areaIII A. Accounting changes and error corrections

Question 1

Accounting Changes
There are two types of accounting changes:

Answer 1

● Change in Accounting Principle: This involves a change from one generally accepted accounting principle (GAAP) to
another. For example, switching from FIFO (First-In, First-Out) to LIFO (Last-In, First-Out) inventory accounting. change in accounting principle requires retrospective change by restating prior financial statements.

● Change in Accounting Estimate: This happens when an estimate is revised due to new information or new experience. For instance, changing the useful life of a fixed
asset. This requires prospective change by reflecting the change on now and future financial statements.

Question 2

Error Corrections refer to

Answer 2

the adjustments made to correct errors resulting from mathematical mistakes, mistakes in applying accounting
principles, or oversight or misuse of facts that existed at the time the financial statements were prepared. understatement of inventory requires retrospective change to financial statements.

Question 3

FAR1A001n
Which organization creates GAAP or the Generally Accepted Accounting Principles?
A. The Financial Accounting Standards Board
B. The Financial Accounting Standards Body
C. The Securities and Exchange Commission
D. The American Institute of Certified Public Accountants

Answer 3

A. The Financial Accounting Standards Board

FASB, the Financial Accounting Standards Board, is the organization that creates and updates the accounting standards that make up GAAP. FASB doesn’t have legal authority to enforce GAAP, since it is a private organization appointed by the government.

Question 4

Polk Co. acquires a forklift from Quest Co. for $30,000.
The terms require Polk to pay $3,000 down and finance the remaining $27,000.
On March 1, year 1, Polk pays the $3,000 down and accepted delivery of the forklift. Polk signed a note that requires Polk to pay principal payments of $1,000 per month for 27 months beginning July 1, year 1.
What amount should Polk report as an investing activity in the statement of cash flows for the year ended December 31, year 1?
A. $3,000
B. $9,000
C. $12,000
D. $30,000

Answer 4

A. $3,000

Only the $3,000 down payment would be an investing activity. The payments would be classified as a financing activity.

Question 5

FAR3B10010
Which of the following best describes the ‘principle of prudence’ in relation to contingencies?
A. Recognizing all possible losses but no gains until they are realized.
B. Avoiding any recognition of contingencies to prevent speculation.
C. Recognizing gains as soon as they are probable.
D. Disclosure of contingencies in the management discussion and analysis section.

Answer 5

A. Recognizing all possible losses but no gains until they are realized.

The principle of prudence involves recognizing all potential losses when they are possible, and gains only when realized.

Question 6

FAR1E10012
A business receives $24,000 for services to be delivered evenly over the next 12 months. What is the correct entry after one month on an accrual basis?
A) Debit Unearned Revenue $2,000, Credit Revenue $2,000
B) Debit Cash $24,000, Credit Revenue $24,000
C) Debit Unearned Revenue $24,000, Credit Revenue $24,000
D) Debit Cash $2,000, Credit Revenue $2,000

Answer 6

A) Debit Unearned Revenue $2,000, Credit Revenue $2,000

On an accrual basis, revenue is recognized when earned. After one month, $2,000 of service (1/12 of $24,000) has been delivered. This entry reduces the liability (unearned revenue) and recognizes the earned revenue.

Question 7

A company recently moved to a new building. The old building is being actively marketed for sale, and the company expects to complete the sale in four months. Each of the following statements is correct regarding the old building, except:
A. It will be reclassified as an asset held for sale.
B. It will be classified as a current asset.
C. It will no longer be depreciated.
D. It will be valued at historical cost.

Answer 7

D. It will be valued at historical cost.

Once an asset is being held for sale, it is no longer PPE and isn’t depreciated, nor will it be valued at historical cost – it will be held at net realizable value until it is sold. The other responses are true.

Question 8

FAR3C10028
Which of the following best describes funds received by a not-for-profit entity for a specified beneficiary where the entity has no variance power?
A. A contribution to the entity
B. An agency transaction
C. An unrestricted donation
D. A conditional promise to give

Answer 8

B. An agency transaction

Funds received by a not-for-profit entity for a specified beneficiary, where the entity has no variance power, are treated as an agency transaction, not as a contribution to the entity.

Question 9

FAR2D10039
Which statement is true regarding the costs to sell an asset held for sale?
A. They are capitalized and added to the asset’s carrying amount
B. They are expensed as incurred
C. They are ignored in measuring the asset’s fair value less costs to sell
D. They are amortized over the expected period until the sale

Answer 9

B. They are expensed as incurred

Costs to sell are expensed as incurred and are not capitalized or added to the asset’s carrying amount.

