accounting changes and error corrections

by Professor Hsieh

Intermediate Financial Accounting

Accounting Changes and Error Corrections

Accounting Changes & Error Corrections 2

Objectives of the Chapter

I. To learn the types of accounting changes.

II. To study the accounting treatments of accounting changes.

III. To analyze the accounting errors and to learn the accounting treatments of errors.


I. Types of Accounting Changes

A. Changes in Accounting Principle (Method).

B. Changes in Accounting Estimate.

C. Changes in Reporting Entity.


Examples of Changes in Accounting Principle (Method) Changes from one acceptable

accounting method to another acceptable accounting method. Examples:

adopting a new accounting standard. changes in inventory method. changes from P-O-C method to C-C

method for long-term construction projects.


Examples of Changes in Accounting Estimates Changes in the estimates of:

a. useful lives and salvage values of depreciable assets;

b. uncollectible accounts expense;

c. liabilities for warranty costs, and income taxes.

Note: Under SFAS 154,changes in depreciation method is considered as changes in accounting estimates.


Examples of Changes in Reporting Entity

1. Presenting consolidated statements for the first time to replace individual statements.

2. Changing subsidiaries that are included in consolidated F/S.


II. Accounting Treatments for Accounting Changes

Three approaches had been suggested: 1.Current-Period Approach (eliminated

by SFAS 154).2.Retrospective Approach (applied to

voluntary accounting method changes and changes in reporting entity).

3.Prospective approach (applicable for accounting estimate change).


1. Current-Period Approach (Eliminated by SFAS 154)

The cumulative effect of all prior years resulting from adoption of the new method is reported in the current year’s income statement.

F/S of prior years should not be restated. Net income and earnings per share, computed on a pro-forma basis (as if the new method were adopted) are shown on the I/S for all periods that appear on the I/S.


Current Period Approach (Eliminated)

This approach has been eliminated by SFAS 154.

SFAS 154 was issued in May 2005, and became effective for fiscal years beginning after 12/15/2005.


Current-Period Approach (contd.) (skip) Advantages

a. Less costly.b Will not affect the financial ratios of prior

years.c. No change in prior years’ earnings.

Disadvantagesa. It has significant impact on current year’s

income.b. Loss comparability among financial

statements (F/S) of different years.


2. Retrospective Approach

A retrospective adjustment of the F/S (i.e., restatement of F/S) is made for prior years as if the new method were used.

Cumulative effect for the non-restated prior years is reported in the statement of retained earnings (not income statement) as an adjustment.


Retrospective Approach (contd.)

Advantagesa. It results in comparable F/S.b. It has no significant impact in the

current year’s income statement.

Disadvantages a. It is costly to restate F/S.b. It has a potential in violating loan

covenant.


3. Prospective Approach

No cumulative effect is reported in any financial statements (F/S).

No prior statements are restated. The new method is applied to the

f/S of the current year and future years.


The Treatments for Changes in Accounting Method (skip) Prior to APB Opinion No. 20

(Accounting Changes, effective 7/31/1971), all three approaches were acceptable for changes in accounting method.

APB 20 only allows the current period approach and the retrospective approach for accounting method changes (except for five situations in which the retrospective approach must be used).


The Treatments for Changes in Accounting Method (contd.)

Under SFAS 154 (effective 2006), the only acceptable treatment for voluntary accounting method changes is the retrospective approach.

SFAS 154 eliminated the current period approach except when proscribed by new accounting standards.


The Treatment for Changes in Accounting Method (contd.)

Reasons of eliminating the current period approach under SFAS 154:

Toward global convergence of accounting standards;

Improve the comparability of financial statements.


The Treatment for Changes in Accounting Estimates The prospective approach is only

acceptable for changes in accounting estimates, NOT for changes in accounting method.

However, a deprecation method change is treated as an estimate change under SFAS 154. Thus, the prospective approach is applied to deprecation method change.


