Chapter 11, Problem 11.7BYP

Requirement – 1

To determine

Errors:

An error is a mistake committed in the process of book-keeping or in accounting.  In some cases, errors may occur but, they will not affect the totals of the trial balance. Such an error can be found while preparing the trial balance or would be indicated by the unusual account balance.

Depreciation:

It refers to the reduction in the monetary value of fixed tangible assets over its useful life due to its wear and tear or, obsolescence. In other words, it is the method of distributing the cost of tangible fixed assets over its estimated useful life.

To prepare: The necessary journal entries for error correction and adjusting entries for the year 2015.

Explanation of Solution

In this case some errors are discovered in W Distributors for overstating/understating the inventories in 2015 and 2016, patent acquired in 2015 has not been amortized and there was change in estimate for depreciation.

Following journal entries are passed in the books of W Distributors to rectify the overstatement/understatement of inventories:

Inventory overstated by $12 million

For the inventory overstated by $12 million in 2015, there is no need of any rectification journal entry as it is self corrected in the year 2017 inventory.

a.

For the inventory understated by $10 million, beginning inventory of 2017 need to be increased and consequently the retained earnings of 2016 need to be increased by the same amount.

                                                                                               ($ in millions)

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
2017	Inventory		10
	Retained earnings			10
	(To rectify the errors of understating inventory in 2016)

Table (1)

• Inventory in an asset and increased, therefore debit inventory.
• Retained earnings is a component of Stockholders’ equity and has increased, therefore credit it.

b.

Journal entry for amortization of patent:

For patent acquired in 2015 for $18 million which is expected to benefit the company for a total of six years, which is not amortized till 2017, the journal entry would be:

                                                                                             ($ in millions)

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
2017	Retained earnings		6
	Patent (1)			6
	(To record the patent amortization for 2015 and 2016)

Table (2)

• Retained earnings is a component of stockholders’ equity and has decreased, therefore debit retained earnings.
• Patent is an asset and has decreased, therefore credit patent.

Working note:

$\begin{array}{c}\text{Patent for 2015 and 2016 = }\frac{\$18\text{ million}}{6\text{ years}}\times 2\text{ years}\\ =\$6\text{ million}\end{array}$ (1)

Adjusting entry for amortization of patent:

Adjusting journal entry for 2017 patent amortization is as follows:

                                                                                           

                                                                                  ($ in millions)

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
2017	Patent amortization expense		3
	Patent			3
	(To record patent amortization for 2017)

Table (2)

• Patent amortization expense is a component of stockholders’ equity and has decreased, therefore debit it.
• Patent is an asset and has decreased, therefore credit it.

Working notes:

$\begin{array}{c}\text{Patent for 2019 = }\frac{\$18\text{million}}{6\text{ years}}\\ =3\text{million}\end{array}$

c.

Adjusting entry for depreciation expenses:

Following adjusting journal entry is prepared for the depreciation of the equipment of W company for the year 2017:

                                                                                                 ($ in millions)

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
2017	Depreciation expense (2)		4
	Accumulated depreciation			4
	(To record the depreciation expense for 2017)

Table (3)

• Depreciation expense is a component of stockholders’ equity and has decreased, therefore debit it.
• Accumulated depreciation is a contra asset account and has increased, therefore credit it.

Working notes:

For depreciation of equipment, sum-of-digit method is followed in 2015 and 2016 but in 2017 the method is changed to straight-line method.

$\text{Depreciation for 2015 = }\frac{\$30\text{million}}{15}\times 5=10\text{million}$

$\text{Depreciation for 2016 = }\frac{\text{\$ 30 million}}{15}\times 4=\text{\$8 million}$

But in 2017, W company changed to straight-line method, therefore fore for balance period of 3 years $\left(\text{5 years - 2 years}\right)$, the depreciation is computed as follows:

$\begin{array}{c}\text{Depreciation= }\frac{\left(\begin{array}{l}\$30\text{ million}\left(\text{cost}\right)\\ -\$18\text{ million}\left(\text{depreciation for 2015 and 2016}\right)\\ -\$0\left(\text{residual value}\right)\end{array}\right)}{3\text{ years}\left(\text{balance period}\right)}\\ =\text{\$4 million}\end{array}$ (2)

Therefore, the correcting journal entries of patent for the year 2017 are recorded.

Requirement – 2

To determine

The amount to be reported in comparative financial statement of 2015 and 2016.

Explanation of Solution

Following is the comparative financial statements of 2015 and 2016 as restated in 2017 after rectification and adjustment for the errors for W company:

                                                                                                             ($ in millions)

	Assets	Liabilities	Stockholders’ equity	Net income	Expenses
2015	$640	$330	$310	$210	$150
Inventory (2015)	($12)		($12)	($12)	$12
Patent amortization	($3)		($3)	($3)	$3
Depreciation	No adjustment
	$625	$330	$295	$195	$165

Table (4)

                                                                                                          ($ in millions)

	Assets	Liabilities	Stockholders’ equity	Net income	Expenses
2016	$820	$400	$420	$230	$175
Inventory (2015)				$12	($12)
Inventory (2016)	$10		$10	$10	($10)
Patent amortization	($6)		($6)	($3)	$3
Depreciation	No adjustment
	$824	$400	$424	$249	$156

Table (5)