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Kieso, Weygandt, Warfield, Young, Wiecek, McConomy

Intermediate Accounting, Tenth Canadian Edition

CHAPTER 21

ACCOUNTING CHANGES AND ERROR ANALYSIS

ASSIGNMENT CLASSIFICATION TABLE Brief Exercises

Topics

Exercises

Writing Problems Assignments

1. Differentiate between 1, 2, 3 change in policy, change in estimate and errors.

1, 2, 3, 4, 5

1, 2, 3, 4, 5, 1, 2, 3, 4, 6 6, 7

2. Change in accounting policy.

4

6, 7, 8, 9

1, 2, 3, 4, 5,1, 2, 3, 4, 6 8

3. Correction of an error.

3, 5, 6

1, 2, 3, 5, 8, 1, 2, 3, 4, 5,1,2,3,4,5,6 10, 11, 12, 13, 6, 7, 9, 10, 14, 15, 16 11, 12, 13

4. Change in estimate.

7, 8, 9

3, 5, 9, 13, 17, 2, 3, 4, 5, 6,1, 2, 3, 4, 6 18 7

5. Motivations for change.

3, 19

14

6. Differences between IFRS 6 and ASPE.

4

4, 5, 8, 14 4,5,7

7. Correct errors and restate 5, 6, 10 financial statements.

11, 12, 13, 14, 5, 6, 7, 11, 1 15, 16 12, 13

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Copyright © 2013 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.



ASSIGNMENT CHARACTERISTICS TABLE Item E21-1 E21-2 E21-3 E21-4 E21-5 E21-6 E21-7 E21-8 E21-9 E21-10 *E21-11 *E21-12 E21-13 *E21-14 *E21-15 *E21-16 E21-17 E21-18 E21-19 P21-1 P21-2 P21-3 P21-4 P21-5 P21-6 P21-7 P21-8 P21-9 P21-10 P21-11 P21-12 P21-13 P21-14

Description Change in policy—long-term contracts. Determine type of change, method of accounting, prepare journal entries. Change in estimate, error correction. Accounting for accounting changes. Change in estimate and error; financial statements. Accounting change—inventory. Change in policy—measurement model for investment property. Various changes in policy—inventory methods. Accounting changes—depreciation. Error correction entries. Error analysis and correcting entry. Error analysis; correcting entries. Error and change in estimate—depreciation. Error analysis. Error analysis. Error analysis. Accounting changes—amortization. Change in estimate—depreciation. Political motivations for policies. Error corrections and changes in policy. Change in estimate, policy, and error correction with tax effect Comprehensive accounting change in estimate and error analysis problem. Error analysis and changes in policy. Effect of changes in policy, estimate and error, financial statements and note disclosure. Comprehensive accounting change and error analysis problem, with statement of retained earnings and notes. Effect of changes in policy and estimate, financial statements. Change in policy (FIFO to average cost), income and retained earnings statement. Error corrections. Error analysis with tax effect. Error analysis and correcting entries. Error analysis and calculation of corrected net income. Error analysis and correcting entries. Economic motives for selection of accounting policies and ethical considerations.

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Level of Time Difficulty (minutes) Simple 10-15 Moderate 20-25 Moderate Simple Moderate

20-30 20-25 25-30

Moderate Simple

25-30 15-20

Moderate Moderate Moderate Simple Moderate Simple Moderate Moderate Moderate Moderate Moderate Simple Moderate Moderate

20-35 15-20 20-25 10-15 20-25 15-20 25-30 25-30 10-15 15-20 10-15 10-15 25-30 30-35

Moderate

30-35

Complex Complex

45-50 50-60

Complex

45-55

Complex

50-60

Complex

50-60

Moderate Moderate Complex Moderate

25-30 20-25 50-60 30-40

Complex Moderate

50-60 25-30 Chapter 21




SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 21-1 1.

The change to a three-year remaining life for the purpose of computing depreciation on production equipment is a change in estimate due to a change in conditions.

2.

This is an expense classification change arising from a change in the use of the building for a different purpose. Thus, it is not a change in principle, a change in estimate, or the correction of an error.

3.

The change to expensing preproduction costs (writing the costs off in one year as opposed to several years) is a change in estimate due to a change in conditions. The change in estimate is to the value used in the base in the allocation. Preproduction costs are included as part of development costs and may be capitalized under IFRS as long as certain criteria are met (IAS 38.59).

BRIEF EXERCISE 21-2 1.

Both FIFO and weighted average cost are acceptable cost formulas under ASPE; thus, this item is a change in accounting principle.

2.

This oversight is a mistake that should be corrected. Such a correction is considered a change due to error.

3.

Both the completed-contract method and the percentage-ofcompletion method are acceptable alternatives under ASPE. However, they are not interchangeable. The company must choose the method that best relates the revenues recognized to the work performed. In general, the completed contract method is only used where performance consists of one act or the progress towards completion is not measurable (3400.18). Thus, such a change is a change in accounting estimate .

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BRIEF EXERCISE 21-3 Accumulated Depreciation - Asset ($117,000 – $76,000) Deferred Tax Liability ................................... Retained Earnings [$41,000 X (1 – 30%)] ....

41,000 12,300 28,700

Note that this is considered to be a correction of an accounting error. BRIEF EXERCISE 21-4 Inventory* ............................................................. 435,000 Income Tax Payable ..................................... 130,500 Retained Earnings [$435,000 X (1 – 30%)] .. 304,500 * Assumes a periodic system and that ending inventory of 2014 has not yet been recorded. If a perpetual system is assumed, the adjustment is to cost of goods sold. This can be done by first adjusting the opening inventory and then transferring the inventory adjustment to cost of goods sold. Note to instructor: CRA generally requires a company to use the same inventory costing method for tax purposes as for financial reporting purposes. Therefore, Crosbie would have additional tax payable on the increased income reported rather than a deferred tax account. Also, the “more relevant information” from FIFO inventory valuation is highly debatable, as older costs are used in the computation of cost of goods sold.

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BRIEF EXERCISE 21-5 Equipment............................................................ 75,000 Depreciation Expense ($75,000 ÷ 5) ................... 15,000 Accumulated Depreciation.......................... 45,000* Deferred Tax Liability .................................. 14,400** Retained Earnings ....................................... 30,600*** * $75,000 ÷ 5 X 3 years = $45,000 ** ($75,000 – $30,000) X 32% = $14,400 *** ($75,000 – $30,000) X (1 – 32%) = $30,600 Assumes income was reported accurately for tax purposes in all years. *BRIEF EXERCISE 21-6 (a) BAKER CORPORATION Statement of Retained Earnings December 31, 2014 Retained earnings, 1/1/14, as previously reported Correction of depreciation error, (net of tax of $125,000) Retained earnings, 1/1/14, as adjusted Add: Net income Deduct: Dividends Retained earnings, 12/31/14 (b)

$2,000,000 (375,000) 1,625,000 900,000 2,525,000 250,000 $2,275,000

If Baker were to follow IFRS, the error correction would be accounted for in the same way, except that Baker would have to prepare a Statement of Changes in Shareholders’ Equity, as required under IFRS, rather than a Statement of Retained Earnings under ASPE.

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BRIEF EXERCISE 21-7 No entry is required to record the change in estimate. In CICA Handbook, Part II, Section 1506, a revision of depreciation policy due to changes in the expected pattern of benefits is identified as a change in estimate. Since the change was made at the beginning of the year, the new accounting policy would be applied to 2014 and prospective years. BRIEF EXERCISE 21-8 Depreciation Expense ......................................... Accumulated Depreciation – Equipment ...

19,000 19,000

Carrying amount: = $60,000 – 2 X (60,000 – 18,000) / 7 = $48,000 New annual depreciation:

 $48,000 – $10,000  = $19,000    4–2

BRIEF EXERCISE 21-9 There would be no further change in reported income and EPS for 2014 since the 2014 net income has already been calculated using the new depreciation method. There would be no adjustment to opening retained earnings for any previous year since changes considered changes in estimate are accounted for prospectively. There would also be no journal entry to adjust the accounting records for accumulated depreciation due to the change in method since a change from one depreciation method to another due to a change in the pattern of consumption is considered a change in estimate, not a change in accounting policy (IAS 8.32).

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*BRIEF EXERCISE 21-10

a. b. c. d. e.

2013 Overstated Overstated Understated Overstated No effect

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SOLUTIONS TO EXERCISES EXERCISE 21-1 (10-15 minutes) (a) The net income to be reported in 2014, would be computed as follows: Income before income tax $700,000 Income tax: Current (30% X $480,000) $144,000 Deferred [30% X ($700,000–$480,000)] 66,000 210,000 Net income $490,000 (b) Construction in Process ................................ 200,000 Deferred Tax Liability.............................. 60,000 Retained Earnings................................... 140,000* *($200,000 X (1 – 30%) = $140,000) (c)

A current ratio of 0.95 indicates that the company has lower current assets than current liabilities as at the end of 2014. The entry in part (b) will result in an increase in current assets (with a debit to construction in process), and a proportionately smaller increase in current liabilities (with a credit to deferred tax liability). (Note that under ASPE, a deferred tax asset or liability must be classified as current or noncurrent based on the classification of the asset or liability underlying the temporary difference). After recording the entry in part (b), the company’s current ratio will appear higher. The error correction had no impact on the company’s actual liquidity position, yet the error correction will cause the company’s current ratio to appear higher. A creditor should review the notes to the financial statements describing the error correction, and note the effect of the correction on the company’s current ratio. A creditor may also note that other aspects of the company’s liquidity position may be analyzed for a more detailed assessment of the company’s short-term ability to pay its maturing obligations.

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EXERCISE 21-2 (20-25 minutes) (a)

1. Change in estimate – prospectively. 2. Change in estimate – prospectively. 3. Accounting error correction – full retrospective application. 4. Change in accounting policy – full retrospective application.* * GAAP specifies that changes in policy should be accounted for retrospectively with full application to prior periods. In certain cases, it may be impracticable to determine estimates for prior periods, in particular if it is impossible to assess circumstances and conditions in prior years that need to be known in order to develop those estimates. Partial retrospective or prospective application would then have to be used.

(b) Event #3: Equipment ....................................................... 100,000 Depreciation Expense .................................... 22,500* Accumulated Depreciation - Equipment ($22,500 X 2) ......................................... 45,000 Retained Earnings................................... 54,250 ** Deferred Tax Liability.............................. 23,250 *** * ($100,000 – $10,000)/4 = $22,500 ** ($100,000 – $22,500) X (1 – 30%) = $54,250 *** ($100,000 – $22,500) X 30% = $23,250 Note to Instructor: The Deferred Income Tax effect for the current year is not included in the above entry as noted in the question.

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EXERCISE 21-2 (Continued) Event #4: Retained Earnings .......................................... Income Tax Payable ....................................... Inventory ..................................................

7,000 3,000 10,000

Changes for 2011 and 2012 have not been included since inventory changes are counterbalancing and their impact on opening 2014 retained earnings is nil. Note to Instructor: Also note that CRA generally requires a company to use the same inventory costing method for tax as it uses for financial reporting purposes. Therefore, the effect of the change in inventory costing method will result in a current tax amount, not a deferred tax asset or liability.

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EXERCISE 21-3 (20-30 minutes) (a) Patent: This is a change in estimate. The change would be applied to the current year and prospectively. Land and Building: This is a correction of an error. The adjustment would be applied retrospectively. This would include restating all prior period financial statements presented for comparison, adjusting the opening balance of retained earnings for the earliest period presented, and providing note disclosure. (b) Amortization of Patent: Amortization Expense ....................................... 76,000 Accumulated Amortization—Patents........ 76,000 Amortization recorded in 2012 and 2013: ($410,000 – $50,000) / 10 years X 2 years = $72,000 Annual amortization incorporating this change: ($410,000 – $110,000 – $72,000) / 3 years (2014 to 2016) = $76,000 Land and Building – error correction entry: Building .......................................................... 101,250 Land ........................................................ 101,250 Depreciation Expense* .................................. 3,213 Retained Earnings ......................................... 8,033 Accumulated Depreciation - Buildings ($3,213* X 3.5)

11,246

*($101,250 – $37,000) / 20 years = $3,213 / year

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EXERCISE 21-3 (Continued) (c) Change in Estimate (Patent): The nature and amount of the change should be disclosed. Amortization expense for the patent has been increased by $40,000 for the current and future years due to a change in estimated useful life and residual value. Correction of Error (Land and Building): The disclosure should enable users to understand the effects of the error on the financial statements. It should include a statement of the nature of the error, the amount of the correction for each prior period presented and the amount related to periods prior to those presented, and a statement that comparative information has been restated. Depreciation expense has been increased by $3,213 for both 2014 and 2013 (include previous years if included in comparative statements). This has decreased net income by $3,213 for both 2014 and 2013 and earnings per share by $XXX in each year. (d) If management determines assets’ useful lives and residual values as part of the year end process, it is likely that the conditions leading to these changes would have occurred during the year. In this case, the change in estimate would be applied to 2014 going forward. If management determines that the factors leading to the change in estimate occurred at or after year end, the changes would be applied to 2015 going forward. In this exercise, it appears that depreciation and amortization expense is recorded once a year. Since the controller uses the adjustment process to revise the estimate of useful life and residual value, it would be appropriate to reflect the change to 2014 going forward.

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EXERCISE 21-3 (Continued) (e) Impairments of depreciable assets frequently involve a revision of estimates of useful life and residual value, but changes in estimates do not necessarily come from impairments of assets. Impairment tests for limited-life intangibles are done at the end of each reporting period. The controller would need to review the patent for impairment, and if events or changes in circumstances indicate that the carrying amount of the patent may not be recovered, the controller would need to compare the patent’s carrying amount to its recoverable amount (the higher of value in use and fair value less costs to sell). If the recoverable amount is less than carrying amount of the patent, the impairment loss would be the excess of the patent’s carrying amount over its recoverable amount. In this exercise there is no indication that the changes in estimates are due to an impairment. Consequently, the changes would be accounted for as a change in estimate.

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EXERCISE 21-4 (20-25 minutes) (a) and (b)

Accounting treatment under IFRS:

1. 2. 3. 4. 5.

(a) Accounting treatment P R P NA* P

6. 7. 8. 9. 10.

P R P P R

(b) Type of change Change in estimate Accounting error correction Change in estimate Change in policy Not an accounting change – selection of policy for first time. Change in estimate Accounting error correction Change in estimate Change in estimate Accounting error correction

* The accounting treatment would be specified in the transitional provisions of the new source of GAAP. If not specified, then apply retrospectively. Note that the only two approaches that are permitted for reporting changes are retrospective and prospective treatment. When new or revised sources of primary GAAP are adopted, recommendations are usually included that specify how an entity should handle the transition. These are called transitional provisions.

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EXERCISE 21-4 (Continued) Under IFRS, an opening statement of financial position must be provided for the earliest comparative period provided when there is a retrospective change. (c) Accounting treatment under ASPE (if different than part (a) for IFRS): For corrections of errors, ASPE assumes that the impact on each specific prior period is measurable. IFRS acknowledges that the full impact may not be determinable There would be no differences to the accounting treatment for the above noted items between IFRS and ASPE, however some items have special considerations worth noting. (5) IAS 23 requires that interest be capitalized for qualifying assets, whereas ASPE still permits a choice between capitalization and expensing, provided that the company is consistently applying the policy. Given that this is the first time they have constructed a building for their own purposes, it’s not a change at all, but rather the selection of a policy for the first time. (9) Under current IFRS (IAS 11 and IAS 18), the percentage of completion method is the preferred method of accounting for long-term contracts. If the outcome cannot be reliably measured, recoverable revenues equal to costs are recognized under IAS 11 and IAS 18 (sometimes referred to as the zero profit method). No gross profit is recorded until the contract is completed and the gross profit can be reliably measured. IFRS does not provide the choice of the completed contract method. Under ASPE, the percentage of completion method is again the preferred method of accounting for long-term contracts. However, the completed contract method is allowed as a default method for long-term contracts under ASPE where the percentage complete cannot be

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EXERCISE 21-4 (Continued) reliably measured. Under the completed contract method, revenue would only be recorded when the contract is completed. (d) Under IFRS, one of the following two situations is required for a change in an accounting policy to be acceptable: 1. The change is required by a primary source of GAAP. 2. A voluntary change results in the financial statements presenting reliable and more relevant information about the effects of the transactions, events, or conditions on the entity’s financial position, financial performance, or cash flows. ASPE provides for further situations where an accounting policy change may be made without having to meet the “reliable and more relevant” criteria in the second situation above. It allows the following voluntary changes in policy to be made: 3. Between or among alternative ASPE methods of accounting and reporting for investments in subsidiary companies, and in companies where the investor has significant influence or joint control; for expenditures during the development phase on internally generated intangible assets; for defined benefit plans; for accounting for income taxes; and for measuring the equity component of a financial instrument that has both a liability and equity component at zero. These further situations allowed under ASPE as an acceptable change in accounting policy relate to standards where accounting policy choices have to be made. These changes are treated as voluntary changes, but they do not have to meet the “reliable and more relevant” hurdle required of other voluntary changes. Although not specifically stated in the actual standard, it is assumed that once that choice has been made, the same policy is followed consistently. Solutions Manual

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EXERCISE 21-5 (25-30 minutes) (a) Change from sum-of-the-years-digits to straight-line Cost of depreciable assets ................................. Depreciation in 2013 ($90,000 X 4/10) ................ Carrying amount at December 31, 2013 .............

