Financial Accounting: Liabilities & Equities
Question 1 (16 marks)
(4 marks for Requirement 1; 12 marks for Requirement 2)
On January 1, 20X1, TV Company purchased a machine that cost €78,000. The estimated
useful life was 20 years with an estimated residual value of €8,000. Starting on January 1,
20X8, the company revised its estimates to 16 years for total life and €9,000 for residual
value.
The company also owns a patent that cost €34,000 when acquired on January 1, 20X5. It
was being amortized over its legal life of 17 years (no residual value). On January 1,
20X8, the patent was estimated to have a total useful life of only 13 years (no residual
value).
The company uses the straight-line method for both of these assets. The annual reporting
period ends December 31. Disregard income tax considerations.
Required
1. What kinds of accounting changes are involved? How should each change be
accounted for: retrospective with restatement, retrospective without restatement, or
prospective? Explain.
2. Give all entries required in 20X7 and 20X8 related to these assets.
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2, First
Edition (Toronto: McGraw-Hill Ryerson, 2000), Question P22-10, page 1267. Adapted
with permission.
Question 2 (15 marks) (11/2 marks each)
Analyze each case and choose a letter code under each category (type and approach) to
indicate the preferable accounting for each case.
Type
Approach
P = Policy
E = Estimate
AE = Error
RWR = Retrospective with restatement
RNR = Retrospective without restatement
P = Prospective
1. Recorded expense, €870; should be €780.
2. Changed useful life of a machine based on evidence of wear and tear over time.
3. Changed from FIFO to average cost for inventory to conform to industry practice. No
prior balances can be reconstructed, not even opening balances.
4. Changed from straight-line to accelerated depreciation to reflect the company’s
changing reporting objectives.
5. Change in residual value of an intangible operational asset based on changed economic circumstances.
6. Changed from deferral to liability basis for accounting for income taxes to conform to
new accounting standard.
7. Changed from percentage-of-completion to completed-contracts for long-term
construction to reflect change in reporting objectives. All prior balances can be
reconstructed.
8. Changed from average cost to FIFO for inventory to facilitate a new system of record
keeping. Only opening balances can be reconstructed.
9. Changed to a new accounting principle required by a revised IFRS.
10. Discovered that a plant and equipment with a 10-year life had been expensed when
acquired five years ago.
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2,
First Edition (Toronto: McGraw-Hill Ryerson, 2000), Question E22-2, page 1257.
Adapted with permission.
Question 3 (17 marks)
(1 mark for Requirement 1; 6 marks for Requirement 2; 4 marks for
Requirement 3; 2 marks each for Requirements 4, 5, and 6)
Bite Corporation has always deferred product promotion costs and amortized the asset
balance on a straight-line basis over the expected life of the related product. The
company decided to change to a policy of immediately expensing such costs to more
closely conform to tax treatment, a recently adopted corporate reporting objective. The
change was adopted at the beginning of 20X7. Costs incurred are as follows:
20X3
20X4
20X5
20X6
20X7
Amount
Life span
€68,000
40,000
20,000
52,000
45,000
10 years
4 years
5 years
10 years
9 years
Required
1.
Identify the type of accounting change involved. Which approach should be used:
current, retrospective with restatement, or retrospective without restatement?
Explain.
2.
Prepare the entry(ies) to appropriately reflect the change in 20X7, the year of the
change, including the entry to record 20X7 expenditures. Disregard income tax.
3.
Explain how the change should be reported on the 20X7 financial statements, which
include the 20X6 results for comparative purposes.
4.
Prepare the entries to reflect the change in the accounts in 20X7, including the
20X7 expenditures, if only the opening 20X7 balance can be reconstructed. What
would change in financial statement presentation?
5.
Prepare the entries to reflect the change in the accounts in 20X7, including the
20X7 expenditures, assuming that no restatement of any balances was possible.
6.
Explain how classification of the costs on the cash flow statement would change as
a result of the new accounting policy.
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2, First
Edition (Toronto: McGraw-Hill Ryerson, 2000), Question E22-7, pages 1259 and 1260.
