Chapter 20, Problem 20.13P

To determine

Accounting changes:

Accounting changes are the alterations made to the accounting methods, accounting estimates, accounting principles (or) the reporting entity.

Error correction:

Error correction is an adjustment made to previously issue financial statements. It is not considered as an accounting change.

Change in estimate

Change in estimate refers to a change where the new information influences the companies to update the previously made estimates.

To identify: The type of accounting change or error in each situation and to prepare the journal entries for the change or error corrections and other steps to be taken to appropriately report the situation.

Explanation of Solution

Situation A:

Correction of an error:

Date	Account Title and Explanation	Post Ref.	Debit	Credit
2018	Prepaid insurance (3)		$21,000
	Income tax payable (1)			$8,400
	Retained earnings (2)			$12,600
	(to record rectification of prepaid insurance)

Table (1)

Adjusting entry for the year 2018:

Date	Account Title and Explanation	Post Ref.	Debit	Credit
2018	Insurance expense (4)		$7,000
	Prepaid insurance			$7,000
	(to record adjusting entries for prepaid expenses)

Table (2)

Here, prepaid insurance was purchased and at that time it was fully debited. This results in the error so that the financial statements are incorrect and thus, error should be retrospectively restated and the correct amount of insurance is reported again for the purpose of current annual report. Prior period adjustment for retained earnings and net of tax should be reported, and the disclosure note should describe the nature of the error, impact of the error and their correction should be reported.

Working note:

Calculate income tax payable:

$\begin{array}{c}\text{Income tax payable}\text{=Prepaid insurance × Tax rate}\\ =\$21,000\times 40\%\\ =\$8,400\end{array}$ (1)

Calculate retained earnings:

$\begin{array}{c}\text{Retained earnings=}\left(\text{Policy amount}-\left[\begin{array}{l}\frac{\text{Policy amount}}{\text{Maturity period}}\\ \times \text{Remaining years}\end{array}\right]\right)-\text{Income tax}\\ =\left(\text{\$35,000}-\left[\frac{\text{\$35,000}}{\text{5years}}\times 2\text{years}\right]\right)-\text{\$8,400}\\ \text{=\$12,600}\end{array}$ (2)

Calculate actual prepaid insurance:

$\begin{array}{c}\text{Prepaid insurance}\text{= \$35,000}\times \frac{3}{5}\\ =\$21,000\end{array}$ (3)

Calculate insurance expense to be expensed for the year 2018:

$\begin{array}{c}\text{Insurance}\text{expense}=\frac{\text{Amount of Insurance policy}}{\text{Number of years}}\\ \text{= }\frac{\text{\$35,000}}{5}\\ =\$7,000\end{array}$ (4)

Situation B

In this situation, there is a change in estimate. So, there is no entry is needed to record the change. Thus, only the adjustment entry is made.

Adjusting entry for the year 2018:

Date	Account Title and Explanation	Post Ref.	Debit	Credit
2018	Depreciation expense (5)		$15,000
	Accumulated depreciation			$15,000
	(To record adjusting depreciation entry)

Table (3)

Working note:

Calculate annual straight-line method:

Annual Straight – Line Method
Account Title and Explanation	Amount($)
Asset cost	600,000
Less: Accumulated depreciation ($12,500×10)	125,000
Un depreciated cost, Jan. 1 2016	475,000
Less: Estimated residual value	25,000
Depreciation over remaining 7 years	450,000
Divide: Remaining years	$÷$ 30 years
Annual straight-line depreciation	15,000

Table (4)

(5)

Explanation:

In the given situation it is based on the depreciation and the depreciation is recorded in the change in estimate so that there is no need to record the change in the journal entry. Only additional adjusting entry is made. The effect of change in estimate should be described in a disclosure note.

