Question

California Incorporated (CI) is a private company that has historically reported its results in accordance with ASPE. To fund its significant growth, the company issued common shares to another investor. In conducting its due diligence on the company before buying the shares, the new investor closely reviewed CI’s financial records. The three issues identified are listed below:

1. Long-term contracts: CI accounts for revenue from long-term contracts using the completed contract method, as all contracts are completed in two years or less. The new investor knows that most companies in the industry use the percentage of completion method and believes that adopting this method would result in financial statements that provide more reliable and relevant information. Income under the completed contract method was $1,500,000 for 20x1 and $2,150,000 for 20x2. If the percentage of completion method had been used, revenue of $2,200,000 would have been recognized in 20x1 and $1,850,000 in 20x2. The existing owners have agreed to make the change.

2. Inventory: CI neglected to properly apply the lower of cost and net realizable value test to ending inventory in 20x1. Upon review, the inventory balance for 20x1 should have been reduced by $120,000. At December 31, 20x2, the recorded cost of the inventory was $150,000 higher than its net realizable value.

3. Building depreciation: CI’s building, acquired at the beginning of 20x1 at a cost of $1,500,000, was depreciated last year using the 10% declining balance method. The company and the investor both agree that the straight-line method would better reflect the consumption of the asset. Based on discussions, the building’s useful life has been estimated to be a total of 20 years and its salvage value to be $0. Depreciation expense of $135,000 has already been recorded for 20x2.

All amounts are considered material. The tax rate for CI is 30%.

As the December 31, 20x2 financial statements have not yet been finalized and income tax expense has yet to be recorded.

Required –

a) For each of the above situations, identify the type of change and the proper accounting treatment.

b) Prepare journal entries for December 31, 20x2, to properly record the changes described.

Answer 1

California Incorporated (CI) is a private company issued the commom shares to investor for growth of the company therefore the Investor has conducted the due diligence and identified the following point:

a. Long term contracts: The CI has adopted the completed completion method for recognition of revenue for contracts and in Investor's point of view the company should adopt the precentage completion method.

Thefore the change from completed completion method to percentage of completion method is considered as change in accounting estimates.

Particulars Year I (2011) Year II (2012) Total

Revenue (completed Contract method) 15,00,000 21,50,000 36,50,000

Reveue (Percentage Completion Method) 22,00,000 18,50,000 40,50,000

Difference 7,00,000 (3,00,000) 4,00,000

Accordingly the company should recognised the revenue in 2012 is 18,50,000+7,00,000= 25,50,000

b. Inventory: The company has not properly applied the lower of cost and NRV in previous year according adjustements are required to be made in current year that will be considered error of previous year which is required to be made during the year.

Therefore the change will be considered as prior period adjustement.

2011 : The company has recognised the Inventory Higher by $1,20,000

2012 : The Cost of inventory is $150000 which is higher than Market value

Accorgingly Company needs to reduce the Inventory by $120000 by recording the prior period expenses.

C.Depreciation: The company has acquried the building in previous year and charge the depreciation on written down value but from Investor point of view Staright line method should have been used that will be required to be change in current year and accordingly changes need to be done.

The change will be considered change in accounting Policy.

2011 :

Building Cost $ 15,00,000

Depreciation $ 1,50,000

WDV at 2011 $ 13,50,000

2012 : Change in method requires the retrospective effect

Building Cost $ 15,00,000

Deprecaition $ 1,50,000 (75000*2)

(1500000-0/20*2 Years)

WDV $ 13,50,000

The change in method of depriation doesn't impact on P and L account.

Therefore no adjustement is need to be made.

Tax Adjustments:

a. Current Year Revenue 18,50,000

Tax @ 30% 5,55,000

Previous Short Revenue 7,00,000

Additional Tax @ 30% 2,10,000

Total Tax 7,65,000

b. Prior period Expenses are not allowed under Income Tax (Assumption)

Prior Period Expenses 1,20,000

Tax @ 30% 36,000

Total Tax Provision 8,01,000 (765000+36000)

C. There is no depreciation has been charged in the books but charged as per Tax laws

Assumptions : Building charged depreciation @10%

2011 :

Building Cost : $ 15,00,000

Depreciation @ 10% 1,50,000

WDV 1,35,000

2012:

WDV 13,50,000

Depreciation @ 10% 1,35,000

Computation of Tax Provisions:

Revenue 25,50,000

+ Prior period expense 1,20,000

- Depreciation 1,35,000

Profit as per Tax Laws 25,35,000

Tax Provision 7,60,500  

2. Journal Entries

a. Reveue from Long term Contracts Dr 25,50,000

To Profit and Loss account 25,50,000

( Being Reveue from long term contracts are recognised)

b.Invetory Dr 1,50,000

To Profit and loss account 1,50,000

( Being Inventory recognised for Current Year)

Prior Period Expenses Dr 1,20,000

To Inventory 1,20,000

(Being Previous year adjustements done)

3. No Entry for Depreciation

(Already Extra Charge previous Year)

4. Profit and loss account Dr. 7,60,500

To Provision for Tax Expense 7,60,500

( Being Tax Provision for expenses for the year made)