Question 10

If a company uses the aging method for its allowance for doubtful accounts, how would this impact its rollforward analysis of trade receivables?

A) It increases the trade receivables balance
B) It decreases the trade receivables balance
C) It is included as a separate line item in the rollforward
D) It has no direct impact on the trade receivables rollforward

Answer 10

D) It has no direct impact on the trade receivables rollforward

The aging method affects the allowance for doubtful accounts and the net realizable value of receivables but does not directly change the gross trade receivables balance in a rollforward analysis.

Question 11

FAR3G10004
Which of the following situations would typically require an adjustment to the financial statements as a subsequent event?
A) A major customer declaring bankruptcy after the balance sheet date.
B) A significant decline in market value of investments after the balance sheet date.
C) The discovery of an error in the financial statements after they have been issued.
D) The sale of a major division of the company after the balance sheet date.

Answer 11

A) A major customer declaring bankruptcy after the balance sheet date.

If a major customer declares bankruptcy after the balance sheet date and this bankruptcy reflects the customer’s financial condition as of the balance sheet date, it is considered a Type I subsequent event. Such events provide additional evidence about conditions that existed at the balance sheet date and typically require an adjustment to the financial statements.

Question 12

FAR2D10042
In subsequent periods, how should an impairment loss recognized on an asset held for sale be reversed if the fair value less costs to sell increases?
A. The impairment loss can be reversed up to the newly estimated fair value less costs to sell
B. The impairment loss cannot be reversed
C. The impairment loss is reversed fully regardless of the new fair value
D. Only half of the impairment loss can be reversed

Answer 12

B. The impairment loss cannot be reversed

For assets classified as held for sale, once an impairment loss is recognized, it cannot be reversed in subsequent periods even if the fair value less costs to sell increases.

Question 13

FAR3F10001
How should a lessee account for a residual value guarantee in a leasing arrangement?
A. Recognize as a liability at the inception of the lease.
B. Expense it evenly over the lease term.
C. Recognize as an asset at the inception of the lease.
D. Include in the measurement of lease liabilities and right-of-use assets.

Answer 13

D. Include in the measurement of lease liabilities and right-of-use assets.

The appropriate treatment for a residual value guarantee by the lessee is to include it in the measurement of lease liabilities and right-of-use assets. This is because the guarantee is a part of the future lease payments, impacting the total lease obligation and the corresponding asset recognized.

Question 14

FAR1A40010
In the context of a statement of changes in equity, what does ‘other comprehensive income’ include?
A) Regular business expenses.
B) Profits from day-to-day operations.
C) Gains and losses not recognized in the profit or loss.
D) Dividends paid to shareholders.

Answer 14

C) Gains and losses not recognized in the profit or loss.

Other comprehensive income includes items of income and expense that are not recognized in the profit or loss as required or permitted by other IFRSs.
This does not include regular business expenses (Option A) or profits from day-to-day operations (Option B), which are part of the income statement. It also does not include dividends paid to shareholders (Option D), as these are distributions of profit, not components of comprehensive income.

Question 15

FAR2G10030
What happens to the ARO liability and ARC when the associated asset is sold before the retirement obligation is settled?
A) The ARO liability and ARC are transferred to the new owner.
B) The ARO liability is settled, and ARC is removed from the balance sheet.
C) The ARO liability and ARC are derecognized, and a gain or loss is recognized.
D) The ARO liability is maintained, and ARC continues to be depreciated.

Answer 15

C) The ARO liability and ARC are derecognized, and a gain or loss is recognized.

Upon the sale of the asset, both the ARO liability and the ARC are derecognized, and any resulting gain or loss is recognized in the income statement.

