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Chapter 21

Chapter 21. Accounting Changes and Error Corrections. Accounting Changes. Accounting Changes. Error corrections . . . Are not classified as accounting changes. Do affect the income of prior periods and require special treatment. Accounting Changes and Error Corrections.

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Chapter 21

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  1. Chapter 21 Accounting Changes and Error Corrections

  2. Accounting Changes

  3. Accounting Changes • Error corrections . . . • Are not classified as accounting changes. • Do affect the income of prior periods and require special treatment.

  4. Accounting Changes and Error Corrections RetroactiveTreatment Three Reporting Approaches ProspectiveTreatment CurrentTreatment

  5. Accounting Changes and Error Corrections RetroactiveTreatment • Cumulative effect of using the new principle is computed as of the beginning of the period and is included on the income statement. • No restatements. • Report pro-forma information. Three Reporting Approaches ProspectiveTreatment CurrentTreatment

  6. Accounting Changes and Error Corrections • No restatements. • No pro forma statements. • Effects of change is reflected in current and future financial statements. RetroactiveTreatment Three Reporting Approaches ProspectiveTreatment CurrentTreatment

  7. Accounting Changes and Error Corrections RetroactiveTreatment Three Reporting Approaches • Restate prior years’ financial statements on a basis consistent with new principle. • Cumulative effect reported in R/E of earliest year presented. ProspectiveTreatment CurrentTreatment

  8. Accounting Changes

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

  10. 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

  11. Cumulative adjustment is reported as a separate income statement item below income from continuing operations. Prior years’ results remain unchanged. Pro forma income amounts are disclosed. Current Approach Summary of the Current Approach

  12. Current Approach During 2005, XYZ Company made a change from the straight-line method to the double- declining balance method for depreciation. The following schedule illustrates the effect of this change.

  13. Current Approach A partial income statement for XYZ is as follows: The company has 100,000 shares of common stock outstanding and is taxed at 30%. How would the change in depreciation method appear on the comparative income statements for 2005 and 2004?

  14. Current Approach Prepare the journal entry to record the accounting change in 2005.

  15. Current Approach Now let’s look at the impact of this change on the income statement.

  16. Current Approach

  17. Current Approach

  18. Any questions?

  19. Cumulative adjustment is reported as an adjustment to retained earnings, beginning balance. In comparative financial statements, prior years’ results are restated to reflect new principle. Retroactive Approach Summary of the Retroactive Approach for Specified Exceptions

  20. Retroactive Approach The following accounting principle changes are subject to the retroactive approach: • Change to a principle required by a new pronouncement recognized as GAAP that requires retroactive application. • Change from LIFO to another inventory method. • Change in the method of accounting for long-term construction contracts. • Change to or from full-cost method in extractive industries. • Changes made when a closely held corporation first issues financial statements to obtain equity financing for registering securities or for effecting a business combination.

  21. Retroactive Approach Pro forma income amounts are requiredunder the retroactive approach. a. True b. False

  22. Retroactive Approach Pro forma income amounts are requiredunder the retroactive approach. a. True b. False Since the retroactive approach requires restatement of prior years’ financial statements to conform to the new accounting principle, pro forma income amounts are not required.

  23. No cumulative adjustment is made. Prior years’ results remain unchanged. New estimates are applied prospectively. Prospective Approach Summary of the Prospective Approach for Specified Exceptions and Changes in Estimates

  24. Prospective Approach Specified exceptions that require use of the prospective approach: • Change to LIFO from another inventory method. • Mandated by new accounting standard. FASB Statement Update

  25. Prospective Approach 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 totaluseful 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

  26. Prospective Approach 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

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

  28. No cumulative adjustment is made. Prior years’ results are restated. Present consolidated financial statements. Change in Reporting Entity Summary of the Retroactive Approach for Changes in Reporting Entity

  29. 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 retroactively restatedto reflect the error correction.

  30. Correction of Accounting Errors • Prepare a journal entryto correct any balances. • Retroactively restateprior years’ financial statements that were incorrect. • Report error as a prior periodadjustmentif retained earnings is one of the incorrect accounts affected. • Include a disclosure note.

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

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

  33. Previous Period Error Not Affecting Net Income Involves incorrect classification of accounts. Requires correction of previously issued statements(retroactive approach). Is notclassified as a prior period adjustment since it does not affect prior income. Disclose nature of error.

  34. Previous Period Error Affecting Net Income Requires correction of previously issued statements(retroactive 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.

  35. Previous Period Error Affecting Net Income In 2005, the accountant at Orion, Inc. discovered the depreciation of $50,000 on a new asset purchased in 2004 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 2004 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 2004 to record income taxes was:

  36. Previous Period Error Affecting Net Income This error affected the following accounts: Remember that the 2004 expense accounts have been closed.

  37. Previous Period Error Affecting Net Income Let’s assume the following: Retained earning as 1/1/05 was $922,000. In 2005, the company paid $65,000 in dividends. Net income for 2005 is $184,000. The Statement of Retained Earnings would be as follows:

  38. 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.

  39. 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.

  40. 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.

  41. 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.

  42. 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.

  43. 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.

  44. 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.

  45. 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.

  46. End of Chapter 21

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