Question

 

You are internal auditor for Shannon Supplies, Inc., and are reviewing the company’s preliminary financial statements. The statements, prepared after making the adjusting entries, but before closing entries for the year ended December 31, 2021, are as follows: 

 

 

Shannon’s income tax rate was 25% in 2021 and previous years. During the course of the audit, the following additional information (not considered when the above statements were prepared) was obtained: 

a. Shannon’s investment portfolio consists of blue chip stocks held for long-term appreciation. To raise working capital, some of the shares with an original cost of $180,000 were sold in May 2021. Shannon accountants debited cash and credited investment in equity securities for the $220,000 proceeds of the sale. 

b. At December 31, 2021, the fair value of the remaining equity securities in the investment portfolio was $274,000. 

c. The state of Alabama filed suit against Shannon in October 2019, seeking civil penalties and injunctive relief for violations of environmental regulations regulating emissions. Shannon’s legal counsel previously believed that an unfavorable outcome of this litigation was not probable, but based on negotiations with state attorneys in 2021, now believes eventual payment to the state of $130,000 is probable, most likely to be paid in 2024. 

d. The $1,060,000 inventory total, which was based on a physical count at December 31, 2021, was priced at cost. Based on your conversations with company accountants, you determined that the inventory cost was overstated by $132,000. 

e. Electronic counters costing $80,000 were added to the equipment on December 29, 2020. The cost was charged to repairs. 

f. Shannon’s equipment, on which the counters were installed, had a remaining useful life of four years on December 29, 2020, and is being depreciated by the straight-line method for both financial and tax reporting. 

g. A new tax law was enacted in 2021 which will cause Shannon’s income tax rate to change from 25% to 20% beginning in 2022. 

 

Required: 

Prepare journal entries to record the effects on Shannon’s accounting records at December 31, 2021, for each of the items described above.

Answer 1

Adjusting Entries

These are the journal entries which are recorded at the end of the accounting period to correct or adjust the income and expense accounts in conformity with the accrual principle of accounting.

 

Accounting changes:

Consistency and comparability are the two qualitative characteristics of accounting information. These financial reporting attributes are maintained by every entity to ensure the reliability of the financial statements. However, changes occur and they are as shown below:

(1) Change in accounting principle

(2) Change in accounting estimate

(3) Change in reporting entity

 

(1)

 

(a)

 

 

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Investment ($220,000 - $180,000)		$40,000
	Gain on investment			$400,000
	(To record accumulated depreciation correction)

 

 

• Investment is an asset. There is an increase in asset value. Therefore, it is debited.

• Gain on investment is a liability. There is an increase in liability value. Therefore, it is credited.

 

(b)

 

Calculation of fair value of adjustment:

The fair value adjustment is calculated by adding the error adjustment to the investment on May 2021 to determine the corrected balance and deducting the ending fair value as shown below:

 

 

 

Particulars	Amount
Investment May 2021	$250,000
Add: Error adjustment	$40,000
Corrected balance Dec, 31, 2021	$290,000
Less: Fair value Dec, 31, 2021	$274,000
Fair value adjustment needed Dec, 31, 2021	$16,000

 

 

Hence, the calculated fair value of adjustment is $16,000.

 

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Unrealized loss-OCI		$16,000
	Fair vale adjustment			$16,000
	(To record accumulated depreciation correction)

 

 

• Unrealized loss is a deferred asset. There is an increase in asset value. Therefore, it is debited.

• Fair value adjustment is a liability. There is an increase in liability value. Therefore, it is credited.

 

(c)

 

 

 

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Loss-lawsuit		$130,000
	Liability – lawsuit			$130,000
	(To record accumulated depreciation correction)

 

 

• Loss is a deferred asset. There is an increase in asset value. Therefore, it is debited.

• Liability – lawsuit is a liability. There is an increase in liability value. Therefore, it is credited.

 

(d)

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Cost of goods sold		$132,000
	Inventory			$132,000
	(To record cos to inventory)

 

 

• Cost of goods sold is an expense. There is a decrease in asset value. Therefore, it is debited.

• Inventory is an asset. There is a decrease in assets value. Therefore, it is credited.

 

(e)

 

 

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Property, plant, and equipment		$80,000
	Retained earnings			$48,000
	Income tax payable ($80,000 × 40%)			$32,000
	(To record income tax payable)

 

 

• Inventory is an asset. There is an increase in assets value. Therefore, it is debited.

• Retained earnings and income tax payables are liability. There is an increase in liability value. Therefore, it is credited.

 

(f)

 

 

 

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Depreciation expense ($80,000/4)		$20,000
	Accumulated depreciation			$20,000
	(To record accumulated depreciation)

 

 

• Depreciation expense is an expense. There is an increase in liability value. Therefore, it is debited.

• Accumulated depreciation is a contra asset. There is a decrease in assets value. Therefore, it is credited.

 

(g)

 

Calculation of income tax payable:

The income tax payable is calculated by applying the applicable tax rate on the adjusted taxable income as shown below:

 

 

 

Particulars	Amount
Taxable income as reported	$1,280,000
Realized gain on sale of investment	$132,000
Additional depreciation	$20,000
Taxable income, as adjusted	$1,168,000
Tax rate	40%
Income tax payable	$467,200

 

 

Hence, the calculated income tax payable is $467,200.

 

Calculation of future deductible amount:

The income tax adjusted is calculated as the difference between the income tax payable and the deferred tax asset calculated as shown below:

 

 

 

Particulars	Amount	Amount
Lawsuit expected to be settled	$130,000
Unrealized loss on investment	$16,000
Total future deductible amounts	$146,000
Tax rate effective after 2021	35%
Deferred tax asset		$51,100
Income tax expense as adjusted		$416,100

 

 

Hence, the calculated future deductible amount is $416,000.

 

Calculation of reduction in income tax expense:

Reduction in income tax expense is calculated by deducting the income tax expense reported and income tax expense adjusted as shown below:

Particulars	Amount
Income tax expense, as reported	$512,000
Income tax expense, as adjusted	$416,100
Reduction in income tax expense	$95,900

 

 

 

Date	Amount Title and Explanation	Post Ref.	Debit	Credit
	Income tax payable		$44,800
	Deferred tax assets		$51,100
	Income tax expense			$95,900
	(To record the estimate liability warranty)

 

 

• Income tax payable and deferred tax assets are liability. There is an increase in liability value. Therefore, it is debited.

• Income tax expense is a liability. There is a decrease in liability value. Therefore, it is debited.

 

(a) $400,000

(b) Hence, the calculated fair value of adjustment is $16,000.

(c) $130,000

(d) $132,000

(e) $32,000

(f) $20,000

(g) Hence, the calculated income tax payable is $467,200.