CPA Exam - FAR (Financial Accounting and Reporting)Select TransactionsMedium
A company is preparing its financial statements and discovers that it failed to record accrued salaries of $15,000 at the end of Year 1. The salaries were paid in Year 2. Assuming the error was discovered in Year 2 before the Year 2 financial statements were issued, and the company uses the accrual basis of accounting, what is the effect of correcting this error on the Year 1 financial statements?
- ANo effect on Year 1 net income, only on Year 2.
- BIncrease Year 1 retained earnings by $15,000.
- CDecrease Year 1 net income by $15,000.
- DIncrease Year 1 net income by $15,000.
Show answer & explanationAnswer & explanation
Correct answer: C. Decrease Year 1 net income by $15,000.
The failure to record accrued salaries at the end of Year 1 means that an expense that should have been recognized in Year 1 was not. Correcting this error requires recognizing the $15,000 salaries expense in Year 1. Expenses reduce net income, so correcting this omission will decrease Year 1 net income by $15,000.
Why the other options are wrong
- A. Since the expense relates to Year 1, the correction impacts Year 1's financial statements.
- B. An increase in retained earnings would occur if net income increased, which is the opposite effect here.
- D. This would be the effect of understating revenue, not expenses.
Prior Period Adjustment (Error Correction)
The correction of a material error in prior period's financial statements by restating affected prior period financial statements and adjusting the opening balance of retained earnings.
- Applies to material errors from prior periods.
- Restates prior financial statements presented.
- Adjusts beginning retained earnings for cumulative effect (net of tax).
Memory trick: Error's Past: Restate, Adjust, and Get it Right at Last.