The Milling Machine Charged to Repairs at Kestrel Design
Kestrel Design Ltd is preparing its 2023 financial statements, which have not yet been issued. While doing so it finds that a $36,000 milling machine bought and placed in service on 2 January 2023 was debited in full to Repairs and Maintenance. The machine has a six-year life, no residual value, and is depreciated straight-line. 2023 draft profit before tax is $95,000; the 2022 comparative profit was $140,000, and the 2022 figures are not affected. Separately, a $1,800 payment for 2024 trade association dues was recorded as a 2023 expense. The 2024 books are open. Management proposes to "fix the machine in 2024 so that 2023 stays as drafted", and asks you to confirm.
1. Classify each of the two misstatements and state, with reasons, whether each should be corrected in the 2023 statements, in 2024, or as a prior period adjustment.
Read the worked answer
Machine error - a material error in the current period, not a prior period error. The statements have not been issued and the 2023 books are still open, so this is simply a 2023 error caught before publication. It is corrected by adjusting the 2023 figures themselves. A prior period adjustment to opening retained earnings would only be the right route if the 2023 statements had already been issued (or were final), in which case comparatives would be restated.
Management's "fix it in 2024" proposal is wrong on two counts: it leaves a published-period misstatement uncorrected, and it produces a bizarre 2024 result in which a full year of depreciation appears with no asset ever capitalised in the accounts.
Trade dues - a cutoff/immaterial error. $1,800 is small in both absolute and relative terms (about 2% of draft profit) and it counterbalances: 2023 is overstated by $1,800, 2024 will be understated by the same amount. If the 2023 statements are still open, correct it now for cleanliness (Dr Prepaid expenses 1,800 / Cr Expense 1,800). If it had already been issued, leaving it and letting 2024 self-correct is an acceptable, documented immateriality call - but it should still be logged.
2. Quantify the correction to 2023 profit and give the correcting journal entries.
Read the worked answer
Correct 2023 expense for the machine:
- Remove the wrongly expensed cost: +$36,000 to profit.
- Record the depreciation that should have been charged: $36,000 / 6 = $6,000 for 2023 (a full year, since it was in service from 2 January), so -$6,000.
- Net increase to 2023 profit before tax: $30,000.
Entries:
- Dr Equipment 36,000 / Cr Repairs and Maintenance 36,000
- Dr Depreciation expense 6,000 / Cr Accumulated depreciation 6,000
The carrying amount at 31 December 2023 becomes $30,000 (cost $36,000 less accumulated depreciation $6,000).
Adding the dues correction (+$1,800) would give a total increase of $31,800, taking draft profit from $95,000 to $126,800 before tax.
3. Assess materiality and explain what the correction means for the comparatives and for 2024.
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Materiality. $30,000 against $95,000 of draft profit is roughly 32% - plainly material on any quantitative benchmark. There is also a qualitative argument: the misstatement converts a capital purchase into a consumable expense, which distorts the balance sheet (assets understated by $30,000 net) and any return-on-assets or capex measure a reader might compute. No reasonable materiality policy clears it.
Comparatives. 2022 is untouched by either error, so no restatement of the earlier year is needed; the 2023 comparative presented in the 2024 accounts will be the corrected 2023 figure.
Effect on 2024. Because the correction is made in 2023, 2024 simply carries on with normal depreciation of $6,000. If management had insisted on deferring the fix, 2024 would absorb a $36,000 credit and a $12,000 depreciation charge (two years' worth), which is precisely the kind of distortion the correction now avoids.
Practical step. Document the correction, the reasoning and management's original proposal in a memo; auditors and reviewers will ask why a fixed asset was sitting in repairs.