Adapted with permission.
Question 4 (20 marks)
(5 marks for Requirement 1; 13 marks for Requirement 2; and 2 marks for
Requirement 3)
Note:
In Requirement 2, you must complete two years of comparative information on the retained earnings
statement. (That is, the retained earnings statement should include 20X6, 20X5, and 20X4.) Also prepare
the accounting policy disclosure note regarding the changes.
In 20X6, Digger Oil Company changed its method of accounting for oil exploration costs
from the successful efforts method (SE) to full costing (FC) for financial reporting
because of a change in corporate reporting objectives. Digger has been in the oil
exploration business since January 20X3; prior to that, the company was active in oil
transportation.
Pre-tax income under each method is as follows:
20X3
20X4
20X5
20X6
SE
FC
€ 5,000
22,000
25,000
40,000
€15,000
25,000
35,000
60,000
Digger reports the result of years 20X4 through 20X6 in its 20X6 annual report and has a
calendar fiscal year. The tax rate is 30%.
Additional information
Ending retained earnings (SE basis)
20X3
20X4
20X5
20X6
€18,000
23,000
31,000
n/a
Dividends declared
€ 9,000
10,400
9,500
18,000
Required
1. Prepare the entry in 20X6 to record the accounting change. Use “natural resources” as
the depletable asset account.
2. Prepare the comparative retained earnings statement.
3. Describe how the accounting policy change would affect the cash flow statement.
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2, First
Edition (Toronto: McGraw-Hill Ryerson, 2000), Question P22-8, page 1266. Adapted
with permission.
Question 5 (10 marks)
(2 marks for Requirement 1 and 8 marks for Requirement 2)
In 20X6, Cathode Company, a calendar fiscal year company, discovered that depreciation
expense was erroneously overstated €1,000 in both 20X4 and 20X5, for financial
reporting purposes. The tax rate is 30%.
Additional information
Beginning retained earnings
Profit, as reported with error
Dividends declared
20X6
20X7
€28,000
18,000
8,000
€18,000
16,000
6,000
Required
1. Record the entry in 20X6 to correct the error.
2. Provide the comparative retained earnings statement for 20X6, including any required
note disclosure.
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2,
First Edition (Toronto: McGraw-Hill Ryerson, 2000), Question P22-13, page 1269.
Adapted with permission.
Question 6 (22 marks)
Case analysis
Carpanthian Technologies Ltd. (CTL) is a long-established company involved in
manufacturing heavy equipment, used mostly by mining companies in Siberia. In the past
ten years, three of its products have accounted for 70% of its sales and are relatively
stable. However, four years ago, the company began a relatively risky project to design
and develop a machine incorporating new technology and materials, which was expected
to be significantly more efficient that the existing alternatives. There was considerable
optimism surrounding the project.
However, as time went on, the project became plagued with problems. There were cost
overruns. Prototypes were not capable of delivering the operational efficiencies
promised. There was significant turnover among the engineering staff and the project
took far longer than expected as a result. Throughout this three-year time period, all costs
associated with the project were deferred. These costs appropriately met the deferral
criteria for development cost category. At the end of 20X4, the deferred development
costs associated with this project amounted to €11,567,000. In 20X5, another €3,112,000
was spent, making the total cost €14,679,000. The project was finally ready for
commercial production.
At this time, markets for the product were formally reassessed, with poor results. Both
the size of the market and the price per unit were found to have been overestimated; as a
result, the deferred development costs could not be recouped through future sales. It was
estimated that deferred costs would have to be written down by €8,500,000. This amount
has been reviewed by the external auditors, and all are in agreement that the amount is
appropriate and that there will be future sales to support the remaining €6,179,000 of
development costs. These remaining development costs will be amortized as units are
sold, resulting in normal profit margins.
At this point, there is some debate about how to account for the €8,500,000 write-down.
