1. Accounting Changes and Error Analysis
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Accounting Changes and Error Analysis
Chapter 22
FAS 154 STATUS - Issued: May 2005 – Now ASC 250
Effective Date: For accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005
What is in the Kieso 11th edition) textbook is NO LONGER CORRECT but the 12th and 13th editions should be okay
Intermediate Accounting
12th & 13th Editions
Kieso, Weygandt, and Warfield
KWW slides Prepared by Coby Harmon, University of California, Santa Barbara as modified by Teresa Gordon, University of Idaho

2. Learning Objectives Identify the types of accounting changes.
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Learning Objectives
Identify the types of accounting changes.
Describe the accounting for changes in accounting principles.
Understand how to account for retrospective accounting changes.
Understand how to account for impracticable changes.
Describe the accounting for changes in estimates.
Identify changes in a reporting entity.
Describe the accounting for correction of errors.
Identify economic motives for changing accounting methods.
Analyze the effect of errors.

3. Accounting Changes and Error Analysis
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Accounting Changes and Error Analysis
Accounting Changes
Error Analysis
Changes in accounting principle
Changes in accounting estimate
Reporting a change in entity
Reporting a correction of an error
Motivations for change of method
Balance sheet errors
Income statement errors
Balance sheet and income statement effects
Comprehensive example
Preparation of statements with error corrections

4. Restatements are common!
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Restatements are common!

5. Accounting Changes & Corrections
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Accounting Changes & Corrections
ASC Topic 250 (SFAS No. 154) discusses 3 types of accounting changes plus correction of errors
Changes in Accounting Principle
Changes in Accounting Estimates
Changes in Reporting Entity
Errors in Financial Statements

6. Change in accounting principle
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Change in accounting principle
A change from one generally accepted principle to another generally accepted accounting principle
Only possible where GAAP permits more than one acceptable choice
Definition includes a change in the method of applying an accounting principle
Must be applied consistently after adopted
IMPORTANT NOTE: The change must be justified on the basis that it is preferable to the principle previously followed.

7. Change in accounting principle
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Change in accounting principle
A change in accounting principle does NOT include
Initial adoption of an accounting principle for a new event or transaction
Modification of an accounting principle made necessary by transactions clearly different in substance from those previously occurring
A change to a generally accepted principle from an incorrect principle (This is considered the correction of an error)

8. Reporting a change in principle
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Reporting a change in principle
Retrospective application to all prior periods unless this is impracticable
Cumulative DIRECT effect of the change on periods prior to those presented is reflected on the balance sheet in the amounts reported for assets and liabilities
The offsetting adjustment (if any) is made to the beginning balance of retained earnings for the earliest period presented
Financial statements will be re-stated as though the new principle had been in use
Indirect effects (if actually incurred) are recognized in the period during which the accounting change is made
Direct effects include income tax impact

9. Earliest Year Presented (or affected by change)
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Earliest Year Presented (or affected by change)
Retained Earnings account is shown as follows:
Balance at beginning of year $ XXX
Adjustment for the cumulative
effect on prior years (net of tax) $ XX
Balance at beginning (as adjusted) $ XX
Net Income $ XXX
Less dividends declared XX
Balance at end of year $ XXX

10. When is a Change in Accounting Principle Appropriate?
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When is a Change in Accounting Principle Appropriate?
Changes are appropriate when the new principle is preferable to the existing accounting principle.
The new principle should result in improved financial reporting.
A change is considered preferable if a FASB standard:
creates a new accounting principle, or
expresses preference for a new principle, or
rejects a specific accounting principle

11. Motivations for Change
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Motivations for Change
Managers and others may have a self- interest in adopting principles or standards:
Companies may want to be less politically visible to avoid regulation
A company’s capital structure may affect its selection of accounting standards
Managers may select accounting standards to maximize their performance-related bonuses
Companies have an incentive to manage or smooth earnings

12. Changes in Accounting Principle
Retrospective Accounting Change: Long-Term Contracts
Illustration: Denson Company has accounted for its income from long-term construction contracts using the completed-contract method. In 2010 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. (We assume a 40 percent enacted tax rate.)
LO 3 Understand how to account for retrospective accounting changes.

13. Changes in Accounting Principle
Income statements for 2008–2010
Illustration 22-1
Net income completed contract
,000
,000
Total 560,000 before tax
Net income % of completion
,000
,000
Total ,000 before tax
Difference = = 220,000 in Construction in Progress
LO 3

14. Changes in Accounting Principle
Data for Retrospective Change Example
Illustration 22-2
Net income completed contract
,000
,000
Total ,000 after tax
Net income % of completion
,000
,000
Total ,000 after tax
Difference = = 132,000 in Retained Earnings
Remember that under % of completion accounting, the gross profit on construction is carried in the “inventory” account – which is where we put the “before tax” difference of $220,000.
Plug change in deferred taxes works fine
Journal entry to record change at beginning of 2010:
Construction in Process 220,000
Deferred Tax Liability 88,000
Retained Earnings 132,000
LO 3 Understand how to account for retrospective accounting changes.

