sm ch (21).doc

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CHAPTER 21 ACCOUNTING CHANGES AND ERROR

ANALYSIS

ASSIGNMENT CLASSIFICATION TABLE

Topics ExercisesBrief Exercises Problems AssignmentsWriting

1. Differentiate between change in policy, change in estimate and errors.

1, 2, 3 1, 2, 3, 4, 5 1, 2, 3, 4, 5, 6, 7 1, 2, 3, 4, 6 2. Change in accounting policy. 4 6, 7, 8, 9 1, 2, 3, 4, 5,8 1, 2, 3, 4, 6 3. Correction of an error. 3, 5, 6 1, 2, 3, 5, 8, 10, 11, 12, 13, 14, 15, 16 1, 2, 3, 4, 5, 6, 7, 9, 10, 11, 12, 13 1,2,3,4,5,6 4. Change in estimate. 7, 8, 9 3, 5, 9, 13, 17, 18 2, 3, 4, 5, 6,7 1, 2, 3, 4, 6

5. Motivations for change. 3, 19 14 1,2,3,4,6

6. Differences between IFRS

and ASPE. 6 4 4, 5, 8, 14 4,5,7

7. Correct errors and restate

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ASSIGNMENT CHARACTERISTICS TABLE

Item Description DifficultyLevel of (minutes)Time

E21-1 Change in policy—long-term contracts. Simple 10-15 E21-2 Determine type of change, method of

accounting, prepare journal entries. Moderate 20-25 E21-3 Change in estimate, error correction. Moderate 20-30 E21-4 Accounting for accounting changes. Simple 20-25 E21-5 Change in estimate and error; financial

statements. Moderate 25-30

E21-6 Accounting change—inventory. Moderate 25-30 E21-7 Change in policy—measurement model for

investment property. Simple 15-20

E21-8 Various changes in policy—inventory methods. Moderate 20-35 E21-9 Accounting changes—depreciation. Moderate 15-20 E21-10 Error correction entries. Moderate 20-25 *E21-11 Error analysis and correcting entry. Simple 10-15 *E21-12 Error analysis; correcting entries. Moderate 20-25 E21-13 Error and change in estimate—depreciation. Simple 15-20

*E21-14 Error analysis. Moderate 25-30

E21-17 Accounting changes—amortization. Moderate 15-20 E21-18 Change in estimate—depreciation. Moderate 10-15 E21-19 Political motivations for policies. Simple 10-15 P21-1 Error corrections and changes in policy. Moderate 25-30 P21-2 Change in estimate, policy, and error correction

with tax effect Moderate 30-35

P21-3 Comprehensive accounting change in estimate

and error analysis problem. Moderate 30-35 P21-4 Error analysis and changes in policy. Complex 45-50 P21-5 Effect of changes in policy, estimate and error,

financial statements and note disclosure. Complex 50-60 P21-6 Comprehensive accounting change and error

analysis problem, with statement of retained earnings and notes.

Complex 45-55

P21-7 Effect of changes in policy and estimate,

financial statements. Complex 50-60

P21-8 Change in policy (FIFO to average cost),

income and retained earnings statement. Complex 50-60

P21-9 Error corrections. Moderate 25-30

P21-10 Error analysis with tax effect. Moderate 20-25 P21-11 Error analysis and correcting entries. Complex 50-60 P21-12 Error analysis and calculation of corrected net

income. Moderate 30-40

P21-13 Error analysis and correcting entries. Complex 50-60 P21-14 Economic motives for selection of accounting Moderate 25-30

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SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 21-1

1. The change to a three-year remaining life for the purpose of computing depreciation on production equipment is a change in estimate due to a change in conditions.

2. This is an expense classification change arising from a change in the use of the building for a different purpose. Thus, it is not a change in principle, a change in estimate, or the correction of an error.

3. The change to expensing preproduction costs (writing the costs off in one year as opposed to several years) is a change in estimate due to a change in conditions. The change in estimate is to the value used in the base in the allocation. Preproduction costs are included as part of development costs and may be capitalized under IFRS as long as certain criteria are met (IAS 38.59).

1. Both FIFO and weighted average cost are acceptable cost formulas under ASPE; thus, this item is a change in accounting principle.

2. This oversight is a mistake that should be corrected. Such a correction is considered a change due to error.

3. Both the completed-contract method and the percentage-of-completion method are acceptable alternatives under ASPE. However, they are not interchangeable. The company must choose the method that best relates the revenues recognized to the work performed. In general, the completed contract method is only used where performance consists of one act or the progress towards completion is not measurable (3400.18).

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Accumulated Depreciation - Asset ($117,000 – $76,000) 41,000 Deferred Tax Liability... 12,300 Retained Earnings [$41,000 X (1 – 30%)]... 28,700

Note that this is considered to be a correction of an accounting error.

Inventory*... 435,000

Income Tax Payable... 130,500 Retained Earnings [$435,000 X (1 – 30%)]... 304,500

* Assumes a periodic system and that ending inventory of 2014 has not yet been recorded. If a perpetual system is

assumed, the adjustment is to cost of goods sold. This can be done by first adjusting the opening inventory and then

transferring the inventory adjustment to cost of goods sold. Note to instructor: CRA generally requires a company to use the same inventory costing method for tax purposes as for financial reporting purposes. Therefore, Crosbie would have additional tax payable on the increased income reported rather than a deferred tax account. Also, the “more relevant information” from FIFO inventory valuation is highly debatable, as older costs are used in the computation of cost of goods sold.

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Equipment... 75,000 Depreciation Expense ($75,000 ÷ 5)... 15,000

Accumulated Depreciation... 45,000 *

Deferred Tax Liability... 14,400 ** Retained Earnings... 30,600 *** * $75,000 ÷ 5 X 3 years = $45,000 ** ($75,000 – $30,000) X 32% = $14,400 *** ($75,000 – $30,000) X (1 – 32%) = $30,600

Assumes income was reported accurately for tax purposes in all years.

