Intermediate Accounting Stice Stice Skousen

 CHAPTER 20  Accounting Changes and Error Corrections MULTIPLE CHOICE QUESTIONS Theory/Definitional Questions 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21

Treatment of change in reporting entity Example of accounting change requiring cumulative effect adjustment Examples of changes in accounting estimate Identify changes in accounting principle Example of changes in principle that require retroactive adjustment Consistency concept behind reporting accounting changes and errors Identify a change in reporting entity Example of prior period adjustment item Example of change in accounting principle Treatment of change from unaccepted principle to accepted When to report pro forma effects on net income Reporting change in depreciation method Reporting cumulative effect on prior years' earnings Timing of recording change in accounting estimate Reporting change in principle and estimate as change in estimate Presentation of error correction on income statement, retained earnings statement Identifying a change in reporting entity Identifying a change in reporting entity International standards on accounting changes and correction of errors International standards on accounting changes and correction of errors International standards on accounting changes and correction of errors

Computational Questions 22 Computation of charge against income because of change in principle 23 Computation of amortization expense for change in life of patent 24 Determine income overstatement amount of errors 25 Cumulative effect of a change from weighted average to LIFO 26 Computation of effect of errors on income 27 Computation of effect of errors on retained earnings, income

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28 29 30 31 32 33 34 35 36 37 38 39 40

Balance of accumulated depreciation after a change in estimate Computation of effect of errors on income Entry to correct unearned revenue errors Computation of effect of errors on income Depreciation expense to be recorded following an error Entry to correct inventory errors Computation of cumulative effect of accounting change Computation of cumulative effect of accounting change Computation of depreciation expense after change in method Entries to record change from LIFO to FIFO Computation of cumulative effect of change in estimated useful life Computation of depreciation expense with change in estimated life Computation of retroactive adjustment to retained earnings for inventory and depreciation expense errors

PROBLEMS 1 2 3 4 5 6 7 8 9 10 11 hypothesis 12

Change in principle--prepare adjustment amount and entries Record depreciation expense after change in estimate Change in estimate--record bad debt expense and allowance balance Change in principle--record depreciation expense and effect of change Change in principle--record depreciation expense and effect of change Change in principle--prepare partial income statement, and pro forma disclosure Journalize error corrections assuming open books for current year Computation of corrected net income given errors Computation of and journalize adjustment from LIFO to FIFO Computation of and disclose change from FIFO to LIFO Managing earnings through accounting changes/efficient market Motivations for managers to make accounting changes

MULTIPLE CHOICE QUESTIONS a LO4

b LO3

c LO2

1. Which of the following accounting treatments is proper for a change in reporting entity? a. Restatement of all financial statements presented b. Restatement of current period financial statements c. Note disclosure and supplementary schedules d. Adjustment to retained earnings and note disclosure 2. An accounting change that requires that the cumulative effect of the adjustment be presented in the income statement is a. a change in the life of equipment from five to seven years. b. a change in depreciation method from straight-line to double-decliningbalance. c. a change in the specific subsidiaries included in consolidated financial statements. d. a change in the percentage used to determine the allowance for bad debts. 3. Which of the following should be reported as a change in accounting estimate? a. Change in the reported beginning inventory amount due to a discovery of a bookkeeping error b. Change from the completed-contract method to the percentage-ofcompletion method for revenue recognition on long-term construction contracts c. Increase in the rate applied to net credit sales from 1 percent to 1-1/2 percent in determining losses from uncollectible receivables d. Change made to comply with a new FASB pronouncement

c LO2

4. Which of the following is not a change in accounting principle? a. A change from FIFO to LIFO for inventory valuation b. A change from completed-contracts to percentage-of-completion c. A change from eight years to five years in the useful life of a depreciable asset d. A change from double-declining-balance to straight-line depreciation

c LO3

5. Which of the following changes in accounting principle does not require retroactive adjustment of the accounts?

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a. Change from the percentage-of-completion to the completed-contract method b. Change of inventory method from LIFO to FIFO c. Change of inventory method from FIFO to LIFO d. All of the above require retroactive adjustment. b LO1

6. Which of the following concepts or principles relates most directly to reporting accounting changes and errors? a. Conservatism b. Consistency c. Objectivity d. Materiality

a LO4

7. Which of the following is not a change in reporting entity? a. A company acquires a subsidiary that is to be accounted for as a purchase. b. A business combination is made using the pooling-of-interests method. c. A company changes the companies included in combined financial statements. d. A company changes the subsidiaries for which consolidated statements are presented.

c

8. An example of an item that should be reported as a prior period adjustment is the a. collection of previously written off accounts receivable. b. payment of taxes resulting from examination of prior years’ income tax returns. c. correction of an error in financial statements of a prior year. d. receipt of insurance proceeds for damage to a building sustained in a prior year.

