End of Chapter 20

Chapter 20: Accounting changes and Error Corrections.

In this chapter we examine the way accounting changes and error corrections are handled in a variety of situations that might be encountered in practice. We see that most changes in accounting principle are reported retrospectively. Changes in estimates are accounted for prospectively. A change in depreciation methods is considered a change in estimate resulting from a change in principle. Both changes in reporting entities and the correction of errors are reported retrospectively.The three types of accounting changes are a change in accounting principle, a change in accounting estimate, and a change in reporting entity. A change in accounting principle involves changing from one generally accepted accounting principle to another generally accepted accounting principle. A change in accounting estimate occurs when new information becomes available that allows a new and better estimate. A change in reporting entity is a change from reporting as one type of entity to another type of entity. The correction of an error is another adjustment sometimes made to financial statements that is not actually an accounting change but is accounted for similarly. Errors occur when transactions are either recorded incorrectly or not recorded at all as shown in the table on this screen.The correction of an error is necessary when a transaction is recorded incorrectly or not recorded at all. An error correction is not actually an accounting change, but it is accounted for in a similar fashion.We use two approaches to reporting accounting changes and error corrections, depending on the situation. The retrospective approach involves the revision of prior years financial statements, while the prospective approach affects the financial statements in the current and future years only.Using the retrospective approach, we restate prior years statements that are presented for comparative purposes to reflect the impact of the change. We adjust the balance in each account affected to appear as if the newly adopted accounting method had been applied all along or that the error had never occurred. If retained earnings is one of the accounts whose balance must be adjusted, we adjust beginning balance of retained earnings for the earliest period reported in the comparative statements.Using the prospective approach, we implement the change in the current period and its effects are reflected in the financial statements of the current and future years only. Prior years statements and account balances are not revised.

Two of the qualitative characteristics of accounting information are consistency and comparability. While accountants make every effort to achieve these financial reporting attributes, they cannot ignore the normal changes that continually occur in a dynamic business environment. The accounting professions response to these changes often involves the development of new or modified reporting standards that are more appropriate for the changed environment.Accounting changes are made by management for a variety of reasons including: Changing business environment. Effect on compensation, such as bonuses and stock options. Effect on debt agreements. Effect on union negotiations. Issuance of new accounting standards. Effect on income taxes.Management must justify the change. Hopefully, changes are made in the best interest of fair and consistent financial reporting, but that may not always be the case.Lets look at an example of a change from the last-in, first-out inventory costing method to the first-in, first-out method. This accounting change is reported using the retrospective approach.At the beginning of 2011, Air Parts Corporation changed from last-in, first-out to first-in, first-out. Air Parts has paid dividends of $40,000,000 each year since 2004. Its income tax rate is forty percent. Retained earnings on January 1, 2009, was $700,000,000; inventory was $500,000,000.Selected income statement amounts for 2011 and prior years can be seen in the table on your screen. All amounts in the table are shown in millions of dollars.For each year reported, Air Parts makes the comparative statements appear as if the newly adopted accounting method (first-in, first out) had been in use all along.Net income using the first-in, first-out inventory method for years 2011, 2010, and 2009 is $210,000,000; $195,000,000; and $186,000,000 respectively.

The cost of goods sold difference for all years before 2009 is a cumulative $300,000,000 lower using the first-in, first-out inventory method. Cost of goods sold for the year 2009 is $45,000,000 lower using the first-in, first-out method. As a result, comparative balance sheets will report 2009 year-end inventory $345,000,000 higher than it was reported in the 2009 balance sheet prepared using the last-in, first-out method.Retained earnings for 2009 will be $207,000,000 higher, as a result of multiplying $345,000,000 times one minus the forty percent tax rate. Cost of goods sold for the year 2010 is $55,000,000 lower using the first-in, first-out method. As a result, comparative balance sheets will report 2010 year-end inventory $400,000,000 higher than it was reported in the 2010 balance sheet prepared using the last-in, first-out method.Retained earnings for 2010 will be $240,000,000 higher, as a result of multiplying $400,000,000 times one minus the forty percent tax rate.Cost of goods sold for the year 2011 is $60,000,000 lower using the first-in, first-out method. As a result, comparative balance sheets will report 2011 year-end inventory $460,000,000 higher than it would have been reported if the change to first-in, first out had not been made.Retained earnings for 2011 will be $276,000,000 higher, as a result of multiplying $460,000,000 times one minus the forty percent tax rate.