*BRIEF EXERCISE 21-6 (a)

BAKER CORPORATION Statement of Retained Earnings

December 31, 2014

Retained earnings, 1/1/14, as previously reported $2,000,000 Correction of depreciation error,

(net of tax of $125,000) (375,000 )

Retained earnings, 1/1/14, as adjusted 1,625,000

Add: Net income 900,000

2,525,000

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Retained earnings, 12/31/14 $2,275,000

(b) If Baker were to follow IFRS, the error correction would be accounted for in the same way, except that Baker would have to prepare a Statement of Changes in Shareholders’ Equity, as required under IFRS, rather than a Statement of Retained Earnings under ASPE.

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No entry is required to record the change in estimate. In CICA

Handbook, Part II, Section 1506, a revision of depreciation policy

due to changes in the expected pattern of benefits is identified as a change in estimate. Since the change was made at the beginning of the year, the new accounting policy would be applied to 2014 and prospective years.

Depreciation Expense... 19,000

Accumulated Depreciation – Equipment.... 19,000 Carrying amount: = $60,000 – 2 X (60,000 – 18,000) / 7 = $48,000 New annual depreciation:

_ $19,000_ 2 – 4 $10,000 – $48,000 BRIEF EXERCISE 21-9

There would be no further change in reported income and EPS for 2014 since the 2014 net income has already been calculated using the new depreciation method. There would be no adjustment to opening retained earnings for any previous year since changes considered changes in estimate are accounted for prospectively. There would also be no journal entry to adjust the accounting records for accumulated depreciation due to the change in method since a change from one depreciation method to another due to a change in the pattern of consumption is considered a change in estimate, not a change in accounting policy (IAS 8.32).

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*BRIEF EXERCISE 21-10 2013 2014 a. b. c. d. e. Overstated Overstated Understated Overstated No effect Understated Overstated Overstated Understated Overstated

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SOLUTIONS TO EXERCISES

EXERCISE 21-1 (10-15 minutes)

(a) The net income to be reported in 2014, would be computed as follows:

Income before income tax $700,000

Income tax:

Current (30% X $480,000) $144,000

Deferred [30% X ($700,000–$480,000)] 66,000 210,000

Net income $490,000

(b) Construction in Process... 200,000

Deferred Tax Liability... 60,000 Retained Earnings...

140,000*

*($200,000 X (1 – 30%) = $140,000)

(c) A current ratio of 0.95 indicates that the company has lower current assets than current liabilities as at the end of 2014. The entry in part (b) will result in an increase in current assets (with a debit to construction in process), and a proportionately smaller increase in current liabilities (with a credit to deferred tax liability). (Note that under ASPE, a deferred tax asset or liability must be classified as current or noncurrent based on the classification of the asset or liability underlying the temporary difference). After recording the entry in part (b), the company’s current ratio will appear higher. The error correction had no impact on the company’s actual liquidity position, yet the error correction will cause the company’s current ratio to appear higher. A creditor should review the notes to the financial statements describing the error correction, and note the effect of the correction on the company’s current ratio. A creditor may also note that other aspects of the company’s liquidity position may be analyzed for a more detailed

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assessment of the company’s short-term ability to pay its maturing obligations.

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(a) 1. Change in estimate – prospectively. 2. Change in estimate – prospectively.

3. Accounting error correction – full retrospective application.

4. Change in accounting policy – full retrospective application.*

* GAAP specifies that changes in policy should be accounted for retrospectively with full application to prior periods. In certain cases, it may be impracticable to determine estimates for prior periods, in particular if it is impossible to assess circumstances and conditions in prior years that need to be known in order to develop those estimates. Partial retrospective or prospective application would then have to be used.

(b) Event #3:

Equipment... 100,000 Depreciation Expense... 22,500 *

Accumulated Depreciation - Equipment

($22,500 X 2)... 45,000 ...

Retained Earnings... 54,250 **

Deferred Tax Liability... 23,250 ***

* ($100,000 – $10,000)/4 = $22,500

** ($100,000 – $22,500) X (1 – 30%) = $54,250 *** ($100,000 – $22,500) X 30% = $23,250

Note to Instructor: The Deferred Income Tax effect for the current year is not included in the above entry as noted in the question.

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EXERCISE 21-2 (Continued) Event #4:

Retained Earnings... 7,000 Income Tax Payable... 3,000

Inventory... 10,000 Changes for 2011 and 2012 have not been included since inventory changes are counterbalancing and their impact on opening 2014 retained earnings is nil.

Note to Instructor: Also note that CRA generally requires a company to use the same inventory costing method for tax as it uses for financial reporting purposes. Therefore, the effect of the change in inventory costing method will result in a current tax amount, not a deferred tax asset or liability.

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(a) Patent: This is a change in estimate. The change would be applied to the current year and prospectively.

Land and Building: This is a correction of an error. The adjustment would be applied retrospectively. This would include restating all prior period financial statements presented for comparison, adjusting the opening balance of retained earnings for the earliest period presented, and providing note disclosure.

(b) Amortization of Patent:

Amortization Expense... 76,000

Accumulated Amortization—Patents... 76,000 Amortization recorded in 2012 and 2013:

($410,000 – $50,000) / 10 years X 2 years = $72,000 Annual amortization incorporating this change:

($410,000 – $110,000 – $72,000) / 3 years (2014 to 2016) = $76,000

Land and Building – error correction entry:

Building... 101,250

Land... 101,250 Depreciation Expense*... 3,213

Retained Earnings... 8,033 Accumulated Depreciation - Buildings ($3,213* X 3.5) 11,246

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EXERCISE 21-3 (Continued)

(c) Change in Estimate (Patent): The nature and amount of the change should be disclosed. Amortization expense for the patent has been increased by $40,000 for the current and future years due to a change in estimated useful life and residual value.

Correction of Error (Land and Building):

The disclosure should enable users to understand the effects of the error on the financial statements. It should include a statement of the nature of the error, the amount of the correction for each prior period presented and the amount related to periods prior to those presented, and a statement that comparative information has been restated. Depreciation expense has been increased by $3,213 for both 2014 and 2013 (include previous years if included in comparative statements). This has decreased net income by $3,213 for both 2014 and 2013 and earnings per share by $XXX in each year.