LO5

c LO1

9. At the time Fisher Corporation became a subsidiary of Ashbury Corporation, Fisher switched depreciation of its plant assets from the straight-line method to the sum-of-the-years’-digits method used by Ashbury. With respect to Fisher, this change was a a. change in an accounting estimate. b. correction of an error. c. change in accounting principle.

d. change in the reporting entity. c LO5

10. A company changes from an accounting principle that is not generally accepted to one that is generally accepted. The effect of the change should be reported, net of applicable income taxes, in the current a. income statement after income from continuing operations and before extraordinary items. b. income statement after extraordinary items. c. retained earnings statement as an adjustment of the opening balance. d. retained earnings statement after net income but before dividends.

d LO1

11. Pro forma effects on net income and earnings per share of retroactive application would usually be reported on the face of the income statement for a Change in Change in Change in Reporting Accounting Accounting Entity Estimate Principle a. Yes Yes Yes b. Yes No Yes c. No Yes No d. No No Yes

d LO3

12. When a company changes from the straight-line method of depreciation for previously recorded assets to the double-declining-balance method, which of the following should be reported? Cumulative Effect Pro Forma Effects of Change in of Retroactive Restatement of Accounting Principle Application Prior Periods a. No No No b. No Yes Yes c. Yes No No d. Yes Yes No

c LO3

13. The cumulative effect on prior years’ earnings of a change in accounting principle should be reported separately as a component of income after income from continuing operations, for a change from a. completed-contract method of accounting for long-term constructiontype contracts to the percentage-of-completion method. b. percentage-of-completion method of accounting for long-term construction-type contracts to the completed-contract method. c. FIFO method of inventory pricing to the weighted-average method. d. LIFO method of inventory pricing to the weighted-average method.

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a LO2

14. Which of the following is the proper time period in which to record a change in accounting estimate? a. Current period and future periods b. Current period and retroactively c. Retroactively only d. Current period only

a LO2

15. The effect of a change in accounting principle that is inseparable from the effect of a change in accounting estimate should be reported a. in the period of change and future periods if the change affects both. b. by restating the financial statements of all prior periods presented. c. by showing the pro forma effects of retroactive application. d. as a correction of an error.

d LO5

16. The correction of an error in the financial statements of a prior period should be reflected, net of applicable income taxes, in the current a. income statement after income from continuing operations and before extraordinary items. b. income statement after income from continuing operations and after extraordinary items. c. retained earnings statement after net income but before dividends. d. retained earnings statement as an adjustment of the opening balance.

b LO4

17. Which of the following does not represent a change in reporting entity? a. A change in the cost, equity, or consolidation method of accounting for subsidiaries and investments b. Disposition of a subsidiary or other business unit c. Presenting consolidated statements in place of the statements of individual companies d. Changing specific subsidiaries that constitute the group of companies for which consolidated financial statements are presented

d LO4 is

18. Which of the following is not correct regarding a change in reporting entity? a. Financial statements of the year in which the change in reporting entity made should disclose the nature of the change and the reason for the change.

b. The effect of the change on income before extraordinary items, net income, and earnings per share amounts should be reported for all periods presented. c. Financial statements presented for all prior periods must be restated. d. The effect of the change on income before extraordinary items, net income, and earnings per share amounts should be reported for all periods presented and must be repeated in all periods subsequent to the period of the change.

c LO6

c LO6

b

19. Which of the following is not correct regarding the provisions of International Accounting Standard (IAS) No. 8 on accounting changes and error corrections? a. A change in accounting estimate is reflected in the current and future periods. b. A change in depreciation method (such as from an accelerated method to the straight-line method) is classified as a change in estimate. c. A change in depreciation method (such as from accelerated method to the straight-line method) is classified as a change in accounting principle. d. IAS No. 8 generally reflects a preference for restating prior results to improve comparability of financial statements. 20. Which of the following is not correct regarding the provisions of International Accounting Standard (IAS) No. 8 on accounting changes and error corrections? a. Under IAS No. 8, the recommended approach for a change in accounting principle is that results from prior periods should be restated. b. IAS No. 8 allows a change in accounting principle to be accounted for by reflecting the cumulative effect of the change in the income of the current period without restating prior-period results. c. IAS No. 8 requires that results from prior periods be presented for all changes in accounting principles. d. IAS No. 8 requires a change in accounting estimate to be reflected in the current and future periods. 21. Which of the following is correct regarding the provisions of International

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LO6

Accounting Standard (IAS) No. 8 on accounting changes and error corrections? a. IAS No. 8 requires that correction of an error be made only by restatement of all prior periods presented. b. IAS No. 8 allows correction of an error to be made either through restatement of all period periods presented or by reflecting the effect of the correction in income of the period in which the error was discovered without restating previously reported results. c. IAS No. 8 requires correction of an error to be made only by reflecting the effect of the correction in income of the period in which the error was discovered without restating previously reported results. d. IAS No. 8 reflects a preference for not restating prior results in reporting accounting changes and error corrections.

