1. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 21 Accounting Changes and Error Corrections

2. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-2 Accounting Changes

3. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-3 Accounting Changes Error corrections... Are not classified as accounting changes. Do affect the income of prior periods and require special treatment. Error corrections... Are not classified as accounting changes. Do affect the income of prior periods and require special treatment.

4. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-4 Accounting Changes and Error Corrections Prospective Treatment Current Treatment Retroactive Treatment Three Reporting Approaches

5. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-5 Accounting Changes and Error Corrections Prospective Treatment Current Treatment Retroactive Treatment Three Reporting Approaches 1.Cumulative effect of using the new principle is computed as of the beginning of the period and is included on the income statement. 2.No restatements. 3.Report pro-forma information.

6. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-6 Accounting Changes and Error Corrections Prospective Treatment Current Treatment Retroactive Treatment Three Reporting Approaches 1.No restatements. 2.No pro forma statements. 3.Effects of change is reflected in current and future financial statements.

7. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-7 Accounting Changes and Error Corrections Prospective Treatment Current Treatment Retroactive Treatment Three Reporting Approaches 1.Restate prior years’ financial statements on a basis consistent with new principle. 2.Cumulative effect reported in R/E of earliest year presented.

8. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-8 Accounting Changes

9. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-9 Change in Accounting Principle ConsistencyComparability Qualitative Characteristics Although consistency and comparability are desirable, changing to a new method is sometimes appropriate.

10. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-10 Motivation for Accounting Choices Changing Conditions New Standard Issued Effect on Compensation Effect on Debt Agreements Effect on Union Negotiations Motivations for Change Effect on Income Taxes

11. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-11 Current Approach Cumulative adjustment is reported as a separate income statement item below income from continuing operations. Prior years’ results remain unchanged. Pro forma income amounts are disclosed. Prior years’ results remain unchanged. Pro forma income amounts are disclosed. Summary of the Current Approach

12. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-12 Current Approach During 2005, XYZ Company made a change from the straight-line method to the double- declining balance method for depreciation. The following schedule illustrates the effect of this change.

13. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-13 Current Approach The company has 100,000 shares of common stock outstanding and is taxed at 30%. How would the change in depreciation method appear on the comparative income statements for 2005 and 2004? A partial income statement for XYZ is as follows:

14. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-14 Current Approach Prepare the journal entry to record the accounting change in 2005.

15. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-15 Current Approach Now let’s look at the impact of this change on the income statement.

16. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-16 Current Approach

17. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-17 Current Approach

18. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-18 Any questions?

19. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-19 Cumulative adjustment is reported as an adjustment to retained earnings, beginning balance. In comparative financial statements, prior years’ results are restated to reflect new principle. Summary of the Retroactive Approach for Specified Exceptions Retroactive Approach

20. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-20 The following accounting principle changes are subject to the retroactive approach:  Change to a principle required by a new pronouncement recognized as GAAP that requires retroactive application.  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 made when a closely held corporation first issues financial statements to obtain equity financing for registering securities or for effecting a business combination. The following accounting principle changes are subject to the retroactive approach:  Change to a principle required by a new pronouncement recognized as GAAP that requires retroactive application.  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 made when a closely held corporation first issues financial statements to obtain equity financing for registering securities or for effecting a business combination. Retroactive Approach

21. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-21 Pro forma income amounts are required under the retroactive approach. a. True b. False Pro forma income amounts are required under the retroactive approach. a. True b. False Retroactive Approach

22. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-22 Pro forma income amounts are required under the retroactive approach. a. True b. False Pro forma income amounts are required under the retroactive approach. a. True b. False Since the retroactive approach requires restatement of prior years’ financial statements to conform to the new accounting principle, pro forma income amounts are not required. Retroactive Approach

23. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-23 No cumulative adjustment is made. Prior years’ results remain unchanged. New estimates are applied prospectively. Prior years’ results remain unchanged. New estimates are applied prospectively. Summary of the Prospective Approach for Specified Exceptions and Changes in Estimates Prospective Approach

24. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-24 Specified exceptions that require use of the prospective approach:  Change to LIFO from another inventory method.  Mandated by new accounting standard. Specified exceptions that require use of the prospective approach:  Change to LIFO from another inventory method.  Mandated by new accounting standard. FASB Statement Update Prospective Approach

25. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-25 On January 1, 2002, Towing, Inc. purchased specialized equipment for $243,000. The equipment was depreciated using straight-line and had an estimated life of 10 years and salvage value of $3,000. In 2006 the total useful life of the equipment was revised to 6 years. The 2006 depreciation expense is a. $24,000 b. $48,000 c. $72,000 d. $73,500 On January 1, 2002, Towing, Inc. purchased specialized equipment for $243,000. The equipment was depreciated using straight-line and had an estimated life of 10 years and salvage value of $3,000. In 2006 the total useful life of the equipment was revised to 6 years. The 2006 depreciation expense is a. $24,000 b. $48,000 c. $72,000 d. $73,500 Prospective Approach

26. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-26 On January 1, 2002, Towing, Inc. purchased specialized equipment for $243,000. The equipment was depreciated using straight-line and had an estimated life of 10 years and salvage value of $3,000. In 2006 the total useful life of the equipment was revised to 6 years. The 2006 depreciation expense is a. $24,000 b. $48,000 c. $72,000 d. $73,500 On January 1, 2002, Towing, Inc. purchased specialized equipment for $243,000. The equipment was depreciated using straight-line and had an estimated life of 10 years and salvage value of $3,000. In 2006 the total useful life of the equipment was revised to 6 years. The 2006 depreciation expense is a. $24,000 b. $48,000 c. $72,000 d. $73,500 $243,000 – $3,000 = $24,000 (2002 – 2005) 10 years $24,000 × 4 years = $96,000 Accum. Depr. $243,000 – $96,000 = $147,000 Book Value $147,000 – $3,000 = $72,000 (2006 – 2007) 2 years Prospective Approach

27. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-27 I wonder why companies make accounting changes? It seems like a lot of trouble to me!

28. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-28 No cumulative adjustment is made. Prior years’ results are restated. Present consolidated financial statements. Prior years’ results are restated. Present consolidated financial statements. Summary of the Retroactive Approach for Changes in Reporting Entity Change in Reporting Entity

29. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-29 Examples include: Use of inappropriate principle Mistakes in applying GAAP Arithmetic mistakes Fraud or gross negligence in reporting For all years disclosed, financial statements are retroactively restated to reflect the error correction. Examples include: Use of inappropriate principle Mistakes in applying GAAP Arithmetic mistakes Fraud or gross negligence in reporting For all years disclosed, financial statements are retroactively restated to reflect the error correction. Error Correction

30. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-30  Prepare a journal entry to correct any balances.  Retroactively restate prior years’ financial statements that were incorrect.  Report error as a prior period adjustment if retained earnings is one of the incorrect accounts affected.  Include a disclosure note.  Prepare a journal entry to correct any balances.  Retroactively restate prior years’ financial statements that were incorrect.  Report error as a prior period adjustment if retained earnings is one of the incorrect accounts affected.  Include a disclosure note. Correction of Accounting Errors

31. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-31 Counterbalancing error discovered in the second year. Noncounterbalancing error discovered in any year. Use the retroactive approach. Prior Period Adjustment Required Prior Period Adjustments

32. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-32 Errors Occurred and Discovered in Same Period Corrected by reversing the incorrect entry and then recording the correct entry (or by making an entry to correct the account balances).

33. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-33 Previous Period Error Not Affecting Net Income 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. 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.

34. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-34 Previous Period Error Affecting Net Income Requires correction of previously issued statements (retroactive approach). All incorrect account balances must be corrected. Is classified as a prior period adjustment since it does affect prior income. Disclose nature of error. Requires correction of previously issued statements (retroactive approach). All incorrect account balances must be corrected. Is classified as a prior period adjustment since it does affect prior income. Disclose nature of error.

35. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-35 In 2005, the accountant at Orion, Inc. discovered the depreciation of $50,000 on a new asset purchased in 2004 had not been recorded on the books. However, the amount was properly reported on the tax return. This is the only difference between book and tax income. Accounting income for 2004 was $275,000 and taxable income was $225,000. Orion, Inc. is subject to a 30% tax rate and prepares current period statements only. The entry made in 2004 to record income taxes was: Previous Period Error Affecting Net Income

36. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-36 This error affected the following accounts: Remember that the 2004 expense accounts have been closed. Previous Period Error Affecting Net Income

37. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-37 Previous Period Error Affecting Net Income Let’s assume the following: Retained earning as 1/1/05 was $922,000. In 2005, the company paid $65,000 in dividends. Net income for 2005 is $184,000. The Statement of Retained Earnings would be as follows:

38. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-38 Identify the type of accounting error for the following item: Ending inventory was incorrectly counted. a. Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above. Identify the type of accounting error for the following item: Ending inventory was incorrectly counted. a. Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above. Correction of Accounting Errors

39. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-39 Identify the type of accounting error for the following item: Ending inventory was incorrectly counted. a. Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above. Identify the type of accounting error for the following item: Ending inventory was incorrectly counted. a. Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above. Correction of Accounting Errors

40. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-40 Identify the type of accounting error for the following item: Loss on sale of furniture was incorrectly recorded as depreciation expense. a. Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above. Identify the type of accounting error for the following item: Loss on sale of furniture was incorrectly recorded as depreciation expense. a. Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above. Correction of Accounting Errors

41. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-41 Identify the type of accounting error for the following item: Loss on sale of furniture was incorrectly recorded as depreciation expense. a. Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above. Identify the type of accounting error for the following item: Loss on sale of furniture was incorrectly recorded as depreciation expense. a. Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above. Correction of Accounting Errors

42. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-42 Identify the type of accounting error for the following item: Depreciation expense was understated. a. Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above. Identify the type of accounting error for the following item: Depreciation expense was understated. a. Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above. Correction of Accounting Errors

43. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-43 Identify the type of accounting error for the following item: Depreciation expense was understated. a. Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above. Identify the type of accounting error for the following item: Depreciation expense was understated. a. Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above. Correction of Accounting Errors

44. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-44 A prior period adjustment is not required for a a. Counterbalancing error affecting net income discovered in the second year. b. Counterbalancing error affecting net income discovered after the second year. c. Noncounterbalancing error affecting net income. d. None of the above. A prior period adjustment is not required for a a. Counterbalancing error affecting net income discovered in the second year. b. Counterbalancing error affecting net income discovered after the second year. c. Noncounterbalancing error affecting net income. d. None of the above. Correction of Accounting Errors

45. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-45 A prior period adjustment is not required for a a. Counterbalancing error affecting net income discovered in the second year. b. Counterbalancing error affecting net income discovered after the second year. c. Noncounterbalancing error affecting net income. d. None of the above. A prior period adjustment is not required for a a. Counterbalancing error affecting net income discovered in the second year. b. Counterbalancing error affecting net income discovered after the second year. c. Noncounterbalancing error affecting net income. d. None of the above. Correction of Accounting Errors

46. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 21-46 End of Chapter 21