$90,000 36,000 $54,000

Depreciation for 2014 using straight-line depreciation Carrying amount at December 31, 2013 ............. Estimated useful life ............................................ Depreciation for 2014 ($54,000 ÷ 3) ....................

$54,000 3 years $18,000

HESSEY INC. Statement of Retained Earnings For the Year Ended Retained earnings, January 1, unadjusted ..... Less: Correction of error for inventory overstatement........................................ Retained earnings, January 1, adjusted ......... Add: Net income............................................. Less: Dividends ............................................... Retained earnings, December 31 ....................

2014 $125,000 (20,000) 105,000 81,000 (30,000) $156,000

2013

$ 72,000 58,000 (25,000) $105,000

Corrected net income: As included in draft statements.................... $52,000 $78,000 Inventory correction ........................................ 20,000 (20,000) Depreciation under sum of the years digits ..27,000 Depreciation under straight line ................... (18,000) _ Corrected net income ........................................... $81,000 $58,000

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EXERCISE 21-5 (Continued) Note to instructor: 1.

2013 Cost of sales was understated by $20,000; 2014 cost of sales was overstated by $20,000. As a result, net income for 2013 is overstated $20,000 and net income for 2014 is understated $20,000 as a result of the inventory error.

2.

2013 depreciation expense is unchanged.

3.

Additional disclosures would be necessitated as indicated in the chapter.

(b) Most likely accounting treatment of change in depreciation method under various circumstances: • If the change is due to changed circumstances, for example, the types of assets has changed and the usage of the new assets is better reflected by straight-line depreciation or a changed pattern of expected benefits, then the change would be treated prospectively. • If the change is due to a change in primary GAAP, the transitional provisions of the new policy will specify the acceptable treatment.

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EXERCISE 21-6 (25-30 minutes)

(a) Retained earnings, January 1, as reported ........... Cumulative effect of change in accounting principle to weighted average cost .................... Retained earnings, January 1, as adjusted ...........

2011 $160,000 (13,000)* $147,000

*[ – $8,000 (2009) – $5,000 (2010)] (b) Retained earnings, January 1, as reported ........... Cumulative effect of change in accounting principle to weighted average cost .................... Retained earnings, January 1, as adjusted ...........

2014 $590,000 (15,000)* $575,000

*[– $8,000 (2009) – $5,000 (2010) – $5,000 (2011) + $10,000 (2012) – $7,000 (2013)] (c) Retained earnings, January 1, as reported ........... Cumulative effect of change in accounting principle to weighted average cost .................... Retained earnings, January 1, as adjusted ...........

2015 $780,000 (9,100)* $770,900

*[–$15,000 at 12/31/2013 + $5,900 (2014)] 2012 (d) Net Income ............................. $130,000

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2013 2014 $293,000 $310,900

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EXERCISE 21-7 (15-20 minutes) (a)

For the years ended December 31, 2012 and 2013, the land was original measured and reported on the statement of financial position at its cost of $1,000,000 with no effects reported in net income (as there is no depreciation on land). 2013

STATEMENT OF FINANCIAL POSITION (partial) Land, at cost Retained earnings, ending balance INCOME STATEMENT (partial) Unrealized gain (loss) in value of Land – Investment Property (b)

2012

$1,000,000 290,000

$1,000,000 230,000

$0

$0

The entry required January 1, 2014 to restate opening Retained Earnings is: Investment Property..................... 50,000 Retained Earnings ................... 50,000

The opening Retained Earnings in 2014 would have to be increased by the net amount of $50,000 for the change in fair value of the investment property up to December 31, 2013 (equal to the fair value holding loss in 2012 of $20,000 and the fair value holding gain in 2013 of $70,000). This is a considered an acceptable change in accounting policy since changing the measurement model will provide more relevant information. Thus, it is accounted for retroactively as a change in accounting policy.

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EXERCISE 21-7 (Continued) (c)

The previous financial statements would be restated as follows to include the change in fair value of the investment property in net income and related presentation on the statement of financial position: 2013 2012 (Restated) (Restated)

STATEMENT OF FINANCIAL POSITION (partial) Land, at fair value Retained earnings, ending balance INCOME STATEMENT (partial) Unrealized gain (loss) in value of Land – Investment Property STATEMENT OF SHAREHOLDERS’ EQUITY / RETAINED EARNINGS (partial) Opening retained earnings, as originally stated Adjusted for 2012 decline in fair value Adjusted for 2013 increase in fair value Opening retained earnings, as restated for change in accounting policy

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$1,050,000 340,000

$980,000 210,000

$70,000

$(20,000)

$290,000 (20,000) 70,000

$230,000 (20,000) _

$340,000

$210,000

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EXERCISE 21-8 (20-35 minutes) (a) Inventory**............................................................ 8,000 Retained Earnings........................................ *2011 *2012 *2013

$2,000 5,000 1,000 $8,000

8,000*

($26,000 – $24,000) ($30,000 – $25,000) ($28,000 – $27,000)

** Cost of Goods Sold could be used if the inventory is already adjusted at year-end. Information shown in comparative form as follows:

Net income (Note A)

2014 $34,000

2013 $28,000

2012 $30,000

2011 $26,000

Note A: In 2014, inventory has been calculated using the first-in, first-out cost formula . In prior years, since incorporation, inventory had been calculated using the weighted average cost formula. The new method of inventory costing was adopted to provide more relevant financial statement information and has been applied retrospectively to inventory valuation of prior years. The impact of the change is an increase (decrease) in inventory of $XXX (increase (decrease) in 2013 of $XXX), increase (decrease) in cost of goods sold of $XXX (increase (decrease) in 2013 of $XXX), increase in net income of $4,000 (increase in 2013 of $1,000), an increase of opening retained earnings of $8,000 (increase of $7,000 in 2013) and an increase in earnings per share of $XXX (increase in 2013 of $XXX).

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EXERCISE 21-8 (Continued) (b) Inventory**............................................................ 19,000 Retained Earnings........................................ 19,000* *2011 *2012 *2013

$ 6,000 9,000 4,000 $19,000

($26,000 – $20,000) ($30,000 – $21,000) ($28,000 – $24,000)

** Cost of Goods Sold could be used if the inventory is already adjusted at year-end.

Net income

2014 $34,000

2013 $28,000

2012 $30,000

2011 $26,000

Note A: In 2014, inventory has been calculated using the first-in, first-out cost formula . In prior years, since incorporation, inventory had been calculated using the last-in, first-out cost formula . The change is required in order to comply with CICA Handbook, Part II, section 3031, and the new standard has been applied retrospectively. The impact of the change is an increase (decrease) in inventory of $XXX (increase (decrease) in 2013 of $XXX), increase (decrease) in cost of goods sold of $XXX (increase (decrease) in 2013 of $XXX), increase in net income of $8,000 (increase in 2013 of $4,000), an increase of opening retained earnings of $19,000 (increase of $15,000 in 2013) and an increase in earnings per share of $XXX (increase in 2013 of $XXX).

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EXERCISE 21-9 (15-20 minutes) (a) Depreciation to date on the equipment: Double-declining depreciation 2011 (2/5 X $465,000) 2012 (2/5 X $279,000) 2013 (2/5 X $167,400) Cost of equipment ............................... Depreciation to date ............................ Carrying amount (Dec. 31, 2013) ........

$186,000 111,600 66,960 $364,560 $465,000 364,560 $100,440

Depreciation for 2014: $(100,440 – 15,000) ÷ (5 – 3) = $42,720 Depreciation Expense .................................... 42,720 Accumulated Depreciation—Equipment . 42,720 (b) Depreciation to date on building: $780,000 / 30 years = $26,000 per year $26,000 X 3 years = $78,000 depreciation to date Cost of building ................................... Depreciation to date ............................ Carrying amount (Dec. 31, 2013) ........

$780,000 78,000 $702,000

Depreciation for 2014: $702,000 ÷ (40 – 3) = $18,973 Depreciation Expense .................................... 18,973 Accumulated Depreciation—Buildings ... 18,973

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EXERCISE 21-10 (20-25 minutes) (a) 1. Accumulated Depreciation—Machinery.......... 22,500 Depreciation Expense ............................... 7,500 Retained Earnings..................................... 15,000

Depreciation taken Depreciation (correct)

2012-2013 *$150,000* * 135,000* *$ 15,000*

2014 $75,000 67,500 $ 7,500

*$450,000 X 1/6 X 2 2.

Salaries and Wages Expense .......................... 36,000 Retained Earnings..................................... 36,000

3.

Current Tax Expense ........................................ 73,000 Retained Earnings..................................... 73,000

4.

Goodwill ............................................................ 202,500 Amortization Expense............................... 45,000 Retained Earnings ($45,000 X 3.5 years) . 157,500 In addition, the company should test goodwill for impairment.

5.

No entry necessary.

6.

Retained Earnings ............................................ 87,000 Loss .......................................................... 87,000

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EXERCISE 21-10 (Continued) (b) 1. 2. 3. 4. 5. 6.

Error correction Error correction Error correction Error correction Change in accounting policy Error correction

(c) 1. Accumulated Depreciation—Machinery.......... 22,500 Depreciation Expense ............................... 7,500 Retained Earnings..................................... 11,250 Deferred Tax Liability................................ 3,750 2.

Salaries and Wages Expense .......................... 36,000 Retained Earnings..................................... 27,000 Income Tax Payable .................................. 9,000

3.

Current Tax Expense ........................................ 73,000 Retained Earnings..................................... 73,000* * Since the full $73,000 was charged to Retained Earnings, the same amount is reversed without factoring in the income tax effect. 4.

Accumulated Amortization – Goodwill............ 202,500 Amortization Expense – Goodwill ............ 45,000 Retained Earnings* ................................... 118,125 Deferred Tax Liability................................ 39,375 *($45,000 X 3.5 years X (1 – 25%)) In addition, the company should test goodwill for impairment.

5.

No entry necessary.

6.

Retained Earnings ............................................ 65,250 Income Tax Payable ......................................... 21,750 Loss .......................................................... 87,000

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*EXERCISE 21-11 (10-15 minutes) 1.

Salaries and Wages Expense ........................ Salaries and Wages Payable ..................

4,100 4,100

2.

Salaries and Wages Expense ........................ 29,400 Salaries and Wages Payable .................. 29,400

3.

Prepaid Insurance ($2,760 X 10/12) ............... Insurance Expense .................................

4.

2,300 2,300

Sales Revenue ................................................ 110,000 [$2,310,000 ÷ (1.00 + .05) X 5%] Sales Tax Payable ................................... 110,000 Sales Tax Payable........................................... 101,300 Sales Tax Expense .................................. 101,300

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*EXERCISE 21-12 (20-25 minutes) (a) 1.

2.

Supplies Expense ($4,100 – $2,100) .......... Supplies ...............................................

2,000

Salaries and Wages Expense ..................... ($5,100 – $3,900) Salaries and Wages Payable ..............

1,200

Interest Income ($5,500 – $4,750) .............. Interest Receivable..............................

750

2,000

1,200 750

3.

Insurance Expense ..................................... 28,000 ($93,000 – $65,000) Prepaid Insurance ............................... 28,000

4.

Rent Revenue ($44,000 ÷ 2) ........................ 22,000 Unearned Rent Revenue ..................... 22,000

5.

Depreciation Expense ................................ 48,150 ($53,500 – $5,350) Accumulated Depreciation - Asset .... 48,150

6.

Retained Earnings ...................................... 13,500 Accumulated Depreciation - Asset .... 13,500

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Chapter 21




*EXERCISE 21-12 (Continued) (b) 1.

2.

Retained Earnings ...................................... Supplies ...............................................

2,000

Retained Earnings ...................................... Salaries and Wages Payable ..............

1,200

Retained Earnings ...................................... Interest Receivable..............................

750

2,000 1,200 750

3.

Retained Earnings ...................................... 28,000 Prepaid Insurance ............................... 28,000

4.

Retained Earnings ...................................... 22,000 Unearned Rent Revenue ..................... 22,000

5.

Retained Earnings ...................................... 48,150 Accumulated Depreciation ................. 48,150

6.

Same as in (a).

(c) Items 1 to 4 are adjusting entries as part of the accounting cycle. The situations presented could have occurred as oversights by the accounting staff in the adjustment process. The normal adjustment process however would normally capture these situations. For salaries and wages payable and interest receivable, the fact that the opening balances were not changed, does not imply an error. Cash receipts of interest and cash disbursements for salaries and wages were posted to the income statement, rather than cleared from the opening balances. This means that interest income and salaries and wages expense are currently overstated. The opening balance needs to be closed to Interest Income / Salaries and Wages Expense, and the year end accrual recorded. This can be accomplished in a compound entry by adjusting the opening balance to the required ending balance. Solutions Manual

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*EXERCISE 21-12 (Continued) For item 4, the company is likely using the alternative form of recording its unearned rent revenue by posting the full amount to a revenue account. Therefore, the adjusting entry has to reduce the revenue account and post the corresponding amount to the unearned rent revenue account. Items 5 and 6 however are accounting errors. For items 1 to 5, since the proper adjustments are posted to the books of account in the current year, no disclosure is necessary. The financial statements will reflect the correct amounts. Under part (b) with the books closed, if the financial statements are not yet issued, the adjustments could be factored into the financial statements as part of the statement preparation process. No special presentation or note disclosure would be required. If the financial statements have been issued, the correction would flow into the subsequent financial statements and would be treated as corrections of errors in a prior period. The opening retained earnings would be adjusted and note disclosure would be required detailing the nature of the errors and the line items in the financial statements affected. Item 6 is an error in a prior period and would be treated as detailed above.

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EXERCISE 21-13 (15-20 minutes) (a) December 31, 2014 Retained Earnings .................................................. 135,000 Accumulated Depreciation—Machinery........ 135,000 (To correct for the omission of depreciation expense in 2012) ($1,350,000 / 10 years = $135,000 depreciation per year) No extra entry is necessary to record the change from one depreciation method to another since a change from one depreciation method to another is a change in estimate, and changes in estimates are treated prospectively. The adjusting entry to be made for depreciation, based on a prospective application of DDB is: Depreciation Expense ............................................ 270,000 Accumulated Depreciation—Machinery........ 270,000 DDB rate: (100% ÷ 7 years remaining) X 2 = 28.5714% $1,350,000 – (3 X $135,000) = $945,000 $945,000 X .285714 = $270,000 (b) December 31, 2014 Retained Earnings .................................................. 101,250 Deferred Tax Asset ($135,000 X 25%) ................... 33,750 Accumulated Depreciation—Machinery........ 135,000 (To correct for the omission of depreciation expense in 2012) As above (see part a), with the same depreciation entry.

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*EXERCISE 21-14 (25-30 minutes) (a) Effect of errors on 2014 net income: $10,700 understatement Calculations – Effect on 2014 net income:

Overstatement of 2013 ending inventory (and 2014 beginning inventory) Understatement of 2014 ending inventory Expensing of insurance premium in 2013 ($66,000 ÷ 3) Failure to record gain on sale of fully depreciated machine in 2014 Total effect of errors on net income (understated)

Over (under) statement $ (9,600)) (8,100)) 22,000 (15,000) $(10,700))

(b) Effect of errors on working capital: $45,100 understatement Calculations – Effect on working capital:

Understatement of 2014 ending inventory Expensing of insurance premium in 2013 (prepaid insurance) Cash from sale of fully depreciated machine unrecorded Total effect on working capital (understated)

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Over (under) statement $( (8,100)) (22,000) (15,000) $(45,100)

Chapter 21




*EXERCISE 21-14 (Continued) (c) Effect of errors on retained earnings: $47,400 understatement Calculations – Effect on retained earnings:

Understatement of 2014 ending inventory Overstatement of depreciation expense in 2013 Expensing of insurance premium applicable to 2015 in 2013 Failure to record sale of fully depreciated machine in 2014 Total effect on retained earnings (understated) (d)

Over (under) statement $( (8,100)) ( (2,300)) (22,000) (15,000) $(47,400)

NEILSON TOOL CORPORATION Statement of Retained Earnings For the Years 2014 and 2013 2014

2013 (restated)

Retained earnings, January 1, as previously reported Less: Effect of error in inventory in previous year Add: Depreciation error in previous year Add: Error in insurance Retained earnings, January 1, as restated Net income Dividends Retained earnings, December 31

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$1,607,000

$1,250,000

(9,600) 2,300 44,000 1,643,700 * 385,700 (45,000) $1,984,400

_ 1,250,000 ** 458,700 (65,000) $1,643,700

Chapter 21




*EXERCISE 21-14 (Continued) *

Net income for 2014 = $375,000 + $10,700 understatement.

