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Kieso, Weygandt, Warfield, Young, Wiecek

Intermediate Accounting, Ninth Canadian Edition

CHAPTER 21

ACCOUNTING CHANGES AND ERROR ANALYSIS

ASSIGNMENT CLASSIFICATION TABLE

TopicsBrief

Exercises Exercises ProblemsWriting

Assignments

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

7, 8 1, 7, 8, 10, 11

1, 2, 6, 7, 8, 10, 14

1, 2, 3, 4, 6

2. Changes in estimate. 2, 5, 7, 8 2, 3, 4, 5, 6,

10

1, 2, 3, 5, 6, 8, 14

1, 2, 3, 4

3. Changes in policies. 1, 2, 4

a. Full / partial retrospective application.

1, 3, 4, 7, 8 5, 7, 8, 9, 12, 13

1, 3, 4, 5, 6, 10, 11, 14

4. Correction of an error. 6, 7, 8, 9 2, 7, 10, 11, 12, 15

1, 2, 3, 6, 8, 9, 10, 12, 13, 14

1, 2, 3, 4, 5 6

5. Statement presentation. 9 3, 12, 16

3, 4, 5, 6, 7

6. Tax implications. 1, 4, 6, 9

2, 5, 6, 7, 8, 11

1, 4, 5, 6, 7, 10, 11

7. Disclosure. 9, 10, 16

3, 6 1, 6

Solutions Manual 21-1 Chapter 21

Copyright © 2010 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.



ASSIGNMENT CLASSIFICATION TABLE (CONTINUED)

TopicsBrief

Exercises Exercises ProblemsWriting

Assignments

8. Error Analysis. 10 11, 15, 16,

17, 18, 19,

8, 9, 11, 12, 13, 14

a.Counterbalancing errors.

11, 16, 17, 19

8, 9, 10, 11,

12, 13

b.Depreciation. 16, 17, 18, 19

3, 8, 9, 11

c. Inventory. 11, 14,

18, 19

8, 9, 10, 11

1

9. Economic motives. 14 7 3

10. Comparison of IFRS and ASPE

7





ASSIGNMENT CHARACTERISTICS TABLE

Item DescriptionLevel ofDifficulty

Time(minutes)

E21-1 Accounting for accounting changes. Simple 20-25 E21-2 Error and change in estimate—depreciation. Simple 15-20 E21-3 Accounting changes—depreciation. Moderate 15-20 E21-4 Accounting changes—amortization. Moderate 15-20 E21-5 Accounting change—inventory. Moderate 25-30 E21-6 Change in estimate—depreciation. Moderate 10-15 E21-7 Determine type of change, method of

accounting, prepare journal entries.Moderate 20-25

E21-8 Change in policy—long-term contracts. Simple 10-15 E21-9 Various changes in policy—inventory methods. Moderate 20-35 E21-10 Change in estimate, error correction. Moderate 20-30 E21-11 Error correction entries. Moderate 20-25 E21-12 Change in estimate and error; financial

statements.Moderate 25-30

E21-13 Change in policy—measurement model for investment property.

Simple 15-20

E21-14 Political motivations for policies. Simple 10-15*E21-15 Error analysis and correcting entry. Simple 10-15*E21-16 Error analysis. Moderate 25-30*E21-17 Error analysis; correcting entries. Moderate 20-25*E21-18 Error analysis. Moderate 25-30*E21-19 Error analysis. Moderate 10-15

P21-1 Change in estimate, policy, and error correction with tax effect

Moderate 30-35

P21-2 Comprehensive accounting change in estimate and error analysis problem.

Moderate 30-35

P21-3 Comprehensive accounting change and error analysis problem, with statement of retained earnings and notes.

Complex 45-55

P21-4 Change in policy (FIFO to average cost), income and retained earnings statement.

Complex 50-60

P21-5 Effect of changes in policy and estimate, financial statements.

Complex 50-60

P21-6 Effect of changes in policy, estimate and error, financial statements and note disclosure.

Complex 50-60

P21-7 Economic motives for selection of accounting policies and ethical considerations.

Moderate 25-30

P21-8 Error analysis and correcting entries. Complex 50-60P21-9 Error corrections. Moderate 25-30P21-10 Error corrections and changes in policy. Moderate 25-30





ASSIGNMENT CHARACTERISTICS TABLE (Continued)

Item DescriptionLevel ofDifficulty

Time(minutes)

P21-11 Error analysis with tax effect. Moderate 20-25P21-12 Error analysis and calculation of corrected net

income.Moderate 30-40

P21-13 Error analysis and correcting entries. Complex 50-60P21-14 Error analysis and changes in policy. Complex 45-50





SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 21-1

Accumulated Depreciation ($117,000 – $76,000) 41,000Future Income Tax Liability.......................... 12,300Retained Earnings – Cumulative Effect of Correction of Accounting Error................ 28,700

[$41,000 X (1 – 30%)]

Note that this is considered to be a correction of an accounting error since the company is changing from a non-GAAP method to a GAAP method.

BRIEF EXERCISE 21-2

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 2011 and prospective years.

Note to instructor: This solution is technically correct, but expect some debate as it still represents the adoption of a GAAP compliant approach for the first time – and thus (although a change in estimate) is also the correction of an error. There would be no debate on this matter if the change were from a GAAP compliant declining balance approach.





BRIEF EXERCISE 21-3

There would be no further change in reported income and EPS for 2011 since the 2011 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 is considered a change in estimate, not a change in accounting policy.

BRIEF EXERCISE 21-4

Inventory*............................................................... 435,000Income Tax Payable...................................... 152,250

Retained Earnings [$435,000 X (1 – 35%)]... 282,750

* Assumes a periodic system and that ending inventory of 2011 has not yet been recorded. If a perpetual system is assumed, adjust 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, Bronson would have additional taxes payable on the increased income reported rather than a future tax account. Also, the “better predictive value” from FIFO inventory valuation is highly debatable, as older costs are used in the computation of cost of goods sold.





BRIEF EXERCISE 21-5

Depreciation Expense.......................................... 19,000Accumulated Depreciation........................... 19,000

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

New annual depreciation:

BRIEF EXERCISE 21-6

Equipment............................................................. 75,000Depreciation Expense ($75,000 ÷ 5).................... 15,000

Accumulated Depreciation........................... 45,000*Future Income 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 21-7

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.

BRIEF EXERCISE 21-8

1. Both FIFO and average cost are generally accepted accounting principles; 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-of-completion method are generally accepted accounting principles; thus, such a change is a change in accounting principle.





*BRIEF EXERCISE 21-9

(a)MOTTERAY CORPORATION

Statement of Retained EarningsDecember 31, 2011

Retained earnings, 1/1/11, as previously reported $2,000,000

Correction of depreciation error, (net of tax of $200,000) (300,000 )

Retained earnings, 1/1/11, as adjusted 1,700,000

Add: Net income 900,000

2,600,000

Deduct: Dividends 250,000

Retained earnings, 12/31/11 $2,350,000

(b) If Motteray were to follow IFRS, the error correction would be accounted for in the same way, except that Motteray would have to prepare a Statement of Changes in Shareholders’ Equity, as required under IFRS, rather than a Statement of Retained Earnings under accounting standards for private enterprises.

*BRIEF EXERCISE 21-10

2011 2012

a.b.c.

OverstatedOverstatedUnderstated

UnderstatedOverstatedOverstated





d.e.

OverstatedNo effect

UnderstatedOverstated





SOLUTIONS TO EXERCISES

EXERCISE 21-1 (20-25 minutes)

(a) and (b) Accounting treatment under IFRS:

(a) (b)Accounting treatment Type of change

1. P Change in estimate2. R Accounting error correction3. P Change in estimate4. NA* Change in policy5. P Not an accounting change – selection of

policy for first time.6. P Change in estimate7. R Accounting error correction8. P Change in estimate9. P Application of a new accounting policy to

transactions that differ in substance from those previously occurring

10. R 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. Accounting for the change in the current year only is not permitted under either IFRS or ASPE. 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.





EXERCISE 21-1 (Continued)

There is a major difference between ASPE and IFRS in accounting for retrospective changes in that IFRS allows partial retrospective treatment and ASPE doesn’t. In addition, under IFRS, an opening balance sheet 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):

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 the situation is one where this is the first time they have constructed a building for their own purposes then 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 accounting standards for private enterprises (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 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.

Accounting standards for private enterprises provide 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 private enterprise GAAP 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 private enterprise accounting standards 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.






(a)December 31, 2012

Retained Earnings................................................... 135,000Accumulated Depreciation—Machinery........

135,000 (To correct for the omission of depreciation expense in 2010)($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 changes from one depreciation method to another is now definitely a change in estimate, not a change in accounting policy. Changes in estimates are treated prospectively.

The adjusting entry to be made for depreciation, based on a prospective application of DDB is:

Depreciation Expense............................................. 189,000Accumulated Depreciation.............................. 189,000

20% X [$1,350,000 – (3 X $1,350,000 / 10)] = $189,000

(b) December 31, 2012Retained Earnings................................................... 89,100Future Income Tax Asset ($135,000 X 34%).......... 45,900

Accumulated Depreciation—Machinery........ 135,000

(To correct for the omission of depreciation expense in 2010)

As above (see part a), with the same depreciation entry.






(a) Depreciation to date on the equipment:

Double-declining depreciation2008 (2/5 X $465,000) $186,0002009 (2/5 X $279,000) 111,6002010 (2/5 X $167,400) 66,960

$364,560

Cost of equipment................................ $465,000Depreciation to date............................. 364,560Carrying amount (Dec. 31, 2010)......... $100,440

Depreciation for 2011: $(100,440 – 15,000) ÷ (5 – 3) = $42,720

Depreciation Expense..................................... 42,720Accumulated 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.................................... $780,000Depreciation to date............................. 78,000Carrying amount (Dec. 31, 2010)......... $702,000

Depreciation for 2011: $702,000 ÷ (40 – 3) = $18,973

Depreciation Expense..................................... 18,973Accumulated Depreciation—Buildings.... 18,973






(a) Calculation of depreciation for 2011 on the building:

Cost of building $1,200,000Less: Depreciation prior to 20112007 ($1,200,000 – $0) X .05* $60,0002008 ($1,200,000 – $60,000) X .05 57,0002009 ($1,200,000 – $117,000) X .05 54,1502010 ($1,200,000 – $171,150) X .05 51,442 222,592 Carrying amount, January 1, 2011 $ 977,408

*Double-declining-balance rate = (1 ÷ 40) X 2 = 5%

Depreciation expense for 2011: $25,761 [($977,408 – $50,000) ÷ 36 (=40 – 4) years]

Depreciation Expense.................................... 25,761Accumulated Depreciation—Building.. . 25,761

(b) Calculation of depreciation for 2011 on the equipment:

Cost of equipment $130,000Less: Accumulated depreciation [($130,000 – $10,000) ÷ 12] X 4 years 40,000 Carrying amount, January 1, 2011 $ 90,000

2011 Depreciation expense = $90,000 – $5,000

(9 – 4)=

$85,0005

= $17,000






2008 (a) Retained earnings, January 1, as reported........... $160,000

Cumulative effect of change in accounting principle to average cost..................................... (13,000 )*Retained earnings, January 1, as adjusted........... $147,000

*[ – $8,000 (2006) – $5,000 (2007)]

2011 (b) Retained earnings, January 1, as reported........... $590,000


*[– $8,000 (2006) – $5,000 (2007) – $5,000 (2008) + $10,000 (2009) – $7,000 (2010)]

2012 (c) Retained earnings, January 1, as reported........... $780,000


*[–$15,000 at 12/31/2010 + $5,900 (2011)]

2009 2010 2011 (d) Net Income.............................. $130,000 $293,000 $310,900






(a) The change in estimate would be applied in 2011. The amount of depreciation expense for 2011 would be calculated as a change in estimate.

