Chapter 22, Problem 3P

1.

To determine

Journalize the cumulative effect of the retrospective adjustment on Company K’s prior year income that would be reported in 2017.

Explanation of Solution

Journal entry: Journal entry is a set of economic events which can be measured in monetary terms. These are recorded chronologically and systematically.

Debit and credit rules:

• Debit an increase in asset account, increase in expense account, decrease in liability account, and decrease in stockholders’ equity accounts.
• Credit decrease in asset account, increase in revenue account, increase in liability account, and increase in stockholders’ equity accounts.

Journalize the cumulative effect of the retrospective adjustment of decrease in pretax income, on Company K’s prior year income that would be reported in 2017.

Date		Account Titles and Explanations		Post. Ref.	Debit ($)	Credit ($)
		Retained Earnings			11,200
		Deferred Tax Liability			4,800
			Inventory			16,000
		(Record the cumulative effect of pretax income due to change from FIFO to average cost)

Table (1)

Description:

• Retained Earnings is an equity account. Earnings decreased due to decrease in pretax income due to decrease in cumulative difference out of the change from FIFO to average cost, and a decrease in equity is debited.
• Deferred Tax Liability is a liability account. The obligation to pay taxes has decreased on saved income taxes, due to decrease in cumulative difference. The liability has decreased and a decrease in liability is debited.
• Inventory is an asset account. Since the cumulative difference has decreased due to change from FIFO to average cost flow, inventory has decreased, and a decrease in asset is credited.

Working Notes:

Compute the deferred tax liability amount.

$\begin{array}{c}\text{Deferred tax liability = Pretax amount }\times \text{ Income tax rate}\\ \text{=}\left(\left(\$57,000–\$50,000\right)+\left(\$69,000–\$60,000\right)\right)\text{×30\%}\\ \text{=\$16,000×30\%}\\ \text{=\$4,800}\end{array}$

Compute retained earnings amount.

$\begin{array}{c}\text{Retained earnings = Pretax amount }\times \left(\text{1–Income tax rate}\right)\\ \text{=}\left(\left(\$57,000–\$50,000\right)+\left(\$69,000–\$60,000\right)\right)\text{×}\left(\text{1–30\%}\right)\\ \text{=\$16,000×70\%}\\ \text{=\$11,200}\end{array}$

2.

To determine

Prepare comparative financial statements for Company K for the year 2017.

Explanation of Solution

Income statement: The financial statement which reports revenues and expenses from business operations, and the result of those operations as net income or net loss for a particular time period is referred to as income statement.

Prepare comparative income statements of Company K for the year 2017.

Company K
Comparative Income Statements
For the Years Ended December 31
	2017	2016 (As Adjusted)
Revenues	$130,000	$100,000
Cost of goods sold	(80,000)	(69,000)
Gross profit	50,000	31,000
Operating expenses	(30,000)	(25,000)
Income before income taxes	20,000	6,000
Income tax expense	(6,000)	(1,800)
Net income	$14,000	$4,200
Earnings per share:
Net income	$1.40	$0.42

Table (2)

Working Notes:

Compute the income tax expense for 2017.

$\begin{array}{c}\text{Income tax expense = Income before taxes }\times \text{ Income tax rate}\\ \text{=\$20,000×30\%}\\ \text{=\$6,000}\end{array}$

Compute the income tax expense for 2016.

$\begin{array}{c}\text{Income tax expense = Income before taxes }\times \text{ Income tax rate}\\ \text{=\$6,000×30\%}\\ \text{=\$1,800}\end{array}$

Compute the earnings per share (EPS) for 2017.

$\begin{array}{c}\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}\\ \text{=}\frac{\text{\$14,000–\$0}}{\text{10,000 shares}}\\ \text{=\$1}\text{.40}\end{array}$

Compute the earnings per share (EPS) for 2016.

$\begin{array}{c}\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}\\ \text{=}\frac{\text{\$4,200–\$0}}{\text{10,000 shares}}\\ \text{=\$0}\text{.42}\end{array}$

Statement of retained earnings: This statement reports the beginning retained earnings and all the changes which led to ending retained earnings. Net income from income statement is added to and dividends is deducted from beginning retained earnings to arrive at the end result, ending retained earnings.

Prepare comparative statements of retained earnings of Company K for the year 2017.

Company K
Comparative Statement of Retained Earnings
For the Years Ended December 31
	2017	2016
Beginning unadjusted retained earnings	$19,500	$15,000
Less: Adjustment for the cumulative effect on prior years of retrospectively applying the average cost inventory method (net of taxes)	(11,200)	(4,900)
Adjusted beginning retained earnings	8,300	10,100
Add: Net income	14,000	4,200
	22,300	14,300
Less: Dividends	(10,000)	(6,000)
Ending retained earnings	$12,300	$8,300

Table (3)

Working Notes:

Compute the adjustment value for 2017.

$\begin{array}{c}\text{Adjustment value = }\left[\begin{array}{l}\left(\begin{array}{l}\text{Excess of average cost of goods sold over }\\ \text{FIFO cost of goods sold in 2015 +}\\ \text{Excess of average cost of goods sold over }\\ \text{FIFO cost of goods sold in 2016}\end{array}\right)\times \\ \left(\text{1–Income tax rate}\right)\end{array}\right]\\ \text{=}\left(\left(\text{\$57,000–\$50,000}\right)+\left(\$69,000–\$60,000\right)\right)\text{×}\left(\text{1–30\%}\right)\\ \text{=\$16,000×0}\text{.70}\\ \text{=\$11,200}\end{array}$

Compute the adjustment value for 2016.

$\begin{array}{c}\text{Adjustment value = }\left[\begin{array}{l}\left(\begin{array}{l}\text{Excess of average cost of goods sold over }\\ \text{FIFO cost of goods sold in 2015}\end{array}\right)\times \\ \left(\text{1–Income tax rate}\right)\end{array}\right]\\ \text{=}\left(\text{\$57,000–\$50,000}\right)\text{×}\left(\text{1–30\%}\right)\\ \text{=\$7,000×0}\text{.70}\\ \text{=\$4,900}\end{array}$

Prepare comparative balance sheets of Company K for the year 2017.

Company K
Comparative Balance Sheets
December 31
	2017	2016 (As Adjusted)
Assets
Cash	$10,000	$9,000
Inventory	24,000	22,000
Other assets	70,800	64,100
Total assets	$104,800	$95,100
Liabilities and Shareholders’ Equity
Accounts payable	$4,500	$3,000
Income taxes payable	6,000	1,800
Common stock, no par	82,000	82,000
Retained earnings	12,300	8,300
Total liabilities and shareholders’ equity	$104,800	$95,100

Table (4)

Working Notes:

Refer to Table (2) for value and computation of income tax expense, which is the income taxes payable in 2017.

Compute adjusted inventory value for 2016.

$\begin{array}{c}\text{Adjusted inventory = }\left\{\begin{array}{l}\text{Inventory value originally reported on 12/31/2016–}\\ \left(\begin{array}{l}\text{Excess of average cost of goods sold over }\\ \text{FIFO cost of goods sold in 2015 +}\\ \text{Excess of average cost of goods sold over }\\ \text{FIFO cost of goods sold in 2016}\end{array}\right)\end{array}\right\}\\ \text{=\$38,000–}\left\{\left(\text{\$57,000–\$50,000}\right)\text{+}\left(\text{\$69,000–\$60,000}\right)\right\}\\ \text{=\$38,000–\$16,000}\\ \text{=\$22,000}\end{array}$