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Accounting Changesand Error Corrections

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Accounting ChangesType of Change Description Examples

Change in accounting principle

Change from one generally

accepted accounting principle to

another

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 %-of-

completion, or vice versa

Change in 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 change estimate of bad debt percentage change estimate of periods benefited by

intangible assets change actuarial estimates pertaining to a

pension plan

Change in reporting

entity

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

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Correction of an ErrorType Description Examples

Error correction

Correction of an error caused by

a transaction being recorded incorrectly or

not at all

mathematical mistakes inaccurate physical count

of inventory 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

fraud or gross negligence

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Accounting Changes andError Corrections

Retrospective

TwoReporting

Approaches

Prospective

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Retrospective

TwoReporting

Approaches

Prospective

Revise prior years’ statements that arepresented again for comparative purposes to reflect the impact of the change.

Revise the balance in each account affected is to appear as if the newly adopted accounted method had been applied all along or that the error had never occurred.Adjust the beginning balance of retained earnings for the earliest period reported.

Accounting Changes andError Corrections

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Retrospective

TwoReporting

Approaches

Prospective

The change is implemented in the currentperiod and its effects are reflected in thefinancial statements of the current andfuture years only.

Prior years’ statements are not revised.Account balances are not revised.

Accounting Changes andError Corrections

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Consistency Comparability

Qualitative Characteristics

Although consistency and comparability are desirable, changing to a new method is sometimes appropriate.

Change in Accounting Principle

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Motivation for Accounting Choices

Changing Conditions

New Standard Issued

Effect on Compensation

Effect on Debt Agreements

Effect on Union Negotiations

Motivations for Change

Effect on Income Taxes

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Retrospective Approach

Previous 2006 2005 2004 Years

Cost of goods sold (LIFO) 430$ 420$ 405$ 2,000$ Cost of goods sold (FIFO) 370 365 360 1,700 Difference 60$ 55$ 45$ 300$

Revenues 950$ 900$ 875$ 4,500$ Operating expenses 230 210 205 1,000

Let’s look at an example of a change from LIFO toFIFO that is reported using the retrospective approach.At the beginning of 2009, Air Parts Corporation changedfrom LIFO to FIFO. Air Parts has paid dividends of $40 millioneach year since 1999. Its income tax rate is 40 percent.Retained earnings on Jan. 1, 2007, was $700 million;inventory was $500 million. Selected income statementamounts for 2009 and prior years are (in millions):

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Retrospective Approach

2006 2005 2004Revenues 950$ 900$ 875$ Less: Cost of goods sold (FIFO) 370 365 360 Operating expenses 230 210 205 Income before tax 350$ 325$ 310$ Less: Income tax expense (40%) 140 130 124 Net income 210$ 195$ 186$

Income Statements (Millions)

For each year reported, Air Parts makes the comparativestatements appear as if the newly adopted accounting

method (FIFO) had been in use all along.

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Retrospective ApproachFor each year reported, Air Parts makes the comparativestatements appear as if the newly adopted accounting

method (FIFO) had been in use all along.

Previous 2006 2005 2004 Years

Cost of goods sold (LIFO) 430$ 420$ 405$ 2,000$ Cost of goods sold (FIFO) 370 365 360 1,700 Difference 60$ 55$ 45$ 300$

Comparative balance sheets will report 2007 inventory $345 million higher than it was reported in last year’s statements.

Retained earnings for 2007 will be $207 million higher.[$345 less 40% of $345]

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Previous 2006 2005 2004 Years

Cost of goods sold (LIFO) 430$ 420$ 405$ 2,000$ Cost of goods sold (FIFO) 370 365 360 1,700 Difference 60$ 55$ 45$ 300$

Retrospective Approach

Comparative balance sheets will report 2008 inventory $400 million higher than it was reported in last year’s statements.

Retained earnings for 2008 will be $240 million higher.[$400 less 40% of $400]

For each year reported, Air Parts makes the comparativestatements appear as if the newly adopted accounting

method (FIFO) had been in use all along.

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Previous 2006 2005 2004 Years

Cost of goods sold (LIFO) 430$ 420$ 405$ 2,000$ Cost of goods sold (FIFO) 370 365 360 1,700 Difference 60$ 55$ 45$ 300$

Retrospective Approach

Comparative balance sheets will report 2009inventory $460 million higher than it would havebeen if the change from LIFO had not occurred.

Retained earnings for 2009 will be $276 million higher.[$460 million less 40% of $460]

For each year reported, Air Parts makes the comparativestatements appear as if the newly adopted accounting

method (FIFO) had been in use all along.

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Retrospective Approach

On January 1, 2009, the date of the change,the following journal entry would be made

to record the change in principle:

January 1, 2009 ($ in millions)Inventory (additional inventory if FIFO had been used) 400 Retained earnings (additional NI if FIFO had been used) 240 Deferred tax liability ($400 x 40%) 160

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 6 years). In the meantime, there is temporary difference, reflected in the deferred tax liability.