c

22. Lexicon Inc. bought a patent for $600,000 on January 2, 1998, at which time the patent had an estimated useful life of ten years. On February 2, 2001, it was determined that the patent’s useful life would expire at the end of 2004. How much would Lexicon record as amortization expense for this patent for the year ending December 31, 2002? a. $140,000 b. $120,000 c. $105,000 d. $60,000

LO2

c LO3

23. Effective January 2, 2002, Kincaid Co. adopted the accounting principle of expensing advertising and promotion costs as they are incurred. Previously, advertising and promotion costs applicable to future periods were recorded in prepaid expenses. Kincaid can justify the change, which was made for both financial statement and income tax reporting purposes. Kincaid’s prepaid advertising and promotion costs totaled $250,000 at December 31, 2001. Assume that the income tax rate is 40 percent for 2001 and 2002. The adjustment for the effect of the change in accounting principle should result in a net charge against income in the income statement for 2002 of a. $0. b. $100,000.

c. $150,000. d. $250,000. b LO5

24. Biden Corp. reports on a calendar-year basis. Its 2001 and 2002 financial statements contained the following errors: 2001 2002 Over(under)statement of ending inventory........... $(10,000) $ 4,000 Depreciation understatement................................ 4,000 6,000 Failure to accrue salaries at year end.................. 8,000 12,000 As a result of the above errors, 2002 income would be a. overstated by $4,000. b. overstated by $24,000. c. overstated by $22,000. d. overstated by $16,000.

c LO3

25. On December 31, 2002, Buckeye Corporation appropriately changed its inventory valuation method to FIFO cost from LIFO cost for both financial statement and income tax purposes. The change will result in a $140,000 increase in the beginning inventory at January 1, 2002. Assume a 30 percent income tax rate. The cumulative effect of this accounting change Buckeye should report for the year ended December 31, 2002, is a. $0. b. $42,000. c. $98,000. d. $140,000.

d

26. Rodney Company’s December 31 year-end financial statements contained the following errors: December 31, 2001 December 31, 2002 Ending inventory............. $4,000 understated $3,600 overstated Depreciation expense..... 800 understated --

LO5

An insurance premium of $3,600 was prepaid in 2001 covering the years 2001, 2002, and 2003. The entire amount was charged to expense in

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2001. In addition, on December 31, 2002, fully depreciated machinery was sold for $6,400 cash, but the sale was not recorded until 2003. There were no other errors during 2001 or 2002, and no corrections have been made for any of the errors. Ignore income tax considerations. What is the total effect of the errors on 2002 net income? a. Net income is understated by $12,800. b. Net income is overstated by $3,600. c. Net income is understated by $1,600. d. Net income is overstated by $2,400. c LO5

a LO2

d

27. Kentucky Enterprises purchased a machine on January 2, 2001, at a cost of $120,000. An additional $50,000 was spent for installation, but this amount was charged erroneously to repairs expense. The machine has a useful life of five years and a salvage value of $20,000. As a result of the error, a. retained earnings at December 31, 2002, was understated by $30,000 and 2002 income was overstated by $6,000. b. retained earnings at December 31, 2002, was understated by $38,000 and 2002 income was overstated by $6,000. c. retained earnings at December 31, 2002, was understated by $30,000 and 2002 income was overstated by $10,000. d. 2001 income was understated by $50,000.

28. Wolverine Corporation purchased a machine for $132,000 on January 1, 1999, and depreciated it by the straight-line method using an estimated useful life of eight years with no salvage value. On January 1, 2002, Wolverine determined that the machine had a useful life of six years from the date of acquisition and will have a salvage value of $12,000. A change in estimate was made in 2002 to reflect these additional data. What amount should Wolverine record as the balance of the accumulated depreciation account for this machine at December 31, 2002? a. $73,000 b. $77,000 c. $320,000 d. $352,000 29. Barker, Inc. receives subscription payments for annual (one year)

LO5

subscriptions to its magazine. Payments are recorded as revenue when received. Amounts received but unearned at the end of each of the last three years are shown below: 2000 2001 2002 Unearned revenues...........................

$120,000

$150,000

$176,000

Barker failed to record the unearned revenues in each of the three years. As a result of the omission, 2002 income was a. overstated by $146,000. b. understated by $146,000. c. understated by $26,000. d. overstated by $26,000.

