Foy Corp. failed to accrue warranty costs of $50,000 in its December 31, 2003 financial statements. In addition, a change from straight-line to accelerated-depreciation made at the beginning of 2004 resulted in a $30,000 decrease in income for the year. Both the $50,000 and the $30,000 are net of related income taxes.
What amount should Foy report as Prior period adjustments in 2004?
The failure to accrue warranty expense is an accounting error. It gives rise to a Prior period adjustment in the year of discovery (2004).
Prior period adjustments are limited to corrections of errors affecting prior-year net income. They adjust the beginning balance of retained earnings in the year of correction. The change in depreciation method is an estimate change, which is reported in earnings. It is not a Prior period adjustment.
How should a company report its decision to change from a cash-basis to an accrual-basis of accounting?
- As a change in accounting principle, requiring the cumulative effect of the change (net of tax) to be reported in the income statement.
- Prospectively, with no amounts restated and no cumulative adjustment.
- As an extraordinary item (net of tax).
- As a Prior period adjustment (net of tax), by adjusting the beginning balance of retained earnings.
As a Prior period adjustment (net of tax), by adjusting the beginning balance of retained earnings.
The accrual basis of accounting is required by GAAP. A change from an inappropriate method to the correct method is treated as an error correction. The procedure requires retrospective application, resulting in an after-tax cumulative adjustment to prior years' earnings (called a Prior period adjustment) to the beginning balance in retained earnings.
Miller Co. discovers 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 is 40%.
What was the impact of the error on Miller's financial statements for the prior year?
- Understatement of accumulated depreciation of $24,000.
- Understatement of accumulated depreciation of $40,000.
- Understatement of depreciation expense of $24,000.
- Understatement of net income of $24,000.
Understatement of accumulated depreciation of $40,000.
Accumulated depreciation is a pre-tax amount. The journal entry omitted in the past is:
dr. Depreciation expense, $40,000;
cr. Accumulated depreciation, $40,000.
The beginning balance of accumulated depreciation in the year the error was discovered is understated by $40,000 because that amount was not recorded in a prior year.
How should the effect of a change in accounting estimate be accounted for?
- By restating amounts reported in financial statements of prior periods.
- By reporting pro forma amounts for prior periods.
- As a Prior period adjustment to beginning retained earnings.
- In the period of change and future periods if the change affects both.
In the period of change and future periods if the change affects both.
Accounting-estimate changes are treated currently and prospectively (in the future).
If the change affects only the current period, then only current-period earnings is affected. More frequently, though, the change affects future periods as well. Then, current and future earnings are affected.
An estimate change is never treated retroactively. Prior-year earnings are never adjusted for a change in estimate, because the information giving rise to the change could not have been known in prior periods.
On January 2, 2003, Raft Corp. discovers that it had incorrectly expensed a $210,000 machine purchased on January 2, 2000. Raft estimates the machine's original useful life to be ten years and its salvage value at $10,000. Raft uses the straight-line method of depreciation and is subject to a 30% tax rate. In its December 31, 2003, financial statements, what amount should Raft report as a Prior period adjustment?
Depreciation for three years (2000-02) is 3($210,000 - $10,000)/10 or $60,000. Through the beginning of 2003, retained earnings before tax, therefore, is understated $150,000 ($210,000 from immediate expensing of the asset, less $60,000 of depreciation, that would have been taken through 2002). The after-tax understatement is .70 x $150,000 = $105,000. Prior period adjustments are recorded as of the beginning of the year in which the error is discovered
Conn Co. reports a retained-earnings balance of $400,000 at December 31, 2004.
In August 2005, Conn determines that insurance premiums of $60,000 for the three-year period beginning January 1, 2004 had been paid and fully expensed in 2004. Conn has a 30% income tax rate.
What amount should Conn report as adjusted beginning retained earnings in its 2005 statement of retained earnings?
