© 2004 the mcgraw-hill companies, inc. mcgraw-hill/irwin chapter 21 accounting changes and error...

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Chapter 21

Accounting Changes and Error Corrections


Slide21-2

Type of Accounting Change Definition

Change in Accounting Principle

Replaces one GAAP with another GAAP

Change in Accounting Estimate

Revision of an estimate because of new information or new experience

Change in Reporting Entity

Change from reporting as one type of entity to another type of entity

Accounting Changes


Slide21-3

Accounting Changes

Error corrections . . .

• Are not classified as accounting changes.

• Do affect the income of prior periods and require special

treatment.

Error corrections . . .

• Are not classified as accounting changes.

• Do affect the income of prior periods and require special

treatment.


Slide21-4


ProspectiveTreatment


CurrentTreatmentCurrent

Treatment

RetroactiveTreatment


Three Reporting Approaches


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Treatment




1. Cumulative effect of using the new principle is computed as of the beginning of the period and is included on the income statement.

2. No restatements.

3. Report pro-forma information.


Slide21-6





Treatment




1.No restatements.

2.No pro forma statements.

3.Effects of change is reflected in current and future financial statements.


Slide21-7





Treatment




1.Restate prior years’ financial statements on a basis consistent with new principle.

2.Cumulative effect reported in R/E of earliest year presented.


Slide21-8

Accounting Changes

Reporting ApproachTypes of Accounting Changes Required

Accounting Changes:1. Changes in accounting principle a. Most principle changes Current Approach b. Specified exceptions Retroactive Approach

or Prospective Approach2. Changes in accounting estimates Prospective Approach

3. Changes in reporting entity Retroactive Approach*

* For changes in reporting entity, an adjustment to current beginning Retained Earnings is not required.


Slide21-9

Change in Accounting Principle

Consistency Comparability

Qualitative Characteristics

Although consistency and comparability are desirable, changing to a new method is sometimes appropriate.


Slide21-10

Motivation for Accounting Choices

Changing ConditionsChanging Conditions

New Standard Issued

New Standard Issued

Effect on Compensation

Effect on Compensation

Effect on Debt Agreements

Effect on Debt Agreements

Effect on Union Negotiations

Effect on Union Negotiations

Motivations for Change

Motivations for Change

Effect on Income Taxes

Effect on Income Taxes


Slide21-11

Current Approach

Cumulative adjustment is reported as a separate income

statement item below income from

continuing operations.

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.


Pro forma income amounts are disclosed.

Summary of the Current Approach


Slide21-12

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.


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Current Approach

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?

A partial income statement for XYZ is as follows:


Slide21-14

Current Approach

Decrease in 2005 Net Income (56,400)$ Less: Tax Benefit [($56,400) × 30%] (16,920)

Net Decrease in 2005 (39,480)$

Prepare the journal entry to record the

accounting change in 2005.


Slide21-15

Current Approach

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


Slide21-16

Current Approach2005 2004

Income before extraordinary items and and accounting change 81,000$ 90,000$ Extraordinary gain (loss), net of tax (3,000) 5,000Effect of accounting change (39,480) -

Net income 38,520$ 95,000$

Earnings per share (100,000 shares)Income before extraordinary items and and accounting change 0.81$ 0.90$ Extraordinary gain (loss), net of tax (0.03) 0.05Effect of accounting change (0.39) -

Net income 0.39$ 0.95$


Slide21-17

Current Approach2005 2004

Pro Forma Income under DDBIncome before extraordinary items and and accounting change 2004: $90,000 - [($38,400 DDB- $30,000 SL) × 70%] 84,120$ 2005: Actual and pro forma same 81,000$ Earnings per share 0.81$ 0.84$

Net income 2004: $95,000 - [($38,400 DDB- $30,000 SL) × 70%] 89,120$ 2005: $38,520 + $39,480 78,000$ Earnings per share 0.78$ 0.89$


Slide21-18

Any questions?


Slide21-19

Cumulative adjustment is reported as an

adjustment to retained earnings, beginning

balance.

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.

In comparative financial statements, prior years’ results are

restated to reflect new principle.

Summary of the Retroactive Approach for Specified Exceptions

Retroactive Approach


Slide21-20

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.

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.



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Pro forma income amounts are required under the retroactive approach.

a. True

b. False


a. True

b. False



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a. True

b. False


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.



Slide21-23

No cumulative adjustment is made.No cumulative

adjustment is made.


New estimates are applied prospectively.


New estimates are applied prospectively.

