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about the implicit rate unavailable to the lessee, and (2) residual value guarantees. 15Richard Dieter, “Is Lessee Accounting Working?” CPA Journal (August 1979), pp. 13–19. This article provides interesting examples of abuses of GAAP in this area, discusses the circumstances that led to the current situation, and proposes a solution. 16The reason is that most lessors are banks, which are not permitted to hold these assets on their balance sheets except for relatively short periods of time. Furthermore, the capital lease transaction from the lessor’s standpoint provides higher income flows in the earlier periods of the lease life. Special Lease Accounting Problems 1303 The lessee’s use of the higher interest rate is probably the more popular subter- fuge. Lessees are knowledgeable about the fair value of the leased property and, of course, the rental payments. However, they generally are unaware of the estimated residual value used by the lessor. Therefore, the lessee who does not know exactly the lessor’s implicit interest rate might use a different (higher) incremental borrowing rate. The residual value guarantee is the other unique, yet popular, device used by lessees and lessors. In fact, a whole new industry has emerged to circumvent symmetry between the lessee and the lessor in accounting for leases. The residual value guarantee has spawned numerous companies whose principal, or even sole, International function is to guarantee the residual value of leased assets. Perspective Because the minimum lease payments include the guaranteed residual The IASB and the FASB are value for the lessor, this satisfies the 90 percent recovery of the fair value test. working on a joint project to The lease is a nonoperating lease to the lessor. But because a third-party guar- reconsider lease accounting antees the residual value, the minimum lease payments of the lessee exclude standards. the guarantee. Thus, by merely transferring some of the risk to a third party, lessees can alter substantially the accounting treatment by converting what would otherwise be capital leases to operating leases.17 The nature of the criteria encourages much of this circumvention, stemming from You will want to weaknesses in the basic objective of the lease accounting guidelines. Accounting rule- read the makers continue to have poor experience with arbitrary break points or other size and IFRS INSIGHTS percentage criteria—such as rules like “90 percent of” and “75 percent of.” Some believe on pages 1331–1341 that a more workable solution is to require capitalization of all leases that have noncancel- for discussion of able payment terms in excess of one year. Under this approach, the lessee acquires an asset IFRS related to lease (a property right) and a corresponding liability, rather than on the basis that the lease trans- accounting. fers substantially all the risks and rewards of ownership. Evolving Issue LEASE ACCOUNTING—IF IT QUACKS LIKE A DUCK Three years after it issued a lease accounting pronounce- A quick look at the current leasing market, and some possible effects ment, a majority of the FASB expressed “the tentative view of the proposed rules: that, if the lease accounting rules were to be reconsidered, • $600 billion. Annual volume of leased equipment. they would support a property right approach in which • 70%. Volume of real estate leases as a percentage of all all leases are included as ‘rights to use property’ and as leases held by U.S. public companies. ‘lease obligations’ in the lessee’s balance sheet.” The FASB • $1.3 trillion. Amount of operating lease payments that U.S. and IASB have issued a proposal on lease accounting to public companies will bring back on balance sheets as capital leases under the proposed rule. address off-balance-sheet reporting of leases. As summa- • 7%. Potential first-year average increase in lease expense rized in the adjacent table, early analysis of the potential for a 3-year lease. impact of the proposed leasing rules indicates significant • 21%. Potential first-year average increase in lease expense

impacts. for a 10-year lease. As indicated, over $1.1 trillion of operating leases will Source: Equipment Leasing and Finance Association, 2009; come on-balance-sheet if the rules are adopted. In addition, PricewaterhouseCoopers and Rotterdam School of Management, 2009. 17As an aside, third-party guarantors have experienced some difficulty. Lloyd’s of London, at one time, insured the fast-growing U.S. computer leasing industry in the amount of $2 billion against revenue losses, and losses in residual value, for canceled leases. Because of “overnight” technological improvements and the successive introductions of more efficient and less expen- sive computers, lessees in abundance canceled their leases. As the market for secondhand computers became flooded, residual values plummeted, and third-party guarantor Lloyd’s of London projected a loss of $400 million. The lessees’ and lessors’ desire to circumvent GAAP stimulated much of the third-party guarantee business. 1304 Chapter 21 Accounting for Leases there will be a significant negative impact on lessee income As shown below, the frontloading of lease expenses will statements in the early years of leases. be felt by lessees in several industry sectors. Lease Expense Impacts by Industry Sector First-Year Cumulative Typical % Increase % Increase Lease Term Prompted by Through Sector (Years) New Rules* Peak Year* Airline 17 26% 128%/yr. 9 Automotive fleet 3 4 N/A Banking 10 21 64%/yr. 5 Copier/office equipment 3 7 7%/yr. 3 Equipment manufacturers 5 11 17%/yr. 2 Health-care equipment 5 11 17%/yr. 2 Information technology 3 7 7%/yr. 2 Rail 22 26 200%/yr. 12 Real estate 10 21 64%/yr. 5 Trucking 7 16 33%/yr. 4 *As compared with the straight-line method of accounting. Source: Equipment Leasing and Finance Association, 2009. Given these effects—increased reported debt and lower the same time, an analysis of the new rules and how they income—as a consequence of these proposed rules, it is not might impact the advantages of leasing presented in the surprising that the FASB (and IASB) are receiving numerous following table suggests that many of the advantages of comments opposing changes in lease accounting rules. At leases will remain after implementation of the new rules. Reason for Leasing Details Status After Proposed New Rules Implemented Funding source Additional capital source, 100% fi nancing, fi xed rate, Still a major benefi t versus a purchase—money level payments, longer terms. loan fi nancing, fi xed rate, level payments— especially for smaller companies with limited sources of capital. Low-cost capital Low payments/rate due to tax benefi ts, residual and Still a benefi t versus a loan. lessor’s comparatively low cost of funds. Tax benefi ts Lessee cannot use tax benefi ts and lease versus buy Still a benefi t. shows lease option offers lowest after tax cost. Manage need for assets/ Lessee has fl exibility to return asset. Still a benefi t. residual risk transfer Convenience Quick and convenient fi nancing process Still a benefi t. often available at point-of-sale. Regulatory Can help in meeting capital requirements. Still a partial benefi t if the capitalized amount is less than the cost of the asset as it is in many leases due to residuals assumed and tax benefi ts. Accounting Asset and liability off-balance-sheet. Still a partial benefi t if the capitalized amount is less than the cost of the asset as it is in many leases due to residuals assumed and tax benefi ts. Source: Equipment Leasing & Finance Foundation, 2011 State of the Equipment Finance Industry Report. So while concerns about changes in lease accounting may book, if it looks like a duck, swims like a duck, and quacks be valid, accounting standard-setters are resolved to like a duck, then it probably is a duck. So is the case with address lease accounting deficiencies. As the chairperson of debt— leasing or otherwise.” the IASB remarked, “. . . a financing, in the form of a loan to We hope that new accounting rules can be developed so purchase an asset, then it would be recorded. Call it a lease that financial statements provide relevant and representa-

and miraculously it does not show up in your books. In my tionally faithful information about leasing arrangements. Sources: M. Leone, “Taking the ‘Ease’ Out of ‘Lease’?” CFO Magazine (December 1, 2010); and Hans Hoogervorst, “Harmonisation and Global Economic Consequences,” Public lecture at the London School of Economics (November 6, 2012). For the latest on the lease project, go to www.fasb.org (click on Leases under the Projects tab). Summary of Learning Objectives 1305 KEY TERMS SUMMARY OF LEARNING OBJECTIVES bargain-purchase option, 1275 bargain-renewal 1 Explain the nature, economic substance, and advantages of lease option, 1276 transactions. A lease is a contractual agreement between a lessor and a lessee that capitalization conveys to the lessee the right to use specific property (real or personal), owned by the criteria, 1275 lessor, for a specified period of time. In return, the lessee periodically pays cash (rent) to capitalization of the lessor. The advantages of lease transactions are (1) 100 percent financing, (2) protec- leases, 1273 tion against obsolescence, (3) flexibility, (4) less costly financing, (5) possible tax advan- capital lease, 1275 tages, and (6) off-balance-sheet financing. direct-financing lease, 1286 2 Describe the accounting criteria and procedures for capitalizing effective-interest leases by the lessee. A lease is a capital lease if it meets one or more of the following method, 1278 criteria. (1) The lease transfers ownership of the property to the lessee. (2) The lease executory costs, 1277 contains a bargain-purchase option. (3) The lease term is equal to 75 percent or more of guaranteed residual the estimated economic life of the leased property. (4) The present value of the mini- value, 1277, 1290 mum lease payments (excluding executory costs) equals or exceeds 90 percent of the fair implicit interest rate, 1277 value of the leased property. For a capital lease, the lessee records an asset and a liability incremental borrowing at the lower of (1) the present value of the minimum lease payments, or (2) the fair value rate, 1277 of the leased asset at the inception of the lease. initial direct costs, 1298 3 Contrast the operating and capitalization methods of recording lease, 1270 leases. The total charges to operations are the same over the lease term whether ac- lease receivable, 1286 counting for the lease as a capital lease or as an operating lease. Under the capital lease lease term, 1272 treatment, the charges are higher in the earlier years and lower in the later years. If using lessee, 1270 an accelerated method of depreciation, the differences between the amounts charged to lessor, 1270 operations under the two methods would be even larger in the earlier and later years. If manufacturer’s or dealer’s using a capital lease instead of an operating lease, the following occurs: (1) an increase profit (or loss), 1285 in the amount of reported debt (both short-term and long-term), (2) an increase in the minimum lease amount of total assets (specifically long-lived assets), and (3) lower income early in the payments, 1276 life of the lease and, therefore, lower retained earnings. noncancelable, 1274 off-balance-sheet 4 Explain the advantages and economics of leasing to lessors and financing, 1272 identify the classifications of leases for the lessor. Three important benefits operating lease, 1275 available to the lessor are (1) interest revenue, (2) tax incentives, and (3) residual value residual value, 1290 profits. Lessors are essentially renting or selling assets, and in many cases are providing sales-type lease, 1296 financing for the purchase of the asset. The lessor determines the amount of the rental, third-party basing it on the rate of return—the implicit rate—needed to justify leasing the asset, tak- guarantors, 1277 ing into account the credit standing of the lessee, the length of the lease, and the status unguaranteed residual of the residual value (guaranteed versus unguaranteed). A lessor may classify leases for accounting purposes as follows: (1) operating leases,

value, 1293 (2) direct-financing leases, and (3) sales-type leases. The lessor should classify and ac- count for an arrangement as a direct-financing lease or a sales-type lease if, at the date of the lease agreement, the lease meets one or more of the Group I criteria (as shown in Learning Objective 2 for lessees) and both of the following Group II criteria: (1) collect- ibility of the payments required from the lessee is reasonably predictable, and (2) no important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease. The lessor classifies and accounts for all leases that fail to meet the criteria as operating leases. 5 Describe the lessor’s accounting for direct-financing leases. Leases that are in substance the financing of an asset purchase by a lessee require the lessor to substitute a “lease receivable” for the leased asset. “Lease receivable” is the present value of the minimum lease payments plus the present value of the unguaranteed residual value. Therefore, lessors include the residual value, whether guaranteed or unguaranteed, as part of the lease receivable. 1306 Chapter 21 Accounting for Leases 6 Identify special features of lease arrangements that cause unique accounting problems. The features of lease arrangements that cause unique account- ing problems are (1) residual values, (2) sales-type leases (lessor), (3) bargain-purchase options, (4) initial direct costs, (5) current versus noncurrent, and (6) disclosures. 7 Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting. Whether the estimated residual value is guaranteed or unguar- anteed is of both economic and accounting consequence to the lessee. The accounting consequence is that the minimum lease payments, the basis for capitalization, include the guaranteed residual value but exclude the unguaranteed residual value. A guaran- teed residual value affects the lessee’s computation of minimum lease payments and the amounts capitalized as a leased asset and a lease obligation. In effect, the guaranteed residual value is an additional lease payment that the lessee will pay in property or cash, or both, at the end of the lease term. An unguaranteed residual value from the lessee’s viewpoint is the same as no residual value in terms of its effect upon the lessee’s method of computing the minimum lease payments and the capitalization of the leased asset and the lease liability. 8 Describe the lessor’s accounting for sales-type leases. A sales-type lease recognizes interest revenue like a direct-financing lease. It also recognizes a manu- facturer’s or dealer’s profit. In a sales-type lease, the lessor records at the inception of the lease the sales price of the asset, the cost of goods sold and related inventory reduc- tion, and the lease receivable. Sales-type leases differ from direct-financing leases in terms of the cost and fair value of the leased asset, which results in gross profit. Lease receivable and interest revenue are the same whether a guaranteed or an unguaranteed residual value is involved. The accounting for guaranteed and for unguaranteed resid- ual values requires recording sales revenue and cost of goods sold differently. The guar- anteed residual value can be considered part of sales revenue because the lessor knows that the entire asset has been sold. There is less certainty that the unguaranteed residual portion of the asset has been “sold.” Therefore, lessors recognize sales and cost of goods sold only for the portion of the asset for which realization is assured. However, the gross profit amount on the sale of the asset is the same whether a guaranteed or unguaranteed residual value is involved. 9 List the disclosure requirements for leases. The disclosure requirements for the lessees and lessors vary based upon the type of lease (capital or operating) and whether the issuer is the lessor or lessee. These disclosure requirements provide inves- tors with the following information: (1) general description of the nature of leasing ar-

rangements; (2) the nature, timing, and amount of cash inflows and outflows associated with leases, including payments to be paid or received for each of the five succeeding years; (3) the amount of lease revenues and expenses reported in the income statement each period; (4) description and amounts of leased assets by major balance sheet classi- fication and related liabilities; and (5) amounts receivable and unearned revenues under lease agreements. APPENDIX 21A SALE-LEASEBACKS The term sale-leaseback describes a transaction in which the owner of the LEARNING OBJECTIVE 10 property (seller-lessee) sells the property to another and simultaneously leases it Describe the lessee’s accounting for back from the new owner. The use of the property is generally continued without sale-leaseback transactions. interruption. Appendix 21A: Sale-Leasebacks 1307 Sale-leasebacks are common. Financial institutions (e.g., Bank of America and First Chicago) have used this technique for their administrative offices, public utilities (Ohio Edison and Pinnacle West Corporation) for their generating plants, and airlines (Continental and Alaska Airlines) for their aircraft. The advantages of a sale-leaseback from the seller’s viewpoint usually involve two primary considerations: 1. Financing. If the purchase of equipment has already been fi nanced, a sale-leaseback can allow the seller to refi nance at lower rates, assuming rates have dropped. In addition, a sale-leaseback can provide another source of working capital, particu- larly when liquidity is tight. 2. Taxes. At the time a company purchased equipment, it may not have known that it would be subject to an alternative minimum tax and that ownership might increase its minimum tax liability. By selling the property, the seller-lessee may deduct the entire lease payment, which is not subject to alternative minimum tax considerations. DETERMINING ASSET USE To the extent the seller-lessee continues to use the asset after the sale, the sale-leaseback is really a form of financing. Therefore, the lessor should not recognize a gain or loss on the transaction. In short, the seller-lessee is simply borrowing funds. On the other hand, if the seller-lessee gives up the right to the use of the Underlying Concepts asset, the transaction is in substance a sale. In that case, gain or loss recogni- A sale-leaseback is similar in tion is appropriate. Trying to ascertain when the lessee has given up the use of substance to the parking of in- the asset is difficult, however, and the FASB has formulated complex rules to ventories (discussed in Chapter 8). identify this situation.18 To understand the profession’s position in this area, The ultimate economic benefi ts we discuss the basic accounting for the lessee and lessor below. remain under the control of the “seller,” thus satisfying the Lessee defi nition of an asset. If the lease meets one of the four criteria for treatment as a capital lease (see Illustra- tion 21-3 on page 1275), the seller-lessee accounts for the transaction as a sale and the lease as a capital lease. The seller-lessee should defer any profit or loss it experiences from the sale of the assets that are leased back under a capital lease; it should amortize that profit over the lease term (or the economic life if either criterion 1 or 2 is satisfied) in proportion to the amortization of the leased assets. For example, assume Scott Paper sells equipment having a book value of $580,000 and a fair value of $623,110 to General Electric Credit for $623,110 and leases the equip- ment back for $50,000 a year for 20 years. Scott should amortize the profit of $43,110 over the 20-year period at the same rate that it depreciates the $623,110. [12] It credits the $43,110 ($623,110 2 $580,000) to Unearned Profit on Sale-Leaseback. If none of the capital lease criteria are satisfied, the seller-lessee accounts for the transaction as a sale and the lease as an operating lease. Under an operating lease, the lessee defers such profit or loss and amortizes it in proportion to the rental payments

over the period when it expects to use the assets. 18Sales and leasebacks of real estate are often accounted for differently. A discussion of the issues related to these transactions is beyond the scope of this textbook. [11] 1308 Chapter 21 Accounting for Leases There are exceptions to these two general rules. They are: 1. Losses recognized. When the fair value of the asset is less than the book value (carrying amount), the lessee must recognize a loss immediately, up to the amount of the difference between the book value and fair value. For example, if Lessee, Inc. sells equipment having a book value of $650,000 and a fair value of $623,110, it should charge the difference of $26,890 to a loss account.19 2. Minor leaseback. Leasebacks in which the present value of the rental payments are 10 percent or less of the fair value of the asset are minor leasebacks. In this case, the seller-lessee gives up most of the rights to the use of the asset sold. Therefore, the transaction is a sale, and full gain or loss recognition is appropriate. It is not a financing transaction because the risks of ownership have been transferred.20 Lessor If the lease meets one of the criteria in Group I and both of the criteria in Group II (see Illustration 21-10 on page 1285), the purchaser-lessor records the transaction as a pur- chase and a direct-financing lease. If the lease does not meet the criteria, the purchaser- lessor records the transaction as a purchase and an operating lease. SALE-LEASEBACK EXAMPLE To illustrate the accounting treatment accorded a sale-leaseback transaction, assume that American Airlines on January 1, 2014, sells a used Boeing 757 having a carrying amount on its books of $75,500,000 to CitiCapital for $80,000,000. American immedi- ately leases the aircraft back under the following conditions: 1. The term of the lease is 15 years, noncancelable, and requires equal rental payments of $10,487,443 at the beginning of each year. 2. The aircraft has a fair value of $80,000,000 on January 1, 2014, and an estimated economic life of 15 years. 3. American pays all executory costs. 4. American depreciates similar aircraft that it owns on a straight-line basis over 15 years. 5. The annual payments assure the lessor a 12 percent return. 6. American’s incremental borrowing rate is 12 percent. This lease is a capital lease to American because the lease term exceeds 75 percent of the estimated life of the aircraft and because the present value of the lease payments exceeds 90 percent of the fair value of the aircraft to CitiCapital. Assuming that collectibility of the lease payments is reasonably predictable and that no important uncertainties exist 19There can be two types of losses in sale-leaseback arrangements. One is a real economic loss that results when the carrying amount of the asset is higher than the fair value of the asset. In this case, the loss should be recognized. An artificial loss results when the sales price is below the carrying amount of the asset but the fair value is above the carrying amount. In this case, the loss is more in the form of prepaid rent, and the lessee should defer the loss and amortize it in the future. 20In some cases, the seller-lessee retains more than a minor part but less than substantially all. The computations to arrive at these values are complex and beyond the scope of this textbook. Summary of Learning Objective for Appendix 21A 1309 in relation to unreimbursable costs yet to be incurred by CitiCapital, it should classify this lease as a direct-financing lease. Illustration 21A-1 presents the typical journal entries to record the sale-leaseback transactions for American and CitiCapital for the first year. ILLUSTRATION 21A-1 Comparative Entries for Sale-Leaseback for Lessee and Lessor American Airlines (Lessee) CitiCapital (Lessor) Sale of Aircraft by American to CitiCapital (January 1, 2014): Cash 80,000,000 Aircraft 80,000,000 Aircraft 75,500,000 Cash 80,000,000 Unearned Profit on Sale-Leaseback 4,500,000 Lease Receivable 80,000,000 Leased Aircraft (under capital leases) 80,000,000 Aircraft 80,000,000

Lease Liability 80,000,000 First Lease Payment (January 1, 2014): Lease Liability 10,487,443 Cash 10,487,443 Cash 10,487,443 Lease Receivable 10,487,443 Incurrence and Payment of Executory Costs by American Corp. throughout 2014: Insurance, Maintenance, Taxes, etc. XXX (No entry) Cash or Accounts Payable XXX Depreciation Expense on the Aircraft (December 31, 2014): Depreciation Expense 5,333,333 (No entry) Accumulated Depr.—Capital Leases 5,333,333 ($80,000,000 4 15) Amortization of Profit on Sale-Leaseback by American (December 31, 2014): Unearned Profit on Sale-Leaseback 300,000 (No entry) Depreciation Expense 300,000 ($4,500,000 4 15) (Note: A case might be made for crediting Sales Revenue instead of Depreciation Expense.) Interest for 2014 (December 31, 2014): Interest Expense 8,341,507a Interest Receivable 8,341,507 Interest Payable 8,341,507 Interest Revenue 8,341,507a aPartial Lease Amortization Schedule: Annual Rental Interest Reduction of Date Payment 12% Balance Balance 1/1/14 $80,000,000 1/1/14 $10,487,443 $ –0– $10,487,443 69,512,557 1/1/15 10,487,443 8,341,507 2,145,936 67,366,621 KEY TERMS SUMMARY OF LEARNING OBJECTIVE minor leaseback, 1308 FOR APPENDIX 21A sale-leaseback, 1306 10 Describe the lessee’s accounting for sale-leaseback transactions. If the lease meets one of the four criteria for treatment as a capital lease, the seller-lessee accounts for the transaction as a sale and the lease as a capital lease. The seller-lessee defers any profit it experiences from the sale of the assets that are leased back under a capital lease. The seller-lessee amortizes any profit over the lease term (or the economic life if either criterion 1 or 2 is satisfied) in proportion to the amortization of the leased 1310 Chapter 21 Accounting for Leases assets. If the lease satisfies none of the capital lease criteria, the seller-lessee accounts for the transaction as a sale and the lease as an operating lease. Under an operating lease, the lessee defers such profit and amortizes it in proportion to the rental payments over the period of time that it expects to use the assets. DEMONSTRATION PROBLEM Morgan Bakeries is involved in four different lease situations. Each of these leases is noncancelable, and in no case does Morgan receive title to the properties leased during or at the end of the lease term. All leases start on January 1, 2014, with the first rental due at the beginning of the year. Additional information is shown in the following table. (a) Harmon, Inc. (b) Arden’s Oven Co. (c) Mendota Truck Co. (d) Appleland Computer Type of property Cabinets Oven Truck Computer Yearly rental $6,000 $15,000 $5,582.62 $3,557.25 Lease term 20 years 10 years 3 years 3 years Estimated economic life 30 years 25 years 7 years 5 years Purchase option None $75,000 at end of None $3,000 at end of 10 years 3 years, which $4,000 at end of approximates fair 15 years value Renewal option None 5-year renewal None 1 year at $1,500; option at $15,000 no penalty for per year nonrenewal; standard renewal clause Fair value at inception of lease $60,000 $120,000 $20,000 $10,000 Cost of asset to lessor $60,000 $120,000 $15,000 $10,000 Residual value Guaranteed –0– –0– $7,000 –0– Unguaranteed $5,000 –0– –0– $3,000 Incremental borrowing rate of lessee 12% 12% 12% 12% Executory costs paid by Lessee Lessee Lessee Lessor $300 per year $1,000 per year $500 per year Estimated to be $500 per year, included in lease payment Present value of minimum lease payments Using incremental borrowing rate of lessee $50,194.68 $115,153.35 $20,000 $8,224.16 Using implicit rate of lessor Not known Not known Not known Known by lessee, $8,027.48 Estimated fair value at end of lease $5,000 $80,000 at end of Not available $3,000 10 years $60,000 at end of 15 years Instructions For each lease arrangement, determine the correct classification of the lease and prepare the journal entry at its inception. DemonstratioLn aPsrto Hbleeamd 11331111 Solution (a) Analysis of the Harmon, Inc. lease: 1. Transfer of title? No. 2. Bargain-purchase option? No. 3. Economic life test (75% test). The lease term is 20 years and the estimated economic life is 30 years.

Thus, it does not meet the 75 percent test. 4. Recovery of investment test (90% test): Fair value $60,000 Rental payments $ 6,000 Rate 3 90% PV of annuity due for 90% of fair value $54,000 20 years at 12% 3 8.36578 PV of rental payments $50,194.68 B ecause the present value of the minimum lease payments is less than 90 percent of the fair value, the lease does not meet the 90 percent test. Both Morgan and Harmon should account for this lease as an operating lease, as indicated by the following January 1, 2014, entries. Morgan Bakeries Harmon, Inc. (Lessee) (Lessor) Rent Expense 6,000 Cash 6,000 Cash 6,000 Rent Revenue 6,000 (b) Analysis of the Arden’s Oven Co. lease: 1. Transfer of title? No. 2. Bargain-purchase option? The $75,000 option at the end of 10 years does not appear to be suffi- ciently lower than the expected fair value of $80,000 to make it reasonably assured that it will be exercised. However, the $4,000 at the end of 15 years when the fair value is $60,000 does appear to be a bargain. From the information given, criterion 2 is therefore met. Note that both the guaranteed and the unguaranteed residual values are assigned zero values because the lessor does not expect to repossess the leased asset. 3. Economic life test (75% test): Given that a bargain-purchase option exists, the lease term is the ini- tial lease period of 10 years plus the five-year renewal option since it precedes a bargain-purchase option. Even though the lease term is now considered to be 15 years, this test is still not met because 75 percent of the economic life of 25 years is 18.75 years. 4. Recovery of investment test (90% test): Fair value $120,000 Rental payments $ 15,000.00 Rate 3 90% PV of annuity due for 90% of fair value $108,000 15 years at 12% 3 7.62817 PV of rental payments $114,422.55 PV of bargain-purchase option: 5 $4,000 3 (PVF ) 5 $4,000 3 .18270 5 $730.80 15,12% PV of rental payments $114,422.55 PV of bargain-purchase option 730.80 PV of minimum lease payments $115,153.35 The present value of the minimum lease payments is greater than 90 percent of the fair value. There- fore, the lease does meet the 90 percent test. Morgan Bakeries should account for this as a capital lease because the lease meets both criteria 2 and 4. Assuming that Arden’s implicit rate is less than Morgan’s incremental borrowing rate, the following entries are made on January 1, 2014. Morgan Bakeries Arden’s Oven Co. (Lessee) (Lessor) Leased Equipment (oven) 115,153.35 Lease Receivable 120,000 Lease Liability 115,153.35 Equipment (oven) 120,000 11331122 CChhaapptteerr 2211 AAccccoouunnttiinngg ffoorr LLeeaasseess Morgan Bakeries would depreciate the leased asset over its economic life of 25 years, given the bargain-purchase option. Arden’s Oven Co. does not use sales-type accounting because the fair value and the cost of the asset are the same at the inception of the lease. (c) Analysis of the Mendota Truck Co. lease: 1. Transfer of title? No. 2. Bargain-purchase option? No. 3. Economic life test (75% test): The lease term is three years and the estimated economic life is seven years. Thus, it does not meet the 75 percent test. 4. Recovery of investment test (90% test): Fair value $20,000 Rental payments $ 5,582.62 Rate 3 90% PV of annuity due for 90% of fair value $18,000 3 years at 12% 3 2.69005 PV of rental payments $15,017.54 (Note: Adjusted for $0.01 due to rounding.) PV of guaranteed residual value: 5 $7,000 3 (PVF ) 5 $7,000 3 .71178 5 $4,982.46 3,12% PV of rental payments $15,017.54 PV of guaranteed residual value 4,982.46 PV of minimum lease payments $20,000.00 The present value of the minimum lease payments is greater than 90 percent of the fair value. There- fore, the lease meets the 90 percent test. Assuming that Mendota’s implicit rate is the same as Morgan’s incremental borrowing rate, the following entries are made on January 1, 2014. Morgan Bakeries Mendota Truck Co. (Lessee) (Lessor) Leased Equipment (truck) 20,000 Lease Receivable 20,000 Lease Liability 20,000 Cost of Goods Sold 15,000 Trucks 15,000 Sales Revenue 20,000

Because the cost of the truck is less than the fair value, this is a sales-type lease for Mendota. Morgan depreciates the leased asset over three years to its guaranteed residual value. (d) Analysis of the Appleland Computer lease: 1. Transfer of title? No. 2. Bargain-purchase option? No. The option to purchase at the end of three years at approximate fair value is clearly not a bargain. 3. Economic life test (75% test): The lease term is three years, and no bargain-renewal period exists. Therefore, the 75 percent test is not met. 4. Recovery of investment test (90% test): Fair value $10,000 Rental payments $3,557.25 Rate 3 90% Less executory costs 500.00 90% of fair value $ 9,000 3,057.25 PV of annuity-due factor for 3 years at 12% 3 2.69005 PV of minimum lease payments using incremental borrowing rate $8,224.16 The present value of the minimum lease payments using the incremental borrowing rate is $8,224.16. Using the implicit rate, it is $8,027.48. The lessor’s implicit rate is therefore higher than the incremen- tal borrowing rate. Given this situation, the lessee uses the $8,224.16 (lower interest rate when dis- counting) when comparing with the 90 percent of fair value. Because the present value of the mini- mum lease payments is lower than 90 percent of the fair value, the lease does not meet the recovery of investment test. The following entries are made on January 1, 2014, indicating an operating lease. FASB Codifi cation 1313 Morgan Bakeries Appleland Computer (Lessee) (Lessor) Rent Expense 3,557.25 Cash 3,557.25 Cash 3,557.25 Rent Revenue 3,557.25 If the lease payments had been $3,557.25 with no executory costs involved, this lease arrangement would have qualified for capital-lease accounting treatment. FASB CODIFICATION FASB Codification References [1] FASB ASC 840-10-25-1. [Predecessor literature: “Accounting for Leases,” FASB Statement No. 13 as amended and inter- preted through May 1980 (Stamford, Conn.: FASB, 1980), par. 7.] [2] FASB ASC 840-10-25. [Predecessor literature: “Accounting for Leases: Sale-Leaseback Transactions Involving Real Estate; Sales-Type Leases of Real Estate; Definition of the Lease Term; Initial Direct Costs of Direct Financing Leases,” Statement of Financial Accounting Standards No. 98 (Stamford, Conn.: FASB, 1988).] [3] FASB ASC 840-10-25-9. [Predecessor literature: “Lessee Guarantee of the Residual Value of Leased Property,” FASB Inter- pretation No. 19 (Stamford, Conn.: FASB, 1977), par. 3.] [4] FASB ASC 840-10-25-22. [Predecessor literature: “Accounting for Leases,” FASB Statement No. 13 as amended and inter- preted through May 1980 (Stamford, Conn.: FASB, 1980), par. 5 (l).] [5] FASB ASC 840-10-25-31. [Predecessor literature: “Accounting for Leases,” FASB Statement No. 13 as amended and inter- preted through May 1980 (Stamford, Conn.: FASB, 1980), par. 5 (k).] [6] FASB ASC 840-30-35-14. [Predecessor literature: “Accounting for Purchase of a Leased Asset by the Lessee During the Term of the Lease,” FASB Interpretation No. 26 (Stamford, Conn.: FASB, 1978), par. 5.] [7] FASB ASC 840-10-25-43. [Predecessor literature: “Accounting for Leases,” FASB Statement No. 13 as amended and inter- preted through May 1980 (Stamford, Conn.: FASB, 1980), paras. 6, 7, and 8.] [8] FASB ASC 840-30-30-12. [Predecessor literature: “Accounting for Nonrefundable Fees and Costs Associated with Originat- ing or Acquiring Loans and Initial Direct Costs of Leases,” Statement of Financial Accounting Standards No. 91 (Stamford: Conn.: FASB, 1987).] [9] FASB ASC 840-30-50-1. [Predecessor literature: “Accounting for Leases,” FASB Statement No. 13 as amended and inter- preted through May 1980 (Stamford, Conn.: FASB, 1980), par. 16.] [10] FASB ASC 840-30-50-4. [Predecessor literature: “Accounting for Leases,” FASB Statement No. 13 as amended and inter- preted through May 1980 (Stamford, Conn.: FASB, 1980), paras. 16 and 23.] [11] FASB ASC 840-40. [Predecessor literature: “Accounting for Leases: Sale-Leaseback Transactions Involving Real Estate; Sales-Type Leases of Real Estate; Definition of the Lease Term; Initial Direct Costs of Direct Financing Leases,” Statement of

Financial Accounting Standards No. 98 (Stamford, Conn.: FASB, 1988).] [12] FASB ASC 840-40. [Predecessor literature: Statement of Financial Accounting Standards No. 28, “Accounting for Sales with Leasebacks” (Stamford, Conn.: FASB, 1979).] Exercises If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE21-1 Access the glossary (“Master Glossary”) to answer the following. (a) What is a bargain-purchase option? (b) What is the definition of “incremental borrowing rate”? (c) What is the definition of “estimated residual value”? (d) What is an unguaranteed residual value? CE21-2 What comprises a lessee’s minimum lease payments? What is excluded? CE21-3 What information should a lessee disclose about its capital leases in its financial statements and footnotes? CE21-4 How should a lessor measure its initial gross investment in either a sales-type lease or a direct-financing lease? An additional Codification case can be found in the Using Your Judgment section, on page 1331. 1314 Chapter 21 Accounting for Leases Be sure to check the book’s companion website for a Review and Analysis Exercise, with solution. Brief Exercises, Exercises, Problems, and many more learning and assessment tools and resources are available for practice in WileyPLUS. Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter. (Unless instructed otherwise, round all amounts to the nearest dollar.) QUESTIONS 1. What are the major lessor groups in the United States? What 10. Outline the accounting procedures involved in applying advantage does a captive have in a leasing arrangement? the direct-financing method. 2. Bradley Co. is expanding its operations and is in the pro- 11. Outline the accounting procedures involved in applying cess of selecting the method of financing this program. the operating method by a lessor. After some investigation, the company determines that it 12. Walker Company is a manufacturer and lessor of com- may (1) issue bonds and with the proceeds purchase the puter equipment. What should be the nature of its lease needed assets or (2) lease the assets on a long-term basis. arrangements with lessees if the company wishes to ac- Without knowing the comparative costs involved, answer count for its lease transactions as sales-type leases? these questions: 13. Metheny Corporation’s lease arrangements qualify as (a) What might be the advantages of leasing the assets sales-type leases at the time of entering into the transac- instead of owning them? tions. How should the corporation recognize revenues (b) What might be the disadvantages of leasing the assets and costs in these situations? instead of owning them? 14. Alice Foyle, M.D. (lessee), has a noncancelable 20-year (c) In what way will the balance sheet be differently affected lease with Brownback Realty, Inc. (lessor) for the use of a by leasing the assets as opposed to issuing bonds and medical building. Taxes, insurance, and maintenance are purchasing the assets? paid by the lessee in addition to the fixed annual pay- 3. Identify the two recognized lease accounting methods for ments, of which the present value is equal to the fair value of the leased property. At the end of the lease period, title lessees and distinguish between them. becomes the lessee’s at a nominal price. Considering the 4. Ballard Company rents a warehouse on a month-to-month terms of the lease described above, comment on the na- basis for the storage of its excess inventory. The company ture of the lease transaction and the accounting treatment periodically must rent space whenever its production that should be accorded it by the lessee. greatly exceeds actual sales. For several years, the com- 15. The residual value is the estimated fair value of the leased pany officials have discussed building their own storage property at the end of the lease term. facility, but this enthusiasm wavers when sales increase

sufficiently to absorb the excess inventory. What is the (a) Of what significance is (1) an unguaranteed and (2) a nature of this type of lease arrangement, and what guaranteed residual value in the lessee’s accounting accounting treatment should be accorded it? for a capitalized-lease transaction? 5. Distinguish between minimum rental payments and (b) Of what significance is (1) an unguaranteed and (2) a minimum lease payments, and indicate what is included guaranteed residual value in the lessor’s accounting in minimum lease payments. for a direct-financing lease transaction? 6. Explain the distinction between a direct-financing lease 16. How should changes in the estimated unguaranteed and a sales-type lease for a lessor. residual value be handled by the lessor? 7. Outline the accounting procedures involved in applying 17. Describe the effect of a “bargain-purchase option” on ac- the operating method by a lessee. counting for a capital lease transaction by a lessee. 8. Outline the accounting procedures involved in applying 18. What are “initial direct costs” and how are they accounted for? the capital lease method by a lessee. 19. What disclosures should be made by lessees and lessors 9. Identify the lease classifications for lessors and the criteria related to future lease payments? that must be met for each classification. * 20. What is the nature of a “sale-leaseback” transaction? Brief Exercises 1315 BRIEF EXERCISES 2 BE21-1 Callaway Golf Co. leases telecommunication equipment. Assume the following data for equip- ment leased from Photon Company. The lease term is 5 years and requires equal rental payments of $31,000 at the beginning of each year. The equipment has a fair value at the inception of the lease of $138,000, an estimated useful life of 8 years, and no residual value. Callaway pays all executory costs directly to third parties. Photon set the annual rental to earn a rate of return of 10%, and this fact is known to Callaway. The lease does not transfer title or contain a bargain-purchase option. How should Callaway classify this lease? 2 BE21-2 Waterworld Company leased equipment from Costner Company. The lease term is 4 years and requires equal rental payments of $43,019 at the beginning of each year. The equipment has a fair value at the inception of the lease of $150,000, an estimated useful life of 4 years, and no salvage value. Waterworld pays all executory costs directly to third parties. The appropriate interest rate is 10%. Prepare Waterworld’s January 1, 2014, journal entries at the inception of the lease. 2 BE21-3 Rick Kleckner Corporation recorded a capital lease at $300,000 on January 1, 2014. The interest rate is 12%. Kleckner Corporation made the first lease payment of $53,920 on January 1, 2014. The lease requires eight annual payments. The equipment has a useful life of 8 years with no salvage value. Prepare Kleckner Corporation’s December 31, 2014, adjusting entries. 2 BE21-4 Use the information for Rick Kleckner Corporation from BE21-3. Assume that at December 31, 2014, Kleckner made an adjusting entry to accrue interest expense of $29,530 on the lease. Prepare Kleck- ner’s January 1, 2015, journal entry to record the second lease payment of $53,920. 3 BE21-5 Jana Kingston Corporation enters into a lease on January 1, 2014, that does not transfer ownership or contain a bargain-purchase option. It covers 3 years of the equipment’s 8-year useful life, and the present value of the minimum lease payments is less than 90% of the fair value of the asset leased. Prepare Jana Kingston’s journal entry to record its January 1, 2014, annual lease payment of $35,000. 4 5 BE21-6 Assume that IBM leased equipment that was carried at a cost of $150,000 to Sharon Swander Com- pany. The term of the lease is 6 years beginning January 1, 2014, with equal rental payments of $30,044 at the beginning of each year. All executory costs are paid by Swander directly to third parties. The fair value of the equipment at the inception of the lease is $150,000. The equipment has a useful life of 6 years with no

salvage value. The lease has an implicit interest rate of 8%, no bargain-purchase option, and no transfer of title. Collectibility is reasonably assured with no additional cost to be incurred by IBM. Prepare IBM’s January 1, 2014, journal entries at the inception of the lease. 4 5 BE21-7 Use the information for IBM from BE21-6. Assume the direct-financing lease was recorded at a present value of $150,000. Prepare IBM’s December 31, 2014, entry to record interest. 4 BE21-8 Jennifer Brent Corporation owns equipment that cost $80,000 and has a useful life of 8 years with no salvage value. On January 1, 2014, Jennifer Brent leases the equipment to Donna Havaci Inc. for one year with one rental payment of $15,000 on January 1. Prepare Jennifer Brent Corporation’s 2014 journal entries. 6 7 BE21-9 Indiana Jones Corporation enters into a 6-year lease of equipment on January 1, 2014, which re- quires 6 annual payments of $40,000 each, beginning January 1, 2014. In addition, Indiana Jones guarantees the lessor a residual value of $20,000 at lease-end. The equipment has a useful life of 6 years. Prepare Indi- ana Jones’ January 1, 2014, journal entries assuming an interest rate of 10%. 6 7 BE21-10 Use the information for Indiana Jones Corporation from BE21-9. Assume that for Lost Ark Com- pany, the lessor, collectibility is reasonably predictable, there are no important uncertainties concerning costs, and the carrying amount of the equipment is $202,921. Prepare Lost Ark’s January 1, 2014, journal entries. 8 BE21-11 Geiberger Corporation manufactures replicators. On January 1, 2014, it leased to Althaus Com- pany a replicator that had cost $110,000 to manufacture. The lease agreement covers the 5-year useful life of the replicator and requires 5 equal annual rentals of $40,800 payable each January 1, beginning January 1, 2014. An interest rate of 12% is implicit in the lease agreement. Collectibility of the rentals is reasonably assured, and there are no important uncertainties concerning costs. Prepare Geiberger’s January 1, 2014, journal entries. 10 *B E21-12 On January 1, 2014, Irwin Animation sold a truck to Peete Finance for $33,000 and immediately leased it back. The truck was carried on Irwin’s books at $28,000. The term of the lease is 5 years, and title transfers to Irwin at lease-end. The lease requires five equal rental payments of $8,705 at the end of each year. The appropriate rate of interest is 10%, and the truck has a useful life of 5 years with no salvage value. Prepare Irwin’s 2014 journal entries. 1316 Chapter 21 Accounting for Leases EXERCISES 2 E21-1 (Lessee Entries; Capital Lease with Unguaranteed Residual Value) On January 1, 2014, Burke Corporation signed a 5-year noncancelable lease for a machine. The terms of the lease called for Burke to make annual payments of $8,668 at the beginning of each year, starting January 1, 2014. The machine has an estimated useful life of 6 years and a $5,000 unguaranteed residual value. The machine reverts back to the lessor at the end of the lease term. Burke uses the straight-line method of depreciation for all of its plant assets. Burke’s incremental borrowing rate is 10%, and the Lessor’s implicit rate is unknown. Instructions (a) What type of lease is this? Explain. (b) Compute the present value of the minimum lease payments. (c) Prepare all necessary journal entries for Burke for this lease through January 1, 2015. 2 E21-2 (Lessee Computations and Entries; Capital Lease with Guaranteed Residual Value) Pat Delaney Company leases an automobile with a fair value of $8,725 from John Simon Motors, Inc., on the following terms: 1. Noncancelable term of 50 months. 2. Rental of $200 per month (at end of each month). (The present value at 1% per month is $7,840.) 3. Estimated residual value after 50 months is $1,180. (The present value at 1% per month is $715.) Delaney Company guarantees the residual value of $1,180. 4. Estimated economic life of the automobile is 60 months. 5. Delaney Company’s incremental borrowing rate is 12% a year (1% a month). Simon’s implicit rate

