Module 19
Accounting Changes, Errors, and Derivatives
Change in Accounting Estimate
When it prepares the financial statements, management makes many estimates based on its
best judgment. When more information is available later, estimates can change. For example,
a company might estimate that a new machine will have a useful life of 10 years. After six
years, however, information about new technologies might suggest that the machine will be
useful for only two more years (for a total of eight). This is an example of the need for a change
in accounting estimate.
Changes in accounting estimates can occur as the result of changes in the following:
 Uncollectible receivables (the percentages deemed uncollectible).
 Warranty obligations.
 Useful lives of intangible assets.
 Actuarial assumptions used in pension and other post-retirement benefits (settlement rate,
long-term expected return rate, salary increase rate, expected mortality rates for retirees,
medical cost increases, etc.).
The rules related to changes in accounting estimates are as follows:
1. Nothing from the past needs to be changed (that is, no retroactive changes are
involved).
2. The change must be reflected in current and future financial statements.
Example
Williams Company purchased a machine on January 1, 2002, for $100,000. Its estimated
useful life was determined to be 10 years, with zero salvage value. On January 1, 2006, the
company revised its estimate. It now expects the machine to be useful for only another three
years. If the company uses straight-line depreciation, what is the amount of the depreciation
each year?
Depreciation based on initial estimates is $10,000 each year (= $100,000/10).
Thus, depreciation for the first four years (2002 through 2005) is $10,000 per year.
As of January 1, 2006, accumulated depreciation is $40,000 (= $10,000 x 4).
Therefore, the book value (amount left to depreciate) as of January 1, 2006, is $60,000
(= $100,000 - $40,000).
As of January 1, 2006, the revised remaining useful life is 3 years.
Hence, depreciation from 2006 (to 2008) is $20,000 per year (= $60,000/3).
Change in Accounting Principle
A change in accounting principle involves a change from one generally accepted accounting
principle to another. The following are examples of changes in accounting principles:
 Change in the inventory method from LIFO to FIFO.
 Change in depreciation method from the straight-line method to the double-decliningbalance method.

Change in the method of accounting for long-term construction contracts from the
percentage of completion method to the completed contract method.
The rules for changes in accounting principle are as follows:
1. Financial statements of prior periods are not changed.
2. The cumulative effect of the change in accounting principle (net of taxes) is included
in the income statement for the period in which the change is made. This is shown
after extraordinary items and before net income.
3. Income before extraordinary items and net income on the income statement is
computed on a pro-forma basis (as if the new principle had been used in prior
periods) for prior years and is shown on the income statement for all periods
presented.
Example
Spencer Company purchased machinery worth $100,000 on January 1, 2002. Its estimated
useful life was five years; the company uses the straight-line method of depreciation. On
January 1, 2004, the company decided to change to the double-declining-balance method.
Ignoring income tax effects, how will the change be reported on the income statement?
Straight-line depreciation schedule:
Straight-line depreciation is $20,000 each year (= $100,000/5).
Straight-line method of accumulated depreciation after two years is $40,000 (= $20,000 x 2).
Straight-line method book value after two years is $60,000 (= $100,000 – $40,000).
Double-declining-balance (DDB) depreciation schedule:
Straight-line rate each year is 20% (1/5).
Hence the DDB rate is 40%.
Year
Beginning
DDB Rate
DDB
Accumulated
Ending Book
Book Value
Depreciation
Depreciation
Value
2002
$100,000
0.40
$ 40,000
$ 40,000
$60,000
2003
60,000
0.40
24,000
64,000
36,000
Excess depreciation as the result of using the DDB method, as of the end of 2003 (or January 1,
2004) is $24,000 (= $64,000 – $40,000).
If the company had used the DDB method throughout, depreciation in prior years would have
been $24,000 higher. This means that the sum of the net income reported in prior years would
have been $24,000 lower, causing retained earnings to be $24,000 lower. Furthermore, if the
company had used the DDB method throughout, the accumulated depreciation would have
been $24,000 higher. Hence, the retained earnings account must be reduced and the
accumulated depreciation account must be increased.
This is accomplished through the following journal entries:
Account
Cumulative Effect of Change in Accounting Principle
Accumulated Depreciation
Debit
24,000
Credit
24,000
The cumulative effect is included in the income statement and reduces net income, thereby
reducing the Retained Earnings account. The credit to the Accumulated Depreciation account
increases its balance.
If the change had been from the DDB method to the straight-line method, the opposite effect
occurs. The Cumulative Effect account would have been credited, thereby increasing net
income and the Retained Earnings account. The Accumulated Depreciation account would
have been debited, thereby reducing its balance.
Effect of Taxes
If taxes are considered, the accounting is substantively similar, but the debit or credit to the
Cumulative Effect account is net of taxes. The balance relates to the impact of taxes, and the
Deferred Tax Asset or Liability account is debited or credited as appropriate. (In some
instances, the debit or credit is to Income Tax Receivable or Payable, as appropriate).