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a LO5

The

b LO5

b LO5

30. Barker, Inc. receives subscription payments for annual (one year) subscriptions to its magazine. Payments are recorded as revenue when received. Amounts received but unearned at the end of each of the last three years are shown below. 2000 2001 2002 Unearned revenues………………… $120,000 $150,000 $176,000 Barker failed to record the unearned revenues in each of the three years. entry needed to correct the above errors is a. Retained Earnings................................................ 150,000 Subscription Revenues......................................... 26,000 Unearned Revenues........................................ 176,000 b. Retained Earnings................................................ 30,000 Subscription Revenues......................................... 26,000 Unearned Revenues........................................ 56,000 c. Subscription Revenues......................................... 176,000 Unearned Revenues........................................ 176,000 d. Subscription Revenues......................................... 150,000 Retained Earnings................................................ 26,000 Unearned Revenues........................................ 176,000 31. Koppell Co. made the following errors in counting its year-end physical inventories: 2000........................................... $ 60,000 overstatement 2001........................................... 108,000 understatement 2002........................................... 90,000 overstatement As a result of the above undetected errors, 2002 income was a. understated by $18,000. b. overstated by $198,000. c. overstated by $18,000. d. understated by $198,000. 32. Badger Corporation purchased a machine for $150,000 on January 1, 2001. Badger will depreciate the machine using the straight-line method using a five-year period with no residual value. As a result of an error in its purchasing records, Badger did not recognize any depreciation for the machine in its 2001 financial statements. Badger discovered the problem during the preparation of its 2002 financial statements. What amount should Badger record for depreciation expense on this machine for 2002?

d LO5

a. $0 b. $30,000 c. $37,500 d. $60,000 33. Koppell Co. made the following errors in counting its year-end physical inventories: 2000........................................... $ 60,000 overstatement 2001........................................... 108,000 understatement 2002........................................... 90,000 overstatement The entry to correct the accounts at the end of 2002 is a. Retained Earnings........................................... 48,000 Cost of Goods Sold......................................... 42,000 Inventory..................................................... b. Retained Earnings........................................... 18,000 Cost of Goods Sold......................................... 72,000 Inventory..................................................... c. Inventory.......................................................... 90,000 Cost of Goods Sold.................................... Retained Earnings...................................... d. Cost of Goods Sold......................................... 198,000 Retained Earnings...................................... Inventory.....................................................

c LO3

b LO3

90,000 90,000 18,000 72,000 108,000 90,000

34. On December 31, 2002, Prince Company appropriately changed to the FIFO cost method from the weighted-average cost method for financial statement and income tax purposes. The change will result in a $700,000 increase in the beginning inventory at January 1, 2002. Assuming a 40 percent income tax rate, the cumulative effect of this accounting change reported for the year ended December 31, 2002, is a. $700,000. b. $350,000. c. $420,000. d. $280,000. 35. On January 2, 2000, McKell Company acquired machinery at a cost of $640,000. This machinery was being depreciated by the double-decliningbalance method over an estimated useful life of eight years, with no residual value. At the beginning of 2002, McKell decided to change to the straight-line method of depreciation. Ignoring income tax considerations, the cumulative effect of this accounting change is a. $0.

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b. $120,000. c. $130,000. d. $280,000. c LO3

36. On January 1, 1999, Grayson Company purchased for $240,000 a machine with a useful life of ten years and no salvage value. The machine was depreciated by the double-declining-balance method, and the carrying amount of the machine was $153,600 on December 31, 2000. Grayson changed retroactively to the straight-line method on January 1, 2001. Grayson can justify the change. What should be the depreciation expense on this machine for the year ended December 31, 2002? a. $15,360 b. $19,200 c. $24,000 d. $30,720

d LO3

37. On January 1, 2002, Apollo Inc. changed its inventory cost flow method to FIFO from LIFO for both financial statement and income tax reporting purposes. The change resulted in a $400,000 increase in the beginning inventory at January 1, 2002. Ignoring income taxes, the accounting change should be reported by Apollo in its 2002 a. income statement as a $400,000 debit. b. retained earnings statement as a $400,000 debit adjustment to the beginning balance. c. income statement as a $400,000 credit. d. retained earnings statement as a credit adjustment to the beginning balance.

a

38. Tyson Company bought a machine on January 1, 2000, for $24,000, at which time it had an estimated useful life of eight years, with no residual value. Straight-line depreciation is used for all of Tyson’s depreciable assets. On January 1, 2002, the machine’s estimated useful life was determined to be only six years from the acquisition date. Accordingly, the appropriate accounting change was made in 2002. Tyson’s income tax rate was 40 percent in all the affected years. In Tyson’s 2002 financial statements, how much should be reported as the cumulative effect on prior years because of the change in the estimated useful life of the machine? a. $0 b. $1,200

LO2

c. $2,000 d. $2,800 b LO2

a LO5

39. On January 1, 1999, Carnival Shipping bought a machine for $1,500,000. At that time, this machine had an estimated useful life of six years, with no salvage value. As a result of additional information, Carnival determined on January 1, 2002, that the machine had an estimated useful life of eight years from the date it was acquired, with no salvage value. Accordingly, the appropriate accounting change was made in 2002. How much depreciation expense for this machine should Carnival record for the year ended December 31, 2002 assuming Carnival uses the straight-line method of depreciation? a. $125,000 b. $150,000 c. $187,500 d. $250,000 40. Coombs, Inc. is a calendar-year corporation whose financial statements for 2001 and 2002 included errors as follows: Ending Depreciation Year Inventory Expense 2001 $30,000 overstated $25,000 overstated 2002 $10,000 understated $ 8,000 understated Assume that purchases were recorded correctly and that no correcting entries were made at December 31, 2001, or December 31, 2002. Ignoring income taxes, by how much should Coombs’ retained earnings be retroactively adjusted at January 1, 2003? a. $27,000 increase b. $27,000 decrease c. $7,000 decrease d. $3,000 decrease

PROBLEMS Problem 1 On January 1, 2002, Nicole Corporation changed its method of accounting for bad debts from the direct write-off method to the allowance method. The company’s controller determined that an allowance of $22,000 should be established on that date.

