Chapter 20, Problem 20.12P

Accounting changes and error correction; seven situations; tax effects ignored

• LO20–1 through LO20–4, LO20–6

Williams-Santana Inc. is a manufacturer of high-tech industrial parts that was started in 2006 by two talented engineers with little business training. In 2018, 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 2018 before any adjusting entries or closing entries were prepared.

a. A five-year casualty insurance policy was purchased at the beginning of 2016 for $35,000. The full amount was debited to insurance expense at the time.

b. Effective January 1, 2018, the company changed the salvage value used in calculating depreciation for its office building. The building cost $600,000 on December 29, 2007, and has been depreciated on a straight-line 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, 2017, merchandise inventory was overstated by $25,000 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 2018 for both financial statement and income tax purposes. The change will cause a $960,000 increase in the beginning inventory at January 1, 2019.

e. At the end of 2017, the company failed to accrue $15,500 of sales commissions earned by employees during 2017. The expense was recorded when the commissions were paid in early 2018.

f. At the beginning of 2016, the company purchased a machine at a cost of $720,000. Its useful life was estimated to be 10 years with no salvage value. The machine has been depreciated by the double-declining balance method. Its book value on December 31, 2017, was $460,800. On January 1, 2018, 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 2018. Credit sales for 2018 are $4,000,000; in 2017 they were $3,700,000.

Required:

For each situation

1. Identify whether it represents an accounting change or an error. If an accounting change, identify the type of change.

2. Prepare any journal entry necessary as a direct result of the change or error correction, as well as any adjusting entry for 2018 related to the situation described. (Ignore tax effects.)

3. Briefly describe any other steps that should be taken to appropriately report the situation.

To determine

Accounting changes:

Accounting changes are the alterations made to the accounting methods, accounting estimates, accounting principles (or) the reporting entity.

To identify: Accounting changes or an error.

Explanation of Solution

(a) This is a correction of an error:

Account title and Explanation	Debit ($)	Credit ($)
Prepaid insurance (1)	21,000
Retained earnings (2)		21,000
(To record the correction of an error).
Insurance expense (3)	7,000
Prepaid insurance		7,000
(To record 2018 adjusting entry).

Table (1)

• Prepaid insurance is an asset. There is an increase in asset value. Therefore, it is debited.
• Retained earnings are liability. There is an increase in liability value. Therefore, it is credited.
• Insurance expense is an expense. There is an increase in liability value. Therefore, it is debited.
• Prepaid insurance is an asset. There is a decrease in assets value. Therefore, it is credited.

Working notes:

Calculate prepaid insurance:

$\begin{array}{l}\text{Prepaid insurance = }\frac{\text{Amount }\times \text{ Number of years unexpired}}{\text{Total number of years}}\\ =\frac{\$3\text{5,000 }\times \text{ 3 (2018}-2020)}{5}\\ \text{ Prepaid expense }=\$21,000\end{array}$ (1)

Calculate retained earnings:

$\begin{array}{l}\text{Retained earnings = Amount }-\frac{\text{Amount }\times \text{ Numder of years unexpired}}{\text{ Total number of years}}\\ =\$35,000-\frac{\left[\$35,000\times \text{ 2(2016}-2017)\right]}{5}\\ \text{ Retained earnings }=\$21,000\end{array}$ (2)

Calculate insurance expense:

$\begin{array}{l}\text{Insurance expense = }\frac{\text{Amount}}{\text{Total number of years}}\\ =\frac{\$35,000}{5}\\ \text{ Insurance expense}=\$7,000\end{array}$ (3)

1. (a) This is a change in estimate:

Account title and explanations	Debit ($)	Credit ($)
Depreciation expense (1)	15,000
Accumulated depreciation		15,000
(To record depreciation adjusting entry for 2018).

Table (2)

• Depreciation expense is an expense. There is a decrease in liability value. Therefore, it is debited.
• Accumulated depreciation is a contra asset. There is a decrease in asset value.

Working notes:

Calculate annual depreciation after the estimate change:

Particulars	Amount ($)
Cost	600,000
Less: Depreciation to date $\text{(\$12,500 }\times \text{ 10Years)}$	(125,000)
Un depreciated cost	475,000
Less: New estimated salvage value	(25,000)
To be depreciated	450,000
New annual depreciation $\left(\frac{\text{\$450,000 }}{30\text{ (40 }-\text{10)}}\right)$	15,000

Table (3)

(c) This is a correction of an error:

Account title and Explanation	Debit ($)	Credit ($)
Retained earnings	25,000
Inventory		25,000
(To record the correction of an error in inventory).

Table (4)

• Retained earnings are liability. There is a decrease in liability value. Therefore, it is debited.
• Inventory is an asset. There is a decrease in asset value. Therefore, it is credited

1. (d) This is a change in accounting principle and is reported retrospectively:

Account title and Explanation	Debit ($)	Credit ($)
Inventory	960,000
Retained earnings		960,000
(To record a change in accounting principles in inventory).

Table (5)

• Inventory is an asset. There is an increase in asset value. Therefore, it is debited.
• Retained earnings are liability. There is an increase in liability value. Therefore, it is credited.

1. (e) This is a correction of an error:

Account title and Explanation	Debit ($)	Credit ($)
Retained earnings	15,500
Compensation expense		15,500
(To record the compensation expense).

Table (6)

• Retained earnings are liability. There is a decrease in liability value. Therefore, it is debited.
• Compensation expense is a liability. There is an increase in liability value. Therefore, it is credited.

1. (f) This is a change in estimate resulting from a change in accounting principle and is accounted for prospectively.

Account title and Explanation	Debit ($)	Credit ($)
Depreciation expense (1)	57,600
Accumulated depreciation		57,600
(To record depreciation).

Table (7)

• Depreciation expense is an expense. There is a decrease in liability value. Therefore, it is debited.
• Accumulated depreciation is a contra asset. There is a decrease in asset value.

Working notes:

Particulars	Amount ($)
Undepreciated cost	460,800
Less: Residual value	(0)
	460,800
Depreciated over remaining 8 years
Annual straight line depreciation 2018-2025 $\left(\frac{\text{\$460,000}}{8}\right)$	57,600

Table (8)

1. (g) This is a change in estimate:

Account title and Explanation	Debit ($)	Credit ($)
Warranty expense $\text{(75\% }\times \text{ \$4,000,000)}$	30,000
Warranty liability		30,000
(To record the change in estimate).

Table (9)

• Warranty expense is an expense. There is an increase in liability value. Therefore, it is debited.
• Estimated warranty liability is a liability. There is an increase in liability value. Therefore, it is credited.