Answered Essay: Novak Tool Company’s December 31 year-end financial statements contained the following errors.

Novak Tool Company’s December 31 year-end financial statements contained the following errors.

December 31, 2017 December 31, 2018
Ending inventory $10,100 understated $7,700 overstated
Depreciation expense $2,400 understated

An insurance premium of $68,100 was prepaid in 2017 covering the years 2017, 2018, and 2019. The entire amount was charged to expense in 2017. In addition, on December 31, 2018, fully depreciated machinery was sold for $13,900 cash, but the entry was not recorded until 2019. There were no other errors during 2017 or 2018, and no corrections have been made for any of the errors. (Ignore income tax considerations.) (Enter negative amounts using either a negative sign preceding the number e.g. -15,000 or parentheses e.g. (15,000).)

(a) Compute the total effect of the errors on 2018 net income.

Total effect of errors on net income $Entry field with incorrect answer

(b) Compute the total effect of the errors on the amount of Novak’s working capital at December 31, 2018.

Total effect on working capital $Entry field with incorrect answer

(c) Compute the total effect of the errors on the balance of Novak’s retained earnings at December 31, 2018.

Total effect on retained earnings $Entry field with incorrect answer

Expert Answer

 

(a) Total effect of errors on 2018 net income is as follows :

(1) Ending inventory of 31 December, 2017 is understated with $ 10,100 which means opening inventory of 2018 is understated with $ 10,100 which means net income of 2018 is overstated with $ 10,100 .

(2) Ending inventory of 31 December, 2018 is overstated with $ 7,700 which means net income of 2018 is overstated with $ 7,700 .

(3) The expense of insurance premium is not charged as expense in income statement of 2018 by amount [ 68,100 / 3 ] = $ 22,700 , hence net income of 2018 is overstated with $ 22,700 .

(4) Profit on sale of fully depreciated machinery on 31 December, 2018 of $ 13,900 was not recorded on 31 December, 2018 in income statement hence, net income of 2018 is understated with $ 13,900 .

After considering the above four points it can be said that net income of 2018 is overstated with = = [ 10,100 + 7,700 + 22,700 – 13,900 ] = 26,600 = $ 26,600 .

(b) Total effect of errors on working capital at 31 December, 2018 is as follows :

Working Capital = Current Assets – Current Liabilities

If current assets increase then working capital increase .

If current liabilities increase then working capital decrease.

(1) Ending inventory of 31 December, 2018 is overstated with $ 7,700 which means current assets is overstated with $ 7,700 which means working capital is overstated with $ 7,700 .

(2) Prepaid Insurance premium of year 2019 [ 68,100 / 3 ] = $ 22,700 is not shown as current asset on 31 December, 2018 because it is shown as expense in year 2017 hence current assets is understated on 31 December, 2018 with $ 22,700 hence working capital is also understated with $ 22,700 .

(3) On 31 December, 2018 cash was received on sale of fully depreciated machinery of $ 13,900 which was recorded in year 2019 hence on 31 December, 2018 current assets is understated with $ 13,900 which means working capital is also understated with $ 13,900 .

After considering the above three points it can be said that working capital at 31 December, 2018 is understated with = [ 13,900 + 22,700 – 7,700 ] = 28,900 = $ 28,900

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