One member of the management team believes that it should be accounted for as an error,
since the past estimates of future sales were obviously significantly incorrect. If correct
sales forecasts had been available, a major portion of the development costs would have
been written off to expenses in the last three years. The president prefers to treat this
change as a retrospective change in accounting policy: a change in the amount of
development expenses that are eligible for deferral. Specifically, accounting policy would
change to exclude the cost of rework and the cost of delays caused by staff turnover or
human error in the development category. These would be expensed as incurred. The
bulk of the writeoff would then affect retained earnings. One of the vice-presidents
believes that this is a change in an estimate — the sales estimate — and thus should be
treated completely on a prospective basis. That is, all that should change is that more
annual expenses should be charged each year. In this scenario, there would be no
immediate write-down, the deferred asset would stay intact at €14,679,000, but future
expenses would be higher. The final scenario is to treat the amount as a writedown in
20X5, as an unusual item on the income statement.
You have been asked to provide your advice on the issue. You are aware that the
company has more debt financing now than ever before, as debt was taken on to finance
this new project. Lenders are fully secured, but are anxious to see profits from the
company.
Required
Prepare a report addressing the issue raised.
Note:
Case analysis is limited to 1,000 words. A maximum of two marks is awarded for the quality of written
communication.
Suggested solutions
Question 1 (16 marks)
Requirement 1 (4 marks)
Each situation involves a change in estimate. A change in estimate is accounted for using
the prospective approach. Under this approach, the effect of the change is allocated to the
current and future periods.
Requirement 2 (12 marks)
a. December 31, 20X7, adjusting entries (prior to the changes)
Depreciation expense, machine .......................................
Accumulated depreciation, machine .........................
3,500
3,500
Computation: (€78,000  €8,000)  20 yrs = €3,500
Amortization expense, patent .........................................
Accumulated amortization, patent .............................
2,000
2,000
Computation: €34,000  17 yrs = €2,000
b. 20X8, Year of change
No entry required to record a change in estimate.
c. December 31, 20X8, adjusting entries
Depreciation expense, machine .......................................
Accumulated depreciation, machine .........................
Computation:
Cost of machine .........................................................
Depreciation to date (€70,000  7/20) .......................
Revised residual value ...............................................
Remaining amount to be depreciated ........................
Annual depreciation, SL [€44,500  (16  7 yrs)] ....
Amortization expense, patent ..........................................
Accumulated amortization, patent .............................
Computation:
Cost ............................................................................
Amortization to date (€34,000  3/17) ......................
Remaining amount to be amortized ...........................
Annual amortization [€28,000  (13  3 yrs)]. ..........
4,944
4,944
€ 78,000
(24,500)
(9,000)
€ 44,500
€ 4,944
2,800
2,800
€ 34,000
(6,000)
€ 28,000
€ 2,800
Question 2 (15 marks)
(11/2 marks each)
Type
P = Policy
E = Estimate
AE = Error
Approach
RWR
RNR
P
1. Recorded expense, €870 not €780.
AE
RWR
2. Changed useful life of a machine.
E
P
3. Changed from FIFO to AC; no restatement possible.
P
P
4. Changed from straight-line to accelerated amortization.
New reporting objectives.
P
RWR
5. Change in residual value of an intangible operational asset.
E
P
6. Changed from accrual to liability for tax: accounting
standard changed.
P
RWR
7. Changed from percentage-of-completion to completed
contracts for long-term construction contracts;
all prior balances can be reconstructed.
P
RWR
8. Changed from average cost to FIFO for inventory; only
opening balances can be reconstructed.
P
RNR
9. Changed to a new accounting principle required
by the revised IFRS.
P
Case (event or transaction)
10. Property, plant and equipment expensed five years ago.
RWR
(unless P or
RNR specified
in section)
AE
Question 3 (17 marks)
Requirement 1 (1 mark)
The change is a change in accounting policy, to be applied retrospectively with
restatement.
RWR
Requirement 2 (6 marks)
Amount
20X3
20X4
20X5
20X6
Beginning of 20X7
Cumulative
Net Book
Amortization
Value
Life
Yearly
Span Amortization
€ 68,000
40,000
20,000
52,000
€ 180,000
10
4
5
10
€
6,800
10,000
4,000
5,200
€ 26,000
(4)
(3)
(2)
(1)
€ 27,200
30,000
8,000
5,200
€ 70,400
Effect on 20X3 – 20X6 profit:
Expense, new policy ........................................................
