22-1 prepared by coby harmon university of california, santa barbara intermediate accounting

22-1

Prepared by Coby Harmon

University of California, Santa Barbara

Intermediate Accounting

22-2

Intermediate Accounting

14th Edition

22Accounting Changes and Error Analysis

Kieso, Weygandt, and Warfield

22-3

1. Identify the two types of accounting changes.

2. Describe the accounting for changes in accounting policies.

3. Understand how to account for retrospective accounting changes.

4. Understand how to account for impracticable changes.

5. Describe the accounting for changes in estimates.

6. Describe the accounting for correction of errors.

7. Identify economic motives for changing accounting policies.

8. Analyze the effect of errors.

Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

22-4

Changes in accounting

policy

Changes in accounting

estimate

Change in reporting entity

Correction of errors

Summary

Motivations for change of

method

Accounting Changes Error Analysis

Balance sheet errors

Income statement errors

Balance sheet and income

statement effects

Comprehensive example

Preparation of statements

with error corrections

Accounting Changes and Error AnalysisAccounting Changes and Error AnalysisAccounting Changes and Error AnalysisAccounting Changes and Error Analysis

22-5

Types of Accounting Changes:

1. Change in Accounting Policy.

2. Changes in Accounting Estimate.

3. Change in Reporting Entity.

Errors are not considered an accounting change.

LO 1 Identify the two types of accounting changes.

Accounting Alternatives:

Diminish the comparability of financial information.

Obscure useful historical trend data.

Accounting ChangesAccounting ChangesAccounting ChangesAccounting Changes

22-6

Average cost to LIFO.

Completed-contract to percentage-of-completion.

Change from one accepted accounting policy to another.

Examples include:

Changes in Accounting PrincipleChanges in Accounting PrincipleChanges in Accounting PrincipleChanges in Accounting Principle

LO 2 Describe the accounting for changes in accounting policies.

Adoption of a new policy in recognition of events that have occurred for

the first time or that were previously immaterial is not an accounting

change.

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Three approaches for reporting changes:

1) Currently.

2) Retrospectively.

3) Prospectively (in the future).

FASB requires use of the retrospective approach.

Rationale - Users can then better compare results from one period to

the next.

LO 2 Describe the accounting for changes in accounting policies.


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Retrospective Accounting Change Approach

LO 3 Understand how to account for retrospective accounting changes.

Company reporting the change

1) Adjusts its financial statements for each prior period

presented to the same basis as the new accounting

principle.

2) Adjusts the carrying amounts of assets and liabilities as

of the beginning of the first year presented, plus the

opening balance of retained earnings.


22-9

Illustration: Denson Company has accounted for its income from

long-term construction contracts using the completed-contract

method. In 2012, the company changed to the percentage-of-

completion method. Management believes this approach provides

a more appropriate measure of the income earned. For tax

purposes, the company uses the completed-contract method and

plans to continue doing so in the future. (Assume a 40 percent

enacted tax rate.)


Retrospective Accounting Change: Long-Term Contracts


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Illustration 22-1



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Data for Retrospective ChangeIllustration 22-2

Construction in Process 220,000

Deferred Tax Liability

88,000

Retained Earnings

132,000LO 3 Understand how to account for retrospective accounting changes.

Journal entry beginning of

2012


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Reporting a Change in Principle


Major disclosure requirements are as follows.

1. Nature of the change in accounting policy;

2. The method of applying the change, and:

a. A description of the prior period information that has been

retrospectively adjusted, if any.

b. The effect of the change on income from continuing operations,

net income (or other appropriate captions of changes in net assets

or performance indicators), any other affected line item.

c. The cumulative effect of the change on retained earnings or other

components of equity or net assets in the balance sheet as of the

beginning of the earliest period presented.


22-13 LO 3

Illustration 22-3Reporting a Change in policy


22-14

Retained Earnings Adjustment


Illustration 22-4

Retained earnings balance is $1,360,000 at the beginning of 2010.

Before Change


22-15 LO 3 Understand how to account for retrospective accounting changes.

Illustration 22-5 After Change

Retained Earnings Adjustment


22-16

E22-1 (Change in Principle—Long-Term Contracts): Cherokee

Construction Company changed from the completed-contract to the

percentage-of-completion method of accounting for long-term

construction contracts during 2012. For tax purposes, the

company employs the completed-contract method and will continue

this approach in the future. (Hint: Adjust all tax consequences

through the Deferred Tax Liability account.)



