Question

Answer the following questions related to a company’s activities for the current year:

1. A review of the notes payable files discovers that three years ago the company reported the entire amount of a payment (principal and interest) on an installment note payable as interest expense. This mistake had a material effect on the amount of income in that year. How should the correction be reported in the current-year financial statements?

2. After using an expected useful life of seven years and no salvage value to depreciate its office equipment over the preceding three years, the company decided early this year that the equipment will last only two more years. How should the effects of this decision be reported in the current-year financial statements?

Short answer

1. Prior period adjustments: Material errors in prior period financial statements. Prior period adjustments are reported/ adjusted in the statement of retained earnings (or the statement of stockholders’ equity), net of any income tax effects.
2. Accounting Estimates: Estimates made previously were inaccurate. These inaccuracies are not considered errors.

Step-by-step solution

Meaning of Prior Period Adjustments

Prior period adjustments refer to correcting the errors that happened in the past and having a material effect on the company's financial statements.

Explanation case 1.

The company has identified the payment of Principle is reported in Interest expense. There is no estimate involved that specifies it’s an Error that happened prior. The Mistake has a material effect. Hence, it’s a Prior Period Error.

All Prior Period errors will directly adjust in the statement of retained earnings, net of any income tax effects.

Therefore this error needs to be reported as a prior period adjustment to the beginning retained earnings balance on the statement of retained earnings.

Explanation case 2.

The company has originally estimated the useful life of depreciable office equipment as seven-year. After seven years, the company estimates the office equipment balance life of two years. It states the concept of change in estimates.

Change in estimates that need to be reported in financial statements.

Therefore, the current year depreciation should be modified in the given case, and revised depreciation should be calculated and reported based on the new estimated useful life.