Amortization, old policy ..................................................
Decrease in NI .................................................................
€ 40,800
10,000
12,000
46,800
€ 109,600
€ (180,000)
70,400
€ (109,600)
Effect on 20X7 profit:
Expense, new policy ........................................................
Amortization, old policy (€26,000 + €5,000*) ................
Decrease in NI .................................................................
* €45,000/9 = €5,000
€ (45,000)
31,000
€ (14,000)
Journal entries
Retained earnings
(cumulative effect of change in accounting policy) ...........
Deferred promotion expenditures ....................................
Promotion expense.................................................................
Cash .................................................................................
109,600
109,600
45,000
45,000
Requirement 3 (4 marks: 1/2 mark for items 1 and 3 and 1 mark for each other item)
The change would be reported as follows:
1. 20X7 expense would be €45,000, following the new policy.
2. 20X7 opening retained earnings would be reduced by the cumulative effect of the
accounting change, €109,600.
3. 20X6 expense would be changed from €26,000 to €52,000 (a difference of €26,000).
4. 20X6 opening retained earnings would be reduced by the remaining cumulative effect
of the accounting change, €83,600 (€109,600 – €26,000).
5. Note disclosure would describe the change and the effect on 20X7 and 20X6 profits
(€14,000 and €26,000 decrease, respectively).
Requirement 4 (2 marks)
If prior years could not be reconstructed, the journal entries recorded in Requirement 2
would remain unchanged, as opening balances only are affected by the journal entries.
Retained earnings
(cumulative effect of change in accounting policy) ...........
Deferred promotion expenditures ....................................
109,600
109,600
Promotion expense.................................................................
Cash .................................................................................
45,000
45,000
Reporting would involve items 1 and 2 listed in Requirement 3. Items 3 and 4 would not
be feasible; the note disclosure would discuss the effect on 20X7 profit only, and explain
that the comparatives are not restated.
Requirement 5 (2 marks)
No restatement possible
Promotion expense.................................................................
Cash .................................................................................
45,000
45,000
The change in policy would be applied prospectively, for 20X7 expenditures only.
Expenditures made prior to 20X7 may be written off if there is evidence that the value of
these expenditures has been impaired, or they may be amortized until their useful life
expires.
Requirement 6 (2 marks)
Before the change, the expenditures would have been reported as an outflow under
investing activities. Amortization would have been an add-back under operations
(indirect disclosure of the operating activities section). After the change, the expenditures
are reported in operations, as part of the profit figure (indirect disclosure) or as an
operating outflow (direct disclosure).
Question 4 (20 marks)
Requirement 1 (5 marks)
Entry to record accounting change, 20X6
Natural resources ...................................................................
Retained earnings, effect of accounting change1 .............
Future income tax liability ...............................................
1
23,000
16,100
6,900
Total difference in pretax income for the two methods for 20X3 – 20X5 is €23,000
[(€5,000 + €22,000 + €25,000) – (€15,000 + €25,000 +€35,000)] =
€23,000  70% = €16,100
(FC has higher income.)
Requirement 2 (13 marks; 3 marks for 20X6, 4 marks for 20X5, 4 marks for 20X4,
and 2 marks for disclosure note)
DIGGER OIL COMPANY
Retained Earnings Statement
Years ended December 31
Beginning balance, as previously reported ................
Cumulative effect of accounting change,
net of €6,900, €3,900, and €3,000 tax ....................
Beginning balance restated ........................................
Profit (after 30% tax) .................................................
Dividends ...................................................................
Ending balance...........................................................
