CPA Exam: FAR · Select Transactions
CPA Exam: FAR: Accounting Changes, Income Taxes, and Other Transactions Concepts
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Overview
This chapter gathers several topics that cut across many accounts: accounting changes and error corrections, contingencies, income taxes, fair value measurement, and subsequent events. Each one is about timing and judgment: when and how to reflect information in the statements.
A change in accounting principle is generally applied retrospectively, recasting prior periods shown. A change in accounting estimate, such as a new useful life, is applied prospectively in the current and future periods. A change in depreciation method is treated as a change in estimate effected by a change in principle, so it is also prospective. Correction of an error in previously issued statements is a restatement of prior periods.
A loss contingency is accrued when a loss is probable and can be reasonably estimated, and disclosed when only reasonably possible; gain contingencies are not recognized until realized. Income tax expense is current tax plus deferred tax. Deferred tax assets and liabilities come from temporary differences between book and tax bases, measured at enacted tax rates for the years they reverse, and are classified as noncurrent.
A valuation allowance reduces deferred tax assets when it is more likely than not that some will not be realized. Fair value is an exit price measured with a three-level input hierarchy, and subsequent events are either recognized, when they give evidence about conditions that existed at the balance sheet date, or only disclosed, when the condition arose afterward.
Key concepts
Types of accounting changes
Change in principle: generally retrospective. Change in estimate: prospective. Change in reporting entity: retrospective. Error correction in previously issued statements: restatement of prior periods, with an adjustment to opening retained earnings for the earliest period shown.
Memory tipA change in depreciation method is treated like a change in estimate, so it is prospective.
Source: FASB ASC 250 · as of 2026
Loss contingencies
Accrue if probable and reasonably estimable. Disclose if reasonably possible, or if probable but not estimable. Remote losses generally need no disclosure, except certain guarantees. If a range is estimated and no amount is better, accrue the low end.
Memory tipGain contingencies are not recorded until realized.
Source: FASB ASC 450 · as of 2026
Deferred taxes
Temporary differences create deferred tax liabilities (future taxable amounts) or deferred tax assets (future deductible amounts), measured at enacted rates expected to apply when they reverse. Permanent differences create no deferred tax.
Memory tipDeferred tax assets and liabilities are all classified as noncurrent.
Source: FASB ASC 740 · as of 2026
Valuation allowance
A deferred tax asset is reduced by a valuation allowance if it is more likely than not (above 50 percent likelihood) that some or all of it will not be realized.
Memory tipDo not use expected future rate changes that are not yet enacted.
Source: FASB ASC 740 · as of 2026
Fair value hierarchy
Fair value is the price to sell an asset or transfer a liability in an orderly transaction between market participants. Level 1: quoted prices for identical items in active markets. Level 2: other observable inputs. Level 3: unobservable inputs.
Memory tipFair value is an exit price, not the price paid to buy.
Source: FASB ASC 820 · as of 2026
Subsequent events
Recognized subsequent events give more evidence about conditions that existed at the balance sheet date, such as a customer bankruptcy revealing an existing receivable problem, and are adjusted for. Nonrecognized events come from conditions arising later, such as a fire; disclose them if material.
Memory tipAsk whether the condition already existed on the balance sheet date.
Source: FASB ASC 855 · as of 2026
Often tested
- Principle change: retrospective; estimate change: prospective; error: restate.
- Accrue a loss contingency only if probable and reasonably estimable.
- Deferred taxes use enacted rates and are classified as noncurrent.
- Valuation allowance uses the more-likely-than-not threshold.
- Fair value Level 1 inputs are quoted prices for identical items in active markets.
- Recognized subsequent events relate to conditions at the balance sheet date.
Easy to confuse: Temporary vs. permanent differences
| Item | Temporary difference | Permanent difference |
|---|---|---|
| Reverses in later years | Yes | No |
| Creates deferred tax | Yes | No |
| Example | Faster tax depreciation than book depreciation | Tax-exempt municipal bond interest |
3 sample questions
Verified practice questions from this unit.
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
▼ Show answer and explanation▲ Hide answer and explanation
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
▼ Show answer and explanation▲ Hide answer and explanation
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.