Accounting changes and error corrections Flashcards
(13 cards)
What kind of accounting treatment do the following changes have
Change in accounting principle
Change in accounting estimate
Change in reporting entity
Error correction
Retrospective
Prospective
Retrospective
Retroactive
A change that is both principle and estimate is treated as a change in accounting estimate
Holt Co. discovered that in the prior year, it failed to report $40,000 of depreciation related to a newly constructed building. The depreciation was computed correctly for tax purposes. The tax rate for the current year was 20%. How should Holt report the correction of error in the current year?
A. As an increase in accumulated depreciation of $32,000.
B. As an increase in accumulated depreciation of $40,000.
C. As an increase in depreciation expense of $32,000.
D. As an increase of depreciation expense of $40,000.
B. As an increase in accumulated depreciation of $40,000.
On January 2, Year 3, Althouse Co. discovered that it had incorrectly expensed equipment that was purchased on January 2, Year 1 for $150,000. The equipment should have been depreciated over five years with no salvage value. What amount, if any, should be adjusted to Althouse’s depreciation expense on January 2, Year 3, when Althouse records the correcting entry?
A. $0
B. $30,000
C. $60,000
D. $150,000
A. $0
An accounting error results from either incorrectly recording or failing to record a transaction. When a material accounting error occurs, it must be corrected. An error discovered during the same year may be corrected by reversing the incorrect journal entry and then recording the appropriate journal entry.
However, if the material error is discovered in a subsequent year and affected prior year’s income statement, a prior period adjustment is required. The adjustment would correct the error by increasing or decreasing beginning retained earnings (R/E) and adjusting the appropriate balance sheet account. Beginning R/E is increased or decreased because the prior period’s net income was closed to R/E. Therefore, the error is reflected in the beginning R/E balance.
In this case, Althouse Co. should have capitalized the cost of the asset, $150,000 (Choice D). The asset would have been depreciated for 2 years, resulting in accumulated depreciation of $60,000 ($150,000 cost / 5-year useful life × 2 years elapsed) (Choice C). On January 2, Year 3, the following journal entry must be made to correct the prior period error.
On January 1, Year 3, a company changed its inventory costing method from LIFO to FIFO. The company’s Year 3 financial statements contain comparative information for Year 2. How should the company present the Year 1 effect of the change in accounting principle in its Year 3 comparative financial statements?
A. As an adjustment to the beginning Year 2 inventory balance with an offsetting adjustment to beginning Year 2 retained earnings.
B. As part of income from continuing operations in the Year 2 income statement.
C. As a prospective change in Year 3 and forward with no adjustment in Year 2.
D. As a note disclosure only.
A. As an adjustment to the beginning Year 2 inventory balance with an offsetting adjustment to beginning Year 2 retained earnings.
During Year 3, Company A increased its investment in Company B from 10% interest, purchased in Year 2, to 30% and acquired a seat on Company B’s board of directors. As a result of its increased investment, Company A changed its method of accounting for the investment from the cost adjusted for fair value method to the equity method. Company A did not elect to use the fair value method to report its 30% investment in Company B. How should Company A classify and treat the above transaction on its financial statements?
A. Company A should classify the transaction as a change in accounting estimate and restate its financial statements retroactively.
B. Company A should classify the transaction as neither an accounting change nor an accounting error and restate its financial statements retroactively.
C. Company A should classify the transaction as neither an accounting change nor an accounting error and make no retroactive adjustments.
D. Company A should classify the transaction as a change in accounting estimate and make no retroactive adjustments.
C. Company A should classify the transaction as neither an accounting change nor an accounting error and make no retroactive adjustments.
In general, retroactive (ie, retrospective) adjustments are required when there is a change in accounting principle (ie, change from one generally accepted accounting principle to another). Historically, when an investor’s ownership interest in an investee’s stock increased to a point at which the equity method was applicable, the retroactive approach was required.
However, there is an exception allowing companies to adopt the equity method prospectively when it becomes applicable. The prospective approach applies the equity method in the current period and applicable future periods; this approach does not require restating prior period financial statements (Choice B).
The adoption of the equity method is not a change in reporting entity but instead results from an increase in an investment that gives the investor additional ownership interest. This adoption is not classified as a change in accounting principle or an error correction.
In this scenario, because Company A’s equity interest in Company B increased from 10% to 30% and the equity method is appropriate, Company A must prospectively apply the equity method without restating any prior period statements.
At the end of Year 1, Ritzcar Co. failed to accrue production costs incurred during Year 1 but paid (and recorded) in Year 2. The error was not repeated in Year 2. What was the effect of this error on Year 1 ending working capital and on the Year 2 ending retained earnings balance?
