Chapter 16, Problem 16.3BYP

Integrating Case 16–3

Tax effects of accounting changes and error correction; six situations

• LO16–1, LO16–2, LO16–8

Williams-Santana Inc. is a manufacturer of high-tech industrial parts that was started in 2004 by two talented engineers with little business training. In 2018, the company was acquired by one of its major customers. As part of an internal audit, the following facts were discovered. The audit occurred during 2018 before any adjusting entries or closing entries were prepared. The income tax rate is 40% for all years.

1. a. A five-year casualty insurance policy was purchased at the beginning of 2016 for $35,000. The full amount was debited to insurance expense at the time.
2. b. On December 31, 2017, merchandise inventory was overstated by $25,000 due to a mistake in the physical inventory count using the periodic inventory system.
3. c. The company changed inventory cost methods to FIFO from LIFO at the end of 2018 for both financial statement and income tax purposes. The change will cause a $960,000 increase in the beginning inventory at January 1, 2017.
4. d. At the end of 2017, the company failed to accrue $15,500 of sales commissions earned by employees during 2017. The expense was recorded when the commissions were paid in early 2018.
5. e. At the beginning of 2016, the company purchased a machine at a cost of $720,000. Its useful life was estimated to be 10 years with no salvage value. The machine has been depreciated by the double declining-balance method. Its carrying amount on December 31, 2017, was $460,800. On January 1, 2018, the company changed to the straight-line method.

f. Additional industrial robots were acquired at the beginning of 2013 and added to the company’s assembly process. The $1,000,000 cost of the equipment was inadvertently recorded as repair expense. Robots have 10-year useful lives and no material salvage value. This class of equipment is depreciated by the straight-line method for both financial reporting and income tax reporting.

Required:

For each situation:

1. 1. Identify whether it represents an accounting change or an error. If an accounting change, identify the type of change.
2. 2. Prepare any journal entry necessary as a direct result of the change or error correction, as well as any adjusting entry for 2018 related to the situation described. Any tax effects should be adjusted for through the deferred tax liability account.
3. 3. Briefly describe any other steps that should be taken to appropriately report the situation.

To determine

Tax effects of accounting changes and error correction

For each and every change of accounting policies and accounting errors, it is required by the business to pass the adjusting entries for change in the accounting policies or for the rectification of errors. These adjusting entries helps in proper taxation.

To identify:  1. if each case represents an accounting change or an error & if it’s an accounting change then identify the type of change.

2. Prepare journal necessary journal entry.

3. Briefly describe any other step that should be taken to report the situation.

Explanation of Solution

WS Incorporation is a manufacturer of high-tech industrial parts and was incorporated in the year 2004. In the year 2018 it was acquired by one of its major customers. During 2018 the audit occurred before any adjusting entries or closing entries were prepared. The tax rate is 40%.

a.

For five year casualty insurance policy, $35,000 was paid in 2016 and the whole amount was debited to insurance expense at that time. So this case represents an accounting error.

In order to rectify the error, the following journal entry is required to be passed.

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
	Prepaid insurance (1)		21,000
	Income tax payable (2)			8,400
	Retained earnings (3)			12,600
	(To adjust the prepaid insurance, income tax payable and retained earnings)

Table (1)

In order to adjust the error in 2018, the following journal entry is required to be passed.

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
	Insurance expense (4)		7,000
	Prepaid insurance			7,000
	(To record the insurance expense for the year 2018)

Table (2)

Description:

For five year casualty insurance policy, $35,000 was paid in 2016 and the whole amount was debited to insurance expense at that time. So this case represents an accounting error.

So to rectify this error, in Table (1) prepaid insurance was debited, as it reduced by $21,000 and Income tax payable and Retained Earnings are credited by $8,400 and $12,600, as they were understated previously.

In Table (2) insurance expense for the year 2018 was adjusted from the prepaid insurance. Insurance expense is a component of stockholders’ equity and has reduced it by $7,000. So it is debited. Prepaid Insurance is an asset has been reduced by $7,000. So it is credited.

