Chapter 20

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

Chapter 20

Accounting Changesand Error Corrections

20-2

Accounting ChangesType of Change Description

Change in accounting • Adopt a new FASB standard.

principle • 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 periods benefited by intangible asset.

• 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.

Change from one generally accepted accounting principle

to another.

Examples

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Type of Change DescriptionError correction • Mathematical mistakes.

• Inaccuract physical count of inventory.• Change from the cash basis of accounting

to the accrual basis.

• Failure to record an adjusting entry.• Recording an asset as an expense, or vice

versa.• Fraud or gross negligence.

Correction of an error caused by a transaction being

recorded incorrectly or not at all

Examples

Correction of an Error

20-4

Accounting Changesand Error Corrections

RetrospectiveRetrospective

TwoReporting

Approaches

TwoReporting

Approaches

Prospective Prospective

20-5

Error Corrections and Most 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 accounting 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 accounting 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.

20-6

Changes in Estimates andSome Changes 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.

20-7

Consistency

Consistency

Comparability

Comparability

Qualitative Characteristic

s

Although consistency and comparability are Although consistency and comparability are desirable, changing to a new method desirable, changing to a new method

sometimes is appropriate.sometimes is appropriate.

Change in Accounting Principle

20-8

Motivation for Accounting Choices

Changing ConditionsChanging Conditions

New AccountingStandard IssuedNew AccountingStandard 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

20-9

Retrospective Approach: Most Changes in Accounting Principle

Previous 2013 2012 2011 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 2013, Air Parts Corporation changed from LIFO to FIFO. Air Parts has paid

dividends of $40 million each year since 2006. Its income tax rate is 40 percent. Retained earnings on

January 1, 2011, was $700 million; inventory was $500 million. Selected income statement amounts

for 2013 and prior years are (in millions):

20-10Revise Comparative Financial

Statements

2013 2012 2011Revenues 950$ 900$ 875$ 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 ($ in 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.



20-11



Comparative balance sheets will report 2011 inventory $345 million higher than it was reported in last year’s statements.

Retained earnings for 2011 will be $207 million higher.[$345 million × (1 – 40% tax rate)]

Revise Comparative Financial Statements





20-12



Comparative balance sheets will report 2012 inventory $400 million higher than it was reported in last year’s statements.

Retained earnings for 2012 will be $240 million higher.[$400 million × (1 – 40% tax rate)]






20-13



Comparative balance sheets will report 2013 Comparative balance sheets will report 2013 inventory $460 million higher than it would haveinventory $460 million higher than it would havebeen if the change from LIFO had not occurred.been if the change from LIFO had not occurred.

Retained earnings for 2013 will be $276 million higher.Retained earnings for 2013 will be $276 million higher.[$460 million × (1 – 40% tax rate)][$460 million × (1 – 40% tax rate)]






20-14

January 1, 2013:Inventory ....................................................... 400,000,000

Retained earnings ............................... 240,000,000 Income tax payable ……….………..…. 160,000,000 To increase inventory, retained earnings, and income tax payable as a result of the change from LIFO to FIFO.

Adjust Accounts for the Change

On January 1, 2013, the date of the change,the following journal entry would be made

to record the change in principle.

On January 1, 2013, the date of the change,the following journal entry would be made

to record the change in principle.

40% of $400,000,000

20-15

Disclosure Notes

In the first set of financial statements after theIn the first set of financial statements after thechange is made, a disclosure note is needed tochange is made, a disclosure note is needed toIn the first set of financial statements after theIn the first set of financial statements after thechange is made, a disclosure note is needed tochange 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.

20-16

U. S. GAAP vs. IFRS

The changes to and from the LIFO method would not occur if international standards were being applied because LIFO is not a

permissible method for accounting for inventory under IFRS.

20-17

U. S. GAAP vs. IFRS

Changing from U.S. GAAP to IFRS

The basic requirement is full retrospective application of IFRS for the company’s first IFRS financial statements, with several optional exemptions and five mandatory exceptions designed to allow companies to avoid excessive costs or difficulties.

