On
May 5, 2012, you were hired by Gavin Inc., a closely held company that follows
ASPE, as a staff member of its newly created internal auditing department.
While reviewing the company’s records for 2010 and 2011, you discover that no
adjustments have yet been made for the items listed below.
1.
Interest income of $18,800 was not accrued at the end of 2010. It was recorded
when received in February 2011.
2.
Equipment costing $18,000 was expensed when purchased on July 1, 2010. It is
expected to have a four-year life with no residual value. The company typically
uses straight-line depreciation for all fixed assets.
3.
Research costs of $36,000 were incurred early in 2010. They were capitalized
and were to be amortized over a three-year period. Amortization of $12,000 was
recorded for 2010 and $12,000 for 2011. For tax purposes, the research costs
were expensed as incurred.
4.
On January 2, 2010, Gower leased a building for five years at a monthly rental
of $9,000. On that date, the company paid the following amounts, which were
expensed when paid for both financial reporting and tax purposes:
Security
deposit ………………………………. $35,000
First
month’s rent …………………………….. 9,000
Last
month’s rent …………………………….. 9,000
$53,000
5.
The company received $42,000 from a customer at the beginning of 2010 for
services that it is to perform evenly over a three-year period beginning in
2010. None of the amount received was reported as unearned revenue at the end
of 2010. The $42,000 was included in taxable income in 2010.
6.
Merchandise inventory costing $16,800 was in the warehouse at December 31,
2010, but was incorrectly omitted from the physical count at that date. The
company uses the periodic inventory method.
Instructions
Using
the table that follows, enter the appropriate dollar amounts in the appropriate
columns to indicate the effect of any errors on the net income figure reported
on the income statement for the year ending December 31, 2010, and the retained
earnings figure reported on the balance sheet at December 31, 2011. Assume that
all amounts are material and that an income tax rate of 25% is appropriate for
all years. Assume also that each item is independent of the other items.
It
is not necessary to total the columns on the grid.
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Net
Income
for
2010
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Retained
Earnings
12/31/11
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Item
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Understated
|
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Overstated
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Understated
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Overstated
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1.
2.
3.
4.
5.
6.
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$14,100
$11,813
0
$33,000
0
$12,600
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0
0
$18,000
0
$21,000
0
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0
$ 8,438
0
$33,000
0
0
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0
0
$ 9,000
0
$10,500
0
|
Explanations:
1. The net income would be understated in 2010
because interest income is understated. The net income would be overstated in
2011 because interest income is overstated. The errors, however, would
counterbalance (wash) so that the Balance Sheet (Retained Earnings) would be
correct at the end of 2011. The amount of understatement in 2010 would be
$18,800 X (1 – 25%) = $14,100.
2. The depreciation expense in 2010 should be
$2,250 for this machine. Since the machine was bought on July 1, 2010, only
one-half of a year should be taken in 2010 ($18,000/4 X 1/2 = $2,250). The
company expensed $18,000 instead of $2,250 so net income is understated by
$15,750 X (1 – 25%) = $11,813 in 2010. An additional $4,500 of depreciation
expense should have been taken in 2011. At the end of 2011, retained earnings
would be understated by $11,250 ($15,750 – $4,500) net of taxes of 25% =
$8,438.
3. GAAP requires that all research costs should
be expensed when incurred. Net income in 2010 is overstated $24,000 ($36,000
research costs capitalized less $12,000 amortized) X (1 – 25%) = $18,000. By
the end of 2011, only $12,000 of the research costs would remain as an asset.
Therefore, retained earnings would be overstated by $12,000 ($36,000 research
costs – $24,000 amortized) X (1 – 25%) = $9,000.
4. The security deposit should be a long-term
asset, such as refundable deposits. The $9,000 of last month’s rent is also an
asset, such as prepaid rent. The net income of 2007 is understated by $44,000
($35,000 + $9,000) X (1 – 25%) = $33,000 because these amounts were expensed.
Retained earnings will continue to be understated by $33,000 until the last
year of the lease. The security deposit will then be refunded, and the last
month’s rent should be expensed.
5. $14,000 or one-third of $42,000 should be
reported as income each year. In 2010, $42,000 was reported as income when only
$14,000 should have been reported. Because $28,000 too much was reported, the
net income of 2010 is overstated by $28,000 X (1 – 25%) = $21,000. At the end
of 2011, $28,000 should have been reported as income, so retained earnings is
still overstated by $14,000 ($42,000 – $28,000) X (1 – 25%) = $10,500.
6. The ending inventory would be understated
since the merchandise was omitted. Because ending inventory and net income have
a direct relationship, net income in 2010 would be understated by $16,800 X (1
– 25%) = $12,600. The ending inventory of 2010 becomes the beginning inventory
of 2011. If beginning inventory of 2011 is understated, then net income of 2011
is overstated (inverse relationship). The omission in inventory over the
two-year period will counterbalance, and retained earnings at the end of 2011
will be correct.