** Net income for 2013 = $422,000 – $9,600 + $2,300 + $44,000 (e) Correction of error: The financial statements must be restated for all prior periods. Opening retained earnings are adjusted. The required disclosure includes a description of the errors, the effect of the correction of the errors on the financial statements of the current and prior periods; and the fact that the financial statements of prior periods that were presented are restated. More specifically, the amounts of the corrections to each line of the financial statements presented for comparative purposes, as well as the amount of the correction made at the beginning of the earliest prior period are presented. Retrospective restatement enhances the consistency and more specifically, the comparability of the financial statements.

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*EXERCISE 21-15 (25-30 minutes)

Income before tax Corrections: Sales erroneously included in 2013 income Understatement of 2013 ending inventory Adjustment to bond interest expense* Repairs erroneously charged to the Equipment account Depreciation recorded on improperly capitalized repairs (10%)*** Corrected income before tax

2013 $101,000

2014 $77,400

(38,200)

38,200

8,640 (1,450)

(8,640) (1,552)

(8,500)

(9,400)

850 $62,340

1,705 $97,713

* Bond interest expense for 2013 and 2014 was computed as follows:

2013 2014

Carrying Amount of Bonds $235,000 236,450

Stated Interest $15,000 15,000

Effective Interest **$16,450** ** 16,552**

**$235,000 X 7% Difference between effective interest at 7% and stated interest (6%): 2013: $1,450 2014: 1,552 ***Erroneous depreciation taken in 2014: on 2013 addition (($8,500 - 850) x 10%)) on 2014 addition ($9,400 ÷ 10) Total excess depreciation 2014 Solutions Manual

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$ 765 940 $1,705 Chapter 21




*EXERCISE 21-15 (Continued) (b) 1. 2.

Retained Earnings ...................................... 38,200 Sales Revenue ..................................... 38,200 Assuming the incorrect opening inventory is still in the Inventory account: Inventory .................................................... Retained Earnings ...............................

8,640 8,640

If the Inventory account has been adjusted during the 2014 year as a result of interim inventory counts in order to prepare interim financial statements, or the ending inventory has been counted at year end and an adjusting entry has already been made to recognize cost of goods sold: Cost of Goods Sold…………………………… 8,640 Retained Earnings ……………………….. 8,640 3.

4.

Retained Earnings ...................................... Bonds Payable .................................... For the 2013 interest.

1,450

Interest Expense ......................................... Bonds Payable .................................... For the 2014 interest.

1,552

Retained Earnings ...................................... Equipment............................................

8,500

Accumulated Depreciation - Equipment ... Retained Earnings ............................... To adjust the 2013 error on equipment.

850

Maintenance and Repairs Expense ........... Equipment............................................

9,400

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1,450

1,552

8,500 850

9,400 Chapter 21




*EXERCISE 21-15 (Continued) Accumulated Depreciation - Equipment ... Depreciation Expense ......................... To adjust the 2014 error on equipment.

1,705 1,705

(c) Quality of earnings refers to how solid the earnings numbers are. High quality earnings numbers are unbiased, reflective of the underlying business fundamentals, and sustainable. Prior to the correction of several errors in reported net income for 2013 and 2014, Marcel Corp. reported before-tax income of $101,000 and $77,400 in 2013 and 2014 respectively. After correction of the errors, Marcel Corp.’s corrected income before tax was $62,340 and $97,798 in 2013 and 2014 respectively. An investor may assess that Marcel Corp. has low quality earnings because the company’s reported earnings may be significantly biased and have a higher margin of potential misstatement. As a result, the shares of Marcel Corp. may be discounted in the capital markets.

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*EXERCISE 21-16 (10-15 minutes) 2013 Item (1)

OverUnderstatement statement

Solutions Manual

OverUnderstatement statement

No Effect

X

X

(3) (5)

No Effect

X

(2) (4)

2014

X X

X

X

X X

X

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EXERCISE 21-17 (15-20 minutes) (a) Calculation of depreciation for 2014 on the building: Cost of building Less: Depreciation prior to 2014 2010 ($1,200,000 – $0) X .05* 2011 ($1,200,000 – $60,000) X .05 2012 ($1,200,000 – $117,000) X .05 2013 ($1,200,000 – $171,150) X .05 Carrying amount, January 1, 2014

$1,200,000 $60,000 57,000 54,150 51,442

222,592 $ 977,408

*Double-declining-balance rate = (1 ÷ 40) X 2 = 5% Depreciation expense for 2014: $25,761 [($977,408 – $50,000) ÷ 36 (=40 – 4) years] Depreciation Expense ................................... 25,761 Accumulated Depreciation—Building ...

25,761

(b) Calculation of depreciation for 2014 on the equipment: Cost of equipment Less: Accumulated depreciation [($130,000 – $10,000) ÷ 12] X 4 years Carrying amount, January 1, 2014

$130,000 40,000 $ 90,000

$90,000 – $5,000 $85,000 = 5 (9 – 4) = $17,000

2014 Depreciation expense =

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EXERCISE 21-18 (10-15 minutes) (a) The change in estimate would be applied in 2014. The amount of depreciation expense for 2014 would be calculated as a change in estimate. Income before depreciation and income tax Depreciation expense* Income before income tax Income tax (30%) Net income

$300,000 250,000 50,000 15,000 $35,000

* Cost of assets = $125,000 X 8 years = $1,000,000 Carrying amount = $1,000,000 – ($125,000 X 2) = $750,000 Depreciation expense = $750,000 X 2/6** = $250,000 ** The remaining useful life is 6 years (8 years less the 2 years already depreciated). (b), (c), (d) There would be no adjustment to opening retained earnings for any previous year since changes in estimate are accounted for prospectively. There would also be no journal entry to adjust the accounting records. The depreciation for 2014 of $250,000 would be recorded.

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EXERCISE 21-19 (10-15 minutes) 1. Management incentive plans. In many large companies, management remuneration packages provide a salary, cash bonuses based on net income or other performance variables, and stock incentives based on share price performance. Common shares are offered to managers based on share price performance to try to align the long-term interests of the firm’s shareholders and managers. The cash bonus is often based on a percentage of income once a target is reached. In some cases, once net income rises above a certain ceiling, no further bonus is paid. This practice provides a great incentive to keep income between the target and the ceiling. That is, managers of units with income above the ceiling would be motivated to pick accounting policies that carry forward “surplus” earnings to the next period. 2. Lending covenants. Long-term lending contracts often include covenants to protect the lender from observable actions by the borrower that are against the lender’s interests, such as additional borrowing or excessive dividend payments. Covenants are often based on ratios such as working capital, times interest earned, debt to equity, and so on. Violation of a debt covenant puts the borrower in default of the loan contract; the lender can demand repayment or, more commonly, renegotiate terms and conditions, including interest rates. Firms affected by these covenants try to select accounting policies that improve critical ratios. 3. Political motivation. Is it possible to report too much income? If a firm is politically visible (usually because of size, the nature of the business, or because of a government-awarded monopoly), high levels of return are potentially undesirable. High profits attract attention and may create enough dissatisfaction and political unrest to cause the government to regulate some aspect of the business or intervene in another fashion. Such firms would rather minimize reported accounting income at levels that provide (barely) satisfactory levels of return to creditors and investors. Solutions Manual

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EXERCISE 21-19 (Continued) 4. Taxation. Reduction of income to lower tax payments is an obvious motivation for accounting policy choice. Remember, though, that there are extensive provisions in the Income Tax Act requiring the use of certain accounting methods for tax purposes, regardless of the accounting policy choice made for external reporting; thus, firms may have little room to manoeuvre. 5. Contracts. Legal agreements often refer to data (numbers) in (audited or unaudited) financial statements. For instance, an agreement may specify that “net income” is to be allocated in a variety of ways or that “book value” of equity (or a multiple thereof) is to be used to establish a buy-out price when a partner retires or a new partner admitted. In these circumstances, there is considerable contractual motivation to manipulate income and book value. How can the contracting parties make sure that manipulation does not lead to inappropriate valuation? Specifying that GAAP must be followed is a first step. However, there are areas of accounting policy where GAAP allows for acceptable alternative methods.

Note to Instructor: Numerous other factors may be acceptable. Student responses will vary; the objective is to provoke debate on personal, political and ethical motivations for accounting policy choice and for students to understand that there may be motivators other than “fair presentation”.

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TIME AND PURPOSE OF PROBLEMS Problem 21-1

(Time 25-30 minutes)

Purpose—to provide a problem that requires the student to: (1) prepare correcting entries for two years’ unrecorded sales commissions and three years’ inventory errors, and (2) prepare entries for two different changes in accounting policy. The student is also required to discuss alternative accounting treatments for the changes.

Problem 21-2


Purpose—to provide a problem that requires the student to: (1) account for a change in estimate, (2) record a correction of an error, and (3) account for a change in accounting policy. The student is also required to account for the tax effect of the changes.

Problem 21-3


Purpose—to provide a problem that requires the student to account for two changes in estimate, record a correction of an error and account for a change in circumstances. The student is also required to calculate corrected/adjusted net income amounts.

Problem 21-4


Purpose—to develop an understanding of the entries required for changes in accounting policies, changes in estimates and accounting errors. This comprehensive problem involves all types of changes. The entries for books open and books closed are required. The student is also required to discuss the type of change involved and how it would be accounted for.

Problem 21-5


Purpose—to develop an understanding of the effect that errors, changes in policies and changes in estimates have on the financial statements. The student is required to prepare the journal entries to record a change in accounting principle, a change in estimate and an error. The student must also prepare restated comparative financial statements and note disclosure. This problem also includes the tax effects for the three items. This is a comprehensive and complex problem.

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TIME AND PURPOSE OF PROBLEMS (CONTINUED) Problem 21-6


Purpose—to develop an understanding of the journal entries and the reporting that are necessitated by an accounting change or correction of an error. The student is required to prepare the entries to reflect such changes or errors and recalculate net income and earnings per share for a two-year period. The student is also required to prepare comparative statements of retained earnings for a two-year period and to provide note disclosure.

Problem 21-7


Purpose—the student is required to compute a list of items for the amounts which would appear on comparative financial statements after adjustment for a correction of an accounting error and a change in estimate. Comparative revised financial statements must also be prepared including the related income tax implications.

Problem 21-8


Purpose—The student is required to prepare a comparative statement of income and retained earnings for the five years assuming a change in policy in inventory costing with an indication of the effects on earnings per share for the years involved. The student must also prepare a comparative statement of retained earnings for a two-year period assuming full and partial retrospective application. The student is also required to identify the comparative statement of financial position accounts affected by the change in policy.

Problem 21-9


Purpose—to provide a problem that requires the student to analyze eleven transactions and to prepare adjusting or correcting entries for these transactions.

Problem 21-10


Purpose—to help a student understand the effect of errors on income and retained earnings. The student must analyze the effects of six errors on the current year’s net income and on the next year’s ending retained earnings balance. The tax effect of the errors must also be considered.

Problem 21-11


Purpose—to develop an understanding of the effect that errors have on the financial statements and the way to record their corrections. The student is required to prepare the journal entries to correct the accounting records and to prepare a comparative schedule portraying the corrected net income for the two-year period involved with this error analysis and a schedule portraying the corrected opening retained earnings. Solutions Manual

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TIME AND PURPOSE OF PROBLEMS (CONTINUED) Problem 21-12


Purpose—to develop an understanding of the effect that errors have on the financial statements. The student is required to prepare a schedule portraying the corrected net income for the years involved with this error analysis. The student is also required to prepare the journal entries to correct the errors and prepare a schedule to show the corrected opening retained earnings balances for the years involved.

Problem 21-13


Purpose—to develop an understanding of the correcting entries and income statement adjustments that are required for accounting errors. This comprehensive problem involves many different concepts such as consignment sales, bonus computations, warranty costs, and bank funding reserves. The student is required to prepare the necessary journal entries to correct the accounting records and a schedule showing the revised income before taxes for each of the three years involved.

Problem 21-14


Purpose—to allow the student to see the impact of accounting changes on income and to examine an ethical situation related to the motivation for change.

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SOLUTIONS TO PROBLEMS PROBLEM 21-1

1.

2.

Retained Earnings [$3,500 X (1 – 25%)] .......... Income Tax Receivabe ..................................... Sales Commissions Payable .................... Sales Commissions Expense ...................

2,500 1,000

Cost of Goods Sold ($19,000 + $6,700) ........... 25,700 Income Tax Payable .................................. 4,750 Retained Earnings [$19,000 X (1 – 25%)] . 14,250 Inventory .................................................... 6,700

Beginning inventory Ending inventory

3.

2,625 875

Income Overstated (Understated) 2012 2013 2014 $16,000 $19,000 $(16,000) (19,000 ) 6,700 $(16,000) $ (3,000 ) $25,700

Accumulated Depreciation—Equipment ......... Depreciation Expense ...............................

4,800 4,800

*Equipment cost ........................................ $100,000 Depreciation before 2014 ......................... (36,000) Carrying amount ....................................... $ 64,000 Depreciation to be taken ($64,000/8) ....... Depreciation recorded ............................. Difference..................................................

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$ 8,000 12,800 $ 4,800

Chapter 21




PROBLEM 21-1 (Continued) 4.

This is a change in circumstances as the company couldn’t reliably measure the revenue in past years and now it can. This would be accounted for on a prospective basis. For example, if the type of the contracts that the company undertakes has changed, thereby allowing the company to estimate the degree of completion, this situation could be the result of transaction that differs substantially from those that were previously occurring. In this case, the new accounting policy (applicable to the new type of contracts) would be applied on a prospective basis.

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PROBLEM 21-2

(a) (1) Litigation Expense ................................................... 25,000 Litigation Liability ............................................. 25,000 (2) Bad Debt Expense .................................................... 15,000* Allowance for Doubtful Accounts ................... 15,000 * ($22,500 ÷ 1.5%) X 1% = $15,000 (3) Land .......................................................................... 40,000 Accumulated Depreciation—Equipment ................ 32,000* Depreciation Expense ...................................... 8,000 Retained Earnings ............................................ 24,000 Equipment ......................................................... 40,000 *$40,000 ÷ 5 = $8,000 per year; $8,000 X 4 years = $32,000 (4) There would be no adjustment to opening retained earnings for any previous year since changes considered changes in estimate are accounted for prospectively. The books are still open for 2014, so the depreciation expense for 2014 will be revised for that year only to the straight line method. Accumulated Depreciation—Building..................... 27,360 Depreciation Expense—Building* ................... 27,360 *($57,760 – $30,400) *Carrying amount of the building at January 1, 2014: Cost less accumulated depreciation to Dec. 31/13 = $1,280,000 - $64,000 - $60,800 = $1,155,200 Remaining useful life from Jan. 1/14 = 38 years Correct Depreciation Expense, 2014 (straight-line basis) = $1,155,200 ÷ 38 = $30,400 Solutions Manual

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PROBLEM 21-2 (Continued) (5) Accumulated Depreciation—Equipment ................ 5,600 Depreciation Expense—Equipment ................ *($54,000 – $4,000) ÷ 5 = $10,000 per year ($54,000 – [$10,000 X 3] – $2,000) ÷ 5 = $4,400 ($10,000 – $4,400 = $5,600)

5,600*

(6) No entry required. This is an error in classification. No amounts or items are missing in the financial statements. (b) Note to Instructor: Corrections to Deferred Income Tax are only necessary when a prior period adjustment is being made and where the item involves a temporary difference between accounting and taxable income. The entries below also assume that the income tax entry(ies) for 2014 taxable income will be made subsequently. (1) Litigation Expense ................................................... 25,000 Litigation Liability ............................................. 25,000 (2) Bad Debt Expense .................................................... 15,000 Allowance for Doubtful Accounts ................... 15,000

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PROBLEM 21-2 (Continued) (3) Land .......................................................................... 40,000 Accumulated Depreciation—Equipment ................ 32,000 Deferred Tax Liability ($24,000 X 25%) ............ 6,000 Depreciation Expense ...................................... 8,000 Retained Earnings [$24,000 X (1 – 25%)] ........ 18,000 Equipment ......................................................... 40,000 (4) Accumulated Depreciation—Building..................... 27,360 Depreciation Expense—Building..................... 27,360 (see part (a) for calculation) (5) Accumulated Depreciation—Equipment ................ 5,600 Depreciation Expense—Equipment ................ 5,600 (6) No entry required. This is an error in classification. No amounts or items are missing in the financial statements. Formal entry possible, as noted above.

