1 Accounting Changes and Error Corrections chapter 20.

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Accounting Accounting Changes and Changes and

Error Error CorrectionsCorrections

chapterchapter 20 20

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1. Understand the two different types of accounting changes that have been identified by accounting standard setters.

2. Recognize the difference between a change in accounting estimate and a change in accounting principle, and know how a change in accounting estimate is reflected in the financial statements.

Learning Objectives

ContinuedContinuedContinuedContinued

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3. Determine if a change in accounting principle requires a cumulative adjustment relating to its effect or a restatement of prior-periods’ financial statements, and be able to compute the necessary adjustment.

4. Report pro forma results for prior years following a business combination.

5. Recognize the various type of errors that can occur in the accounting process, understand when errors counterbalance, and be able to correct errors when necessary.

6. Describe the differences between the U.S. approach to accounting changes and error corrections and the

international standard found in IFRS 8.

Learning Objectives

4Why Are Accounting Changes Made?

1. A company, as a result of experience or new information, may change its estimates of revenues or expenses.

2. Due to changes in economic conditions, companies may need to change methods of accounting to more clearly reflect the current economic situation.

3. Accounting standard-setting bodies may require the use of a new accounting method or principle.

4. Management may be pressured to report profitable performance. Making accounting changes can often result in higher net income, thereby reflecting favorably on management.

5Effect of SFAS No. 106 – Employers' Accounting for Postretirement Benefits Other

Than Pensions

CompanyOne-Time Charge (in millions)

IBM $2,263Gen. Electric 1,799Bell Atlantic 1,550PepsiCo 357The Coca-Cola Company 7Tiffany & Co. 6

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^ Change in accounting estimate

^ Change in accounting principle

Accounting Changes

Several alternatives have been suggested for reporting accounting changes.

1. Restate the financial statements presented for prior periods to reflect the effect of the change.

2. Make no adjustment to statements prepared for prior periods.

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Accounting Changes

3. Same as (2), except report the cumulative effect of the change as a special item in the income statement instead of directly to Retained Earnings.

4. Report the cumulative effect in the current year as in (3) but also present limited pro forma information for all prior periods included in the financial statements reporting “what might have been” if the change had been made in the prior year.


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Accounting Changes

5. Make the change effective only for current and future periods with no catch-up adjustment.

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• Uncollectible receivables• Useful lives of depreciable or intangible assets• Residual values for depreciable assets• Warranty obligations• Quantities of mineral reserves to be depleted• Actuarial assumptions for pensions or other

postemployment benefits• Number of periods benefited by deferred costs

• Uncollectible receivables• Useful lives of depreciable or intangible assets• Residual values for depreciable assets• Warranty obligations• Quantities of mineral reserves to be depleted• Actuarial assumptions for pensions or other

postemployment benefits• Number of periods benefited by deferred costs

Change in Accounting Estimate –Applied Prospectively i.e. #5 on slide 8

Examples of areas where changes in accounting estimates often are needed:

10Changes in Accounting PrincipleUses approach #4 on slide 8

A change in accounting principle involves a change from one generally accepted

principle or method to another.

A change in accounting principle involves a change from one generally accepted

principle or method to another.

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Changes in Accounting Principle

A change from a principle that is not generally accepted to one that is generally

accepted is considered to be an error correction rather than a change in

accounting principle.

A change from a principle that is not generally accepted to one that is generally

accepted is considered to be an error correction rather than a change in

accounting principle.

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…APB Opinion No. 20 requires that the change be treated as a

change in estimation rather than a change in principle.

…APB Opinion No. 20 requires that the change be treated as a

change in estimation rather than a change in principle.

If an asset if affected by both a change in principle and a

change in estimation during the same period…

If an asset if affected by both a change in principle and a

change in estimation during the same period…

13Changes in Accounting Principle Recall that approach #4 on slide 8 is used

Report current year’s income components on the new basis.