22-17

E22-1 (Change in policy—Long-Term Contracts):


Instructions: (assume a tax rate of 35%)

(b) What entry(ies) are necessary to adjust the accounting records for

the change in accounting principle?

(a) What is the amount of net income and retained earnings that would

be reported in 2012? Assume beginning retained earnings for 2011 to

be $100,000.


22-18

Journal entry

2012 Construction in progress 170,000

Deferred tax liability 59,500

Retained earnings 110,500


35%Percentage- Completed- Tax Net of

Date of-Completion Contract Difference Effect Tax

2011 780,000$ 610,000$ 170,000 59,500 110,500$

2012 700,000 480,000 220,000 77,000 143,000


E22-1: Pre-Tax Income from Long-Term Contracts

22-19

Restated Previous2012 2011 2011

Pre-tax income 700,000$ 780,000$ 610,000$

Income tax (35%) 245,000 273,000 213,500

Net income 455,000$ 507,000$ 396,500$

Beg. Retained earnings 496,500$ 100,000$ 100,000$

Accounting change 110,500

Beg. R/Es restated 607,000$ 100,000 100,000

Net income 455,000 507,000 396,500

End. Retained earnings 1,062,000$ 607,000$ 496,500$


Income Statement

Statement of Retained

Earnings


E22-1: Comparative Statements

22-20 LO 3 Understand how to account for retrospective accounting changes.

Direct Effects - FASB takes the position that

companies should retrospectively apply the direct

effects of a change in accounting principle.

Indirect Effect is any change to current or future cash

flows of a company that result from making a change in

accounting principle that is applied retrospectively.

Direct and Indirect Effects of Changes


22-21

Impracticability

LO 4 Understand how to account for impracticable changes.

Companies should not use retrospective application if one of the

following conditions exists:

1. Company cannot determine the effects of the retrospective

application.

2. Retrospective application requires assumptions about

management’s intent in a prior period.

3. Retrospective application requires significant estimates that

the company cannot develop.


If any of the above conditions exists, the company prospectively applies the new accounting principle.

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Changes in Accounting EstimateChanges in Accounting EstimateChanges in Accounting EstimateChanges in Accounting Estimate

LO 5 Describe the accounting for changes in estimates.

Examples of Estimates

1. Uncollectible receivables.

2. Inventory obsolescence.

3. Useful lives and salvage values of assets.

4. Periods benefited by deferred costs.

5. Liabilities for warranty costs and income taxes.

6. Recoverable mineral reserves.

7. Change in depreciation methods.

22-23



Prospective Reporting

Changes in accounting estimates are reported prospectively.

Account for changes in estimates in

1. the period of change if the change affects that period only,

or

2. the period of change and future periods if the change

affects both.

FASB views changes in estimates as normal recurring corrections

and adjustments and prohibits retrospective treatment.

22-24

Illustration: Arcadia High School purchased equipment for

$510,000 which was estimated to have a useful life of 10 years

with a salvage value of $10,000 at the end of that time.

Depreciation has been recorded for 7 years on a straight-line

basis. In 2012 (year 8), it is determined that the total estimated life

should be 15 years with a salvage value of $5,000 at the end of

that time.

Required:

What is the journal entry to correct

prior years’ depreciation expense?

Calculate depreciation expense for 2012.

No Entry No Entry RequiredRequired

Change in Estimate ExampleChange in Estimate ExampleChange in Estimate ExampleChange in Estimate Example


22-25

Equipment $510,000

Fixed Assets:

Accumulated depreciation 350,000

Net book value (NBV) $160,000

Balance Sheet (Dec. 31, 2011)

Change in Estimate ExampleChange in Estimate ExampleChange in Estimate ExampleChange in Estimate Example After 7 years

Equipment cost $510,000

Salvage value - 10,000

Depreciable base 500,000

Useful life (original) 10 years

Annual depreciation $ 50,000 x 7 years = $350,000

First, establish NBV at date of change in

estimate.

First, establish NBV at date of change in

estimate.


22-26

Net book value $160,000

Salvage value (if any) 5,000

Depreciable base 155,000

Useful life 8 years

Annual depreciation $ 19,375

Change in Estimate ExampleChange in Estimate ExampleChange in Estimate ExampleChange in Estimate Example

Second, calculate Second, calculate depreciation expense depreciation expense

for 2012.for 2012.

Second, calculate Second, calculate depreciation expense depreciation expense

for 2012.for 2012.