Working Notes

Calculate the prepaid insurance for expired period

$\begin{array}{c}\text{Expired}\text{Prepaid}\text{Insurance}\text{=}\frac{\text{Total}\text{Insurance}\text{Amount}}{\text{Total}\text{Time}\text{Period}\text{of}\text{Insurance}}\text{×}\text{Expired}\text{Time}\text{Period}\\ \text{=}\frac{\text{\$35,000}}{\text{5}}\text{×3}\\ \text{=\$21,000}\end{array}$ (1)

Calculate the Income Tax Payable

Income tax Payable was under stated for $21,000 in the year 2016 as the whole insurance expense was debited. So it is required to calculate income tax payable on $21,000.

$\begin{array}{c}\text{Income}\text{}\text{Tax}\text{Payable}\text{=}\frac{\text{40}}{\text{100}}\text{×\$21,000}\\ \text{=}\text{\$8,400}\end{array}$ (2)

Calculate the Retained Earning

Retained Earnings were under stated for $21,000 in the year 2016 as the whole insurance expense was debited. So it is required to calculate the correct retained earnings

$\begin{array}{c}\text{Retained}\text{Earnings}\text{=}\left(\begin{array}{l}\text{Expired}\text{Prepaid}\\ \text{Insurance}\end{array}\right)\text{-}\left(\begin{array}{l}\text{Income}\text{Tax}\\ \text{Payable}\end{array}\right)\\ \text{=}\text{\$21,000}\text{-}\text{\$8,400}\\ \text{=}\text{\$12,600}\end{array}$ (3)

Calculate the insurance expense from prepaid insurance for the year 2018

$\begin{array}{c}\text{Insurance Expense}\text{=}\frac{\text{Total}\text{Insurance}\text{Amount}}{\text{Total}\text{Time}\text{Period}\text{of}\text{Insurance}}\text{×}\text{Expired}\text{Time}\text{Period}\\ \text{=}\frac{\text{\$35,000}}{\text{5}}\text{×1}\\ \text{=\$7,000}\end{array}$ (4)

b.

On December 31, 2017, the merchandise inventory was overstated by $25,000, due to mistake in physical count using periodic inventory system. So it represents the case of accounting error.

In order to rectify the error, the following journal entry is required to be passed.

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
	Retained earnings (bal fig.)		15,000
	Refund of income tax (5)		10,000
	Inventory			25,000
	(To correct the overstatement of inventory)

Table (3)

Description:

The inventory was overstated by $25,000 due to mistake. Inventory is an asset so to rectify the error it has been credited. Due to the overstated inventory in 2017, more income tax was paid by the company and retained earnings are overstated. So to rectify this, refund will be received from income tax. It is receivable, so it is an asset, and hence it has been debited and retained earnings are components of stockholders’ equity and to rectify the error it has been reduced. So retained earnings are debited.

Working notes:

Calculate the Refund of Income Tax

Income tax was over stated for the overstated inventory. So it is required to calculate the refund of income tax.

$\begin{array}{c}\text{Refund of Income}\text{}\text{Tax}\text{=}\frac{\text{40}}{\text{100}}\text{×\$25,000}\\ \text{=}\text{\$10,000}\end{array}$ (5)

c.

The company changed the accounting policy i.e. the inventory cost method was changed from LIFO to FIFO for both financial statements as well as tax purposes at the end of 2018. This change caused a $96,000 increase in the beginning inventory at January 1, 2017. So this case represents an error of accounting change.

In order to report the change of accounting policy the following journal entry is required to be passed in the books of company retrospectively.

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
	Inventory		960,000
	Deferred tax liability (6)			384,000
	Retained earnings (bal. fig.)			576,000
	( To record retrospective effect of the change inventory valuation)

Table (4)

Description:

The changes of accounting principles have retrospective effect. Previous year financial statements are used to analyze the use of new accounting principle. The company has to increase in the balance of retained earnings to show the effect of, if the company had used FIFO method instead of LIFO method for inventory valuation previously. A disclosure note should be mentioned in annual report explaining the requirement for this change and its effect on the financial statements.

Due to the change in the accounting method for inventory valuation that has a retrospective effect for pre-tax accounting income, without a change in taxable income. This cause a temporary difference that reverses as the inventory become part of the cost of goods sold in subsequent years. Hence, the taxable income would be higher than the accounting income in subsequent years that requires the company to record a deferred tax liability.

  Calculate the Deferred Tax Liability

$\begin{array}{c}\text{Deferred}\text{Tax}\text{Liability}\text{=}\frac{\text{40}}{\text{100}}\text{×\$960,000}\\ \text{=}\text{\$384,000}\end{array}$ (6)

d.