is unknown. Instructions (a) What is the nature of this lease to Delaney Company? (b) What is the present value of the minimum lease payments? (c) Record the lease on Delaney Company’s books at the date of inception. (d) Record the first month’s depreciation on Delaney Company’s books (assume straight-line). (e) Record the first month’s lease payment. 2 7 E21-3 (Lessee Entries; Capital Lease with Executory Costs and Unguaranteed Residual Value) Assume that on January 1, 2014, Kimberly-Clark Corp. signs a 10-year noncancelable lease agreement to lease a stor- age building from Sheffield Storage Company. The following information pertains to this lease agreement. 1. The agreement requires equal rental payments of $72,000 beginning on January 1, 2014. 2. The fair value of the building on January 1, 2014 is $440,000. 3. The building has an estimated economic life of 12 years, with an unguaranteed residual value of $10,000. Kimberly-Clark depreciates similar buildings on the straight-line method. 4. The lease is nonrenewable. At the termination of the lease, the building reverts to the lessor. 5. Kimberly-Clark’s incremental borrowing rate is 12% per year. The lessor’s implicit rate is not known by Kimberly-Clark. 6. The yearly rental payment includes $2,471 of executory costs related to taxes on the property. Instructions Prepare the journal entries on the lessee’s books to reflect the signing of the lease agreement and to record the payments and expenses related to this lease for the years 2014 and 2015. Kimberly-Clark’s corporate year-end is December 31. 5 E21-4 (Lessor Entries; Direct-Financing Lease with Option to Purchase) Castle Leasing Company signs a lease agreement on January 1, 2014, to lease electronic equipment to Jan Way Company. The term of the noncancelable lease is 2 years, and payments are required at the end of each year. The following informa- tion relates to this agreement: 1. Jan Way has the option to purchase the equipment for $16,000 upon termination of the lease. 2. The equipment has a cost and fair value of $160,000 to Castle Leasing Company. The useful eco- nomic life is 2 years, with a salvage value of $16,000. 3. Jan Way Company is required to pay $5,000 each year to the lessor for executory costs. 4. Castle Leasing Company desires to earn a return of 10% on its investment. 5. Collectibility of the payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. Exercises 1317 Instructions (a) Prepare the journal entries on the books of Castle Leasing to reflect the payments received under the lease and to recognize income for the years 2014 and 2015. (b) Assuming that Jan Way Company exercises its option to purchase the equipment on December 31, 2015, prepare the journal entry to reflect the sale on Castle’s books. 2 3 E21-5 (Type of Lease; Amortization Schedule) Mike Macinski Leasing Company leases a new machine that has a cost and fair value of $95,000 to Sharrer Corporation on a 3-year noncancelable contract. Sharrer Corporation agrees to assume all risks of normal ownership including such costs as insurance, taxes, and maintenance. The machine has a 3-year useful life and no residual value. The lease was signed on January 1, 2014. Mike Macinski Leasing Company expects to earn a 9% return on its investment. The annual rentals are payable on each December 31. Instructions (a) Discuss the nature of the lease arrangement and the accounting method that each party to the lease should apply. (b) Prepare an amortization schedule that would be suitable for both the lessor and the lessee and that covers all the years involved. 8 E21-6 (Lessor Entries; Sales-Type Lease) Crosley Company, a machinery dealer, leased a machine to Dexter Corporation on January 1, 2014. The lease is for an 8-year period and requires equal a nnual payments of $35,013 at the beginning of each year. The first payment is received on January 1, 2014. Crosley had pur- chased the machine during 2013 for $160,000. Collectibility of lease payments is reasonably predictable,

and no important uncertainties surround the amount of costs yet to be incurred by Crosley. Crosley set the annual rental to ensure an 11% rate of return. The machine has an economic life of 10 years with no residual value and reverts to Crosley at the termination of the lease. Instructions (a) Compute the amount of the lease receivable. (b) Prepare all necessary journal entries for Crosley for 2014. 8 E21-7 (Lessee-Lessor Entries; Sales-Type Lease) On January 1, 2014, Bensen Company leased equipment to Flynn Corporation. The following information pertains to this lease. 1. The term of the noncancelable lease is 6 years, with no renewal option. The equipment reverts to the lessor at the termination of the lease. 2. Equal rental payments are due on January 1 of each year, beginning in 2014. 3. The fair value of the equipment on January 1, 2014, is $150,000, and its cost is $120,000. 4. The equipment has an economic life of 8 years, with an unguaranteed residual value of $10,000. Flynn depreciates all of its equipment on a straight-line basis. 5. Bensen set the annual rental to ensure an 11% rate of return. Flynn’s incremental borrowing rate is 12%, and the implicit rate of the lessor is unknown. 6. Collectibility of lease payments is reasonably predictable, and no important uncertainties surround the amount of costs yet to be incurred by the lessor. Instructions (Both the lessor and the lessee’s accounting period ends on December 31.) (a) Discuss the nature of this lease to Bensen and Flynn. (b) Calculate the amount of the annual rental payment. (c) Prepare all the necessary journal entries for Flynn for 2014. (d) Prepare all the necessary journal entries for Bensen for 2014. 8 E21-8 (Lessee Entries with Bargain-Purchase Option) The following facts pertain to a noncancelable lease agreement between Mooney Leasing Company and Rode Company, a lessee. Inception date: May 1, 2014 Annual lease payment due at the beginning of each year, beginning with May 1, 2014 $21,227.65 Bargain-purchase option price at end of lease term $ 4,000.00 Lease term 5 years Economic life of leased equipment 10 years Lessor’s cost $65,000.00 Fair value of asset at May 1, 2014 $91,000.00 Lessor’s implicit rate 10% Lessee’s incremental borrowing rate 10% 1318 Chapter 21 Accounting for Leases The collectibility of the lease payments is reasonably predictable, and there are no important u ncertainties surrounding the costs yet to be incurred by the lessor. The lessee assumes responsibility for all executory costs. Instructions (Round all numbers to the nearest cent.) (a) Discuss the nature of this lease to Rode Company. (b) Discuss the nature of this lease to Mooney Company. (c) Prepare a lease amortization schedule for Rode Company for the 5-year lease term. (d) Prepare the journal entries on the lessee’s books to reflect the signing of the lease agreement and to record the payments and expenses related to this lease for the years 2014 and 2015. Rode’s annual accounting period ends on December 31. Reversing entries are used by Rode. 8 E21-9 (Lessor Entries with Bargain-Purchase Option) A lease agreement between Mooney Leasing Company and Rode Company is described in E21-8. Instructions (Round all numbers to the nearest cent.) Refer to the data in E21-8 and do the following for the lessor. (a) Compute the amount of the lease receivable at the inception of the lease. (b) Prepare a lease amortization schedule for Mooney Leasing Company for the 5-year lease term. (c) Prepare the journal entries to reflect the signing of the lease agreement and to record the receipts and income related to this lease for the years 2014, 2015, and 2016. The lessor’s accounting period ends on December 31. Reversing entries are not used by Mooney. 5 E21-10 (Computation of Rental; Journal Entries for Lessor) Morgan Leasing Company signs an agree- ment on January 1, 2014, to lease equipment to Cole Company. The following information relates to this agreement. 1. The term of the noncancelable lease is 6 years with no renewal option. The equipment has an esti-

mated economic life of 6 years. 2. The cost of the asset to the lessor is $245,000. The fair value of the asset at January 1, 2014, is $245,000. 3. The asset will revert to the lessor at the end of the lease term, at which time the asset is expected to have a residual value of $43,622, none of which is guaranteed. 4. Cole Company assumes direct responsibility for all executory costs. 5. The agreement requires equal annual rental payments, beginning on January 1, 2014. 6. Collectibility of the lease payments is reasonably predictable. There are no important uncertainties surrounding the amount of costs yet to be incurred by the lessor. Instructions (Round all numbers to the nearest cent.) (a) Assuming the lessor desires a 10% rate of return on its investment, calculate the amount of the annual rental payment required. (Round to the nearest dollar.) (b) Prepare an amortization schedule that would be suitable for the lessor for the lease term. (c) Prepare all of the journal entries for the lessor for 2014 and 2015 to record the lease agreement, the receipt of lease payments, and the recognition of income. Assume the lessor’s annual accounting period ends on December 31. 2 E21-11 (Amortization Schedule and Journal Entries for Lessee) Laura Leasing Company signs an agree- ment on January 1, 2014, to lease equipment to Plote Company. The following information relates to this agreement. 1. The term of the noncancelable lease is 5 years with no renewal option. The equipment has an esti- mated economic life of 5 years. 2. The fair value of the asset at January 1, 2014, is $80,000. 3. The asset will revert to the lessor at the end of the lease term, at which time the asset is expected to have a residual value of $7,000, none of which is guaranteed. 4. Plote Company assumes direct responsibility for all executory costs, which include the following annual amounts: (1) $900 to Rocky Mountain Insurance Company for insurance and (2) $1,600 to Laclede County for property taxes. 5. The agreement requires equal annual rental payments of $18,142.95 to the lessor, beginning on January 1, 2014. Exercises 1319 6. The lessee’s incremental borrowing rate is 12%. The lessor’s implicit rate is 10% and is known to the lessee. 7. Plote Company uses the straight-line depreciation method for all equipment. 8. Plote uses reversing entries when appropriate. Instructions (Round all numbers to the nearest cent.) (a) Prepare an amortization schedule that would be suitable for the lessee for the lease term. (b) Prepare all of the journal entries for the lessee for 2014 and 2015 to record the lease agreement, the lease payments, and all expenses related to this lease. Assume the lessee’s annual accounting period ends on December 31. 3 4 E21-12 (Accounting for an Operating Lease) On January 1, 2014, Doug Nelson Co. leased a building to Patrick Wise Inc. The relevant information related to the lease is as follows. 1. The lease arrangement is for 10 years. 2. The leased building cost $4,500,000 and was purchased for cash on January 1, 2014. 3. The building is depreciated on a straight-line basis. Its estimated economic life is 50 years with no salvage value. 4. Lease payments are $275,000 per year and are made at the end of the year. 5. Property tax expense of $85,000 and insurance expense of $10,000 on the building were incurred by Nelson in the first year. Payment on these two items was made at the end of the year. 6. Both the lessor and the lessee are on a calendar-year basis. Instructions (a) Prepare the journal entries that Nelson Co. should make in 2014. (b) Prepare the journal entries that Wise Inc. should make in 2014. (c) If Nelson paid $30,000 to a real estate broker on January 1, 2014, as a fee for finding the lessee, how much should be reported as an expense for this item in 2014 by Nelson Co.? 3 4 E21-13 (Accounting for an Operating Lease) On January 1, 2014, a machine was purchased for $900,000 by Young Co. The machine is expected to have an 8-year life with no salvage value. It is to be depreciated on a straight-line basis. The machine was leased to St. Leger Inc. on January 1, 2014, at an annual rental of

$210,000. Other relevant information is as follows. 1. The lease term is for 3 years. 2. Young Co. incurred maintenance and other executory costs of $25,000 in 2014 related to this lease. 3. The machine could have been sold by Young Co. for $940,000 instead of leasing it. 4. St. Leger is required to pay a rent security deposit of $35,000 and to prepay the last month’s rent of $17,500. Instructions (a) How much should Young Co. report as income before income tax on this lease for 2014? (b) What amount should St. Leger Inc. report for rent expense for 2014 on this lease? 3 4 E21-14 (Operating Lease for Lessee and Lessor) On February 20, 2014, Barbara Brent Inc., purchased a machine for $1,500,000 for the purpose of leasing it. The machine is expected to have a 10-year life, no residual value, and will be depreciated on the straight-line basis. The machine was leased to Rudy Company on March 1, 2014, for a 4-year period at a monthly rental of $19,500. There is no provision for the renewal of the lease or purchase of the machine by the lessee at the expiration of the lease term. Brent paid $30,000 of commissions associated with negotiating the lease in February 2014. Instructions (a) What expense should Rudy Company record as a result of the facts above for the year ended December 31, 2014? Show supporting computations in good form. (b) What income or loss before income taxes should Brent record as a result of the facts above for the year ended December 31, 2014? (Hint: Amortize commissions over the life of the lease.) (AICPA adapted) 10 * E21-15 (Sale-Leaseback) Assume that on January 1, 2014, Elmer’s Restaurants sells a computer system to Liquidity Finance Co. for $680,000 and immediately leases the computer system back. The relevant information is as follows. 1. The computer was carried on Elmer’s books at a value of $600,000. 2. The term of the noncancelable lease is 10 years; title will transfer to Elmer. 3. The lease agreement requires equal rental payments of $110,666.81 at the end of each year. 1320 Chapter 21 Accounting for Leases 4. The incremental borrowing rate for Elmer is 12%. Elmer is aware that Liquidity Finance Co. set the annual rental to insure a rate of return of 10%. 5. The computer has a fair value of $680,000 on January 1, 2014, and an estimated economic life of 10 years. 6. Elmer pays executory costs of $9,000 per year. Instructions Prepare the journal entries for both the lessee and the lessor for 2014 to reflect the sale and leaseback agree- ment. No uncertainties exist, and collectibility is reasonably certain. 10 *E 21-16 (Lessee-Lessor, Sale-Leaseback) Presented below are four independent situations. (a) On December 31, 2014, Zarle Inc. sold computer equipment to Daniell Co. and immediately leased it back for 10 years. The sales price of the equipment was $520,000, its carrying amount is $400,000, and its estimated remaining economic life is 12 years. Determine the amount of deferred revenue to be reported from the sale of the computer equipment on December 31, 2014. (b) On December 31, 2014, Wasicsko Co. sold a machine to Cross Co. and simultaneously leased it back for one year. The sale price of the machine was $480,000, the carrying amount is $420,000, and it had an estimated remaining useful life of 14 years. The present value of the rental payments for the one year is $35,000. At December 31, 2014, how much should Wasicsko report as deferred revenue from the sale of the machine? (c) On January 1, 2014, McKane Corp. sold an airplane with an estimated useful life of 10 years. At the same time, McKane leased back the plane for 10 years. The sales price of the airplane was $500,000, the carrying amount $379,000, and the annual rental $73,975.22. McKane Corp. intends to depreciate the leased asset using the sum-of-the-years’-digits depreciation method. Discuss how the gain on the sale should be reported at the end of 2014 in the financial statements. (d) On January 1, 2014, Sondgeroth Co. sold equipment with an estimated useful life of 5 years. At the same time, Sondgeroth leased back the equipment for 2 years under a lease classified as an operat-

ing lease. The sales price (fair value) of the equipment was $212,700, the carrying amount is $300,000, the monthly rental under the lease is $6,000, and the present value of the rental payments is $115,753. For the year ended December 31, 2014, determine which items would be reported on its income statement for the sale-leaseback transaction. EXERCISES SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of exercises. PROBLEMS 2 8 P21-1 (Lessee-Lessor Entries, Sales-Type Lease) Glaus Leasing Company agrees to lease machinery to Jensen Corporation on January 1, 2014. The following information relates to the lease agreement. 1. The term of the lease is 7 years with no renewal option, and the machinery has an estimated eco- nomic life of 9 years. 2. The cost of the machinery is $525,000, and the fair value of the asset on January 1, 2014, is $700,000. 3. At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $100,000. Jensen depreciates all of its equipment on a straight-line basis. 4. The lease agreement requires equal annual rental payments, beginning on January 1, 2014. 5. The collectibility of the lease payments is reasonably predictable, and there are no important uncer- tainties surrounding the amount of costs yet to be incurred by the lessor. 6. Glaus desires a 10% rate of return on its investments. Jensen’s incremental borrowing rate is 11%, and the lessor’s implicit rate is unknown. Instructions (Assume the accounting period ends on December 31.) (a) Discuss the nature of this lease for both the lessee and the lessor. (b) Calculate the amount of the annual rental payment required. Problems 1321 (c) Compute the present value of the minimum lease payments. (d) Prepare the journal entries Jensen would make in 2014 and 2015 related to the lease arrangement. (e) Prepare the journal entries Glaus would make in 2014 and 2015. 3 4 P21-2 (Lessee-Lessor Entries, Operating Lease) Cleveland Inc. leased a new crane to Abriendo Construc- tion under a 5-year noncancelable contract starting January 1, 2014. Terms of the lease require payments of $33,000 each January 1, starting January 1, 2014. Cleveland will pay insurance, taxes, and maintenance charges on the crane, which has an estimated life of 12 years, a fair value of $240,000, and a cost to Cleve- land of $240,000. The estimated fair value of the crane is expected to be $45,000 at the end of the lease term. No bargain-purchase or renewal options are included in the contract. Both Cleveland and Abriendo adjust and close books annually at December 31. Collectibility of the lease payments is reasonably certain, and no uncertainties exist relative to unreimbursable lessor costs. Abriendo’s incremental borrowing rate is 10%, and Cleveland’s implicit interest rate of 9% is known to Abriendo. Instructions (a) Identify the type of lease involved and give reasons for your classification. Discuss the accounting treatment that should be applied by both the lessee and the lessor. (b) Prepare all the entries related to the lease contract and leased asset for the year 2014 for the lessee and lessor, assuming the following amounts. (1) Insurance $500. (2) Taxes $2,000. (3) Maintenance $650. (4) Straight-line depreciation and salvage value $15,000. (c) Discuss what should be presented in the balance sheet, the income statement, and the related notes of both the lessee and the lessor at December 31, 2014. 2 8 P21-3 (Lessee-Lessor Entries, Balance Sheet Presentation, Sales-Type Lease) Winston Industries and 9 Ewing Inc. enter into an agreement that requires Ewing Inc. to build three diesel-electric engines to W inston’s specifications. Upon completion of the engines, Winston has agreed to lease them for a period of 10 years and to assume all costs and risks of ownership. The lease is noncancelable, becomes effective on January 1, 2014, and requires annual rental payments of $413,971 each January 1, starting January 1, 2014. Winston’s incremental borrowing rate is 10%. The implicit interest rate used by Ewing Inc. and known

to Winston is 8%. The total cost of building the three engines is $2,600,000. The economic life of the engines is estimated to be 10 years, with residual value set at zero. Winston depreciates similar equipment on a straight-line basis. At the end of the lease, Winston assumes title to the engines. Collectibility of the lease payments is reasonably certain; no uncertainties exist relative to unreimbursable lessor costs. Instructions (a) Discuss the nature of this lease transaction from the viewpoints of both lessee and lessor. (b) Prepare the journal entry or entries to record the transaction on January 1, 2014, on the books of Winston Industries. (c) Prepare the journal entry or entries to record the transaction on January 1, 2014, on the books of Ewing Inc. (d) Prepare the journal entries for both the lessee and lessor to record the first rental payment on January 1, 2014. (e) Prepare the journal entries for both the lessee and lessor to record interest expense (revenue) at December 31, 2014. (Prepare a lease amortization schedule for 2 years.) (f) Show the items and amounts that would be reported on the balance sheet (not notes) at December 31, 2014, for both the lessee and the lessor. 2 9 P21-4 (Balance Sheet and Income Statement Disclosure—Lessee) The following facts pertain to a noncancelable lease agreement between Alschuler Leasing Company and McKee Electronics, a lessee, for a computer system. Inception date October 1, 2014 Lease term 6 years Economic life of leased equipment 6 years Fair value of asset at October 1, 2014 $300,383 Residual value at end of lease term –0– Lessor’s implicit rate 10% Lessee’s incremental borrowing rate 10% Annual lease payment due at the beginning of each year, beginning with October 1, 2014 $62,700 1322 Chapter 21 Accounting for Leases T he collectibility of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. The lessee assumes responsibility for all executory costs, which amount to $5,500 per year and are to be paid each October 1, beginning October 1, 2014. (This $5,500 is not included in the rental payment of $62,700.) The asset will revert to the lessor at the end of the lease term. The straight-line depreciation method is used for all equipment. The following amortization schedule has been prepared correctly for use by both the lessor and the lessee in accounting for this lease. The lease is to be accounted for properly as a capital lease by the lessee and as a direct-financing lease by the lessor. Annual Lease Interest (10%) Reduction Balance of Payment/ on Unpaid of Lease Lease Date Receipt Liability/Receivable Liability/Receivable Liability/Receivable 10/01/14 $300,383 10/01/14 $ 62,700 $ 62,700 237,683 10/01/15 62,700 $23,768 38,932 198,751 10/01/16 62,700 19,875 42,825 155,926 10/01/17 62,700 15,593 47,107 108,819 10/01/18 62,700 10,882 51,818 57,001 10/01/19 62,700 5,699* 57,001 –0– $376,200 $75,817 $300,383 *Rounding error is $1. Instructions (a) Assuming the lessee’s accounting period ends on September 30, answer the following questions with respect to this lease agreement. (1) What items and amounts will appear on the lessee’s income statement for the year ending September 30, 2015? (2) What items and amounts will appear on the lessee’s balance sheet at September 30, 2015? (3) W hat items and amounts will appear on the lessee’s income statement for the year ending September 30, 2016? (4) What items and amounts will appear on the lessee’s balance sheet at September 30, 2016? (b) Assuming the lessee’s accounting period ends on December 31, answer the following questions with respect to this lease agreement. (1) W hat items and amounts will appear on the lessee’s income statement for the year ending December 31, 2014? (2) What items and amounts will appear on the lessee’s balance sheet at December 31, 2014? (3) W hat items and amounts will appear on the lessee’s income statement for the year ending December 31, 2015? (4) What items and amounts will appear on the lessee’s balance sheet at December 31, 2015?

5 9 P21-5 (Balance Sheet and Income Statement Disclosure—Lessor) Assume the same information as in P21-4. Instructions (a) Assuming the lessor’s accounting period ends on September 30, answer the following questions with respect to this lease agreement. (1) What items and amounts will appear on the lessor’s income statement for the year ending September 30, 2015? (2) What items and amounts will appear on the lessor’s balance sheet at September 30, 2015? (3) What items and amounts will appear on the lessor’s income statement for the year ending September 30, 2016? (4) What items and amounts will appear on the lessor’s balance sheet at September 30, 2016? (b) Assuming the lessor’s accounting period ends on December 31, answer the following questions with respect to this lease agreement. (1) What items and amounts will appear on the lessor’s income statement for the year ending December 31, 2014? (2) What items and amounts will appear on the lessor’s balance sheet at December 31, 2014? (3) What items and amounts will appear on the lessor’s income statement for the year ending December 31, 2015? (4) What items and amounts will appear on the lessor’s balance sheet at December 31, 2015? Problems 1323 2 7 P21-6 (Lessee Entries with Residual Value) The following facts pertain to a noncancelable lease agree- ment between Faldo Leasing Company and Vance Company, a lessee. Inception date January 1, 2014 Annual lease payment due at the beginning of each year, beginning with January 1, 2014 $124,798 Residual value of equipment at end of lease term, guaranteed by the lessee $50,000 Lease term 6 years Economic life of leased equipment 6 years Fair value of asset at January 1, 2014 $600,000 Lessor’s implicit rate 12% Lessee’s incremental borrowing rate 12% The lessee assumes responsibility for all executory costs, which are expected to amount to $5,000 per year. The asset will revert to the lessor at the end of the lease term. The lessee has guaranteed the lessor a residual value of $50,000. The lessee uses the straight-line depreciation method for all equipment. Instructions (a) Prepare an amortization schedule that would be suitable for the lessee for the lease term. (b) Prepare all of the journal entries for the lessee for 2014 and 2015 to record the lease agreement, the lease payments, and all expenses related to this lease. Assume the lessee’s annual accounting period ends on December 31 and reversing entries are used when appropriate. 2 9 P21-7 (Lessee Entries and Balance Sheet Presentation, Capital Lease) Ludwick Steel Company as lessee signed a lease agreement for equipment for 5 years, beginning December 31, 2014. Annual rental pay- ments of $40,000 are to be made at the beginning of each lease year (December 31). The taxes, insurance, and the maintenance costs are the obligation of the lessee. The interest rate used by the lessor in setting the payment schedule is 9%; Ludwick’s incremental borrowing rate is 10%. Ludwick is unaware of the rate being used by the lessor. At the end of the lease, Ludwick has the option to buy the equipment for $1, considerably below its estimated fair value at that time. The equipment has an estimated useful life of 7 years, with no salvage value. Ludwick uses the straight-line method of depreciation on similar owned equipment. Instructions (a) Prepare the journal entry or entries, with explanations, that should be recorded on December 31, 2014, by Ludwick. (b) Prepare the journal entry or entries, with explanations, that should be recorded on December 31, 2015, by Ludwick. (Prepare the lease amortization schedule for all five payments.) (c) Prepare the journal entry or entries, with explanations, that should be recorded on December 31, 2016, by Ludwick. (d) What amounts would appear on Ludwick’s December 31, 2016, balance sheet relative to the lease arrangement? 2 9 P21-8 (Lessee Entries and Balance Sheet Presentation, Capital Lease) On January 1, 2014, Cage Company contracts to lease equipment for 5 years, agreeing to make a payment of $137,899 (including the executory costs of $6,000) at the beginning of each year, starting January 1, 2014. The taxes, the

insurance, and the maintenance, estimated at $6,000 a year, are the obligations of the lessee. The leased equipment is to be capitalized at $550,000. The asset is to be depreciated on a double-declining-balance basis, and the obligation is to be reduced on an effective-interest basis. Cage’s incremental borrowing rate is 12%, and the implicit rate in the lease is 10%, which is known by Cage. Title to the equipment transfers to Cage when the lease expires. The asset has an estimated useful life of 5 years and no residual value. Instructions (a) Explain the probable relationship of the $550,000 amount to the lease arrangement. (b) Prepare the journal entry or entries that should be recorded on January 1, 2014, by Cage Company. (c) Prepare the journal entry to record depreciation of the leased asset for the year 2014. (d) Prepare the journal entry to record the interest expense for the year 2014. (e) Prepare the journal entry to record the lease payment of January 1, 2015, assuming reversing entries are not made. (f) What amounts will appear on the lessee’s December 31, 2014, balance sheet relative to the lease contract? 1324 Chapter 21 Accounting for Leases 2 P21-9 (Lessee Entries, Capital Lease with Monthly Payments) Shapiro Inc. was incorporated in 2013 to operate as a computer software service firm with an accounting fiscal year ending August 31. Shapiro’s primary product is a sophisticated online inventory-control system; its customers pay a fixed fee plus a usage charge for using the system. Shapiro has leased a large, Alpha-3 computer system from the manufacturer. The lease calls for a monthly rental of $40,000 for the 144 months (12 years) of the lease term. The estimated useful life of the computer is 15 years. Each scheduled monthly rental payment includes $3,000 for full-service maintenance on the computer to be performed by the manufacturer. All rentals are payable on the first day of the month beginning with August 1, 2014, the date the computer was installed and the lease agreement was signed. The lease is non- cancelable for its 12-year term, and it is secured only by the manufacturer’s chattel lien on the Alpha-3 system. This lease is to be accounted for as a capital lease by Shapiro, and it will be depreciated by the straight- line method with no expected salvage value. Borrowed funds for this type of transaction would cost Shap- iro 12% per year (1% per month). Following is a schedule of the present value of $1 for selected periods discounted at 1% per period when payments are made at the beginning of each period. Periods Present Value of $1 per Period (months) Discounted at 1% per Period 1 1.000 2 1.990 3 2.970 143 76.658 144 76.899 Instructions Prepare all entries Shapiro should have made in its accounting records during August 2014 relating to this lease. Give full explanations and show supporting computations for each e ntry. Remember, August 31, 2014, is the end of Shapiro’s fiscal accounting period and it will be preparing financial statements on that date. Do not prepare closing entries. (AICPA adapted) 4 7 P21-10 (Lessor Computations and Entries, Sales-Type Lease with Unguaranteed Residual Value) George 8 Company manufactures a check-in kiosk with an estimated economic life of 12 years and leases it to N ational Airlines for a period of 10 years. The normal selling price of the equipment is $278,072, and its unguaranteed residual value at the end of the lease term is estimated to be $20,000. National will pay annual payments of $40,000 at the beginning of each year and all maintenance, insurance, and taxes. George incurred costs of $180,000 in manufacturing the equipment and $4,000 in negotiating and closing the lease. George has determined that the collectibility of the lease payments is reasonably predictable, that no additional costs will be incurred, and that the implicit interest rate is 10%. Instructions (a) Discuss the nature of this lease in relation to the lessor and compute the amount of each of the following items. (1) Lease receivable. (2) Sales price.

(3) Cost of sales. (b) Prepare a 10-year lease amortization schedule. (c) Prepare all of the lessor’s journal entries for the first year. 2 6 P21-11 (Lessee Computations and Entries, Capital Lease with Unguaranteed Residual Value) Assume 7 the same data as in P21-10 with National Airlines Co. having an incremental borrowing rate of 10%. Instructions (a) Discuss the nature of this lease in relation to the lessee, and compute the amount of the initial lease liability. (b) Prepare a 10-year lease amortization schedule. (c) Prepare all of the lessee’s journal entries for the first year. 2 6 P21-12 (Basic Lessee Accounting with Difficult PV Calculation) In 2013, Grishell Trucking Company negotiated and closed a long-term lease contract for newly constructed truck terminals and freight storage facilities. The buildings were erected to the company’s specifications on land owned by the company. On January 1, 2014, Grishell Trucking Company took possession of the lease properties. On Problems 1325 January 1, 2014 and 2015, the company made cash payments of $948,000 that were recorded as rental expenses. Although the terminals have a composite useful life of 40 years, the noncancelable lease runs for 20 years from January 1, 2014, with a bargain-purchase option available upon expiration of the lease. The 20-year lease is effective for the period January 1, 2014, through December 31, 2033. Advance rental payments of $800,000 are payable to the lessor on January 1 of each of the first 10 years of the lease term. Advance rental payments of $320,000 are due on January 1 for each of the last 10 years of the lease. The company has an option to purchase all of these leased facilities for $1 on December 31, 2033. It also must make annual payments to the lessor of $125,000 for property taxes and $23,000 for insurance. The lease was negotiated to assure the lessor a 6% rate of return. Instructions (a) Prepare a schedule to compute for Grishell Trucking Company the present value of the terminal facilities and related obligation at January 1, 2014. (b) Assuming that the present value of terminal facilities and related obligation at January 1, 2014, was $7,600,000, prepare journal entries for Grishell Trucking Company to record the: (1) Cash payment to the lessor on January 1, 2016. (2) Amortization of the cost of the leased properties for 2016 using the straight-line method and assuming a zero salvage value. (3) Accrual of interest expense at December 31, 2016. Selected present value factors are as follows. For an Ordinary Periods Annuity of $1 at 6% For $1 at 6% 1 .943396 .943396 2 1.833393 .889996 8 6.209794 .627412 9 6.801692 .591898 10 7.360087 .558395 19 11.158117 .330513 20 11.469921 .311805 (AICPA adapted) 4 7 P21-13 (Lessor Computations and Entries, Sales-Type Lease with Guaranteed Residual Value) Amirante 8 Inc. manufactures an X-ray machine with an estimated life of 12 years and leases it to Chambers Medical Center for a period of 10 years. The normal selling price of the machine is $411,324, and its guaranteed residual value at the end of the noncancelable lease term is estimated to be $15,000. The hospital will pay rents of $60,000 at the beginning of each year and all maintenance, insurance, and taxes. Amirante Inc. incurred costs of $250,000 in manufacturing the machine and $14,000 in negotiating and closing the lease. Amirante Inc. has determined that the collectibility of the lease payments is reasonably predictable, that there will be no additional costs incurred, and that the implicit interest rate is 10%. Instructions (a) Discuss the nature of this lease in relation to the lessor and compute the amount of each of the following items. (1) Lease receivable at inception of the lease. (2) Sales price. (3) Cost of sales. (b) Prepare a 10-year lease amortization schedule. (c) Prepare all of the lessor’s journal entries for the first year. 2 7 P21-14 (Lessee Computations and Entries, Capital Lease with Guaranteed Residual Value) Assume the same data as in P21-13 and that Chambers Medical Center has an incremental borrowing rate of 10%.

Instructions (a) Discuss the nature of this lease in relation to the lessee, and compute the amount of the initial lease liability. (b) Prepare a 10-year lease amortization schedule. (c) Prepare all of the lessee’s journal entries for the first year. 1326 Chapter 21 Accounting for Leases 2 3 P21-15 (Operating Lease vs. Capital Lease) You are auditing the December 31, 2014, financial statements 7 of Hockney, Inc., manufacturer of novelties and party favors. During your inspection of the company g arage, you discovered that a used automobile not listed in the equipment subsidiary ledger is parked there. You ask Stacy Reeder, plant manager, about the vehicle, and she tells you that the company did not list the automobile because the company was only leasing it. The lease agreement was entered into on January 1, 2014, with Crown New and Used Cars. You decide to review the lease agreement to ensure that the lease should be afforded operating lease treatment, and you discover the following lease terms. 1. Noncancelable term of 4 years. 2. Rental of $3,240 per year (at the end of each year). (The present value at 8% per year is $10,731.) 3. Estimated residual value after 4 years is $1,100. (The present value at 8% per year is $809.) Hockney guarantees the residual value of $1,100. 4. Estimated economic life of the automobile is 5 years. 5. Hockney’s incremental borrowing rate is 8% per year. Instructions You are a senior auditor writing a memo to your supervisor, the audit partner in charge of this audit, to discuss the above situation. Be sure to include (a) why you inspected the lease agreement, (b) what you determined about the lease, and (c) how you advised your client to account for this lease. Explain every journal entry that you believe is necessary to record this lease properly on the client’s books. (It is also necessary to include the fact that you communicated this information to your client.) 2 4 P21-16 (Lessee-Lessor Accounting for Residual Values) Goring Dairy leases its milking equipment from 7 King Finance Company under the following lease terms. 1. The lease term is 10 years, noncancelable, and requires equal rental payments of $30,300 due at the beginning of each year starting January 1, 2014. 2. The equipment has a fair value and cost at the inception of the lease (January 1, 2014) of $220,404, an estimated economic life of 10 years, and a residual value (which is guaranteed by Goring Dairy) of $20,000. 3. The lease contains no renewable options, and the equipment reverts to King Finance Company upon termination of the lease. 4. Goring Dairy’s incremental borrowing rate is 9% per year. The implicit rate is also 9%. 5. Goring Dairy depreciates similar equipment that it owns on a straight-line basis. 6. Collectibility of the payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. Instructions (a) Evaluate the criteria for classification of the lease, and describe the nature of the lease. In general, discuss how the lessee and lessor should account for the lease transaction. (b) Prepare the journal entries for the lessee and lessor at January 1, 2014, and December 31, 2014 (the lessee’s and lessor’s year-end). Assume no reversing entries. (c) What would have been the amount capitalized by the lessee upon the inception of the lease if: (1) The residual value of $20,000 had been guaranteed by a third party, not the lessee? (2) The residual value of $20,000 had not been guaranteed at all? (d) On the lessor’s books, what would be the amount recorded as the Net Investment (Lease Receiv- able) at the inception of the lease, assuming: (1) The residual value of $20,000 had been guaranteed by a third party? (2) The residual value of $20,000 had not been guaranteed at all? (e) Suppose the useful life of the milking equipment is 20 years. How large would the residual value have to be at the end of 10 years in order for the lessee to qualify for the operating method? (Assume that the residual value would be guaranteed by a third party.) (Hint: The lessee’s annual payments

will be appropriately reduced as the residual value increases.) PROBLEMS SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of problems. Concepts for Analysis 1327 CONCEPTS FOR ANALYSIS CA21-1 (Lessee Accounting and Reporting) On January 1, 2014, Evans Company entered into a noncan- celable lease for a machine to be used in its manufacturing operations. The lease transfers ownership of the machine to Evans by the end of the lease term. The term of the lease is 8 years. The minimum lease payment made by Evans on January 1, 2014, was one of eight equal annual payments. At the inception of the lease, the criteria established for classification as a capital lease by the lessee were met. Instructions (a) What is the theoretical basis for the accounting standard that requires certain long-term leases to be capitalized by the lessee? Do not discuss the specific criteria for classifying a specific lease as a capital lease. (b) How should Evans account for this lease at its inception and determine the amount to be recorded? (c) What expenses related to this lease will Evans incur during the first year of the lease, and how will they be determined? (d) How should Evans report the lease transaction on its December 31, 2014, balance sheet? CA21-2 (Lessor and Lessee Accounting and Disclosure) Sylvan Inc. entered into a noncancelable lease ar- rangement with Breton Leasing Corporation for a certain machine. Breton’s primary business is leasing; it is not a manufacturer or dealer. Sylvan will lease the machine for a period of 3 years, which is 50% of the ma- chine’s economic life. Breton will take possession of the machine at the end of the initial 3-year lease and lease it to another, smaller company that does not need the most current version of the machine. Sylvan does not guarantee any residual value for the machine and will not purchase the machine at the end of the lease term. Sylvan’s incremental borrowing rate is 10%, and the implicit rate in the lease is 9%. Sylvan has no way of knowing the implicit rate used by Breton. Using either rate, the present value of the minimum lease pay- ments is between 90% and 100% of the fair value of the machine at the date of the lease agreement. Sylvan has agreed to pay all executory costs directly, and no allowance for these costs is included in the lease payments. Breton is reasonably certain that Sylvan will pay all lease payments. Because Sylvan has agreed to pay all executory costs, there are no important uncertainties regarding costs to be incurred by Breton. Assume that no indirect costs are involved. Instructions (a) With respect to Sylvan (the lessee), answer the following. (1) What type of lease has been entered into? Explain the reason for your answer. (2) H ow should Sylvan compute the appropriate amount to be recorded for the lease or asset acquired? (3) What accounts will be created or affected by this transaction, and how will the lease or asset and other costs related to the transaction be matched with earnings? (4) What disclosures must Sylvan make regarding this leased asset? (b) With respect to Breton (the lessor), answer the following. (1) What type of leasing arrangement has been entered into? Explain the reason for your answer. (2) How should this lease be recorded by Breton, and how are the appropriate amounts determined? (3) H ow should Breton determine the appropriate amount of earnings to be recognized from each lease payment? (4) What disclosures must Breton make regarding this lease? (AICPA adapted) CA21-3 (Lessee Capitalization Criteria) On January 1, Santiago Company, a lessee, entered into three noncancelable leases for brand-new equipment, Lease L, Lease M, and Lease N. None of the three leases transfers ownership of the equipment to Santiago at the end of the lease term. For each of the three leases, the present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the

lessor, is 75% of the fair value of the equipment. The following information is peculiar to each lease. 1. Lease L does not contain a bargain-purchase option. The lease term is equal to 80% of the estimated economic life of the equipment. 2. Lease M contains a bargain-purchase option. The lease term is equal to 50% of the estimated eco- nomic life of the equipment. 3. Lease N does not contain a bargain-purchase option. The lease term is equal to 50% of the estimated economic life of the equipment. 1328 Chapter 21 Accounting for Leases Instructions (a) How should Santiago Company classify each of the three leases above, and why? Discuss the ratio- nale for your answer. (b) What amount, if any, should Santiago record as a liability at the inception of the lease for each of the three leases above? (c) Assuming that the minimum lease payments are made on a straight-line basis, how should Santiago record each minimum lease payment for each of the three leases above? (AICPA adapted) CA21-4 (Comparison of Different Types of Accounting by Lessee and Lessor) Part 1: Capital leases and operating leases are the two classifications of leases described in FASB pro- nouncements from the standpoint of the lessee. Instructions (a) Describe how a capital lease would be accounted for by the lessee both at the inception of the lease and during the first year of the lease, assuming the lease transfers ownership of the property to the lessee by the end of the lease. (b) Describe how an operating lease would be accounted for by the lessee both at the inception of the lease and during the first year of the lease, assuming equal monthly payments are made by the lessee at the beginning of each month of the lease. Describe the change in accounting, if any, when rental payments are not made on a straight-line basis. Do not discuss the criteria for distinguishing between capital leases and operating leases. Part 2: Sales-type leases and direct-financing leases are two of the classifications of leases described in FASB pronouncements from the standpoint of the lessor. Instructions Compare and contrast a sales-type lease with a direct-financing lease as follows. (a) Lease receivable. (b) Recognition of interest revenue. (c) Manufacturer’s or dealer’s profit. Do not discuss the criteria for distinguishing between the leases described above and operating leases. (AICPA adapted) CA21-5 (Lessee Capitalization of Bargain-Purchase Option) Albertsen Corporation is considering pro- posals for either leasing or purchasing aircraft. The proposed lease agreement involves a twin-engine turboprop Viking that has a fair value of $1,000,000. This plane would be leased for a period of 10 years beginning January 1, 2014. The lease agreement is cancelable only upon accidental destruction of the plane. An annual lease payment of $141,780 is due on January 1 of each year; the first payment is to be made on January 1, 2014. Maintenance operations are strictly scheduled by the lessor, and Albertsen Cor- poration will pay for these services as they are performed. Estimated annual maintenance costs are $6,900. The lessor will pay all insurance premiums and local property taxes, which amount to a combined total of $4,000 annually and are included in the annual lease payment of $141,780. Upon expiration of the 10-year lease, Albertsen Corporation can purchase the Viking for $44,440. The estimated useful life of the plane is 15 years, and its salvage value in the used plane market is estimated to be $100,000 after 10 years. The salvage value probably will never be less than $75,000 if the engines are overhauled and maintained as prescribed by the manufacturer. If the purchase option is not exercised, possession of the plane will revert to the lessor, and there is no provision for renewing the lease agreement beyond its termination on December 31, 2023. Albertsen Corporation can borrow $1,000,000 under a 10-year term loan agreement at an annual inter- est rate of 12%. The lessor’s implicit interest rate is not expressly stated in the lease agreement, but this rate

appears to be approximately 8% based on 10 net rental payments of $137,780 per year and the initial fair value of $1,000,000 for the plane. On January 1, 2014, the present value of all net rental payments and the purchase option of $44,440 is $888,890 using the 12% interest rate. The present value of all net rental pay- ments and the $44,440 purchase option on January 1, 2014, is $1,022,226 using the 8% interest rate implicit in the lease agreement. The financial vice president of Albertsen Corporation has established that this lease agreement is a capital lease as defined in GAAP. Instructions (a) What is the appropriate amount that Albertsen Corporation should recognize for the leased aircraft on its balance sheet after the lease is signed? Using Your Judgment 1329 (b) Without prejudice to your answer in part (a), assume that the annual lease payment is $141,780 as stated in the question, that the appropriate capitalized amount for the leased aircraft is $1,000,000 on January 1, 2014, and that the interest rate is 9%. How will the lease be reported in the December 31, 2014, balance sheet and related income statement? (Ignore any income tax implications.) (CMA adapted) CA21-6 (Lease Capitalization, Bargain-Purchase Option) Baden Corporation entered into a lease agree- ment for 10 photocopy machines for its corporate headquarters. The lease agreement qualifies as an operat- ing lease in all terms except there is a bargain-purchase option. After the 5-year lease term, the corporation can purchase each copier for $1,000, when the anticipated fair value is $2,500. Jerry Suffolk, the financial vice president, thinks the financial statements must recognize the lease agreement as a capital lease because of the bargain-purchase option. The controller, Diane Buchanan, dis- agrees: “Although I don’t know much about the copiers themselves, there is a way to avoid recording the lease liability.” She argues that the corporation might claim that copier technology advances rapidly and that by the end of the lease term the machines will most likely not be worth the $1,000 bargain price. Instructions Answer the following questions. (a) What ethical issue is at stake? (b) Should the controller’s argument be accepted if she does not really know much about copier tech- nology? Would it make a difference if the controller were knowledgeable about the pace of change in copier technology? (c) What should Suffolk do? *C A21-7 (Sale-Leaseback) On January 1, 2014, Perriman Company sold equipment for cash and leased it back. As seller-lessee, Perriman retained the right to substantially all of the remaining use of the equipment. The term of the lease is 8 years. There is a gain on the sale portion of the transaction. The lease portion of the transaction is classified appropriately as a capital lease. Instructions (a) What is the theoretical basis for requiring lessees to capitalize certain long-term leases? Do not discuss the specific criteria for classifying a lease as a capital lease. (b) (1) H ow should Perriman account for the sale portion of the sale-leaseback transaction at January 1, 2014? (2) How should Perriman account for the leaseback portion of the sale-leaseback transaction at January 1, 2014? (c) How should Perriman account for the gain on the sale portion of the sale-leaseback transaction during the first year of the lease? Why? (AICPA adapted) USING YOUR JUDGMENT FINANCIAL REPORTING Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report, including the notes to the financial statements, can be accessed at the book’s companion website, www. wiley.com/college/kieso. Instructions Refer to P&G’s financial statements, accompanying notes, and management’s discussion and analysis to answer the following questions. (a) What types of leases are used by P&G? (b) What amount of capital leases was reported by P&G in total and for less than one year? (c) What minimum annual rental commitments under all noncancelable leases at June 30, 2011, did P&G disclose?

