[Luna]

I just started preparing FAR, and I’m confused about this question, can somebody help please?

Q: On January 2, Year 4, Raft Corp. discovered that it had incorrectly expensed a $210,000 machine purchased on January 2, Year 1.

Raft estimated the machine’s original useful life to be 10 years and its salvage value to be $10,000. Raft uses the straight-line method of depreciation and is subject to a 30% tax rate. In its December 31, Year 4, financial statements, what amount should Raft report as a prior period adjustment?

A. $102,900

B. $105,000

C. $165,900

D. $168,000

Answer: B. The requirement is to determine the amount of the prior period adjustment. ASC Topic 250 provides that an error in the financial statements requires restatement of the financial statements with an adjusting entry to retained earnings for the earliest period presented.

When Raft incorrectly expensed the machine in Year 1, earnings before tax were understated by $210,000. Had Raft properly capitalized this asset, it would have recorded $20,000 depreciation expense per year in Year 1, Year 2, and Year 3. Depreciation expense is calculated on a straight-line basis as $20,000 per year:

($210,000 – $10,00) / 10 years

Over the three years, Raft would have recorded a total of $60,000 of depreciation expense. Therefore, as of January 2, Year 4, expenses have been overstated by $150,000, ($210,000 – $60,000), and the tax effect of the adjustment is 30% x $150,000, or $45,000. Therefore, the prior period adjustment to retained earnings net of taxes is $105,000, ($150,000 – $45,000).

I think I didn’t totally understand the question, does it mean that Raft posted the purchasing expense but didn’t do depreciation? For me the adjustment should be $210,000 + $60,000, I don’t understand why this two expenses are contra.

[Anonymous]

@Jia Liu

The way I understand this problem is that Raft posted an expense of $210,000 when he should have posted an expense of $60,000 in accumulated depreciation (before we account for the tax effect). – therefore Raft would have overstated the expenses by $150,000.

The tax effect of $45,000 is a contra because that is how much of tax relief Raft got from overstating the expenses by $150,000. By overstating the expenses by $150,000 Raft understated his income also by $150,000 and he was not taxed on that $150,000. (He should have been taxed $45,000 for that extra $150,000 income)

The way the question is asked is a little tricky – ultimately it is asking what is the difference between the results achieved by the incorrect expense and the results if everything was recorded correctly. Imagine reversing the incorrect transactions and recording the correct ones.

Hope it helps 🙂

[monikernc]

in year1, the entry they made was
DR Equipment Expense $210,000
CR Cash $210,000
and never recorded depreciation. net income was understated the full amount of the expensed cost of the equipment.

in years2, and 3, no depreciation expense was ever recorded so net income was overstated by the depreciation net the tax amount $20,000*30%

the overstatement and the understatements to net income result in the $105,000 in year4 when they realize the mistake.

the explanation provided walks you through the prior period adjustment's effect on retained earnings.

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[Missy]

Think of the basics of capital fixed assets. If something is capitalized the expense is spread over a period of years. So the purchase would be to assets on the balance sheet, then periodically a fraction is expensed to the income statement and the other side is a contra asset account accumulated depreciation.

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[Luna]

Thank you guys! I don't know how to reply to everyone, I think I got it.
Really appreciate your help! 😀

[Author]

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