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Intermediate Accounting: Reporting...

3rd Edition
James M. Wahlen + 2 others
ISBN: 9781337788281

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BuyFindarrow_forward

Intermediate Accounting: Reporting...

3rd Edition
James M. Wahlen + 2 others
ISBN: 9781337788281
Textbook Problem
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At the beginning of 2020, Holden Company’s controller asked you to prepare correcting entries for the following three situations:

  1. 1. Machine X was purchased for $100,000 on January 1, 2015. Straight-line depreciation has been recorded for 5 years, and the Accumulated Depreciation account has a balance of $45,000. The estimated residual value remains at $10,000, but the service life is now estimated to be 1 year longer than originally estimated.
  2. 2. Machine Y was purchased for $40,000 on January 1, 2018. It had an estimated residual value of $4,000 and an estimated service life of 8 years. It has been depreciated under the sum-of-the-years’-digits method for 2 years. Now, the company has decided to change to the straight-line method.
  3. 3. Machine Z was purchased for $80,000 on January 1, 2019. Double-declining-balance depreciation has been recorded for 1 year. The estimated residual value is $8,000 and the estimated service life is 5 years. The computation of the depreciation erroneously included the estimated residual value.

Required:

Prepare any necessary correcting journal entries for each situation. Also prepare the journal entry for each situation to record the depreciation for 2020. Ignore income taxes.

To determine

Prepare correct journal entries for the changes and corrections in depreciation in the given three independent situations.

Explanation

Accounting changes: When a company requires to sacrifice the consistent accounting methods and procedures, to enhance the usefulness and relevance of the accounting information, those changes are referred to as accounting changes. Such inevitable accounting changes decrease the comparability and consistency of accounting information. The reasons for accounting changes could be new methods introduced by FASB (Financial Accounting Standards Board), changes in accounting principles, and changes in accounting estimates.

The following are the three types of accounting changes:

  • Change in an accounting principle: This change occurs when a company decides to change from an accounting principle to another, like change from LIFO to FIFO. A change in accounting principle effects the values that impact the figures of previous and current years, thus, impairs the consistency and comparability. Hence, the changes in accounting principle should be adjusted with a retrospective effect to impact the previous financial statements, to increase the comparability and the consistency of the values between the previous and current accounting periods.
  • Change in an accounting estimate: This change occurs when a company decides to change the estimates based on the additional information or future events. A change in accounting estimate results out of new experiences and effects the values of current and future period only, but not the previous periods. Hence, the changes in accounting estimates should be accounted for prospectively.
  • Change in a reporting entity: A change in reporting entity occurs due to changes in ownership and operating control due to acquisition. Hence, the changes in reporting entity should be adjusted with a retrospective effect to represent the parent and subsidiary companies as one entity.

Accounting treatment of change in depreciation method: In the case of a change in depreciation method, the change in estimate depends on the estimated benefits out of the depreciation method applied, hence, cannot be concluded as to whether it is a change in accounting principle, or a change in accounting estimate. As per Generally Accepted Accounting Principles (GAAP) this change should be accounted for as a change in accounting estimate, and not as a change in accounting principle. A change in accounting estimate like the change in depreciation method, or change in service life of an asset, effects the values of the year in which the change is made, and future period only, but not the previous periods. Hence, the change in depreciation method is accounted for prospectively.

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.

Prepare correct journal entries for the changes and corrections in depreciation in the given three independent situations.

1.

Change in service life of the machinery: Change in service life is a change in estimate and should be accounted for prospectively.

Journal entry:

DateAccount Titles and ExplanationPost Ref.Debit ($)Credit ($)
2020    
  Depreciation Expense 7,500 
   Accumulated Depreciation–Machine X  7,500
  (Record depreciation expense)   

Table (1)

Description:

  • Depreciation Expense is an expense account. Since expenses decrease equity, equity value is decreased, and a decrease in equity is debited.
  • Accumulated Depreciation–Machine X is a contra-asset account, and contra-asset accounts would have a normal credit balance, hence, the account is credited.

Working Note 1:

Compute depreciation expense using straight-line method.

Computation of Depreciation Expense
Acquisition cost on January 1, 2015$100,000
Less: Accumulated depreciation(45,000)
Book value as at the beginning of 202055,000
Less: Salvage value(10,000)
Depreciable base45,000
Revised estimated useful life÷   6 years
Revised depreciation expense per year$7,500

Table (2)

2.

Change in deprecation method: Change in depreciation method from sum-of-the-years’-digits method to straight-line method is due to either change in estimated future benefits or due to change in service life is referred to as a change in accounting estimate effected by the change in accounting principle. This change is a change in estimate and is accounted for prospectively.

Journal entry:

DateAccount Titles and ExplanationPost Ref.Debit ($)Credit ($)
2020    
  Depreciation Expense 3,500 
   Accumulated Depreciation–Machine Y  3,500
  (Record depreciation expense)   

Table (3)

Description:

  • Depreciation Expense is an expense account. Since expenses decrease equity, equity value is decreased, and a decrease in equity is debited.
  • Accumulated Depreciation–Machine Y is a contra-asset account, and contra-asset accounts would have a normal credit balance, hence, the account is credited.

Working Note 2:

Compute the denominator value for the building that has 8 remaining useful years, under the sum-of-years’-digits method.

Sum of the years' digits = {Number of estimated useful life× (Number of estimated useful life  + 1)}28×(8+1)2= 36

Working Note 3:

Compute book value of Machine Y at the beginning of 2020, using sum-of-the-years’-digits method (Refer to Working Note (2) for sum of the years’ digits)

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