Question

A client's previous two years of financial statements understated estimated warranty payable by $30,000 and $50,000 respectively, immaterial amounts. This year the auditors estimate that the accrual is understated by an additional $60,000. In this year's audit $100,000 represents a material amount. Assuming that the entire understatement is to be recorded, following SEC SAB 108 the decrease in this year's income due to these understatements is:

A. $0
B. $60,000
C. $110,000
D. $140,000

Answer 1

The entire cumulative warranty payable understatement of $140,000 (sum of understatements from previous two years and this year) must be recorded to correct the prior period errors, leading to a decrease in this year's income by that amount.

Step-by-step explanation:

The question posed by the student relates to the treatment of prior period errors in financial statements according to SEC Staff Accounting Bulletin No. 108 (SAB 108).

Since the previous understatements of warranty payable for the two years were $30,000 and $50,000 and considered immaterial, but this year's understatement of an additional $60,000 makes the cumulative error material, SEC SAB 108 would require the correction of the entire cumulative error.

As the threshold for materiality this year is $100,000, the total correction amount of $140,000 ($30,000 + $50,000 + $60,000) exceeds this threshold. Therefore, this year's income would be decreased by the cumulative understatement amount to correct the error.

The correct answer to the student's question is D. $140,000, which represents the cumulative amount by which the warranty payable accrual was understated over three years including the current year's understatement.