In this video, we walk through 5 FAR practice questions teaching about adjusting the income statement to correct errors. These questions are from FAR content area 1 on the AICPA CPA exam blueprints: Financial Reporting.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Adjusting the Income Statement to Correct Errors
Adjusting the income statement to correct identified errors is a crucial aspect of financial accounting. Such adjustments ensure the accuracy of financial reporting, compliance with accounting standards, and provide stakeholders with reliable information about the company’s financial performance. This overview will discuss various types of adjustments commonly required on the income statement, using examples from our previous discussion.
Misclassification of Income and Expenses
One common error in financial statements is the misclassification of items between income and expense accounts. For instance, rental income erroneously recorded as an expense.
Let’s consider a scenario where Summit Enterprises recorded $18,000 received as rental income directly into the “Miscellaneous Expense” account. This misclassification not only inflates expenses but also understates income, distorting the company’s profitability.
To correct this, a two-step journal entry is needed:
- Debit Cash $18,000 and Credit Miscellaneous Expense $18,000 to reverse the incorrect expense recording.
- Debit Cash $18,000 and Credit Rental Revenue $18,000 to accurately reflect the rental income.
These entries ensure that the income statement reflects true operational performance by correctly categorizing rental income and adjusting the expense downwards.
Revenue Recognition
Proper revenue recognition is essential to comply with the accrual basis of accounting. Revenue should be recognized when it is earned, regardless of when payment is received. A common error occurs when revenue is recognized either too early or too late. For example, Elmwood Technology recorded $300,000 from a multi-year contract as revenue in the current fiscal year, even though the services are to be delivered evenly over three years.
To correct premature revenue recognition:
- Debit Revenue $200,000 and Credit Unearned Revenue $200,000. This entry defers the revenue that has not yet been earned to future periods, ensuring that the income statement aligns with the revenue recognition principle.
Adjustments for Depreciation
Changes in depreciation estimates can arise from adjustments to an asset’s useful life or salvage value. Consider Clearwater Manufacturing, which initially valued factory equipment at $600,000 with a salvage value of $50,000 over 15 years. After ten years, the remaining life was adjusted to just 2 years. The annual depreciation calculation needs to be revised to reflect this shortened useful life.
The adjustment involves recalculating depreciation based on the new remaining life:
- Original annual depreciation: $36,667.
- Revised annual depreciation for the last 2 years: $91,665.
This example illustrates the need to adjust depreciation expense in the income statement to reflect the updated asset use duration.
Classification of Non-operating Income
Items unrelated to core business operations, such as legal settlements or one-time gains, should be classified as non-operating income. For instance, if Springwood Inc. received $75,000 from a legal settlement related to a patent infringement, this amount should not be recorded under operating revenue but rather as non-operating income:
- Debit Cash $75,000 and Credit Legal Settlement Revenue $75,000.
Recording it correctly as non-operating income ensures that the income statement provides a clear distinction between core operational results and incidental financial gains.
Tax Implications of Misclassified Income
Misclassifying income can significantly impact the calculation of taxable income and, consequently, tax expenses. If Hazelwood Corp. mistakenly included $123,450 from discontinued operations within its continuing operations, the correction involves adjusting both the reported income and the associated tax expense:
- Debit Tax Payable $37,035 and Credit Income Tax Expense $37,035 to correct the overstatement of tax liability due to the misclassified income.
This adjustment is crucial for presenting an accurate measure of tax expense relative to the correctly classified income, ensuring compliance with tax laws and financial reporting standards.
By understanding and applying these principles of adjusting entries on the income statement, accountants can ensure that financial statements accurately reflect the economic reality of the company, adhering to accounting standards and providing stakeholders with dependable financial information.
