2. by Professor Hsieh Intermediate Financial Accounting Accounting Changes and Error Corrections

3. Accounting Changes & Error Corrections2 Objectives of the Chapter I.To learn the types of accounting changes. II.To study the accounting treatments of accounting changes. III.To analyze the accounting errors and to learn the accounting treatments of errors.

4. Accounting Changes & Error Corrections3 I. Types of Accounting Changes A.Changes in Accounting Principle (Method). B.Changes in Accounting Estimate. C.Changes in Reporting Entity.

5. Accounting Changes & Error Corrections4 Examples of Changes in Accounting Principle (Method) Changes from one acceptable accounting method to another acceptable accounting method. Examples: n adopting a new accounting standard. n changes in inventory method. n changes from P-O-C method to C-C method for long-term construction projects.

6. Accounting Changes & Error Corrections5 Examples of Changes in Accounting Estimates n Changes in the estimates of: a. useful lives and salvage values of depreciable assets; b. uncollectible accounts expense; c. liabilities for warranty costs, and income taxes. Note: Under SFAS 154,changes in depreciation method is considered as changes in accounting estimates.

7. Accounting Changes & Error Corrections6 Examples of Changes in Reporting Entity 1. Presenting consolidated statements for the first time to replace individual statements. 2. Changing subsidiaries that are included in consolidated F/S.

8. Accounting Changes & Error Corrections7 II. Accounting Treatments for Accounting Changes n Three approaches had been suggested: n 1.Current-Period Approach (eliminated by SFAS 154). 2.Retrospective Approach (applied to voluntary accounting method changes and changes in reporting entity). 3.Prospective approach (applicable for accounting estimate change).

9. Accounting Changes & Error Corrections8 1. Current-Period Approach (Eliminated by SFAS 154) n The cumulative effect of all prior years resulting from adoption of the new method is reported in the current year’s income statement. n F/S of prior years should not be restated. u Net income and earnings per share, computed on a pro-forma basis (as if the new method were adopted) are shown on the I/S for all periods that appear on the I/S.

10. Accounting Changes & Error Corrections9 Current Period Approach (Eliminated) n This approach has been eliminated by SFAS 154. n SFAS 154 was issued in May 2005, and became effective for fiscal years beginning after 12/15/2005.

11. Accounting Changes & Error Corrections10 Current-Period Approach (contd.) (skip) n Advantages a. Less costly. b Will not affect the financial ratios of prior years. c. No change in prior years’ earnings. n Disadvantages a. It has significant impact on current year’s income. b. Loss comparability among financial statements (F/S) of different years.

12. Accounting Changes & Error Corrections11 2. Retrospective Approach n A retrospective adjustment of the F/S (i.e., restatement of F/S) is made for prior years as if the new method were used. n Cumulative effect for the non-restated prior years is reported in the statement of retained earnings (not income statement) as an adjustment.

13. Accounting Changes & Error Corrections12 Retrospective Approach (contd.) n Advantages a. It results in comparable F/S. b. It has no significant impact in the current year’s income statement. n Disadvantages a. It is costly to restate F/S. b. It has a potential in violating loan covenant.

14. Accounting Changes & Error Corrections13 3. Prospective Approach n No cumulative effect is reported in any financial statements (F/S). n No prior statements are restated. n The new method is applied to the f/S of the current year and future years.

15. Accounting Changes & Error Corrections14 The Treatments for Changes in Accounting Method (skip) n Prior to APB Opinion No. 20 (Accounting Changes, effective 7/31/1971), all three approaches were acceptable for changes in accounting method. n APB 20 only allows the current period approach and the retrospective approach for accounting method changes (except for five situations in which the retrospective approach must be used).

16. Accounting Changes & Error Corrections15 The Treatments for Changes in Accounting Method (contd.) n Under SFAS 154 (effective 2006), the only acceptable treatment for voluntary accounting method changes is the retrospective approach. n SFAS 154 eliminated the current period approach except when proscribed by new accounting standards.

17. Accounting Changes & Error Corrections16 The Treatment for Changes in Accounting Method (contd.) n Reasons of eliminating the current period approach under SFAS 154: n Toward global convergence of accounting standards; n Improve the comparabili ty of financial statements.

18. Accounting Changes & Error Corrections17 The Treatment for Changes in Accounting Estimates n The prospective approach is only acceptable for changes in accounting estimates, NOT for changes in accounting method. n However, a deprecation method change is treated as an estimate change under SFAS 154. Thus, the prospective approach is applied to deprecation method chan ge.

