Chapter 22, Problem 14P

1.

To determine

Prepare correct journal entries for Corporation I, if the errors are discovered before the books are closed, at the end of 2020.

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.

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.

Prepare correct journal entries for Corporation I, if the errors are discovered before the books are closed, at the end of 2020.

Journal entry to correct the reduction in loss experience rate:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
2020
December	31	Allowance for Doubtful Accounts			10,000
			Administrative Expenses			10,000
		(Record reduction in loss experience rate)

Table (1)

Description:

• 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 contra-asset is debited.
• Administrative Expenses is an expense account. Since expenses are reduced, equity value increased, and an increase in equity is credited.

Working Notes:

Compute allowance for doubtful accounts.

Details	Amount ($)
Net sales for the year ended December 31, 2020	$1,000,000
Percentage of loss experience rate	×    1%
Allowance for doubtful accounts	$10,000

Table (2)

Journal entry to record the valuation of available-for-sale securities:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
2020
December	31	Available-for-Sale Securities			16,000
			Allowance for Change in Fair Value Adjustment			16,000
		(Record reduction in market value of available-for-sale securities)

Table (3)

Description:

• Available-for-Sale Securities (AFSS) is an adjustment account used to report gain or loss on adjusting cost of investment at fair market value. Since loss has occurred and losses decrease stockholders’ equity value, and a decrease in stockholders’ equity value is debited.
• Allowance for Change in Fair Value Adjustment is a contra-asset account. The account is credited because the market price was decreased, the decreased value is adjusted to this account.

Working Notes:

Compute unrealized gain or loss on investment in AFSS.

$\begin{array}{c}\text{Unrealized gain or }\left(\text{loss}\right)\text{= }\left\{\begin{array}{l}\text{Fair market value of AFSS investment – }\\ \text{Cost of AFSS }\text{}\text{investment}\end{array}\right\}\\ \text{=\$62,000–\$78,000}\\ \text{=\$}\left(\text{16,000}\right)\end{array}$

Journal entry to correct the 2019 overstated inventory:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
2020
December	31	Retained Earnings			4,000
			Cost of Goods Sold			4,000
		(Record reduction in overstated retained earnings)

Table (4)

Description:

• Retained Earnings is an equity account. Since ending inventory in 2019 was overstated, cost of goods sold of 2019 were understated, and hence, revenue is overstated in 2019. The retained earnings account is debited to decrease the overstated equity.
• Cost of Goods Sold is an equity account. Since cost of goods sold of 2020 was overstated, the expense account is credited to decrease the overstated equity.

Journal entry to correct the 2020 overstated inventory:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
2020
December	31	Cost of Goods Sold			6,100
			Inventory			6,100
		(Record reduction in overstated inventory and increase in understated cost of goods sold)

Table (5)

Description:

• Cost of Goods Sold is an equity account. Since ending inventory in 2020 was overstated, cost of goods sold of 2020 were understated. The expense account is debited to increase the understated equity.
• Inventory is an asset account. Since ending inventory in 2020 was overstated, the value of assets increased. The asset account is credited to decrease the overstated asset account.

Journal entry to correct the incorrectly charged operating expenses:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
2020
December	31	Equipment			12,000
		Depreciation Expense			1,100
			Retained Earnings			10,900
			Accumulated Depreciation			2,200
		(Record increase in  equipment account and increase in understated retained earnings)

Table (6)

Description:

• Equipment is an asset account. Since equipment in was understated, the value of assets decreased. The asset account is debited to increase the understated asset account.
• Depreciation Expense is an expense account. Since expenses are increased, equity value decreased, and a decrease in equity is debited.
• Retained Earnings is an equity account. Since operating expenses are overstated, revenue was understated, and hence, revenue is understated in 2020. The retained earnings account is credited to increase the understated equity.
• Accumulated Depreciation is a contra-asset account, and contra-asset accounts would have a normal credit balance, hence, the account is credited.

Working Notes:

Compute accumulated depreciation.

Computation of Accumulated Depreciation
Acquisition cost on January 1, 2019	$12,000
Less: Salvage value	(1,000)
Original depreciable base	11,000
Original estimated useful life	÷   10 years
Straight-line depreciation expense per year	1,100
Number of years the asset was consumed, 2 years (2019 to 2020)	×   2 years
Accumulated depreciation	$2,200

Table (7)

Journal entry to correct the incorrect crediting of sale proceeds:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
2020
December	31	Accumulated Depreciation			17,500
			Equipment			15,000
			Other Income			2,500
		(Record sale of equipment)

Table (8)

Description:

• Accumulated Depreciation is a contra-asset account. Since the equipment is sold, the accumulated depreciation balance is reversed to reduce the balance in the account, hence, the account is debited.
• Equipment is an asset account. Since equipment is sold, asset account decreased, and a decrease in asset is credited.
• Other Income is a revenue account. Since gains and revenues increase equity, equity value is increased, and an increase in equity is credited.

Journal entry for prepaid expenses paid in 2019:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Prepaid Insurance			900
		Insurance Expenses			900
			Retained Earnings			1,800
		(Record unrecognized prepaid expenses and incurred in 2020)

Table (9)

Description:

• Prepaid Insurance is an asset account. Since balance of prepaid expenses were recorded in 2020, asset value increased, and an increase in asset is debited.
• Insurance Expense is an equity account. Expenses decrease equity value, and a decrease in equity is debited.
• Retained Earnings is an equity account. Since prepaid expenses of 2019 were recorded as expenses in 2020, and was included in the computation of net income, the net income in 2020 was understated. The equity account is credited to increase the understated value.

Working Notes:

Calculate the value of insurance expense for one year.

$\begin{array}{c}\text{Insurance expense per year =}\frac{\text{Amount of three-year premium}}{\text{Number of years}}\\ =\frac{\$2,700}{\text{3 years}}\\ =\$900\end{array}$

Journal entry for reducing additional paid-in capital in excess of par from common stock value:

Date		Account Titles and Explanation		Post Ref	Debit ($)	Credit ($)
		Common Stock			60,000
			Paid-In Capital in Excess of Par			60,000
		(Record reduction of additional paid-in capital from common stock)

Table (10)

Description:

• Common Stock is a stockholders’ equity account. Since additional paid-in capital is adjusted from common stock, equity value is decreased, and a decrease in equity is debited.
• Paid-In Capital in Excess of Par is a stockholders’ equity account. Since common stock issued at a value in excess of par value is adjusted, paid-in capital value is increased, and an increase in equity is credited.

2.

To determine

Calculate the correct net income for 2019 and 2020, after including the omissions.

Explanation of Solution

Calculate the correct net income for the years 2019 and 2020.

Details	2020	2019
Reported net income	$220,000	$195,000
Change in loss experience rate	10,000
Overstated ending merchandise inventory in 2019	4,000	(4,000)
Overstated ending merchandise inventory in 2020	(6,100)
Decrease in operating expenses in 2019		10,900
Increase in operating expenses in 2020	(1,100)
Proceeds from sale of equipment	2,500
Recognition of prepaid insurance	(900)	1,800
Correct pretax income	$228,400	$203,7000

Table (11)