1.
2-33 Nature of Retained Earnings This is an exercise on the relationships between assets,
liabilities, and ownership equities. The numbers are small, but the underlying concepts are large.
1. Assume an opening balance sheet of Cash $1,000 Paid-in capital $1,000 2. Purchase inventory
for $600 cash. Prepare a balance sheet. A heading is unnecessary in this and subsequent
requirements. 3. Sell the entire inventory for $850 cash. Prepare a balance sheet. What does
retained earnings represent and how is it related to other balance sheet accounts? Explain in your
own words. 4. Buy inventory for $300 cash and equipment for $800 cash. Prepare a balance
sheet. What does retained earnings represent and how is it related to other balance sheet
accounts? Explain in your own words. 5. Buy inventory for $500 on open account. Prepare a
balance sheet. What do retained earnings and account payable represent and how are they related
to other balance sheet accounts? Explain in your own words.
Solution
2 BALANCE SHEET LIABILITIES AMOUNT ASSETS AMOUNT PAIDUP CAPITAL 1000
CASH 400 INVENTORY 600 TOTAL 1000 TOTAL 1000 3 BALANCE SHEET
PARTICULARS AMOUNT PARTICULAR AMOUNT PAIDUP CAPITAL 1000 CASH 1250
RESERVES AND SURPLUS INVENTORY 0 PROFIT AND LOSS ACCOUNT 250 TOTAL
1250 TOTAL 1250 IN THIS CASE INVENOTRY IS SOLD AT PROFIT HENCE INCREASES
THE CAPITAL OF OWNER AND THIS IS A REALISED EARNING HENCE CASH ALSO
INCREASED WITH PROFIT.RETAINED EARNING HERE REPRESENTS THE REALISED
PROFIT OF THE TRANSACTION. 4 BALANCE SHEET PARTICULARS AMOUNT
PARTICULAR AMOUNT PAIDUP CAPITAL 1000 EQUIPMENT 800 RESERVES AND
SURPLUS CASH 150 PROFIT AND LOSS ACCOUNT 250 INVENTORY 300 TOTAL 1250
TOTAL 1250 IN THIS CASE THERE IS NO CHANGE IN THE VALUE OF RETAINED
EARNING BECAUSE ON ASSET SIDE ITEMS ARE CHANGED DUE TO PURCHASE OF
INVENTORY AND EQUIPMENT. 5 BALANCE SHEET PARTICULARS AMOUNT
PARTICULAR AMOUNT PAIDUP CAPITAL 1000 EQUIPMENT 800 RESERVES AND
SURPLUS CASH 150 PROFIT AND LOSS ACCOUNT 250 CREDITORS 500 INVENTORY
800 TOTAL 1750 TOTAL 1750 IN THIS CASE THERE IS NO CHANGE IN THE VALUE
OF RETAINED EARNING BECAUSE LIABILITY INCREASED WITH INCREASE IN
INVENTORY.