Additional Reporting Issues

8/8/2019 Additional Reporting Issues

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CHAPTER 18

ADDITIONAL REPORTING ISSUES

INTERMEDIATE ACCOUNTING

Principles and Analysis

2nd Edition

WarfieldWyegandt

Kieso


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Changes inaccounting principle

Changes inaccountingestimate

Reporting acorrection of anerror

Summary

AccountingChanges

ReportingEarnings Per

Share

Simple capitalstructure

Complex capitalstructure

EPS summary

Additional Reporting Issues


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Learning Objectives

1. Identify the types of accounting changes.2. Understand how to account for retrospective

accounting changes.

3. Understand how to account for impracticable changes.

4. Describe the accounting for changes in estimates.

5. Describe the accounting for correction of errors.

6. Compute earnings per share in a simple capital

structure.

7. Compute earnings per share in a complex capitalstructure.


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Types of Accounting Changes:

Change in Accounting Principle.

Changes in Accounting Estimate.

Change in Reporting Entity.

Errors are not considered an accounting change.

LO 1 Identify the types of accounting changes.

Accounting alternatives:1) Diminish the comparability of financial information.

2) Obscure useful historical trend data.

Accounting Changes


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Average cost to LIFO.

Completed-contract to percentage-of-completion.

A change from one generally accepted accountingprinciple to another. Examples include:

Changes in Accounting Principle

Adoption of a new principle in recognition of events that haveoccurred for the first time or that were previously immaterial is

not an accounting change.


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Retrospective Accounting Change Approach


LO 2 Understand how to account for retrospective accounting changes.

Company reporting the change

1) adjusts its financial statements for each prior

period presented to the same basis as the newaccounting principle.

2) adjusts the carrying amounts of assets andliabilities as of the beginning of the first yearpresented, plus the opening balance of retainedearnings.


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Example (Retrospective Change): BuildmoreConstruction Company used the completed contractmethod to account for long-term constructioncontracts for financial accounting and tax purposes in

2007, its first year of operations. In 2008, thecompany decided to change to the percentage-of-completion method for financial accounting purposes.Income before long-term contracts and taxes in 2007

and 2008 was $80,000 and $100,000. The tax rate is40% and the company will continue to use thecompleted contract method for tax purposes.

Retrospective Change Example



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Example Income from Long-Term Contracts



40%Percentage- Completed Tax Net of

Date of-Completion Contract Difference Effect Tax

2007 40,000$ 25,000$ 15,000$ 6,000$ 9,000$2008 60,000 55,000 5,000 2,000 3,000

Journal entry

2008 Construction in progress 15,000

Deferred tax liability 6,000

Retained earnings 9,000


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Example Retained Earnings Statement



Restated Previous2008 2007 2007

Beg. balance previously reported 63,000$ -$ -$

Effect of accounting change 9,000 - -

Beg. balance restated 72,000 - -

Net income 96,000 72,000 63,000

Ending balance 168,000$ 72,000$ 63,000$


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Impracticability


LO 3 Understand how to account for impracticable changes.

Companies should not use retrospective application ifone of the following conditions exists:

1. Company cannot determine the effects of theretrospective application.

2. Retrospective application requires assumptions aboutmanagements intent in a prior period.

3. Retrospective application requires significant estimatesthat the company cannot develop.

If any of the above conditions exists, the company prospectivelyapplies the new accounting principle.


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Changes in Accounting Estimate

LO 4 Describe the accounting for changes in estimates.

The following items require estimates.1. Uncollectible receivables.

2. Inventory obsolescence.

3. Useful lives and salvage values of assets.4. Liabilities for warranty costs and income taxes.

5. Change in depreciation methods.

Companies report prospectively changes in accountingestimates.


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Change in Estimate Example

Arcadia HS, purchased equipment for $510,000 whichwas estimated to have a useful life of 10 years with asalvage value of $10,000 at the end of that time.Depreciation has been recorded for 7 years on astraight-line basis. In 2005 (year 8), it is determined

that the total estimated life should be 15 years with asalvage value of $5,000 at the end of that time.

