FAR · Select transactions · 6 practice questions
Prior-Period Error Correction: Retained Earnings Calculation
Material prior-period errors require restatement, with earlier cumulative effects adjusting opening retained earnings of the earliest period presented. Below: rebuild an equipment balance and calculate the retained earnings correction.
Try one first
Hint
Compare the cumulative expense that should have been recognized through the end of Year 2 with the amount that was actually recognized.
Answer B. This is a prior-period error correction, so opening retained earnings should be adjusted for the cumulative prior-period income effect through the end of Year 2. Depreciation should have been $20,000 for July-December Year 1 (6 months) and $40,000 for Year 2, a total of $60,000. Because Lark expensed $200,000 instead of capitalizing and recognizing $60,000 of depreciation, prior-period expenses were overstated by $140,000, so retained earnings was understated and should be credited $140,000.
Why not A: This reflects reversing the original $200,000 repair expense but subtracting only the 6 months of Year 1 depreciation ($20,000) and ignoring Year 2; opening retained earnings must reflect the full cumulative effect through Year 2.
Why not C: This comes from incorrectly assuming two full years (24 months) of depreciation had accrued by Jan 1, Year 3. The asset was placed in service July 1, Year 1, so only 18 months of depreciation ($60,000) had accrued.
Why not D: This would be the amount if one simply reversed the original repairs expense and reclassified the cost as an asset without recognizing the depreciation that should have been recorded in Years 1 and 2; the retained earnings adjustment is therefore less than $200,000.
Worked example
Vale Co. incorrectly expensed $240,000 of equipment purchased July 1, Year 1. It should have used straight-line depreciation from that date over five years, with no salvage value. The material error is discovered while preparing comparative Year 3 and Year 4 statements. Ignore income taxes. Calculate the correction to January 1, Year 3 retained earnings.
| 1 | Monthly depreciation$240,000 / 60 months | $4,000 |
| 2 | Months before the earliest period presented6 months in Year 1 + 12 months in Year 2 | 18 months |
| 3 | Required opening accumulated depreciation$4,000 × 18 months | $72,000 |
| 4 | Cumulative expense overstatement$240,000 incorrectly expensed - $72,000 required depreciation | $168,000 |
Credit opening retained earnings on January 1, Year 3 for $168,000.
Check: Shortcut: the retained earnings credit equals the missing asset's net carrying amount, $240,000 - $72,000 = $168,000.
Key points
- Restate each comparative period for its own error; only effects before the earliest period go into its opening retained earnings.
- If only one period is presented, adjust that period's opening retained earnings for cumulative prior-period errors.
- Include tax effects unless the question explicitly says to ignore income taxes.
- A revised depreciation estimate is prospective; correcting an improper expense or omitted depreciation is an error correction.
How the exam traps you
- Reverse the full purchase price into retained earnings. Subtract all depreciation required before the opening adjustment date, not just the purchase year's depreciation.
- Put the correction in current-year income because the error was discovered this year. Restate prior periods and adjust opening retained earnings; record only current-year depreciation in current-year income.
- Adjust only the discovery year's opening retained earnings when comparative statements are presented. Restate affected comparatives and adjust the earliest presented period's opening retained earnings for errors before that period.
Question 2
Hint
First decide whether the situation is an error correction or an accounting change. Then ask whether comparative prior-year statements are being issued.
Answer A. The omitted depreciation is a material prior-period error. Under U.S. GAAP, a material prior-period error is corrected by retrospective restatement when comparative financial statements are presented, so Pine should restate the 20X5 amounts and adjust the opening balances of 20X6 to reflect the corrected amounts. This prevents distorting 20X6 results by shifting prior-period items into the current year.
Why not B: This is tempting because candidates may want to 'catch up' in the current year. However, recording the missed 20X5 depreciation in 20X6 would misstate both periods; material prior-period errors should be corrected by restating the prior period, not by current-period expense.
Why not C: A change in estimate applies when new information changes expected useful life or salvage value. The facts describe a bookkeeping omission, an error, not a revised estimate, so the correction is retrospective rather than prospective.
Why not D: A cumulative-effect adjustment is not the correct treatment for a material prior-period error when comparative statements are presented. The required approach is to retrospectively restate the prior period and adjust the opening balances of the current period.
Question 3
Hint
Decide first whether the facts describe a new estimate or a mistake in applying GAAP. That classification drives the reporting treatment.
Answer D. This is a prior-period error because Mason incorrectly applied GAAP by expensing a capitalizable asset. When comparative financial statements are presented and the error is material, U.S. GAAP requires correction by restating the prior-period financial statements affected (rather than treating it prospectively or as a current-period cumulative-effect item).
Why not A: Candidates might confuse capitalization/depreciation with an estimate change, but the fact pattern describes an error in applying GAAP (wrong classification), not a change in estimate. Changes in estimate are handled prospectively, whereas errors are corrected by restatement when comparative statements are presented.
Why not B: Adjusting opening retained earnings without revising the comparative Year 1 statements would leave the presented Year 1 information misstated. Because Year 1 is being shown and was directly affected, the correct approach is to restate Year 1.
