Question

Drago Inc. is a calendar-year corporation. Its financial statements for the years 2012 and 2011 contained errors as follows:

2012:
Ending inventory $6,000 overstated
Depreciation expense $4,000 understated
2011:
Ending inventory $12,000 overstated
Depreciation expense $9,000 overstated
Assume that the proper correcting entries were made at December 31, 2011. By how much will 2012 income before taxes be overstated or understated?
a. $10,000 overstated
b. $2,000 understated
c. $5,000 overstated
d. $7,000 overstated

Answer 1

The 2012 income before taxes will be overstated by $10,000 because the ending inventory was overstated by $6,000 and depreciation expense was understated by $4,000, which cumulatively increased the income before taxes by $10,000.

This correct answer is a.

Step-by-step explanation:

To determine how much the 2012 income before taxes will be overstated or understated due to the errors, we need to analyze the impact of ending inventory and depreciation expense adjustments on the income statement.

For the year 2012:

• Ending inventory was overstated by $6,000. An overstatement in ending inventory will cause the cost of goods sold (COGS) to be understated, thus overstating the income.
• Depreciation expense was understated by $4,000. An understatement in expense will overstate the income.

So, the net effect on 2012 income before taxes due to these two errors will be an overstatement of $10,000.

The proper correcting entries made at December 31, 2011, should have amended the 2011 errors:

• Ending inventory was overstated by $12,000.
• Depreciation expense was overstated by $9,000.

However, these corrections will already be reflected in the beginning balances for 2012 and thus don't directly affect the 2012 income statement.

Therefore, the correct answer is a. $10,000 overstated.

This correct answer is a.