A company’s first IFRS financial statements must include at least three balance sheets and two of each of the other financial statements. The date of transition to IFRS is the date of the opening balance sheet.

Almost all adjustments arising from the first-time application of IFRS are to opening retained earnings of the first period presented on an IFRS basis.

20-18

Prospective Approach

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.

Most changes in principle are reportedby the retrospective approach, but:

20-19Prospective Approach: Change in

Accounting Estimate

A change in depreciation methodis 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.

20-20

On January 1, 2009, 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 2013 the total useful life of the equipment was revised to 6 years. Calculate the 2013 depreciation expense.

Change in Accounting Estimate

$243,000 – $3,000 = $24,000 (2009 – 2012) 10 years

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

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

$147,000 – $3,000 = $72,000 (2013 & 2014) 2 years

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

in a depreciation estimate.

20-21

Universal Semiconductors switched from SYDdepreciation to straight-line depreciation in 2013. The asset was purchased at the beginning of 2011for $63 million, has a useful life of five years, and

an estimated residual value of $3 million.

Universal Semiconductors switched from SYDdepreciation to straight-line depreciation in 2013. The asset was purchased at the beginning of 2011for $63 million, has a useful life of five years, and

an estimated residual value of $3 million.

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

2011 depreciation 20$ ($60 x 5/15)2012 depreciation 16 ($60 x 4/15) Accumulated depreciation 36$

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

2011 depreciation 20$ ($60 x 5/15)2012 depreciation 16 ($60 x 4/15) Accumulated depreciation 36$

Changing Depreciation Methods

20-22


÷

20-23

Depreciation adjusting entryfor 2013, 2014, and 2015.

Depreciation adjusting entryfor 2013, 2014, and 2015.


Depreciation expense ................................... 8,000,000 Accumulated depreciation .................. 8,000,000To record depreciation expense.

20-24

Change in Reporting Entity

A change in reporting entity occurs as a result ofA change in reporting entity occurs as a result of

presenting consolidated financial statementspresenting consolidated financial statements in place of statements of individual companies, or in place of statements of individual companies, or

changing specific companies that constitute thechanging specific companies that constitute the group for which consolidated statements are group for which consolidated statements are prepared. prepared.

A change in reporting entity occurs as a result ofA change in reporting entity occurs as a result of

presenting consolidated financial statementspresenting consolidated financial statements in place of statements of individual companies, or in place of statements of individual companies, or

changing specific companies that constitute thechanging specific companies that constitute the group for which consolidated statements are group for which consolidated statements are prepared. prepared.

20-25

Change in Reporting Entity

Summary of the Retrospective Approachfor Changes in Reporting Entity

Summary of the Retrospective Approachfor Changes in Reporting Entity

Recast all previous periods’ financial Recast all previous periods’ financial statements statements as if the new reporting entity as if the new reporting entity existed in those periodsexisted in those periods..

In the first financial statements after the In the first financial statements after the change:change:

A disclosure note should describe the A disclosure note should describe the nature ofnature of and the reason for the change. and the reason for the change.

The effect of the change on revenue, net The effect of the change on revenue, net income, income before extraordinary income, income before extraordinary items, and related per share amounts should items, and related per share amounts should be shown for all periods presented.be shown for all periods presented.

Recast all previous periods’ financial Recast all previous periods’ financial statements statements as if the new reporting entity as if the new reporting entity existed in those periodsexisted in those periods..

In the first financial statements after the In the first financial statements after the change:change:

A disclosure note should describe the A disclosure note should describe the nature ofnature of and the reason for the change. and the reason for the change.

The effect of the change on revenue, net The effect of the change on revenue, net income, income before extraordinary income, income before extraordinary items, and related per share amounts should items, and related per share amounts should be shown for all periods presented.be shown for all periods presented.

20-26

Error Correction

Examples include: Use of inappropriate principle Mistakes in applying GAAP Arithmetic mistakes Fraud or gross negligence in reporting

For all years presented, 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 presented, financial statements are retrospectively restated to reflect the error correction.