19. Accounting Changes & Error Corrections18 Reasons for Changes in Accounting Method n Reasons for changes in accounting method: 1.Changes in economic environment. 2. Mandated by a new accounting standard (i.e., recognition of post retirement benefit expenses on an accrual basis); 3. Changes in technology. 4. Economical Reasons (see p66 for details).

20. Accounting Changes & Error Corrections19 Change in Accounting Method - An Example n On 1/1 20x2, Doherty Corporation purchased a machine for $110,000. A 10- year economic life and zero residual value were expected for this machine. n The sum-of-the-years’-digits method had been used for depreciation purposes starting 20x2. n On 1/1/ 20x6, the depreciation method was changed to straight line method. The income tax rate is 30%.

21. Accounting Changes & Error Corrections20 Change in Accounting Method Example (contd.) – A Note n SFAS 154 requires that the changes in depreciation methods be treated as an estimate change. n Thus, a prospective approach should be applied for such a change. n However, for illustration and comparison purposes, the current period, retrospective and the prospective approaches are applied for this change.

22. Accounting Changes & Error Corrections21 Example (contd.)-Depreciation Expense under the Old Method (SYD) vs. New Method (S-L) SYD S-L Diff. Diff. (net) C.Eff. (net) 20x2 $20,000 $11,000 $9,000 6,300 6,300 20x3 18,000 11,000 7,000 4,900 11,200 20x4 16,000 11, 000 5,000 3,500 14,700 20x5 14,000 11,000 3,000 2,100 16,800 $68,000 44,000 $24,000 16,800 Diff (net).= difference, net of income tax ;C.Eff (net)= cumulative effect, net of income tax. For 20x6, the depre. Expense is $12,000 and $11,000 under SYD and S-L, respectively. The difference is $1000 (or $700 net of 30% tax )

23. Accounting Changes & Error Corrections22 Example – A Current Period Approach (this approach has been eliminated by SFAS 154) Cumulative Effect= $68,000-44,000=$24,000 Net Cum. Effect = 24,000x (1-30%)= $16,800 JE to reflect this change applying the current period approach (assuming a 30% income tax rate): Accumulated Depreciation 24,000 Cumulative Effect of Change in Acct. Method-Depre. 16,800 Deferred Income Tax Lia.7,200

24. Accounting Changes & Error Corrections23 Example (contd.)- A Current Period Approach Comparative Income Statements * 20x6 20x5 20x4 Revenues$50,000$50,000$50,000 Depr. Exp. (Note A)(11,000)(14,000)(16,000) Other expe.(10,000)(10,000)(10,000) Income taxes (8,700) (7,800) (7,200) Income before changes in acct. principle$20,300 Cumulative effect 16,800 Net income$37,100$18,200$16,800 Earnings per share$3.71$1.82$1.68 Pro Forma (Note A) Net income$20,300$20,300$20,300 Earnings per share$2.03$2.03$2.03 *Assume a 30% tax rate and 10,000 shares outstanding.

25. Accounting Changes & Error Corrections24 Comparative Retained Earnings Assuming a retained earnings balance of $140,000 at the beginning of 20x4 and a dividends of $20,000 for years 20x4-20x6, the following statements of retained earnings will be in the 20x6 annual report: 20x6 20x5 20x4 Balance at beg.(R/E)$135,000136,800140,000 Net income 4 37,10018,20016,800 Cash dividens(20,000)(20,000)(20,000) Balance at end of year152,100135,000136,800

26. Accounting Changes & Error Corrections25 Example (contd.)-A Current Period Approach n Note A: Prior to 20x6, Doherty used sum-of- the-years’-digits depreciation on its plant assets. In 20x6 Doherty changed to the straight-line method of depreciation, which management felt better represented the service expiration of its plan assets..

27. Accounting Changes & Error Corrections26 Example (contd.)-A Current Period Approach n Note A (contd): The cumulative effect of the change in accounting principle of $16,800 (net of I/T) has been included in 20x6 net income. The effect of this change on income of 20x6 was an increase of $700 (net of I/T). The pro forma data report what would have been had the straight- line method been used prior to 20x6.

28. Accounting Changes & Error Corrections27 Example: A Retrospective Approach n The F/S of prior years (i.e., two years) are restated on a basis consistent with the new method. n The cumulative effect of the non-restated prior years is reported in the statement of retained earnings. n This part of cumulative effect is treated as an adjustment of beginning retained earnings of the earliest year presented.

