Accounting Changes and Error Corrections chapter 20 Accounting Changes and Error Corrections

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. Continued

Learning Objectives 3. 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. Report pro forma results for prior years following a business combination. 5. 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. 6. Describe the differences between the U.S. approach to accounting changes and error corrections and the international standard found in IFRS 8.

Why Are Accounting Changes Made? 1. A company, as a result of experience or new information, may change its estimates of revenues or expenses. 2. 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. Management may be pressured to report profitable performance. Making accounting changes can often result in higher net income, thereby reflecting favorably on management.

Effect of SFAS No. 106 – Employers' Accounting for Postretirement Benefits Other Than Pensions One-Time Charge (in millions) Company IBM $2,263 Gen. Electric 1,799 Bell Atlantic 1,550 PepsiCo 357 The Coca-Cola Company 7 Tiffany & Co. 6

Accounting Changes ^ Change in accounting estimate ^ Change in accounting principle Several alternatives have been suggested for reporting accounting changes. 1. Restate the financial statements presented for prior periods to reflect the effect of the change. 2. Make no adjustment to statements prepared for prior periods.

Accounting Changes 3. Same as (2), except report the cumulative effect of the change as a special item in the income statement instead of directly to Retained Earnings. 4. Report the cumulative effect in the current year as in (3) but also present limited pro forma information for all prior periods included in the financial statements reporting “what might have been” if the change had been made in the prior year. Continued

Accounting Changes 5. Make the change effective only for current and future periods with no catch-up adjustment.

Change in Accounting Estimate – Applied Prospectively i. e Change in Accounting Estimate – Applied Prospectively i.e. #5 on slide 8 Examples of areas where changes in accounting estimates often are needed: 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

Changes in Accounting Principle Uses approach #4 on slide 8 A change in accounting principle involves a change from one generally accepted principle or method to another.

Changes in Accounting Principle 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.

Changes in Accounting Principle If an asset if affected by both a change in principle and a change in estimation during the same period… …APB Opinion No. 20 requires that the change be treated as a change in estimation rather than a change in principle.

Changes in Accounting Principle Recall that approach #4 on slide 8 is used 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. 5

Changes in Accounting Principle Telstar Company elected in 2005 to change depreciation methods from double-declining balance to straight-line. The income results are summarized as: Net difference $131,000 Tax effect (39,300) Net effect on income $91,700 Continued 6

Changes in Accounting Principle Base on these data, the journal entry to record the cumulative effect adjustment and to eliminate the previously recorded deferred taxes is as follows: Accumulated Depreciation 131,000 Deferred Tax Asset 39,300 Cumulative Effect of Change in Accounting Principle 91,700 Continued

Changes in Accounting Principle Telstar Company Pro Forma Income Statement for 2003 Income from continuing operations $450,000 Effect of change in accounting principle (net of tax) 19,600 Pro forma income (restated) $469,600 Depreciation (DDB) $60,000 Depreciation (S/L) (32,000) Difference $28,000 Assume tax effect (30%) (8,400) Effect on income $19,600 Continued

Changes in Accounting Principle Telstar Company Pro Forma Income Statement for 2004 Income from continuing operations $500,000 Effect of change in accounting principle (net of tax) 21,000 Pro forma income (restated) $521,000 Depreciation (DDB) $65,000 Depreciation (S/L) (32,000) Difference $30,000 Assume tax effect (30%) (9,000) Effect on income $21,000 Continued 7

Changes in Accounting Principle Since the release of the SEC’s SAB 101 on revenue recognition, many companies have changed their revenue recognition practices to be in accord with the SEC guidelines. SAFB No. 142 mandated the cessation of amortization of goodwill. This standard also requires firms to test for asset impairment annually.

Restatement of Prior Periods for Change in Principle (approach #1 on slide 8 Restatement required in the following five circumstances: 1. A change from LIFO method of inventory pricing to another method. 2. A change in the method of accounting for long-term construction contracts. 3. A change to or from the full cost method of accounting used in extractive industries. Continued 8

Restatement of Prior Periods for Change in Principle 4. Changes made at the time of an initial distribution of company stock. 5. A change from retirement-replacement-betterment accounting to depreciation accounting for railroads.

Restatement of 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. 10

Restatement of Prior Periods for Change in Principle In 2005 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 $420,000 (an $85,000 difference). Applying a tax rate of 30%, the income tax effect is $25,500. Continued

Restatement of Prior Periods for Change in Principle The entry in 2005 to record the prior-period effects of the change in accounting principle follows: Inventory 85,000 Income Taxes Payable 25,500 Retained Earnings 59,500 To adjust the beginning 2005 inventory to its FIFO cost.

