Question

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Armstrong Inc. is a calendar-year corporation. Its financial statements for the years ended 12/31/14 and 12/31/15 contained the following errors:

2014 2015
Ending inventory $25,000 overstatement $40,000 understatement
Depreciation expense 10,000 understatement 20,000 overstatement

Assume that the 2014 errors were not corrected and that no errors occurred in 2013. By what amount will 2014 income before income taxes be overstated or understated?
a. $35,000 overstatement
b. $15,000 overstatement
c. $35,000 understatement
d. $15,000 understatement

Assume that no correcting entries were made at 12/31/14, or 12/31/15. Ignoring income taxes, by how much will retained earnings at 12/31/15 be overstated or understated?
a. $40,000 overstatement
b. $35,000 overstatement
c. $50,000 understatement
d. $15,000 understatement

Answer 1

Armstrong Inc.'s income before taxes for 2014 was overstated by $35,000 due to errors in ending inventory and depreciation. Retained earnings at the end of 2015, considering the cumulative effect of errors over two years and ignoring correcting entries, are understated by $25,000, which is not an option provided in the question.

Step-by-step explanation:

Determination of Overstatement or Understatement in Income and Retained Earnings

To find out how much Armstrong Inc.'s income before taxes will be overstated or understated in 2014 due to financial statement errors, we need to consider the impacts of the error in ending inventory and depreciation expense.

Since ending inventory was overstated by $25,000, the cost of goods sold (COGS) was understated by this amount, which in turn overstated the income. The understatement of the depreciation expense by $10,000 also led to an overstatement of income. Combining these two errors, the income before taxes for 2014 was overstated by $35,000 ($25,000 overstated inventory + $10,000 understated depreciation), which means option (a) $35,000 overstatement is the correct answer.

Next, to determine how much retained earnings at the end of 2015 would be affected, we must consider the cumulative effect of errors from both years. The 2014 errors were not corrected; therefore, the 2014 overstatement in income of $35,000 carries over. In 2015, the effect is the opposite for the inventory (a $40,000 understatement, which reduces income) but also includes a $20,000 overstatement of depreciation expense that reduces income further. So, the net effect for 2015 is a $60,000 reduction in income ($40,000 inventory + $20,000 depreciation). Since retained earnings are a cumulative measure of a company's profit, we must calculate the net effect over the two years. The total effect is a combined understatement of $25,000 ($35,000 overstatement from 2014 - $60,000 understatement from 2015). Thus, retained earnings at the end of 2015 are understated by $25,000, so the correct answer is not provided in the given options.