1
2
3
20X6
20X5
20X4
€ 31,000
€ 23,000
€ 18,000
16,100 1
47,100
42,000
(18,000)
€ 71,100 €
9,100 2
7,000 3
32,100
25,000
24,500
17,500
(9,500)
(10,400)
47,100
€ 32,100
€16,100 = [€23,000 (1 – 0.3)] amount from entry covering all years affected
€9,100 = [€13,000 (1 – 0.3)] after-tax income difference for 20X3-20X4
€7,000 = [€10,000 (1 – 0.3)] after-tax income difference for 20X3
Disclosure note:
The company changed from the successful efforts to the full costing method of
accounting for oil exploration costs in 20X6. The after-tax effects of the change on
income are as follows:
Effect of change on:
Increase in profit ...........................................
4
5
6
20X6
€14,000 4
20X5
€ 7,000 5
20X4
€ 2,100 6
€14,000 = (€60,000 – €40,000) (1 – 0.3)
€7,000 = (€35,000 – €25,000) (1 – 0.3)
€2,100 = (€25,000 – €22,000) (1 – 0.3)
Requirement 3 (2 marks)
Under SE, all development expenses for unsuccessful properties would be reflected in
operations, either directly, listed as a cash outflow under the direct method of
presentation, or indirectly, as part of profit under the indirect method of presentation.
Under FC, the expenditures would be shown as an outflow under the investing activities
section.
Question 5 (10 marks)
Requirement 1 (2 marks)
20X6 entry to correct error
Accumulated amortization .....................................................
Future income tax liability (€2,000  30%).....................
Retained earnings, error correction..................................
2,000
600
1,400
Requirement 2 (8 marks: 3 marks for 20X6 and 5 marks for 20X5)
CATHODE COMPANY
Retained Earnings Statement
Year ended December 31
20X6
Beginning retained earnings, as previously reported ............. € 28,000
Error correction, amortization, net of €600 and €300 tax,
respectively .........................................................................
1,400 1
Beginning balance restated ....................................................
29,400
Profit ................................................................................... 18,000
Dividends declared ................................................................
(8,000)
Ending balance....................................................................... € 39,400
1
2
3
20X5
€ 18,000
700 2
18,700
16,700 3
(6,000)
€ 29,400
See entry
After-tax effect of error on 20X4 income, (€1,000  70%)
€16,000 + (€1,000 (20X5 error)  70%)
Disclosure note:
In 20X6, the company discovered that amortization expense was overstated by €1,000 in
both 20X4 and 20X5. The 20X5 statements are restated to reflect the correct
amortization. The error decreased 20X5 profit by €700.
Question 6 (22 marks)
Case analysis solution
Overview
Carpanthian Technologies Ltd. (CTL) is a long-established company. It has fully secured
lenders who are anxious to see profits from a new project; the level and pattern of
earnings is important to this group.
Issue
Classification and treatment of an accounting change — error, estimate, policy and
retrospective, one-year write-off, or future write-off.
Analysis
Development costs were deferred in the past, but this deferral was too aggressive and
current estimates of future sales indicate the need for a write-down of €8,500,000.
This write-down could be viewed as an error — prior estimates were in error. If prior
sales estimates had been correct, the costs would not have qualified for deferral in the
past as they would not meet the test of probable future recovery. Past expenses would
have been higher, and assets and retained earnings lower. Correcting an error would
involve retrospective restatement of assets, expenses, and retained earnings. This would
largely bypass this year’s (20X5) income statement.
This treatment might reassure lenders by not excessively affecting 20X5 income. With
lower future depreciation of the lower asset values, future income patterns would be more
reassuring for lenders as well.
However, a change in a sales estimate is not an error and the change is not included under
this category. This was not an accidental mis-estimate, so it does not qualify as an error.
Another suggestion is that this is a change in estimate and should only be accounted for
prospectively. This would result in the asset remaining on the books, with higher future
depreciation. There are a number of problems with this approach. First, although users
may be reassured by the presence of the asset, future (higher) depreciation will result in
low or negative earnings from this project. It has been stated that the full amount of the
deferred development costs would not be recoverable from normal sales, which certainly
implies that unadjusted depreciation would exceed gross profit. This would not reassure
lenders, and is contrary to the desired result. Finally, it is not acceptable to leave a
deferred development cost on the books when that has no future benefit. The future
benefit is the future cash flow from the revenue stream. If the revenue stream will not
support the full amount of the deferred costs, then a write-down is necessary. Assets must
have integrity. Furthermore, prospective treatment of a change in estimate means that the
change is accounted for in current and future periods, not just future periods. Thus, this
suggestion is not acceptable.