Report the cumulative effect of the adjustment, net of tax, on the income statement.

Present prior period financial statements as previously reported.

Include pro-forma information as if the change were retroactive—direct and indirect effects.

Present earnings per share data for all prior periods presented.

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• Telstar Company elected in 2005 to change depreciation methods from double-declining balance to straight-line. The income results are summarized as:

– Net difference $131,000

– Tax effect (39,300)

– Net effect on income$91,700



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Base on these data, the journal entry to record the cumulative effect adjustment and to eliminate the previously recorded deferred taxes is as follows:

Accumulated Depreciation 131,000Deferred Tax Asset 39,300Cumulative Effect of Change in Accounting Principle 91,700


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Telstar CompanyPro Forma Income Statement for 2003

Income from continuing operations

$450,000Effect of change in accounting principle (net of tax)

19,600Pro forma income (restated)

$469,600


Depreciation (DDB)

$60,000Depreciation (S/L)

(32,000)Difference

$28,000Assume tax effect (30%)

(8,400)Effect on income

$19,600


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Telstar CompanyPro Forma Income Statement for 2004

Income from continuing operations $500,000Effect of change in accounting principle (net of tax) 21,000Pro forma income (restated) $521,000


Depreciation (DDB)

$65,000Depreciation (S/L)

(32,000)Difference

$30,000Assume tax effect (30%)

(9,000)Effect on income

$21,000


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Since the release of the SEC’s SAB 101 on

revenue recognition, many companies have changed their revenue

recognition practices to be in accord with the

SEC guidelines.

Since the release of the SEC’s SAB 101 on

revenue recognition, many companies have changed their revenue

recognition practices to be in accord with the

SEC guidelines.

SAFB No. 142 mandated the cessation

of amortization of goodwill. This

standard also requires firms to test for asset impairment annually.

SAFB No. 142 mandated the cessation

of amortization of goodwill. This

standard also requires firms to test for asset impairment annually.

19Restatement of Prior Periods for Change in Principle (approach #1 on slide 8

Restatement required in the following five circumstances:

1. A change from LIFO method of inventory pricing to another method.

2. A change in the method of accounting for long-term construction contracts.

3. A change to or from the full cost method of accounting used in extractive industries.


20Restatement of Prior Periods for Change in Principle

4. Changes made at the time of an initial distribution of company stock.

5. A change from retirement-replacement-betterment accounting to depreciation accounting for railroads.

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• Change to LIFO—past records often inadequate to prepare pro-formas.

• Beginning inventory becomes first LIFO layer.

• No cumulative effect adjustment is required.

Restatement of Prior Periods for Change in Principle


In 2005 Forester Company changed from the LIFO inventory costing method

to the FIFO method for both financial reporting and income tax purposes. At this time LIFO costing provided a pretax income of $335,000. By converting to

FIFO, this pretax income is $420,000 (an $85,000 difference). Applying a tax rate of 30%, the income tax effect is $25,500.

In 2005 Forester Company changed from the LIFO inventory costing method

to the FIFO method for both financial reporting and income tax purposes. At this time LIFO costing provided a pretax income of $335,000. By converting to

FIFO, this pretax income is $420,000 (an $85,000 difference). Applying a tax rate of 30%, the income tax effect is $25,500.



The entry in 2005 to record the prior-period effects of the change in accounting principle follows:Inventory 85,000

Income Taxes Payable 25,500Retained Earnings 59,500

To adjust the beginning To adjust the beginning 2005 inventory to its 2005 inventory to its

FIFO cost.FIFO cost.

To adjust the beginning To adjust the beginning 2005 inventory to its 2005 inventory to its

FIFO cost.FIFO cost.

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Errors discovered currently in the course of normal accounting procedures.

Errors discovered currently in the course of normal accounting procedures.

Error Corrections

Math errors Posting to the wrong

account Misstating an account Omitting an account

from the trial balance

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Errors limited to balance sheet accounts.Errors limited to balance sheet accounts.

