Chapter 11 Accounting Changes and Error Analysis

1.Identify the types of accounting changes. 2.Describe the accounting for changes in accounting principles. 3.Understand how to account for retrospective accounting changes. 4.Understand how to account for impracticable changes. 5.Describe the accounting for changes in estimates. 6.Identify changes in a reporting entity. 7.Describe the accounting for correction of errors. 8.Identify economic motives for changing accounting methods. 9.Analyze the effect of errors.

Why are accounting changes made? New FASB pronouncements Changing economic conditions Changing internal circumstances Accounting Changes Reporting Issues & Approaches

Essential issues in reporting accounting changes: ¶ Whether an accounting change is allowed. ¶ Whether to restate prior years?financial statements.  Whether to recognize the effect of the change in the current year ’ s net income or in the beginning retained earnings balance. Accounting Changes Reporting Issues & Approaches

Accounting Changes

Error corrections... Are not classified as accounting changes. Do affect the income of prior periods and require special treatment. Accounting Changes

Relevance Consistency Public Confidence Objectives of Reporting Accounting Changes

Accounting Principle Changes

The following are not accounting principle changes:  Initial adoption of an accounting principle  Adopting an accounting principle for a new group of assets or liabilities  Change from inappropriate accounting principle to GAAP  Planned change to straight-line depreciation  Change in accounting principle that cannot be distinguished from a change in accounting estimate Accounting Principle Changes

Three approaches for reporting changes: 1) Currently (cumulative effect). 2) Retrospectively. 3) Prospectively (in the future). FASB requires use of the retrospective approach. Changes in Accounting Principle

 A change in an accounting principle is accounted for by the retrospective application of the new accounting principle.  A change in an accounting estimate is accounted for prospectively.  A change in a reporting entity is accounted for by the retrospective application of the new accounting principle.  A material error is accounted for by prior period restatement (adjustment). According to the provisions of FASB No. 154: Basic Principles

A company accounts for a change in principle by the retrospective application of the new accounting principle as follows: 1.The company computes the cumulative effect of the change to the new accounting principle as of the beginning of the first period presented. That is, it computes the amounts that would have been in the financial statements if it had always used the new principle. ContinuedContinued Retrospective Adjustment Method

2.The company adjusts the carrying values of those assets and liabilities (including income taxes) that are affected by the change. The company makes an offsetting adjustment to the beginning balance of retained earnings to report the cumulative effect of the change (net of taxes) for each period presented. ContinuedContinued Retrospective Adjustment Method

3.The company adjusts the financial statements of each prior period to reflect the specific effects of applying the new accounting principle. That is, each item in each financial statement that is affected by the change is restated to the appropriate amount under the new accounting principle. The company uses the new accounting principle in its current financial statements. ContinuedContinued Retrospective Adjustment Method

4.The company’s disclosures include (a) the nature and reason for the change in accounting principle, including an explanation of why the new principle is preferable, (b) a description of the prior-period information that has been retrospectively adjusted, (c) the effect of the change on income, earnings per share, and any other financial statement line item for the current period and the prior periods retrospectively adjusted, and (d) the cumulative effect of the change on retained earnings (or other appropriate component of equity) at the beginning of the earliest period presented. Retrospective Adjustment Method

The following accounting principle changes are subject to the retroactive approach: ¶ Change from LIFO to another inventory method ¶ Change in the method of accounting for long-term construction contracts ¶ Change to or from full-cost method in extractive industries ¶ Changes in accounting principle made in conjunction with an initial public offering of equity securities (exemption available only once) Retrospective Adjustment Method

The following accounting principle changes are subject to the retroactive approach: ¶ Change from retirement/replacement accounting to depreciation accounting for railroad track structures ¶ Change to a principle required by a new pronouncement recognized as GAAP that requires retroactive application ¶ Change to the equity method of accounting for investments in common stock (sometimes classified as a change in reporting entity) Retrospective Adjustment Method

Example (Retrospective Change) Buildmore Construction Company used the completed contract method to account for long-term construction contracts for financial accounting and tax purposes in 2007, its first year of operations. In 2008, the company decided to change to the percentage-of- completion method for financial accounting purposes. Income before long-term contracts and taxes in 2007 and 2008 was $80,000 and $100,000. The tax rate is 40% and the company will continue to use the completed contract method for tax purposes. Retrospective Change Example

