Chapter 22, Problem 9P

At the end of 2020, while auditing Sandlin Company’s books, before the books have been closed, you find the following items:

1. a. A building with a 30-year life (no residual value, depreciated using the straight-line method) was purchased on January 1, 2020, by issuing a $90,000 non-interest-bearing, 4-year note. The entry made to record the purchase was a debit to Building and a credit to Notes Payable for $90,000; 12% is a fair rate of interest on the note.
2. b. The inventory at the end of 2020 was found to be overstated by $15,000. At the same time, it was discovered that the inventory at the end of 2019 had been overstated by $35,000. The company uses the perpetual inventory system.
3. c. For the last 3 years, the company has failed to accrue salaries and w-ages. The correct amounts at the end of each year were: 2018, $12,000; 2019, $18,000; and 2020, $10,000.

Required:

1. 1. Prepare journal entries to correct the errors. Ignore income taxes.
2. 2. Assume, instead, that the company discovered the errors after it had closed the books. Prepare journal entries to correct the errors. Ignore income taxes.

To determine

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

a.

Journal entry to correct the failure to record discount on note payable:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Discount on Note Payable			32,803
			Building			32,803
		(Record discount on notes payable)

Table (1)

Description:

• Discount on Note Payable is a contra-liability account to Notes Payable account. The contra-liability account increased, and an increase in contra-liability is debited.
• Building is an asset account. The asset value decreased due to discount, and a decrease in asset is credited.

Working Note 1:

Compute discount on note payable value.

$\begin{array}{c}\text{Discount on note payable = }\left\{\begin{array}{l}\text{Note payable value–}\\ \left(\begin{array}{l}\text{Note payable value}\times \\ \text{Present value of \$1 at 12\% for 1 time period}\end{array}\right)\end{array}\right\}\\ \text{=\$90,000–}\left(\text{\$90,000}\times \text{0}\text{.635518}\right)\\ \text{=\$90,000–\$57,197}\\ \text{=\$32,803}\end{array}$

Journal entry to correct the erroneous depreciation expense:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Accumulated Depreciation–Building			1,093
			Depreciation Expense–Building			1,093
		(Record reduction in depreciation expense)

Table (2)

Description:

• Accumulated Depreciation–Building is a contra-asset account. Since the depreciation expense was overstated by $1,093, the accumulated depreciation is also overstated.  Hence, the contra-asset account is debited to decrease the expense value.
• Depreciation Expense is an expense account. Since the depreciation expense was overstated by $1,093, the expense account is credited to decrease the expense value.

Working Note 2:

Compute overstated (understated) depreciation expense value (Refer to Working Note 1 for value and computation of discount on note payable).

$\begin{array}{c}\begin{array}{l}\text{Overstated }\left(\text{understated}\right)\\ \text{depreciation expense}\end{array}\}\text{ = }\left\{\begin{array}{l}\text{Incorrectly recorded depreciation expense–}\\ \text{Correct depreciation expense}\end{array}\right\}\\ \text{=}\frac{\text{\$90,000}}{\text{30 years}}\text{ – }\frac{\left(\text{\$90,000–\$32,903}\right)}{\text{30 years}}\\ =\$3,000–\$1,907\\ \text{=\$1,093}\end{array}$

Journal entry to correct the failure to record interest expense:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Interest Expense			6,864
			Discount on Note Payable			6,864
		(Record interest expense on notes payable)

Table (3)

Description:

• Interest Expense is an expense account. Since expenses decrease equity, equity value is decreased, and a decrease in equity is debited.
• Discount on Note Payable is a contra-liability account to Notes Payable account. The discount is amortized, hence the contra-liability account value decreased, and a decrease in contra-liability is credited.

Working Note 3:

Compute interest expense.

$\begin{array}{c}\text{Interest expense = }\left(\begin{array}{l}\text{Building value}\times \\ \text{Interest rate percentage}\end{array}\right)\\ \text{=}\left(\text{\$57,197}\times 12\%\right)\\ \text{=\$6,864}\end{array}$

b.

Journal entry to correct the 2019 overstated inventory:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Retained Earnings			35,000
			Cost of Goods Sold			35,000
		(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 ($)	Credit ($)
		Cost of Goods Sold			15,000
			Inventory			15,000
		(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.

c.

Journal entry to correct the 2019 failure to accrue salaries and wages:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Retained Earnings			18,000
			Salaries and Wages Expense			18,000
		(Record reduction in overstated retained earnings)

Table (6)

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 of 2019 was overstated. Hence, the equity account is debited to decrease the overstated value.
• Salaries and Wages Expense is an equity account. Since salaries and wages expense of $18,000 which belong to 2019 were recorded in 2020, the expenses of 2020 was overstated. The expense account is credited to decrease the overstated equity.

Journal entry to correct the 2020 failure to accrue salaries and wages:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Salaries and Wages Expense			10,000
			Salaries and Wages Payable			10,000
		(Record accrued salaries and wages expense)

Table (7)

Description:

• Salaries and Wages Expense is an expense account. Since expenses decrease equity, equity value is decreased, and a decrease in equity is debited.
• Salaries and Wages Payable is a liability account. Since the liability to pay salaries and wages expense has increased, liability increased, and an increase in liability is credited.

To determine

Prepare correct journal entries for Company S, if the errors are discovered after the books are closed, at the end of 2020.

Explanation of Solution

Prepare correct journal entries for Company S, if the errors are discovered after the books are closed, at the end of 2020.

a.

Journal entry to correct the failure to record discount on note payable, accumulated depreciation, and interest expense (Refer to Requirement 1-(a) for all the computations):

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Discount on Note Payable			25,939
		Accumulated Depreciation–Building			1,093
		Retained Earnings			5,771
			Building			32,803
		(Record discount on notes payable, accumulated depreciation)

Table (8)

Description:

• Discount on Note Payable is a contra-liability account to Notes Payable account. The contra-liability account increased, and an increase in contra-liability is debited with the total of discount of $32,803, less discount of $6,864 amortized in 2020.
• Accumulated Depreciation–Building is a contra-asset account. Since the depreciation expense was overstated by $1,093, the accumulated depreciation is also overstated.  Hence, the contra-asset account is debited to decrease the expense value.
• Retained Earnings is an equity account. Since understatement of $6,864 of interest expense and overstatement of $1,093 of depreciation expense overstated the net income of 2020. Hence, the equity account is debited by the difference of $5,771 to decrease the overstated value.
• Building is an asset account. The asset value decreased due to discount, and a decrease in asset is credited.

b.

The error of 2019 overstated inventory would be counterbalanced at the end of 2020.

Journal entry to correct the 2020 overstated inventory:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Retained Earnings			15,000
			Inventory			15,000
		(Record reduction in overstated inventory and increase in understated cost of goods sold)

Table (9)

Description:

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

c.

The errors of 2018 and 2019 un-accrued expenses would be counterbalanced at the end of 2019 and 2020 respectively.

Journal entry to correct the 2020 failure to accrue salaries and wages:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Retained Earnings			10,000
			Salaries and Wages Payable			10,000
		(Record accrued salaries and wages expense)

Table (10)

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 of 2020 was overstated. Hence, the equity account is debited to decrease the overstated value.
• Salaries and Wages Payable is a liability account. Since the liability to pay salaries and wages expense has increased, liability increased, and an increase in liability is credited.