Required:

What is the journal entry to correctthe prior years depreciation?

Calculate the depreciation expensefor 2005.

No EntryRequired



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Equipment $510,000

Fixed Assets:

Accumulated depreciation 350,000

Net book value (NBV) $160,000

Balance Sheet (Dec. 31, 2004)

Change in Estimate Example After 7 years

Equipment cost $510,000Salvage value - 10,000

Depreciable base 500,000

Useful life (original) 10 years

Annual depreciation $ 50,000 x 7 years = $350,000

First, establishNBV at date of

change in estimate.



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Change in Estimate Example After 7 years

Net book value $160,000Salvage value (new) 5,000

Depreciable base 155,000

Useful life remaining 8 years

Annual depreciation $ 19,375

Second, calculatedepreciation

expense for 2005.

Depreciation expense 19,375

Accumulated depreciation 19,375

Journal entry for 2005



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Reporting a Correction of an Error

LO 5 Describe the accounting for correction of errors.

Accounting errors include the following types:1. A change from an accounting principle that is not

generally accepted to an accounting principle that isacceptable.

2. Mathematical mistakes.

3. Changes in estimates that occur because a company didnot prepare the estimates in good faith.

4. Failure to accrue or defer certain expenses or revenues.

5. Misuse of facts.

6. Incorrect classification of a cost as an expense insteadof an asset, and vice versa.


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Reporting a Correction of an Error


All material errors must be corrected.

Record corrections of errors from prior periods asan adjustment to the beginning balance of retained

earnings in the current period.Such corrections are called prior periodadjustments.

For comparative statements, a company shouldrestate the prior statements affected, to correctfor the error.


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Woods, Inc.

Statement of Retained Earnings

For the Year Ended December 31, 2007

Balance, January 1 1,050,000$

Net income 360,000Dividends (300,000)

Balance, December 31 1,110,000$

Before issuing the report for the year ended December 31, 2007, you

discover a $62,500 error that caused the 2006 inventory to beoverstated (overstated inventory caused COGS to be lower and thus netincome to be higher in 2006). Would this discovery have any impact onthe reporting of the Statement of Retained Earnings for 2007? Assumea 20% tax rate.

Retained Earnings Statement



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Woods, Inc.Statement of Retained Earnings

For the Year Ended December 31, 2007

Balance, January 1, as previously reported 1,050,000$

Prior period adjustment, net of tax (50,000)Balance, January 1, as restated 1,000,000

Net income 360,000

Dividends (300,000)

Balance, December 31 1,060,000$

Retained Earnings Statement



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Summary of Accounting Changes andCorrections of Errors


Changes in accounting principle are appropriate onlywhen a company demonstrates that the newlyadopted generally accepted accounting principle is

preferable to the existing one.

Companies and accountants determine preferabilityon the basis of whether the new principle

constitutes an improvement in financial reporting,not on the basis of the income tax effect alone.


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Earnings per share indicates the income earned byeach share of common stock.

Companies report earnings per share only forcommon stock.

When income statement contains intermediatecomponents of income, companies should discloseearnings per share for each component.

Section 2 Reporting Earnings Per Share

Illustration 18-18


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LO 6 Compute earnings per share in a simple capital structure.

Earnings Per Share-Simple Capital Structure

Simple Structure--Only common stock; nopotentially dilutive securities.

Complex Structure--Potentially dilutivesecurities are present.

Dilutive means the ability to influence the EPSin a downward direction.


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Preferred Stock DividendsSubtracts the current year preferred stock dividendfrom net income to arrive at income available to

common stockholders. Illustration 18-19

Preferred dividends are subtracted on cumulativepreferred stock, whether declared or not.


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Weighted-Average Number of SharesCompanies must weight the shares by the fractionof the period they are outstanding.