Income before depreciation and income taxes $300,000Depreciation expense* 250,000Income before income taxes 50,000Income taxes (30%) 15,000Net income $35,000

* Cost of assets = $125,000 X 8 years = $1,000,000Carrying amount = $1,000,000 – ($125,000 X 2) = $750,000Depreciation expense = $750,000 X 2/6** = $250,000

** The remaining useful life is 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 2011 of $250,000 would be recorded.






(a) 1. Change in accounting policy – full retrospective application *.

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........................................................ 100,000Depreciation Expense..................................... 22,500*

Accumulated Depreciation ($22,500 X 2) 45,000

Retained Earnings–Correction of Error. 46,500**

Future Income Tax Asset/Liability.......... 31,000***

* ($100,000 – $10,000)/4 = $22,500** ($100,000 – $22,500) X (1 – 40%) = $46,500*** ($100,000 – $22,500) X 40% = $31,000

Note to Instructor: The Future Income Tax effect for the current year is not included in the above entry.






Event #4:Retained Earnings........................................... 6,000Income Tax Payable......................................... 4,000

Inventory................................................... 10,000

Changes for 2008 and 2009 have not been included since inventory changes are counterbalancing and their impact on opening 2011 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 future tax asset or liability.






(a) The net income to be reported in 2011, would be computed as follows:

Income before income taxes $700,000Income taxes:

Current (35% X $480,000) $168,000Future [35% X ($700,000 – $480,000)] 77,000 245,000

Net income $455,000

(b) Construction in Process................................. 200,000Future Income Tax Liability..................... 70,000Retained Earnings....................................

130,000*

*($200,000 X (1 – 35%) = $130,000)

(c) This would not be recognized as a change in policy since the new policy is appropriate for the changed circumstances. The change would be accounted for prospectively, to be reflected in the current income statement only with no restatement of opening balances or of previous years’ financial results.






(a) Inventory**............................................................. 8,000Retained Earnings – Cumulative Effect of Change in Accounting Policy.................. 8,000

*

*2008 $2,000 ($26,000 – $24,000) *2009 5,000 ($30,000 – $25,000) *2010 1,000 ($28,000 – $27,000)

$8,000

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

Information shown in comparative form as follows:

2011 2010 2009 2008

Net income (Note A) $34,000 $28,000 $30,000 $26,000

Note A:In 2011, inventory has been calculated by the first-in, first-out method. In prior years, from incorporation, inventory had been calculated by the average cost method. 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 2010 of $XXX), increase (decrease) in cost of goods sold of $XXX (increase (decrease) in 2010 of $XXX), increase in net income of $4,000 (increase in 2010 of $1,000), an increase of opening retained earnings of $8,000 (increase of $7,000 in 2010) and an increase in earnings per share of $XXX (increase in 2010 of $XXX).






(b) Inventory**.............................................................19,000Retained Earnings........................................ 19,000

*

*2008 $ 6,000 ($26,000 – $20,000) *2009 9,000 ($30,000 – $21,000) *2010 4,000 ($28,000 – $24,000)

$19,000

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

2011 2010 2009 2008

Net income $34,000 $28,000 $30,000 $26,000

Note A:In 2011, inventory has been calculated by the first-in, first-out method. In prior years, from incorporation, inventory had been calculated by the last-in, first-out method. The change is due to the initial application of the revised CICA Handbook, Part II, section 3031 requirement. The new standard has been applied retrospectively to inventory valuation of prior years in accordance with the transitional provisions. The impact of the change is an increase (decrease) in inventory of $XXX (increase (decrease) in 2010 of $XXX), increase (decrease) in cost of goods sold of $XXX (increase (decrease) in 2010 of $XXX), increase in net income of $8,000 (increase in 2010 of $4,000), an increase of opening retained earnings of $19,000 (increase of $15,000 in 2010) and an increase in earnings per share of $XXX (increase in 2010 of $XXX).






(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......................................... 76,000Accumulated Amortization—Patent........... 76,000

Amortization recorded in 2009 and 2010:($410,000 – $50,000) / 10 years X 2 years = $72,000

Annual amortization incorporating this change: ($410,000 – $110,000 – $72,000) / 3 years (2011 to 2013)

= $76,000

Land and Building – error correction entry:

Building........................................................... 101,250Land......................................................... 101,250

Depreciation Expense*................................... 3,213Retained Earnings – Correction of an Error. 8,033

Accumulated Depreciation ($3,213* X 3.5) 11,246

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






(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 2011 and 2010 (include previous years if included in comparative statements). This has decreased net income by $3,213 for both 2011 and 2010 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 2011 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 2012 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 2011 going forward.






(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. The controller would need to review the patent for impairment if events or changes in circumstances indicate that the carrying amount of the patent may not be recovered. If events or circumstances indicate an impairment, the controller would need to do a recoverability test and compare the patent’s carrying amount to the undiscounted cash flows. If the recoverability test is not met, the impairment loss would be the excess of the patent’s carrying amount over its fair value. Impairment tests are done whenever events or circumstances indicate an impairment and not necessarily as part of the year end adjustment process. In this exercise there is no indication that the change in estimates is due to an impairment and information to calculate any cost recovery is not provided. Consequently, the changes would be accounted for as a change in estimate.






(a)1. Accumulated Depreciation—Machinery........... 22,500

Depreciation Expense................................ 7,500Retained Earnings...................................... 15,000

2009-2010 2011

Depreciation takenDepreciation (correct)

*$150,000** 135,000**$ 15,000*

$75,000 67,500$ 7,500

*$450,000 X 1/6 X 2

2. Sales Salaries Expense..................................... 36,000Retained Earnings...................................... 36,000

3. Income Tax Expense.......................................... 73,000Retained Earnings...................................... 73,000

4. Accumulated Amortization (Goodwill).............202,500Amortization Expense – Goodwill............. 45,000Retained 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.............................................. 87,000Loss on Write-down of Inventories........... 87,000






(b) 1. Error correction2. Error correction3. Error correction4. Error correction5. Change in accounting policy6. Error correction

(c) 1. Accumulated Depreciation—Machinery........... 22,500

Depreciation Expense................................ 7,500Retained Earnings...................................... 11,250Future Income Tax Liability....................... 3,750

2. Sales Salaries Expense..................................... 36,000Retained Earnings...................................... 27,000Income Tax Payable................................... 9,000

3. Income Tax Expense.......................................... 73,000Retained 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).............202,500Amortization Expense – Goodwill............. 45,000Retained Earnings*..................................... 118,125Future Income 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........................................... 21,750Loss on Write-down of Inventories........... 87,000






(a) Change from sum-of-the-years-digits to straight-line

Cost of depreciable assets.................................. $90,000Depreciation in 2010 ($90,000 X 4/10)................. 36,000Carrying amount at December 31, 2010............. $54,000

Depreciation for 2011 using straight-line depreciation

Carrying amount at December 31, 2010............. $54,000Estimated useful life............................................. 3 yearsDepreciation for 2011 ($54,000 ÷ 3)..................... $18,000

HESSEY INC.Statement of Retained Earnings

For the Year Ended

2011 2010 Retained earnings, January 1, unadjusted............$125,000Less: Correction of error for inventory

overstatement............................................... (20,000 )

Retained earnings, January 1, adjusted................105,000 $ 72,000Add: Net income.................................................... 81,000 58,000Less: Dividends...................................................... (30,000 ) (25,000 )Retained earnings, December 31...........................$156,000 $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...27,000Depreciation under straight line....................(18,000) _

Corrected net income............................................$81,000 $58,000






Note to instructor:

1. 2010 Cost of sales increased $20,000; 2011 cost of sales decreased $20,000. As a result, net income for 2010 is overstated $20,000 and net income for 2011 is understated $20,000 as a result of the inventory error.

2. 2010 depreciation expense is unchanged.

3. Additional disclosures would be a 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.






(a) For the years ended December 31, 2010 and 2011, the land was original measured and reported on the balance sheet at its cost of $1,000,000 with no effects reported in net income (as there is no depreciation on land).

2011 2010BALANCE SHEET (partial)Land, at cost $1,000,000 $1,000,000Retained earnings, ending balance 290,000 230,000

INCOME STATEMENT (partial)Gain (loss) in value of Land – Investment Property $0 $0

(b) The entry required January 1, 2012 to restate opening Retained Earnings is:

Land – Investment Property 50,000Retained Earnings 50,000

The opening Retained Earnings in 2012 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, 2011 (equal to the fair value holding loss in 2010 of $20,000 and the fair value holding gain in 2011 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.






(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 balance sheet:

2011 2010(Restated) (Restated)

BALANCE SHEET (partial)Land, at fair value $1,050,000 $980,000Retained earnings, ending balance 340,000 210,000

INCOME STATEMENT (partial)Gain (loss) in value of Land – Investment Property $70,000 $(20,000)

STATEMENT OF SHAREHOLDERS’ EQUITY / RETAINED EARNINGS (partial)Opening retained earnings, as originally stated $290,000 $230,000Adjusted for 2010 decline in fair value (20,000) (20,000)Adjusted for 2011 increase in fair value 70,000 _ Opening retained earnings, as restated for change in accounting policy $340,000 $210,000






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.






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”.





*EXERCISE 21-15 (10-15 minutes)

1. Wages Expense................................................ 4,100Wages Payable......................................... 4,100

2. Vacation Wages Expense................................ 29,400Vacation Wages Payable......................... 29,400

3. Prepaid Insurance ($2,760 X 10/12)................ 2,300Insurance Expense.................................. 2,300

4. Sales Revenue.................................................. 110,000 [$2,310,000 ÷ (1.00 + .05) X 5%]

Sales Tax Payable.................................... 110,000

Sales Tax Payable............................................ 101,300Sales Tax Expense................................... 101,300






(a) Effect of errors on 2011 net income: $10,700 understatement

Calculations – Effect on 2011 net income:Over

(under) statement

Overstatement of 2010 ending inventoryUnderstatement of 2011 ending inventoryExpensing of insurance premium in 2010 ($66,000 ÷ 3)Failure to record gain on sale of fully depreciated machine in 2011Total effect of errors on net income (understated)

$ (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:Over

(under) statement

Understatement of 2011 ending inventoryExpensing of insurance premium in 2010 (prepaid insurance)Cash from sale of fully depreciated machine

unrecordedTotal effect on working capital (understated)

$( (8,100))

(22,000)

(15,000)$(45,100)





*EXERCISE 21-16 (Continued)

(c) Effect of errors on retained earnings: $47,400 understatement

Calculations – Effect on retained earnings:Over

(under) statement

Understatement of 2011 ending inventoryOverstatement of depreciation expense in 2010Expensing of insurance premium applicable to 2012 in 2010Failure to record sale of fully depreciated machine in 2011Total effect on retained earnings (understated)

$( (8,100)) (

(2,300))

(22,000)

(15,000)

$(47,400)

(d) HENNESEY TOOL CORPORATIONStatement of Retained Earnings

For the Years 2011 and 2010

2011 2010(restated)

Retained earnings, January 1, as previously reported

Less: Effect of error in inventory in previous year

Add: Depreciation error inprevious year

Add: Error in insurance Retained earnings, January 1,

as restatedNet incomeDividends

$1,607,000

(9,600)

2,300

44,000

1,643,700* 385,700

$1,250,000

_

1,250,000** 458,700





Retained earnings, December 31 (45,000 )$1,984,400

(65,000 )$1,643,700






* Net income for 2011 = $375,000 + $10,700 understatement.

