Question

A review of the notes payable files discovers that three years ago the company reported the entire \(1,000 cash payment (consisting of \)800 principal and $200 interest) toward an installment note payable as interest expense. This mistake had a material effect on the amount of income in that year. How should the correction be reported in the current-year financial statements?

Short answer

Due to incorrect journal entries, theexpenses of the business entitywill be overstated, and theretained earnings andnet income will be understated. The liabilities will be overstated.

Step-by-step solution

Definition of Interest Expense

The fee paid by the business entity against any amount of money borrowed from the creditor is known as interest expense. Such expenses are calculated as a specific percentage of the principal amount borrowed.

Reporting corrections in the current year’s financial statements

The incorrect journal entry made is:

Date	Accounts and Explanation	Debit ($)	Credit ($)
	Interest expenses	1,000
	Cash		1,000

The correct journal entry:

Date	Accounts and Explanation	Debit ($)	Credit ($)
	Note payable	800
	Interest expenses	200
	Cash		1,000

Now the correcting entry made will be:

Date	Accounts and Explanation	Debit ($)	Credit ($)
	Note payable	800
	Retained earnings		800