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PROBLEM 21-2 (Continued) (c) 1. This item is an adjustment to the current year financial statements. It is not an error in a prior year’s financial statements and does not require retrospective adjustment. 2. This is a change in estimate – prospective treatment. 3. This is an error in a prior year – retrospective treatment. 4. This is a change in estimate – prospective treatment, but requiring a change in the current year as adjustments have already been recorded. 5. This is a change in estimate – prospective treatment, but requiring a change in the current year as adjustments have already been recorded. 6. This is a statement of financial position change in classification. No journal entry and no adjustment to opening retained earnings are required. However, comparative financial information will need to be restated to properly reflect the change in classification. A note indicating the nature of the adjustment would be included.

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PROBLEM 21-3 (a) 1.

No entry is necessary. A change in estimate is accounted for prospectively in the current and future years.

2.

No entry is necessary as long as Wilson did not recognize depreciation expense of $54,000 in 2014. At January 1, 2014, the asset’s carrying amount was $1,200,000 – ($108,000 + $120,000) = $972,000. The correct amount of depreciation for 2014 is ($972,000 – $120,000)/18 years = $47,333. If $54,000 has been recognized, the following entry is needed: Accumulated Depreciation—Building ...... 6,667 Depreciation Expense ..................................

6,667

A change in estimate is accounted for prospectively in the current and future years. A revision of depreciation policy due to changes in the expected pattern of benefits is treated as a change in estimate. 3.

Accumulated Depreciation—Machinery ....... [($20,000* – $18,000**) X 3½ years] Retained Earnings .................................. Depreciation Expense ............................

7,000 5,000 2,000

*$160,000 ÷ 8 = $20,000 **($160,000 – $16,000) ÷ 8 = $18,000 4.

Amortization Expense ($4,500 /3) ................. 1,500 Deferred Development Costs ................ 1,500 This is not a change in policy. Since the amounts were not material in previous years, this is a new policy applied to changed circumstances.

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PROBLEM 21-3 (Continued) (b) Calculation of 2014 depreciation expense on the equipment: 2011 to 2013 depreciation [($130,000 – $10,000) ÷ 10] $12,000 Cost of equipment Accumulated depreciation ($12,000 X 3 years) Carrying amount, 1/2/2014 2014 deprec. expense:

$130,000 36,000 $94,000

$94,000 – $6,000 $88,000 = = $22,000 7–3 4

Additional depreciation in 2014: $22,000 – $12,000 = $10,000

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PROBLEM 21-3 (Continued) (c)

WILSON CORPORATION Comparative Net Income Calculation For the Years 2014 and 2013 2014

Income before depreciation expense and before effects of changes Depreciation of equipment – item 1 Depreciation of building – item 2* Depreciation of machine – item 3 Development costs – item 4 Net income *

$600,000 (22,000 ) (47,333 ) (18,000 ) (1,500 ) $511,167

2013 $420,000 (12,000 ) (108,000 ) (18,000 ) $282,000

Calculation of 2014 depreciation expense on the Building – item 2: Cost of building $1,200,000 Accumulated depreciation ($120,000 + $108,000) 228,000 Carrying amount, 1/1/2014 $972,000 2014 depreciation expense:

$972,000 – $120,000 $852,000 = 20 – 2 18 = $47,333

(d) Quality of earnings refers to how solid the earnings numbers are. High quality earnings numbers are unbiased, reflective of the underlying business fundamentals, and sustainable. Prior to the correction of several errors in reported net income for 2013 and 2014, Wilson reported before-tax income of $420,000 and $600,000 in 2013 and 2014 respectively. After correction of the errors, Wilson’s corrected income before tax was $282,000 and $511,167 in 2013 and 2014 respectively. An investor may assess that Wilson has low quality earnings because the company’s reported earnings may be significantly biased and have a higher margin of potential misstatement.

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PROBLEM 21-4 (a) and (b) (1) Retained Earnings .................................................... 52,000 Allowance for Doubtful Accounts ................... 47,000 Accounts Receivable ........................................ 5,000 This is a correction of an error. The company must apply retrospective application in order to correct the presentation of receivables and bad debt expense in its comparative financial statements. (2) The company is changing from a non-GAAP method to a GAAP method, and this should be treated as a correction of an error (a retrospective change). The following solution takes the view that this is an accounting error that is applied to the 2012 and 2013 years. As of October 1, 2014, the company should account for the change in useful life as a change in estimate--prospectively. Accounts needing correction as of October 1, 2014: Accumulated Depreciation and Retained Earnings, representing the difference in depreciation expense between CCA and the straight-line method: Depreciation taken (CCA): $35,000 – 20,825 = $14,175 Depreciation (straight-line): $35,000 ÷ 10 X 2 = $ 7,000 $ 7,175

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PROBLEM 21-4 (Continued) The 2014 accounts have to be adjusted through Retained Earnings because the books for fiscal 2014 have also been closed. Accounts needing correction as of September 30, 2014: Accumulated Depreciation and Retained Earnings, representing the Depreciation Expense (straight-line method) for the year ending September 30, 2014 using a remaining (and revised) useful life of 5 years: Net carrying amount of asset, October 1, 2014 now = $35,000 - $7,000 = $28,000 Revised depreciation rate = $28,000 ÷ 5 years = $5,600/year Entry needed to adjust years ended September 30, 2012, 2013 and 2014: Accumulated Depreciation - Equipment 1,575 Retained Earnings ............................................ 1,575 $7,175 - $5,600 = $1,575 (3) Office Equipment...................................................... 3,000 Retained Earnings ............................................ Retained Earnings .................................................... 1,000 Accumulated Depreciation—Equipment ......... ($3,000 / 3)

3,000 1,000

This is a correction of an error. Since the error affects only 2014, no retrospective application is necessary.

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Chapter 21




PROBLEM 21-4 (Continued) (4) Supplies .................................................................... 1,500 Retained Earnings ............................................

1,500

This is a correction of an error. Retrospective application is required for the 2013 balance in supplies. Since this is a counterbalancing error, no journal entry is required, but the opening balance in supplies of $1,000 will need to be adjusted on the comparative financial statements. (5) FV-NI Investments ................................................... 3,000 Unrealized Gain or Loss ...................................

3,000

This is the initial choice of an accounting policy for a new type of transaction. It is not an accounting change. (c) As a privately held entity, Maglite may choose to follow either ASPE or IFRS. Under IFRS, Maglite would have to account for the trading securities at FV-NI – the option to account for them at FV-OCI is not available for trading investments. Under ASPE, the trading investment must be accounted for using the fair value through net income (FV-NI) model. (d) (1) Retained Earnings* .................................................. 30,000 Bad Debt Expense .................................................... 22,000 Allowance for Doubtful Accounts ................... 47,000 Accounts Receivable ........................................ 5,000 *Beginning balance in the allowance for doubtful accounts.

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Chapter 21




PROBLEM 21-4 (Continued) (2) If two entries are made: Accumulated Depreciation* Retained earnings

7,175 7,175

*($35,000 – $20,825) – 2 X ($35,000/10) Depreciation Expense** Accumulated Depreciation **($35,000 – $7,000) / 5 (3) Office Equipment...................................................... Office Expense ..................................................

5,600 5,600

3,000

Depreciation Expense .............................................. 1,000 Accumulated Depreciation—Office Equipment ($3,000 / 3)

3,000 1,000

(4) Supplies .................................................................... 1,500 Supplies Expense ............................................. Retained Earnings ............................................

500 1,000

(5) FV-NI Investments .................................................... 3,000 Unrealized Gain or Loss ...................................

3,000

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Chapter 21




PROBLEM 21-5 (a) Item #1 Equipment................................................................. 9,200 Deferred Tax Liability (30% X $9,200) .............. Retained Earnings (70% X $9,200)................... Depreciation Expense ($9,200 / 5) ........................... 1,840 Retained Earnings ($1,840 X 70%) .......................... 1,288 Deferred Tax Liability ($3,680 X 30%) ..................... 1,104 Deferred Tax Benefit ($1,840 X 30%) ............... Accumulated Depreciation - Equipment ........ ($1,840 X 2 years)

2,760 6,440

552 3,680

Item #2 Depreciation Expense* ............................................ 8,000 Deferred Development Costs ...........................

8,000

Deferred Tax Liability ($8,000 X 30%) ..................... 2,400 Deferred Tax Benefit.........................................

2,400

* A loss on impairment account could also be debited. Item #3 Retained Earnings .................................................... 21,000 Deferred Tax Asset ($30,000 X 30%) ....................... 9,000 Sales Revenue .................................................. 30,000 Deferred Tax Expense ($30,000 X 30%) .................. 9,000 Deferred Tax Asset ...........................................

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21-59

9,000

Chapter 21




PROBLEM 21-5 (Continued) (b)

Assets

Hawthorne Corp. Statement of Financial Position December 31 2014 2013 (restated)

Current assets Long-term assets

$ 192,300 319,520 $ 511,820

3

$

177,400 318,360 495,760

$

133,000

6

5

$

155,208 50,000 157,552 495,760

$ 1

2

Liabilities & Equity Current liabilities Long-term Liabilities Share capital Retained earnings 1&2

$ 117,000 165,256 50,000 179,564 $ 511,820

4

7

8

Long-term assets:

Beginning balance Item #1: Add: capitalized interest on equipment Less: Accumulated depreciation on capitalized interest on equipment Item #2: Deferred dev. costs Ending balance

2014 322,000

2013 311,000

9,200

9,200

(3,680) (8,000) $319,520

(1,840) $318,360

3

Current assets – 2013: Beginning balance of $168,400 + $9,000 (deferred tax asset related to item #3) = $177,400. Classified as current since it is related to Unearned Revenue, a current liability account of Hawthorne Corp. Solutions Manual

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Chapter 21




PROBLEM 21-5 (Continued) 4&5

Long-term liabilities:

Beginning balance Item #1: Deferred tax liability 2011: $2,760 – 1,104 = $1,656 2010: $2,760 – 552 = $2,208 Item #2: Deferred tax liability reversal on change in estimate Ending balance 6

2014 $166,000

2013 $153,000

1,656 2,208 (2,400) $165,256

$155,208

Current liabilities – 2013:

Beginning balance of $103,000 + $30,000 (Unearned revenue on deposit related to item #3) = $133,000. 7&8

Retained earnings:

Beginning balance Item #1: Change in policy net of tax ($9,200 X [1 – 30%]) Less: Amortization on revised cost of equipment net of tax 2014: $1,840 X 2 X [1 – 30%] 2013: $1,840 X [1 – 30%] Item #2: Deferred dev. costs net of tax ($8,000 X [1 – 30%]) Item #3: Reversal of contract revenue in 2012 net of tax ($30,000 X [1 – 30%]) Ending balance

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2014 $181,300

2013 $173,400

6,440

6,440

(2,576) ) (1,288) (5,600)

$179,564

(21,000) $157,552

Chapter 21




PROBLEM 21-5 (Continued) Hawthorne Corp. Income Statement Year Ended December 31 2014 Revenues Expenses Income tax (30%) Net income Earnings per share Dividends declared per share 1

$ 505,000 387,840 117,160 35,148 $ 82,012 $8.20

1 2

4

$6.00

2013 (restated) $ 460,000 377,840 82,160 24,648 $ 57,512 $5.75

3

5

$2.50

Revenues – 2014:

Beginning balance of $475,000 + $30,000 (Revenue on long-term contract item #3) = $505,000. 2&3

Expenses:

Beginning balance Item #1: Depreciation on capitalized interest Item #2: Additional depreciation or loss on deferred dev. costs Ending balance

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2014 $378,000

2013 $376,000

1,840

1,840

8,000 $387,840

$377,840

Chapter 21




PROBLEM 21-5 (Continued) 4&5

Current tax expense:

Beginning balance Item #1: Reversal of timing difference on additional depreciation expense Item #2: Reversal of timing difference on deferred dev. costs Item #3: Reversal of timing difference on long-term contract revenue Ending balance

2014 $29,100 (552)

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(552)

(2,400) 9,000 $35,148

Hawthorne Corp. Statement of Retained Earnings Year Ended December 31 2014 Retained earnings, January 1, as previously reported Add: Adjustment for the cumulative effect on prior periods of the change in accounting policy, net of income tax of $2,208 (2013: $2,760) Less: Correction of error on revenue, net of tax of $9,000 Retained earnings, January 1, as restated Net income Less: Dividends declared Retained earnings, December 31

2013 $25,200

$ 173,400

$24,648

2013 (restated) $

139,600

5,152

2

6,440

(21,000)

4

(21,000)

157,552 82,012 (60,000) $ 179,564

5

$

125,040 57,512 (25,000) 157,552

Chapter 21


1

3

6



PROBLEM 21-5 (Continued) 1

Opening balance of retained earnings – 2013:

Ending balance of $173,400 – $58,800 (Net income) + $25,000 (dividends declared) = $139,600. 2

Adjustment due to change in policy – 2014:

Capitalized interest net of tax of $9,200 X [1 – 30%] less additional depreciation expense for 2013 of $1,840 X [1 – 30%] = $5,152. 3

Adjustment due to change in policy – 2013:

Capitalized interest of $9,200 X [1 – 30%] = $6,440 (net of tax). 4

Correction of error – 2014 and 2013:

Contract revenue of $30,000 X [1 – 30%] = $21,000. 5&6

Dividends declared – 2014 and 2013:

2014: Dividends per share $6.00 X 10,000 shares = $60,000 2013: Dividends per share $2.50 X 10,000 shares = $25,000 (c) Note A – Change in Accounting Principle on Capitalization of Interest In 2014, the company has changed its accounting principle regarding the capitalization of interest. Interest on self-constructed assets will be capitalized as part of the cost of these assets. This change was done to provide more relevant presentation of the company’s financial information and to be consistent with other companies in the reporting entity on a consolidated basis. The change has been applied retrospectively with restatement of comparative information to 2012, when interest was incurred. The effect of this change on income of prior periods was to increase 2013 depreciation expense by $1,840 and decrease net income of 2013 by $1,288. Earnings per share for 2013 has also decreased by $0.13. Solutions Manual

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PROBLEM 21-5 (Continued) Note B – Error in Revenue Recognition of Prior Periods The company recognized as revenue a down-payment received in 2012 prior to completion of the related contract. This contract was completed in 2014. There was no impact on 2013 income statement items. This error has been corrected and the comparative balance sheet and statement of retained earnings information has been restated to effect the correction of this error. There are no current tax implications to this error. (d) 1. Under IFRS, IAS 23 requires capitalization of borrowing costs. Private entities that choose to apply ASPE have the choice of either capitalizing or expensing the interest costs for relevant PP&E assets. Thus, under IFRS, if Hawthorne previously expensed the interest costs and now decides to capitalize the interest costs, rather than being a change in policy, the change to a generally accepted accounting method is considered the correction of an error and retrospective application with restatement would be applied (similar to the accounting treatment of a change in accounting policy) to the extent practicable to do so. 2. No difference in accounting treatment between IFRS and ASPE. Under IFRS assuming the capitalization criteria are met, development costs must be capitalized (which they were in this case). 3. No difference in accounting treatment between IFRS and ASPE.

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PROBLEM 21-6

(a) 1.

Depreciation Expense ............................... 108,108 Accumulated Depreciation—Building Computations: Cost of Asset A ...................................... Less: Depreciation prior to 2014 ........... Carrying amount, January 1, 2014 ........

108,108

$540,000 162,000* $378,000

*($540,000 ÷ 10) X 3 The DDB rate is calculated as 100% ÷ 7 X 2 = 28.6% Depreciation for 2014: $378,000 X 28.6% = $108,108* * rounded 2.

Depreciation Expense ................................ 25,800 Accumulated Depreciation—Machinery 25,800 Calculations: Original cost Accumulated depreciation (1/1/14) $12,000 X 4 Carrying amount (1/1/14) Estimated residual value Remaining depreciable base Remaining useful life (9 years—4 years taken) Depreciation expense—2014

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$180,000 48,000 132,000 3,000 129,000 ÷ 5 $ 25,800

Chapter 21





Equipment ................................................... 160,000 Accumulated Depreciation—Equipment (4 X $16,000) Retained Earnings .................................

64,000 96,000

Depreciation Expense ................................ 16,000 Accumulated Depreciation—Equipment

16,000

(b) Restated net income and earnings per share: 2014 Net income

2013

$195,092 * $354,000 **

Earnings per common share

$1.95

$3.54

Calculations: *Income before depreciation expense (2014) $400,000 Depreciation for 2014 Asset A $108,108 Asset B 25,800 Asset C 16,000 Other Assets 55,000 (204,908) Income after depreciation expense $195,092 ***Income before change in depreciation and error correction (2013) $370,000 Error correction—Depreciation Asset C (16,000 ) Income after error correction $354,000

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MADRASA INC. Comparative Statement of Retained Earnings For the Years Ending December 31 2014 Balance, January 1, as previously reported Plus: Adjustment due to error in recording Asset C (net of tax) (Note B) Balance, January 1, as restated Add: Net income Balance, December 31

2013 (restated)

$570,000** $200,000 96,000 666,000 195,092 $861,092

112,000* 312,000 354,000 $666,000

*Amount expensed incorrectly in 2010 .................. $160,000 Depreciation to be taken to January 1, 2013 ($16,000 X 3) ...................................................... 48,000 Prior period adjustment for income ...................... $112,000 ** Opening balance of $200,000 + unadjusted income for 2013 of $370,000. (d) Note A – Change in Depreciation Method In 2014, the company has changed its depreciation method for certain capital assets from the straight-line basis to the doubledeclining basis, due to a change in the pattern of benefits received from the assets. The change has been applied prospectively.