Depreciation expense 19,375


Journal entry for 2012


22-27



Disclosures

Companies need not disclose changes in accounting estimate

made as part of normal operations, such as bad debt allowances

or inventory obsolescence, unless such changes are material.

However, for a change in estimate that affects several periods

(such as a change in the service lives of depreciable assets),

companies should disclose the effect on income from continuing

operations and related per-share amounts of the current period.

22-28

Change in Reporting EntityChange in Reporting EntityChange in Reporting EntityChange in Reporting Entity

LO 6 Identify changes in a reporting entity.

Examples of a change in reporting entity are:

1. Presenting consolidated statements in place of statements of individual companies.

2. Changing specific subsidiaries that constitute the group of companies for which the entity presents consolidated financial statements.

3. Changing the companies included in combined financial statements.

4. Changing the cost, equity, or consolidation method of accounting for subsidiaries and investments.

Reported by changing the financial statements of all prior periods presented.

22-29

Correction of ErrorsCorrection of ErrorsCorrection of ErrorsCorrection of Errors

LO 7 Describe the accounting for correction of errors.

Types of Accounting Errors:

1. A change from an accounting principle that is not generally

accepted to an accounting policy that is acceptable.

2. Mathematical mistakes.

3. Changes in estimates that occur because a company did not

prepare the estimates in good faith.

4. Failure to accrue or defer certain expenses or revenues.

5. Misuse of facts.

6. Incorrect classification of a cost as an expense instead of an

asset, and vice versa.

22-30


All material errors must be corrected.

Record corrections of errors from prior periods as an

adjustment to the beginning balance of retained earnings

in the current period.

Such corrections are called prior period adjustments.

For comparative statements, a company should restate

the prior statements affected, to correct for the error.


22-31


Illustration: In 2013 the bookkeeper for Selectro Company

discovered an error:

In 2012 the company failed to record $20,000of depreciation

expense on a newly constructed building. This building is the only

depreciable asset Selectro owns. The company correctly

included the depreciation expense in its tax return and correctly

reported its income taxes payable.


22-32


Illustration: Selectro’s income statement for 2012 with and

without the error.Illustration 22-19

Show the entries that Selectro should have made and did make for

recording depreciation expense and income taxes.


22-33


Illustration: Show the entries that Selectro should have made and

did make for recording depreciation expense and income taxes.

Illustration 22-18

Correcting Entry in

2013


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Retained Earnings 12,000Correcting Entry in

2013


Illustration 22-18

22-35




Retained Earnings 12,000

Deferred Tax Liability 8,000

Correcting Entry in

2013

ReversalReversal


Illustration 22-18

22-36




Retained Earnings 12,000

Deferred Tax Liability 8,000

Accumulated Depreciation—Buildings

20,000

Correcting Entry in

2013

RecordRecord


Illustration 22-18

22-37


Illustration (Single-Period Statement): Assume that Selectro

Company has a beginning retained earnings balance at January 1,

2013, of $350,000. The company reports net income of $400,000 in

2013.Illustration 22-21


22-38


Comparative Statements

Company should

1. make adjustments to correct the amounts for all affected

accounts reported in the statements for all periods

reported.

2. restate the data to the correct basis for each year

presented.

3. show any catch-up adjustment as a prior period

adjustment to retained earnings for the earliest period it

reported.


22-39

Woods, Inc.Statement of Retained Earnings

For the Year Ended December 31, 2012

Balance, January 1 1,050,000$ Net income 360,000 Dividends (300,000) Balance, December 31 1,110,000$

Before issuing the report for the year ended December 31, 2012, you discover

a $62,500 error that caused the 2011 inventory to be overstated (overstated

inventory caused COGS to be lower and thus net income to be higher in

2011). Would this discovery have any impact on the reporting of the

Statement of Retained Earnings for 2012? Assume a 20% tax rate.



22-40

Woods, Inc.Statement of Retained Earnings

For the Year Ended December 31, 2012

Balance, January 1, as previously reported 1,050,000$

Prior period adjustment, net of tax (50,000)

Balance, January 1, as restated 1,000,000

Net income 360,000

Dividends (300,000)

Balance, December 31 1,060,000$



22-41

Summary of Accounting Changes and ErrorsSummary of Accounting Changes and ErrorsSummary of Accounting Changes and ErrorsSummary of Accounting Changes and Errors

Illustration 22-23

LO 7

22-42

Summary of Accounting Changes and ErrorsSummary of Accounting Changes and ErrorsSummary of Accounting Changes and ErrorsSummary of Accounting Changes and Errors

Illustration 22-23

LO 7

22-43

Motivations for Change of Motivations for Change of Accounting MethodAccounting Method

Motivations for Change of Motivations for Change of Accounting MethodAccounting Method

LO 8 Identify economic motives for changing accounting policies.