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(1) Ignoring income taxes, what is the amount of adjustment required, and where would it be reported in the financial statements? (2) Prepare the journal entry (excluding income taxes) required to adjust the accounts.

Solution 1 LO5 (1) The change is from an unacceptable principle to GAAP, which is an error correction, not a change in accounting principle. The change must be reported as a prior period adjustment to Retained Earnings at January 1, 2002. (2) Retained Earnings...................................................... Allowance for Doubtful Accounts........................

22,000 22,000

Problem 2 Stone Enterprise purchased a machine on January 3, 1999. The machine cost $46,000 with an estimated salvage value of $2,000 and an estimated useful life of 10 years. As a result of technological improvements, a revision of the machine’s useful life and estimated salvage value was made. On January 1, 2002, the equipment was estimated to last through 2003 with an estimated value at that time of $500. Stone uses the straight-line method for depreciation. Prepare the journal entry to record depreciation on December 31, 2002. Solution 2 LO2 Book value on January 1, 2002: [$46,000 - $2,000] / 10 years = $4,400 per year. Year 1/3/1999 1/1/2000 1/1/2001 1/1/2002

Depreciation $4,400 4,400 4,400

Book Value $46,000 41,600 37,200 32,800

Depreciation expense for 2002: [$32,800 - $500] / 2 years = $16,150. Depreciation Expense...................................................... Accumulated Depreciation.......................................

16,150 16,150

Problem 3 Perfect Technologies has estimated bad debts using the percentage-of-sales method since their business began operations in 1999. Information relating to bad debts and sales is as follows: Estimated Bad Debt Expense Actual Year Sales (% of Sales) Bad Debts 1999 $ 87,000 $2,610 $1,200 2000 123,000 3,690 2,850 2001 147,000 4,410 3,222 At the beginning of 2002, Perfect proposes changing their estimation of bad debt expense from 3 percent of sales to 2 percent. Sales for the year totaled $163,000 and actual bad debts amounted to $3,720. (1) Prepare the journal entry to record bad debt expense at the end of 2002. (2) Determine the balance in "Allowance for Bad Debts” on December 31, 2002. Solution 3 LO2 (1) $163,000 x 2% = $3,260 Bad Debt Expense........................................................... Allowance for Bad Debts ........................................ (2)

3,260 3,260

Allowance for Bad Debts $1,200 $2,610 2,850 3,690 3,220 4,410 3,720 3,260 $2,980 ending balance

Problem 4 On January 1, 1999, Fulbrite Services Inc. purchased a new machine for $600,000. The machine had an estimated useful life of eight years and a salvage value of $150,000. Fulbrite elected to depreciate the machine using the double-decliningbalance method. On January 1, 2002, the company decided to change to straightline depreciation. Ignoring income tax considerations, prepare the entries to record (1) Fulbrite’s 2001 depreciation expense. (2) the effect of the change in depreciation methods. (3) Fulbrite’s 2002 depreciation expense. Solution 4 LO3 (1)

Double-Declining-

Date 12/31/99 12/31/00 12/31/01

Asset Book Value $600,000 450,000 337,500

Percentage 25% 25% 25%

Balance Depreciation $150,000 112,500 84,375 $346,875

Depreciation Expense...................................................... Accumulated Depreciation....................................... (2) Date 12/31/99 12/31/00 12/31/01

Double-DecliningBalance Depreciation $150,000 112,500 84,375 $346,875

84,375 84,375

Straight-Line Depreciation $ 56,250* 56,250 56,250 $168,750

Excess Depreciation $ 93,750 56,250 28,125 $178,125

*($600,000 - $150,000)/8 = $56,250 Accumulated Depreciation............................................... 178,125 Cumulative Effect of Change in Accounting Principle

178,125

(3) 2002 depreciation expense: ($600,000 - $150,000 - $168,750)/5 = $56,250 Depreciation Expense...................................................... Accumulated Depreciation.......................................