11333300 CChhaapptteerr 2211 AAccccoouunnttiinngg ffoorr LLeeaasseess Comparative Analysis Case UAL, Inc. and Southwest Airlines Instructions Go to the book’s companion website or the company websites and use information found there to answer the following questions related to UAL, Inc. and Southwest Airlines. (a) What types of leases are used by Southwest and on what assets are these leases primarily used? (b) How long-term are some of Southwest’s leases? What are some of the characteristics or provisions of Southwest’s (as lessee) leases? (c) What did Southwest report in 2011 as its future minimum annual rental commitments under noncan- celable leases? (d) At year-end 2011, what was the present value of the minimum rental payments under Southwest’s capital leases? How much imputed interest was deducted from the future minimum annual rental commitments to arrive at the present value? (e) What were the amounts and details reported by Southwest for rental expense in 2011, 2010, and 2009? (f) How does UAL’s use of leases compare with Southwest’s? Financial Statement Analysis Case Wal-Mart Stores, Inc. Presented in Illustration 21-31 are the financial statement disclosures from the January 31, 2012, annual report of Wal-Mart Stores, Inc. Instructions Answer the following questions related to these disclosures. (a) What is the total obligation under capital leases at January 31, 2012, for Wal-Mart? (b) What is the total rental expense reported for leasing activity for the year ended January 31, 2012, for Wal-Mart? (c) Estimate the off-balance-sheet liability due to Wal-Mart’s operating leases at January 31, 2012. Accounting, Analysis, and Principles Salaur Company is evaluating a lease arrangement being offered by TSP Company for use of a computer system. The lease is noncancelable, and in no case does Salaur receive title to the computers during or at the end of the lease term. The lease starts on January 1, 2014, with the first rental payment due on January 1, 2014. Additional information related to the lease is as follows. Yearly rental $3,557.25 Lease term 3 years Estimated economic life 5 years Purchase option $3,000 at end of 3 years, which approximates fair value Renewal option 1 year at $1,500; no penalty for nonrenewal; standard renewal clause Fair value at inception of lease $10,000 Cost of asset to lessor $10,000 Residual value: Guaranteed –0– Unguaranteed $3,000 Lessor’s implicit rate (known by the lessee) 12% Executory costs paid by: Lessor; estimated to be $500 per year (included in rental equipment) Estimated fair value at end of lease $3,000 Accounting Analyze the lease capitalization criteria for this lease for Salaur Company. Prepare the journal entry for Salaur on January 1, 2014. IFRLSa Isnts Higehatds 11333311 Analysis Briefly discuss the impact of the accounting for this lease for two common ratios: return on assets and debt to total assets. Principles What element of faithful representation (completeness, neutrality, free from error) is being addressed when a company like Salaur evaluates lease capitalization criteria? BRIDGE TO THE PROFESSION Professional Research: FASB Codifi cation Daniel Hardware Co. is considering alternative financing arrangements for equipment used in its ware- houses. Besides purchasing the equipment outright, Daniel is also considering a lease. Accounting for the outright purchase is fairly straightforward, but because Daniel has not used equipment leases in the past, the accounting staff is less informed about the specific accounting rules for leases. The staff is aware of some lease rules related to a “90 percent of fair value,” “75 percent of useful life,” and “residual value deficiencies,” but they are unsure about the meanings of these terms in lease accounting. Daniel has asked you to conduct some research on these items related to lease capitalization criteria. Instructions If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses.

(a) What is the objective of lease classification criteria? (b) An important element of evaluating leases is determining whether substantially all of the risks and rewards of ownership are transferred in the lease. How is “substantially all” defined in the authorita- tive literature? (c) Besides the noncancelable term of the lease, name at least three other considerations in determining the “lease term.” (d) A common issue in the accounting for leases concerns lease requirements that the lessee make up a residual value deficiency that is attributable to damage, extraordinary wear and tear, or excessive us- age (e.g., excessive mileage on a leased vehicle). Do these features constitute a lessee guarantee of the residual value such that the estimated residual value of the leased property at the end of the lease term should be included in minimum lease payments? Explain. Additional Professional Resources See the book’s companion website, at www.wiley.com/college/kieso, for professional simulations as well as other study resources. IFRS INSIGHTS Leasing is a global business. Lessors and lessees enter into arrangements with 11 LEARNING OBJECTIVE one another without regard to national boundaries. Although GAAP and IFRS Compare the accounting for leases for leasing are similar, both the FASB and the IASB have decided that the exist- under GAAP and IFRS. ing accounting does not provide the most useful, transparent, and complete information about leasing transactions that should be provided in the financial statements. 1332 Chapter 21 Accounting for Leases RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to the accounting for leases. Similarities • Both GAAP and IFRS share the same objective of recording leases by lessees and l essors according to their economic substance—that is, according to the defi nitions of assets and liabilities. • Much of the terminology for lease accounting in IFRS and GAAP is the same. • Under IFRS, lessees and lessors use the same general lease capitalization criteria to determine if the risks and rewards of ownership have been transferred in the lease. Differences • One difference in lease terminology is that fi nance leases are referred to as capital leases in GAAP. • GAAP for leases uses bright-line criteria to determine if a lease arrangement transfers the risks and rewards of ownership; IFRS is more general in its provisions. • GAAP has additional lessor criteria: payments are collectible and there are no addi- tional costs associated with a lease. • IFRS requires that lessees use the implicit rate to record a lease unless it is impractical to determine the lessor’s implicit rate. GAAP requires use of the incremental rate unless the implicit rate is known by the lessee and the implicit rate is lower than the incremental rate. • Under GAAP, extensive disclosure of future non-cancelable lease payments is re- quired for each of the next fi ve years and the years thereafter. Although some interna- tional companies (e.g., Nokia) provide a year-by-year breakout of payments due in years 1 through 5, IFRS does not require it. • The FASB standard for leases was originally issued in 1976. The standard (SFAS No. 13) has been the subject of more than 30 interpretations since its issuance. The IFRS leasing standard is IAS 17, fi rst issued in 1982. This standard is the subject of only three interpretations. One reason for this small number of interpretations is that IFRS does not specifi cally address a number of leasing transactions that are covered by GAAP. Examples include lease agreements for natural resources, sale-leasebacks, real estate leases, and leveraged leases. ABOUT THE NUMBERS Accounting by the Lessee If Air France (the lessee) capitalizes a lease, it records an asset and a liability generally equal to the present value of the rental payments. ILFC (the lessor), having transferred substantially all the benefits and risks of ownership, recognizes a sale by removing the asset from the statement of financial position and replacing it with a receivable.

Under IFRS, a lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. In order to record a lease as a finance lease, the lease must be non-cancelable. The IASB identifies the four criteria listed in Illustra- tion IFRS21-1 for assessing whether the risks and rewards have been transferred in the lease arrangement. IFRS Insights 1333 ILLUSTRATION Capitalization Criteria (Lessee) IFRS21-1 1. The lease transfers ownership of the property to the lessee. Capitalization Criteria 2. The lease contains a bargain-purchase option. for Lessee 3. The lease term is for the major part of the economic life of the asset. 4. The present value of the minimum lease payments amounts to substantially all of the fair value of the leased asset. Air France classifies and accounts for leases that do not meet any of the four criteria as operating leases. Illustration IFRS21-2 shows that a lease meeting any one of the four criteria results in the lessee having a finance lease. Lease Agreement Is Is Is Is Present There a There a Lease Value of Bargain- Transfer of No Purchase No Term for the Major No Payments No Ownership? Part of Economic Substantially Option? Life? All of Fair Value? Operating Yes Yes Yes Yes Lease Finance Lease ILLUSTRATION IFRS21-2 Thus, the proper classification of a lease is determined based on the substance of the Diagram of Lessee’s lease transaction rather than on its mere form. This determination often requires the use Criteria for Lease of professional judgment of whether the risks and rewards of ownership are transferred. Classifi cation As indicated, the capitalization criteria for finance leases are similar to those used in GAAP for capital leases (see Illustration 21-3 on page 1275). The main differences relate to the economic life and recoverability tests, which we describe in the following sections. Economic Life Test If the lease period is for a major part of the asset’s economic life, the lessor transfers most of the risks and rewards of ownership to the lessee. Capitalization is therefore appropri- ate. However, determining the lease term and what constitutes the major part of the economic life of the asset can be troublesome. The IASB has not defined what is meant by the “major part” of an asset’s economic life. In practice, following the IASB Hierarchy, it has been customary to look to GAAP, which has a 75 percent of economic life threshold for evaluating the economic life test. While the 75 percent guideline may be a useful reference point, it does not represent an automatic cutoff point. Rather, lessees and lessors should consider all relevant factors when assessing whether substantially all the risks and rewards of ownership have been transferred in the lease.21 For purposes of homework, assume a 75 percent threshold for the economic life test, unless otherwise stated. 21See KPMG, Insights into IFRS, Fifth Edition (Thomson Reuters: London, 2008), p. 1011; and The International Financial Reporting Group of Ernst and Young, International GAAP, 2009 (John Wiley and Sons: New York, 2009), p. 1356. 1334 Chapter 21 Accounting for Leases The lease term is generally considered to be the fixed, non-cancelable term of the lease. However, a bargain-renewal option, if provided in the lease agreement, can e xtend this period. A bargain-renewal option allows the lessee to renew the lease for a rental that is lower than the expected fair rental at the date the option becomes exercisable. At the inception of the lease, the difference between the renewal rental and the expected fair rental must be great enough to make exercise of the option to renew reasonably assured. For example, assume that Carrefour leases Lenovo PCs for two years at a rental of $100 per month per computer and subsequently can lease them for $10 per month per computer for another two years. The lease clearly offers a bargain-renewal option; the lease term is considered to be four years. However, with bargain-renewal options, as with bargain-purchase options, it is sometimes difficult to determine what is a bargain.

Determining estimated economic life can also pose problems, especially if the leased item is a specialized item or has been used for a significant period of time. For example, determining the economic life of a nuclear core is extremely difficult. It is subject to much more than normal “wear and tear.” Recovery of Investment Test If the present value of the minimum lease payments equals or exceeds substantially all of the fair value of the asset, then a lessee like Air France should capitalize the leased asset. Why? If the present value of the minimum lease payments is reasonably close to the fair value of the aircraft, Air France is effectively purchasing the asset. As with the economic life test, the IASB has not defined what is meant by “substan- tially all” of an asset’s fair value. In practice, it has been customary to look to GAAP, which has a 90 percent of fair value threshold for assessing the recovery of investment test. Again, rather than focusing on any single element of the lease classification indica- tors, lessees and lessors should consider all relevant factors when evaluating lease clas- sification criteria.22 For purposes of homework, assume a 90 percent threshold for the recovery of investment test. Determining the present value of the minimum lease payments involves three im- portant concepts: (1) minimum lease payments, (2) executory costs, and (3) discount rate. The IFRS guidelines for minimum lease payments and executory costs are the same as that of GAAP. Discount Rate. A lessee, like Air France, computes the present value of the minimum lease payments using the implicit interest rate. This rate is defined as the discount rate that, at the inception of the lease, causes the aggregate present value of the minimum lease payments and the unguaranteed residual value to be equal to the fair value of the leased asset. While Air France may argue that it cannot determine the implicit rate of the lessor, in most cases Air France can approximate the implicit rate used by ILFC. In the event that it is impracticable to determine the implicit rate, Air France should use its incremental borrowing rate. The incremental borrowing rate is the rate of interest the lessee would have to pay on a similar lease or the rate that, at the inception of the lease, the lessee would incur to borrow over a similar term the funds necessary to purchase the asset. 22Ibid. The 75 percent of useful life and 90 percent of fair value “bright-line” cutoffs in GAAP have been criticized. Many believe that lessees structure leases so as to just miss the 75 and 90 percent cutoffs, thereby avoiding classifying leases as finance leases and keeping leased assets and the related liabilities off the statement of financial position. See Warren McGregor, “Accounting for Leases: A New Approach,” Special Report (Norwalk, Conn.: FASB, 1996). IFRS Insights 1335 If known or practicable to estimate, use of the implicit rate is preferred. This is because the implicit rate of ILFC is generally a more realistic rate to use in determin- ing the amount (if any) to report as the asset and related liability for Air France. In addi- tion, use of the implicit rate avoids use of an artificially high incremental borrowing rate that would cause the present value of the minimum lease payments to be lower, supporting an argument that the lease does not meet the recovery of investment test. Use of such a rate would thus make it more likely that the lessee avoids capitalization of the leased asset and related liability. The determination of whether or not a reasonable estimate could be made will re- quire judgment, particularly where the result from using the incremental borrowing rate comes close to meeting the fair value test. Because Air France may not capitalize the leased property at more than its fair value (as we discuss later), it cannot use an excessively low discount rate. Finance Lease Method (Lessee) To illustrate a finance lease, assume that CNH Capital (a subsidiary of CNH Global) and Ivanhoe Mines Ltd. sign a lease agreement dated January 1, 2014, that calls for CNH to

lease a front-end loader to Ivanhoe beginning January 1, 2014. The terms and provisions of the lease agreement, and other pertinent data, are as follows. • The term of the lease is fi ve years. The lease agreement is non-cancelable, requiring equal rental payments of $25,981.62 at the beginning of each year (annuity-due basis). • The loader has a fair value at the inception of the lease of $100,000, an estimated eco- nomic life of fi ve years, and no residual value. • Ivanhoe pays all of the executory costs directly to third parties except for the property taxes of $2,000 per year, which is included as part of its annual payments to CNH. • The lease contains no renewal options. The loader reverts to CNH at the termination of the lease. • Ivanhoe’s incremental borrowing rate is 11 percent per year. • Ivanhoe depreciates similar equipment that it owns on a straight-line basis. • CNH sets the annual rental to earn a rate of return on its investment of 10 percent per year; Ivanhoe knows this fact. The lease meets the criteria for classification as a finance lease for the following reasons: 1. The lease term of fi ve years, being equal to the equipment’s estimated economic life of fi ve years, satisfi es the economic life test. 2. The present value of the minimum lease payments ($100,000 as computed below) equals the fair value of the loader ($100,000). The minimum lease payments are $119,908.10 ($23,981.62 3 5). Ivanhoe com- putes the amount capitalized as leased assets as the present value of the minimum lease payments (excluding executory costs—property taxes of $2,000) as shown in Illustration IFRS21-3. ILLUSTRATION Capitalized amount 5 ($25,981.62 2 $2,000) 3 Present value of an annuity due of 1 for IFRS21-3 5 periods at 10% (Table 6-5) 5 $23,981.62 3 4.16986 Computation of 5 $100,000 Capitalized Lease Payments 1336 Chapter 21 Accounting for Leases Ivanhoe uses CNH’s implicit interest rate of 10 percent instead of its incremental Calculator Solution for borrowing rate of 11 percent because it knows about it.23 Ivanhoe records the finance Lease Payment lease on its books on January 1, 2014, as: Inputs Answer Leased Equipment (under finance leases) 100,000 Lease Liability 100,000 N 5 Note that the entry records the obligation at the net amount of $100,000 (the present value of the future rental payments) rather than at the gross amount of $119,908.10 I 10 ($23,981.62 3 5). Ivanhoe records the first lease payment on January 1, 2014, as follows. PV ? 100,000 Property Tax Expense 2,000.00 Lease Liability 23,981.62 Cash 25,981.62 PMT –23,981.59* Each lease payment of $25,981.62 consists of three elements: (1) a reduction in the lease liability, (2) a financing cost (interest expense), and (3) executory costs (property FV 0 taxes). The total financing cost (interest expense) over the term of the lease is $19,908.10. This amount is the difference between the present value of the lease payments ($100,000) *Set payments to beginning of period. and the actual cash disbursed, net of executory costs ($119,908.10). The annual interest expense, applying the effective-interest method, is a function of the outstanding liabil- ity, as Illustration IFRS21-4 shows. ILLUSTRATION IVANHOE MINES IFRS21-4 LEASE AMORTIZATION SCHEDULE Lease Amortization ANNUITY-DUE BASIS Schedule for Lessee— Annuity-Due Basis Annual Reduction Lease Executory Interest (10%) of Lease Lease Date Payment Costs on Liability Liability Liability (a) (b) (c) (d) (e) 1/1/14 $100,000.00 1/1/14 $ 25,981.62 $ 2,000 $ –0– $ 23,981.62 76,018.38 1/1/15 25,981.62 2,000 7,601.84 16,379.78 59,638.60 1/1/16 25,981.62 2,000 5,963.86 18,017.76 41,620.84 1/1/17 25,981.62 2,000 4,162.08 19,819.54 21,801.30 1/1/18 25,981.62 2,000 2,180.32* 21,801.30 –0– $129,908.10 $10,000 $19,908.10 $100,000.00 (a) Lease payment as required by lease. (b) Executory costs included in rental payment. (c) Ten percent of the preceding balance of (e) except for 1/1/14; since this is an annuity due, no time has elapsed at the date of the first payment and no interest has accrued. (d) (a) minus (b) and (c).

(e) Preceding balance minus (d). *Rounded by 19 cents. At the end of its fiscal year, December 31, 2014, Ivanhoe records accrued interest as follows. Interest Expense 7,601.84 Interest Payable 7,601.84 Depreciation of the leased equipment over its five-year lease term, applying I vanhoe’s normal depreciation policy (straight-line method), results in the following entry on December 31, 2014. 23If it is impracticable for Ivanhoe to determine the implicit rate and it has an incremental borrowing rate of, say, 9 percent (lower than the 10 percent rate used by CNH), the present value computation would yield a capitalized amount of $101,675.35 ($23,981.62 3 4.23972). Thus, use of an unrealistically low discount rate could lead to a lessee recording a leased asset at an amount exceeding the fair value of the equipment, which is generally prohibited in IFRS. This explains why the implicit rate should be used to capitalize the minimum lease payments. IFRS Insights 1337 Depreciation Expense (finance leases) 20,000 Accumulated Depreciation—Finance Leases 20,000 ($100,000 4 5 years) At December 31, 2014, Ivanhoe separately identifies the assets recorded under finance leases on its statement of financial position. Similarly, it separately identifies the related obligations. Thus, once a lessee capitalizes a finance lease, the accounting under IFRS is the same as that applied for capital leases under GAAP. Accounting by the Lessor For accounting purposes, under IFRS the lessor also classifies leases as operating or finance leases. Finance leases may be further subdivided into direct-financing and sales- type leases. As with lessee accounting, if the lease transfers substantially all the risks and re- wards incidental to ownership, the lessor shall classify and account for the arrangement as a finance lease. Lessors evaluate the same criteria shown in Illustration IFRS21-1 to make this determination. The distinction for the lessor between a direct-financing lease and a sales-type lease is the presence or absence of a manufacturer’s or dealer’s profit (or loss). A sales-type lease involves a manufacturer’s or dealer’s profit, and a direct-financing lease does not. The profit (or loss) to the lessor is evidenced by the difference between the fair value of the leased property at the inception of the lease and the lessor’s cost or carrying amount (book value). Normally, sales-type leases arise when manufacturers or dealers use leasing as a means of marketing their products. For example, a computer manufacturer will lease its computer equipment (possibly through a captive) to businesses and institutions. Direct- financing leases generally result from arrangements with lessors that are primarily engaged in financing operations (e.g., banks). ILLUSTRATION Lessors classify and account for all leases that do not qualify as direct-financing IFRS21-5 or sales-type leases as operating leases. Illustration IFRS21-5 shows the circumstances Diagram of Lessor’s under which a lessor classifies a lease as operating, direct-financing, or sales-type. Criteria for Lease Classifi cation Lease Agreement Is Is Is Is Present There a There a Lease Value of Bargain- Transfer of No Purchase No Term for the Major No Payments No Ownership? Part of Economic Substantially Option? Life? All of Fair Value? Operating Yes Yes Yes Yes Lease Finance Lease Does Asset Fair Direct- Sal Le es a- sT eype No LV ea sl su oe r 'sE q Bu oa ol k Yes Fin La en ac seing Value? 1338 Chapter 21 Accounting for Leases For purposes of comparison with the lessee’s accounting, we will illustrate only the operating and direct-financing leases in the following section. Direct-Financing Method (Lessor) Direct-financing leases are in substance the financing of an asset purchase by the les- see. In this type of lease, the lessor records a lease receivable instead of a leased asset. The lease receivable is the present value of the minimum lease payments plus the pres- ent value of the unguaranteed residual value. Remember that “minimum lease pay- ments” include (1) rental payments (excluding executory costs), (2) bargain-purchase

option (if any), (3) guaranteed residual value (if any), and (4) penalty for failure to re- new (if any). Thus, the lessor records the residual value, whether guaranteed or not. Also, recall that if the lessor pays any executory costs, then it should reduce the rental payment by that amount in computing minimum lease payments. The following presentation, using the data from the preceding CNH/Ivanhoe e xample on pages 1335–1337, illustrates the accounting treatment for a direct-financing lease. We repeat here the information relevant to CNH in accounting for this lease transaction. 1. The term of the lease is fi ve years beginning January 1, 2014, non-cancelable, and requires equal rental payments of $25,981.62 at the beginning of each year. Pay- ments include $2,000 of executory costs (property taxes). 2. The equipment (front-end loader) has a cost of $100,000 to CNH, a fair value at the inception of the lease of $100,000, an estimated economic life of fi ve years, and no residual value. 3. CNH incurred no initial direct costs in negotiating and closing the lease transaction. 4. The lease contains no renewal options. The equipment reverts to CNH at the termi- nation of the lease. 5. CNH sets the annual lease payments to ensure a rate of return of 10 percent (implicit rate) on its investment, as shown in Illustration IFRS21-6. ILLUSTRATION Fair value of leased equipment $100,000.00 IFRS21-6 Less: Present value of residual value –0– Computation of Lease Amount to be recovered by lessor through lease payments $100,000.00 Payments Five beginning-of-the-year lease payments to yield a 10% return ($100,000 4 4.16986a) $ 23,981.62 aPV of an annuity due of 1 for 5 years at 10% (Table 6-5). As shown in the earlier analysis, the lease meets the criteria for classification as a direct-financing lease for two reasons. (1) The lease term equals the equipment’s estimated economic life, and (2) the present value of the minimum lease payments equals the equipment’s fair value. It is not a sales-type lease because there is no difference between the fair value ($100,000) of the loader and CNH’s cost ($100,000). The Lease Receivable is the present value of the minimum lease payments (exclud- ing executory costs which are property taxes of $2,000). CNH computes it as follows. ILLUSTRATION Lease receivable 5 ($25,981.62 2 $2,000) 3 Present value of an annuity due of 1 for 5 IFRS21-7 periods at 10% (Table 6-5) Computation of Lease 5 $23,981.62 3 4.16986 Receivable 5 $100,000 IFRS Insights 1339 CNH records the lease of the asset and the resulting receivable on January 1, 2014 (the inception of the lease), as follows. Lease Receivable 100,000 Equipment 100,000 Companies often report the lease receivable in the statement of financial position as “Net investment in finance leases.” Companies classify it either as current or non-current, depending on when they recover the net investment. Under IFRS, once a lessor determines classification of a lease as either direct- financing or sales-type, the accounting for the lease arrangement is the same as GAAP (as shown on pages 1286–1289 and 1296–1298). ON THE HORIZON Lease accounting is one of the areas identified in the IASB/FASB Memorandum of U nderstanding. The Boards have issued proposed rules based on “right of use,” which requires that all leases, regardless of their terms, be accounted for in a manner similar to how finance leases are treated today. That is, the notion of an operating lease will be eliminated, which will address the concerns under current rules in which no asset or liability is recorded for many operating leases. A final standard is expected in 2013. You can follow the lease project at either the FASB (http://www.fasb.org) or IASB (http://www. iasb.org) websites. IFRS SELF-TEST QUESTIONS 1. Which of the following is not a criterion for a lease to be recorded as a finance lease? (a) There is transfer of ownership. (b) The lease is cancelable. (c) The lease term is for the major part of the economic life of the asset. (d) There is a bargain-purchase option.

2. Under IFRS, in computing the present value of the minimum lease payments, the lessee should: (a) use its incremental borrowing rate in all cases. (b) use either its incremental borrowing rate or the implicit rate of the lessor, whichever is higher, assuming that the implicit rate is known to the lessee. (c) use either its incremental borrowing rate or the implicit rate of the lessor, whichever is lower, assuming that the implicit rate is known to the lessee. (d) use the implicit rate of the lessor, unless it is impracticable to determine the implicit rate. 3. A lease that involves a manufacturer’s or dealer’s profit is a(an): (a) direct financing lease. (c) operating lease. (b) finance lease. (d) sales-type lease. 4. Which of the following statements is true when comparing the accounting for leasing transactions under GAAP with IFRS? (a) IFRS for leases is more “rules-based” than GAAP and includes many bright-line criteria to determine ownership. (b) IFRS requires that companies provide a year-by-year breakout of future non-cancelable lease payments due in years 1 through 5. (c) The IFRS leasing standard is the subject of over 30 interpretations since its issuance in 1982. (d) IFRS does not provide detailed guidance for leases of natural resources, sale-leasebacks, and leveraged leases. 5. All of the following statements about lease accounting under IFRS and GAAP are true except: (a) IFRS requires a year-by-year breakout of payments related to leasing arrangements. (b) IFRS is more general in its lease accounting provisions than is GAAP. (c) The IFRS leasing standard, IAS 17, is the subject of only three interpretations. (d) Finance leases under IFRS are referred to as capital leases under GAAP. 1340 Chapter 21 Accounting for Leases IFRS CONCEPTS AND APPLICATION IFRS21-1 Where can authoritative IFRS related to the accounting for leases be found? IFRS21-2 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to the accounting for leases. IFRS21-3 Briefly discuss the IASB and FASB efforts to converge their accounting guidelines for leases. IFRS21-4 Outline the accounting procedures involved in applying the operating lease method by a lessee. IFRS21-5 Outline the accounting procedures involved in applying the finance lease method by a lessee. IFRS21-6 Identify the lease classifications for lessors and the criteria that must be met for each classification. IFRS21-7 Rick Kleckner Corporation recorded a finance lease at $300,000 on January 1, 2014. The interest rate is 12%. Kleckner Corporation made the first lease payment of $53,920 on January 1, 2014. The lease requires eight annual payments. The equipment has a useful life of 8 years with no residual value. Prepare Kleckner Corporation’s December 31, 2014, adjusting entries. IFRS21-8 Use the information for Rick Kleckner Corporation from IFRS21-7. Assume that at December 31, 2014, Kleckner made an adjusting entry to accrue interest expense of $29,530 on the lease. Prepare Kleckner’s January 1, 2015, journal entry to record the second lease payment of $53,920. IFRS21-9 Brecker Company leases an automobile with a fair value of $10,906 from Emporia Motors, Inc., on the following terms: 1. Non-cancelable term of 50 months. 2. Rental of $250 per month (at end of each month). (The present value at 1% per month is $9,800.) 3. Estimated residual value after 50 months is $1,180. (The present value at 1% per month is $715.) Brecker Company guarantees the residual value of $1,180. 4. Estimated economic life of the automobile is 60 months. 5. Brecker Company’s incremental borrowing rate is 12% a year (1% a month). It is impracticable to determine Emporia’s implicit rate. Instructions (a) What is the nature of this lease to Brecker Company? (b) What is the present value of the minimum lease payments? (c) Record the lease on Brecker Company’s books at the date of inception. (d) Record the first month’s depreciation on Brecker Company’s books (assume straight-line). (e) Record the first month’s lease payment.

IFRS21-10 The following facts pertain to a non-cancelable lease agreement between Lennox Leasing Company and Gill Company, a lessee. (Round all numbers to the nearest cent.) Inception date: May 1, 2014 Annual lease payment due at the beginning of each year, beginning with May 1, 2014: $18,829.49 Bargain-purchase option price at end of lease term: $4,000.00 Lease term: 5 years Economic life of leased equipment: 10 years Lessor’s cost: $65,000.00; fair value of asset at May 1, 2014, $81,000.00 Lessor’s implicit rate: 10%; lessee’s incremental borrowing rate 10% The lessee assumes responsibility for all executory costs. Instructions (a) Discuss the nature of this lease to Gill Company. (b) Discuss the nature of this lease to Lennox Company. (c) Prepare a lease amortization schedule for Gill Company for the 5-year lease term. (d) Prepare the journal entries on the lessee’s books to reflect the signing of the lease agreement and to record the payments and expenses related to this lease for the years 2014 and 2015. Gill’s annual accounting period ends on December 31. Reversing entries are used by Gill. IFRS21-11 A lease agreement between Lennox Leasing Company and Gill Company is described in IFRS21-10. Refer to the data in IFRS21-10 and do the following for the lessor. (Round all numbers to the nearest cent.) IFRS Insights 1341 Instructions (a) Compute the amount of the lease receivable at the inception of the lease. (b) Prepare a lease amortization schedule for Lennox Leasing Company for the 5-year lease term. (c) Prepare the journal entries to reflect the signing of the lease agreement and to record the receipts and income related to this lease for the years 2014, 2015, and 2016. The lessor’s accounting period ends on December 31. Reversing entries are not used by Lennox. Professional Research IFRS21-12 Daniel Hardware Co. is considering alternative financing arrangements for equipment used in its warehouses. Besides purchasing the equipment outright, Daniel is also considering a lease. Account- ing for the outright purchase is fairly straightforward, but because Daniel has not used equipment leases in the past, the accounting staff is less informed about the specific accounting rules for leases. The staff is aware of some general lease rules related to “risks and rewards,” but they are unsure about the meanings of these terms in lease accounting. Daniel has asked you to conduct some research on these items related to lease capitalization criteria. Instructions Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.) (a) What is the objective of lease classification criteria? (b) An important element of evaluating leases is determining whether substantially all of the risks and rewards of ownership are transferred in the lease. How is “substantially all” defined in the authori- tative literature? (c) Besides the non-cancelable term of the lease, name at least three other considerations in determining the “lease term.” International Financial Reporting Problem Marks and Spencer plc IFRS21-13 The financial statements of Marks and Spencer plc (M&S) are available at the book’s com- panion website or can be accessed at http://annualreport.marksandspencer.com/_assets/downloads/Marks- and-Spencer-Annual-report-and-financial-statements-2012.pdf. Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions. (a) What types of leases are used by M&S? (b) What amount of finance leases was reported by M&S in total and for less than one year? (c) What minimum annual rental commitments under all non-cancelable leases at 31 March 2012 did M&S disclose? ANSWERS TO IFRS SELF-TEST QUESTIONS 1. b 2. d 3. d 4. d 5. a Remember to check the book’s companion website to fi nd additional resources for this chapter.

Accounting Changes and Error Analysis 1 Identify the types of accounting changes. 5 Describe the accounting for changes in estimates. 2 Describe the accounting for changes in accounting 6 Identify changes in a reporting entity. principles. 7 Describe the accounting for correction of errors. 3 Understand how to account for retrospective 8 Identify economic motives for changing accounting accounting changes. methods. 4 Understand how to account for impracticable 9 Analyze the effect of errors. changes. In the Dark The FASB’s conceptual framework describes comparability (including consistency) as one of the qualitative characteristics that contribute to the usefulness of accounting information. Unfortunately, companies are finding it difficult to maintain comparabil- ity and consistency due to the numerous changes in accounting principles mandated by the FASB. In addition, a number of companies have faced restatements due to errors in their financial statements. For example, the table below shows types and numbers of recent accounting changes. Although the percentage of companies reporting material changes or errors is small, readers of financial statements still must be careful. The reason: The amounts in the financial statements may have changed due to changing accounting principles and/or restatements. The chart below indicates the recent trends in restatements. There is much good news in the chart. In 2007, restatements declined by 32.2 percent (from 1,790 to 1,213). In 2008, restatements declined another 24 percent (from 1,213 to 922). The declining trend continued in 2009, with restatements stabilized at pre-crisis levels in 2010 and 2011. However, investors can be in the dark when a company has an error that requires restate- ment. It may take some time for companies to sort out the source of an error, prepare corrected statements, and get auditor RETPAHC 22 LEARNING OBJECTIVES After studying this chapter, you should be able to: Business combinations 49 Debt–equity financial instruments 18 Noncontrolling interests 38 Transfers of financial instruments 12 Fair value measurements 32 Earnings per share 6 Defined benefit pension and Other, including depreciation, stock-based postretirement plans 21 compensation, derivatives, inventory, and revenue 75 Total Restatements by Year 2,000 1,790 1,550 1,500 1,213 1,000 811 949 922 708 790 787 500 0 03 04 05 06 07 08 09 10 11 CONCEPTUAL FOCUS > See the Underlying Concepts sign-off. Recent data indicate it takes on average about 3 months on pages 1344, 1346, and 1366. to resolve a restatement. The following table reports the range of periods when investors are in the dark due to a restatement. INTERNATIONAL FOCUS Time to File Restated % of All > See the International Perspectives Financial Statements Restatements on pages 1345 and 1355. Up to 3 Months 77 3–9 Months 11 > Read the IFRS Insights Greater than 9 Months 12 on pages 1404–1408 for a discussion of: —Direct and indirect effects of changes While most companies (77%) resolve their errors within 3 months, —Impracticability 12 percent (or over 200 companies) take more than 9 months to file corrected statements. These lengthy “dark periods” have caught the attention of policy-setters and were a topic of discussion of the Committee for Improvements in Financial Reporting (CIFR). As one member of CIFR noted, “The dark period is bad for users.” As a result, the committee is proposing that for some errors, companies might not need to go through the pain of restatement, but enhanced disclosures about errors are needed. Sources: Accounting change data from Accounting Trends and Techniques—2011–2012 (New York: AICPA, 2011–2012). Restatement data from 2011 Financial Restatements: A Nine Year Comparison, Audit Analytics (April 2012), p. 3; M. Leone, “Materiality Debate Emerges from the Dark,” CFO.com (July 14, 2008); and B. Badertscher and J. Burks, “Accounting Restatements and the Timeliness of Disclosures,” Accounting Horizons (December 2011), pp. 609–629. As our opening story indicates, changes in accounting principles and

