Hollington
Corp.’s controller was preparing the year-end adjusting entries for the
company’s year ended December 31, 2011, when the V.P. Finance called him into
her office. “Jean-Pierre,” she said, “I’ve been considering a couple of matters
that may require different treatment this year. First, the patent we acquired
in early January 2009 for $410,000 will now likely be used until the end of
2013 and then be sold for $110,000. We previously thought that we’d use it for
10 years in total and then be able to sell it for $50,000. We’ve been using
straight-line amortization on the patent.
“Secondly,
I just discovered that the property we bought midway through 2008 for $135,000
was charged entirely to the Land account instead of being allocated between
Land ($33,750) and Building ($101,250). The building should be of use to us for
a total of 20 years. At that point, it’ll be sold and we should be able to
realize at least $37,000 from the sale of the building.
“Please
let me know how these changes should be accounted for and what effect they will
have on the financial statements.”
Instructions
(a)
Briefly identify the accounting treatment that should be applied to each
accounting change that is required.
(b)
Assuming that no amortization has been recorded as yet for the patent for 2011,
prepare the December 31, 2011 entries that are necessary to make the accounting
changes and to record patent amortization expense for 2011.
(c)
Identify, and calculate where possible, the required disclosures for each
change.
(d)
Discuss the timing of applying the change in the patent’s useful life and
residual value. Since the determination of the change was done as part of the
year-end process, should the change be applied to 2011 going forward, or to
2012 going forward? What are the implications of each approach?
(e)
Could Hollington’s controller consider the patent to be impaired instead of
revising its useful life and residual value?
What
criteria should the controller look at to determine the appropriate treatment?
(a) Patent: This
is a change in estimate. The change would be applied to the current year and
prospectively.
Land and
Building: This is a correction of an error. The adjustment would be applied
retrospectively. This would include
restating all prior period financial statements presented for comparison,
adjusting the opening balance of retained earnings for the earliest period
presented, and providing note disclosure.
(b) Amortization of Patent:
Amortization
Expense.................... 76,000
Accumulated
Amortization—Patent..... 76,000
Amortization
recorded in 2009 and 2010:
($410,000 –
$50,000) / 10 years X 2 years = $72,000
Annual
amortization incorporating this change:
($410,000 –
$110,000 – $72,000) / 3 years (2011 to 2013)
................................. =
$76,000
Land and
Building – error correction entry:
Building.............................. 101,250
Land.............................. 101,250
Depreciation
Expense*................. 3,213
Retained
Earnings – Correction of an Error 8,033
Accumulated
Depreciation ($3,213* X 3.5) 11,246
*($101,250 –
$37,000) / 20 years = $3,213 / year
(c) Change in Estimate (Patent): The nature
and amount of the change should be disclosed. Amortization expense for the
patent has been increased by $40,000 for the current and future years due to a
change in estimated useful life and residual value.
Correction of Error (Land and Building):
The disclosure should enable users to understand the
effects of the error on the financial statements. It should include a statement
of the nature of the error, the amount of the correction for each prior period
presented and the amount related to periods prior to those presented, and a
statement that comparative information has been restated. Depreciation expense
has been increased by $3,213 for both 2011 and 2010 (include previous years if
included in comparative statements). This has decreased net income by $3,213
for both 2011 and 2010 and earnings per share by $XXX in each year.
(d) If
management determines assets’ useful lives and residual values as part of the
year end process, it is likely that the conditions leading to these changes
would have occurred during the year. In this case, the change in estimate would
be applied to 2011 going forward. If management determines that the factors
leading to the change in estimate occurred at or after year end, the changes
would be applied to 2012 going forward.
In this exercise, it appears that
depreciation and amortization expense is recorded once a year. Since the
controller uses the adjustment process to revise the estimate of useful life
and residual value, it would be appropriate to reflect the change to 2011 going
forward.
(e) Impairments
of depreciable assets frequently involve a revision of estimates of useful life
and residual value, but changes in estimates do not necessarily come from
impairments of assets. The controller would need to review the patent for
impairment if events or changes in circumstances indicate that the carrying
amount of the patent may not be recovered. If events or circumstances indicate
an impairment, the controller would need to do a recoverability test and
compare the patent’s carrying amount to the undiscounted cash flows. If the recoverability test is not met, the
impairment loss would be the excess of the patent’s carrying amount over its
fair value. Impairment tests are done whenever events or circumstances indicate
an impairment and not necessarily as part of the year end adjustment process.
In this exercise there is no indication that the change in estimates is due to
an impairment and information to calculate any cost recovery is not provided.
Consequently, the changes would be accounted for as a change in estimate.
