22-1 Prepared by Coby Harmon University of California, Santa Barbara Intermediat e Accounting Prepared by Coby Harmon University of California, Santa Barbara.

22-1 Prepared by Coby Harmon University of California, Santa Barbara Intermediat e Accounting Prepared by Coby Harmon University of California, Santa Barbara Westmont College INTERMEDIATE ACCOUNTING F I F T E E N T H E D I T I O N Prepared by Coby Harmon University of California, Santa Barbara Westmont College kieso weygandt warfield team for success

22-2 PREVIEW OF CHAPTER Intermediate Accounting 15th Edition Kieso Weygandt Warfield 22 Changes in accounting principle Changes in accounting estimate Change in reporting entity Correction of errors Accounting Literature: APB Opinion 20 FAS 154 (2005, Current GAAP) (Now listed as ASC Topic 250) Definition - Limited Coverage Extended

22-3 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. After studying this chapter, you should be able to: LEARNING OBJECTIVES 1. 1.Identify the types of accounting changes. 2. 2.Describe the accounting for changes in accounting principles. 3. 3.Understand how to account for retrospective accounting changes. 4. 4.Understand how to account for impracticable changes. Accounting Changes and Error Analysis 22

22-4 Types of Accounting Changes: 1.Change in Accounting Principle (Policy). 2.Changes in Accounting Estimate. 3.Change in Reporting Entity. Correction of errors are not considered an accounting change. Accounting Alternatives:  Diminish the comparability and consistency of financial information.  Obscure useful historical trend data and financial ratios. Accounting Changes LO 1

22-6  Average cost to FIFO.  Completed-contract to percentage-of-completion method. Change from one accepted accounting policy to another. Examples include: Changes in Accounting Principle Adoption of a new principle in recognition of events that have occurred for the first time or that were previously immaterial is not an accounting change. Example: implementing a credit sales policy when one had not previously existed. LO 2

22-7 Three possible approaches for reporting changes: 1)Currently (affecting this year’s income only). 2)Retrospectively (affecting RE directly and restating prior years’ financials). 3)Prospectively (affecting this year and future years). FASB requires use of the retrospective approach for a change in principle. Rationale - Users can then better compare results from one period to the next. LO 2 Changes in Accounting Principle Retrospectively

22-9 Retrospective Accounting Change Approach Two requirements: 1)Prior years’ financials are restated Financial statements are adjusted for each prior period presented to the same basis as the new accounting principle. 2)RE and other balance sheet account(s) are adjusted Journal entry adjusts the opening balance of retained earnings plus carrying amounts of effected assets and liabilities as of the beginning of the first year presented. Changes in Accounting Principle LO 3

22-10 Illustration: Denson Company has accounted for its income from long-term construction contracts using the completed-contract method. On January 1, 2012, the company changed to the percentage-of-completion method. Management believes this approach provides a more appropriate measure of the income earned. For tax purposes, the company uses the completed- contract method and plans to continue doing so in the future. (Assume a 40 percent enacted tax rate.) LO 3 Understand how to account for retrospective accounting changes. Retrospective Accounting Change: Long-Term Contracts Changes in Accounting Principle

22-11 LO 3 Understand how to account for retrospective accounting changes. Income statements for 2010–2012 under each method: Last Slide Viewed Changes in Accounting Principle (Old Method) (New Method) Historicallyreported Restated Calculate cumulative effect of change on prior years

22-12 Data for Retrospective Change Illustration 22-2 Construction in Process (pre-tax) 220,000 Deferred Tax Liability 88,000 Retained Earnings (after tax) 132,000 LO 3 Understand how to account for retrospective accounting changes. Journal entry beginning of 2012 Last Slide Viewed Changes in Accounting Principle (2010)

22-13 Disclosing a Change in Principle in the Notes (example on next slide): LO 3 Understand how to account for retrospective accounting changes. 1.Nature of the change in accounting policy; 2.The method of applying the change, and: a.A description of the prior period information that has been retrospectively adjusted, if any. b.The effect of the change on income from continuing operations, net income (or other appropriate captions of changes in net assets or performance indicators), any other affected line item. c.The cumulative effect of the change on retained earnings or other components of equity or net assets in the balance sheet as of the beginning of the earliest period presented. Changes in Accounting Principle

22-14 LO 3 Illustration 22-3 Reporting a Change in policy Go to Slide 22-11 Changes in Accounting Principle

22-15 Adjustment on the Retained Earnings Statement (Depends on how many years you present; first let’s consider two years: 2012 and one prior year): LO 3 Understand how to account for retrospective accounting changes. Before Change Go to Slide 22-12 Go to Slide 22-11 Back into this number (if change was not made) (see Slide 22-12) (if old method was used) 1 2 3 Changes in Accounting Principle Assume a Retained earnings balance of $1,360,000 at the beginning of 2010.