(d) If management determines assets’ useful lives and residual values as part of the year end process, it is likely that the conditions leading to these changes would have occurred during the year. In this case, the change in estimate would be applied to 2014 going forward. If management determines that the factors leading to the change in estimate occurred at or after year end, the changes would be applied to 2015 going forward.

In this exercise, it appears that depreciation and amortization expense is recorded once a year. Since the controller uses the adjustment process to revise the estimate of useful life and residual value, it would be appropriate to reflect the change to 2014 going forward.

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(e) Impairments of depreciable assets frequently involve a revision of estimates of useful life and residual value, but changes in estimates do not necessarily come from impairments of assets. Impairment tests for limited-life intangibles are done at the end of each reporting period. The controller would need to review the patent for impairment, and if events or changes in circumstances indicate that the carrying amount of the patent may not be recovered, the controller would need to compare the patent’s carrying amount to its recoverable amount (the higher of value in use and fair value less costs to sell). If the recoverable amount is less than carrying amount of the patent, the impairment loss would be the excess of the patent’s carrying amount over its recoverable amount. In this exercise there is no indication that the changes in estimates are due to an impairment. Consequently, the changes would be accounted for as a change in estimate.

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(a) and (b) Accounting treatment under IFRS: (a) (b)

Accounting

treatment Type of change

1. P Change in estimate

2. R Accounting error correction

4. NA* Change in policy

5. P Not an accounting change – selection of policy for first time.

7. R Accounting error correction

10. R Accounting error correction

* The accounting treatment would be specified in the transitional provisions of the new source of GAAP. If not specified, then apply retrospectively.

Note that the only two approaches that are permitted for reporting changes are retrospective and prospective treatment. When new or revised sources of primary GAAP are adopted, recommendations are usually included that specify how an entity should handle the transition. These are called transitional provisions.

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Under IFRS, an opening statement of financial position must be provided for the earliest comparative period provided when there is a retrospective change.

(c) Accounting treatment under ASPE (if different than part (a) for IFRS):

For corrections of errors, ASPE assumes that the impact on each specific prior period is measurable. IFRS acknowledges that the full impact may not be determinable

There would be no differences to the accounting treatment for the above noted items between IFRS and ASPE, however some items have special considerations worth noting.

(5) IAS 23 requires that interest be capitalized for qualifying assets, whereas ASPE still permits a choice between capitalization and expensing, provided that the company is consistently applying the policy. Given that this is the first time they have constructed a building for their own purposes, it’s not a change at all, but rather the selection of a policy for the first time.

(9) Under current IFRS (IAS 11 and IAS 18), the percentage of completion method is the preferred method of accounting for long-term contracts. If the outcome cannot be reliably measured, recoverable revenues equal to costs are recognized under IAS 11 and IAS 18 (sometimes referred to as the zero profit method). No gross profit is recorded until the contract is completed and the gross profit can be reliably measured. IFRS does not provide the choice of the completed contract method. Under ASPE, the percentage of completion method is again the preferred method of accounting for long-term contracts. However, the completed contract method is allowed as a default method for long-term contracts under ASPE where the percentage complete cannot be

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reliably measured. Under the completed contract method,

revenue would only be recorded when the contract is completed. (d) Under IFRS, one of the following two situations is required

for a change in an accounting policy to be acceptable: 1. The change is required by a primary source of GAAP. 2. A voluntary change results in the financial statements

presenting reliable and more relevant information

about the effects of the transactions, events, or conditions on the entity’s financial position, financial performance, or cash flows.

ASPE provides for further situations where an accounting policy change may be made without having to meet the “reliable and more relevant” criteria in the second situation above. It allows the following voluntary changes in policy to be made:

3. Between or among alternative ASPE methods of accounting and reporting for investments in subsidiary companies, and in companies where the investor has significant influence or joint control; for expenditures during the development phase on internally generated intangible assets; for defined benefit plans; for accounting for income taxes; and for measuring the equity component of a financial instrument that has both a liability and equity component at zero.

These further situations allowed under ASPE as an acceptable change in accounting policy relate to standards where accounting policy choices have to be made. These changes are treated as voluntary changes, but they do not have to meet the “reliable and more relevant” hurdle required of other voluntary changes. Although not specifically stated in the actual

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standard, it is assumed that once that choice has been made, the same policy is followed consistently.

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(a) Change from sum-of-the-years-digits to straight-line

Cost of depreciable assets... $90,000 Depreciation in 2013 ($90,000 X 4/10)... 36,000 Carrying amount at December 31, 2013... $54,000 Depreciation for 2014 using straight-line depreciation

Carrying amount at December 31, 2013... $54,000 Estimated useful life... 3 years Depreciation for 2014 ($54,000 ÷ 3)... $18,000

HESSEY INC.

Statement of Retained Earnings For the Year Ended

2014 2013 Retained earnings, January 1, unadjusted...$125,000

Less: Correction of error for inventory

overstatement... (20,000)

Retained earnings, January 1, adjusted...105,000 $ 72,000 Add: Net income... 81,000 58,000 Less: Dividends... (30,000) (25,000) Retained earnings, December 31...$156,000 $105,000

Corrected net income:

As included in draft statements...$52,000 $78,000 Inventory correction...20,000 (20,000) Depreciation under sum of the years digits...27,000

Depreciation under straight line...(18,000) _ Corrected net income...$81,000 $58,000

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EXERCISE 21-5 (Continued) Note to instructor:

1. 2013 Cost of sales was understated by $20,000; 2014 cost of sales was overstated by $20,000. As a result, net income for 2013 is overstated $20,000 and net income for 2014 is understated $20,000 as a result of the inventory error.

2. 2013 depreciation expense is unchanged.

3. Additional disclosures would be necessitated as indicated in the chapter.

(b) Most likely accounting treatment of change in depreciation method under various circumstances:

 If the change is due to changed circumstances, for example, the types of assets has changed and the usage of the new assets is better reflected by straight-line depreciation or a changed pattern of expected benefits, then the change would be treated prospectively.