29. Accounting Changes & Error Corrections28 Example - A Retrospective Approach n Using the example on page 19 except applying the retrospective approach, the following comparative I/S will be reported on the 20x6 annual report: 20x6 20x5 20x4. (restated)(restated) Revenues$50,000$50,000$50,000 Depr. Exp.(Note A)(11,000)(11,000)(11,000) Other Expe.(10,000)(10,000)(10,000) Income Taxes(8,700)(8,700)(8,700) Net Income$20,300 $20,300$20,300 Earnings per share$2.03$2.03$2.03

30. Accounting Changes & Error Corrections29 A Retrospective Approach (contd.) Note A: n Prior to 20x6, Doherty used sum-of- the-years’- digits depreciation on its plant assets. n In 20x6 Doherty changed to the straight-line method of depreciation, which management felt better represented the service expiration of its plan assets. n The financial statements of 20x4 and 20x5 have been restated to reflect this change.

31. Accounting Changes & Error Corrections30 A Retrospective Approach (Contd.) n Note A (contd.): n The effect of this change on income of 20x6 was an increase of $700 (net of income tax) and on income of 20x5 and 20x4 was an increase of $2,100 and $3,500 (net of income tax), respectively. n The balances of retained earnings of 20x4 and 20x5 have been adjusted for the effect of applying retrospectively the new method.

32. Accounting Changes & Error Corrections31 Example (contd.)-Depreciation Expense under the Old Method (SYD) vs. New Method (S-L) SYD S-L Diff. Diff. (net) C.Eff. (net) 20x2 $20,000 $11,000 $9,000 6,300 6,300 20x3 18,000 11,000 7,000 4,900 11,200 20x4 16,000 11, 000 5,000 3,500 14,700 20x5 14,000 11,000 3,000 2,100 16,800 $68,000 44,000 $24,000 16,800 Diff (net).= difference, net of income tax ;C.Eff (net)= cumulative effect, net of income tax. For 20x6, the depre. Expense is $12,000 and $11,000 under SYD and S-L, respectively. The difference is $1000 (or $700 net of 30% tax )

33. Accounting Changes & Error Corrections32 A Retrospective Approach (contd.) n The entry to reflect this accounting change under the retrospective approach of 20x6 is: Accu. Depr.24,000 Retained Earnings16,800 Deferred Income tax Lia. 7,200

34. Accounting Changes & Error Corrections33 A Retrospective Approach (contd.) Assuming a retained earnings balance of $140,000 at the beginning of 20x4 and a dividends of $20,000 for years 20x4-20x6, the following statements of retained earnings will be in the 20x6 annual report: 20x6 20x5 20x4 Balance at beg.(R/E)$135,000 2 136,800 1 140,000 Adjustment for the Cum. effect 3 16,800 14,700 11,200 Adjusted balance$151,800151,500151,200 Net income 4 20,30020,30020,300 Cash dividens(20,000)(20,000)(20,000) Balance at end of year152,100151,800151,500

35. Accounting Changes & Error Corrections34 Example (contd.) 1. 140,000 + 16,800 - 20,000 = 136,800 (See p23 for unadjusted net income of x4.) 2. 136,800 + 18,200 - 20,000 = 135,000 (See p 23 for unadjusted net income of x5) 3. Cumulative difference (effect), see p31. 4. Restated net income to reflect the change of depreciation method made in 20x6, see p28 for restated net income for 20x4 and 20x5.

36. Accounting Changes & Error Corrections35 Change in Depreciation Method A Prospective Approach Under SFAS 154, a prospective approach should be applied to a change in depreciation method. Thus, the change from a SYD depreciation to a straight-line deprecation would not result in any restatement of prior years’ financial statements. The new depreciation method would only be applied for years of 2006 - 2011.

37. Accounting Changes & Error Corrections36 Change in Depreciation Method A Prospective Approach (contd.) The annual depreciation expense for 2006- 2011 is: ($110,000-$68,000)/ (10-4) = $7,000 Note: Prior to 20x6, Doherty used sum-of- the-years’-digits depreciation on its plant assets. In 20x6 Doherty changed to the straight-line method of depreciation, which management felt better represented the service expiration of its plan assets.

38. Accounting Changes & Error Corrections37 Change in Depreciation Method A Prospective Approach (contd.) Note (contd): The effect of this change on income of 20x6 is an increase of $3,500 a (net of 30% income taxes). a. The depreciation expense of 2006 would have been $12,000 under the SYD (the old method) while it is $7,000 under the straight-line method (the new method).

