Intermediate Accounting II - ERROR ANALYSIS

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ERROR ANALYSIS In reviewing the accounts of Painter Company in 2006 after the books for the prior year have been closed, you find that the following errors have been made in summarizing activities: In 2004 the ending inventory was understated by $3,000. You also find that the company failed to accrue depreciation expense of $800 in 2004. You also find that an insurance premium of $7,200 was prepaid in 2004 covering the years 2004, 2005, and 2006. The prepayment was recorded with a debit to insurance expense. REQUIRED: Ignoring taxes, determine what amount, if any, net income and retained earnings would be over or under stated in 2004 and 2005 as a result of these errors. Show your calculations and clearly label your answers. Please be sure to show work by the format out below to list overstated or understated how the error will affect each part. Do both years separately. Year 1 BI +Purch GAFS - EI COGS Revenue -Expense Taxable Income -taxes Net income Year 2 BI +Purch GAFS - EI COGS Revenue -Expense Taxable Income -taxes Net income \fErrors 1. Understatement of ending inventory of 2004 by $3,000. 2. Omission of accrual of Depreciation expense of $800 in 2004. 3. Recording of insurance expense of $7,200 fully in 2004 which relates to 2004,2005 and 2006. Year 2004 1. The inventory effect the income statement of a company through cost of goods sold as an expense. Cost of goods sold = Beginning inventory + Purchases - ending inventory Above formula shows that the understatement of ending inventory will have inverse effect of cost of goods sold i.e. cost of goods sold shall be overstated. Due to overstatement of cost of gods, the net income shall gets reduced and it shall be understated by $3,000 2. Failure to accrue depreciation expense shall directly increase the net income which shall be overstated by $800. 3. Insurance payment of $7,200 relates to 3 years. Hence, Insurance expense related to 2004 is $7,200/3 years = $2,400. Excess insurance expense recorded = $7,200-$2,400 = $4,800 Understatement of net income = $4,800 Retained earnings are just an accumulation of net income and hence, any effect of net income shall effect on retained earnings along with the effect of errors made in prior periods. Assuming that no such errors were made in years prior to 2004,effect on retained earnings for 2004 shall be same as effect on net income of 2004. Error Understatement of ending inventory Omission to accrue depreciation expense Recording of prepaid insurance as insurance expense Net effect Year 2005 Effect of Net income $3,000.0 0 Understated $800.00 Overstated $4,800.0 0 Understated $7,000.0 0 Understated Effect of retained earnings $3,000.0 0 Understated $800.00 Overstated $4,800.0 0 Understated $7,000.0 0 Understated 1. The ending inventory of 2004 is carried forward to 2005 as beginning inventory. Hence, beginning inventory of 2005 is overstated by $3,000. Going back to the formula for Cost of goods sold, it can be seen that the beginning inventory is directly related to cost of goods sold. Any understatement of beginning inventory shall understate the cost of goods sold. Understatement of cost of goods sold shall overstate the net income of 2005. Effect on Retained earnings shall be aggregate of current year effect along with the effect of previous years. Current year overstatement of $3,000 shall get crossed off with the understatement of $3,000 in 2004. Thus, retained earnings of 2005 shall have no effect. 2. Failure to accrue depreciation in 2004 shall not effect the net income of 2005. However, the retained earnings shall have the same carried forward effect of 2004 i.e. Overstated by $800. 