The 2005 statement of retained earnings must disclose a Prior period adjustment to the beginning retained-earnings balance for the amount required to correct prior-year net income.
- 2004 insurance expense actually recognized (in error) $60,000
- Less 2004 correct insurance expense - the amount that should have been recognized ($60,000/3 - a three-year policy) ($20,000)
- Equals the error in pre-tax income before 2005(income understated) $40,000
- Times (1 - tax rate) to determine after-tax errorx .70
- Equals the error correction, the amount by which retained earnings at January 1, 2005 must be increased(the Prior period adjustment) $28,000
- Plus unadjusted retained earnings at January 1, 2005 $400,000
- Equals adjusted retained earnings at January 1, 2005 $428,000
On January 2, 2005, Air, Inc. agrees to pay its former president $300,000 under a deferred-compensation arrangement.
Air should have recorded this expense in 2004, but did not do so. Air's reported income tax expense would have been $70,000 lower in 2004 had it properly accrued this deferred compensation.
In its December 31, 2005 financial statements, Air should adjust the beginning balance of its retained earnings by a
- $230,000 credit.
- $230,000 debit.
- $300,000 credit.
- $370,000 debit.
The after-tax amount of the overstatement of 2004 earnings is $230,000 ($300,000 - $70,000 tax effect).
2004 income is overstated by this amount, because the expense and tax effect were not recorded. Ending 2004 retained earnings is overstated by $230,000. Therefore, beginning 2005 retained earnings must be decreased (debited) $230,000. This is accomplished by adjusting the beginning 2005 retained earnings balance with a Prior period adjustment of $230,000 (debit).
In which of the following situations should a company report a Prior period adjustment?
- A change in the estimated useful lives of fixed assets purchased in prior years.
- The correction of a mathematical error in the calculation of prior years' depreciation.
- A switch from the straight-line to double-declining-balance method of depreciation.
- The scrapping of an asset prior to the end of its expected useful life.
The correction of a mathematical error in the calculation of prior years' depreciation.
A Prior period adjustment is defined as the correction of an error affecting prior-year income. The adjustment reverses the error by correcting beginning retained earnings in the year of discovery. If depreciation in a prior year is misstated, then income in that year is also incorrect, as well as the balance in retained earnings. The Prior period adjustment corrects retained earnings and accumulated depreciation.
On January 1, year one, Newport Corp. purchases a machine for $100,000. The machine is depreciated using the straight-line method over a ten-year period with no residual value. Because of a bookkeeping error, no depreciation was recognized in Newport's year-one financial statements, resulting in a $10,000 overstatement of the book value of the machine on December 31, year one. The oversight was discovered during the preparation of Newport's year-two financial statements. What amount should Newport report for depreciation expense on the machine in the year-two financial statements?
The year-one error has no bearing on the amount of depreciation to be recognized in subsequent years. Annual depreciation is $10,000 (= $100,000/10). In year two, a Prior period adjustment will be recorded, correcting beginning retained earnings and accumulated depreciation. Year-one statements reported comparatively with year two's statements will be shown correctly. Year two will report $10,000 of depreciation expense.
At the end of 2003, Ritzcar Co. fails to accrue sales commissions earned during 2003, but paid in 2004. The error is not repeated in 2004.
What was the effect of this error on 2003 ending working capital and on the 2004 ending retained earnings balance?
- 2003 ending working capital
- 20x4 ending retained earnings
- 2003 ending working capital - Overstated
- 20x4 ending retained earnings - No effect
The entry that should have been accrued at the end of 2003 is:
dr.Commission expense xxx
- cr.Commission payable xxx
Working capital (current assets, less current liabilities) is overstated, because current liabilities (via unrecorded commission payable) are understated. By the end of 2004, the error has counterbalanced. The commission expense attributable to 2003 (in the above entry) would have been recognized as expense upon payment in 2004. Although earnings of both years are in error, the ending retained earnings balance for 2004 is correct.