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Accounting Changes and Error Analysis

Chapter 22

Intermediate Accounting12th Edition

Kieso, Weygandt, and Warfield

Prepared by Coby Harmon, University of California, Santa Barbara as modified by Teresa Gordon, University of Idaho

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Learning Objectives Identify the types of accounting changes. Describe the accounting for changes in accounting principles. Understand how to account for retrospective accounting

changes. Understand how to account for impracticable changes. Describe the accounting for changes in estimates. Identify changes in a reporting entity. Describe the accounting for correction of errors. Identify economic motives for changing accounting methods. Analyze the effect of errors.

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Changes in accounting principle

Changes in accounting estimate

Reporting a change in entity

Reporting a correction of an error

Motivations for change of method

Accounting Changes

Error Analysis

Balance sheet errors

Income statement errors

Balance sheet and income statement effects

Comprehensive example

Preparation of statements with error corrections

Accounting Changes and Error Analysis

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Restatements are common!

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Accounting Changes & Corrections

SFAS No. 154 discusses 3 types of accounting changes plus correction of errors

1. Changes in Accounting Principle

2. Changes in Accounting Estimates

3. Changes in Reporting Entity

4. Errors in Financial Statements

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Change in accounting principle A change from one generally accepted

principle to another generally accepted accounting principle Only possible where GAAP permits more than

one acceptable choice Definition includes a change in the method of

applying an accounting principle Must be applied consistently after adopted

IMPORTANT NOTE: The change must be justified on the basis that it is preferable to the principle previously followed.

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Change in accounting principle

A change in accounting principle does NOT include Initial adoption of an accounting principle for a

new event or transaction Modification of an accounting principle made

necessary by transactions clearly different in substance from those previously occurring

A change to a generally accepted principle from an incorrect principle (This is considered the correction of an error)

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Reporting a change in principle

Retrospective application to all prior periods unless this is impracticable Cumulative DIRECT effect of the change on periods prior

to those presented is reflected on the balance sheet in the amounts reported for assets and liabilities

The offsetting adjustment (if any) is made to the beginning balance of retained earnings for the earliest period presented

Financial statements will be re-stated as though the new principle had been in use

Direct effects include income tax impact

Indirect effects (if actually incurred) are recognized in the period during which the accounting change is made

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Earliest Year Presented (or affected by change)

Retained Earnings account is shown as follows:

Balance at beginning of year $ XXX

Adjustment for the cumulative

effect on prior years (net of tax) $ XX

Balance at beginning (as adjusted) $ XX

Net Income $ XXX

Less dividends declared - XX

Balance at end of year $ XXX

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When is a Change in Accounting Principle Appropriate?

Changes are appropriate when the new principle is preferable to the existing accounting principle.

The new principle should result in improved financial reporting.

A change is considered preferable if a FASB standard: creates a new accounting principle, or expresses preference for a new principle, or rejects a specific accounting principle

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Motivations for Change

Managers and others may have a self- interest in adopting principles or standards: Companies may want to be less politically visible

to avoid regulation A company’s capital structure may affect its

selection of accounting standards Managers may select accounting standards to

maximize their performance-related bonuses Companies have an incentive to manage or

smooth earnings

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Example (Retrospective Change) Buildmore Construction Company used the completed contract method to account for long-term construction contracts for financial accounting and tax purposes in 2006, its first year of operations. In 2008, the company decided to change to the percentage-of-completion method for financial accounting purposes. Income before long-term contracts and taxes in 2006, 2007, and 2008 was $50,000, $80,000 and $100,000. The tax rate is 40% and the company will continue to use the completed contract method for tax purposes.

Retrospective Change ExampleRetrospective Change Example

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Example Income from Long-Term Contracts

Retrospective Change ExampleRetrospective Change Example

40%Percentage- Completed Tax Net of

Date of -Completion Contract Diff erence Eff ect Tax

2006 20,000$ -$ 20,000$ 8,000$ 12,000$

2007 40,000 25,000 15,000 6,000 9,000

2008 60,000 55,000 5,000 2,000 3,000

J ournal entry

2008 Construction in progress 35,000

Deferred tax liability 14,000

Retained earnings 21,000

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Example Comparative Income Statements

LO 3 Understand how to account for retrospective accounting changes.