PREVIEW OF CHAPTER 22 errors in financial information have increased substantially in recent years. When these changes occur, companies must follow specific accounting and reporting requirements. In addition, to ensure comparability among companies, the FASB has standardized reporting of accounting changes, accounting estimates, error corrections, and related earnings per share information. In this chapter, we discuss these reporting standards, which help investors better understand a company’s financial condition. The content and organization of the chapter are as follows. Accounting Changes and Error Analysis Accounting Changes in Changes in Changes in Accounting Error Analysis Changes Principle Estimates Entity Errors • Retrospective • Prospective • Example • Balance sheet • Direct and • Disclosures • Summary errors indirect effects • Motivations • Income statement • Impracticability errors • Balance sheet and income statement errors • Comprehensive example • Preparation of statements with error corrections 1343 1344 Chapter 22 Accounting Changes and Error Analysis ACCOUNTING CHANGES Accounting alternatives diminish the comparability of financial information LEARNING OBJECTIVE 1 between periods and between companies; they also obscure useful historical trend Identify the types of accounting data. For example, if Ford revises its estimates for equipment useful lives, depre- changes. ciation expense for the current year will not be comparable to depreciation expense reported by Ford in prior years. Similarly, if OfficeMax changes to FIFO inven- tory pricing while Staples uses LIFO, it will be difficult to compare these companies’ reported results. A reporting framework helps preserve comparability when there is an accounting change. See the FASB Codification section The FASB has established a reporting framework, which involves three types of (page 1381). accounting changes. [1] The three types of accounting changes are: 1. Change in accounting principle. A change from one generally accepted Underlying Concepts accounting principle to another one. For example, a company may change While changes in accounting its inventory valuation method from LIFO to average-cost. may enhance the qualitative 2. Change in accounting estimate. A change that occurs as the result of new characteristic of usefulness, information or additional experience. For example, a company may change these changes may adversely its estimate of the useful lives of depreciable assets. affect the enhancing charac- 3. Change in reporting entity. A change from reporting as one type of entity teristics of comparability and to another type of entity. As an example, a company might change the consistency. subsidiaries for which it prepares consolidated fi nancial statements. A fourth category necessitates changes in accounting, though it is not classified as an accounting change. 4. Errors in fi nancial statements. Errors result from mathematical mistakes, mistakes in applying accounting principles, or oversight or misuse of facts that existed when preparing the fi nancial statements. For example, a company may incorrectly apply the retail inventory method for determining its fi nal inventory value. The FASB classifies changes in these categories because each category involves dif- ferent methods of recognizing changes in the financial statements. In this chapter, we discuss these classifications. We also explain how to report each item in the accounts and how to disclose the information in comparative statements. CHANGES IN ACCOUNTING PRINCIPLE By definition, a change in accounting principle involves a change from one gen- LEARNING OBJECTIVE 2 erally accepted accounting principle to another. For example, a company might Describe the accounting for changes change the basis of inventory pricing from average-cost to LIFO. Or, it might in accounting principles. change its method of revenue recognition for long-term construction contracts from the completed-contract to the percentage-of-completion method. Companies must carefully examine each circumstance to ensure that a change in

principle has actually occurred. Adoption of a new principle in recognition of events that have occurred for the first time or that were previously immaterial is not an accounting change. For example, a change in accounting principle has not occurred when a company adopts an inventory method (e.g., FIFO) for newly acquired items of inventory, even if FIFO differs from that used for previously recorded inventory. Another example is certain marketing expenditures that were previously immaterial Changes in Accounting Principle 1345 and expensed in the period incurred. It would not be considered a change in accounting principle if they become material and so may be acceptably deferred and amortized. Finally, what if a company previously followed an accounting principle that was not acceptable? Or what if the company applied a principle incorrectly? In such cases, the profession considers a change to a generally accepted accounting principle a correc- tion of an error. For example, a switch from the cash (income tax) basis of accounting to the accrual basis is a correction of an error. Or, if a company deducted salvage value when computing double-declining depreciation on plant assets and later recomputed depreciation without deducting estimated salvage value, it has corrected an error. There are three possible approaches for reporting changes in accounting principles: 1. Report changes currently. In this approach, companies report the cumulative effect of the change in the current year’s income statement as an irregular item. The cumulative effect is the difference in prior years’ income between the newly adopted and prior accounting method. Under this approach, the effect of the change on prior years’ income appears only in the current-year income statement. The company does not change prior year fi nancial statements. Advocates of this position argue that changing prior years’ fi nancial statements results in a loss of confi dence in fi nancial reports. How do investors react when told that the earnings computed three years ago are now entirely different? Changing prior periods, if permitted, also might upset contractual arrangements based on the old fi gures. For example, profi t-sharing arrangements computed on the old basis might have to be recomputed and completely new distributions made, creating numerous legal problems. Many practical diffi culties also exist. The cost of chang- ing prior period fi nancial statements may be excessive, or determining the amount of the prior period effect may be impossible on the basis of available data. 2. Report changes retrospectively. Retrospective application refers to the application of a different accounting principle to recast previously issued fi nancial statements— as if the new principle had always been used. In other words, the company “goes back” and adjusts prior years’ statements on a basis consistent with the newly adopted principle. The company shows any cumulative effect of the change as an adjustment to beginning retained earnings of the earliest year presented. Advocates of this position argue that retrospective application ensures compa- rability. Think for a moment what happens if this approach is not used. The year previous to the change will be on the old method, the year of the change will report the entire cumulative adjustment, and the following year will present fi nancial state- ments on the new basis without the cumulative effect of the change. Such lack of consistency fails to provide meaningful earnings-trend data and other fi nancial relationships necessary to evaluate the business. 3. Report changes prospectively (in the future). In this approach, previously reported results remain. As a result, companies do not adjust opening balances to refl ect the change in principle. Advocates of this position argue that once manage- International ment presents fi nancial statements based on acceptable accounting princi- Perspective ples, they are fi nal. Management cannot change prior periods by adopting IFRS (IAS 8) generally requires

a new principle. According to this line of reasoning, the current-period retrospective application to prior cumulative adjustment is not appropriate because that approach includes years for accounting changes. amounts that have little or no relationship to the current year’s income or However, IAS 8 permits the economic events. prospective method if a company cannot reasonably Given these three possible approaches, which does the accounting profession determine the amounts to which prefer? The FASB requires that companies use the retrospective approach. Why? to restate prior periods. Because it provides financial statement users with more useful information than 1346 Chapter 22 Accounting Changes and Error Analysis the cumulative-effect or prospective approaches. [2] The rationale is that changing the prior statements to be on the same basis as the newly adopted principle results in greater consistency across accounting periods. Users can then better compare results from one period to the next.1 What do the numbers mean? QUITE A CHANGE The cumulative-effect approach results in a loss of compara- depreciating railroad equipment to more generally used bility. Also, reporting the cumulative adjustment in the period methods such as straight-line depreciation. Using cumula- of the change can signifi cantly affect net income, resulting in tive treatment, railroad companies would have made a misleading income fi gure. For example, at one time Chrysler substantial adjustments to income in the period of change. Corporation changed its inventory accounting from LIFO to Many in the industry argued that including such large cumu- FIFO. If Chrysler had used the cumulative-effect approach, it lative-effect adjustments in the current year would distort would have reported a $53,500,000 adjustment to net income. the information and make it less useful. That adjustment would have resulted in net income of Such situations lend support to retrospective application $45,900,000, instead of a net loss of $7,600,000. so that comparability is maintained. A second case: In the early 1980s, the railroad industry switched from the retirement-replacement method of Retrospective Accounting Change Approach A presumption exists that once a company adopts an accounting principle, it LEARNING OBJECTIVE 3 should not change. That presumption is understandable, given the idea that con- Understand how to account for sistent use of an accounting principle enhances the usefulness of financial state- retrospective accounting changes. ments. However, the environment continually changes, and companies change in response. Recent standards on such subjects as stock options, exchanges of non- Underlying Concepts monetary assets, and derivatives indicate that changes in accounting principle will continue to occur. Retrospective application When a company changes an accounting principle, it should report the contributes to comparability. change using retrospective application. In general terms, here is what it must do: 1. It adjusts its fi nancial statements for each prior period presented. Thus, fi nancial statement information about prior periods is on the same basis as the new accounting principle. 2. It adjusts the carrying amounts of assets and liabilities as of the beginning of the fi rst year presented. By doing so, these accounts refl ect the cumulative effect on periods prior to those presented of the change to the new accounting principle. The company also makes an offsetting adjustment to the opening balance of retained earnings or other appropriate component of stockholders’ equity or net assets as of the beginning of the fi rst year presented. For example, assume that Target decides to change its inventory valuation method in 2014 from the retail inventory method (FIFO) to the retail inventory method (average- cost). It provides comparative information for 2012 and 2013 based on the new method. Target would adjust its assets, liabilities, and retained earnings for periods prior to 2012 and report these amounts in the 2012 financial statements, when it prepares compara-

tive financial statements. 1Adoption of the retrospective approach contributes to international accounting convergence. As discussed throughout the textbook, the FASB and the IASB are collaborating on a project in which they have agreed to converge around high-quality solutions to resolve differences between GAAP and IFRS. By adopting the retrospective approach, which is the method used in IFRS, the FASB agreed that this approach is superior to the current approach. Changes in Accounting Principle 1347 Retrospective Accounting Change: Long-Term Contracts To illustrate the retrospective approach, assume that Denson Company has accounted for its income from long-term construction contracts using the completed-contract method. In 2014, the company changed to the percentage-of-completion method. Man- agement believes this approach provides a more appropriate measure of the income earned. For tax purposes, the company uses the completed-contract method and plans to continue doing so in the future. (We assume a 40% enacted tax rate.) Illustration 22-1 shows portions of three income statements for 2012–2014—for both the completed-contract and percentage-of-completion methods (2012 was Denson’s first year of operations). ILLUSTRATION 22-1 COMPLETED-CONTRACT METHOD Comparative Income DENSON COMPANY Statements for INCOME STATEMENT (PARTIAL) FOR THE YEARS ENDED DECEMBER 31 Completed-Contract versus Percentage-of- 2012 2013 2014 Completion Methods Income before income tax $400,000 $160,000 $190,000 Income tax (40%) 160,000 64,000 76,000 Net income $240,000 $ 96,000 $114,000 PERCENTAGE-OF-COMPLETION METHOD DENSON COMPANY INCOME STATEMENT (PARTIAL) FOR THE YEARS ENDED DECEMBER 31 2012 2013 2014 Income before income tax $600,000 $180,000 $200,000 Income tax (40%) 240,000 72,000 80,000 Net income $360,000 $108,000 $120,000 To record a change from the completed-contract to the percentage-of-completion method, we analyze the various effects, as Illustration 22-2 shows. ILLUSTRATION 22-2 Pretax Income from Difference in Income Data for Retrospective Percentage-of- Completed- Tax Effect Income Effect Change Example Year Completion Contract Difference 40% (net of tax) Prior to 2013 $600,000 $400,000 $200,000 $80,000 $120,000 In 2013 180,000 160,000 20,000 8,000 12,000 Total at beginning of 2014 $780,000 $560,000 $220,000 $88,000 $132,000 Total in 2014 $200,000 $190,000 $ 10,000 $ 4,000 $ 6,000 The entry to record the change at the beginning of 2014 would be: Construction in Process 220,000 Deferred Tax Liability 88,000 Retained Earnings 132,000 The Construction in Process account increases by $220,000 (as indicated in the first column under “Difference in Income” in Illustration 22-2). The credit to Retained Earn- ings of $132,000 reflects the cumulative income effects prior to 2014 (third column under “Difference in Income” in Illustration 22-2). The company credits Retained Earnings because prior years’ income is closed to this account each year. The credit to Deferred Tax Liability represents the adjustment to prior years’ tax expense. The company now 1348 Chapter 22 Accounting Changes and Error Analysis recognizes that amount, $88,000, as a tax liability for future taxable amounts. That is, in future periods, taxable income will be higher than book income as a result of current temporary differences. Therefore, Denson must report a deferred tax liability in the current year. What do the numbers mean? CHANGE MANAGEMENT Halliburton offers a case study in the importance of good It appears that the problem with Halliburton’s accounting reporting of an accounting change. Note that Halliburton stems more from how the company handled its accounting uses percentage-of-completion accounting for its long- change than from the new method itself. That is, Halliburton term construction-services contracts. The SEC questioned the did not provide in its annual report in the year of the change company about its change in accounting for disputed claims. an explicit reference to its change in accounting method. In Prior to the year of the change, Halliburton took a very fact, rather than stating its new policy, the company simply

conservative approach to its accounting for disputed claims. deleted the sentence that described how it accounted for dis- That is, the company waited until all disputes were resolved puted claims. Then later, in its next year’s annual report, the before recognizing associated revenues. In contrast, in the company stated its new accounting policy. year of the change, the company recognized revenue for When companies make such changes in accounting, in- disputed claims before their resolution, using estimates of vestors need to be informed about the change and about its amounts expected to be recovered. Such revenue and its effects on the fi nancial results. With such information, inves- related profi t are more tentative and subject to possible later tors and analysts can compare current results with those of adjustment. The accounting method adopted is more aggres- prior periods and can make a more informed assessment sive than the company’s former policy but is within the about the company’s future prospects. boundaries of GAAP. Source: Adapted from “Accounting Ace Charles Mulford Answers Accounting Questions,” Wall Street Journal Online (June 7, 2002). Reporting a Change in Principle. The disclosure of accounting changes is particularly important. Financial statement readers want consistent information from one period to the next. Such consistency ensures the usefulness of financial statements. The major disclosure requirements are as follows. 1. The nature of and reason for the change in accounting principle. This must include an explanation of why the newly adopted accounting principle is preferable. 2. The method of applying the change, and: (a) A description of the prior period information that has been retrospectively adjusted, if any. (b) The effect of the change on income from continuing operations, net income (or other appropriate captions of changes in net assets or performance indicators), any other affected line item, and any affected per share amounts for the current period and for any prior periods retrospectively adjusted. (c) The cumulative effect of the change on retained earnings or other components of equity or net assets in the statement of fi nancial position as of the beginning of the earliest period presented.2 To illustrate, Denson will prepare comparative financial statements for 2013 and 2014 using the percentage-of-completion method (the new construction accounting method). Illustration 22-3 indicates how Denson presents this information. 2Presentation of the effect on financial statement subtotals and totals other than income from continuing operations and net income (or other appropriate captions of changes in the applicable net assets or performance indicator) is not required. [3] Changes in Accounting Principle 1349 ILLUSTRATION 22-3 DENSON COMPANY Comparative Information INCOME STATEMENT (PARTIAL) Related to Accounting FOR THE YEAR ENDED Change (Percentage-of- 2014 2013 Completion) As Adjusted (Note A) Income before income tax $200,000 $180,000 Income tax (40%) 80,000 72,000 Net income $120,000 $108,000 Note A: Change in Method of Accounting for Long-Term Contracts. The company has accounted for revenue and costs for long-term construction contracts by the percentage-of-completion method in 2014, whereas in all prior years, revenue and costs were determined by the completed-contract method. The new method of accounting for long-term contracts was adopted to recognize . . . [state justification for change in accounting principle] . . . and financial statements of prior years have been restated to apply the new method retrospectively. For income tax purposes, the completed-contract method has been continued. The effect of the accounting change on income of 2014 was an increase of $6,000 net of related taxes and on income of 2013 as previously reported was an increase of $12,000 net of related taxes. The balances of retained earnings for 2013 and 2014 have been adjusted for the effect of applying retroactively the new method of accounting. As a result of the accounting change, retained earnings as of January 1,

2013, increased by $120,000 compared to that reported using the completed-contract method. As Illustration 22-3 shows, Denson Company reports net income under the newly adopted percentage-of-completion method for both 2013 and 2014. The company retro- spectively adjusted the 2013 income statement to report the information on a percentage- of-completion basis. Also, the note to the financial statements indicates the nature of the change, why the company made the change, and the years affected. In addition, companies are required to provide data on important differences between the amounts reported under percentage-of-completion versus completed- contract. When identifying the significant differences, some companies show the entire financial statements and line-by-line differences between percentage-of-completion and completed-contract. However, most companies will show only line-by-line differences. For example, Denson would show the differences in construction in process, retained earnings, gross profit, and net income for 2013 and 2014 under the completed-contract and percentage-of-completion methods. Retained Earnings Adjustment. As indicated earlier, one of the disclosure requirements is to show the cumulative effect of the change on retained earnings as of the beginning of the earliest period presented. For Denson Company, that date is January 1, 2013. Denson disclosed that information by means of a narrative description (see Note A in Illustration 22-3). Denson also would disclose this information in its retained earnings statement. Assuming a retained earnings balance of $1,360,000 at the beginning of 2012, Illustration 22-4 shows Denson’s retained earnings statement under the completed- contract method—that is, before giving effect to the change in accounting principle. (The income information comes from Illustration 22-1 on page 1347.) ILLUSTRATION 22-4 DENSON COMPANY Retained Earnings RETAINED EARNINGS STATEMENT Statement before FOR THE YEAR ENDED Retrospective Change 2014 2013 2012 Retained earnings, January 1 $1,696,000 $1,600,000 $1,360,000 Net income 114,000 96,000 240,000 Retained earnings, December 31 $1,810,000 $1,696,000 $1,600,000 If Denson presents comparative statements for 2013 and 2014 under percentage- of-completion, then it must change the beginning balance of retained earnings at 1350 Chapter 22 Accounting Changes and Error Analysis January 1, 2013. The difference between the retained earnings balances under completed- contract and percentage-of-completion is computed as follows. Retained earnings, January 1, 2013 (percentage-of-completion) $1,720,000 Retained earnings, January 1, 2013 (completed-contract) (1,600,000) Cumulative-effect difference $ 120,000 The $120,000 difference is the cumulative effect. Illustration 22-5 shows a comparative retained earnings statement for 2013 and 2014, giving effect to the change in accounting principle to percentage-of-completion. ILLUSTRATION 22-5 DENSON COMPANY Retained Earnings RETAINED EARNINGS STATEMENT Statement after FOR THE YEAR ENDED Retrospective Application 2014 2013 Retained earnings, January 1, as reported — $1,600,000 Add: Adjustment for the cumulative effect on prior years of applying retrospectively the new method of accounting for construction contracts 120,000 Retained earnings, January 1, as adjusted $1,828,000 1,720,000 Net income 120,000 108,000 Retained earnings, December 31 $1,948,000 $1,828,000 Denson adjusted the beginning balance of retained earnings on January 1, 2013, for the excess of percentage-of-completion net income over completed-contract net income in 2012. This comparative presentation indicates the type of adjustment that a company needs to make. It follows that this adjustment would be much larger if a number of prior periods were involved. Retrospective Accounting Change: Inventory Methods As a second illustration of the retrospective approach, assume that Lancer Company has accounted for its inventory using the LIFO method. In 2014, the company changes to the FIFO method because management believes this approach provides a more appropriate

reporting of its inventory costs. Illustration 22-6 provides additional information related to Lancer Company. ILLUSTRATION 22-6 1. Lancer Company started its operations on January 1, 2012. At that time, stockholders invested Lancer Company $100,000 in the business in exchange for common stock. Information 2. All sales, purchases, and operating expenses for the period 2012–2014 are cash transactions. Lancer’s cash flows over this period are as follows. 2012 2013 2014 Sales $300,000 $300,000 $300,000 Purchases 90,000 110,000 125,000 Operating expenses 100,000 100,000 100,000 Cash flow from operations $110,000 $ 90,000 $ 75,000 3. Lancer has used the LIFO method for financial reporting since its inception. 4. Inventory determined under LIFO and FIFO for the period 2012–2014 is as follows. LIFO Method FIFO Method Difference January 1, 2012 $ 0 $ 0 $ 0 December 31, 2012 10,000 12,000 2,000 December 31, 2013 20,000 25,000 5,000 December 31, 2014 32,000 39,000 7,000 Changes in Accounting Principle 1351 ILLUSTRATION 22-6 5. Cost of goods sold under LIFO and FIFO for the period 2012–2014 are as follows. (Continued) Cost of Goods Sold Cost of Goods Sold LIFO FIFO Difference 2012 $ 80,000 $ 78,000 $2,000 2013 100,000 97,000 3,000 2014 113,000 111,000 2,000 6. Earnings per share information is not required on the income statement. 7. All tax effects for this illustration should be ignored. Given the information about Lancer Company, Illustration 22-7 shows its income statement, retained earnings statement, balance sheet, and statement of cash flows for 2012–2014 under LIFO. ILLUSTRATION 22-7 LANCER COMPANY Lancer Financial INCOME STATEMENT Statements (LIFO) FOR THE YEAR ENDED DECEMBER 31 2012 2013 2014 Sales $300,000 $300,000 $300,000 Cost of goods sold (LIFO) 80,000 100,000 113,000 Operating expenses 100,000 100,000 100,000 Net income $120,000 $100,000 $ 87,000 LANCER COMPANY RETAINED EARNINGS STATEMENT FOR THE YEAR ENDED DECEMBER 31 2012 2013 2014 Retained earnings (beginning) $ 0 $120,000 $220,000 Add: Net income 120,000 100,000 87,000 Retained earnings (ending) $120,000 $220,000 $307,000 LANCER COMPANY BALANCE SHEET AT DECEMBER 31 2012 2013 2014 Cash $210,000 $300,000 $375,000 Inventory (LIFO) 10,000 20,000 32,000 Total assets $220,000 $320,000 $407,000 Common stock $100,000 $100,000 $100,000 Retained earnings 120,000 220,000 307,000 Total liabilities and stockholders’ equity $220,000 $320,000 $407,000 LANCER COMPANY STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31 2012 2013 2014 Cash flows from operating activities Sales $300,000 $300,000 $300,000 Purchases 90,000 110,000 125,000 Operating expenses 100,000 100,000 100,000 Net cash provided by operating activities 110,000 90,000 75,000 Cash flows from financing activities Issuance of common stock 100,000 — — Net increase in cash 210,000 90,000 75,000 Cash at beginning of year 0 210,000 300,000 Cash at end of year $210,000 $300,000 $375,000 1352 Chapter 22 Accounting Changes and Error Analysis As Illustration 22-7 indicates, under LIFO Lancer Company reports $120,000 net income in 2012, $100,000 net income in 2013, and $87,000 net income in 2014. The amount of inventory reported on Lancer’s balance sheet reflects LIFO costing. Illustration 22-8 shows Lancer’s income statement, retained earnings statement, balance sheet, and statement of cash flows for 2012–2014 under FIFO. You can see that the cash flow statement under FIFO is the same as under LIFO. Although the net incomes are different in each period, there is no cash flow effect from these differences in net income. (If we considered income taxes, a cash flow effect would result.) ILLUSTRATION 22-8 LANCER COMPANY Lancer Financial INCOME STATEMENT Statements (FIFO) FOR THE YEAR ENDED DECEMBER 31 2012 2013 2014 Sales $300,000 $300,000 $300,000 Cost of goods sold (FIFO) 78,000 97,000 111,000 Operating expenses 100,000 100,000 100,000 Net income $122,000 $103,000 $ 89,000 LANCER COMPANY RETAINED EARNINGS STATEMENT FOR THE YEAR ENDED DECEMBER 31 2012 2013 2014 Retained earnings (beginning) $ 0 $122,000 $225,000 Add: Net income 122,000 103,000 89,000

Retained earnings (ending) $122,000 $225,000 $314,000 LANCER COMPANY BALANCE SHEET AT DECEMBER 31 2012 2013 2014 Cash $210,000 $300,000 $375,000 Inventory (FIFO) 12,000 25,000 39,000 Total assets $222,000 $325,000 $414,000 Common stock $100,000 $100,000 $100,000 Retained earnings 122,000 225,000 314,000 Total liabilities and stockholders’ equity $222,000 $325,000 $414,000 LANCER COMPANY STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31 2012 2013 2014 Cash flows from operating activities Sales $300,000 $300,000 $300,000 Purchases 90,000 110,000 125,000 Operating expenses 100,000 100,000 100,000 Net cash provided by operating activities 110,000 90,000 75,000 Cash flows from financing activities Issuance of common stock 100,000 — — Net increase in cash 210,000 90,000 75,000 Cast at beginning of year 0 210,000 300,000 Cash at end of year $210,000 $300,000 $375,000 Compare the financial statements reported in Illustration 22-7 and Illustration 22-8. You can see that under retrospective application, the change to FIFO inventory valua- tion affects reported inventories, cost of goods sold, net income, and retained earnings. In the following sections, we discuss the accounting and reporting of Lancer’s account- ing change from LIFO to FIFO. Changes in Accounting Principle 1353 Given the information provided in Illustrations 22-6, 22-7, and 22-8, we now are ready to account for and report on the accounting change. Our first step is to adjust the financial records for the change from LIFO to FIFO. To do so, we perform the analysis in Illustration 22-9. ILLUSTRATION 22-9 Net Income Difference in Income Data for Recording Year LIFO FIFO Change in Accounting 2012 $120,000 $122,000 $2,000 Principle 2013 100,000 103,000 3,000 Total at beginning of 2014 $220,000 $225,000 $5,000 Total in 2014 $ 87,000 $ 89,000 $2,000 The entry to record the change to the FIFO method at the beginning of 2014 is as follows. Inventory 5,000 Retained Earnings 5,000 The change increases the Inventory account by $5,000. This amount represents the difference between the ending inventory at December 31, 2013, under LIFO ($20,000) and the ending inventory under FIFO ($25,000). The credit to Retained Earnings indi- cates the amount needed to change the prior year’s income, assuming that Lancer had used FIFO in previous periods. Reporting a Change in Principle. Lancer Company will prepare comparative financial statements for 2013 and 2014 using FIFO (the new inventory method). Illustration 22-10 indicates how Lancer might present this information. ILLUSTRATION 22-10 LANCER COMPANY Comparative Information INCOME STATEMENT Related to Accounting FOR THE YEAR ENDED DECEMBER 31 Change (FIFO) 2014 2013 As adjusted (Note A) Sales $300,000 $300,000 Cost of goods sold 111,000 97,000 Operating expenses 100,000 100,000 Net income $ 89,000 $103,000 Note A Change in Method of Accounting for Inventory Valuation On January 1, 2014, Lancer Company elected to change its method of valuing its inventory to the FIFO method; in all prior years, inventory was valued Nature and reason for change; using the LIFO method. The Company adopted the new method of accounting for inventory to better description of prior period report cost of goods sold in the year incurred. Comparative financial statements of prior years have been information adjusted adjusted to apply the new method retrospectively. The following financial statement line items for years 2014 and 2013 were affected by the change in accounting principle. 2014 2013 Balance Sheet LIFO FIFO Difference LIFO FIFO Difference Inventory $ 32,000 $ 39,000 $7,000 $ 20,000 $ 25,000 $5,000 Effect of change on key Retained earnings 307,000 314,000 7,000 220,000 225,000 5,000 performance indicators Income Statement Cost of goods sold $113,000 $111,000 $2,000 $100,000 $ 97,000 $3,000 Net income 87,000 89,000 2,000 100,000 103,000 3,000 Statement of Cash Flows (no effect) As a result of the accounting change, retained earnings as of January 1, 2013, increased from $120,000, Cumulative effect on as originally reported using the LIFO method, to $122,000 using the FIFO method. retained earnings

1354 Chapter 22 Accounting Changes and Error Analysis As Illustration 22-10 shows, Lancer Company reports net income under the newly adopted FIFO method for both 2013 and 2014. The company retrospectively adjusted the 2013 income statement to report the information on a FIFO basis. In addition, the note to the financial statements indicates the nature of the change, why the company made the change, and the years affected. The note also provides data on important dif- ferences between the amounts reported under LIFO versus FIFO. (When identifying the significant differences, some companies show the entire financial statements and line- by-line differences between LIFO and FIFO.) Retained Earnings Adjustment. As indicated earlier, one of the disclosure requirements is to show the cumulative effect of the change on retained earnings as of the beginning of the earliest period presented. For Lancer Company, that date is January 1, 2013. Lancer disclosed that information by means of a narrative description (see Note A in Illustration 22-10). Lancer also would disclose this information in its retained earnings statement. Illustration 22-11 shows Lancer’s retained earnings statement under LIFO— that is, before giving effect to the change in accounting principle. (This information comes from Illustration 22-7 on page 1351.) ILLUSTRATION 22-11 2014 2013 2012 Retained Earnings Retained earnings, January 1 $220,000 $120,000 $ 0 Statements (LIFO) Net income 87,000 100,000 120,000 Retained earnings, December 31 $307,000 $220,000 $120,000 If Lancer presents comparative statements for 2013 and 2014 under FIFO, then it must change the beginning balance of retained earnings at January 1, 2013. The difference between the retained earnings balances under LIFO and FIFO is computed as follows. Retained earnings, January 1, 2013 (FIFO) $122,000 Retained earnings, January 1, 2013 (LIFO) (120,000) Cumulative effect difference $ 2,000 The $2,000 difference is the cumulative effect. Illustration 22-12 shows a compara- tive retained earnings statement for 2013 and 2014, giving effect to the change in ac- counting principle to FIFO. ILLUSTRATION 22-12 2014 2013 Retained Earnings Retained earnings, January 1, as reported $120,000 Statements after Add: Adjustment for the cumulative effect on Retrospective Application prior years of applying retrospectively the new method of accounting for inventory 2,000 Retained earnings, January 1, as adjusted $225,000 122,000 Net income 89,000 103,000 Retained earnings, December 31 $314,000 $225,000 Lancer adjusted the beginning balance of retained earnings on January 1, 2013, for the excess of FIFO net income over LIFO net income in 2012. This comparative presenta- tion indicates the type of adjustment that a company needs to make. It follows that the amount of this adjustment would be much larger if a number of prior periods were involved. Changes in Accounting Principle 1355 Direct and Indirect Effects of Changes Are there other effects that a company should report when it makes a change in account- ing principle? For example, what happens when a company like Lancer has a bonus plan based on net income and the prior year’s net income changes when FIFO is retro- spectively applied? Should Lancer also change the reported amount of bonus expense? Or what happens if we had not ignored income taxes in the Lancer example? Should Lancer adjust net income, given that taxes will be different under LIFO and FIFO in prior periods? The answers depend on whether the effects are direct or indirect. Direct Effects The FASB takes the position that companies should retrospectively apply the direct effects of a change in accounting principle. An example of a direct effect is an adjustment to an inventory balance as a result of a change in the inventory valuation method. For example, Lancer Company should change the inventory amounts in prior periods to indicate the change to the FIFO method of inventory valuation. Another inventory-related example would be an impairment adjustment resulting from applying the lower-of-cost-or-market test to the adjusted inventory balance.

Related changes, such as deferred income tax effects of the impairment adjustment, are also considered direct effects. This entry was illustrated in the Denson example, in which the change to percentage-of-completion accounting resulted in recording a deferred tax liability. Indirect Effects In addition to direct effects, companies can have indirect effects related to a change in accounting principle. An indirect effect is any change to current or future cash flows of a company that result from making a change in accounting principle that is applied retrospectively. An example of an indirect effect is a change in profit-sharing or royalty payment that is based on a reported amount such as revenue or net income. Indirect effects do not change prior period amounts. For example, let’s assume that Lancer has an employee profit-sharing plan International based on net income. As Illustration 22-9 showed (on page 1353), Lancer would Perspective report higher income in 2012 and 2013 if it used the FIFO method. In addition, IFRS does not explicitly address let’s assume that the profit-sharing plan requires that Lancer pay the incremen- the accounting and disclosure of tal amount due based on the FIFO income amounts. In this situation, Lancer indirect effects. reports this additional expense in the current period; it would not change prior periods for this expense. If the company prepares comparative financial statements, it follows that it does not recast the prior periods for this additional expense.3 If the terms of the profit-sharing plan indicate that no payment is necessary in the cur- rent period due to this change, then the company need not recognize additional profit- sharing expense in the current period. Neither does it change amounts reported for prior periods. When a company recognizes the indirect effects of a change in accounting prin- ciple, it includes in the financial statements a description of the indirect effects. In doing so, it discloses the amounts recognized in the current period and related per share information. 3The rationale for this approach is that companies should recognize, in the period the adoption occurs (not the prior period), the effect on the cash flows that is caused by the adoption of the new accounting principle. That is, the accounting change is a necessary “past event” in the definition of an asset or liability that gives rise to the accounting recognition of the indirect effect in the current period. [4] 1356 Chapter 22 Accounting Changes and Error Analysis Impracticability It is not always possible for companies to determine how they would have reported LEARNING OBJECTIVE 4 prior periods’ financial information under retrospective application of an accounting Understand how to account for principle change. Retrospective application is considered impracticable if a company impracticable changes. cannot determine the prior period effects using every reasonable effort to do so. Companies should not use retrospective application if one of the following condi- tions exists: 1. The company cannot determine the effects of the retrospective application. 2. Retrospective application requires assumptions about management’s intent in a prior period. 3. Retrospective application requires signifi cant estimates for a prior period, and the com- pany cannot objectively verify the necessary information to develop these estimates. If any of the above conditions exists, it is deemed impracticable to apply the retro- spective approach. In this case, the company prospectively applies the new accounting principle as of the earliest date it is practicable to do so. [5] For example, assume that Williams Company changed its inventory method from FIFO to LIFO, effective January 1, 2015. Williams prepares statements on a calendar-year basis and has used the FIFO method since its inception. Williams judges it impracticable to retrospectively apply the new method. Determining prior period effects would require subjective assumptions about the LIFO layers established in prior periods. These assump-

tions would ordinarily result in the computation of a number of different earnings figures. As a result, the only adjustment necessary may be to restate the beginning inventory to a cost basis from a lower-of-cost-or-market approach (which establishes the begin- ning LIFO layer). Williams must disclose only the effect of the change on the results of operations in the period of change. Also, the company should explain the reasons for omitting the computations of the cumulative effect for prior years. Finally, it should disclose the justification for the change to LIFO. [6]4 Illustration 22-13, from the annual report of The Quaker Oats Company, shows the type of disclosure needed. ILLUSTRATION 22-13 The Quaker Oats Company Disclosure of Change to LIFO Note 1 (In Part): Summary of Significant Accounting Policies Inventories. Inventories are valued at the lower of cost or market, using various cost methods, and include the cost of raw materials, labor and overhead. The percentage of year-end inventories valued using each of the methods is as follows: June 30 Current Year Prior Year Average quarterly cost 21% 54% Last-in, first-out (LIFO) 65% 29% First-in, first-out (FIFO) 14% 17% Effective July 1, the Company adopted the LIFO cost flow assumption for valuing the majority of remaining U.S. Grocery Products inventories. The Company believes that the use of the LIFO method better matches current costs with current revenues. The cumulative effect of this change on retained earnings at the beginning of the year is not determinable, nor are the pro-forma effects of retroactive application of LIFO to prior years. The effect of this change on current-year fiscal results was to decrease net income by $16.0 million, or $.20 per share. If the LIFO method of valuing certain inventories were not used, total inventories would have been $60.1 million higher in the current year, and $24.0 million higher in the prior year. 4In practice, many companies defer the formal adoption of LIFO until year-end. Management thus has an opportunity to assess the impact that a change to LIFO will have on the financial statements and to evaluate the desirability of a change for tax purposes. As indicated in Chapter 8, many companies use LIFO because of the advantages of this inventory valuation method in a period of inflation. Changes in Accounting Estimates 1357 CHANGES IN ACCOUNTING ESTIMATES To prepare financial statements, companies must estimate the effects of future 5 LEARNING OBJECTIVE conditions and events. For example, the following items require estimates. Describe the accounting for changes in estimates. 1. Uncollectible receivables. 2. Inventory obsolescence. 3. Useful lives and salvage values of assets. 4. Periods benefi ted by deferred costs. 5. Liabilities for warranty costs and income taxes. 6. Recoverable mineral reserves. 7. Change in depreciation methods. A company cannot perceive future conditions and events and their effects with certainty. Therefore, estimation requires the exercise of judgment. Accounting estimates will change as new events occur, as a company acquires more experience, or as it obtains additional information. Prospective Reporting Companies report prospectively changes in accounting estimates. That is, companies should not adjust previously reported results for changes in estimates. Instead, they account for the effects of all changes in estimates in (1) the period of change if the change affects that period only, or (2) the period of change and future periods if the change affects both. The FASB views changes in estimates as normal recurring corrections and adjust- ments, the natural result of the accounting process. It prohibits retrospective treatment. The circumstances related to a change in estimate differ from those for a change in accounting principle. If companies reported changes in estimates retrospectively, con- tinual adjustments of prior years’ income would occur. It seems proper to accept the view that, because new conditions or circumstances exist, the revision fits the new situ-

ation (not the old one). Companies should therefore handle such a revision in the cur- rent and future periods. To illustrate, Underwriters Labs Inc. purchased for $300,000 a building that it originally estimated to have a useful life of 15 years and no salvage value. It recorded depreciation for 5 years on a straight-line basis. On January 1, 2014, Underwriters Labs revises the estimate of the useful life. It now considers the asset to have a total life of 25 years. (Assume that the useful life for financial reporting and tax purposes and depreciation method are the same.) Illustration 22-14 shows the accounts at the beginning of the sixth year. ILLUSTRATION 22-14 Buildings $300,000 Book Value after Five Less: Accumulated depreciation—buildings (5 3 $20,000) 100,000 Years’ Depreciation Book value of building $200,000 Underwriters Labs records depreciation for the year 2014 as follows. Depreciation Expense 10,000 Accumulated Depreciation—Buildings 10,000 The company computes the $10,000 depreciation charge as shown in Illustration 22-15. ILLUSTRATION 22-15 Book Value of Asset $200,000 Depreciation Charge5 5 5$10,000 Depreciation after Remaining Service Life 25 years25 years Change in Estimate 1358 Chapter 22 Accounting Changes and Error Analysis Companies sometime find it difficult to differentiate between a change in estimate and a change in accounting principle. Is it a change in principle or a change in estimate when a company changes from deferring and amortizing marketing costs to expensing them as incurred because future benefits of these costs have become doubtful? If it is impossible to determine whether a change in principle or a change in estimate has occurred, the rule is this: Consider the change as a change in estimate. This is often referred to as a change in estimate effected by a change in accounting principle. Another example of a change in estimate effected by a change in principle is a change in depreciation (as well as amortization or depletion) methods. Because companies change depreciation methods based on changes in estimates about future benefits from long-lived assets, it is not possible to separate the effect of the accounting principle change from that of the estimates. As a result, companies account for a change in depreciation methods as a change in estimate effected by a change in accounting principle. [7] A similar problem occurs in differentiating between a change in estimate and a correction of an error, although here the answer is more clear-cut. How does a company determine whether it overlooked the information in earlier periods (an error), or whether it obtained new information (a change in estimate)? Proper classification is important because the accounting treatment differs for corrections of errors versus changes in esti- mates. The general rule is this: Companies should consider careful estimates that later prove to be incorrect as changes in estimate. Only when a company obviously com- puted the estimate incorrectly because of lack of expertise or in bad faith should it con- sider the adjustment an error. There is no clear demarcation line here. Companies must use good judgment in light of all the circumstances.5 Disclosures Illustration 22-16 shows disclosure of a change in estimated useful lives, which appeared in the annual report of Ampco–Pittsburgh Corporation. ILLUSTRATION 22-16 Ampco–Pittsburgh Corporation Disclosure of Change in Estimated Useful Lives Note 11: Change in Accounting Estimate. The Corporation revised its estimate of the useful lives of certain machinery and equipment. Previously, all machinery and equipment, whether new when placed in use or not, were in one class and depreciated over 15 years. The change principally applies to assets purchased new when placed in use. Those lives are now extended to 20 years. These changes were made to better reflect the estimated periods during which such assets will remain in service. The change had the effect of reducing depreciation expense and increasing net income by approximately $991,000

($.10 per share). For the most part, companies need not disclose changes in accounting estimates made as part of normal operations, such as bad debt allowances or inventory obsoles- cence, unless such changes are material. However, for a change in estimate that affects several periods (such as a change in the service lives of depreciable assets), companies should disclose the effect on income from continuing operations and related per share 5In evaluating reasonableness, the auditor should use one or a combination of the following approaches. (a) Review and test the process used by management to develop the estimate. (b) Develop an independent expectation of the estimate to corroborate the reasonableness of management’s estimate. (c) Review subsequent events or transactions occurring prior to completion of fieldwork. “Auditing Accounting Estimates,” Statement on Auditing Standards No. 57 (New York: AICPA, 1988). Accounting Errors 1359 amounts of the current period. When a company has a change in estimate effected by a change in accounting principle, it must indicate why the new method is preferable. In addition, companies are subject to all other disclosure guidelines established for changes in accounting principle. CHANGES IN REPORTING ENTITY Occasionally, companies make changes that result in different reporting entities. 6 LEARNING OBJECTIVE In such cases, companies report the change by changing the financial statements Identify changes in a reporting entity. of all prior periods presented. The revised statements show the financial informa- tion for the new reporting entity for all periods. Examples of a change in reporting entity are: 1. Presenting consolidated statements in place of statements of individual companies. 2. Changing specifi c subsidiaries that constitute the group of companies for which the entity presents consolidated fi nancial statements. 3. Changing the companies included in combined fi nancial statements. 4. Changing the cost, equity, or consolidation method of accounting for subsidiaries and investments.6 In this case, a change in the reporting entity does not result from creation, cessation, purchase, or disposition of a subsidiary or other business unit. In the year in which a company changes a reporting entity, it should disclose in the financial statements the nature of the change and the reason for it. It also should report, for all periods presented, the effect of the change on income before extraordinary items, net income, and earnings per share. These disclosures need not be repeated in subse- quent periods’ financial statements. Illustration 22-17 shows a note disclosing a change in reporting entity, from the annual report of Hewlett-Packard Company. ILLUSTRATION 22-17 Hewlett-Packard Company Disclosure of Change in Reporting Entity Note: Accounting and Reporting Changes (In Part) Consolidation of Hewlett-Packard Finance Company. The company implemented a new accounting pro- nouncement on consolidations. With the adoption of this new pronouncement, the company consolidated the accounts of Hewlett-Packard Finance Company (HPFC), a wholly owned subsidiary previously accounted for under the equity method, with those of the company. The change resulted in an increase in consolidated assets and liabilities but did not have a material effect on the company’s financial position. Since HPFC was previously accounted for under the equity method, the change did not affect net earnings. Prior years’ consolidated financial information has been restated to reflect this change for comparative purposes. ACCOUNTING ERRORS No business, large or small, is immune from errors. As the opening story discusses, 7 LEARNING OBJECTIVE the number of accounting errors that lead to restatement are beginning to decline. Describe the accounting for correction However, without accounting and disclosure guidelines for the reporting of errors, of errors. investors can be left in the dark about the effects of errors. Certain errors, such as misclassifications of balances within a financial statement,

are not as significant to investors as other errors. Significant errors would be those resulting in overstating assets or income, for example. However, investors should know 6An exception to retrospective application occurs when changing from the equity method. We provide an expanded illustration of the accounting for a change from or to the equity method in Appendix 22A. 1360 Chapter 22 Accounting Changes and Error Analysis the potential impact of all errors. Even “harmless” misclassifications can affect impor- tant ratios. Also, some errors could signal important weaknesses in internal controls that could lead to more significant errors. In general, accounting errors include the following types: 1. A change from an accounting principle that is not generally accepted to an account- ing principle that is acceptable. The rationale is that the company incorrectly pre- sented prior periods because of the application of an improper accounting principle. For example, a company may change from the cash (income tax) basis of accounting to the accrual basis. 2. Mathematical mistakes, such as incorrectly totaling the inventory count sheets when computing the inventory value. 3. Changes in estimates that occur because a company did not prepare the estimates in good faith. For example, a company may have adopted a clearly unrealistic depreciation rate. 4. An oversight, such as the failure to accrue or defer certain expenses and revenues at the end of the period. 5. A misuse of facts, such as the failure to use salvage value in computing the depre- ciation base for the straight-line approach. 6. The incorrect classifi cation of a cost as an expense instead of an asset, and vice versa. ILLUSTRATION 22-18 Accounting errors occur for a variety of reasons. Illustration 22-18 indicates 11 Accounting-Error Types major categories of accounting errors that drive restatements. Accounting Category Type of Restatement Expense recognition Recording expenses in the incorrect period or for an incorrect amount. Revenue recognition Improper revenue accounting. This category includes instances in which revenue was improperly recognized, questionable revenues were recognized, or any other number of related errors that led to misreported revenue. Misclassification M isclassifying significant accounting items on the balance sheet, income statement, or statement of cash flows. These include restatements due to misclassification of short- or long-term accounts or those that impact cash flows from operations. Equity—other Improper accounting for EPS, restricted stock, warrants, and other equity instruments. Reserves/Contingencies E rrors involving bad debts related to accounts receivable, inventory reserves, income tax allowances, and loss contingencies. Long-lived assets Asset impairments of property, plant, and equipment; goodwill; or other related items. Taxes Errors involving correction of tax provision, improper treatment of tax liabilities, and other tax-related items. Equity—other comprehensive Improper accounting for comprehensive income equity transactions including foreign currency items, income unrealized gains and losses on certain investments in debt, equity securities, and derivatives. Inventory Inventory costing valuations, quantity issues, and cost of sales adjustments. Equity—stock options Improper accounting for employee stock options. Other Any restatement not covered by the listed categories including those related to improper accounting for acquisitions or mergers. Source: T. Baldwin and D. Yoo, “Restatements—Traversing Shaky Ground,” Trend Alert, Glass Lewis & Co. (June 2, 2005), p. 8. As soon as a company discovers an error, it must correct the error. Companies record corrections of errors from prior periods as an adjustment to the beginning balance of retained earnings in the current period. Such corrections are called prior period adjustments.7 [8] 7See Mark L. Defond and James Jiambalvo, “Incidence and Circumstances of Accounting Errors,” The Accounting Review (July 1991) for examples of different types of errors and why

these errors might have occurred. Accounting Errors 1361 If it presents comparative statements, a company should restate the prior state- ments affected, to correct for the error.8 The company need not repeat the disclosures in the financial statements of subsequent periods. Example of Error Correction To illustrate, in 2015 the bookkeeper for Selectro Company discovered an error. In 2014, the company failed to record $20,000 of depreciation expense on a newly constructed building. This building is the only depreciable asset Selectro owns. The company cor- rectly included the depreciation expense in its tax return and correctly reported its income taxes payable. Illustration 22-19 presents Selectro’s income statement for 2014 (starting with income before depreciation expense) with and without the error. ILLUSTRATION 22-19 SELECTRO COMPANY Error Correction INCOME STATEMENT Comparison FOR THE YEAR ENDED, DECEMBER 31, 2014 Without Error With Error Income before depreciation expense $100,000 $100,000 Depreciation expense 20,000 0 Income before income tax 80,000 100,000 Current income tax expense $32,000 $32,000 Deferred income tax expense –0– 32,000 8,000 40,000 Net income $ 48,000 $ 60,000 Illustration 22-20 shows the entries that Selectro should have made and did make for recording depreciation expense and income taxes. ILLUSTRATION 22-20 Entries Company Should Have Made Entries Company Did Make Error Entries (Without Error) (With Error) Depreciation Expense 20,000 No entry made for depreciation Accumulated Depreciation —Buildings 20,000 Income Tax Expense 32,000 Income Tax Expense 40,000 Income Taxes Payable 32,000 Deferred Tax Liability 8,000 Income Taxes Payable 32,000 As Illustration 22-20 indicates, the $20,000 omission error in 2014 results in the following effects. Income Statement Effects Depreciation expense (2014) is understated $20,000. Income tax expense (2014) is overstated $8,000 ($20,000 3 40%). Net income (2014) is overstated $12,000 ($20,000 2 $8,000). Balance Sheet Effects Accumulated depreciation—buildings is understated $20,000. Deferred tax liability is overstated $8,000 ($20,000 3 40%). To make the proper correcting entry in 2015, Selectro should recognize that net in- come in 2014 is overstated by $12,000, the Deferred Tax Liability is overstated by $8,000, 8The term restatement is used for the process of revising previously issued financial statements to reflect the correction of an error. This distinguishes an error correction from a change in accounting principle. [9] 1362 Chapter 22 Accounting Changes and Error Analysis and Accumulated Depreciation—Buildings is understated by $20,000. The entry to correct this error in 2015 is as follows. Retained Earnings 12,000 Deferred Tax Liability 8,000 Accumulated Depreciation—Buildings 20,000 The debit to Retained Earnings results because net income for 2014 is overstated. The debit to Deferred Tax Liability is made to remove this account, which was caused by the error. The credit to Accumulated Depreciation—Buildings reduces the book value of the building to its proper amount. Selectro will make the same journal entry to record the correction of the error in 2015 whether it prepares single-period (noncomparative) or comparative financial statements. Single-Period Statements To demonstrate how to show this information in a single-period statement, assume that Selectro Company has a beginning retained earnings balance at January 1, 2015, of $350,000. The company reports net income of $400,000 in 2015. Illustration 22-21 shows Selectro’s retained earnings statement for 2015. ILLUSTRATION 22-21 SELECTRO COMPANY Reporting an Error— RETAINED EARNINGS STATEMENT Single-Period Financial FOR THE YEAR ENDED DECEMBER 31, 2015 Statement Retained earnings, January 1, as reported $350,000 Correction of an error (depreciation) $20,000 Less: Applicable income tax reduction 8,000 (12,000) Retained earnings, January 1, as adjusted 338,000 Add: Net income 400,000 Retained earnings, December 31 $738,000 The balance sheet in 2015 would not have any deferred tax liability related to the

building, and Accumulated Depreciation—Buildings is now restated at a higher amount. The income statement would not be affected. Comparative Statements If preparing comparative financial statements, a company should make adjustments to correct the amounts for all affected accounts reported in the statements for all periods reported. The company should restate the data to the correct basis for each year presented. It should show any catch-up adjustment as a prior period adjustment to retained earnings for the earliest period it reported. These requirements are essentially the same as those for reporting a change in accounting principle. For example, in the case of Selectro, the error of omitting the depreciation of $20,000 in 2014, discovered in 2015, results in the restatement of the 2014 financial statements. Illustration 22-22 shows the accounts that Selectro restates in the 2014 financial statements. ILLUSTRATION 22-22 In the balance sheet: Reporting an Error— Accumulated depreciation—buildings $20,000 increase Comparative Financial Deferred tax liability $ 8,000 decrease Statements Retained earnings, ending balance $12,000 decrease In the income statement: Depreciation expense—buildings $20,000 increase Income tax expense $ 8,000 decrease Net income $12,000 decrease In the retained earnings statement: Retained earnings, ending balance (due to lower net income for the period) $12,000 decrease Accounting Errors 1363 Selectro prepares the 2015 financial statements in comparative form with those of 2014 as if the error had not occurred. In addition, Selectro must disclose that it has re- stated its previously issued financial statements, and it describes the nature of the error. Selectro also must disclose the following. 1. The effect of the correction on each fi nancial statement line item and any per share amounts affected for each prior period presented. 2. The cumulative effect of the change on retained earnings or other appropriate com- ponents of equity or net assets in the statement of fi nancial position, as of the begin- ning of the earliest period presented. [10] Summary of Accounting Changes and Correction of Errors Having guidelines for reporting accounting changes and corrections has helped resolve several significant and long-standing accounting problems. Yet, because of diversity in situations and characteristics of the items encountered in practice, use of professional judgment is of paramount importance. In applying these guidelines, the primary objec- tive is to serve the users of the financial statements. Achieving this objective requires accuracy, full disclosure, and an absence of misleading inferences. Illustration 22-23 summarizes the main distinctions and treatments presented in the discussion in this chapter. ILLUSTRATION 22-23 Changes in accounting principle Summary of Guidelines for Accounting Changes Employ the retrospective approach by: and Errors a. Changing the financial statements of all prior periods presented. b. Disclosing in the year of the change the effect on net income and earnings per share for all prior periods presented. c. Reporting an adjustment to the beginning retained earnings balance in the retained earnings statement in the earliest year presented. If impracticable to determine the prior period effect (e.g., change to LIFO): a. Do not change prior years’ income. b. Use opening inventory in the year the method is adopted as the base-year inventory for all subsequent LIFO computations. c. Disclose the effect of the change on the current year, and the reasons for omitting the computation of the cumulative effect and pro forma amounts for prior years. Changes in accounting estimate Employ the current and prospective approach by: a. Reporting current and future financial statements on the new basis. b. Presenting prior period financial statements as previously reported. c. Making no adjustments to current-period opening balances for the effects in prior periods. Changes in reporting entity Employ the retrospective approach by: a. Restating the financial statements of all prior periods presented.