22-16 LO 3 Understand how to account for retrospective accounting changes. Illustration 22-5 After Change Adjustment on the Retained Earnings Statement (showing two years, adjustment on the earliest year presented): Go to Slide 22-11 (if showing two years in RE statement) Changes in Accounting Principle

22-17 LO 3 Understand how to account for retrospective accounting changes. Illustration 22-5 Adjustment on the Retained Earnings Statement (showing one year, adjusting the beginning balance of RE): Go to Slide 22-11 (if showing one year in RE statement) Changes in Accounting Principle $1,696,000 (old method: CC) 132,000

22-18 E22-1 (Change in Principle—Long-Term Contracts): Pam Erickson Construction Company changed from the completed-contract to the percentage-of-completion method of accounting for long-term construction contracts during 2015. For tax purposes, the company employs the completed-contract method and will continue this approach in the future. (Hint: Adjust all tax consequences through the Deferred Tax Liability account.) Changes in Accounting Principle LO 3

22-19 Instructions: (assume a tax rate of 35%) (b) What entry(ies) are necessary to adjust the accounting records for the change in accounting principle? (a) What is the amount of net income and retained earnings that would be reported in 2015? Assume beginning retained earnings for 2014 to be $100,000. Changes in Accounting Principle LO 3 E22-1 (Change in Principle—Long-Term Contracts):

22-20 E22-1: Pre-Tax Income from Long-Term Contracts Changes in Accounting Principle LO 3 Journal entry for 2015 Construction in Process190,000 Deferred Tax Liability 66,500 Retained Earnings123,500

22-21 Income Statement Statement of Retained Earnings E22-1: Comparative Statements for two years: Changes in Accounting Principle LO 3

22-22  Direct Effects - FASB takes the position that companies should retrospectively apply the direct effects of a change in accounting principle.  Example: Change from LIFO to FIFO directly affects inventory and deferred taxes  Indirect Effect is any change to current or future cash flows of a company that result from making a change in accounting principle that is applied retrospectively.  Example: Executive bonus based on net income Direct and Indirect Effects of Changes Changes in Accounting Principle LO 3

22-24 Impracticability 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 (hindsight). 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. Changes in Accounting Principle LO 4

22-25 LO 4 Understand how to account for impracticable changes. Example: A change from the FIFO inventory valuation method to the LIFO inventory valuation method. It is virtually impossible reconstruct the old LIFO layers of inventory over an extended period of time and thus, to calculate the cumulative effect of the change in principle LIFO procedures are applied prospectively from the earliest date practicable (date of the change in this example) No adjustment of RE is made It is impracticable to restate prior financials Changes in Accounting Principle Impracticability

22-27 Changes in Accounting Estimate Examples of Estimates 1.Uncollectible receivables (bad debts). 2.Inventory obsolescence. 3.Useful lives and salvage values of assets. 4.Liabilities for warranty costs. 5.Change in depreciation methods. LO 5

22-28 Prospective Reporting Changes in accounting estimates are reported prospectively. Account for changes in estimates in 1.The period of change if the change affects that period only, or 2.The period of change and future periods if the change affects both. FASB views changes in estimates as normal recurring corrections and adjustments and prohibits retrospective treatment. Changes in Accounting Estimate LO 5

22-29 Illustration: Arcadia High School 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 2014 (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 prior years’ depreciation expense? Calculate depreciation expense for 2014. Prospective Method; No Entry Required Changes in Accounting Estimate LO 5

22-30 Equipment$510,000 Fixed Assets: Accumulated depreciation 350,000 Net book value (NBV)$160,000 Balance Sheet (Dec. 31, 2013) 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. Changes in Accounting Estimate LO 5

22-31 Net book value $160,000 Salvage value (if any) 5,000 Depreciable base155,000 Useful life 8 years Annual depreciation $ 19,375 Second, calculate depreciation expense for 2014. Depreciation expense 19,375 Accumulated depreciation 19,375 Journal entry for 2014 Changes in Accounting Estimate LO 5 Advance slide in presentation mode to reveal answers.