Question 16

FAR2H004n
Drake Inc. recorded in its books a loan obtained on January 1, year 2. The loan is a 8%, $1,000,000 loan with interest due annually on December 31. Drake did not record or pay the required year 2 interest payment until January 1, year 3.
Calculate the interest expense Drake should record on December 31, year 2.
A. $80,000
B. $0
C. $1,080,000
D. $40,000

Answer 16

A. $80,000

Interest amount calculation: $1,000,000 x 8% = $80,000
Provision for liability entry to be recorded in the books on December 31, year 2:
Debit: Interest expense $80,000
Credit: Accrued interest payable $80,000

Question 17

FAR2D10018
A piece of equipment with a cost of $100,000, accumulated depreciation of $40,000, and a remaining loan balance of $30,000 is sold for $70,000. What is the gain or loss on the sale?
A. Gain of $10,000
B. Loss of $10,000
C. Gain of $30,000
D. No gain or loss

Answer 17

A. Gain of $10,000

The book value is the cost ($100,000) minus accumulated depreciation ($40,000), equaling $60,000. The sale price is $70,000. Thus, the gain is $70,000 – $60,000 = $10,000. The loan balance does not affect the calculation.

Question 18

Hudson Corp. operates several factories that manufacture medical equipment. The factories have a historical cost of $200 million. Near the end of the company’s fiscal year, a change in business climate related to a competitor’s innovative products indicated to Hudson’s management that the $170 million carrying amount of the assets of one of Hudson’s factories may not be recoverable. Management identified cash flows from this factory and estimated that the undiscounted future cash flows over the remaining useful life of the factory would be $150 million. The fair value of the factory’s assets is reliably estimated to be $135 million. The change in business climate requires investigation of possible impairment. Which of the following amounts is the impairment loss?

A. $15 million
B. $20 million
C. $35 million
D. $65 million

Answer 18

C. $35 million

To test for an impairment loss, there are two steps:

Is the carrying value greater than the undiscounted cash flows? In this case yes, so step two is:
Subtract fair value from carrying value: $170 million – $135 million = $35 million impairment

Question 19

FAR1B30008
How does the statement of cash flows complement the balance sheet in a not-for-profit entity?
A. By providing a detailed analysis of the entity’s market value.
B. By showing changes in the entity’s equity structure.
C. By explaining the changes in cash balances reported on the balance sheet.
D. By revealing the entity’s creditworthiness to lenders.

Answer 19

C. By explaining the changes in cash balances reported on the balance sheet.

The statement of cash flows complements the balance sheet by detailing the reasons behind changes in cash balances over the period, linking the opening and closing balances of cash on the balance sheet.

Question 20

FAR1A20025
If a company failed to record the write-down of inventory, the necessary adjustment in the income statement would be to:
A) Increase the cost of goods sold.
B) Decrease the cost of goods sold.
C) Increase operating income.
D) No adjustment needed as inventory write-downs affect only the balance sheet.

Answer 20

A) Increase the cost of goods sold.

A write-down of inventory should be reflected as an increased cost of goods sold, affecting net income.

B) is incorrect as it decreases cost of goods sold, which is contrary to the needed adjustment. C) is incorrect as the write-down decreases, not increases, operating income. D) is incorrect because inventory write-downs affect both the balance sheet and the income statement.

Question 21

White Inc owes a bank $500,000 and one year of accrued interest at 10%. White is having financial difficulties and the bank agrees to restructure the loan to be $200,000 due in 10 years at the same 10% interest. What gain would White recognize on this debt restructuring?
A. There is no gain
B. $150,000
C. $240,000
D. $300,000

Answer 21

B. $150,000

The gain in this type of question compares the original loan amount to the total cash flows of the new deal.
The original loan is $500,000 + $50,000 of accrued interest = $550,000.
The cash flows from the new agreement total: $20,000 per year interest for 10 years = $200,000 + the new $200,000 principal amount = $400,000.
So overall White was relieved of $150,000 (550,000 – 400,000), so the gain is $150,000.

Question 22

FAR2G10017
A company announces a voluntary redundancy program and estimates that 30% of eligible employees will accept. How should this be accounted for?
A) As a liability for the estimated 30% acceptance rate.
B) No liability is recognized until actual acceptances are received.
C) Recognized as a liability for all eligible employees.
D) Expensed in the income statement as a contingent liability.

Answer 22

A) As a liability for the estimated 30% acceptance rate.

A liability should be recognized based on a reasonable estimate of the number of employees expected to accept the offer.

Question 23

FAR3E10026
What is the primary difference between Level 2 and Level 3 inputs in the fair value hierarchy?
A. Level 2 inputs are observable, while Level 3 inputs are not.
B. Level 2 inputs are for liabilities only, while Level 3 inputs are for assets only.
C. Level 2 inputs use historical cost, while Level 3 inputs use replacement cost.
D. Level 2 inputs are based on market participant assumptions, while Level 3 inputs are not.