In the Spencer Company example, assume that the company has always used the DDB method
for tax purposes (and continues to do so after the change for financial reporting purposes from
straight-line to DDB).
Since the depreciation with DDB method is $24,000 higher than the depreciation with the
straight-line method, the depreciation for tax purposes is higher than that for financial statement
purposes.
That is, taxable income in the past has been lower than financial income.
This, in turn, means that future taxable income will be higher.
Therefore, the company must set up a deferred tax liability of $7,200 ($24,000 x 0.30).
Once the company decides to change the method from straight-line to DDB, the deferred tax
liability is no longer applicable. Hence, the Deferred Tax Liability account is eliminated with a
$7,200 debit. As before, the Accumulated Depreciation account is credited with the $24,000
difference in depreciation arising from the switch. The “plug” number is the debit to the
Cumulative Effect account. Thus, the journal entry is as follows:
Account
Debit
Credit
Deferred Tax Liability
7,200
Cumulative Effect of Change in Accounting Principle
16,800
Accumulated Depreciation
24,000
Change to LIFO Method
Assume that a company changed its inventory method from FIFO to LIFO during 2002. Such a
change is made effective with the beginning inventory for the period (as of January 1, 2002).
This is because it is extremely difficult (if not impossible) to determine changes in prior-year
LIFO layers or dollar-value pools.
Hence, the beginning inventory under LIFO as of January 1, 2002, is assumed to be the same
as the ending inventory using FIFO as of December 31, 2001. Thus, when a company changes
to the LIFO method, no cumulative effect adjustment is needed. The change is disclosed in the
footnotes to the financial statements.
Prior-Period Restatement
In several specific situations, GAAP requires a retroactive treatment for accounting changes. In
such instances, the financial statements of prior periods must be revised using the new
accounting principle. The specific changes include the following:
 Change from LIFO to another inventory accounting method.
 Change to or from the full cost method used in extractive industries.
 Change in the method of accounting for long-term construction contracts.
 Changes made at the time of initial public offering of stock.
 Change from the fair value method to the equity method for investments.
Example
Dallas Company began operations in the year 2000 and used the LIFO method for inventory
accounting. The company changed from LIFO to FIFO for both financial reporting and tax
purposes in 2002. The following table gives the relevant details:
Year
LIFO Income
FIFO Income
Difference
before Taxes
before Taxes
2000
$ 50,000
$ 60,000
$ 10,000
2001
70,000
82,000
12,000
2002
80,000
95,000
15,000
Assuming a tax rate of 30%, prepare the necessary journal entry for the change in method.
Because both the previous and new methods were used simultaneously for financial and tax
purposes, the change has no deferred tax consequences. However, additional taxes could be
payable (or receivable) because of the change in method used for tax purposes.
In this case, the net income using the new method in the previous years is higher by $22,000
($10,000 in 2000 and $12,000 in 2001). Hence, the income tax payable (relating to operations
of prior years) is higher under the new method by $6,600 (30% of $22,000).
Furthermore, the value of the ending inventory as of December 31, 200,1 using FIFO would be
higher than the corresponding value using LIFO: the same $22,000.
(Note: The company started with beginning inventory of zero, and the value of purchases is the
same under both methods. Therefore, the difference in the Ending Inventory account under the
two methods must equal the opposite of the difference in the Cost of Goods Sold account for
the two methods or equal the difference in net income between the two methods.)
To account for the higher value of inventory under FIFO, the Inventory account must be debited
for $22,000. To record the higher tax payable, the Income Tax Payable account must be
credited for $6,600. The plug number is the increase to the Retained Earnings, representing the
after-tax increase in net income of the previous periods and the resultant increase in Retained
Earnings. (Note that the increase occurs in the beginning balance of the Retained Earnings
account, as explained later.)
Hence, the journal entry in 2002 to account for the change is as follows:
Account
Debit
Inventory
22,000
Income Tax Payable
Credit
6,600
Retained Earnings
15,400
The income statements for 2000 and 2001 must be restated, assuming that the FIFO method
had been used. The net income for 2000 and 2001 would be higher by $7,000 and $8,400
(after-tax amounts of the impact of the change), respectively. This means that the ending
balance of the 2000 Retained Earnings account will be higher by $7,000. Since Retained
Earnings is a permanent account, its 2001 ending balance (that is, the beginning balance of
2002 Retained Earnings) will be higher by $15,400 ($7,000 + $8,400).
(Note: Pro-forma information is not required with the retroactive approach because the financial
statements for the prior years are restated directly.)
Accounting for Errors
Accounting errors occur for a variety of reasons, including the following:
 Calculation mistakes (e.g., inventory counting mistakes).
 Classification (e.g., including items in wrong categories, such as classifying a current liability
as a noncurrent liability).
 Omission of an accrual or deferral (e.g., failure to accrue warranty costs).
