Chapter 20, Problem 20.22E

To determine

Error correction:

Error correction is an adjustment to previously issued financial statements. It is not considered as an accounting change.

To Journalize: Entry necessary to correct the error, and adjusting entry for the year 2016

Explanation of Solution

 Journal Entry to correct the error

Date	Account Title and Explanation	Debit Amount($)	Credit Amount($)
	Retained earnings	61,000
	Interest expense (1)		61,000
	(To record error found before adjustment)

Table (1)

• Retained earnings are component of shareholders’ equity. There is a decrease in the value of shareholders’ equity. Therefore, it is debited.
• Interest expense is a liability. There is an increase in liability value. Therefore, it is credited.

 Adjusting entry for the year 2016

Date	Account Title and Explanation	Debit Amount($)	Credit Amount($)
	Interest expense (1)	61,000
	Discount on bonds payable(2)		1,000
	Interest payable(3)		60,000
	(To record error discovered before adjustment)

Table (2)

• Interest expense is a liability. There is a decrease in liability value. Therefore, it is debited.
• Discount on bonds payable and notes payable are liability. There is an increase in liability value. Therefore, it is credited.
• Interest payable is a liability which is increased; hence credit the interest payable.

Journal entries that should have been recorded:

 Adjusting entry for the year 2015

Date	Account Title and Explanation	Debit Amount($)	Credit Amount($)
	Interest expense(1)	61,000
	Discount on bonds payable(2)		1,000
	Interest  payable(3)		60,000
	(To record error discovered before adjustment)

Table (3)

• Interest expense is a liability. There is a decrease in liability value. Therefore, it is debited.
• Discount on bonds payable and notes payable are liability. There is an increase in liability value. Therefore, it is credited.
• Interest payable is a liability which is increased; hence credit the interest payable.

 Journal Entry for the year 2016

Date	Account Title and Explanation	Debit Amount($)	Credit Amount($)
	Interest expense(4)	12,200
	Interest payable(3)	60,000
	Discount on bonds payable(5)		200
	Cash(Given)		72,000
	(To record the correct entry)

Table (4)

• Interest expense is a liability. There is a decrease in liability value. Therefore, it is debited.
• Interest payable is a liability which is decreased; hence debit the interest payable.
• Discount on bonds payable is a liability which is increased; hence credit the discount on bonds payable.
• Cash is being paid, cash is an asset which is being decreased; hence credit the cash account.

Working notes:

a. Calculate the interest expense for the year 2015

$\begin{array}{c}\text{Interest expense}=\text{Cash}\times \left(\frac{\text{Number of months completed}}{\text{Interest period }}\right)\\ =\$\text{72},000\times \left(\frac{\text{5months}}{\text{6 months}}\right)\\ =\$72,000\times 0.833333\\ =\$61,000.\end{array}$ (1)

b. Calculate discount on bonds payable for the year 2015

$\begin{array}{c}\left(\begin{array}{l}\text{Discount}\text{on}\text{bond}\\ \text{after}\text{correction}\end{array}\right)\text{=}\left(\begin{array}{l}\text{Discount}\text{on}\text{bond}\\ \text{before}\text{correction}\end{array}\right)\text{×}\left(\frac{\text{Number}\text{of}\text{months}\text{completed}}{\text{interest}\text{payable}}\right)\\ =\$1,200\times \left(\frac{\text{5}\text{months}}{\text{6}\text{months}}\right)\\ \text{=\$1,200×0}\text{.833333}\\ \text{=\$1,000}\text{.}\end{array}$ (2)

c. Calculate the interest payable for both the years of 2015 and 2016

$\begin{array}{c}\text{Interest}\text{payable=cash×}\left(\frac{\text{Number}\text{of}\text{months}\text{completed}}{\text{Interest}\text{period}}\right)\\ =\$\text{72,000×}\left(\frac{\text{5}\text{months}}{\text{6}\text{months}}\right)\\ \text{=}\text{\$72,000×0}\text{.833333}\\ \text{=\$60,000}\text{.}\end{array}$ (3)

d. Calculate the interest expense for the year 2016 up to February 1.

$\begin{array}{c}\left(\begin{array}{l}\text{Interest}\text{expense}\\ \text{after}\text{correction}\end{array}\right)\text{=}\left(\text{Interest}\text{expense}\text{before}\text{correction}\right)\text{×}\left(\frac{\text{Number of months completed}}{\text{Interest period }}\right)\\ \text{=\$73,200×}\left(\frac{\text{1}\text{month}}{\text{6}\text{months}}\right)\\ \text{=\$73,200×0}\text{.16666}\\ \text{=\$12,200}\text{.}\end{array}$ (4)

e. Calculate the discount on bonds payable for the year 2016 up to February 1.

$\begin{array}{c}\left(\begin{array}{l}\text{Discount}\text{on}\text{bond}\\ \text{after}\text{correction}\end{array}\right)\text{=}\left(\begin{array}{l}\text{Discount}\text{on}\text{bond}\\ \text{before}\text{correction}\end{array}\right)\text{×}\left(\frac{\text{Number}\text{of}\text{months}\text{completed}}{\text{interest}\text{period}}\right)\\ =\$1,200\times \left(\frac{\text{1}\text{month}}{\text{6}\text{months}}\right)\\ \text{=\$1,200×0}\text{.16666}\\ \text{=\$200}\text{.}\end{array}$ (5)

Interest expenses of 2016 are overstated by recording extra interest in the month of February. Likewise, retained earnings are overstated by the exact amount as the interest expense of 2015 was understated when the accrued interest was not reported.