56,250 56,250

Problem 5 Johnson's Distributing purchased equipment on January 1, 1999. The equipment cost $124,000 with a salvage value of $12,000 and an estimated life of 8 years. Initially, Johnson depreciated the equipment using the sum-of-the-years’-digits method. On January 1, 2002, the company elected to change to the straight-line method of depreciation. (1) Ignoring income tax considerations, prepare the journal entry to record the effect of the change in depreciation methods. (2) Determine depreciation expense for 2002 and prepare the appropriate journal entry. Solution 5 LO3 (1) Date 12/31/99

Straight-line Depreciation $14,000

Sum-of-theYears’-Digits Depreciation $24,889

Excess Depreciation $10,889

12/31/00 12/31/01

14,000 14,000 $42,000

21,778 18,667 $65,334

7,778 4,666 $23,334

Accumulated Depreciation............................................... 23,334 Cumulative Effect of Change in Accounting Principle

23,334

(2) ($124,000 - $12,000 - $42,000) / 5 years = $14,000. Depreciation Expense...................................................... Accumulated Depreciation.......................................

14,000 14,000

Problem 6 Cameron Co. began operations on January 1, 1999, at which time it acquired depreciable assets of $100,000. The assets have an estimated useful life of ten years and no salvage value. In 2002, Cameron Co. changed from the sum-of-the-years’-digits depreciation method to the straight-line depreciation method. In 2002, Cameron Co. had income from continuing operations of $670,000. Net income from prior years was as follows: 2001.................................................................... $300,000 2000.................................................................... 450,000 1999.................................................................... 350,000 (1) Ignoring income tax considerations, prepare a partial income statement for Cameron Co. to reflect the preceding information at December 31, 2002 (round to the nearest dollar). (2) Show the proper disclosure of pro forma amounts.

Solution 6 LO3 (1) Sum-of-the-Years’-Digits Year Depreciation 1999 10/55 x $100,000 = $18,182 2000 9/55 x $100,000 = $16,364 2001 8/55 x $100,000 = $14,545

Straight-Line Depreciation $100,000/10 = $10,000 $100,000/10 = $10,000 $100,000/10 = $10,000

Excess Depreciation $ 8,182 6,364 4,545 $19,091

Cameron Co. Partial Income Statement For Year Ended December 31, 2002 Income from continuing operations.............................................................. $670,000 Cumulative effect on prior years of change from sum-of-theyears’-digits to straight-line depreciation..................................................... 19,091 Net income.................................................................................................... $689,091 (2) Pro forma income disclosure: 2001 Net income as previously recorded $300,000 Effect of change in principle 4,545 $304,545

2000 $450,000 6,364 $456,364

1999 $350,000 8,182 $358,182

Note: Pro forma earnings per share would also be required although they cannot be computed from the data given. Problem 7 In reviewing the books of Meyers Retailers Inc., the auditor discovered certain errors that had occurred during 2001 and 2002. No errors were corrected during 2001. The errors are summarized below: (a) (b)

(c) (d)

(e)

Beginning merchandise inventory (January 1, 2001) was understated by $8,640. Merchandise costing $2,400 was sold for $4,000 to B.J. Taylor on December 29, 1999, but the sale was recorded in 2002. The merchandise was shipped F.O.B. shipping point and was not included in ending inventory. Meyers uses a periodic inventory system. A two-year fire insurance policy was purchased on May 1, 2001, for $5,760. The entire amount was debited to Prepaid Insurance. No adjusting entry was made in 2001 or 2002. A one-year note receivable of $9,600 was held by Meyers beginning October 1, 2001. Payment of the 10 percent note and accrued interest was received upon maturity. No adjusting entry was made on December 31, 2001. Equipment with a ten-year life was purchased on January 1, 2001, for $39,200. No depreciation expense was recorded during 2001 or 2002.

Assume that the equipment has no salvage value and that Meyers uses the straight-line method for recording depreciation. Prepare journal entries to correct each of these independent situations. Assume that the nominal accounts for 2002 have not yet been closed into the income summary account. Solution 7 LO5 (a) No journal entry is required. The 2001 beginning inventory understatement is offset by the 2000 ending inventory understatement. The error is counterbalanced. (b) (c)

(d) (e)

Sales........................................................................ Retained Earnings..............................................

4,000

Insurance Expense.................................................. Retained Earnings................................................... Prepaid Insurance..............................................

2,880 1,920

Interest Revenue..................................................... Retained Earnings..............................................

240

Depreciation Expense.............................................. Retained Earnings................................................... Accumulated Depreciation--Equipment.............

3,920 3,920

4,000

4,800 240

7,840

Problem 8 Since its organization on January 1, 2000, Langley Inc. failed to properly recognize accruals and prepayments. Selected accounts revealed the following information: Accruals and Prepayments Not Recognized 2000 Accrued expenses.............................................. $2,900 Prepaid expenses............................................... 2,000 Accrued revenue................................................ 2,750 Unearned revenue……………………………….. 4,250

2001 $3,000 2,800 2,500 4,500

2002 $3,400 1,500 2,700 4,100

Net income reported by the company was: Year Net Income (Loss) 2000.....................................................$40,000 2001……………………………………………….. (15,000) 2002……………………………………………….. 35,000 Compute the corrected net income for the years 2000, 2001, and 2002. (Ignore income taxes.) Solution 8 LO5 Langley Inc. Corrected Net Income--2000, 2001, 2002 (Adjusted for Accruals and Prepayments) 2000 Reported net income.............................................. $40,000 Accruals and prepayments not properly recognized: Accrued expenses........................................... (2,900)

Prepaid expenses............................................ Accrued revenue.............................................. Unearned revenue...........................................