15. Changes in Accounting Principle
Reporting a Change in Principle
Major disclosure requirements are as follows.
Nature and reason for the change in accounting principle.
The method of applying the change, and:
A description of the prior-period information that has been retrospectively adjusted, if any.
The effect of the change on income from continuing operations, net income, any other affected line items.
The cumulative effect of the change on retained earnings or other components of equity or net assets as of the beginning of the earliest period presented.
LO 3 Understand how to account for retrospective accounting changes.

16. Changes in Accounting Principle
Reporting a Change in Principle
Illustration 22-3
LO 3 Understand how to account for retrospective accounting changes.

17. Changes in Accounting Principle
Retained Earnings Adjustment
Assuming a retained earnings balance of $1,360,000 at the beginning of 2008.
Illustration 22-4
Before Change
1,360,000 beginning RE at 1/1/08
+240,000 Net income completed contract 2008
1,600,000 bal fwd using completed contract
-240,000 Net income completed contract 2008
+360,000 Net income % of completion 2008
1,720,000 RE adjusted to % of completion 1/1/09
+ 108,000 Net income % of completion 2009
1,828,000 RE end of 2009 using % of completion
+ 120,000 Net income % of completion 2010
1,948,000 RE at end of 2010 using % of completion
LO 3 Understand how to account for retrospective accounting changes.

18. Changes in Accounting Principle
Retained Earnings Adjustment
Illustration 22-5
After Change
$120,000 is the difference between 2008 net income under the two methods
$360,000 % of completion 2008
$240,000 completed contract 2008
$120,000 adjustment to beginning 2009 RE
Note that this number is NOT on the journal entry we made because we were “catching up” for both 2008 and 2009
LO 3 Understand how to account for retrospective accounting changes.

19. Changes in accounting estimates
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Changes in accounting estimates
Current and prospective method

20. Many amounts on FS involve estimates, including:
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Many amounts on FS involve estimates, including:
Uncollectible receivables.
Inventory obsolescence.
Useful lives and salvage values of assets.
Periods benefited by deferred costs.
Liabilities for warranty costs and income taxes.
Recoverable mineral reserves.
Change in depreciation methods.

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Change in Estimate
Estimates that are later determined to be incorrect should be corrected as changes in estimates
Result from availability of new or additional information
Companies report prospectively changes in accounting estimates.

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Change in Estimate
Sometimes effected in the form of a change in accounting principle
Bad debt accounting – change from percentage of sales method to aging of accounts receivable (allowance) method
Fixed assets – change from sum-of-year’s-digits depreciation to straight-line depreciation
FAS154, para. 20. Distinguishing between a change in an accounting principle and a change in an accounting estimate is sometimes difficult. In some cases, a change in accounting estimate is effected by a change in accounting principle. One example of this type of change is a change in method of depreciation, amortization, or depletion for long-lived, nonfinancial assets (hereinafter referred to as depreciation method). The new depreciation method is adopted in partial or complete recognition of a change in the estimated future benefits inherent in the asset, the pattern of consumption of those benefits, or the information available to the entity about those benefits. The effect of the change in accounting principle, or the method of applying it, may be inseparable from the effect of the change in accounting estimate. Changes of that type often are related to the continuing process of obtaining additional information and revising estimates and, therefore, are considered changes in estimates for purposes of applying this Statement.

23. Changes in Accounting Estimates
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Changes in Accounting Estimates
Are handled with what used to be called the current and prospective method
This means that we do not go back and change previously reported numbers on the financial statements (no retroactive restatement)
We make changes to current and future years only
Two numeric examples
Depreciation expense
Depletion expense
FAS154, para. 21 Like other changes in accounting principle, a change in accounting estimate that is effected by a change in accounting principle may be made only if the new accounting principle is justifiable on the basis that it is preferable. For example, an entity that concludes that the pattern of consumption of the expected benefits of an asset has changed, and determines that a new depreciation method better reflects that pattern, may be justified in making a change in accounting estimate effected by a change in accounting principle.

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Depreciation Example
Consider these facts related to an asset acquired January 1, 2010:
The company uses straight-line depreciation
Assume that after 2 years, it becomes obvious that the asset will be used for a total of 8 years
At the end of 8 years, it will be worth $10,000
What depreciation expense should be recorded for 2012?

25. Solution $240,000 - 40,000 - 40,000 = $160,000 Carrying Value
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Solution
$240, , ,000 = $160,000 Carrying Value
new estimate
160, ,000 =
$ 25,000
8 - 2

26. Alternate treatment If we had originally known new facts:
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Alternate treatment
If we had originally known new facts:
We would have had $57,500 in accumulated depreciation at end of 2011.
Actually in acc’d depreciation = $80,000
Make adjusting JE and then continue with $28,750 depreciation for remaining useful life
240, ,000 = $28,

27. Alternate treatment 2012 240,000 -10,000 = $28,750 8 Correcting JE:
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Alternate treatment
240, ,000 = $28,
2012
Correcting JE:
Acc’d Depr ,500 Depr Exp ,500
Record 2012 depreciation:
Depr Exp ,750
Acc’d Depr ,750
Note that the first method is the more common but there is nothing theoretically wrong with either method