 Use of an accounting principle not in conformity with GAAP.
The different types of errors have different consequences:
1. Errors affecting the balance sheet only. For example, a long-term receivable could be
included as a current receivable. No correcting journal entries are required for such errors,
which are usually detected and corrected in the period in which it occurs. However, if such an
error is not found until a subsequent period, the prior period financial statements must be
corrected by reclassifying the item.
2. Errors affecting the income statement only. For example, sales commission could be
included with manufacturing salaries. This error does not affect net income, so if it is found in a
subsequent period, no correcting journal entries are required. However, the financial
statements of prior periods must be reclassified and presented using the correct classification.
3. Errors affecting both the income statement and the balance sheet.
Some of these errors are counterbalancing. That is, an error that understates an item in one
period will automatically overstate it in the next period, but, for example, no further
consequences occur after the end of the second period. An example is a mistake in inventory
count at the end of one year but correct counts in previous and subsequent years.
Other errors do not balance over two periods. Examples are (1) capitalizing and amortizing an
item that must be expensed in one period (2) and incorrectly expensing the purchase of a
machine that must be capitalized and depreciated in future periods.
Counterbalancing Errors
Assume that Olson Company, which uses the periodic system for inventory, made an error in
counting the ending inventory as of December 31, 2001. This error led to understating the
inventory amount by $600 on December 31, 2001. The inventory counts at the end of 2000 and
2002 were correct. (Income taxes are ignored in this example.)
In this case, the understatement of inventory as of December 31, 2001, leads to overstating the
Cost of Goods Sold account for the year ended December 31, 2001, by $600.
(Explanation: Assume beginning inventory of zero and purchases of $10,000. If the correct
amount of ending inventory is $2,000, the cost of goods sold is $8,000. However, if the ending
inventory is counted to be only $1,400, the cost of goods sold is calculated to be $8,600.)
This, in turn, leads to understating net income for the year ended December 31, 2001, by $600.
However, because the inventory for December 31, 2001, also is the beginning inventory for
2002, this error also leads to understating the cost of goods sold and overstating the net income
for the year ended December 31, 2002 by $600.
Thus, as of the end of 2002, the two errors have canceled, or counterbalanced, each other. The
ending Inventory and Retained Earnings accounts as of December 31, 2002, are correct.
If a counterbalancing error is discovered in the next year (in this case, some time during 2002),
an adjustment is made to the Retained Earnings account and the other affected account. In this
example, if the error is discovered sometime before the end of 2002, the correcting journal
entries are as follows.
The understatement error at the end of 2001 led to understating the balance in the Inventory
account. Correcting this requires increasing the Inventory account, with a debit.
Because the inventory for 2001 was understated, the net income for 2001 was understated.
Hence, the beginning balance of Retained Earnings also is understated. Correcting this
requires increasing the Retained Earnings account with a credit.
Account
Debit
Credit
Inventory
600
Retained Earnings
600
However, if a counterbalancing error is discovered only after the subsequent year (that is,
sometime in 2003 in the example), no correcting journal entry would be needed.
Other examples of counterbalancing errors include the following:
1. Incorrectly recording year-end sales made at the end of one year in the second year.
If a $3,000 sale should have been recorded at the end of 2003 but was recorded in January
2004 and was discovered in 2004, the correcting journal entry is as follows:
Account
Debit
Credit
Sales
2,000
Retained Earnings
2,000
The debit to Sales reverses the incorrect increase to 2004 sales, and the credit to Retained
Earnings increases its beginning balance in 2004.
If the error was not discovered in 2004 but later, no correcting journal entry is needed.
2. Incorrectly recording inventory purchases in the next year:
The logic for correcting this error is the same as the one to correct sales incorrectly posted to
the wrong year. If such an error in the amount of $1,200 relating to the end of 2003 is
discovered in 2004, the correcting journal entry is as follows:
Account
Debit
Credit
Sales
1,200
Retained Earnings
1,200
3. Failure to record accrued expenses or revenues.
4. Failure to account for prepaid expenses or unearned revenue.
Derivatives
A derivative is a financial instrument that derives its value from changes in its price or any other
feature (such as interest rate). There are many types of derivatives, and they can be used to
protect against various types of risk. Some of the common types of derivatives are swaps,
futures, and options.
A swap is a contract in which two parties agree to exchange payments in the future based on
the price or value of some item. In an interest rate swap, two companies agree to exchange the
interest payments related to a given loan amount over a specified period in the future. Usually,
one party pays interest based on a fixed interest rate and the other pays interest based on a
rate that varies over time.
A futures contract permits a company to buy a specified amount of a commodity (such as corn,
wheat, coffee, or oil) at a specified price on a specified date in the future. An option gives the
holder the right, but not the obligation, to sell or buy an item at a specified price any time before
a specified period in the future. A call option gives the owner the right to buy; a put option gives
the owner the right to sell.