** Net income for 2010 = $422,000 – $9,600 + $2,300 + $44,000

(e) Correction of error: The financial statements must be restated for all prior periods, when it is practicable to do so. 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 basic and fully diluted earnings per share and 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.






(a) 1. Supplies Expense ($4,100 – $2,100)........... 2,000Supplies on Hand................................. 2,000

Salary and Wages Expense......................... 1,200 ($5,100 – $3,900)

Accrued Salaries and Wages............... 1,200

2. Interest Revenue ($5,500 – $4,750)............. 750Interest Receivable on Investments.... 750

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

Prepaid Insurance................................. 28,000

4. Rental Income ($44,000 ÷ 2)......................... 22,000Unearned Rent...................................... 22,000

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

Accumulated Depreciation.................. 48,150

6. Retained Earnings........................................ 13,500Accumulated Depreciation..................

13,500






(b) 1. Retained Earnings........................................ 2,000Supplies on Hand................................. 2,000

Retained Earnings........................................ 1,200Accrued Salaries and Wages............... 1,200

2. Retained Earnings........................................ 750Interest Receivable on Investments.... 750

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

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

5. Retained Earnings........................................ 48,150Accumulated 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 accrued salaries and wages and interest receivable, the fact that the opening balances were not changed, does not imply an error. Cash receipts on interest and cash disbursements for salaries and wages were posted to the income statement, rather than clear the opening balances. This means that interest revenue and salaries and wages expense are currently overstated. The opening balance needs to be closed to the Interest Revenue / 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.


For item 4, the company is likely using the alternative form of recording its prepaid rental income by posting the full amount to a revenue account. The adjusting entry has to reduce the revenue account and post the corresponding amount to an unearned 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.






2010 2011

Income before taxCorrections:

Sales erroneously included in 2010 incomeUnderstatement of 2010 ending inventoryAdjustment to bond interest expense*Repairs erroneously charged to the Equipment accountDepreciation recorded on improperly capitalized repairs (10%)***

Corrected income before tax

$101,000

(38,200)

8,640 (1,450)

(8,500)

850 $62,340

$77,400

38,200

(8,640) (1,552)

(9,400)

1,790$97,798

* Bond interest expense for 2010 and 2011 was computed as follows:

Carrying Amount of

BondsStated Interest

Effective Interest

20102011

$235,000 236,450

$15,000 15,000

**$16,450**** 16,552**

**$235,000 X 7%

Difference between effective interest at 7% and stated interest (6%):

2010: $1,4502011: 1,552

***Erroneous depreciation taken in 2011: on 2010 addition ($8,500 ÷ 10) $ 850 on 2011 addition ($9,400 ÷ 10) 940Total excess depreciation 2011 $1,790






(b) 1. Retained Earnings........................................ 38,200Sales...................................................... 38,200

2. Cost of Goods Sold (Income Summary)..... 8,640Retained Earnings................................ 8,640

3. Retained Earnings........................................ 1,450Bonds Payable...................................... 1,450

For the 2010 interest.

Interest Expense........................................... 1,552Bonds Payable...................................... 1,552

For the 2011 interest.

4. Retained Earnings........................................ 8,500Equipment............................................. 8,500

Accumulated Depreciation.......................... 850 Retained Earnings................................ 850To adjust the 2010 error on equipment.

Repair Expense............................................ 9,400Equipment............................................. 9,400

Accumulated Depreciation.......................... 1,790 Deporeciation Expense........................ 1,790To adjust the 2011 error on equipment.






2010 2011

ItemOver-

statementUnder-

statementNo

EffectOver-

statementUnder-

statementNo

Effect

(1) X X

(2) X X

(3) X X

(4) X X

(5) X X





TIME AND PURPOSE OF PROBLEMS

Problem 21-1 (Time 30-35 minutes)

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.


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.


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.


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 balance sheet accounts affected by the change in policy.


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.





TIME AND PURPOSE OF PROBLEMS (CONTINUED)


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.


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.


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.


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


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.


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.





TIME AND PURPOSE OF PROBLEMS (CONTINUED)


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.


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.


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.





SOLUTIONS TO PROBLEMS

PROBLEM 21-1

(a) (1)Estimated Litigation Loss......................................... 25,000

Estimated Litigation Liability............................ 25,000

(2)Bad Debts Expense................................................... 15,000*

Allowance for Doubtful Accounts..................... 15,000* ($22,500 ÷ 1.5%) X 1% = $15,000

(3)Land............................................................................ 40,000Accumulated Depreciation—Equipment................. 32,000*

Depreciation Expense........................................ 8,000Retained Earnings.............................................. 24,000Equipment........................................................... 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 2011, so the depreciation expense for 2011 will be revised for that year only to the straight line method.

Accumulated Depreciation—Building*.................... 22,150Depreciation Expense—Building...................... 22,150*($54,150 – $32,000)





PROBLEM 21-1 (Continued)

(5)Accumulated Depreciation—Equipment................. 5,600

Depreciation Expense—Equipment.................. 5,600**($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)

(6)No entry required. This is an error in classification. No amounts or items are missing in the financial statements. A formal entry is possible to report the partial reclassification for reporting purposes:

Note Payable – Long Term........................................25,000Current Portion of Note Payable – Long Term........... 25,000

(b)Note to Instructor: Corrections to Future Income Taxes 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 2011 taxable income will be made subsequently.

(1)Estimated Litigation Loss......................................... 25,000


(2)Bad Debts Expense................................................... 15,000

Allowance for Doubtful Accounts..................... 15,000






(3)Land............................................................................ 40,000Accumulated Depreciation—Equipment................. 32,000

Future Income Tax Liability ($24,000 X 25%)... 6,000Depreciation Expense........................................ 8,000Retained Earnings [$24,000 X (1 – 25%)]......... 18,000Equipment........................................................... 40,000

(4)

Accumulated Depreciation—Building*.................... 22,150Depreciation Expense—Building...................... 22,150


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.






(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 balance sheet 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.





PROBLEM 21-2

(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 Oatfield did not recognize depreciation expense of $54,000 in 2011. At January 1, 2011, the asset’s carrying amount was $1,200,000 – ($108,000 + $120,000) = $972,000. The correct amount of depreciation for 2011 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—Machine........... 7,000 [($20,000* – $18,000**) X 3½ years]

Retained Earnings................................... 5,000Depreciation Expense............................. 2,000

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

4. Training expenses ($4,500 / 3)....................... 1,500Deferred Training 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.






(b) Calculation of 2011 depreciation expense on the equipment:

2008 to 2010 depreciation [($130,000 – $10,000) ÷ 10] $12,000

Cost of equipment $130,000Accumulated depreciation ($12,000 X 3 years) 36,000Carrying amount, 1/2/2011 $94,000

2011 deprec. expense: = = $22,000

Additional depreciation in 2011: $22,000 – $12,000 = $10,000






(c) OATFIELD CORPORATIONComparative Net Income Calculation

For the Years 2011 and 2010

2011 2010Income before depreciation expense and before effects of changes

Depreciation of equipment – item 1Depreciation of building – item 2*Depreciation of machine – item 3Training costs – item 4

Net income

$600,000 (22,000

)(47,333

) (18,000

) (1,500

) $511,167

$420,000(12,000

)(108,000

)(18,000

) $282,000

* Calculation of 2011 depreciation expense on the Building – item 2:

Cost of building $1,200,000Accumulated depreciation ($120,000 + $108,000) 228,000Carrying amount, 1/1/2011 $972,000

2011 depreciation expense: =

= $47,333





PROBLEM 21-3

(a) 1. Depreciation Expense.................................108,108Accumulated Depreciation—Asset A 108,108

Computations:Cost of Asset A........................................ $540,000Less: Depreciation prior to 2011............ 162,000 *Carrying amount, January 1, 2011......... $378,000

*($540,000 ÷ 10) X 3

The DDB rate is calculated as 100% ÷ 7 X 2 = 28.6%Depreciation for 2011: $378,000 X 28.6% = $108,108** rounded

2. Depreciation Expense.................................. 25,800Accumulated Depreciation—Asset B.... 25,800

Calculations:Original cost $180,000Accumulated depreciation (1/1/11) $12,000 X 4 48,000Carrying amount (1/1/11) 132,000Estimated residual value 3,000Remaining depreciable base 129,000Remaining useful life (9 years—4 years taken) ÷ 5 Depreciation expense—2011 $ 25,800






3. Asset C..........................................................160,000Accumulated Depreciation—Asset C.... 64,000

(4 X $16,000)Retained Earnings................................... 96,000

Depreciation Expense.................................. 16,000Accumulated Depreciation—Asset C.... 16,000

(b) Restated net income and earnings per share:

Net income

Earnings per common share

2011

$227,600

$2.28

*

2010

$354,000

$3.54

**

Calculations:*Income before depreciation expense (2011) $400,000

Depreciation for 2011Asset 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 (2010) $370,000





Error correction—Depreciation Asset C (16,000 )

Income after error correction $354,000






(c) MADRASA INC.Comparative Statement of Retained Earnings

For the Years Ending December 31

2011 2010(restated)

Balance, January 1, as previously reported

Plus: Adjustment due to error in recording Asset C (net of taxes)(Note B)

Balance, January 1, as restatedAdd: Net incomeBalance, December 31

$570,000*

96,000 666,000 195,092$861,092

$200,000

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

*Amount expensed incorrectly in 2007................... $160,000 Depreciation to be taken to January 1, 2010 ($16,000 X 3)....................................................... 48,000 Prior period adjustment for income....................... $112,000

** Opening balance of $200,000 + unadjusted income for 2010 of $370,000.

(d) Note A – Change in Depreciation MethodIn 2011, the company has changed its amortization method for certain capital assets from the straight-line basis to the double-declining basis. This change was done to provide more relevant presentation of the company’s financial information (provide specific rationale here). The change has been applied prospectively.






Note B – Error in Depreciation Expense of Prior PeriodsThe company expensed a capital asset purchased in 2007. Depreciation was not recorded for 2007 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 2010 and 2011. 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 cash flows and will not change the totals for any of the three sections of the 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 statement of cash flows prepared on the direct basis.

The change in estimate is applied on a prospective basis only and will not affect the statement of cash flows for prior periods.



