1. COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Accounting Changes and Error Corrections Chapter 20 S t I c e | S t I c e | S k o u s e n Intermediate Accounting 16E Prepared by: Sarita Sheth | Santa Monica College

2. Learning Objectives 1.Understand the two different types of accounting changes that have been identified by accounting standard setters. 2.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. 3.Prepare the retrospective adjustment of prior periods’ financial statements, and any necessary cumulative adjustment, associated with a change in accounting principle.

3. Learning Objectives 4.Report pro forma results for prior years following a business combination. 5.Recognize the various types of errors that can occur in the accounting process understand when errors counterbalance, and be able to correct errors when necessary.

4. Effect of FASB Statement No. 106 Company One-Time Charge (in millions) IBM$2,263 Gen. Electric1,799 Bell Atlantic1,550 PepsiCo357 The Coca-Cola Company7 Tiffany & Co.6

5. Accounting Changes Two main categories of accounting changes: 1.Change in accounting estimate 2.Change in accounting principle Basic issue is if the changes should be reported as adjustments of the prior periods statements or only affect current and future years.

6. Change in Accounting Estimate Accounting information can not be measured precisely. Estimates may need to be revised to give a better reflection of the business’s activities. Examples accounting estimate changes: –Uncollectible receivables –Useful lives of depreciation –Residual values of depreciable assets –Warranty obligations –Quantities of mineral reserves to be depleted

7. Stop and Think Why aren’t changes in estimates accounted for by restating prior years’ financial statements?

8. Change in Accounting Estimate All changes in estimates should be reflected either in the current period or in current and future periods. No retroactive adjustments or pro forma statements are to be prepared for a change in estimate. All changes in estimates should be reflected either in the current period or in current and future periods. No retroactive adjustments or pro forma statements are to be prepared for a change in estimate.

9. Change in Accounting Estimate Assume Telestar Co, a telescope sales and manufacturing firm, elected in 2008 to change from double-declining balance method of depreciation to the straight- line method to make it more consistent with the majority of its competitors. Depreciable assets have a cost of $500,000 and they were all acquired on 1/1/2005 and have a useful life of 10 years with a zero salvage value. The income tax rate is 30%.

10. Change of Accounting Estimate Balance Straight-Line Effect on Year Depreciation Depreciation Difference Income 2005 2006 2007 Cumulative before 2008 $ 100,000 80,000 64,000 $244,000 $ 50,000 50,000 $150,000 $ 50,000 30,000 14,000 $94,000 $ 35,000 21,000 9,800 $65,800 Double-Declining- Income would have been $94,000 higher leaving a net income difference of $65,800. No change to depreciation for 2005,2006, 2007. Income would have been $94,000 higher leaving a net income difference of $65,800. No change to depreciation for 2005,2006, 2007.

11. Change in Accounting Principle A change in accounting principle involves a change from one generally accepted principle or method to another. A change from a principle that is not generally accepted to one that is generally accepted is considered to be an error correction rather than a change in accounting principle.

12. Change in Accounting Principle 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.

13. Restatement for Prior Periods for Change in Principle 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. A change from retirement-replacement- betterment accounting to depreciation accounting for railroads.

14. Restatement for Prior Periods for Change in Principle Change to LIFO—past records often inadequate to prepare pro-formas. Beginning inventory becomes first LIFO layer. No cumulative effect adjustment is required.

15. Restatement for Prior Periods for Change in Principle In 2008 Forester Company changed from the LIFO inventory costing method to the FIFO method for both financial reporting and income tax purposes. At this time LIFO costing provided a pretax income of $335,000. By converting to FIFO, this pretax income is $335,000 (an $85,000 difference). Applying a tax rate of 30%, the income tax effect is $25,500.

16. Restatement for Prior Periods for Change in Principle The entry in 2008 to record the prior- period effects of the change in accounting principle follows: Inventory 85,000 Income Taxes Payable25,500 Retained Earnings59,500 To adjust the beginning 2008 inventory to its FIFO cost.

17. Pro Forma Disclosures after a Business Combination On December 31, 2008, Sump Pump Company acquired Rock Wall Company for $500,000. This amount exceeded the recorded value of Rock Wall Company’s net assets by $100,000. The entire excess was attributed to a piece of Rock Wall’s equipment that had a remaining useful life of five years as of the acquisition date.

18. Pro Forma Disclosures after a Business Combination Sump Pump Company: Revenue$3,500,000$3,000,000 Net income250,000200,000 Rock Wall Company: Revenue$250,000$400,000 Net income40,00075,000 Sump Pump Company: Revenue$3,500,000$3,000,000 Net income250,000200,000 Rock Wall Company: Revenue$250,000$400,000 Net income40,00075,000 2008 2007 Information reported on the two companies for 2007 and 2008 was as follows:

19. Pro Forma Disclosures after a Business Combination The pro forma information included in the notes to Sump Pump Company’s 2008 financial statements is: Revenue$3,500,000$3,750,000 Net income250,000270,000 Revenue$3,500,000$3,750,000 Net income250,000270,000 20082008 Results Combinedfor Combined ResultsCompanies Revenue$3,000,000$3,400,000 Net income200,000255,000 Revenue$3,000,000$3,400,000 Net income200,000255,000 20072007 Results Combinedfor Combined ResultsCompanies

