Question

While preparing its year 3 financial statements, Dek Corp. discovered computational errors in its year 2 and year 1 depreciation expense. These errors resulted in overstatement of each year’s income by $25,000, net of income taxes. The following amounts were reported in the previously issued financial statements:

Year 2 Year 1
Retained earnings, 1/1 $700,000 $500,000
Net income 150,000 200,000
Retained earnings, 12/31 $850,000 $700,000

Dek’s year 3 income is correctly reported at $180,000. Which of the following amounts should be adjusted to retained earnings and presented for net income in Dek’s year 3 and year 2 comparative financial statements?

Year Retained earnings Net income
year 2 --    150,000
year 3    ($50,000)      180,000
year 2 ($50,000) $150,000
year 3    --      180,000
year 2 ($50,000) $125,000
year 3    --      180,000
year 2 -- $125,000
year 3    --      180,000

Answer 1

For year 2, adjust retained earnings by ($50,000) and net income by $125,000 due to prior errors. In year 3, no adjustments are needed to retain earnings, and net income should be reported correctly at $180,000.

Step-by-step explanation:

When correcting prior-year errors in financial statements, it is necessary to adjust the previously reported figures for retained earnings and net income. Given that Dek Corp. overstated its income by $25,000 net of income taxes for both year 1 and year 2, the year 2 retained earnings and net income should be reduced by $50,000, which is the total overstatement for the two years combined. The comparative financial statements for year 3 should show the corrected figures from year 2 alongside the correctly reported year 3 income.

The adjustment results in the following entries:

• For year 2, retained earnings should be presented as $800,000 ($850,000 originally reported − $50,000 correction).
• For year 2, net income should be presented as $125,000 ($150,000 originally reported − $25,000 correction).
• For year 3, retained earnings should show no adjustment, as there were no errors in year 3.
• For year 3, net income is correctly reported at $180,000.

Therefore, the correct answer is that year 2 should have retained earnings adjusted by ($50,000) and net income by $125,000, and for year 3 there should be no adjustment to retained earnings and net income should remain at $180,000.