b. Disclosing in the year of change the effect on net income and earnings per share data for all prior periods presented. Changes due to error Employ the restatement approach by: a. Correcting all prior period statements presented. b. Restating the beginning balance of retained earnings for the first period presented when the error effects occur in a period prior to the first period presented. Changes in accounting principle are appropriate only when a company demon- strates that the newly adopted generally accepted accounting principle is preferable to 1364 Chapter 22 Accounting Changes and Error Analysis the existing one. Companies and accountants determine preferability on the basis of whether the new principle constitutes an improvement in financial reporting, not on the basis of the income tax effect alone.9 But it is not always easy to determine an improvement in financial reporting. How does one measure preferability or improvement? Such measurement varies from company to company. Quaker Oats Company, for example, argued that a change in accounting principle to LIFO inventory valuation “better matches current costs with current revenues” (see Illustration 22-13, page 1356). Conversely, another company might change from LIFO to FIFO because it wishes to report a more realistic ending inventory. How do you determine which is the better of these two arguments? Deter- mining the preferable method requires some “standard” or “objective.” Because no universal standard or objective is generally accepted, the problem of determining preferability continues to be difficult. Initially, the SEC took the position that the auditor should indicate whether a change in accounting principle was preferable. The SEC has since modified this approach, noting that greater reliance may be placed on management’s judgment in assessing preferability. Even though the preferability criterion is difficult to apply, the general guidelines have acted as a deterrent to capricious changes in accounting principles.10 If a FASB rule creates a new principle, expresses preference for, or rejects a specific accounting principle, a change is considered clearly acceptable. What do the numbers mean? CAN I GET MY MONEY BACK? When companies report restatements, investors usually lose Class-action activity has picked up in recent years, and money. What should investors do if a company misleads settlements can be large. To fi nd out about class actions, them by misstating its fi nancial results? Join other investors investors can go online to see if they are eligible to join any in a class-action suit against the company and in some cases, class actions. Below are some recent examples. the auditor. Company Settlement Amount Contact for Claim Samsung $1 billion www.lawyersandsettlements.com Merck $950 million www.lawyersandsettlements.com Wal-Mart $13.5 million www.lawyersandsettlements.com The amounts reported are before attorney’s fees, which can investment. Thus, investors can get back some of the money range from 15 to 30 percent of the total. Also, investors may they lost due to restatements, but they should be prepared to owe taxes if the settlement results in a capital gain on the pay an attorney and the government fi rst. Sources: Adapted from C. Coolidge, “Lost and Found,” Forbes (October 1, 2001), pp. 124–125; data from www.lawyersandsettlements.com as of 11/13/12. 9A change in accounting principle, a change in the reporting entity (special type of change in accounting principle), and a correction of an error require an explanatory paragraph in the auditor’s report discussing lack of consistency from one period to the next. A change in account- ing estimate does not affect the auditor’s opinion relative to consistency. However, if the change in estimate has a material effect on the financial statements, disclosure may still be required. Error correction not involving a change in accounting principle does not require disclosure relative to consistency. 10If management has not provided reasonable justification for the change in accounting principle,

the auditor should express a qualified opinion. Or, if the effect of the change is sufficiently material, the auditor should express an adverse opinion on the financial statements. “Reports on Audited Financial Statements,” Statement on Auditing Standards No. 58 (New York: AICPA, 1988). Accounting Errors 1365 Motivations for Change of Accounting Method Difficult as it is to determine which accounting standards have the strongest con- 8 LEARNING OBJECTIVE ceptual support, other complications make the process even more complex. These Identify economic motives for changing complications stem from the fact that managers have self-interest in how the finan- accounting methods. cial statements make the company look. They naturally wish to show their finan- cial performance in the best light. A favorable profit picture can influence investors, and a strong liquidity position can influence creditors. Too favorable a profit picture, however, can provide union negotiators and government regulators with ammunition during bargaining talks. Hence, managers might have varying motives for reporting income numbers. Research has provided additional insight into why companies may prefer certain accounting methods.11 Some of these reasons are as follows. 1. Political costs. As companies become larger and more politically visible, politicians and regulators devote more attention to them. The larger the fi rm, the more likely it is to become subject to regulation such as antitrust, and the more likely it is to be required to pay higher taxes. Therefore, companies that are politically visible may seek to report low income numbers, to avoid the scrutiny of regulators. In addition, other constituents, such as labor unions, may be less willing to ask for wage in- creases if reported income is low. Researchers have found that the larger the com- pany, the more likely it is to adopt income-decreasing approaches in selecting accounting methods. 2. Capital structure. A number of studies have indicated that the capital structure of the company can affect the selection of accounting methods. For example, a com- pany with a high debt to equity ratio is more likely to be constrained by debt cove- nants. The debt covenant may indicate that the company cannot pay dividends if retained earnings fall below a certain level. As a result, such a company is more likely to select accounting methods that will increase net income. 3. Bonus payments. Studies have found that if compensation plans tie managers’ bonus payments to income, management will select accounting methods that maxi- mize their bonus payments. 4. Smooth earnings. Substantial earnings increases attract the attention of politicians, regulators, and competitors. In addition, large increases in income are diffi cult to achieve in following years. Further, executive compensation plans would use these higher numbers as a baseline and make it diffi cult for managers to earn bonuses in subsequent years. Conversely, investors and competitors might view large decreases in earnings as a signal that the company is in fi nancial trouble. Also, substantial decreases in income raise concerns on the part of stockholders, lenders, and other interested parties about the competency of management. For all these reasons, com- panies have an incentive to “manage” or “smooth” earnings. In general, manage- ment tends to believe that a steady 10 percent growth a year is much better than a 30 percent growth one year and a 10 percent decline the next.12 In other words, man- agers usually prefer a gradually increasing income report and sometimes change accounting methods to ensure such a result. 11See Ross L. Watts and Jerold L. Zimmerman, “Positive Accounting Theory: A Ten-Year Perspective,” The Accounting Review (January 1990) for an excellent review of research findings related to management incentives in selecting accounting methods. 12O. Douglas Moses, “Income Smoothing and Incentives: Empirical Tests Using Accounting Changes,” The Accounting Review (April 1987). The findings provide evidence that earnings

smoothing is associated with firm size, the existence of bonus plans, and the divergence of actual earnings from expectations. 1366 Chapter 22 Accounting Changes and Error Analysis Management pays careful attention to the accounting it follows and often changes accounting methods, not for conceptual reasons, but for economic reasons. As indicated throughout this textbook, such arguments have come to be known as economic conse- quences arguments. These arguments focus on the supposed impact of the accounting method on the behavior of investors, creditors, competitors, governments, or managers of the reporting companies themselves.13 To counter these pressures, standard-setters such as the FASB have declared, Underlying Concepts as part of their conceptual framework, that they will assess the merits of pro- Neutrality is an important ele- posed standards from a position of neutrality. That is, they evaluate the sound- ment of faithful representation. ness of standards on the basis of conceptual soundness, not on the grounds of possible impact on behavior. It is not the FASB’s place to choose standards a ccording to the kinds of behavior it wishes to promote and the kinds it wishes to d iscourage. At the same time, it must be admitted that some standards often will have the effect of influencing behavior. Yet their justification should be conceptual, and not viewed in terms of their economic impact. ERROR ANALYSIS In this section, we show some additional types of accounting errors. Companies LEARNING OBJECTIVE 9 generally do not correct for errors that do not have a significant effect on the Analyze the effect of errors. presentation of the financial statements. For example, should a company with a total annual payroll of $1,750,000 and net income of $940,000 correct its financial state- ments if it finds it failed to record accrued wages of $5,000? No—it would not consider this error significant or material. Obviously, defining materiality is difficult, and managers and auditors must use experience and judgment to determine whether adjustment is necessary for a given error. We assume all errors discussed in this section to be material and to require adjustment. (Also, we ignore all tax effects in this section.) Companies must answer three questions in error analysis: 1. What type of error is involved? 2. What entries are needed to correct for the error? 3. After discovery of the error, how are fi nancial statements to be restated? As indicated earlier, companies treat errors as prior period adjustments and report them in the current year as adjustments to the beginning balance of Retained Earnings. If a company presents comparative statements, it restates the prior affected statements to correct for the error. Balance Sheet Errors Balance sheet errors affect only the presentation of an asset, liability, or stockholders’ equity account. Examples are the classification of a short-term receivable as part of the investment section, the classification of a note payable as an account payable, and the classification of plant assets as inventory. When the error is discovered, the company reclassifies the item to its proper posi- tion. If the company prepares comparative statements that include the error year, it should correctly restate the balance sheet for the error year. 13Lobbyists use economic consequences arguments—and there are many of them—to put pressure on standard-setters. We have seen examples of these arguments in the oil and gas industry about successful-efforts versus full-cost in the technology area, with the issue of mandatory expensing of research and developmental costs and stock options. Error Analysis 1367 Income Statement Errors Income statement errors involve the improper classification of revenues or expenses. Examples include recording interest revenue as part of sales, purchases as bad debt expense, and depreciation expense as interest expense. An income statement classifica- tion error has no effect on the balance sheet and no effect on net income. A company must make a reclassification entry when it discovers the error, if it

makes the discovery in the same year in which the error occurs. If the error occurred in prior periods, the company does not need to make a reclassification entry at the date of discovery because the accounts for the current year are correctly stated. (Remember that the company has closed the income statement accounts from the prior period to retained earnings.) If the company prepares comparative statements that include the error year, it restates the income statement for the error year. Balance Sheet and Income Statement Errors The third type of error involves both the balance sheet and income statement. For ex- ample, assume that the bookkeeper overlooked accrued wages payable at the end of the accounting period. The effect of this error is to understate expenses, understate liabili- ties, and overstate net income for that period of time. This type of error affects both the balance sheet and the income statement. We classify this type of error in one of two ways—counterbalancing or noncounterbalancing. Counterbalancing errors are those that will be offset or corrected over two periods. For example, the failure to record accrued wages is a counterbalancing error because over a two-year period the error will no longer be present. In other words, the failure to record accrued wages in the previous period means: (1) net income for the first period is overstated, (2) accrued wages payable (a liability) is understated, and (3) wages expense is understated. In the next period, net income is understated, accrued wages payable (a liability) is correctly stated, and wages expense is overstated. For the two years combined: (1) net income is correct, (2) wages expense is correct, and (3) accrued wages payable at the end of the second year is correct. Most errors in accounting that affect both the balance sheet and income statement are counterbalancing errors. Noncounterbalancing errors are those that are not offset in the next accounting period. An example would be the failure to capitalize equipment that has a useful life of five years. If we expense this asset immediately, expenses will be overstated in the first period but understated in the next four periods. At the end of the second period, the effect of the error is not fully offset. Net income is correct in the aggregate only at the end of five years because the asset is fully depreciated at this point. Thus, noncounterbal- ancing errors are those that take longer than two periods to correct themselves. Only in rare instances is an error never reversed. An example would be if a com- pany initially expenses land. Because land is not depreciable, theoretically the error is never offset, unless the land is sold. Counterbalancing Errors We illustrate the usual types of counterbalancing errors on the following pages. In studying these illustrations, keep in mind a couple of points. First, determine whether the company has closed the books for the period in which the error is found: 1. If the company has closed the books in the current year: (a) If the error is already counterbalanced, no entry is necessary. (b) If the error is not yet counterbalanced, make an entry to adjust the present bal- ance of retained earnings. 1368 Chapter 22 Accounting Changes and Error Analysis 2. If the company has not closed the books in the current year: (a) If the error is already counterbalanced, make an entry to correct the error in the current period and to adjust the beginning balance of Retained Earnings. (b) If the error is not yet counterbalanced, make an entry to adjust the beginning balance of Retained Earnings. Second, if the company presents comparative statements, it must restate the amounts for comparative purposes. Restatement is necessary even if a correcting journal entry is not required. To illustrate, assume that Sanford’s Cement Co. failed to accrue revenue in 2012 when it fulfilled its performance obligation, but recorded the revenue in 2013 when it received payment. The company discovered the error in 2015. It does not need to make an entry to correct for this error because the effects have been counterbalanced by the

time Sanford discovered the error in 2015. However, if Sanford presents comparative financial statements for 2012 through 2015, it must restate the accounts and related amounts for the years 2012 and 2013 for financial reporting purposes. The sections that follow demonstrate the accounting for the usual types of counter- balancing errors. Failure to Record Accrued Wages. On December 31, 2014, Hurley Enterprises did not accrue wages in the amount of $1,500. The entry in 2015 to correct this error, assuming Hurley has not closed the books for 2015, is: Retained Earnings 1,500 Salaries and Wages Expense 1,500 The rationale for this entry is as follows. (1) When Hurley pays the 2014 accrued wages in 2015, it makes an additional debit of $1,500 to 2015 Salaries and Wages Expense. (2) Salaries and Wages Expense—2015 is overstated by $1,500. (3) Because the company did not record 2014 accrued wages as Salaries and Wages Expense in 2014, the net income for 2014 was overstated by $1,500. (4) Because 2014 net income is overstated by $1,500, the Retained Earnings account is overstated by $1,500 (because net income is closed to Retained Earnings). If Hurley has closed the books for 2015, it makes no entry because the error is counterbalanced. Failure to Record Prepaid Expenses. In January 2014, Hurley Enterprises purchased a two-year insurance policy costing $1,000. It debited Insurance Expense, and credited Cash. The company made no adjusting entries at the end of 2014. The entry on December 31, 2015, to correct this error, assuming Hurley has not closed the books for 2015, is: Insurance Expense 500 Retained Earnings 500 If Hurley has closed the books for 2015, it makes no entry because the error is counterbalanced. Understatement of Unearned Revenue. On December 31, 2014, Hurley Enterprises received $50,000 as a prepayment for renting certain office space for the following year. At the time of receipt of the rent payment, the company recorded a debit to Cash and a credit to Rent Revenue. It made no adjusting entry as of December 31, 2014. The entry on December 31, 2015, to correct for this error, assuming that Hurley has not closed the books for 2015, is: Retained Earnings 50,000 Rent Revenue 50,000 Error Analysis 1369 If Hurley has closed the books for 2015, it makes no entry because the error is counterbalanced. Overstatement of Accrued Revenue. On December 31, 2014, Hurley Enterprises accrued as interest revenue $8,000 that applied to 2015. On that date, the company recorded a debit to Interest Receivable and a credit to Interest Revenue. The entry on December 31, 2015, to correct for this error, assuming that Hurley has not closed the books for 2015, is: Retained Earnings 8,000 Interest Revenue 8,000 If Hurley has closed the books for 2015, it makes no entry because the error is counterbalanced. Overstatement of Purchases. Hurley’s accountant recorded a purchase of merchandise for $9,000 in 2014 that applied to 2015. The physical inventory for 2014 was correctly stated. The company uses the periodic inventory method. The entry on December 31, 2015, to correct for this error, assuming that Harley has not closed the books for 2015, is: Purchases 9,000 Retained Earnings 9,000 If Hurley has closed the books for 2015, it makes no entry because the error is counterbalanced. Noncounterbalancing Errors The entries for noncounterbalancing errors are more complex. Companies must make correcting entries, even if they have closed the books. Failure to Record Depreciation. Assume that on January 1, 2014, Hurley Enterprises purchased a machine for $10,000 that had an estimated useful life of five years. The ac- countant incorrectly expensed this machine in 2014, but discovered the error in 2015. If we assume that Hurley uses straight-line depreciation on this asset, the entry on Decem- ber 31, 2015, to correct for this error, given that Hurley has not closed the books, is: Equipment 10,000 Depreciation Expense 2,000 Retained Earnings 8,000* Accumulated Depreciation—Equipment (20% 3 $10,000 3 2) 4,000 *Computations:

Retained Earnings Overstatement of expense in 2014 $10,000 Proper depreciation for 2014 (20% 3 $10,000) (2,000) Retained earnings understated as of Dec. 31, 2014 $ 8,000 If Hurley has closed the books for 2015, the entry is: Equipment 10,000 Retained Earnings 6,000* Accumulated Depreciation—Equipment 4,000 *Computations: Retained Earnings Retained earnings understated as of Dec. 31, 2014 $ 8,000 Proper depreciation for 2015 (20% 3 $10,000) (2,000) Retained earnings understated as of Dec. 31, 2015 $ 6,000 Failure to Adjust for Bad Debts. Companies sometimes use a specific charge-off method in accounting for bad debt expense when a percentage of sales is more appropriate. They then make adjustments to change from the specific write-off to some type of allow- ance method. For example, assume that Hurley Enterprises has recognized bad debt expense when it has the following uncollectible debts. 1370 Chapter 22 Accounting Changes and Error Analysis 2014 2015 From 2014 sales $550 $690 From 2015 sales 700 Hurley estimates that it will charge off an additional $1,400 in 2016, of which $300 is applicable to 2014 sales and $1,100 to 2015 sales. The entry on December 31, 2015, assuming that Hurley has not closed the books for 2015, is: Bad Debt Expense 410 Retained Earnings 990 Allowance for Doubtful Accounts 1,400 Allowance for doubtful accounts: Additional $300 for 2014 sales and $1,100 for 2015 sales. Bad debts and retained earnings balance: 2014 2015 Bad debts charged for $1,240* $ 700 Additional bad debts anticipated in 2016 300 1,100 Proper bad debt expense 1,540 1,800 Charges currently made to each period (550) (1,390) Bad debt adjustment $ 990 $ 410 *$550 1 $690 5 $1,240 If Hurley has closed the books for 2015, the entry is: Retained Earnings 1,400 Allowance for Doubtful Accounts 1,400 Comprehensive Example: Numerous Errors In some circumstances a combination of errors occurs. The company therefore prepares a worksheet to facilitate the analysis. The following problem demonstrates use of the worksheet. The mechanics of its preparation should be obvious from the solution format. The income statements of Hudson Company for the years ended December 31, 2013, 2014, and 2015, indicate the following net incomes. 2013 $17,400 2014 20,200 2015 11,300 An examination of the accounting records for these years indicates that Hudson Company made several errors in arriving at the net income amounts reported: 1. The company consistently omitted from the records wages earned by workers but not paid at December 31. The amounts omitted were: December 31, 2013 $1,000 December 31, 2014 $1,400 December 31, 2015 $1,600 When paid in the year following that in which they were earned, Hudson recorded these amounts as expenses. 2. The company overstated merchandise inventory on December 31, 2013, by $1,900 as the result of errors made in the footings and extensions on the inventory sheets. 3. On December 31, 2014, Hudson expensed prepaid insurance of $1,200, applicable to 2015. 4. The company did not record on December 31, 2014, interest receivable in the amount of $240. 5. On January 2, 2014, Hudson sold for $1,800 a piece of equipment costing $3,900. At the date of sale, the equipment had accumulated depreciation of $2,400. The Error Analysis 1371 company recorded the cash received as Miscellaneous Income in 2014. In addition, the company continued to record depreciation for this equipment in both 2014 and 2015 at the rate of 10 percent of cost. The first step in preparing the worksheet is to prepare a schedule showing the corrected net income amounts for the years ended December 31, 2013, 2014, and 2015. Each correction of the amount originally reported is clearly labeled. The next step is to ILLUSTRATION 22-24 indicate the balance sheet accounts affected as of December 31, 2015. Illustration 22-24 Worksheet to Correct shows the completed worksheet for Hudson Company. Income and Balance Sheet Errors HHUUDDSSOONN CCOOMMPPAANNYY..xxllss Home Insert Page Layout Formulas Data Review View P18 fx A B C D E F G H 1 HUDSON COMPANY 2 Worksheet to Correct Income and

3 Balance Sheet Errors 4 Worksheet Analysis of Changes Balance Sheet Correc!on in Net Income at December 31, 2015 5 2013 2014 2015 Totals Debit Credit Account 6 Net income as reported $17,400 $20,200 $11,300 $48,900 7 Wages unpaid, 12/31/13 (1,000) 1,000 –0– 8 Wages unpaid, 12/31/14 (1,400) 1,400 –0– 9 Wages unpaid, 12/31/15 (1,600) (1,600) $1,600 Salaries and Wages Payable 10 Inventory overstatement, 12/31/13 (1,900) 1,900 –0– 11 Prepaid insurance, 12/31/14 1,200 (1,200) –0– 12 Interest receivable, 12/31/14 240 (240) –0– 13 Correc!on for entry made upon (1,500) (1,500) $2,400 Accumulated Deprecia!on—Equipment sale of equipment, 1/2/14a 3,900 Equipment 14 Overcharge of deprecia!on, 2014 390 390 390 Accumulated Deprecia!on—Equipment 15 Overcharge of deprecia!on, 2015 390 390 390 Accumulated Deprecia!on—Equipment 16 Corrected net income $14,500 $22,030 $10,050 $46,580 17 aCost $ 3,900 18 Less: Accumulated deprecia!on 2,400 19 Book value 1,500 20 Less: Proceeds from sale 1,800 21 Gain on sale 300 22 Income reported (1,800) 23 Adjustment $(1,500) Assuming that Hudson Company has not closed the books, correcting entries on December 31, 2015, are: Retained Earnings 1,400 Salaries and Wages Expense 1,400 (To correct improper charge to Salaries and Wages Expense for 2015) Salaries and Wages Expense 1,600 Salaries and Wages Payable 1,600 (To record proper wages expense for 2015) 1372 Chapter 22 Accounting Changes and Error Analysis Insurance Expense 1,200 Retained Earnings 1,200 (To record proper insurance expense for 2015) Interest Revenue 240 Retained Earnings 240 (To correct improper credit to Interest Revenue in 2015) Retained Earnings 1,500 Accumulated Depreciation—Equipment 2,400 Equipment 3,900 (To record write-off of equipment in 2014 and adjustment of Retained Earnings) Accumulated Depreciation—Equipment 780 Depreciation Expense 390 Retained Earnings 390 (To correct improper charge for depreciation expense in 2014 and 2015) If Hudson Company has closed the books for 2015, the correcting entries are: Retained Earnings 1,600 Salaries and Wages Payable 1,600 (To record proper wage expense for 2015) Retained Earnings 1,500 Accumulated Depreciation—Equipment 2,400 Equipment 3,900 (To record write-off of equipment in 2014 and adjustment of Retained Earnings) Accumulated Depreciation—Equipment 780 Retained Earnings 780 (To correct improper charge for depreciation expense in 2014 and 2015) What do the numbers mean? GUARD THE FINANCIAL STATEMENTS! Restatements sometimes occur because of fi nancial fraud. assets. Financial frauds made up around 8 percent of the frauds Financial frauds involve the intentional misstatement or in a recent study on occupational fraud but caused a median omission of material information in the organization’s loss of more than $1 million in 2012 ($4 million in 2010)—by financial reports. Common methods of financial fraud far the most costly category of fraud. The following chart manipulation include recording fi ctitious revenues, conceal- compares loss amounts for 2012 versus 2010 for fi nancial ing liabilities or expenses, and artifi cially infl ating reported statement fraud, corruption, and asset misappropriation. Occupational Frauds by Category—Median Loss Financial Statement Fraud Corruption Asset Misappropriation duarf fo epyT 2010 $4,100,000 2012 $1,000,000 $250,000 $250,000 $135,000 $120,000 $0 $1,000,000 $2,000,000 $3,000,000 $4,000,000 $5,000,000 Median loss Error Analysis 1373 While the trend in the dollar amount of losses is going in of fraud has increased with regulation that provides whistle- the right direction, another study indicates that the number of blower protections (i.e., the incidence of fraud is not increas- fraud reports at 1,400 companies in the “Quarterly Corporate ing as much as the reporting of fraud), companies must Fraud Index” is on the climb—with 2,348 reported frauds in increase their efforts to protect their statements from the the 2nd quarter of 2005 to over 7,800 in the 2nd quarter of negative effects of fraud. 2012. While there is some debate about whether the reporting

Sources: Report to the Nations on Occupational Fraud and Abuse, 2012 Global Fraud Study, Association of Certifi ed Fraud Examiners (2012), p. 11; and C. McDonald, “Fraud Reports Climb Still Higher,” CFO.com (September 26, 2012). Preparation of Financial Statements with Error Corrections Up to now, our discussion of error analysis has focused on identifying the type of error involved and accounting for its correction in the records. We have noted that companies must present the correction of the error on comparative financial statements. The following example illustrates how a company would restate a typical year’s financial statements, given many different errors. Dick & Wally’s Outlet is a small retail outlet in the town of Holiday. Lacking exper- tise in accounting, the company does not keep adequate records, and numerous errors occurred in recording accounting information. 1. The bookkeeper inadvertently failed to record a cash receipt of $1,000 on the sale of merchandise in 2015. 2. Accrued wages expense at the end of 2014 was $2,500; at the end of 2015, $3,200. The company does not accrue for wages; all wages are charged to Administrative Expenses. 3. The company had not set up an allowance for estimated uncollectible receivables. Dick and Wally decided to set up such an allowance for the estimated probable losses, as of December 31, 2015, for 2014 accounts of $700, and for 2015 accounts of $1,500. They also decided to correct the charge against each year so that it shows the losses (actual and estimated) relating to that year’s sales. The company has written off accounts to bad debt expense (selling expense) as follows. In 2014 In 2015 2014 accounts $400 $2,000 2015 accounts 1,600 4. Prepaid insurance not recorded at the end of 2014 was $600, and at the end of 2015, $400. All insurance is charged to Administrative Expenses. 5. An account payable of $6,000 should have been a note payable. 6. During 2014, the company sold for $7,000 an asset that cost $10,000 and had a book value of $4,000. At the time of sale, Cash was debited and Miscellaneous Income was credited for $7,000. 7. As a result of the last transaction, the company overstated depreciation expense (an administrative expense) in 2014 by $800 and in 2015 by $1,200. Illustration 22-25 (page 1374) presents a worksheet that begins with the unadjusted trial balance of Dick & Wally’s Outlet. You can determine the correcting entries and their effect on the financial statements by examining the worksheet. 1374 Chapter 22 Accounting Changes and Error Analysis DDIICCKK && WWAALLLLYY’’SS OOUUTTLLEETT..xxllss Home Insert Page Layout Formulas Data Review View P18 fx A B C D E F G H I J 1 DICK & WALLY’S OUTLET 2 3 Worksheet Analysis to Adjust Financial Statements for the Year 2015 4 5 Trial Balance Income Statement Balance Sheet 6 Unadjusted Adjustments Adjusted Adjusted 7 Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. 8 Cash 3,100 (1) 1,000 4,100 9 Accounts Receivable 17,600 17,600 10 Notes Receivable 8,500 8,500 11 Inventory 34,000 34,000 12 Property, Plant, and Equipment 112,000 (6) 10,000a 102,000 13 Accumulated Deprecia!on— 83,500 (6) 6,000a 75,500 Equipment (7) 2,000 14 15 Investments 24,300 24,300 16 Accounts Payable 14,500 (5) 6,000 8,500 17 Notes Payable 10,000 (5) 6,000 16,000 18 Capital Stock 43,500 43,500 19 Retained Earnings 20,000 (3) 2,700b 20 (6) 4,000a (4) 600 21 (2) 2,500 (7) 800 12,200 22 Sales Revenue 94,000 (1) 1,000 95,000 23 Cost of Goods Sold 21,000 21,000 24 Selling Expenses 22,000 (3) 500b 21,500 25 Administra!ve Expenses 23,000 (2) 700 (4) 400 22,700 26 (4) 600 (7) 1,200 27 Totals 265,500265,500 28 29 Salaries and Wages Payable (2) 3,200 3,200 30 Allowance for Doub"ul (3) 2,200b 2,200 31 Accounts 32 Prepaid Insurance (4) 400 400 33 Net Income 29,800 29,800 34 Totals 25,900 25,900 95,000 95,000 190,900 190,900 35 Computa!ons: aMachinery bBad Debts 2014 2015 Proceeds from sale $ 7,000 Bad debts charged for $2,400 $1,600 Book value of machinery (4,000 ) Addi!onal bad debts an!cipated 700 1,500 Gain on sale 3,000 3,100 3,100 Less: Income credited 7,000 Charges currently made to each year (400) (3,600)

Retained earnings adjustment $(4,000) Bad debt adjustment $2,700 $ (500) ILLUSTRATION 22-25 Worksheet to Analyze You will Effect of Errors in want to Financial Statements read IFRS INSIGHTS on pages 1404–1408 for discussion of IFRS related to accounting changes and errors. Summary of Learning Objectives 1375 KEY TERMS SUMMARY OF LEARNING OBJECTIVES change in accounting estimate, 1344, 1357 change in accounting 1 Identify the types of accounting changes. The three different types of estimate effected by a accounting changes are as follows. (1) Change in accounting principle: a change from one change in accounting generally accepted accounting principle to another generally accepted accounting prin- principle, 1358 ciple. (2) Change in accounting estimate: a change that occurs as the result of new informa- change in accounting tion or as additional experience is acquired. (3) Change in reporting entity: a change from principle, 1344 reporting as one type of entity to another type of entity. change in reporting entity, 1344 2 Describe the accounting for changes in accounting principles. A correction of an change in accounting principle involves a change from one generally accepted account- error, 1360 ing principle to another. A change in accounting principle is not considered to result counterbalancing from the adoption of a new principle in recognition of events that have occurred for the errors, 1367 first time or that were previously immaterial. If the accounting principle previously fol- cumulative effect, 1345 lowed was not acceptable or if the principle was applied incorrectly, a change to a gener- direct effects of change ally accepted accounting principle is considered a correction of an error. in accounting 3 Understand how to account for retrospective accounting changes. principle, 1355 economic The general requirement for changes in accounting principle is retrospective applica- consequences, 1366 tion. Under retrospective application, companies change prior years’ financial state- errors in financial ments on a basis consistent with the newly adopted principle. They treat any part of statements, 1344 the effect attributable to years prior to those presented as an adjustment of the earliest impracticable, 1356 retained earnings presented. indirect effects of change 4 Understand how to account for impracticable changes. Retrospective in accounting application is impracticable if the prior period effect cannot be determined using every principle, 1355 reasonable effort to do so. For example, in changing to LIFO, the base-year inventory for noncounterbalancing all subsequent LIFO calculations is generally the opening inventory in the year the com- errors, 1367 pany adopts the method. There is no restatement of prior years’ income because it is prior period often too impractical to do so. adjustments, 1360 prospectively, 1345 5 Describe the accounting for changes in estimates. Companies report restatement, 1361(n) changes in estimates prospectively. That is, companies should make no changes in pre- retrospective viously reported results. They do not adjust opening balances nor change financial application, 1345 statements of prior periods. 6 Identify changes in a reporting entity. An accounting change that results in financial statements that are actually the statements of a different entity should be re- ported by restating the financial statements of all prior periods presented, to show the financial information for the new reporting entity for all periods. 7 Describe the accounting for correction of errors. Companies must cor- rect errors as soon as they discover them, by proper entries in the accounts, and report them in the financial statements. The profession requires that a company treat correc- tions of errors as prior period adjustments, record them in the year in which it discov- ered the errors, and report them in the financial statements in the proper periods. If presenting comparative statements, a company should restate the prior statements affected to correct for the errors. The company need not repeat the disclosures in the

financial statements of subsequent periods. 8 Identify economic motives for changing accounting methods. Manag- ers might have varying motives for income reporting, depending on economic times and whom they seek to impress. Some of the reasons for changing accounting methods are (1) political costs, (2) capital structure, (3) bonus payments, and (4) smoothing of earnings. 1376 Chapter 22 Accounting Changes and Error Analysis 9 Analyze the effect of errors. Three types of errors can occur. (1) Balance sheet errors, which affect only the presentation of an asset, liability, or stockholders’ equity account. (2) Income statement errors, which affect only the presentation of revenue, expense, gain, or loss accounts in the income statement. (3) Balance sheet and income statement errors, which involve both the balance sheet and income statement. Errors are classified into two types. (1) Counterbalancing errors are offset or corrected over two periods. (2) Noncounterbalancing errors are not offset in the next accounting period and take longer than two periods to correct themselves. As an aid to understanding accounting changes, we provide the following glossary. KEY TERMS RELATED TO ACCOUNTING CHANGES ACCOUNTING CHANGE. A change in (1) an accounting principle, (2) an accounting es- timate, or (3) the reporting entity. The correction of an error in previously issued fi nancial statements is not an accounting change. CHANGE IN ACCOUNTING PRINCIPLE. A change from one generally accepted ac- counting principle to another generally accepted accounting principle when two or more generally accepted accounting principles apply or when the accounting principle formerly used is no longer generally accepted. CHANGE IN ACCOUNTING ESTIMATE. A change that has the effect of adjusting the carrying amount of an existing asset or liability or altering the subsequent accounting for existing or future assets or liabilities. Changes in accounting estimates result from new information. CHANGE IN ACCOUNTING ESTIMATE EFFECTED BY A CHANGE IN ACCOUNT- ING PRINCIPLE. A change in accounting estimate that is inseparable from the effect of a related change in accounting principle. CHANGE IN THE REPORTING ENTITY. A change that results in fi nancial statements that, in effect, are those of a different reporting entity (see page 1359). DIRECT EFFECTS OF A CHANGE IN ACCOUNTING PRINCIPLE. Those recognized changes in assets or liabilities necessary to effect a change in accounting principle. ERROR IN PREVIOUSLY ISSUED FINANCIAL STATEMENTS. An error in recognition, measurement, presentation, or disclosure in fi nancial statements resulting from mathemat- ical mistakes, mistakes in the application of GAAP, or oversight or misuse of facts that existed at the time the fi nancial statements were prepared. A change from an accounting principle that is not generally accepted to one that is generally accepted is a correction of an error. INDIRECT EFFECTS OF A CHANGE IN ACCOUNTING PRINCIPLE. Any changes to current or future cash fl ows of an entity that result from making a change in accounting principle that is applied retrospectively. RESTATEMENT. The process of revising previously issued fi nancial statements to refl ect the correction of an error in those fi nancial statements. RETROSPECTIVE APPLICATION. The application of a different accounting principle to one or more previously issued fi nancial statements, or to the statement of fi nancial position at the beginning of the current period, as if that principle had always been used, or a change to fi nancial statements of prior accounting periods to present the fi nancial statements of a new reporting entity as if it had existed in those prior years. [11] Appendix 22A: Changing from or to the Equity Method 1377 APPENDIX 22A CHANGING FROM OR TO THE EQUITY METHOD As noted in the chapter, companies generally should report an accounting change 10 LEARNING OBJECTIVE that results in financial statements for a different entity by changing the financial Make the computations and prepare statements of all prior periods presented.

the entries necessary to record a An example of a change in reporting entity is when a company’s level of own- change from or to the equity method ership or influence changes, such as when it changes from or to the equity method. of accounting. When changing to the equity method, companies use retrospective application. Companies treat a change from the equity method prospectively. We present examples of these changes in entity in the following two sections. CHANGE FROM THE EQUITY METHOD If the investor level of influence or ownership falls below that necessary for continued use of the equity method, a company must change from the equity method to the fair value method. The earnings or losses that the investor previously recognized under the equity method should remain as part of the carrying amount of the investment, with no retrospective application to the new method. When a company changes from the equity method to the fair value method, the cost basis for accounting purposes is the carrying amount of the investment at the date of the change. The investor applies the new method in its entirety once the equity method is no longer appropriate. At the next reporting date, the investor should record the unrealized holding gain or loss to recognize the difference between the carrying amount and fair value.14 Dividends in Excess of Earnings In subsequent periods, dividends received by the investor company may exceed its share of the investee’s earnings for such periods (all periods following the change in method). To the extent that they do so, the investor company should account for such dividends as a reduction of the investment carrying amount, rather than as revenue. The reason: Dividends in excess of earnings are viewed as a liquidat- ing dividend, with this excess then accounted for as a reduction of the equity investment. To illustrate, assume that on January 1, 2013, Investor Company purchased 250,000 shares of Investee Company’s 1,000,000 shares of outstanding stock for $8,500,000. Investor correctly accounted for this investment using the equity method. After accounting for dividends received and investee net income, in 2013 Investor reported its investment in Investee Company at $8,780,000 at December 31, 2013. On January 2, 2014, Investee Company sold 1,500,000 additional shares of its own common stock to the public, thereby reducing Investor Company’s ownership from 25 percent to 10 per- cent. Illustration 22A-1 (page 1378) shows the net income (or loss) and dividends of Investee Company for the years 2014 through 2016. 14A retrospective application for this type of change is impracticable in many cases. Determining fair values on a portfolio basis for securities in previous periods may be quite difficult. As a result, prospective application is used. 1378 Chapter 22 Accounting Changes and Error Analysis ILLUSTRATION 22A-1 Investor’s Share of Investee Dividends Income Earned and Year Investee Income (Loss) Received by Investor Dividends Received 2014 $600,000 $ 400,000 2015 350,000 400,000 2016 –0– 210,000 Totals $950,000 $1,010,000 Assuming a change from the equity method to the fair value method as of January 2, 2014, Investor Company’s reported investment in Investee Company and its reported income would be as shown in Illustration 22A-2. ILLUSTRATION 22A-2 Cumulative Excess of Impact on Investment Dividend Revenue Share of Earnings over Investment at Carrying Amount Year Recognized Dividends Received December 31 2014 $400,000 $200,000a $8,780,000 2015 400,000 150,000b 8,780,000 2016 150,000 (60,000)c $8,780,000 2 $60,000 5 $8,720,000 a$600,000 2 $400,000 5 $200,000 b($350,000 2 $400,000) 1 $200,000 5 $150,000 c$150,000 2 $210,000 5 $(60,000) Investor Company would record the dividends and earnings data for the three years subsequent to the change in methods as shown by the following entries. 2014 and 2015 Cash 400,000 Dividend Revenue 400,000 (To record dividend received from Investee Company) 2016 Cash 210,000 Equity Investments (available-for-sale) 60,000 Dividend Revenue 150,000 (To record dividend revenue from Investee Company

in 2016 and to recognize cumulative excess of dividends received over share of Investee earnings in periods subsequent to change from equity method) CHANGE TO THE EQUITY METHOD When converting to the equity method, companies use retrospective application. Such a change involves adjusting the carrying amount of the investment, results of current and prior operations, and retained earnings of the investor as if the equity method has been in effect during all of the previous periods in which this investment was held. [12] When changing from the fair value method to the equity method, companies also must eliminate any balances in the Unrealized Holding Gain or Loss—Equity account and the Fair Value Adjustment account. In addition, they eliminate the available-for-sale classi- fication for this investment, and they record the investment under the equity method. For example, on January 2, 2014, Amsted Corp. purchased, for $500,000 cash, 10 per- cent of the outstanding shares of Cable Company common stock. On that date, the net identifiable assets of Cable Company had a fair value of $3,000,000. The excess of cost over the underlying equity in the net identifiable assets of Cable Company is goodwill. Appendix 22A: Changing from or to the Equity Method 1379 On January 2, 2016, Amsted Corp. purchased an additional 20 percent of Cable Com- pany’s stock for $1,200,000 cash when the fair value of Cable’s net identifiable assets was $4,000,000. The excess of cost over fair value related to this additional investment is goodwill. Now having a 30 percent interest, Amsted Corp. must use the equity method. From January 2, 2014, to January 2, 2016, Amsted Corp. used the fair value method and categorized these securities as available-for-sale. At January 2, 2016, Amsted has a credit balance of $92,000 in its Unrealized Holding Gain or Loss—Equity account and a debit balance in its Fair Value Adjustment account of the same amount. This change in fair value occurred in 2014. (Income tax effects are ignored.) Illustration 22A-3 shows the net income reported by Cable Company and the Cable Company dividends received by Amsted during the period 2014 through 2016. ILLUSTRATION 22A-3 Cable Company Cable Co. Dividends Income Earned and Year Net Income Paid to Amsted Dividends Received 2014 $ 500,000 $ 20,000 2015 1,000,000 30,000 2016 1,200,000 120,000 Amsted makes the following journal entries from January 2, 2014, through Decem- ber 31, 2016, relative to Amsted Corp.’s investment in Cable Company, reflecting the data above and a change from the fair value method to the equity method.15 January 2, 2014 Equity Investments (available-for-sale) 500,000 Cash 500,000 (To record the purchase of a 10% interest in Cable Company) December 31, 2014 Cash 20,000 Dividend Revenue 20,000 (To record the receipt of cash dividends from Cable Company) Fair Value Adjustment (available-for-sale) 92,000 Unrealized Holding Gain or Loss—Equity 92,000 (To record increase in fair value of securities) December 31, 2015 Cash 30,000 Dividend Revenue 30,000 (To record the receipt of cash dividends from Cable Company) January 2, 2016 Equity Investments (Cable Company) 1,300,000 Cash 1,200,000 Retained Earnings 100,000 (To record the purchase of an additional interest in Cable Company and to reflect retrospectively a change from the fair value method to the equity method of accounting for the investment. The $100,000 adjustment is computed as follows:) 20 14 2 015 Total Amsted Corp. equity in earnings of Cable Company (10%) $50,000 $100,000 $150,000 Dividend received (20,000) (30,000) (50,000) Retrospective application $30,000 $ 70,000 $100,000 15Adapted from Paul A. Pacter, “Applying APB Opinion No. 18—Equity Method,” Journal of Accountancy (September 1971), pp. 59–60. 1380 Chapter 22 Accounting Changes and Error Analysis January 2, 2016 Equity Investments (Cable Company) 500,000 Equity Investments (available-for-sale) 500,000 (To reclassify initial 10% interest to equity method) January 2, 2016 Unrealized Holding Gain or Loss—Equity 92,000 Fair Value Adjustment (available-for-sale) 92,000