22-32 Disclosures Companies need not disclose changes in accounting estimate made as part of normal operations, such as bad debt allowances or inventory obsolescence, unless such changes are material. However, for a change in estimate that affects several periods (such as a change in the service lives of depreciable assets), companies should disclose the effect on income from continuing operations and related per-share amounts of the current period. Changes in Accounting Estimate LO 5

22-34 Change in Reporting 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 (retrospective method). LO 6

22-36 Accounting Errors Types of Accounting Errors: 1.A change from an accounting principle that is not generally accepted to an accounting policy 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. LO 7

22-37  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 (restatement method). LO 7 Accounting Errors

22-38 Illustration: In 2015 the bookkeeper for Selectro Company discovered an error. In 2014 the company failed to record $20,000 of depreciation expense on a newly constructed building. This building is the only depreciable asset Selectro owns. The company correctly included the depreciation expense in its tax return and correctly reported its income taxes payable. LO 7 Example of Error Correction This bookkeeper will be looking for a new job soon!

22-39 Selectro’s income statement for 2014 with and without the error. Illustration 22-19 LO 7 Example of Error Correction What are the entries that Selectro should have made and did make for recording depreciation expense and income taxes?

22-40 Entries that Selectro should have made and did make for recording depreciation expense and income taxes. Illustration 22-20 Example of Error Correction Illustration 22-19

22-41 Illustration 22-20 LO 7 Example of Error Correction Advance slide in presentation mode to reveal complete illustration.

22-42 Retained Earnings 12,000 Correcting Entry in 2015 Illustration 22-20 LO 7 Example of Error Correction Prepare the proper correcting entry in 2015, that should be made by Selectro.

22-43 Retained Earnings 12,000 Correcting Entry in 2015 Reversal LO 7 Example of Error Correction Prepare the proper correcting entry in 2015, that should be made by Selectro. Illustration 22-20 Deferred Tax Liability 8,000

22-44 Retained Earnings 12,000 Correcting Entry in 2015 LO 7 Example of Error Correction Prepare the proper correcting entry in 2015, that should be made by Selectro. Illustration 22-20 Accumulated Depreciation—Buildings 20,000 Deferred Tax Liability 8,000

22-45 Illustration: Selectro Company has a beginning retained earnings balance at January 1, 2015, of $350,000. The company reports net income of $400,000 in 2015. Illustration 22-21 LO 7 Example of Error Correction Single-Period Statements

22-46 Comparative Statements Company should 1.Make adjustments to correct the amounts for all affected accounts reported in the statements for all periods reported. 2.Restate the data to the correct basis for each year presented. 3.Show any catch-up adjustment as a prior period adjustment to retained earnings for the earliest period it reported. LO 7 Accounting Errors

22-47 Before issuing the report for the year ended December 31, 2014, you discover a $62,500 error that caused the 2013 inventory to be overstated (overstated inventory caused COGS to be lower and thus net income to be higher in 2013). Would this discovery have any impact on the reporting of the Statement of Retained Earnings for 2014? Assume a 20% tax rate. LO 7 Accounting Error Illustration

22-48 LO 7 Accounting Error Illustration Advance slide in presentation mode to reveal answers. Entry at December 31, 2014 (assuming books have not been closed for 2014): Retained Earnings50,000 Deferred Tax Liability12,500 Inventory62,500

22-49 Illustration 22-23 LO 7 Summary of Changes and Errors Changes in accounting principle are appropriate only when a company demonstrates that the newly adopted generally accepted accounting principle is preferable to the existing one. (“Preferable” means the change constitutes an improvement in financial reporting, not on the basis of the income tax effect alone).

22-50 Illustration 22-23 LO 7 Summary of Changes and Errors

22-51 LO 7 Describe the accounting for correction of errors. 1.Change from FIFO to average cost inventory method. 2.Change due to overstatement of inventory. 3.Change from sum-of-the-years'-digits to straight- line method of depreciation. 4.Change from presenting unconsolidated to consolidated financial statements. 5.Change from LIFO to FIFO inventory method. 6.Change in the rate used to compute warranty costs. 7.Change from an unacceptable accounting principle to an acceptable accounting principle. 8.Change in a patent's amortization period. 9.Change from completed-contract to percentage-of- completion method on construction contracts. 10.Change in a plant asset's salvage value. E22-8 How would these changes be accounted for? Retrospectively Restatement Prospectively Retrospectively Retrospectively Prospectively Restatement Prospectively Retrospectively Prospectively Summary of Changes and Errors

