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Hello John!
My question relates to the following objective question from the Kaplan exam kit.
(269 Driver incurred bank charges of $40, which was then credited to the bank interest receivable
account.
What was the effect upon profit for the year of recording the bank charges in this way?
A Profit will be unchanged
B Profit will be overstated by $80
C Profit will be understated by $80
D Profit will be understated by $40)Kaplan says the correct is answer is C and provides the following explanation.
“Accounting for an expense should reduce profit. By crediting $40 to the Bank interest
receivable account, when bank charges should have been debited to an expense account,
has the effect of increasing profit by $40, rather than the proper outcome of reducing profit
by $40. As a result of this error, profit has been overstated by 2 × $40 = $80.”As per my understanding the correct answer should be “Profit will be overstated by $40”. Because it is only the bank charges that will affect profit and not Interest receivable as it is a SOFP item. Is my reasoning correct?
Also what exact entry did driver record? is it Dr Suspense A/c Cr Interest Receivable
or Cr Bank and Cr Interest receivable(double credit in error)Thank you.
The bank charges are an expense. They should have been debited to the bank charges account and this should have reduced the profit by $40.
Instead the credited the bank interest account by mistake. Bank interest is income and so this will have increased the profit by $40.
So to correct it the need to remove the income (which reduces the profit by 40) and then record the expense (which reduces the profit by another 40). So in total the existing profit needs reducing by $80.
(The correcting entry is as you have written, although is not relevant for answering this question.)
Have you watched my free lectures on this? The lectures are a complete free course for Paper FA and cover everything needed to be able to pass the exam well.
Thank you for replying John! Your lectures have been helpful in my preparation, and yes, I do watch them before moving on to the Kaplan text and kit.
But my confusion remains. Is bank interest receivable, not a SOFP item? If so, it shouldn’t affect the profit, right? OR if a SOFP item does affect the profit, then, say, if driver debited receivables instead (by error), is profit overstated in this case too?
Bank interest received is a SOPL item – it is income (just as bank interest paid is an expense).
Unfortunately, bank interest is sometimes referred to as ‘received’ and sometimes as ‘receivable’ which understandably causes confusion. However in both cases it is income.
The fact that here they incurred bank charges means that there is certainly a cash entry (which should have been debited to an expense account) and so the fact that they credited interest receivable must mean that they credited an income account in error.
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