(To eliminate fair value accounts for change to equity method) December 31, 2016 Equity Investments (Cable Company) 360,000 Investment Revenue 360,000 [To record equity in earnings of Cable Company (30% of $1,200,000)] Cash 120,000 Equity Investments (Cable Company) 120,000 (To record the receipt of cash dividends from Cable Company) Companies change to the equity method by placing the accounts related to and affected by the investment on the same basis as if the equity method had always been the basis of accounting for that investment. Thus, they report the effects of this ac- counting change using the retrospective approach.16 SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 22A 10 Make the computations and prepare the entries necessary to record a change from or to the equity method of accounting. When changing from the equity method to the fair value method, the cost basis for accounting purposes is the carrying amount used for the investment at the date of change. The investor company applies the new method in its entirety once the equity method is no longer appropriate. When changing to the equity method, the company adjusts the accounts to be on the same basis as if the equity method had always been used for that investment. DEMONSTRATION PROBLEM Wangerin Company is in the process of adjusting and correcting its books at the end of 2014. In reviewing its records, the following information is compiled. 1. At December 31, 2014, Wangerin decided to change the depreciation method on its office equipment from double-declining-balance to straight-line. The equipment had an original cost of $200,000 when purchased on January 1, 2012. It has a 10-year useful life and no salvage value. Depreciation expense recorded prior to 2014 under the double-declining-balance method was $72,000. Wangerin has already recorded 2014 depreciation expense of $25,600 using the double-declining-balance method. 16The change to the equity method illustration assumes that the fair value and the book value of the net identifiable assets of the investee are the same. However, the fair value of the net identifiable assets of the investee may be greater than their book value. In this case, this excess (if depreciable or amortizable) reduces the net income reported by the investor from the investee. For example, assume that the fair value of an investee’s building is $1,000,000 and its book value is $800,000 at the time of change to the equity method. In that case, this difference of $200,000 is depreciated over the useful life of the building, thereby reducing the amount of investee’s net income reported on the investor’s books. FASB Codifi cation 1381 2. Before 2014, Wangerin accounted for its income from long-term construction contracts on the completed-contract basis. Early in 2014, Wangerin changed to the percentage-of-completion basis for accounting purposes. It continues to use the completed-contract method for tax purposes. Income for 2014 has been recorded using the percentage-of-completion method. The following information is available. Pretax Income Percentage-of-Completion Completed-Contract Prior to 2014 $450,000 $315,000 2014 180,000 60,000 3. Insurance for a 12-month period purchased on November 1 of this year was charged to insurance expense in the amount of $3,300 because “the amount of the check is about the same every year.” 4. Reported sales revenue for the year is $1,908,000. This includes all sales taxes collected for the year. The sales tax rate is 6%. Because the sales tax is forwarded to the state’s Department of Revenue, the Sales Tax Expense account is debited. The bookkeeper thought that “the sales tax is a selling expense.” At the end of the current year, the balance in the Sales Tax Expense account is $103,400. Instructions Prepare the journal entries necessary at December 31, 2014, to record the above corrections and changes. The books are still open for 2014. The income tax rate is 40%. Wangerin has not yet recorded its 2014 income tax expense and payable amounts so current-year tax effects may be ignored. Prior-year tax effects must be

considered in item 2. Solution 1. Accumulated Depreciation—Equipment 9,600 Depreciation Expense 9,600* *Equipment cost $200,000 Depreciation before 2012 (72,000) Book value $128,000 Depreciation recorded $ 25,600 Depreciation to be taken ($128,000/8) (16,000) Difference $ 9,600 2. Construction in Process 135,000 Deferred Tax Liability 54,000* Retained Earnings 81,000 *($450,000 2 $315,000) 3 40% 3. Prepaid Insurance ($3,300 3 10/12) 2,750 Insurance Expense 2,750 4. Sales Revenue [$1,908,000 4 (1.00 1 .06) 3 6%] 108,000 Sales Taxes Payable 108,000 Sales Taxes Payable 103,400 Sales Tax Expense 103,400 FASB CODIFICATION FASB Codification References [1] FASB ASC 250-10-05-1. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005).] [2] FASB ASC 250-10-05-2. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005).] [3] FASB ASC 250-10-50-1. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), par. 17.] [4] FASB ASC 250-10-50-1. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), par. B19.] 1382 Chapter 22 Accounting Changes and Error Analysis [5] FASB ASC 250-10-45-6. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), paras. 8–11.] [6] FASB ASC 250-10-50-1. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), par. 17.] [7] FASB ASC 250-10-45-18. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), par. 20.] [8] FASB ASC 250-10-45-24. [Predecessor literature: “Prior Period Adjustments,” Statement of Financial Accounting Standards No. 16 (Stamford, Conn.: FASB, 1977), p. 5.] [9] FASB ASC 250-10-50-4. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Account- ing Standards No. 154 (Stamford, Conn.: FASB, 2005), par. 2.] [10] FASB ASC 250-10-50-7. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Account- ing Standards No. 154 (Stamford, Conn.: FASB, 2005), par. 26.] [11] FASB ASC 250-10-50-1. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Account- ing Standards No. 154 (Stamford, Conn.: FASB, 2005), par. 2.] [12] FASB ASC 323-10-35-33. [Predecessor literature: “The Equity Method of Accounting for Investments in Common Stock,” Opinions of the Accounting Principles Board No. 18 (New York: AICPA, 1971), par. 17.] Exercises If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE22-1 Access the glossary (“Master Glossary”) to answer the following. (a) What is a change in accounting estimate? (b) What is a change in accounting principle? (c) What is a restatement? (d) What is the definition of “retrospective application”? CE22-2 When a company has to restate its financial statements to correct an error, what information must the company disclose? CE22-3 What reporting requirements does retrospective application require? CE22-4 If a company registered with the SEC justifies a change in accounting method as preferable under the circumstances, and the circumstances change, can that company switch back to its prior method of accounting before the change? Why or why not? An additional Codification case can be found in the Using Your Judgment section, on page 1404. Be sure to check the book’s companion website for a Review and Analysis Exercise, with solution. Brief Exercises, Exercises, Problems, and many more learning and assessment tools

and resources are available for practice in WileyPLUS. Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter. QUESTIONS 1. In recent years, the Wall Street Journal has indicated that (a) Change from FIFO to LIFO method for inventory many companies have changed their accounting princi- valuation purposes. ples. What are the major reasons why companies change (b) Charge for failure to record depreciation in a previous accounting methods? period. 2. State how each of the following items is reflected in the (c) Litigation won in current year, related to prior period. financial statements. Questions 1383 (d) Change in the realizability of certain receivables. consolidation. During the current year, the foreign subsid- (e) Write-off of receivables. iary was included in the financial statements. How should this change in accounting entity be reflected in the finan- (f) Change from the percentage-of-completion to the cial statements? completed-contract method for reporting net income. 14. Distinguish between counterbalancing and noncounter- 3. Discuss briefly the three approaches that have been sug- balancing errors. Give an example of each. gested for reporting changes in accounting principles. 4. Identify and describe the approach the FASB requires for 15. Discuss and illustrate how a correction of an error in pre- viously issued financial statements should be handled. reporting changes in accounting principles. 5. What is the indirect effect of a change in accounting prin- 16. Prior to 2014, Heberling Inc. excluded manufacturing overhead costs from work in process and finished goods ciple? Briefly describe the reporting of the indirect effects inventory. These costs have been expensed as incurred. In of a change in accounting principle. 2014, the company decided to change its accounting 6. Define a change in estimate and provide an illustration. methods for manufacturing inventories to full costing by When is a change in accounting estimate effected by a including these costs as product costs. Assuming that change in accounting principle? these costs are material, how should this change be 7. Lenexa State Bank has followed the practice of capitalizing reflected in the financial statements for 2013 and 2014? certain marketing costs and amortizing these costs over 17. Elliott Corp. failed to record accrued salaries for 2013, their expected life. In the current year, the bank determined $2,000; 2014, $2,100; and 2015, $3,900. What is the amount that the future benefits from these costs were doubtful. of the overstatement or understatement of Retained Earn- Consequently, the bank adopted the policy of expensing ings at December 31, 2016? these costs as incurred. How should the bank report this accounting change in the comparative financial statements? 18. In January 2014, installation costs of $6,000 on new machinery were charged to Maintenance and Repairs 8. Indicate how the following items are recorded in the Expense. Other costs of this machinery of $30,000 were accounting records in the current year of Coronet Co. correctly recorded and have been depreciated using the (a) Impairment of goodwill. straight-line method with an estimated life of 10 years (b) A change in depreciating plant assets from accelerated and no salvage value. At December 31, 2015, it is decided to the straight-line method. that the machinery has a remaining useful life of 20 years, (c) Large write-off of inventories because of obsolescence. starting with January 1, 2015. What entry(ies) should be (d) Change from the cash basis to accrual basis of ac- made in 2015 to correctly record transactions related to machinery, assuming the machinery has no salvage value? counting. The books have not been closed for 2015 and depreciation (e) Change from LIFO to FIFO method for inventory expense has not yet been recorded for 2015. valuation purposes. 19. On January 2, 2014, $100,000 of 11%, 10-year bonds were (f) Change in the estimate of service lives for plant assets. issued for $97,000. The $3,000 discount was charged to

9. Whittier Construction Co. had followed the practice of Interest Expense. The bookkeeper, Mark Landis, records expensing all materials assigned to a construction job interest only on the interest payment dates of January 1 without recognizing any salvage inventory. On December and July 1. What is the effect on reported net income for 31, 2014, it was determined that salvage inventory should 2014 of this error, assuming straight-line amortization of be valued at $52,000. Of this amount, $29,000 arose during the discount? What entry is necessary to correct for this the current year. How does this information affect the error, assuming that the books are not closed for 2014? financial statements to be prepared at the end of 2014? 20. An entry to record Purchases and related Accounts Payable 10. Parsons Inc. has proposed a change from the completed- of $13,000 for merchandise purchased on December 23, contract to the percentage-of-completion method for finan- 2015, was recorded in January 2016. This merchandise cial reporting purposes. The auditor indicates that a change was not included in inventory at December 31, 2015. What would be permitted only if it is to a preferable method. effect does this error have on reported net income for What difficulties develop in assessing preferability? 2015? What entry should be made to correct for this error, 11. Discuss how a change to the LIFO method of inventory assuming that the books are not closed for 2015? valuation is handled when it is impracticable to deter- 21. Equipment was purchased on January 2, 2014, for $24,000, mine previous LIFO inventory amounts. but no portion of the cost has been charged to deprecia- 12. How should consolidated financial statements be re- tion. The corporation wishes to use the straight-line ported this year when statements of individual compa- method for these assets, which have been estimated to nies were presented last year? have a life of 10 years and no salvage value. What effect 13. Simms Corp. controlled four domestic subsidiaries does this error have on net income in 2014? What entry is and one foreign subsidiary. Prior to the current year, necessary to correct for this error, assuming that the books Simms Corp. had excluded the foreign subsidiary from are not closed for 2014? 1384 Chapter 22 Accounting Changes and Error Analysis BRIEF EXERCISES 3 BE22-1 Wertz Construction Company decided at the beginning of 2014 to change from the completed- contract method to the percentage-of-completion method for financial reporting purposes. The company will continue to use the completed-contract method for tax purposes. For years prior to 2014, pretax income under the two methods was as follows: percentage-of-completion $120,000, and completed-contract $80,000. The tax rate is 35%. Prepare Wertz’s 2014 journal entry to record the change in accounting principle. 3 BE22-2 Refer to the accounting change by Wertz Construction Company in BE22-1. Wertz has a profit- sharing plan, which pays all employees a bonus at year-end based on 1% of pretax income. Compute the indirect effect of Wertz’s change in accounting principle that will be reported in the 2014 income state- ment, assuming that the profit-sharing contract explicitly requires adjustment for changes in income numbers. 3 BE22-3 Shannon, Inc., changed from the LIFO cost flow assumption to the FIFO cost flow assumption in 2014. The increase in the prior year’s income before taxes is $1,200,000. The tax rate is 40%. Prepare Shannon’s 2014 journal entry to record the change in accounting principle. 5 BE22-4 Tedesco Company changed depreciation methods in 2014 from double-declining-balance to straight-line. Depreciation prior to 2014 under double-declining-balance was $90,000, whereas straight-line depreciation prior to 2014 would have been $50,000. Tedesco’s depreciable assets had a cost of $250,000 with a $40,000 salvage value, and an 8-year remaining useful life at the beginning of 2014. Prepare the 2014 journal entries, if any, related to Tedesco’s depreciable assets.

5 BE22-5 Sesame Company purchased a computer system for $74,000 on January 1, 2013. It was depreciated based on a 7-year life and an $18,000 salvage value. On January 1, 2015, Sesame revised these estimates to a total useful life of 4 years and a salvage value of $10,000. Prepare Sesame’s entry to record 2015 deprecia- tion expense. 7 BE22-6 In 2014, Bailey Corporation discovered that equipment purchased on January 1, 2012, for $50,000 was expensed at that time. The equipment should have been depreciated over 5 years, with no salvage value. The effective tax rate is 30%. Prepare Bailey’s 2014 journal entry to correct the error. 7 BE22-7 At January 1, 2014, Beidler Company reported retained earnings of $2,000,000. In 2014, Beidler discovered that 2013 depreciation expense was understated by $400,000. In 2014, net income was $900,000 and dividends declared were $250,000. The tax rate is 40%. Prepare a 2014 retained earnings statement for Beidler Company. 7 BE22-8 Indicate the effect—Understate, Overstate, No Effect—that each of the following errors has on 2014 net income and 2015 net income. 2014 2015 (a) Equipment purchased in 2012 was expensed. (b) Wages payable were not recorded at 12/31/14. (c) Equipment purchased in 2014 was expensed. (d) 2014 ending inventory was overstated. (e) Patent amortization was not recorded in 2015. 3 5 BE22-9 Roundtree Manufacturing Co. is preparing its year-end financial statements and is considering the accounting for the following items. 1. The vice president of sales had indicated that one product line has lost its customer appeal and will be phased out over the next 3 years. Therefore, a decision has been made to lower the estimated lives on related production equipment from the remaining 5 years to 3 years. 2. The Hightone Building was converted from a sales office to offices for the Accounting Department at the beginning of this year. Therefore, the expense related to this building will now appear as an administrative expense rather than a selling expense on the current year’s income statement. 3. Estimating the lives of new products in the Leisure Products Division has become very difficult because of the highly competitive conditions in this market. Therefore, the practice of deferring and amortizing preproduction costs has been abandoned in favor of expensing such costs as they are incurred. Identify and explain whether each of the above items is a change in principle, a change in estimate, or an error. Exercises 1385 3 7 BE22-10 Palmer Co. is evaluating the appropriate accounting for the following items. 1. Management has decided to switch from the FIFO inventory valuation method to the LIFO inven- tory valuation method for all inventories. 2. When the year-end physical inventory adjustment was made for the current year, the controller discovered that the prior year’s physical inventory sheets for an entire warehouse were mislaid and excluded from last year’s count. 3. Palmer’s Custom Division manufactures large-scale, custom-designed machinery on a contract basis. Management decided to switch from the completed-contract method to the percentage-of- completion method of accounting for long-term contracts. Identify and explain whether each of the above items is a change in accounting principle, a change in estimate, or an error. 10 *B E22-11 Simmons Corporation owns stock of Armstrong, Inc. Prior to 2014, the investment was accounted for using the equity method. In early 2014, Simmons sold part of its investment in Armstrong, and began using the fair value method. In 2014, Armstrong earned net income of $80,000 and paid dividends of $95,000. Prepare Simmons’s entries related to Armstrong’s net income and dividends, assuming Simmons now owns 10% of Armstrong’s stock. 10 *B E22-12 Oliver Corporation has owned stock of Conrad Corporation since 2011. At December 31, 2014, its balances related to this investment were: Equity Investments $185,000 Fair Value Adjustment (AFS) 34,000 Dr. Unrealized Holding Gain or Loss—Equity 34,000 Cr. On January 1, 2015, Oliver purchased additional stock of Conrad Company for $475,000 and now has

significant influence over Conrad. If the equity method had been used in 2011–2014, Oliver’s share of income would have been $33,000 greater than dividends received. Prepare Oliver’s journal entries to record the purchase of the investment and the change to the equity method. EXERCISES 3 E22-1 (Change in Principle—Long-Term Contracts) Pam Erickson Construction Company changed from the completed-contract to the percentage-of-completion method of accounting for long-term construction contracts during 2015. For tax purposes, the company employs the completed-contract method and will continue this approach in the future. (Hint: Adjust all tax consequences through the Deferred Tax Liability account.) The appropriate information related to this change is as follows. Pretax Income from: Percentage-of-Completion Completed-Contract Difference 2014 $780,000 $590,000 $190,000 2015 700,000 480,000 220,000 Instructions (a) Assuming that the tax rate is 35%, what is the amount of net income that would be reported in 2015? (b) What entry(ies) are necessary to adjust the accounting records for the change in accounting principle? 3 E22-2 (Change in Principle—Inventory Methods) Holder-Webb Company began operations on January 1, 2012, and uses the average-cost method of pricing inventory. Management is contemplating a change in inventory methods for 2015. The following information is available for the years 2012–2014. Net Income Computed Using Average-Cost Method FIFO Method LIFO Method 2012 $15,000 $19,000 $12,000 2013 18,000 23,000 14,000 2014 20,000 25,000 17,000 1386 Chapter 22 Accounting Changes and Error Analysis Instructions (Ignore all tax effects.) (a) Prepare the journal entry necessary to record a change from the average-cost method to the FIFO method in 2015. (b) Determine net income to be reported for 2012, 2013, and 2014, after giving effect to the change in accounting principle. (c) Assume Holder-Webb Company used the LIFO method instead of the average-cost method during the years 2012–2014. In 2015, Holder-Webb changed to the FIFO method. Prepare the journal entry necessary to record the change in principle. 3 E22-3 (Accounting Change) Taveras Co. decides at the beginning of 2014 to adopt the FIFO method of inventory valuation. Taveras had used the LIFO method for financial reporting since its inception on January 1, 2012, and had maintained records adequate to apply the FIFO method retrospectively. Taveras concluded that FIFO is the preferable inventory method because it reflects the current cost of inventory on the balance sheet. The following table presents the effects of the change in accounting principles on inven- tory and cost of goods sold. Inventory Determined by Cost of Goods Sold Determined by Date LIFO Method FIFO Method LIFO Method FIFO Method January 1, 2012 $ 0 $ 0 $ 0 $ 0 December 31, 2012 100 80 800 820 December 31, 2013 200 240 1,000 940 December 31, 2014 320 390 1,130 1,100 Other information: 1. For each year presented, sales are $3,000 and operating expenses are $1,000. 2. Taveras provides two years of financial statements. Earnings per share information is not required. Instructions (a) Prepare income statements under LIFO and FIFO for 2012, 2013, and 2014. (b) Prepare income statements reflecting the retrospective application of the accounting change from the LIFO method to the FIFO method for 2014 and 2013. (c) Prepare the note to the financial statements describing the change in method of inventory valuation. In the note, indicate the income statement line items for 2014 and 2013 that were affected by the change in accounting principle. (d) Prepare comparative retained earnings statements for 2013 and 2014 under FIFO. Retained earnings reported under LIFO are as follows: Retained Earnings Balance December 31, 2012 $1,200 December 31, 2013 2,200 December 31, 2014 3,070 3 E22-4 (Accounting Change) Gordon Company started operations on January 1, 2009, and has used the FIFO method of inventory valuation since its inception. In 2015, it decides to switch to the average-cost method. You are provided with the following information.

Net Income Retained Earnings (Ending Balance) Under FIFO Under Average-Cost Under FIFO 2009 $100,000 $ 90,000 $100,000 2010 70,000 65,000 160,000 2011 90,000 80,000 235,000 2012 120,000 130,000 340,000 2013 300,000 290,000 590,000 2014 305,000 310,000 780,000 Instructions (a) What is the beginning retained earnings balance at January 1, 2011, if Gordon prepares comparative financial statements starting in 2011? (b) What is the beginning retained earnings balance at January 1, 2014, if Gordon prepares comparative financial statements starting in 2014? (c) What is the beginning retained earnings balance at January 1, 2015, if Gordon prepares single- period financial statements for 2015? (d) What is the net income reported by Gordon in the 2014 income statement if it prepares comparative financial statements starting with 2012? Exercises 1387 3 E22-5 (Accounting Change) Presented below are income statements prepared on a LIFO and FIFO basis for Kenseth Company, which started operations on January 1, 2013. The company presently uses the LIFO method of pricing its inventory and has decided to switch to the FIFO method in 2014. The FIFO income statement is computed in accordance with the requirements of GAAP. Kenseth’s profit-sharing agreement with its employees indicates that the company will pay employees 10% of income before profit-sharing. Income taxes are ignored. LIFO Basis FIFO Basis 2014 2013 2014 2013 Sales $3,000 $3,000 $3,000 $3,000 Cost of goods sold 1,130 1,000 1,100 940 Operating expenses 1,000 1,000 1,000 1,000 Income before profi t-sharing 870 1,000 900 1,060 Profi t-sharing expense 87 100 96 100 Net income $ 783 $ 900 $ 804 $ 960 Instructions Answer the following questions. (a) If comparative income statements are prepared, what net income should Kenseth report in 2013 and 2014? (b) Explain why, under the FIFO basis, Kenseth reports $100 in 2013 and $96 in 2014 for its profit-sharing expense. (c) Assume that Kenseth has a beginning balance of retained earnings at January 1, 2014, of $8,000 using the LIFO method. The company declared and paid dividends of $500 in 2014. Prepare the retained earnings statement for 2014, assuming that Kenseth has switched to the FIFO method. 5 E22-6 (Accounting Changes—Depreciation) Kathleen Cole Inc. acquired the following assets in January of 2012. Equipment, estimated service life, 5 years; salvage value, $15,000 $525,000 Building, estimated service life, 30 years; no salvage value $693,000 The equipment has been depreciated using the sum-of-the-years’-digits method for the first 3 years for financial reporting purposes. In 2015, the company decided to change the method of computing depreciation to the straight-line method for the equipment, but no change was made in the estimated service life or salvage value. It was also decided to change the total estimated service life of the building from 30 years to 40 years, with no change in the estimated salvage value. The building is depreciated on the straight-line method. Instructions (a) Prepare the general journal entry to record depreciation expense for the equipment in 2015. (b) Prepare the journal entry to record depreciation expense for the building in 2015. (Round all computations to two decimal places.) 5 7 E22-7 (Change in Estimate and Error; Financial Statements) Presented below are the comparative income and retained earnings statements for Denise Habbe Inc. for the years 2014 and 2015. 2015 2014 Sales $340,000 $270,000 Cost of sales 200,000 142,000 Gross profi t 140,000 128,000 Expenses 88,000 50,000 Net income $ 52,000 $ 78,000 Retained earnings (Jan. 1) $125,000 $ 72,000 Net income 52,000 78,000 Dividends (30,000) (25,000) Retained earnings (Dec. 31) $147,000 $125,000 The following additional information is provided: 1. In 2015, Denise Habbe Inc. decided to switch its depreciation method from sum-of-the-years’-digits to the straight-line method. The assets were purchased at the beginning of 2014 for $100,000 with an estimated useful life of 4 years and no salvage value. (The 2015 income statement contains depre-

ciation expense of $30,000 on the assets purchased at the beginning of 2014.) 2. In 2015, the company discovered that the ending inventory for 2014 was overstated by $24,000; ending inventory for 2015 is correctly stated. 1388 Chapter 22 Accounting Changes and Error Analysis Instructions Prepare the revised retained earnings statement for 2014 and 2015, assuming comparative statements. (Ignore income taxes.) 3 5 E22-8 (Accounting for Accounting Changes and Errors) Listed below are various types of accounting 7 changes and errors. ______ 1. Change in a plant asset’s salvage value. ______ 2. Change due to overstatement of inventory. ______ 3. Change from sum-of-the-years’-digits to straight-line method of depreciation. ______ 4. Change from presenting unconsolidated to consolidated financial statements. ______ 5. Change from LIFO to FIFO inventory method. ______ 6. Change in the rate used to compute warranty costs. ______ 7. Change from an unacceptable accounting principle to an acceptable accounting principle. ______ 8. Change in a patent’s amortization period. ______ 9. Change from completed-contract to percentage-of-completion method on construction contracts. ______ 10. Change from FIFO to average-cost inventory method. Instructions For each change or error, indicate how it would be accounted for using the following code letters: (a) Accounted for prospectively. (b) Accounted for retrospectively. (c) Neither of the above. 5 7 E22-9 (Error and Change in Estimate—Depreciation) Joy Cunningham Co. purchased a machine on January 1, 2012, for $550,000. At that time, it was estimated that the machine would have a 10-year life and no salvage value. On December 31, 2015, the firm’s accountant found that the entry for depreciation expense had been omitted in 2013. In addition, management has informed the accountant that the company plans to switch to straight-line depreciation, starting with the year 2015. At present, the company uses the sum-of-the-years’-digits method for depreciating equipment. Instructions Prepare the general journal entries that should be made at December 31, 2015, to record these events. (Ignore tax effects.) 5 E22-10 (Depreciation Changes) On January 1, 2011, Jackson Company purchased a building and equip- ment that have the following useful lives, salvage values, and costs. Building, 40-year estimated useful life, $50,000 salvage value, $800,000 cost Equipment, 12-year estimated useful life, $10,000 salvage value, $100,000 cost The building has been depreciated under the double-declining-balance method through 2014. In 2015, the company decided to switch to the straight-line method of depreciation. Jackson also decided to change the total useful life of the equipment to 9 years, with a salvage value of $5,000 at the end of that time. The equipment is depreciated using the straight-line method. Instructions (a) Prepare the journal entry(ies) necessary to record the depreciation expense on the building in 2015. (b) Compute depreciation expense on the equipment for 2015. 5 E22-11 (Change in Estimate—Depreciation) Peter M. Dell Co. purchased equipment for $510,000 which was estimated to have a useful life of 10 years with a salvage value of $10,000 at the end of that time. Depreciation has been entered for 7 years on a straight-line basis. In 2015, it is determined that the total estimated life should be 15 years with a salvage value of $5,000 at the end of that time. Instructions (a) Prepare the entry (if any) to correct the prior years’ depreciation. (b) Prepare the entry to record depreciation for 2015. 5 E22-12 (Change in Estimate—Depreciation) Gerald Englehart Industries changed from the double- declining-balance to the straight-line method in 2015 on all its plant assets. There was no change in the assets’ salvage values or useful lives. Plant assets, acquired on January 2, 2012, had an original cost of $1,600,000, with a $100,000 salvage value and an 8-year estimated useful life. Income before depreciation expense was $270,000 in 2014 and $300,000 in 2015. Instructions

(a) Prepare the journal entry(ies) to record depreciation expense in 2015. Exercises 1389 (b) Starting with income before depreciation expense, prepare the remaining portion of the income statement for 2014 and 2015. 3 E22-13 (Change in Principle—Long-Term Contracts) Cullen Construction Company, which began opera- tions in 2014, changed from the completed-contract to the percentage-of-completion method of accounting for long-term construction contracts during 2015. For tax purposes, the company employs the completed- contract method and will continue this approach in the future. The appropriate information related to this change is as follows. Pretax Income Percentage-of-Completion Completed-Contract Difference 2014 $880,000 $590,000 $290,000 2015 900,000 480,000 420,000 Instructions (a) Assuming that the tax rate is 40%, what is the amount of net income that would be reported in 2015? (b) What entry(ies) are necessary to adjust the accounting records for the change in accounting principle? 3 E22-14 (Various Changes in Principle—Inventory Methods) Below is the net income of Anita Ferreri Instrument Co., a private corporation, computed under the three inventory methods using a periodic system. FIFO Average-Cost LIFO 2012 $26,000 $24,000 $20,000 2013 30,000 25,000 21,000 2014 28,000 27,000 24,000 2015 34,000 30,000 26,000 Instructions (Ignore tax considerations.) (a) Assume that in 2015 Ferreri decided to change from the FIFO method to the average-cost method of pricing inventories. Prepare the journal entry necessary for the change that took place during 2015, and show net income reported for 2012, 2013, 2014, and 2015. (b) Assume that in 2015 Ferreri, which had been using the LIFO method since incorporation in 2012, changed to the FIFO method of pricing inventories. Prepare the journal entry necessary to record the change in 2015 and show net income reported for 2012, 2013, 2014, and 2015. 7 E22-15 (Error Correction Entries) The first audit of the books of Bruce Gingrich Company was made for the year ended December 31, 2015. In examining the books, the auditor found that certain items had been overlooked or incorrectly handled in the last 3 years. These items are: 1. At the beginning of 2013, the company purchased a machine for $510,000 (salvage value of $51,000) that had a useful life of 6 years. The bookkeeper used straight-line depreciation, but failed to deduct the salvage value in computing the depreciation base for the 3 years. 2. At the end of 2014, the company failed to accrue sales salaries of $45,000. 3. A tax lawsuit that involved the year 2013 was settled late in 2015. It was determined that the com- pany owed an additional $85,000 in taxes related to 2013. The company did not record a liability in 2013 or 2014 because the possibility of loss was considered remote, and charged the $85,000 to a loss account in 2015. 4. Gingrich Company purchased a copyright from another company early in 2013 for $45,000. Gingrich had not amortized the copyright because its value had not diminished. The copyright has a useful life at purchase of 20 years. 5. In 2015, the company wrote off $87,000 of inventory considered to be obsolete; this loss was charged directly to Retained Earnings. Instructions Prepare the journal entries necessary in 2015 to correct the books, assuming that the books have not been closed. Disregard effects of corrections on income tax. 7 E22-16 (Error Analysis and Correcting Entry) You have been engaged to review the financial statements of Gottschalk Corporation. In the course of your examination, you conclude that the bookkeeper hired during the current year is not doing a good job. You notice a number of irregularities as follows. 1. Year-end wages payable of $3,400 were not recorded because the bookkeeper thought that “they were immaterial.” 2. Accrued vacation pay for the year of $31,100 was not recorded because the bookkeeper “never heard that you had to do it.” 1390 Chapter 22 Accounting Changes and Error Analysis 3. Insurance for a 12-month period purchased on November 1 of this year was charged to insurance

expense in the amount of $2,640 because “the amount of the check is about the same every year.” 4. Reported sales revenue for the year is $2,120,000. This includes all sales taxes collected for the year. The sales tax rate is 6%. Because the sales tax is forwarded to the state’s Department of Revenue, the Sales Tax Expense account is debited. The bookkeeper thought that “the sales tax is a selling expense.” At the end of the current year, the balance in the Sales Tax Expense account is $103,400. Instructions Prepare the necessary correcting entries, assuming that Gottschalk uses a calendar-year basis. 7 E22-17 (Error Analysis and Correcting Entry) The reported net incomes for the first 2 years of Sandra Gustafson Products, Inc., were as follows: 2014, $147,000; 2015, $185,000. Early in 2016, the following errors were discovered. 1. Depreciation of equipment for 2014 was overstated $17,000. 2. Depreciation of equipment for 2015 was understated $38,500. 3. December 31, 2014, inventory was understated $50,000. 4. December 31, 2015, inventory was overstated $16,200. Instructions Prepare the correcting entry necessary when these errors are discovered. Assume that the books are closed. (Ignore income tax considerations.) 7 9 E22-18 (Error Analysis) Peter Henning Tool Company’s December 31 year-end financial statements contained the following errors. December 31, 2014 December 31, 2015 Ending inventory $9,600 understated $8,100 overstated Depreciation expense $2,300 understated — An insurance premium of $66,000 was prepaid in 2014 covering the years 2014, 2015, and 2016. The entire amount was charged to expense in 2014. In addition, on December 31, 2015, fully depreciated machinery was sold for $15,000 cash, but the entry was not recorded until 2016. There were no other errors during 2014 or 2015, and no corrections have been made for any of the errors. (Ignore income tax considerations.) Instructions (a) Compute the total effect of the errors on 2015 net income. (b) Compute the total effect of the errors on the amount of Henning’s working capital at December 31, 2015. (c) Compute the total effect of the errors on the balance of Henning’s retained earnings at December 31, 2015. 7 9 E22-19 (Error Analysis; Correcting Entries) A partial trial balance of Julie Hartsack Corporation is as follows on December 31, 2015. Dr. Cr. Supplies $ 2,700 Salaries and wages payable $ 1,500 Interest receivable 5,100 Prepaid insurance 90,000 Unearned rent –0– Interest payable 15,000 Additional adjusting data: 1. A physical count of supplies on hand on December 31, 2015, totaled $1,100. 2. Through oversight, the Salaries and Wages Payable account was not changed during 2015. Accrued salaries and wages on December 31, 2015, amounted to $4,400. 3. The Interest Receivable account was also left unchanged during 2015. Accrued interest on invest- ments amounts to $4,350 on December 31, 2015. 4. The unexpired portions of the insurance policies totaled $65,000 as of December 31, 2015. 5. $28,000 was received on January 1, 2015, for the rent of a building for both 2015 and 2016. The entire amount was credited to rent revenue. 6. Depreciation on equipment for the year was erroneously recorded as $5,000 rather than the correct figure of $50,000. 7. A further review of depreciation calculations of prior years revealed that equipment depreciation of $7,200 was not recorded. It was decided that this oversight should be corrected by a prior period adjustment. Exercises 1391 Instructions (a) Assuming that the books have not been closed, what are the adjusting entries necessary at Decem- ber 31, 2015? (Ignore income tax considerations.) (b) Assuming that the books have been closed, what are the adjusting entries necessary at December 31, 2015? (Ignore income tax considerations.) (c) Repeat the requirements for items 6 and 7, taking into account income tax effects (40% tax rate) and assuming that the books have been closed. 7 9 E22-20 (Error Analysis) The before-tax income for Lonnie Holdiman Co. for 2014 was $101,000 and $77,400 for 2015. However, the accountant noted that the following errors had been made:

1. Sales for 2014 included amounts of $38,200 which had been received in cash during 2014, but for which the related products were delivered in 2015. Title did not pass to the purchaser until 2015. 2. The inventory on December 31, 2014, was understated by $8,640. 3. The bookkeeper in recording interest expense for both 2014 and 2015 on bonds payable made the following entry on an annual basis. Interest Expense 15,000 Cash 15,000 The bonds have a face value of $250,000 and pay a stated interest rate of 6%. They were issued at a discount of $15,000 on January 1, 2014, to yield an effective-interest rate of 7%. (Assume that the effective-yield method should be used.) 4. Ordinary repairs to equipment had been erroneously charged to the Equipment account during 2014 and 2015. Repairs in the amount of $8,500 in 2014 and $9,400 in 2015 were so charged. The company applies a rate of 10% to the balance in the Equipment account at the end of the year in its determination of depreciation charges. Instructions Prepare a schedule showing the determination of corrected income before taxes for 2014 and 2015. 7 9 E22-21 (Error Analysis) When the records of Debra Hanson Corporation were reviewed at the close of 2015, the errors listed below were discovered. For each item, indicate by a check mark in the appropriate column whether the error resulted in an overstatement, an understatement, or had no effect on net income for the years 2014 and 2015. 2014 2015 Over- Under- No Over- Under- No Item statement statement Effect statement statement Effect 1. Failure to record amortization of patent in 2015. 2. Failure to record the correct amount of ending 2014 inventory. The amount was understated because of an error in calculation. 3. Failure to record merchandise purchased in 2014. Merchandise was also omitted from ending inventory in 2014 but was not yet sold. 4. Failure to record accrued interest on notes payable in 2014; that amount was recorded when paid in 2015. 5. Failure to refl ect supplies on hand on balance sheet at end of 2014. 1392 Chapter 22 Accounting Changes and Error Analysis 10 *E 22-22 (Change from Fair Value to Equity) On January 1, 2014, Beyonce Co. purchased 25,000 shares (a 10% interest) in Elton John Corp. for $1,400,000. At the time, the book value and the fair value of John’s net assets were $13,000,000. On July 1, 2015, Beyonce paid $3,040,000 for 50,000 additional shares of John common stock, which represented a 20% investment in John. The fair value of John’s identifiable assets net of liabilities was equal to their carrying amount of $14,200,000. As a result of this transaction, Beyonce owns 30% of John and can exercise significant influence over John’s operating and financial policies. John reported the following net income and declared and paid the following dividends. Net Income Dividend per Share Year ended 12/31/14 $700,000 None Six months ended 6/30/15 500,000 None Six months ended 12/31/15 815,000 $1.55 Instructions (Any excess fair value is attributed to goodwill.) Determine the ending balance that Beyonce Co. should report as its investment in John Corp. at the end of 2015. 10 *E 22-23 (Change from Equity to Fair Value) Dan Aykroyd Corp. was a 30% owner of Steve Martin Company, holding 210,000 shares of Martin’s common stock on December 31, 2013. The investment account had the following entries. Investment in Martin 1/1/12 Cost $3,180,000 12/6/12 Dividend received $150,000 12/31/12 Share of income 390,000 12/5/13 Dividend received 240,000 12/31/13 Share of income 510,000 On January 2, 2014, Aykroyd sold 126,000 shares of Martin for $3,440,000, thereby losing its significant influence. During the year 2014, Martin experienced the following results of operations and paid the following dividends to Aykroyd. Martin Dividends Paid Income (Loss) to Aykroyd 2014 $300,000 $50,400 At December 31, 2014, the fair value of Martin shares held by Aykroyd is $1,570,000. This is the first reporting date since the January 2 sale. Instructions (a) What effect does the January 2, 2014, transaction have upon Aykroyd’s accounting treatment for its

investment in Martin? (b) Compute the carrying amount of the investment in Martin as of December 31, 2014 (prior to any fair value adjustment). (c) Prepare the adjusting entry on December 31, 2014, applying the fair value method to Aykroyd’s long-term investment in Martin Company securities. EXERCISES SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of exercises. PROBLEMS 2 5 P22-1 (Change in Estimate and Error Correction) Holtzman Company is in the process of preparing 7 its financial statements for 2014. Assume that no entries for depreciation have been recorded in 2014. The following information related to depreciation of fixed assets is provided to you. 1. Holtzman purchased equipment on January 2, 2011, for $85,000. At that time, the equipment had an estimated useful life of 10 years with a $5,000 salvage value. The equipment is depreciated on a Problems 1393 straight-line basis. On January 2, 2014, as a result of additional information, the company deter- mined that the equipment has a remaining useful life of 4 years with a $3,000 salvage value. 2. During 2014, Holtzman changed from the double-declining-balance method for its building to the straight-line method. The building originally cost $300,000. It had a useful life of 10 years and a salvage value of $30,000. The following computations present depreciation on both bases for 2012 and 2013. 2013 2012 Straight-line $27,000 $27,000 Declining-balance 48,000 60,000 3. Holtzman purchased a machine on July 1, 2012, at a cost of $120,000. The machine has a salvage value of $16,000 and a useful life of 8 years. Holtzman’s bookkeeper recorded straight-line depre- ciation in 2012 and 2013 but failed to consider the salvage value. Instructions (a) Prepare the journal entries to record depreciation expense for 2014 and correct any errors made to date related to the information provided. (Ignore taxes.) (b) Show comparative net income for 2013 and 2014. Income before depreciation expense was $300,000 in 2014, and was $310,000 in 2013. (Ignore taxes.) 3 5 P22-2 (Comprehensive Accounting Change and Error Analysis Problem) Botticelli Inc. was organized in 7 late 2012 to manufacture and sell hosiery. At the end of its fourth year of operation, the company has been fairly successful, as indicated by the following reported net incomes. 2012 $140,000a 2014 $205,000 2013 160,000b 2015 276,000 aIncludes a $10,000 increase because of change in bad debt experience rate. bIncludes extraordinary gain of $30,000. The company has decided to expand operations and has applied for a sizable bank loan. The bank officer has indicated that the records should be audited and presented in comparative statements to facilitate analysis by the bank. Botticelli Inc. therefore hired the auditing firm of Check & Doublecheck Co. and has provided the following additional information. 1. In early 2013, Botticelli Inc. changed its estimate from 2% of sales to 1% on the amount of bad debt expense to be charged to operations. Bad debt expense for 2012, if a 1% rate had been used, would have been $10,000. The company therefore restated its net income for 2012. 2. In 2015, the auditor discovered that the company had changed its method of inventory pricing from LIFO to FIFO. The effect on the income statements for the previous years is as follows. 2012 2013 2014 2015 Net income unadjusted—LIFO basis $140,000 $160,000 $205,000 $276,000 Net income unadjusted—FIFO basis 155,000 165,000 215,000 260,000 $ 15,000 $ 5,000 $ 10,000 $ (16,000) 3. In 2015, the auditor discovered that: (a) The company incorrectly overstated the ending inventory (under both LIFO and FIFO) by $14,000 in 2014. (b) A dispute developed in 2013 with the Internal Revenue Service over the deductibility of enter- tainment expenses. In 2012, the company was not permitted these deductions, but a tax settle- ment was reached in 2015 that allowed these expenses. As a result of the court’s finding, tax expenses in 2015 were reduced by $60,000. Instructions (a) Indicate how each of these changes or corrections should be handled in the accounting records.

