Question

Mathys 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 Mathys Inc.'s 2017 financial statements.1. At December 31, 2016, 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) 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, 2016, would have been $250,000 less. The effect of the change on 2017 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 operated a leasing division was 2017. If straight-line depreciation were used, 2017 income would be $110,000 greater.3.In preparing its 2016 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 2017, retained earnings at December 31, 2016, 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 making this change on 2017 earnings will be an increase of $320,000. The client says that the effect of the change on December 31, 2016, retained earnings cannot be determined.6. To achieve an appropriate recognition of revenues and expenses in its building construction division, the client 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, 2016, 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, 2016, retained earnings?

Answer 1

Mathys Inc.

a. (1) Change in accounting principle, accounting estimate, or correction of an error:

1. Write-off of Accounts Receivable = Change in accounting estimate

2. Changes in depreciation policies = Changes in accounting estimate for the office furniture and the introduction of the sum-of-years' digit for the new leasing division's equipment.

3. Overstated Ending Inventory = Correction of an error

4. New accounting method for pre-production costs = Change in accounting estimate

5. Change from FIFO to LIFO = Change in accounting principle

6. Change from completed-contract method of accounting to the percentage-of-completion method = Change in accounting principle

a. (2) If Restatement of opening retained earnings is required:

1. No restatement of opening retained earnings is required.

2. No restatement of opening retained earnings is required.

3. Restatement of opening retained earnings is required.

4. No restatement of opening retained earnings is required.

5. Restatement of opening retained earnings is required.

6. Restatement of opening retained earnings is required.

b) December 31, 2016 Retained Earnings Adjustments:

3. Debit Retained Earnings = ($235,000)

5. Debit Retained Earnings = ($320,000)

6. Credit Retained EArnings = $1,075,000

Net effect on 2016 Retained Earnings = an increase of $520,000

Step-by-step explanation:

a) Data:

1. December 31, 2016 Write-off of Receivable (Hendricks Inc.) = $820,000

2. Changes in depreciation policies:

a) Office Furniture and Fixtures 10-year to 8-year useful life: Effect on Retained Earnings at December 31, 2016 = $250,000 less. Effect on 2017 Income = $60,000 less.

b) Equipment: sum-of-the-years' digits depreciation method: Effect on 2017 income = $110,000 more.

3. Ending inventory for 2016 overstated by $235,000 Prior period adjustment.

4. Preproduction costs for furniture division: New accounting method. Effect on 2016 Retained earnings = $375,000 less.

5. Inventories for Nursery division, from FIFO to LIFO to match current costs with revenues. Effect on 2017, an increase in Earnings = $320,000.

6. Building Construction Division from completed-contract method of accounting to the percentage-of-completion method. Effect on Retained Earnings 2016 = $1,075,000 greater.

b) Mathys Inc. must correct accounting errors by adjusting previously issued financial statements retrospectively. An example of an accounting error is the overstatement of the ending inventory by $235,000. This implies that the 2016 Retained Earnings were overstated.

c) A good example of a change in accounting estimate is the change Mathys Inc. made of the office furniture's useful life from 10 years to 8. Such changes are not applied retroactively to prior years' financial statements.

d) When Marthys Inc. change the inventory valuation method from LIFO to FIFO, it made a change in an accounting principle. Such principle changes are done retroactively, with the restatement of the financial statements.