 If the change is due to a change in primary GAAP, the transitional provisions of the new policy will specify the acceptable treatment.

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2011 (a) Retained earnings, January 1, as reported... $160,000

Cumulative effect of change in accounting

principle to weighted average cost... (13,000)* Retained earnings, January 1, as adjusted... $147,000 *[ – $8,000 (2009) – $5,000 (2010)]

2014 (b) Retained earnings, January 1, as reported... $590,000

principle to weighted average cost... (15,000)* Retained earnings, January 1, as adjusted... $575,000 *[– $8,000 (2009) – $5,000 (2010) – $5,000 (2011)

+ $10,000 (2012) – $7,000 (2013)]

2015 (c) Retained earnings, January 1, as reported... $780,000

principle to weighted average cost... (9,100)* Retained earnings, January 1, as adjusted... $770,900 *[–$15,000 at 12/31/2013 + $5,900 (2014)]

2012 2013 2014 (d) Net Income... $130,000 $293,000 $310,900

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(a) For the years ended December 31, 2012 and 2013, the land was original measured and reported on the statement of financial position at its cost of $1,000,000 with no effects reported in net income (as there is no depreciation on land).

2013 2012

STATEMENT OF FINANCIAL POSITION (partial)

Land, at cost $1,000,000 $1,000,000

Retained earnings, ending balance 290,000 230,000 INCOME STATEMENT (partial)

Unrealized gain (loss) in value of

Land – Investment Property $0 $0

(b) The entry required January 1, 2014 to restate opening Retained Earnings is:

Investment Property 50,000

Retained Earnings 50,000

The opening Retained Earnings in 2014 would have to be increased by the net amount of $50,000 for the change in fair value of the investment property up to December 31, 2013 (equal to the fair value holding loss in 2012 of $20,000 and the fair value holding gain in 2013 of $70,000).

This is a considered an acceptable change in accounting policy since changing the measurement model will provide more relevant information. Thus, it is accounted for retroactively as a change in accounting policy.

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(c) The previous financial statements would be restated as follows to include the change in fair value of the investment property in net income and related presentation on the statement of financial position:

2013 2012

(Restated) (Restated) STATEMENT OF FINANCIAL POSITION

(partial)

Land, at fair value $1,050,000 $980,000

Retained earnings, ending balance 340,000 210,000 INCOME STATEMENT (partial)

Unrealized gain (loss) in value of Land –

Investment Property $70,000 $(20,000)

STATEMENT OF SHAREHOLDERS’ EQUITY / RETAINED EARNINGS (partial) Opening retained earnings, as originally

stated $290,000 $230,000

Adjusted for 2012 decline in fair value (20,000) (20,000) Adjusted for 2013 increase in fair value 70,000 _ Opening retained earnings, as restated

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EXERCISE 21-8 (20-35 minutes) (a) Inventory**... 8,000 Retained Earnings... 8,000 * *2011 $2,000 ($26,000 – $24,000) *2012 5,000 ($30,000 – $25,000) *2013 1,000 ($28,000 – $27,000) $8,000

** Cost of Goods Sold could be used if the inventory is already adjusted at year-end.

Information shown in comparative form as follows:

2014 2013 2012 2011

Net income (Note A) $34,000 $28,000 $30,000 $26,000 Note A:

In 2014, inventory has been calculated using the first-in, first-out cost formula . In prior years, since incorporation, inventory had been calculated using the weighted average cost formula. The new method of inventory costing was adopted to provide more relevant financial statement information and has been applied retrospectively to inventory valuation of prior years. The impact of the change is an increase (decrease) in inventory of $XXX (increase (decrease) in 2013 of $XXX), increase (decrease) in cost of goods sold of $XXX (increase (decrease) in 2013 of $XXX), increase in net income of $4,000 (increase in 2013 of $1,000), an increase of opening retained earnings of $8,000 (increase of $7,000 in 2013) and an increase in earnings per share of $XXX (increase in 2013 of $XXX).

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EXERCISE 21-8 (Continued) (b) Inventory**...19,000 Retained Earnings... 19,000 * *2011 $ 6,000 ($26,000 – $20,000) *2012 9,000 ($30,000 – $21,000) *2013 4,000 ($28,000 – $24,000) $19,000

** Cost of Goods Sold could be used if the inventory is already adjusted at year-end.

2014 2013 2012 2011

Net income $34,000 $28,000 $30,000 $26,000 Note A:

In 2014, inventory has been calculated using the first-in, first-out cost formula . In prior years, since incorporation, inventory had been calculated using the last-in, first-out cost formula . The change is required in order to comply with CICA Handbook, Part II, section 3031, and the new standard has been applied retrospectively. The impact of the change is an increase (decrease) in inventory of $XXX (increase (decrease) in 2013 of $XXX), increase (decrease) in cost of goods sold of $XXX (increase (decrease) in 2013 of $XXX), increase in net income of $8,000 (increase in 2013 of $4,000), an increase of opening retained earnings of $19,000 (increase of $15,000 in 2013) and an increase in earnings per share of $XXX (increase in 2013 of $XXX).

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(a) Depreciation to date on the equipment: Double-declining depreciation 2011 (2/5 X $465,000) $186,000 2012 (2/5 X $279,000) 111,600 2013 (2/5 X $167,400) 66,960 $364,560 Cost of equipment... $465,000 Depreciation to date... 364,560 Carrying amount (Dec. 31, 2013)... $100,440

Depreciation for 2014: $(100,440 – 15,000) ÷ (5 – 3) = $42,720 Depreciation Expense... 42,720

Accumulated Depreciation—Equipment. 42,720 (b) Depreciation to date on building:

$780,000 / 30 years = $26,000 per year

$26,000 X 3 years = $78,000 depreciation to date Cost of building... $780,000 Depreciation to date... 78,000 Carrying amount (Dec. 31, 2013)... $702,000 Depreciation for 2014: $702,000 ÷ (40 – 3) = $18,973 Depreciation Expense... 18,973

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EXERCISE 21-10 (20-25 minutes) (a) 1. Accumulated Depreciation—Machinery... 22,500 Depreciation Expense... 7,500 Retained Earnings... 15,000 2012-2013 2014 Depreciation taken Depreciation (correct) *$150,000* * 135,000* *$ 15,000 * $75,000 67,500 $ 7,500 *$450,000 X 1/6 X 2

2. Salaries and Wages Expense... 36,000

Retained Earnings... 36,000 3. Current Tax Expense... 73,000

Retained Earnings... 73,000 4. Goodwill...202,500

Amortization Expense... 45,000 Retained Earnings ($45,000 X 3.5 years).. 157,500 In addition, the company should test goodwill for impairment.