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

Errors limited to balance sheet accounts. 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

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

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

Error Corrections Errors affecting both income statement accounts and balance sheet accounts. There are errors in net income that are not detected, such as misstatement of inventories, that are automatically counterbalanced in the following fiscal period.

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

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. 13

Example of Error Correction (1) Supply Masters, Inc., began operations at the beginning of 2003. Before the accounts are adjusted and closed for 2005, it was discovered that merchandise inventory as of December 31, 2003, was understated by $1,000. Because this type of error counterbalances after two years, no correcting entry is required in 2005. Continued 15

Example of Error Correction If this error had been discovered in 2004 instead of 2005, the following entry would have to be made to correct the account balances. Merchandise Inventory 1,000 Retained Earnings 1,000

Example of Error Correction (2) It is discovered that purchase invoices of December 31, 2003, for $850 had not been recorded until 2004. The goods had been included in the inventory at the end of 2003. Because this type of error counterbalances after two years, no correcting entry is required in 2005. Continued

Example of Error Correction If this error had been discovered in 2004 instead of 2005, the following entry would have to be made to correct the account balances. Periodic System: Retained Earnings 850 Purchases 850 Perpetual System: Retained Earnings 850 Inventory 850

Example of Error Correction (3) It is discovered that sales on account of $1,800 for the last week of December 2004 had not been recorded until 2005. The goods were included in the inventory at the end of 2004. The following correcting entry would be required in 2005. Sales 1,800 Retained Earnings 1,800

Example of Error Correction (4) Accrued sales salaries of $450 as of December 31, 2003, 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 2005. Continued

Example of Error Correction If this error had been discovered in 2004 instead of 2005, the following entry would have to be made to correct the account balances. Retained Earnings 450 Sales Salaries 450

Example of Error Correction (5) It is discovered that Miscellaneous General Expense for 2003 included taxes of $275 that should have been deferred in adjusting the accounts on December 31, 2003. Because this type of error counterbalances after two years, no correcting entry is required in 2005. Continued

Example of Error Correction If this error had been discovered in 2004 instead of 2005, the following entry would have to be made to correct the account balances. Miscellaneous General Expense 275 Retained Earnings 275

Example of Error Correction (6) Accrued interest on notes receivable of $150 was overlooked in adjusting the accounts on December 31, 2003. The revenue was recognized when the interest was collected in 2004. Because this type of error counterbalances after two years, no correcting entry is required in 2005. Continued

Example of Error Correction If this error had been discovered in 2004 instead of 2005, the following entry would have to be made to correct the account balances. Interest Revenue 150 Retained Earnings 150

Example of Error Correction (7) Fees of $225 received in advance for miscellaneous services as of December 31, 2004, were overlooked in adjusting the accounts. Miscellaneous Revenue had been credited when fees were received. The correcting entry in 2005 is: Retained Earnings 225 Miscellaneous Revenue 225

Example of Error Correction (8) Delivery equipment was acquired at the beginning of 2003 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 2003 and 2004. Misstatements arising from the failure to record depreciation are not counterbalanced in the succeeding year. Continued

Example of Error Correction When the omission is recognized, Retained Earnings must be decreased by the net income overstatements and Accumulated Depreciation—Delivery Equipment must be increased. The 2005 correcting entry is: Retained Earnings 2,400 Accumulated Depreciation— Delivery Equipment 2,400 $1,200 per year x 2

Example of Error Correction (9) Operating expenses of $2,000 were paid in cash at the beginning of 2003. 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 2003 and 2004. The required correcting entry is: Retained Earnings 1,200 Accumulated Depreciation— Equipment 800 Equipment 2,000

Additional Thoughts About Error Corrections 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. 17

Accounting Changes and Error Corrections Under IFRS 8 Change in Accounting Estimate The treatment under IFRS 8 is consistent with U.S. GAAP. However, a change in depreciation method is classified as a change in estimate under IFRS 8 rather than a change in principle. Under IFRS 8, a change in accounting principle that results from prior periods should be restated. This approach is followed under U.S. GAAP for only a small set of accounting changes.

Accounting Changes and Error Corrections Under IFRS 8 The benchmark treatment for accounting for significant error corrections under IFRS 8 is the same as that required under U.S. GAAP. However, IFRS 8 allows an alternative—the error correction can be accounted for by reflecting the effect of the error correction in income of the period in which the error was discovered without restating previously reported results.