Kieso, Weygandt, Warfield, Young, Wiecek Intermediate Accounting, Ninth Canadian

Edition

PROBLEM 21-4

(a) KIMMEL INSTRUMENT CORPORATIONStatement of Income and Retained Earnings

For the Years Ended May 31

2007 2008 2009 2010 2011Sales—netCost of goods sold

Beginning inventoryPurchasesEnding inventory

TotalGross profitAdministrative expensesIncome before taxesIncome taxes (50%)Net incomeRetained earnings– beginning:

As originally reportedAdjustment (See note* and schedule)As restated

Retained earnings – ending

Earnings per share (100 shares)

$13,964

950 13,000 (1,124 12,826 1,138 700 438 219 219

1,206

(25 1,181$ 1,400

$ 2.19

)

)

$15,506

1,124 13,900 (1,091 13,933 1,573 763 810 405 405

1,388

12 1,400$ 1,805

$ 4.05

)

$16,673

1,091 15,000 (1,270 14,821 1,852 832 1,020 510 510

1,759

46 1,805$ 2,315

$ 5.10

)

$18,221

1,270 15,900 (1,480 15,690 2,531 907 1,624 812 812

2,237

78 2,315$ 3,127

$ 8.12

)

$18,898

1,480 17,100 (1,699 16,881 2,017 989 1,028 514 514

3,005

122 3,127$ 3,641

$ 5.14

)




Edition






* Note to instructor:

The adjustments are simply the cumulative difference in income between the two inventory methods, net of tax. For example, the negative $25 in 2007 reflects the difference in ending inventories in 2006 ($1,000 – $950) times the tax rate 50%. In 2008, the difference in income of $37 between the two methods in 2007is added to the negative $25 to arrive at a $12 adjustment to the beginning balance of retained earnings in 2008.

In 2011, 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:

Increase in

2007 2008 2009 2010 2011

Net incomeEarnings per share

$ 37$0.37

$ 34$0.34

$ 32$0.32

$ 44$0.44

$ 44$0.44




Edition

PROBLEM 21-4 (Continued)Schedule of Income Reconciliation

and Retained Earnings Adjustments2007–2011

2006 2007 2008 2009 2010 2011

Beginning Inventory FIFOAverage CostDifferenceTax Effect (50%)Effect on Income*

Ending Inventory FIFOAverage CostDifferenceTax Effect (50%)Effect on Income**

Net Effect on Income

Cumulative Effect on Beginning Retained Earnings

$1,000 950 50 25 $ (25

$ (25

)

)

$1,000 950 50 25 $ 25

$1,100 1,124 (24 12 $ 12

$ 37

$ 12

)

$1,100.00 1,124.00 (24.00 12.00 $ (12.00

$1,000.00 1,091.00 (91.00 45.50 $ 45.50

$ 33.50

$ 45.50

)

)

)††

†

†

$1,000.00 1,091.00 (91.00 45.50 $ (45.50

$1,115.00 1,270.00 (155.00 77.50 $ 77.50

$ 32.00

$ 77.50

)†)†

)††

†

$1,115.00 1,270.00 (155.00 77.50 $ (77.50

$1,237.00 1,480.00 (243.00 121.50 $ 121.50

$ 44.00

$ 121.50

)†)†

)††

†

$1,237.00 1,480.00 (243.00 121.50 $ (121.50

$1,369.00 1,699.00 (330.00 165.00 $ 165.00

$ 43.50

$ 165.00

)†)

)

†

**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




Edition

dollar.






(b)

KIMMEL INSTRUMENT CORPORATIONStatement of Retained Earnings

For the Years Ended May 312011 2010

(restated)2009

(restated)Retained earnings,

April 1, as previously stated $3,005 $2,237 $1,759

Adjustment for the cumulative

effect on prior periods due to change in inventory costing method from FIFO to

average cost

$243 $155 $91

Less applicable taxes(50%) 121 122 77 78 45 46

Retained earnings, April 1, as restated 3,127 2,315 1,805

Net income 514 812 510

Retained earnings, May 31 $3,641 $3,127 $2,315

(c)

2008 2007 2006Inventory:

FIFO basis $1,369 $1,237 $1,115Average cost basis 1,699 1,480 1,270Change, incr. (decr.) $ 330 $ 243 $ 155

Income Tax Payable $164 $121 $77

Retained earnings:FIFO basis $3,475 $3,005 $2,237Average cost basis 3,641 3,127 2,315Change, incr. (decr.) $ 166 $ 122 $ 78






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 taxes payable on the increased income reported rather than a future 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. In these circumstances, there is a major difference between IFRS and ASPE, in that IFRS allows for partial retrospective application and ASPE does not.

For partial retrospective application under IFRS, 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. 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.

Under ASPE, if the entity cannot practicably determine the cumulative effect of the change even at the beginning of the current period, retrospective treatment cannot be applied. Instead, the entity applies the new accounting policy prospectively from the earliest date that is practicable. This





situation may arise if the necessary data were not collected and cannot be recreated appropriately.






If the company were allowed to applying partial retrospective application, the statement of retained earnings would be presented as follows:

KIMMEL INSTRUMENT CORPORATIONStatement of Retained Earnings

For the Years Ended May 312011 2010

(not restated)Retained earnings, April 1, as

previously stated $3,005 $2,237Adjustment for the cumulative

effect on prior periods due to change in inventory costing method from FIFO to average cost $243

Less applicable taxes (50%) 121 122 0 Retained earnings, April 1, as

restated 3,127 2,237Net income 514 768 Retained earnings, May 31 $3,641 $3,005

Also note another major difference between IFRS and ASPE. IFRS requires that a statement of changes in shareholders’ equity be prepared and that an opening balance sheet 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 balance sheet for the earliest comparative period when there is a retrospective change.





PROBLEM 21-5

(a)

1. Accumulated depreciation at:December 31, 2010: $21,474,950

[balance before change (using CCA) ($22,946,000) less excess of CCA over diminishing balance depreciation for financial statement purposes ($1,365,000 + $106,050)]

December 31, 2011: $22,186,000 [balance before change (using CCA) ($23,761,000)

less excess of CCA over diminishing balance depreciation for financial statement purposes ($1,575,000)]

2. Future income tax liability (long-term) at:December 31, 2010: $661,973

[tax effect (45%) of excess of CCA over diminishing balance depreciation for financial statement purposes ($1,365,000 + $106,050)]

December 31, 2011: $708,750 [tax effect (45%) of excess of CCA

over diminishing balance depreciation for financial statement purposes ($1,575,000)]






3. Selling, general, and administrative expenses for the year ended:

December 31, 2010: $18,384,487[balance before change (using CCA)

($18,411,000) less 25% of excess of CCA over diminishing balance depreciation for financial statement purposes for 2010 (.25 X $106,050 = $26,513)]

December 31, 2011: $19,715,312 [balance before change (using CCA) ($19,540,000)

less 25% of excess of CCA accelerated depreciation over diminishing balance depreciation for financial statement purposes for 2011 (.25 X $103,950 = $25,988) plus increase in bad debt expense for 2011 (.0025 X $80,520,000 = $201,300)]

4. Current portion of federal income tax expense for the year ended:

December 31, 2010: $2,860,200December 31, 2011: $2,211,750 [Total income taxes of $2,220,750 less future income

tax expense of $9,000 (decrease in Future Income Tax Asset from 2010 to 2011 [$234,000 – $225,000]) = $2,211,750]






5. Future portion of income tax expense (benefit) for the year ended:

December 31, 2010: $47,723 [tax rate (45%) times excess of CCA over diminishing balance depreciation for financial statement purposes for 2010 ($106,050)]

December 31, 2011: ($34,807) (benefit) [balance before change (using CCA) of $9,000 plus

tax rate (45%) times excess of accelerated depreciation over diminishing balance depreciation for financial statement purposes for 2011 ($103,950) less 45% times increase in bad debts expense for 2011 ($201,300)]






(b) McINTOSH CORPORATIONCondensed Balance Sheet

As at December 312011 2010

Restatedsee note XX

AssetsCurrent assets $43,450,285 a $43,900,000Plant assets, at cost 45,792,000 43,974,000Less: Accumulated

depreciation 22,186,000 21,474,950$67,056,285 $66,399,050

Liabilities and Shareholders’ EquityCurrent liabilities $21,124,000 $23,650,000Long-term debt 15,862,750 b 14,758,973 d

Share capital 11,620,000 11,620,000Retained earnings 18,449,535 c 16,370,077 e

$67,056,285 $66,399,050

a. Current assets – 2011: balance before change (using CCA) $43,561,000 less additional allowance for doubtful accounts, $201,300 plus additional future income tax asset, $90,585 = $43,450,285

b. Long-term debt – 2011: balance before change (using CCA) $15,154,000 plus future income tax liability, $708,750 = $15,862,750

c. Retained earnings – 2011: balance before change $17,694,000 plus reduction in accumulated depreciation 2011 and previous years, net of tax, [$1,575,000 X (1 – 45%) = $866,250] less additional allowance for doubtful accounts, net of tax [($201,300 X 55%) = $110,715] = $18,449,535

d. Long-term debt – 2010: balance before change (using CCA) $14,097,000 plus future income tax liability, $661,973 = $14,758,973

e. Retained earnings – 2010: balance before change (using CCA) $15,561,000 plus reduction in accumulated depreciation for 2010 and previous years, net of tax,





[($1,365,000 + $106,050) X (1 – 45%) = $809,077] = $16,370,077






McINTOSH CORPORATIONIncome Statement

For the Years Ended December 312011 2010

Restatedsee note XX

Net sales $80,520,000 $78,920,000Cost of goods sold 54,769,038 a 52,994,463 b

25,750,962 25,925,537Selling, general and

administrative expenses 19,715,312 c 18,384,487 d

6,035,650 7,541,050Other income (expense), net (1,198,000) (1,079,000)Income before income taxes 4,837,650 6,462,050Income taxes:

Current 2,211,750 2,860,200Future (benefit) (34,807) 47,723

2,176,943 2,907,923Net income $2,660,707 $3,554,127

a. Cost of goods sold – 2011: 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 – 2010: 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. – 2011: 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. – 2010: balance before change (using CCA) $18,411,000 less additional depreciation using correct depreciation calculations, $106,050 X 25% = $18,384,487






McINTOSH CORPORATIONStatement of Retained Earnings

For the Years Ended December 312011 2010

Restatedsee note XX

Opening balance, as previously reported $15,561,000 $12,065,200 a

Plus: Adjustment for the cumulative effect on prior periods of the change in accounting policy (errorcorrection), net of taxes of $661,973 (2010 – $614,250)

809,077 750,750

Opening balance, as restated 16,370,077 12,815,950Net income 2,660,707 3,554,127Less: Dividends (581,250) b c

Ending balance $18,449,534 $16,370,077

a. Beginning Balance – 2010: Ending balance of $16,370,077 (from adjusted balance sheet) less adjusted net income of $3,554,127 less reduction in accumulated depreciation for years prior to 2010, net of tax, [$1,365,000 X (1 – 45%) = $750,750] = $12,065,200

b. Dividends – 2011: beginning balance of retained earnings for 2011 before change $15,561,000 plus unadjusted net income for 2011 $2,714,250 less ending balance of retained earnings for 2011 using incorrect CCA depreciation calculation $17,694,000 = $581,250

c. Dividends – 2010: Since beginning balance of retained earnings for 2010 is not available, the dividends for 2010 are assumed to be nil.





PROBLEM 21-6

(a)Item #1

Equipment.................................................................. 9,200Future Income Tax Liability (30% X $9,200)..... 2,760Retained Earnings (70% X $9,200).................... 6,440

Depreciation Expense ($9,200 / 5)............................ 1,840Retained Earnings ($1,840 X 70%)........................... 1,288Future Income Tax Liability ($3,680 X 30%)............ 1,104

Future Income Tax Benefit ............................... 552($1,840 X 30%)Accumulated Depreciation ($1,840 X 2 years). 3,680

Item #2Depreciation Expense*.............................................. 8,000

Deferred Charges............................................... 8,000

Future Income Tax Liability ($8,000 X 30%)............ 2,400Future Income Tax Expense/Benefit................ 2,400

* A loss on impairment account could also be debited.