Stock dividends or stock splits: companies need torestate the shares outstanding before the stockdividend or split.


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Exercise: On January 1, 2008, Wilke Corp. had 480,000shares of common stock outstanding. During 2008, it hadthe following transactions that affected the commonstock account.

February 1 Issued 120 SharesMarch 1 Issued a 10% stock dividend

May 1 Acquired 100,000 share of treasury stock

June 1 Issued a 3-for-1 stock split

October 1 Reissued 60,000 shares of treasury stock

Instructions: Determine the weighted-average number ofshares outstanding as of December 31, 2008.


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Weighted-Average Number of SharesWeighted

Change in Shares Fraction 10% 3/1 Average

Date Shares Outstanding of Year Dividend Split Shares

Jan. 1 480,000 x 1/12 x 110% x 3 132,000

Feb. 1 120,000 600,000 x 1/12 x 110% x 3 165,000Mar. 1 60,000 660,000 x 2/12 x 3 330,000

May 1 (100,000) 560,000 x 1/12 x 3 140,000

June 1 3/1 split 1,680,000 x 4/12 x 560,000

Oct. 1 60,000 1,740,000 x 3/12 x 435,000

1,762,000


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LO 7 Compute earnings per share in a complex capital structure.

Earnings Per Share-Complex Capital Structure

Complex Capital Structure exists when a businesshas

convertible securities,

options, warrants, or other rights

that upon conversion or exercise could diluteearnings per share.

Company reports both basic and diluted earningsper share.


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Diluted EPS includes the effect of all potential dilutivecommon shares that were outstanding during the period.

Illustration 18-28

Companies will not report diluted EPS if the securities intheir capital structure are antidilutive.


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Diluted EPS Convertible SecuritiesMeasure the dilutive effects of potentialconversion on EPS using the if-converted method.

This method for a convertible bond assumes:

(1) the conversion at the beginning of the period(or at the time of issuance of the security, if

issued during the period), and

(2) the elimination of related interest, net of tax.




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Exercise: (Convertible Bonds) In 2006 Chirac Enterprisesissued, at par, 60, $1,000, 8% bonds, each convertible into 100shares of common stock. Chirac had revenues of $17,500 andexpenses other than interest and taxes of $8,400 for 2007.(Assume that the tax rate is 40%.) Throughout 2007, 2,000shares of common stock were outstanding; none of the bondswas converted or redeemed.

Instructions:

(a) Compute diluted earnings per share for 2007.(b) Assume same facts as those for Part (a), except the 60bonds were issued on September 1, 2007 (rather than in2006), and none have been converted or redeemed.


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Exercise: (a) Compute diluted EPS for 2007.

Revenues 17,500$

Expenses 8,400Bond interest expense (60 x $1,000 x 8%) 4,800

Income before taxes 4,300

Income taxes (40%) 1,720

Net income 2,580$

Calculation of Net Income


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When calculating Diluted EPS, begin with Basis EPS.

Net income = $2,580

Weighted average shares = 2,000= $1.29

Basic EPS



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$2,580

2,000= $.68

Diluted EPS+ $4,800 (1 - .40)

6,000

Basic EPS= 1.29

$5,460

8,000=

Effect on EPS = .48

+



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Revenues 17,500$

Expenses 8,400Bond interest expense (60 x $1,000 x 8% x 4/12) 1,600

Income before taxes 7,500

Income taxes (40%) 3,000

Net income 4,500$

Calculation of Net Income

Exercise: (b) Assume bonds were issued on Sept. 1, 2007


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$4,500

2,000= $1.37

Diluted EPS$1,600 (1 - .40)

6,000 x 4/12 yr.

$5,460

4,000=

Effect on EPS = .48Basic EPS

= 2.25

+

+

Exercise: (b) Assume bonds were issued on Sept. 1, 2007


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Problem: (Variation-Convertible Preferred Stock) Priorto 2007, Prancer Company issued 30,000 shares of 6%convertible, cumulative preferred stock, $100 par value.Each share is convertible into 5 shares of common stock.

