Question

Question: William Murray achieved one of his life-long dreams by opening his own business, The Caddie Shack Driving Range, on May 1, 2017. He invested \(20,000 of his own savings in the business. He paid \)6,000 cash to have a small building constructed to house the operations and spent \(800 on golf clubs, golf balls, and yardage signs. Murray leased 4 acres of land for \)1,000 per month. (He paid the first month’s rent in cash.) During the first month, advertising costs totaled \(750, of which \)150 was unpaid at the end of the month. Murray paid his three nephews \(400 for retrieving golf balls. He deposited in the company’s bank account all revenues from customers (\)4,700). On May 15, Murray withdrew \(800 in cash for personal use. On May 31, the company received a utility bill for \)100 but did not immediately pay it. On May 31, the balance in the company bank account was \(15,100.

Murray is feeling pretty good about results for the first month, but his estimate of profitability ranges from a loss of \)4,900 to a profit of \(1,650.

Accounting

Prepare a balance sheet at May 31, 2017. Murray appropriately records any depreciation expense on a quarterly basis. How could Murray have determined that the business operated at a profit of \)1,650? How could Murray conclude that the business operated at a loss of \(4,900?

Analysis

Assume Murray has asked you to become a partner in his business. Under the partnership agreement, after paying him \)10,000, you would share equally in all future profits. Which of the two income measures above would be more useful in deciding whether to become a partner? Explain.

Principles

What is income according to GAAP? What concepts do the differences in the three income measures for The Caddie Shack Driving Range illustrate?

Short answer

Answer

1. Owner’s capital totals$21,650.
2. Most relevant figure for net income is$2,450.
3. Income under GAAP is calculated on an accrual basis.

Step-by-step solution

Definition of Balance Sheet

The statement that summarizes the information of all the obligations and the resources of the business entity is known as a balance sheet. This reflects the financial position of the business entity.

Balance Sheet

Balance sheet
Assets	Amount $	Liabilities	Amount $
Bank	$15,100	Advertising payable	$150
Building	6,000	Utility payable	100
Equipment	800	Owner’s equity:
		Owner’s capital	21,650
Total assets	$21,900	Total liabilities and equity	$21,900

Working note:

Particular	Amount $
Revenue	$4,700
Less: Rent	(1,000)
Less: Advertisement cost	(750)
Less: Retrieving cost	(400)
Less: Utility expenses	(100)
Income	$2,450
Add: Capital invested	$20,000
Less: Personal withdrawal	($800)
Owner’s capital	$21,650

1. Murray has concluded that the business entity is operating at a profit of $1,650 by taking the difference between the beginning capital balance of $20,000 and the ending capital balance of $21,650.
2. Murray will conclude that the business entity is operating at a loss of $4,900 by taking the amount of reduction in the ending cash balance as compared to the opening cash balance.

Useful measure for investment decision

The net income calculated, which is equal to $2,450, is the most useful measure to evaluate the profitability of the business entity. If the business entity charges the cost incurred for the acquisition of the building, then it will understate the income. This cost must be allocated in various operating periods under depreciation expenses. However, the unpaid expenses are charged because, according to principles, the expenses incurred for generating revenue must be charged as they are incurred.

Income defined under GAAP

The income under GAAP is calculated on an accrual basis as calculated above $2,450. The difference between the two figures, a profit of $1,650 and a loss of $4,900, are due to the expense recognition principle, which states the expense must be recognized as incurred.

The exclusion of cash withdrawal from income measurement defines the concept of basic elements. The cash distribution is the element of the owner’s equity rather than income.