5. No entry necessary.

6. Retained Earnings... 87,000

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EXERCISE 21-10 (Continued) (b) 1. Error correction

2. Error correction 3. Error correction 4. Error correction

5. Change in accounting policy 6. Error correction

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1. Accumulated Depreciation—Machinery... 22,500

Depreciation Expense... 7,500 Retained Earnings... 11,250 Deferred Tax Liability... 3,750 2. Salaries and Wages Expense... 36,000

Retained Earnings... 27,000 Income Tax Payable... 9,000 3. Current Tax Expense... 73,000

Retained Earnings... 73,000* * Since the full $73,000 was charged to Retained Earnings, the same amount is reversed without factoring in the income tax effect.

4. Accumulated Amortization – Goodwill...202,500

Amortization Expense – Goodwill... 45,000 Retained Earnings*... 118,125 Deferred Tax Liability... 39,375 *($45,000 X 3.5 years X (1 – 25%))

In addition, the company should test goodwill for impairment.

5. No entry necessary.

6. Retained Earnings... 65,250 Income Tax Payable... 21,750

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*EXERCISE 21-11 (10-15 minutes)

1. Salaries and Wages Expense... 4,100

Salaries and Wages Payable... 4,100 2. Salaries and Wages Expense... 29,400

Salaries and Wages Payable... 29,400 3. Prepaid Insurance ($2,760 X 10/12)... 2,300

Insurance Expense... 2,300 4. Sales Revenue... 110,000

[$2,310,000 ÷ (1.00 + .05) X 5%]

Sales Tax Payable... 110,000 Sales Tax Payable... 101,300

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(a) 1. Supplies Expense ($4,100 – $2,100)... 2,000

Supplies... 2,000 Salaries and Wages Expense... 1,200

($5,100 – $3,900)

Salaries and Wages Payable... 1,200 2. Interest Income ($5,500 – $4,750)... 750 Interest Receivable... 750 3. Insurance Expense... 28,000 ($93,000 – $65,000) Prepaid Insurance... 28,000 4. Rent Revenue ($44,000 ÷ 2)... 22,000

Unearned Rent Revenue... 22,000 5. Depreciation Expense... 48,150

($53,500 – $5,350)

Accumulated Depreciation - Asset... 48,150 6. Retained Earnings... 13,500

Accumulated Depreciation - Asset... 13,500

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*EXERCISE 21-12 (Continued)

(b) 1. Retained Earnings... 2,000

Supplies... 2,000 Retained Earnings... 1,200

Salaries and Wages Payable... 1,200 2. Retained Earnings... 750

Interest Receivable... 750 3. Retained Earnings... 28,000

Prepaid Insurance... 28,000 4. Retained Earnings... 22,000

Unearned Rent Revenue... 22,000 5. Retained Earnings... 48,150

Accumulated Depreciation... 48,150 6. Same as in (a).

(c) Items 1 to 4 are adjusting entries as part of the accounting cycle. The situations presented could have occurred as oversights by the accounting staff in the adjustment process. The normal adjustment process however would normally capture these situations.

For salaries and wages payable and interest receivable, the fact that the opening balances were not changed, does not imply an error. Cash receipts of interest and cash disbursements for salaries and wages were posted to the income statement, rather than cleared from the opening balances. This means that interest income and salaries and wages expense are currently overstated. The opening balance needs to be closed to Interest Income / Salaries and Wages Expense, and the year end accrual recorded. This can be accomplished in a compound entry by adjusting the opening balance to the required ending balance.

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For item 4, the company is likely using the alternative form of recording its unearned rent revenue by posting the full amount to a revenue account. Therefore, the adjusting entry has to reduce the revenue account and post the corresponding amount to the unearned rent revenue account. Items 5 and 6 however are accounting errors. For items 1 to 5, since the proper adjustments are posted to the books of account in the current year, no disclosure is necessary. The financial statements will reflect the correct amounts. Under part (b) with the books closed, if the financial statements are not yet issued, the adjustments could be factored into the financial statements as part of the statement preparation process. No special presentation or note disclosure would be required. If the financial statements have been issued, the correction would flow into the subsequent financial statements and would be treated as corrections of errors in a prior period. The opening retained earnings would be adjusted and note disclosure would be required detailing the nature of the errors and the line items in the financial statements affected.

Item 6 is an error in a prior period and would be treated as detailed above.

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EXERCISE 21-13 (15-20 minutes) (a) December 31, 2014 Retained Earnings... 135,000 Accumulated Depreciation—Machinery... 135,000

(To correct for the omission of depreciation

expense in 2012)

($1,350,000 / 10 years = $135,000 depreciation per year)

No extra entry is necessary to record the change from one depreciation method to another since a change from one depreciation method to another is a change in estimate, and changes in estimates are treated prospectively.

