Chapter 22, Problem 5P

1.

To determine

Journalize the cumulative effect of the retrospective adjustment of $1,330,000$\left(\$550,000+\$780,000\right)$, on Company GO’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 of $1,330,000, on Company GO’s prior year income that would be reported in 2020.

Date		Account Titles and Explanations		Post. Ref.	Debit ($)	Credit ($)
		Retained Earnings			1,050,700
		Deferred Tax Liability			279,300
			Oil and Gas Properties			1,330,000
		(Record the cumulative effect of income due to change from full-cost method to successful-efforts method)

Table (1)

Description:

• Retained Earnings is an equity account. Earnings decreased due to decrease in pretax income due to change from successful-efforts method to full-cost method, and a decrease in equity is debited.
• Deferred Tax Liability is a liability account. The obligation to pay taxes has decreased on saved income taxes. The liability decreased and a decrease in liability is debited.
• Oil and Gas Properties is an asset account. Since the cumulative difference has decreased due to change from full-cost method to successful-efforts method, oil and gas properties has decreased, and a decrease in asset is credited.

Working Notes:

Compute retained earnings amount.

$\begin{array}{c}\text{Retained earnings = }\left(\begin{array}{l}\text{Exploration expenses in 2018+}\\ \text{Exploration expense in 2019}\end{array}\right)\times \left(\text{1–Income tax rate}\right)\\ \text{=}\left(\text{\$550,000+\$780,000}\right)\text{×}\left(\text{1–21\%}\right)\\ =\$1,330,000\times 0.79\\ \text{=\$1,050,700}\end{array}$

Compute the deferred tax liability amount.

$\begin{array}{c}\text{Deferred tax liability = }\left(\begin{array}{l}\text{Exploration expenses in 2018+}\\ \text{Exploration expense in 2019}\end{array}\right)\times \text{ Income tax rate}\\ \text{=}\left(\text{\$550,000+\$780,000}\right)\text{×21\%}\\ =\$1,330,000\times 21\%\\ \text{=\$279,300}\end{array}$

2.

To determine

Prepare comparative income statements and comparative statement of retained earnings of Company GO for the years 2018, 2019 and 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 GO for the years 2018, 2019 and 2020.

Company GO
Comparative Income Statements (Partial)
	2020	2019 (As Adjusted)	2018 (As Adjusted)
Income before income taxes	$3,100,000	$1,220,000	$1,650,000
Income tax expense	(651,000)	(256,200)	(346,500)
Net income	$2,449,000	$963,800	$1,303,500
Earnings per share:
Net income	$24.49	$9.64	$13.04

Table (2)

Working Notes:

Compute income before income taxes for 2019.

$\begin{array}{c}\text{Income before taxes = }\left\{\begin{array}{l}\text{Reported pretax income in 2019– }\\ \text{Exploration costs due to successful-efforts method in 2019}\end{array}\right\}\\ \text{=\$2,000,000–\$780,000}\\ \text{=\$1,220,000}\end{array}$

Compute income before income taxes for 2018.

$\begin{array}{c}\text{Income before taxes = }\left\{\begin{array}{l}\text{Reported pretax income in 2018– }\\ \text{Exploration costs due to successful-efforts method in 2018}\end{array}\right\}\\ \text{=\$2,200,000–\$550,000}\\ \text{=\$1,650,000}\end{array}$

Compute the income tax expense for 2020.

$\begin{array}{c}\text{Income tax expense = Income before taxes }\times \text{ Income tax rate}\\ \text{=\$3,150,000×21\%}\\ \text{=\$651,000}\end{array}$

Compute the income tax expense for 2019.

$\begin{array}{c}\text{Income tax expense = Income before taxes }\times \text{ Income tax rate}\\ \text{=\$1,220,000×21\%}\\ \text{=\$256,200}\end{array}$

Compute the income tax expense for 2018.

