ABC Inc. began operations on January 1, Y1. During its first three years of operations, ABC reported net income and declared dividends as follows:
| Year
Y1 Y2 Y3 Y4 |
Net Income
$50,000 $75,000 $125,000 $150,000 |
Dividends
$0 $10,000 $0 $50,000 |
The following information relates to Y5.
At the end of Y5, after the net income above was determined ABC decided to change from FIFO to LIFO. The following COGS information was determined under each method. The net income number given above was calculated for Y5 using FIFO.
| Year
Y1 Y2 Y3 Y4 Y5 |
FIFO COGS
$135,000 $115,000 $140,000 $150,000 $145,000 |
LIFO COGS
$120,000 $130,000 $110,000 $100,000 $115,000 |
ABC reported two years on the face of the income statement during Y5.
2. What is the correcting entry (or you can separate into separate entries) required to fix he depreciation errors in Y3 and Y4?
Starting Retained Earnings (from Y3) = $0 (assuming the company had no prior retained earnings)
Net Income (Y4) = $150,000
Dividends (Y4) = $50,000
Retained Earnings (Y4) = Starting Retained Earnings (Y4) + Net Income (Y4) – Dividends (Y4)
Retained Earnings (Y4) = $0 + $150,000 – $50,000 = $100,000
Statement of Retained Earnings for Year 5 (Y5)
Starting Retained Earnings (from Y4) = $100,000
Net Income (Y5) = $200,000 (original calculation, before adjustments)
Dividends (Y5) = $0 (no dividends declared)
Retained Earnings (Y5) = Starting Retained Earnings (Y5) + Net Income (Y5) – Dividends (Y5)
Retained Earnings (Y5) = $100,000 + $200,000 – $0 = $300,000
However, it’s important to address the depreciation errors in Y3 and Y4:
Correcting Entry for Y3
To correct the understatement of depreciation expense in Y3 by $25,000, ABC Inc. needs to make an adjusting journal entry. Depreciation expense should be increased by $25,000 to accurately reflect the expense for that year. The entry would be as follows:
Debit: Depreciation Expense (Y3) $25,000 Credit: Accumulated Depreciation (Y3) $25,000
Correcting Entry for Y4
To correct the understatement of depreciation expense in Y4 by $20,000, ABC Inc. also needs to make an adjusting journal entry. Depreciation expense should be increased by $20,000 to accurately reflect the expense for that year. The entry would be as follows:
Debit: Depreciation Expense (Y4) $20,000 Credit: Accumulated Depreciation (Y4) $20,000
These correcting entries will adjust the financial statements for Y3 and Y4 to reflect the correct depreciation expenses, ensuring the accuracy of the company’s financial records.
In summary, the Statement of Retained Earnings for Y4 shows that the retained earnings at the end of Y4 were $100,000, and for Y5, they were $300,000. To correct the depreciation errors in Y3 and Y4, adjusting journal entries were made to increase depreciation expenses by the respective amounts of $25,000 and $20,000. These entries will rectify the misstatements in the financial statements and provide a more accurate picture of the company’s financial position.
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