In 2001, two engineers created Jervis-Bannister, Inc. with little business and no accounting training. In 2013, the company was acquired by one of their major manufacturers. After conducting an internal audit that same year, many false accounting facts were surfaced. In this paper, I will identify whether the six false accounting facts represent an accounting error or accounting change and if so what type. I will also explain the accounting and reporting guidelines for each false fact using the Financial Accounting Standards Board (FASB).
The first false accounting fact the auditor found was in a five-year causality insurance policy that was purchased at the beginning of 2011 for $35,000. The false fact became evident when the two engineers debited the full $35,000 to insurance expense at one time. According to the following FASB rule, this mistake is considered to be an accounting error and explains how a restatement should be conducted.
Prior interim periods of the current fiscal year shall be restated to include the portion of the item that is directly related to business activities of the entity during each prior interim period in the determination of net income for that period. (270-10-45-18)
The calculations that should be done to follow this rule are as follows. They should have taken the full $35,000 and divided it by the five-year policy to equal $7,000 insurance paid per year. So $7,000 times two years that are yet to be used times the tax rate of 40% equals $5,600. Then $7,000 times the three years (2001-2013) that are already used up divided by the tax rate would equal $8,400. The $8,400 represents the portion of the insurance that was used in prior periods and according to the FASB rule, the number that should be recorded. Although there is no correcting entry required for the accounting error, a 2013 adjusting entry will be required. The 2013 adjusting journal entry below is what the auditor should record on the books:
Prepaid insurance 5,600
Insurance expense 8,400
Retained Earnings 14,000
The second false accounting fact that surfaced by the auditor was a change in the salvage values used in calculation deprecation, effective on January 1, 2013. Starting on December 29, 2002 the $600,000 cost of the building has been on a straight-line depreciation method, which would result in a salvage value of $100,000. Unfortunately for this company, the declining real estate values in the area indicate that the salvage value will be $25,000. According to FASB, this mistake is considered to be an accounting change in estimate.
A change in accounting estimate shall be accounted for in the period of change if the change affects that period only or in the period of change and future periods if the change affects both. A change in accounting estimate shall not be accounted for by restating or retrospectively adjusting amounts reported in financial statements of prior periods or by reporting pro forma amounts for prior periods. (250-10-45-17)
According to this FASB rule, a 2013 adjustment should be made by adjusting the depreciation amount to match the new estimates that were discovered. To do this, a new calculation is required to determine yearly depreciation. Start with the $600,000 cost of the building and subtract $125,000, which represents the old depreciation equation ($12,500 x 10). Next, take the remainder of $ 475,000 and subtract the new estimated salvage value, $25,000, which equals $450,000 left to be depreciated. Lastly divide $450,000 by 30 year (40 years – 10 years used up) to equal a new yearly depreciation value of $15,000. In accordance to the FASB rule regarding an accounting change in estimate and the new depreciation value, the 2013 adjusting journal entry that will be recorded on the books is as follows:
Depreciation 15,000
Accumulated Depreciation 15,000
The third false accounting error was committed on December 31, 2012, due to a mistake in the physical inventory count using the periodic inventory system. As a result of this error, the auditor discovered that the merchandise was overstated by $25,000. In this case, overstatement means that there was $25,000 worth of merchandise accounted for that the company did not have. According to the FASB, this is another false accounting fact that represents an accounting error.