Chapter 22, Problem 16E

Dudley Company failed to recognize the following accruals. It also recorded the prepaid expenses and unearned revenues as expenses and revenues, respectively', in the following year when paid or collected.

The reported pretax income was $20,000 in 2018, $25,000 in 2019, and $23,000 in 2020.

Required:

1. 1. Compute the correct pretax income for 2018, 2019, and 2020.
2. 2. Prepare the journal entries necessary in 2020 if the errors are discovered at the end of that year. Ignore income taxes.
3. 3. Prepare the journal entries necessary in 2021 if the errors are discovered at the end of that year. Ignore income taxes.

To determine

Calculate the correct pretax income for 2018, 2019, and 2020, after including the omissions.

Explanation of Solution

Errors: The comparability and consistency of the financial statements decreases when a company records arithmetic mistakes, or errors. Such errors do require adjustments to make the financial information more reliable, and more relevant.

Calculate the correct pretax income for the years 2018, 2019, and 2020.

Details	2018	2019	2020
Reported pretax income	$20,000	$25,000	$23,000
Prepaid expenses:
Add: Expense paid in the year	500	900	1,100
Deduct: Expense incurred in the year		(500)	(900)
Accrued expenses:
Deduct: Expense incurred in the year	(800)	(700)	(950)
Add: Expense paid in the year		800	700
Revenue received in advance:
Deduct: Revenue in the year received	(300)	(400)	(1,300)
Add: Revenue in the year earned		300	400
Revenue earned but not received:
Deduct: Revenue in the year received		(600)	(1,000)
Add: Revenue in the year earned	600	1,000	1,200
Correct pretax income	$20,000	$25,800	$22,250

Table (1)

To determine

Journalize the correction of errors at the end of 2020 for the prior period errors.

Explanation of Solution

Journal entry: Journal entry is a set of economic events which can be measured in monetary terms. These are recorded chronologically and systematically.

Debit and credit rules:

• Debit an increase in asset account, increase in expense account, decrease in liability account, and decrease in stockholders’ equity accounts.
• Credit decrease in asset account, increase in revenue account, increase in liability account, and increase in stockholders’ equity accounts.

Journalize the correction of errors at the end of 2020 for the prior period errors.

Prepaid expenses paid in 2020:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Prepaid Expenses			1,100
			Expense			1,100
		(Record prepaid expenses)

Table (2)

Description:

• Prepaid Expenses is an asset account. Since prepaid expenses were recorded in 2020, asset value increased, and an increase in asset is debited.
• Expense is an equity account. Since prepaid expenses of 2019 were recorded as expenses in 2020, the expenses in 2020 were overstated. The equity account is credited to decrease the overstated expense value.

Prepaid expenses incurred in 2020:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Expense			900
			Retained Earnings			900
		(Record expenses paid and increase the retained earnings value)

Table (3)

Description:

• Expense is an equity account. Expenses decrease equity value, and a decrease in equity is debited.
• Retained Earnings is an equity account. Since prepaid expenses of 2019 were recorded as expenses in 2020, and was included in the computation of net income, the net income in 2020 was understated. The equity account is credited to increase the understated value.

Accrued expenses incurred in 2020:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Expense			950
			Accrued Expenses			950
		(Record accrued expenses incurred)

Table (4)

Description:

• Expense is an equity account. Expenses decrease equity value, and a decrease in equity is debited.
• Accrued Expenses is a liability account. Since amount to be paid has increased, liabilities value increased, and an increase in liabilities is credited.

Accrued expenses paid in 2020:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Retained Earnings			700
			Expense			700
		(Record accrued expenses paid)

Table (5)

Description:

• Retained Earnings is an equity account. Since accrued expenses of 2019 were recorded as expenses in 2020, the net income in 2020 was decreased, and a decrease in equity account is debited.
• Expense is an equity account. Since accrued expenses of 2019 were recorded as expenses in 2020, the expenses in 2020 were overstated. The equity account is credited to decrease the overstated expense value.