The adjusting entry to be made for depreciation, based on a prospective application of DDB is:

Accumulated Depreciation—Machinery... 270,000 DDB rate: (100% ÷ 7 years remaining) X 2 = 28.5714%

$1,350,000 – (3 X $135,000) = $945,000 $945,000 X .285714 = $270,000

(b)

December 31, 2014

Retained Earnings... 101,250 Deferred Tax Asset ($135,000 X 25%)... 33,750

Accumulated Depreciation—Machinery... 135,000

(To correct for the omission of depreciation

expense in 2012)

(36)

(a) Effect of errors on 2014 net income: $10,700 understatement

Calculations – Effect on 2014 net income:

Over (under) statement Overstatement of 2013 ending inventory

(and 2014 beginning inventory)

Understatement of 2014 ending inventory Expensing of insurance premium in 2013 ($66,000 ÷ 3)

Failure to record gain on sale of fully depreciated machine in 2014

Total effect of errors on net income (understated) $ (9,600 )) (8,100)) 22,000 (15,000 ) $(10,700 ))

(b) Effect of errors on working capital: $45,100 understatement Calculations – Effect on working capital:

Over (under) statement Understatement of 2014 ending inventory

Expensing of insurance premium in 2013 (prepaid insurance)

Cash from sale of fully depreciated machine unrecorded

Total effect on working capital (understated)

$( (8,100))

(22,000) (15,000) $(45,100)

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(c) Effect of errors on retained earnings: $47,400 understatement

Calculations – Effect on retained earnings:

Over (under) statement Understatement of 2014 ending inventory

Overstatement of depreciation expense in 2013

Expensing of insurance premium applicable to 2015 in 2013

Failure to record sale of fully depreciated machine in 2014

Total effect on retained earnings (understated) $( (8,100)) ( (2,300)) (22,000) (15,000) $(47,400)

(d) NEILSON TOOL CORPORATION

Statement of Retained Earnings For the Years 2014 and 2013

2014 2013

(restated)

Retained earnings, January 1, as previously reported Less: Effect of error in

inventory in previous year Add: Depreciation error in

previous year

Add: Error in insurance

Retained earnings, January 1, as restated

Net income Dividends

Retained earnings, December 31

$1,607,000 (9,600) 2,300 44,000 1,643,700 * 385,700 (45,000) $1,984,400 $1,250,000 _ 1,250,000 ** 458,700 (65,000) $1,643,700

(38)

* Net income for 2014 = $375,000 + $10,700 understatement. ** Net income for 2013 = $422,000 – $9,600 + $2,300 + $44,000

(e) Correction of error: The financial statements must be restated for all prior periods. Opening retained earnings are adjusted.

The required disclosure includes a description of the errors, the effect of the correction of the errors on the financial statements of the current and prior periods; and the fact that the financial statements of prior periods that were presented are restated. More specifically, the amounts of the corrections to each line of the financial statements presented for comparative purposes, as well as the amount of the correction made at the beginning of the earliest prior period are presented.

Retrospective restatement enhances the consistency and more specifically, the comparability of the financial statements.

(39)

2013 2014

Income before tax Corrections:

Sales erroneously included in 2013 income

Understatement of 2013 ending inventory

Adjustment to bond interest expense* Repairs erroneously charged to the

Equipment account

Depreciation recorded on improperly capitalized repairs (10%)***

Corrected income before tax

$101,000 (38,200) 8,640 (1,450) (8,500) 850 $62,340 $77,400 38,200 (8,640) (1,552) (9,400) 1,705 $97,713 * Bond interest expense for 2013 and 2014 was computed as

follows: Carrying Amount of Bonds Stated Interest Effective Interest 2013 2014 $235,000 236,450 $15,000 15,000 ****$16,450** 16,552** **$235,000 X 7%

Difference between effective interest at 7% and stated interest (6%):

2013: $1,450 2014: 1,552

***Erroneous depreciation taken in 2014: on 2013 addition (($8,500 - 850) x 10%))

$ 765

on 2014 addition ($9,400 ÷ 10)

940

(40)

(b) 1. Retained Earnings... 38,200

Sales Revenue... 38,200 2. Assuming the incorrect opening inventory is still in the

Inventory account:

Inventory ... 8,640

Retained Earnings... 8,640 If the Inventory account has been adjusted during the 2014 year as a result of interim inventory counts in order to prepare interim financial statements, or the ending inventory has been counted at year end and an adjusting entry has already been made to recognize cost of goods sold:

Cost of Goods Sold……… 8,640

Retained Earnings ……….. 8,640 3. Retained Earnings... 1,450

Bonds Payable... 1,450 For the 2013 interest.

Interest Expense... 1,552

Bonds Payable... 1,552 For the 2014 interest.

4. Retained Earnings... 8,500

Equipment... 8,500 Accumulated Depreciation - Equipment.... 850

Retained Earnings... 850 To adjust the 2013 error on equipment.

Maintenance and Repairs Expense... 9,400

(41)

Accumulated Depreciation - Equipment.... 1,705

Depreciation Expense... 1,705 To adjust the 2014 error on equipment.

(c)

Quality of earnings refers to how solid the earnings numbers are. High quality earnings numbers are unbiased, reflective of the underlying business fundamentals, and sustainable. Prior to the correction of several errors in reported net income for 2013 and 2014, Marcel Corp. reported before-tax income of $101,000 and $77,400 in 2013 and 2014 respectively. After correction of the errors, Marcel Corp.’s corrected income before tax was $62,340 and $97,798 in 2013 and 2014 respectively. An investor may assess that Marcel Corp. has low quality earnings because the company’s reported earnings may be significantly biased and have a higher margin of potential misstatement. As a result, the shares of Marcel Corp. may be discounted in the capital markets.

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*EXERCISE 21-16 (10-15 minutes) 2013 2014 Item Over-statement Under-statement No Effect Over-statement Under-statement No Effect (1) X X (2) X X (3) X X (4) X X (5) X X

(43)

(a) Calculation of depreciation for 2014 on the building:

Cost of building $1,200,000

Less: Depreciation prior to 2014

2010 ($1,200,000 – $0) X .05* $60,000 2011 ($1,200,000 – $60,000) X .05 57,000 2012 ($1,200,000 – $117,000) X .05 54,150

2013 ($1,200,000 – $171,150) X .05 51,442 222,592 Carrying amount, January 1, 2014 $ 977,408

*Double-declining-balance rate = (1 ÷ 40) X 2 = 5% Depreciation expense for 2014: $25,761

[($977,408 – $50,000) ÷ 36 (=40 – 4) years]

Accumulated Depreciation—Building... 25,761 (b) Calculation of depreciation for 2014 on the equipment:

Cost of equipment $130,000

Less: Accumulated depreciation

[($130,000 – $10,000) ÷ 12] X 4 years 40,000 Carrying amount, January 1, 2014 $ 90,000

2014 Depreciation expense = $90,000 – $5,000_{(9 – 4)} = $85,000₅ = $17,000

(44)

(a) The change in estimate would be applied in 2014. The amount of depreciation expense for 2014 would be calculated as a change in estimate.

