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Cheyenne Ltd.'s December 31 year-end financial statements contained the following errors: An insurance premium of $ 3,600 was prepaid in 2019 covering the calendar years 2019, 2020, and 2021. This had been debited to insurance expense. In addition, on December 31, 2020, fully depreciated machinery was sold for $ 1,900 cash, but the sale was not recorded until 2021. There were no other errors during 2020 or 2021 and no corrections have been made for any of the errors. Ignore income tax considerations.
-What is the total net effect of the errors on the amount of Cheyenne's working capital at December 31, 2020?
A) Working capital overstated by $ 1,000
B) Working capital overstated by $ 300
C) Working capital understated by $ 900
D) Working capital understated by $ 2,400

Question

Use the following information for questions.
Cheyenne Ltd.'s December 31 year-end financial statements contained the following errors:  An insurance premium of $ 3,600 was prepaid in 2019 covering the calendar years 2019, 2020, and 2021. This had been debited to insurance expense. In addition, on December 31, 2020, fully depreciated machinery was sold for $ 1,900 cash, but the sale was not recorded until 2021. There were no other errors during 2020 or 2021 and no corrections have been made for any of the errors. Ignore income tax considerations.
-What is the total net effect of the errors on the amount of Cheyenne's working capital at December 31, 2020?
A) Working capital overstated by $ 1,000 
B) Working capital overstated by $ 300 
C) Working capital understated by $ 900 
D) Working capital understated by $ 2,400

Quizplus · Accepted Answer

The error of debiting the insurance premium to insurance expense resulted in an overstatement of the expense and a corresponding understatement of prepaid insurance. Prepaid insurance is a current asset that represents the amount paid for insurance that has not yet expired. Therefore, the understatement of prepaid insurance resulted in a decrease in current assets and working capital. The amount of the prepaid insurance that should have been recorded as an asset in 2020 is $ 1,200 ($ 3,600/3 years).

The error of not recording the sale of fully depreciated machinery in 2020 resulted in an understatement of cash and an overstatement of property, plant, and equipment. Property, plant, and equipment is a long-term asset, and therefore, the error did not affect working capital.

Thus, the total net effect of the errors on the amount of Cheyenne's working capital at December 31, 2020, is an understatement of $ 900 ($ 1,200 decrease in current assets - $ 300 increase in long-term assets).

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