5,400 4,220 1,800 45,200 65,100 6,500 4,000 55,700 14,900 $128,220 $128,220 Credits

Capital, Dec. 31 $98,000

Prepare income statement, owners equity statement, and balance sheet.

(SO 1, 2, 3, 4)

14,000

Instructions (a) Prepare an income statement and an owners equity statement for the year. Mozart 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

F-10

appendix F Accounting for Sole Proprietorships

Problems
Prepare income statement, owners equity statement, and balance sheet.

(SO 1, 2, 3, 4)

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 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

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

Instructions (a) Prepare an income statement and owners equity statement for the month of May and a balance sheet at May 31. (b) Prepare an income statement and owners 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. 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 Trial Balance Account Titles Cash Accounts Receivable Supplies Prepaid Insurance Office Equipment Accumulated DepreciationOffice Equipment Notes Payable Accounts Payable Salaries Payable Interest Payable S. Skywalker, Capital S. Skywalker, Drawing Service Revenue Advertising Expense Supplies Expense Depreciation Expense Insurance Expense Salaries Expense Interest Expense Totals Dr. 20,800 15,400 2,300 4,800 44,000 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 Cr.

(SO 1, 2, 3, 4)

Account No. 101 112 126 130 151 152 200 201 212 230 301 306 400 610 631 711 722 726 905

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

Instructions (a) Prepare an income statement, owners equity statement, and a classified balance sheet. $10,000 of the notes payable become due in 2011. S. Skywalker did not make any additional investments in the business during 2010. (b) Prepare the closing entries.

Problems

F-11

(c) Post the closing entries. Use the three-column form of account. Income summary is No. 350. (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 Account No. 101 112 126 130 151 152 200 201 212 230 301 306 400 610 631 711 722 726 905 Adjusted Trial Balance Account Titles Cash Accounts Receivable Supplies Prepaid Insurance Office Equipment Accumulated DepreciationOffice Equipment Notes Payable Accounts Payable Salaries Payable Interest Payable Boss Nass, Capital Boss Nass, Drawing Service Revenue Advertising Expense Supplies Expense Depreciation Expense Insurance Expense Salaries Expense Interest Expense Totals Dr. 13,600 15,400 1,500 2,800 34,000 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 Cr.

(d) Post-closing trial balance $87,300

Prepare financial statements, closing entries, and postclosing trial balance.

(SO 1, 2, 3, 4)

Instructions (a) Prepare an income statement, owners 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. 350. (d) Prepare a post-closing trial balance.

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

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