FAR 38 - Accounting Changes and Error Corrections Flashcards Preview

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Flashcards in FAR 38 - Accounting Changes and Error Corrections Deck (42):
1

Lore Co. changed from the cash basis to the accrual basis of accounting during 2005. The cumulative effect of this change should be reported in Lore's 2005 financial statements as a
A. Prior period adjustment resulting from the correction of an error.
B. Prior period adjustment resulting from the change in accounting principle.
C. Adjustment to retained earnings for an accounting principle change.
D. Component of income after extraordinary item.

A. The cash basis of accounting is not acceptable under GAAP. Therefore, the change to the accrual basis is a change from an unacceptable method or basis of accounting to an acceptable method or basis. Such a change is treated as an error correction, which is reported as a Prior period adjustment. This adjustment is to the beginning balance in retained earnings for the current year.

2

The effect of a change in accounting principle that is inseparable from the effect of a change in accounting estimate should be reported
A. By restating the financial statements of all prior periods presented.
B. As a correction of an error.
C. As a component of income from continuing operations, in the period of change and future periods if the change affects both.
D. As a separate disclosure after income from continuing operations, in the period of change and future periods if the change affects both.

C. When an accounting principle change cannot be distinguished from an estimate change, it is accounted for as an estimate change. Changes in accounting estimate are accounted for currently and prospectively and are reported in income from continuing operations. The relevant accounts affected by the change are adjusted for the current and future years. The change is not retroactively applied.

3

The cumulative effect of a change in accounting principle should be recorded as an adjustment to retained earnings, when the change is:
A. Cash basis of accounting for vacation pay to the accrual basis.
B. Straight-line method of depreciation for previously recorded assets to the double-declining-balance method.
C. Longer useful life of equipment to shorter useful life.
D. Completed-contract method of accounting for long-term construction-type contracts to the percentage-of-completion method.

D. Accounting-principle changes such as this one are recorded by retroactively restating prior-year financial statements. The entry to record the change results in an adjustment to the beginning balance of retained earnings in the year of the change.

4

How should a company report its decision to change from a cash-basis to an accrual-basis of accounting?
A. As a change in accounting principle, requiring the cumulative effect of the change (net of tax) to be reported in the income statement.
B. Prospectively, with no amounts restated and no cumulative adjustment.
C. As an extraordinary item (net of tax).
D. As a Prior period adjustment (net of tax), by adjusting the beginning balance of retained earnings.

D. 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.

5

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?

$50,000
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.

6

In 2005, Brighton Co. changed from the individual-item approach to the aggregate approach in applying the lower of FIFO cost or market to inventories.

The cumulative effect of this change should be reported in Brighton's financial statements as a
A. Prior period adjustment, with separate disclosure.
B. Component of income from continuing operations, with separate disclosure.
C. Component of income from continuing operations, without separate disclosure.
D. Cumulative-effect adjustment to retained earnings, with separate disclosure.

D. This accounting change is a change in the application of an accounting principle, which merits the reporting of a cumulative effect of accounting principle change.

Accounting-principle changes, as well as changes in the application of principles, are accounted for using the retrospective approach, which recognizes the effect of the change on all prior years affected as an adjustment to retained earnings at the beginning of the year of change.

7

T/F: A change from an inappropriate principle to the correct method requires restated prior year financial statements.

True

8

T/F: Estimate changes and accounting principle changes both cause an adjustment to beginning retained earnings in the year of the change.

False.
Accounting principle change is either retrospective or prospective; accounting estimate change is prospective; correction of an error requires restatement.
Error corrections and accounting principle changes are both recorded with the same procedures.

9

T/F: A principle change that is indistinguishable from an estimate change is treated under the current and prospective approach.

True

10

T/F: A change to weighted average from FIFO is an accounting principle change.

True
and vice versa is true

11

T/F: Most accounting principle changes require a cumulative effect to be reported in the year of change.

True

12

T/F: The change to the percentage of completion method from the completed contract method is applied retrospectively.

True

13

T/F: A change in accounting estimate is an accounting principle change.

False.
A change in accounting estimate is not always considered an accounting principle change such as:
1) initial adoption of a new principle to new events for the first time or for events that were immaterial in their effect in the past.
2) Adoption or modification of a principle for transactions that are clearly different in substance from those in the past.
3) A change in method that is a planned procedure as part of the normal application of a method.
4) The change from a principle that is not generally accepted to one that is accepted.

14

T/F: A change in accounting estimate is treated prospectively.

True

15

T/F: The correction of an error affecting prior year net income is treated as an accounting principle change.