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PROBLEM 21-6 (Continued) Note B – Error in Depreciation Expense of Prior Periods The company expensed a capital asset purchased in 2010. Depreciation was not recorded for 2010 and subsequent periods. This error has been corrected and the comparative information has been restated to effect the correction of this error. Depreciation expense of $16,000 has been recorded for each of 2013 and 2014. Net income and earnings per share have decreased by $16,000 and $0.16 respectively for each of the years presented. (e) Changes in policy, changes in estimates and corrections of errors will not have any impact on current period cash flows and will not change the totals for any of the three sections of the current period statement of cash flows or the net increase or decrease in cash and cash equivalents. If the statement is prepared on an indirect basis, the changes will be reflected in the net income figure and in the depreciation expense. Since the change affects both net income and depreciation expense, the adjustment to determine cash flow from operations will offset the expense, and the same total cash from operating activities will be achieved. The changes will not have any impact on a current period statement of cash flows prepared on the direct basis. However, there will be a change in the cash flow statement in the year of the error for the situation described in part 3. While there will be no net change in the amount of cash for 2010, the expenditure was originally recognized as an expense, and therefore as an operating outflow in 2010, whereas the corrected cash flow statement for 2010 will indicate that the $160,000 was an investing outflow. The change in estimate is applied on a prospective basis only and will not affect the statement of cash flows for prior periods.

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PROBLEM 21-7 (a) 1.This change is considered the correction of an error – from a non-GAAP method to a GAAP method. Accumulated depreciation at: December 31, 2013: $21,474,950 [balance before change (using CCA) ($22,946,000) less excess of CCA over straight-line depreciation for financial statement purposes ($1,365,000 + $106,050)] December 31, 2014: $22,186,000 [balance before change (using CCA) ($23,761,000) less excess of CCA over straight-line depreciation for financial statement purposes ($1,575,000)] 2.

Deferred tax liability (long-term) at: December 31, 2013: $441,315 [tax effect (30%) of excess of CCA over straight-line depreciation for financial statement purposes ($1,365,000 + $106,050)] December 31, 2014: $472,500 [tax effect (30%) of excess of CCA over straight-line depreciation for financial statement purposes ($1,575,000)]

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Selling, general, and administrative expenses for the year ended: December 31, 2013: $18,384,487 [balance before change (using CCA) ($18,411,000) less 25% of excess of CCA over straight-line depreciation for financial statement purposes for 2013 (.25 X $106,050 = $26,513)] December 31, 2014: $19,715,312 [balance before change (using CCA) ($19,540,000) less 25% of excess of CCA depreciation over straight-line depreciation for financial statement purposes for 2014 (.25 X $103,950 = $25,988) plus increase in bad debt expense for 2014 (.0025 X $80,520,000 = $201,300)]

4.

Current portion of income tax expense for the year ended: December 31, 2013: $1,906,800 December 31, 2014: $1,471,500 [Total income tax of $1,480,500 less deferred tax expense of $9,000 (decrease in Deferred Tax Asset from 2013 to 2014 [$234,000 – $225,000]) = $1,471,500]

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Chapter 21





Deferred portion of tax expense (benefit) for the year ended: December 31, 2013: $31,815 [tax rate (30%) times excess of CCA over straightline depreciation for financial statement purposes for 2013 ($106,050)] December 31, 2014: ($20,205) (benefit) [balance before change (using CCA) of $9,000 plus tax rate (30%) times excess of CCA over straight-line depreciation for financial statement purposes for 2014 ($103,950) less 30% times increase in bad debts expense for 2014 ($201,300)]

(b)

SHARMA CORPORATION Condensed Statement of Financial Position As at December 31 2014 2013 Restated see note XX

Assets Current assets Plant assets, at cost Less: Accumulated depreciation Other long-term assets

$28,138,700 45,792,000

a

$29,252,000 43,974,000

22,186,000 14,996,000 $66,740,700 Liabilities and Shareholders’ Equity Current liabilities $21,124,000 Long-term debt 15,341,110 Share capital 11,620,000 Retained earnings 18,655,590 $66,740,700

b

21,474,950 14,414,000 $66,165,050

c

d

$23,650,000 14,304,315 11,620,000 16,590,735 $66,165,050

e

f

a. Current assets – 2014: balance before change (using CCA) $28,340,000 less additional allowance for doubtful accounts, $201,300 = $28,138,700 b. Other long-term assets – 2014: balance before change $15,221,000 less deferred tax asset balance before change, $225,000 = $14,996,000 Solutions Manual

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Chapter 21




PROBLEM 21-7 (Continued) c. Long-term debt – 2014: balance before change (using CCA) $15,154,000 plus deferred tax liability, $472,500 less deferred tax asset balance before change, $225,000 less additional deferred tax asset, $60,390 = $15,341,110 d. Retained earnings – 2014: balance before change $17,694,000 plus reduction in accumulated depreciation 2014 and previous years, net of tax, [$1,575,000 X (1 – 30%) = $1,102,500] less additional allowance for doubtful accounts, net of tax [($201,300 X 70%) = $140,910] = $18,655,590 e. Long-term debt – 2013: balance before change (using CCA) $14,097,000 plus deferred tax liability, $441,315 less deferred tax asset balance before change, $234,000 = $14,304,315 f. Retained earnings – 2013: balance before change (using CCA) $15,561,000 plus reduction in accumulated depreciation for 2013 and previous years, net of tax, [($1,365,000 + $106,050) X (1 – 30%) = $1,029,735] = $16,590,735

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Chapter 21




PROBLEM 21-7 (Continued) SHARMA CORPORATION Income Statement For the Years Ended December 31 2014

2013 Restated see note XX

Net sales Cost of goods sold

$80,520,000 54,769,038 25,750,962

Selling, general and administrative expenses

19,715,312 6,035,650 (1,198,000) 4,837,650

Other income (expense), net Income before income tax Income tax: Current Deferred (benefit)

1,471,500 (20,205) 1,451,295 $3,386,355

Net income

a

c

$78,920,000 52,994,463 25,925,537 18,384,487 7,541,050 (1,079,000) 6,462,050

b

d

1,906,800 31,815 1,938,615 $4,523,435

a. Cost of goods sold – 2014: balance before change (using CCA) $54,847,000 less additional depreciation using correct calculations, $103,950 X 75% = $54,769,038 b. Cost of goods sold – 2013: balance before change (using CCA) $53,074,000 less additional depreciation using correct calculations, $106,050 X 75% = $52,994,463 c. Selling, general and admin. – 2014: balance before change (using CCA) $19,540,000 less additional depreciation using correct calculations, $103,950 X 25% plus additional bad debts expense, $201,300 = $19,715,312 d. Selling, general and admin. – 2013: balance before change (using CCA) $18,411,000 less additional depreciation using correct depreciation calculations, $106,050 X 25% = $18,384,487

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Chapter 21




PROBLEM 21-7 (Continued) SHARMA CORPORATION Statement of Retained Earnings For the Years Ended December 31 2014

2013 Restated see note XX

Opening balance, as previously reported Plus: Adjustment for the cumulative effect on prior periods of the error correction, net of tax of $441,315 (2013 – $409,500) Opening balance, as restated Net income Less: Dividends Ending balance

$15,561,000

$11,111,800

1,029,735 16,590,735 3,386,355 (1,321,500) $18,655,590

955,500 12,067,300 4,523,435

a

b

$16,590,735

a. Beginning Balance – 2013: Ending balance of $16,590,735 (from adjusted statement of financial position) less adjusted net income of $4,523,435 less reduction in accumulated depreciation for years prior to 2013, net of tax, [$1,365,000 X (1 – 30%) = $955,500] = $11,111,800 b. Dividends – 2014: beginning balance of retained earnings for 2014 before change $15,561,000 plus unadjusted net income for 2014 $3,454,500 less ending balance of retained earnings for 2014 using incorrect CCA depreciation calculation $17,694,000 = $1,321,500

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Chapter 21




PROBLEM 21-8 (a)

KIMMEL INSTRUMENT CORPORATION Statement of Income and Retained Earnings For the Years Ended May 31 2010 $13,964

Sales—net Cost of goods sold Beginning inventory Purchases Ending inventory Total Gross profit Administrative expenses Income before tax Income tax (30%) Net income Retained earnings– beginning: As originally reported Adjustment (See note* and schedule) As restated Retained earnings – ending Earnings per share (100 shares)

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2011 $15,506

2012 $16,673

2013 $18,221

2014 $18,898

950 13,000 (1,124 ) 12,826 1,138 700 438 131 307

1,124 13,900 (1,091 ) 13,933 1,573 763 810 243 567

1,091 15,000 (1,270 ) 14,821 1,852 832 1,020 306 714

1,270 15,900 (1,480 ) 15,690 2,531 907 1,624 487 1,137

1,480 17,100 (1,699 ) 16,881 2,017 989 1,028 308 720

1,206

1,461

1,981

2,650

3,725

(35 ) 1,171 $ 1,478

17 1,478 $ 2,045

64 2,045 $ 2,759

109 2,759 $ 3,896

171 3,896 $ 4,616

$

$

$

$

$

3.07

5.67

7.14

Chapter 21


11.37

7.20



PROBLEM 21-8 (Continued) * Note to instructor: The adjustments are simply the cumulative difference in income between the two inventory methods, net of tax. For example, the negative $35 in 2010 reflects the difference in ending inventories in 2009 ($1,000 – $950) times the after-tax rate of 1 - 30% = 70%. In 2011, the difference in income of $52 between the two methods in 2010 is added to the negative $35 to arrive at a $17 adjustment to the beginning balance of retained earnings in 2011. In 2014, the Company changed its method of pricing inventory from the first-in, first-out (FIFO) to the average cost method in order to more fairly present the financial operations of the company. The financial statements for prior years have been restated to retrospectively reflect this change, resulting in the following effects on net income and related per share amounts:

Net income Earnings per share

Solutions Manual

2010 $ 52 $0.52

Increase in 2011 2012 2013 $ 47 $ 45 $ 62 $0.47 $0.45 $0.62

21-77

2014 $ 61 $0.61

Chapter 21




PROBLEM 21-8 (Continued) Schedule of Income Reconciliation and Retained Earnings Adjustments 2010–2014 2009

2010 $1,000 950 50 15 $ 35

Beginning Inventory FIFO Average Cost Difference Tax Effect (30%) Effect on Income* Ending Inventory FIFO Average Cost Difference Tax Effect (30%) Effect on Income**

$1,000 950 50 15 $ (35)

Net Effect on Income

$

$1,100 1,124 (24) 7.20 $16.80

2011 $1,100.00 1,124.00 (24.00) 7.20 $ (16.80)

2012 2013 $1,000.00 $1,115.00 1,091.00 1,270.00 (91.00) (155.00) 27.30† 46.50† $ (63.70)† $ (108.50)†

$1,000.00 $1,115.00 1,091.00 1,270.00 (91.00) (155.00) 27.30† 46.50† $ 63.70† $ 108.50†

$1,237.00 1,480.00 (243.00) 72.90† $ 170.10†

$1,369.00 1,699.00 (330.00) 99.00 $ 231.00

$

$

(35) $

51.80

$

46.90†

$

16.80

$

63.70† $

Cumulative Effect on Beginning Retained Earnings

2014 $1,237.00 1,480.00 (243.00) 72.90† $ (170.1)

$

44.80

108.50†

61.60

$ 170.10†

60.90†

$ 231.00

**Larger (smaller) beginning inventory has negative (positive) effect on net income. **Larger (smaller) ending inventory has positive (negative) effect on net income. † The tax effects are rounded up to the next whole dollar in the problem. Therefore, the net

effects on income and retained earnings are effectively rounded down to the next whole dollar. Solutions Manual

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Chapter 21




PROBLEM 21-8 (Continued) (b) KIMMEL INSTRUMENT CORPORATION Statement of Retained Earnings For the Years Ended May 31 2014 2013 (restated) Retained earnings, April 1, as previously stated $3,725 $2,650 Adjustment for the cumulative effect on prior periods due to change in inventory costing method from FIFO to average cost $243 $155 Less applicable tax (30%) 72 171 46 109 Retained earnings, April 1, as restated 3,896 2,759 720 1,137 Net income Retained earnings, $4,616 $3,896 May 31

2012 (restated)

$1,981

$91 27

64 2,045 714 $2,759

(c) Inventory: FIFO basis Average cost basis Change, incr. (decr.) Income Tax Payable Retained earnings: FIFO basis Average cost basis Change, incr. (decr.)

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2014

2013

2012

$1,369 1,699 $ 330

$1,237 1,480 $ 243

$1,115 1,270 $ 155

$131

$72

$46

$4,384 4,616 $ 231

$3,725 3,896 $ 171

$2,650 2,759 $ 109

Chapter 21




PROBLEM 21-8 (Continued) Note to instructor: CRA generally requires a company to use the same inventory costing method for tax purposes as for financial reporting purposes. Therefore, Kimmel would have additional tax payable on the increased income reported rather than a deferred tax account. (d) Retrospectively restating the financial statements of a prior year requires information that may, in many cases, be impracticable to obtain, even though the cumulative effect can be determined. For partial retrospective application, if the effect of a change in policy can be determined for some of the prior periods, the change in policy is applied retrospectively with restatement to the carrying amounts of assets, liabilities, and affected components of equity at the beginning of the earliest period for which restatement is possible (1506.15 and 8. 25 and .26). This could be only the current year. An adjustment is made to the opening balances of the equity components for that earliest period, similar to the adjustments in the full restatement. Note that it is not appropriate to apply hindsight in developing measurements that need to be used. Measurements must be based on conditions that existed and were known in the prior period.

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PROBLEM 21-8 (Continued) If the company were allowed to applying partial retrospective application, the statement of retained earnings would be presented as follows: KIMMEL INSTRUMENT CORPORATION Statement of Retained Earnings For the Years Ended May 31 2014 2013 (not restated) Retained earnings, April 1, as previously stated $3,725 $2,650 Adjustment for the cumulative effect on prior periods due to change in inventory costing method from FIFO to average cost $243 Less applicable tax (30%) 72 171 0 Retained earnings, April 1, as restated 3,896 2,650 Net income 720 1,075 Retained earnings, May 31 $4,616 $3,725 Also note IFRS requires that a statement of changes in shareholders’ equity be prepared and that an opening statement of financial position must be provided for the earliest comparative period provided when there is a retrospective change. On the other hand, ASPE allows for either a statement of retained earnings or a statement of changes in equity, and there is no requirement in the standards to provide an opening statement of financial position for the earliest comparative period when there is a retrospective change.

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PROBLEM 21-9 (1) Inventory ................................................................... 26,000 Retained Earnings ............................................ 26,000 (2) No entry, as ending inventory has not yet been recorded. However, the count amount should be adjusted (reduced by $15,400) before making the entry to record year-end inventory. This is an example of a correction that could be found when checking the cut-off procedures in connection with the count. (3) Cash .......................................................................... Accounts Receivable ........................................

6,700 6,700

(4) Depreciation Expense .............................................. 4,600 Accumulated Depreciation—Trucks ...............

4,600

(5) Accumulated Depreciation—Equipment ................ 25,000 Equipment ......................................................... 21,300 Gain on Sale of Equipment .............................. 3,700 (6) Litigation Expense ................................................... 450,000 Litigation Liability ............................................. 450,000 (7) Depreciation Expense .............................................. Equipment................................................................. Maintenance and Repairs Expense ................. Accumulated Depreciation—Equipment .........

5,125 41,000 41,000 5,125

(8) Unrealized Gain or Loss .......................................... 12,000 FV-NI Investments .......................................

12,000

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PROBLEM 21-9 (Continued) (9) Salaries and Wages Payable ($16,000 – $10,600) .. Salaries and Wages Expense ..........................

5,400

(10) Insurance Expense ($18,000 ÷ 3)............................. Prepaid Insurance ($18,000 ÷ 3 X 1.5) ..................... Retained Earnings ............................................

6,000 9,000

(11) Amortization Expense ($36,000 ÷ 12) ...................... Retained Earnings .................................................... Accumulated Amortization—Trademarks .......

3,000 3,000

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5,400

15,000

6,000

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PROBLEM 21-10

Item 1. 2. 3. 4. 5. 6.