20-27

Correction of Accounting ErrorsFour-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.

20-28

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 Prior Period Adjustment Adjustment

RequiredRequired

Prior Period Prior Period Adjustment Adjustment

RequiredRequired

Prior Period Adjustments

20-29Errors Occurred and Discovered

in 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)

20-30Errors Not Affecting

Prior Years’ Net Income

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.


20-31

Error 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.


20-32

In 2013, the accountant at Orion, Inc. discovered the depreciation of $50,000 on a new asset

purchased in 2012 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 2012 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 2013, the accountant at Orion, Inc. discovered the depreciation of $50,000 on a new asset

purchased in 2012 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 2012 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 2012 to record income

taxes was


December 31, 2012:Income tax expense (30% of $275,000) ..................... 82,500 Deferred tax liability (30% of $50,000) .............. 15,000 Income tax payable (30% of $225,000) ……..… 67,500 To record income tax expense.

20-33

Depreciation expense for 2012 - understated 50,000$

Accumulated depreciation for 2012 - understated 50,000

Net income in 2012 - overstated ($50,000 x 70%) 35,000

Income tax expense in 2012 - overstated 15,000

Deferred tax liability for 2012 - overstated 15,000

Depreciation expense for 2012 - understated 50,000$

Accumulated depreciation for 2012 - understated 50,000

Net income in 2012 - overstated ($50,000 x 70%) 35,000

Income tax expense in 2012 - overstated 15,000

Deferred tax liability for 2012 - overstated 15,000

This error affected the following accounts:

Remember, the 2012 expense accounts were closed to RE.


2013:Retained earnings …………………………................... 35,000Deferred tax liability ……………………………............. 15,000 Accumulated depreciation …………………....… 50,000To correct recording error.

20-34

Retained earnings, January 1, 2013

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, 2013 887,000

Add: Net income 184,000

Less: Dividends (65,000)

Retained earnings, December 31, 2013 1,006,000$

Retained earnings, January 1, 2013

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, 2013 887,000

Add: Net income 184,000

Less: Dividends (65,000)

Retained earnings, December 31, 2013 1,006,000$

Let’s assume the following for Orion, Inc.:

On 1/1/13, the retained earnings balance was $922,000. In 2013, the company paid $65,000 in dividends. Net income for 2013 was $184,000.


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

20-35

Correction of Accounting Errors

Identify the type of accounting error for the following item:

Ending inventory was incorrectly counted. Identify the type of accounting error for the following item:

Ending inventory was incorrectly counted.

Counterbalancing error affecting net income

The ending inventory in one period will be incorrect and the beginning inventory in the next period will also be incorrect. Since the inventory balance effects cost of goods sold,

income will also be incorrect in the two periods, by the same amount. At the end of the two

periods, if no other errors are made, the balances in inventory and retained earnings

are correct.

20-36



Loss on sale of furniture was incorrectlyrecorded as depreciation expense.


Loss on sale of furniture was incorrectlyrecorded as depreciation expense.

Error not affecting net income.

When the furniture sale transaction was recorded, depreciation expense was debited for the amount that should have been a debit

to loss on sale. Since both expenses and losses reduce income, the error does not affect

income.

20-37



Depreciation expense was understated. Identify the type of accounting error for the following item:

Depreciation expense was understated.

Noncounterbalancing error affecting net income.

An expense is understated, so income is understated. The error affects only the year in

which the error was made. It is a noncounterbalancing error since only one period’s

income is affected.

20-38Reporting Accounting Changes and

Error Corrections

20-39

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 AccountingChanges and Errors

20-40

U. S. GAAP vs. IFRS

When correcting errors in previously issued financial statements, IFRS (IAS No. 8) permits

the effect of the error to be reported in the current period if it’s not considered

practicable to report it retrospectively as is required by U.S. GAAP.

20-41

End of Chapter 20

Documents

Chapter 20