Companies seeking to protect themselves against future changes in price use futures and
options. That is, they use these derivatives to hedge against future risks (hedging refers to
transactions designed to reduce risk).
A company need not actually purchase the specified item when executing a futures contract or
an option. The parties to the contract simply exchange the necessary payment.
Example
Assume that Company X has entered into a futures contract with Company Y to buy some item
in the future for $50. The actual price on the date the contract is executed is $60. In this case,
Company X will pay Company Y the difference ($10), and the contract is deemed to be
completed.
Accounting for Futures Contracts
Example
On September 1, 2002, Texas Bakery entered into a futures contract to purchase 20,000
pounds of sugar at $0.50 per pound on January 1, 2003. The price of sugar was $0.50 per
pound on September 1, 2002, but was $0.53 per pound on December 31, 2002, and on January
1, 2003. The contract was duly completed. Prepare the necessary journal entries on
1) September 1, 2002.
2) December 31, 2002.
3) January 1, 2003.
1. No entry is required on September 1, 2002, because as of that date, the fair value of the
future is zero.
2. On December 31, 2002, the price had changed to $0.53 per pound. Since this is higher than
the contracted price at that Texas Bakery contracted to purchase ($0.50 per pound), as of
December 31, 2002, Texas Bakery expects to receive a payment of $600 ([$0.53 – $0.50] x
20,000). Because this amount is expected to offset any changes in the price of the item to be
purchased in January 2003, the gain on the futures contract is not recognized during 2002 but is
deferred to 2003. The journal entry on December 31 is as follows:
Account
Debit
Credit
Futures Contract (asset)
600
Other Comprehensive Income
600
The credit to Other Comprehensive Income means that the expected gain is temporarily
reported as an increase in equity without including it in the income statement.
3. On January 1, 2003, when the price is $0.53 per pound, the contract is executed. The journal
entries are as follows:
a. To purchase 20,000 pounds of sugar at $0.53 per pound:
Account
Debit
Credit
Sugar Inventory
10,600
Cash
10,600
b. To settle the futures contract:
Account
Cash
Futures Contract (Asset)
Debit
600
Credit
600
c. To recognize the gain on the contract (by moving the gain from temporary holding in Other
Comprehensive Income to the income statement):
Account
Debit
Credit
Other Comprehensive Income
600
Gain on Futures Contract
600
Accounting for Options
Example
On October 1, 2002, Boston Cookies entered into a call option to purchase 10,000 pounds of
sugar at $0.50 per pound on January 1, 2003. The price of sugar was $0.50 per pound on
September 1, 2002, but was $0.53 per pound on December 31, 2002, and on January 1, 2003.
Boston Cookies paid $100 to purchase the option, and the contract was duly completed.
Prepare the necessary journal entries on
1) October 1, 2002.
2) December 31, 2002.
3) January 1, 2003.
1. Because $700 cash was paid to purchase the option on October 1, 2002, the journal entry is
as follows:
Account
Debit
Credit
Sugar Call Option (asset)
Cash
100
100
2. On December 31, 2002, the price is $0.53 per pound. Since this is higher than the contracted
price at which Texas Bakery is obligated to purchase ($0.50 per pound), as of December 31,
2002, the call option is valuable.
At this price, Boston Cookies expects to receive $300 ([$0.53 – $0.50] x 10,000) from settling
the call option.
Hence, the value of the option as of December 31, 2002, is $300. Because the option is
currently on the books at $100, the $200 increase in the asset’s value must be recorded. The
journal entry on December 31 is as follows:
Account
Debit
Credit
Sugar Call Option (asset)
200
Other Comprehensive Income
200
The debit increases the Sugar Call Option account from $100 to $300.
The credit to Other Comprehensive Income means that the expected gain is temporarily
reported as an increase in equity without including it in the 2002 income statement.
3. On January 1, 2003, the contract is executed. The journal entries are as follows.
a. To purchase 10,000 pounds of sugar at $0.53 per pound:
Account
Debit
Credit
Sugar Inventory
5,300
Cash
5,300
b. To settle the call option:
Account
Cash
Sugar Call Option (asset)
Debit
300
Credit
300
c. To recognize the gain on the contract (by moving the gain from the temporary holding in
Other Comprehensive Income to the income statement):
Account
Debit
Credit
Other Comprehensive Income
200
Gain on Call Option
200
Glossary
Accounting errors are the result of mistakes in calculation or classification, omission of an
accrual or deferral, and using an accounting principle not in conformity with GAAP.
Call options give the owner the right (but not the obligation) to buy a specified item at a specified
price during a specified period in the future.
Change in accounting estimate involves changes in estimates made by management.
Change in accounting principle involves a change from one generally accepted accounting
principle to another.
Counterbalancing errors occur in one period and will cause an automatic error in the next period
(e.g., an overstatement in one period results in an understatement in the next period). The error
has no further consequences after the end of the second period.
Derivative is a financial instrument that derives its value from changes in its price or any other
feature (such as interest rate).
