Question

Change in Accounting Method

Instructions

Delta Oil Company uses the successful-efforts method to account for oil exploration costs. Delta started business in 2014 and prepared the following income statements:

DELTA OIL COMPANY

Income Statements

For the Years Ended December 31, 2014 - 2015

1		2014	2015
2	Revenue	$1,000,000.00	$3,000,000.00
3	Other expenses	400,000.00	1,300,000.00
4	Exploration expenses	120,000.00	238,000.00
5	Income before income taxes	$480,000.00	$1,462,000.00
6	Income tax expense (30%)	144,000.00	438,600.00
7	Net income	$336,000.00	$1,023,400.00
8	Earnings per share	$3.36	$10.23

The company chose to change to the full-cost method at the beginning of 2016. Under the full-cost method, Delta capitalizes all exploration costs of the Oil and Gas Properties asset account on its balance sheet. It determines the exploration and amortization expense amounts under the full-cost method to be as follows:

	2014	2015	2016
Exploration expense	$0	$0	$0
Amortization expense	8,000	18,200	42,000

In addition, Delta reported revenue of $9,000,000 and other expenses of $4,200,000 in 2016. With the 2016 financial statements, the company issues comparative statements for the previous 2 years.

Required:

1.	Prepare the journal entry to reflect the change.
2.	Prepare the comparative income statements and the comparative statements of retained earnings for 2016, 2015, and 2014. Notes to the financial statements are not necessary.
3.	Next Level Discuss the advantages and disadvantages of accounting for a change in this manner.

Chart of Accounts

CHART OF ACCOUNTS
Delta Oil Company
General Ledger
ASSETS 111 Cash 121 Accounts Receivable 141 Inventory 152 Prepaid Insurance 154 Deferred Tax Asset 172 Oil and Gas Properties 181 Equipment 189 Accumulated Depreciation LIABILITIES 211 Accounts Payable 231 Salaries Payable 250 Unearned Revenue 260 Deferred Tax Liability EQUITY 311 Common Stock 331 Retained Earnings	REVENUE 411 Sales Revenue EXPENSES 500 Cost of Goods Sold 511 Insurance Expense 512 Utilities Expense 521 Salaries Expense 532 Bad Debt Expense 540 Interest Expense 541 Depreciation Expense 542 Amortization Expense 559 Miscellaneous Expenses 910 Income Tax Expense

Amount Descriptions

Amount Descriptions
Adjustment for the cumulative effect of accounting method change
Balance at beginning of year, as previously reported
Balance at beginning of year, as adjusted
Balance at end of year
Income before income taxes
Net income
Other expenses
Revenue

General Journal

Prepare the journal entry to reflect the change on January 1, 2016

PAGE 1

GENERAL JOURNAL

	DATE	ACCOUNT TITLE	POST. REF.	DEBIT	CREDIT
1
2
3

Income Statements

Prepare the comparative income statements for 2016, 2015, and 2014. Notes to the financial statements are not necessary. Additional Instructions

DELTA OIL COMPANY

Comparative Income Statements

For the Years Ended December 31, 2014 - 2016

1		2016	2015 As Adjusted	2014 As Adjusted
2
3
4
5
6
7
8	Earnings per share (100,000 shares)

Retained Earnings

Prepare the comparative statements of retained earnings for 2016, 2015, and 2014. Notes to the financial statements are not necessary. Additional Instructions

DELTA OIL COMPANY

Comparative Statements of Retained Earnings

For the Years Ended December 31, 2014 - 2016

1		2016	2015	2014
2
3
4
5
6

Next Level

Discuss the advantages and disadvantages of accounting for a change in this manner.

Advantages and disadvantages of the retrospective adjustment method include:

I.	A risk of loss of public confidence due to changing previously reported information
II.	Comparability
III.	Costs may outweigh benefits
IV.	Faithful representation of financial information

Answer 1

ANSWER:

1.         In 2014 and 2015, Delta had recognized exploration expenses of $358,000 ($120,000 + $238,000 ) using the successful-efforts method. Under the full-cost method, Delta would have capitalized this amount as an asset (Oil and Gas Properties) and recognized $26,200 ($8,000 + $18,200) of amortization expense and no exploration expenses on its income statement. The following journal entry for the difference of $331,800 ($358,000 – $26,200) should be made at the beginning of 2016 to apply the retrospective adjustment method:

	Oil and Gas Properties ................................						331,800
	Deferred Tax Liability ($331,800 × 30%) ..											99,540
	Retained Earnings .......................................											232,260
2.	Condensed Comparative Income Statements
							2015						2014
			2016			As Adjusted	As Adjusted
	Revenue ……………………………….	$9,000,000	$3,000,000	$1,000,000
	Other expenses .......................................	(4,200,000)	(1,300,000)	(400,000)
	Amortization expense .............................		(42,000)	(18,200)				(8,000)
	Income before income taxes	$4,758,000		$ ,681,800		$ 592,000
	Income tax expense (30%) ......................	(1,427,400)		(504,540)	(177,600)
	Net income ..............................................	$3,330,600		$ 1,177,260		$ 414,400
	Earnings per share (100,000 shares) .......	$33.31		$11.77					$4.14
	Comparative Statements of Retained Earnings
	Balance at beginning of year,	2016			2015						2014
	as previously reported ………………	$1,359,400		$336,000			$0
	Add: Adjustment for the cumulative
	effect on prior years of applying
	retrospectively the new method
	of accounting for long-term
	contracts (net of income taxes of
	$232,260 in 2016 and $78,400								78,400a				0
	in 2015) .........................................			232,260b
	Balance at beginning of year,
	as adjusted .............................................	$ 1,591,660		$ 414,400			$	0
	Net income ...................................................	3,330,600		1,177,260		414,400
	Balance at end of year ...............................	$4,922,260		$1,591,660		$414,400

^a($120,000 – $8,000) × 0.7

            ^b($120,000 + $238,000) – ($8,000 + $18,200) × 0.7

  

3.         The major advantage of the retrospective adjustment method is that it achieves comparability between accounting periods that allows financial statement users to make more meaningful comparisons with the previous years’ financial statements. Therefore, the retrospective adjustment method provides a more faithful representation of financial information by presenting the effect of prior economic events and transactions in the period in which they occurred instead of the period in which the accounting change is made. However, the retrospective adjustment method does have some disadvantages. First, the cost of determining the effect of the accounting change and revising prior period financial statements may be greater than the benefits obtained (cost vs. benefit), there is a risk of loss of public confidence due to changing previously reported information, and significant costs may be incurred relating to a company’s contractual arrangements.