CPA Exam - FAR (Financial Accounting and Reporting)Financial ReportingEasy
A publicly traded company is preparing its annual financial statements for the year ended December 31, Year 1. The company discovered that it had incorrectly expensed a $50,000 piece of equipment purchased on January 1, Year 1, that should have been capitalized. The equipment has an estimated useful life of 5 years and no salvage value. The company uses the straight-line depreciation method. Assuming a 25% tax rate, what is the impact of this error correction on the net income for Year 1, before considering the tax effect?
- ADecrease of $40,000
- BIncrease of $50,000
- CDecrease of $50,000
- DIncrease of $40,000
Show answer & explanationAnswer & explanation
Correct answer: D. Increase of $40,000
The equipment was incorrectly expensed for $50,000. It should have been capitalized and depreciated. The correct depreciation for Year 1 is $50,000 / 5 years = $10,000. Therefore, the expense should have been $10,000 instead of $50,000, resulting in an increase to net income of $40,000 ($50,000 - $10,000).
Why the other options are wrong
- A. This would imply the error caused an understatement of net income, but to a lesser extent.
- B. This would be the increase if no depreciation was considered.
- C. This would imply the error caused an overstatement of net income.
Error Correction Impact
Correcting an error involves adjusting the financial statements to reflect what should have been recorded, impacting prior or current period net income and balance sheet accounts.
- Prior period errors are usually corrected retrospectively.
- Current period errors are corrected by adjusting the current period's accounts.
- The impact on net income is the difference between the incorrect and correct expense/revenue recognition.
Memory trick: Fixing mistakes makes financials right, like a puzzle piece fitting just so.