Transcript Slide 1

20
Accounting Changes
and Error
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
Accounting Changes
Type of Change
Change in Accounting
Principle
Description
Change from one generally
accepted accounting principle
to another.
Examples
Adopt a new FASB standard.
Change method of inventory costing.
Change from FV method to equity method,
or vice versa.
Change from completed contract to
percentage-of completion, or vice versa.
Change in Accounting
Estimate
Revision of an estimate
because of new information
or new experience
Change depreciation methods.
Change estimate of useful life of
depreciable asset.
Change estimate of residual value of
depreciable asset.
Change estimate of bad debt %
Change acturial estimates pertaining to a
pension plan.
Change in Reporting
Entity
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Change from reporting as one
type of entity to
another type of entity
Consolidate a subsidiary not
previously included in consolidated
financial statements.
Report consolidated financial statements
in place of individual statements.
Correction of an Error
Type of Change
Error correction
Description
Examples
Correction of an error caused Mathematical mistakes.
by a transaction being recorded Inaccuract physical count of inventory.
incorrectly or not at all
Change from the cash basis of accounting
to the accrual basis.
Failure to record an adjusting entry.
Recording an asset as an expense, or vice
versa.
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Accounting Changes
and Error Corrections
Retrospective
Two
Reporting
Approaches
Prospective
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Error Corrections and
Most Changes in Principle
Retrospective
ReviseTwo
prior years’ statements (that are
presented
for comparative purposes) to reflect
Reporting
the
impact of the change.
Approaches
•The balance in each account affected is revised to
appear as if the newly adopted accounted method
had been applied all along or that the error had
Prospective
never occurred.
•Adjust the beginning balance of retained earnings
for the earliest period reported.
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Changes in Estimates and
Some Changes in Principle
The change is implemented in the Retrospective
current
period, and its effects are reflected in the
financial statements of the current and
future Two
years only.
Reporting
•Prior years’ statements are not revised.
•Account balances are not revised.
Approaches
Prospective
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Change in Accounting Principle
Qualitative
Characteristics
Consistency
Comparability
Although consistency and comparability are desirable,
changing to a new method sometimes is appropriate.
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Motivation for Accounting Choices
Effect on
Compensation
Changing
Conditions
Motivations
for Change
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Effect on Debt
Agreements
Effect on Union
Negotiations
New Accounting
Standard Issued
Effect on
Income Taxes
Retrospective Approach
Most Changes in Accounting Principle
Let’s look at an examples of a change from LIFO to FIFO.
At the beginning of 2011, Air Parts Corporation changed from
LIFO to FIFO. Air Parts has paid dividends of $40 million
each year since 2004. Its income tax rate is 40 percent.
Retained earnings on January 1, 2009, was $700 million;
inventory was $500 million. Selected income statement
amounts for 20011 and prior years are (in millions):
Cost of goods sold (LIFO)
Cost of goods sold (FIFO)
Difference
Revenues
Operating expenses
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2011
$
430
370
$
60
2010
$
420
365
$
55
2009
$
405
360
$
45
Previous
Years
$
2,000
1,700
$
300
$
$
$
$
950
230
900
210
875
205
4,500
1,000
Revise Comparative Financial
Statements
For each year reported, Air Parts makes the comparative
statements appear as if the newly adopted accounting
method (FIFO) had been in use all along.
Income Statements ($ in millions)
Revenues
Cost of goods sold (FIFO)
Operating expenses
Income before tax
Less: Income tax expense (40%)
Net income
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2011
$
950
370
230
$
350
140
$
210
2010
$
900
365
210
$
325
130
$
195
2009
$
875
360
205
$
310
124
$
186
Revise Comparative Financial
Statements
For each year reported, Air Parts makes the comparative
statements appear as if the newly adopted accounting
method (FIFO) had been in use all along.
Cost of goods sold (LIFO)
Cost of goods sold (FIFO)
Difference
2011
$
430
370
$
60
2010
$
420
365
$
55
2009
$
405
360
$
45
Previous
Years
$
2,000
1,700
$
300
Comparative balance sheets will report 2009 inventory $345
million higher than it was reported in last year’s statements.
Retained earnings for 2009 will be $207 million higher.