Reasons for Changes in Accounting Method Reasons for changes in accounting

method:

1. Changes in economic environment.2. Mandated by a new accounting standard

(i.e., recognition of post retirement benefit expenses on an accrual basis);

3. Changes in technology.4. Economical Reasons (see p66 for

details).


Change in Accounting Method - An Example On 1/1 20x2, Doherty Corporation

purchased a machine for $110,000. A 10-year economic life and zero residual value were expected for this machine.

The sum-of-the-years’-digits method had been used for depreciation purposes starting 20x2.

On 1/1/ 20x6, the depreciation method was changed to straight line method. The income tax rate is 30%.


Change in Accounting Method

Example (contd.) – A Note

SFAS 154 requires that the changes in depreciation methods be treated as an estimate change.

Thus, a prospective approach should be applied for such a change.

However, for illustration and comparison purposes, the current period, retrospective and the prospective approaches are applied for this change.


Example (contd.)-Depreciation Expense under the Old Method (SYD) vs. New Method (S-L)

SYD S-L Diff. Diff.(net) C.Eff.(net)

20x2 $20,000 $11,000 $9,000 6,300 6,30020x3 18,000 11,000 7,000 4,900 11,20020x4 16,000 11, 000 5,000 3,500 14,70020x5 14,000 11,000 3,000 2,100 16,800 $68,000 44,000 $24,000 16,800Diff (net).= difference, net of income tax ;C.Eff (net)= cumulative effect, net of income tax. For 20x6, the depre. Expense is $12,000 and $11,000 under SYD and S-L, respectively. The difference is $1000 (or $700 net of 30% tax)


Example – A Current Period Approach (this approach has been eliminated by SFAS 154)Cumulative Effect= $68,000-44,000=$24,000

Net Cum. Effect = 24,000x (1-30%)= $16,800

JE to reflect this change applying the current period approach (assuming a 30% income tax rate):Accumulated Depreciation 24,000 Cumulative Effect of Change in Acct. Method-Depre. 16,800 Deferred Income Tax Lia.

7,200


Example (contd.)- A Current Period ApproachComparative Income Statements* 20x6 20x5 20x4 Revenues $50,000 $50,000 $50,000Depr. Exp. (Note A) (11,000) (14,000) (16,000)Other expe. (10,000) (10,000) (10,000)Income taxes (8,700) (7,800) (7,200)Income before changesin acct. principle $20,300Cumulative effect 16,800Net income $37,100 $18,200 $16,800Earnings per share $3.71 $1.82 $1.68 Pro Forma (Note A) Net income $20,300 $20,300 $20,300Earnings per share $2.03 $2.03 $2.03*Assume a 30% tax rate and 10,000 shares outstanding.


Comparative Retained EarningsAssuming a retained earnings balance of $140,000 at the beginning of 20x4 and a dividends of $20,000 for years 20x4-20x6, the following statements of retained earnings will be in the 20x6 annual report:

20x6 20x5 20x4 Balance at beg.(R/E) $135,000 136,800 140,000Net income4 37,100 18,200 16,800Cash dividens (20,000) (20,000) (20,000)Balance at end of year 152,100 135,000 136,800


Example (contd.)-A Current Period Approach

Note A: Prior to 20x6, Doherty used sum-of-

the-years’-digits depreciation on its plant assets. In 20x6 Doherty changed to the straight-line method of depreciation, which management felt better represented the service expiration of its plan assets..


Example (contd.)-A Current Period Approach

Note A (contd): The cumulative effect of the change in

accounting principle of $16,800 (net of I/T) has been included in 20x6 net income. The effect of this change on income of 20x6 was an increase of $700 (net of I/T). The pro forma data report what would have been had the straight-line method been used prior to 20x6.


Example: A Retrospective Approach The F/S of prior years (i.e., two years) are

restated on a basis consistent with the new method.

The cumulative effect of the non-restated prior years is reported in the statement of retained earnings.

This part of cumulative effect is treated as an adjustment of beginning retained earnings of the earliest year presented.


