Chapter 22.docx

CHAPTER 22Accounting Changes and Error Analysis

CHAPTER REVIEW

1. Chapter 22 discusses the different procedures used to report accounting changes and error corrections. The use of estimates in accounting as well as the uncertainty that surrounds many of the events accountants attempt to measure may make adjustments to the financial reporting process necessary. The accurate reporting of these adjustments in a manner that facilitates analysis and understanding of financial statements is the focus of this chapter.

Types of Accounting Changes

2. (S.O. 1) The FASB has standardized the manner in which accounting changes are reported. The three types of accounting changes are as follows:

a. Change in Accounting Principle. A change from one generally accepted accounting principle to another one.

b. Change in Accounting Estimate. A change that occurs as the result of new information or additional experience. An example is a change in the estimate of the useful lives of depreciable assets.

c. Change in Reporting Entity. A change from reporting as one type of entity to another type of entity, for example, changing specific subsidiaries comprising the group of companies for which consolidated financial statements are prepared.

*Note: All asterisked (*) items relate to material contained in the Appendix to the chapter.

Errors in Financial Statements

3. Errors result from mathematical mistakes, mistakes in applying accounting principles, or oversight or misuse of facts that existed when preparing financial statements.

Changes in Accounting Principle

4. (S.O. 2) A change in accounting principle is not considered to result from the adoption of a new principle in recognition of events that have occurred for the first time or that were previously immaterial. For example, implementing a credit sales policy when one had not previously existed is not considered a change in accounting principle. Also, a change from an accounting principle that is not acceptable to a principle that reflects GAAP is considered a correction of an error. Thus, only those changes from one GAAP to another GAAP are defined as a change in accounting principle. Also, an enterprise wishing to change from one GAAP to another GAAP must disclose the nature of and reasons for the change in principle and an explanation of why the newly adopted accounting principle is preferable.

Copyright © 2010 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 13/e Instructor’s Manual (For Instructor Use Only) 22-1

5. Three approaches are suggested for recording the effect of changes in accounting principles: (a) currently, (b) retrospectively, and (c) prospectively. The FASB requires that companies use the retrospective approach.

6. Treating a change in accounting principle currently requires computation of the cumulative effect of the change on financial statements in the current year’s income statement as an irregular item. Advocates of this method contend that investor confidence is lost by a retroactive adjustment of financial statements for prior periods.

7. Retrospective Application refers to the application of a different accounting principle to recast previously issued financial statements as if the new principle had always been used. The company shows any cumulative effect of the change as an adjustment to beginning retained earnings of the earliest year presented.

8. Prospective treatment of a change in accounting principle requires no change in previously reported results. Opening balances are not adjusted and no attempt is made to compensate for prior events. Advocates of this position contend that financial statements based on acceptable accounting principles are final since management cannot change prior periods by subsequently adopting a new principle.

Retrospective Changes

9. (S.O. 3) A retrospective adjustment of the financial statements presented is made by recasting the statements of prior years on a basis consistent with the newly adopted principle. Any part of the cumulative effect attributable to years prior to those presented is treated as an adjustment of beginning retained earnings of the earliest year presented.

10. When a company makes a change in accounting principle, the FASB takes the position that all direct effects should be presented retrospectively, but indirect effects should not be shown retrospectely. The indirect effects are reported only in the current period.

11. When a company cannot determine the prior period effects using every reasonable effort to do so, it is considered impracticable and the company should not use retrospective application. If any one of the following conditions exists, a company should not use retrospective application (a) The company cannot determine the effects of the retrospective application; (b) Retrospective application requires assumptions about management’s intent in a prior period or (c) Retrospective application requires significant estimates for a prior period and the company cannot objectively verify the necessary information to develop these estimates.

Changes in Estimates

12. (S.O. 5) The FASB requires that changes in estimates (for example, uncollectible receivables, useful lives, and salvage values of assets) should be handled prospectively. Opening balances are not adjusted and no attempt is made to “catch up” for prior periods. The effects of all changes in estimates are accounted for in (a) the period of change if the change affects that period only or (b) the period of change and future periods if the change affects both.

22-2 Copyright © 2010 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 13/e Instructor’s Manual (For Instructor Use Only)

13. For example, if an asset with a cost of $250,000 and no salvage value was originally depreciated on a straight-line basis for the first 7 years of its 25 year useful life, the book value of the asset at the end of year 7 would be $180,000 ($250,000 – $70,000). If the estimated useful life was revised at the end of year 7, and the asset was assumed to have a remaining useful life of 9 years, the following journal entry would be made for depreciation at the end of year 8:

Depreciation Expense............................................. 20,000*Accumulated Depreciation................................. 20,000

*($180,000/9)

Whenever it is impossible to determine whether a change in principle or a change in estimate has occurred, the change should be considered a change in estimate. Also, some problems arise in differentiating between a change in an estimate and a correction of an error. The general rule is that careful estimates that later prove to be incorrect should be considered changes in estimates.

Change in an Entity

14. (S.O. 6) Reporting a change in an entity requires restating the financial statements of all prior periods presented to show the financial information for the new reporting entity for all periods. The financial statements of the year in which the change in reporting entity is made should describe the nature of the change and the reason for it.

