Accounting Changes and Error corrections

1. Chapter 20 Accounting Changes and Error corrections

2. Accounting Changes

3. Accounting Changes and Error Corrections Retrospective TwoReporting Approaches Prospective

4. Error Corrections and Most Changes in Principle Retrospective • Revise prior years’ statements (that arepresented for comparative purposes) to reflectthe impact of the change. • The balance in each account affected is revised to appear as if the newly adopted accounted method had been applied all along or that the error had never occurred. • Adjust the beginning balance of retained earnings for the earliest period reported. TwoReporting Approaches Prospective

5. Changes in Estimates and Some Changes in Principle • The change is implemented in the current period, and its effects are reflected in thefinancial statements of the current andfuture years only. • Prior years’ statements are not revised. • Account balances are not revised. Retrospective TwoReporting Approaches Prospective

6. Change in Accounting Principle Qualitative Characteristics Consistency Comparability Although consistency and comparability are desirable, changing to a new method sometimes is appropriate.

7. Motivation for Accounting Choices Effect on Compensation Changing Conditions Motivations for Change Effect on Debt Agreements Effect on Union Negotiations New Standard Issued Effect on Income Taxes

8. Retrospective Approach – Most Changes in Principle Let’s look at an examples of a change from LIFO to FIFO. At the beginning of 2009, Air Parts Corporation changed from LIFO to FIFO. Air Parts has paid dividends of $40 million each year since 2002. Its income tax rate is 40 percent. Retained earnings on January 1, 2007, was $700 million; inventory was $500 million. Selected income statement amounts for 2009 and prior years are (in millions):

9. Retrospective Approach For each year reported, Air Parts makes the comparativestatements appear as if the newly adopted accountingmethod (FIFO) had been in use all along.

10. Comparative balance sheets will report 2007 inventory $345 million higher than it was reported in last year’s statements. Retained earnings for 2007 will be $207 million higher.[$345 million × (1 – 40% tax rate)] Retrospective Approach For each year reported, Air Parts makes the comparativestatements appear as if the newly adopted accountingmethod (FIFO) had been in use all along.

11. Comparative balance sheets will report 2008 inventory $400 million higher than it was reported in last year’s statements. Retained earnings for 2008 will be $240 million higher.[$400 million × (1 – 40% tax rate)] Retrospective Approach For each year reported, Air Parts makes the comparativestatements appear as if the newly adopted accountingmethod (FIFO) had been in use all along.

12. Comparative balance sheets will report 2009 inventory $460 million higher than it would havebeen if the change from LIFO had not occurred. Retained earnings for 2009 will be $276 million higher.[$460 million × (1 – 40% tax rate)] Retrospective Approach For each year reported, Air Parts makes the comparativestatements appear as if the newly adopted accountingmethod (FIFO) had been in use all along.

13. Retrospective Approach On January 1, 2009, the date of the change,the following journal entry would be madeto record the change in principle. 40% of $400,000,000

14. Retrospective Approach In the first set of financial statements after thechange is made, a disclosure note is needed to Providejustification for the change. Point out thatcomparativeinformation hasbeen revised. Report any pershare amountsaffected for thecurrent and allprior periods.

15. Prospective Approach – Some Changes in Principle The prospective approach is used for changes in principle when: • It is impracticable to determine some period- specific effects. • It is impracticable to determine the cumulative effect of prior years. • The change is mandated by authoritative pronouncements. Most changes in principle are reported by the retrospective approach, but:

16. Prospective Approach – Change in Accounting Estimate A change in depreciation method is considered to be achange in accounting estimatethat is achieved by a change in accounting principle. It is accounted forprospectivelyas a change in accounting estimate.