Example - A Retrospective Approach Using the example on page 19 except applying the

retrospective approach, the following comparative I/S will be reported on the 20x6 annual report:

20x6 20x5 20x4 . (restated) (restated)

Revenues $50,000 $50,000 $50,000Depr. Exp.(Note A) (11,000) (11,000) (11,000)Other Expe. (10,000) (10,000) (10,000)Income Taxes (8,700) (8,700) (8,700)Net Income $20,300 $20,300 $20,300Earnings per share $2.03 $2.03 $2.03


A Retrospective Approach (contd.)

Note A: Prior to 20x6, Doherty used sum-of- the-years’-

digits depreciation on its plant assets. In 20x6 Doherty changed to the straight-line

method of depreciation, which management felt better represented the service expiration of its plan assets.

The financial statements of 20x4 and 20x5 have been restated to reflect this change.


A Retrospective Approach (Contd.)

Note A (contd.): The effect of this change on income of 20x6

was an increase of $700 (net of income tax) and on income of 20x5 and 20x4 was an increase of $2,100 and $3,500 (net of income tax), respectively.

The balances of retained earnings of 20x4 and 20x5 have been adjusted for the effect of applying retrospectively the new method.


Example (contd.)-Depreciation Expense under the Old Method (SYD) vs. New Method (S-L)

SYD S-L Diff. Diff.(net) C.Eff.(net)

20x2 $20,000 $11,000 $9,000 6,300 6,30020x3 18,000 11,000 7,000 4,900 11,20020x4 16,000 11, 000 5,000 3,500 14,70020x5 14,000 11,000 3,000 2,100 16,800 $68,000 44,000 $24,000 16,800Diff (net).= difference, net of income tax ;C.Eff (net)= cumulative effect, net of income tax. For 20x6, the depre. Expense is $12,000 and $11,000 under SYD and S-L, respectively. The difference is $1000 (or $700 net of 30% tax)


A Retrospective Approach (contd.) The entry to reflect this accounting change

under the retrospective approach of 20x6 is:

Accu. Depr. 24,000 Retained Earnings16,800 Deferred Income tax Lia. 7,200


A Retrospective Approach (contd.)Assuming a retained earnings balance of $140,000 at the beginning of 20x4 and a dividends of $20,000 for years 20x4-20x6, the following statements of retained earnings will be in the 20x6 annual report: 20x6 20x5 20x4 Balance at beg.(R/E) $135,0002 136,8001 140,000Adjustment for theCum. effect 3 16,800 14,700 11,200Adjusted balance $151,800 151,500 151,200Net income4 20,300 20,300 20,300Cash dividens (20,000) (20,000) (20,000)Balance at end of year 152,100 151,800 151,500


Example (contd.)

1. 140,000 + 16,800 - 20,000 = 136,800 (See p23 for unadjusted net income of x4.)

2. 136,800 + 18,200 - 20,000 = 135,000 (See p 23 for unadjusted net income of x5)

3. Cumulative difference (effect), see p31.4. Restated net income to reflect the change

of depreciation method made in 20x6, see p28 for restated net income for 20x4 and 20x5.


Change in Depreciation Method A Prospective Approach Under SFAS 154, a prospective approach

should be applied to a change in depreciation method.

Thus, the change from a SYD depreciation to a straight-line deprecation would not result in any restatement of prior years’ financial statements.

The new depreciation method would only be applied for years of 2006 - 2011.


Change in Depreciation Method A Prospective Approach (contd.)The annual depreciation expense for 2006-

2011 is:

($110,000-$68,000)/ (10-4) = $7,000

Note: Prior to 20x6, Doherty used sum-of- the-years’-digits depreciation on its plant assets. In 20x6 Doherty changed to the straight-line method of depreciation, which management felt better represented the service expiration of its plan assets.


Change in Depreciation Method

A Prospective Approach (contd.)Note (contd): The effect of this change on

income of 20x6 is an increase of $3,500a (net of 30% income taxes).

a. The depreciation expense of 2006 would have been $12,000 under the SYD (the old method) while it is $7,000 under the straight-line method (the new method).


