Chapter 22, Problem 5P

1.

To determine

Journalize the cumulative effect of the retrospective adjustment of $1,330,000$\left(\$550,000+\$780,000\right)$, on Company GO’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 $1,330,000, on Company GO’s prior year income that would be reported in 2017.

Date		Account Titles and Explanations		Post. Ref.	Debit ($)	Credit ($)
		Retained Earnings			931,000
		Deferred Tax Liability			399,100
			Oil and Gas Properties			1,330,000
		(Record the cumulative effect of income due to change from full-cost method to successful-efforts method)

Table (1)

Description:

• Retained Earnings is an equity account. Earnings decreased due to decrease in pretax income due to change from successful-efforts method to full-cost method, 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. The liability decreased and a decrease in liability is debited.
• Oil and Gas Properties is an asset account. Since the cumulative difference has decreased due to change from full-cost method to successful-efforts method, oil and gas properties has decreased, and a decrease in asset is credited.

Working Notes:

Compute retained earnings amount.

$\begin{array}{c}\text{Retained earnings = }\left(\begin{array}{l}\text{Exploration expenses in 2015+}\\ \text{Exploration expense in 2016}\end{array}\right)\times \left(\text{1–Income tax rate}\right)\\ \text{=}\left(\text{\$550,000+\$780,000}\right)\text{×}\left(\text{1–30\%}\right)\\ =\$1,330,000\times 0.70\\ \text{=\$931,000}\end{array}$

Compute the deferred tax liability amount.

$\begin{array}{c}\text{Deferred tax liability = }\left(\begin{array}{l}\text{Exploration expenses in 2018+}\\ \text{Exploration expense in 2019}\end{array}\right)\times \text{ Income tax rate}\\ \text{=}\left(\text{\$550,000+\$780,000}\right)\text{×30\%}\\ =\$1,330,000\times 30\%\\ \text{=\$399,000}\end{array}$

2.

To determine

Prepare comparative income statements and comparative statement of retained earnings of Company GO for the years 2015, 2016 and 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 GO for the years 2015, 2016 and 2017.

Company GO
Comparative Income Statements (Partial)
	2017	2016 (As Adjusted)	2015 (As Adjusted)
Income before income taxes	$3,100,000	$1,220,000	$1,650,000
Income tax expense	(930,000)	(366,000)	(495,000)
Net income	$2,170,000	$854,000	$1,155,000
Earnings per share:
Net income	$21.70	$8.54	$11.55

Table (2)

Working Notes:

Compute income before income taxes for 2016.

$\begin{array}{c}\text{Income before taxes = }\left\{\begin{array}{l}\text{Reported pretax income in 2016– }\\ \text{Exploration costs due to successful-efforts method in 2016}\end{array}\right\}\\ \text{=\$2,000,000–\$780,000}\\ \text{=\$1,220,000}\end{array}$

Compute income before income taxes for 2015.

$\begin{array}{c}\text{Income before taxes = }\left\{\begin{array}{l}\text{Reported pretax income in 2015– }\\ \text{Exploration costs due to successful-efforts method in 2015}\end{array}\right\}\\ \text{=\$2,200,000–\$550,000}\\ \text{=\$1,650,000}\end{array}$

Compute the income tax expense for 2017.

$\begin{array}{c}\text{Income tax expense = Income before taxes }\times \text{ Income tax rate}\\ \text{=\$3,100,000×30\%}\\ \text{=\$930,000}\end{array}$

Compute the income tax expense for 2016.

$\begin{array}{c}\text{Income tax expense = Income before taxes }\times \text{ Income tax rate}\\ \text{=\$1,220,000×30\%}\\ \text{=\$366,000}\end{array}$

Compute the income tax expense for 2015.

$\begin{array}{c}\text{Income tax expense = Income before taxes }\times \text{ Income tax rate}\\ \text{=\$1,650,000×30\%}\\ \text{=\$495,000}\end{array}$

Compute the earnings per share (EPS) for 2017.

$\begin{array}{c}\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}\\ \text{=}\frac{\text{\$2,170,000–\$0}}{\text{100,000 shares}}\\ \text{=\$21}\text{.70}\end{array}$

Compute the earnings per share (EPS) for 2016.

$\begin{array}{c}\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}\\ \text{=}\frac{\text{\$854,000–\$0}}{\text{100,000 shares}}\\ \text{=\$8}\text{.54}\end{array}$

Compute the earnings per share (EPS) for 2015.

$\begin{array}{c}\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}\\ \text{=}\frac{\text{\$1,155,000–\$0}}{\text{100,000 shares}}\\ \text{=\$11}\text{.55}\end{array}$

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 statement of retained earnings of Company GO for the years 2017, 2016, and 2015.

Company GO
Comparative Statement of Retained Earnings
	2017	2016	2015
Beginning unadjusted retained earnings	$2,940,000	$1,540,000	$0
Less: Adjustment for the cumulative effect on prior years of retrospectively applying the average cost inventory method (net of taxes)	(931,000)	(385,000)	0
Adjusted retained earnings	2,009,000	1,155,000	0
Net income	2,170,000	854,000	1,155,000
Ending retained earnings	$4,179,000	$2,009,000	$1,155,000

Table (3)

Working Notes:

Compute beginning unadjusted retained earnings for 2017.

$\begin{array}{c}\begin{array}{l}\text{Beginning unadjusted }\\ \text{retained earnings for 2017}\end{array}\}\text{ = }\left\{\begin{array}{l}\left(\begin{array}{l}\text{Reported net income in 2015+}\\ \text{Reported net income in 2016}\end{array}\right)\text{×}\\ \left(\text{1–Income tax rate}\right)\end{array}\right\}\\ \text{=}\left(\text{\$2,200,000+\$2,000,000}\right)\times \left(1–30\%\right)\\ =\$4,200,000\times 70\%\\ \text{=\$2,940,000}\end{array}$

Compute beginning unadjusted retained earnings for 2016.

$\begin{array}{c}\begin{array}{l}\text{Beginning unadjusted }\\ \text{retained earnings for 2016}\end{array}\}\text{ = }\left\{\begin{array}{l}\text{Reported net income in 2015×}\\ \left(\text{1–Income tax rate}\right)\end{array}\right\}\\ \text{=\$2,200,000}\times \left(1–30\%\right)\\ =\$2,200,000\times 70\%\\ \text{=\$1,540,000}\end{array}$

Compute the adjustment value for 2017.

$\begin{array}{c}\text{Adjustment value = }\left(\begin{array}{l}\text{Exploration expenses in 2015+}\\ \text{Exploration expense in 2016}\end{array}\right)\times \left(\text{1–Income tax rate}\right)\\ \text{=}\left(\text{\$550,000+\$780,000}\right)\text{×}\left(\text{1–30\%}\right)\\ =\$1,330,000\times 0.70\\ \text{=\$931,000}\end{array}$

Compute the adjustment value for 2016.

$\begin{array}{c}\text{Adjustment value = Exploration expenses in 2015 }\times \left(\text{1–Income tax rate}\right)\\ \text{=\$550,000×}\left(\text{1–30\%}\right)\\ =\$550,000\times 0.70\\ \text{=\$385,000}\end{array}$

3.

To determine

Indicate the items that would be restated on the financial statements.

Explanation of Solution

The following items would be restatedon the financial statements:

• Exploration expenses would be restated on the 2015 and 2016 income statements indicating the change from full-cost method to successful-efforts method.
• Oil and Gas Properties, Deferred Tax Liability, and Retained Earnings would be restated on the 2015 and 2016 balance sheets.