Background: Judgment can at times be required to determine whether an event shou

Question

Background: Judgment can at times be required to determine whether an event should be accounted for as a change in accounting estimate or as the correction of an error. The accounting for these topics is addressed in ASC 250 (Accounting Changes and Error Corrections). After reading the following fact pattern, you will be challenged to evaluate whether an event is an error correction or change in estimate, and you will be asked to discuss the differences in the accounting treatment for these two alternatives.

Facts: You are the owner of a lawn service company (LawnCo) which provides grounds and maintenance services to a range of corporate customers. Customers are expected to pay on the first of each month, in advance of receiving services. One of your corporate customers is an eldercare facility whose grounds you have maintained for many years. The customer has not paid for the last three months of services (from Oct.-Dec. 20X1); nevertheless, to maintain a positive relationship, your company continued to provide mowing and weed control services to the eldercare facility during that time. Your company ceased providing services in January 20X2 and found out in that same month that the eldercare facility filed for bankruptcy in September. Your company now believes that collection of the missed payments is extremely unlikely. Your company has already issued financial statements (for the period ending 12/31/X1) which reflected revenue and a corresponding account receivable related to this customer of $10,000 per month for services provided to this customer. Those financial statements also reflected the company’s standard allowance (reserve) amount on receivables, of 4% of sales. In total, your company’s average monthly sales amount to $500,000.

Required:

1. Evaluate whether receipt of this information indicates you have a change in accounting estimate or whether the customer’s bankruptcy should result in this event being considered an error in previously issued financial statements. First, locate the definitions of these terms; next, provide a list of factors which would support each alternative.

2. Next, describe the accounting treatment (as required by the Codification) for each alternative, then support your explanations with draft journal entries. You are not required to provide detail on how financial statements would be presented/prepared, rather focus on describing the Codification’s requirements and how they relate to this issue, and include journal entries that you believe are consistent with those requirements.

3. Finally, briefly state which treatment appears to be more appropriate given the circumstances. If you must make any assumptions in reaching this conclusion, state these.

Explanation / Answer

Answers

Answer 1

Evaluate whether receipt of this information indicates you have a change in accounting estimate or whether the customer’s bankruptcy should result in this event being considered an error in previously issued financial statements. First, locate the definitions of these terms; next, provide a list of factors which would support each alternative.

Answer :

Accounting Estimates

Due to uncertainties involved in business, many items in financial statements cannot be measured with precision. It involves judgements based on latest available information. They are called Accounting estimates. Estimate may require for bad debts, inventory obsolescence, Fair value of financial assets and liability, useful life of depreciable assets etc. It may need revision on changes in circumstances of such estimate or as a result of new information.

Prior period errors

Prior Period errors are omissions or misstatement in financial statements for one or more prior period arising from failure to use, or misuse of, reliable information that was available when financial statements for those periods were approved for issue and could reasonably be expected to have been obtained and taken into account in preparation and presentation of those financial statements. Such errors include effects of mathematical mistakes, mistake in applying accounting policies, oversights, misinterpretations of facts, fraud.

Here, the customer (eldercare facility) has not paid for the last three months of services (from Oct.-Dec. 20X1); nevertheless, to maintain a positive relationship, your company continued to provide mowing and weed control services to the eldercare facility during that time.

Your company ceased providing services in January 20X2 and found out in that same month that the eldercare facility filed for bankruptcy in September.

So Fact information that eldercare facility filed for bankruptcy was available in September 20X1 and it should have been taken into account while preparing financial statements for the period ending 12/31/X1. It is failure to use reliable information that was available when financial statements for those periods were approved for issue. So It is an error in previously issued financial statements.

Answer 2

Next, describe the accounting treatment (as required by the Codification) for each alternative, then support your explanations with draft journal entries.

You are not required to provide detail on how financial statements would be presented/prepared, rather focus on describing the Codification’s requirements and how they relate to this issue, and include journal entries that you believe are consistent with those requirements.

Answer :

Here, The customer (eldercare facility) has not paid for the last three months of services (from Oct.-Dec. 20X1).So Fact information that eldercare facility filed for bankruptcy was available in September 20X1 and it should have been taken into account while preparing financial statements for the period ending 12/31/X1. It is failure to use reliable information that was available when financial statements for those periods were approved for issue. So It is an error in previously issued financial statements.

Your company has reflected revenue and a corresponding account receivable related to eldercare facility of $ 30,000 [$10,000 per month *3 months (Oct – Dec 20X1)]. Which is 6% of total sales revenue ($ 30000 / $500,000). This Prior period error is material.

All material prior period errors should be corrected retrospectively. Here $ 30000 of eldercare facility has failed to meet revenue recognition criteria due to bankruptcy filed by eldercare facility in September 20X1 itself. So such revenue recognised should be reversed.

Draft Journal Entry

Sales revenue A/c Dr.

                  To Account Receivables A/c Cr

Answer 3

Finally, briefly state which treatment appears to be more appropriate given the circumstances, If you must make any assumptions in reaching this conclusion, state these.

Answer :

It is more appropriate to consider it as prior period error because company has recognised 6% of total revenue which is not fulfilling revenue recognition criteria due to bankruptcy filed by customer.

Assumptions made is

When any customer files bankruptcy, Company should stop recognize its revenue immediately and any error in this regard should be corrected retrospectively.

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