3. (Comprehensive Accounting Change and Error Analysis Problem) Larry Kingston
Inc. was organized in late 2002 to manufacture and sell hosiery. At the end of its fourth year of operation, the company has been fairly successful, as indicated by the following reported net incomes.
2002 $140,000a 2004 $205,000
2003 160,000b 2005 276,000
a Includes a $12,000 increase because of change in bad debt experience rate.
b Includes extraordinary gain of $40,000.
The company has decided to expand operations and has applied for a sizable bank
loan. The bank officer has indicated that the records should be audited and presented in comparative statements to facilitate analysis by the bank. Larry Kingston Inc. therefore hired the auditing firm of Check & Doublecheck Co. and has provided the following additional information.
1. In early 2003, Larry Kingston Inc. changed its estimate from 2% to 1% on the
amount of bad debt expense to be charged to operations. Bad debt expense for
2002, if a 1% rate had been used, would have been $12,000. The company therefore restated its net income for 2002.
2002 2003 2004 2005
Net income $140,000 $160,000 $205,000 $276,000
Net income 155,000 165,000 215,000 260,000
$ 15,000 $ 5,000 $ 10,000 ($ 16,000)
3. In 2003, the company changed its method of depreciation from the accelerated
method to the straight-line approach. The company used the straight-line method
in 2003. The effect on the income statement for the previous year is as follows.
Net income unadjusted-accelerated $140,000
Net income unadjusted-straight-line 147,000
4. In 2005, the auditor discovered that:
a. The company incorrectly overstated the ending inventory by $11,000 in 2004.
b. A dispute developed in 2003 with the Internal Revenue Service over the
deductibility of entertainment expenses. In 2002, the company was not
permitted these deductions, but a tax settlement was reached in 2005 that
allowed these expenses. As a result of the court's finding, tax expenses in
2005 were reduced by $60,000.
a. Indicate how each of these changes or corrections should be handled in the
accounting records. Ignore income tax considerations.
b. Present comparative income statements for the years 2002 to 2005, starting with
income before extraordinary items. Do not prepare pro-forma amounts. Ignore
income tax considerations.
Comprehensive Accounting Change and Error Analysis is achieved.