Net Income for 2013 Understated Overstated $14,100 0 $11,813 0 0 $18,000 $33,000 0 0 $21,000 $12,600 0

Retained Earnings 12/31/14 Understated Overstated 0 0 $ 8,438 0 0 $ 9,000 $33,000 0 0 $10,500 0 0

Explanations: 1.

The net income would be understated in 2013 because interest income is understated. The net income would be overstated in 2014 because interest income is overstated. The errors, however, would counterbalance (wash) so that the Balance Sheet (Retained Earnings) would be correct at the end of 2014. The amount of understatement in 2013 would be $18,800 X (1 – 25%) = $14,100.

2.

The depreciation expense in 2013 should be $2,250 for this machine. Since the machine was bought on July 1, 2013, only one-half of a year should be taken in 2013 ($18,000/4 X 1/2 = $2,250). The company expensed $18,000 instead of $2,250 so net income is understated by $15,750 X (1 – 25%) = $11,813 in 2013. An additional $4,500 of depreciation expense should have been taken in 2014. At the end of 2014, retained earnings would be understated by $11,250 ($15,750 – $4,500) net of taxes of 25% = $8,438.

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GAAP requires that all research costs should be expensed when incurred. Net income in 2013 is overstated $24,000 ($36,000 research costs capitalized less $12,000 amortized) X (1 – 25%) = $18,000. By the end of 2014, only $12,000 of the research costs would remain as an asset. Therefore, retained earnings would be overstated by $12,000 ($36,000 research costs – $24,000 amortized) X (1 – 25%) = $9,000.

4.

The security deposit should be a long-term asset, such as refundable deposits. The $9,000 of last month’s rent is also an asset, such as prepaid rent. The net income of 2010 is understated by $44,000 ($35,000 + $9,000) X (1 – 25%) = $33,000 because these amounts were expensed. Retained earnings will continue to be understated by $33,000 until the last year of the lease. The security deposit will then be refunded, and the last month’s rent should be expensed.

5.

$14,000 or one-third of $42,000 should be reported as income each year. In 2013, $42,000 was reported as income when only $14,000 should have been reported. Because $28,000 too much was reported, the net income of 2013 is overstated by $28,000 X (1 – 25%) = $21,000. At the end of 2014, $28,000 should have been reported as income, so retained earnings is still overstated by $14,000 ($42,000 – $28,000) X (1 – 25%) = $10,500.

6.

The ending inventory would be understated since the merchandise was omitted. Because ending inventory and net income have a direct relationship, net income in 2013 would be understated by $16,800 X (1 – 25%) = $12,600. The ending inventory of 2013 becomes the beginning inventory of 2014. If beginning inventory of 2014 is understated, then net income of 2014 is overstated (inverse relationship). The omission in inventory over the two-year period will counterbalance, and retained earnings at the end of 2014 will be correct.

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PROBLEM 21-11

(a)

KESTERMAN CORPORATION Adjusting Journal Entries December 31, 2014 1.

Allowance for Doubtful Accounts ............ 5,000* Administrative Expenses .................. 5,000 To reflect reduction in loss experience rate. *$1,000,000 X (2% – 1½%)

2.

Unrealized Gain or Loss ............................ 13,000* FV-NI Investments ........................... 13,000 To reduce trading securities to fair value. *$78,000 – $65,000

3.

Retained Earnings..................................... 8,900 Cost of Goods Sold................................... 4,700 Inventory ............................................ 13,600 To adjust for overstatements in opening and closing Inventories.

4.

Equipment ................................................. 30,000 Operating Expenses ................................. 2,500 ([$30,000 – $5,000] ÷ 10) Retained Earnings ............................. 27,500 ($30,000 – $2,500) Accumulated Depreciation— Equipment ...................................... 5,000* To correct posting of equipment purchase as expense in 2013. *$2,500 X 2

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PROBLEM 21-11 (Continued) Accumulated Depreciation—Equipment . 17,500 Equipment .......................................... 14,700 Gain on Sale of Equipment ............... 2,800 To correct the disposal of equipment. 5.

6. (b)

Prepaid Expenses ..................................... 2,350 Operating Expenses ($4,700 ÷ 4) ............. 1,175 Retained Earnings ............................. ($4,700 – $1,175) To adjust for nonrecognition of prepaid expense in 2013.

3,525

No entry is required. The items will be properly reclassified as part of the financial statement preparation. KESTERMAN CORPORATION Computation of Corrected Net Income For the Years Ended December 31, 2014 and 2013

Reported income Change in accounts receivable loss experience rate from 2% to 1½% Loss on FV-NI investments Ending inventories overstated: December 31, 2013 December 31, 2014 Misposting of equipment purchase Decrease in operating expenses—2013 Increase in operating expenses—2014 Misposting of proceeds of equipment sold Recognition of prepaid insurance Corrected net income

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2014 2013 $220,000 $195,000 5,000 (13,000)

—

8,900 (13,600)

(8,900) 27,500

(2,500) 2,800 (1,175) 3,525 $206,425 $217,125

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KESTERMAN CORPORATION Calculation of Corrected Retained Earnings At January 1, 2014

Retained earnings, January 1, Change in accounts receivable loss experience rate from 2% to 1½% Loss on FV-NI investments Ending inventories overstated: December 31, 2013 Misposting of equipment purchase Decrease in operating expenses—2013 Recognition of prepaid insurance Retained earnings, January 1, restated

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2013 $247,000 — — (8,900) 27,500 3,525 $269,125

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PROBLEM 21-12 (a) Net income, as reported Rent received in 2013, earned in 2014 Wages not accrued, 12/31/12 Wages not accrued, 12/31/13 Wages not accrued, 12/31/14 Inventory of supplies, 12/31/12 Inventory of supplies, 12/31/13 Inventory of supplies, 12/31/14 Corrected net income

2013 $29,000 (1,300) 1,100 (1,500) (1,300) 740 000,000 $26,740

(b) 1. Retained Earnings ............................................ Rent Revenue ............................................ 2.

3.

2014 $37,000 1,300 1,500 (940) (740) 1,420 $39,540 1,300 1,300

Salaries and Wages Expense .......................... Salaries and Wages Payable ....................

940

Retained Earnings ............................................ Salaries and Wages Expense ...................

1,500

Supplies ............................................................ Supplies Expense .....................................

1,420

Supplies Expense ............................................. Retained Earnings.....................................

740

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940 1,500

1,420 740

Chapter 21




PROBLEM 21-12 (Continued) (c) Retained earnings, Jan. 1 as reported Rent received in 2013, earned in 2014 Wages not accrued, 12/31/12 Wages not accrued, 12/31/13 Wages not accrued, 12/31/14 Inventory of supplies, 12/31/12 Inventory of supplies, 12/31/13 Inventory of supplies, 12/31/14 Retained earnings, Jan. 1 as restated Net income (from part (a)) Retained earnings, Dec. 31

2013 $95,000

2014 $124,000 (1,300 )

(1,100) (1,500) 1,300 740 000,000 $95,200 26,740 $121,940

$121,940 39,540 $161,480

(d) For 2013, reported net income of $29,000 divided by total net sales revenue of $1,200,000 results in profit margin of 2.4%, and corrected net income of $26,740 divided by total net sales revenue of $1,200,000 results in profit margin of 2.2%. For 2014, reported net income of $37,000 divided by total net sales revenue of $1,100,000 results in profit margin of 3.4%, and corrected net income of $39,540 divided by total net sales revenue of $1,100,000 results in profit margin of 3.6%. An investor who analyzed Kitchener’s profitability based on reported net income may have noted a change in profit margin from 2.4% to 3.4% in 2013 and 2014, whereas the actual change in profit margin (based on corrected net income) was from 2.2% to 3.6% in 2013 and 2014, signalling stronger improvement in profitability than originally reported. The investor may also note that errors in net income often affect multiple periods, and that other measures of the company’s profitability may also be analyzed for a more detailed assessment of the company’s ability to generate profit in the future.

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PROBLEM 21-13 INTEQ CORPORATION Schedule of Revised Income Before Income Tax For the Years Ended March 31, 2012, 2013, and 2014 CALCULATIONS 2012 1. Income before tax, as reported 2. Elimination of profit on consignments Billed at 130% of cost Cost Profit error 3. To correct C.O.D. sale 4. Adjustment of warranty expense: Sales per books Correction for consignments Correction for C.O.D. sale Corrected sales Normal warranty expense, one-half of 1% Less costs charged to expense Additional expense 6. Bad debt adjustments: Normal bad debt expense, one-quarter 1% of sales Less previous write-offs Additional expense 7. Adjustment for contract financing 8. Adjustment for commissions

SUMMARY Increases (Decreases) in Income

2013

2014

$ ÷ $

6,500 130 % 5,000 1,500

$ ÷ $

1,500

$

5,590 130 % 4,300 1,290

$940,000 (6,500) 0000,0 $933,500

$1,010,000 6,500 6,100 $1,022,600

$1,795,000 (5,590 ) (6,100 ) $1,783,310

$

4,668 760 3,908

$

5,113 1,670 3,443

$

2,334 750 1,584

$

2,557 1,320 1,237

$

$

$ $

$

$

$

$

8,917 3,850 5,067

4,458 3,850 608

5. Adjustment for bonus, one-half of 1% of income before tax and bonus Revised income before income tax

*$1,400 – $800 Solutions Manual

**$800 – $1,120 21-92

2012 $71,600

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2013 $111,400

2014 $103,580

(1,500)

1,500 6,100

(1,290 ) (6,100 )

(3,908)

(3,443 )

(5,067 )

(1,584) 3,000 (1,400) 66,208

(1,237 ) 3,900 600 * 118,820

(331) $65,877

(594 ) $118,226

(608 ) 5,100 (320 )** 95,295 (476 ) $94,819



PROBLEM 21-13 (Continued) (b) INTEQ CORPORATION Journal Entries March 31, 2014 Sales Revenue .................................................. 5,590 Inventory on Consignment .............................. 4,300 Cost of Goods Sold................................... Accounts Receivable ................................ To adjust for consignments treated as sales, 3/31/14 Sales Revenue .................................................. 6,100 Retained Earnings..................................... To adjust for C.O.D. sales not recorded, 3/31/13

4,300 5,590

6,100

Warranty Expense ............................................ 5,067 Retained Earnings ($3,908 + $3,443) ............... 7,351 Warranty Liability ...................................... 12,418 To set up allowance for warranty expense Retained Earnings ($331 + $594) ..................... Salaries and Wages Expense .......................... Salaries and Wages Payable .................... To set up accrued bonus payable to manager

925 476 1,401

Retained Earnings ($1,584 + $1,237) ............... 2,821 Bad Debt Expense ............................................ 608 Allowance for Doubtful Accounts ............ To set up allowance for uncollectible accounts Cash (held by bank).......................................... 12,000 Finance Expense ....................................... Retained Earnings ($3,000 + $3,900)........ To record finance charge reserve held by bank Commission Expense ...................................... Retained Earnings ($1,400 – $600) .................. Commission Payable ................................ To adjust for accrued commissions Solutions Manual

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3,429

5,100 6,900

320 800 1,120

Chapter 21




PROBLEM 21-14

(a)

BAYBERRY CORPORATION Projected Income Statement For the Year Ended December 31, 2014 ______________________________________________________ Sales $29,000,000 Cost of goods sold $14,000,000 Depreciation 1,600,000 a Operating expenses 6,400,000 22,000,000 Income before income tax 7,000,000 Gain on FV-NI investments 1,000,000 b Income before tax and bonus 8,000,000 President’s bonus 1,000,000 Income before income tax 7,000,000 Provision for income tax Current $ 1,800,000 Deferred 300,000 c 2,100,000 Net Income $ 4,900,000 Conditions met: 1. 2.

Income before bonus and tax > $7,000,000. Payable for income taxes does not exceed $2,500,000.

a

Depreciation for the current year in the initial projected statements includes $600,000 for the old equipment and $2,000,000 for the robotic equipment. If the robotic equipment is changed to straight-line, its depreciation is only $1,000,000 and the total is $1,600,000.

b

By urging the board of directors to change the classification of Securities A and D to securities recorded using the fair-value through net income (FV-NI) model, income is increased by a $1,000,000 recognition of a holding gain.

c

The holding gain on the securities is not currently taxable as it is not realized.

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PROBLEM 21-14 (Continued) (b) Students’ answers will vary. Changing the first-year election of depreciation back to the straight-line method is unethical if this method does not provide the most relevant information for the users of financial statements. GAAP requires company management to select the depreciation method that best represents the pattern in which the entity receives the asset’s benefits. Since this is the first time the company has used robotic equipment, it may be difficult for corporate officers to challenge the choice of depreciation policy because of lack of knowledge about the pattern of use of the assets. The change would not be unethical depending on the rationale used by the corporate decision makers. It could only be justified on the basis that all production equipment, including the new robotic equipment, provides equal benefits over time. Considering the immediate needs for cash of $1,000,000 for the president’s bonus and $1,800,000 for income taxes, there may be a need to sell some of the securities. Therefore, the transfer of $3,000,000 of investment securities (FV-OCI) to securities accounted as FV-NI may also be appropriate. Note that under IFRS, no reclassifications are permitted between these categories except on the rare occasion that there is a change in the entity’s business model (Under ASPE, the fair value option designation is irrevocable; otherwise the issue is not addressed).

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PROBLEM 21-14 (Continued) It is naive to believe that corporate officers do no planning for year-end (or interim) financial statements. The slippery slope arises with manipulation of financial statements. The reclassification of the selected securities clearly manipulates the income to the benefit of the president. The reclassification of the securities is not within GAAP guidelines. GAAP clearly states that transfers in or out of the trading classification should not be done. Since the investments were purchased during the year, management could argue that the classification was not specified until year end. The ethics of this decision are questionable. Any auditor would automatically bring this transaction to the attention of the board of directors. Some stakeholders and their interests are: Stakeholder

Interests

President

Personal gain of $1,000,000 bonus.

CFO

Placed in ethical dilemma between the interests of the president and the corporation.

Board of Directors

May be subject to the manipulations of the CEO for his personal gain.

Shareholders

Increased income from higher (paper) income may increase demand for dividends. Lower income from bonus may decrease cash available for dividends.

Employees

President takes approximately 20% of net income for himself. This could have been used to start a pension plan for all of the employees.

Creditors

The increased income represents a 17% inflation of the economic income of the corporation. This may lead to unreliable assessments as to creditworthiness.

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PROBLEM 21-14 (Continued) In discussing the merits of these decisions, the impact of the changes on the benefits of the users on a long-term basis need to be considered. (c) There usually are no cash flow implications to changes in policy. In this case however, the change in policy triggers a bonus to the president. If this bonus is paid out before year-end the change in policies would generate a cash outflow of $1,000,000. (d) If the company were to follow ASPE instead of IFRS, the only difference would be that the investment securities would not be permitted to be classified as FV-OCI, since there is not an FVOCI option under ASPE. As a result, management would not be able to “cherry-pick” the investments with holding gains for the intention to reclassify them as securities (FV-NI) in order to have the holding gains appear in net income while the holding losses appear in other comprehensive income, instead all holding gains and losses would be required to be presented in net income under ASPE. All other items would be treated similarly under both IFRS and ASPE.

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CASES Note: See the Case Primer on the Student website, as well as the Summary of the Case Primer in the front of the text. Note that the first few chapters in volume 1 lay the foundation for financial reporting decision making. CA 21-1 USHER CORPORATION Overview -

-

UC is a public company and therefore IFRS is a constraint. As auditor you would want to ensure that changes were made only to provide relevant and more reliable statements or to refine prior estimates (assuming more information is now available). You would want to ensure that there was no intent to manage/manipulate the numbers. Client infers that earnings maximization is a goal—this however is not acceptable since accounting should be neutral. Users, including shareholders and creditors, would want to have high quality earnings—not earnings propped up by accounting bias.

Analysis and recommendations -

-

Accounting estimates are a way of dealing with measurement uncertainty. It is very difficult to estimate the residual values of assets but auditors must attempt to provide the best estimate and must back it up with evidence. Having said this, remember these are just estimates and estimates change. For each reporting period, management must revisit all estimates and refine them. This happens on a prospective basis. The auditor must ensure that the changes are due to new and better information being provided/gathered and not due to attempt to manipulate earnings. The auditor must look for and management must provide supporting documentation for the changes. The auditor must review the information (and be skeptical).

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IC 21-1 TEMPLE LIMITED Memo The company is expanding and assets are recorded at historical cost, which does not reflect their current value. Since it is a public company with shares trading on the TSX, IFRS is required. Under IFRS, the company may use cost or fair value to measure its properties. The company is looking for a loan, yet its debt to equity ratio is already high at 5:1—the concern is that the asset value does not reflect current values and also the negative impact of this and the new loan on the debt to equity ratio. Investors and creditors (Lendall Bank) would appreciate statements that reflect more current values and risk (reflect the hidden value). This will allow them to make more informed decisions. If fair value is used to measure the assets and the statements are audited, the bank will be able to rely on the values. Use of fair value is the most transparent and relevant and gains/losses will be booked through income showing how the company is performing in terms of its investments in the properties. Although not a reason for switching to fair value, the impact of switching is that the debt to equity ratio will be lower.