Working capital RE
A. Overstated Overstated
B. No effect Overstated
C. No effect No effect
D. Overstated No effect
D. Overstated No effect
Working capital (Current assets – Current liabilities) is a metric used to measure a company’s ability to meet its payment obligations as they come due. Ritzcar Co.’s failure to accrue production costs in Year 1 resulted in unrecorded accounts payable (lower current liabilities) and unrecorded expenses. The unrecorded liability overstates working capital in Year 1.
The unrecorded expense overstated net income, and therefore retained earnings, in Year 1. In Year 2, Ritzcar paid the costs and (incorrectly) recorded the expense (which should have been recorded in Year 1), resulting in an understatement of net income for Year 2. The overstatement from beginning (Year 1 ending) retained earnings, when combined with Year 2 net income, cancels out the error, so the Year 2 ending retained earnings are correct (no effect).
Things to remember:
Failure to record accounts payable results in understated liabilities, and therefore overstated working capital (Current assets – Current liabilities). Failure to record an expense will initially result in overstated net income and retained earnings, but the retained earnings error will cancel out if the expense is recorded in a later year.
Which of the following items requires a prior period adjustment to retained earnings?
A. Purchases of inventory this year were overstated by $5 million.
B. Available-for-sale debt securities were improperly valued last year by $20 million.
C. Revenue of $5 million that should have been deferred was recorded in the previous year as earned.
D. The prior year’s foreign currency translation gain of $2 million was never recorded.
C. Revenue of $5 million that should have been deferred was recorded in the previous year as earned.
This one assumes things in my opinion, but see below.
Restatement is accomplished by recording the cumulative effect of the error on the prior periods as an adjustment to the beginning balances of the affected assets and/or liabilities. An offsetting adjustment is made to the beginning balance of either retained earnings (for errors affecting net income) or accumulated othercomprehensive income (AOCI) (for errors affecting other comprehensive income [OCI]).
In this question, recording revenue of $5 million that should have been deferred in the previous year represents an error in applying GAAP. Since the error affected net income (ie, overstated last year’s income), a prior period adjustment to retained earnings is required.
(Choice A) Although overstating purchases of inventory in the current year represents an error (ie, COGS would be affected), it would not require a prior period adjustment to retained earnings if it is corrected during the current year.
On January 1, 2003, Warren Co. purchases a $600,000 machine, with a five-year useful life and no salvage value.
The machine is depreciated by the accelerated method for book and tax purposes. The machine’s carrying amount is $240,000 on December 31, 2004. On January 1, 2005, Warren changes to the straight-line method for financial-statement purposes. Warren can justify the change. Warren’s income tax rate is 30%.
In its 2005 financial statements, what amount should Warren report as the cumulative effect of this change?
A. $120,000
B. $84,000
C. $36,000
D. $0
D. $0
A change in depreciation method is treated as a change in estimate with the remaining book value at the beginning of the year of change being subject to the new method for the remainder of the asset’s life. No cumulative effect is reported.
During year 3, Paul Company discovered that the ending inventories reported on its financial statements were incorrect by the following amounts:
Year 1 $60,000 understated
Year 2 75,000 overstated
Paul uses the periodic inventory system to ascertain year-end quantities that are converted to dollar amounts using the FIFO cost method. Prior to any adjustments for these errors and ignoring income taxes, Paul’s retained earnings at January 1, year 3, would be
A. Correct.
B. $15,000 overstated.
C. $75,000 overstated.
D. $135,000 overstated.
C. $75,000 overstated.
The error in understating the year 1 ending inventory would have self-corrected by 1/1/Y3 (year 1 income understated by $60,000; year 2 income overstated by $60,000). The error in overstating the year 2 ending inventory would not have been corrected by 1/1/Y3. This error overstates both year 2 income and the 1/1/Y3 retained earnings balance by $75,000.
On January 1, year 2, Belmont Company changed its inventory cost flow method to the FIFO cost method from the LIFO cost method. Belmont can justify the change, which was made for both financial statement and income tax reporting purposes. Belmont’s inventories aggregated $4,000,000 on the LIFO basis at December 31, year 1. Supplementary records maintained by Belmont showed that the inventories would have totaled $4,800,000 at December 31, year 1, on the FIFO basis. Belmont does not have sufficient information to calculate the effect of the change in inventories for years prior to year 1. Assuming Belmont prepares comparative statements, and ignoring income taxes, the adjustment for the effect of changing to the FIFO method from the LIFO method should be reported by Belmont
A. In the year 2 income statement as an $800,000 loss from cumulative effect of change in accounting principle.
B. In the year 1 retained earnings statement as an $800,000 debit adjustment to the beginning balance.
C. As an adjustment to the balances of inventory, and a retrospective application to cost of goods sold, net income, and retained earnings in the year 1 comparative financial statements.