Retrospective Change ExampleRetrospective Change Example

Restated Previous2008 2007 2007

I ncome before LT contracts 100,000$ 80,000$ 80,000$

I ncome f rom LT contracts 60,000 40,000 25,000

I ncome before tax 160,000 120,000 105,000

I ncome tax 64,000 48,000 42,000

Net income 96,000$ 72,000$ 63,000$

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Example Retained Earnings Statement

LO 3 Understand how to account for retrospective accounting changes.

Retrospective Change ExampleRetrospective Change Example

Restated Previous2008 2007 2007

Beg. balance previously reported 30,000$ 30,000$

Eff ect of accounting change 12,000 -

Beg. balance restated 114,000 42,000 30,000

Net income 96,000 72,000 63,000

Ending balance 210,000$ 114,000$ 93,000$

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Changes in accounting estimates

Current and prospective method

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Many amounts on FS involve estimates, including:Many amounts on FS involve estimates, including:

1. Uncollectible receivables.

2. Inventory obsolescence.

3. Useful lives and salvage values of assets.

4. Periods benefited by deferred costs.

5. Liabilities for warranty costs and income taxes.

6. Recoverable mineral reserves.

7. Change in depreciation methods.

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Change in Estimate

Estimates that are later determined to be incorrect should be corrected as changes in estimates Result from availability of new or additional

information

Companies report prospectively changes in accounting estimates.

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Change in Estimate

Sometimes effected in the form of a change in accounting principle Bad debt accounting – change from percentage of

sales method to aging of accounts receivable (allowance) method

Fixed assets – change from sum-of-year’s-digits depreciation to straight-line depreciation

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Changes in Accounting Estimates

Are handled with what used to be called the current and prospective method This means that we do not go back and change

previously reported numbers on the financial statements (no retroactive restatement)

We make changes to current and future years only

Two numeric examples Depreciation expense Depletion expense

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Asset cost $240,000Estimated residual value $40,000Estimated service life 5 years

Depreciation Example

Consider these facts related to an asset acquired January 1, 2010:

The company uses straight-line depreciation Assume that after 2 years, it becomes obvious that the

asset will be used for a total of 8 years At the end of 8 years, it will be worth $10,000 What depreciation expense should be recorded for 2012?

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160,000 -10,000 = 6

$240,000

YearDepreciation

Book value at end of year

2010 40,000$ $200,0002011 40,000$ $160,000

2012 25,000$ $135,000

2013 25,000$ $110,0002014 25,000$ $85,0002015 25,000$ $60,0002016 25,000$ $35,0002017 25,000$ $10,000

$240,000 - 40,000- 40,000 =$160,000

Carrying Value

Solution

8 - 2

new estimate

$ 25,000

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Alternate treatment

If we had originally known new facts:

We would have had $57,500 in accumulated depreciation at end of 2011.

Actually in acc’d depreciation = $80,000 Make adjusting JE and then continue with

$28,750 depreciation for remaining useful life

240,000 -10,000 = $28,750 8

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Alternate treatment

2012Correcting JE:

Acc’d Depr 22,500 Depr Exp 22,500

Record 2012 depreciation:

Depr Exp 28,750

Acc’d Depr 28,750

240,000 -10,000 = $28,750 8

$240,000

YearDepreciation

Book value at end of year

2010 40,000$ $200,0002011 40,000$ $160,000

2012 6,250$ $153,750

2013 28,750$ $125,0002014 28,750$ $96,2502015 28,750$ $67,5002016 28,750$ $38,7502017 28,750$ $10,000

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Example - Coal Mine Cost of property $9,000,000 Cost to restore property $1,200,000* Value after restoration $1,000,000 Recoverable resources 4,000,000 tons First year production 150,000 tons Sold for $30 per ton

* Present value (asset retirement obligation measured in accordance with SFAS No. 143)

Statutory depletion rate for tax purposes = 10%

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Cost basis + cost to restore - residual value after restoration Total estimated recoverable units