Why companies may prefer certain accounting

methods. Some reasons are:

1. Political costs.

2. Capital Structure.

3. Bonus Payments.

4. Smooth Earnings.

22-44

Error AnalysisError AnalysisError AnalysisError Analysis

LO 9 Analyze the effect of errors.

Companies must answer three questions:

1. What type of error is involved?

2. What entries are needed to correct for the error?

3. After discovery of the error, how are financial statements to

be restated?

Companies treat errors as prior-period adjustments and report

them in the current year as adjustments to the beginning

balance of Retained Earnings.

22-45

Balance sheet errors affect only the presentation of an asset,

liability, or stockholders’ equity account.

Current year error - reclassify item to its proper position.

Prior year error - restate the balance sheet of the prior year

for comparative purposes.

Balance Sheet ErrorsBalance Sheet ErrorsBalance Sheet ErrorsBalance Sheet Errors


22-46

Improper classification of revenues or expenses.

Current year error - reclassify item to its proper position.

Prior year error - restate the income statement of the prior

year for comparative purposes.

Income Statement ErrorsIncome Statement ErrorsIncome Statement ErrorsIncome Statement Errors


22-47

Counterbalancing Errors

Will be offset or corrected over two periods.

If company has closed the books:

a. If the error is already counterbalanced, no entry is necessary.

b. If the error is not yet counterbalanced, make entry to adjust the present balance of retained earnings.


For comparative purposes, restatement is necessary even if a correcting journal entry is not required.

Balance Sheet and Income Statement ErrorsBalance Sheet and Income Statement ErrorsBalance Sheet and Income Statement ErrorsBalance Sheet and Income Statement Errors

22-48

Will be offset or corrected over two periods.

If company has not closed the books:

a. If error already counterbalanced, make entry to correct the error in the current period and to adjust the beginning balance of Retained Earnings.

b. If error not yet counterbalanced, make entry to adjust the beginning balance of Retained Earnings.



Counterbalancing Errors

22-49

Non-Counterbalancing Errors

Not offset in the next accounting period.

Companies must make correcting entries, even if they have closed the books.



22-50

E22-19 (Error Analysis; Correcting Entries): A partial trial balance of

Dickinson Corporation is as follows on December 31, 2012.

Error Analysis ExampleError Analysis ExampleError Analysis ExampleError Analysis Example

Dr. Cr.

Supplies 2,500$

Salaries and wages payable 1,500$

Interest receivable 5,100

Prepaid insurance 90,000

Unearned rent 0

Interest payable 15,000


Instructions: (a) Assuming that the books have not been closed, what are

the adjusting entries necessary at December 31, 2012?

22-51

Salaries and wages expense 2,900

Salaries and wages payable 2,900

Supplies expense 1,400

Supplies 1,400



1. A physical count of supplies on hand on December 31, 2012, totaled

$1,100.

2. Accrued salaries and wages on December 31, 2012, amounted to

$4,400.

(a) Assuming that the books have not been closed, what are the

adjusting entries necessary at December 31, 2012?

22-52

Interest revenue 750

Interest receivable 750

Insurance expense 25,000




3. Accrued interest on investments amounts to $4,350 on December 31,

2012.

4. The unexpired portions of the insurance policies totaled $65,000 as of December 31, 2012.



22-53

Depreciation expense 45,000


Rental income 12,000

Unearned rent 12,000



5. $24,000 was received on January 1, 2012 for the rent of a building for

both 2012 and 2013. The entire amount was credited to rental income.

6. Depreciation for the year was erroneously recorded as $5,000 rather

than the correct figure of $50,000.



22-54

E22-19 (Error Analysis; Correcting Entries) A partial trial balance of

Dickinson Corporation is as follows on December 31, 2012.



Instructions: (b) Assuming that the books have been closed, what are

the adjusting entries necessary at December 31, 2012?

Dr. Cr.

Supplies 2,500$

Salaries and wages payable 1,500$

Interest receivable 5,100


Unearned rent 0

Interest payable 15,000

22-55


Salaries and wages payable 2,900


Supplies 1,400



(b) Assuming that the books have been closed, what are the adjusting

entries necessary at December 31, 2012?