Unearned revenue received in 2020:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Revenue			1,300
			Unearned Revenue			1,300
		(Record unearned revenue received)

Table (6)

Description:

• Revenue is an equity account. Since unearned revenue is recorded as revenue in 2020, the revenue value is overstated. The equity account is debited to decrease equity value.
• Unearned Revenue is a liability account. Since revenue received in advance in 2020 were recorded as revenue in 2020, the liability value in 2020 was understated. The liability account is credited to increase the understated liability value.

Unearned revenue earned in 2020:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Retained Earnings			400
			Revenue			400
		(Record unearned revenue being earned)

Table (7)

Description:

• Retained Earnings is an equity account. Since unearned revenue of 2019 were recorded as revenue in 2020, and was included in the computation of net income, the net income in 2020 was overstated. The equity account is debited to decrease the overstated value.
• Revenue is an equity account. Revenues increase equity value, and an increase in equity is credited.

Accrued revenue received in 2020:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Revenue			1,000
			Retained Earnings			1,000
		(Record revenue received and increase the retained earnings value)

Table (8)

Description:

• Revenue is an equity account. Accrued revenues earned in 2019 but recorded as received in 2020 would increase the revenue value of 2020. So, the equity is debited to decrease the 2020 revenue.
• Retained Earnings is an equity account. Since accrued revenue of 2019 were recorded as revenue in 2020, and was not included in the computation of net income, the net income in 2019 was understated. The equity account is credited to increase the understated value.

Accrued revenue earned in 2020:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Accounts Receivable			1,200
			Revenue			1,200
		(Record revenue earned on account)

Table (9)

Description:

• Accounts Receivable is an asset account. Since amount to be received has increased, the assets have increase, and an increase in assets is debited.
• Revenue is an equity account. Revenues increase equity value, and an increase in equity is credited.

To determine

Journalize the correction of errors at the end of 2021 for the prior period errors.

Explanation of Solution

Journalize the correction of errors at the end of 2021 for the prior period errors.

Prepaid expenses incurred in 2021:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Expense			1,100
			Retained Earnings			1,100
		(Record expenses paid and increase the retained earnings value)

Table (10)

Description:

• Expense is an equity account. Expenses decrease equity value, and a decrease in equity is debited.
• Retained Earnings is an equity account. Since prepaid expenses of 2020 were recorded as expenses in 2021, and was included in the computation of net income, the net income in 2020 was understated. The equity account is credited to increase the understated value.

Accrued expenses paid in 2021:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Retained Earnings			950
			Expense			950
		(Record accrued expenses paid)

Table (11)

Description:

• Retained Earnings is an equity account. Since accrued expenses of 2020 were recorded as expenses in 2021, the net income in 2021 was decreased, and a decrease in equity account is debited.
• Expense is an equity account. Since accrued expenses of 20220 were recorded as expenses in 2021, the expenses in 2021 were overstated. The equity account is credited to decrease the overstated expense value.

Unearned revenue earned in 2021:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Retained Earnings			1,300
			Revenue			1,300
		(Record unearned revenue being earned)

Table (12)

Description:

• Retained Earnings is an equity account. Since unearned revenue of 2020 were recorded as revenue in 2021, and was included in the computation of net income, the net income in 2020 was overstated. The equity account is debited to decrease the overstated value.
• Revenue is an equity account. Revenues increase equity value, and an increase in equity is credited.

Accrued revenue received in 2021:

Date		Account Titles and Explanation		Post Ref.	Debit ($)	Credit ($)
		Revenue			1,200
			Retained Earnings			1,200
		(Record revenue received and increase the retained earnings value)

Table (13)

Description:

• Revenue is an equity account. Accrued revenues earned in 2020 but recorded as received in 2021 would increase the revenue value of 2021. So, the equity is debited to decrease the 2021 revenue.
• Retained Earnings is an equity account. Since accrued revenue of 2020 were recorded as revenue in 2021, and was not included in the computation of net income, the net income in 2020 was understated. The equity account is credited to increase the understated value.