Income before depreciation and income tax $300,000

Depreciation expense* 250,000

Income before income tax 50,000

Income tax (30%) 15,000

Net income $35,000

* Cost of assets = $125,000 X 8 years = $1,000,000

Carrying amount = $1,000,000 – ($125,000 X 2) = $750,000 Depreciation expense = $750,000 X 2/6** = $250,000

** The remaining useful life is 6 years (8 years less the 2 years already depreciated).

(b), (c), (d)

There would be no adjustment to opening retained

earnings for any previous year since changes in estimate are accounted for prospectively. There would also be no journal entry to adjust the accounting records. The depreciation for 2014 of $250,000 would be recorded.

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1. Management incentive plans. In many large companies, management remuneration packages provide a salary, cash bonuses based on net income or other performance variables, and stock incentives based on share price performance. Common shares are offered to managers based on share price performance to try to align the long-term interests of the firm’s shareholders and managers. The cash bonus is often based on a percentage of income once a target is reached. In some cases, once net income rises above a certain ceiling, no further bonus is paid. This practice provides a great incentive to keep income between the target and the ceiling. That is, managers of units with income above the ceiling would be motivated to pick accounting policies that carry forward “surplus” earnings to the next period.

2. Lending covenants. Long-term lending contracts often include covenants to protect the lender from observable actions by the borrower that are against the lender’s interests, such as additional borrowing or excessive dividend payments. Covenants are often based on ratios such as working capital, times interest earned, debt to equity, and so on. Violation of a debt covenant puts the borrower in default of the loan contract; the lender can demand repayment or, more commonly, renegotiate terms and conditions, including interest rates. Firms affected by these covenants try to select accounting policies that improve critical ratios.

3. Political motivation. Is it possible to report too much income? If a firm is politically visible (usually because of size, the nature of the business, or because of a government-awarded monopoly), high levels of return are potentially undesirable. High profits attract attention and may create enough dissatisfaction and political unrest to cause the government to regulate some aspect of the business or intervene in another fashion. Such firms would rather minimize reported accounting income at levels that

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provide (barely) satisfactory levels of return to creditors and investors.

(47)

4. Taxation. Reduction of income to lower tax payments is an obvious motivation for accounting policy choice. Remember, though, that there are extensive provisions in the Income Tax Act requiring the use of certain accounting methods for tax purposes, regardless of the accounting policy choice made for external reporting; thus, firms may have little room to manoeuvre.

5. Contracts. Legal agreements often refer to data (numbers) in (audited or unaudited) financial statements. For instance, an agreement may specify that “net income” is to be allocated in a variety of ways or that “book value” of equity (or a multiple thereof) is to be used to establish a buy-out price when a partner retires or a new partner admitted. In these circumstances, there is considerable contractual motivation to manipulate income and book value. How can the contracting parties make sure that manipulation does not lead to inappropriate valuation? Specifying that GAAP must be followed is a first step. However, there are areas of accounting policy where GAAP allows for acceptable alternative methods.

Note to Instructor: Numerous other factors may be acceptable. Student responses will vary; the objective is to provoke debate on personal, political and ethical motivations for accounting policy choice and for students to understand that there may be motivators other than “fair presentation”.

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TIME AND PURPOSE OF PROBLEMS

Problem 21-1 (Time 25-30 minutes)

Purpose—to provide a problem that requires the student to: (1) prepare correcting entries for two years’ unrecorded sales commissions and three years’ inventory errors, and (2) prepare entries for two different changes in accounting policy. The student is also required to discuss alternative accounting treatments for the changes.

Purpose—to provide a problem that requires the student to: (1) account for a change in estimate, (2) record a correction of an error, and (3) account for a change in accounting policy. The student is also required to account for the tax effect of the changes.

Purpose—to provide a problem that requires the student to account for two changes in estimate, record a correction of an error and account for a change in circumstances. The student is also required to calculate corrected/adjusted net income amounts.

Purpose—to develop an understanding of the entries required for changes in accounting policies, changes in estimates and accounting errors. This comprehensive problem involves all types of changes. The entries for books open and books closed are required. The student is also required to discuss the type of change involved and how it would be accounted for.

Purpose—to develop an understanding of the effect that errors, changes in policies and changes in estimates have on the financial statements. The student is required to prepare the journal entries to record a change in accounting principle, a change in estimate and an error. The student must also prepare restated comparative financial statements and note disclosure. This problem also includes the tax effects for the three items. This is a comprehensive and complex problem.

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TIME AND PURPOSE OF PROBLEMS (CONTINUED)

Purpose—to develop an understanding of the journal entries and the reporting that are necessitated by an accounting change or correction of an error. The student is required to prepare the entries to reflect such changes or errors and recalculate net income and earnings per share for a two-year period. The student is also required to prepare comparative statements of retained earnings for a two-year period and to provide note disclosure.

Purpose—the student is required to compute a list of items for the amounts which would appear on comparative financial statements after adjustment for a correction of an accounting error and a change in estimate. Comparative revised financial statements must also be prepared including the related income tax implications.

Purpose—The student is required to prepare a comparative statement of income and retained earnings for the five years assuming a change in policy in inventory costing with an indication of the effects on earnings per share for the years involved. The student must also prepare a comparative statement of retained earnings for a two-year period assuming full and partial retrospective application. The student is also required to identify the comparative statement of financial position accounts affected by the change in policy.

Purpose—to provide a problem that requires the student to analyze eleven transactions and to prepare adjusting or correcting entries for these transactions.

