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Homework answers / question archive / AC Co
AC Co. began Operations in 2001 and have never been audited. You have been hired to audit their 12/31/04 financial statements. The books are kept on a cash basis. In the past the bookkeeper has prepared the tax return on the same basis as the books, thus no temporary differences were recognized. You are, therefore, assuming that the same errors were made on the tax return and will be corrected by amended returns, except the temporary differences created by the Warranty expense, unreal gain/loss on trading securities, and the real gain/loss on available for sale securities. The tax rate is 30% for all 4 yrs and it is more likely than not that AC Co. will be profitable in the future.
Prepare correcting entries for the following, rounding to the nearest dollar:
1) Ending inventory was misstated at the end of each year as follows:
2001- 30,000 overstated
2002- 25,000 overstated
2003- 27,000 overstated
2004- 23,123 understated
2) On 7/1/2003 the company accepted a $24,232 non-interest bearing note from a customer in settlement of an overdue accounts receivable. The note requires 4 equal payments of $6,058 every 6 months beginning on 12/31/03. The annual market rate of interest is 10% (use effective intereste rate method). The bookkeeper made the following entries:
7/1/03 Notes Receivable 24,232
Accounts Receivable PV of PMTs ($21,481)
Gain on Note Receivable Difference ( $2,751)
12/31/03 Cash 6,058
Note Receivable 6058
6/30/04 & 12/31/04- Same as above
3) You discover that delivery equipment costing $39,900 on 01/01/01 has been depreciated (including 04)as if it were display equipment (display equipment is depreciated using 5 yr. life, no salvage value, straight-line depreciation). Delivery equipment is depreciated using 5 yr, 20% salvage value, SYD method. You decide to account for this as a change in accounting estimate, not as an error.
4) The 10 yr, 10%, $399,000 face value bonds were issued on 01/01/02. The proceeds of $400,000 were used to acquire the current store building. The interest payments (on 6/30 and 12/31 each yr.) have been debited to Interest Expense-Bonds. Since the difference between straight-line and effective-interest amortization of the premium will be immaterial you decide to use straight-line amortization. Each $1000 bond is convertible into 75 Shares of AC Co. Stock.
5) On 01/01/03 the company leased some display equipment from XYZ leasing for 5 yrs. The lease calls for 5 equal payments of $14,232 at 01/01/03, 01/01/04, 05, 06, & 07. The first and second payments were debited to lease expense. Since the lease is for 100% of the estimated life, you decide the lease should be capitalized and depreciated in accordance to normal policy for display equipment (display equipment is depreciated using 5 yr. life, no salvage value, straight-line depreciation). An appropriate interest rate is 10% for a lease of this type.
1. For purposes of the audit, you will only correct 2004. Any errors or adjustments that effect any of the prior years will be lumped into prior period adjustments as one amount. Amended tax returns by year are another story, but we are only concerned with 2004. Note there would not be comparable statements to the prior year because it was not audited or reviewed by an outside CPA. Since ending inventory is a cumulative account, we only have to deal with the 2004 misstatement. You would debit inventory for 23,123 and credit cost of goods sold.
2. This problem states that the company has agreed to collect the full amount of the account receivable, but it will take 2 years to recover the funds. Considering the time value of money, the company will not really collect the full amount. Using an amortization program to calculate the present value of the note, I agree with her amounts. Adjust the original entry to reduce the amount of the note receivable and get rid of the gain she reported. The credit side of that correcting entry is a prior period adjustment. Don't forget the offsetting tax entry of $825 ($2751 x 30%). There are no entries to be made for the discount because it is unstated.
The amount of uncollectible receivable should have been written off in 2003 because there is no chance it would ever be collected. Yes, it is the same amount as the interest income you will receive over the life of the note, but time is money. You will need to make 4 entries to fix this.
(1) adjust the note as stated above with the offsetting tax entry,
(2) write off the remaining balance of the receivable less tax benefit,
(3) adjust the 12-31-03 entry to record a prior period adjustment for interest income from your amortization schedule. I get $1074 of interest for the first payment. Don't forget the income tax offset.
(4) Make the correcting entries for the 2 payments received in 2004 (to record interest income).
3. Because it was decided to call this a change in estimate, there will be no prior period adjustment. Any changes will be run through the current period. It is just a matter of computing what the amount should have been as opposed to what it was. Check your calculations against mine: I show a book value of $7980 for SL5 at the end of 4 years (12-31-2004). Using a 20% salvage value and SYD, I calculate a book value at the end of 2004 of $10108. The difference of $2128 is an adjustment to reduce depreciation expense and reduce accumulated depreciation.
4. The bonds were sold at a $1000 premium at 1-1-02. The original entry to record the sale should have had a credit entry to Premium on bonds - $1000. As stated in the problem, the premium should have been amortized against the interest payments as they were paid. Interest expense has been overstated in the prior years by the amount of the premium amortization not recorded. Although this is a small amount, some might say it is immaterial as far as proposing a prior period adjustment. You can either pass any adjustment or you can make two entries: one to fix the current year and second to fix the past years. For the current year, there is a $100 entry to be made to reduce the premium and to reduce the interest expense. The prior period adjustment is for two years: $200 to debit the premium and credit interest expense. For the prior period, don't forget the income tax effect which also needs an entry: $200 x 30%. The net entry is debit premium on bonds for $200; credit income tax payable for $60 and credit prior period adjustment for $140. Clear as mud...
5. This is a straight capital lease problem because we don't have go through the hoops to be certain it is a financing lease. The equipment should have been recorded as an asset at 1-1-03 based on the present value of the stream of payments. The calculation of an annuity due for 5 periods is $14232 x 4.16986 = $59345. Debit leased equipment for $59345 and credit Lease obligation for $59,345 in the prior period. The first payment was made on the day of signing the deal and therefore there is no interest to record (because no time had passed), but $14232 was charged to expense in error plus the equipment wasn't booked. You have 4 entries to make.
(1) record the equipment (above),
(2) make a prior period adjustment for the first lease payment to debit lease obligation and credit prior period adjustment. Don't forget to net out the income tax at 30% of the 14,232. There will be additional income tax due of $4270.
(3) correct the current year entry with a debit to interest expense, a debit to lease obligation and a credit to lease expense. The interest for the first year is $4511,
(4) now you need depreciation expense in both one prior period and the current year. Each year's depreciation is 59,345 / 5 = 11,869. One debit is prior period and the second is current year depreciation expense, and both are credited to accumulated depreciation. Don't forgot to make the offsetting tax entry of $3561 which is income tax benefit.
