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Retained Earnings: Prior Period Adjustments quiz #1

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  • What are prior period adjustments in retained earnings, and when are they necessary?
    Prior period adjustments in retained earnings are corrections made to the beginning balance of retained earnings due to errors or changes in accounting principles from previous periods. They are necessary when errors such as unrecorded expenses or revenues are discovered, or when a company changes its accounting principles, like switching inventory methods.
  • How does an unrecorded expense from a previous period affect retained earnings, and what is the correcting journal entry?
    An unrecorded expense from a previous period overstates retained earnings because net income was too high. The correcting journal entry is a debit to retained earnings (to decrease it) and a credit to the related asset or expense account, such as prepaid expenses.
  • What is the accounting treatment when a company changes its inventory costing method from weighted average to FIFO, and the cumulative effect is a \$40,000 increase in inventory?
    When changing from weighted average to FIFO, the company debits inventory for \$40,000 (to increase it) and credits retained earnings for \$40,000 (to reflect higher past income), adjusting the beginning balances as if FIFO had always been used.
  • Why is it important to restate previous years' financial statements when a company changes its accounting principle, such as inventory costing methods?
    Restating previous years' financial statements ensures comparability across periods, providing a true and fair view of the company's financial position and performance, and allowing users to make informed decisions based on consistent accounting methods.
  • What are the two main reasons for making a prior period adjustment to retained earnings?
    Prior period adjustments are made for errors in previous periods or for changes in accounting principles, such as inventory costing methods.
  • How does an unrecorded expense from a previous period affect retained earnings?
    An unrecorded expense overstates retained earnings because net income was too high in the previous period.
  • What is the correcting journal entry for an unrecorded legal expense that was incorrectly capitalized as a prepaid expense in a prior year?
    Debit retained earnings and credit prepaid expenses for the amount of the unrecorded expense.
  • Why can't a prior period expense be recorded in the current year's income statement?
    Because the expense relates to a previous period, recording it in the current year would misstate this year's financial results; instead, retained earnings must be adjusted.
  • What journal entry is required when a company changes its inventory costing method from weighted average to FIFO, resulting in a \$40,000 increase in inventory?
    Debit inventory for \$40,000 and credit retained earnings for \$40,000 to reflect the cumulative effect of the change.
  • Why is it important to restate previous years' financial statements when changing accounting principles?
    Restating ensures comparability across periods and provides a true and fair view of the company's financial position and performance.