Question

Williams-Santana Inc. is a manufacturer of high-tech industrial parts that was started in 2009 by two talented engineers with little business training. In 2021, the company was acquired by one of its major customers. As part of an internal audit, the following facts were discovered. The audit occurred during 2021 before any adjusting entries or closing entries were prepared.

1. A five-year casualty insurance policy was purchased at the beginning of 2019 for $31,000. The full amount was debited to insurance expense at the time.
2. Effective January 1, 2021, the company changed the salvage value used in calculating depreciation for its office building. The building cost $568,000 on December 29, 2010, and has been depreciated on a straight-line basis assuming a useful life of 40 years and a salvage value of $100,000. Declining real estate values in the area indicate that the salvage value will be no more than $25,000.
3. On December 31, 2020, merchandise inventory was overstated by $21,000 due to a mistake in the physical inventory count using the periodic inventory system.
4. The company changed inventory cost methods to FIFO from LIFO at the end of 2021 for both financial statement and income tax purposes. The change will cause a $920,000 increase in the beginning inventory at January 1, 2022.
5. At the end of 2020, the company failed to accrue $14,700 of sales commissions earned by employees during 2020. The expense was recorded when the commissions were paid in early 2021.
6. At the beginning of 2019, the company purchased a machine at a cost of $640,000. Its useful life was estimated to be 10 years with no salvage value. The machine has been depreciated by the double-declining balance method. Its book value on December 31, 2020, was $409,600. On January 1, 2021, the company changed to the straight-line method.
7. Warranty expense is determined each year as 1% of sales. Actual payment experience of recent years indicates that 0.75% is a better indication of the actual cost. Management effects the change in 2021. Credit sales for 2021 are $3,200,000; in 2020 they were $2,900,000.

Required:
For each situation:
1. Identify whether it represents an accounting change or an error. If an accounting change, identify the type of change. For accounting errors, choose "Not applicable".
2. Prepare any journal entry necessary as a direct result of the change or error correction, as well as any adjusting entry for 2021 related to the situation described. (Ignore tax effects.)

Answer 1

Solution:-

a. A five-year casualty insurance policy was purchased at the beginning of 2019 for $31,000. The full amount was debited to insurance expense at the time:-

This is an accounting error that requires retrospective restatement. The amount that should be charged to expense every year is $6,200 ($31,000 ÷ 5)

2019: Expense O/S NI U/S R/E U/S by $24,800 ($31,000 - $6,200)

2020: Expense U/S NI O/S by $6,200 R/E is now U/S by $18,600

Particulars	Account title and explanation	Debit	Credit
Correcting entry	Prepaid insurance (3 x $6,200)	18,600
	R/E		18,600
Adjusting Entry	Insurance expense	6,200
	Prepaid insurance		6,200

A prior period adjustment to retained earnings would be reported, along with a disclosure note describing the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and EPS.

b. Effective January 1, 2021, the company changed the salvage value used in calculating depreciation for its office building. The building cost $568,000 on December 29, 2010, and has been depreciated on a straight-line basis assuming a useful life of 40 years and a salvage value of $100,000. Declining real estate values in the area indicate that the salvage value will be no more than $25,000:-

This is a change in estimate that is handled prospectively

Annual depreciation before the change = ($568,000 - $100,000) ÷ 40 = $11,700

2021 Book value = $568,000 – [(10 x $11,700)] = $451,000

New residual value = $25,000

Remaining life = 30 years (40 – 10)

New depreciation = ($451,000 - $25,000) ÷ 30 = $14,200

Account titles and explanation	Debit	Credit
Depreciation expense	14,200
Accumulated depreciation		14,200

Disclosure is required describing the effect of the change in estimate on income before extraordinary items, net income and EPS.

c. On December 31, 2020, merchandise inventory was overstated by $21,000 due to a mistake in the physical inventory count using the periodic inventory system:-

This is an accounting error that requires retrospective restatement.

2020: EI O/S COGS U/S NI O/S R/E O/S; also the asset inventory is overstated.

Account titles and explanation	Debit	Credit
R/E	21,000
Inventory		21,000

A prior period adjustment to retained earnings would be reported, along with a disclosure note describing the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and EPS.

d. The company changed inventory cost methods to FIFO from LIFO at the end of 2021 for both financial statement and income tax purposes. The change will cause a $920,000 increase in the beginning inventory at January 1, 2022:-

This is a change in accounting principle that is reported retrospectively

2021: EI U/S COGS O/S NI U/S R/E U/S; also, the asset inventory is understated.

Account titles and explanation	Debit	Credit
Inventory	920,000
Retained Earnings		920,000

Prior years’ financial statements would be restated to reflect the use of the new accounting method. A disclosure note justifying the change and describing the effect of the change on any financial statement line items and EPS for all periods reported is required.

e. At the end of 2020, the company failed to accrue $14,700 of sales commissions earned by employees during 2020. The expense was recorded when the commissions were paid in early 2021:-

This is an accounting error that requires retrospective restatement.

2020: Expense U/S NI O/S R/E O/S

2021: Expense O/S

Account titles and explanation	Debit	Credit
R/E	14,700
Sales Commission Expense		14,700

A prior period adjustment to retained earnings would be reported, along with a disclosure note describing the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and EPS.

f. At the beginning of 2019, the company purchased a machine at a cost of $640,000. Its useful life was estimated to be 10 years with no salvage value. The machine has been depreciated by the double-declining balance method. Its book value on December 31, 2020, was $409,600. On January 1, 2021, the company changed to the straight-line method:-

This is treated as a change in estimate that is handled prospectively.

2020 Book value = $409,600

Residual Value = $0

Remaining life = 8 years (10 – 2)

New depreciation = $409,600 ÷ 8 = $51,200

Account titles and explanation	Debit	Credit
Depreciation expense	51,200
Accumulated depreciation		51,200

Previous financial statements are not restated. Rather, the company simply utilizes the straight-line method from this point on.

g. Warranty expense is determined each year as 1% of sales. Actual payment experience of recent years indicates that 0.75% is a better indication of the actual cost. Management effects the change in 2021. Credit sales for 2021 are $3,200,000; in 2020 they were $2,900,000:-

This is a change in estimate that is handled prospectively

2021 Warranty expense = 0.75% x $3,200,000 = $24,000

Account titles and explanation	Debit	Credit
Warranty expense	24,000
Warranty Payable		24,000

If the impact of the change in estimate is material, then a disclosure note should describe the effect of the change in estimate on income before extraordinary items, net income and EPS for the current period.

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