20. Error Corrections Errors discovered currently in the course of normal accounting procedures. Math errors Posting to the wrong account Misstating an account Omitting an account from the trial balance

21. Error Corrections Errors limited to balance sheet accounts. 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

22. Error Corrections Errors limited to income statement accounts. Debiting Office Salaries instead of Sales Salaries Crediting Rent Revenue instead of Commissions Revenue

23. Error Corrections Errors affecting both income statement accounts and balance sheet accounts. Debiting Office Equipment instead of Repairs Expense Crediting Depreciation Expense instead of Accumulated Depreciation

24. Error Corrections Errors affecting both income statement accounts and balance sheet accounts. Debiting Office Equipment instead of Repairs Expense Crediting Depreciation Expense instead of Accumulated Depreciation

25. Error Corrections Errors affecting both income statement accounts and balance sheet accounts. There are errors in net income that, when not detected, are not automatically counterbalanced in the following fiscal period. There are also errors in net income that, when not detected, are not automatically counterbalanced in the following fiscal period: Recognition of capital expenditures as expenses.Recognition of capital expenditures as expenses. The omission of charges for depreciation and amortization.The omission of charges for depreciation and amortization.

26. Error Corrections 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.

27. Example of Error Corrections (1) Understatement of Merchandise Inventory: Supply Masters, Inc., began operations at the beginning of 2006. Before the accounts are adjusted and closed for 2008, it was discovered that merchandise inventory as of December 31, 2006, was understated by $1,000. Because this type of error counterbalances after two years, no correcting entry is required in 2008.

28. Example of Error Corrections If this error had been discovered in 2007 instead of 2008, the following entry would have to be made to correct the account balances. Merchandise Inventory1,000 Retained Earnings1,000

29. Example of Error Corrections (2) Failure to Record Merchandise Purchases It is discovered that purchase invoices of December 31, 2006, for $850 had not been recorded until 2007. The goods had been included in the inventory at the end of 2006. Because this type of error counterbalances after two years, no correcting entry is required in 2008.

30. Example of Error Corrections If this error had been discovered in 2007 instead of 2008, the following entry would have to be made to correct the account balances. Periodic System: Retained Earnings850 Inventory850 Perpetual System: Retained Earnings850 Purchases850

31. Example of Error Corrections (3) Failure to Record Merchandise Sales It is discovered that sales on account of $1,800 for the last week of December 2007 had not been recorded until 2008. The goods were included in the inventory at the end of 2007. The following correcting entry would be required in 2008. Sales1,800 Retained Earnings1,800

32. Example of Error Corrections (4) Failure to Record Accrued Expense Accrued sales salaries of $450 as of December 31, 2006, were overlooked in adjusting the accounts. Sales Salaries is debited for salary payments. Because this type of error counterbalances after two years, no correcting entry is required in 2008.

33. Example of Error Corrections If this error had been discovered in 2007 instead of 2008, the following entry would have to be made to correct the account balances. Retained Earnings450 Sales Salaries450

34. Example of Error Corrections (5) Failure to Record Prepaid Expense It is discovered that Miscellaneous General Expense for 2006 included taxes of $275 that should have been deferred in adjusting the accounts on December 31, 2006. Because this type of error counterbalances after two years, no correcting entry is required in 2008.

35. Example of Error Corrections If this error had been discovered in 2007 instead of 2008, the following entry would have to be made to correct the account balances. Miscellaneous General Expense 275 Retained Earnings275

36. Example of Error Corrections (6) Failure to Record Accrued Revenue Accrued interest on notes receivable of $150 was overlooked in adjusting the accounts on December 31, 2006. The revenue was recognized when the interest was collected in 2007. Because this type of error counterbalances after two years, no correcting entry is required in 2008.

37. Example of Error Corrections If this error had been discovered in 2007 instead of 2008, the following entry would have to be made to correct the account balances. Interest Revenue150 Retained Earnings150

38. Example of Error Corrections (7) Failure to Record Unearned Revenue Fees of $225 received in advance for miscellaneous services as of December 31, 2007, were overlooked in adjusting the accounts. Miscellaneous Revenue had been credited when fees were received. The correcting entry in 2007 is: Retained Earnings225 Miscellaneous Revenue225

39. Example of Error Corrections (8) Failure to Record Depreciation Delivery equipment was acquired at the beginning of 2006 at a cost of $6,000. The equipment has an estimated five- year life. Its depreciation of $1,200 was overlooked at the end of 2006 and 2007. Misstatements arising from the failure to record depreciation are not counterbalanced in the succeeding year.

40. Example of Error Corrections When the omission is recognized, Retained Earnings must be decreased by the net income overstatements and Accumulated Depreciation—Delivery Equipment must be increased. The 2008 correcting entry is: Retained Earnings2,400 Accumulated Depreciation— Delivery Equipment2,400 $1,200 per year x 2

41. Example of Error Corrections (9) Incorrectly Capitalizing an Expenditure Operating expenses of $2,000 were paid in cash at the beginning of 2006. The payment was incorrectly debited to Equipment. The “equipment” was assumed to have a five-year life and no residual value; thus, depreciation of $400 was recognized at the end of 2006 and 2007. The required correcting entry is: Retained Earnings1,200 Accumulated Depreciation— Equipment800 Equipment2,000

42. Required Disclosure for Error Restatements 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.