39. Accounting Changes & Error Corrections38 Change in Accounting Method - Inventory Cost Method Change Example (Example 20-1 of Spiceland, etc. with some revisions) n Air Parts Corporation used the LIFO inventory costing method. At the beginning of 2006, Air Parts decided to change to the FIFO method. n Under SFAS 154, the retrospective approach is applied for all voluntary accounting method change except for the change in depreciation method.

40. Accounting Changes & Error Corrections39 Changes in Inventory Cost Flow Assumption (contd.) n Additional information: n The company has paid dividends of $40 million each year beginning 1999. n The income tax rate is 40%. n Retained earnings on January 1, 2004 was $700 million. n $Inventory on January 1, 2004 was $500 million.

41. Accounting Changes & Error Corrections40 Cost Flow Assumption Change (Contd.)-A Retrospective Approach The income statements of 2004, 2005 and 2006 are as follows (under LIFO assumption): ($ in millions) 20x6 20x5 20x4 Revenues$950$900$875 CGS (LIFO) (430) (420) (405) Operating expenses (230) (210) (205) Pre-tax Income 290 270 265 Income taxes (116) (108) (106) Net income$174$162$159.

42. Accounting Changes & Error Corrections41 Cost Flow Assumption Change (Contd.)-A Retrospective Approach The statement of retained earnings of 2004 and and 2005 are as follows (under (LIFO)) ($ in millions): 20x5 20x4 R/E (Beg. Bal.) $819 $700 Net Income 162 159 Dividends (40) (40) R/E (End. Bal.) $941 $819.

43. Accounting Changes & Error Corrections42 Cost Flow Assumption Change (Contd.) cost of Goods Sold ($ in millions) LIFO FIFO Diff. C. D.. Net.C.D. PY $2,000 $1,700 $300 $ 300 180 20x4 405 360 45 345 207 20x5 420 365 55 400 240 $2,825 $ 2,425 $400 u PY = previous years. C.D.=cumulative difference. Net C.D.= cumulative difference, net of income tax of 40%. u For 2006, The CGS is $430 million and $370 million under LIFO and FIFO, respectively. The CGS difference is $60 million for 2006.

44. Accounting Changes & Error Corrections43 Change in Cost Flow Assumption (contd.) n The cumulative difference of CGS from the change of LIFO to FIFO inventory method is equivalent to the impact of this change on the inventory.

45. Accounting Changes & Error Corrections44 Change in Cost Flow Assumption (contd.) n Since the cumulative difference of CGS is $345 and $400 million lower for 20x4 and 20x5, respectively, the inventory for 2004 and 2005 would be $345 million and $400 million higher under FIFO than under LIFO, respectively.

46. Accounting Changes & Error Corrections45 Change in Cost Flow Assumption (contd.) n For 2006, cumulative difference of CGS would be $460 million lower (i.e., $400 million + $60 million), the inventory of 2006 would be $460 million higher under FIFO than under LIFO.

47. Accounting Changes & Error Corrections46 Cost Flow Assumption Change –A Retrospective Approach The cumulative difference of CGS up to 2005 equals: $2,825-2,425 or 300+45+55 = 400 (million) The journal entry to record the change from LIFO to FIFO : 1/1 2006 Inventory 400 Retained Earnings 240 Deferred Income Tax Lia. 160 *assuming a 40% income tax rate

48. Accounting Changes & Error Corrections47 Comparative Income Statements-A Retrospective Approach 20x6 20x5 20x4 restated restated Revenues $950 $900 $875 CGS (FIFO) (370) (365) (360) Operating expenses (230) (210) (205) Pre-tax Income 350 325 310 Income taxes 1 (140) (130) (124) Net income $210 $195 R $186 R 1Assume a 40% tax rate. R. Restated net income for 20x4 and 20x5.

49. Accounting Changes & Error Corrections48 Comparative Retained Earnings Statement -A Retrospective Approach Assuming a retained earnings balance of $700 million at the beginning of 20x4, the following statement of retained earnings will be in the 20x6 annual report ($ in millions): 20x6 20x5 20x4 Balance at beg.(R/E) 1 $941 819 700 Adjustment for the Cum. difference 2 240 207 180 Adjusted Beg. Balance $1,181 $1,026 $880 Net income 3 210 195 186 Dividens(40) (40) (40) Balance at end of year $1,351 $1,181 $1,026

50. Accounting Changes & Error Corrections49 Comparative Retained Earnings Statement (contd.) Notes: n 1.Begining Retained earnings under the old method (i.e., the unadjusted), see p41. n 2.Cumulative difference, net of income tax, see p42. n 3. Net income under the new method (i.e., LIFO) for 2006 and restated net income (i.e., under LIFO) for 2005 and 2004, see p47.