(Ignore income tax considerations.) (b) Present comparative income statements for the years 2012 to 2015, starting with income before extraordinary items. (Ignore income tax considerations.) 3 5 P22-3 (Error Corrections and Accounting Changes) Penn Company is in the process of adjusting 7 and correcting its books at the end of 2014. In reviewing its records, the following information is compiled. 1. Penn has failed to accrue sales commissions payable at the end of each of the last 2 years, as follows. December 31, 2013 $3,500 December 31, 2014 $2,500 1394 Chapter 22 Accounting Changes and Error Analysis 2. In reviewing the December 31, 2014, inventory, Penn discovered errors in its inventory-taking pro- cedures that have caused inventories for the last 3 years to be incorrect, as follows. December 31, 2012 Understated $16,000 December 31, 2013 Understated $19,000 December 31, 2014 Overstated $ 6,700 Penn has already made an entry that established the incorrect December 31, 2014, inventory amount. 3. At December 31, 2014, Penn decided to change the depreciation method on its office equipment from double-declining-balance to straight-line. The equipment had an original cost of $100,000 when purchased on January 1, 2012. It has a 10-year useful life and no salvage value. Depreciation expense recorded prior to 2014 under the double-declining-balance method was $36,000. Penn has already recorded 2014 depreciation expense of $12,800 using the double-declining-balance method. 4. Before 2014, Penn accounted for its income from long-term construction contracts on the completed- contract basis. Early in 2014, Penn changed to the percentage-of-completion basis for accounting purposes. It continues to use the completed-contract method for tax purposes. Income for 2014 has been recorded using the percentage-of-completion method. The following information is available. Pretax Income Percentage-of-Completion Completed-Contract Prior to 2014 $150,000 $105,000 2014 60,000 20,000 Instructions Prepare the journal entries necessary at December 31, 2014, to record the above corrections and changes. The books are still open for 2014. The income tax rate is 40%. Penn has not yet recorded its 2014 income tax expense and payable amounts so current-year tax effects may be ignored. Prior-year tax effects must be considered in item 4. 5 P22-4 (Accounting Changes) Aston Corporation performs year-end planning in November of each year before its calendar year ends in December. The preliminary estimated net income is $3 million. The CFO, Rita Warren, meets with the company president, J. B. Aston, to review the projected numbers. She presents the following projected information. ASTON CORPORATION PROJECTED INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2014 Sales $29,000,000 Cost of goods sold $14,000,000 Depreciation 2,600,000 Operating expenses 6,400,000 23,000,000 Income before income tax 6,000,000 Income tax 3,000,000 Net income $ 3,000,000 ASTON CORPORATION SELECTED BALANCE SHEET INFORMATION AT DECEMBER 31, 2014 Estimated cash balance $ 5,000,000 Available-for-sale securities (at cost) 10,000,000 Fair value adjustment (1/1/14) —0— Estimated fair value at December 31, 2014: Security Cost Estimated Fair Value A $ 2,000,000 $ 2,200,000 B 4,000,000 3,900,000 C 3,000,000 3,100,000 D 1,000,000 1,800,000 Total $10,000,000 $11,000,000 Problems 1395 Other information at December 31, 2014: Equipment $3,000,000 Accumulated depreciation (5-year SL) 1,200,000 New robotic equipment (purchased 1/1/14) 5,000,000 Accumulated depreciation (5-year DDB) 2,000,000 The corporation has never used robotic equipment before, and Warren assumed an accelerated method because of the rapidly changing technology in robotic equipment. The company normally uses straight- line depreciation for production equipment. Aston explains to Warren that it is important for the corporation to show a $7,000,000 income before taxes because Aston receives a $1,000,000 bonus if the income before taxes and bonus reaches $7,000,000. Aston also does not want the company to pay more than $3,000,000 in income taxes to the government.

Instructions (a) What can Warren do within GAAP to accommodate the president’s wishes to achieve $7,000,000 in income before taxes and bonus? Present the revised income statement based on your decision. (b) Are the actions ethical? Who are the stakeholders in this decision, and what effect do Warren’s actions have on their interests? 3 P22-5 (Change in Principle—Inventory—Periodic) The management of Utrillo Instrument Company had concluded, with the concurrence of its independent auditors, that results of operations would be more fairly presented if Utrillo changed its method of pricing inventory from last-in, first-out (LIFO) to average- cost in 2014. Given below is the 5-year summary of income under LIFO and a schedule of what the inven- tories would be if stated on the average-cost method. UTRILLO INSTRUMENT COMPANY STATEMENT OF INCOME AND RETAINED EARNINGS FOR THE YEARS ENDED MAY 31 2010 2011 2012 2013 2014 Sales—net $13,964 $15,506 $16,673 $18,221 $18,898 Cost of goods sold Beginning inventory 1,000 1,100 1,000 1,115 1,237 Purchases 13,000 13,900 15,000 15,900 17,100 Ending inventory (1,100) (1,000) (1,115) (1,237) (1,369) Total 12,900 14,000 14,885 15,778 16,968 Gross profi t 1,064 1,506 1,788 2,443 1,930 Administrative expenses 700 763 832 907 989 Income before taxes 364 743 956 1,536 941 Income taxes (50%) 182 372 478 768 471 Net income 182 371 478 768 470 Retained earnings—beginning 1,206 1,388 1,759 2,237 3,005 Retained earnings—ending $ 1,388 $ 1,759 $ 2,237 $ 3,005 $ 3,475 Earnings per share $1.82 $3.71 $4.78 $7.68 $4.70 SCHEDULE OF INVENTORY BALANCES USING AVERAGE-COST METHOD FOR THE YEARS ENDED MAY 31 2009 2010 2011 2012 2013 2014 $1,010 $1,124 $1,101 $1,270 $1,500 $1,720 Instructions Prepare comparative statements for the 5 years, assuming that Utrillo changed its method of inventory pricing to average-cost. Indicate the effects on net income and earnings per share for the years involved. Utrillo Instruments started business in 2009. (All amounts except EPS are rounded up to the nearest dollar.) 5 7 P22-6 (Accounting Change and Error Analysis) On December 31, 2014, before the books were closed, the 9 management and accountants of Madrasa Inc. made the following determinations about three pieces of equipment. 1. Equipment A was purchased January 2, 2011. It originally cost $540,000 and, for depreciation pur- poses, the straight-line method was originally chosen. The asset was originally expected to be 1396 Chapter 22 Accounting Changes and Error Analysis useful for 10 years and have a zero salvage value. In 2014, the decision was made to change the depreciation method from straight-line to sum-of-the-years’-digits, and the estimates relating to useful life and salvage value remained unchanged. 2. Equipment B was purchased January 3, 2010. It originally cost $180,000 and, for depreciation pur- poses, the straight-line method was chosen. The asset was originally expected to be useful for 15 years and have a zero residual value. In 2014, the decision was made to shorten the total life of this asset to 9 years and to estimate the residual value at $3,000. 3. Equipment C was purchased January 5, 2010. The asset’s original cost was $160,000, and this amount was entirely expensed in 2010. This particular asset has a 10-year useful life and no residual value. The straight-line method was chosen for depreciation purposes. Additional data: 1. Income in 2014 before depreciation expense amounted to $400,000. 2. Depreciation expense on assets other than A, B, and C totaled $55,000 in 2014. 3. Income in 2013 was reported at $370,000. 4. Ignore all income tax effects. 5. 100,000 shares of common stock were outstanding in 2013 and 2014. Instructions (a) Prepare all necessary entries in 2014 to record these determinations. (b) Prepare comparative retained earnings statements for Madrasa Inc. for 2013 and 2014. The company had retained earnings of $200,000 at December 31, 2012. 7 9 P22-7 (Error Corrections) You have been assigned to examine the financial statements of Zarle Company for the year ended December 31, 2014. You discover the following situations.

1. Depreciation of $3,200 for 2014 on delivery vehicles was not recorded. 2. The physical inventory count on December 31, 2013, improperly excluded merchandise costing $19,000 that had been temporarily stored in a public warehouse. Zarle uses a periodic inventory system. 3. A collection of $5,600 on account from a customer received on December 31, 2014, was not recorded until January 2, 2015. 4. In 2014, the company sold for $3,700 fully depreciated equipment that originally cost $25,000. The company credited the proceeds from the sale to the Equipment account. 5. During November 2014, a competitor company filed a patent-infringement suit against Zarle claim- ing damages of $220,000. The company’s legal counsel has indicated that an unfavorable verdict is probable and a reasonable estimate of the court’s award to the competitor is $125,000. The company has not reflected or disclosed this situation in the financial statements. 6. Zarle has a portfolio of trading securities. No entry has been made to adjust to market. Information on cost and fair value is as follows. Cost Fair Value December 31, 2013 $95,000 $95,000 December 31, 2014 $84,000 $82,000 7. At December 31, 2014, an analysis of payroll information shows accrued salaries of $12,200. The Salaries and Wages Payable account had a balance of $16,000 at December 31, 2014, which was un- changed from its balance at December 31, 2013. 8. A large piece of equipment was purchased on January 3, 2014, for $40,000 and was charged to Maintenance and Repairs Expense. The equipment is estimated to have a service life of 8 years and no residual value. Zarle normally uses the straight-line depreciation method for this type of equipment. 9. A $12,000 insurance premium paid on July 1, 2013, for a policy that expires on June 30, 2016, was charged to insurance expense. 10. A trademark was acquired at the beginning of 2013 for $50,000. No amortization has been recorded since its acquisition. The maximum allowable amortization period is 10 years. Instructions Assume the trial balance has been prepared but the books have not been closed for 2014. Assuming all amounts are material, prepare journal entries showing the adjustments that are required. (Ignore income tax considerations.) 7 9 P22-8 (Comprehensive Error Analysis) On March 5, 2015, you were hired by Hemingway Inc., a closely held company, as a staff member of its newly created internal auditing department. While reviewing the company’s records for 2013 and 2014, you discover that no adjustments have yet been made for the items listed on the next page. Problems 1397 Items 1. Interest income of $14,100 was not accrued at the end of 2013. It was recorded when received in February 2014. 2. A computer costing $4,000 was expensed when purchased on July 1, 2013. It is expected to have a 4-year life with no salvage value. The company typically uses straight-line depreciation for all fixed assets. 3. Research and development costs of $33,000 were incurred early in 2013. They were capitalized and were to be amortized over a 3-year period. Amortization of $11,000 was recorded for 2013 and $11,000 for 2014. 4. On January 2, 2013, Hemingway leased a building for 5 years at a monthly rental of $8,000. On that date, the company paid the following amounts, which were expensed when paid. Security deposit $20,000 First month’s rent 8,000 Last month’s rent 8,000 $36,000 5. The company received $36,000 from a customer at the beginning of 2013 for services that it is to perform evenly over a 3-year period beginning in 2013. None of the amount received was reported as unearned revenue at the end of 2013. 6. Merchandise inventory costing $18,200 was in the warehouse at December 31, 2013, but was incor- rectly omitted from the physical count at that date. The company uses the periodic inventory method. Instructions Indicate the effect of any errors on the net income figure reported on the income statement for the year ending December 31, 2013, and the retained earnings figure reported on the balance sheet at December 31,

2014. Assume all amounts are material, and ignore income tax effects. Using the following format, enter the appropriate dollar amounts in the appropriate columns. Consider each item independent of the other items. It is not necessary to total the columns on the grid. Net Income for 2013 Retained Earnings at 12/31/14 Item Understated Overstated Understated Overstated (CIA adapted) 7 9 P22-9 (Error Analysis) Lowell Corporation has used the accrual basis of accounting for several years. A review of the records, however, indicates that some expenses and revenues have been handled on a cash basis because of errors made by an inexperienced bookkeeper. Income statements prepared by the book- keeper reported $29,000 net income for 2013 and $37,000 net income for 2014. Further examination of the records reveals that the following items were handled improperly. 1. Rent was received from a tenant in December 2013. The amount, $1,000, was recorded as revenue at that time even though the rental pertained to 2014. 2. Salaries and wages payable on December 31 have been consistently omitted from the records of that date and have been entered as expenses when paid in the following year. The amounts of the accruals recorded in this manner were: December 31, 2012 $1,100 December 31, 2013 1,200 December 31, 2014 940 3. Invoices for supplies purchased have been charged to expense accounts when received. Inventories of supplies on hand at the end of each year have been ignored, and no entry has been made for them. December 31, 2012 $1,300 December 31, 2013 940 December 31, 2014 1,420 Instructions Prepare a schedule that will show the corrected net income for the years 2013 and 2014. All items listed should be labeled clearly. (Ignore income tax considerations.) 1398 Chapter 22 Accounting Changes and Error Analysis 7 9 P22-10 (Error Analysis and Correcting Entries) You have been asked by a client to review the records of Roberts Company, a small manufacturer of precision tools and machines. Your client is interested in buying the business, and arrangements have been made for you to review the accounting records. Your examina- tion reveals the following information. 1. Roberts Company commenced business on April 1, 2012, and has been reporting on a fiscal year ending March 31. The company has never been audited, but the annual statements prepared by the bookkeeper reflect the following income before closing and before deducting income taxes. Year Ended Income March 31 Before Taxes 2013 $ 71,600 2014 111,400 2015 103,580 2. A relatively small number of machines have been shipped on consignment. These transactions have been recorded as ordinary sales and billed as such. On March 31 of each year, machines billed and in the hands of consignees amounted to: 2013 $6,500 2014 none 2015 5,590 Sales price was determined by adding 25% to cost. Assume that the consigned machines are sold the following year. 3. On March 30, 2014, two machines were shipped to a customer on a C.O.D. basis. The sale was not entered until April 5, 2014, when cash was received for $6,100. The machines were not included in the inventory at March 31, 2014. (Title passed on March 30, 2014.) 4. All machines are sold subject to a 5-year warranty. It is estimated that the expense ultimately to be incurred in connection with the warranty will amount to 1⁄2 of 1% of sales. The company has charged an expense account for warranty costs incurred. Sales per books and warranty costs were as follows. Warranty Expense Year Ended for Sales Made in March 31 Sales 2013 2014 2015 Total 2013 $ 940,000 $760 $ 760 2014 1,010,000 360 $1,310 1,670 2015 1,795,000 320 1,620 $1,910 3,850 5. Bad debts have been recorded on a direct write-off basis. Experience of similar enterprises indicates that losses will approximate 1⁄4 of 1% of sales. Bad debts written off were: Bad Debts Incurred on Sales Made in 2013 2014 2015 Total 2013 $750 $ 750 2014 800 $ 520 1,320 2015 350 1,800 $1,700 3,850 6. The bank deducts 6% on all contracts financed. Of this amount, 1⁄2% is placed in a reserve to the

credit of Roberts Company that is refunded to Roberts as finance contracts are paid in full. (Thus, Roberts should have a receivable for these payments and should record revenue when the net bal- ance is remitted each year.) The reserve established by the bank has not been reflected in the books of Roberts. The excess of credits over debits (net increase) to the reserve account with Roberts on the books of the bank for each fiscal year were as follows. 2013 $ 3,000 2014 3,900 2015 5,100 $12,000 7. Commissions on sales have been entered when paid. Commissions payable on March 31 of each year were as follows. 2013 $1,400 2014 900 2015 1,120 Problems Set B 1399 8. A review of the corporate minutes reveals the manager is entitled to a bonus of 1% of the income before deducting income taxes and the bonus. The bonuses have never been recorded or paid. Instructions (a) Present a schedule showing the revised income before income taxes for each of the years ended March 31, 2013, 2014, and 2015. (Make computations to the nearest whole dollar.) (b) Prepare the journal entry or entries you would give the bookkeeper to correct the books. Assume the books have not yet been closed for the fiscal year ended March 31, 2015. Disregard correction of income taxes. (AICPA adapted) 10 *P 22-11 (Fair Value to Equity Method with Goodwill) On January 1, 2014, Millay Inc. paid $700,000 for 10,000 shares of Genso Company’s voting common stock, which was a 10% interest in Genso. At that date, the net assets of Genso totaled $6,000,000. The fair values of all of Genso’s identifiable assets and liabilities were equal to their book values. Millay does not have the ability to exercise significant influence over the operating and financial policies of Genso. Millay received dividends of $1.50 per share from Genso on October 1, 2014. Genso reported net income of $550,000 for the year ended December 31, 2014. On July 1, 2015, Millay paid $2,325,000 for 30,000 additional shares of Genso Company’s voting common stock which represents a 30% investment in Genso. The fair values of all of Genso’s identifiable assets net of liabilities were equal to their book values of $6,550,000. As a result of this transaction, Millay has the ability to exercise significant influence over the operating and financial policies of Genso. Millay received dividends of $2.00 per share from Genso on April 1, 2015, and $2.50 per share on October 1, 2015. Genso reported net income of $650,000 for the year ended December 31, 2015, and $350,000 for the 6 months ended December 31, 2015. Instructions (For both purchases, assume any excess of cost over book value is due to goodwill.) (a) Prepare a schedule showing the income or loss before income taxes for the year ended December 31, 2014, that Millay should report from its investment in Genso in its income statement issued in March 2015. (b) During March 2016, Millay issues comparative financial statements for 2014 and 2015. Prepare schedules showing the income or loss before income taxes for the years ended December 31, 2014 and 2015, that Millay should report from its investment in Genso. (AICPA adapted) 10 *P 22-12 (Change from Fair Value to Equity Method) On January 3, 2013, Martin Company purchased for $500,000 cash a 10% interest in Renner Corp. On that date, the net assets of Renner had a book value of $3,700,000. The excess of cost over the underlying equity in net assets is attributable to undervalued depre- ciable assets having a remaining life of 10 years from the date of Martin’s purchase. The fair value of Martin’s investment in Renner securities is as follows: December 31, 2013, $560,000, and December 31, 2014, $515,000. On January 2, 2015, Martin purchased an additional 30% of Renner’s stock for $1,545,000 cash when the book value of Renner’s net assets was $4,150,000. The excess was attributable to depreciable assets having a remaining life of 8 years. During 2013, 2014, and 2015, the following occurred. Renner Dividends Paid by Net Income Renner to Martin 2013 $350,000 $15,000 2014 450,000 20,000

2015 550,000 70,000 Instructions On the books of Martin Company, prepare all journal entries in 2013, 2014, and 2015 that relate to its invest- ment in Renner Corp., reflecting the data above and a change from the fair value method to the equity method. PROBLEMS SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of problems. 1400 Chapter 22 Accounting Changes and Error Analysis CONCEPTS FOR ANALYSIS CA22-1 (Analysis of Various Accounting Changes and Errors) Mathys Inc. has recently hired a new independent auditor, Karen Ogleby, who says she wants “to get everything straightened out.” Conse- quently, she has proposed the following accounting changes in connection with Mathys Inc.’s 2014 finan- cial statements. 1. At December 31, 2013, the client had a receivable of $820,000 from Hendricks Inc. on its balance sheet. Hendricks Inc. has gone bankrupt, and no recovery is expected. The client proposes to write off the receivable as a prior period item. 2. The client proposes the following changes in depreciation policies. (a) F or office furniture and fixtures, it proposes to change from a 10-year useful life to an 8-year life. If this change had been made in prior years, retained earnings at December 31, 2013, would have been $250,000 less. The effect of the change on 2014 income alone is a reduction of $60,000. (b) For its new equipment in the leasing division, the client proposes to adopt the sum-of-the- years’-digits depreciation method. The client had never used SYD before. The first year the cli- ent operated a leasing division was 2014. If straight-line depreciation were used, 2014 income would be $110,000 greater. 3. In preparing its 2013 statements, one of the client’s bookkeepers overstated ending inventory by $235,000 because of a mathematical error. The client proposes to treat this item as a prior period adjustment. 4. In the past, the client has spread preproduction costs in its furniture division over 5 years. Because its latest furniture is of the “fad” type, it appears that the largest volume of sales will occur during the first 2 years after introduction. Consequently, the client proposes to amortize preproduction costs on a per-unit basis, which will result in expensing most of such costs during the first 2 years after the furniture’s introduction. If the new accounting method had been used prior to 2014, retained earnings at December 31, 2013, would have been $375,000 less. 5. For the nursery division, the client proposes to switch from FIFO to LIFO inventories because it believes that LIFO will provide a better matching of current costs with revenues. The effect of mak- ing this change on 2014 earnings will be an increase of $320,000. The client says that the effect of the change on December 31, 2013, retained earnings cannot be determined. 6. To achieve an appropriate recognition of revenues and expenses in its building construction division, the c lient proposes to switch from the completed-contract method of accounting to the percentage-of-completion method. Had the percentage-of-completion method been employed in all prior years, retained earnings at December 31, 2013, would have been $1,075,000 greater. Instructions (a) For each of the changes described above, decide whether: (1) The change involves an accounting principle, accounting estimate, or correction of an error. (2) Restatement of opening retained earnings is required. (b) What would be the proper adjustment to the December 31, 2013, retained earnings? CA22-2 (Analysis of Various Accounting Changes and Errors) Various types of accounting changes can affect the financial statements of a business enterprise differently. Assume that the following list describes changes that have a material effect on the financial statements for the current year of your business enterprise. 1. A change from the completed-contract method to the percentage-of-completion method of account- ing for long-term construction-type contracts. 2. A change in the estimated useful life of previously recorded fixed assets as a result of newly acquired

information. 3. A change from deferring and amortizing preproduction costs to recording such costs as an expense when incurred because future benefits of the costs have become doubtful. The new accounting method was adopted in recognition of the change in estimated future benefits. 4. A change from including the employer share of FICA taxes with payroll tax expenses to including it with “Retirement benefits” on the income statement. 5. Correction of a mathematical error in inventory pricing made in a prior period. 6. A change from presentation of statements of individual companies to presentation of consolidated statements. 7. A change in the method of accounting for leases for tax purposes to conform with the financial ac- counting method. As a result, both deferred and current taxes payable changed substantially. 8. A change from the FIFO method of inventory pricing to the LIFO method of inventory pricing. Concepts for Analysis 1401 Instructions Identify the type of change that is described in each item above and indicate whether the prior year’s finan- cial statements should be recast when presented in comparative form with the current year’s financial statements. CA22-3 (Analysis of Three Accounting Changes and Errors) The following are three independent, unre- lated sets of facts relating to accounting changes. Situation 1: Sanford Company is in the process of having its first audit. The company has used the cash basis of accounting for revenue recognition. Sanford president, B. J. Jimenez, is willing to change to the accrual method of revenue recognition. Situation 2: Hopkins Co. decides in January 2015 to change from FIFO to weighted-average pricing for its inventories. Situation 3: Marshall Co. determined that the depreciable lives of its fixed assets are too long at present to fairly match the cost of the fixed assets with the revenue produced. The company decided at the beginning of the current year to reduce the depreciable lives of all of its existing fixed assets by 5 years. Instructions For each of the situations described, provide the information indicated below. (a) Type of accounting change. (b) Manner of reporting the change under current generally accepted accounting principles, including a discussion where applicable of how amounts are computed. (c) Effect of the change on the balance sheet and income statement. CA22-4 (Analysis of Various Accounting Changes and Errors) Katherine Irving, controller of Lotan Corp., is aware of a pronouncement on accounting changes. After reading the pronouncement, she is confused about what action should be taken on the following items related to Lotan Corp. for the year 2014. 1. In 2014, Lotan decided to change its policy on accounting for certain marketing costs. Previously, the company had chosen to defer and amortize all marketing costs over at least 5 years because Lotan believed that a return on these expenditures did not occur immediately. Recently, however, the time differential has considerably shortened, and Lotan is now expensing the marketing costs as incurred. 2. In 2014, the company examined its entire policy relating to the depreciation of plant equipment. Plant equipment had normally been depreciated over a 15-year period, but recent experience has indicated that the company was incorrect in its estimates and that the assets should be depreciated over a 20-year period. 3. One division of Lotan Corp., Hawthorne Co., has consistently shown an increasing net income from period to period. On closer examination of its operating statement, it is noted that bad debt expense and inventory obsolescence charges are much lower than in other divisions. In discussing this with the controller of this division, it has been learned that the controller has increased his net income each period by knowingly making low estimates related to the write-off of receivables and inventory. 4. In 2014, the company purchased new machinery that should increase production dramatically. The company has decided to depreciate this machinery on an accelerated basis, even though other

machinery is depreciated on a straight-line basis. 5. All equipment sold by Lotan is subject to a 3-year warranty. It has been estimated that the expense ultimately to be incurred on these machines is 1% of sales. In 2014, because of a production break- through, it is now estimated that 1/ of 1% of sales is sufficient. In 2012 and 2013, warranty expense 2 was computed as $64,000 and $70,000, respectively. The company now believes that these warranty costs should be reduced by 50%. 6. In 2014, the company decided to change its method of inventory pricing from average-cost to the FIFO method. The effect of this change on prior years is to increase 2012 income by $65,000 and increase 2013 income by $20,000. Instructions Katherine Irving has come to you, as her CPA, for advice about the situations above. Prepare a report, indicating the appropriate accounting treatment that should be given for each of these situations. CA22-5 (Change in Principle, Estimate) As a certified public accountant, you have been contacted by Joe Davison, CEO of Sports-Pro Athletics, Inc., a manufacturer of a variety of athletic equipment. He has asked you how to account for the following changes. 1402 Chapter 22 Accounting Changes and Error Analysis 1. Sports-Pro appropriately changed its depreciation method for its machinery from the double- declining-balance method to the units-of-production method effective January 1, 2014. 2. Effective January 1, 2014, Sports-Pro appropriately changed the salvage values used in computing depreciation for its office equipment. 3. On December 31, 2014, Sports-Pro appropriately changed the specific subsidiaries constituting the group of companies for which consolidated financial statements are presented. Instructions Write a 1–1.5 page letter to Joe Davison explaining how each of the above changes should be presented in the December 31, 2014, financial statements. CA22-6 (Change in Estimate) Mike Crane is an audit senior of a large public accounting firm who has just been assigned to the Frost Corporation’s annual audit engagement. Frost has been a client of Crane’s firm for many years. Frost is a fast-growing business in the commercial construction industry. In reviewing the fixed asset ledger, Crane discovered a series of unusual accounting changes, in which the useful lives of assets, depreciated using the straight-line method, were substantially lowered near the midpoint of the original estimate. For example, the useful life of one dump truck was changed from 10 to 6 years during its fifth year of service. Upon further investigation, Mike was told by Kevin James, Frost’s accounting man- ager, “I don’t really see your problem. After all, it’s perfectly legal to change an accounting estimate. Be- sides, our CEO likes to see big earnings!” Instructions Answer the following questions. (a) What are the ethical issues concerning Frost’s practice of changing the useful lives of fixed assets? (b) Who could be harmed by Frost’s unusual accounting changes? (c) What should Crane do in this situation? USING YOUR JUDGMENT FINANCIAL REPORTING Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report, including the notes to the financial statements, can be accessed at the book’s companion website, www. wiley.com/college/kieso. Instructions Refer to P&G’s financial statements and the accompanying notes to answer the following questions. (a) Were there changes in accounting principles reported by P&G during the three years covered by its income statements (2009–2011)? If so, describe the nature of the change and the year of change. (b) What types of estimates did P&G discuss in 2011? Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc. Instructions Go to the book’s companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) Identify the changes in accounting principles reported by Coca-Cola during the 3 years covered by its

income statements (2009–2011). Describe the nature of the change and the year of change. (b) Identify the changes in accounting principles reported by PepsiCo during the 3 years covered by its income statements (2009–2011). Describe the nature of the change and the year of change. (c) For each change in accounting principle by Coca-Cola and PepsiCo, identify, if possible, the cumula- tive effect of each change on prior years and the effect on operating results in the year of change. Using Your Judgment 1403 Accounting, Analysis, and Principles In preparation for significant expansion of its international operations, ABC Co. has adopted a plan to gradually shift to the same accounting methods as used by its international competitors. Part of this plan includes a switch from LIFO inventory accounting to FIFO (recall that IFRS does not allow LIFO). ABC decides to make the switch to FIFO at January 1, 2014. The following data pertains to ABC’s 2014 financial statements (in millions of dollars). Sales $550 Inventory purchases 350 12/31/14 inventory (using FIFO) 580 Compensation expense 17 All sales and purchases were with cash. All of 2014’s compensation expense was paid with cash. (Ignore taxes.) ABC’s property, plant, and equipment cost $400 million and has an estimated useful life of 10 years with no salvage value. ABC Co. reported the following for fiscal 2013 (in millions of dollars): ABC CO. BALANCE SHEET AT DECEMBER 31, 2013 2013 2012 2013 2012 Cash $ 365 $ 200 Common stock $ 500 $ 500 Inventory 500 480 Retained earnings 685 540 Property, plant, and equipment 400 400 Accumulated depreciation (80) (40) Total assets $1,185 $1,040 Total equity $1,185 $1,040 ABC CO. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2013 2013 Sales $ 500 Cost of goods sold (300) Depreciation expense (40) Compensation expense (15) Net income $ 145 Summary of Significant Accounting Policies Inventory: The company accounts for inventory by the LIFO method. The current cost of the company’s inventory, which approximates FIFO, was $60 and $50 higher at the end of fi scal 2013 and 2012, respectively, than those reported in the balance sheet. Accounting Prepare ABC’s December 31, 2014, balance sheet and an income statement for the year ended December 31, 2014. In columns beside 2014’s numbers, include 2013’s numbers as they would appear in the 2014 financial statements for comparative purposes. Analysis Compute ABC’s inventory turnover for 2013 and 2014 under both LIFO and FIFO. Assume averages are equal to year-end balances where necessary. What causes the differences in this ratio between LIFO and FIFO? Principles Briefly explain, in terms of the principles discussed in Chapter 2, why GAAP requires that companies that change accounting methods recast prior year’s financial statement data. 1404 Chapter 22 Accounting Changes and Error Analysis BRIDGE TO THE PROFESSION Professional Research: FASB Codifi cation As part of the year-end accounting process and review of operating policies, Cullen Co. is considering a change in the accounting for its equipment from the straight-line method to an accelerated method. Your supervisor wonders how the company will report this change in principle. He read in a newspaper article that the FASB has issued a standard in this area and has changed GAAP for a “change in estimate that is effected by a change in accounting principle.” (Thus, the accounting may be different from what he learned in intermediate accounting.) Your supervisor wants you to research the authoritative guidance on a change in accounting principle related to depreciation methods. Instructions If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. (a) What are the accounting and reporting guidelines for a change in accounting principle related to depreciation methods? (b) What are the conditions that justify a change in depreciation method, as contemplated by Cullen Co.? (c) What guidance does the SEC provide concerning the impact that recently issued accounting standards

will have on the financial statements in a future period? Additional Professional Resources See the book’s companion website, at www.wiley.com/college/kieso, for professional simulations as well as other study resources. IFRS INSIGHTS ACCOUNTING CHANGES AND ERRORS The IFRS addressing accounting and reporting for changes in accounting princi- LEARNING OBJECTIVE 11 ples, changes in estimates, and errors is IAS 8 (“Accounting Policies, Changes in Compare the procedures for accounting Accounting Estimates and Errors”). Various presentation issues related to restate- changes and error analysis under GAAP and IFRS. ments are addressed in IAS 1 (“Presentation of Financial Statements”). As indicated in the chapter, the FASB has issued guidance on changes in accounting principles, changes in estimates, and corrections of errors, which essentially converges GAAP to IAS 8. RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to the procedures for accounting changes. Similarities • The accounting for changes in estimates is similar between GAAP and IFRS. • Under GAAP and IFRS, if determining the effect of a change in accounting policy is considered impracticable, then a company should report the effect of the change in the period in which it believes it practicable to do so, which may be the current period. Differences • One area in which GAAP and IFRS differ is the reporting of error corrections in previ- ously issued fi nancial statements. While both sets of standards require restatement, GAAP is an absolute standard—that is, there is no exception to this rule. IFRS Insights 1405 • Under IFRS, the impracticality exception applies both to changes in accounting prin- ciples and to the correction of errors. Under GAAP, this exception applies only to changes in accounting principle. • IFRS (IAS 8) does not specifi cally address the accounting and reporting for indirect effects of changes in accounting principles. As indicated in the chapter, GAAP has detailed guidance on the accounting and reporting of indirect effects. ABOUT THE NUMBERS Direct and Indirect Effects of Changes Are there other effects that a company should report when it makes a change in account- ing policy? For example, what happens when a company like Lancer (see pages 1350– 1354) has a bonus plan based on net income and the prior year’s net income changes when FIFO is retrospectively applied? Should Lancer also change the reported amount of bonus expense? Or, what happens if we had not ignored income taxes in the Lancer example? Should Lancer adjust net income, given that taxes will be different under average-cost and FIFO in prior periods? The answers depend on whether the effects are direct or indirect. Direct Effects Similar to GAAP, IFRS indicates that companies should retrospectively apply the direct effects of a change in accounting policy. An example of a direct effect is an adjustment to an inventory balance as a result of a change in the inventory valuation method. For example, referring to Lancer Company on pages 1350–1354, Lancer should change the inventory amounts in prior periods to indicate the change to the FIFO method of inven- tory valuation. Another inventory-related example would be an impairment adjustment resulting from applying the lower-of-cost-or-net realizable value test to the adjusted inventory balance. Related changes, such as deferred income tax effects of the impair- ment adjustment, are also considered direct effects. This entry was illustrated in the Denson example on page 1349, in which the change to percentage-of-completion account- ing resulted in recording a deferred tax liability. Indirect Effects In addition to direct effects, companies can have indirect effects related to a change in accounting policy. An indirect effect is any change to current or future cash flows of a company that results from making a change in accounting policy that is applied retrospectively. An example of an indirect effect is a change in profit-sharing or roy- alty payment that is based on a reported amount such as revenue or net income. The

IASB is silent on what to do in this situation. GAAP (likely because its standard in this area was issued after IAS 8) requires that indirect effects do not change prior period amounts. For example, let’s assume that Lancer Company has an employee profit-sharing plan based on net income and it changed from the weighted-average inventory method to FIFO in 2014. Lancer reports higher income in 2013 and 2014 if it used the FIFO method. In addition, let’s assume that the profit-sharing plan requires that Lancer pay the incremental amount due based on the FIFO income amounts. In this situation, Lancer reports this additional expense in the current period; it would not change prior periods for this expense. If the company prepares comparative financial statements, it follows that it does not recast the prior periods for this additional expense. If the terms of the profit-sharing plan indicate that no payment is necessary in the current period due to this change, then the company need not recognize additional profit-sharing expense in the current period. Neither does it change amounts reported for prior periods. 1406 Chapter 22 Accounting Changes and Error Analysis When a company recognizes the indirect effects of a change in accounting policy, it includes in the financial statements a description of the indirect effects. In doing so, it discloses the amounts recognized in the current period and related per share information. Impracticability It is not always possible for companies to determine how they would have reported prior periods’ financial information under retrospective application of an accounting policy change. Retrospective application is considered impracticable if a company cannot determine the prior period effects using every reasonable effort to do so. Companies should not use retrospective application if one of the following condi- tions exists: 1. The company cannot determine the effects of the retrospective application. 2. Retrospective application requires assumptions about management’s intent in a prior period. 3. Retrospective application requires signifi cant estimates for a prior period, and the company cannot objectively verify the necessary information to develop these estimates. If any of the above conditions exists, it is deemed impracticable to apply the retrospec- tive approach. In this case, the company prospectively applies the new accounting policy as of the earliest date it is practicable to do so. For example, assume that Williams Company changed its accounting policy for depreciable assets so as to more fully apply component depreciation under revaluation accounting. Unfortunately, the company does not have detailed accounting records to establish a basis for the components of these assets. As a result, Williams determines it is not practicable to account for the change to full component depreciation using the retrospective application approach. It therefore applies the policy prospectively, starting at the beginning of the current year. Williams must disclose only the effect of the change on the results of operations in the period of change. Also, the company should explain the reasons for omitting the computations of the cumulative effect for prior years. Finally, it should disclose the jus- tification for the change to component depreciation. ON THE HORIZON For the most part, IFRS and GAAP are similar in the area of accounting changes and reporting the effects of errors. Thus, there is no active project in this area. A related devel- opment involves the presentation of comparative data. Under IFRS, when a company prepares financial statements on a new basis, two years of comparative data are reported. GAAP requires comparative information for a three-year period. Use of the shorter comparative data period must be addressed before U.S. companies can adopt IFRS. IFRS SELF-TEST QUESTIONS 1. Which of the following is false? (a) GAAP and IFRS have the same absolute standard regarding the reporting of error corrections in previously issued financial statements.

(b) The accounting for changes in estimates is similar between GAAP and IFRS. (c) Under IFRS, the impracticability exception applies both to changes in accounting principles and to the correction of errors. (d) GAAP has detailed guidance on the accounting and reporting of indirect effects; IFRS does not. IFRS Insights 1407 2. Which of the following is not classified as an accounting change by IFRS? (a) Change in accounting policy. (c) Errors in financial statements. (b) Change in accounting estimate. (d) None of the above. 3. IFRS requires companies to use which method for reporting changes in accounting policies? (a) Cumulative effect approach. (c) Prospective approach. (b) Retrospective approach. (d) Averaging approach. 4. Under IFRS, the retrospective approach should not be used if: (a) retrospective application requires assumptions about management’s intent in a prior period. (b) the company does not have trained staff to perform the analysis. (c) the effects of the change have counterbalanced. (d) the effects of the change have not counterbalanced. 5. Which of the following is true regarding whether IFRS specifically addresses the accounting and reporting for effects of changes in accounting policies? Direct effects Indirect effects (a) Yes Yes (b) No No (c) No Yes (d) Yes No IFRS CONCEPTS AND APPLICATION IFRS22-1 Where can authoritative IFRS related to accounting changes be found? IFRS22-2 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to reporting accounting changes. IFRS22-3 How might differences in presentation of comparative data under GAAP and IFRS affect adop- tion of IFRS by U.S. companies? IFRS22-4 What is the indirect effect of a change in accounting policy? Briefly describe the approach to reporting the indirect effects of a change in accounting policy under IFRS. IFRS22-5 Discuss how a change in accounting policy is handled when it is impracticable to determine previous amounts. IFRS22-6 Joblonsky Inc. has recently hired a new independent auditor, Karen Ogleby, who says she wants “to get everything straightened out.” Consequently, she has proposed the following accounting changes in connection with Joblonsky Inc.’s 2014 financial statements. 1. At December 31, 2013, the client had a receivable of $820,000 from Hendricks Inc. on its statement of financial position. Hendricks Inc. has gone bankrupt, and no recovery is expected. The client proposes to write off the receivable as a prior period item. 2. The client proposes the following changes in depreciation policies. (a) For office furniture and fixtures, it proposes to change from a 10-year useful life to an 8-year life. If this change had been made in prior years, retained earnings at December 31, 2013, would have been $250,000 less. The effect of the change on 2014 income alone is a reduction of $60,000. (b) For its new equipment in the leasing division, the client proposes to adopt the sum-of-the-years’- digits depreciation method. The client had never used SYD before. The first year the client oper- ated a leasing division was 2014. If straight-line depreciation were used, 2014 income would be $110,000 greater. 3. In preparing its 2013 statements, one of the client’s bookkeepers overstated ending inventory by $235,000 because of a mathematical error. The client proposes to treat this item as a prior period adjustment. 4. In the past, the client has spread preproduction costs in its furniture division over 5 years. Because its latest furniture is of the “fad” type, it appears that the largest volume of sales will occur during the first 2 years after introduction. Consequently, the client proposes to amortize preproduction costs on a per-unit basis, which will result in expensing most of such costs during the first 2 years after the furniture’s introduction. If the new accounting method had been used prior to 2014, retained earnings at December 31, 2013, would have been $375,000 less. 1408 Chapter 22 Accounting Changes and Error Analysis 5. For the nursery division, the client proposes to switch from FIFO to average-cost inventories

because it believes that average-cost will provide a better income measure. The effect of mak- ing this change on 2014 earnings will be an increase of $320,000. The client says that the effect of the change on December 31, 2013, retained earnings cannot be determined. 6. To achieve an appropriate recognition of revenues and expenses in its building construction divi- sion, the client proposes to switch from the cost-recovery method of accounting to the percentage- of-completion method. Had the percentage-of-completion method been employed in all prior years, retained earnings at December 31, 2013, would have been $1,075,000 greater. Instructions (a) For each of the changes described above, decide whether: (1) The change involves an accounting policy, accounting estimate, or correction of an error. (2) Restatement of opening retained earnings is required. (b) What would be the proper adjustment to the December 31, 2013, retained earnings? Professional Research IFRS22-7 As part of the year-end accounting process and review of operating policies, Cullen Co. is con- sidering a change in the accounting for its equipment from the straight-line method to an accelerated method. Your supervisor wonders how the company will report this change in accounting. It has been a few years since he took intermediate accounting, and he cannot remember whether this change would be treated in a retrospective or prospective manner. Your supervisor wants you to research the authoritative guidance on a change in accounting policy related to depreciation methods. Instructions Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.) (a) What are the accounting and reporting guidelines for a change in accounting policy related to depreciation methods? (b) What are the conditions that justify a change in depreciation method, as contemplated by Cullen Co.? International Financial Reporting Problem Marks and Spencer plc IFRS22-8 The financial statements of Marks and Spencer plc (M&S) are available at the book’s com- panion website or can be accessed at http://annualreport.marksandspencer.com/assets/downloads/Marks-and- Spencer-Annual-report-and-financial-statements-2012 pdf. Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions. (a) Were there changes in accounting policies reported by M&S during the two years covered by its income statements (2011–2012)? If so, describe the nature of the change and the year of change. (b) What types of estimates did M&S discuss in 2012? ANSWERS TO IFRS SELF-TEST QUESTIONS 1. a 2. c 3. b 4. a 5. d Remember to check the book’s companion website to fi nd additional resources for this chapter. This page is intentionally left blank 1 Describe the purpose of the statement of 6 Identify sources of information for a statement cash flows. of cash flows. 2 Identify the major classifications of cash flows. 7 Contrast the direct and indirect methods of calculating net cash flow from operating activities. 3 Prepare a statement of cash flows. 8 Discuss special problems in preparing a statement 4 Differentiate between net income and net cash of cash flows. flow from operating activities. 9 Explain the use of a worksheet in preparing a 5 Determine net cash flows from investing and statement of cash flows. financing activities. Show Me the Money! Investors usually look to net income as a key indicator of a company’s financial health and future prospects. The following graph shows the net income of one company over a seven-year period. The company showed a pattern of consistent profitability and even some periods of income growth. Between years 1 and 4, net income for this company grew by 32 percent, from $31 million to $41 million. Would you expect its profitability to continue? The company had consistently paid dividends and interest.