Change in Accounting Method - Inventory Cost Method Change Example (Example 20-1 of Spiceland, etc. with some revisions)

Air Parts Corporation used the LIFO inventory costing method. At the beginning of 2006, Air Parts decided to change to the FIFO method.

Under SFAS 154, the retrospective approach is applied for all voluntary accounting method change except for the change in depreciation method.


Changes in Inventory Cost Flow Assumption (contd.)

Additional information: The company has paid dividends of $40

million each year beginning 1999. The income tax rate is 40%. Retained earnings on January 1, 2004

was $700 million. $Inventory on January 1, 2004 was $500

million.


Cost Flow Assumption Change (Contd.)-A Retrospective Approach

The income statements of 2004, 2005 and 2006 are as follows (under LIFO assumption):($ in millions) 20x6 20x5 20x4 Revenues $950 $900 $875CGS (LIFO) (430) (420) (405) Operating expenses (230) (210) (205)Pre-tax Income 290 270 265Income taxes (116) (108) (106)Net income $174 $162 $159

.


Cost Flow Assumption Change (Contd.)-A Retrospective Approach

The statement of retained earnings of 2004 and and 2005 are as follows (under (LIFO)) ($ in millions):

20x5 20x4 R/E (Beg. Bal.) $819 $700Net Income 162 159 Dividends (40) (40)R/E (End. Bal.) $941 $819

.


Cost Flow Assumption Change (Contd.)

cost of Goods Sold ($ in millions) LIFO FIFO Diff. C. D.. Net.C.D.PY $2,000 $1,700 $300 $ 300 18020x4 405 360 45 345 20720x5 420 365 55 400 240 $2,825 $ 2,425 $400 PY = previous years. C.D.=cumulative difference. Net C.D.= cumulative difference, net of

income tax of 40%.

For 2006, The CGS is $430 million and $370 million under LIFO and FIFO, respectively. The CGS difference is $60 million for 2006.


Change in Cost Flow Assumption (contd.)

The cumulative difference of CGS from the change of LIFO to FIFO inventory method is equivalent to the impact of this change on the inventory.



Since the cumulative difference of CGS is $345 and $400 million lower for 20x4 and 20x5, respectively, the inventory for 2004 and 2005 would be $345 million and $400 million higher under FIFO than under LIFO, respectively.



For 2006, cumulative difference of CGS would be $460 million lower (i.e., $400 million + $60 million), the inventory of 2006 would be $460 million higher under FIFO than under LIFO.


Cost Flow Assumption Change –A Retrospective ApproachThe cumulative difference of CGS up to 2005

equals: $2,825-2,425 or 300+45+55 = 400

(million) The journal entry to record the change from LIFO to

FIFO :1/1 2006Inventory 400 Retained Earnings 240 Deferred Income Tax Lia. 160

*assuming a 40% income tax rate


Comparative Income Statements-A Retrospective Approach 20x6 20x5 20x4 restated restatedRevenues $950 $900 $875CGS (FIFO) (370) (365) (360) Operating expenses (230) (210) (205)Pre-tax Income 350 325 310Income taxes1 (140) (130) (124)Net income $210 $195R $186R

1Assume a 40% tax rate.R. Restated net income for 20x4 and 20x5.


Comparative Retained Earnings Statement -A Retrospective Approach

Assuming a retained earnings balance of $700 million at the beginning of 20x4, the following statement of retained earnings will be in the 20x6 annual report ($ in millions): 20x6 20x5 20x4 Balance at beg.(R/E)1 $941 819 700Adjustment for theCum. difference2 240 207 180 Adjusted Beg. Balance $1,181 $1,026 $880Net income3 210 195 186Dividens (40) (40) (40)Balance at end of year $1,351 $1,181 $1,026


Comparative Retained Earnings Statement (contd.)

Notes:1.Begining Retained earnings under the old method (i.e., the unadjusted), see p41.2.Cumulative difference, net of income tax, see p42.3. Net income under the new method (i.e., LIFO) for 2006 and restated net income (i.e., under LIFO) for 2005 and 2004, see p47.