51. Accounting Changes & Error Corrections50 Change to LIFO Method (An Exception) n When change from other inventory method to LIFO, a prospective approach is applied when a retrospective adjustment is impractical. n No cumulative effect will be reported in the income statement and no restatement of prior years’ F/S.

52. Accounting Changes & Error Corrections51 Change to LIFO Method –contd. n The base-year inventory for all subsequent LIFO calculations is the cost of opening inventory in the year the method is adopted. n The base-year inventory needs to be adjusted back to the cost.

53. Accounting Changes & Error Corrections52 Examples of Changes in Accounting Estimates n Changes in: a. useful lives and salvage values of depreciable assets; b. uncollectible accounts expense; c. liabilities for warranty costs, and income taxes; d. periods benefited by deferred costs;

54. Accounting Changes & Error Corrections53 Examples of Changes in Accounting Estimates (contd.) n e. inventory obsolescence; f. liabilities of employee related benefits; Note (an exception): Under SFAS 154,changes in depreciation method is considered as an estimate change.

55. Accounting Changes & Error Corrections54 Changes in Accounting Estimate Accounting Treatment n A prospective approach is applied for changes in accounting estimates. n The effect of the change on current year’s income will be disclosed in the footnotes. n SFAS 154 requires to apply the prospective approach for the changes in depreciation method.

56. Accounting Changes & Error Corrections55 How to Distinguish Changes In Estimates from an Error? n Changes in estimate are changes made based on new information not available before, Not based on information overlooked in prior period (i.e., an error).

57. Accounting Changes & Error Corrections56 Changes in Estimates Example of Changes in Estimates n Change the bad debt exp. estimation from 2% to 4% of the net sale in 20x6. The net sale of 20x6 amounts to $50,000. 12/31/x6 Bad debt exp.2,000 Allow. for bad debt2,000 Note: Due to the accounting estimate change, the bad debt expense is increased from $1,000 (at 2%) to $2,000 (at 4%). The net impact (net of income tax credit) from this change is a $700 decrease in net income of 20x6.

58. Accounting Changes & Error Corrections57 Changes in Estimates Example of Changes in Estimates (contd.) n Machine costing $15,000 was purchased on 1/1/x4 with estimated life of 5 years and zero residual value. The straight-line method was used for depreciation. On 1/1/x6, the estimated life of the machine had been changed to 6 years and the residual value had been changed to $1,000 due to new information available. u Book value of the machine on 1/1/x6: (15,000-6000) =9,000 u Depreciation expense for 20x6, 20x7,20x8, and 20x9: ($9,000 -$1,000) / (6-2) = $2,000

59. Accounting Changes & Error Corrections58 Example B (contd.) 12/31/x6 Depr. Exp. 2,000 Acc. Depr. 2,000 Note: Due to the accounting estimate changes on the estimated life and the salvage value of machine purchased on 1/1/x4, the depreciation expense of 20x 6 is decreased by $1,000. The net of income tax effect is a $700 increase in net income of 20x6.

60. Accounting Changes & Error Corrections59 Changes In Reporting Entity n The treatment is to restate the F/S of all prior periods presented (for comparability).

61. Accounting Changes & Error Corrections60 Examples of Changes in Reporting Entity 1. Presenting consolidated statements for the first time to replace individual statements. 2. Changing subsidiaries that are included in consolidated F/S (i.e. with new mergers or spin offs). 3. A change in the accounting for investments (i.e., change to the equity method or change from equity to consolidation).

62. Accounting Changes & Error Corrections61 Examples of Changes in Reporting Entity (contd.) An example of changes in reporting entity: In adopting SFAS 94 (“Consolidation of All Majority-Owned Subsidiaries”), Hewlett- Packard Company (HP) consolidated the accounts of its wholly owned subsidiary, Hewlett-Packard Finance Company, previously accounted for under the equity method, with accounts of HP. HP restated its prior years’ consolidated financial statements to reflect this change for comparative purposes.

63. Accounting Changes & Error Corrections62 Motivations for Changes and Income Management n Management often changes accounting methods not for conceptual reasons (i.e., to improve the fairness of financial statements), but rather for economic reasons (for economic consequence).

64. Accounting Changes & Error Corrections63 Motivations for Changes and Income Management n The followings are possible reasons suggested by academic research in explaining why companies prefer certain accounting methods: 1. Political Costs. 2. Capital Structure (maintain D/E ratio). 3. Bonus Payments. 4. Income Smoothing. 5. Labor Renegotiation Costs.

