Question

Hendry Corp. reported net incomes for the last three years as follows:

2018: $180,000

2017: $240,000

2016: $225,000

During the 2018 year-end audit, Hendry's newly appointed auditors discover that Hendry bought a machine on January 1, 2015 for $125,000 cash, with a $25,000 estimated residual value and a five-year life. The company debited an expense account for the entire cost of the asset. Hendry uses straight-line depreciation for all machinery.

Instructions (Ignore all income tax effects)

a) Prepare the general journal entry required to correct the books for this situation, assuming that the books have not been closed for 2018.

b) Prepare a schedule showing, for each of the years 2016 to 2018, income before the effect of any accounting changes, the effect of the accounting changes, and the income after the effect of any accounting changes.

c) Assume that the retained earnings balance at January 1, 2018 is $720,000 (before any adjustment). At what adjusted amount should this beginning retained earnings balance be shown on the financial statements?

Answer 1

a) due to recording asset as expense , profit of company is understated in 2015. Accordingly retained earnings are understated.

To correct this mistake we will increase the retained earning eith what should be the book value of asset today if it would have been recorded correctly.

Cost of assrt = 125000

Salvage value = 25000

Life = 5 years

Dep per year = (Cost - salvage value) / Life of asset

= (125000 - 25000) / 5 = 20000 per year

If asset recorded correctly , there will be depreciation expense in year 2015 to 2018

= 20000* 4 year = 80000

Should be book value of asset = Cost - 4 year depreciation

= 125000 - 80000 = 45000

Correction entry

Particulars	Debit	Credit
Machinery account	45000
Retained earnings		45000

b) Schedule showing effect

Particulars	2016	2017	2018
income before the effect of any accounting changes	180000	240000	225000
Effect of accounting change (Note)	(20000)	(20000)	(20000)
income after the effect of any accounting changes	160000	220000	205000

Note - For year 2015 there should be 2 rectification - removal of expense and recording depreciation. however for year 2016 to 2018 there will be only one rectification i. e. recording depreciation.

c) To rectify opening balance of retained earning in 2018 , we have to make following adjustments

• Adding expense recorded in 2015 mistakenly
• Depreciation of 2015 to 2017

Hence Retained earning balance on 1 jan 2018 =

= Balance without adjustment + Asset recorded as expense - Dep for 3 years

= 720000 + 125000 - (20000*3 year)

= 785000