Financial Accounting and Accounting Standards

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• Chapter 11

Accounting Changes and Error Analysis
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Learning Objectives

1. Identify the types of accounting changes.
2. Describe the accounting for changes in accounting
   principles.
3. Understand how to account for retrospective
   accounting changes.
4. Understand how to account for impracticable
   changes.
5. Describe the accounting for changes in estimates.
6. Identify changes in a reporting entity.
7. Describe the accounting for correction of errors.
8. Identify economic motives for changing accounting
   methods.
9. Analyze the effect of errors.

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Accounting Changes Reporting Issues Approaches

• Why are accounting changes made?
• New FASB pronouncements
• Changing economic conditions
• Changing internal circumstances

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Accounting Changes Reporting Issues Approaches

• Essential issues in reporting accounting
  changes
• Whether an accounting change is allowed.
• Whether to restate prior years?financial
  statements.
• Whether to recognize the effect of the change in
  the current years net income or in the beginning
  retained earnings balance .

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Accounting Changes
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Accounting Changes

• Error corrections . . .
• Are not classified as accounting changes.
• Do affect the income of prior periods and
• require special treatment.

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Objectives of Reporting Accounting Changes
Relevance
Consistency
Public Confidence
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Accounting Principle Changes
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Accounting Principle Changes

• The following are not accounting principle
  changes
• Initial adoption of an accounting principle
• Adopting an accounting principle for a new group
  of assets or liabilities
• Change from inappropriate accounting principle to
  GAAP
• Planned change to straight-line depreciation
• Change in accounting principle that cannot be
  distinguished from a change in accounting estimate

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Changes in Accounting Principle

• Three approaches for reporting changes
• Currently (cumulative effect).
• Retrospectively.
• Prospectively (in the future).
• FASB requires use of the retrospective approach.

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Basic Principles
According to the provisions of FASB No. 154

• A change in an accounting principle is accounted
  for by the retrospective application of the new
  accounting principle.
• A change in an accounting estimate is accounted
  for prospectively.
• A change in a reporting entity is accounted for
  by the retrospective application of the new
  accounting principle.
• A material error is accounted for by prior period
  restatement (adjustment).

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Retrospective Adjustment Method
A company accounts for a change in principle by
the retrospective application of the new
accounting principle as follows

1. The company computes the cumulative effect of the
   change to the new accounting principle as of the
   beginning of the first period presented. That is,
   it computes the amounts that would have been in
   the financial statements if it had always used
   the new principle.

Continued
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Retrospective Adjustment Method

1. The company adjusts the carrying values of those
   assets and liabilities (including income taxes)
   that are affected by the change. The company
   makes an offsetting adjustment to the beginning
   balance of retained earnings to report the
   cumulative effect of the change (net of taxes)
   for each period presented.

Continued
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Retrospective Adjustment Method

1. The company adjusts the financial statements of
   each prior period to reflect the specific effects
   of applying the new accounting principle. That
   is, each item in each financial statement that is
   affected by the change is restated to the
   appropriate amount under the new accounting
   principle. The company uses the new accounting
   principle in its current financial statements.

Continued
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Retrospective Adjustment Method

1. The companys disclosures include (a) the nature
   and reason for the change in accounting
   principle, including an explanation of why the
   new principle is preferable, (b) a description of
   the prior-period information that has been
   retrospectively adjusted, (c) the effect of the
   change on income, earnings per share, and any
   other financial statement line item for the
   current period and the prior periods
   retrospectively adjusted, and (d) the cumulative
   effect of the change on retained earnings (or
   other appropriate component of equity) at the
   beginning of the earliest period presented.

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Retrospective Adjustment Method

• The following accounting principle changes are
  subject to the
• retroactive approach
• Change from LIFO to another inventory method
• Change in the method of accounting for long-term
  construction contracts
• Change to or from full-cost method in extractive
  industries
• Changes in accounting principle made in
  conjunction with an initial public offering of
  equity securities (exemption available only once)

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Retrospective Adjustment Method

• The following accounting principle changes are
  subject to the
• retroactive approach
• Change from retirement/replacement accounting to
  depreciation accounting for railroad track
  structures
• Change to a principle required by a new
  pronouncement recognized as GAAP that requires
  retroactive application
• Change to the equity method of accounting for
  investments in common stock (sometimes classified
  as a change in reporting entity)

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Retrospective Change Example
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 2007, 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 2007 and 2008 was 80,000
and 100,000. The tax rate is 40 and the company
will continue to use the completed contract
method for tax purposes.
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Retrospective Change Example
Example Income from Long-Term Contracts
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Retrospective Change Example
Example Comparative Income Statements
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Retrospective Change Example
Example Retained Earnings Statement
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Changes in Accounting Principle
Impracticability
Companies should not use retrospective
application if one of the following conditions
exists

1. Company cannot determine the effects of the
   retrospective application.
2. Retrospective application requires assumptions
   about managements intent in a prior period.
3. Retrospective application requires significant
   estimates that the company cannot develop.

