Question

A company switched from the cash basis to the accrual basis for recognizing warranty expense. The unrecorded liability for warranties was $2.1 million at the beginning of the year. Its tax rate is 35%. The company booked a year-end warranty liability of $3 million. As a result of this change, the firm would:A) Report a current period charge decreasing net income by $735,000.B) Report a prior period adjustment decreasing retained earnings by $735,000.C) Report a current period charge decreasing net income by $1,365,000.D) Report a prior period adjustment decreasing retained earnings by $1,365,000.

Answer 1

Answer:

D) Report a prior period adjustment decreasing retained earnings by $1,365,000

Explanation:

Accrual accounting rate-of-return method: In this method, the recording of the transactions should be done based on an accrual basis which means whether the amount is received or not but it is recorded in the books of accounts.

In the given case, there is an unrecorded liability for $2.1 million for prior year which is recorded after considering the tax expense. So, the computation is shown below:

= Unrecorded liability - unrecorded liability × tax rate

= $2,100,000 -  $2,100,000 × 35%

=  $2,100,000 - $735,000

= $1,365,000