Chapter 22, Problem 13E

The following are independent errors made by a company that uses the periodic inventory system:

a. Goods in transit, purchased on credit and shipped FOB destination, $10,000, were included in purchases but not in the physical count of ending inventory.

b. Purchase of a machine for $2,000 was expensed. The machine has a 4-year life, no residual value, and straight-line depreciation is used.

c. Wages payable of $2,000 were not accrued.

d. Payment of next year’s rent, $4,000, was recorded as rent expense.

e. Allowance for doubtful accounts of $5,000 was not recorded. The company normally uses the aging method.

f. Equipment with a book value of $70,000 and a fair value of $100,000 was sold at the beginning of the year. A 2-year, non-interest-bearing note for $129,960 was received and recorded at its face value, and a gain of $59,960 was recognized. No interest revenue was recorded and 14% is a fair rate of interest.

Required:

1. 1. Next Level Indicate the effect of each of the preceding errors on the company’s assets, liabilities, shareholders’ equity, and net income in the year in which the error occurs. State whether the error causes an overstatement (+), an understatement (−), or no effect (NE).
2. 2. Prepare the correcting journal entry or entries required at the beginning of the year for each of the preceding errors, assuming the company discovers the error in the year after it was made. Ignore income taxes.

To determine

Mention the effect of the given errors on the company’s assets, liabilities, shareholders, equity, and net income, in the year the error occurred.

Explanation of Solution

Errors: The comparability and consistency of the financial statements decreases when a company records arithmetic mistakes, or errors. Such errors do require adjustments to make the financial information more reliable, and more relevant.

Effect of the errors:

a.

Record credit purchases when the goods are in transit, but did not include in the ending inventory:

Effect:

Net Income	Assets	Liabilities	Shareholders’ Equity
–	NE	+	–

Table (1)

Justification:

Revenues	Expenses	Net Income	Assets	Liabilities	Shareholders’ Equity
	Overstated expenses	Understated income		Overstated accounts payable	Understated retained earnings

Table (2)

b.

Expensing the cost of machine:

Effect:

Net Income	Assets	Liabilities	Shareholders’ Equity
–	–	NE	–

Table (3)

Justification:

Revenues	Expenses	Net Income	Assets	Liabilities	Shareholders’ Equity
	Overstated expenses	Understated income	Understated machine value		Understated retained earnings

Table (4)

c.

Failure to accrue wages:

Effect:

Net Income	Assets	Liabilities	Shareholders’ Equity
+	NE	–	+

Table (5)

Justification:

Revenues	Expenses	Net Income	Assets	Liabilities	Shareholders’ Equity
	Understated wages expense	Overstated income		Understated wages payable	Overstated retained earnings

Table (6)

d.

Recorded prepaid rent as expense:

Effect:

Net Income	Assets	Liabilities	Shareholders’ Equity
–	–	NE	–

Table (7)

Justification:

Revenues	Expenses	Net Income	Assets	Liabilities	Shareholders’ Equity
	Overstated rent expenses	Understated income	Understated prepaid rent		Overstated retained earnings

Table (8)

e.

Failure to record allowance for uncollectible accounts:

Effect:

Net Income	Assets	Liabilities	Shareholders’ Equity
+	+	NE	+

Table (9)

Justification:

Revenues	Expenses	Net Income	Assets	Liabilities	Shareholders’ Equity
	Understated expenses	Overstated income	Overstated accounts receivables		Overstated retained earnings

Table (10)

f.

Failure to record discount on note receivable:

Effect:

Net Income	Assets	Liabilities	Shareholders’ Equity
+	+	NE	+

Table (11)

Justification:

Revenues	Expenses	Net Income	Assets	Liabilities	Shareholders’ Equity
	Understated discount on note receivable	Overstated income	Overstated note receivables		Overstated retained earnings

Table (12)

To determine

Journalize the correction of errors at the beginning of the year for the prior period errors.

Explanation of Solution

Journal entry: Journal entry is a set of economic events which can be measured in monetary terms. These are recorded chronologically and systematically.

Debit and credit rules:

• Debit an increase in asset account, increase in expense account, decrease in liability account, and decrease in stockholders’ equity accounts.
• Credit decrease in asset account, increase in revenue account, increase in liability account, and increase in stockholders’ equity accounts.

Journalize the correction of errors at the beginning of the year for the prior period errors.

a.