At the end of 2017 the company failed to accrue $15,500 of sales commission earned by employees during the 2017. This expense was recorded when the commissions were paid in early 2018. So this case represents an accounting error.

The journal entry to rectify such error is as follows:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
	Retained earnings (bal. fig.)		9,300
	Refund of income tax (7)		6,200
	Compensation expense			15,500
	(To record retrospective effect of not recording the sales commission)

Table (5)

Description:

The correct journal entry would show the financial statement with retrospective effect for the compensation expense, net income and retained earnings because of the error. A “prior period adjustment” in respect to retained earnings would be reported along with disclosure note to explain the nature of correction, effect on the net income, income before extraordinary items and the earning per share of the company in its annual report.

Working notes:

Calculate the Refund of Income Tax

$\begin{array}{c}\text{Refund of Income}\text{}\text{Tax}\text{=}\frac{\text{40}}{\text{100}}\text{×\$15,500}\\ \text{=}\text{\$6,200}\end{array}$ (7)

e.

The company change the method of depreciation from double declining-balance method to straight-line method. So this case represents an accounting change.

Since In the beginning of 2016 the company purchased the machine at a cost of $ 720,000 with its useful life of 10 years. The company changed the depreciation method from double- declining balance method to straight-line method only on January 1, 2018. So, no journal entry is necessary apart from the journal entry to account the depreciation expense for 2018 under new depreciation method.

The journal entry to report depreciation expense for 2018 would be as follows:

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
	Depreciation expense (8)		57,600
	Accumulated depreciation			57,600
	(To record the depreciation expense for 2018)

Table (6)

Working notes:

Calculate the depreciation expense for 2018

The carrying amount of machine in the beginning of 2018 is $ 460,800

The machine was purchased on 2016, which is 2 years before 2018. The total life of machine was 10 years.

So Depreciation expense in straight line method for the year 2018 will be:

$\begin{array}{c}\text{Depreciation}\text{Expense}\text{=}\frac{\text{\$460,800}}{\left(\text{10-2}\right)}\\ \text{=}\frac{\text{\$460,800}}{\text{8}}\\ \text{=\$57,600}\end{array}$ (8)

The financial statements are restated retrospectively to rectify the error and to report correct compensation expense, net income and retained earnings. A “ prior period adjustment” to retained earnings along with the disclosure note to explain the nature of the error, effect on the net income, income before the extraordinary items and earnings per share should be disclosed in the current annual report of the company.

f.

The cost of equipment was recorded as repair expense. So this case represents an accounting error.

In order to rectify the error, the following journal entry is required to be passed.

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
	Equipment(at cost)		1,000,000
	Accumulated depreciation (9)			300,000
	Deferred tax liability(10)			280,000
	Retained earnings			420,000
	(To record retrospective effect of the error of recording to repair expense)

Table (7)

In order to adjust the error in 2018, the following journal entry is required to be passed.

Date	Account Title and Explanation	Post Ref.	Debit ($)	Credit ($)
	Depreciation expense (11)		100,000
	Accumulated depreciation			100,000
	( To record depreciation expense for the year 2018)

Table (8)

Working Note:

Calculate Accumulated Depreciation

$\begin{array}{c}\text{Accumulated}\text{Depreciation}\text{=}\frac{\text{\$1,000,000}}{\text{10}}\text{×}\text{3}\\ \text{=}\text{\$300,000}\end{array}$ (9)

Calculate Deferred Tax Liability

$\begin{array}{c}\text{Deferred}\text{Tax}\text{Liability}\text{=}\left(\text{\$1,000,000}\text{-}\text{\$300,000}\right)\text{×}\frac{\text{40}}{\text{100}}\\ \text{=}\text{\$700,000}\text{×}\frac{\text{40}}{\text{100}}\\ \text{=\$280,000}\end{array}$ (10)

Calculate the depreciation expense for 2018

$\begin{array}{c}\text{Depreciation}\text{Expense}\text{=}\frac{\text{\$1,000,000}}{\text{10}}\\ \text{=}\text{\$100,000}\end{array}$ (11)

The financial statements are restated retrospectively to rectify the error and to report correct amount of depreciation, assets (machine) and the retained earnings in the current annual report of the company for the users. A “ prior period adjustment” to retained earnings along with the disclosure note to explain the nature of the error, effect on the net income, income before the extraordinary items and earnings per share should be disclosed in the current annual report of the company.