Problem 17 - Accounting

Question

The accountant for Glacier Medical Co., a medical services consulting firm, mistakenly omitted adjusting entries for (a) unearned revenue earned during the year \((\$ 6,900)\) and (b) accrued wages \((\$ 3,740)\). Indicate the effect of each error, considered individually, on the income statement for the current year ended December 31 . Also indicate the effect of each error on the December 31 balance sheet. Set up a table similar to the following, and record your answers by inserting the dollar amount in the appropriate spaces. Insert a zero if the error does not affect the item. \begin{tabular}{lccccc} \cline { 5 - 6 } & \multicolumn{2}{c}{ Error (a) } & & \multicolumn{2}{c}{ Error (b) } \\ \cline { 2 - 3 } \cline { 5 - 6 } & Overstated & Understated & & Overstated & Understated \\ \hline 1. Revenue for the year would be & \(\$$ & \)\$$ & \(\$$ & \)\$$ & \(\$$ \\ 2\. Expenses for the year would be & \)\$$ & \(\$$ & \)\$$ & \(\$$ \\ 3\. Net income for the year would be & \)\$$ & \(\$$ & \)\$$ & \(\$$ \end{tabular} \begin{tabular}{lcccccc} & \multicolumn{2}{c}{ Error (a) } & & \multicolumn{2}{c}{ Error (b) } \\ \cline { 2 - 3 } \cline { 5 - 6 } & Overstated & Understated & & Overstated & Understated \\ \hline 4. Assets at December 31 would be & \)\$$ & \(\$$ & \)\$$ & \(\$$ \\ 5\. Liabilities at December 31 would be & \)\$$ & \(\$$ & \)\$$ & \(\$$ \\ 6\. Owner's equity at December 31 would be & \)\$$ & \(\$$ & \)\$$ & $\$$ \end{tabular}

Step-by-Step Solution

Answer

Error (a): Revenue understated $6,900, Liabilities overstated $6,900, Equity understated $6,900. Error (b): Expenses understated $3,740, Liabilities understated $3,740, Equity overstated $3,740.

Step 1: Understand the Effect of Error (a) on Income Statement

Error (a) is an omission of unearned revenue being recognized as earned during the year. This leads to the understated revenue by $6,900. As a result: 1. Revenue for the year would be * Overstated: $0; * Understated: $6,900. 3. Net income for the year would also be understated by $6,900 because revenue contributes directly to net income.

Step 2: Understand the Effect of Error (b) on Income Statement

Error (b) relates to the omission of accrued wages, leading to understated expenses by $3,740. Therefore: 2. Expenses for the year would be * Overstated: $0; * Understated: $3,740. 3. Net income for the year would be overstated by $3,740 because understated expenses generally increase net income.

Step 3: Analyze the Effect of Error (a) on Balance Sheet

When Error (a) occurs, liabilities (unearned revenue) are overstated but should have been recorded as revenue: 4. Assets at December 31 would be * Overstated: $0; * Understated: $0. 5. Liabilities at December 31 would be * Overstated: $6,900; * Understated: $0. 6. Owner's equity at December 31 would be * Overstated: $0; * Understated: $6,900.

Step 4: Analyze the Effect of Error (b) on Balance Sheet

For Error (b), the omission of accrued wages affects both liabilities and owner's equity: 4. Assets at December 31 would be * Overstated: $0; * Understated: $0. 5. Liabilities at December 31 would be * Overstated: $0; * Understated: $3,740. 6. Owner's equity at December 31 would be * Overstated: $3,740; * Understated: $0.

Step 5: Consolidate Findings into Table Format

Organize the conclusions into the requested table format, showing overstated and understated entries for each error on the income statement and balance sheet. Income Statement: 1. Error (a): Revenue is understated by $6,900. 2. Error (b): Expenses are understated by $3,740. 3. Error (a) & Error (b): Net Income is understated by $6,900, but offset by $3,740 of understatement in expenses (overstatement). Balance Sheet: 4. Error (a): Liabilities overstated by $6,900, decreasing owner's equity. 5. Error (b): Liabilities understated by $3,740, increasing owner's equity.

Key Concepts

Income Statement Impact

Adjusting entries are a key component of accurate financial reporting. They ensure revenues and expenses are recorded in the correct period. If unearned revenue remains unrecognized, as seen in the omission discussed, the income statement shows understated revenue by \(\\(6,900\). This means the company appears to have earned less revenue than it actually did. Since revenue directly impacts net income, the understatement causes net income to drop by the same amount, \(\\)6,900\). This misrepresents the financial health of the company to external parties such as investors. Equally, when accrued wages aren't recorded, expenses are understated by \(\\(3,740\). This reduction in reported expenses artificially inflates net income by \(\\)3,740\), posing a false impression of profitability. Both errors highlight the importance of making accurate adjusting entries to provide a true reflection of the company's financial performance.

Balance Sheet Effect

Each adjusting entry made in accounting affects both the income statement and the balance sheet. With unearned revenue erroneously reported, liabilities on the balance sheet become overstated by \(\\(6,900\). The original mistaken figure is still treated as a liability instead of being recognized as revenue. Consequently, the overstated liability reduces the equity of owners by the same amount, leading to an understated owner's equity of \(\\)6,900\).

On the other hand, not accounting for accrued wages results in understated liabilities by \(\$3,740\). Since these wages represent amounts the company owes but hasn't paid, the missed adjustment artificially indicates a lower liability figure. This understatement increases the owner's equity by the same amount, suggesting there is more wealth retained within the company than actually exists. These balance sheet discrepancies underscore the potential for misinformation about the company's financial position.

Unearned Revenue

Unearned revenue refers to payments received before delivering goods or services. It's recorded as a liability since it's essentially a debt owed to the customer until the service is performed. For example, Glacier Medical Co. received \(\$6,900\) but hadn't fully recognized this as earned by year-end, resulting in erroneous liability as unearned revenue.

Recognizing revenue when earned corrects this error. The transition from unearned to earned displays on the income statement as actual revenue, and reduces liabilities on the balance sheet. This process involves debit entries to reduce liabilities and credit entries to reflect earned income. It's crucial for businesses to differentiate between cash collected and revenue earned to maintain financial integrity, ensuring accurate disclosure of both profitability and obligations.

Accrued Wages

Accrued wages are wages that have been earned by employees but not yet paid by the period's end. This adjustment is necessary in accounting to reflect expenses accurately incurred within a specific period. Glacier Medical Co.'s failure to recognize \(\$3,740\) of accrued wages understated both expense accounts and liabilities in their financial records.

To address this, accrued wages are recorded as an expense, thereby increasing reported expenses on the income statement. Simultaneously, they appear as liabilities on the balance sheet, acknowledging the company's obligation to settle these wages in the following period. Adjusting entries for accrued liabilities such as wages help maintain the accuracy of financial reporting and ensure that a business's financial obligations are appropriately recorded and disclosed.