D. In the year 2 retained earnings statement as an $800,000 credit adjustment to the beginning balance.
C. As an adjustment to the balances of inventory, and a retrospective application to cost of goods sold, net income, and retained earnings in the year 1 comparative financial statements.
This answer is correct. Per ASC Topic 250, retrospective application requires the changes to be reflected in the carrying amounts of assets and liabilities of the first period presented. The financial statements for each individual prior period are adjusted to reflect the period-specific effects of applying the new accounting principle if it can be determined.
A company discovered two errors in its previously issued financial statements as of and for the year ended December 31, Year 1. A bonus of $10,000, which was earned but unpaid in Year 1, was not recorded. In addition, a refund of $250 for the December, Year 1, utilities was received and recorded as income in January, Year 2. Based on the correction of these errors, what debit (credit) adjustment, if any, should be made to retained earnings as of January 1, Year 2, ignoring tax effects?
A. ($250)
B. $0
C. $9,750
D. $10,000
C. $9,750
In this case, the company failed to record a $10,000 bonus payable to an employee. In accordance with the matching principle, because the bonus was earned by the employee in Year 1, it should have been recorded by the company in Year 1. Ignoring tax effects, the correcting entry is:
Retained earnings 10,000
Bonus payable
10,000
Additionally, the company failed to record a $250 utilities refund in Year 1. Although the refund was not received until Year 2, the refund relates to Year 1 utilities. Therefore, it should have been recorded as income in Year 1 (ie, as per the matching principle). The refund should be reclassified from income to retained earnings. Ignoring tax effects, the correcting entry is:
Income 250
Retained earnings
250
The two correcting entries can be combined as follows, resulting in a net debit to beginning retained earnings of $9,750 (Choices A, B, and D):
Retained earnings 9,750
Income 250
Bonus payable
10,000
Things to remember:
When an error is discovered in a prior period’s F/S, it is reported as an error correction and the prior F/S are restated. The cumulative effect of the error is reflected in the carrying values of affected assets or liabilities, with an offsetting adjustment (net of tax) to beginning retained earnings.
Conn Co. reported a retained earnings balance of $400,000 at December 31, year 1. In August, year 2, Conn determined that insurance premiums of $60,000 for the three-year period beginning January 1, year 1, had been paid and fully expensed in year 1. Conn has a 30% income tax rate. What amount should Conn report as adjusted beginning retained earnings in its year 2 statement of retained earnings?
A. $420,000
B. $428,000
C. $440,000
D. $442,000
B. $428,000
A correction of an error is treated as a prior period adjustment and is reported in the financial statements as an adjustment to the beginning balance of retained earnings in the year the error is discovered. The adjustment is reported net of the related tax effect. In year 1, insurance expense of $60,000 was recorded. The correct year 1 insurance expense was $20,000 ($60,000 × 1/3). Therefore, before taxes, 1/1/Y2 retained earnings is understated by $40,000. The net of tax effect is $28,000 [$40,000 − (30% × $40,000)], so the adjusted beginning retained earnings is $428,000 ($400,000 + $28,000).
On January 2, year 3, to better reflect the variable use of its only machine, Holly, Inc. elects to change its method of depreciation from the straight-line method to the units-of-production method. The original cost of the machine on January 2, year 1, is $50,000, and its estimated life is ten years. Holly estimates that the machine’s total life is 50,000 machine hours.
Machine-hour usage was 8,500 during year 2 and 3,500 during year 1. Machine-hour usage for year 3 is 3,800.
Holly’s income tax rate is 30%. Holly should report the accounting change in its year 3 financial statements as a(an)
A. Estimate change recognizing $3,800 of depreciation in year 3.
B. Estimate change recognizing $4,000 of depreciation in year 3.
C. Cumulative effect of a change in accounting principle of $1,400 in its income statement.
D. Adjustment to beginning retained earnings of $1,400.
B. Estimate change recognizing $4,000 of depreciation in year 3.
A change in depreciation method is accounted for as an estimate change. The remaining book value at the beginning of the year of change is allocated over the remaining useful life using the new method.
Book value January 1, year 3 = $50,000 - ($50,000/10)2 = $40,000.
Estimated remaining machine hours at January 1, year 3 = 50,000 − 8,500 − 3,500 = 38,000.
Depreciation expense for year 3 = 3,800($40,000/38,000) = $4,000.