Summary of the Prospective Approach for Specified Exceptions and Changes in Estimates

Prospective Approach


Slide21-24

Specified exceptions that require use of the prospective approach:

Change to LIFO from another inventory method.

Mandated by new accounting standard.

Specified exceptions that require use of the prospective approach:

Change to LIFO from another inventory method.

Mandated by new accounting standard.

FASB Statement Update



Slide21-25

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. $24,000b. $48,000c. $72,000d. $73,500


a. $24,000b. $48,000c. $72,000d. $73,500



Slide21-26


a. $24,000b. $48,000c. $72,000d. $73,500


a. $24,000b. $48,000c. $72,000d. $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



Slide21-27

I wonder why companies make

accounting changes? It seems like a lot of

trouble to me!


Slide21-28

No cumulative adjustment is made.No cumulative

adjustment is made.

Prior years’ results are restated.

Present consolidated financial statements.

Prior years’ results are restated.

Present consolidated financial statements.

Summary of the Retroactive Approach for Changes in Reporting Entity

Change in Reporting Entity


Slide21-29

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 restated to reflect the 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 restated to reflect the error correction.

Error Correction


Slide21-30

Prepare a journal entry to correct any balances.

Retroactively restate prior years’ financial statements that were incorrect.

Report error as a prior period adjustment if retained earnings is one of the incorrect accounts affected.

Include a disclosure note.

Prepare a journal entry to correct any balances.

Retroactively restate prior years’ financial statements that were incorrect.

Report error as a prior period adjustment if retained earnings is one of the incorrect accounts affected.

Include a disclosure note.

Correction of Accounting Errors


Slide21-31

Counterbalancing error discovered in

the second year.

Counterbalancing error discovered in

the second year.

Noncounterbalancing error discovered in

any year.

Noncounterbalancing error discovered in

any year.

Use the retroactive approach.

Prior Period Adjustment Required

Prior Period Adjustment Required

Prior Period Adjustments


Slide21-32

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).

Corrected by reversing the incorrect entry and then recording the correct entry (or by making

an entry to correct the account balances).


Slide21-33

Previous Period Error Not Affecting Net Income

Involves incorrect classification of accounts.

Requires correction of previously issued statements (retroactive approach).

Is not classified as a prior period adjustment since it does not affect prior

income.

Disclose nature of error.

Involves incorrect classification of accounts.


Is not classified as a prior period adjustment since it does not affect prior

income.



Slide21-34

Previous Period Error Affecting Net Income


All incorrect account balances must be corrected.

Is classified as a prior period adjustment since it does affect prior income.



All incorrect account balances must be corrected.

Is classified as a prior period adjustment since it does affect prior income.



Slide21-35

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.

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.

Date Description Debit Credit2004

Dec. 31 Income tax expense 82,500 Deferred tax liability 15,000

Income tax payable 67,500

General Journal

The entry made in 2004 to record income taxes was:



Slide21-36

Depreciation expense for 2004 - understated 50,000$

Accumulated depreciation for 2004 - understated 50,000

Net income in 2004 - overstated ($50,000 x 70%) 35,000

Income tax expense in 2004 - overstated 15,000

Deferred tax liability for 2004 - overstated 15,000

Depreciation expense for 2004 - understated 50,000$

Accumulated depreciation for 2004 - understated 50,000

Net income in 2004 - overstated ($50,000 x 70%) 35,000

Income tax expense in 2004 - overstated 15,000

Deferred tax liability for 2004 - overstated 15,000

This error affected the following accounts:

Remember that the 2004 expense accounts have been closed.



Slide21-37

Retained earnings, January 1, 2005

As previously reported 922,000$

Correction of error in depreciation 50,000$

Less: Income tax reduction 15,000 (35,000)

Retained earnings as restated, January 1, 2005 887,000

Add: Net income 184,000

Less: Dividends (65,000)

Retained earnings, December 31, 2005 1,006,000$

Retained earnings, January 1, 2005

As previously reported 922,000$

Correction of error in depreciation 50,000$

Less: Income tax reduction 15,000 (35,000)

Retained earnings as restated, January 1, 2005 887,000

Add: Net income 184,000

Less: Dividends (65,000)

Retained earnings, December 31, 2005 1,006,000$


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:


Slide21-38

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.









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Slide21-40


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.






Slide21-41









Slide21-42


Depreciation expense was understated.













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Slide21-44

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.









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End of Chapter 21

© 2004 the mcgraw-hill companies, inc. mcgraw-hill/irwin chapter 21 accounting changes and error...

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