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Accounting Accounting Changes Changes and Error and Error

CorrectionsCorrections

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Understand the three different types of accounting changes that have been identified by accounting standard setters.

Recognize the difference between a change in accounting estimate and a change in accounting principle, and know how a change in accounting estimate is reflected in the financial statements.

Learning Objectives

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Determine if a change in accounting principle requires a cumulative adjustment relating to its effect or a restatement of prior-periods’ financial statements, and be able to compute the necessary adjustment.

Determine when a change in reporting entity has occurred, and understand the disclosure requirements associated with this change.

Learning Objectives

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Recognize the various type of errors that can occur in the accounting process, understand when errors counterbalance, and be able to correct errors when necessary.

Describe the differences between the U.S. approach to accounting changes and error corrections and the international standard found in IAS 8.

Learning Objectives

5Why Are Accounting Changes Made?

A company, as a result of experience or new information may change its estimates of revenues or expenses.

Due to changes in economic conditions, companies may need to change methods of accounting to more clearly reflect the current economic situation.

Accounting standard-setting bodies may require the use of a new accounting method or principle.

6Why Are Accounting Changes Made?

The acquisition or divestiture of companies may cause a change in the reporting entity.

Management may be pressured to report profitable performance. Making accounting changes can often result in higher net income, thereby reflecting favorably on management.

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Effect of SFAS No. 106

CompanyOne-Time Charge (in millions)

IBM $2,263Gen. Electric 1,799Bell Atlantic 1,550PepsiCo 357The Coca-Cola Company 7Tiffany & Co. 6

8Categories of Accounting Changes

Change in accounting estimateChange in accounting principleChange in reporting entity

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Change in Accounting Estimate

• Employ current and prospective approach.

• Report current and future financial statements on new basis.

• Present prior periods as previously reported.

• Make no adjustments to current period opening balances.

• Present no pro-forma data.

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• Uncollectible receivables.• Useful lives of depreciable or intangible assets.• Residual values for depreciable assets.• Warranty obligations.• Quantities of mineral reserves to be depleted.• Actuarial assumptions for pensions or other

postemployment benefits.• Number of periods benefited by deferred costs.

• Uncollectible receivables.• Useful lives of depreciable or intangible assets.• Residual values for depreciable assets.• Warranty obligations.• Quantities of mineral reserves to be depleted.• Actuarial assumptions for pensions or other

postemployment benefits.• Number of periods benefited by deferred costs.

Change in Accounting Estimate

Examples of areas where changes in accounting estimates often are needed:

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Change in Accounting Principle

• Report cumulative effect on income statement after extraordinary items.

• Criteria for change: change only if the new principle is preferable:– provides more useful information.– is less costly per benefit.

12Changes in Accounting Principle--Disclosure Requirements

• Report current year’s income components on the new basis.

• Report the cumulative effect of the adjustment, net of tax, on the income statement.

• Present prior period financial statements as previously reported.

• Include pro-forma information as if the change were retroactive--direct and indirect effects.

• Present earnings per share data for all prior periods presented.

13Change in Accounting Principle--Example: Basic Data

• AlphaTronics, Inc. has decided to change depreciation methods from double-declining balance to straight-line. The income results are summarized as:

– Net difference $173

– Tax effect (52)

– Net effect on income $121

14Change in Accounting Principle--Example: Income Statement

AlphaTronics, Inc.Partial Income Statement

Income from continuing operations $500

Cumulative effect of change in

accounting principle (net of $52

income tax effect) 121

Net income $621

Note: pro-forma information should also be disclosed if available.

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Sample Partial Income Statement

Income from continuing operations $560,000Extraordinary gain, net of income taxes of $30,000 70,000Cumulative effect on prior years of change in accounting principle--change to the straight-line method of depreciation fromdouble-declining-balance method, net oftaxes of $39,300 91,750

Net income $721,700

16Exceptions to GeneralRule--Situations

A change from LIFO method of inventory pricing to another method.

A change in the method of accounting for long-term construction contracts.

A change to or from the “full cost” method of accounting used in extractive industries.

Changes made at the time of an initial distribution of company stock.

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Retroactive Restatement

Several FASB statements require retroactive restatement.

Adjust Retained Earnings and the prior year’s income for the effects of the change.

Pro-forma information is not required.

18Exceptions to GeneralRule--Change to LIFO

• Change to LIFO--past records often inadequate to prepare pro-formas.

• Beginning inventory becomes first LIFO layer.

• No cumulative effect adjustment is required.

19Change of Principle andChange of Estimate

If there is If there is bothboth a change a change in principle and a change in principle and a change

in estimate for an item, the in estimate for an item, the event is treated as a event is treated as a change in estimatechange in estimate..

If there is If there is bothboth a change a change in principle and a change in principle and a change

in estimate for an item, the in estimate for an item, the event is treated as a event is treated as a change in estimatechange in estimate..

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Change in Reporting Entity

• Employ retroactive approach.• Restate financial statements for all prior

periods presented.• Disclose, in year of change, effect on income

from continuing operations, net income, and earning per share data for all periods presented.

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Errors discovered currently in the course of normal accounting procedures.

Errors discovered currently in the course of normal accounting procedures.

Error Correction--Types of Errors

Math errors. Posting to the wrong

account. Misstating an account. Omitting an account

from the trial balance.

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Errors limited to balance sheet accounts.Errors limited to balance sheet accounts.

Error Correction--Types of Errors

Debiting Accounts Receivable instead of Notes Receivable.

Crediting Interest Payable instead of Notes Payable.

Debiting an investment account instead of Land when property was purchased for plant expansion.

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Errors limited to income statement accounts.Errors limited to income statement accounts.

Error Correction--Types of Errors

Debiting Office Salaries instead of Sales Salaries.

Crediting Rent Revenue instead of Commissions Revenue.

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Errors affecting both income statement accounts and balance sheet accounts.

Errors affecting both income statement accounts and balance sheet accounts.

Error Correction--Types of Errors

Debiting Office Equipment instead of Repairs Expense.

Crediting Depreciation Expense instead of Accumulated Depreciation.

25Errors--Automatically Counterbalanced

Errors in the income statement that are not

detected are automatically counterbalanced in the following fiscal period.

Errors in the income statement that are not

detected are automatically counterbalanced in the following fiscal period.

26Errors--Not Automatically Counterbalanced

Except for merchandise, errors in the balance sheet

are inaccurately stated until such time as

correcting entries are made.

Except for merchandise, errors in the balance sheet

are inaccurately stated until such time as

correcting entries are made.

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Error Correction

• If detected in current period, before books are closed:

– Correct the account through normal accounting adjustment.

• If detected in subsequent period, after books are closed:

– adjust financial records for effect of material errors.

– make adjustment directly to Retained Earnings.

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Example: Error Correction

• In 2001, the accountant for Jackman Enterprises, Inc. forgot to record $5,000 of depletion at an iron mine Jackman owns.

• Record the 2003 correcting entry.

• In 2001, the accountant for Jackman Enterprises, Inc. forgot to record $5,000 of depletion at an iron mine Jackman owns.

• Record the 2003 correcting entry.

Retained Earnings 5,000Mineral Rights--Iron Mine 5,000

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Error Correction--Disclosure

• If comparative statements are provided, apply correction retroactively to prior years.

• Restate beginning balance of Retained Earnings for first period presented if error extends beyond.

• Disclose and explain error correction in notes.

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The EndThe End