22-52 LO 7 Describe the accounting for correction of errors. E22-2 Change in Principle: Inventory Methods Whitman Company began operations on January 1, 2010, and uses the average cost method of pricing inventory. Management is contemplating a change in inventory methods for 2013. The following information is available for the years 2010–2012. Net Income Computed Using Net Income Computed Using Average Cost Method FIFO Method LIFO Method 2010$16,000$19,000$12,000 2011 18,000 21,000 14,000 2012 20,000 25,000 17,000 Summary of Changes and Errors

22-53 LO 7 Describe the accounting for correction of errors. E22-2 Change in Principle: Inventory Methods (a) Prepare the journal entry necessary to record a change from the average cost method to the FIFO method in 2013. Net Income Computed Using Net Income Computed Using Average Cost Method FIFO Method LIFO Method 2010$16,000$19,000$12,000 2011 18,000 21,000 14,000 2012 20,000 25,000 17,000 Inventory 11,000* Retained Earnings11,000 *($19,000 + $21,000 + $25,000) – ($16,000 + $18,000 + $20,000) Summary of Changes and Errors

22-54 LO 7 Describe the accounting for correction of errors. E22-2 Change in Principle: Inventory Methods (b) Determine net income to be reported for 2010, 2011, and 2012, after giving effect to the change in accounting principle Net Income Computed Using Net Income Computed Using Average Cost Method FIFO Method LIFO Method 2010$16,000$19,000$12,000 2011 18,000 21,000 14,000 2012 20,000 25,000 17,000 Net Income (FIFO) 2010$19,000 2011 21,000 2012 25,000 Summary of Changes and Errors

22-55 LO 7 Describe the accounting for correction of errors. E22-2 Change in Principle: Inventory Methods (c) Assume Whitman Company used the LIFO method instead of the average cost method during the years 2010–2012. In 2013, Whitman changed to the FIFO method. Prepare the journal entry necessary to record the change in principle Net Income Computed Using Net Income Computed Using Average Cost Method FIFO Method LIFO Method 2010$16,000$19,000$12,000 2011 18,000 21,000 14,000 2012 20,000 25,000 17,000 Inventory 22,000* Retained Earnings22,000 *($19,000 + $21,000 + $25,000) – ($12,000 + $14,000 + $17,000) Summary of Changes and Errors

22-57 LO 10 Make the computations and prepare the entries necessary to record a change from or to the equity method of accounting. Change From The Equity Method Not covered on the Final Exam APPENDIX APPENDIX 22A CHANGING FROM OR TO THE EQUITY METHOD

22-58 RELEVANT FACTS - Similarities  The accounting for changes in estimates is similar between GAAP and IFRS.  Under GAAP and IFRS, if determining the effect of a change in accounting policy is considered impracticable, then a company should report the effect of the change in the period in which it believes it practicable to do so, which may be the current period. (But…see next slide for differences.) LO 11 Compare the procedures for accounting changes and error analysis under GAAP and IFRS.

22-59 RELEVANT FACTS - Differences  Under IFRS, the impracticality exception applies both to changes in accounting principles and to the correction of errors. Under GAAP, this exception applies only to changes in accounting principle.  IFRS (IAS 8) does not specifically address the accounting and reporting for indirect effects of changes in accounting principles. GAAP has detailed guidance on the accounting and reporting of indirect effects.  A change to or from LIFO would not occur under IFRS because LIFO is not a permissible inventory valuation method under IFRS. LO 11

22-60 Which of the following is not classified as an accounting change by IFRS? a.Change in accounting policy. b.Change in accounting estimate. c.Errors in financial statements. d.None of the above. IFRS SELF-TEST QUESTION LO 11

22-61 IFRS requires companies to use which method for reporting changes in accounting policies? a.Cumulative effect approach. b.Retrospective approach. c.Prospective approach. d.Averaging approach. IFRS SELF-TEST QUESTION LO 11

22-62 Under IFRS, the impracticality exception applies to a.Changes involving LIFO. b.Changes in accounting policy only. c.Corrections of errors only. d.Both changes in accounting policy and correction of errors. IFRS SELF-TEST QUESTION LO 11

22-63 Copyright © 2013 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. Copyright

22-1 Prepared by Coby Harmon University of California, Santa Barbara Intermediat e Accounting Prepared by Coby Harmon University of California, Santa Barbara.

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22-1 Prepared by Coby Harmon University of California, Santa Barbara Intermediat e Accounting Prepared by Coby Harmon University of California, Santa Barbara.

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