If any of the above conditions exists, the
company prospectively applies the new accounting
principle.
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Prospective Approach
Summary of the Approach for Changes in Accounting
Estimates

• No cumulative adjustment is made.

• Prior years results remain unchanged.
• New estimates are applied prospectively.

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Changes in Accounting Estimate
The following items require estimates.

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.

Companies report prospectively changes in
accounting estimates.
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Change in Estimate Example

• Arcadia HS, purchased equipment for 510,000
  which was estimated to have a useful life of 10
  years with a salvage value of 10,000 at the end
  of that time. Depreciation has been recorded for
  7 years on a straight-line basis. In 2005 (year
  8), it is determined that the total estimated
  life should be 15 years with a salvage value of
  5,000 at the end of that time.
• Required
• What is the journal entry to correct
• the prior years depreciation?
• Calculate the depreciation expense
  
• for 2005.

No Entry Required
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Change in Estimate Example
After 7 years
Equipment cost 510,000 Salvage value
- 10,000 Depreciable base 500,000 Useful life
(original) 10 years Annual depreciation
50,000
First, establish NBV at date of change in
estimate.
x 7 years 350,000
Balance Sheet (Dec. 31, 2004)
Fixed Assets
Equipment
510,000
Accumulated depreciation
350,000
Net book value (NBV)
160,000
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Change in Estimate Example
After 7 years
Net book value 160,000 Salvage value (new)
5,000 Depreciable base 155,000 Useful life
remaining 8 years Annual depreciation
19,375
Second, calculate depreciation expense for 2005.
Journal entry for 2005
Depreciation expense 19,375 Accumulated
depreciation 19,375
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Reporting a Change in Entity
Examples of a change in reporting entity are

1. Presenting consolidated statements in place of
   statements of individual companies.
2. Changing specific subsidiaries that constitute
   the group of companies for which the entity
   presents consolidated financial statements.
3. Changing the companies included in combined
   financial statements.
4. Changing the cost, equity, or consolidation
   method of accounting for subsidiaries and
   investments.

Reported by changing the financial statements of
all prior periods presented.
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Reporting a Change in Entity
Summary of the Approach for Changes in Reporting
Entity

• No cumulative adjustment is made.

• Prior years results are restated.

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Justification for Accounting Changes

• New principle must be preferable.
• Nature of change and justification disclosed in
  notes.
• Justifications
• Improved matching
• Enhanced asset valuation
• New information
• Changing conditions
• Compliance with new reporting standards

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I wonder why companies make accounting changes?
It seems like a lot of trouble to me!
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Reporting a Correction of an Error
Accounting errors include the following types

1. A change from an accounting principle that is not
   generally accepted to an accounting principle
   that is acceptable.
2. Mathematical mistakes.
3. Changes in estimates that occur because a company
   did not prepare the estimates in good faith.
4. Failure to accrue or defer certain expenses or
   revenues.
5. Misuse of facts.
6. Incorrect classification of a cost as an expense
   instead of an asset, and vice versa.

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Reporting a Correction of an Error

• All material errors must be corrected.
• Record corrections of errors from prior periods
  as an adjustment to the beginning balance of
  retained earnings in the current period.
• Such corrections are called prior period
  adjustments.
• For comparative statements, a company should
  restate the prior statements affected, to correct
  for the error.

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Prior Period Restatement
A company accounts for a change in accounting
principle by prior period restatement as follows

1. The company computes the cumulative effect of the
   error correction on prior period financial
   statements. That is, it computes the amounts that
   would have been in the financial statements if it
   had not made the error.

Continued
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Prior Period Restatement

1. The company adjusts the carrying values of those
   assets and liabilities (including income taxes)
   that are affected by the error. The company makes
   an offsetting entry to the beginning balance of
   retained earnings to report the cumulative effect
   of the error correction (net of taxes) for each
   period presented.

Continued
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Prior Period Restatement

1. The company adjusts the financial statements of
   each prior period to reflect the specific effects
   of correcting the error.