Debiting Accounts Receivable instead of Notes Receivable

Crediting Interest Payable instead of Notes Payable

Debiting an investment account instead of Land when property was purchased for plant expansion

Error Corrections

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Errors limited to income statement accounts.Errors limited to income statement accounts.

Debiting Office Salaries instead of Sales Salaries

Crediting Rent Revenue instead of Commissions Revenue

Error Corrections

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Errors affecting both income statement accounts and balance sheet accounts.


Debiting Office Equipment instead of Repairs Expense

Crediting Depreciation Expense instead of Accumulated Depreciation

Error Corrections

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Error Corrections

There are errors in net income that are not detected, such as

misstatement of inventories, that are automatically counterbalanced

in the following fiscal period.

There are errors in net income that are not detected, such as

misstatement of inventories, that are automatically counterbalanced


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Error Corrections

And then, there are errors in net income that, when not detected, are not automatically counterbalanced


And then, there are errors in net income that, when not detected, are not automatically counterbalanced


Recognition of capital Recognition of capital expenditures as expensesexpenditures as expenses

The omission of charges The omission of charges for depreciation and for depreciation and amortization amortization

Recognition of capital Recognition of capital expenditures as expensesexpenditures as expenses

The omission of charges The omission of charges for depreciation and for depreciation and amortization amortization



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• If detected in current period, before books are closed:– Correct the account through normal

accounting adjustment.• If detected in subsequent period, after books are

closed:– adjust financial records for effect of material

errors.– make adjustment directly to Retained

Earnings.

Error Corrections

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(1) Supply Masters, Inc., began operations at the beginning of 2003. Before the accounts are adjusted and

closed for 2005, it was discovered that merchandise inventory as of December 31, 2003, was understated by $1,000.

(1) Supply Masters, Inc., began operations at the beginning of 2003. Before the accounts are adjusted and

closed for 2005, it was discovered that merchandise inventory as of December 31, 2003, was understated by $1,000.

Example of Error Correction

Because this type of error counterbalances Because this type of error counterbalances after two years, after two years, no correcting entry is no correcting entry is

requiredrequired in 2005. in 2005.




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If this error had been discovered in 2004 instead of 2005, the following

entry would have to be made to correct the account balances.




Merchandise Inventory 1,000 Retained Earnings 1,000

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(2) It is discovered that purchase invoices of December 31, 2003, for

$850 had not been recorded until 2004. The goods had been included in the

inventory at the end of 2003.

(2) It is discovered that purchase invoices of December 31, 2003, for

$850 had not been recorded until 2004. The goods had been included in the

inventory at the end of 2003.







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Periodic System:

Retained Earnings 850 Inventory 850

Perpetual System:

Retained Earnings 850 Purchases 850

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(3) It is discovered that sales on account of $1,800 for the last week of

December 2004 had not been recorded until 2005. The goods were included in the inventory at the end of 2004. The following correcting entry would be

required in 2005.

(3) It is discovered that sales on account of $1,800 for the last week of

December 2004 had not been recorded until 2005. The goods were included in the inventory at the end of 2004. The following correcting entry would be

required in 2005.


Sales 1,800 Retained Earnings 1,800

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(4) Accrued sales salaries of $450 as of December 31, 2003, were overlooked

in adjusting the accounts. Sales Salaries is debited for salary payments.

(4) Accrued sales salaries of $450 as of December 31, 2003, were overlooked

in adjusting the accounts. Sales Salaries is debited for salary payments.







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Retained Earnings 450 Sales Salaries 450

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(5) It is discovered that Miscellaneous General Expense for 2003 included taxes of $275 that should have been deferred in adjusting the accounts on

December 31, 2003.

(5) It is discovered that Miscellaneous General Expense for 2003 included taxes of $275 that should have been deferred in adjusting the accounts on

December 31, 2003.







