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Flashcards in FAR 38 (2) Deck (25):
1

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?

$10,000
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.

2

In single period statements, which of the following should be reflected as an adjustment to the opening balance of retained earnings?
A. Effect of a failure to provide for uncollectible accounts in the previous period.
B. Effect of a decrease in the estimated useful life of depreciable equipment.
C. Adoption of a new accounting method for transactions that in the past had an immaterial effect on the financial statements.
D. Cumulative effect of a change from an accelerated method to straight-line depreciation.

A. This is an error correction. The correction of an error affecting the income of prior periods is accounted for as a Prior period adjustment. This adjustment corrects the beginning retained earnings balance in the period the error was discovered, thereby correcting the retained earnings carried forward from earlier periods.

3

Cuthbert Industrials, Inc. prepares three-year comparative financial statements. In year 3, Cuthbert discovered an error in the previously issued financial statements for year 1. The error affects the financial statements that were issued in years 1 and 2. How should the company report the error?
A. The financial statements for years 1 and 2 should be restated; an offsetting adjustment to the cumulative effect of the error should be made to the comprehensive income in the year 3 financial statements.
B. The financial statements for years 1 and 2 should not be restated; financial statements for year 3 should disclose the fact that the error was made in prior years.
C. The financial statements for years 1 and 2 should not be restated; the cumulative effect of the error on years 1 and 2 should be reflected in the carrying amounts of assets and liabilities as of the beginning of year 3.
D. The financial statements for years 1 and 2 should be restated; the cumulative effect of the error on years 1 and 2 should be reflected in the carrying amounts of assets and liabilities as of the beginning of year 3.

D. When there is an error in prior period financial statements and those statements are presented with the current year, the error should be corrected in years 1 and 2 so they are comparative to year 3. The effect of the error should be reflected in the year 3 beginning balances of the appropriate asset and liabilities.

4

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
A. $230,000 credit.
B. $230,000 debit.
C. $300,000 credit.
D. $370,000 debit.

B. 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).

5

In which of the following situations should a company report a Prior period adjustment?
A. A change in the estimated useful lives of fixed assets purchased in prior years.
B. The correction of a mathematical error in the calculation of prior years' depreciation.
C. A switch from the straight-line to double-declining-balance method of depreciation.
D. The scrapping of an asset prior to the end of its expected useful life.

B. 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.

6

How should the effect of a change in accounting estimate be accounted for?
A. By restating amounts reported in financial statements of prior periods.
B. By reporting pro forma amounts for prior periods.
C. As a Prior period adjustment to beginning retained earnings.
D. In the period of change and future periods if the change affects both.

D. 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.

7

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?
A. $102,900
B. $105,000
C. $165,900
D. $168,000

B. 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

8

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?
A. Understatement of accumulated depreciation of $24,000.
B. Understatement of accumulated depreciation of $40,000.
C. Understatement of depreciation expense of $24,000.
D. Understatement of net income of $24,000.

B. 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.

9

T/F: All prior period adjustments cause an adjustment to beginning retained earnings.

True

10

T/F: A machine purchased at the beginning of Year 1 is expensed immediately. The machine had no salvage value but was expected to last five years. The error is discovered in Year 3. The prior period adjustment is recorded (the adjustment to retained earnings in the journal entry) in an amount equal to 3 years of depreciation.

True

11

T/F: Because most errors eventually counterbalance, no correction is needed.

False.
If corrections are not applied, FS for prior years will remain in error.

12

T/F: Beginning inventory is understated in Year 3 by $6,000. The error is discovered in Year 3. No prior period adjustment is needed.

False.
This means the inventory is understated in the ending inv. balance in Year 2.

13

T/F: Inventory is overstated at the end of Year 3. The error is not discovered until Year 5. The error has counterbalanced; therefore, there are no errors in prior year statements shown comparatively with Year 5.

False.
The beginning inventory balance in Year 4 would be understated, even if it corrected itself by the end of Year 4, there is still an error in the FS.

14

T/F: All error corrections require a prior period adjustment.

False.
Errors made in the current year but discovered before the closing process are corrected without special procedures.

15

T/F: All error corrections require an adjustment to beginning retained earnings.

