Chapter 22, Problem 4P

Schmidt Company began operations on January 1, 2018, and used the LIFO inventory method for both financial reporting and income taxes. However, at the beginning of 2020, Schmidt decided to switch to the average cost inventory method for financial and income tax reporting. It had previously reported the following financial statement information for 2019:

An analysis of the accounting records discloses the following cost of goods sold under the LIFO and average cost inventory methods:

There are no indirect effects of the change in inventory method. Revenues for 2020 total $130,000; operating expenses for 2020 total $30,000. Schmidt is subject to a 21% income tax rate in all years; it pays all income taxes payable in the next quarter. Assume that any deferred tax liability was paid in the subsequent year. Schmidt had 10,000 shares of common stock outstanding during all years; it paid dividends of $1 per share in 2020. At the end of 2020, Schmidt had cash of $15,600, inventory of $34,000, other assets of $76,000, income taxes payable of $4,200, and accounts payable of $3,000. It desires to show financial statements for the current year and previous year in its 2020 annual report.

Required:

1. 1. Prepare the journal entry to reflect the change in method at the beginning of 2020. Show supporting calculations.
2. 2. Prepare the 2020 financial statements. Notes to the financial statements are not necessary. Show supporting calculations.

To determine

Journalize the cumulative effect of the retrospective adjustment on Company S’s prior year income that would be reported in 2020.

Explanation of Solution

Journal entry: Journal entry is a set of economic events which can be measured in monetary terms. These are recorded chronologically and systematically.

Debit and credit rules:

• Debit an increase in asset account, increase in expense account, decrease in liability account, and decrease in stockholders’ equity accounts.
• Credit decrease in asset account, increase in revenue account, increase in liability account, and increase in stockholders’ equity accounts.

Journalize the cumulative effect of the retrospective adjustment on Company S’s prior year income that would be reported in 2020.

Date		Account Titles and Explanations		Post. Ref.	Debit ($)	Credit ($)
		Inventory			15,000
			Deferred Tax Liability			3,150
			Retained Earnings			11,850
		(Record the cumulative effect of pretax income due to change from LIFO to average cost)

Table (1)

Description:

• Inventory is an asset account. Since the cumulative difference has increased due to change from LIFO to average cost, inventory has increased, the asset account increased, and an increase in asset is debited.
• Deferred Tax Liability is a liability account. The obligation to pay taxes has increased on saved income taxes, due to increase in cumulative difference. The liability increased and an increase in liability is credited.
• Retained Earnings is an equity account. Since earnings increased due to increase in pretax income due to increase in cumulative difference out of the change from LIFO to average cost, and an increase in equity is credited.

Working Notes:

Compute the deferred tax liability amount.

$\begin{array}{c}\text{Deferred tax liability = Pretax amount }\times \text{ Income tax rate}\\ \text{=}\left(\left(\$62,000–\$56,000\right)+\left(\$78,000–\$69,000\right)\right)\text{×21\%}\\ \text{=\$15,000×21\%}\\ \text{=\$3,150}\end{array}$

Compute retained earnings amount.

$\begin{array}{c}\text{Retained earnings = Pretax amount }\times \left(\text{1–Income tax rate}\right)\\ \text{=}\left(\left(\$62,000–\$56,000\right)+\left(\$78,000–\$69,000\right)\right)\text{×}\left(\text{1–21\%}\right)\\ \text{=\$15,000×79\%}\\ \text{=\$11,850}\end{array}$

To determine

Prepare comparative financial statements for Company S for the year 2020.

Explanation of Solution

Income statement: The financial statement which reports revenues and expenses from business operations, and the result of those operations as net income or net loss for a particular time period is referred to as income statement.

Prepare comparative income statements of Company S for the year 2020.

Company S
Comparative Income Statements
For the Years Ended December 31
	2020	2019 (As Adjusted)
Revenues	$130,000	$128,000
Cost of goods sold	(80,000)	(69,000)
Gross profit	50,000	59,000
Operating expenses	(30,000)	(25,000)
Income before income taxes	20,000	14,000
Income tax expense	(4,200)	(7,140)
Net income	$15,800	$26,860
Earnings per share:
Net income	$1.58	$2.69

Table (2)

Working Notes:

Compute the income tax expense for 2020.

$\begin{array}{c}\text{Income tax expense = Income before taxes }\times \text{ Income tax rate}\\ \text{=\$20,000×21\%}\\ \text{=\$4,200}\end{array}$

Compute the income tax expense for 2019.