Futures contracts permit a company to buy a specified amount of a commodity (such as corn,
wheat, coffee, or oil) at a specified price on a specified date in the future.
Hedging refers to transactions designed to reduce risk.
Interest rate swap is a contract in which two companies agree to exchange the interest
payments related to a given loan amount over a specified period in the future. Usually, one
party pays interest based on a fixed interest rate and the other pays interest based on a rate
that will vary over time.
Options give the holder the right, but not the obligation, to sell or buy an item at a specified price
any time during a specified period in the future.
Pro forma bases are “amounts calculated as if a new accounting principle had been used in
previous years.
Put options give the owner the right (but not the obligation) to sell a specified item at a specified
price during a specified period in the future.
Retroactive changes involve changing past financial statements.
Swap is a contract in which two parties agree to exchange payments in the future based on the
price or value of some item.
Demonstration Problem 1
Albany Company
Albany Company purchased machinery worth $200,000 on January 1, 2002. Its estimated
useful life was five years, and the expected salvage value was $20,000. The company used the
double-declining-balance method of depreciation for tax purposes but used the straight-line
method for financial reporting. On January 1, 2004, the company decided to change to the
double-declining-balance method for financial reporting (and continued to maintain the same
method for tax reporting). The tax rate is 30% in all the years. Assuming that the company has
properly recognized the deferred tax asset or liability as appropriate, prepare the journal entries
for
a. Depreciation for the year 2003.
b. Effect of change in depreciation methods.
c. Depreciation for the year 2004.
Solution to Demonstration Problem 1, Albany Company
Straight-line depreciation each year is $36,000 ([$200,000 – $20,000]/5).
Straight-line method accumulated depreciation after two years is $72,000 ($36,000 x 2).
Straight-line method book value after two years is $128,000 ($200,000 – $72,000).
Double-declining-balance (DDB) depreciation schedule:
Straight-line rate is 20% each year (1/5).
Hence, DDB rate is 40%.
Year
Beginning
DDB Rate
DDB
Accumulated
Ending Book
Book Value
Depreciation
Depreciation
Value
2002
$200,000
0.40
$ 80,000
$ 80,000
$120,000
2003
120,000
0.40
48,000
128,000
72,000
2004
72,000
0.40
28,800
156,800
43,200
Excess depreciation using the DDB method, as of the end of 2003 (or, January 1, 2004) is
$56,000 ($128,000 – $72,000).
This means that over two years, the company’s depreciation for tax purposes is $56,000 higher
than the depreciation used for financial statement purposes. That is, taxable income was lower
than financial income in the past. This, in turn, means that future taxable income will be higher.
Therefore, the company must set up a deferred tax liability of $16,800 ($56,000 x 0.30).
a. Depreciation for 2003 (straight-line method):
Account
Debit
Depreciation Expense
36,000
Accumulated Depreciation
Credit
36,000
b. Accounting for change in method:
Once the company changes the method from DDB to straight line, it credits the Accumulated
Depreciation account with the difference in depreciation arising from the switch.
The deferred tax liability is no longer applicable and hence is eliminated with a debit.
The plug number is the debit to the Cumulative Effect account:
Account
Debit
Credit
Deferred Tax Liability
16,800
Cumulative Effect of Change in Accounting Principle
39,200
Accumulated Depreciation
56,000
c. Depreciation for 2004 (double-declining-balance method):
Account
Debit
Depreciation Expense
28,800
Accumulated Depreciation
Credit
28,800
Demonstration Problem 2
Bell Company
Bell Company purchased an asset for $25,000 on January 1, 2002. The estimated useful life of
the asset was five years (with zero salvage value), but the company erroneously expensed the
entire amount in 2002. The error was detected at the end of 2003. The company uses straightline depreciation for its assets.
Ignoring the effect of income taxes, what is the impact of the error on the following:
a. Net income of 2002.
b. Net income of 2003.
c. Total assets as of December 31, 2002.
d. Total assets as of December 31, 2003.
e. Retained earnings as of December 31, 2002.
f. Retained earnings as of December 31, 2003.
Use a minus sign for understatements. For example, show an overstatement of $3,000 would
be shown as $3,000: show an understatement of $3,000 as $-3,000
Solution to Demonstration Problem 2, Bell Company
Since the cost is $25,000 and estimated useful life is five years, depreciation expense each year
must be $5,000 ($25,000/5). The depreciation expense should have been $5,000 for 2002 and
2003. Instead, the company expensed $25,000 in 2002.
Thus, the expense for 2002 has been overstated by $20,000, which means that net income for
2002 has been understated by $20,000.
Conversely, the company has failed to include depreciation of $5,000 in its income statement for
2003, which means that the net income for 2003 has been overstated by $5,000.
Because the entire $25,000 was expensed in 2002, the asset balance as of December 31,
2002, was understated by $20,000 (after depreciation for one year, the correct net book value of
the asset is $20,000).