$9,000,000 + 1,200,000 - 1,000,000 = 4,000,000 tons $2.30 per ton

Sold 150,000 tons, therefore cost depletion = 150,000 * 2.30 = $345,000

Coal mine example:

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Coal mine example, continued

Assume that 250,000 tons of coal were produced and sold during the second year of operation

However, new EPA regulations increased the projected restoration costs to $2,000,000 (asset retirement obligation)

At the beginning of the second year of production, geologist estimate 4,050,000 tons remain

We start over estimating the depletion rate per ton -- using the current BOOK VALUE instead of cost

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Coal Mine Example

Cost basis + cost to restore - residual value after restoration Remaining recoverable units (estimated)

Cost basis is now $9,000,000 - $345,000 = $8,655,000

The cost to restore is now $2,000,000

The new estimate of recoverable units (including 2nd year’s production) is 4,050,000 tons(3,800K left + 250K mined this year)

$8,655,000 + $2,000,000 - $1,000,000 = $2.38 per ton 4,050,000

250,000 tons * $2.38 = $595,000 depletion expense

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Statutory Depletion

Note that the tax deduction would be much higher using statutory depletion allowance (a permanent difference between accounting and tax return)

Year 1 - 150,000 tons * $30 per ton = $4,500,000 revenue * 10% statutory rate = $450,000 on tax deduction vs. $345,000 on income statement

Year 2 - 250,000 tons * $33 per ton = $8,250,000 Revenue * 10% statutory rate =

$825,000 tax deduction vs. $595,000 on income statement

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Disclosure of Changes in Estimate

Not required for routine changes in estimate that happen every year Allowance for uncollectible accounts Inventory obsolescence Warranty obligations

UNLESS material If material, the change in estimate should be

discussed in footnotes to financial statements with per share disclosures

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Other Changes & Corrections

Change in Entity

Correction of Error

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Reporting a Change in Entity

The reporting entity changes Financial statements are restated for all prior

periods presented Examples of a change in reporting entity are:

Consolidated statements in lieu of individual financials

Loss in control of formerly consolidated subsidiary Acquisition or sale of subsidiaries

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Reporting the Correction of an Error

Corrections are treated as prior period adjustments to retained earnings for the earliest period being reported

Examples of accounting errors include: A change from an accounting principle that is not generally

accepted to one that is accepted Mathematical errors Changes in estimates that were not prepared in good faith A failure to properly accrue or defer expenses or revenues A misapplication or omission of relevant facts

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Restatement Example

SFAS No. 154, Appendix A Illustration 1 - detailed example of a change

from LIFO to FIFO inventory method Shows extensive disclosures that would be

needed to communicate impact on balance sheet, income statement, and statement of cash flows

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Error Analysis in General

Firms do not correct errors that are insignificant. Three questions must be answered in this regard:

1. What type of error is involved?

2. What correcting entries are needed?

3. How are financial statements to be restated? Error corrections are reported as prior period

adjustments to the beginning retained earnings balance in the current year

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A. Change in Accounting Estimate (prospectively)B. Change in Accounting Principle (retroactively or

disclosed)C. Change in Accounting Entity (retroactively)D. Correction of an Error (retroactively)

1. Change in a plant asset’s salvage value.

2. Change due to overstatement of inventory

4. Change from presenting unconsolidated financial statements to consolidated financial statements

5. Change from LIFO to FIFO inventory method

Accounting ChangesAccounting Changes

3. Change from sum-of-years’-digits to straight-line depreciation method

6. Change in rate used to compute warranty costs

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7. Change from an unacceptable to an acceptable accounting principle

9. Change from completed contract to percentage of completion accounting for long-term contracts

10. Change from FIFO to LIFO inventory method

Accounting ChangesAccounting Changes

8. Change in a patent’s amortization period

11. Change from allowance method to the percentage of sales method to account for bad debt expense

A. Change in Accounting Estimate (prospectively)B. Change in Accounting Principle (retroactively or

disclosed)C. Change in Accounting Entity (retroactively)D. Correction of an Error (retroactively)