Another suggestion is that there should be a write-down in the current year, followed by
lower future depreciation. This write-down would be an unusual item on the income
statement. This is analogous to a “lower of cost or market” write-down for any asset and
is supportable. It is the logical result of deciding that this change is a change in estimate.
(The estimate is of future sales.) Recording a large write-down will result in very low
income this year (a bath) and respectable earnings in the future. The future earnings will
be acceptable to lenders, although the current year results will be a shock. Perhaps
lenders should be consulted about the situation as soon as possible to cushion the shock.
The final solution is to treat the change as a change in policy: a change in the types of
costs that are eligible for capitalization. It seems logical to suggest that the costs of
human error, rework, turnover and so on are not appropriate for deferral and that this
accounting policy change is correctly treated on a retrospective basis. This means that the
bulk of the write-off would affect retained earnings and comparative earnings. This
action results in more stable current and future earnings — current earnings do not have
to bear the cost of the write-down and future earnings are protected through the lower
depreciation.
However, it is necessary to consider whether this really is a change in policy. It would, of
course, be helpful to know what others in the industry do when categorizing development
costs. Is this a change to comply with industry practice?
Conclusion
It seems that the driving force behind the write-down is the reduced sales estimates. This
is a change in an estimate and supports the write-down in 20X5 (unusual item) treatment.
The suggestion to use retrospective treatment consistent with a change in policy appears
to be more manipulative and brought up after the fact to support an accounting treatment
that might look attractive to users. It is not ethical to manipulate accounting information
in this way. Accordingly, the accounting treatment that seems the most appropriate is to
record the write-down in the current year as an unusual item.
Note:
Students may support the change in policy treatment and retrospective restatement. If their position is
appropriately justified, it is acceptable.
Marking key
Note:
This marking key is provided for guidance and is not intended to be a complete solution. Since there is no
right answer to a case analysis, the marking key provides for more than the maximum mark allocation. Use
considerable judgment in applying the key. Award marks for valid approach and commentary and keep in
mind that no student will cover all the points.
Overview
Long established company (½)
Lenders looking for profits from new project (1)
Level and pattern of earnings important (1)
Maximum 2
Issues
Classification and treatment of accounting change (1/2)
Maximum 1/2
Analysis
Error
Prior sales were in error (1)
Costs would have been written off as incurred (1)
Past expenses higher, assets and RE lower (1)
Correct error with retrospective approach (1)
Avoid this IS (1), restate prior years (1/2)
Lenders might prefer — current NI higher (1), future NI higher (1)
Not accidental misstatement, though (1)
Other valid points (1 each)
Estimate, prospective, future only
Asset still on books, future earnings lower (1)
Users might like asset, but not lower future earnings (1)
Future earnings would be negative (1)
No future benefit to support asset (2)
Lenders not well served (1)
Other valid points (1 each)
Write down this year, lower future depreciation
Analogous to LCM (and so on) (1)
Logical result after change of estimate (1)
Unusual item (why) (1)
Bath this year (1)
Future earnings respectable (1)
Effect on lenders (1)
Other valid points (1 each)
Change in policy
Policy is types of costs eligible for deferral (1)
Treatment is retrospective: avoid IS (1)
Future amort still low (½)
Effect on lenders; stable pattern? (1)
Window dressing? (1)
Other valid points (1 each)
Maximum 18
Recommendations
A sensible recommendation, consistent with analysis
0 for no recommendation or illogical recommendation
1 for a weak recommendation
2 for an intelligent recommendation
Maximum 2
Communication
Organization, quality of expression
0 for unacceptable communication skills
1 for weak communication skills
2 for acceptable communications skills
Maximum 2
Overall —
maximum 22