ACC 423 Week 4 Leases and Accounting Changes Example

Tractors, a Terminal and Three Kinds of Change: A Finance Lease, an Operating Lease, a Switch From LIFO to FIFO and a Prior-Year Error at a Composite Regional Trucking Company

[Student Name]

University of Phoenix

ACC/423: Intermediate Financial Accounting III

Week 4 Assignment

[Instructor Name]

[Date]

The company and all figures are composites written for a model paper; accounting rules and research findings come from the sources listed.

A composite trucking company hauls freight for manufacturers and retailers across five states with 180 tractors and 420 trailers. It leases part of its fleet and several terminals and keeps a parts inventory for its maintenance shops. This year brought new equipment, a new approach to inventory and the discovery of a mistake in last year's books. Each of these events changes the numbers, but the rules care as much about when a change is shown as about how large it is. This paper records the leases and applies the correct treatment to each change.

A Finance Lease of Ten Tractors

The company leased ten new tractors for five years, their expected economic life, with annual payments of $260,000 due at the start of each year and ownership transferring at the end. Because ownership transfers and the term covers the tractors' economic life, the lease is a finance lease (Financial Accounting Standards Board, 2016). The lessor's implicit rate, which the company can determine from the lease terms, is 7%.

Because each payment falls on the first day of its year, the stream is an annuity due. The ordinary five-period factor at 7%, 4.10020, is multiplied by 1.07 to give 4.38721. The lease liability and right-of-use asset are each about $1,140,700.

The first payment on the lease date reduces the liability to about $880,700. Over the first year, interest at 7% is about $61,600, which is accrued and paid with the second payment. The right-of-use asset is amortized over five years, about $228,100 a year. The income statement shows interest expense and amortization separately, $289,700 in total for the first year, more than the annual payment, because finance lease costs are front-loaded.

An Operating Lease of a Terminal

The company also leased a cross-dock terminal for eight years at $180,000 a year. The lease does not transfer ownership, has no purchase option and covers a small part of the building's life, so it is an operating lease. Its balance sheet still gains an obligation and a matching asset, each measured at the present value of the eight payments, but the income statement shows a single straight-line lease cost of $180,000 a year. Behind that single figure, the liability still grows by interest each year, and the asset is written down by whatever part of the $180,000 is not interest, so both balances reach zero together at the end of the term.

A Change in Principle: LIFO to FIFO

The company has valued its parts inventory using LIFO. Management concluded that FIFO better reflects the cost of parts actually used, since the shop issues the oldest stock first, and changed to FIFO. A change in accounting principle is applied retrospectively: prior periods presented are adjusted as if FIFO had always been used (Financial Accounting Standards Board, 2005).

Under FIFO, inventory at the start of this year would have been $1.8 million higher. Cost of goods sold in all prior years combined would have been $1.8 million lower, and at a 25% tax rate, income taxes $450,000 higher. The cumulative effect is added to the retained earnings balance at the start of the first year shown, $1.35 million, and last year's comparative statements are restated. A deferred tax liability of $450,000 is recognized for the difference between book inventory and its tax basis.

A Change in Estimate: Depreciation Method

The company changed its trailers from straight-line to declining-balance depreciation, because trailers lose value faster in early years than engineers had assumed. Although this looks like a change in principle, the standard treats a switch in depreciation method as a change in estimate that happens to be carried out through a new method, so it is applied prospectively. The trailers' remaining book value is depreciated under the new method from this year forward. No prior periods are restated.

An Error: Unrecorded Wages

While closing the year, the payroll team found that drivers' wages for the last week of the prior year, $240,000, had never been accrued. As a result, the prior year's wage cost was too low and its profit too high. This is an error, not a change. The prior year's statements are restated, and the opening balance of retained earnings for this year is reduced by the error net of tax, $180,000, as a prior-period adjustment. Because the wages were paid in January and charged to this year's wage expense, this year's expense is overstated by the same $240,000. The correcting entry debits retained earnings for $180,000, records the $60,000 tax effect and credits wage expense for $240,000, so both years now carry the wages they actually incurred. The payroll team has added a cutoff check to the year-end close: the last payroll period is compared with the calendar, and any days worked but not yet paid are accrued.

Effect on Ratios

The new leases change the balance sheet more than the income statement. Together they add about $2.3 million of liabilities, raising total liabilities to equity from 1.4 to about 1.6. The company's lender measures its covenant on funded debt, and the loan agreement states that operating lease liabilities are excluded, so the covenant is unaffected, but the finance lease counts. The controller confirmed the effect with the lender before signing.

Disclosures

For the LIFO to FIFO change, the company discloses the nature of and reason for the change and its effects on each line of the statements. For the depreciation change, it discloses the effect on income. For the error, it discloses the nature of the error, the restatement and its effect on each prior period. Hennes et al. (2008) found that restatements classified as irregularities rather than errors were followed by higher turnover of chief executives and chief financial officers, evidence that investors and boards read these disclosures closely.

Conclusion

The trucking company's finance lease of tractors shows interest and amortization separately, while its terminal lease shows a single straight-line cost, but both are on the balance sheet. Its three changes received three treatments: a new inventory principle applied retrospectively, a depreciation method change applied prospectively and an error corrected by restatement. Weygandt et al. (2021) note that these rules exist so that readers can compare periods on the same basis, which is the purpose of each adjustment here.

References

Financial Accounting Standards Board. (2005). Accounting changes and error corrections (Statement of Financial Accounting Standards No. 154).

Financial Accounting Standards Board. (2016). Leases (Topic 842) (Accounting Standards Update No. 2016-02).

Hennes, K. M., Leone, A. J., & Miller, B. P. (2008). The importance of distinguishing errors from irregularities in restatement research: The case of restatements and CEO/CFO turnover. The Accounting Review, 83(6), 1487-1519. https://doi.org/10.2308/accr.2008.83.6.1487

Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2021). Accounting principles (14th ed.). Wiley.