Item #3Retained Earnings..................................................... 21,000Future Income Tax Asset ($30,000 X 30%).............. 9,000

Revenues............................................................ 30,000

Future Income Tax Expense ($30,000 X 30%)......... 9,000Future Income Tax Asset................................... 9,000






(b) Hawthorne Corp.Statement of Financial Position

December 31Assets 2011 2010

(restated)

Current assets $ 192,300 $ 177,400 3

Long-term assets 319,520 1 318,360 2

$ 511,820 $ 495,760

Liabilities & Equity

Current liabilities $ 117,000 $ 133,000 6

Long-term

Liabilities 165,256 4 155,208 5

Share capital 50,000 50,000

Retained earnings 179,564 7 157,552 8

$ 511,820 $ 495,760

1 & 2 Long-term assets :2011 2010

Beginning balance 322,000 311,000Item #1:

Add: capitalized interest on equipment 9,200 9,200Less: Accumulated depreciation on capitalized interest on equipment

(3,680)

(1,840)

Item #2: Deferred charge (8,000)

Ending balance $319,520 $318,360

3 Current assets – 2010:





Beginning balance of $168,400 + $9,000 (Future income tax asset related to item #3) = $177,400. Classified as current since it corresponds to operating cycle of Hawthorne Corp.






4 & 5 Long-term liabilities :2011 2010

Beginning balance$166,000

$153,000

Item #1: Future income tax liability 2008: $2,760 – 1,104 = $1,6562007: $2,760 – 552 = $2,208

1,6562,208

Item #2: Future income tax liability reversal on change in estimate

(2,400

)

Ending balance$165,256

$155,208

6 Current liabilities – 2010:

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

7 & 8 Retained earnings :2011 2010


$173,400

Item #1:Change in policy net of tax

($9,200 X [1 – 30%]) 6,440 6,440Less: Amortization on revised

cost of equipment net of tax 2011: $1,840 X 2 X [1 – 30%]2010: $1,840 X [1 – 30%]

(2,576)) (1,288)

Item #2: Deferred charge net of tax ($8,000 X [1 – 30%]) (5,600)

Item #3: Reversal of contract revenue in 2009 net of tax ($30,000 X [1 – 30%])

(21,000)


$157,552






Hawthorne Corp.Income Statement

Year Ended December 312011 2010

(restated)

Revenues $ 505,000 1 $ 460,000

Expenses 387,840 2 377,840 3

117,160 82,160

Income tax (30%) 35,148 4 24,648 5

Net income $ 82,012 $ 57,512 Earnings per share $8.20 $5.75Dividends declared

per share $6.00 $2.50

1 Revenues – 2011:

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

2 & 3 Expenses :2011 2010


$376,000

Item #1: Depreciation on capitalized interest 1,840 1,840

Item #2: Additional depreciation or loss on deferred charges

8,000


$377,840






4 & 5 Income tax expense :2011 2010

Beginning balance $29,100 $25,200Item #1: Reversal of timing difference

on additional depreciation expense (552

)

(552)

Item #2: Reversal of timing difference on deferred charges (2,400

)

Item #3: Reversal of timing difference on long-term contract revenue

9,000

Ending balance $35,148 $24,648

Hawthorne Corp.Statement of Retained Earnings

Year Ended December 312011 2010

(restated)Retained earnings, January 1,

as previously reported $ 173,400 $ 139,600 1

Add: Adjustment for thecumulative effect on priorperiods of the change inaccounting policy, net ofincome tax of $2,208

(2010: $2,760) 5,152 2 6,440 3

Less: Correction of error on

revenue, net of tax of $9,000 (21,000) 4 (21,000)Retained earnings, January 1,

as restated 157,552 125,040 Net income 82,012 57,512





Less: Dividends declared (60,000 ) 5 (25,000) 6

Retained earnings, December 31 $ 179,564 $ 157,552






1 Opening balance of retained earnings – 2010:

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

2 Adjustment due to change in policy – 2011:

Capitalized interest net of tax of $9,200 X [1 – 30%] less additional amortization expense for 2007 of $1,840 X [1 – 30%] = $5,152.

3 Adjustment due to change in policy – 2010:

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

4 Correction of error – 2011 and 2010:

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

5 & 6 Dividends declared – 2011 and 2010:

2011: Dividends per share $6.00 X 10,000 shares = $60,0002010: Dividends per share $2.50 X 10,000 shares = $25,000

(c)

Note A – Change in Accounting Principle on Capitalization of InterestIn 2011, 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 2009, when interest was incurred. The effect of this change on income of prior periods was to increase 2010 depreciation





expense by $1,840 and decrease net income of 2010 by $1,288. Earnings per share for 2010 has also decreased by $0.13.






Note B – Error in Revenue Recognition of Prior PeriodsThe company recognized as revenue a down-payment received in 2009 prior to completion of the related contract. This contract was completed in 2011. There was no impact on 2010 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.

3. No difference in accounting treatment between IFRS and ASPE.





PROBLEM 21-7

(a) ASTON CORPORATIONProjected Income Statement

For the Year Ended December 31, 2011 ________________________________________________________Sales $29,000,000Cost of goods sold $14,000,000Depreciation 1,600,000

a

Operating expenses 6,400,000 22,000,000Income before income taxes 7,000,000Gain on FV-NI investments 1,000,000b

Income before taxes and bonus 8,000,000President’s bonus 1,000,000Income before income taxes 7,000,000Provision for income taxes

Current $ 3,000,000Future 500,000

c 3,500,000

Net Income $ 3,500,000

Conditions met:

1. Net income before taxes and bonus > $7,000,000.2. Payable for income taxes does not exceed $3,000,000.

aDepreciation 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.

bBy 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.





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






(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. Company management is responsible to select the depreciation method that is most relevant to users of financial statements and this is not achieved if the double-declining method achieves better matching of costs to revenues. 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 and related contribution to revenues.

The change would not be unethical depending on the rationale used by the corporate decision makers. It could be justified on the basis that all production equipment should be depreciated using the same policy on the basis of cost-benefit. Considering the immediate needs for cash of $1,000,000 for the president’s bonus and $3,000,000 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).






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 for 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 in-come from bonus may decrease cash available for dividends.

Employees President takes 25% 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 true net income of the corporation. This may lead to unreliable assessments as to creditworthiness.






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 FV-OCI option in 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.





PROBLEM 21-8

(a) KESTERMAN CORPORATIONAdjusting Journal Entries

December 31, 2011

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. Investment Income (FV-NI)......................... 13,000*Investments (FV-NI).......................... 13,000

To reduce trading securities to fair value.*$78,000 – $65,000

3. Retained Earnings...................................... 8,900Cost of Sales............................................... 4,700

Merchandise Inventory....................... 13,600

To adjust for overstatements in opening and closing Inventories.

4. Equipment................................................... 30,000Operating 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 2010.*$2,500 X 2






Accumulated Depreciation—Equipment. . 17,500Equipment........................................... 14,700Gain on Sale of Equipment................ 2,800

To correct the disposal of equipment.

5. Prepaid Expenses....................................... 2,350Operating Expenses ($4,700 ÷ 4).............. 1,175

Retained Earnings.............................. 3,525 ($4,700 – $1,175)

To adjust for nonrecognition of prepaid expense in 2010.

6. No entry is required. The items will be properly reclassified as part of the financial statement preparation.

(b) KESTERMAN CORPORATIONComputation of Corrected Net Income

For the Years Ended December 31, 2011 and 2010

2011 2010

Reported incomeChange in accounts receivable loss experience rate from 2% to 1½%Loss on trading securities Ending inventories overstated: December 31, 2010 December 31, 2011Misposting of equipment purchase Decrease in operating expenses—2010 Increase in operating expenses—2011Misposting of proceeds of equipment soldRecognition of prepaid insurance

Corrected net income

$220,000

5,000(13,000

8,900 (13,600

(2,500 2,800 (1,175 $206,425

)

)

)

)

$195,000

—

(8,900

27,500

3,525$217,125

)






(c) KESTERMAN CORPORATIONCalculation of Corrected Retained Earnings

At January 1, 2011

2010

Retained earnings, January 1,Change in accounts receivable loss experience rate from 2% to 1½%Loss on trading securities Ending inventories overstated: December 31, 2010Misposting of equipment purchase Decrease in operating expenses—2010Recognition of prepaid insuranceRetained earnings, January 1, restated

$247,000

——

(8,900

27,500 3,525$269,125

)





PROBLEM 21-9

(1)Inventory..................................................................... 26,000

Retained Earnings.............................................. 26,000

(2)No entry, as ending inventory has not yet been recorded.

(3)Cash............................................................................ 6,700

Accounts Receivable......................................... 6,700

(4)Depreciation Expense............................................... 4,600

Accumulated Depreciation—Delivery Vehicles........................................................... 4,600


Equipment........................................................... 21,300Gain on Sale of Equipment................................ 3,700

(6)Estimated Litigation Loss.........................................450,000


(7)Depreciation Expense............................................... 5,125Equipment.................................................................. 41,000

Repairs Expense................................................ 41,000

Accumulated Depreciation—Equipment.......... 5,125

(8)Solutions Manual 21-100 Chapter 21




Investment Income/Loss (FV-NI).............................. 12,000Investments (FV-NI)......................................

12,000






(9)Accrued Salaries Payable ($16,000 – $10,600)........ 5,400

Salaries Expense................................................ 5,400

(10)Insurance Expense ($18,000 ÷ 3).............................. 6,000Prepaid Insurance ($18,000 ÷ 3 X 1.5)...................... 9,000


(11)Amortization Expense ($36,000 ÷ 12)....................... 3,000Retained Earnings..................................................... 3,000

Accumulated Amortization—Trademark.......... 6,000





PROBLEM 21-10

(a)1. Retained Earnings [$3,500 X (1 – 40%)]........... 2,100

Income Tax Recoverable / Payable................... 1,400Sales Commissions Payable..................... 2,500Sales Commissions Expense.................... 1,000

2. Cost of Sales ($19,000 + $6,700)....................... 25,700Income Tax Payable................................... 7,600Retained Earnings [$19,000 X (1 – 40%)].. 11,400Inventory..................................................... 6,700

Income Overstated (Understated)

2009 2010 2011

Beginning inventoryEnding inventory

$(16,000)$(16,000)

$16,000) (19,000 $ (3,000

))

$19,000 6,700$25,700

3. Accumulated Depreciation—Equipment.......... 4,800Depreciation Expense................................ 4,800

*Equipment cost......................................... $100,000Depreciation before 2011......................... (36,000 )Carrying amount....................................... $ 64,000

Depreciation to be taken ($64,000/8)....... $ 8,000Depreciation recorded.............................. 12,800Difference.................................................. $ 4,800






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

(b) In the case of long-term contracts, management may not be able to recreate the estimates required to adjust comparative financial information or to recalculate the effect on opening retained earnings for years before 2011.

A change in accounting policy should be applied on a full retrospective basis except where it is impracticable to do so.

Alternative methods of accounting for Situation 4 would include treating the change as a change in accounting policy with full retrospective application if the effect on specific prior periods presented for comparative purposes can be determined.