1. A physical count of supplies on hand on December 31, 2012, totaled

$1,100.

2. Accrued salaries and wages on December 31, 2012, amounted to

$4,400.

22-56



Retained earnings 750

Interest receivable 750



3. Accrued interest on investments amounts to $4,350 on December 31,

2012.

4. The unexpired portions of the insurance policies totaled $65,000 as

of December 31, 2012.



22-57




Unearned rent 12,000



5. $24,000 was received on January 1, 2012 for the rent of a building for

both 2012 and 2013. The entire amount was credited to rental income.

6. Depreciation for the year was erroneously recorded as $5,000 rather

than the correct figure of $50,000.



22-58LO 10 Make the computations and prepare the entries necessary to

record a change from or to the equity method of accounting.

Change From The Equity Method

Change from the equity method to the fair-value method.

Earnings or losses previously recognized under the equity method

should remain as part of the carrying amount of the investment.

The cost basis is the carrying amount of the investment at the date

of the change.

The investor applies the new method in its entirety.

At the next reporting date, the investor should record the unrealized

holding gain or loss to recognize the difference between the

carrying amount and fair value.

APPENDIXAPPENDIX 22A CHANGING FROM OR TO THE EQUITY METHOD

22-59

Accounted for such dividends as a reduction of the

investment carrying amount, rather than as revenue.

Reason: Dividends in excess of earnings are viewed as a

________________ with this excess then accounted for as a

reduction of the equity investment.

liquidating dividend


LO 10 Make the computations and prepare the entries necessary to record a change from or to the equity method of accounting.

Dividends in Excess of Earnings

22-60

Illustration: On January 1, 2011, Investor Company purchased

250,000 shares of Investee Company’s 1,000,000 shares of outstanding

stock for $8,500,000. Investor correctly accounted for this investment

using the equity method. After accounting for dividends received and

investee net income, in 2011, Investor reported its investment in

Investee Company at $8,780,000 at December 31, 2011. On January 2,

2012, Investee Company sold 1,500,000 additional shares of its own

common stock to the public, thereby reducing Investor Company’s

ownership from 25 percent to 10 percent.




22-61

Illustration 22A-1




22-62

Illustration 22A-2Impact on Investment Carrying Amount

Cash 400,000Dividend Revenue

400,000

Cash 210,000Equity Investments (AFS)

60,000Dividend Revenue

150,000

2012 & 2013

2014


LO 10

22-63

Change To The Equity Method

Companies use retrospective application.

The carrying amount of the investment, results of current

and prior operations, and retained earnings of the investor

are adjusted as if the equity method has been in effect

during all of the previous periods.

Companies also eliminate any balances in the Unrealized

Holding Gain or Loss—Equity account and the Securities

Fair Value Adjustment account.



22-64

RELEVANT FACTS

One area in which GAAP and IFRS differ is the reporting of error corrections in previously issued financial statements. While both sets of standards require restatement, GAAP is an absolute standard—that is, there is no exception to this rule.

The accounting for changes in estimates is similar between GAAP and IFRS.

Under GAAP and IFRS, if determining the effect of a change in accounting policy is considered impracticable, then a company should report the effect of the change in the period in which it believes it practicable to do so, which may be the current period.

22-65

RELEVANT FACTS

Under IFRS, the impracticality exception applies both to changes in accounting principles and to the correction of errors. Under GAAP, this exception applies only to changes in accounting principle.

IFRS (IAS 8) does not specifically address the accounting and reporting for indirect effects of changes in accounting principles. As indicated in the chapter, GAAP has detailed guidance on the accounting and reporting of indirect effects.

22-66

Which of the following is false?

a. GAAP and IFRS have the same absolute standard regarding

the reporting of error corrections in previously issued financial

statements.

b. The accounting for changes in estimates is similar between

GAAP and IFRS.

c. Under IFRS, the impracticality exception applies both to

changes in accounting principles and to the correction of errors.

d. GAAP has detailed guidance on the accounting and reporting of

indirect effects; IFRS does not.

IFRS SELF-TEST QUESTION

22-67

Which of the following is not classified as an accounting change by

IFRS?

a. Change in accounting policy.

b. Change in accounting estimate.

c. Errors in financial statements.

d. None of the above.


22-68

IFRS requires companies to use which method for reporting changes

in accounting policies?

a. Cumulative effect approach.

b. Retrospective approach.

c. Prospective approach.

d. Averaging approach.


22-69

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22-1 prepared by coby harmon university of california, santa barbara intermediate accounting

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