1. 1 Accounting Changes and Errors C hapter 22

2. 2 1. Identify the types of accounting changes. 2. Explain the methods of disclosing an accounting change. 3. Account for a change in accounting principle using the cumulative effect method. 4.Account for a change in accounting principle using a prior period restatement. 5.Account for a change in estimate. Objectives ContinuedContinued

3. 3 6.Explain the conceptual issues regarding a change in accounting principle and a change in estimate. 7.Identify a change in a reporting entity. 8. Account for a correction of an error. 9.Summarize the methods for making accounting changes and correcting errors. Objectives

4. 4 Types of Accounting Changes 1.Change in an Accounting Principle. This type of change occurs when a company adopts a generally accepted accounting principle different from the one used previously for reporting purposes. 2.Change in an Accounting Estimate. This type of change is required because an earlier estimate has proven to require modifying as additional information is obtained or circumstances change. 3Change in a Reporting Entity. This type of change is the result of a change in the entity being reported.

5. 5 Methods of Disclosing an Accounting Change Retroactively adjust its past financial statements. Include the cumulative effect of the change in its income of the current period. Adjust for the change prospectively. Retroactively adjust its past financial statements. Include the cumulative effect of the change in its income of the current period. Adjust for the change prospectively.

6. 6 Basic Principles A change in an accounting principle is accounted for by the cumulative effect method. A change in an accounting estimate is accounted for prospectively. A change in a reporting entity is accounted for by prior period restatement (retroactively). An error is accounted for by prior period restatement (retroactively). A change in an accounting principle is accounted for by the cumulative effect method. A change in an accounting estimate is accounted for prospectively. A change in a reporting entity is accounted for by prior period restatement (retroactively). An error is accounted for by prior period restatement (retroactively). The basic principles of APB Opinion No. 20 requires that generally:

7. 7 The general rule is that a company accounts for a change in principle as a cumulative effect change as follows: Accounting for a Change in Accounting Principle 1.The financial statements for prior periods included for comparative purposes are presented as previously reported. Continued

8. 8 Accounting for a Change in Accounting Principle 2.The cumulative effect of changing to the new accounting principle (net of applicable income taxes) on the amount of retained earnings at the beginning of the period in which the change is made is reported immediately before the caption “net income” on the income statement of the period of the change. Continued

9. 9 Accounting for a Change in Accounting Principle 3.Income before extraordinary items and net income computed on a pro forma basis (that is, as if the new principle had been in effect for all past periods) are shown on the face of the income statement (below earnings per share) for all periods presented. Continued

10. 10 Accounting for a Change in Accounting Principle 4.A description of the change and the reason for it, as well as the effect of the change on income before extraordinary items and on net income (and on related earnings per share amounts) of the period of the change are disclosed in the notes to the financial statements.

11. 11 Goddard Company has assets for which it has been using straight-line depreciation for its financial reporting, and MACRS depreciation for its income tax reporting. At the beginning of 2005 it adopts an accelerated depreciation method for financial reporting. The tax rate is 30%. Illustration of Cumulative Effect Method

12. 12 Income before cumulative effect of a change in accounting principle$840,000 Cumulative effect on prior years (to December 31, 2004) of changing to a different depreciation method (net of $27,000 income taxes) (63,000) Net income$777,000 Income before cumulative effect of a change in accounting principle$840,000 Cumulative effect on prior years (to December 31, 2004) of changing to a different depreciation method (net of $27,000 income taxes) (63,000) Net income$777,000 Straight-Line Accelerated Difference Year Depreciation Depreciation Net of Tax (30%) Prior to 2004$240,000$300,000$42,000 2004 100,000 130,000 21,000 Total at begin- ning of 2005$340,000$430,000$63,000 Change in Accounting Principle (Cumulative Effect Method) Partial Income Statement ContinuedContinued