As of the end of 2003, if the company had correctly depreciated the asset, its net book value
would have been $15,000 ($25,000 cost - $10,000 accumulated depreciation for two years).
Hence, the total assets as of December 31, 2002, are understated by $15,000.
Because the net income for 2002 has been understated by $20,000, the balances in the
Retained Earnings account as of December 31, 2002, has been understated by $20,000.
However, because the net income for 2003 has been overstated by $5,000, the Retained
Earnings balance understatement as of December 31, 2003, has decreased by $5,000; hence,
the understatement as of December 31, 2003, is $15,000.
Net income of 2002
Net income of 2003
Total assets as of December 31, 2002
Total assets as of December 31, 2003
Retained earnings as of December 31, 2002
Retained earnings as of December 31, 2003
$-20,000
$5,000
$-20,000
$-15,000
$-20,000
$-15,000
Demonstration Problem 3
Tasty Bakery
On September 1, 2002, Tasty Bakery entered into (1) a firm commitment with Sweet Sugar
Growers to purchase 50,000 pounds of sugar at $0.50 per pound and (2) a futures contract to
sell 50,000 pounds of sugar at $0.50 per pound. Both contracts were to be executed on
January 1, 2003. The futures contract was designated as a hedge of the value of sugar to be
purchased from the firm commitment. The price of sugar was $0.46 per pound on December
31, 2002, and on January 1, 2003. The commitment and contract were duly completed.
Prepare the journal entries on the books of Tasty Bakery on
a. September 1, 2002.
b. December 31, 2002.
c. January 1, 2003.
Solution to Demonstration Problem 3, Tasty Bakery
a. September 1, 2002:
No journal entry is required.
b. December 31, 2002:
For purchase commitment:
The price on December 31, 2002, was only $0.46 per pound. The committed price was $0.50
per pound for 50,000 pounds.
Hence, the loss on commitment is $2,000 ([$0.50 – $0.46] x 50,000 = $0.04 x 50,000).
Account
Debit
Credit
Loss on Firm Commitment
2,000
Firm Commitment
2,000
For futures contract:
Tasty Bakery expects to receive payment because the contract price ($0.50 per pound) is
higher than the market price ($0.46 per pound), and the contracted amount is 50,000 pounds.
The expected payment amount is $2,000 ([$0.50 – $0.46] x 50,000 = $0.04 x 50,000).
Account
Debit
Credit
Futures Contract (asset)
2,000
Other Comprehensive Income
2,000
d. On January 1, 2003:
For purchase of sugar:
Value of sugar purchased is $23,000 (50,000 pounds x $0.46 per pound).
Cash paid for sugar is $25,000 (50,000 pounds x $0.59 per pound).
Account
Debit
Credit
Sugar Inventory
23,000
Firm Commitment
2,000
Cash
25,000
d. For settlement of futures contract:
Cash received from settlement of futures contract is $2,000.
Account
Debit
Cash
2,000
Futures Contract (asset)
Credit
2,000
Practice Problem 1
Boulder Company
Boulder Company purchased machinery worth $300,000 on January 1, 2002. The estimated
useful life was five years, and the expected salvage value was $50,000. The company used the
double-declining-balance method of depreciation for financial reporting but used the straight-line
method for tax reporting. On January 1, 2004, the company decided to change to straight-line
depreciation for financial reporting (and continued to use the straight-line method for tax
reporting). The tax rate is 30% in all the years. Assuming that the company has properly
recognized the deferred tax asset or liability as appropriate, prepare the journal entries for the
following:
a. Depreciation for the year 2003.
b. Effect of change in depreciation methods.
c. Depreciation for the year 2004.
Solution to Practice Problem 1, Boulder Company
Straight-line depreciation each year $50,000 ([$300,000 – $50,000]/5).
Straight-line method accumulated depreciation after two years is $100,000 ($50,000 x 2).
Straight-line method book value after two years is $200,000 ($300,000 – $100,000).
Double-declining-balance (DDB) depreciation schedule:
Straight-line rate is 20% each year (1/5).
Hence, (DDB) rate is 40%.
Year
Beginning
DDB Rate
DDB
Accumulated
Ending Book
Book Value
Depreciation
Depreciation
Value
2002
$300,000
0.40
$120,000
$120,000
$180,000
2003
180,000
0.40
72,000
192,000
108,000
2004
108,000
Excess depreciation using the DDB method is $92,000 ($192,000 – $100,000).
This means that over two years, the company’s depreciation for tax purposes is $92,000 lower
than the depreciation used for financial statement purposes. That is, taxable income in the past
was higher than financial income. This, in turn, means future taxable income will be lower.
Therefore, the company must set up a deferred tax asset of $27,600 ($92,000 x 0.30).
a. Depreciation for 2003 (double-declining-balance method):
Account
Debit
Depreciation Expense
72,000
Accumulated Depreciation
Credit
72,000
b. Accounting for change in method:
Once the company changes the method from DDB to straight line, it credits the Accumulated
Depreciation account with the difference in depreciation arising from the switch.