3. Insurance expense of $2,400 which relates to 2005 and was supposed to be recorded as an expense of 2005 was recorded as expense in 2004. Due to this, expenses of 2005 are understated and thus the net income of2005 shall be overstated by $2,400. Retained earnings shall be overstated by $2,400 in 2005 and understated by $4,800 in 2004. Thus, net effect on the retained earnings of 2005 shall be $2,400 understatement. Error Overstatement of beginning inventory Omission to accrue depreciation expense in 2004 Recording of prepaid insurance as insurance expense in 2004 Net effect Effect of Net income $3,000.0 0 Overstated $2,400.0 0 $5,400.0 0 Overstated Overstated Effect of retained earnings $800.00 $2,400.0 0 $1,600.0 0 Overstated Understated Understated Year 1 BI +Purchases GAFS -EI Cost of goods sold Revenue -Expenses Taxable income -Taxes Net income Retained earnings Year 2 Understated $3000 Overstated $3000 Overstated $7000 Understated $7000 Understated $7000 Understated $7000 BI +Purchases GAFS -EI Cost of goods sold Revenue -Expenses Taxable income -Taxes Net income Retained earnings Understated $3000 Understated $3000 Understated $5400 Overstated $5400 Overstated $5400 Understated $1600 \fErrors 1. Understatement of ending inventory of 2004 by $3,000. 2. Omission of accrual of Depreciation expense of $800 in 2004. 3. Recording of insurance expense of $7,200 fully in 2004 which relates to 2004,2005 and 2006. Year 2004 1. The inventory effect the income statement of a company through cost of goods sold as an expense. Cost of goods sold = Beginning inventory + Purchases - ending inventory Above formula shows that the understatement of ending inventory will have inverse effect of cost of goods sold i.e. cost of goods sold shall be overstated. Due to overstatement of cost of gods, the net income shall gets reduced and it shall be understated by $3,000 2. Failure to accrue depreciation expense shall directly increase the net income which shall be overstated by $800. 3. Insurance payment of $7,200 relates to 3 years. Hence, Insurance expense related to 2004 is $7,200/3 years = $2,400. Excess insurance expense recorded = $7,200-$2,400 = $4,800 Understatement of net income = $4,800 Retained earnings are just an accumulation of net income and hence, any effect of net income shall effect on retained earnings along with the effect of errors made in prior periods. Assuming that no such errors were made in years prior to 2004,effect on retained earnings for 2004 shall be same as effect on net income of 2004. Error Understatement of ending inventory Omission to accrue depreciation expense Recording of prepaid insurance as insurance expense Net effect Year 2005 Effect of Net income $3,000.0 0 Understated $800.00 Overstated $4,800.0 0 Understated $7,000.0 0 Understated Effect of retained earnings $3,000.0 0 Understated $800.00 Overstated $4,800.0 0 Understated $7,000.0 0 Understated 1. The ending inventory of 2004 is carried forward to 2005 as beginning inventory. Hence, beginning inventory of 2005 is overstated by $3,000. Going back to the formula for Cost of goods sold, it can be seen that the beginning inventory is directly related to cost of goods sold. Any understatement of beginning inventory shall understate the cost of goods sold. Understatement of cost of goods sold shall overstate the net income of 2005. Effect on Retained earnings shall be aggregate of current year effect along with the effect of previous years. Current year overstatement of $3,000 shall get crossed off with the understatement of $3,000 in 2004. Thus, retained earnings of 2005 shall have no effect. 2. Failure to accrue depreciation in 2004 shall not effect the net income of 2005. However, the retained earnings shall have the same carried forward effect of 2004 i.e. Overstated by $800. 3. Insurance expense of $2,400 which relates to 2005 and was supposed to be recorded as an expense of 2005 was recorded as expense in 2004. Due to this, expenses of 2005 are understated and thus the net income of2005 shall be overstated by $2,400. Retained earnings shall be overstated by $2,400 in 2005 and understated by $4,800 in 2004. Thus, net effect on the retained earnings of 2005 shall be $2,400 understatement. Error Overstatement of beginning inventory Omission to accrue depreciation expense in 2004 Recording of prepaid insurance as insurance expense in 2004 Net effect Effect of Net income $3,000.0 0 Overstated $2,400.0 0 $5,400.0 0 Overstated Overstated Effect of retained earnings $800.00 $2,400.0 0 $1,600.0 0 Overstated Understated Understated Year 1 BI +Purchases GAFS -EI Cost of goods sold Revenue -Expenses Taxable income -Taxes Net income Retained earnings Year 2 Understated $3000 Overstated $3000 Overstated $7000 Understated $7000 Understated $7000 Understated $7000 BI +Purchases GAFS -EI Cost of goods sold Revenue -Expenses Taxable income -Taxes Net income Retained earnings Understated $3000 Understated $3000 Understated $5400 Overstated $5400 Overstated $5400 Understated $1600