13. 13 Change in Accounting Principle (Cumulative Effect Method) Income before cumulative effect of a change in accounting principle$840,000 Cumulative effect on prior years (to December 31, 2004) of changing to a different depreciation method (net of $27,000 income taxes) (63,000) Net income$777,000 Earnings per share (100,000 shares outstanding): Income before cumulative effect of a change in accounting principle$8.40 Cumulative effect on prior years (to December 31, 2,004) of changing to a different depreciation method(0.63) Earnings per share$7.77 Income before cumulative effect of a change in accounting principle$840,000 Cumulative effect on prior years (to December 31, 2004) of changing to a different depreciation method (net of $27,000 income taxes) (63,000) Net income$777,000 Earnings per share (100,000 shares outstanding): Income before cumulative effect of a change in accounting principle$8.40 Cumulative effect on prior years (to December 31, 2,004) of changing to a different depreciation method(0.63) Earnings per share$7.77

14. 14 Before tax differences $90,000 Change in Accounting Principle (Cumulative Effect Method) Loss on Cumulative Effect of a Change in Depreciation Method63,000 Deferred Tax Liability27,000 Accumulated Depreciation90,000 Straight-Line Accelerated Difference Year Depreciation Depreciation Net of Tax (30%) Prior to 2004$240,000$300,000$42,000 2004 100,000 130,000 21,000 Total at begin- ning of 2005$340,000$430,000$63,000

15. 15 Exceptions to the General Rule for a Change in Accounting Principle 1.Adoption of New Principle for Future Events. If a company adopts a new principle for future events, but does not change the method currently used, it does not make a cumulative effect change. ContinuedContinued

16. 16 Exceptions to the General Rule for a Change in Accounting Principle 2.Cumulative Effect Not Determinable. If the cumulative effect is not determinable, the company does not make a cumulative effect change. ContinuedContinued

17. 17 Exceptions to the General Rule for a Change in Accounting Principle 3.Initial Public Sale of Common Stock. If a company makes accounting changes when it makes an initial public distribution, it restates retroactively the financial statements for all prior periods. ContinuedContinued

18. 18 Exceptions to the General Rule for a Change in Accounting Principle 4.Prior Period Restatement (Retroactive Adjustment) More Useful. For certain changes in accounting principles, the APB requires the company to make a prior period restatement instead of a cumulative effect adjustment.

19. 19 - A change from the LIFO inventory cost flow method to another method. -A change in the method of accounting for long-term construction-type contracts. -A change to or from the “full cost” method of accounting that is used in the extractive industries. -A change from retirement-replacement-betterment accounting for railroad track structures. -A change from the fair value method to the equity method for investments in common stock. - A change from the LIFO inventory cost flow method to another method. -A change in the method of accounting for long-term construction-type contracts. -A change to or from the “full cost” method of accounting that is used in the extractive industries. -A change from retirement-replacement-betterment accounting for railroad track structures. -A change from the fair value method to the equity method for investments in common stock. Examples of Item 4

20. 20 Prior Period Restatement Method 1.The revenues and expenses (including applicable income taxes) affected by the changes are restated in the income statements of previous years included for comparative purposes. ContinuedContinued A company accounts for a change in accounting principle by prior period restatement as follows:

21. 21 Prior Period Restatement Method 2.The aggregate change in income (net of applicable income taxes) at the beginning of each year is added to (or subtracted from) retained earnings as a prior period adjustment on comparative statements of retained earnings. ContinuedContinued

22. 22 Prior Period Restatement Method 3.The related assets and liabilities, including income taxes, are restated in the comparative balance sheets of previous years. 4.A description of the change and the reason for it, as well as the effect of the change on income before extraordinary items and on net income (and on related earnings per amounts) for all periods, are disclosed in notes to the financial statements.

