Question

On April 1, 2018, ABC Corporation exchanged 1,000 shares of its $5 par common stock for equipment. The stock is traded on the NYSE and on the date of the acquisition was trading at $80 per share. The equipment had a book value of $40,000 on the seller's books and a fair value of $85,000. ABC recorded the Equipment at fair value. The equipment has a 5-year life, no salvage and ABC uses the straight-line method to depreciate this class of equipment.

Determine the errors on the following financial statement components due to this error as of December 31, 2018.

Assets	Liabilities	Stockholder's Equity	Net Income

*Use O for Overstated, U for Understated, or NE for No Effect. Do not use $ signs or commas and do not space between the O/U and the dollar amount. For example, if your answer is Understated for $1,000, enter your answer as U1000.  

Answer 1

When stock is issued to acquire an asset in exchange, then the cost of the asset acquired will be the market value of the stock issued.

Here on April 1, 2018, ABC Corporation exchanged 1,000 shares of its $5 par common stock for equipment. Market price of share is $ 80 per share. ABC Corporation should have recorded cost of asset at $ 80,000 ( 1000 shares * $ 80 market price)

But ABC recorded the Equipment at its fair value of $ 85,000

Scenario 1)

Scenario will be as under if ABC Corporation would have recorded cost of equipment at $ 80,000 ( 1000 shares * $ 80 market price) which is the correct method :

Annual Depreciation as per straight line method = (Original cost - Salvage value ) / useful life in years

= ( $ 80,000 - 0) / 5 = $ 16,000

Depreciation from April 2018 to December 2018 = $ 12,000 ($ 16,000 * 9 months / 12 months)

Value of asset to be reported in balance sheet = Original cost - Accumulated depreciation

= $ 80,000 - 12,000= $ 68,000

Stock holder's equity= 1,000 * $ 80 = $ 80,000

Depreciation provided for the year will decrease the net income so for the current year if depreciation is provided for $ 12,000, it will decrease net income by $ 12,000

A table showing values for each section can be prepared as under:

Assets	Liabilities	Stockholder's Equity	Net Income
$                       68,000	NE	$                       80,000	$                     (12,000)

Scenario 2)

Scenario will be as under if ABC Corporation records cost of equipment at $ 85,000 ( at fair value of equipment) which ABC Corporation did actually:

Annual Depreciation as per straight line method = (Original cost - Salvage value ) / useful life in years

= ( $ 85,000 - 0) / 5 = $ 17,000

Depreciation from April 2018 to December 2018 = $ 12,750 ($ 17,000 * 9 months / 12 months)

Value of asset to be reported in balance sheet = Original cost - Accumulated depreciation

= $ 85,000 - 12,750= $ 72,250

Stock holder's equity= $ 85,000 ( issue price will be $ 85,000 / 1000 shares = $ 85 per share)

Depreciation provided for the year will decrease the net income so for the current year if depreciation is provided for $12,750, it will decrease net income by $12,750

A table showing values for each section can be prepared as under:

Assets	Liabilities	Stockholder's Equity	Net Income
$                       72,250	NE	$                       85,000	$                     (12,750)

Conclusion:

Since now we have tables for both the scenarios, we can easily find out the understatement or overstatement of financial statement components

Scenario 1 (correct way) (Record equipment at $ 80,000 (at market price of stock) the value of components will be:

Assets	Liabilities	Stockholder's Equity	Net Income
$                       68,000	NE	$                       80,000	$                     (12,000)

Scenario 2 (incorrect way but actually done by ABC corporation ) (Record equipment at $ 85,000 (at fair value of equipment) the value of components will be:

Assets	Liabilities	Stockholder's Equity	Net Income
$                       72,250	NE	$                       85,000	$                     (12,750)

Effect of the errors on the following financial statement components due to this error as of December 31, 2018

Assets	Liabilities	Stockholder's Equity	Net Income
O4250	NE	O5000	U750

Explanation:

Correct value of asset should be $ 68,000 but it is reported at $ 72,250 so asset is over reported by $ 4,250 (72,250 - 68,000). Like wise equity over stated by $ 5,000 ( $ 85,000 - 80,000)

Net income should be ($12,000) but it is reported at ($12,750). Suppose the income for the period is $ 100,000 so net income should be reported at $ 88,000 ( $ 100,000- 12,000) but actually it is reported at $ 87,250 ( $ 100,000- 12,750). There has been understatement of net income by $ 750 (going through example also $ 87,250 - $ 88,000 = $ 750)

Loss is reported by higher amount which means income is under reported. In this case income is under reported by $ 750 (12,750 - 12,000)

There is no effect of this error on liabilities component as it is not affected by this transaction.