Change to LIFO Method (An Exception)

When change from other inventory method to LIFO, a prospective approach is applied when a retrospective adjustment is impractical.

No cumulative effect will be reported in the income statement and no restatement of prior years’ F/S.


Change to LIFO Method –contd. The base-year inventory for all

subsequent LIFO calculations is the cost of opening inventory in the year the method is adopted.

The base-year inventory needs to be adjusted back to the cost.


Examples of Changes in Accounting Estimates Changes in:

a. useful lives and salvage values of depreciable assets;

b. uncollectible accounts expense;c. liabilities for warranty costs, and

income taxes;d. periods benefited by deferred costs;


Examples of Changes in Accounting Estimates (contd.) e. inventory obsolescence;

f . liabilities of employee related benefits;Note (an exception): Under SFAS

154,changes in depreciation method is considered as an estimate change.


Changes in Accounting Estimate

Accounting Treatment A prospective approach is applied for

changes in accounting estimates. The effect of the change on current

year’s income will be disclosed in the footnotes.

SFAS 154 requires to apply the prospective approach for the changes in depreciation method.


How to Distinguish Changes In Estimates from an Error? Changes in estimate are changes made

based on new information not available before, Not based on information overlooked in prior period (i.e., an error).


Changes in Estimates

Example of Changes in Estimates Change the bad debt exp. estimation from 2% to 4% of

the net sale in 20x6. The net sale of 20x6 amounts to $50,000.

12/31/x6 Bad debt exp. 2,000Allow. for bad debt

2,000

Note: Due to the accounting estimate change, the bad debt expense is increased from $1,000 (at 2%) to $2,000 (at 4%). The net impact (net of income tax credit) from this change is a $700 decrease in net income of 20x6.


Changes in EstimatesExample of Changes in Estimates (contd.) Machine costing $15,000 was purchased on

1/1/x4 with estimated life of 5 years and zero residual value. The straight-line method was used for depreciation. On 1/1/x6, the estimated life of the machine had been changed to 6 years and the residual value had been changed to $1,000 due to new information available. Book value of the machine on 1/1/x6:

(15,000-6000) =9,000 Depreciation expense for 20x6, 20x7,20x8,

and 20x9: ($9,000 -$1,000) / (6-2) = $2,000


Example B (contd.)

12/31/x6 Depr. Exp. 2,000 Acc. Depr. 2,000

Note: Due to the accounting estimate changes on the estimated life and the salvage value of machine purchased on 1/1/x4, the depreciation expense of 20x 6 is decreased by $1,000. The net of income tax effect is a $700 increase in net income of 20x6.


Changes In Reporting Entity

The treatment is to restate the F/S of all prior periods presented (for comparability).


Examples of Changes in Reporting Entity

1. Presenting consolidated statements for the first time to replace individual statements.

2. Changing subsidiaries that are included in consolidated F/S (i.e. with new mergers or spin offs).

3. A change in the accounting for investments (i.e., change to the equity method or change from equity to consolidation).


Examples of Changes in Reporting Entity (contd.)

An example of changes in reporting entity: In adopting SFAS 94 (“Consolidation of All

Majority-Owned Subsidiaries”), Hewlett-Packard Company (HP) consolidated the accounts of its wholly owned subsidiary, Hewlett-Packard Finance Company, previously accounted for under the equity method, with accounts of HP. HP restated its prior years’ consolidated financial statements to reflect this change for comparative purposes.


Motivations for Changes and Income Management

Management often changes accounting methods not for conceptual reasons (i.e., to improve the fairness of financial statements), but rather for economic reasons (for economic consequence).


Motivations for Changes and Income Management

The followings are possible reasons suggested by academic research in explaining why companies prefer certain accounting methods:1. Political Costs.2. Capital Structure (maintain D/E ratio).3. Bonus Payments.4. Income Smoothing.5. Labor Renegotiation Costs.