1. The companys disclosures include (a) that its
   previously issued financial statements have been
   restated, along with a description of the nature
   of the error,

Continued
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Prior Period Restatement

• (b) the effect of the correction of each
  financial statement line item, and any per share
  amounts affected for each prior period presented,
  and
• (c) the cumulative effect of the change on
  retained earnings (or other appropriate component
  of equity) at the beginning of the earliest
  period presented.

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Retained Earnings Statement
Before issuing the report for the year ended
December 31, 2007, you discover a 62,500 error
that caused the 2006 inventory to be overstated
(overstated inventory caused COGS to be lower and
thus net income to be higher in 2006). Would
this discovery have any impact on the reporting
of the Statement of Retained Earnings for 2007?
Assume a 20 tax rate.
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Retained Earnings Statement
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Accounting ErrorsClassifications

• I. Errors occurred and discovered in the
• same accounting period.
• II. Errors occurred in previous period.
• A. Errors did not affect prior period net
• income.
• B. Errors did affect prior period net
• income.
• 1. Counterbalancing errors
• 2. Noncounterbalancing errors

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Errors Occurred and Discovered in Same Period

• Corrected by reversing the incorrect entry
  and then recording the correct entry (or by
  making an entry to correct the account balances)

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Previous Period Errors Not Affecting Net Income

• Involves incorrect classification of accounts.
• Requires correction of previously issued
  statements (retroactive approach).
• Is not classified as a prior period adjustment
  since it does not affect prior income.
• Disclose nature of error.

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Counterbalancing Errors Affecting Prior Net Income

• Counterbalancing errors discovered after two or
  more years do not require a correcting entry.
• Counterbalancing errors discovered in the second
  year of the cycle require a correcting entry.
• -- Treated as a prior period adjustment (net of
  tax) to beginning Retained Earnings balance.

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Noncounterbalancing Errors Affecting Prior Net
Income

• These errors do not automatically correct
  themselves after two years.
• Correction of a noncounterbalancing error usually
  requires a prior period adjustment (retroactive
  approach).

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Error Analysis Example

• E22-19 (Error Analysis Correcting Entries) A
  partial trial balance of Julie Hartsack
  Corporation is as follows on December 31, 2008.

Instructions (a) Assuming that the books have not
been closed, what are the adjusting entries
necessary at December 31, 2008?
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Error Analysis Example

1. Assuming that the books have not been closed,
   what are the adjusting entries necessary at
   December 31, 2008?

1. A physical count of supplies on hand on
December 31, 2008, totaled 1,100.
2. Accrued salaries and wages on December 31,
2008, amounted to 4,400.
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Error Analysis Example

1. Assuming that the books have not been closed,
   what are the adjusting entries necessary at
   December 31, 2008?

3. Accrued interest on investments amounts to
4,350 on December 31, 2008.
4. The unexpired portions of the insurance
policies totaled 65,000 as of December 31,
2008.
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Error Analysis Example

1. Assuming that the books have not been closed,
   what are the adjusting entries necessary at
   December 31, 2008?

5. 28,000 was received on January 1, 2008 for
the rent of a building for both 2008 and 2009.
The entire amount was credited to rental income.
6. Depreciation for the year was erroneously
recorded as 5,000 rather than the correct figure
of 50,000.
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Error Analysis Example

• E22-19 (Error Analysis Correcting Entries) A
  partial trial balance of Julie Hartsack
  Corporation is as follows on December 31, 2008.

Instructions (b) Assuming that the books have
been closed, what are the adjusting entries
necessary at December 31, 2008?
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Error Analysis Example
(b) Assuming that the books have been closed,
what are the adjusting entries necessary at
December 31, 2008?
1. A physical count of supplies on hand on
December 31, 2008, totaled 1,100.
2. Accrued salaries and wages on December 31,
2008, amounted to 4,400.
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Error Analysis Example
(b) Assuming that the books have been closed,
what are the adjusting entries necessary at
December 31, 2008?
3. Accrued interest on investments amounts to
4,350 on December 31, 2008.
4. The unexpired portions of the insurance
policies totaled 65,000 as of December 31, 2008.
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Error Analysis Example
(b) Assuming that the books have been closed,
what are the adjusting entries necessary at
December 31, 2008?
5. 28,000 was received on January 1, 2008 for
the rent of a building for both 2008 and 2009.
The entire amount was credited to rental income.
6. Depreciation for the year was erroneously
recorded as 5,000 rather than the correct figure
of 50,000.
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All-Inclusive Concept of Income

• Comprehensive income is defined as the net of
  all changes in equity except those resulting from
  investments by and distributions to owners.

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Hang in there! Were coming down the home
stretch!
Yeah, thats easy for you to say!
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C
11
hapter
The End
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