Question

During 2019, Wolverhampton Wanderers Inc. paid $1 million in cash for ordinary maintenance expenses. It improperly capitalized this amount. As a result of this error: A. Cash flow from operations is not affected. B. Net income is understated. C. Leverage (total liabilities/total assets) is understated. D. All of the above. E. None of the above.

Answer 1

C

Step-by-step explanation:

In this question, we are asked to state what happens as a result of an error of improper capitalization. We answer as follows:

Firstly, we need to know the kind of payment in which this is. It is a payment for maintenance and hence, we can categorize this as simply a liability. It is a liability because it is taking money away from the business.

Now, we are told that there is an error in capitalization of this amount. This error will affect the amount of total liabilities. Affecting the total liabilities would have a ripple effect on the leverage. This is because it is expected that the ratio will be wrong due to error in capitalization which of course would affect it, making it understated