False.
A correction of an error is a prior period adjustment that is required. Whereas, an accounting principle change is a voluntary change that the entity chooses to do.
Although both use the same procedures for recording.

16

T/F: The restatement approach to reporting accounting changes does not use a catch up adjustment.

False.
Each account affected by the restatement changes are adjusted as if the new method had been used in those periods.

17

T/F: Most accounting principle changes are recorded using the retrospective approach.

True

18

T/F: Accounting-principle changes are reported as an adjustment to retained earnings at the beginning of the year of change. Prior financial statements are retrospectively adjusted.

True

19

T/F: A firm changes from LIFO to FIFO in Year 4. The total effect of the change on all years before Year 4 is a decrease in earnings of $23,000. The effect on Year 4 is a decrease of $3,000. The entry to record the change will include dr. Retained earnings $23,000.

True

20

T/F: Pro forma income disclosures are not required for accounting principle changes.

True

21

T/F: Cumulative effects of changes in accounting principle are recorded net of tax.

True

22

T/F: The cumulative effect of an accounting principle change to be recorded in 20x7 covers years before 20x7.

True

23

T/F: A firm changed from FIFO to weighted average for inventory costing purposes. The effect on earnings of all prior years was an increase of $30,000. The tax rate was 30%. The cumulative effect reported increases retained earnings by $21,000.

True

24

T/F: Accounting principle changes affect income in the year of the change.

True

25

T/F: The total prior year earnings increase from an accounting principle change is $50,000 before tax of 40%. Net income in the year of the change is unaffected by this amount.

True

26

T/F: The change to LIFO from FIFO uses the ending FIFO balance of the year before the change as the beginning LIFO balance in the year of the change.

True

27

T/F: Accounting principle changes require an adjustment to beginning retained earnings in the year of the change but do not require application of the new principle to prior year financial statements.
The retroactive approach's catch up adjustment is reported in current period earnings.

False
Each account affected by the restatement changes are adjusted as if the new method had been used in those periods.

28

T/F: The change from LIFO generally does not require a cumulative effect to be reported.

False.
Each account affected by the restatement changes are adjusted as if the new method had been used in those periods.

29

T/F: In an accounting principle change, the adjustment to retained earnings includes the effect of the change on income in the year of the change.

False
This would be an indirect effect, which are not recognized in the period of change. Although these changes are disclosed in the FN

30

T/F: Retained earnings is adjusted for depreciation method change and error correction.

False.
Not for error corrections.

31

Belle Co. determined after four years that the estimated useful life of its labeling machine should be ten, rather than 12 years. The machine originally cost $46,000 and had an estimated salvage value of $1,000. Belle uses straight-line depreciation. What amount should Belle report as depreciation expense for the current year?

$5,000
The asset has a depreciable base of $46,000-$1,000=$45,000. The depreciation expense for years one through four is $45,000/12=$3,750.
Accumulated depreciation after four years is $3,750 X 4 =$15,000.
The carrying value after four years is $46,000-$15,000=$31,000.
Depreciation based on the new estimated useful life is $31,000-$1,000 = $30,000 for the depreciable base. The remaining useful life is 10-4=6 years.
Depreciation for the current year is $30,000/6 = $5,000.

32

During 2005, Krey Co. increased the estimated quantity of copper recoverable from its mine. Krey uses the units-of-production-depletion method.

Which of the following statements correctly describes the appropriate accounting for this change?
A. Accumulated depletion is recalculated back to the date of acquiring the mine and the depletion for each period included in the annual report will reflect the new estimate.
B. The effect of the change on all prior years is treated as a catch-up adjustment in the 2005 income statement.
C. The change in estimate is applied as of the beginning of 2005 for current and future periods.
D. The retained-earnings balance at the beginning of 2005 is adjusted for the effect of the change on prior years.

C. This is an accounting-estimate change. These accounting changes are handled currently and prospectively by applying the new estimate to the current and future periods, if affected. The effect of the change on prior years' earnings is not computed, because the new information causing the estimate change was not known at that time.

Cumulative effects are reported for accounting principle changes, not estimate changes, because the effect of the change on prior years is computed and reported for accounting principle changes only.

33

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?

$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.

34

For 2003, Pac Co. estimates its two-year equipment warranty costs based on $100 per unit sold in 2003. Experience during 2004 indicates that the estimate should have been based on $110 per unit.

The effect of this $10 difference from the estimate is reported
A. In 2004 income from continuing operations.
B. As an accounting change, net of tax, below 2004 income from continuing operations.
C. As an accounting change requiring 2003 financial statements to be restated.
D. As a correction of an error requiring 2003 financial statements to be restated.