65. Accounting Changes & Error Corrections64 III. Error Analysis n Questions need to be addressed: 1. What type of error is involved? 2. What entries needed to correct the error? 3. How would the financial statements be restated when the error is discovered?

66. Accounting Changes & Error Corrections65 Correction of an Error Made in Prior Years (prior period adjustments, SFAS No. 16): Examples of accounting errors: 1. A change from an incorrect accounting principle (not GAAP) to a GAAP. 2. Mathematical mistakes. 3. Changes in estimates which were not prepared in good faith. 4. A misuse of facts (i.e., failure to consider salvage value in depreciation).

67. Accounting Changes & Error Corrections66 Correction of an Error Made in Prior Years (contd.) Examples of accounting errors (contd.): 5. An oversight (i.e., failure to accrue expense at year end). 6. An incorrect classification of a cost as an expense (i.e., improper capitalization).

68. Accounting Changes & Error Corrections67 General Treatments for Prior Years’ Errors  The corrections of errors in previously issued financial statements are referred to as prior period adjustments.  The corrections are made to Retained Earnings and are reported as adjustments to the beginning balance of current year’s retained earnings.

69. General Treatments for Prior Years’ Errors (contd.)  If comparative F/S are presented, the prior affected statements should be restated to correct the errors. Accounting Changes & Error Corrections68

70. Accounting Changes & Error Corrections69 Types of Errors 1. Balance Sheet Errors. 2. Income Statement (I/S) Errors. 3. Balance Sheet and Income Statement Effects.

71. Accounting Changes & Error Corrections70 1. Balance Sheet Errors n Errors affect only the presentation of accounts on the B/S statement (i.e., classification of notes payable as accounts payable or inventory as plant assets). Procedures of correction: a. reclassification of the item to its proper position. b. If comparative statements that include the error year are presented, the B/S of the error year is restated correctly.

72. Accounting Changes & Error Corrections71 2. Income Statement (I/S) Errors n Errors affect only accounts on the I/S (i.e, recording interest revenue as sales revenue, depre. exp. as interest exp., etc.) Impact: no impact on the net income or the B/S.

73. Accounting Changes & Error Corrections72 2. Income Statement (I/S) Errors (contd.) n Accounting Treatment: a.If the error is discovered in the year it is made, just do a reclassification. b.If the error occurred in prior years, no entry is needed at the date of discovery because all accounts for the current year is correctly stated including the beg. balance of the retained earnings..

74. Accounting Changes & Error Corrections73 2. Income Statement (I/S) Errors (contd.) n Accounting Treatment (contd.): If comparative statements that include the error year are presented, the I/S for the error year is restated correctly.

75. Accounting Changes & Error Corrections74 3. Balance Sheet and Income Statement Effects n The errors involve both B/S and I/S accounts (i.e., the accrued wages were overlooked at the end of the year). n This type of errors can be further classified as: a. Counterbalancing errors. b. Noncounterbalancing errors.

76. Accounting Changes & Error Corrections75 a. Counterbalancing Errors n Errors that will be offset or corrected over two periods. n If books of the second year (the year following the error year) were closed, no adjustments are needed for the correction because the error has already been corrected in the second year. n Most of B/S and I/S effect type of errors are counterbalancing errors.

77. Accounting Changes & Error Corrections76 b. Noncounterbalancing Errors n These errors do not counterbalance over 2-year period (no self-correction in two years). n Therefore, entries are needed even if the books have been closed for the year following the error.

78. Accounting Changes & Error Corrections77 Counterbalancing Errors Example 1 n Failure to record accrued wages of $5,000 in 20x5. This error was discovered in 20x6. Impact of this error on wages expense, net income (N/I) and wages liabilities of 20x5 and 20x6 assuming this liability of $5,000 has been paid in 20x6: Wages Exp. N/I Wages Lib. 20x5underoverunder 20x6 over under correctly stated 2-yearcorrectcorrectcorrectly stated combinedat end of 20x6

79. Accounting Changes & Error Corrections78 Example 1 (contd.) n Accounting Treatment: a. If the books of 20x6 have been closed, no entry is necessary. b. If the books of 20x6 have not been closed, the entry in 20x6 to correct the error is: 12/31/x6 Retained Earnings5,000 Wages Expense5,000

80. Accounting Changes & Error Corrections79 Example 1 (contd.) n Rational: When the accrued wages of 20x5 are paid in 20x6, an additional debit of $5,000 is made to 20x6 wage expense (i.e., instated of debit to wages payable, it was debited to wages expense). Thus, the wages exp. of 20x6 is overstated by $5,000. n Also, because accrued wages expense of $5,000 was not recorded in 20x5, the net income of 20x5 was overstated by $5,000 and the retained earnings accounting of 20x5 were overstated by $5,000.

