Accounting Changes and Errors

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Accounting Changes and

Errors

Accounting Changes and

Errors

Chapter22

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1. Identify the types of accounting changes.2. Explain the methods of disclosing an

accounting change.

3. Account for a change in accounting principle using the cumulative effect method.

4. Account for a change in accounting principle using a prior period restatement.

5. Account for a change in estimate.

ObjectivesObjectives

ContinuedContinuedContinuedContinued

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6. Explain the conceptual issues regarding a change in accounting principle and a change in estimate.

7. Identify a change in a reporting entity.

8. Account for a correction of an error.

9. Summarize the methods for making accounting changes and correcting errors.

ObjectivesObjectives

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Types of Accounting ChangesTypes of Accounting Changes

1. Change in an Accounting Principle. This type of change occurs when a company adopts a generally accepted accounting principle different from the one used previously for reporting purposes.

2. Change in an Accounting Estimate. This type of change is required because an earlier estimate has proven to require modifying as additional information is obtained or circumstances change.

3 Change in a Reporting Entity. This type of change is the result of a change in the entity being reported.

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Methods of Disclosing an Accounting Change

Methods of Disclosing an Accounting Change

Retroactively adjust its past financial statements.

Include the cumulative effect of the change in its income of the current period.

Adjust for the change prospectively.

Retroactively adjust its past financial statements.

Include the cumulative effect of the change in its income of the current period.

Adjust for the change prospectively.

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Basic PrinciplesBasic Principles

• A change in an accounting principle is accounted for by the cumulative effect method.

• A change in an accounting estimate is accounted for prospectively.

• A change in a reporting entity is accounted for by prior period restatement (retroactively).

• An error is accounted for by prior period restatement (retroactively).

• A change in an accounting principle is accounted for by the cumulative effect method.

• A change in an accounting estimate is accounted for prospectively.

• A change in a reporting entity is accounted for by prior period restatement (retroactively).

• An error is accounted for by prior period restatement (retroactively).

The basic principles of APB Opinion No. 20 requires that generally:

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The general rule is that a company accounts for a change in principle as a cumulative effect change as follows:

Accounting for a Change in Accounting Principle


1. The financial statements for prior periods included for comparative purposes are presented as previously reported.

1. The financial statements for prior periods included for comparative purposes are presented as previously reported.

ContinuedContinued

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2. The cumulative effect of changing to the new accounting principle (net of applicable income taxes) on the amount of retained earnings at the beginning of the period in which the change is made is reported immediately before the caption “net income” on the income statement of the period of the change.

2. The cumulative effect of changing to the new accounting principle (net of applicable income taxes) on the amount of retained earnings at the beginning of the period in which the change is made is reported immediately before the caption “net income” on the income statement of the period of the change.

ContinuedContinued

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3. Income before extraordinary items and net income computed on a pro forma basis (that is, as if the new principle had been in effect for all past periods) are shown on the face of the income statement (below earnings per share) for all periods presented.

3. Income before extraordinary items and net income computed on a pro forma basis (that is, as if the new principle had been in effect for all past periods) are shown on the face of the income statement (below earnings per share) for all periods presented.

ContinuedContinued

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4. A description of the change and the reason for it, as well as the effect of the change on income before extraordinary items and on net income (and on related earnings per share amounts) of the period of the change are disclosed in the notes to the financial statements.

4. A description of the change and the reason for it, as well as the effect of the change on income before extraordinary items and on net income (and on related earnings per share amounts) of the period of the change are disclosed in the notes to the financial statements.

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Goddard Company has assets for which it has been using straight-line depreciation for

its financial reporting, and MACRS depreciation for its income tax reporting.

At the beginning of 2005 it adopts an accelerated depreciation method for

financial reporting. The tax rate is 30%.

Goddard Company has assets for which it has been using straight-line depreciation for

its financial reporting, and MACRS depreciation for its income tax reporting.

At the beginning of 2005 it adopts an accelerated depreciation method for

financial reporting. The tax rate is 30%.

