mcgraw-hill /irwin© 2009 the mcgraw-hill companies, inc. accounting changes and error corrections...

McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.

ACCOUNTING CHANGES ACCOUNTING CHANGES AND ERROR AND ERROR CORRECTIONS CORRECTIONS

Chapter 20

20-2

Type of Change Description ExamplesChange in Accounting Replaces one GAAP Adopt a new FASB standard.

Principle with another GAAP Change method of inventory costing.

Change from FV method to equity method, or vice versa.

Change from completed contract to percentage-of completion, or vice versa.

Change in Accounting Revision of an estimate Change depreciation methods.

Estimate because of new information Change estimate of useful life of

or new experience depreciable asset.

Change estimate of residual value of depreciable asset.

Change estimate of bad debt %

Change acturial estimates pertaining to a pension plan.

Change in Reporting Change from reporting as one Consolidate a subsidiary notEntity type of entity to previously included in consolidated

another type of entity financial statements.Report consolidated financial statementsin place of individual statements.

Accounting ChangesAccounting Changes

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Accounting Changes and Error Accounting Changes and Error CorrectionsCorrections

RetrospectiveRetrospective

TwoReporting

Approaches

TwoReporting

Approaches

Prospective Prospective

20-4

Error Corrections and Error Corrections and Most Changes in PrincipleMost Changes in Principle


TwoReporting

Approaches

TwoReporting

Approaches


Revise prior years’ 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 years’ 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.

20-5

Changes in Estimates and Some Changes in Estimates and Some Changes in PrincipleChanges in Principle


TwoReporting

Approaches

TwoReporting

Approaches


The change is implemented in the current period, 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.

20-6

Consistency Comparability

Qualitative Characteristics

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

Change in Accounting PrincipleChange in Accounting Principle

20-7

Motivation for Accounting ChoicesMotivation 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

20-8

Retrospective ApproachRetrospective Approach – Most Changes in Principle – Most Changes in Principle

Previous 2009 2008 2007 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 to FIFO.

At the beginning of 2009, Air Parts Corporation changed from LIFO to FIFO. Air Parts has paid dividends of $40 million each year since 2002. Its income tax rate is 40 percent.

Retained earnings on January 1, 2007, was $700 million; inventory was $500 million. Selected income statement

amounts for 2009 and prior years are (in millions):

20-9

Retrospective ApproachRetrospective Approach

2009 2008 2007Revenues 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 2007 inventory $345 million higher than it was reported in last year’s statements.

Retained earnings for 2007 will be $207 million higher.[$345 million × (1 – 40% tax rate)]

20-11




Comparative balance sheets will report 2008 inventory $400 million higher than it was reported in last year’s statements.






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Comparative balance sheets will report 2009 inventory $460 million higher than it would havebeen if the change from LIFO had not occurred.






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On January 1, 2009, the date of the change,the following journal entry would be made

to record the change in principle.

On January 1, 2009, 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 toIn the first set of financial statements after the

change 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.

20-15

The prospective approach is used for changes in principle when:

It is impracticable to determine some period- specific effects.

It is impracticable to determine the cumulative effect of prior years.

The change is mandated by authoritative pronouncements.

The prospective approach is used for changes in principle when:

It is impracticable to determine some period- specific effects.

It is impracticable to determine the cumulative effect of prior years.

The change is mandated by authoritative pronouncements.

Prospective ApproachProspective Approach – Some Changes in Principle – Some Changes in Principle

Most changes in principle are reported by the retrospective approach, but:

20-16

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 ApproachProspective Approach – Change in Accounting Estimate – Change in Accounting Estimate

20-17

On January 1, 2005, Towing, Inc. purchased specialized equipment for $243,000. The equipment has been depreciated using the straight-line method and had an estimated life of 10 years and salvage value of $3,000. In 2009 the total useful life of the equipment was revised to 6 years. The 2009 depreciation expense is

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

Change in Accounting EstimateChange in Accounting Estimate

$243,000 – $3,000 = $24,000 (2005 – 2008) 10 years

$24,000 × 4 years = $96,000 Accum. Depr.