81. Accounting Changes & Error Corrections80 Counterbalancing Errors Example 2 n Sanbor has failed to accrued wages payable at the end of the last three years as follows: 12/31/20x4 $1,600 12/31/20x5 $3,000 12/31/20x6 $2,400 Impact of these errors on net income of 20x4, 20x5, and 20x6: 20x4 20x5 20x6 Beg.----(1,600)(3,000) Ending$1,6003,0002,400 Cum. Effect$1,6001,400 600

82. Accounting Changes & Error Corrections81 Example 2 (contd.) n Entries to correct the errors of the last three years assuming the books of 20x6 are still open: 12/31/x6 a. No entry is necessary for the error of 20x4 because it has been counterbalanced by the end of 20x5 when the books of 20x5 were closed. b. To correct the error of 20x5 when the books of 20x6 have not been closed: Retained Earnings3,000 Wages Expense3,000

83. Accounting Changes & Error Corrections82 Example 2 (contd.) n Entries to correct the error of the last three years assuming the books of 20x6 are still open: (contd.) 12/31/20x6 c. To correct the error of 20x6 (the current year’s error): Wages Exp.2,400 Wages Payable2,400 a, b and c combined: Retained Earnings3,000 Wages Exp.600 Wages Payable2,400

84. Accounting Changes & Error Corrections83 Counterbalancing Errors Example 3 n Failure to Record Prepaid Expense In 20x5, Hurley Enterprise purchased a 2- year insurance policy costing $1,000. Insurance expense was debited and cash was credited. No adjusting entry was made at the end of 20x5. Assuming the books of 20x6 have not been closed, the entry on 12/31/20x6 to correct the error on 12/31/20x6 as follows is :

85. Accounting Changes & Error Corrections84 Example 3 (contd.) Insurance Exp.500 Retained Earnings500 OR (1) + (2) (1)Prepaid Insurance500 Retained Earnings500 (2)Insurance Exp.500 Prepaid Insurance500 If the books of 20x6 have been closed, no entry is necessary to correct the error.

86. Accounting Changes & Error Corrections85 Counterbalancing Errors Example 4 n Understatement of Unearned Revenue: On 12/31/20x5, Hurley received $50,000 as a prepayment for renting office space for the next year. A rent revenue account was credited on 12/31/20x5. No adjusting entry was made in 20x5. If the books of 20x6 are still open, the entry to correct the error is:

87. Accounting Changes & Error Corrections86 Example 4 (contd.) Retained Earnings50,000 Rent Revenue50,000 OR (1) + (2) (1)Retained Earnings50,000 Unearned Rent50,000 (2)Unearned Rent50,000 Rent Revenue50,000 If the books of 20x6 have been closed, no entry is necessary to correct the error.

88. Accounting Changes & Error Corrections87 Counterbalancing Errors Example 5 n Overstatement of Accrued Revenue On 12/31/20x5, Hurley accrued interest revenue $8,000 that applied to 20x6. The entry made in 12/31/20x5 was: Interest Receivable8,000 Interest Revenue8,000 If the books of 20x6 have not been closed, the entry to correct the error is : Retained Earnings8,000 Interest Revenue8,000 If the books of 20x6 have been closed, no entry is necessary.

89. Accounting Changes & Error Corrections88 Counterbalancing Errors Example 6 n Understatement of Ending Inventory On 12/31/20x5, the physical count of the inventory was understated by $25,000. Assuming the books of 20x6 are still open, the entry on 12/31/20x6 to correct the error is : Inventory (beg.)25,000 Retained Earnings25,000 OR Cost of Goods Sold25,000* Retained Earnings25,000 * if the beg. inv. has already been closed to cost of goods sold.

90. Accounting Changes & Error Corrections89 Example 6 (contd.) n The impact of the understatement of ending inventory of 20x5 on the income of 20x5 and 20x6: 20x5 20x6 2-year comb. Beg. inv.--------25,000 ------- End. Inv.(25,000) ------- ------- Net Effect(25,000)25,0000 Thus, if the books of 20x6 have been closed, no entry is necessary. When the books of 20x6 are still open, the beg. inv. of 20x6 is understated for $25,000 and the beg. balance of 20x6 retained earnings is understated for $25,000 (due to the net income of 20x5 was understated for $25,000).