III. Error Analysis Questions need to be addressed:

1. What type of error is involved?

2. What entries needed to correct the error?

3. How would the financial statements be restated when the error is discovered?


Correction of an Error Made in Prior Years (prior period adjustments, SFAS No. 16):

Examples of accounting errors:1. A change from an incorrect accounting

principle (not GAAP) to a GAAP.2. Mathematical mistakes.3. Changes in estimates which were not

prepared in good faith.4. A misuse of facts (i.e., failure to

consider salvage value in depreciation).


Correction of an Error Made in Prior Years (contd.)

Examples of accounting errors (contd.):5. An oversight (i.e., failure to accrue

expense at year end).6. An incorrect classification of a cost as

an expense (i.e., improper capitalization).


General Treatments for Prior Years’ ErrorsThe corrections of errors in previously issued financial statements are referred to as prior period adjustments.

The corrections are made to Retained Earnings and are reported as adjustments to the beginning balance of current year’s retained earnings.

General Treatments for Prior Years’ Errors (contd.) If comparative F/S are presented, the

prior affected statements should be restated to correct the errors.



Types of Errors

1. Balance Sheet Errors.

2. Income Statement (I/S) Errors.

3. Balance Sheet and Income Statement Effects.


1. Balance Sheet Errors Errors affect only the presentation of

accounts on the B/S statement (i.e., classification of notes payable as accounts payable or inventory as plant assets).

Procedures of correction:a. reclassification of the item to its proper

position.b. If comparative statements that include the

error year are presented, the B/S of the error year is restated correctly.


2. Income Statement (I/S) Errors

Errors affect only accounts on the I/S (i.e, recording interest revenue as sales revenue, depre. exp. as interest exp., etc.)

Impact: no impact on the net income or the B/S.


2. Income Statement (I/S) Errors (contd.)

Accounting Treatment: a.If the error is discovered in the year it is

made, just do a reclassification.b.If the error occurred in prior years, no

entry is needed at the date of discovery because all accounts for the current year is correctly stated including the beg. balance of the retained earnings.

.


2. Income Statement (I/S) Errors (contd.)

Accounting Treatment (contd.): If comparative statements that include

the error year are presented, the I/S for the error year is restated correctly.


3. Balance Sheet and Income Statement Effects

The errors involve both B/S and I/S accounts (i.e., the accrued wages were overlooked at the end of the year).

This type of errors can be further classified as:

a. Counterbalancing errors.

b. Noncounterbalancing errors.


a. Counterbalancing Errors

Errors that will be offset or corrected over two periods.

If books of the second year (the year following the error year) were closed, no adjustments are needed for the correction because the error has already been corrected in the second year.

Most of B/S and I/S effect type of errors are counterbalancing errors.


b. Noncounterbalancing Errors

These errors do not counterbalance over 2-year period (no self-correction in two years).

Therefore, entries are needed even if the books have been closed for the year following the error.


Counterbalancing Errors Example 1 Failure to record accrued wages of $5,000

in 20x5. This error was discovered in 20x6.Impact of this error on wages expense, net income (N/I) and wages liabilities of 20x5 and 20x6 assuming this liability of $5,000 has been paid in 20x6:

Wages Exp. N/I Wages Lib. 20x5 under over under20x6 over under correctly stated2-year correct correct correctly stated

combined at end of 20x6


Example 1 (contd.)

Accounting Treatment:

a. If the books of 20x6 have been closed, no entry is necessary.

b. If the books of 20x6 have not been closed, the entry in 20x6 to correct the error is:

12/31/x6 Retained Earnings 5,000

Wages Expense5,000


Example 1 (contd.) Rational: When the accrued wages of 20x5

are paid in 20x6, an additional debit of $5,000 is made to 20x6 wage expense (i.e., instated of debit to wages payable, it was debited to wages expense). Thus, the wages exp. of 20x6 is overstated by $5,000.

Also, because accrued wages expense of $5,000 was not recorded in 20x5, the net income of 20x5 was overstated by $5,000 and the retained earnings accounting of 20x5 were overstated by $5,000.


