Question

Harrison Purvis is preparing his balance sheet and income and expense statement for the year ending December 31, 2016. He is having difficulty classifying six items and asks for your help. Which, if any, of the following transactions are assets, liabilities, income, or expense items? Some items will appear on both statements.

a. Harrison rents a house for $1,350 a month.

b. On June 21, 2016, Harrison bought diamond earrings for his wife and charged them using his Master Card. The earrings cost $900, but he hasn't yet received the bill.

c. Harrison borrowed $3,500 from his parents last fall, but so far, he has made no payments to them.

d. Harrison makes monthly payments of $225 on an installment loan, about half of it is interest, and the balance is repayment of principal. He has 20 payments left, totaling $4500.

e. Harrison paid $3,800 in taxes during the year and is due a tax refund of $650, which he hasn't yet received.

f. Harrison invested $2,300 in some common stock.

g. Harrison's Aunt June gave him a birthday gift of $300.

A matrix below may help in organizing your answers

	Asset	Liability	Income	Expense
a. Rent paid
b. Earrings
c. $3500 loan
d. Payments
e. Taxes
f. Common Stock
g. Aunt June

Answer 1

a. Rent paid is listed as an expense. For the year, his rent expense would be $16,200 ($1,350 x 12) unless he has rent due, the amount of which would show up as a current liability on his balance sheet.

b. The earrings should be shown on the income statement as an expense—gifts. Although the earrings have not been paid for, credit card purchases are treated as expenses—the credit card is a substitute for cash. The $ 900 debt outstanding is listed as a current liability on the balance sheet.

c. Since no loan payments were made during the period, a corresponding expense would not appear, but the obligation to repay the $3,500 would be shown as a liability on the balance sheet. However since he is “borrowing” from his parents, this may not be a liability, rather a gift from his parents. If the parents expect the amount to be repaid it is a loan; otherwise, it is a gift. Regardless, it will increase cash and increase either liability or equity, depending upon whether it is a loan or a gift.

d. Assuming he made 12 payments during the year, Harrison would list loan payments as an expense of $2,700. Whether the expense is principle or interest is of no interest to Harrison; he has to pay the $2,700. If the loan cannot be prepaid [that is the principle may not be paid before it is due], the remaining liability is $4,500. If the loan can be prepaid then of the 20 remaining payments, only about half are for principal. Therefore, on the balance sheet he should show the unpaid principal of about $2,250 (20 x $225/2) as a liability. The balance of the future payments is interest not yet due and therefore should not appear on the balance sheet. If the loan was used to purchase something of value, he would list the fair market value of the item as an asset on his balance sheet.

e. The $3,800 of taxes paid should appear as an expense on the income and expense statement for the period, but because the tax refund was not received during the year it would not be included as income on the statement.

f. The investment in common stock would appear on balance sheet as a reduction in cash (an asset) and an increase in "investments” (an asset) at the current fair market value of the stock.

g. Harrison’s Aunt June gave him $300. The cash on the balance sheet will increase by $300 and the equity or net worth will also increase by $300. Aunt June is investing in Harrison.