CPA Exam: FAR · Select Transactions
Written by AI · Not yet reviewed by staffCPA Exam: FAR Accounting Changes, Income Taxes, and Other Transactions Summary
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- About 7 of 14 Select Transactions questions (50%)
Accounting changes and error corrections, contingencies, income taxes, fair value measurement, and subsequent events.
📖 See Accounting Changes, Income Taxes, and Other Transactions concepts →Accounting Changes, Income Taxes, and Other Transactions: must-know points
- Changes in estimate are prospective; errors are restated.
- Deferred taxes come from temporary differences at enacted rates.
- Recognized subsequent events give evidence about conditions at the balance sheet date.
Accounting Changes, Income Taxes, and Other Transactions: 10 sample questions
Question 1. A company changes its depreciation method from double-declining balance to straight-line. How is this change reported?
- ① Retrospectively, by restating all prior periods presented
- ② Prospectively, as a change in estimate effected by a change in principle
- ③ As a prior-period adjustment to beginning retained earnings
- ④ As a cumulative-effect amount in current-year income
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Answer: ② Prospectively, as a change in estimate effected by a change in principle
Key point: Depreciation method change = prospective
A change in depreciation method is treated as a change in accounting estimate effected by a change in accounting principle. Because it cannot be separated from a change in estimate, it is applied prospectively: the remaining book value is depreciated with the new method from now on.
Wrong choices
- Retrospective restatement: this is for most changes in accounting principle, but not depreciation method changes.
- Prior-period adjustment: this is for correcting errors.
- Cumulative effect in income: this older approach is not used under current GAAP.
Question 2. A company finds that it made a material error in last year's issued financial statements. How should it correct the error?
- ① Report the correction in current-year income as an unusual item
- ② Correct it prospectively in current and future periods only
- ③ Disclose it in the notes without changing any amounts
- ④ Restate the prior-period statements and adjust the beginning retained earnings of the earliest period shown
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Answer: ④ Restate the prior-period statements and adjust the beginning retained earnings of the earliest period shown
Key point: Material prior error = restatement
A material error in previously issued statements is corrected by restatement. Prior periods shown are corrected, and the effect on earlier periods is recorded as an adjustment to the opening retained earnings of the earliest period presented.
Wrong choices
- Current-year income: correcting an old error through current income would distort this year's results.
- Prospective: prospective treatment is for changes in estimate, not errors.
- Disclose only: a material error must be corrected in the amounts, not just disclosed.
Question 3. A company is being sued. Its lawyers say a loss is probable, and the loss can be reasonably estimated at $200,000. How should the company report this?
- ① Accrue a $200,000 liability and loss, and disclose the matter
- ② Disclose the lawsuit in the notes only
- ③ Do nothing until the case is settled
- ④ Record the loss only if the company has insurance
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Answer: ① Accrue a $200,000 liability and loss, and disclose the matter
Key point: Probable and estimable loss = accrue
A loss contingency is accrued (recorded) when it is both probable and reasonably estimable. Both conditions are met, so the company records a $200,000 loss and liability and also discloses the nature of the matter.
Wrong choices
- Disclose only: disclosure alone is for losses that are reasonably possible, or probable but not estimable.
- Wait until settled: GAAP requires recording the loss now because both conditions are met.
- Only if insured: insurance does not decide whether the loss is recorded.
Question 4. A company holds shares that trade on a major stock exchange. It measures them at fair value using the exchange's closing price for those same shares. Which level of the fair value hierarchy is this input?
- ① Level 2
- ② Level 3
- ③ Level 1
- ④ Level 4
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Answer: ③ Level 1
Key point: Quoted price, identical asset, active market = Level 1
Level 1 inputs are quoted prices in active markets for identical assets. A closing exchange price for the very same shares fits this exactly.
Wrong choices
- Level 2: this is for observable inputs other than Level 1 prices, such as prices for similar assets.
- Level 3: this is for unobservable inputs, such as the company's own models.
- Level 4: the hierarchy has only three levels.
Question 5. Which item creates a permanent difference between book income and taxable income?
- ① Using faster depreciation for tax than for books
- ② A warranty expense accrued for books but deducted for tax when paid
- ③ Rent collected in advance that is taxed when received
- ④ Interest earned on tax-exempt municipal bonds
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Answer: ④ Interest earned on tax-exempt municipal bonds
Key point: Tax-exempt interest is a permanent difference
A permanent difference is an item that is counted for books but never for tax (or the reverse). Municipal bond interest is book income but is never taxed, so it never reverses and creates no deferred tax.
Wrong choices
- Faster tax depreciation: this is a temporary difference that reverses over the asset's life.
- Warranty accrual: this is a temporary difference that reverses when the warranty is paid.
