ABC is a private company, which started on 1/1/Y1. They only report one year of financial data on their financial statements. Their tax rate is 40%.
For each of the scenarios below determine the effect on current year income from operations before taxes and retained earnings, if necessary. Include the appropriate dollar amounts.
Scenario 1:
ABC purchased a piece of equipment on 1/1/Y2. They determined that straight-line was the appropriate depreciation method. However, when they calculated depreciation for Y2-Y4 they did not subtract salvage value, resulting in depreciation expense of $1,000 per year. If they had subtracted salvage value depreciation expense for each year would have been $700. Depreciation expense was already included in income from operations before taxes for Y4 before the error was detected.
What adjustment is required to Y4 Income from Operations before Taxes?
What is the correcting journal entry for the retrospective adjustment to RE (if required) in Y4?
Scenario 2:
ABC changed from LIFO to FIFO in Y4. COGS under the new method would have been $2,000 higher for Y1, $1,000 lower for Y2, $3,000 higher for Y3 and $750 lower for Y4. COGS using LIFO was already included in income from operations before taxes for Y4 before the company decided to switch to FIFO.
What adjustment is required to Y4 Income from Operations before Taxes?
What is the correcting journal entry for the retrospective adjustment to RE (if required) in Y4?
In Scenario 1, ABC made an error in calculating depreciation expenses for the years Y2-Y4. They initially used a straight-line depreciation method but failed to subtract the salvage value when determining the annual depreciation expense. Consequently, depreciation expense was overstated by $300 per year ($1,000 – $700). This overstatement affected the income from operations before taxes for Y2, Y3, and Y4.
To adjust Y4’s Income from Operations before Taxes, we need to correct this error. Since the error was only detected in Y4, we must retroactively adjust the prior years as well. Here’s the calculation for Y4:
Adjust Y4 Income from Operations before Taxes:
Original Depreciation Expense: $1,000
Corrected Depreciation Expense: $700
Adjustment needed: $1,000 – $700 = $300 (overstated)
Correcting Journal Entry for Retained Earnings (if required) in Y4:
Debit: Retained Earnings $300 (to decrease)
Credit: Accumulated Depreciation $300 (to increase)
This journal entry ensures that the overstatement of depreciation expense is reflected in the retained earnings, thus correcting the error.
In Scenario 2, ABC changed its inventory valuation method from LIFO (Last-In, First-Out) to FIFO (First-In, First-Out) in Y4. This change resulted in different cost of goods sold (COGS) figures for the prior years. COGS under FIFO was $2,000 higher for Y1, $1,000 lower for Y2, $3,000 higher for Y3, and $750 lower for Y4 compared to LIFO.
To adjust Y4’s Income from Operations before Taxes, we need to account for the change in COGS. Since the change in accounting method only occurred in Y4, we retroactively adjust the prior years as well:
Adjust Y4 Income from Operations before Taxes:
Original COGS (LIFO): $
Corrected COGS (FIFO): $
Adjustment needed: $ (difference between LIFO and FIFO COGS)
Correcting Journal Entry for Retained Earnings (if required) in Y4:
Debit: Retained Earnings $ (to decrease)
Credit: Accumulated Adjustment – Inventory Method Change $ (to increase)
This journal entry ensures that the change in COGS due to the shift from LIFO to FIFO is properly reflected in the retained earnings.
In both scenarios, it is crucial to make these adjustments to maintain the accuracy of financial statements and comply with accounting principles. These retrospective adjustments help correct errors and ensure that the company’s financial records are a faithful representation of its financial performance.
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