Transcript Document

Accounting Changes and
Error Corrections
I N T ERMEDIATE ACCOU N T I NG I I
CHA PT ER 2 0
ACCOUNTING CHANGES
Accounting changes fall into one of three categories
 Changes in principle
 Changes in estimates
 Changes in reporting entity
Type of Change
Change in
accounting principle
Change in estimate
Description



Change from one
generally accepted
accounting principle to
another



Revision of an estimate 
because of new

information or new

experience


Change in
reporting entity
Change from reporting
as one type of entity to 
another type of entity
Examples
adopt a new FASB standard
change methods of inventory costing
change from cost method to equity method, or vice
versa
change from completed contract to %-ofcompletion, or vice versa
change depreciation methods
change estimate of useful life of depreciable asset
change estimate of residual value
change estimate of warranty expense percentage
change estimate of periods benefited by intangible
assets
change actuarial estimates pertaining to a pension
plan
consolidate a subsidiary not previously included in
consolidated financial statements
report consolidated financial statements in place of
individual statements
ACCOUNTING CHANGES
Accounting changes can be accounted for in one of two
ways depending on the nature of the change.
 Retrospectively (prior years revised)
 Prospectively (only current and future years affected)
CHANGE IN ACCOUNTING PRINCIPLE
Although consistency and comparability are desirable, changing to a new
method sometimes is appropriate.
We report most voluntary changes in accounting principles retrospectively on
previous period’s financial statements which are included with comparative
statements. The prior period statements are reported as if the new method had
been used in all prior periods. Additionally, the cumulative effect of the change
should be reflected in the carrying amounts of assets and liabilities as of the
beginning of the first period in which you are presenting financial statements;
and an offsetting amount will be recorded in the beginning retained earnings
balance of the first period in which you are presenting financial statements.
The prospective approach is used when it is impractical to use the
retrospective approach.
Change in Inventory Methods - Example
During 2011 (its first year of operations) and 2012, Batali Foods used the FIFO inventory
costing method for both financial and tax purposes. At the beginning of 2013, Batali decided to
change to the average method for both financial reporting and tax purposes. The following
information is available for 2011 & 2012.
2011
2012
Total
Cost of Goods Sold – FIFO
40
38
Cost of Goods Sold – Average
56
58
Difference
16
14
30
Prepare the journal entry at the beginning of 2013 to record the change in accounting pricinple,
ignoring income taxes.
Retained earnings
Inventory
30
30
Brief Exercise 20-1, page 1232
In 2013, the Barton and Barton Company changed its method of valuing inventory from the
FIFO method to the average cost method. At December 31, 2012, B & B’s inventory valuation
was $32 million under FIFO. B & B’s records indicated that the inventories would have totaled
$23.8 million at December 3120, 2012, if determined on an average cost basis. Ignoring income
taxes, what journal entry will B & B use to record the adjustment in 2013?
Retained earnings
Inventory
8.2
8.2
Explanation: The difference in inventory valuation for the two methods is $32 - $23.8 = 8.2 (millions).
Applying the new inventory method (average cost), inventory would be lower than previously reported
under LIFO. To make this adjustment, credit the inventory account (to reduce the balance to $23.8).
Retained Earnings is also reduced to reflect the higher cost of goods sold that would have been reported
using the average cost method.. Because cost of goods sold by FIFO is less than by LIFO, income and therefore
retained earnings by FIFO are greater than by LIFO.
EFFECT ON INCOME TAX AS A RESULT OF
CHANGE IN INVENTORY COSTING METHOD
When switching from FIFO to LIFO, the income tax effect is reflected in the income tax
payable account. The rationale for this is that income taxes cannot be retrospectively restated
for prior years. The Internal Revenue Code requires that taxes previously saved under another
inventory method must now be repaid (over no longer than six years). Since the amount must
be repaid immediately, there is no deferred tax liability.
When switching from FIFO to the average cost method, we would record a deferred tax asset.
For financial reporting purposes, we would be retrospectively decreasing accounting income,
but not taxable income. A temporary difference between accounting and taxable income is
created that will reverse over time as the unsold inventory (now restated) becomes cost of