17. Change in Accounting Estimate Changes in accounting estimates are accounted for prospectively. Let’s look at an example of a change in a depreciation estimate. On January 1, 2005, Towing, Inc. purchased specialized equipment for $243,000. The equipment has been depreciated using the straight-line method and had an estimated life of 10 years and salvage value of $3,000. In 2009 the total useful life of the equipment was revised to 6 years. The 2009 depreciation expense is a. $24,000 b. $48,000 c. $72,000 d. $73,500 $243,000 – $3,000 = $24,000 (2005 – 2008) 10 years $24,000 × 4 years = $96,000 Accum. Depr. $243,000 – $96,000 = $147,000 Book Value $147,000 – $3,000 = $72,000 (2009 – 2010) 2 years

18. Changing Depreciation Methods Universal Semiconductors switched from SYDdepreciation to straight-line depreciation in 2009. The asset was purchased at the beginning of 2007for $63 million, has a useful life of 5 years andan estimated residual value of $3 million.

19. Changing Depreciation Methods ÷

20. Changing Depreciation Methods Depreciation adjusting entryfor 2009, 2010, and 2011.

21. Change in Reporting Entity A change in reporting entity occurs as a result of:  presenting consolidated financial statements in place of statements of individual companies, or  changing specific companies that constitute the group for which consolidated statements are prepared.

22. Change in Reporting Entity Summary of the Retrospective Approach for Changes in Reporting Entity Recast all previous periods’ financial statements as if the new reporting entity existed in those periods. In the first financial statements after the change:  A disclosure note should describe the nature of and the reason for the change.  The effect of the change on net income, income before extraordinary items, and related per share amounts should be shown for all periods presented.

23. Error Correction • Examples include: • Use of inappropriate principle • Mistakes in applying GAAP • Arithmetic mistakes • Fraud or gross negligence in reporting • For all years disclosed, financial statements are retrospectively restatedto reflect the error correction.

24. Correction of Accounting Errors Four-step process • Prepare a journal entryto correct any balances. • Retrospectively restateprior years’ financial statements that were incorrect. • Report correction as a prior period adjustmentif retained earnings is one of the incorrect accounts affected. • Include a disclosure note.

25. Prior Period Adjustments Prior Period Adjustment Required Counterbalancing error discovered in the second year. Noncounterbalancing error discovered in any year. Use the retrospective approach

26. Errors Occurred and Discovered in the Same Period Corrected byreversingthe incorrect entry and then recording the correct entry (or by making an entry to correct the account balances)

27. Involves incorrect classification of accounts. Requires correction of previously issued statements(retrospective approach). Is notclassified as a prior period adjustment since it does not affect prior income. Disclose nature of error. Errors Not Affecting Prior Years’ Net Income

28. Requires correction of previously issued statements(retrospective approach). All incorrect account balances must be corrected. Is classified as a prior period adjustment since it does affect prior income. Disclose nature of error. Error Affecting Prior Year’s Net Income

29. Error Affecting Prior Year’s Net Income In 2009, the accountant at Orion, Inc. discovered the depreciation of $50,000 on a new asset purchased in 2008 had not been recorded on the books. However, the amount was properly reported on the tax return. This is the only difference between book and tax income. Accounting income for 2008 was $275,000 and taxable income was $225,000. Orion, Inc. is subject to a 30% tax rate and prepares current period statements only. The entry made in 2008 to record income taxes was

30. Error Affecting Prior Year’s Net Income This error affected the following accounts Remember, the 2008 expense accounts were closed to RE.

31. Error Affecting Prior Year’s Net Income Let’s assume the following: On 1/1/09, the retained earnings balance was $922,000. In 2009, the company paid $65,000 in dividends. Net income for 2009 was $184,000. The Statement of Retained Earnings (or RE column of the Statement of Shareholders’ Equity) would be as follows:

32. Correction of Accounting Errors Identify the type of accounting error for the following item: Ending inventory was incorrectly counted. a.Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above.

33. Correction of Accounting Errors Identify the type of accounting error for the following item: Loss on sale of furniture was incorrectly recorded as depreciation expense. a.Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above.

34. Correction of Accounting Errors Identify the type of accounting error for the following item: Depreciation expense was understated. a. Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above.

35. Correction of Accounting Errors A prior period adjustment is not required for a a. Counterbalancing error affecting net income discovered in the second year. b. Counterbalancing error affecting net income discovered after the second year. c. Noncounterbalancing error affecting net income. d. None of the above.

36. Summary of Accounting Changes and Errors