$\begin{array}{c}\text{Income tax expense = Income before taxes }\times \text{ Income tax rate}\\ \text{=\$34,000×21\%}\\ \text{=\$7,140}\end{array}$

Compute the earnings per share (EPS) for 2020.

$\begin{array}{c}\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}\\ \text{=}\frac{\text{\$15,800–\$0}}{\text{10,000 shares}}\\ \text{=\$1}\text{.58}\end{array}$

Compute the earnings per share (EPS) for 2019.

$\begin{array}{c}\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}\\ \text{=}\frac{\text{\$26,860–\$0}}{\text{10,000 shares}}\\ \text{=\$2}\text{.69}\end{array}$

Statement of retained earnings: This statement reports the beginning retained earnings and all the changes which led to ending retained earnings. Net income from income statement is added to and dividends is deducted from beginning retained earnings to arrive at the end result, ending retained earnings.

Prepare comparative statements of retained earnings of Company S for the year 2020.

Company S
Comparative Statement of Retained Earnings
For the Years Ended December 31
	2020	2019
Beginning unadjusted retained earnings	$40,750	$27,000
Plus: Adjustment for the cumulative effect on prior years of retrospectively applying the average cost inventory method (net of taxes)	11,850	4,740
Adjusted beginning retained earnings	52,600	31,740
Add: Net income	15,800	26,860
	68,400	58,600
Less: Dividends	(10,000)	(6,000)
Ending retained earnings	$58,400	$52,600

Table (3)

Working Notes:

Compute the adjustment value for 2020.

$\begin{array}{c}\text{Adjustment value = }\left[\begin{array}{l}\left(\begin{array}{l}\text{Excess of average cost of goods sold over }\\ \text{LIFO cost of goods sold in 2018 +}\\ \text{Excess of average cost of goods sold over }\\ \text{LIFO cost of goods sold in 2019}\end{array}\right)\times \\ \left(\text{1–Income tax rate}\right)\end{array}\right]\\ \text{=}\left(\left(\text{\$62,000–\$56,000}\right)+\left(\$78,000–\$69,000\right)\right)\text{×}\left(\text{1–21\%}\right)\\ \text{=\$15,000×0}\text{.79}\\ \text{=\$11,850}\end{array}$

Compute the adjustment value for 2019.

$\begin{array}{c}\text{Adjustment value = }\left[\begin{array}{l}\left(\begin{array}{l}\text{Excess of average cost of goods sold over }\\ \text{FIFO cost of goods sold in 2018}\end{array}\right)\times \\ \left(\text{1–Income tax rate}\right)\end{array}\right]\\ \text{=}\left(\text{\$62,000–\$56,000}\right)\text{×}\left(\text{1–21\%}\right)\\ \text{=\$6,000×0}\text{.79}\\ \text{=\$4,740}\end{array}$

Prepare comparative balance sheets of Company S for the year 2020.

Company S
Comparative Balance Sheets
December 31
	2020	2019 (As Adjusted)
Assets
Cash	$15,600	$8,000
Inventory	34,000	57,000
Other assets	76,000	60,000
Total assets	$125,600	$125,000
Liabilities and Shareholders’ Equity
Accounts payable	$3,000	$4,000
Income taxes payable	4,200	5,250
Deferred tax liability	0	3,150
Common stock, no par	60,000	60,000
Retained earnings	58,400	52,600
Total liabilities and shareholders’ equity	$125,600	$125,000

Table (4)

Working Notes:

Refer to Table (2) for value and computation of income tax expense, which is the income taxes payable in 2020, and Table (1) for value and computation of deferred tax liability in 2019.

Compute adjusted inventory value for 2019.

$\begin{array}{c}\text{Adjusted inventory = }\left\{\begin{array}{l}\text{Inventory value originally reported on 12/31/2019+}\\ \left(\begin{array}{l}\text{Excess of average cost of goods sold over }\\ \text{FIFO cost of goods sold in 2018 +}\\ \text{Excess of average cost of goods sold over }\\ \text{FIFO cost of goods sold in 2019}\end{array}\right)\end{array}\right\}\\ \text{=\$42,000+}\left\{\left(\text{\$62,000–\$56,000}\right)\text{+}\left(\text{\$78,000–\$69,000}\right)\right\}\\ \text{=\$42,000+\$15,000}\\ \text{=\$57,000}\end{array}$