Accounting Changes and Error Corrections

Insert Book Cover Picture Accounting Changesand Error Corrections 20

Learning Objectives Differentiate between the three types of accounting changes and between the retrospective and prospective approaches to accounting for and reporting accounting changes. LO1

Accounting Changes

Accounting Changes • Error corrections are . . . • Transactions that are either recorded incorrectly or not recorded at all. • Not actually accounting changes, but are accounted for similarly.

Accounting Changes andError Corrections Retrospective TwoReporting Approaches Prospective

Accounting Changes andError Corrections Retrospective • Revise prior year’s 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

Accounting Changes andError Corrections • The change is implemented in the currentperiod 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

Learning Objectives Describe how changes in accounting principle typically are reported. LO2

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

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

Retrospective Approach Let’s look at an examples of a change from LIFO toFIFO that is reported using the retrospective approach. At the beginning of 2006, Air Parts Corporation changedfrom LIFO to FIFO. Air Parts has paid dividends of $40 millioneach year since 1999. Its income tax rate is 40 percent.Retained earnings on January 1, 2004, was $700 million;inventory was $500 million. Selected income statementamounts for 2006 and prior years are (in millions):

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.

Comparative balance sheets will report 2004 inventory $345 million higher than it was reported in last year’s statements. Retained earnings for 2004 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.

Comparative balance sheets will report 2005 inventory $400 million higher than it was reported in last year’s statements. Retained earnings for 2005 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.

Comparative balance sheets will report 2006inventory $460 million higher than it would havebeen if the change from LIFO had not occurred. Retained earnings for 2006 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.

Retrospective Approach On January 1, 2006, the date of the change,the following journal entry would be madeto record the change in principle: 40% of $400,000,000

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.

Learning Objectives Explain how and why some changes in accounting principle are reported prospectively. LO3 Explain how and why changes in estimates are treated prospectively. LO4

Prospective Approach The prospective approach is used when it is: • Impracticable to determine some period- specific effects. • Impracticable to determine the cumulative effect of prior years. • Mandated by authoritative pronouncements. FASB Statement Update

Prospective Approach 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.

Changing Depreciation Methods Universal Semiconductors switched from SYDdepreciation to straight-line depreciation in 2006. The asset was purchased at the beginning of 2004for $63 million, has a useful life of 5 years andan estimated residual value of $3 million.

Changing Depreciation Methods ÷

Changing Depreciation Methods Depreciation adjusting entryfor 2006, 2007, and 2008.

Changing an Estimate Changes in accounting estimates are also accountedfor prospectively.Let’s look at an exampleof a change in adepreciation estimate.

Changing an Estimate On January 1, 2002, Towing, Inc. purchased specialized equipment for $243,000. The equipment was depreciated using straight-line and had an estimated life of 10 years and salvage value of $3,000. In 2006 the total useful life of the equipment was revised to 6 years. The 2006 depreciation expense is a. $24,000 b. $48,000 c. $72,000 d. $73,500

Changing an Estimate On January 1, 2002, Towing, Inc. purchased specialized equipment for $243,000. The equipment was depreciated using straight-line and had an estimated life of 10 years and salvage value of $3,000. In 2006 the total useful life of the equipment was revised to 6 years. The 2006 depreciation expense is a. $24,000 b. $48,000 c. $72,000 d. $73,500 $243,000 – $3,000 = $24,000 (2002 – 2005) 10 years $24,000 × 4 years = $96,000 Accum. Depr. $243,000 – $96,000 = $147,000 Book Value $147,000 – $3,000 = $72,000 (2006 – 2007) 2 years

I wonder why companies make accounting changes? It seems like a lot of trouble to me!

Learning Objectives Describe the situations that constitute a change in reporting entity. LO5

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.

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.

Learning Objectives Understand and apply the four-step process of correcting and reporting errors, regardless of the type of error or the timing of its discovery. LO6

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.

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

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

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

Error Not Affecting Prior Year’sNet Income 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.

Error Affecting Prior Year’s Net Income 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 In 2006, the accountant at Orion, Inc. discovered the depreciation of $50,000 on a new asset purchased in 2005 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 2005 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 2005 to record income taxes was:

Error Affecting Prior Year’s Net Income This error affected the following accounts: Remember that the 2005 expenseaccounts have been closed.

Error Affecting Prior Year’s Net Income Let’s assume the following: Retained earning as 1/1/06 was $922,000. In 2006, the company paid $65,000 in dividends. Net income for 2006 is $184,000. The Statement of Retained Earnings would be as follows:

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.

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.

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.

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.

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.

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.

Summary of Accounting Changes and Errors

End of Chapter 20

Accounting Changes and Error Corrections