Counterbalancing Errors

Example 2 Sanbor has failed to accrued wages payable

at the end of the last three years as follows:12/31/20x4 $1,60012/31/20x5 $3,00012/31/20x6 $2,400

Impact of these errors on net income of 20x4, 20x5, and 20x6:

20x4 20x5 20x6

Beg. ---- (1,600) (3,000)Ending $1,600 3,000 2,400Cum. Effect $1,600 1,400 600


Example 2 (contd.) Entries to correct the errors of the last three

years assuming the books of 20x6 are still open: 12/31/x6a. No entry is necessary for the error of 20x4

because it has been counterbalanced by the end of 20x5 when the books of 20x5 were closed.

b. To correct the error of 20x5 when the books of 20x6 have not been closed:Retained Earnings 3,000

Wages Expense 3,000


Example 2 (contd.) Entries to correct the error of the last three

years assuming the books of 20x6 are still open: (contd.)12/31/20x6c. To correct the error of 20x6 (the current year’s

error):Wages Exp. 2,400

Wages Payable 2,400

a, b and c combined: Retained Earnings 3,000

Wages Exp. 600Wages Payable 2,400



Example 3 Failure to Record Prepaid Expense

In 20x5, Hurley Enterprise purchased a 2-year insurance policy costing $1,000. Insurance expense was debited and cash was credited. No adjusting entry was made at the end of 20x5. Assuming the books of 20x6 have not been closed, the entry on 12/31/20x6 to correct the error on 12/31/20x6 as follows is :


Example 3 (contd.)

Insurance Exp. 500Retained Earnings 500

OR (1) + (2)

(1)Prepaid Insurance 500Retained Earnings 500

(2)Insurance Exp. 500Prepaid Insurance 500

If the books of 20x6 have been closed, no entry is necessary to correct the error.



Example 4 Understatement of Unearned Revenue:

On 12/31/20x5, Hurley received $50,000 as a prepayment for renting office space for the next year. A rent revenue account was credited on 12/31/20x5. No adjusting entry was made in 20x5. If the books of 20x6 are still open, the entry to correct the error is:


Example 4 (contd.)

Retained Earnings 50,000Rent Revenue 50,000

OR (1) + (2)

(1)Retained Earnings 50,000Unearned Rent 50,000

(2) Unearned Rent 50,000Rent Revenue 50,000

If the books of 20x6 have been closed, no entry is necessary to correct the error.



Example 5 Overstatement of Accrued Revenue

On 12/31/20x5, Hurley accrued interest revenue $8,000 that applied to 20x6. The entry made in 12/31/20x5 was: Interest Receivable 8,000

Interest Revenue 8,000

If the books of 20x6 have not been closed, the entry to correct the error is :Retained Earnings 8,000

Interest Revenue 8,000

If the books of 20x6 have been closed, no entry is necessary.



Example 6 Understatement of Ending Inventory

On 12/31/20x5, the physical count of the inventory was understated by $25,000. Assuming the books of 20x6 are still open, the entry on 12/31/20x6 to correct the error is : Inventory (beg.) 25,000

Retained Earnings 25,000ORCost of Goods Sold 25,000*

Retained Earnings 25,000* if the beg. inv. has already been closed to cost

of goods sold.


Example 6 (contd.) The impact of the understatement of ending

inventory of 20x5 on the income of 20x5 and 20x6:

20x5 20x6 2-year comb.

Beg. inv. -------- 25,000 ------- End. Inv. (25,000) ------- -------Net Effect (25,000) 25,000 0 • Thus, if the books of 20x6 have been closed, no

entry is necessary. When the books of 20x6 are still open, the beg. inv. of 20x6 is understated for $25,000 and the beg. balance of 20x6 retained earnings is understated for $25,000 (due to the net income of 20x5 was understated for $25,000).