Illustration of Cumulative Effect Method

Illustration of Cumulative Effect Method

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Income before cumulative effect of a change in accounting principle $840,000 Cumulative effect on prior years (to December 31, 2004) of changing to a different depreciation method (net of $27,000 income taxes) (63,000 )Net income $777,000


Straight-Line Accelerated DifferenceYear Depreciation Depreciation Net of Tax (30%)

Prior to 2004 $240,000 $300,000 $42,0002004 100,000 130,000 21,000Total at begin-

ning of 2005 $340,000 $430,000 $63,000

Change in Accounting Principle(Cumulative Effect Method)


Partial Income Partial Income StatementStatement

Partial Income Partial Income StatementStatement


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Earnings per share (100,000 shares outstanding):Income before cumulative effect of a change in

accounting principle $8.40 Cumulative effect on prior years (to December 31,

2,004) of changing to a different depreciation method (0.63 )Earnings per share $7.77


Earnings per share (100,000 shares outstanding):Income before cumulative effect of a change in

accounting principle $8.40 Cumulative effect on prior years (to December 31,

2,004) of changing to a different depreciation method (0.63 )Earnings per share $7.77

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Before tax differences

$90,000



Loss on Cumulative Effect of a Change in Depreciation Method 63,000Deferred Tax Liability 27,000

Accumulated Depreciation90,000

Straight-Line Accelerated DifferenceYear Depreciation Depreciation Net of Tax (30%)

Prior to 2004 $240,000 $300,000 $42,0002004 100,000 130,000 21,000Total at begin-

ning of 2005 $340,000 $430,000 $63,000

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Exceptions to the General Rule for a Change in Accounting Principle


1. Adoption of New Principle for Future Events. If a company adopts a new principle for future events, but does not change the method currently used, it does not make a cumulative effect change.


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2. Cumulative Effect Not Determinable. If the cumulative effect is not determinable, the company does not make a cumulative effect change.


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3. Initial Public Sale of Common Stock. If a company makes accounting changes when it makes an initial public distribution, it restates retroactively the financial statements for all prior periods.


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4. Prior Period Restatement (Retroactive Adjustment) More Useful. For certain changes in accounting principles, the APB requires the company to make a prior period restatement instead of a cumulative effect adjustment.

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- A change from the LIFO inventory cost flow method to another method.

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

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

- A change from retirement-replacement-betterment accounting for railroad track structures.

- A change from the fair value method to the equity method for investments in common stock.

- A change from the LIFO inventory cost flow method to another method.

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

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

- A change from retirement-replacement-betterment accounting for railroad track structures.

- A change from the fair value method to the equity method for investments in common stock.

Examples of Item 4Examples of Item 4

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Prior Period Restatement MethodPrior Period Restatement Method

1. The revenues and expenses (including applicable income taxes) affected by the changes are restated in the income statements of previous years included for comparative purposes.

1. The revenues and expenses (including applicable income taxes) affected by the changes are restated in the income statements of previous years included for comparative purposes.


A company accounts for a change in accounting principle by prior period restatement as follows:

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2. The aggregate change in income (net of applicable income taxes) at the beginning of each year is added to (or subtracted from) retained earnings as a prior period adjustment on comparative statements of retained earnings.

2. The aggregate change in income (net of applicable income taxes) at the beginning of each year is added to (or subtracted from) retained earnings as a prior period adjustment on comparative statements of retained earnings.


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3. The related assets and liabilities, including income taxes, are restated in the comparative balance sheets of previous years.

3. The related assets and liabilities, including income taxes, are restated in the comparative balance sheets of previous years.

4. A description of the change and the reason for it, as well as the effect of the change on income before extraordinary items and on net income (and on related earnings per amounts) for all periods, are disclosed in notes to the financial statements.

4. A description of the change and the reason for it, as well as the effect of the change on income before extraordinary items and on net income (and on related earnings per amounts) for all periods, are disclosed in notes to the financial statements.

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Werner Company changes from the LIFO to the FIFO inventory method at the beginning of 2005, and it presents comparative financial

statements for 2005 and 2004.

Werner Company changes from the LIFO to the FIFO inventory method at the beginning of 2005, and it presents comparative financial

statements for 2005 and 2004.

LIFO FIFO Inventory Inventory Difference Year Method Method Net of Tax (30%)

Prior to 2004 $ 550,000 $ 850,000 $210,000 2004 650,000 600,000 (35,000)Total at begin-

ning of 2005 $1,200,000 $1,450,000 $175,000 2005 500,000 700,000 140,000

Total $1,700,000 $2,150,000 $315,000

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Prior Period Restatement MethodPrior Period Restatement MethodComparative Statements of Retained Earnings

Balance at beginning of year, aspreviously reported $2,445,000 $2,000,000

Add: Adjustment for the cumu-lative effect on prior years ofinventory (net of $75,000 in income taxes in 2005 and $90,000 income taxes in 2004) 175,000 210,000

Balance at beginning of year $2,630,000 $2,210,000Net income 490,000 420,000Balance at end of year $3,120,000 $2,630,000

2005 2004

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Prior Period Restatement MethodPrior Period Restatement Method LIFO FIFO Inventory Inventory Difference Year Method Method Net of Tax (30%)

Prior to 2004 $ 550,000 $ 850,000 $210,000 2004 650,000 600,000 (35,000 )Total at begin-

ning of 2005 $1,200,000 $1,450,000 $175,000 2005 500,000 700,000 140,000

Total $1,700,000 $2,150,000 $315,000

Inventory 250,000Retained Earnings175,000Income Taxes Payable75,000

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Transition MethodTransition Method

When a statement specifies a method, the transition rule usually requires retroactive

restatement.