$\begin{array}{c}\text{Income tax expense = Income before taxes }\times \text{ Income tax rate}\\ \text{=\$1,650,000×21\%}\\ \text{=\$346,500}\end{array}$

Compute the earnings per share (EPS) for 2020.

$\begin{array}{c}\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}\\ \text{=}\frac{\text{\$2,449,000–\$0}}{\text{100,000 shares}}\\ \text{=\$24}\text{.49}\end{array}$

Compute the earnings per share (EPS) for 2019.

$\begin{array}{c}\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}\\ \text{=}\frac{\text{\$963,800–\$0}}{\text{100,000 shares}}\\ \text{=\$9}\text{.64}\end{array}$

Compute the earnings per share (EPS) for 2018.

$\begin{array}{c}\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}\\ \text{=}\frac{\text{\$1,303,500–\$0}}{\text{100,000 shares}}\\ \text{=\$13}\text{.04}\end{array}$

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 statement of retained earnings of Company GO for the years 2020, 2019, and 2018.

Company GO
Comparative Statement of Retained Earnings
	2020	2019	2018
Beginning unadjusted retained earnings	$3,318,000	$1,738,000	$0
Less: Adjustment for the cumulative effect on prior years of retrospectively applying the average cost inventory method (net of taxes)	1,050,700	434,500	0
Adjusted retained earnings	2,267,300	1,303,500	0
Net income	2,449,000	963,800	1,303,500
Ending retained earnings	$4,716,300	$2,267,300	$1,303,500

Table (3)

Working Notes:

Compute beginning unadjusted retained earnings for 2020.

$\begin{array}{c}\begin{array}{l}\text{Beginning unadjusted }\\ \text{retained earnings for 2020}\end{array}\}\text{ = }\left\{\begin{array}{l}\left(\begin{array}{l}\text{Reported net income in 2018+}\\ \text{Reported net income in 2019}\end{array}\right)\text{×}\\ \left(\text{1–Income tax rate}\right)\end{array}\right\}\\ \text{=}\left(\text{\$2,200,000+\$2,000,000}\right)\times \left(1–21\%\right)\\ =\$4,200,000\times 79\%\\ \text{=\$3,318,000}\end{array}$

Compute beginning unadjusted retained earnings for 2019.

$\begin{array}{c}\begin{array}{l}\text{Beginning unadjusted }\\ \text{retained earnings for 2019}\end{array}\}\text{ = }\left\{\begin{array}{l}\text{Reported net income in 2018×}\\ \left(\text{1–Income tax rate}\right)\end{array}\right\}\\ \text{=\$2,200,000}\times \left(1–21\%\right)\\ =\$2,200,000\times 79\%\\ \text{=\$1,738,000}\end{array}$

Compute the adjustment value for 2020.

$\begin{array}{c}\text{Adjustment value = }\left(\begin{array}{l}\text{Exploration expenses in 2018+}\\ \text{Exploration expense in 2019}\end{array}\right)\times \left(\text{1–Income tax rate}\right)\\ \text{=}\left(\text{\$550,000+\$780,000}\right)\text{×}\left(\text{1–21\%}\right)\\ =\$1,330,000\times 0.79\\ \text{=\$1,050,700}\end{array}$

Compute the adjustment value for 2019.

$\begin{array}{c}\text{Adjustment value = Exploration expenses in 2018 }\times \left(\text{1–Income tax rate}\right)\\ \text{=\$550,000×}\left(\text{1–21\%}\right)\\ =\$550,000\times 0.79\\ \text{=\$434,500}\end{array}$

3.

To determine

Indicate the items that would be restated on the financial statements.

Explanation of Solution

The following items would be restated on the financial statements:

• Exploration expenses would be restated on the 2018 and 2019 income statements indicating the change from full-cost method to successful-efforts method.
• Oil and Gas Properties, Deferred Tax Liability, and Retained Earnings would be restated on the 2018 and 2019 balance sheets.