Corrections of Errors

15. (S.O. 7) The FASB requires that corrections of errors be (a) treated as prior period adjustments, (b) recorded in the year in which the error was discovered, and (c) reported in the financial statements as an adjustment to the beginning balance of retained earnings. If comparative statements are presented, the prior statements affected should be restated to correct for the error.

16. The text includes a summary of guidelines for accounting change and errors (Illustration 22-23). This summary indicates the accounting to be accorded an accounting change or an error correction along with the financial statement presentation and disclosure requirements to be considered. This summary is an effective way to review the major concepts and to assess your understanding of the manner in which accounting changes and errors should be handled in the financial statements.

Motivations for Change of Accounting Method

17. (S.O. 8) Managers might have varying motives for reporting income numbers. Research shows some of these reasons involve political costs, capital structure, bonus payments, and to smooth earnings. To counter these pressures, the FASB has declared they will assess proposed standards from a position of neutrality.


Error Analysis

18. (S.O. 9) Errors occurring in the accounting process can result from mathematical mistakes, bad faith accounting estimates, misapplication of accounting principles, as well as numerous other causes. As indicated earlier, the profession requires that errors be treated as prior period adjustments and be reported in the current year as adjustments to the beginning balance of Retained Earnings.

19. Counterbalancing errors are errors that occur in one period and correct themselves in the next period. Noncounterbalancing errors take longer than two periods to correct themselves and sometimes may exist until the item in error is no longer a part of the entity’s financial statements. In the case of counterbalancing errors found at the end of the first period, the necessity for preparing a correcting journal entry depends on whether or not the books have been closed. If the books have been closed, no correcting entry is needed. Noncounterbalancing errors should always be corrected if discovered before they correct themselves, even if the books have been closed. The following indicates the accounting treatment for counterbalancing errors based on whether or not the books are closed.

1. The books have been closed.

a. If the error has already counterbalanced, no entry is necessary.

b. If the error has not yet counterbalanced, an entry is necessary to adjust the beginning balance of Retained Earnings.

2. The books have not been closed.

a. If the error has already counterbalanced and we are in the second year, an entry is necessary to correct the current period and to adjust the beginning balance of Retained Earnings.

b. If the error is not yet counterbalanced, an entry is necessary to adjust the beginning balance of Retained Earnings and correct the current period.

20. Some examples of counterbalancing and noncounterbalancing errors are presented here:

Counterbalancing Errors

a. Failure to record accrued revenues or expenses.

b. Failure to record prepaid revenues or expenses.

c. Overstatement or understatement of purchases.

d. Overstatement or understatement of ending inventory.

Noncounterbalancing Errors

a. Failure to record depreciation.

b. Recording a depreciable asset as an expense.

c. Recording the purchase of land as an expense.

d. Recording the discount on bonds as interest expense in the year of issue.


21. To demonstrate a counterbalancing error assume a building owner received a rent payment for the 2010 rent of $24,000 on December 31, 2009. The following entry was made on 12/31/09 and no adjustment was recorded:

Cash.................................................................. 24,000Rent Revenue.............................................. 24,000

This would cause Rent Revenue to be overstated in 2009. If the error was found in 2010, the following entry would be made assuming the books had not been closed for 2010:

Retained Earnings............................................. 24,000Rent Revenue.............................................. 24,000

This entry would reduce Retained Earnings for the overstatement of Rent Revenue in 2009 and properly state the Rent Revenue account for 2010. If this error were discovered after the books were closed in 2010, no entry would be made because the error is counterbalanced.

22. In situations where a great many errors are encountered, use of a work sheet, as demon-strated in the text, can facilitate analysis and ultimate correction of account balances. When numerous accounting errors are encountered, it is important to have an organized approach in deciding on the account balances in need of adjustment. The work sheet provides the organization necessary to provide an orderly approach to error correction. Review of the comprehensive illustration on error correction at the end of the chapter will benefit the student’s understanding of the work sheet and the suggested approach to error analysis and correction.

Change from the Equity Method

*23. (S.O. 10) If the investor level of influence or ownership falls below that necessary for continued use of the equity method, a change must be made to the fair value method. The earnings or losses that were previously recognized by the investor under the equity method should remain as part of the carrying amount of the investment with no retroactive restatement to the new method.

Change to the Equity Method

*24. When converting to the equity method, a retroactive adjustment is necessary. Such a change involves adjusting retroactively the carrying amount of the investment, results of current and prior operations, and retained earnings of the investor as if the equity method had been in effect during all of the previous periods in which this investment was held.


ILLUSTRATION 22-1RETROSPECTIVE ACCOUNTING CHANGE APPROACH


ILLUSTRATION 22-1 (continued)


ILLUSTRATION 22-2CHANGES IN ACCOUNTING ESTIMATE


ILLUSTRATION 22-3CATEGORIES OF ACCOUNTING ERRORSTHAT DRIVE RESTATEMENTS


ILLUSTRATION 22-4ACCOUNTING CHANGES AND ERRORS


ILLUSTRATION 22-5COUNTERBALANCING ERRORS


ILLUSTRATION 22-6COUNTERBALANCING VS NONCOUNTERBALANCING ERRORS


ILLUSTRATION 22-7CHANGES FROM AND TO THE EQUITY METHOD


Documents

Chapter 22.docx