False.
Errors made in the current year but discovered before the closing process are corrected without special procedures.

16

Finch Co. reported a total asset retirement obligation of $257,000 in last year's financial statements. This year, Finch acquired assets subject to unconditional retirement obligations measured at undiscounted cash flow estimates of $110,000 and discounted cash flow estimates of $68,000. Finch paid $87,000 toward the settlement of previously recorded asset retirement obligations and recorded an accretion expense of $26,000. What amount should Finch report for the asset retirement obligation in this year's balance sheet?

$264,000
The ending balance of the ARO should be the beginning balance plus the discounted cash flow estimate of the new asset plus accretion expense less the amount paid.

257,000 + 68,000 - 87,000 + 26,000 = 264,000

17

The recording of an asset retirement obligation for a natural resources development site increases which of the following for the firm involved in the site?
Liability
Depletion base

Yes, yes
An asset retirement obligation is recorded when a firm has a probable and estimable future cost to reclaim the property exploited at the end of the project life. The amount is the fair value or present value of future cash payments to be made. The asset retirement obligation is recorded as a debit to the natural resources account (depletion base) and a credit to a liability.

18

Choose the best description of accretion expense associated with an asset retirement obligation.
A. Interest expense.
B. Finance charge.
C. Growth in asset retirement obligation.
D. Depletion expense.

C. Accretion expense is simply the increase in the asset retirement obligation over time. The asset retirement obligation is initially recorded at present value or fair value and, over time, grows with interest until it reaches its future value - the amount due. Accretion expense is similar to the interest cost component of pension expense - the growth in projected benefit obligation. It is caused by the fact that the asset retirement obligation is recorded at present value but not paid until later.

19

At the beginning of the year, the carrying value of an asset was $1,000,000 with 20 years of remaining life. The fair value of the liability for the asset retirement obligation was $100,000. At year end, the carrying value of the asset was $950,000. The risk-free interest rate was 5%. The credit-adjusted risk-free interest rate was 10%. What was the amount of accretion expense for the year related to the asset retirement obligation?

$10,000
The ARO increases over time while the book value of the asset decreases through the depreciation or depletion of the asset. The accretion rate for the ARO is based on the liability (not the asset) at the credit-adjusted risk-free rate. Therefore, the ARO $100,000 x .10 = $10,000 of accretion expense for the year.

20

At the beginning of the current year, a firm invested $30 million in a natural resources site. This amount was applied to the acquisition of the mineral rights, exploring for the resource (full-costing method is used), and development. In addition, the firm must bring the property back to its original state three years from today. Two estimates of the future cost for that future effort are: (1) $6 million with 30% probability, and (2) $4 million with 70% probability. 6% is the appropriate risk adjusted rate of return. The present value of $1 in three years at 6% is 0.83962. By the end of the current year, the firm had removed 20% of the total estimated resource in the deposit. Compute depletion and accretion expense for the current year.
Depletion
Accretion expense

Depletion = 6,772,450
Accretion expense = 231,735

Asset retirement obligation beginning balance = [$6,000,000(.30) + $4,000,000(.70)](0.83962) = $3,862,252. This is the present value of the expected future cost of reclaiming the property. The risk-adjusted rate of return is used because the probabilities account for the uncertainty of the cash flow amounts. This beginning balance is added to the $30 million figure for a total of $33,862,252 capitalized depletion base. Depletion is 20% of that amount or $6,772,450. Accretion expense is the growth in the asset retirement obligation for the year or .06($3,862,252) = $231,735.

21

T/F: Accretion expense is not included in the amount of interest capitalized for a period.

True

22

T/F: The amount recognized in an asset retirement obligation is also capitalized to the natural resources depletion base.

True

23

T/F: An asset retirement obligation is expensed when recognized.

False.
Firms are required to capitalize future asset retirement costs in the underlying asset account, and also in an ARO liability. The costs are incurred at the end of an asset's life, but are capitalized when they become estimable.

24

T/F: Environmental obligations are not directly associated with an asset.

True
Not directly.

25

T/F: An environmental liability must be accrued when the responsibility for the environmental remediation is probable although not estimable.

False.
It must also be estimable to be accrued.

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