Business law 201

As seen in this trial balance, both Glenwood and Eads have the same amount of debits and credits at December 31. On this date, however, the two companies begin to differentiate on several things, including their adjusting entries and the estimations used in the entries. The adjustments are done differently by each company, and therefore affect net income for each company differently. These adjustments and their effects are best reflected in the income statements for the two companies. The adjustments deal with bad debts, cost of goods sold, depreciation expense, a lease agreement, and income tax expense. As shown below in the income statements, the cost of goods sold directly affects net income, as do bad debt expense and depreciation expense. Rent expense also directly affects net income, and is only present on Glenwood's income statement because Eads capitalized the lease as an asset. 4 Eads Company Multistep Income Statement For year ended December 31, 20X1 Sales $398,500 Cost of Goods Sold (188,800) Gross Profit $209,700 Operating Expenses Bad Debt Expense 4,970 Depreciation Expense 41,500 Other Operating Expenses 34,200 Total operating expenses 80,670 Operating Income $129,030 Other expenses Interest Expense 35,010 Income before taxes $94,020 Income tax expense 23,505 Net Income $70,515 Glenwood Company Multistep Income Statement For year ended December 31, 20X1 Sales $398,500 Cost of Goods Sold (177,000) Gross Profit $221,500 Operating Expenses Bad Debt Expense 994 Depreciation Expense 19,000 Other Operating Expenses 34,200 Total operating expenses $54,194 Operating Income $167,306 Other expenses Rent Expense 16,000 Interest Expense 27,650 Total other expenses $43,650 Income before taxes $123,656 Income tax expense 30,914 Net income $92,742 5 The first adjustment deals with bad debts. Glenwood estimates that one percent of accounts receivable will be uncollectable, while Eads estimates that five percent of accounts receivable will be uncollectable. This method is the same for both companies, but they have different percentage estimations based on their customers. Glenwood recorded $994.00 in bad debt expense; Eads calculated $4,970.00 to be uncollectable. This estimation decreases both assets (accounts receivable) and net income (bad debt expense). The second adjustment is the estimation of cost of goods sold. Glenwood uses a periodic first in, first out inventory system; cost of goods sold expense is based on the historical cost of the units when they were purchased possibly several months ago. This method often uses outdated costs that are not current and therefore does not align well with the matching principle. Glenwood's cost of goods sold is calculated to be $177,000, while Eads' cost of goods sold is $188,800. Eads uses a periodic last in, first out inventory, which uses current costs instead of old costs to calculate cost of goods sold. Third is the adjustment to account for depreciation. The two companies both use the straight line method for depreciation on their building, which is estimated to be $10,000 per year each. Glenwood also uses the straight line method for depreciation on their equipment, bringing their total depreciation to $19,000. Eads uses the doubledeclining balance method for their equipment's depreciation, totaled at $20,000. Eads also must depreciate the leased equipment in the fourth adjustment; they use the straight line method to calculate this at $11,500. Eads' total depreciation expense including building, equipment, and leased equipment is $41,500. 6 The fourth adjustment is the payment of a lease agreement for equipment used by the companies. Glenwood simply rents the equipment for one year at a time, payable on December 31 of each year. The adjustment for this lease is a debit to rent expense and a credit to cash. Eads capitalizes the lease as an asset because they agree to lease the equipment for eight years, paying $16,000 at the end of each year to cover both the rent expense and the interest expense. The last adjustment deals with income tax provisions. The stated rate for income tax is 25 percent; thus, each company sets aside 25 percent of their income before taxes to pay to the IRS for income tax. Glenwood has a higher income, so their income tax expense is more than Eads'

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