Why not C: This reflects an outdated or incorrect notion that prior-period errors flow through current income. Under current U.S. GAAP, material prior-period errors are corrected by restating prior-period statements when presented, not by a cumulative-effect adjustment to current-period income.
Question 4
Hint
First determine how much expense should have been recognized by the end of Year 2, then compare that with the amount actually recognized through depreciation.
Answer C. The $120,000 should have been expensed in Year 1 as routine maintenance. Instead, Noll capitalized the cost and recorded two years of depreciation (2 × $30,000 = $60,000), so only $60,000 of the cost has flowed through income by the start of Year 3. Therefore, retained earnings is overstated by $60,000 and the prior-period adjustment debits opening retained earnings for $60,000.
Why not A: This ignores that two years of depreciation ($60,000) have already reduced net income. Retained earnings should be adjusted only for the cumulative amount still overstated at the correction date, not the original cash outlay.
Why not B: This result reflects miscounting the depreciation recognized (for example, assuming only one and a half years or similar). Two full years of depreciation (2 × $30,000) have been recorded, totaling $60,000, leaving a $60,000 overstatement, not $90,000.
Why not D: This assumes only one year of depreciation was recorded or focuses on Year 2 alone. Because depreciation for Years 1 and 2 totals $60,000, the correcting debit must reflect the full cumulative overstatement of $60,000.
Question 5
Hint
First classify which item requires a prior-period correction and which is handled prospectively; then compute the error's cumulative income effect through the end of Year 3.
Answer B. Only the equipment that was fully expensed in Year 2 is a prior-period error requiring correction to opening retained earnings. Annual SL depreciation is $96,000/8 = $12,000, so by January 1, Year 4 two years of depreciation ($24,000) should have been recognized. Because $96,000 was expensed instead, retained earnings are understated by $96,000 − $24,000 = $72,000. The depreciation-method change for the other machine is a change in estimate accounted for prospectively (ASC 250), so it does not adjust opening retained earnings.
Why not A: Tempting because it reverses the Year 2 mischarge relative to Year 2 depreciation only: $96,000 − $12,000 = $84,000. It fails because by January 1, Year 4 Pine should also have recognized Year 3 depreciation of $12,000, reducing the cumulative correction to $72,000.
Why not C: Tempting to candidates who incorrectly treat the change in depreciation method retrospectively: under DDB the second machine's Years 2-3 depreciation would be 20% and then 20% of the declining balance (20% of 100,000 = 20,000; then 20% of 80,000 = 16,000) totaling $36,000 versus $20,000 under SL, a $16,000 increase in prior depreciation that would reduce opening retained earnings. Combining that (incorrect) retrospective effect with the $72,000 error correction yields $56,000. It fails because the method change is a change in estimate applied prospectively, so no prior-period reduction applies.
Why not D: Tempting because one might simply reverse the $96,000 repairs expense and capitalize it. It fails because two years of depreciation ($12,000 × 2 = $24,000) should have been recognized by January 1, Year 4, so the net prior-period effect on retained earnings is $96,000 − $24,000 = $72,000, not the full $96,000.
Question 6
Hint
First determine how much depreciation should have been recognized through January 1, Year 3. Then compare that total with what was actually expensed.
Answer A. Annual depreciation is $120,000 ÷ 6 = $20,000. By January 1, Year 3, two years of depreciation should have been recognized (2 × $20,000 = $40,000). Because the asset was expensed for $120,000 and no depreciation was recorded, the cumulative prior-period effect on retained earnings is $120,000 − $40,000 = $80,000, so opening retained earnings is credited $80,000.
Why not B: $40,000 is tempting because it equals the accumulated depreciation that should exist by January 1, Year 3. However, the question asks for the retained earnings adjustment (the cumulative effect on prior-period income), which is the difference between the amount expensed ($120,000) and the depreciation that should have been recognized ($40,000) = $80,000.
Why not C: $100,000 is tempting if you look only at Year 1 (expensing $120,000 instead of $20,000 depresses Year 1 income by $100,000). But Year 2 had no depreciation recorded (which overstates Year 2 income by $20,000), so the net prior-period effect through January 1, Year 3 is $100,000 − $20,000 = $80,000.
Why not D: $120,000 is tempting because that was the amount originally expensed. However, not all of that amount is a retained earnings adjustment: two years' depreciation ($40,000) should have been recognized by January 1, Year 3, so the retained earnings credit is $120,000 − $40,000 = $80,000.
Common questions
How do you calculate a retained earnings adjustment for equipment incorrectly expensed?
Subtract depreciation required before the adjustment date from the amount incorrectly expensed. Ignoring taxes, credit opening retained earnings for that difference.
Do you restate comparative statements for a prior-period error under ASC 250?
Yes, if the error is material. Restate affected comparative periods and adjust opening retained earnings of the earliest period presented for cumulative effects from earlier periods.
Does omitted depreciation increase or decrease opening retained earnings?
Omitted depreciation overstated prior-period income, so the correction decreases retained earnings. Restate the affected comparative period, or debit opening retained earnings if the omission occurred before the earliest period presented.
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