CRITICAL THINKING PROBLEM 5.1

TO: FROM:

DATE:

SUBJEC

James Parkland, Owner Student’s Name

Current Date

Effect on Financial Statements of Omitting Adjusting Entries

Adjusting entries are recorded to update the accounts at the end of the accounting period for previously unrecorded items that belong to that period. If these entries are omitted, the net income will not be an accurate measure of the operation of the company for the year and certain accounts on the balance sheet will not report correct end-of-year balances.

In particular, Parkland Industries' net income for the year will be overstated by $26,150; net income should be $56,600 instead of $82,750. This amount represents a 32% decrease in net income over the amount that would be reported if the adjusting entries were not made. ($26,150 ÷ $82,750 = 0.32).

This decrease in net income results from not making adjusting entries for the following unrecorded expenses:

1. Expense of Rent for the year ($21,000 x 6/12 = $10,500 for 6 months)

2. Expense of supplies used during the year (Total supplies of $9,000 - Ending Inventory of $1,750 = $7,250 supplies used)

3. Depreciation expense for the year ($210,000 ÷ 25 years = $8,400 per year)

In addition to overstating the net income, the balances of Prepaid Rent and Supplies on the balance sheet would be overstated and the book value of Building would also be overstated.

Preparation of the adjusting entries would permit the financial statements to present a more accurate measure of the company’s operations for the year and its financial condition at the end of the year Therefore, it is important and the time is well spent to prepare adjusting entries so that the financial statements are up-to-date and present an accurate picture of the business.