[$345 million × (1 – 40% tax rate)]
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Revise Comparative Financial
Statements
For each year reported, Air Parts makes the comparative
statements appear as if the newly adopted accounting
method (FIFO) had been in use all along.
Cost of goods sold (LIFO)
Cost of goods sold (FIFO)
Difference
2011
$
430
370
$
60
2010
$
420
365
$
55
2009
$
405
360
$
45
Previous
Years
$
2,000
1,700
$
300
Comparative balance sheets will report 2010 inventory $400
million higher than it was reported in last year’s statements.
Retained earnings for 2010 will be $240 million higher.
[$400 million × (1 – 40% tax rate)]
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Revise Comparative Financial
Statements
For each year reported, Air Parts makes the comparative
statements appear as if the newly adopted accounting
method (FIFO) had been in use all along.
Cost of goods sold (LIFO)
Cost of goods sold (FIFO)
Difference
2011
$
430
370
$
60
2010
$
420
365
$
55
2008
$
405
360
$
45
Previous
Years
$
2,000
1,700
$
300
Comparative balance sheets will report 2011
inventory $460 million higher than it would have
been if the change from LIFO had not occurred.
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Retained earnings for 2011 will be $276 million higher.
[$460 million × (1 – 40% tax rate)]
Adjust Accounts for the Change
On January 1, 2011, the date of the change,
the following journal entry would be made
to record the change in principle.
January 1, 2011:
Inventory .......................................................
Retained earnings ...............................
Income tax payable ……….………..….
400,000,000
240,000,000
160,000,000
To increase inventory, retained earnings, and income
tax payable as a result of the change from LIFO to FIFO.
40% of $400,000,000
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Disclosure Notes
In the first set of financial statements after the
change is made, a disclosure note is needed to
Provide
justification
for the change.
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Point out that
comparative
information has
been revised.
Report any per
share amounts
affected for the
current and all
prior periods.
Prospective Approach
Some Changes in Principle
Most changes in principle are reported
by the retrospective approach, but:
The prospective approach is used for changes in
principle when:
 It is impracticable to determine some periodspecific effects.
 It is impracticable to determine the cumulative effect
of prior years.
 The change is mandated by authoritative
pronouncements.
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U. S. GAAP vs. IFRS
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.
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Prospective Approach
Change in Accounting Estimate
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 as a
change in accounting estimate.
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Change in Accounting Estimate
Changes in accounting estimates are accounted for
prospectively. Let’s look at an example of a change in a
depreciation estimate.
On January 1, 2007, Towing, Inc. purchased specialized
equipment for $243,000. The equipment has been
depreciated using the straight-line method and had an
estimated life of 10 years and salvage value of $3,000. In
2010 the total useful life of the equipment was revised to 6
years. Calculate the 2011 depreciation expense.
$243,000 – $3,000 = $24,000 (2006 – 2009)
10 years
$24,000 × 4 years = $96,000 Accum. Depr.
$243,000 – $96,000 = $147,000 Book Value
$147,000 – $3,000 = $72,000 (2011 & 2012)
2 years
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Changing Depreciation Methods
Universal Semiconductors switched from SYD
depreciation to straight-line depreciation in 2011.
The asset was purchased at the beginning of 2009
for $63 million, has a useful life of 5 years and
an estimated residual value of $3 million.
Sum-of-the-Years-Digits Depreciaton (millions)
2009 depreciation
2010 depreciation
Accumulated depreciation
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$ 20
16
$ 36
($60 x 5/15)
($60 x 4/15)
Changing Depreciation Methods
÷
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Changing Depreciation Methods
Depreciation adjusting entry
for 2011, 2012, and 2013.
Depreciation expense ...................................
Accumulated depreciation ..................
To record depreciation expense.
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8,000,000
8,000,000
Change in Reporting Entity
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.
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Change in Reporting Entity
Summary of the Retrospective Approach for
Changes in Reporting Entity
Recast all previous periods’ financial statements 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.
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Error Correction
 Examples include:
•
•
•
•
Use of inappropriate principle
Mistakes in applying GAAP
Arithmetic mistakes
Fraud or gross negligence in reporting
 For all years disclosed, financial statements
are retrospectively restated to reflect the error
correction.
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Correction of Accounting Errors
Four-step process
Prepare a journal entry to correct any balances.