Air Parts will report retained earnings using FIFO each year as well. Retained earnings is different because the two inventory methods affect income differently. Because cost of goods sold using FIFO is less than cost of goods sold using LIFO, income and therefore retained earnings using FIFO are greater than income and retained earnings using LIFO.

On January 1, 2011, the date of the change, we make a journal entry adjusting the accounts for the effect of the change. We increase inventory by $400,000,000, increase retained earnings by $240,000,000, and increase income tax payable by $160,000,000.

Notice that the income tax effect increases income tax payable. An accounting method used for tax purposes cannot be changed retrospectively for prior years. The Internal Revenue Code requires that taxes saved previously ($160 million in this case) from having used another inventory method must now be repaid (over no longer than six years). As a result, this liability has both current (portion payable within one year) and noncurrent (payable after one year).In the first set of financial statements after the change is made, a disclosure note is needed to: Provide justification for the change. Point out that comparative information has been revised. Report any per share amounts affected for the current and all prior periods presented.

The prospective approach is used instead of the retrospective approach when it is: Impracticable to determine some period-specific effects. Impracticable to determine the cumulative effect of prior years. Mandated by Financial Accounting Standards Board or other authoritative pronouncements.

The changes to and from the LIFO method would not occur if international standards were being applied because LIFO is not a permissible method for accounting for inventory under IFRS.A change in depreciation method is considered to be a change in accounting estimate that is achieved by a change in accounting principle. It is accounted for prospectively, the same way that we account for a change in accounting estimate.

Part I.Changes in accounting estimates are also accounted for prospectively. Lets look at an example of a change in a depreciation estimate.

Lets examine the accounting for a change in accounting estimate with a multiple choice question.On January 1, 2007, Towing, Inc. purchased specialized equipment for $243,000. The equipment was depreciated using the straight-line method and had an estimated life of ten years and salvage value of $3,000. In 2011 the total useful life of the equipment was revised to six years. How much is the depreciation expense for 2011 using the revised estimated useful life?

Part II.The depreciation expense for each of the first four years is $24,000 ($243,000 minus $3,000, divided by the original estimated useful life of ten years). The accumulated depreciation for the first four years is $96,000, computed by multiplying the $24,000 of depreciation each year times four years. The undepreciated cost (book value) of the equipment on January 1, 2011 is $147,000, computed by subtracting $96,000 of accumulated depreciation from the $243,000 cost.To calculate the amount of straight-line depreciation for each of the remaining two years of the equipments life, we divide the $147,000 book value of the equipment, less the $3,000 by two years. The resulting straight-line depreciation is $72,000 per year for 2011 and 2012.Note that the prospective approach used for this change in estimate affected only 2011, the year of the change, and 2012. There was no restatement of depreciation for the prior years.I think you would agree that accounting changes involve a good deal of additional work. They should only be made in the best interest of fair and consistent financial reporting.

Lets consider an example of a change in depreciation method.Universal Semiconductors switched from sum-of-the-years-digits depreciation to straight-line depreciation in 2011. The change affects precision equipment purchased at the beginning of 2009 for $63,000,000. The equipment has an expected useful life of five years and an estimated residual value of $3,000,000.Sum-of-the-years-digits depreciation for 2009 was $20,000,000, and $16,000,000 for 2010, resulting in a total of $36,000,000 of accumulated depreciation.

The undepreciated cost (book value) of the equipment on January 1, 2011, the date of the change, is $27,000,000, computed by subtracting $36,000,000 of accumulated depreciation from the $63,000,000 cost of the equipment.To calculate the amount of straight-line depreciation for each of the remaining three years of the equipments life, we divide the $27,000,000 book value of the equipment, less the $3,000,000 estimated residual value, by three years. The resulting straight-line depreciation is $8,000,000 per year.

For each of the remaining three years of the equipments life (2011, 2012, 2015), the adjusting entry for depreciation is the same. We debit depreciation expense and credit accumulated depreciation for $8,000,000.Note that the prospective approach used for this accounting change affected only 2011, the year of the change, and 2012 and 2013. There was no restatement of prior years depreciation for 2009 and 2010.A reporting entity can be a single company or a group of companies that reports a single set of consolidated financial statements. A change in reporting entity occurs as a result of: presenting consolidated financial statements in place of statements of individual companies, or changing specific companies that constitute the group for which consolidated statements are prepared.

A change in reporting entity requires that financial statements of prior periods be retrospectively revised to report the financial information for the new reporting entity in all periods presented. All previous periods financial statements that are presented are recasted as if the new reporting entity existed in those periods.In the first financial statements after the change: A disclosure note should describe the nature of and the reason for the change. The effect of the change on net income, income before extraordinary items, and related per share amounts should be shown for all periods presented.These two disclosures are not necessary in subsequent financial statements.