Answer 23

A. Level 2 inputs are observable, while Level 3 inputs are not.

The primary distinction between Level 2 and Level 3 inputs is observability. Level 2 inputs are observable in the market, albeit not as directly as Level 1 inputs. Level 3 inputs are not observable and require significant estimation and judgment.

Question 24

FAR3C10001

Which of the following is the first step in the five-step revenue recognition model?

A. Determine the transaction price
B. Identify the contract with a customer
C. Recognize revenue when or as performance obligations are satisfied
D. Allocate the transaction price to the performance obligations in the contract

Answer 24

B. Identify the contract with a customer

The first step in the five-step revenue recognition model is to identify the contract with a customer. This step is crucial as it establishes the formal agreement between the parties that creates enforceable rights and obligations.

A is incorrect because determining the transaction price is the third step. C is incorrect as recognizing revenue is the fifth and final step. D is incorrect because allocating the transaction price is the fourth step.

Question 25

FAR3G10012

If a company discovers a significant error in its inventory valuation after the balance sheet date but before the issuance of financial statements, how should this be reflected?
A) Adjust the inventory and retained earnings in the financial statements.
B) Disclose the error in the notes to the financial statements without adjusting inventory.
C) Treat the error as a prior period adjustment.
D) Ignore the error as it was discovered after the balance sheet date.

Answer 25

A) Adjust the inventory and retained earnings in the financial statements.

The discovery of a significant error in inventory valuation after the balance sheet date but before the issuance of financial statements is a Type I subsequent event. It provides evidence about conditions that existed at the balance sheet date and requires adjustment to the financial statements. The inventory and possibly retained earnings accounts should be adjusted to reflect the correct valuation.

Question 26

FAR3F10012
Which of the following conditions would lead to a lease being classified as an operating lease?
A. Ownership of the asset transfers to the lessee at the end of the lease term.
B. The present value of lease payments equals or exceeds substantially all of the fair value of the leased asset.
C. The lessee has the option to purchase the asset at a price expected to be lower than the fair value at the date the option becomes exercisable.
D. None of the indicators for a finance lease are met.

Answer 26

D. None of the indicators for a finance lease are met.

A lease is classified as an operating lease if it does not meet any of the criteria for a finance lease. This includes not transferring ownership, not covering the major part of the asset’s life, and not having a bargain purchase option.

Question 27

FAR3G10024
If a company identifies a significant overstatement in its inventory valuation after the balance sheet date but before the financial statements are issued, what is the appropriate treatment?
A) Revise the previous year’s financial statements.
B) Adjust the current period’s inventory and retained earnings.
C) Disclose the overstatement in the notes but do not adjust inventory.
D) Treat it as a non-adjusting event and take no action.

Answer 27

B) Adjust the current period’s inventory and retained earnings.

Discovering an overstatement in inventory valuation after the balance sheet date but before the financial statements are issued is a Type I subsequent event. It provides evidence about conditions that existed at the balance sheet date and requires an adjustment to the financial statements. The inventory and possibly retained earnings should be adjusted to reflect the correct valuation.

Question 28

FAR3D10006
What is the treatment of interest and penalties related to uncertain tax positions in financial statements?
A. They are recognized as part of income tax expense.
B. They are recognized as a separate line item under operating expenses.
C. They are only disclosed in the notes to the financial statements.
D. They are not recognized until paid.

Answer 28

A. They are recognized as part of income tax expense.

Interest and penalties related to uncertain tax positions are generally recognized as part of the income tax expense in the financial statements. This treatment is consistent with the principle of recognizing all expenses related to income taxes in the income tax expense line.

Question 29

FAR3G10013
A lawsuit that had been pending at the balance sheet date was settled for $500,000 after the balance sheet date but before the financial statements were issued. The company had previously recognized a provision of $300,000 related to this lawsuit. What adjustment is required?
A) Increase the provision by $200,000.
B) Decrease the provision by $200,000.
C) No adjustment is required.
D) Disclose the settlement in the notes and adjust the provision to $500,000.

Answer 29

A) Increase the provision by $200,000.

Since the lawsuit settlement amount ($500,000) is higher than the previously recognized provision ($300,000), the company should increase its provision by $200,000 to reflect the actual settlement amount. This is a Type I subsequent event as it provides additional information about a condition (the lawsuit liability) that existed at the balance sheet date.