Retrospectively restate prior years’ financial
statements that were incorrect.
Report correction as a prior period adjustment if
retained earnings is one of the incorrect
accounts affected.
Include a disclosure note.
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Prior Period Adjustments
Prior Period
Adjustment Required
Counterbalancing
error discovered in
the second year.
Noncounterbalancing
error discovered in
any year.
Use the retrospective approach
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Errors Occurred and Discovered
in the 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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Errors Not Affecting
Prior Years’ Net Income
Involves incorrect classification of accounts.
Requires correction of previously issued
statements (retrospective approach).
Is not classified as a prior period adjustment
since it does not affect prior income.
Disclose nature of error.
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Error Affecting Prior Year’s Net Income
• Requires correction of previously issued
statements (retrospective approach).
• All incorrect account balances must be
corrected.
• Is classified as a prior period adjustment since it
does affect prior income.
• Disclose nature of error.
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Error Affecting Prior Year’s Net 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 30% tax rate and prepares current
period statements only.
The entry made in 2010 to record income taxes was
December 31, 2010:
Income tax expense (30% of $275,000) .....................
Deferred tax liability (30% of $50,000) ..............
Income tax payable (30% of $225,000) ……..…
To record income tax expense.
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82,500
15,000
67,500
Error Affecting Prior Year’s Net Income
This error affected the following accounts:
Depreciation expense for 2010 - understated
$
50,000
Accumulated depreciation for 2010 - understated
50,000
Net income in 2010 - overstated ($50,000 x 70%)
35,000
Income tax expense in 2010 - overstated
15,000
Deferred tax liability for 2010 - overstated
15,000
Remember, the 2010 expense accounts were closed to RE.
2011:
Retained earnings …………………………...................
Deferred tax liability …………………………….............
Accumulated depreciation …………………....…
To correct recording error.
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35,000
15,000
50,000
Error Affecting Prior Year’s Net Income
Let’s assume the following for Orion, Inc.:
On 1/1/11, the retained earnings balance was $922,000. In
2011, the company paid $65,000 in dividends. Net income
for 2011 was $184,000.
The Statement of Retained Earnings (or RE column of the
Statement of Shareholders’ Equity) would be as follows:
Retained earnings, January 1, 2011
As previously reported
Correction of error in depreciation
Less: Income tax reduction
$
922,000
50,000
15,000
(35,000)
Retained earnings as restated, January 1, 2011
887,000
Add: Net income
184,000
Less: Dividends
(65,000)
Retained earnings, December 31, 2011
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$
$
1,006,000
Correction of Accounting Errors
Identify the type of accounting error for the following item:
Ending inventory was incorrectly counted.
Counterbalancing error affecting net income
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. At the end of the
two periods, if no other errors are made, the balances
in inventory and retained earnings are correct.
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Correction of Accounting Errors
Identify the type of accounting error for the following item:
Loss on sale of furniture was incorrectly
recorded as depreciation expense.
Error not affecting net income.
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.
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Correction of Accounting Errors
Identify the type of accounting error for the following item:
Depreciation expense was understated.
Noncounterbalancing error affecting net income.
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
period’s income is affected.
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Summary of Accounting
Changes and Errors
Change in Accounting Principle
Most
Prospective
Changes
Exceptions
Method of accounting
Retrospective
Prospective
Revise prior years?
Yes
No
Cumulative effect on An adjustment to
prior years' income
earliest reported
Not
reported?
retained earnings.
reported.
Journal entries?
Adjust affected
None
balances to new
method.
Disclosure note?
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Subsequent
accounting is
affected by
change.
Yes
Subsequent
accounting is
affected by
change.
Yes
Change in
Estimate
Change in
Reporting
Entity
Prospective
No
Retrospective
Yes
Not
reported.
None
Not
reported.
None
Subsequent
accounting is
affected by
change.
Yes
Consolidated
statements are
discussed in
other courses.
Yes
Error
Retrospective
Yes
An adjustment to
earliest reported
retained earnings.
Involves any
incorrect balances
as a result of the
error.
Yes
U. S. GAAP vs. IFRS
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 it’s
not considered practicable to report it retrospectively
as is required by U.S. GAAP.
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End of Chapter 20