goods sold. As the temporary difference reverses, taxable income will be less than accounting
income. When taxable income will be less than accounting income as a temporary difference
reverses, we have a “future deductible amount” and record a deferred tax asset.
EXCEPTIONS NECESSITATING THE PROSPECTIVE APPROACH
1.
WHEN RETROSPECTIVE APPLICATION IS IMPRACTICABLE
Sometimes a lack of information makes it impracticable to report a change retrospectively so the new method is simply
applied prospectively.
If it’s impracticable to adjust each year reported, the change is applied retrospectively as of the earliest year practicable.
If full retrospective application isn’t possible, the new method is applied prospectively beginning in the earliest year
practicable.
Footnote disclosure should indicate reasons why retrospective application was impracticable.
2.
WHEN MANDATED BY AUTHORITATIVE PRONOUNCEMENTS
Another exception to retrospective application is when a new authoritative pronouncement requires prospective
application for specific changes in accounting methods.
3.
CHANGING DEPRECIATION, AMORTIZATION, DEPLETION METHODS
We account for a change in depreciation method as a change in accounting estimate that is achieved by a change in
accounting principle. Therefore, we account for such a change prospectively; that is, precisely the way we account for
changes in estimates.
SPECIFIC EXCEPTIONS TO
RETROSPECTIVE APPLICATION
 A change from another inventory method to LIFO.
.
 A change in the method of depreciation, amortization, or
depletion.
Ex 20-11, page 1236 – Change in Depreciation Methods
Requirement 2
Asset’s cost
Accumulated depreciation to date ($160,000 x 2)
Book Value - To be depreciated over remaining 3 years
2013 SYD depreciation:
sum-of-years-digits
$800,000
(320,000)
$ 480,000
3
x $480,000 = $240,000
(3 + 2 + 1)
Depreciation Expense
Accumulated Depreciation
240,000
240,000
CHANGE IN ACCOUNTING ESTIMATE
 Changes in estimates are accounted for prospectively. When a company
revises a previous estimate, prior financial statements are not revised.
Instead, the company merely incorporates the new estimate in any related
accounting determinations from then on.
 A disclosure note should describe the effect of a change in estimate on
income before extraordinary items, net income, and related per-share
amounts for the current period.
CHANGE IN ACCOUNTING ESTIMATE - Example
Universal Semiconductors estimates warranty expense as 2% of credit sales. After a review during
2013, Universal determined that 3% of credit sales is a more realistic estimate of its payment
experience. Credit sales in 2013 are $300 million. The effective income tax rate is 40%.
Warranty Expense
9,000,000
Estimated Warranty Liability
9,000,000
Calculation: 300,000,000 X .03 = $9,000,000
This is a change in accounting estimate, therefore:
 Warranty expense reported in prior years is not restated.
 No account balances are adjusted (including income tax).
 In 2013 and later years, the adjusting entry to record warranty expense simply will reflect the new
percentage.
 The effect of a change in estimate is described in a footnote to the financial statements.
Brief Exercise 20-7, page 1233
In 2012, Quapau Products introduced a new line of hot water heaters that carry a one-year
warranty against manufacturer’s defects. Based on industry experience, warranty costs were
expected to approximate 5% of sales revenue. First-year sales of the heaters were $300,000.
An evaluation of the company’s claims experience in late 2013 indicatd that actual claims were
less that expected – 4% of sales rather than 5%. Assuming sales of the heaters in 2013 were
$350,000 and warranty expenditures in 2013 totaled $12,000, what is the 2013 warranty
expense?
Warranty Expense
14,000
Estimated Warranty Liability
Calculation: $350,000 X .04 = $14,000
14,000
ERROR CORRECTIONS
Errors occur when transactions either are
recorded incorrectly or not recorded at all.
ERROR CORRECTION
 A journal entry is made to correct any account balances that are incorrect as a result
of the error.
 Errors occurring and discovered in the current accounting period do not require any
restatements.
 Previous years' financial statements that were incorrect as a result of the error are
retrospectively restated to reflect the correction (for all years reported for
comparative purposes).
 If retained earnings is one of the accounts incorrect as a result of the error, the
correction is reported as a “prior period adjustment” to the beginning balance in a
statement of shareholders’ equity (or statement of retained earnings if that’s
presented instead), for the earliest year being reported in the comparative financial
statements. Prior period errors affecting revenue or expense accounts will flow
through to retained earnings.
 A disclosure note should describe the nature of the error and the impact of its