Example 7 Overstatement of ending inventory

On 12/31/20x5, the ending inv. was overstated by $10,000. Assuming the books of 20x6 have not been closed, the following entry is to correct the error of 20x5:12/31/20x6 Retained Earnings 10,000

Inventory (beg.) 10,000OR Retained Earnings 10,000* Cost of Goods Sold 10,000

* if the beg. inv. has been closed to cost of goods sold.


Example 7 (contd.)

The impact of overstatement of end. inv. of 20x5 on the net income of 20x5 and 20x6:

20x5 20x6 2-year Comb.

Beg. Inv. ---- (10,000) -------End. Inv. 10,000 ------ -------Net Effect 10,000 (10,000) 0• Thus, if the books of 20x6 have been closed,

no entry is needed to correct the error. • When the books of 20x6 are still open, the

beg. inv. of 20x6 is overstated for $10,000 and the beg. balance of the 20x6 retained earnings is also overstated for $10,000 (because the net income of 20x5 was overstated).



Example 8 Over or Understatement of End. Inv.

Assuming inv. at the end of 20x4 was overstated $11,000. At the end of 20x5, it was overstated for $20,000 and at the end of 20x6, it was understated for $19,000.

20x4 20x5 20x6 Beg. Inv. (11,000) (20,000)End. Inv. 11,000 20,000 (19,000)Net Effect 11,000 9,000 (39,000)


Example 8 (contd.)

If the books for 20x6 have not been closed, the entries to correct the error are as follows:12/31/20x6

for the inv. error of 20x4: no entryfor the inv. error of 20x5: Retained Earnings 20,000 *

Cost of Goods Sold 20,000for the inv. error of 20x6:Inventory19,000 *

Cost of Goods Sold 19,000*Assuming inventory has been closed to the cost of goods sold account.


Example 8 (contd.) Thus, the combined entry is (when the books of

20x6 are still open):12/31/20x6Inventory 19,000Retained Earnings 20,000

Cost of Goods Sold* 39,000*or Income Summary if cost of goods sold has been closed to the income summary account.

If the books of 20x6 are closed, the entry to correct the errors is :12/31/20x6 Inventory 19,000

Cost of Goods Sold 19,000



Example 9 Overstatement of Purchase

Hurley’s accountant recorded a purchase of $9,000 in 20x5 which applied to 20x6. The inventory account of 20x5 was correctly stated. The entry on 12/31/20x6 to correct this error (assuming the books of 20x6 are still open):12/31/20x6Purchases 9,000

Retained Earnings 9,000

If the books of 20x6 are closed, no entry is needed to correct the error.



Example 10 Overstatement of Purchases and

Inventories

Assuming the purchases of 20x5 are overstated by $9,000 and the ending inv. is overstated by $7,000.


Example 10 (contd.)

If the books of 20x6 are not closed, the entries to correct the error:12/31/20x6 Purchases 9,000

Retained Earnings 9,000 Retained Earnings 7,000

Inventory (Beg.) 7,000(or Cost of Goods sold)

Combined Entry: Purchases 9,000

Retained Earnings 2,000Inventory 7,000

If the books of 20x6 are closed, no entry is needed.


Noncounterbalancing Errors

These errors do not counterbalance over 2-year period. The correcting entries are needed even if the books of the year in which the error is discovered have been closed.


Example

Assume that on 1/1/20x5, Hurley purchased a machine for $10,000 that had an estimated life of 5 years. The accountant incorrectly expensed this machine in 20x5. The error was discovered in 20x6. Assume the company uses straight line depreciation on the asset, the entry to correct this error given that the books of 20x6 have not been closed:


Example (contd.)

12/31/20x6Machine 10,000

Retained Earnings 10,000Retained Earnings 2,000

Accu. Depre. 2,000Depre. Exp. 2,000

Accu. Depre. 2,000Combined:Machine 10,000Depre. Exp. 2,000

Retained earnings 8,000Accu. Depre. 4,000

If the books of 20x6 have been closed, the entry is:Machine 10,000

Retained Earnings 6,000Accu. Depre. 4,000

accounting changes and error corrections

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