$243,000 – $96,000 = $147,000 Book Value

$147,000 – $3,000 = $72,000 (2009 – 2010) 2 years

Changes in accounting estimates are accounted for prospectively. Let’s look at an example of a change in a

depreciation estimate.

20-18

Universal Semiconductors switched from SYDdepreciation to straight-line depreciation in 2009. The asset was purchased at the beginning of 2007

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 2009. The asset was purchased at the beginning of 2007

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

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

2007 depreciation 20$ ($60 x 5/15)2008 depreciation 16 ($60 x 4/15) Accumulated depreciation 36$

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

2007 depreciation 20$ ($60 x 5/15)2008 depreciation 16 ($60 x 4/15) Accumulated depreciation 36$

Changing Depreciation MethodsChanging Depreciation Methods

20-19


÷

20-20

Depreciation adjusting entryfor 2009, 2010, and 2011.

Depreciation adjusting entryfor 2009, 2010, and 2011.


20-21

Change in Reporting EntityChange in Reporting Entity

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.

20-22

Change in Reporting EntityChange in Reporting Entity

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.

20-23

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 CorrectionError Correction

20-24

Four-step process

Prepare a journal entry to correct any balances.

Retrospectively restate prior years’ financial statements that were incorrect.

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

Include a disclosure note.

Correction of Accounting ErrorsCorrection of Accounting Errors

20-25

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 AdjustmentsPrior Period Adjustments

20-26

Errors Occurred and Discovered in the Errors Occurred and Discovered in the Same PeriodSame 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)

20-27

Errors Not Affecting Prior Years’ Net Errors Not Affecting Prior Years’ Net IncomeIncome

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.


20-28

Error Affecting Prior Year’s Net IncomeError Affecting Prior Year’s 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.


20-29

In 2009, the accountant at Orion, Inc. discovered the depreciation of $50,000 on a new asset purchased in 2008 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 2008 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 2009, the accountant at Orion, Inc. discovered the depreciation of $50,000 on a new asset purchased in 2008 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 2008 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 2008 to record income taxes was


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Depreciation expense for 2008 - understated 50,000$

Accumulated depreciation for 2008 - understated 50,000

Net income in 2008 - overstated ($50,000 x 70%) 35,000

Income tax expense in 2008 - overstated 15,000

Deferred tax liability for 2008 - overstated 15,000

Depreciation expense for 2008 - understated 50,000$

Accumulated depreciation for 2008 - understated 50,000

Net income in 2008 - overstated ($50,000 x 70%) 35,000

Income tax expense in 2008 - overstated 15,000

Deferred tax liability for 2008 - overstated 15,000

This error affected the following accounts

Remember, the 2008 expense accounts were closed to RE.


20-31

Retained earnings, January 1, 2009

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, 2009 887,000

Add: Net income 184,000

Less: Dividends (65,000)

Retained earnings, December 31, 2009 1,006,000$

Retained earnings, January 1, 2009

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, 2009 887,000

Add: Net income 184,000

Less: Dividends (65,000)

Retained earnings, December 31, 2009 1,006,000$

Let’s assume the following:

On 1/1/09, the retained earnings balance was $922,000. In 2009, the company paid $65,000 in dividends. Net income for 2009 was $184,000.


The Statement of Retained Earnings (or RE column of the Statement of Shareholders’ Equity) would be as follows:

20-32


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.


Ending inventory was incorrectly counted.





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Loss on sale of furniture was incorrectly recorded as depreciation expense.






Loss on sale of furniture was incorrectly recorded as depreciation expense.






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Depreciation expense was understated.






Depreciation expense was understated.






20-35

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.


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.



20-36

Change in Change in Reporting

Change in Accounting Principle Estimate Entity ErrorMost Prospective

Changes ExceptionsMethod of accounting Retrospective Prospective Prospective Retrospective RetrospectiveRevise prior years? Yes No No Yes YesCumulative 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 ErrorsSummary of Accounting Changes and Errors

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