Purpose—to help a student understand the effect of errors on income and retained earnings. The student must analyze the effects of six errors on the current year’s net income and on the next year’s ending retained earnings balance. The tax effect of the errors must also be considered.

Purpose—to develop an understanding of the effect that errors have on the financial statements and the way to record their corrections. The student is required to prepare the journal entries to correct the accounting records and to prepare a comparative schedule portraying the corrected net income for the

(50)

two-year period involved with this error analysis and a schedule portraying the corrected opening retained earnings.

TIME AND PURPOSE OF PROBLEMS (CONTINUED)

Purpose—to develop an understanding of the effect that errors have on the financial statements. The student is required to prepare a schedule portraying the corrected net income for the years involved with this error analysis. The student is also required to prepare the journal entries to correct the errors and prepare a schedule to show the corrected opening retained earnings balances for the years involved.

Purpose—to develop an understanding of the correcting entries and income statement adjustments that are required for accounting errors. This comprehensive problem involves many different concepts such as consignment sales, bonus computations, warranty costs, and bank funding reserves. The student is required to prepare the necessary journal entries to correct the accounting records and a schedule showing the revised income before taxes for each of the three years involved.

Purpose—to allow the student to see the impact of accounting changes on income and to examine an ethical situation related to the motivation for change.

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SOLUTIONS TO PROBLEMS

PROBLEM 21-1

1. Retained Earnings [$3,500 X (1 – 25%)]... 2,625 Income Tax Receivabe... 875

Sales Commissions Payable... 2,500 Sales Commissions Expense... 1,000 2. Cost of Goods Sold ($19,000 + $6,700)... 25,700

Income Tax Payable... 4,750 Retained Earnings [$19,000 X (1 – 25%)].. 14,250 Inventory... 6,700 Income Overstated (Understated) 2012 2013 2014 Beginning inventory Ending inventory $(16,000) $(16,000) $16,000) (19,000 $ (3,000 ) ) $19,000 6,700 $25,700 3. Accumulated Depreciation—Equipment... 4,800 Depreciation Expense... 4,800 *Equipment cost... $100,000 Depreciation before 2014... (36,000) Carrying amount... $ 64,000 Depreciation to be taken ($64,000/8)... $ 8,000 Depreciation recorded... 12,800 Difference... $ 4,800

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PROBLEM 21-1 (Continued)

4. This is a change in circumstances as the company couldn’t reliably measure the revenue in past years and now it can. This would be accounted for on a prospective basis. For example, if the type of the contracts that the company undertakes has changed, thereby allowing the company to estimate the degree of completion, this situation could be the result of transaction that differs substantially from those that were previously occurring. In this case, the new accounting policy (applicable to the new type of contracts) would be applied on a prospective basis.

(53)

PROBLEM 21-2

(a) (1)

Litigation Expense... 25,000

Litigation Liability... 25,000 (2)

Bad Debt Expense... 15,000*

Allowance for Doubtful Accounts... 15,000 * ($22,500 ÷ 1.5%) X 1% = $15,000 (3) Land... 40,000 Accumulated Depreciation—Equipment... 32,000* Depreciation Expense... 8,000 Retained Earnings... 24,000 Equipment... 40,000 *$40,000 ÷ 5 = $8,000 per year; $8,000 X 4 years = $32,000 (4)

There would be no adjustment to opening retained earnings for any previous year since changes considered changes in estimate are accounted for prospectively. The books are still open for 2014, so the depreciation expense for 2014 will be revised for that year only to the straight line method.

Accumulated Depreciation—Building... 27,360

Depreciation Expense—Building*... 27,360 *($57,760 – $30,400)

*Carrying amount of the building at January 1, 2014: Cost less accumulated depreciation to Dec. 31/13 = $1,280,000 - $64,000 - $60,800 = $1,155,200 Remaining useful life from Jan. 1/14 = 38 years

Correct Depreciation Expense, 2014 (straight-line basis) = $1,155,200 ÷ 38 = $30,400

(54)

PROBLEM 21-2 (Continued) (5) Accumulated Depreciation—Equipment... 5,600 Depreciation Expense—Equipment... 5,600 * *($54,000 – $4,000) ÷ 5 = $10,000 per year ($54,000 – [$10,000 X 3] – $2,000) ÷ 5 = $4,400 ($10,000 – $4,400 = $5,600) (6)

No entry required. This is an error in classification. No amounts or items are missing in the financial statements.

(b)

Note to Instructor: Corrections to Deferred Income Tax are only necessary when a prior period adjustment is being made and where the item involves a temporary difference between

accounting and taxable income. The entries below also assume that the income tax entry(ies) for 2014 taxable income will be made subsequently.

(1)

Litigation Expense... 25,000

Litigation Liability... 25,000 (2)

Bad Debt Expense... 15,000

(55)

(3)

Land... 40,000 Accumulated Depreciation—Equipment... 32,000

Deferred Tax Liability ($24,000 X 25%)... 6,000 Depreciation Expense... 8,000 Retained Earnings [$24,000 X (1 – 25%)]... 18,000 Equipment... 40,000 (4) Accumulated Depreciation—Building... 27,360 Depreciation Expense—Building... 27,360 (see part (a) for calculation)

(5)

Accumulated Depreciation—Equipment... 5,600

Depreciation Expense—Equipment... 5,600

(6)

No entry required. This is an error in classification. No amounts or items are missing in the financial statements. Formal entry possible, as noted above.

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(c) 1. This item is an adjustment to the current year financial statements. It is not an error in a prior year’s financial statements and does not require retrospective adjustment.

2. This is a change in estimate – prospective treatment. 3. This is an error in a prior year – retrospective treatment. 4. This is a change in estimate – prospective treatment, but

requiring a change in the current year as adjustments have already been recorded.

5. This is a change in estimate – prospective treatment, but requiring a change in the current year as adjustments have already been recorded.

6. This is a statement of financial position change in classification. No journal entry and no adjustment to opening retained earnings are required. However, comparative financial information will need to be restated to properly reflect the change in classification. A note indicating the nature of the adjustment would be included.