Situation C:

Correction of an error:

Date	Account Title and Explanation	Post Ref.	Debit	Credit
2018	Retained earnings		$15,000
	Refund - income tax (6)		$10,000
	Inventory			$25,000
	(To record adjusting the inventory)

Table (5)

Working note:

Calculate the refund-income tax:

$\begin{array}{c}\text{Refund income tax =Overstated net income}\times \text{Income tax expense}\\ \text{=}\text{\$25,000}\times 40\%\\ =\$10,000\end{array}$ (6)

In the given situation the inventory is overstated. The overstated inventory should be retrospectively restated with the correct amount when those statements are reported again for comparative purpose in the current annual report. Prior period adjustment for retained earnings and net of tax should be reported, and the disclosure note should describe the nature of the error, impact of the error and their correction should be reported.

Situation D:

In this situation there is a change in accounting principle and it is reported retrospectively.

Journal entry:

Date	Account Title and Explanation	Post Ref.	Debit	Credit
2018	Inventory		$960,000
	Income tax payable			$384,000
	Retained earnings			$576,000
	(To record error correction)

Table (6)

Changes in the accounting principle are accounted for retrospectively. The previous year’s financial statements are re-formed to reflect the use of new accounting method. If a company has used FIFO method previously then the company should increase the retained earnings to balance that by the increasing the net income, difference between the LIFO and FIFO methods, and net of tax. A disclosure note should justify the changes is preferable and that should describe the effect of change in any financial statement and per share amount for every period that is reported.

The taxes that are saved by the company using LIFO method should be repaid within six years. As the payment of the taxes are done within one year and six year it is considered as current and non-current liability but not as a deferred tax liability.

Situation E:

Correction of an error:

Date	Account Title and Explanation	Post Ref.	Debit	Credit
2018	Retained earnings		$9,300
	Refund - income tax (7)		$6,200
	Compensation expense			$15,500
	(To record compensation expense)

Table (7)

Working note:

$\begin{array}{c}\text{Refund income tax =Compenstation expenses }\times \text{Income tax expense}\\ \text{=}\text{\$15,500}\times 40\%\\ =\$6,200\end{array}$ (7)

In this the retained earnings is showing a net effect in the debit balance and to correct the compensate expenses, net income and retained earnings should be retrospectively restated when the statements are reported again for comparative purpose in the current annual report. A disclosure note should justify the changes is preferable and that should describe the effect of change in any financial statement and per share amount for every period that is reported.

Situation F:

There is a change in estimate that results in the change in accounting principle and it is accounted for prospectively. There is no entry is needed for the change in the estimate. Only the adjusting entry is recorded.

Adjusting entry for the year 2018:

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

Table (8)

Working note:

Calculate annual straight-line depreciation:

Particulars	Amount($)
Undepreciated cost	460,800
Less: Estimated residual value	0
Depreciation over remaining 8 years	460,800
Divide: Remaining years	8 years
Annual straight-line depreciation2018-2025	57,600

Table (9)

(8)

Change in depreciation method is considered as the change in accounting estimate that result from the change in accounting principle. The Corporation WS reported the changes prospectively and then the previous year financial statements are not revised. The straight-line method is used for calculating the depreciation from now. The undepreciated cost will remain at the time of the changes is depreciated straight line over the remaining useful of life.

Situation G:

In this situation G there is a change in estimate so there is no entry is needed for the change in estimate. Only the adjusting entries are made for this change in estimate.

Adjusting entry for the year 2018:

Date	Account Title and Explanation	Post Ref.	Debit	Credit
2018	Warranty expense		$30,000
	Estimated warranty liability  (9)			$30,000
	(To record the estimated liability warranty)

Table (10)

Working note:

$\begin{array}{c}\text{warranty expenses=Acutal sales×Percentage of actual cost}\\ \text{=\$400,000×75\%}\\ \text{=\$30,000}\end{array}$

(9)

When the effect is a material in nature then a disclosure note should describe the effect of change in estimate on income from continuing operations, net income and related per share amount for the current period.