Answer: This situation is a self-correcting error that exceeds two years. The proper way to handle this is to compute the errors that occurred before 2017 and correct those with an adjustment to retained earnings. This error affects both the income statements and balance sheets for 2015 and 2016. If material in amounts, the financial statements must be restated retrospectively for 2015 and 2016 if presented on a comparative basis. To compute the errors, the following analysis is required:
Correction to 2015:
Pre-tax income as presented
$1,040,000
Correction of Insurance Expense ($300,000 - 60,000)
240,000
Pre-tax income as corrected
$1,280,000
Adjusted income tax expense ($1,280,000 × 40%)
(512,000)
Corrected net income
$768,000
Correction to 2016:
Pre-tax income as presented
$1,220,000
Correction of Insurance Expense ($0 + 60,000)
(60,000)
Pre-tax income as corrected
$1,160,000
Adjusted income tax expense ($1,160,000 × 40%)
(464,000)
Corrected net income
$696,000
Correction to 2017:
Two journal entries are required for 2017.
(A) To correct the Prior Period Adjustment for the 2015 and 2016 errors:
Account
Debit
Credit
Prepaid Plant Insurance (*)
180,000
Retained Earnings-Prior Period Adj.
108,000
Income Taxes Payable
72,000
(*) Remaining Prepaid Insurance is 60% of $300,000.
(B) To record the insurance expense for 2017:
Account
Debit
Credit
Insurance Expense
60,000
Prepaid Plant Insurance
60,000