The deferred tax asset is no longer applicable and hence is eliminated with a credit.
The plug number is the credit to the Cumulative Effect account:
Account
Debit
Credit
Accumulated Depreciation
92,000
Deferred Tax Asset
27,600
Cumulative Effect of Change in Accounting Principle
64,400
c. Depreciation for 2004 (straight-line method):
Account
Debit
Depreciation Expense
50,000
Accumulated Depreciation
Credit
50,000
Practice Problem 2
Chen Company
Chen Company spent $50,000 on a special project in 2002 and capitalized the expenditure.
Because of an oversight, the accountant was amortizing this amount over five years (straightline basis) as opposed to expensing the amount in 2002. The error was detected at the end of
2003.
Ignoring the effect of income taxes, what is the impact of the error on the following:
g. Net income of 2002.
h. Net income of 2003.
i. Total assets as of December 31, 2002.
j. Total assets as of December 31, 2003.
k. Retained earnings as of December 31, 2002.
l. Retained earnings as of December 31, 2003.
Use a minus sign for understatements. For example, show an overstatement of $3,000 as
$3,000; show an understatement of $3,000 as -$3,000.
Solution to Practice Problem 2, Chen Company
Since the expenditure was $50,000 and the amortization period was five years, amortization
expense each year must be $10,000 ($50,000/5).
The proper expense should have been $50,000 for 2002.
Instead, the company expensed $10,000 in both 2002 and 2003.
Thus, the expense for 2002 has been understated by $40,000 ($50,000 – $10,000), which
means that the net income for 2002 has been overstated by $40,000.
Conversely, the company has included amortization of $10,000 in its income statement for
2003, which means that the net income for 2003 has been understated by $10,000.
Because $50,000 was capitalized in 2002, the asset balance as of December 31, 2002 was
overstated by $40,000 (after amortization for one year, the net book value of the asset is
$40,000).
As of the end of 2003, the net book value of the asset is $30,000 ($50,000 cost - $20,000
accumulated depreciation for two years). Hence, the total assets as of December 31, 2002, are
overstated by $30,000.
Because the net income for 2002 has been overstated by $40,000, the balances in the Retained
Earnings account as of December 31, 2002, has been overstated by $40,000.
However, because the net income for 2003 has been understated by $10,000, the Retained
Earnings balance overstatement as of December 31, 2003, has decreased by $10,000; hence,
the overstatement as of December 31, 2003, is $30,000.
Net income of 2002
Net income of 2003
Total assets as of December 31, 2002
Total assets as of December 31, 2003
Retained earnings as of December 31, 2002
Retained earnings as of December 31, 2003
$40,000
$-10,000
$40,000
$30,000
$40,000
$30,000
Practice Problem 3
Southern Foods
On October 1, 2002, Southern Foods purchased a call option for 60,000 bushels of wheat on
January 1, 2003, at $3.50 per bushel (the market price on October 1, 2002). Southern Foods
paid $3,000 for the call option and designated this option as a hedge against the price
fluctuations of the wheat to be purchased in January 2003. The price of wheat was $3.25 per
bushel on December 31, 2002, and on January 1, 2003, and the company purchased the
60,000 bushels of wheat.
Prepare the journal entries on the books of Southern Foods on
a. October 1, 2002.
b. December 31, 2002.
c. January 1, 2003.
Solution to Practice Problem 3, Southern Foods
a. October 1, 2002:
Account
Wheat Call Option (asset)
Cash
Debit
3,000
Credit
3,000
b. December 31, 2002:
The market price on December 31 was only $3.25 per bushel. The option price was $3.50 per
bushel. Hence, the option has no value, and Southern Foods can expect that the option will not
be exercised.
Account
Debit
Credit
Other Comprehensive Income
3,000
Wheat Call Option (asset)
3,000
c. On January 1, 2003:
Purchase of wheat cost $195,000 (60,000 bushels x $3.25 per bushel).
Account
Debit
Credit
Wheat Inventory
195,000
Cash
195,000
To record the option expiration and loss on option.
Account
Debit
Loss on Wheat Call Option
3,000
Other Comprehensive Income
Credit
3,000
Homework Problem 1
Austin Company
Austin Company purchased machinery worth $500,000 on January 1, 2002. The estimated
useful life was four years and the expected salvage value was $20,000. The company used the
double-declining-balance method of depreciation for financial reporting but used the straight-line
method for tax reporting. On January 1, 2004, the company decided to change to straight-line
depreciation for financial reporting (and continued to use the straight-line method for tax
reporting). The tax rate is 30% in all the years. Assuming that the company has properly
recognized the deferred tax asset or liability as appropriate, prepare the journal entries for the
following:
a. Depreciation for the year 2003.
b. Effect of change in depreciation methods.
c. Depreciation for the year 2004.