When a statement specifies a method, the transition rule usually requires retroactive

restatement.

Transition rules define the accounting method a company uses

when it changes an accounting principle to conform to a new

principle required by the issuance of a new statement.

Transition rules define the accounting method a company uses

when it changes an accounting principle to conform to a new

principle required by the issuance of a new statement.

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Accounting For a Change in an Estimate


…and future periods if the change affects both. A change in accounting estimate does not result in a cumulative change or

a prior period adjustment.

…and future periods if the change affects both. A change in accounting estimate does not result in a cumulative change or

a prior period adjustment.

APB Opinion Number 20 requires that a company account for a

change in an accounting estimate in the period of change if the

change affects that period only,...

APB Opinion Number 20 requires that a company account for a

change in an accounting estimate in the period of change if the

change affects that period only,...

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A company uses an asset with an original cost of $100,000, an estimated life of 20 years, and an estimated residual

value of zero (the company uses the straight-line method for depreciation). When adjusting entries are made in the ninth year, a new estimation of the total life of the asset is 23 years. Depreciation expense is determined as follows:

A company uses an asset with an original cost of $100,000, an estimated life of 20 years, and an estimated residual

value of zero (the company uses the straight-line method for depreciation). When adjusting entries are made in the ninth year, a new estimation of the total life of the asset is 23 years. Depreciation expense is determined as follows:

Remaining Book Value

Remaining Life= Annual Depreciation

$60,000

15 Years= $4,000 Per Year

$100,000 $100,000 –– (8 x $5,000) (8 x $5,000)$100,000 $100,000 –– (8 x $5,000) (8 x $5,000)

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Additional IssuesAdditional Issues

A change in accounting estimate that is related in whole

or in part to a change in accounting principle is reported

as a change in estimate.

A change in accounting estimate that is related in whole

or in part to a change in accounting principle is reported

as a change in estimate.

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Additional IssuesAdditional Issues

A change in the amortization or depreciation method is considered a change in accounting principle

under the provision of APB Opinion Number 20.

A change in the amortization or depreciation method is considered a change in accounting principle

under the provision of APB Opinion Number 20.

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Accounting for a Change in a Reporting Entity

Accounting for a Change in a Reporting Entity

A company accounts for a change in reporting entity as a prior period adjustment.

A company accounts for a change in reporting entity as a prior period adjustment.

I’ll fax you this list of situations where a change in

a reporting entity occurs.

I’ll fax you this list of situations where a change in

a reporting entity occurs.

321. When a company presents

consolidated or combined financial statements in place of the statements of individual companies.

2. When there is a change in the specific subsidiaries that make up the group of companies for which consolidated financial statements are presented.

3. When the companies included in combined financial statements change.

1. When a company presents consolidated or combined financial statements in place of the statements of individual companies.

2. When there is a change in the specific subsidiaries that make up the group of companies for which consolidated financial statements are presented.

3. When the companies included in combined financial statements change.

FAX Machine

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Accounting For a Correction of An Error


1. The use of an accounting principle that is not generally accepted.

2. The use of an estimate that was not made in good faith.

3. Mathematical miscalculations.

4. The omission of a deferral or accrual.

Examples of errors that a company might make include:

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Slider Company issued a bond for $100,000 due in five years. The liability was incorrectly recorded as a long-term notes payable. Interest

was paid and correctly recorded as interest expense on December 31.

Error Affecting Only the Balance SheetError Affecting Only the Balance SheetError Affecting Only the Balance SheetError Affecting Only the Balance Sheet

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Error Affecting Only the Balance SheetError Affecting Only the Balance SheetError Affecting Only the Balance SheetError Affecting Only the Balance Sheet

The error can be corrected in the following year by charging a balance

sheet account, Long-Term Notes Payable, and crediting Bonds Payable. Since both accounts are real accounts, there is no prior period adjustment.

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Error Affecting Only the Income StatementError Affecting Only the Income Statement

Slider Company recorded interest revenue as revenue from sales. Discovery of this error in

the succeeding year does not require a correcting entry. If Slider presents

comparative financial statements in the current year, it corrects the financial statements of the

prior period by reclassifying the item.

