Question

Change in Estimate versus Error Correction Facts: Your company, PlumbAll, provides routine and quick response plumbing services to a range of corporate customers. Customers are expected to pay on the first of each month, in advance of receiving services. One of your customers is a private school that has been a longtime customer. The customer has not paid for the last four months of services (September–December 20X1); nevertheless, to maintain a positive relationship, your company continued to provide services during that time. Your company ceased providing services in January 20X2 and found out in that same month that the school filed for bankruptcy in August. You now believe that the collection of the missed payments is extremely unlikely. Your company has already issued financial statements to lenders (for the period ending 12/31/X1) that reflected revenue and a corresponding account receivable related to this customer of $11,000 per month for services provided to this customer. Those financial statements also reflected the company’s standard allowance (reserve) amount on receivables of 3% of sales. In total, your company’s average monthly sales amount to $300,000.

Required:

1. Evaluate whether receipt of this information indicates you have a change in estimate or whether the customer’s bankruptcy results in this event being considered an error in previously issued financial statements.

2. Describe the accounting treatment required by the Codification for each alternative. Support your explanations with draft journal entries.

3. Briefly state which treatment appears to be more appropriate given the circumstances, describing any assumptions you made in concluding.

Answer 1

1. Evaluate whether receipt of this information indicates you have a change in estimate or whether the customer’s bankruptcy results in this event being considered an error in previously issued financial statements.

ANSWER:

The receipt of information should be considered a prior period error.

IAS 8 defines as error as omissions from, and misstatements in, an entity's financial statements for one or more prior periods arising from a failure to use, or misuse of, reliable information that was available and could reasonably be expected to have been obtained and taken into account in preparing those statements. The information of filing of bankruptcy of the customer in August should have been obtained by the company as it should investigate why the customer was unable to pay for 4 months. The information was already available but was not used by the company in the preparation of its financial statements.

2. Describe the accounting treatment required by the Codification for each alternative. Support your explanations with draft journal entries.

ANSWER:

For changes in estimate, the adjustment should be treated prospectively. For a prior period error, the change should be treated retrospectively by restating comparative amounts for the prior period(s) presented in which the error occurred.

For changes in estimate, the adjustment should be treated prospectively, that is, the adjustment will reflect only to the balances of the financial statements at the period of change. The entry to be recorded is:

Dr Allowance for doubtful accounts (11,000*4) 44,000

Cr Accounts receivable 44,000

To record writeoff of receivable

For prior period error, the comparative amount should be restated as the standard requires that the change be effected retrospectively. The entry on January 20X2 will be:

Dr Allowance for doubtful accounts, beginning 44,000

Cr Accounts receivable, beginning 44,000

To record write off of receivables

Please note that for prior period changes, the comparative balances (20X1 balances) should be adjusted to reflect the writeoff as this should be accounted for in 20x1. Also, the writeoff will no longer recognize bad debts expense as the percentage of sales method is used in determining the bad debts expense for the year. Lastly, we should not reverse the revenues recorded as the services were actually performed by the company.

3. Briefly state which treatment appears to be more appropriate given the circumstances, describing any assumptions you made in concluding.

ANSWER:

The retrospective application is more appropriate as the event was considered a prior period error.

The second treatment or the retrospective application is more appropriate as we have established that this is a prior period error and that the financial statements should be restated as required by IAS 8.