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Errors: inventory, notes, depreciation, bonds, leases

AC Co. began Operations in 2001 and have never been audited. You have been hired to audit their 12/31/04 financial statements. The books are kept on a cash basis. In the past the bookkeeper has prepared the tax return on the same basis as the books, thus no temporary differences were recognized. You are, therefore, assuming that the same errors were made on the tax return and will be corrected by amended returns, except the temporary differences created by the Warranty expense, unreal gain/loss on trading securities, and the real gain/loss on available for sale securities. The tax rate is 30% for all 4 yrs and it is more likely than not that AC Co. will be profitable in the future.

Prepare correcting entries for the following, rounding to the nearest dollar:

1) Ending inventory was misstated at the end of each year as follows:

2001- 30,000 overstated
2002- 25,000 overstated
2003- 27,000 overstated
2004- 23,123 understated

2) On 7/1/2003 the company accepted a $24,232 non-interest bearing note from a customer in settlement of an overdue accounts receivable. The note requires 4 equal payments of $6,058 every 6 months beginning on 12/31/03. The annual market rate of interest is 10% (use effective intereste rate method). The bookkeeper made the following entries:

7/1/03 Notes Receivable 24,232
Accounts Receivable PV of PMTs ($21,481)
Gain on Note Receivable Difference ( $2,751)

12/31/03 Cash 6,058
Note Receivable 6058
6/30/04 & 12/31/04- Same as above

3) You discover that delivery equipment costing $39,900 on 01/01/01 has been depreciated (including 04)as if it were display equipment (display equipment is depreciated using 5 yr. life, no salvage value, straight-line depreciation). Delivery equipment is depreciated using 5 yr, 20% salvage value, SYD method. You decide to account for this as a change in accounting estimate, not as an error.

4) The 10 yr, 10%, $399,000 face value bonds were issued on 01/01/02. The proceeds of $400,000 were used to acquire the current store building. The interest payments (on 6/30 and 12/31 each yr.) have been debited to Interest Expense-Bonds. Since the difference between straight-line and effective-interest amortization of the premium will be immaterial you decide to use straight-line amortization. Each $1000 bond is convertible into 75 Shares of AC Co. Stock.

5) On 01/01/03 the company leased some display equipment from XYZ leasing for 5 yrs. The lease calls for 5 equal payments of $14,232 at 01/01/03, 01/01/04, 05, 06, & 07. The first and second payments were debited to lease expense. Since the lease is for 100% of the estimated life, you decide the lease should be capitalized and depreciated in accordance to normal policy for display equipment (display equipment is depreciated using 5 yr. life, no salvage value, straight-line depreciation). An appropriate interest rate is 10% for a lease of this type.

Solution Preview

1. For purposes of the audit, you will only correct 2004. Any errors or adjustments that effect any of the prior years will be lumped into prior period adjustments as one amount. Amended tax returns by year are another story, but we are only concerned with 2004. Note there would not be comparable statements to the prior year because it was not audited or reviewed by an outside CPA. Since ending inventory is a cumulative account, we only have to deal with the 2004 misstatement. You would debit inventory for 23,123 and credit cost of goods sold.

2. This problem states that the company has agreed to collect the full amount of the account receivable, but it will take 2 years to recover the funds. Considering the time value of money, the company will not really collect the full amount. Using an amortization program to calculate the present value of the note, I agree with her amounts. Adjust the original entry to reduce the amount of the note receivable and get rid of the gain she reported. The credit side of that correcting entry is a prior period adjustment. Don't forget the offsetting tax entry of $825 ($2751 x 30%). There are no entries to be made for the discount because it is unstated.

The amount of uncollectible receivable should ...

Solution Summary

The solution presents an explanation of each item followed by a summary of entries to be made.