Question

in 2012 the new bookkeeper at the Washington group discovered that his predecessors had made a couple of errors in a previous year. Specifically, the inventory was overvalues by $15,000 at the end of 2010. Also, a three year fire insurance policy purchased in early January of 2010 for $54,000 was charged to insurance expense instead of prepaid insurance, and no subsequent adjustments involving this insurance involving this insurance policy was made. The company is subject to a 30% tax rate.

Determine what amount, if any, net income and retained earnings would be over/understated in 2010, 2011, 2012 as a result of the error above. Show calculations and label your answer.

Answer 1

Calculation of Over / Understated due to errors

Effect on Net income	2010	2011	2012
Closing Inventory overvalued , so decreasing the same	($15,000)
Beginning inventory effect (Closing inventory of previous year)		$15,000	$15,000
Prepaid insurance wrongly charged as expense in first year itself , so correcting now (Due to which net income would have decreased , so increasing now)	$54,000
Actual Insurance expense = $54,000/3	($18,000)	($18,000)	($18,000)
Overvalued / (understated)	$21,000	($3,000)	($3,000)
Tax effect on errors @ 30%	($6,300)	$900	$900
Overvalued / (understated) After tax effect	$14,700	($2,700)	($2,700)

Above amount in each year will be adjusted to 2012 retained earnings if the books of previous years closed. If not, amount of effect to retained earnings would be the amount of net income or loss.