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Errors Affecting Both the Income Errors Affecting Both the Income Statement and Balance SheetStatement and Balance Sheet


Slider Company fails to accrue interest of $2,000. Assuming a tax rate of 30%, the effects of the error on Slider’s financial

statements in the period of the errors are—

Interest Expense is understated by $2,000.

Income before income taxes is

overstated by $2,000.

Income Tax Expense is overstated by $600.

Net income is overstated by $1,400.

Retained Earnings is overstated by $1,400.

Interest Payable is understated by $2,000.

Income Taxes

Payable is overstated by $600.

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In the next period, when the company pays the interest and records the entire payment as an expense, these additional errors occur—

Interest Expense is overstated by $2,000.

Income before

income taxes is understated

by $2,000.

Income Tax Expense is understated

by $600.

Net income is understated by

$1,400.

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Error CorrectionError Correction

Handel Company spent $20,000 on building improvements that the company incorrectly recorded as Repair Expense rather than capitalizing the item. A single comprehensive journal entry to correct the

error when it is discovered is:

Building 20,000Retained Earnings 20,000

Note that this entry ignores income taxes and depreciation

considerations.

Note that this entry ignores income taxes and depreciation

considerations.

Error Recording Building Error Recording Building Improvement ExpenditureImprovement ExpenditureError Recording Building Error Recording Building Improvement ExpenditureImprovement Expenditure

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Assuming the building improvements are expected to last 10 years and have no residual

value, a depreciation entry for $2,000 should have been made (assuming straight-line depreciation).

The necessary correcting entry is:

Retained Earnings 2,000Accumulated Depreciation 2,000

Error Recording Building Error Recording Building Improvement ExpenditureImprovement ExpenditureError Recording Building Error Recording Building Improvement ExpenditureImprovement Expenditure

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1. Analyze the original erroneous journal entry and determine all the debits and credits that were recorded.

2. Determine the correct journal entry and the appropriate debits and credits.

3. Evaluate whether the error has caused additional errors in other accounts.

4. Prepare the correcting entry(ies).


Steps in Analyzing and Correction ErrorsSteps in Analyzing and Correction Errors

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Omission of Unearned RevenueOmission of Unearned RevenueOmission of Unearned RevenueOmission of Unearned Revenue

In December 2004 the Huggins Company received $10,000 as a prepayment for renting a building to another company for all of 2005.

The company debited Cash and credited Rent Revenue. This error was discovered in

2005. The correcting entry is—Retained Earnings 10,000

Rent Revenue 10,000

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Failure to Accrue RevenueFailure to Accrue Revenue

On December 31, 2004 the Huggins Company failed to accrue interest revenue of $500 that it had earned but not received on an outstanding

note receivable. When the cash was received the company debited Cash and credited Interest Revenue. The correcting entry needed is--

Interest Revenue 500Retained Earnings 500

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Omission of Prepaid ExpenseOmission of Prepaid ExpenseOmission of Prepaid ExpenseOmission of Prepaid Expense

On December 31, 2004 the Huggins Company paid $1,000 for insurance coverage for the year 2005. It recorded the original entry as a debit to Insurance Expense and a credit to Cash. The

error was discovered at the end of 2005, and the company makes the following correcting entry:

Insurance Expense 1,000Retained Earnings 1,000

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Error in Ending InventoryError in Ending Inventory

On December 31, 2004 the Huggins Company recorded its ending inventory at $50,000. During 2005 it discovered that the correct

inventory value should have been $55,000. The following correcting entry is needed.

Inventory 5,000Retained Earnings 5,000

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Error in PurchasesError in Purchases

During December 4, Huggins Company made a purchase on credit that it had not paid at year’s end. It recorded this transaction incorrectly at

$17,000 although the invoice price was $27,000. In 2005, Huggins made the following

correcting entry:Retained Earnings 10,000

Accounts Payable 10,000

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Failure to Accrue Estimated Bad DebtsFailure to Accrue Estimated Bad DebtsFailure to Accrue Estimated Bad DebtsFailure to Accrue Estimated Bad Debts

Huggins Company failed to accrue an allowance for doubtful accounts of $7,000 in its 2004 financial statements. The discovery of the

error in 2005 requires the following entry:

Retained Earnings 7,000Allowance for Doubtful

Accounts 7,000

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Chapter22

The EndThe EndThe EndThe End

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This electronic presentation was

prepared by Douglas Cloud,

Professor of Accounting, Pepperdine University

Documents

Accounting Changes and Errors