Question

Company ABC acquired a machine at the beginning of the year. The machine had a 6-year useful life. He expensed the entire acquisition cost in the current year. His error has what effect on current period net income (NI) and retained earnings at the end of the 4th year (RE4)?

a. NI is understated; RE4 is understated

b. NI is understated; RE4 is correct

c. NI is overstated; RE4 is correct

d. NI is overstated; RE4 is understated

e. None of the above

Please help to explain for my better understanding.

Answer 1

Correct answer: a) NI is understated; RE4 is understated

- Explanation with the help of an example:

Suppose Company ABC acquired a machine for $ 60,000 at the beginning of the year with a 6-year useful life. He expensed the entire acquisition cost of $ 60,000 in the current year which is the wrong treatment. The correct treatment would be that he should have expensed 1/6th of $ 60,000 in 6 years.

- NI, i.e. Net income of current year is understated because the P/L a/c should have been debited with 10,000$ but it has actually been debited with 60,000$, thus an expense of $ 50,000 (60,000-10,000) has been overcharged.

-  RE4 is understated because the RE4 should have been debited with only 40,000$ of depreciation expense as per the correct treatment, i.e. Debit $ 10,000 for 4 years but in reality, it is debited with $ 60,000 in the year, therefore an expense of $20,000 ( $ 60,000-$40,000) has been charged excessively.