Would you expect it to continue to do so? Investors answered these questions by buying the company’s stock. Eighteen months later, this company—W. T. Grant—filed for bankruptcy, in what was then the largest bankruptcy filing in the United States. How could this happen? As indicated by the second line in the graph, the company had experienced several years of negative cash flow from its operations, even though it reported profits. How can a company have negative cash flows while reporting profits? The answer lays partly in the fact that W. T. Grant was having trouble collecting the receivables from its credit sales, causing cash flow to be less than RETPAHC 23 Statement of Cash Flows LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 Year sralloD fo snoilliM $50 40 Income 30 0 Cash Flows from Operations −30 −60 2 3 4 5 6 7 CONCEPTUAL FOCUS > See the Underlying Concepts on pages 1412 and 1437. net income. Investors who analyzed the cash flows would > Read the Evolving Issue on page 1433 for a have been likely to find an early warning signal of W. T. Grant’s discussion of the direct versus indirect method. operating problems. Investors can also look to cash flow information to sniff out INTERNATIONAL FOCUS companies that can be good buys. As one analyst stated when it comes to valuing stocks: “Show me the money!” Here’s the > See the International Perspectives on thinking behind that statement. Start with the “cash flows from pages 1413, 1415, and 1434. operations” reported in the statement of cash flows, which (as > Read the IFRS Insights on pages 1480–1485 you will learn in this chapter) consists of net income with non- for a discussion of: cash charges (like depreciation and deferred taxes) added back —Significant non-cash transactions and cash-draining events (like an inventory pile-up) taken out. —Special disclosures Now subtract capital expenditures and dividends. What you’re left with is free cash flow (as discussed in Chapter 5). Many analysts like companies trading at low multiples of their free cash flow—low, that is, in relation to rivals today or the same company in past years. Why? They know that reported earnings can be misleading. Case in point: Computer-game firm Activision Blizzard reported net income of $113 million in a recent year. But it did better than that. It took in an additional $300 million, mostly for subscriptions to online multiplayer games. It gets the cash now but records the revenue only over time, as the subscriptions run out. A couple of investment houses put this stock on their buy list on the strength of its cash flows. So watch cash flow—to get an indicator of companies headed for trouble, as well as companies that may be undervalued. Sources: Adapted from James A. Largay III and Clyde P. Stickney, “Cash Flows, Ratio Analysis, and the W. T. Grant Company Bankruptcy,” Financial Analysts Journal (July–August 1980), p. 51; and D. Fisher, “Cash Doesn’t Lie,” Forbes (April 12, 2010), pp. 52–55. As the opening story indicates, examination of W. T. Grant’s cash PREVIEW OF CHAPTER 23 flows from operations would have shown the financial inflexibility that eventually caused the company’s bankruptcy. This chapter explains the main components of a statement of cash flows and the types of information it provides. The content and organization of the chapter are as follows. Statement of Cash Flows Preparation of Illustrations—Tax Special Problems in Use of a Worksheet the Statement Consultants Statement Preparation • Usefulness of statement • Change in cash • Adjustments to net income • Preparation of worksheet • Classification of cash flows • Operating cash flows • Accounts receivable (net) • Analysis of transactions • Format of statement • Cash flows from investing • Other working capital • Preparation of final • Steps in preparation and financing changes statement • Statement of cash • Net losses flows—2013 • Significant non-cash • Illustrations—2014 transactions and 2015 • Sources of information • Indirect vs. direct method 1411 1412 Chapter 23 Statement of Cash Flows

PREPARATION OF THE STATEMENT OF CASH FLOWS The primary purpose of the statement of cash flows is to provide information LEARNING OBJECTIVE 1 about a company’s cash receipts and cash payments during a period. A secondary Describe the purpose of the statement objective is to provide cash-basis information about the company’s operating, of cash flows. investing, and financing activities. The statement of cash flows therefore reports cash receipts, cash payments, and net change in cash resulting from a company’s operat- ing, investing, and financing activities during a period. Its format reconciles the beginning and ending cash balances for the period. Usefulness of the Statement of Cash Flows See the FASB The statement of cash flows provides information to help investors, creditors, and Codification section others assess the following [1]: (page 1454). 1. The entity’s ability to generate future cash fl ows. A primary objective of fi nancial reporting is to provide information with which to predict the amounts, timing, and uncertainty of future cash fl ows. By examining relationships between items such as sales and net cash fl ow from operating activities, or net cash fl ow from Underlying Concepts operating activities and increases or decreases in cash, it is possible to better Reporting information in the predict the future cash fl ows than is possible using accrual-basis data alone. statement of cash fl ows 2. The entity’s ability to pay dividends and meet obligations. Simply put, cash contributes to meeting the is essential. Without adequate cash, a company cannot pay employees, settle objective of fi nancial reporting. debts, pay out dividends, or acquire equipment. A statement of cash fl ows indicates where the company’s cash comes from and how the company uses its cash. Employees, creditors, stockholders, and customers should be particularly interested in this statement, because it alone shows the fl ows of cash in a business. 3. The reasons for the difference between net income and net cash fl ow from operating activities. The net income number is important: It provides information on the perfor- mance of a company from one period to another. But some people are critical of accrual- basis net income because companies must make estimates to arrive at it. Such is not the case with cash. Thus, as the opening story showed, fi nancial statement readers can benefi t from knowing why a company’s net income and net cash fl ow from operating activities differ, and can assess for themselves the reliability of the income number. 4. The cash and noncash investing and fi nancing transactions during the period. Besides operating activities, companies undertake investing and fi nancing transac- tions. Investing activities include the purchase and sale of assets other than a com- pany’s products or services. Financing activities include borrowings and repayments of borrowings, investments by owners, and distributions to owners. By examining a company’s investing and fi nancing activities, a fi nancial statement reader can better understand why assets and liabilities increased or decreased during the period. For example, by reading the statement of cash fl ows, the reader might fi nd answers to the following questions: • Why did cash decrease for Home Depot when it reported net income for the period? • How much did Southwest Airlines spend on property, plant, and equipment last year? • Did dividends paid by Campbell’s Soup increase? • How much money did Coca-Cola borrow last year? • How much cash did Hewlett-Packard use to repurchase its common stock? Preparation of the Statement of Cash Flows 1413 Classifi cation of Cash Flows The statement of cash flows classifies cash receipts and cash payments by operat- 2 LEARNING OBJECTIVE ing, investing, and financing activities.1 Transactions and other events characteris- Identify the major classifications of tic of each kind of activity are as follows. cash flows. 1. Operating activities involve the cash effects of transactions that enter into the determination of net income, such as cash receipts from sales of goods and services,

and cash payments to suppliers and employees for acquisitions of inventory and expenses. 2. Investing activities generally involve long-term assets and include (a) making and collecting loans, and (b) acquiring and disposing of investments and productive long-lived assets. 3. Financing activities involve liability and stockholders’ equity items and include (a) obtaining cash from creditors and repaying the amounts borrowed, and (b) obtain- ing capital from owners and providing them with a return on, and a return of, their investment. Illustration 23-1 classifies the typical cash receipts and payments of a company according to operating, investing, and financing activities. The operating activities category is the most important. It shows the cash provided by company operations. This source of cash is generally considered to be the best measure of a company’s ability to generate enough cash to continue as a going concern. ILLUSTRATION 23-1 Operating ⎫ Classifi cation of Typical Cash inflows ⎪ From sales of goods or services. ⎪ Cash Infl ows and From returns on loans (interest) and on equity ⎪ Outfl ows ⎪ securities (dividends). ⎪ Income Cash outflows ⎬ Statement To suppliers for inventory. ⎪ Items ⎪ To employees for services. ⎪ To government for taxes. ⎪ To lenders for interest. ⎪ To others for expenses. ⎭ Investing ⎫ Cash inflows ⎪ From sale of property, plant, and equipment. ⎪ ⎪ From sale of debt or equity securities of other entities. Generally ⎪ From collection of principal on loans to other entities. ⎬ Long-Term Cash outflows ⎪ Asset Items To purchase property, plant, and equipment. ⎪ ⎪ To purchase debt or equity securities of other entities. ⎪ To make loans to other entities. ⎭ Financing ⎫ Cash inflows ⎪ Generally ⎪ From sale of equity securities. Long-Term ⎪ From issuance of debt (bonds and notes). ⎬ Liability Cash outflows ⎪ and Equity ⎪ International To stockholders as dividends. ⎪ Items To redeem long-term debt or reacquire capital stock. ⎭ Perspective According to IFRS, companies 1The basis recommended by the FASB for the statement of cash flows is actually “cash and can defi ne “cash and cash cash equivalents.” Cash equivalents are short-term, highly liquid investments that are both equivalents” as “net (a) readily convertible to known amounts of cash, and (b) so near their maturity that they monetary assets”—that is, present insignificant risk of changes in interest rates. Generally, only investments with as “cash and demand original maturities of three months or less qualify under this definition. Examples of cash equivalents are Treasury bills, commercial paper, and money market funds purchased with deposits and highly liquid cash that is in excess of immediate needs. investments less short-term Although we use the term “cash” throughout our discussion and illustrations, we mean cash borrowings.” and cash equivalents when reporting the cash flows and the net increase or decrease in cash. 1414 Chapter 23 Statement of Cash Flows Note the following general guidelines about the classification of cash flows. 1. Operating activities involve income statement items. 2. Investing activities involve cash fl ows resulting from changes in investments and long-term asset items. 3. Financing activities involve cash fl ows resulting from changes in long-term liability and stockholders’ equity items. Companies classify some cash flows relating to investing or financing activities as operating activities.2 For example, companies classify receipts of investment income (in- terest and dividends) and payments of interest to lenders as operating activities. Why are these considered operating activities? Companies report these items in the income statement, where the results of operations are shown. Conversely, companies classify some cash flows relating to operating activities as investing or financing activities. For example, a company classifies the cash received from the sale of property, plant, and equipment at a gain, although reported in the in- come statement, as an investing activity. It excludes the effects of the related gain in net

cash flow from operating activities. Likewise, a gain or loss on the payment (extinguish- ment) of debt is generally part of the cash outflow related to the repayment of the amount borrowed. It therefore is a financing activity. What do the numbers mean? HOW’S MY CASH FLOW? To evaluate overall cash fl ow, it is useful to understand shows, the pattern of cash fl ows from operating, fi nancing, where in the product life cycle a company is. Generally, com- and investing activities will vary depending on the stage of panies move through several stages of development, which the product life cycle. have implications for cash fl ow. As the following graph Introductory Growth In the introductory phase, the product is likely not gener- product off the ground, cash fl ow from investment is nega- ating much revenue (operating cash fl ow is negative). Be- tive, and fi nancing cash fl ows are positive. cause the company is making heavy investments to get a 2Banks and brokers must classify cash flows from purchases and sales of loans and securities specifically for resale and carried at fair value as operating activities. This requirement recognizes that for these firms these assets are similar to inventory in other businesses. [2] evitisoP evitageN Maturity Phase wolF hsaC Financing Operating Investing Decline Preparation of the Statement of Cash Flows 1415 As the product moves to the growth and maturity phases, investments needed to support the product, and less cash is these cash fl ow relationships reverse. The product generates needed from fi nancing. So is a negative operating cash fl ow more cash fl ow from operations, which can be used to cover bad? Not always. It depends on the product life cycle. Source: Adapted from Paul D. Kimmel, Jerry J. Weygandt, and Donald E. Kieso, Financial Accounting: Tools for Business Decision Making, 6th ed. (New York: John Wiley & Sons, 2011), p. 628. Format of the Statement of Cash Flows The three activities we discussed above constitute the general format of the statement of cash flows. The operating activities section always appears first. It is followed by the investing activities section and then the financing activities section. A company reports the individual inflows and outflows from investing and financ- ing activities separately. That is, a company reports them gross, not netted against one another. Thus, a cash outflow from the purchase of property is reported separately from the cash inflow from the sale of property. Similarly, a cash inflow from the issuance of debt is reported separately from the cash outflow from its retirement. The net increase or decrease in cash reported during the period should reconcile the beginning and ending cash balances as reported in the comparative balance sheets. The general format of the statement of cash flows presents the results of the three activities discussed previously–operating, investing, and financing. Illustration 23-2 shows a widely used form of the statement of cash flows. ILLUSTRATION 23-2 COMPANY NAME Format of the Statement STATEMENT OF CASH FLOWS of Cash Flows PERIOD COVERED Cash flows from operating activities Net income XXX Adjustments to reconcile net income to net cash provided (used) by operating activities: (List of individual items) XX XX Net cash provided (used) by operating activities XXX Cash flows from investing activities (List of individual inflows and outflows) XX Net cash provided (used) by investing activities XXX International Cash flows from financing activities Perspective (List of individual inflows and outflows) XX Net cash provided (used) by financing activities XXX Both IFRS and GAAP specify Net increase (decrease) in cash XXX that companies must classify Cash at beginning of period XXX cash fl ows as operating, Cash at end of period XXX investing, or fi nancing. Steps in Preparation Companies prepare the statement of cash flows differently from the three other basic financial statements. For one thing, it is not prepared from an adjusted trial balance. The cash flow statement requires detailed information concerning the changes in account

balances that occurred between two points in time. An adjusted trial balance will not provide the necessary data. Second, the statement of cash flows deals with cash receipts and payments. As a result, the company must adjust the effects of the use of accrual 1416 Chapter 23 Statement of Cash Flows accounting to determine cash flows. The information to prepare this statement usually comes from three sources: 1. Comparative balance sheets provide the amount of the changes in assets, liabilities, and equities from the beginning to the end of the period. 2. Current income statement data help determine the amount of cash provided by or used by operations during the period. 3. Selected transaction data from the general ledger provide additional detailed infor- mation needed to determine how the company provided or used cash during the period. Preparing the statement of cash flows from the data sources above involves three major steps: Step 1. Determine the change in cash. This procedure is straightforward. A com- pany can easily compute the difference between the beginning and the ending cash balance from examining its comparative balance sheets. Step 2. Determine the net cash fl ow from operating activities. This procedure is complex. It involves analyzing not only the current year’s income statement but also comparative balance sheets as well as selected transaction data. Step 3. Determine net cash fl ows from investing and fi nancing activities. A com- pany must analyze all other changes in the balance sheet accounts to determine their effects on cash. On the following pages, we work through these three steps in the process of prepar- ing the statement of cash flows for Tax Consultants Inc. over several years. ILLUSTRATIONS—TAX CONSULTANTS INC. We show the steps in preparing the statement of cash flows using data for Tax LEARNING OBJECTIVE 3 Consultants Inc. To begin, we use the first year of operations for Tax Consultants Inc. Prepare a statement of cash flows. The company started on January 1, 2013, when it issued 60,000 shares of $1 par value common stock for $60,000 cash. The company rented its office space, furniture, and equip- ment, and performed tax consulting services throughout the first year. The comparative balance sheets at the beginning and end of the year 2013 appear in Illustration 23-3. ILLUSTRATION 23-3 TAX CONSULTANTS INC. Comparative Balance COMPARATIVE BALANCE SHEETS Sheets, Tax Consultants Inc., Year 1 Change Assets Dec. 31, 2013 Jan. 1, 2013 Increase/Decrease Cash $49,000 $–0– $49,000 Increase Accounts receivable 36,000 –0– 36,000 Increase Total $85,000 $–0– Liabilities and Stockholders’ Equity Accounts payable $ 5,000 $–0– $ 5,000 Increase Common stock ($1 par) 60,000 –0– 60,000 Increase Retained earnings 20,000 –0– 20,000 Increase Total $85,000 $–0– Illustration 23-4 shows the income statement and additional information for Tax Consultants. Illustrations—Tax Consultants Inc. 1417 ILLUSTRATION 23-4 TAX CONSULTANTS INC. Income Statement, Tax INCOME STATEMENT Consultants Inc., Year 1 FOR THE YEAR ENDED DECEMBER 31, 2013 Revenues $125,000 Operating expenses 85,000 Income before income taxes 40,000 Income tax expense 6,000 Net income $ 34,000 Additional Information Examination of selected data indicates that a dividend of $14,000 was declared and paid during the year. Step 1: Determine the Change in Cash To prepare a statement of cash flows, the first step is to determine the change in cash. This is a simple computation. Tax Consultants had no cash on hand at the beginning of the year 2013. It had $49,000 on hand at the end of 2013. Thus, cash changed (increased) in 2013 by $49,000. Step 2: Determine Net Cash Flow from Operating Activities To determine net cash flow from operating activities,3 companies adjust net income 4 LEARNING OBJECTIVE in numerous ways. A useful starting point is to understand why net income must Differentiate between net income and be converted to net cash provided by operating activities. net cash flow from operating activities. Under generally accepted accounting principles, most companies use the

accrual basis of accounting. As you have learned, this basis requires that companies record revenue when a performance obligation is met and record expenses when incurred. Revenues may include credit sales for which the company has not yet collected cash. Expenses incurred may include some items that the company has not yet paid in cash. Thus, under the accrual basis of accounting, net income is not the same as net cash flow from operating activities. To arrive at net cash flow from operating activities, a company must determine reve- nues and expenses on a cash basis. It does this by eliminating the effects of income state- ment transactions that do not result in an increase or decrease in cash. Illustration 23-5 shows the relationship between net income and net cash flow from operating activities. ILLUSTRATION 23-5 Net Income versus Net Recognized Cash Flow from Eliminate noncash revenues revenues Operating Activities Net Net cash flow from income operating activities Incurred Eliminate noncash expenses expenses 3“Net cash flow from operating activities” is a generic phrase, replaced in the statement of cash flows with either “Net cash provided by operating activities” if operations increase cash, or “Net cash used by operating activities” if operations decrease cash. 1418 Chapter 23 Statement of Cash Flows In this chapter, we use the term net income to refer to accrual-based net income. A company may convert net income to net cash flow from operating activities through either a direct method or an indirect method. Due to its widespread use in practice, in the following sections we illustrate use of the indirect method. Later in the chapter, we describe the direct method and discuss the advantages and disadvantages of the two methods.4 The indirect method (or reconciliation method) starts with net income and con- verts it to net cash flow from operating activities. In other words, the indirect method adjusts net income for items that affected reported net income but did not affect cash. To compute net cash flow from operating activities, a company adds back noncash charges in the income statement to net income and deducts noncash credits. We explain the two adjustments to net income for Tax Consultants, namely, the increases in accounts receivable and accounts payable, as follows. Increase in Accounts Receivable—Indirect Method Tax Consultants’ accounts receivable increased by $36,000 (from $0 to $36,000) during the year. For Tax Consultants, this means that cash receipts were $36,000 lower than revenues. The Accounts Receivable account in Illustration 23-6 shows that Tax Consul- tants had $125,000 in revenues (as reported on the income statement), but it collected only $89,000 in cash. ILLUSTRATION 23-6 Accounts Receivable Analysis of Accounts 1/1/13 Balance –0– Receipts from customer 89,000 Receivable Revenues 125,000 12/31/13 Balance 36,000 As shown in Illustration 23-7, to adjust net income to net cash provided by operat- ing activities, Tax Consultants must deduct the increase of $36,000 in accounts receiv- able from net income. When the Accounts Receivable balance decreases, cash receipts are higher than revenue recognized under the accrual basis. Therefore, the company adds to net income the amount of the decrease in accounts receivable to arrive at net cash provided by operating activities. Increase in Accounts Payable—Indirect Method When accounts payable increase during the year, expenses on an accrual basis exceed those on a cash basis. Why? Because Tax Consultants incurred expenses, but some of the expenses are not yet paid. To convert net income to net cash flow from operating activities, Tax Consultants must add back the increase of $5,000 in accounts payable to net income. As a result of the accounts receivable and accounts payable adjustments, Tax Con- sultants determines net cash provided by operating activities is $3,000 for the year 2013. Illustration 23-7 shows this computation. 4Accounting Trends and Techniques—2012 reports that out of its 500 surveyed companies, 495 (99 percent) used the indirect method, and only 5 used the direct method. In doing homework

assignments, you should follow instructions for use of either the direct or indirect method. Illustrations—Tax Consultants Inc. 1419 ILLUSTRATION 23-7 Net income $ 34,000 Computation of Net Adjustments to reconcile net income to net Cash Flow from cash provided by operating activities: Increase in accounts receivable $(36,000) Operating Activities, Increase in accounts payable 5,000 (31,000) Year 1—Indirect Method Net cash provided by operating activities $ 3,000 What do the numbers mean? EARNINGS AND CASH FLOW MANAGEMENT? Investors must be vigilant in their monitoring of manage- discussed in this section, decreases in accounts receivable ment incentives to manipulate both earnings and cash fl ows. increase cash fl ow from operations. So while it appeared that That is, fi nancial success is dependent not only on a com- Federated’s core operations had improved, the company pany’s ability to generate revenues and earnings, but also cash really did little more than accelerate collections of its receiv- fl ow. A company that shows profi ts but is unable to generate ables. In fact, the cash fl ow from the securitizations repre- cash will also experience waning investor enthusiasm. sented more than half of Federated’s operating cash fl ow. Thus, management has an incentive to make operating Similarly, companies may time the recognition of noncash cash fl ow look good because Wall Street has paid a premium gains to mask cash fl ow problems. Take the example of for companies that generate a lot of cash from operations, Chesapeake Energy Corp. In a recent quarter, Chesapeake, rather than through borrowings. However, similar to earn- the second-largest U.S. gas producer, reported a $929 million ings, companies have ways to pump up cash fl ow from net profi t, nearly double from a year earlier. These results operations. seem pretty good until you take a closer look. Falling com- One way that companies can boost their operating cash modity prices for natural gas resulted in a 45 percent fl ow is by “securitizing” receivables. That is, companies can decrease in Chesapeake’s operating cash fl ow. To plug the speed up cash collections by selling their receivables. For hole in its bottom line, the company sold pipeline assets. As example, Federated Department Stores reported a $2.2 billion a result, all but $3 million of its net income came from these increase in cash fl ow from operations. This seems impressive sales and other noncash gains. Thus, in evaluating the quality until you read the fi ne print, which indicates that a big of accounting, investors must keep an eye on the quality of part of the increase was due to the sale of receivables. As earnings and cash fl ows. Source: Adapted from Ann Tergesen, “Cash Flow Hocus Pocus,” BusinessWeek (July 16, 2002), pp. 130–131. See also C. Mulford and A. Lopez de Mesa, Cash Flow Trends and Their Fundamental Drivers: Comprehensive Industry Review, Georgia Tech Financial Analysis Lab (October 2, 2012); and D. Gilbert, “Chesapeake Plans Increase in Asset Sales as Net Rises,” Wall Street Journal (August 6, 2012). Step 3: Determine Net Cash Flows from Investing and Financing Activities After Tax Consultants has computed the net cash provided by operating activities, 5 LEARNING OBJECTIVE the next step is to determine whether any other changes in balance sheet accounts Determine net cash flows from caused an increase or decrease in cash. investing and financing activities. For example, an examination of the remaining balance sheet accounts for Tax Consultants shows increases in both common stock and retained earnings. The common stock increase of $60,000 resulted from the issuance of common stock for cash. The issu- ance of common stock is reported in the statement of cash flows as a receipt of cash from a financing activity. Two items caused the retained earnings increase of $20,000: 1. Net income of $34,000 increased retained earnings. 2. Declaration of $14,000 of dividends decreased retained earnings. 1420 Chapter 23 Statement of Cash Flows Tax Consultants has converted net income into net cash flow from operating activi-

ties, as explained earlier. The additional data indicate that it paid the dividend. Thus, the company reports the dividend payment as a cash outflow, classified as a financing activity. Statement of Cash Flows—2013 We are now ready to prepare the statement of cash flows. The statement starts with the operating activities section. Tax Consultants uses the indirect method to report net cash flow from operating activities. Illustration 23-8 shows the statement of cash flows for Tax Consultants Inc., for year 1 (2013). ILLUSTRATION 23-8 TAX CONSULTANTS INC. Statement of Cash Flows, STATEMENT OF CASH FLOWS Tax Consultants Inc., FOR THE YEAR ENDED DECEMBER 31, 2013 Year 1 Cash flows from operating activities Net income $ 34,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable $(36,000) Increase in accounts payable 5,000 (31,000) Net cash provided by operating activities 3,000 Cash flows from financing activities Issuance of common stock 60,000 Payment of cash dividends (14,000) Net cash provided by financing activities 46,000 Net increase in cash 49,000 Cash, January 1, 2013 –0– Cash, December 31, 2013 $ 49,000 As indicated, the $60,000 increase in common stock results in a financing activity cash inflow. The payment of $14,000 in cash dividends is a financing activity outflow of cash. The $49,000 increase in cash reported in the statement of cash flows agrees with the increase of $49,000 shown in the comparative balance sheets as the change in the Cash account. Illustration—2014 Tax Consultants Inc. continued to grow and prosper in its second year of operations. The company purchased land, building, and equipment, and revenues and net income increased substantially over the first year. Illustrations 23-9 and 23-10 present informa- tion related to the second year of operations for Tax Consultants Inc. Step 1: Determine the Change in Cash To prepare a statement of cash flows from the available information, the first step is to determine the change in cash. As indicated from the information presented, cash decreased $12,000 ($49,000 2 $37,000). Illustrations—Tax Consultants Inc. 1421 ILLUSTRATION 23-9 TAX CONSULTANTS INC. Comparative Balance COMPARATIVE BALANCE SHEETS Sheets, Tax Consultants AS OF DECEMBER 31 Inc., Year 2 Change Assets 2014 2013 Increase/Decrease Cash $ 37,000 $ 49,000 $ 12,000 Decrease Accounts receivable 26,000 36,000 10,000 Decrease Prepaid expenses 6,000 –0– 6,000 Increase Land 70,000 –0– 70,000 Increase Buildings 200,000 –0– 200,000 Increase Accumulated depreciation—buildings (11,000) –0– 11,000 Increase Equipment 68,000 –0– 68,000 Increase Accumulated depreciation—equipment (10,000) –0– 10,000 Increase Total $386,000 $ 85,000 Liabilities and Stockholders’ Equity Accounts payable $ 40,000 $ 5,000 $ 35,000 Increase Bonds payable 150,000 –0– 150,000 Increase Common stock ($1 par) 60,000 60,000 –0– Retained earnings 136,000 20,000 116,000 Increase Total $386,000 $ 85,000 ILLUSTRATION 23-10 TAX CONSULTANTS INC. Income Statement, Tax INCOME STATEMENT Consultants Inc., Year 2 FOR THE YEAR ENDED DECEMBER 31, 2014 Revenues $492,000 Operating expenses (excluding depreciation) $269,000 Depreciation expense 21,000 290,000 Income from operations 202,000 Income tax expense 68,000 Net income $134,000 Additional Information (a) The company declared and paid an $18,000 cash dividend. (b) The company obtained $150,000 cash through the issuance of long-term bonds. (c) Land, building, and equipment were acquired for cash. Step 2: Determine Net Cash Flow from Operating Activities—Indirect Method Using the indirect method, we adjust net income of $134,000 on an accrual basis to arrive at net cash flow from operating activities. Explanations for the adjustments to net income follow. Decrease in Accounts Receivable. Accounts receivable decreased during the period because cash receipts (cash-basis revenues) are higher than revenues reported on an accrual basis. To convert net income to net cash flow from operating activities, the decrease of $10,000 in accounts receivable must be added to net income.

Increase in Prepaid Expenses. When prepaid expenses (assets) increase during a period, expenses on an accrual-basis income statement are lower than they are on a cash-basis income statement. The reason: Tax Consultants has made cash payments in the current period, but expenses (as charges to the income statement) have been deferred to future periods. To convert net income to net cash flow from operating activities, the company must deduct from net income the increase of $6,000 in prepaid expenses. An increase in prepaid expenses results in a decrease in cash during the period. 1422 Chapter 23 Statement of Cash Flows Increase in Accounts Payable. Like the increase in 2013, Tax Consultants must add the 2014 increase of $35,000 in accounts payable to net income, to convert to net cash flow from operating activities. The company incurred a greater amount of expense than the amount of cash it disbursed. Depreciation Expense (Increase in Accumulated Depreciation). The purchase of depre- ciable assets is a use of cash, shown in the investing section in the year of acquisition. Tax Consultants’ depreciation expense of $21,000 (also represented by the increase in accumulated depreciation) is a noncash charge; the company adds it back to net income, to arrive at net cash flow from operating activities. The $21,000 is the sum of the $11,000 depreciation on the building plus the $10,000 depreciation on the equipment. Certain other periodic charges to expense do not require the use of cash. Examples are the amortization of intangible assets and depletion expense. Such charges are treated in the same manner as depreciation. Companies frequently list depreciation and similar noncash charges as the first adjustments to net income in the statement of cash flows. As a result of the foregoing items, net cash provided by operating activities is $194,000 as shown in Illustration 23-11. ILLUSTRATION 23-11 Net income $134,000 Computation of Net Adjustments to reconcile net income to Cash Flow from net cash provided by operating activities: Operating Activities, Depreciation expense $21,000 Year 2—Indirect Method Decrease in accounts receivable 10,000 Increase in prepaid expenses (6,000) Increase in accounts payable 35,000 60,000 Net cash provided by operating activities $194,000 Step 3: Determine Net Cash Flows from Investing and Financing Activities After you have determined the items affecting net cash provided by operating activities, the next step involves analyzing the remaining changes in balance sheet accounts. Tax Consultants Inc. analyzed the following accounts. Increase in Land. As indicated from the change in the Land account, the company purchased land of $70,000 during the period. This transaction is an investing activity, reported as a use of cash. Increase in Buildings and Related Accumulated Depreciation. As indicated in the additional data and from the change in the Buildings account, Tax Consultants acquired an office building using $200,000 cash. This transaction is a cash outflow, reported in the investing section. The $11,000 increase in accumulated depreciation results from record- ing depreciation expense on the building. As indicated earlier, the reported depreciation expense has no effect on the amount of cash. Increase in Equipment and Related Accumulated Depreciation. An increase in equip- ment of $68,000 resulted because the company used cash to purchase equipment. This transaction is an outflow of cash from an investing activity. The depreciation expense entry for the period explains the increase in Accumulated Depreciation—Equipment. Increase in Bonds Payable. The Bonds Payable account increased $150,000. Cash received from the issuance of these bonds represents an inflow of cash from a financing activity. Illustrations—Tax Consultants Inc. 1423 Increase in Retained Earnings. Retained earnings increased $116,000 during the year. Two factors explain this increase. (1) Net income of $134,000 increased retained earn- ings, and (2) dividends of $18,000 decreased retained earnings. As indicated earlier, the

company adjusts net income to net cash provided by operating activities in the operat- ing activities section. Payment of the dividends is a financing activity that involves a cash outflow. Statement of Cash Flows—2014 Combining the foregoing items, we get a statement of cash flows for 2014 for Tax Consultants Inc., using the indirect method to compute net cash flow from operating activities. ILLUSTRATION 23-12 TAX CONSULTANTS INC. Statement of Cash Flows, STATEMENT OF CASH FLOWS Tax Consultants Inc., FOR THE YEAR ENDED DECEMBER 31, 2014 Year 2 Cash flows from operating activities Net income $ 134,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $ 21,000 Decrease in accounts receivable 10,000 Increase in prepaid expenses (6,000) Increase in accounts payable 35,000 60,000 Net cash provided by operating activities 194,000 Cash flows from investing activities Purchase of land (70,000) Purchase of building (200,000) Purchase of equipment (68,000) Net cash used by investing activities (338,000) Cash flows from financing activities Issuance of bonds 150,000 Payment of cash dividends (18,000) Net cash provided by financing activities 132,000 Net decrease in cash (12,000) Cash, January 1, 2014 49,000 Cash, December 31, 2014 $ 37,000 Illustration—2015 Our third example, covering the 2015 operations of Tax Consultants Inc., is more complex. It again uses the indirect method to compute and present net cash flow from operating activities. Tax Consultants Inc. experienced continued success in 2015 and expanded its operations to include the sale of computer software used in tax-return preparation and tax planning. Thus, inventory is a new asset appearing in the company’s December 31, 2015, balance sheet. Illustrations 23-13 and 23-14 (on page 1424) show the comparative balance sheets, income statements, and selected data for 2015. Step 1: Determine the Change in Cash The first step in the preparation of the statement of cash flows is to determine the change in cash. As the comparative balance sheets show, cash increased $17,000 in 2015. 1424 Chapter 23 Statement of Cash Flows ILLUSTRATION 23-13 TAX CONSULTANTS INC. Comparative Balance COMPARATIVE BALANCE SHEETS Sheets, Tax Consultants AS OF DECEMBER 31 Inc., Year 3 Change Assets 2015 2014 Increase/Decrease Cash $ 54,000 $ 37,000 $ 17,000 Increase Accounts receivable 68,000 26,000 42,000 Increase Inventory 54,000 –0– 54,000 Increase Prepaid expenses 4,000 6,000 2,000 Decrease Land 45,000 70,000 25,000 Decrease Buildings 200,000 200,000 –0– Accumulated depreciation—buildings (21,000) (11,000) 10,000 Increase Equipment 193,000 68,000 125,000 Increase Accumulated depreciation—equipment (28,000) (10,000) 18,000 Increase Totals $569,000 $386,000 Liabilities and Stockholders’ Equity Accounts payable $ 33,000 $ 40,000 $ 7,000 Decrease Bonds payable 110,000 150,000 40,000 Decrease Common stock ($1 par) 220,000 60,000 160,000 Increase Retained earnings 206,000 136,000 70,000 Increase Totals $569,000 $386,000 ILLUSTRATION 23-14 TAX CONSULTANTS INC. Income Statement, Tax INCOME STATEMENT Consultants Inc., Year 3 FOR THE YEAR ENDED DECEMBER 31, 2015 Revenues $890,000 Cost of goods sold $465,000 Operating expenses 221,000 Interest expense 12,000 Loss on sale of equipment 2,000 700,000 Income from operations 190,000 Income tax expense 65,000 Net income $125,000 Additional Information (a) Operating expenses include depreciation expense of $33,000 and expiration of prepaid expenses of $2,000. (b) Land was sold at its book value for cash. (c) Cash dividends of $55,000 were declared and paid. (d) Interest expense of $12,000 was paid in cash. (e) Equipment with a cost of $166,000 was purchased for cash. Equipment with a cost of $41,000 and a book value of $36,000 was sold for $34,000 cash. (f) Bonds were redeemed at their book value for cash. (g) Common stock ($1 par) was issued for cash. Step 2: Determine Net Cash Flow from Operating Activities—Indirect Method We explain the adjustments to net income of $125,000 as follows. Increase in Accounts Receivable. The increase in accounts receivable of $42,000 repre-

sents recorded accrual-basis revenues in excess of cash collections in 2015. The company deducts this increase from net income to convert from the accrual basis to the cash basis. Increase in Inventory. The $54,000 increase in inventory represents an operating use of cash, not an expense. Tax Consultants therefore deducts this amount from net income, Illustrations—Tax Consultants Inc. 1425 to arrive at net cash flow from operations. In other words, when inventory purchased exceeds inventory sold during a period, cost of goods sold on an accrual basis is lower than on a cash basis. Decrease in Prepaid Expenses. The $2,000 decrease in prepaid expenses represents a charge to the income statement for which Tax Consultants made no cash payment in the current period. The company adds back the decrease to net income, to arrive at net cash flow from operating activities. Decrease in Accounts Payable. When accounts payable decrease during the year, cost of goods sold and expenses on a cash basis are higher than they are on an accrual basis. To convert net income to net cash flow from operating activities, the company must deduct the $7,000 in accounts payable from net income. Depreciation Expense (Increase in Accumulated Depreciation). Accumulated Deprecia- tion—Buildings increased $10,000 ($21,000 2 $11,000). The Buildings account did not change during the period, which means that Tax Consultants recorded depreciation expense of $10,000 in 2015. Accumulated Depreciation—Equipment increased by $18,000 ($28,000 2 $10,000) during the year. But Accumulated Depreciation—Equipment decreased by $5,000 as a result of the sale during the year. Thus, depreciation for the year was $23,000. The company reconciled Accumulated Depreciation—Equipment as follows. Beginning balance $10,000 Add: Depreciation for 2015 23,000 33,000 Deduct: Sale of equipment 5,000 Ending balance $28,000 The company must add back to net income the total depreciation of $33,000 ($10,000 1 $23,000) charged to the income statement, to determine net cash flow from operating activities. Loss on Sale of Equipment. Tax Consultants Inc. sold for $34,000 equipment that cost $41,000 and had a book value of $36,000. As a result, the company reported a loss of $2,000 on its sale. To arrive at net cash flow from operating activities, it must add back to net in- come the loss on the sale of the equipment. The reason is that the loss is a noncash charge to the income statement. The loss did not reduce cash, but it did reduce net income.5 From the foregoing items, the company prepares the operating activities section of the statement of cash flows, as shown in Illustration 23-15. ILLUSTRATION 23-15 Cash flows from operating activities Operating Activities Net income $125,000 Section of Cash Flow Adjustments to reconcile net income to net cash provided by operating activities: Statement Depreciation expense $ 33,000 Loss on sale of equipment 2,000 Increase in accounts receivable (42,000) Increase in inventory (54,000) Decrease in prepaid expenses 2,000 Decrease in accounts payable (7,000) (66,000) Net cash provided by operating activities 59,000 5A similar adjustment is required for unrealized gains or losses recorded on trading security investments or other financial assets and liabilities accounted for under the fair value option. Marking these assets and liabilities to fair value results in an increase or decrease in income, but there is no effect on cash flows. 1426 Chapter 23 Statement of Cash Flows Step 3: Determine Net Cash Flows from Investing and Financing Activities By analyzing the remaining changes in the balance sheet accounts, Tax Consultants identifies cash flows from investing and financing activities. Land. Land decreased $25,000 during the period. As indicated from the information presented, the company sold land for cash at its book value. This transaction is an investing activity, reported as a $25,000 source of cash. Equipment. An analysis of the Equipment account indicates the following. Beginning balance $ 68,000 Purchase of equipment 166,000 234,000

Deduct: Sale of equipment 41,000 Ending balance $193,000 The company used cash to purchase equipment with a fair value of $166,000—an investing transaction reported as a cash outflow. The sale of the equipment for $34,000 is also an investing activity, but one that generates a cash inflow. Bonds Payable. Bonds payable decreased $40,000 during the year. As indicated from the additional information, the company redeemed the bonds at their book value. This financing transaction used $40,000 of cash. Common Stock. The Common Stock account increased $160,000 during the year. As indicated from the additional information, Tax Consultants issued common stock of $160,000 at par. This financing transaction provided cash of $160,000. Retained Earnings. Retained earnings changed $70,000 ($206,000 2 $136,000) during the year. The $70,000 change in retained earnings results from net income of $125,000 from operations and the financing activity of paying cash dividends of $55,000. Statement of Cash Flows—2015 Tax Consultants Inc. combines the foregoing items to prepare the statement of cash flows shown in Illustration 23-16. Sources of Information for the Statement of Cash Flows Important points to remember in the preparation of the statement of cash flows are LEARNING OBJECTIVE 6 these: Identify sources of information for a statement of cash flows. 1. Comparative balance sheets provide the basic information from which to prepare the report. Additional information obtained from analyses of specifi c accounts is also included. 2. An analysis of the Retained Earnings account is necessary. The net increase or decrease in Retained Earnings without any explanation is a meaningless amount in the statement. Without explanation, it might represent the effect of net income, dividends declared, or prior period adjustments. 3. The statement includes all changes that have passed through cash or have resulted in an increase or decrease in cash. 4. Write-downs, amortization charges, and similar “book” entries, such as deprecia- tion of plant assets, represent neither infl ows nor outfl ows of cash because they have no effect on cash. To the extent that they have entered into the determination of net income, however, the company must add them back to or subtract them from net income, to arrive at net cash provided (used) by operating activities. Illustrations—Tax Consultants Inc. 1427 ILLUSTRATION 23-16 TAX CONSULTANTS INC. Statement of Cash Flows, STATEMENT OF CASH FLOWS Tax Consultants Inc., FOR THE YEAR ENDED DECEMBER 31, 2015 Year 3 Cash flows from operating activities Net income $ 125,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $ 33,000 Loss on sale of equipment 2,000 Increase in accounts receivable (42,000) Increase in inventory (54,000) Decrease in prepaid expenses 2,000 Decrease in accounts payable (7,000) (66,000) Net cash provided by operating activities 59,000 Cash flows from investing activities Sale of land 25,000 Sale of equipment 34,000 Purchase of equipment (166,000) Net cash used by investing activities (107,000) Cash flows from financing activities Redemption of bonds (40,000) Sale of common stock 160,000 Payment of dividends (55,000) Net cash provided by financing activities 65,000 Net increase in cash 17,000 Cash, January 1, 2015 37,000 Cash, December 31, 2015 $ 54,000 Indirect Method—Additional Adjustments For consistency and comparability and because it is the most widely used method in practice, we used the indirect method in the Tax Consultants’ illustrations. We deter- mined net cash flow from operating activities by adding back to or deducting from net income those items that had no effect on cash. Illustration 23-17 presents a more complete set of common adjustments that companies make to net income to arrive at net cash flow from operating activities. ILLUSTRATION 23-17 Net Income Adjustments Needed to Additions Deductions Determine Net Cash Depreciation expense Amortization of bond premium Flow from Operating Amortization of intangibles and deferred charges Decrease in deferred income tax liability Activities—Indirect