91. Accounting Changes & Error Corrections90 Counterbalancing Errors Example 7 n Overstatement of ending inventory On 12/31/20x5, the ending inv. was overstated by $10,000. Assuming the books of 20x6 have not been closed, the following entry is to correct the error of 20x5: 12/31/20x6 Retained Earnings10,000 Inventory (beg.)10,000 OR Retained Earnings10,000* Cost of Goods Sold10,000 * if the beg. inv. has been closed to cost of goods sold.

92. Accounting Changes & Error Corrections91 Example 7 (contd.) n The impact of overstatement of end. inv. of 20x5 on the net income of 20x5 and 20x6: 20x5 20x6 2-year Comb. Beg. Inv.----(10,000) ------- End. Inv.10,000 ------ ------- Net Effect10,000(10,000)0 Thus, if the books of 20x6 have been closed, no entry is needed to correct the error. When the books of 20x6 are still open, the beg. inv. of 20x6 is overstated for $10,000 and the beg. balance of the 20x6 retained earnings is also overstated for $10,000 (because the net income of 20x5 was overstated).

93. Accounting Changes & Error Corrections92 Counterbalancing Errors Example 8 n Over or Understatement of End. Inv. Assuming inv. at the end of 20x4 was overstated $11,000. At the end of 20x5, it was overstated for $20,000 and at the end of 20x6, it was understated for $19,000. 20x4 20x5 20x6 Beg. Inv.(11,000)(20,000) End. Inv.11,00020,000(19,000) Net Effect11,0009,000(39,000)

94. Accounting Changes & Error Corrections93 Example 8 (contd.) If the books for 20x6 have not been closed, the entries to correct the error are as follows: 12/31/20x6 for the inv. error of 20x4: no entry for the inv. error of 20x5: Retained Earnings20,000* Cost of Goods Sold20,000 for the inv. error of 20x6: Inventory19,000* Cost of Goods Sold19,000 *Assuming inventory has been closed to the cost of goods sold account.

95. Accounting Changes & Error Corrections94 Example 8 (contd.) n Thus, the combined entry is (when the books of 20x6 are still open): 12/31/20x6 Inventory19,000 Retained Earnings20,000 Cost of Goods Sold*39,000 *or Income Summary if cost of goods sold has been closed to the income summary account. If the books of 20x6 are closed, the entry to correct the errors is : 12/31/20x6 Inventory19,000 Cost of Goods Sold19,000

96. Accounting Changes & Error Corrections95 Counterbalancing Errors Example 9 n Overstatement of Purchase Hurley’s accountant recorded a purchase of $9,000 in 20x5 which applied to 20x6. The inventory account of 20x5 was correctly stated. The entry on 12/31/20x6 to correct this error (assuming the books of 20x6 are still open): 12/31/20x6 Purchases9,000 Retained Earnings9,000 If the books of 20x6 are closed, no entry is needed to correct the error.

97. Accounting Changes & Error Corrections96 Counterbalancing Errors Example 10 n Overstatement of Purchases and Inventories Assuming the purchases of 20x5 are overstated by $9,000 and the ending inv. is overstated by $7,000.

98. Accounting Changes & Error Corrections97 Example 10 (contd.) If the books of 20x6 are not closed, the entries to correct the error: 12/31/20x6 Purchases9,000 Retained Earnings9,000 Retained Earnings7,000 Inventory (Beg.)7,000 (or Cost of Goods sold) Combined Entry: Purchases9,000 Retained Earnings2,000 Inventory7,000 If the books of 20x6 are closed, no entry is needed.

99. Accounting Changes & Error Corrections98 Noncounterbalancing Errors n These errors do not counterbalance over 2-year period. The correcting entries are needed even if the books of the year in which the error is discovered have been closed.

100. Accounting Changes & Error Corrections99 Example n Assume that on 1/1/20x5, Hurley purchased a machine for $10,000 that had an estimated life of 5 years. The accountant incorrectly expensed this machine in 20x5. The error was discovered in 20x6. Assume the company uses straight line depreciation on the asset, the entry to correct this error given that the books of 20x6 have not been closed:

101. Accounting Changes & Error Corrections100 Example (contd.) 12/31/20x6 Machine10,000 Retained Earnings10,000 Retained Earnings2,000 Accu. Depre.2,000 Depre. Exp.2,000 Accu. Depre.2,000 Combined: Machine10,000 Depre. Exp.2,000 Retained earnings8,000 Accu. Depre.4,000 If the books of 20x6 have been closed, the entry is: Machine10,000 Retained Earnings6,000 Accu. Depre.4,000