Cross Company Limited, a private company, was started on January 1, 2017. For the first year, the chief accountant prepared the financial statements and a local accountant completed the necessary review of these statements. However, for the year ended December 31, 2018, an external auditor was appointed. The income statement for 2017 and the preliminary amounts for 2018 are as follows:

In the process of examining the accounting records, the auditor noted the following issues: 

i. Long-term contracts: Cross Company used the completed contract method for revenue recognition in 2017. Management now believes that the percentage of completion method would be better. Income under the completed contract method for 2017 was $3,000,000 and for 2018 it was $4,000,000. If the percentage of completion method had been used, the incomes would have been $4,200,000 (2017) and $3,700,000 (2018). 

ii. Accounts receivable: The accounts receivable on December 31, 2017, included a $100,000 account that was not provided for but subsequently was written off during 2018 as the customer went bankrupt after the issuance of the financial statements. Cross Company would like to adjust 2017 for this oversight as it sees this as an error. 

iii. Machine depreciation: Cross Company has one huge machine that cost $5,000,000 and was depreciated over an estimated useful life of 10 years. Upon reviewing the manufacturer’s reports in 2018, management now firmly believes the machine will last a total of 15 years from date of purchase. They would like to change last year’s depreciation charge based on this analysis. Depreciation expense of $500,000 has been recorded for 2018. 

iv. Building depreciation: The company’s building (cost $3,000,000, estimated salvage value $0, useful life 20 years) was depreciated last year using the 10% declining balance method. The company and auditor now agree that the straight-line method would be a more appropriate method to use. A depreciation provision of $270,000 has been made for 2018. 

v. Inventories: The accountant last year failed to apply the lower of cost and net realizable value test to ending inventory. Upon review, the inventory balance for last year should have been reduced by $200,000. The closing inventory allowance for this year end should be $300,000. No entry has been made for this matter. 

vi. Warranties: Cross Company does not accrue for warranties; rather it records the warranty expense when amounts are paid. Cross provides a one-year warranty for defective goods. Payments to satisfy warranty claims were $200,000 in 2017, and $320,000 in 2018. Out of the $320,000 paid in 2018, $150,000 related to 2017 sales. A reasonable estimate of warranties payable at the end of 2018 is $275,000. 

Required:

a. As the audit senior on this engagement, what is your recommended treatment for each of these matters in terms of whether they are errors, changes in accounting policy, or changes in estimate? Explain your conclusion. 

b. Assume that management of Cross Company agrees with your recommendations. Prepare the corrected statements of comprehensive income for 2017 and 2018.

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Long-term contract income Other income (loss) Bad debt expense Depreciation expense-machine Depreciation expense-building Warranty expense Income before taxes Income taxes (at 30%) Net income 2017 $3,000,000 (800,000) (400,000) (500,000) (300,000) (200,000) 800,000 (240,000) $ 560,000 2018 $4,000,000 (900,000) (500,000) (500,000) (270,000) (320,000) 1,510,000 (453,000) $1,057,000