copyright © 2007 by the mcgraw-hill companies, inc. all rights reserved. accounting changes and...

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Accounting Changesand Error

Corrections

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Learning Objectives

Differentiate between the three types of accounting changes and between the

retrospective and prospective approaches to accounting for and reporting accounting

changes.

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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

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Error corrections are . . .

Transactions that are either recorded incorrectly or not recorded at all.

Not actually accounting changes, but are accounted for similarly.

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

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Accounting Changes andError Corrections

RetrospectiveRetrospective

TwoReporting

Approaches

TwoReporting

Approaches

Prospective Prospective

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TwoReporting

Approaches

TwoReporting

Approaches


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.

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.


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TwoReporting

Approaches

TwoReporting

Approaches


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.


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Learning Objectives

Describe how changes in accounting principle typically are reported.

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Consistency Comparability

Qualitative Characteristics

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

Change in Accounting Principle

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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 ChangeMotivations for Change

Effect on Income Taxes

Effect on Income Taxes

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Retrospective Approach

Previous 2006 2005 2004 Years

Cost of goods sold (LIFO) 430$ 420$ 405$ 2,000$ Cost of goods sold (FIFO) 370 365 360 1,700 Difference 60$ 55$ 45$ 300$

Revenues 950$ 900$ 875$ 4,500$ Operating expenses 230 210 205 1,000

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 million

each 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 statement

amounts for 2006 and prior years are (in millions):

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 million

each 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 statement

amounts for 2006 and prior years are (in millions):

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2006 2005 2004Revenues 950$ 900$ 875$ Less: Cost of goods sold (FIFO) 370 365 360 Operating expenses 230 210 205 Income before tax 350$ 325$ 310$ Less: Income tax expense (40%) 140 130 124 Net income 210$ 195$ 186$

Income Statements (Millions)

For each year reported, Air Parts makes the comparativestatements appear as if the newly adopted accounting

method (FIFO) had been in use all along.



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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)]

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






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






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On January 1, 2006, the date of the change,the following journal entry would be made

to record the change in principle:

On January 1, 2006, the date of the change,the following journal entry would be made

to record the change in principle:

40% of $400,000,000

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In the first set of financial statements after thechange is made a disclosure note is needed to:In the first set of financial statements after thechange is made a disclosure note is needed to:

Providejustification

for the change.

Point out thatcomparative

information hasbeen revised.

Report any pershare amountsaffected for thecurrent and allprior periods.

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Learning Objectives

Explain how and why some changes in accounting principle are reported

prospectively.

Explain how and why changes in estimates are treated prospectively.

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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.

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

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A change in depreciation method is considered to be a change in accounting estimate that is

achieved by a change in accounting principle. It is

accounted for prospectively as a change in accounting estimate.

Prospective Approach

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Universal Semiconductors switched from SYDdepreciation to straight-line depreciation in 2006. The asset was purchased at the beginning of 2004

for $63 million, has a useful life of 5 years andan estimated residual value of $3 million.

Universal Semiconductors switched from SYDdepreciation to straight-line depreciation in 2006. The asset was purchased at the beginning of 2004

for $63 million, has a useful life of 5 years andan estimated residual value of $3 million.

Sum-of-the-Years-Digits Depreciaton (millions)

2004 depreciation 20$ ($60 x 5/15)2005 depreciation 16 ($60 x 4/15) Accumulated depreciation 36$

Sum-of-the-Years-Digits Depreciaton (millions)

2004 depreciation 20$ ($60 x 5/15)2005 depreciation 16 ($60 x 4/15) Accumulated depreciation 36$

Changing Depreciation Methods

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÷

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Depreciation adjusting entryfor 2006, 2007, and 2008.

Depreciation adjusting entryfor 2006, 2007, and 2008.


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Changing an Estimate

Changes in accounting estimates are also accounted

for prospectively.Let’s look at an example

of a change in adepreciation estimate.

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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


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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


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I wonder why companies make

accounting changes? It seems like a lot of

trouble to me!

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Learning Objectives

Describe the situations that constitute a change in reporting entity.

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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.

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.

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Summary of the Retrospective Approach for Changes 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.

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.

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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.

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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 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 retrospectively restated to reflect the error correction.

Error Correction

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Four-step process Prepare a journal entry to correct any

balances. Retrospectively 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.

Four-step process Prepare a journal entry to correct any

balances. Retrospectively 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

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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 retrospective approach.

Prior Period Adjustment Required

Prior Period Adjustment Required

Prior Period Adjustments

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Errors Occurred and Discoveredin the 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).

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Involves incorrect classification of accounts.

Requires correction of previously issued statements (retrospective 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.


Error Not Affecting Prior Year’sNet Income

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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.


Error Affecting Prior Year’s Net Income

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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.

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:


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Depreciation expense for 2005 - understated 50,000$

Accumulated depreciation for 2005 - understated 50,000

Net income in 2005 - overstated ($50,000 x 70%) 35,000

Income tax expense in 2005 - overstated 15,000

Deferred tax liability for 2005 - overstated 15,000

Depreciation expense for 2005 - understated 50,000$

Accumulated depreciation for 2005 - understated 50,000

Net income in 2005 - overstated ($50,000 x 70%) 35,000

Income tax expense in 2005 - overstated 15,000

Deferred tax liability for 2005 - overstated 15,000

This error affected the following accounts:

Remember that the 2005 expenseaccounts have been closed.


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Retained earnings, January 1, 2006

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, 2006 887,000

Add: Net income 184,000

Less: Dividends (65,000)

Retained earnings, December 31, 2006 1,006,000$

Retained earnings, January 1, 2006

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, 2006 887,000

Add: Net income 184,000

Less: Dividends (65,000)

Retained earnings, December 31, 2006 1,006,000$

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:


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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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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.





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Depreciation expense was understated.












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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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Change in Change in Reporting

Change in Accounting Principle Estimate Entity ErrorMost Prospective

Changes ExceptionsMethod of accounting Retrospective Prospective Prospective Retrospective RetrospectiveRestate prior years? Yes No No Yes YesPro forma disclosureof income and EPS? No No No No NoCumulative effect on An adjustment to An adjustment to prior years' income earliest reported Not Not Not earliest reportedreported? retained earnings. reported. reported. reported. retained earnings.Journal entries? Adjust affected None None None Involves any

balances to new incorrect balancesmethod. as a result of the

error.Subsequent Subsequent Subsequent Consolidated

accounting is accounting is accounting is statements are affected by affected by affected by discussed in

change. change. change. other courses.Disclosure note? Yes Yes Yes Yes Yes

Summary of Accounting Changes and Errors

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End of Chapter 20

copyright © 2007 by the mcgraw-hill companies, inc. all rights reserved. accounting changes and...

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