23. 23 Prior Period Restatement Method Werner Company changes from the LIFO to the FIFO inventory method at the beginning of 2005, and it presents comparative financial statements for 2005 and 2004. LIFO FIFO Inventory Inventory Difference Year Method Method Net of Tax (30%) Prior to 2004$ 550,000$ 850,000$210,000 2004 650,000 600,000 (35,000) Total at begin- ning of 2005$1,200,000$1,450,000$175,000 2005 500,000 700,000 140,000 Total$1,700,000$2,150,000$315,000

24. 24 Prior Period Restatement Method Comparative Statements of Retained Earnings Balance at beginning of year, as previously reported$2,445,000$2,000,000 Add: Adjustment for the cumu- lative effect on prior years of inventory (net of $75,000 in income taxes in 2005 and $90,000 income taxes in 2004) 175,000 210,000 Balance at beginning of year$2,630,000$2,210,000 Net income 490,000 420,000 Balance at end of year$3,120,000$2,630,000 2005 2004

25. 25 Prior Period Restatement Method LIFO FIFO Inventory Inventory Difference Year Method Method Net of Tax (30%) Prior to 2004$ 550,000$ 850,000$210,000 2004 650,000 600,000 (35,000) Total at begin- ning of 2005$1,200,000$1,450,000$175,000 2005 500,000 700,000 140,000 Total$1,700,000$2,150,000$315,000 Inventory250,000 Retained Earnings175,000 Income Taxes Payable75,000

26. 26 Transition Method When a statement specifies a method, the transition rule usually requires retroactive restatement. Transition rules define the accounting method a company uses when it changes an accounting principle to conform to a new principle required by the issuance of a new statement.

27. 27 Accounting For a Change in an Estimate …and future periods if the change affects both. A change in accounting estimate does not result in a cumulative change or a prior period adjustment. APB Opinion Number 20 requires that a company account for a change in an accounting estimate in the period of change if the change affects that period only,...

28. 28 Accounting For a Change in an Estimate A company uses an asset with an original cost of $100,000, an estimated life of 20 years, and an estimated residual value of zero (the company uses the straight-line method for depreciation). When adjusting entries are made in the ninth year, a new estimation of the total life of the asset is 23 years. Depreciation expense is determined as follows: Remaining Book Value Remaining Life = Annual Depreciation $60,000 15 Years = $4,000 Per Year $100,000 – (8 x $5,000)

29. 29 Additional Issues A change in accounting estimate that is related in whole or in part to a change in accounting principle is reported as a change in estimate.

30. 30 Additional Issues A change in the amortization or depreciation method is considered a change in accounting principle under the provision of APB Opinion Number 20.

31. 31 Accounting for a Change in a Reporting Entity A company accounts for a change in reporting entity as a prior period adjustment. I’ll fax you this list of situations where a change in a reporting entity occurs.

32. 32 1.When a company presents consolidated or combined financial statements in place of the statements of individual companies. 2.When there is a change in the specific subsidiaries that make up the group of companies for which consolidated financial statements are presented. 3.When the companies included in combined financial statements change. 1.When a company presents consolidated or combined financial statements in place of the statements of individual companies. 2.When there is a change in the specific subsidiaries that make up the group of companies for which consolidated financial statements are presented. 3.When the companies included in combined financial statements change. FAX Machine

33. 33 Accounting For a Correction of An Error 1.The use of an accounting principle that is not generally accepted. 2.The use of an estimate that was not made in good faith. 3.Mathematical miscalculations. 4.The omission of a deferral or accrual. Examples of errors that a company might make include:

34. 34 Accounting For a Correction of An Error Slider Company issued a bond for $100,000 due in five years. The liability was incorrectly recorded as a long-term notes payable. Interest was paid and correctly recorded as interest expense on December 31. Error Affecting Only the Balance Sheet

35. 35 Accounting For a Correction of An Error Error Affecting Only the Balance Sheet The error can be corrected in the following year by charging a balance sheet account, Long-Term Notes Payable, and crediting Bonds Payable. Since both accounts are real accounts, there is no prior period adjustment.

36. 36 Accounting For a Correction of An Error Error Affecting Only the Income Statement Slider Company recorded interest revenue as revenue from sales. Discovery of this error in the succeeding year does not require a correcting entry. If Slider presents comparative financial statements in the current year, it corrects the financial statements of the prior period by reclassifying the item.