Solution to Homework Problem 1, Austin Company
Straight-line depreciation each year is $120,000 ([$500,000 – $20,000]/4).
Accumulated depreciation after two years is $240,000 ($120,000 x 2).
Book value after two years is $260,000 ($500,000 – $240,000).
Double-declining-balance (DDB) depreciation schedule:
Straight-line rate is 25% each year (1/4).
Hence, (DDB) rate is 50%.
Year
Beginning
DDB Rate
DDB
Accumulated
Ending Book
Book Value
Depreciation
Depreciation
Value
2002
$500,000
0.50
$250,000
$250,000
$250,000
2003
250,000
0.50
125,000
375,000
125,000
2004
125,000
Excess depreciation using the DDB method is $135,000 ($375,000 – $240,000).
This means that over two years, the company’s depreciation for tax purposes is $135,000 lower
than the depreciation used for financial statement purposes.
That is, taxable income in the past was higher than financial income.
This, in turn, means that future taxable income will be lower. Therefore, the company must set
up a deferred tax asset of $40,500 ($135,000 x 0.30).
a. Depreciation for 2003 (double-declining-balance method):
Account
Debit
Depreciation Expense
125,000
Accumulated Depreciation
Credit
125,000
b. Accounting for change in method:
Once the company changes the method from DDB to straight-line, it credits the Accumulated
Depreciation account with the difference in depreciation arising from the switch.
The deferred tax asset also is no longer applicable and hence is eliminated with a credit.
The plug number is the credit to the Cumulative Effect account:
Account
Debit
Credit
Accumulated Depreciation
135,000
Deferred Tax Asset
40,500
Cumulative Effect of Change in Accounting Principle
94,500
c. Depreciation for 2004 (straight-line method):
Account
Debit
Depreciation Expense
120,000
Accumulated Depreciation
Credit
120,000
Homework Problem 2
Hardy Company
Hardy Company made a mistake in counting its inventory on December 31, 2002. The
inventory was understated by $4,000. The count was correct at the end of 2003.
Ignoring the effect of income taxes, what is the impact of the error on the following:
a. Net income of 2002.
b. Net income of 2003.
c. Total assets as of December 31, 2002.
d. Total assets as of December 31, 2003.
e. Retained earnings as of December 31, 2002.
f. Retained earnings as of December 31, 2003.
Use a minus sign for understatements. For example, show an overstatement of $3,000 as
“$3,000”; show an understatement of $3,000 as $-3,000.
Solution to Homework Problem 2, Hardy Company
Net income of 2002
Net income of 2003
Total assets as of December 31, 2002
Total assets as of December 31, 2003
Retained earnings as of December 31, 2002
Retained earnings as of December 31, 2003
$-4,000
$4,000
$-4,000
$0
$-4,000
$0
Homework Problem 3
Crispy Cereals
On August 1, 2002, Crispy Cereals entered into (1) a firm commitment with Midwest Corn
Growers to purchase 40,000 bushels of corn at $2.50 per bushel and (2) a futures contract to
sell 40,000 bushels of corn at $2.50 per pound. Both contracts were to be executed on January
1, 2003. The futures contract was designated as a hedge of the value of corn to be purchased
from the firm commitment. The price of corn was $2.70 per bushel on December 31, 2002, and
on January 1, 2003. The commitment and contract were duly completed.
Prepare the journal entries on the books of Crispy Cereals on
a. August 1, 2002.
b. December 31, 2002.
c. January 1, 2003.
Solution to Homework Problem 3, Crispy Cereals
a. August 1, 2002:
No journal entry is required.
b. December 31, 2002:
For purchase commitment:
The price on December 31, 2002, was $2.70 per bushel. The committed price was $2.50 per
bushel for 40,000 bushels.
Hence, the gain on commitment is $8,000 ([$2.70 – $2.50] x 40,000 = $0.20 x 40,000).
Account
Debit
Credit
Firm Commitment
8,000
Gain on Firm Commitment
8,000
For futures contract:
Crispy Cereals expects to make a payment because the contract price ($2.50 per bushel) is
lower than the market price ($2.70 per bushel), and the contracted amount is 40,000 bushels.
The expected payment amount is $8,000= ([$2.70 – $2.50] x 40,000 = $0.20 x 40,000).
Account
Debit
Credit
Other Comprehensive Income
8,000
Futures Contract (liability)
8,000
c. On January 1, 2003:
For purchase of corn:
Value of corn purchased is $108,000 (40,000 bushels x $2.70 per bushel).
Cash paid for corn is $100,000 (40,000 bushels x $2.50 per bushel).
Account
Debit
Credit
Corn Inventory
108,000
Cash
100,000
Firm Commitment
8,000
For settlement of contract:
Cash received from settlement of futures contract is $2,000.
Account
Debit
Futures Contract (liability)
2,000
Cash
Credit
2,000