Situation 4 could also arguably be considered a change in accounting policy under GAAP rather than as the application of a policy to new circumstances. If this was the case, it would likely be an error correction since if you could have measured the revenue appropriately under the percentage of completion you would not have been following GAAP if you used completed contract (since you should have been using percentage of completion).





PROBLEM 21-11

Net Incomefor 2010

Retained Earnings12/31/11

Item Understated Overstated Understated Overstated

1.2.3.4.5.6.

$14,100$11,813 0$33,000 0$12,600

0 0$18,000 0$21,000 0

0$ 8,438 0$33,000 0 0

0 0$ 9,000 0$10,500 0

Explanations:

1. The net income would be understated in 2010 because interest income is understated. The net income would be overstated in 2011 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 2011. The amount of understatement in 2010 would be $18,800 X (1 – 25%) = $14,100.

2. The depreciation expense in 2010 should be $2,250 for this machine. Since the machine was bought on July 1, 2010, only one-half of a year should be taken in 2010 ($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 2010. An additional $4,500 of depreciation expense should have been taken in 2011. At the end of 2011, retained earnings would be understated by $11,250 ($15,750 – $4,500) net of taxes of 25% = $8,438.






3. GAAP requires that all research costs should be expensed when incurred. Net income in 2010 is overstated $24,000 ($36,000 research costs capitalized less $12,000 amortized) X (1 – 25%) = $18,000. By the end of 2011, 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 2007 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 2010, $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 2010 is overstated by $28,000 X (1 – 25%) = $21,000. At the end of 2011, $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 2010 would be understated by $16,800 X (1 – 25%) = $12,600. The ending inventory of 2010 becomes the beginning inventory of 2011. If beginning inventory of 2011 is understated, then net income of 2011 is overstated (inverse relationship). The omission in inventory over the two-year period will counterbalance, and retained earnings at the end of 2011 will be correct.





PROBLEM 21-12

(a)2010 2011

Net income, as reportedRent received in 2010, earned in 2011Wages not accrued, 12/31/09Wages not accrued, 12/31/10Wages not accrued, 12/31/11Inventory of supplies, 12/31/09Inventory of supplies, 12/31/10Inventory of supplies, 12/31/11Corrected net income

$29,000 (1,300 1,100 (1,500

(1,300 740000,000$26,740

)

)

)

$37,000 1,300

1,500 (940

(740 1,420$39,540

)

)

(b)1. Retained Earnings.............................................. 1,300

Rent Revenue.............................................. 1,300

2. Wages Expense.................................................. 940Wages Payable........................................... 940

Retained Earnings.............................................. 1,500Wages Expense.......................................... 1,500

3. Supplies.............................................................. 1,420Supplies Expense....................................... 1,420

Supplies Expense.............................................. 740Retained Earnings...................................... 740






(c)2010 2011

Retained earnings, Jan. 1 as reportedRent received in 2010, earned in 2011Wages not accrued, 12/31/09Wages not accrued, 12/31/10Wages not accrued, 12/31/11Inventory of supplies, 12/31/09Inventory of supplies, 12/31/10Inventory of supplies, 12/31/11Retained earnings, Jan. 1 as restatedNet income (from part (a))Retained earnings, Dec. 31

$95,000

(1,100

1,300

000,000$95,200

26,740 $121,940

)

$124,000 (1,300

(1,500

740

$121,940 39,540

$161,480

)

)




Edition

PROBLEM 21-13INTEQ CORPORATION

Schedule of Revised Income Before Income TaxesFor the Years Ended March 31, 2009, 2010, and 2011

CALCULATIONS SUMMARYIncreases (Decreases) in Income

2009 2010 2011 2009 2010 2011

1. Income before taxes, as reported2. Elimination of profit on consignments:

Billed at 130% of cost

CostProfit error

3. To correct C.O.D. sale4. Adjustment of warranty expense:

Sales per booksCorrection for consignmentsCorrection for C.O.D. saleCorrected salesNormal warranty expense, one-half of 1%Less costs charged to expenseAdditional expense

6. Bad debt adjustments:Normal bad debt expense, one-quarter 1% of salesLess previous write-offsAdditional expense

7. Adjustment for contract financing8. Adjustment for commissions

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

Revised income before income taxes

$ 6,500÷ 130 5,000

$ 1,500

$940,000 (6,5000000,0

$933,500

$ 4,668 760

$ 3,908

$ 2,334 750

$ 1,584

%

)

$ 1,500

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

$1,022,600

$ 5,113 1,670

$ 3,443

$ 2,557 1,320 $ 1,237

$ 5,590÷ 130 4,300

$ 1,290

$1,795,000 (5,590

(6,100 $1,783,310

$ 8,917 3,850

$ 5,067

$ 4,458 3,850

$ 608

%

))

$71,600

(1,500

(3,908

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

(331 $65,877

)

)

)

)

)

$111,400

1,500 6,100

(3,443

(1,237 3,900 600 118,820

(594 $118,226

)

)

*

)

$103,580

(1,290(6,100

(5,067

(608 5,100 (320 95,295

(476

$94,819

))

)

)

)**

)




Edition

*$1,400 – $800 **$800 – $1,120





PROBLEM 21-13 (Continued)(b) INTEQ CORPORATION

Journal EntriesMarch 31, 2011

Sales.................................................................... 5,590Merchandise on Consignment.......................... 4,300

Cost of Goods Sold.................................... 4,300Accounts Receivable................................. 5,590

To adjust for consignments treated as sales, 3/31/11

Sales.................................................................... 6,100Retained Earnings...................................... 6,100

To adjust for C.O.D. sales not recorded, 3/31/10

Warranty Expense.............................................. 5,067Retained Earnings ($3,908 + $3,443)................ 7,351

Estimated Liability Under Warranties....... 12,418To set up allowance for warranty expense

Retained Earnings ($331 + $594)...................... 925Manager’s Bonus Expense................................ 476

Accrued Bonus Payable............................ 1,401To set up accrued bonus payable to manager

Retained Earnings ($1,584 + $1,237)................ 2,821Bad Debt Expense.............................................. 608

Allowance for Doubtful Accounts............. 3,429To set up allowance for uncollectible accounts

Dealers’ Fund Reserve (held by bank)............. 12,000Finance Expense........................................ 5,100Retained Earnings ($3,000 + $3,900)......... 6,900

To record finance charge reserve held by bank

Commissions Expense...................................... 320Retained Earnings ($1,400 – $600)................... 800

Accrued Commissions Payable................ 1,120





To adjust for accrued commissions

PROBLEM 21-14

(a) and (b)(1)

Retained Earnings..................................................... 52,000Allowance for Doubtful Accounts..................... 47,000Accounts 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 debts expense in its comparative financial statements.

(2)

Note that 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 for accumulated depreciation due to the change in method since a change from one depreciation method to another is a change in estimate, not a change in accounting policy.

The change in estimate during 2011 for the remaining useful life is accounted for prospectively. Changes in estimates are applied after any change in policy has been accounted for.

(3)Computer.................................................................... 3,000


Retained Earnings..................................................... 1,000Accumulated Depreciation—Computer........... 1,000($3,000 / 3)





This is a correction of an error. Since the error affects only 2011, no retrospective application is necessary.






(4)Supplies...................................................................... 1,500


This is a correction of an error. Retrospective application is required for the 2010 balance in supplies. Since this is a counter-balancing 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)Temporary Trading Investments (FV-NI)................. 3,000

Investment Income (FV-NI)................................ 3,000

This is a correction of an error that affects only the current year. Retrospective correction is not required.

(c) As a privately held entity, Vegatron may choose to follows either accounting standards for private enterprises (ASPE) or IFRS. Vegatron could possibly account for its trading investment using the fair value through other comprehensive income (FV-OCI) model under IFRS (provided that the investment qualifies for the special election), which must be accounted for using the fair value through net income (FV-NI) model under ASPE, This would allow the holding gains and losses to bypass net income and be reporting in other comprehensive income instead.

(d) (1)

Retained Earnings*.................................................... 30,000Bad Debts Expense................................................... 22,000

Allowance for Doubtful Accounts..................... 47,000Accounts Receivable......................................... 5,000

*Beginning balance in the allowance for doubtful accounts.






(2)

Note that this is considered to be a correction of an accounting error since the company is changing from a non-GAAP method to a GAAP method. The change in estimate is accounted for prospectively.

Accumulated Depreciation* 7,175Retained earnings 7,175

*($35,000 – $20,825) – 2 X ($35,000/10)

Depreciation Expense** 5,400Accumulated Depreciation5,400

**($35,000 – $7,000) / 5(3)

Computer.................................................................... 3,000Operating Expenses.......................................... 3,000

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

(4)Supplies...................................................................... 1,500

Supplies Expense.............................................. 500Retained Earnings.............................................. 1,000

(5)Temporary Trading Investments (FV-NI)................. 3,000

Investment Income (FV-NI)................................ 3,000





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.


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.


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.


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.





TIME AND PURPOSE OF WRITING ASSIGNMENTS(Continued)


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.


Purpose—to provide the student with an opportunity to understand the differences between ASPE and IFRS and the conceptual reasons for any differences.





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 prohibited.

2. This is a change in an accounting estimate. Restatement of opening retained earnings is prohibited.

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, 2011. The entry required at January 1, 2011, would be the following:

Land ($900,000 – $750,000).......................................... 250,000Deferred Income Taxes ($250,000 X 30%).......... 75,000Revaluation Surplus (in equity)............................. 175,000

5. As this is a correction of an error, the change must be applied retrospectively. As this is a change to other comprehensive income for 2010, a restatement of the AOCI in equity is required, not retained earnings. The journal entry would be as follows:

Deferred Income Taxes ($200,000 X 30%).................... 60,000AOCI - Investment at FV through OCI – equity.............. 140,000

Investment............................................................ 200,000





WA 21-1 (Continued)

(c) The statement of changes in equity for 2011 would be the following:

All in C$s Share capital

Retained earnings

OCI – investments

at FV through OCI

Revalua-tion

Surplus

Total

Balance - January 1, 2010 $1,000,000 $2,500,000 $650,000 $4,150,000

Comprehensive Income – as restated 910,000 335,000 * 1,245,000

Balance – December 31, 2010 as restated 1,000,000 3,410,000 1,125,000 5,535,000

Effect of adoption of change in policy to revaluation for land 175,000 175,000

Balance – January 1, 2011 as restated 1,000,000 3,410,000 1,125,000 175,000 5,710,000

Comprehensive income 2011 1,350,000 150,000 1,500,000

Balance December 31, 2011. 1,000,000 4,760,000 1,275,000 175,000 7,210,000

* Comprehensive income for 2010 is restated for the overstatement in the investment:$475,000 – $140,000 = $335,000





WA 21-1 (Continued)

(d) For the error correction for item 5, the company needs to report the impact of this change on 2010’s comprehensive income and restate the opening balances of 2011 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, 2011. 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 only affect 2010, this would already be provided as the comparative information for 2011.

WA 21-2

ItemChange Type of Change

Restatementof 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.

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.

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

Yes

No

4. Treated as if it were an error correction, as a change in classification.

Yes

5. An error correction. Yes





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

No





WA 21-2 (Continued)

ItemChange Type of Change

Restatementof Prior Years

7. 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.

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.





WA 21-3

Memorandum to: Ali Reiners, ControllerFrom: AccountantSubject: 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, 2011. 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 IAS8. 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, 2011 – 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.