(3,400) 2,000 2,750 (4,250)

(4,100) Corrected net income (loss)…….…………………. $37,600

2001 2002 $(15,000) $35,000 2,900 (3,000) (2,000) 2,800 (2,750) 2,500 4,250 (4,500)

3,000

(2,800) 1,500 (2,500) 2,700 4,500

$(14,800) $33,900

Problem 9 On January 1, 2002, Hamwell Corporation changed its inventory cost flow assumption from LIFO to FIFO. Hamwell’s inventory values at the end of each year since inception under both methods are summarized below. FIFO LIFO 1998....................................................$200,000 $180,000 1999......................................................250,000 226,000 2000......................................................310,000 283,000 2001......................................................400,000 360,000 Ignore income tax considerations. (1) What is the amount of adjustment required in the 2002 accounts, and where would it be reported in the financial statements? (2) Prepare the journal entry required to adjust the accounts. Solution 9 LO3 (1) The inventory should be adjusted to the FIFO basis at the beginning of 2002, which would necessitate a $40,000 increase to the inventory at January 1, 2002. The change is an exception to the general rule and should be reported as an adjustment to retained earnings at January 1, 2002. (2) Inventory.......................................................................... Retained Earnings...................................................

40,000 40,000

Problem 10 On January 1, 2002, Wiley Corporation changed its inventory cost flow assumption from FIFO to LIFO. The change was made for financial statement and tax reporting. Wiley’s inventory values at the end of each year since inception under both methods are summarized below. FIFO LIFO 1998....................................................$400,000 $360,000 1999......................................................500,000 452,000 2000......................................................620,000 566,000 2001......................................................800,000 720,000 Ignoring income taxes, what is the amount of adjustment required in the 2002 accounts, and where would it be reported in the financial statement?

Solution 10 LO3 The change is an exception to the general rule and should be reported by note disclosure only. Determination of inventory under LIFO is usually impractical, so the carrying value of the inventory at the date of change becomes the beginning inventory value under LIFO. Problem 11 Managers often are accused of making accounting changes in order to avoid regulation, to achieve compliance with debt covenants, to increase compensation through earnings-based bonus plans, or to smooth earnings. Managers may indeed believe that by increasing earnings, and thus increasing earnings per share, stock prices will increase. Explain the relationship between attempts by managers to manipulate earnings through accounting changes and the efficient market hypothesis. Solution 11 LO1 Market efficiency requires that security prices instantaneously and fully reflect all publicly available information. Some available information may not be relevant in determining the market value of a company. Research suggests that investors in efficient markets attempt to evaluate news about the effect on managerial decisions (including accounting changes) on cash flows and not on earnings per share. Stock prices usually do not react to changes in earnings caused by accounting changes unless those changes cause a firm’s cash flows to change either through tax effects or indirect effects such as changes in bonuses, royalties, borrowing costs, or the level of regulation. Many accounting changes thus may be irrelevant in terms of the information actually processed by an efficient market. Problem 12 Ideally, managers should make accounting changes only as a result of new experience or information, or due to changes in economic conditions that demand methods of accounting that more accurately reflect such changing conditions. Managers should be attempting to achieve the closest match between reporting and economic reality. Identify motivations for managers to make accounting changes other than the goal of achieving congruence between reporting and economic reality. Solution 12 LO1 1. Accounting standard-setting bodies may require the use of new accounting methods or principles. The fact that a standard-setting body enacts such a requirement does not provide assurance that the new standard always reflects

the economic realties facing a firm, however. Standard setting is an extremely political process in which compromise may be necessary on the part of standard setters to reach consensus. 2.

An enterprise may make an accounting change if its accounting and reporting practices in one or more areas are inconsistent with practices in the industry in which the enterprise operates.

3.

An enterprise in a highly regulated industry may make an accounting change in order to minimize reported net income and thus avoid the scrutiny of regulators. Large, highly visible firms do not wish to draw the attention of politicians and regulators who may attempt to portray higher earnings of regulated enterprises as detrimental to their constituents and representing a “problem” in need of resolution. Proposing solutions to such problems allows politicians and regulators to attract favorable public attention to themselves and thus increase the probability of their reelection.

4. Debt covenants typically are based on ratios computed from externally reported financial information. Managers may be motivated to choose those accounting principles that enhance financial ratios and allow the enterprise to comply with existing debt covenants. They may try to increase the probability of obtaining additional capital as a result of what appears to be the more robust financial health of the company. 5. Many management compensation plans are based in part on reported net income. Managers have some incentive to make accounting changes that favorably affect the level of compensation received. 6. Managers dislike earnings volatility. Large increases in earnings are difficult to sustain and may result in (a) demands from shareholders for higher dividends and (b) investigations by politicians and regulators eager to find a “crisis” in need of resolution. Large decreases in earnings may raise questions about the financial health of the enterprise and the competence of management. Investors perceive an erratic earnings trend as more risky than a smooth trend. Accordingly, management has an incentive to smooth earnings in order to avoid these problems. 7.