Question 30

Fern Co. has net income, before taxes, of $100,000, including $20,000 interest revenue from municipal bonds and $10,000 paid for officers’ life insurance premiums where the company is the beneficiary. The tax rate for the current year is 10%. What is Fern’s effective tax rate?

A. 8%
B. 9%
C. 7%
D. 10%

Answer 30

B. 9%

The ‘effective’ tax rate is the taxes actually paid over net income. Temporary and permanent differences can increase or decrease taxable income from net income (book income), and then the taxes actually paid over the net income amount gives you the effective tax rate.

In this example, taxable income is $90,000: $100,000 – 20,000 for muni bond interest, + 10,000 paid for officers’ life insurance = $90,000

So taxes paid are 90,000 * 10% = $9,000.

Then, the $9,000 over the original $100,000 of net income is an effective tax rate of 9%

Just in case: The muni bond interest is subtracted because this isn’t taxable but it was counted as revenue in net income. The $10,000 of officer life insurance is an expense for book income, but it is taxable so it is added back in to taxable income.

Question 31

FAR3B10016
A company is facing a possible fine of $500,000, but the likelihood of being fined is unknown. What should be the accounting treatment?
A. Record a liability of $500,000.
B. Record a contingent liability.
C. Disclose the situation in the financial notes.
D. No action is necessary.

Answer 31

C. Disclose the situation in the financial notes.

When the likelihood cannot be determined, disclosure in the notes is appropriate.

Question 32

FAR3B004nsim

Peterson Co. owns 100% of the outstanding common stock of Silver Corp. On January 1, year 2, Peterson sold equipment to Silver for $120,000, which was originally purchased on January 1, year 1 for $100,000. Peterson was depreciating the equipment over 5 years using straight-line depreciation. There was no salvage value. Siver decides to depreciate the equipment over four years, also using straight-line depreciation with no salvage value. Assume all other appropriate year-end and income tax journal entries have been made.

Calculate the Value of asset to be considered in the eliminating journal entries required for consolidation purposes for the year ended December 31, year 2.

A. $30,000
B. $20,000
C. $10,000
D. $120,000

Answer 32

B. $20,000

Elimination entries are made for removing the effects of intercompany transactions.

There are, basically, three types of intercompany eliminations as follows:

1. Intercompany debt: Eliminates any loans made from one entity to another within the group, since these only result in offsetting notes payable and receivable, as well as offsetting interest expense and interest income. These issues most commonly arise when funds are being moved between entities by a centralized treasury department.
2. Intercompany revenue and expenses: Eliminates the sale of goods or services from one entity to another within the group. This means that the related revenues, cost of goods sold, and profits are all eliminated. The reason for these eliminations is that a company cannot recognize revenue from sales to itself; all sales must be to external entities. These issues most commonly arise when a company is vertically integrated.
3. Intercompany stock ownership: Eliminates the ownership interest of the parent company in its subsidiaries

The original cost of equipment for Peterson = $100,000. Accumulated depreciation as of January 1, year 2 = $20,000 [($100,000/5)x1]. Hence the value of the equipment in the books of Peterson as on January 1, Year 2 = Cost – accumulated depreciation = $100,000 – $20,000 = $80,000

Cost of the equipment in the books of Silver on purchase of the asset = $120,000. Silver has decided to depreciate the equipment over eight years, also using straight-line depreciation with no salvage value.

The cost of the asset should be written down to its original price $100,000 in the books for consolidation purposes. Hence the asset is overvalued by $20,000 [$120,000 – $100,000] which is to be eliminated by giving credit to the Equipment account in the Consolidated Financial Statements.

Question 33

FAR1A50031
How does the purchase of inventory on credit affect the statement of cash flows?
A. It increases cash flows from operating activities.
B. It decreases cash flows from operating activities.
C. It has no immediate impact on the statement of cash flows.
D. It increases cash flows from financing activities.

Answer 33

C. It has no immediate impact on the statement of cash flows.

Transactions on credit do not impact the cash flows until the actual payment is made.

Question 34

FAR1F10016
To determine a company’s efficiency in generating profit from operations before financing and taxes, which ratio is used?
A. Gross Profit Margin
B. Operating Margin
C. Net Profit Margin
D. Return on Assets

Answer 34

B. Operating Margin

Operating Margin is calculated by dividing Operating Income (income from operations before interest and taxes) by Revenue. It assesses how much profit a company makes on a dollar of sales before interest and taxes. A focuses on cost of goods sold, C includes all income and expenses, and D measures asset efficiency.