Example Income from Long-Term Contracts Retrospective Change Example

Example Comparative Income Statements Retrospective Change Example

Example Retained Earnings Statement Retrospective Change Example

Impracticability Changes in Accounting Principle Companies should not use retrospective application if one of the following conditions exists: 1.Company cannot determine the effects of the retrospective application. 2.Retrospective application requires assumptions about management’s intent in a prior period. 3.Retrospective application requires significant estimates that the company cannot develop. If any of the above conditions exists, the company prospectively applies the new accounting principle.

No cumulative adjustment is made. Prior years ’ results remain unchanged. New estimates are applied prospectively. Summary of the Approach for Changes in Accounting Estimates Prospective Approach

Changes in Accounting Estimate The following items require estimates. 1.Uncollectible receivables. 2.Inventory obsolescence. 3.Useful lives and salvage values of assets. 4.Periods benefited by deferred costs. 5.Liabilities for warranty costs and income taxes. 6.Recoverable mineral reserves. 7.Change in depreciation methods. Companies report prospectively changes in accounting estimates.

Arcadia HS, purchased equipment for $510,000 which was estimated to have a useful life of 10 years with a salvage value of $10,000 at the end of that time. Depreciation has been recorded for 7 years on a straight-line basis. In 2005 (year 8), it is determined that the total estimated life should be 15 years with a salvage value of $5,000 at the end of that time. Required: ◦ What is the journal entry to correct the prior years’ depreciation? ◦ Calculate the depreciation expense for No Entry Required

Equipment$510,000 Fixed Assets: Accumulated depreciation 350, ,000 Net book value (NBV) Net book value (NBV)$160,000 Balance Sheet (Dec. 31, 2004) After 7 years Equipment cost $510,000 Salvage value - 10,000 Depreciable base500,000 Useful life (original) 10 years Annual depreciation $ 50,000 x 7 years = $350,000 First, establish NBV at date of change in estimate.

After 7 years Net book value $160,000 Salvage value (new) 5,000 Depreciable base155,000 Useful life remaining 8 years Annual depreciation $ 19,375 Second, calculate depreciation expense for Depreciation expense 19,375 Accumulated depreciation 19,375 Journal entry for 2005

Reporting a Change in Entity Examples of a change in reporting entity are: 1.Presenting consolidated statements in place of statements of individual companies. 2.Changing specific subsidiaries that constitute the group of companies for which the entity presents consolidated financial statements. 3.Changing the companies included in combined financial statements. 4.Changing the cost, equity, or consolidation method of accounting for subsidiaries and investments. Reported by changing the financial statements of all prior periods presented.

No cumulative adjustment is made. Prior years ’ results are restated. Summary of the Approach for Changes in Reporting Entity Reporting a Change in Entity

 New principle must be preferable.  Nature of change and justification disclosed in notes. Justifications Improved matching Enhanced asset valuation New information Changing conditions Compliance with new reporting standards Justification for Accounting Changes

I wonder why companies make accounting changes? It seems like a lot of trouble to me!

Reporting a Correction of an Error Accounting errors include the following types: 1.A change from an accounting principle that is not generally accepted to an accounting principle that is acceptable. 2.Mathematical mistakes. 3.Changes in estimates that occur because a company did not prepare the estimates in good faith. 4.Failure to accrue or defer certain expenses or revenues. 5.Misuse of facts. 6.Incorrect classification of a cost as an expense instead of an asset, and vice versa.

Reporting a Correction of an Error All material errors must be corrected. Record corrections of errors from prior periods as an adjustment to the beginning balance of retained earnings in the current period. Such corrections are called prior period adjustments. For comparative statements, a company should restate the prior statements affected, to correct for the error.