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

WA 21-4

1. The change to a units-of-production method from straight-line is a change in an estimate under IFRS, but a change in accounting policy under ASPE. 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. As a change in an accounting policy, the change would be retrospectively applied with disclosure on the impact on prior periods (if practicable to determine) and the current period.

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 be 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. The change in the treatment of the actuarial gains and losses is an accounting policy change that must be applied retrospectively. Under IFRS, the changes would be made in prior periods and an opening balance sheet for the earliest comparative period would be required. The company would have to justify this new treatment by stating why it is more relevant than the corridor approach. In addition, disclosure is required on the impact on the assets and liabilities of the prior years and the impact on earnings for the current year, as well as prior years. An opening balance sheet for the earliest comparative period would be required.

Under ASPE, this is a choice in measuring and reporting actuarial gains and losses, and is also a change in accounting policy. However, there is no need to justify this change in the notes. The change would be retrospectively applied, and disclosure of the impact on the current and prior financial statements would be noted. There is no requirement for an opening balance sheet for the earliest comparative period.

4. 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 OFRS and ASPE, along with the nature of the error and its impact on the current and prior periods. Again, under IFRS, an opening balance sheet is required for the earliest comparative period presented.





WA 21-4 (Continued)

5. 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.

6. 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.





WA 21-5

(a) The Canadian standard for private enterprises for accounting changes 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 as 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 on a basis that is consistent with the newly adopted policy, as 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.





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.





WA 21-6

The first case, the incorrect calculation of the current portion of long-term debt, is related to an error correction. Under GAAP, 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 21-132 Chapter 21




WA 21-6 (Continued)

(b) Whenever changes are made to a standard, the IASB also provides transitional rules. There are two options here: a requirement for retrospective restatement or an allowance for prospective treatment. If retrospective restatement is required, then all prior years would be restated implementing the new definition of what is current. This would ensure that all prior years presented were fully comparative. But this restatement would also take more time to gather the data and it may be that the information is not practicably available. Prospective treatment would be less time consuming and would not require prior period information to be gathered. In contrast, however, the prior period would not be comparable and ratios such as the current ratio could be significantly distorted over the comparative periods.





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 minimal 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.





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).





IC 21-1 TEMPLE LIMITED

Overview

- The company is expanding and assets are recorded at historical costs, which do not reflect its true value.

- 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 true value and also the negative impact of this and the new loan on the debt to equity ratio. There may be some bias to attempt to “manage” these numbers.

- Investors and creditors (Lendall Bank) would appreciate statements that reflect true value and risk (reflect the hidden value).

- It is a public company (shares list on TSX) and therefore IFRS is a constraint.

- Controller should ensure that statements are transparent.


- Using fair values to value real estate assets is acceptable under IFRS. It provides greater transparency and more relevant information. Gains and losses are booked through income.

- The company is currently constrained by pre-2011 Canadian GAAP however, which does not allow comprehensive revaluation of assets except if change of ownership or financial reorganization.

- Canada will be transitioning over to IFRS for years beginning on or after January 1 2011, for public companies.

- Will need to gather information for comparative balance sheet (including opening balance sheet and closing balance sheet for 2010), so should start to collect this information. IFRS will be accounted for retrospectively and IFRS 1 is the standard that governs the transition.

- Not allowed to early adopt but should provide note disclosure regarding market values as this represents more relevant information and will allow users to recalculate the debt to equity ratio— a key ratio in a capital intensive industry such as this.





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 his bonus (NI is a key number since bonus is based on this). A bias may also exist since Theo will want to pay his 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.

Assume IFRS since the company is being audited (role –—auditor). 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 Theo is performing.

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


Issue: Revenue recognition Due to the aggressive sales policy, sales are up 20%, however, this figure might be inflated.

Recognize revenues Defer recognition- 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.

- 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.

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

future benefit since it will help track inventory. In the past, this has been a source of lost profits.

- SEM owns the new system and will be able to use it once it is complete.

- Theo is confident that he will be able to find another software company to complete.

- The software company SL has gone bankrupt and therefore may not be able to finish the software – thus there is no future benefit and this is a sunk cost.

- Without the project being completed, SEM has no access to potential future benefits.

- Care should be taken since Theo may not want to admit failure, since it will also affect his bonus and the perception about how he 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.





IC 21-2 (Continued)

Issue: Bonus

Accrue bonus for Theo and sales staff Do not accrue- The payment for Theo is likely

as he 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.

- 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





RESEARCH AND FINANCIAL ANALYSIS

RA21-1 EASTERN PLATINUM

(a) (i) Note 25 outlines the company’s adoption of IFRS. The company has applied IFRS retrospectively from January 1, 2008, except for exemptions allowed under IFRS1.

(ii) The exemptions applied were as follows: Business combinations – the standard IFRS 3 related to business

combinations has been prospectively applied, effective January 1, 2008.

Cumulative translation differences – the company has applied the exemption from IAS 21 which allows the company to eliminate all cumulative translation differences to retained earnings. This will result in no impact on future disposals of these foreign subsidiaries related to translation gains or losses arising prior to January 1, 2008.

Share based payments – Eastplats 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 1, 2008.

Consolidated financial statements – Since Eastplats did not retrospectively adopt IFRS 3 on business combinations, the company may also apply the exemption of IAS 27 related to consolidation. Consequently, IAS 27 is applied prospectively.

Borrowing costs – The company has decided to apply IAS 23 on borrowing costs prospectively, effective January 1, 2009.

(iii) As indicated in note 25 (h) to (o), the company’s assets and liabilities at January 1, 2008, December 31, 2008 and revenue and expenses for 2008, have been impacted as follows:





RA 21-1 (Continued)

In thousands of $USs

January 1, 2008 Balances

December 31, 2008Balances

2008 profit or loss

(h) revenue – due to present value of revenue

(597) reduction in receivables

(125) reduction in receivables

1,517 reduction in revenue; 1,863 increase in interest income

(i) property plant and equipment due to environmental rehabilitation provision

1,929 increase in PP&E

277,566 reduction in PP&E - cumulative with impairment and environmental rehabilitation provision

63 increase in depreciation

(j) share-based payments vesting and forfeiture revisions

336 increase in equity settled employee benefits

335 increase in share based payments

(k) environmental rehabilitation provision adjusted for changes in the discount rate

1,929 increase in PP&E;3,335 increase in environmental rehabilitation provision

277,566 reduction in PP&E - cumulative with impairment and environmental rehabilitation provision; 2,752 increase in environmental rehabilitation provision

174 increase in finance costs

(l) classification of all deferred tax accounts as non-current

1,646 reclassification of deferred tax liabilities from current to non-current

1,178 reclassification of deferred tax liabilities from current to non-current;82,798 (81,620 + 1178) increase in deferred tax liabilities due to impairment





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

January 1, 2008 Balances

December 31, 2008Balances

2008 profit or loss

(m) OCI adjustments related to cumulative translations adjustments

3,994 reduction in currency translation adjustment

27,475, reduction in Increase in other comprehensive loss related to translation gains and losses

(n) Impairment tests for mineral properties

277,566 reduction in PP&E - cumulative with impairment and environmental rehabilitation provision

297,285 increase in impairment losses; 71,490 increase in deferred tax recovery

(o)_ some presentation changes

748 increase in current portion of finance lease liabilities; reclassification of finance leases for 5,057 and loans for 3,322 from capital lease non-current liabilities ;

7,396 increase exchange differences on translating non-controlling interests;247 increase in current loans

(b) For standards issued, but not yet effective, Eastplats listed these in Note 3 (x), noting the standard number and title and its effective date. The company disclosed that it did not early adopt any these standards and it is currently assessing the impact on its financial statements.





RA21-2 RESEARCH IN MOTION LIMITED

(a) As indicated in Note 4, the restatement is a result of errors made in the reporting of certain stock options granted by the company since December 4, 1996, when the stock option plan was adopted.

The review was completed by the Special Committee and involved the revising of all the facts related to 3,231 grants of options to acquire common shares that were made to 2,034 employees between December, 1996 and August 2006. The Committee reviewed electronic and paper documents and interviewed senior managers and the directors. The error was in using the wrong measurement date on which to determine the value of the options. The Stock Option Plan outlined that all options were to be approved by the Board of Directors or the Compensation Committee. Furthermore, the exercise price of the options granted was to be no less than the closing price of the common shares on the last trading day preceding the date on which the grant was approved. The review by the Special Committee found that the majority of grants made used an incorrect measurement date for accounting purposes, causing the exercise price to be less than the fair market value of the common shares on date on which the options were approved. In some cases, hindsight had been used to determine the most favourable exercise price for the option. This resulted in some options being in the money, but not being correctly recorded as an in-the-money option for reporting purposes. Three different types of errors were found that related to misapplying the accounting standards related to share awards.

Under the company’s policy, the exercise price for options was to be set as the share price on the last trading day preceding the date of the approval for the granting of the options. Back dating of the options means to set an exercise price that was before the actual date of the grant. In this case, the company looked to find the lowest price in the past to set as the exercise price, even though this was well before the actual date that the options were approved for granting.





RA 21-2 (Continued)

(b) The net impact of these errors each year are as follows: (as provided in note 4)

In millions of US$ Expense (Benefit)

Cumulative effect on Retained earnings

1999 27.7 27.72000 551.7 579.42001 (316.9) 262.52002 (46.5) 216.02003 11.5 227.52004 5.5 233.02005 7.8 240.82006 7.4 248.2

It appears that the largest impacts were in the early years of 2000 and 2001.

(c) The impact on the expenses for each of the years is as follows:(additional expenses)

In thousands of US$ March 4, 2006 February 26, 2005Cost of sales 383 396Research and development 1,258 1,485Selling, marketing and administration 2,897 3,108Tax impact 2,884 2,786Net reduction to net income 7,422 7,775Net income before error corrections 382,078 213,387Error correction as % of net income 1.9% 3.6%Impact on EPS - basic $(0.04) $(0.04)Impact on EPS – diluted $(0.05) $(0.05)

(d) The impact on the balance sheet of March 4, 2006 is to increase the Deferred income tax asset by $1,775 million, increase Accrued liabilities by $5,127 million, increase Capital stock by $216,315 million, decrease Retained earnings by 248,202 million and increase Paid- in capital by 28,535 million. The impact on ratios is calculated below:





RA 21-2 (Continued)

In thousands of US$ Before restatement After restatementCurrent assets 1,256,997 1,258,772Current liabilities 279,098 284,225Current ratio 4.50 4.43Total liabilities 313,807 318,934Total equity 1,998,767 1,995,415Debt /equity 0.16 0.16

There is a slight deterioration in the current ratio, but since it is already very high, at over 4, this slight reduction would not have impacted an investor’s decision. Similarly, the debt to equity does not change, since the equity is so high, and it remains consistent at 0.16 before and after the restatement.

(e) There is no net impact on the operational cash flows for either year. The restatements in the net income are offset by restatements in the deferred tax adjustments, the share based payments adjustments and net working capital adjustments.





RA21-3 CANADIAN TIRE CORPORATION, LIMITED

(a) As indicated on the Consolidated Statement of Changes in Shareholders’ Equity, the company had transitional adjustments on adoption of HB 1000 and 3064 which impacted the opening balance of Retained Earnings for the years ended January 2, 2010 and January 3, 2009. The impacts on the opening balances were reductions of $4.3 million in 2009 and $3.1 million in 2010. These accounting changes would be retrospectively applied. The company also had a transitional adjustment to 2010 retained earnings of an increase of $1.1 million related to the adoption of EIC 173. Finally, there was a transitional amount to accumulated other comprehensive income in 2010 which resulted in a reduction of $2.5 million and was related to the adoption of EIC 173.All of these changes are discussed in Note 1.