A. This is a change in accounting estimate, because experience in the current period implies that a different estimate should be used. This new information does not invalidate the good-faith estimate made in 2003, because the new information was not known at that time. These changes are treated currently and prospectively; that is, in the current and future periods, if affected. They are not applied retroactively.

In this instance, the $10 increase in warranty costs per unit is recognized as an increase in warranty expense of 2004. Therefore, income from continuing operations will reflect this increase.

35

Matt Co. included a foreign subsidiary in its 2008 consolidated financial statements.
The subsidiary was acquired in 2002 and was excluded from previous consolidations. The change was caused by the elimination of foreign-exchange controls.

Including the subsidiary in the 2008 consolidated financial statements results in an accounting change that should be reported
A. By footnote disclosure only.
B. Currently and prospectively.
C. Currently with footnote disclosure of pro forma effects of retroactive application.
D. By restating the financial statements of all prior periods presented.

D. The elimination of foreign-currency controls would legitimately change the status of the foreign sub from non-consolidated to consolidated.

This causes a change in the reporting entity, since both companies must now be reported together. A change in reporting entity utilizes the retrospective method.

36

Oak Co. offers a three-year warranty on its products.

Oak previously estimated warranty costs to be 2% of sales. Owing to a technological advance in production at the beginning of 2005, Oak now believes 1% of sales to be a better estimate of warranty costs. Warranty costs of $80,000 and $96,000 were reported in 2003 and 2004, respectively. Sales for 2005 were $5mn.

What amount should be disclosed in Oak's 2005 financial statements as warranty expense?

$50,000
The modification of the warranty-cost percentage is a change in estimate. Therefore, the new estimate is applied to 2005 and later years. There is no retroactive adjustment for changes in estimates, because the new information could not possibly have been known in the past.

Therefore, warranty expense, which is a direct percentage of sales, is $50,000, or 1% of $5mn.

37

On January 2, 2005, 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, 2003, 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 2004 and 3,500 during 2003. Machine-hour usage for 2005 is 3,800.
Holly's income tax rate is 30%. Holly should report the accounting change in its 2005 financial statements as a(an)
A. Estimate change recognizing $3,800 of depreciation in 2005.
B. Estimate change recognizing $4,000 of depreciation in 2005.
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. 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, 2005 = $50,000 - ($50,000/10)2 = $40,000.

Estimated remaining machine hours at January 1, 2005 = $50,000 - $8,500 - $3,500 = $38,000.

Depreciation expense for 2005 = $3,800($40,000/$38,000) = $4,000.

38

Which of the following statements is correct as it relates to changes in accounting estimates?
A. Most changes in accounting estimates are accounted for retrospectively.
B. Whenever it is impossible to determine whether a change in an estimate or a change in accounting principle occurred, the change should be considered a change in principle.
C. Whenever it is impossible to determine whether a change in accounting estimate or a change in accounting principle has occurred, the change should be considered a change in estimate.
D. It is easier to differentiate between a change in accounting estimate and a change in accounting principle than it is to differentiate between a change in accounting estimate and a correction of an error.

C. When it is impossible to determine whether the change is an estimate or a change in accounting principle, the change should be considered a change in estimate and accounted for prospectively.

39

At December 31, 2004, Off-Line Co. changes its method of accounting for demo costs from writing off the costs over two years to expensing the costs immediately.

Off-Line makes the change in recognition of an increasing number of demos placed with customers that did not result in sales. Off-Line has deferred demo costs of $500,000 at December 31, 2003, $300,000 of which were to be written off in 2004 and the remainder in 2005.

Off-Line's income tax rate is 30%. In its 2004 retained-earnings statement, what amount should Off-Line report as cumulative effect of change in accounting principle?

$0
The change in accounting principle is indistinguishable from a change in accounting estimate. This change can be effected by changing the useful life of the demo costs to zero - a change in estimate. The firm should write off the remaining unamortized costs at the beginning of the year of change. Earnings in 2004 will be reduced by $500,000 before tax as a result.

40

T/F: Equipment with an estimated useful life of six years was purchased at the beginning of Year 1. During Year 3, the firm estimated that, as of the beginning of Year 3, the asset would have six years of service life remaining. DDB depreciation for Year 3 equals the book value at the beginning of Year 3 multiplied by 2/6.

True

41

T/F: Both error corrections and estimate changes require retrospective restatement.

False.
Error corrections require restatements, but estimate changes only require prospective application

42

T/F: When an estimate change is made, a catch-up adjustment is computed and recorded.

False.
Changes only affect the subsequent accounting for an asset or liability, NOT applied retrospectively.

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