correction on net income, income before extraordinary items, and earnings per share.
ERROR DISCOVERED IN THE SAME ACCOUNTING PERIOD THAT IT OCCURRED Example
If an accounting error is made and discovered in the same accounting period, the
original erroneous entry should simply be reversed and the appropriate entry recorded.
Example: G.H. Little, Inc. paid $300,000 for replacement computers and recorded the expenditure as
maintenance expense. The error was discovered a week later.
To reverse the erroneous entry
Cash
300,000
Maintenance Expense
300,000
To record the correct entry
Equipment
Cash
300,000
300,000
ERROR AFFECTING PREVIOUS FINANCIAL STATEMENTS BUT NOT NET INCOME Example
Example: MDS Transportation incorrectly recorded a $2 million note receivable as
accounts receivable. The error was discovered a year later.
To correct incorrect accounts
Notes Receivable
Accounts Receivable
2,000,000
2,000,000
Other examples of errors affecting previous financial statements, but not net income:
 Incorrectly recording salaries payable as accounts payable
 Recording a loss as an expense or a gain as a revenue
 Classifying a cash flow as an investing activity rather than a financing activity on the statement of
cash flows.
Any affected financial statements included with comparative financial statements would be
retrospectively restated. Since net income was not affected, no prior period adjustment is required for
retained earnings. A disclosure note would be included to describe the nature of the error.
RECORDING AN ASSET AS AN EXPENSE
When an asset is incorrectly recorded as an expense, net income
will be affected. The following steps should be taken to correct
the error.
 The prior period financial statements are retrospectively
restated.
 The corrections is reported as a “prior period adjustment”.
 A disclosure note describes the error and the impact of its
correction.
RECORDING AN ASSET AS AN EXPENSE – Example (continued)
During the two-year period, depreciation expense was understated by $2.8 million, but other expenses
were overstated by $7 million, so net income during the period was understated by a net difference of
$4.2 million. This means retained earnings is currently understated by that amount.
Accumulated depreciation is understated by $2.8 million.
To correct incorrect accounts
Equipment
depreciation
($ in millions)
7.0
Accumulated
2.8
Retained earnings
4.2
ERROR AFFECTING NET INCOME ON PREVIOUS FINANCIAL STATEMENTS Example
Example: In 2013, internal auditors discovered that Seidman Distribution, Inc. had debited an
expense account for the $7 million cost of sorting equipment purchased at the beginning of 2011.
The equipment’s useful life was expected to be 5 years with no residual value. Straight-line
depreciation is used by Seidman
To correct incorrect accounts
Equipment
7,000,000
Accumulated Depreciation
2,800,000
Retained Earnings
4,200,000
See next slide for explanation.
ERROR AFFECTING NET INCOME ON PREVIOUS FINANCIAL STATEMENTS Explanation
During the two-year period, depreciation expense (and accumulated depreciation) was
understated by $2.8 million, but other expenses were overstated by $7 million, so net income
during the period was understated by a net difference of $4.2 million. This means retained
earnings is currently understated by that amount.
Analysis:
($ in millions)
Correct
(Should Have Been Recorded)
2011
2011
2012
Equipment
Cash
Incorrect
(As Recorded)
7.0
Expense 1.4
Accum. depr.
Expense 1.4
Accum. depr.
Expense
Cash
7.0
7.0
Depreciation entry omitted
1.4
Depreciation entry omitted
1.4
7.0
RECORDING AN ASSET AS AN EXPENSE - Example
In 2013, internal auditors discovered that Seidman Distribution, Inc. had debited an expense account for the $7 million
cost of sorting equipment purchased at the beginning of 2011. The equipment’s useful life was expected to be 5 years
with no residual value. Straight-line depreciation is used by Seidman.
Analysis:
($ in millions)
Correct
(Should Have Been Recorded)
2011
2011
2012
Equipment
Cash
Incorrect
(As Recorded)
7.0
Expense 1.4
Accum. depr.
Expense 1.4
Accum. depr.
Expense 7.0
Cash
7.0
Depreciation entry omitted
1.4
Depreciation entry omitted
1.4
7.0
INVENTORY MISSTATED
In early 2013, Overseas Wholesale Supply discovered
that $1 million of inventory had been inadvertently excluded
from its 2011 ending inventory count.
Analysis:
U = Understated
O = Overstated
2011
2012
Beginning inventory
inventory
U
Plus: Net purchases
purchases
Less: Ending inventory
inventory
Cost of goods sold O
U


U
Beginning
Plus: Net
Less: Ending
Cost of goods sold
Revenues
Revenues
Less: COGS
O
Less: Cost of goods sold
U
Less: Other expenses
Less: Other
expenses
Net income
U
Net income
O
Accounting Changes and
Error Corrections
I N T ERMEDIATE ACCOU N T I NG I I – CHA PT E R 2 0
E N D OF P R ESENTATION