28. Example - Coal Mine Cost of property $9,000,000
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Example - Coal Mine
Cost of property $9,000,000
Cost to restore property $1,200,000*
Value after restoration $1,000,000
Recoverable resources 4,000,000 tons
First year production ,000 tons
Sold for $30 per ton
* Present value (asset retirement obligation measured in accordance with SFAS No. 143)
Statutory depletion rate for tax purposes = 10%

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Coal mine example:
Cost basis + cost to restore - residual value after restoration Total estimated recoverable units
$9,000, ,200, ,000, = ,000,000 tons $ per ton
Sold 150,000 tons, therefore cost depletion = 150,000 * 2.30 = $345,000

30. Coal mine example, continued
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Coal mine example, continued
Assume that 250,000 tons of coal were produced and sold during the second year of operation
However, new EPA regulations increased the projected restoration costs to $2,000,000 (asset retirement obligation)
At the beginning of the second year of production, geologist estimate 4,050,000 tons remain
We start over estimating the depletion rate per ton -- using the current BOOK VALUE instead of cost

31. Coal Mine Example Cost basis is now $9,000,000 - $345,000 = $8,655,000
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Coal Mine Example
Cost basis + cost to restore - residual value after restoration Remaining recoverable units (estimated)
Cost basis is now $9,000,000 - $345,000 = $8,655,000
The new estimate of recoverable units (including 2nd year’s production) is 4,050,000 tons (3,800K left + 250K mined this year)
The cost to restore is now $2,000,000
$8,655,000 + $2,000,000 - $1,000,000 = $2.38 per ton ,050,000
250,000 tons * $2.38 = $595,000 depletion expense

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Statutory Depletion
Note that the tax deduction would be much higher using statutory depletion allowance (a permanent difference between accounting and tax return)
Year ,000 tons * $30 per ton = $4,500,000 revenue * 10% statutory rate = $450,000 on tax deduction vs. $345,000 on income statement
Year ,000 tons * $33 per ton =
$8,250,000 Revenue * 10% statutory rate = $825,000 tax deduction vs. $595,000 on income statement

33. Disclosure of Changes in Estimate
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Disclosure of Changes in Estimate
Not required for routine changes in estimate that happen every year
Allowance for uncollectible accounts
Inventory obsolescence
Warranty obligations
UNLESS material
If material, the change in estimate should be discussed in footnotes to financial statements with per share disclosures

34. Other Changes & Corrections
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Other Changes & Corrections
Change in Entity
Correction of Error

35. Reporting a Change in Entity
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Reporting a Change in Entity
The reporting entity changes
Financial statements are restated for all prior periods presented
Examples of a change in reporting entity are:
Consolidated statements in lieu of individual financials
Loss in control of formerly consolidated subsidiary
Acquisition or sale of subsidiaries

36. Reporting the Correction of an Error
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Reporting the Correction of an Error
Corrections are treated as prior period adjustments to retained earnings for the earliest period being reported
Examples of accounting errors include:
A change from an accounting principle that is not generally accepted to one that is accepted
Mathematical errors
Changes in estimates that were not prepared in good faith
A failure to properly accrue or defer expenses or revenues
A misapplication or omission of relevant facts

37. Restatement Example ASC 250-10-55-2 (SFAS No. 154, Appendix A)
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Restatement Example
ASC (SFAS No. 154, Appendix A)
Illustration 1 - detailed example of a change from LIFO to FIFO inventory method
Shows extensive disclosures that would be needed to communicate impact on balance sheet, income statement, and statement of cash flows

38. Error Analysis in General
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Error Analysis in General
Firms do not correct errors that are insignificant.
Three questions must be answered in this regard:
What type of error is involved?
What correcting entries are needed?
How are financial statements to be restated?
Error corrections are reported as prior period adjustments to the beginning retained earnings balance in the current year

39. Accounting Changes A. Change in Accounting Estimate (prospectively)
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Accounting Changes
A. Change in Accounting Estimate (prospectively)
B. Change in Accounting Principle (retroactively or disclosed)
C. Change in Accounting Entity (retroactively)
D. Correction of an Error (retroactively)
1. Change in a plant asset’s salvage value.
2. Change due to overstatement of inventory
3. Change from sum-of-years’-digits to straight-line depreciation method
4. Change from presenting unconsolidated financial statements to consolidated financial statements
Student version
5. Change from LIFO to FIFO inventory method
6. Change in rate used to compute warranty costs

40. Accounting Changes A. Change in Accounting Estimate (prospectively)
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Accounting Changes
A. Change in Accounting Estimate (prospectively)
B. Change in Accounting Principle (retroactively or disclosed)
C. Change in Accounting Entity (retroactively)
D. Correction of an Error (retroactively)
7. Change from an unacceptable to an acceptable accounting principle
8. Change in a patent’s amortization period
9. Change from completed contract to percentage of completion accounting for long-term contracts
STUDENT VERSION
10. Change from FIFO to LIFO inventory method
11. Change from allowance method to the percentage of sales method to account for bad debt expense

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