Analysis and recommendations -

-

-

-

Using fair values to value real estate assets is acceptable under IFRS. It provides greater transparency and more relevant information as the significant capital assets (investment property) would be presented much closer to the cash flows the property is expected to generate. Gains and losses are booked through income. This statement of performance, therefore, will provide better information as changes in the fair value of the investment property is what management works toward and on which its performance is probably compensated. IAS 8 indicates that a voluntary change in accounting policy should only be made if the resulting information is reliable and more relevant. IAS 40.1 indicates that this could not be substantiated for a move from fair value to the cost basis, so a reader might assume that the reverse—from cost to fair value—could be justified on these grounds. Although temple is required, at a minimum, to disclose the fair value of its investment property in the notes to the financial statements, actually changing to measurement of the fair value attribute is preferred and is relatively low cost due to the fact the fair values are already determined. This would provide more reasonable inputs into the debt/equity ratio. The bank is then better able to make its decision on the ability of Temple to handle additional debt.

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IC 21-2 SUNLIGHT EQUIPMENT MANUFACTURER Overview •

There may be a reporting bias since new manager may opt to make numbers look better to earn her bonus (NI is a key number since bonus is based on this). A bias may also exist since Agneta will want to pay her sales staff a bonus, which is based on sales. The slowdown in the economy may also put pressure on the financial statements— the company may want to make the numbers look better.

•

Although it is a private company, the company has the choice to prepare the statements according to IFRS or ASPE. They have elected to use IFRS.

•

Users of the financial statements will want transparency to assess how the company is faring in the economic downturn and also to assess how Agneta is performing.

•

As auditor you must be aware of these pressures on financial reporting.

Analysis and recommendations

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IC 21-2 (Continued) Issue: Revenue recognition Due to the aggressive sales policy, sales are up 20%, however, this figure might be inflated. Recognize revenues - 20% cash down payment will help ensure collectibility. Note also that only customers with excellent credit history have been allowed to purchase under the new policy. - Legal title to the BBQs has passed. - Persuasive evidence of an arrangement since legal title has passed.

Defer recognition - Only 20% cash down and in many cases (if customers’ orders double) – no down payment. Therefore collectibility an issue. Customers may have ordered double just to avoid the down payment but may not be able to sell. - Measurability is also an issue since the customer does not have to pay until he resells to a third party— is this real sale or like consignment? Economic substance over legal form. SEM still has the risks and rewards of ownership thus if the consignment is not sold by the customer, the inventory reverts to them. - Possession remains with SEM – BBQs stored on premises— have not even shipped them— bill and hold arrangement— may be evidence that risks and rewards rest with SEM.

Recommendation: Defer recognition – more conservative.

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IC 21-2 (Continued) Issue: New inventory system The company has purchased a new inventory tracking system however it is incomplete and therefore does it have value? Capitalize Expense - The new system has/will have - The software company SL has future benefit since it will help gone bankrupt and therefore track inventory. In the past, this may not be able to finish the has been a source of lost profits. software – thus there is no - SEM owns the new system and future benefit and this is a sunk will be able to use it once it is cost. complete. - Without the project being - Agneta is confident that he will completed, SEM has no access be able to find another software to potential future benefits. company to complete. - Care should be taken since Agneta may not want to admit failure, since it will also affect his bonus and the perception about how she is performing in terms of turning the company around. - Presentation of loss on Income Statement – discuss. Recommendation: Expense since significant uncertainty as to future benefit.

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IC 21-2 (Continued) Issue: Bonus Accrue bonus for Agneta and sales staff - The payment for Agneta is likely as she has a reputation as a turnaround specialist and has put new policies in place to turn the company around: new sales policies/remuneration and new inventory tracking system. - It is measurable since it is defined – all the company has to do is achieve the combined two year profit of $5,000,000 – has been profitable in the past. - More conservative to accrue.

Do not accrue -

-

-

Currently breakeven situation— may not achieve profitability— future uncertain. Appears to have created income by overly aggressive sales policies and changes in accounting policies. Note that the software acquisition is a large loss. This is a condition involving uncertainty that will only be resolved when the company hits the 2 year profit target.

Recommendation: Do not accrue due to overstated net income – which should be restated. Issue: Accounting policy change - Must be skeptical. SEM may have changed just to make net Income higher. - Just because competitors use straight-line, it does not justify SEM changing its accounting policy. The accounting policy can only change if results are reliable and more relevant information is given/provided. - The fact that the machinery is most productive when new would support the double declining balance method. - Straight line would be arbitrary and unjustifiable. Conclusion: should not change

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TIME AND PURPOSE OF WRITING ASSIGNMENTS WA 21-1 (Time 20-30 minutes) Purpose—this case describes several proposed accounting changes for which the student is required to identify whether the change involves an accounting policy, accounting estimate, or correction of an error. The company in this question follows IFRS. A revised statement of changes in equity is also required along with a discussion of the note disclosure.

WA 21-2 (Time 20–30 minutes) Purpose—to provide the student with an understanding of the application and reporting requirements of CICA Handbook Part II Section 1506. This case describes several accounting changes. The student must identify the type of change involved and indicate whether the restatement of prior years’ comparative financial statements is required. The company in this question follows only ASPE.

WA 21-3 (Time 20–30 minutes) Purpose—to provide the student with an understanding of how changes in accounting can be reflected in the accounting records for a company following IFRS. This case involves several situations for which the student is required to indicate the appropriate accounting treatment. The student must also identify any ethical issues and suggest appropriate action.

WA 21-4 (Time 30–40 minutes) Purpose—to help a student identify the type of change and explain the accounting treatment required. For each of seven changes described, the student explains which type of accounting change is occurring. Where insufficient information is provided, the student must identify the additional information required and state how the response is affected. IFRS and ASPE differences are required to be discussed for each of the situations.

WA 21-5 (Time 20–30 minutes) Purpose—to provide the student with an opportunity to explain why international standards and Canadian GAAP for private enterprises have different approaches for the correction of an error. The student is encouraged to use the conceptual framework.

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TIME AND PURPOSE OF WRITING ASSIGNMENTS (Continued) WA 21-6 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to understand different types of accounting changes. The student is required to explain the differences using similar cases and describe the disclosure requirements for each case.

WA 21-7 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to understand the differences between ASPE and IFRS and the conceptual reasons for any differences.

WA 21-8 (Time 20–30 minutes) Purpose—to provide the student with an opportunity to discuss the motivations for changing to IFRS and comment on the validity of the changeover. The student must also identify the potential impact the IFRS adoption will have on financial analysis focusing on the impact on key ratio analysis.

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SOLUTIONS TO WRITING ASSIGNMENTS WA 21-1 (a) and (b) 1. Uncollectible accounts receivable. This is a change in accounting estimate. Restatement of prior periods is not required. 2.

This is a change in an accounting estimate. Restatement of opening retained earnings is not required.

3.

This is a new method for a new class of assets. No change is involved.

4.

Adoption of the revaluation method is a voluntary change in an accounting policy, as required by IAS 16 for property, plant and equipment. IAS 8 paragraph 17 indicates that the initial application of the revaluation model is dealt within IAS 16, not IAS 8. As a result, IAS 16 allows prospective treatment since it would be difficult to go back and determine fair values at previous dates. Consequently, for this specific change, the entity can apply this change prospectively and retrospective application is not required. However, the company would still be required to disclose why it believes that the revaluation method is reliable and more relevant than the cost model. This change in policy is applied prospectively. Therefore, there would be a restatement of the opening balances at January 1, 2014. The entry required at January 1, 2014, would be the following:

Land ($900,000 – $750,000) ......................................... 250,000 Deferred Tax Liability ($250,000 X 30%) ............. Revaluation Surplus (OCI) ................................... 5.

75,000 175,000

As this is a correction of an error, the change must be applied retrospectively. As this is a change to other comprehensive income for 2013, a restatement of the AOCI in equity is required, not retained earnings. The journal entry would be as follows:

Deferred Tax Liability ($200,000 X 30%) ....................... 60,000 Accumulated Other Comprehensive Income ................. 140,000 FV-OCI Investments.............................................

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WA 21-1 (Continued) (c) The statement of changes in equity for 2014 would be the following: All in C$s

Balance - January 1, 2013

Share capital

Retained earnings

$1,000,000

$2,500,000

$650,000

$4,150,000

910,000

335,000 *

1,245,000

Comprehensive Income – as restated

Investments at FV through OCI

Revaluation Surplus

Total

Balance – December 31, 2013 as restated

1,000,000

3,410,000

985,000

5,395,000

Balance – January 1, 2014 as restated

1,000,000

3,410,000

985,000

5,395,000

1,350,000

150,000

175,000

1,675,000

4,760,000

1,135,000

175,000

7,070,000

Comprehensive income 2014 Balance December 31, 2014.

1,000,000

* Comprehensive income for 2013 is restated for the overstatement in the investment: $475,000 – $140,000 = $335,000

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WA 21-1 (Continued) (d)

For the error correction for item 5, the company needs to report the impact of this change on 2013’s comprehensive income and restate the opening balances of 2014 for the investment, the deferred taxes and the OCI in equity. Disclosures should be made that enable users of the financial statements to understand the effects of any changes on the financial statements so that the statements remain comparable to those of other years and of other entities. For item 1, which is a change in estimate, disclosure is required if it is material for the current period and may impact the future periods. In this case, it might be argued that the amount is material and requires disclosure of the amount and its impact on the current earnings. The nature and the amount of the change should be disclosed. For item 2, the change in an estimate impacts both the current and the future earnings and therefore the nature and amount of the change on the current year needs to be disclosed. If the future impact can be estimated then this should also be disclosed, otherwise a statement that this is impracticable. The accounting policy note would also provide the straight-line method of disclosure. For item 3, this is a new transaction so the accounting policy is being applied on this transaction for the first time. The only disclosure required is in the accounting policy notes. For item 4, the note disclosure for this change in the policy would state that it is being applied prospectively, so there is no impact on prior years, and the changes are made to the opening balances at January 1, 2014. The company would also have to explain why it believes that the revaluation method is reliable and more relevant than the cost model. There will also be a note in the accounting policies describing the revaluation accounting policy. Finally, the note on the land requires disclosure of the effective date of the revaluation, whether an independent valuator was used, the methods and assumptions used to determine the fair value and the level applied in the fair value hierarchy, the carrying amount of the land that would have been recognized under the cost model, and the revaluation surplus and changes to it during the year. For item 5, the error correction, the company must disclose the nature and amount of the error and its impact on the current and prior periods’ earnings. Finally, under IFRS, a revised opening balance sheet would normally be required for the earliest comparative period. However, since the changes

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WA 21-1 (Continued) only affect 2013, this would already be provided as the comparative information for 2014.

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WA 21-2 Item Change Type of Change

Restatement of Prior Years

1.

This appears to be a voluntary change in an accounting policy which is allowed under ASPE. The company has adopted the taxes payable method. There is no justification that is required that this represents more relevant information. .

Yes

2.

An accounting change involving a change in an accounting estimate.

No

3.

This may represent a change in an accounting policy or a change in an estimate. If it is a change in the accounting policy to expense all development costs from now on, then under ASPE, there is no requirement to disclose why the change was made or why it is more relevant. But retrospective application would be required and prior year’s statements adjusted.

Yes

However, it may be that the conditions for these particular development costs have changed. This then means that the estimated future benefits arising from these capitalized development costs have changed (declined). This would then be a change in an estimate and disclosure would be required if material.

No

Not all situations are clear cut and students should be aware that alternative answers may be justified. 4.

Treated as a change in classification. Like an error correction, previous comparative statements would also have to be restated.

Yes

5.

An error correction.

Yes

6.

This is a change in estimate from a change in the pattern of benefits.

No

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WA 21-2 (Continued) Item Change 7.

*

Type of Change Under ASPE, the company has a choice to report subsidiaries as consolidated, or using either the equity method or the cost method. This is a voluntary change in an accounting policy and requires retrospective application. However, the standard does not require the company to justify that the change is more relevant.

Restatement of Prior Years Yes

8.

Not a change in accounting policy. Simply, a change in tax accounting; done prospectively.

No

9.

This change should not have any impact on the financial statements. The cost of goods sold and the ending inventory should be the same regardless of whether the periodic or perpetual method was used.

n/a

10.

A change in accounting principle that results from applying the transitional provisions of a primary source of GAAP.

Yes/No*

The treatment would be specified in the transitional provisions of the new accounting pronouncement.

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WA 21-3 Memorandum to: Ali Reiners, Controller From: Accountant Subject: Accounting treatment of various issues at Luftsa Corp. Here are my recommendations on the various issues you have brought to my attention. If you have further questions or wish to discuss these issues, please do not hesitate to contact me. 1.

This situation is an adoption of a new accounting policy. In previous years, the loyalty points award program was immaterial. Now however, the item has become material and the company is going to apply the appropriate accounting policy to defer loyalty points awards at the time of the sale. Consequently, the accounting policy can be applied prospectively starting January 1, 2014. Note disclosure is appropriate to describe this new policy and its impact on the current and future periods, if practicable to estimate.

2.

In this situation, the company is changing its policies to use components for depreciation and the revaluation model. Luftsa has determined that it was not practicable to determine the impact of depreciation on components on prior years since the information was not available, so the policy change cannot be applied retrospectively. Additionally, the revaluation model may be implemented prospectively even though it is also a change in policy. IAS 8 paragraph 17 indicates that the initial application of the revaluation model is dealt within IAS 16, not IAS 8. As a result, IAS 16 allows prospective treatment since it would be difficult to go back and determine fair values at previous dates. The note disclosure would state why the company believes that these policies provide reliable and more relevant information. The company would also be required to note the impact on the opening balances as the company adopts the revaluation method for the assets at January 1, 2014 – that is the changes to the assets, deferred taxes and the revaluation surplus. Finally, the company should also disclose the impact on the depreciation and taxes for the current period with the adoption of these two new policies.

3.

This situation is considered a correction of an error. The general rule is that careful estimates that later prove to be incorrect should be considered changes in estimates. Where the estimate was obviously computed incorrectly because of lack of expertise or in bad faith, the adjustment should be considered an error. Changes due to error should employ the retrospective approach by: a.

Restating, via a prior period adjustment, the beginning balance of retained earnings for the statements of the current period.

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WA 21-3 (Continued) b.

Correcting all prior period statements presented in comparative financial statements. The amount of the error related to periods prior to the earliest year’s statement presented for comparative purposes should beincluded as an adjustment to the beginning balance of retained earnings of that earliest year’s statement. In addition, an opening balance sheet must be presented for the earliest comparative period.

There are ethical issues involved in this situation. These involve the honesty and integrity of Rosentiel’s financial reporting practices versus the corporation’s and the division controller’s profit motives. Understating inventory obsolescence would overstate the division’s net income. Such a practice distorts Rosentiel’s operating results and misleads users of the financial statements. This practice is unethical and must be reported to Luftsa’s Board of Directors. In addition, the result of these practices is that excess bonuses may have been paid to the divisional controller, at the expense of other divisional controllers whose results would not have looked favourable in comparison. 4.

No adjustment is necessary—a change in accounting policy is not considered to have happened if a new policy is adopted in recognition of events that have occurred for the first time.

5.

This situation is considered a change in estimate because new events have occurred which call for a change in estimate. The accounting change is made prospectively. Note disclosure would describe the impact of the change on the current earnings, and any impact that is practicable to estimate for the future.

6.

Even though this situation looks like a change in estimate, the facts of the case indicate that the estimates were not revised based on better information, but rather revised incorrectly due to bad faith by the divisional manager. This situation is considered a correction of an error. The accounting treatment would be the same as discussed in 3. There are ethical issues involved in this situation as well that relate to the honesty and integrity of Usher’s financial reporting practices and the divisional manager’s profit motives. Shortening the life of assets from 10 to 6 years may be evidence that depreciation expenses during the first five years were understated. Such a practice distorts Usher’s operating results and misleads users of Usher’s (and ultimately Luftsa's) financial statements. If this practice is intentional, it is unethical. In addition, the result of these practices is that excess bonuses may have been paid to the

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WA 21-3 (Continued) divisional manager. This situation should be reported to the highest levels of management within Luftsa (the Board of Directors).

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WA 21-4 1.

The change to a units-of-production method from straight-line is a change in an estimate. As a change in estimate, the policy is applied prospectively, but the company would require disclosure on the impact on the current and future earnings. 2.The change to expensing development costs is a change in estimate due to a change in conditions in the case of IFRS. In this case, the conditions have changed and the future estimated benefit for these costs is now questionable. This is a prospective change. However, it could also be seen as a change in policy under ASPE, if the company will continue to expense development costs, which is a choice that is allowed. If this is the case, then the change in policy must be applied retrospectively. However, the company does not need to provide justification as to whether or not this is a more relevant treatment for reporting purposes.

