Ali
Reiners, a new controller of Luftsa Corp., is preparing the financial
statements for the year ended December 31, 2011. Luftsa is a publicly traded
entity and therefore follows IFRS. As a result of this review, Ali has found the
following information.
1.
Luftsa has been offering a loyalty rewards program to its customers for about
five years. In the past, the company has not recorded any accrual related to
the accumulated points as the amounts were not significant. However, with
recent changes to the plan in 2011, the loyalty points are now accumulating
much more rapidly and have become material.
Ali
has decided that effective January 1, 2011, the company will defer the revenue
related to these points at the time of each sale, which will result in a liability.
2.
In 2011, Luftsa decided to change its accounting policy for depreciating
property, plant, and equipment to depreciate based on components and also to
adopt the revaluation model. The company hired specialized appraisers at
January 1, 2011, to determine the fair values, useful lives, and depreciable
amounts for all of the components of the assets. In prior years, the company
did not have sufficient documentation to be able to apply component accounting,
and the appraisers were not able to determine this information.
3.
One division of Luftsa Corp., Rosentiel Co., has consistently shown an
increasing net income from period to period. On closer examination of its
operating statement, Ali Reiners noted that inventory obsolescence charges are
much lower than in other divisions. In discussing this with the division’s
controller, Ali learned that the controller knowingly makes low estimates
related to the writeoff of inventory in order to manage his bottom line.
4.
In 2011, the company purchased new machinery that is expected to increase
production dramatically, particularly in the early years. The company has
decided to depreciate this machinery on an accelerated basis, even though other
machinery is depreciated on a straight-line basis.
5.
All products sold by Luftsa are subject to a three-year warranty. It has been
estimated that the expense ultimately to be incurred on these machines is 1% of
sales. In 2011, because of a production breakthrough, it is now estimated that 0.5%
of sales is sufficient. In 2009 and 2010, warranty expense was calculated as
$64,000 and $70,000, respectively.
The
company now believes that warranty costs should be reduced by 50%.
6.
In reviewing the capital asset ledger in another division, Usher Division, Ali
found a series of unusual accounting changes in which the useful lives of
assets were substantially reduced when halfway through the original life
estimate. For example, the useful life of one truck was changed from 10 to 6
years during its fifth year of service. The divisional manager, who is
compensated in large part by bonuses, indicated on investigation, “It’s
perfectly legal to change an accounting estimate. We always have better
information after time has passed.”
Instructions
Ali
Reiners has come to you for advice about each of the situations. Prepare a
memorandum to the controller, indicating the appropriate accounting treatment
that should be given to each situation. For any situations where there might be
ethical considerations, identify and assess the issues and suggest what should
be done.
Memorandum to: Ali Reiners, Controller
From: Accountant
Subject: Accounting
treatment of various issues at Luftsa Corp.
Here are my
recommendations on the various issues you have brought to my attention. If you
have further questions or wish to discuss these issues, please do not hesitate
to contact me.
1. This
situation is an adoption of a new accounting policy. In previous years, the loyalty points award
program was immaterial. Now, however,
the item has become material and the company is going to apply the appropriate
accounting policy to defer loyalty points awards at the time of the sale. Consequently, the accounting policy can be
applied prospectively starting January 1, 2011. Note disclosure is appropriate to describe
this new policy and its impact on the current and future periods, if
practicable to estimate.
2. In
this situation, the company is changing its policies to use components for
depreciation and the revaluation model.
Luftsa has determined that it was not practicable to determine the
impact of depreciation on components on prior years since the information was
not available, so the policy change cannot be applied retrospectively. Additionally, the revaluation model may be
implemented prospectively even though it is also a change in policy. IAS 8 paragraph 17 indicates that the initial
application of the revaluation model is dealt within IAS 16, not IAS8. As a result, IAS 16 allows prospective
treatment since it would be difficult to go back and determine fair values at
previous dates. The note disclosure would state why the company believes that
these policies provide reliable and more
relevant information. The company would
also be required to note the impact on the opening balances as the company
adopts the revaluation method for the assets at January 1, 2011 – that is the
changes to the assets, deferred taxes and the revaluation surplus. Finally, the company should also disclose
the impact on the depreciation and taxes for the current period with the
adoption of these two new policies.
3. This
situation is considered a correction of an error. The general rule is that
careful estimates that later prove to be incorrect should be considered changes
in estimates. Where the estimate was obviously computed incorrectly because of
lack of expertise or in bad faith, the adjustment should be considered an
error. Changes due to error should employ the retrospective approach by:
a. Restating, via a prior period adjustment, the
beginning balance of retained earnings for the statements of the current
period.
b.
Correcting all prior period statements
presented in comparative financial statements. The amount of the error related
to periods prior to the earliest year’s statement presented for comparative
purposes should be
included
as an adjustment to the beginning balance of retained earnings of that earliest
year’s statement. In addition, an
opening balance sheet must be presented for the earliest comparative period.
There
are ethical issues involved in this situation. These involve the honesty and
integrity of Rosentiel’s financial reporting practices versus the corporation’s
and the division controller’s profit motives. Understating inventory
obsolescence would overstate the division’s net income. Such a practice
distorts Rosentiel’s operating results and misleads users of the financial
statements. This practice is unethical and must be reported to Luftsa’s Board
of Directors. In addition, the result of these practices is that excess bonuses
may have been paid to the divisional controller, at the expense of other
divisional controllers whose results would not have looked favourable in
comparison.
4. No
adjustment is necessary—a change in accounting policy is not considered to have
happened if a new policy is adopted in recognition of events that have occurred
for the first time.
5. This
situation is considered a change in estimate because new events have occurred
which call for a change in estimate. The accounting change is made
prospectively. Note disclosure would
describe the impact of the change on the current earnings, and any impact that
is practicable to estimate for the future.
6. Even
though this situation looks like a change in estimate, the facts of the case
indicate that the estimates were not revised based on better information, but
rather revised incorrectly due to bad faith by the divisional manager. This
situation is considered a correction of an error. The accounting treatment
would be the same as discussed in 3.
There
are ethical issues involved in this situation as well that relate to the
honesty and integrity of Usher’s financial reporting practices and the
divisional manager’s profit motives. Shortening the life of assets from 10 to 6
years may be evidence that depreciation expenses during the first five years
were understated. Such a practice distorts Usher’s operating results and
misleads users of Usher’s (and ultimately Luftsa's) financial statements. If
this practice is intentional, it is unethical. In addition, the result of these
practices is that excess bonuses may have been paid to the divisional manager. This situation should be reported to the
highest levels of management within Luftsa (the Board of Directors).