- Rent received in advance: this is a temporary difference that reverses when the rent is earned for books.
Question 6. At year-end, a machine's book value is $60,000 higher than its tax basis because of faster tax depreciation. The enacted tax rate for all future years is 25%. What deferred tax amount should be reported?
- ① Deferred tax asset of $15,000
- ② Deferred tax liability of $15,000
- ③ Deferred tax liability of $60,000
- ④ No deferred tax, because the difference is permanent
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Answer: ② Deferred tax liability of $15,000
Key point: Book basis > tax basis on asset = DTL
When an asset's book value is higher than its tax basis, the company will pay more tax in the future when the difference reverses, so it records a deferred tax liability.
- Deferred tax liability = $60,000 x 25% = $15,000
Wrong choices
- Deferred tax asset: an asset with book value above tax basis leads to future taxable amounts, so it is a liability.
- $60,000 liability: this is the temporary difference itself, not the tax on it.
- No deferred tax: depreciation differences reverse over time, so they are temporary.
Question 7. A machine cost $100,000, has no salvage value, and was depreciated straight-line over 10 years. At the start of Year 5, the company decides the machine will last only 3 more years. What is Year 5 depreciation?
- ① $10,000
- ② $14,286
- ③ $15,000
- ④ $20,000
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Answer: ④ $20,000
Key point: Change in useful life: spread book value over new life
A change in useful life is a change in estimate, applied prospectively. The remaining book value is spread over the remaining life.
- Accumulated depreciation after 4 years = $10,000 x 4 = $40,000
- Book value = $100,000 - $40,000 = $60,000
- Year 5 depreciation = $60,000 / 3 = $20,000
Wrong choices
- $10,000: this keeps the old 10-year life.
- $14,286: this divides the original cost by a 7-year total life, as if restating past years.
- $15,000: this divides the book value by 4 years instead of the 3 remaining years.
Question 8. A company has pretax book income of $500,000. This includes $20,000 of tax-exempt municipal bond interest. Tax depreciation is $40,000 more than book depreciation. The enacted tax rate is 25% for all years. What is total income tax expense?
- ① $110,000
- ② $125,000
- ③ $130,000
- ④ $120,000
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Answer: ④ $120,000
Key point: Tax expense = current + deferred; permanent items excluded
Total tax expense is current tax plus deferred tax. The municipal interest is never taxed, while the depreciation difference only shifts tax to later years.
- Taxable income = $500,000 - $20,000 - $40,000 = $440,000
- Current tax = $440,000 x 25% = $110,000
- Deferred tax expense = $40,000 x 25% = $10,000
- Total = $110,000 + $10,000 = $120,000
Check: ($500,000 - $20,000) x 25% = $120,000.
Wrong choices
- $110,000: this is only the current tax and leaves out deferred tax expense.
- $125,000: this taxes the tax-exempt interest, which is a permanent difference.
- $130,000: this adds the depreciation difference to income instead of treating it as temporary.
Question 9. A lawsuit loss is probable. The lawyers estimate the loss will be between $100,000 and $300,000, with no amount in the range more likely than any other. How much should be accrued?
- ① $200,000
- ② $300,000
- ③ $100,000
- ④ $0
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Answer: ③ $100,000
Key point: Range with no best estimate: accrue the minimum
When a loss is probable and only a range can be estimated, the company accrues the best estimate in the range. If no amount is better than another, it accrues the minimum of the range, which is $100,000, and discloses the possible additional loss of up to $200,000.
Wrong choices
- $200,000: the midpoint is not used under US GAAP when no amount is a better estimate.
- $300,000: the maximum is not required; the extra possible loss is disclosed.
- $0: a probable loss that can be estimated as a range must still be accrued.
Question 10. A company's year ends December 31. On January 20, before the statements are issued, a fire destroys one of its warehouses. The warehouse was in good condition at year-end. How should the company report this?
- ① Disclose it in the notes without adjusting the year-end amounts
- ② Reduce the warehouse's carrying amount in the year-end balance sheet
- ③ Record a loss in the year just ended
- ④ Ignore it because it happened after year-end
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Answer: ① Disclose it in the notes without adjusting the year-end amounts
Key point: New condition after year-end = disclose, don't adjust
The fire is a nonrecognized subsequent event because the condition (the fire) did not exist at the balance sheet date. The year-end amounts are not changed, but a material event like this is disclosed so readers are not misled.
Wrong choices
- Reduce the carrying amount: year-end amounts are adjusted only for conditions that existed at year-end.
- Record a loss in the year just ended: the loss belongs to the new year, when the fire happened.
- Ignore it: a material subsequent event must be disclosed.
Test yourself.