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Miscellaneous General Expense 275 Retained Earnings 275

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(6) Accrued interest on notes receivable of $150 was overlooked in adjusting the accounts on December 31, 2003. The revenue was recognized when the

interest was collected in 2004.

(6) Accrued interest on notes receivable of $150 was overlooked in adjusting the accounts on December 31, 2003. The revenue was recognized when the

interest was collected in 2004.







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Interest Revenue 150 Retained Earnings 150

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(7) Fees of $225 received in advance for miscellaneous services as of December 31,

2004, were overlooked in adjusting the accounts. Miscellaneous Revenue had been credited when fees were received.

The correcting entry in 2005 is:

(7) Fees of $225 received in advance for miscellaneous services as of December 31,

2004, were overlooked in adjusting the accounts. Miscellaneous Revenue had been credited when fees were received.

The correcting entry in 2005 is:


Retained Earnings 225 Miscellaneous Revenue 225

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(8) Delivery equipment was acquired at the beginning of 2003 at a cost of $6,000. The equipment has an estimated five-year life. Its depreciation of $1,200 was overlooked

at the end of 2003 and 2004.

(8) Delivery equipment was acquired at the beginning of 2003 at a cost of $6,000. The equipment has an estimated five-year life. Its depreciation of $1,200 was overlooked

at the end of 2003 and 2004.


Misstatements arising from the failure to Misstatements arising from the failure to record depreciation are not counterbalanced record depreciation are not counterbalanced

in the succeeding year.in the succeeding year.

Misstatements arising from the failure to Misstatements arising from the failure to record depreciation are not counterbalanced record depreciation are not counterbalanced

in the succeeding year.in the succeeding year.


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When the omission is recognized, Retained Earnings must be decreased by the net

income overstatements and Accumulated Depreciation—Delivery Equipment must

be increased. The 2005 correcting entry is:

When the omission is recognized, Retained Earnings must be decreased by the net

income overstatements and Accumulated Depreciation—Delivery Equipment must

be increased. The 2005 correcting entry is:


Retained Earnings 2,400 Accumulated Depreciation— Delivery Equipment 2,400

$1,200 per year x 2

$1,200 per year x 2

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(9) Operating expenses of $2,000 were paid in cash at the beginning of 2003. The payment was incorrectly debited to Equipment. The

“equipment” was assumed to have a five-year life and no residual value; thus, depreciation of

$400 was recognized at the end of 2003 and 2004. The required correcting entry is:

(9) Operating expenses of $2,000 were paid in cash at the beginning of 2003. The payment was incorrectly debited to Equipment. The

“equipment” was assumed to have a five-year life and no residual value; thus, depreciation of

$400 was recognized at the end of 2003 and 2004. The required correcting entry is:


Retained Earnings 1,200Accumulated Depreciation— Equipment 800 Equipment 2,000

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• If comparative statements are provided, apply correction retroactively to prior years.

• Restate beginning balance of Retained Earnings for first period presented if error extends beyond.

• Disclose and explain error correction in notes.

Additional Thoughts About Error Corrections

47Accounting Changes and Error Corrections Under IFRS 8

Change in Accounting EstimateChange in Accounting Estimate

The treatment under IFRS 8 is consistent with U.S. GAAP. However, a change

in depreciation method is classified

as a change in estimate under IFRS

8 rather than a change in principle.

Under IFRS 8, a change in accounting principle that results from prior periods should be restated. This

approach is followed under U.S. GAAP for only a small set of accounting

changes.

48Accounting Changes and Error Corrections Under IFRS 8

Error CorrectionsError Corrections

The benchmark treatment for accounting for significant error corrections under IFRS 8 is the

same as that required under U.S. GAAP. However, IFRS 8 allows an alternative—the error correction can be accounted for by reflecting the

effect of the error correction in income of the period in which the error was discovered without

restating previously reported results.

1 Accounting Changes and Error Corrections chapter 20.

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