As at December 31, 2020, Kendrick Corporation is having its financial statements audited for the first time ever. The auditor has found the following items that might have an effect on previous years.

 

1. Kendrick purchased equipment on January 2, 2017, for $130,000. At that time, the equipment had an estimated useful life of 10 years, with a $10,000 residual value. The equipment is depreciated on a straight-line basis. On January 2, 2020, as a result of additional information, the company determined that the equipment had a total useful life of seven years with a $6,000 residual value.
2. During 2020, Kendrick changed from the double-declining-balance method for its building to the straight-line method because the company thinks the straight-line method now more closely follows the benefits received from using the assets. The current year depreciation was calculated using the new method following straight-line depreciation. In case the following information was needed, the auditor provided calculations that present depreciation on both bases. The building had originally cost $1.2 million when purchased at the beginning of 2018 and has a residual value of $120,000. It is depreciated over 20 years. The original estimates of useful life and residual value are still accurate.
3. 2020 2019 2018
4. Straight-line $54,000 $ 54,000 $ 54,000
5. Double-declining-balance 97,200 108,000 120,000
6. Kendrick purchased a machine on July 1, 2017, at a cost of $160,000. The machine has a residual value of $16,000 and a useful life of eight years. Kendrick's bookkeeper recorded straight-line depreciation during each year but failed to consider the residual value.
7. Prior to 2020, development costs were expensed immediately because they were immaterial. Due to an increase in development phase projects, development costs have now become material and management has decided to capitalize and depreciate them over three years. The development costs meet all six specific conditions for capitalization of development phase costs. Amounts expensed in 2017, 2018, and 2019 were $300, $500, and $1,000, respectively. During 2020, $4,500 was spent and the amount was debited to Deferred Development Costs (an asset account).

 

Instructions

 

a. Prepare the necessary journal entries to record each of the changes or errors. The books for 2020 have been adjusted but not closed. Ignore income tax effects and round to the nearest dollar.

b. Calculate the 2020 depreciation expense on the equipment.

c. Calculate the comparative net income amounts for 2019 and 2020, starting with income before the effects of any of the changes identified above. Income before depreciation expense was $600,000 in 2020 and $420,000 in 2019.

d. From the perspective of an investor, comment on the quality of Kendrick Corporation's earnings as reported in 2019 and 2020.

Answer:

a)

Change in accounting estimate does not require adjustments in previous years or beginning equity and based on the information available with regard to useful life and residual value, depreciation and remaining book value is reported.

So no entry is required for change in accounting estimate.

Change in accounting policy should be adjusted retrospectively from the beginning of purchase of asset but if it is impracticable then the cumulative effect of changes should be adjusted in the beginning equity of previous comparative reporting period

Entity has changed the method of depreciation from straight line method to double declining balance method so the difference between total depreciation of both methods is adjusted in beginning equity.

Total depreciation under straight line method in 2018 and 2019 =54,000*2 => 108,000

Total depreciation under Double declining balance method = 108,000+120,000=> 228,000

Difference = 228,000 - 162,000 =>66,000

Debit Retained earnings     66,000

Credit Building                                 66,000

Prior period error refers to omission from or misstatement in the entity's financial statements of one or more prior period arising from failure to use or misuse of reliable information.

If there is any prior period error then adjustment should be made retrospectively, if the adjustment could not be made retrospectively then adjustment should be made in the earliest comparative reporting period by adding as a separate line item.

In the present case there was an error in considering residual value so depreciation would be charged high in the previous reporting periods hence, adjustment should be made retrospectively from the beginning of purchase of asset or by adding as a separate line item in the previous financial statement.

Depreciation charged for 2017 and 2018 = (160,000 / 8) * 2.5 => 50,000

Actual Depreciation for 2017 and 2018 = ((160,000 - 16,000) / 8)*2.5 => 45,000

Additional depreciation charged = 50,000 - 45,000 => 5,000

Debit Machine                  5,000

Credit Retained earnings          5,000

Development cost which didn't satisfy the capitalization criteria should be treated as an expense and any development cost previously recognized as an expense can be reversed when capitalization criteria has been met.

Adjustment should be made retrospectively from the beginning.

Development cost expensed in 2017, 2018 and 2019 = 300 + 500 + 1,000 => 1,800

Debit Development cost    1,800

Credit Retained earnings             1,800

b)

Depreciation expense of equipment for 2020

Total value 130,000

Estimated life = 10 years

Residual value = 10,000

Depreciation per year = (130,000 - 10,000) / 10 => 12,000

Book value after depreciation for 3 years from 2017 to 2019 = (130,000 - 12,000 * 3)

=>94,000

Estimated remaining life = 7 years

Estimated residual value = 6,000

Depreciation per year = (94,000 - 6,000) / 7 => 12,571.43

c)

Comparative net incomes for 2019 and 2020

PFA

d)

Due to change in accounting method, estimates and errors in accounting there is a decrease in net profit in both the years so investors interest in the company would decrease because earnings per share will decrease and the market price of shares will also decrease.

This can be avoided when proper notes to accounts is provided with explanation and it would be helpful for the investors to understand and take proper decisions.