Accounting errors can occur for any of the following reasons: Use of an inappropriate accounting principle Mistakes in applying generally accepted accounting principles Arithmetic mistakes Fraud or gross negligence in reportingAn error correction may involve the restatement of prior years account balances. If so, financial statements for all years presented for comparative purposes are retrospectively restated to reflect the effects of the error correction.The correction of accounting errors involves four steps: Prepare a journal entry to correct any balances that are incorrect as a result of the error. Retrospectively restate all prior years financial statements that were incorrect and presented for comparative purposes. Report the correction as a prior period adjustment if retained earnings is one of the incorrect accounts affected. Include a disclosure note describing the nature of the error and the impact of its correction on net income.A prior period adjustment is required for: Counterbalancing errors discovered in the second year. Noncounterbalancing errors discovered in any year after the year of the error.Remember that we use the retrospective approach for error corrections.

If an error is discovered in the same year that it was made, we can correct it by reversing the incorrect entry and then recording the correct entry, or by making a correcting entry to adjust the incorrect account balances to the correct amounts. If an error is discovered that does not affect the income of prior years, a prior period adjustment to retained earnings is not necessary since income for prior years and retained earnings are correct.We still use the retrospective approach to correct the incorrect account balances and restate all financial statements that are presented for comparative purposes. A disclosure note is included to describe the nature of the error.The correction of errors affecting the income of prior years requires the retrospective approach: All incorrect account balances are corrected. A prior period adjustment to retained earnings is necessary since the income of prior periods is incorrect. All financial statements presented for comparative purposes are restated. A disclosure note is included to describe the nature of the error.

Consider this example of an error affecting a prior years income:In 2011, the accountant at Orion, Inc. discovered the depreciation of $50,000 on a new asset purchased in 2010 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 2010 was $275,000 and taxable income was $225,000. Orion, Inc. is subject to a thirty percent tax rate and prepares current period statements only.The journal entry made in 2010 to record income taxes included a debit to income tax expense for $82,500, a credit to deferred tax liability for $15,000, and a credit to income tax payable for $67,500.The depreciation expense error affected the following accounts in 2010: depreciation expense is understated by $50,000. accumulated depreciation is understated by $50,000. net income is overstated by $35,000 ($50,000 times one minus the thirty percent tax rate). income tax expense is overstated by $15,000 ($50,000 times the thirty percent tax rate). deferred tax liability is overstated by $15,000.The entry to correct the error reduces retained earnings by $35,000, reduces deferred tax liability by $15,000, and increases accumulated depreciation by $50,000.The entry to correct the error does not include income tax expense and depreciation expense because those accounts were closed at the end of 2010. The statement of retained earnings reports a prior period adjustment for $35,000 ($50,000 less the $15,000 tax effect).Part I.Identify the type of accounting error for the following item: Ending inventory was incorrectly counted.

Part II.If ending inventory is incorrectly counted, the ending inventory in one period will be incorrect and the beginning inventory in the next period will also be incorrect. Since the inventory balance effects cost of goods sold, income will also be incorrect in the two periods, by the same amount. For example, if the error overstates ending inventory in the current period, cost of goods sold will be understated and income will be overstated in the current period. The error will result in an overstatement of beginning in the next period, which will cause an overstatement of cost of goods sold and an understatement of income in that period. Since the income is overstated in the current period and understated in the next period, this is called a counterbalancing error. At the end of the two periods, if no other errors are made, the balances in inventory and retained earnings are correct.

Part I.Identify the type of accounting error for the following item: Loss on sale of furniture was incorrectly recorded as depreciation expense.

Part II.When the furniture sale transaction was recorded, depreciation expense was debited for the amount that should have been a debit to loss on sale. Since both expenses and losses reduce income, the error does not effect income.

Part I.Identify the type of accounting error for the following item: Depreciation expense was understated.

Part II.An expense is understated, so income is understated. The error affects only the year in which the error was made. It is a noncounterbalancing error since only one periods income is affected.

The table on this screen summarizes the accounting and reporting for accounting changes and error corrections. The highly summarized information presented here should provide you with a quick reference and a very useful study guide for the material in this chapter.U.S. GAAP and International standards are largely converged regarding accounting changes and error corrections, but one difference concerns error corrections. When correcting errors in previously issued financial statements, IFRS (IAS No. 8) permits the effect of the error to be reported in the current period if its not considered practicable to report it retrospectively as is required by U.S. GAAP.End of chapter 20.