Final answer:
Ernst Company's net income for the year ended December 31, 2012, was understated due to incorrectly expensing the entire cost of the equipment. The correct depreciation should have been $160,000 for the year, with a resultant net understatement of $1,276,000 after considering the tax effect.
Step-by-step explanation:
The question refers to an accounting error relating to the purchase of equipment by the Ernst Company. The equipment, which cost $1,500,000, was incorrectly recorded entirely as an expense in the year it was purchased instead of being depreciated over its useful life. According to the straight-line method of depreciation, the annual depreciation expense should be calculated by subtracting the residual value from the cost of the equipment and then dividing it by the useful life of the equipment. This error affected the net income statement.
To determine how much the net income for the year ended December 31, 2012, was understated, we need to consider the correct depreciation expense for a full year, which is:
(Cost of the Equipment - Residual Value) / Useful Life
= ($1,500,000 - $60,000) / 9
= $1,440,000 / 9
= $160,000 per year.
Since the entire cost was expensed in 2012, we need only to add back the overstatement from the incorrect expense recording minus the depreciation that should have been recorded: $1,500,000 (incorrectly expensed) - $160,000 (depreciation expense) = $1,340,000
However, we must also consider the tax effect. The tax saving from the depreciation expense would be 40% of $160,000, which equals $64,000. So, the net effect on 2012's net income is $1,340,000 - $64,000 = $1,276,000. None of the answer choices provided (a. $804,000, b. $900,000, c. $1,340,000, d. $1,500,000) match this correct calculation, indicating a possible mistake in the options provided.