3.

This oversight is a mistake that should be corrected. Such a correction is considered a correction of an error of a prior period. Retrospective application is required under both IFRS and ASPE, along with the nature of the error and its impact on the current and prior periods. Under IFRS, an opening balance sheet is required for the earliest comparative period presented.

4.

This change is not one of the three types mentioned. Neither the method of accounting for certain receivables nor the method of accounting for income taxes (inter-period allocation) was changed. The only change is for tax reporting purposes. 5.In this case, no reason is provided for the change. If the nature of the change is to provide more relevant information, then this would be treated as a voluntary change in accounting policy. The change would be applied retroactively to restate comparative information as if the average cost method had been used for all prior periods. However, if the reason for the change is due to changed circumstances, for example the type and composition of inventory items has materially changed, the change would be treated as the application of GAAP to a new situation and would be accounted for on a prospective basis. The change may also be due to a change in estimate in that the inventory flow pattern is different from what was previously estimated. This situation would be treated as a change in estimate and would be accounted for on a prospective basis. The justification for the change will determine the appropriate accounting treatment in this case. Similar treatment would be required under IFRS and ASPE.

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WA 21-5 (a)

ASPE requires the correction of an error to be accounted for using full

retrospective restatement, and it does not permit the use of partial retrospective or prospective restatement. The result is the correction of amounts that were reported in the financial statements of prior periods to what the amounts would have been if the error had never occurred. In other words, the cumulative effect of the change on the financial statements at the beginning of the period is calculated and an adjustment is made to the financial statements. In addition, all prior years’ financial statements that are affected are restated It is believed that an accounting error, by its definition and nature, can be traced to a specific prior year.

This standard supports the position that only by restating prior periods can accounting changes lead to comparable information. If this approach is not used, the years before the change will contain errors and the current and following years will present financial statements without errors. In addition, partial retrospective restatement to the carrying amounts at the beginning of the earliest period (this could even be the current year) for which restatement is possible would result in “catch-up” adjustments, such as the adjustment of the opening balance of retained earnings for error correction that may not be clear enough for the financial statements users to understand. As consistency is considered essential in providing meaningful trend data and other financial relationships that are necessary to evaluate a business, partial retrospective or even prospective restatement could cause confusion for the users and a loss of confidence by investors. (b) International Accounting Standard (IAS) 8, on the other hand, indicates that if full retrospective restatement is not practicable, then an entity is permitted to restate information for the earliest period for which it is practicable. Regarding how to judge ‘practicability’, IAS 8 states that hindsight should not be used when correcting amounts for a prior period, either in making assumptions about what management’s intentions would have been in a prior period or estimating the amounts recognized, measured, or disclosed in a prior period.

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WA 21-5 (Continued) It specifically requires that, when an enterprise retrospectively applies a new accounting policy or corrects a prior period error, it should distinguish information that 1. provides evidence of circumstances that existed on the date(s) at which the transaction, other event, or condition occurred; and 2. would have been available when the financial statements for that prior period were authorized for issue from other information. When retrospective restatement would require making a significant estimate for which it is impossible to distinguish these two types of information, it is impracticable to correct the prior period error retrospectively. When an enterprise becomes aware of its accounting error but the correction is impracticable, the best thing it can do to achieve the objective of financial statements—communicating information that is useful to users—would be to provide partial retrospective or prospective treatment if it is impracticable to determine the full impact of the error correction on prior periods. Also, this approach can be supported when an entity may find that data from specific prior periods may only be available at too high a cost.

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WA 21-6 The first case, the incorrect calculation of the current portion of long-term debt, is related to an error correction. Under IFRS, the company must use the full retrospective method to correct errors by 1) restating the comparative amounts for the prior period(s) presented in which the error occurred and 2) restating the opening balances of assets, liabilities, and equity for the earliest period presented if the error took place before that period. In the year of the correction, the company should disclose 1. the nature of the error. 2. the amount of the correction to basic and fully diluted earnings per share and to each line item on the financial statements presented for comparative purposes. 3. the amount of the correction made at the beginning of the earliest prior period presented. The second case is also considered to be an error correction. Prior period errors are omissions or misstatements and are caused by the misuse of, or failure to use, reliable information that existed and could reasonably have been found and used in the preparation and presentation of those financial statements. The accounting standard requires that the operating cycle be used, if it is more than one year. Assuming that the company’s “operating cycle” has always been approximately 18 months (i.e., no recent event occurred to cause a change in the cycle), using one year to classify current and non-current assets is failure to use reliable information to prepare financial statements. What steps to take and what disclosures to make are the same as in the first case. In the third case, although it appears that the company changed its accounting policy regarding operating cycle; it is not a change in accounting policy. This is because a different policy is applied to transactions, events, or conditions that differ in substance from those that were previously occurring. In other words, using one year to classify assets and liabilities was appropriate when the company’s business involved short-term contracts. Now, the circumstances having changed due to the implementation of the company’s strategic plan, the average life of the company’s contracts has now grown to about two years. Thus, the new policy, using its “operating cycle” for classification, is appropriate for the changed circumstances. The company should disclose the nature of the new policy so that the readers understand what new circumstances caused the change in classification and what impact it would have on financial statements. Solutions Manual

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WA 21-7 There are only a few differences between IFRS and ASPE with respect to reporting errors, and changes in policies and estimates. Primarily, ASPE follows historical practice in Canada. Given that generally the primary users of private enterprise financial statements are creditors who have access to management; the disclosure has also been simplified. These differences are highlighted below: a) The hierarchy of accounting policies to follow when there is no standard is very similar. b) ASPE has choices in a number of specifically identified accounting policies where a change in policy can be made without justification as to why it is more relevant. Examples of these standards include income taxes, defined benefit pension plans, consolidation of subsidiaries and development costs. ASPE has these choices to keep the reporting and measurement of these items more simple, so preparers may choose the simpler method if they want, even if it results in reliable but less relevant information. c) ASPE requires that errors be corrected using only retrospective restatement. The reason for this is to follow historical practice in Canada. IFRS allows partial retrospective restatement or prospective treatment when the information is impracticable to determine. d) ASPE does not require an additional opening balance sheet for the earliest period restated when applying retrospective treatment. This disclosure is not required in order to keep the notes to a minimum and reduce the preparer’s time. e) ASPE does not require disclosure on issued standards not yet effective. This will simplify the disclosure for the primary users, who are the creditors.

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WA 21-8 The conversion to IFRS will result in many benefits to both companies and users of the financial statements. The most obvious benefit from applying IFRS is an increase in consistency and comparability across industry groups. Public companies in over 100 countries are using IFRS. Thus, adopting international accounting standard allows for more comparable and consistent financial statements recognized globally. In addition, IFRS adoption will allow companies with foreign operations to have internal consistency in reporting standards. Although the benefits of IFRS adoption are substantial, the effects of the increased emphasis on fair value accounting may lead to some comparability issues (e.g. income properties, biological assets, revaluation method). Greater use of fair value accounting may have three possible effects on financial statements. First, balance sheet figures are adjusted to fair value. Second, some unrealized gains and losses are directly recognized in the income statement. Third, other unrealized gains and losses bypass the income statement and are recognized directly in OCI. Therefore, there will be several ratios that become affected by fair value accounting: liquidity and leverage ratios, as a result of balance sheet variations; profitability and coverage ratios, as a result of balance sheet variations and recognition of unrealized gains/losses. Fair value adjustments introduce volatility in accounting figures as unrealized gains and losses are recognized before the realization of a transaction with external parties. Although these ratios will be relatively stable for the majority of companies under both accounting standards, the increased emphasis of fair value accounting of IFRS leads to higher ranges overall for these ratios and thus a greater susceptibility to misleading financial results.

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RESEARCH AND FINANCIAL ANALYSIS RA21-1

SHOPPERS DRUG MART

(a) (i) Note 30 outlines the company’s adoption of IFRS. The company has applied IFRS retrospectively from January 3, 2010, for the opening balance sheet. The first financial statements issued under IFRS were for the year ended December 31, 2011. At the date of transition, January 3, 2012, some elections allowed under IFRS1 were applied. (ii) The elections applied were as follows: • Business combinations – the standard IFRS 3 related to business combinations has been prospectively applied, effective January 1, 2008. Shoppers elected to apply IFRS 3 prospectively to business combinations occurring on or after January 3, 2010. • Share based payments – Shoppers decided to apply the exemption that allowed them not to have to apply IFRS 2 to share based awards granted and vested prior to January 3, 2010. • Deemed Cost – Shoppers elected not to use fair value as the deemed cost of property and equipment or intangibles on adoption of IFRS. • Leases – Shoppers applied IFRIC 4 to determine whether an arrangement contains a lease on a retrospective basis, instead of based on facts at the date of transition. • Employee Benefits – Shoppers elected to recognize all unrecognized gains and losses on employee pension and benefit plans at January 3, 2010 into retained earnings. • Borrowing costs – The company has decided to apply the transitional guidance in IAS 23 on borrowing costs from December 30, 2007. (iii) As indicated in note 30(b)reconciliation tables, the company’s assets and liabilities at January 3, 2010, January 1, 2011 and revenue and expenses for the year ended January 1, 2011, have been impacted as follows:

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RA 21-1 (Continued) In thousands of $USs

January 3, 2010 Balances (i) Revenue – due 15,453 increase to Loyalty Card in accounts Program payable and accrued liabilities (ii) Sale-leaseback 7,336 decrease transactions in other longterm liabilities (iii) Rent expense 48,162 during the fixturing reduction in period property and equipment; 1,382 decrease in other longterm liabilities (iv) Financing 51,247 increase Lease classification in PP&E; 1,267 increase in accounts payable and accrued liabilities; 53,268 increase in other longterm liabilities (v) Impairment of 21,384 store assets reduction in PP&E (vi) Employee 5,409 reduction Benefits in other longterm liabilities

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January 1, 2011 Balances 19,735 increase in accounts payable and accrued liabilities

18,242 decrease in other long-term liabilities 49,726 reduction in property and equipment;

Year ended January 1, 2011 profit or loss 183,353 reduction in revenue; 179,071 increase in cost of goods sold 10,906 increase in operating expenses 2,946 increase in operating expenses

58,741 increase in PP&E; 1,580 increase in accounts payable and accrued liabilities; 61,079 increase in other long-term liabilities

4,597 increase in financing expenses; 3,967 decrease in operating expenses

28,561 reduction in PP&E

7,177 increase in operating expenses 59 increase in operating expenses; 8,150 increase in actuarial losses through OCI

1,488 increase in other long-term liabilities, 4,217 decrease in other assets, 8,150 increase in OCI 21-122

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RA 21-1 (Continued) (vii) Business Combinations

(b)

2,077 increase in Goodwill; 1,367 decrease in prepaid expenses, 94 decrease in accounts receivable; 384 increase in accounts payable and accrued liabilities

38 decrease in Goodwill

38 increase in operating expenses

For standards issued, but not yet effective, Shoppers listed these in Note 3 (v), noting the standard number and title and its effective date. The company disclosed that it did not early adopt any these standards.

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RA21-2


CANADIAN TIRE CORPORATION, LIMITED

(a) As indicated on the Consolidated Statement of Changes in Shareholders’ Equity, the company had transitioned to International Financial Reporting Standards (IFRS) for the fiscal year beginning January 1, 2011. These changes resulted in transitional adjustments of approximately $61.8M to Shareholders’ equity for 2011 and $44.8M for 2010. Also there were transitional adjustments to 2011 Revenue in the amount of $9.4M. All of these changes are discussed in Note 10 and 44. (b) Note 10 discusses the changes in accounting policies as part of disclosure on significant accounting policies. All of these changes related to changes in the standards for the adoption of IFRS. There were no voluntary changes, changes in estimates, or errors noted. The following changes were discussed: •

Consolidations – There is no concept of qualifying special purpose entities or variable interest entities under IFRS, rather consolidation occurs when the Company displays control. As a result, the Company has recognized additional assets and liabilities on the 2011 and 2010 balance sheets. This also resulted in the recognition of additional revenue along with finance (interest) costs.

•

Securitizations – Under IAS 39, versus the old AcG 12, financial assets are only to be derecognized after meeting specific criteria. The Company’s securitization transactions with GCCT no longer meet this de-recognition criteria and are therefore consolidated into the financial statements.

•

Borrowing Costs - The Company has historically chosen to capitalize borrowing costs on major real estate projects only. Upon adoption of IFRS, the Company has capitalized borrowing costs only on those real estate projects that meet the qualifying asset criteria under IAS 23.

•

Property Plant & Equipment and Investment Property – Under IAS 16 & 40, there is the choice to measure PP&E and investment property using the cost model or the revaluation model. The company has elected to use the cost model, and re-componentized certain items resulting in a lower net book value of fixed assets.

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RA21-2 (CONTINUED) •

Leases – Under the IFRS standard IAS 17, there are no specific quantitative guidelines in determining the nature of lease arrangements. As a result, previously recognized operating leases were deemed finance leases under IFRS, resulting in an increase in assets and liabilities in the opening IFRS balance sheet.

•

Share-based payments – With the transition to IFRS, all stock-based awards must now be recorded at fair value. The impact of this accounting change resulted in increases to total liabilities as well as decreases to equity for the Company.

•

Employee Benefits – Under IAS 19, gains and losses related to the revaluation of defined benefit obligations can now be recorded using either a 10 per cent corridor approach or be immediately recognized in other comprehensive income. The Company’s election to record the gains and losses immediately resulted in an increase to liabilities and a decrease to equity.

(c) In Note 10, Canadian Tire also discloses future accounting changes as follows: • Financial instruments – The issuance of IFRS 9 occurred in November of 2009 and will replace IAS 39. This standard will become effective for annual periods beginning on or after January 1, 2015. Canadian Tire is assessing the potential impact of this standard. • Fair value measurement - In May 2011, the IASB issued IFRS 13 which is a comprehensive standard for fair value measurement and disclosure requirements for use across all IFRS standards. IFRS 13 is effective for annual periods beginning on or after January 1, 2013. The Company is assessing the potential impact of these amendments. • Post-employment benefits - In June 2011, the IASB amended IAS 19 – Employment Benefits, which applies to Defined Benefit Plans. This amendment is not expected to have any significant impact as Canadian Tire already immediately records any actuarial gains and losses in OCI. • Other comprehensive income presentation – The amended IAS 1 requires companies to group together items within OCI that may be reclassified to net income. The amendments are effective for annual periods beginning on or after July 1, 2012. Canadian Tire is assessing the potential impact of these amendments.

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RA 21-3 Answers will depend on the newly released standards.

RA 21-4

RESEARCH CASE LOBLAW COMPANIES INC

a)Note 31 of the financial statements outlines the company’s adoption of IFRS. The company has applied IFRS retrospectively from January 3, 2010, except for exemptions allowed under IFRS1. b)The following major decreases were made to shareholders’ equity as of January 1, 2011 as a result of the transition to IFRS. •Employee Benefits – Decrease of $370M – Under IFRS, companies’ are to recognize actuarial gains and losses in the period in which they arise where they were previously deferred under pre-changeover GAAP. This adjustment amends for the past gains/losses which should have been recognized. •Borrowing Costs – Decrease of $216M – The Company has elected to apply IAS 23 prospectively from the transition date, and as such as derecognized the carrying amounts of capitalized interest under prechangeover GAAP for qualifying assets commencing prior to the transition date, resulting in the reduction of shareholders’ equity. •Impairment of Assets – Decrease of $146M – Since IFRS requires assets be tested for impairment at the cash generating unit level, the company has begun testing impairment at the individual retail location level as opposed to groupings of definite life stores dependent on each other. The result is recognition of impairment losses from prior periods for assets other than goodwill. •Financial Instruments – Decrease of $374M – This reduction is a result of no longer consolidating certain independent franchisees, discontinuance of hedge accounting for items not qualifying under IFRS as well as recognition of credit card receivables and short term debt previously derecognized under prechangeover GAAP.

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RA 21-4 (Continued) c)The total impact of the changes to the shareholders’ equity as a result of the transition to IFRS was a decrease of $1,277M. Shareholders’ equity is the component of many financial ratios which would reflect the stability of a company. Such ratios include Debt to Equity, Leverage, and Return on Equity. The table below summarizes the impact this change on Shareholders' equity had on these ratios as of January 1, 2011.

Shareholders’ Equity Total Debt Total Assets Net Earnings

CGAAP $6,880 4,646 15,919 681

IFRS $5,603 6,635 16,841 675

0.68:1 2.31 9.90%

1.18:1 3.01 12.05%

Debt to Equity Leverage ROE

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LEGAL NOTICE Copyright © 2013 by John Wiley & Sons Canada, Ltd. or related companies. All rights reserved.

The data contained in these files are protected by copyright. This manual is furnished under licence and may be used only in accordance with the terms of such licence. The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd. (MMXIII iv FI)

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sm ch (21)

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