Question

On April 1, 2016, SBD Corp. purchased a year of property insurance for $120,000, and recorded this payment as an increase to insurance expense. What is wrong with SBD’s financial statements if no adjustment is made at SBD’s fiscal year of December 31, 2016?

a) Insurance expense is understated by $30,000

b) Current liabilities are understated by $30,000

c) Retained earnings is understated by $30,000

d) Cash flows from operations is overstated by $30,000

e) None of the above

Answer 1

Answer)

The correct option in the given question is (c) Retained earnings is understated by $ 30,000.

Justifications:

(a) Insurance expense is under stated by $ 30,000: this option is incorrect as insurance expense for the year ended December 31, 2016 should be $ 90,000 (i.e. from Apr’2016 to Dec’2016). However insurance expense is recorded as $ 120,000. Thus insurance expense is overstated by $ 30,000.

(b) Current liabilities are understated by $ 30,000: This option is incorrect as current assets (being prepaid insurance of $ 30,000) is under by $ 30,000 and current liabilities is unaffected.

(c) Retained earnings are underestimated by$ 30,000: This option is CORRECT. It is because of excess expense of $ 30,000 is recognized in the accounting year 2016, Net profit will be understated by $ 30,000 and since the net profit is transferred to retained earnings, the balance of retained earnings is also understated by $ 30,000.

(d) Cash flow from operations is understated by $ 30,000: This option is incorrect cash flow records the actual cash outflows. Since the cash outflows will be same (i.e. $ 120,000), the cash flow from operations will not be affected.

(e) None of the above: This answer is incorrect as option (c) is the correct answer.