Managers may make accounting changes so that accounting practices correspond with tax practices.

8.

Managers may make accounting changes in order to move from a very costly practice or method to a less costly practice or method.

CHAPTER 20 -- QUIZ A

Name _________________________ Section ________________________

T F

1. The three main categories of accounting changes are change in estimate, change in principle, and correction of prior period errors.

T F

2. Pro forma statements should be prepared for a change in accounting estimate.

T F

3. Changes in accounting estimates are considered to be part of the normal accounting process and not corrections or changes of past periods.

T F

4. A change in the percentage used in determining uncollectible accounts receivable is a change in accounting principle.

T F

5. A change from a principle that is not generally accepted to one that is generally accepted is considered to be a correction of an error.

T F

6. A change in accounting principle, as defined in APB Opinion No. 20, includes the initial adoption of an accounting principle as a result of transactions or events that had not occurred in previous periods.

T F

7. In most cases, the effect of a change from one accepted accounting principle to another is reflected by reporting the cumulative effect of the change in the income statement.

T F

8. A change from FIFO to LIFO is a change in accounting principle requiring restatement of prior period financial statements.

T F

9. A change from LIFO to FIFO is a change in accounting principle requiring restatement of prior period financial statements.

T F 10. Pro forma amounts disclosed under the cumulative effect method should include nondiscretionary adjustments that would have been recognized if newly adopted accounting principles had been followed in prior periods.

255

CHAPTER 20 -- QUIZ B

Name _________________________ Section ________________________

T F

1. The cumulative effect of a change from double-declining-balance to straightline depreciation is properly reported on the income statement immediately before net income (loss).

T F

2. A change in reporting entity is considered a change in accounting principle.

T F

3. If an asset is affected by both a change in estimate and a change in principle, the change is treated as a change in principle as required by APB Opinion No. 20.

T F

4. A change in reporting entity must be adjusted retroactively to disclose what the statements would have looked like if the current entity had been in existence in the prior years.

T F

5. If a change in accounting principle is caused by a new pronouncement by an authoritative accounting body, the cumulative effect must be reported by retroactive restatement.

T F

6. Accounting errors made in prior years that have not already “counterbalanced” are reported as prior period adjustments and recorded directly to Retained Earnings.

T F

7. The understatement of merchandise inventory is an example of an error that counterbalances after two years.

T F

8. Pro forma income information is required when prior period financial statements are restated for a change in accounting principle.

T F

9. Failure to record amortization is an example of a non counter balancing error.

T F 10. The primary distinction between a change in accounting estimate and the correction of an error is the timing of availability of information; a change in estimate is based on new information not previously available.

256

CHAPTER 20 -- QUIZ C

A. B. C. D. E.

Name _________________________ Section ________________________

Prior period adjustment Change in reporting entity Change in accounting estimate Change in accounting principle--retroactive Cumulative effect of change in accounting principle

Select the term that best fits each of the following independent situations. Indicate your answer by placing the appropriate letter in the space provided. ____ 1. A company switches from LIFO to a FIFO inventory valuation during the current period. ____ 2. The computation of depreciation for 1993 was overstated by 96,500. The mistake was discovered in 1997. ____ 3. A company changes from presenting nonconsolidated to consolidated financial statements. ____ 4. A company changes its depreciation method for machinery and equipment from sum-of-the-years’-digits depreciation to the straight-line method. ____ 5. A company reduces the lives of several patents from 17 to 10 years because of rapid technological change. ____ 6. A company changes from the completed-contract to percentage-ofcompletion method for recognizing income. ____ 7. During the current year, a company adopted the inventory costing rules under the Tax Reform Act of 1986 for financial reporting purposes. Such rules require including in inventories certain costs that had previously been expensed when incurred. ____ 8. An analysis of the allowance for doubtful accounts showed the balance should be reduced by $27,500 due to recent changes in economic conditions. ____ 9. A company changes from a nonacceptable to an acceptable accounting principle. ____ 10. A company changes its depreciation method at the same time it recognizes a change in the estimated useful life of the asset. ____ 11. A company includes all majority owned subsidiaries in its consolidated financial statements in accordance with FASB Statement No. 94. In previous years, the company had included only wholly owned subsidiaries in its consolidated financial statements. ____ 12. A company deliberately understated various expenses in order to present higher net incomes in the previous three years.

CHAPTER 20 -- QUIZ SOLUTIONS 257

Quiz A

Quiz B

1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

F F T F T F T F T T

Quiz C

T F F T F T T F T T

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.

258

D A B E C D E C A C B A