Journal entry to correct the failure to record credit purchases:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Accounts Payable			10,000
			Retained Earnings			10,000
		(Record decrease in overstated accounts payable and retained earnings)

Table (13)

Description:

• Accounts Payable is a liability account. Since credit purchases were recorded in the prior period before the goods are received, the accounts payable was overstated. The liability account is debited to decrease the overstated value.
• Retained Earnings is an equity account. Since credit purchases was included in the computation of net income, the net income in the prior years was understated. The equity account is credited to increase the understated value.

b.

Journal entry to correct the failure to capitalize cost of the machine:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Machinery			2,000
			Retained Earnings			1,500
			Accumulated Depreciation			500
		(Record capitalization of cost and increase understated retained earnings)

Table (14)

Description:

• Machinery is an asset account. Since machine is purchased, asset account increased, and an increase in asset is debited.
• Retained Earnings is an equity account. Since cost of machine which should have been capitalized is expensed, the net income in the prior years was understated. The equity account is credited to increase the understated value.
• Accumulated Depreciation is a contra-asset account, and contra-asset accounts would have a normal credit balance, hence, the account is credited.

Working Note:

Compute the depreciation expense for the machine under straight-line method, if cost is $2,000, useful life is 4 years, and no salvage value.

$\begin{array}{c}\text{Depreciation expense}=\text{Depreciable cost }\text{× Depreciation rate}\\ \text{= }\left(\text{Cost–Salvage value}\right)\text{×}\frac{1}{\text{Useful life}}\\ =\left(\$2,000–\$0\right)\times \frac{1}{\text{4 years}}\\ =\$500\end{array}$

c.

Journal entry to correct the failure to record accrued wages:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Retained Earnings			2,000
			Wages Payable			2,000
		(Record increase in understated wages payable and decrease in retained earnings)

Table (15)

Description:

• Retained Earnings is an equity account. Since accrued wages were not recorded and wages expense was not included in the computation of net income, the net income in the prior years was overstated. Hence, the equity account is debited to decrease the overstated value.
• Wages Payable is a liability account. Since accrued wages were not recorded in the prior period, the wages payable was understated. The liability account is credited to increase the understated value.

d.

Journal to correct the unrecorded prepaid rent as expense:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Rent Expense			4,000
			Retained Earnings			4,000
		(Record rent expense for current period and increase prior period understated retained earnings in the current period)

Table (16)

Description:

• Rent Expense is an expense account. Since expenses decrease equity value and a decrease in equity is debited, expense account is debited.
• Retained Earnings is an equity account. Since prepaid rent which should have been capitalized is expensed, the net income in the prior years was understated. The equity account is credited to increase the understated value.

e.

Journalize to correct the failure to record allowance for uncollectible accounts:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Retained Earnings			5,000
			Allowance for Doubtful Accounts			5,000
		(Record decrease in overstated retained earnings and increase in expense)

Table (17)

Description:

• Retained Earnings is an equity account. Since expenses in prior period are understated and revenue is overstated, the net income in prior period is overstated. To reduce the overstated earnings, the earnings in current year is debited to decrease the overstated equity.
• Allowance for Doubtful Accounts is a contra-asset account to Accounts Receivable account. The contra-asset accounts decrease the asset value, and a decrease in asset is credited.

f.

Journalize to correct failure to record discount on note receivable:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Retained Earnings			15,960
			Discount on Note Receivable			15,960
		(Record decrease in overstated retained earnings and increase in expense)

Table (18)

Description:

• Retained Earnings is an equity account. Since expenses in prior period are understated and revenue is overstated, the net income in prior period is overstated. To reduce the overstated earnings, the earnings in current year is debited to decrease the overstated equity.
• Discount on Note Receivable is a contra-asset account to Notes Receivable account. The contra-asset accounts decrease the asset value, and a decrease in asset is credited.

Working Note:

Compute discount on note receivable value.

$\begin{array}{c}\text{Discount on note receivable = }\left\{\begin{array}{l}\text{Note value–}\\ \text{Fair value of equipment–}\\ \text{Interest revenue on note}\end{array}\right\}\\ \text{=\$129,960–\$100,000–}\left(\left(\text{\$129,960–\$100,000}\right)\text{×14\%}\right)\\ \text{=\$29,960–\$14,000}\\ \text{=\$15,960}\end{array}$