Question

As a reviewer for the Ontario Securities Commission, you are in the process of reviewing the financial statements of public companies. The following items have come to your attention: 1. A merchandising company overstated its ending inventory two years ago by a material amount. Inventory for all other periods is correctly calculated. 2. An automobile dealer sells for $137,000 an extremely rare 1930 S-type Invicta, which it purchased for $21,000 10 years ago. The Invicta is the only such display item that the dealer owns. 3. During the current year, a drilling company extended the estimated useful life of certain drilling equipment from 9 to 15 years. As a result, amortization for the current year was materially lowered. 4. A retail outlet changed its calculation for bad debt expense from 1% to 0.5% of sales because of changes in its clientele. 5. A mining company sells a large foreign subsidiary that does uranium mining, although the company continues to mine uranium in other countries. 6. A steel company changes from straight-line depreciation to accelerated amortization in accounting for its plant assets, stating that the expected pattern of consumption of the future economic benefits has changed. 7. A construction company, at great expense to itself, prepares a major proposal for a government loan. The loan is not approved. 8. A water pump manufacturer has had large losses resulting from a strike by its employees early in the year. 9. Amortization for a prior period was incorrectly understated by $950,000. The error was discovered in the current year. 10. A large sheep rancher suffered a major loss because the provincial government required that all sheep in the province be killed to halt the spread of a rare dis- ease. Such a situation has not occurred in the province for 20 years. 11. A food distributor that sells wholesale to supermarket chains and to fast-food restaurants (two major classes of customers) decides to discontinue the division that sells to one of the two classes of customers. Instructions Discuss the financial reporting issues.

Answer 1

1. A merchandising company overstated its ending inventory two years ago by a material amount. Inventory for all other periods is correctly calculated.

Description: Inventory overstated two years ago.

Discussion: Because the subsequent income statement compensated for the error thus the error has washed out. But prior year income statements must be restated if presented for comparative goal and a discussion of the error reported in the notes, because the prior year’s information has been restated

2. An automobile dealer sells for $137,000 an extremely rare 1930 S-type Invicta, which it purchased for $21,000 10 years ago. The Invicta is the only such display item that the dealer owns.

Description: Unusual item

Discussion: The sale would be categorised as an extraordinary item, because it is an unusual practice for the company and is infrequent in occurrence

3. During the current year, a drilling company extended the estimated useful life of certain drilling equipment from 9 to 15 years. As a result, amortization for the current year was materially lowered.

Description: Amortization period extended

Discussion: Changes in estimates are handled with the usage of the prospective treatment. The income of the current and future years ‘will be increased from the reduced charge for amortization. Note disclosure is significant as the amortization is materially lower. Care must be taken to watch for a possible bias to overstate net income

4. A retail outlet changed its calculation for bad debt expense from 1% to 0.5% of sales because of changes in its clientele.

Description: Change in bad debt percentage (lower).

Discussion: Change in estimate is categorised as part of normal business activity and provided a prospective treatment. Care has to be taken to watch for a possible bias to overstate net income. No separate disclosure would be needed unless such change has a material impact in which case a disclosure need to be provided.

5. A mining company sells a large foreign subsidiary that does uranium mining, although the company continues to mine uranium in other countries.

Description: Potential discontinued operations

Discussion: The loss or gain on discontinued operations reported on the income statement, net of taxes and with separate earnings per share disclosure, when the criteria for discontinued operation accounting are satisfied. As a separate subsidiary and geographical area, it will be categorised as a separate component with separately distinguishable operations and financial information. Thus qualifies for separate presentation

6. A steel company changes from straight-line depreciation to accelerated amortization in accounting for its plant assets, stating that the expected pattern of consumption of the future economic benefits has changed.

Description: Change in accounting policy

Discussion: An amortization method change is a change in accounting principle. Thus the cumulative effect of a change in accounting principle for prior years will be termed as a charge to the opening balance of retained earnings, net of applicable taxes. A voluntary change in accounting method should be made when the new method is viewed reliable and more relevant. But a change in depreciation method is considered a change in estimate when the change is made because reassessment of the pattern in which the entity receives gains from the asset. If such scenario, it would be accounted for on a prospective basis.

7. A construction company, at great expense to itself, prepares a major proposal for a government loan. The loan is not approved.

Description: Expense related to failed proposal

Discussion: Loss on preparation of such proposals should be treated as an unusual loss

8. A water pump manufacturer has had large losses resulting from a strike by its employees early in the year.

Description: Strike

Discussion: Strikes are typical business risks for companies that are unionized. Because the strikes are unusual the loss incurred due to it needs to be treated as an unusual loss

9. Amortization for a prior period was incorrectly understated by $950,000. The error was discovered in the current year.

Description: Correction of error

Discussion: Corrections of errors relating to prior years should be adjustments to prior years’ income in the retained earnings statements. Thus the beginning balance of Retained earnings must be adjusted along with accumulated depreciation to reflect the understatement

10. A large sheep rancher suffered a major loss because the provincial government required that all sheep in the province be killed to halt the spread of a rare disease. Such a situation has not occurred in the province for 20 years.

Description: Costs associated with loss due to government decree

Discussion: Material, infrequent in occurrence and unusual in nature. It does not depend primarily on determinations or decisions by owners or management or owners because the government was responsible for the loss. Thus should treat as an unusual item.

11. A food distributor that sells wholesale to supermarket chains and to fast-food restaurants (two major classes of customers) decides to discontinue the division that sells to one of the two classes of customers.

Description: Classified as Discontinued Operations

Discussion: Since the food distributor decides to discontinue the division that sells to one of the two classes of customers will be classified as ddiscontinued operations