Question

QUESTION 2:

(A) Consider the following two independent scenarios:

Scenario 1: Fishtail Ltd has always measured its’ manufacturing equipment using the cost basis. In the current year, it decides the revaluation method will provide more relevant and reliable information to investors.

Scenario 2: Fishtail Ltd has always depreciated its’ motor vehicle fleet using the straight-line method. In the current year, Fishtail decides that the diminishing value method will better reflect the consumption of the assets going forward.

REQUIRED

Which of the above scenarios is a change in accounting policy, and which is a change in accounting estimate? Describe the accounting for each scenario naming the affected accounts.

(B) Consider the following two independent scenarios:

Scenario 1: Rabbit Ltd has always calculated its warranty provision as 2% of sales. In the current year, Rabbit decides the provision should be 3% of sales.

Scenario 2: During the preparation of the financial statements, Rabbit Ltd learns a flood in the previous financial year destroyed raw materials (inventory) that had been stored off-site. The materials were uninsured. There was no expense recorded in the previous year in relation to the flood damage. The raw material was valued at $75 000 which is a material amount for the company. The loss is deductible and the tax rate is 30 per cent.

REQUIRED

Which of the above scenarios is a prior period error, and which is a change in accounting estimate? Describe the accounting for each scenario naming the affected accounts. Provide the current year journal entry for the second scenario.

Answer 1

Question A

In the first scenario , effects of changes in accounting policy instead of changes in accounting estimate

Changes in accounting policy results in the financial statements providing reliable and more relevant information about the effects of transactions , other events or conditions on the entity’s financial position, financial performance , or cash flow.

In this scenario manufacturing equipment using the cost basis it means the asset is carried at its cost less accumulated depreciation less impartment loss and Revaluation method means fair value can be measured reliably; revalued amount is equal to Fair value at revaluation date minus any subsequent accumulated depreciation & impairment losses. Revaluation Method is more reliable because the figures mentioned in accounting estimates or statements are real value after deducting accumulated depreciation and other losses.

In the second scenario, change in depreciation method is not a change in accounting policy rather it is a change in accounting estimate

· Straight Line method of calculated by dividing the difference between an asset's cost and its expected salvage value by the number of years it is expected to be used

Example :

If the cost of Motor car is $50000 , salvage / residual value is $5000 and expected life is 5years

First Step : Cost price minus salvage / residual value

                   = $50000-$5000

                   = $45000

            Second Step : Amount arrived in first step divided by expected life

                                  = $45000 / 5

                                  = $9000

            Here $9000 is deducting from cost for 5 years

• · Diminishing value method of calculated as a percentage on book value of the tangible asset., book value is the real value of asset (cost of asset – accumulated depreciation)

Changes in accounting estimate

We can explain through an example

If the cost of Motor car is $50000 , salvage / residual value is $5000 and expected life is 5years and company decided to take 5% as depreciation

As per Straight Line Method depreciation Amount is $ 9000 per year ( as per above calculation)

As per Diminishing method

Cost = $ 50000

% of depreciation = 5%

Depreciation Amount = $50000 x 5%

                                  = $ 2500 per year

Answer B

In the first scenario its happened changes in accounting estimate , Accounting estimates are approximate values assigned by a company’s management to different accounting variables. Whenever a company changes such estimates, it is required to reflect the change only in current and future periods, but not in past periods.

The value in changes in estimate is only change in current and future values not in past figures or book value , conclude to this scenario changing the percentage of warranty provision its effects on current year and future year

In the second scenario it’s an effect of PRIOR PERIOD ERROR , and mentioning in IAS 8 . In this scenario Omission to written-off damaged inventory in previous year.

Journal Entries for Prior Period Error

1. Journal Entry for Written-off Inventory

Retained Earnings A/c Dr                   $75000

    To Inventory A/c                                                     $75000

2. Journal Entry for adjustment in Tax

Income Tax Payable A/c Dr               XXXXX

    To Income Tax Expenses A/c                                  XXXXX