37. 37 Accounting For a Correction of An Error Errors Affecting Both the Income Statement and Balance Sheet Slider Company fails to accrue interest of $2,000. Assuming a tax rate of 30%, the effects of the error on Slider’s financial statements in the period of the errors are— Interest Expense is understated by $2,000. Income before income taxes is overstated by $2,000. Income Tax Expense is overstated by $600. Net income is overstated by $1,400. Retained Earnings is overstated by $1,400. Interest Payable is understated by $2,000. Income Taxes Payable is overstated by $600.

38. 38 Accounting For a Correction of An Error Errors Affecting Both the Income Statement and Balance Sheet In the next period, when the company pays the interest and records the entire payment as an expense, these additional errors occur— Interest Expense is overstated by $2,000. Income before income taxes is understated by $2,000. Income Tax Expense is understated by $600. Net income is understated by $1,400.

39. 39 Error Correction Handel Company spent $20,000 on building improvements that the company incorrectly recorded as Repair Expense rather than capitalizing the item. A single comprehensive journal entry to correct the error when it is discovered is: Building20,000 Retained Earnings20,000 Note that this entry ignores income taxes and depreciation considerations. Error Recording Building Improvement Expenditure

40. 40 Error Correction Assuming the building improvements are expected to last 10 years and have no residual value, a depreciation entry for $2,000 should have been made (assuming straight-line depreciation). The necessary correcting entry is: Retained Earnings2,000 Accumulated Depreciation2,000 Error Recording Building Improvement Expenditure

41. 41 1.Analyze the original erroneous journal entry and determine all the debits and credits that were recorded. 2.Determine the correct journal entry and the appropriate debits and credits. 3.Evaluate whether the error has caused additional errors in other accounts. 4.Prepare the correcting entry(ies). Error Correction Steps in Analyzing and Correction Errors

42. 42 Error Correction Omission of Unearned Revenue In December 2004 the Huggins Company received $10,000 as a prepayment for renting a building to another company for all of 2005. The company debited Cash and credited Rent Revenue. This error was discovered in 2005. The correcting entry is— Retained Earnings10,000 Rent Revenue10,000

43. 43 Error Correction Failure to Accrue Revenue On December 31, 2004 the Huggins Company failed to accrue interest revenue of $500 that it had earned but not received on an outstanding note receivable. When the cash was received the company debited Cash and credited Interest Revenue. The correcting entry needed is-- Interest Revenue500 Retained Earnings500

44. 44 Error Correction Omission of Prepaid Expense On December 31, 2004 the Huggins Company paid $1,000 for insurance coverage for the year 2005. It recorded the original entry as a debit to Insurance Expense and a credit to Cash. The error was discovered at the end of 2005, and the company makes the following correcting entry: Insurance Expense1,000 Retained Earnings1,000

45. 45 Error Correction Error in Ending Inventory On December 31, 2004 the Huggins Company recorded its ending inventory at $50,000. During 2005 it discovered that the correct inventory value should have been $55,000. The following correcting entry is needed. Inventory5,000 Retained Earnings5,000

46. 46 Error Correction Error in Purchases During December 4, Huggins Company made a purchase on credit that it had not paid at year’s end. It recorded this transaction incorrectly at $17,000 although the invoice price was $27,000. In 2005, Huggins made the following correcting entry: Retained Earnings10,000 Accounts Payable10,000

47. 47 Error Correction Failure to Accrue Estimated Bad Debts Huggins Company failed to accrue an allowance for doubtful accounts of $7,000 in its 2004 financial statements. The discovery of the error in 2005 requires the following entry: Retained Earnings7,000 Allowance for Doubtful Accounts7,000

48. 48 C hapter 22 The End

49. 49 This electronic presentation was prepared by Douglas Cloud, Professor of Accounting, Pepperdine University