Question

Williams-Santana, Inc., is a manufacturer of high-tech industrial parts that was started in 2004 by two talented engineers with little business training. In 2016, 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 2016 before any adjusting entries or closing entries were prepared. The income tax rate is 40% for all years.

a. A five-year casualty insurance policy was purchased at the beginning of 2014 for $34,000. The full amount was debited to insurance expense at the time.

b. Effective January 1, 2016, the company changed the salvage value used in calculating depreciation for its office building. The building cost $592,000 on December 29, 2005, and has been depreciated on a straightline 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.

c. On December 31, 2015, merchandise inventory was overstated by $24,000 due to a mistake in the physical inventory count using the periodic inventory system.

d. The company changed inventory cost methods to FIFO from LIFO at the end of 2016 for both financial statement and income tax purposes. The change will cause a $950,000 increase in the beginning inventory at January 1, 2017

. e. At the end of 2015, the company failed to accrue $15,300 of sales commissions earned by employees during 2015. The expense was recorded when the commissions were paid in early 2016.

f. At the beginning of 2014, the company purchased a machine at a cost of $700,000. Its useful life was estimated to be ten years with no salvage value. The machine has been depreciated by the double-declining balance method. Its book value on December 31, 2015, was $448,000. On January 1, 2016, the company changed to the straight-line method.

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 2016. Credit sales for 2016 are $3,800,000; in 2015 they were $3,500,000. Required: For each situation:

Prepare any journal entry necessary as a direct result of the change or error correction as well as any adjusting entry for 2016 related to the situation described. Any tax effects should be adjusted for through Income tax payable or Refund-income tax. (If no entry is required for a transaction/event, select "No journal entry required" in the first account field.) a(1), a(2), b(1),b(2), c(1), c(3) , d(1), d(2), e(1), e(2) , f(1), f(2), g(1), g(2)

Answer 1

This is an accounting error that requires retrospective restatement.

The amount that should be changed to expense every year is $6800 ($34,000 / 5 Years)

2014 = Expense overstated = Net Income Understated = Retained Earnings understated by $27,200 ($34,000 - $6800)

2015 = Expenses Understated = Net Income Overstated by $6,800 , Retained Earnings is now understade by $20,400.

Correcting Entry:

Prepaid Insurance Dr. 20,400

To Retained Earnings 20,400

Adjusting Entry:

Insurance Expense Dr. 6,800

To Prepaid Insurance 6,800

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.

Answer b.

This is a change in estimate that is handled prospectively

Annual depreciation before the change = ($592,000 - $100,000) ÷ 40 = $12,300

2016 Book value = $592,000 – [(10 x $12,300)] = $469,000

New residual value = $25,000

Remaining life = 30 years (40 – 10)

New depreciation = ($469,000 - $25,000) ÷ 30 = $14,800

Depreciation Expense Dr. 14,800

To Accumulated Depreciation 14,800

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

Answer c.

This is an accounting error that requires retrospective restatement

2015: Ending Inventory overstated = Cost of goods Sold Understated = Net Income Overstated = Retained Earning Overstated and also the asset inventory is overstated.

Retained Earnings Dr. 24,000

To Inventory 24,000

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.

Answer d.

This is a change in accounting principle that is reported retrospectively

2016: Ending Inventory Understated = COGS Overstated = Net Income Understated = Retained Earning Understated and also, the asset inventory is understated

Inventory Dr. 950,000

To Retained Earnings 950,000

Answer e.

This is an accounting error that requires retrospective restatement.

2015: Expense Understated = Net Income Overstated = Retained Earnings Overstated

2016: Expenes Overstated

Retained Earnings Dr. 15,300

To Sales Commission Expense 15,300

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.

Answer f.

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

2016 Book value = $448,000

Residual Value = 0

Remaining life = 8 years (10 – 2)

New depreciation = $448,000 ÷ 8 = $56,000

Depreciation Expense Dr. 56,000

To Accumulated Depreciation 56,000

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

Answer g.

This is a change in estimate that is handled prospectively.

2016 Warranty expense = $380000-$350000 = $30,000

Warranty Expenses Dr. 30,000

To Warranty Payable 30,000

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.