Net income for 2007 was $1,200,000. There were600,000 common shares outstanding during 2007. Therewere no changes during 2007 in the number of commonor preferred shares outstanding.

Instructions:

(a) Compute diluted earnings per share for

2007.


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Problem: (a) Compute diluted EPS for 2007.


Net income $1,200,000 Pfd. Div. $180,000*

Weighted average shares = 600,000= $1.70

Basic EPS

* 30,000 shares x $100 par x 6% = $180,000 dividend


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600,000=

$1.60

Diluted EPS$180,000

Basic EPS = 1.70

=

Effect onEPS = 1.20

$1,200,000 $180,000

150,000*

$1,200,000

750,000

*(30,000 x 5)

+

+

Problem: (a) Compute diluted EPS for 2007.


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600,000=

$1.74

Diluted EPS$180,000

Basic EPS = 1.70

=

Effect onEPS = 2.00

Problem: (a) Compute diluted earnings per share for2007 assuming each share of preferred is convertibleinto 3 shares of common stock.

$1,200,000 $180,000

90,000*

$1,200,000

750,000

*(30,000 x 3)

+

+


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600,000=

$1.70

Diluted EPS$180,000

Basic EPS = 1.70

=

Effect onEPS = 2.00

$1,200,000 $180,000

90,000*

$1,200,000

750,000

*(30,000 x 3)

Antidilutive

Basic = Diluted EPS

Problem: (a) Compute diluted earnings per share for2007 assuming each share of preferred is convertibleinto 3 shares of common stock.

+

+


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Diluted EPS Options and WarrantsMeasure the dilutive effects of potentialconversion using the treasury-stock method.

This method assumes:

(1) company exercises the options or warrants atthe beginning of the year (or date of issue if

later), and

(2) that it uses those proceeds to purchasecommon stock for the treasury.




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Exercise: (EPS with Options) Venzuela Companys net incomefor 2007 is $50,000. The only potentially dilutive securitiesoutstanding were 1,000 options issued during 2006, eachexercisable for one share at $6. None has been exercised, and

10,000 shares of common were outstanding during 2007. Theaverage market price of the stock during 2007 was $20.

Instructions:

(a) Compute diluted earnings per share.

(b) Assume the 1,000 options were issued on October 1, 2007(rather than in 2006). The average market price duringthe last 3 months of 2007 was $20.


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Proceeds if shares issued (1,000 x $6) 6,000$

Purchase price for treasury shares 20$Shares assumed purchased 300

Shares assumed issued 1,000

Incremental share increase 700

Treasury-Stock Method


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$50,000

10,000= $4.67

Diluted EPS+

700

Basic EPS= 5.00

$50,000

10,700=

Options

+


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Proceeds if shares issued (1,000 x $6) 6,000$

Purchase price for treasury shares 20$

Shares assumed purchased 300

Shares assumed issued 1,000

Incremental share increase 700Weight for 3 months assumed outstanding 3/12

Weighted incremental share increase 175

Treasury-Stock Method

Exercise: (b) Compute diluted EPS assuming the 1,000options were issued on October 1, 2007.

x


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Exercise: (b) Compute diluted EPS assuming the 1,000options were issued on October 1, 2007.

$50,000

10,000= $4.91

Diluted EPS

175

Basic EPS= 5.00

$50,000

10,175=

Options

+


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Antidilution RevisitedIgnore antidilutive securities in all calculations andin computing diluted earnings per share.

Intent is to inform investor of possible dilution inreported earnings per share and not to beconcerned with securities that would result in an

increase in earnings per share.


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EPS Presentation and DisclosureA company should show per share amounts for:

income from continuing operations,

income before extraordinary items, and

net income.

Per share amounts for a discontinued operation oran extraordinary item should be presented on theface of the income statement or in the notes.




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Additional Reporting Issues