(Understanding the effect of errors on the elements of the accounting equation, LO 4, 5) For each of the following situations, indicate how the recording errors affect the amount of assets, liabilities, owners’ equity, revenues, and expenses reported in the 2005 financial statements. Indicate whether each category is overstated (too high), understated (too low), or unaffected by the error. Assume that the year end is December 31. Briefly explain why the effects occur and state any assumptions that you make.

Example:

On January 3, 2005, a three-year insurance policy was purchased for $9,000 cash. The bookkeeper debited insurance expense for $9,000 when the policy was purchased. No adjusting entry was made at year end.

a. On January 3, 2005 a three-year insurance policy was purchased for $9,000 cash. The bookkeeper debited Prepaid Insurance for $9,000 when the policy was purchased. No adjusting entry was made at year end.

b. On December 15, 2005 $400 was received from a customer paying in advance for lawn care services that were going to be provided in 2006. The bookkeeper credited Revenue for $400 when the cash was received.

c. On December 31, 2005 no entry was made to reflect the use of electricity during the month of December. The bill for electricity will not be received until late February. In December 2004 the company used $2,000 of electricity and management estimates that about the same amount was used this year.

d. On September 1, 2005 the company invested $1,000,000 in government bonds that pay interest on September 1 and March 1 of each year. The interest rate is 6% per year. No adjusting entry was made.

e. On July 17, 2005 a $5,750 cash expenditure for some required items was recorded as $7,570.

Situation Assets Liabilities Example Understated No effect Owners' equity Revenue Understated Expense No effect Overstated Explanation By expensing 100% of the insurance cost in the current year, three years of insurance is expensed in a single year, thereby overstating expenses. Since expenses are closed to owners' equity, the equity section of the bal- ance sheet would be understated. Assets would be understated because the two years of insurance that should be reported on the bal- ance sheet would not be. After three years the financial statements would be correct if the error were not corrected.