1. The company computes the cumulative effect of the error correction on prior period financial statements. That is, it computes the amounts that would have been in the financial statements if it had not made the error. ContinuedContinued A company accounts for a change in accounting principle by prior period restatement as follows: Prior Period Restatement

2.The company adjusts the carrying values of those assets and liabilities (including income taxes) that are affected by the error. The company makes an offsetting entry to the beginning balance of retained earnings to report the cumulative effect of the error correction (net of taxes) for each period presented. ContinuedContinued Prior Period Restatement

3. The company adjusts the financial statements of each prior period to reflect the specific effects of correcting the error. 4. The company’s disclosures include (a) that its previously issued financial statements have been restated, along with a description of the nature of the error, ContinuedContinued Prior Period Restatement

4. (b) the effect of the correction of each financial statement line item, and any per share amounts affected for each prior period presented, and (c) the cumulative effect of the change on retained earnings (or other appropriate component of equity) at the beginning of the earliest period presented. 4. (b) the effect of the correction of each financial statement line item, and any per share amounts affected for each prior period presented, and (c) the cumulative effect of the change on retained earnings (or other appropriate component of equity) at the beginning of the earliest period presented. Prior Period Restatement

Before issuing the report for the year ended December 31, 2007, you discover a $62,500 error that caused the 2006 inventory to be overstated (overstated inventory caused COGS to be lower and thus net income to be higher in 2006). Would this discovery have any impact on the reporting of the Statement of Retained Earnings for 2007? Assume a 20% tax rate.

I. Errors occurred and discovered in the same accounting period. II. Errors occurred in previous period. A. Errors did not affect prior period net income. B. Errors did affect prior period net income. 1. Counterbalancing errors 2. Noncounterbalancing errors Accounting Errors Classifications

Corrected by reversing the incorrect entry and then recording the correct entry (or by making an entry to correct the account balances) Errors Occurred and Discovered in Same Period

 Involves incorrect classification of accounts.  Requires correction of previously issued statements (retroactive approach).  Is not classified as a prior period adjustment since it does not affect prior income.  Disclose nature of error. Previous Period Errors Not Affecting Net Income

 Counterbalancing errors discovered after two or more years do not require a correcting entry.  Counterbalancing errors discovered in the second year of the cycle require a correcting entry. -- Treated as a prior period adjustment (net of tax) to beginning Retained Earnings balance. Counterbalancing Errors Affecting Prior Net Income

 These errors do not automatically correct themselves after two years.  Correction of a noncounterbalancing error usually requires a prior period adjustment (retroactive approach). Noncounterbalancing Errors Affecting Prior Net Income

E22-19 (Error Analysis; Correcting Entries) A partial trial balance of Julie Hartsack Corporation is as follows on December 31, Instructions (a) Assuming that the books have not been closed, what are the adjusting entries necessary at December 31, 2008?

1. A physical count of supplies on hand on December 31, 2008, totaled $1, Accrued salaries and wages on December 31, 2008, amounted to $4,400. (a)Assuming that the books have not been closed, what are the adjusting entries necessary at December 31, 2008?

3. Accrued interest on investments amounts to $4,350 on December 31, The unexpired portions of the insurance policies totaled $65,000 as of December 31, (a)Assuming that the books have not been closed, what are the adjusting entries necessary at December 31, 2008?

5. $28,000 was received on January 1, 2008 for the rent of a building for both 2008 and The entire amount was credited to rental income. 6. Depreciation for the year was erroneously recorded as $5,000 rather than the correct figure of $50,000.

E22-19 (Error Analysis; Correcting Entries) A partial trial balance of Julie Hartsack Corporation is as follows on December 31, Instructions (b) Assuming that the books have been closed, what are the adjusting entries necessary at December 31, 2008?

1. A physical count of supplies on hand on December 31, 2008, totaled $1, Accrued salaries and wages on December 31, 2008, amounted to $4,400.

3. Accrued interest on investments amounts to $4,350 on December 31, The unexpired portions of the insurance policies totaled $65,000 as of December 31, (b) Assuming that the books have been closed, what are the adjusting entries necessary at December 31, 2008?

5. $28,000 was received on January 1, 2008 for the rent of a building for both 2008 and The entire amount was credited to rental income. 6. Depreciation for the year was erroneously recorded as $5,000 rather than the correct figure of $50,000. (b ) Assuming that the books have been closed, what are the adjusting entries necessary at December 31, 2008?

Comprehensive income is defined as the net of all changes in equity except those resulting from investments by and distributions to owners. All-Inclusive Concept of Income

Hang in there! We’re coming down the home stretch! Yeah, that’s easy for you to say!

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