Question

Use the following information for questions:

Langley Company's December 31 year-end financial statements contained the following errors:
Dec. 31, 2014 Dec. 31, 2015
Ending inventory - $22,500 understated $33,000 overstated
Depreciation expense 6,000 understated - none

An insurance premium of $54,000 was prepaid in 2014 covering the years 2014, 2015, and 2016. The prepayment was recorded with a debit to insurance expense. In addition, on December 31, 2015, fully depreciated machinery was sold for $28,500 cash, but the sale was not recorded until 2016. There were no other errors during 2015 or 2016 and no corrections have been made for any of the errors. Ignore income tax considerations.

What is the total net effect of the errors on Langley's 2015 net income?
a. Net income understated by $43,500.
b. Net income overstated by $22,500.
c. Net income overstated by $39,000.
d. Net income overstated by $45,000.

What is the total net effect of the errors on the amount of Langley's working capital at December 31, 2015?
a. Working capital overstated by $15,000
b. Working capital overstated by $4,500
c. Working capital understated by $13,500
d. Working capital understated by $36,000

What is the total effect of the errors on the balance of Langley's retained earnings at December 31, 2015?
a. Retained earnings understated by $30,000
b. Retained earnings understated by $13,500
c. Retained earnings understated by $7,500
d. Retained earnings overstated by $10,500

Answer 1

Final Answers:

1. The total net effect of the errors on Langley's 2015 net income is:

c. Net income overstated by $39,000.

2. The total net effect of the errors on the amount of Langley's working capital at December 31, 2015 is:

c. Working capital understated by $13,500.

3. The total effect of the errors on the balance of Langley's retained earnings at December 31, 2015 is:

b. Retained earnings understated by $13,500.

Step-by-step explanation:

The ending inventory error of $22,500 understated and the depreciation expense error of $6,000 understated both lead to an overstatement of net income. On the other hand, the ending inventory error of $33,000 overstated has the opposite effect, understating net income. Therefore, the net effect on net income is the difference between the overstatement and understatement, resulting in a net income overstatement of $39,000.

Working capital is calculated as current assets minus current liabilities. The ending inventory error affects current assets, and the net effect is a $22,500 ($33,000 - $22,500) overstatement. However, the prepaid insurance expense error of $54,000 (recorded as an expense but should be an asset) and the machinery sale error ($28,500 cash received but not recorded) both impact current assets negatively, leading to a combined understatement of $67,500 ($54,000 + $28,500). Therefore, the net effect on working capital is an understatement of $13,500.

Retained earnings are affected by net income and dividends. The net income overstatement of $39,000 increases retained earnings. However, since the net effect on working capital is an understatement of $13,500, there is an additional negative impact on retained earnings. The combined effect is a retained earnings understatement of $13,500.