(b) Note 1 discusses the changes in accounting policies as part of disclosure on significant accounting policies. All of these changes related to changes in the standards. There were no voluntary changes, changes in estimates, or errors noted. The following changes were discussed:

Financial statement concepts – Effective January 4, 2009, the company adopted retrospectively changes to CICA HB 1000 which impacted deferred costs and which is part of the adoption of CICA HB 3064 on Goodwill and Intangible Assets. The changes were effective for year ends beginning on or after October 1, 2008.

Credit risk and the fair value of financial assets and financial liabilities – Effective January 4, 2009, the company adopted CICA HB EIC 173 which states that credit risk of the entity and the counterparty must be considered in determining the appropriate discount rate to determine the fair values of the financial instruments. This adoption was applied retrospectively with the opening balances of financial assets and liabilities remeasured using the appropriate credit risk adjusted rates. Any differences are to be reported as an adjustment to opening retained earnings or the accumulated other comprehensive income account (as appropriate). This adoption required an adjustment to increase opening retained earnings (for 2010) by $1.1 million and to decrease the opening AOCI for 2010 by $2.5 million. These amendments were effective for financial statements ending on or after January 1, 2009.





RA 21-3 (Continued)

Financial Instruments disclosures – CICA HB 3862 was amended in June 2009 to require disclosure on categorizing the measures used to determine the fair values of financial instruments into three levels. The company does not need to provide comparative disclosure and as a result disclosure for only 2010 is provided in the notes. There is no numerical impact on the financial statements for the adoption of this amendment. These amendments were effective for years ending after September 30, 2009.

Financial instruments – impairment of debt instruments – In August 2009, CICA HB 3855 and HB 3025 were amended to outline the classifications allowed for debt instruments and the impairment for held-to-maturity financial assets. The company was not impacted by this change. The amendments were effective for years beginning after November 1, 2008.

Capital Management Disclosures – CICA HB 1535 requires companies to disclose information about its objectives, policies and processes for managing its capital. This new standard is disclosure only, so there is no numerical impact on Canadian Tire’s financial statements. The new note disclosure was effective for years beginning on or after October 1, 2007.

Goodwill and intangible assets – CICA HB 3064 was effective for years beginning on or after October 1, 2008 and is to be applied retrospectively. Canadian Tire implemented this new standard effective January 4, 2009. The standard changes the accounting policies on recognizing, measuring and reporting goodwill and intangible assets. Internally developed software must now be reported as intangible assets, rather than as property and equipment. In addition, development costs can only be recognized as assets if they meet the definition of an intangible asset, otherwise they need to be expensed when incurred. The total impact of the adoption of this standard had the following impact on the company’s prior years’ statements:





RA 21-3 (Continued)

In millions of $ January 3, 2009 December 29, 2007Retained earnings (3.1) (4.3)Long-term receivables and other assets

(3.3) (4.6)

Intangible assets 189.5 174.0Property and equipment

(190.9) (175.8)

Income taxes recoverable

0.4 0.4

Future income tax liabilities

(1.2) (1.7)

In addition, there were the following retrospective impacts to net earnings for the year ended January 3, 2009 as follows:

i. decrease of $2.7 million to depreciation and amortization ii. an increase of $0.9 million for the write off of deferred development

costs to cost of merchandise and other operating expense ;iii. net impact on net earnings was an increase of $1.2 million.

(c) In Note 1, Canadian Tire also discloses future accounting changes as follows:

Business combinations – CICA HB 1582 was introduced and is effective for acquisitions arising in years beginning on or after January 1, 2011, with earlier adoption permitted. This standard is to be applied prospectively. Canadian Tire did not elect to early adopt this standard.

Financial instruments – recognition and measurement – CICA HB 3855 was amended to include guidance on embedded prepayment options and is effective for years beginning on or after January 1, 2011. This standard has no impact on Canadian Tire’s financial statements.

Multiple deliverable revenue arrangements - EIC 175 was issued and requires the use of the relative selling price method (and prohibits the residual method) to determine revenue under multiple deliverable contracts. This EIC is effective for years beginning on or after January 1, 2011, and Canadian Tire is currently determining the impact that this new guidance will have.





IFRS – IFRS adoption will be required effective for years beginning on or after January 1, 2011. The company is currently assessing the impact of this adoption.





RA 21-3 (Continued)

(d) In the MD&A for Canadian Tire, the company has outlined its transition plans to IFRS. The company has developed three phases for this adoption as follows:

Phase One – Preliminary scoping and diagnostic impact assessment – Over the period 2007 to 2008, this phase included high level assessment of differences between Canadian GAAP and IFRS, and the hiring and training of appropriate personnel.

Phase Two – Detailed Analysis and Design – Starting in Quarter 4 of 2008, this Phase involves detailed work in 13 key areas that the company has assessed to have the most significant impact for the company. The detailed work included the choices to be made, where applicable, and the new disclosure required.

Phase Three – Execution – This Phase builds on the analysis completed in Phase 2. Work is being done to determine the impact on the financial statements, changes to systems and processes required, drafting of pro-forma statements and related note disclosure.

The company also provides a detailed table of the impact that the changeover to IFRS will have on the company’s financial statements. These impacts are summarized below:

Standard Preliminary assessment of impactConsolidations (IAS 27,28)

Glacier Credit Card Trust will be consolidated (currently a VIE off the balance sheet). This will impact assets and liabilities.Other relationships with CTR Dealers, PartSource franchisees, Mark’s franchisees and charities do not need to be consolidated.

Securitizations (IAS 39)

As noted above, the Glacier Credit Card Trust will be consolidated and no longer meet the derecognition criteria to record the securitization transactions.

Borrowing costs (IAS 23)

Borrowing costs will be capitalized on real estate projects that only meet the criteria, and will also start to capitalize borrowing costs on other classes of assets if the criteria are met ( IT projects)





RA 21-3 (Continued)

Property, plant and equipment (IAS 16)

Company will continue to use the cost model, and adopt components for depreciation purposes for some of the fixed assets

Leases (IAS 17) Some of the current operating leases will be classified as finance leases under IFRS and will be capitalized impacting the assets, liabilities and net earnings

Impairment of assets(IAS 36)

Assets are more likely to be impaired under IFRS; the company is also determining its cash generating units

Share based payments (IFRS 2)

The company is still assessing the impact of using fair values for these awards

Compensation and benefits (IAS 19)

The company has decided to record revaluation gains and losses on post employment benefit plans to OCI which will increase liabilities and decrease equity

(e) Below, the table outlines the exemptions that the company proposes to apply on adoption of IFRS:

Optional exemption Description of exemption Company’s intention

Business combinations May apply IFRS 3 prospectively from date of adoption

Use this exemption

Share based payments Exempt from adopting IFRS 2 to previous grants of share awards

Use this exemption to the extent possible

Fair value or revaluation as deemed cost

May initially measure PP&E at fair value on transition

Will selectively adopt

Employee benefits Reset cumulative actuarial Intends to use





gains and losses to zeroRA 21-3 (Continued)

Cumulative translation differences

Reset cumulative translation differences to zero

Intends to use

Designation of previously recognized financial instruments

May designate any financial assets as available-for-sale or fair value through profit or loss

Intends to use on selective basis

Decommissioning liabilities Not to apply IFRIC 1 which requires specified changes to the decommissioning liabilities to be reported against the related asset

Intends to use

Borrowing costs Adopts IAS 23 prospectively

Intends to use





RA21-4 RESEARCH CASE

The answers will vary based on which companies are chosen once 2009 and 2010 financial statements are released.





RA21-5 RESEARCH CASE L’OREAL

(a) In note 1, L’Oreal details the changes in accounting policies during the year as follows:

Consolidated financial statements have been prepared in accordance with the IFRS standard adopted by the EU on December 31, 2009.

The company only applied standards and interpretations that were compulsory in 2009.

IFRS 8 – Operating segments – was effective January 1, 2009 but has no impact on the presentation of segments.

IAS 23 – Borrowing costs – Real estate assets being constructed may be impacted by the required capitalization of borrowing costs which is effective January 1, 2009. During the year, the company did not have any assets under construction that would qualify for these borrowing costs to be capitalized.

Other new standards or interpretations do not have any impact on the statements, unless specifically identified in the notes. (There is no listing of what these were.)

The company states that it is concerned about the Business Combination and Consolidation standards that have not been early adopted but will be for 2010. But these concerns are not described.

The company also notes concerns about IFRS 9 Financial instruments which will be implemented in 2013. But these concerns are not described.

Advertising and promotion expenses – IAS 38 requires that costs for samplers , non-amortizable POS and mail order catalogues now be expensed when incurred rather than on delivery to the customer. The impact of this change is the following:

In millions of Euros December 31, 2008

December 31, 2007

January 1, 2007

Other current assets POS and samples

-121.7 -118.5 -121.7

Deferred tax assets 26.4 25.6 25.9Deferred tax liabilities -6.0 -5.4 -6.0Shareholders’ equity -89.3 -87.5 -89.8





RA 21-5 (Continued)

The prior years’ income statements have not been restated because the impact on profit or loss is not significant due to the “stability of the prepaid expenses”.

Immediate recognition of actuarial gains and losses related to employee benefits – L’Oreal adopted the choice to immediately recognize actuarial gains and losses in equity, rather than using the corridor approach, effective January 1, 2009. This change had the following impact:


December 31, 2007

January 1, 2007

Provision for employee retirement

267.2 101.4 272.4

Deferred tax assets 43.8 22.4 67.4Deferred tax liabilities

-54.0 -14.4 -26.4

Shareholders’ equity -169.4 -64.6 -178.6

Customer loyalty program – IFRIC 13 provides guidance on customer loyalty programs effective January 1, 2009. The company uses free products or gifts to customers for brand loyalty. The implementation of this guidance results in timing differences of revenue recognition and related costs when the gift is a free catalogue product. The impact of this change on the prior years, is as follows:


December 31, 2007

January 1, 2007

Other current liabilities

10.0 9.2 9.7

Deferred tax assets 1.6 2.0 2.1Deferred tax liabilities -1.0 -0.3 -0.4Shareholders’ equity -7.4 -6.9 -7.2

Even though profit or loss is slightly impacted, the prior year results have not been restated.





RA 21-5 (Continued)

In the Statement of Changes in Equity, the company reported the impact on the opening balances for January 1, 2007 as follows:

Retained earnings – a decrease of €96.9 million Items directly recognized in equity – a decrease of €278.6 million, and Minority interest - a decrease of €0.1 million.

The balance sheet has been adjusted for January 1, 2007, December 31, 2007, and December 31, 2008 for the changes in the accounting policies noted above.The Profit or Loss Statements have not been restated.

(b) Under IFRS, the company must provide an opening balance sheet for the earliest comparable period when restating financial information. In this case, the company has provided the opening balance sheet as of January 1, 2007.

(c) Yes, the company has reported two changes in presentation in note 1: The company now has a new statement entitled “Consolidated Statement

of net profit and gains and losses directly recognized in equity”, as required by IAS 1.

Foreign exchange gains and losses are now included in the various line items to which they relate, rather than being grouped into a single line item.





RA 21-6

Answers will depend on the newly released standards.





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