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Williams- Santana, Inc., is a manufacturer of high-tech industrial parts that was started in 1997 by two talented engineers with little business training. In 2011, the company was acquired by one of its major customers. As part of an internal audit, the following facts were discovered. The audit occurred during 2011 before any adjusting entries or closing entries were prepared. The income tax rate is 40% for all years.
 
a. A five-year casualty insurance policy was purchased at the beginning of 2009 for $49,000. The full amount was debited to insurance expense at the time.
b. On December 31, 2010, merchandise inventory was overstated by $40,000 due to a mistake in the physical inventory count using the periodic inventory system.
 
c. The company changed inventory cost methods to FIFO from LIFO at the end of 2011 for both financial statement and income tax purposes. The change will cause a $980,000 increase in the beginning inventory at January 1, 2010.
d. At the end of 2010 the company failed to accrue $25,000 f sales commissions earned by employees during 2010. The expense was recorded when the commissions were paid in early 2011.
 
e. At the beginning of 2009, the company purchased a machine at a cost of $550,000. Its useful life was estimated to be 10 years with no salvage value. The machine has been depreciated by the double declining balance method. Its carrying amount on December 31, 2010, was $460,800. On January 1, 2011, the company changed to the straight to the straight-line method.
f. Additional industrial robots were acquired at the beginning of 2008 and added to the company’s assembly process. The $1,300,000 cost of the equipment was inadvertently recorded as repair expense. Robots have 10-year useful lives and no material salvage value. This class of equipment is depreciated by the straight line method for both financial reporting and income tax reporting.
 
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Required
 
For each situation
 
1. Identify whether it represents an accounting change or an error. If an accounting change, identify the type of change.
2. Prepare any journal entry necessary as a direct result of the change or error correction as well as any adjustment entry for 2011 related to the situation described. Any tax effects should be adjusted for through the deferred tax liability account.
 
3. Briefly describe any other steps that should be taken to appropriately report the situation.
 
a. This is a correction of an error.
To correct the error
Prepaid insurance
Income tax payable
Retained earnings
2011 adjusting entry:
Insurance expense
Prepaid insurance
 
The financial statements that were incorrect as a result of the error would be retrospectively restated to report the prepaid insurance acquired and reflect the correct amount of insurance expense when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share.
 
b. This is a correction of an error.
 
To correct the error:
Retained earnings (net effect)
Refund – income tax
Inventory
 
The financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct inventory amounts, cost of goods sold, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share.
 
c. This is a change in accounting principle and is reported retrospectively.

To record the change:
Inventory (given)
Deferred tax liability
Retained earnings (net effect)

Most changes in accounting principle are accounted for retrospectively. Prior years’ financial statements are recast to reflect the use of the new accounting method. The company should increase retained earnings to the balance it would have had if the FIFO method had been used previously; that is, by the cumulative net income difference between the LIFO and FIFO methods. Simultaneously, inventory is increased to the balance it would have had if the FIFO method had always been used. A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported.
For financial reporting purposes, but not for tax, the company is retrospectively increasing pretax accounting income, but not taxable income. This creates a temporary difference between the two that will reverse over time as the unsold inventory becomes cost of goods sold. When that happens, taxable income will be higher than pretax accounting income. When taxable income will be higher than pretax accounting income as a temporary difference reverses, we have a “future taxable amount” and record a deferred tax liability.
 
d. This is a correction of an error.

To correct the error:
Retained earnings (net effect)
Refund – income tax
Compensation expense
The 2010 financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct compensation expense, net income, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share.
e. This is a change in estimate resulting from a change in accounting principle and is accounted for prospectively.
 
No entry is needed to record the change
 
2011 adjusting entry
Depreciation expense
Accumulated depreciation
 
 

A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. Accordingly, Williams-Santana reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change is depreciated straight-line over the remaining useful life.
 
Undepreciated cost, Jan. 1, 2011 (given) $
Estimated residual value (0)
To be depreciated over remaining 8 years $
years
Annual straight-line depreciation 2011-18 $
 
f. This is a correction of an error.
To correct the error
Equipment (cost)
Accumulated depreciation
Deferred tax liability
Retained earnings

 
2011 adjusting entry
Depreciation expense
Accumulated depreciation
 
The financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct depreciation, assets, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share

 
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