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Retrospective Approach

In the first set of financial statements after thechange is made a disclosure note is needed to:

Providejustification

for the change.

Point out thatcomparative

information hasbeen revised.

Report any pershare amountsaffected for thecurrent and allprior periods.

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The prospective approach is used for accounting changes when it is:

Impracticable to determine some period- specific effects.

Impracticable to determine the cumulative effect of prior years.

Mandated by authoritative pronouncements.

Prospective Approach

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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.

Change in Depreciation Method

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Universal Semiconductors switched from SYDdepreciation to straight-line depreciation in 2009. The asset was purchased at the beginning of 2007

for $63 million, has a useful life of 5 years andan estimated residual value of $3 million.

Sum-of-the-Years-Digits Depreciaton ($ in millions)

2004 depreciation 20$ ($60 x 5/15)2005 depreciation 16 ($60 x 4/15) Accumulated depreciation 36$

Changing Depreciation Methods

n x (n+1) / 2 = 5 x (5+1) / 2 = 15

$63 - 3 = $60

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Changing Depreciation Methods

÷

SYD depreciation from previous slide

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Changing an EstimateWhen 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.

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CHANGE IN ACCOUNTING ESTIMATEUniversal Semiconductors estimates bad debt expense as

2% of credit sales. After a review during 2009, Universal determined that 3% of credit sales is a more realistic estimate of its collection experience. Credit sales in 2009 are $300 million. The effective income tax rate is 40%.

Neither bad debt expense nor the allowance for uncollectible accounts reported in prior years is restated.

No account balances are adjusted.

In 2009 and later years, the adjusting entry to record bad debt expense simply will reflect the new percentage. In 2009, the entry would be: ($ in millions)

Bad debt expense (3% x $300 million) 9Allowance for uncollectible accounts 9

The effect of a change in estimate is described in a footnote to the financial statements.

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On January 1, 2005, Towing, Inc. purchased specialized equipment for $243,000. The equipment was depreciated using straight-line and had an estimated life of 10 years and salvage value of $3,000. In 2009 the total useful life of the equipment was revised to 6 years. The 2009 depreciation expense isa. $24,000b. $48,000c. $72,000d. $73,500

Changing an Estimate

$243,000 – $3,000 = $24,000 (2005 – 2008) 10 years$24,000 × 4 years = $96,000 Accum. Depr.$243,000 – $96,000 = $147,000 Book Value$147,000 – $3,000 = $72,000 (2009 – 2010) 2 years

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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 EntityRecast all previous periods’ financial statements as if the new reporting entity existed in those periods.

A disclosure note should describe the nature ofand the reason for the change and the effect of the change on net income, income before extraordinary items, and related per share amounts for all periods presented.

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Examples include:Use of inappropriate principleMistakes in applying GAAPArithmetic mistakesFraud or gross negligence in reporting

For all years disclosed, financial statements are retrospectively restated to reflect the error correction.

Error Correction

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Four-step processPrepare a journal entry to correct any

balances.Retrospectively restate prior years’

financial statements that were incorrect.Report error as a prior period adjustment

if retained earnings is one of the incorrect accounts affected.

Include a disclosure note.

Correction of Accounting Errors

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.

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.

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Errors Occurred and Discoveredin 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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ERROR DISCOVERED IN THE SAME REPORTING PERIOD THAT IT OCCURRED

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.

G.H. Little, Inc. paid $3 million for replacement computers and recorded the expenditure as maintenance expense. The error was discovered a week later.

To reverse erroneous entry ($ in millions)

Cash 3Maintenance expense 3

To record correct entryEquipment 3

Cash 3

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ERROR AFFECTING PREVIOUS FINANCIAL STATEMENTS, BUT NOT NET INCOME

Example: Incorrectly recording salaries payable as accounts payable, recording a loss as an expense, or classifying a cash flow as an investing activity rather than a financing activity on the statement of cash flows.

MDS Transportation incorrectly recorded a $2 million note receivable as accounts receivable. The error was discovered a year later.

To correct incorrect accounts ($ in millions)

Note receivable 2Accounts receivable 2

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RECORDING AN ASSET AS AN EXPENSE

In 2009, 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 2007. 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 Incorrect

(Should Have Been Recorded) (As Recorded)2007 Equipment 7.0 Expense 7.0

Cash 7.0 Cash 7.0

2007 Expense 1.4 Depreciation entry omitted Accum. depr. 1.4

2008 Expense 1.4 Depreciation entry omitted Accum. depr. 1.4

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RECORDING AN ASSET AS AN EXPENSE(Illustration 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 $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 ($ in millions)Equipment 7.0

Accumulated depreciation 2.8Retained earnings 4.2

o The 2007 and 2008 financial statements are retrospectively restated.

o The correction is reported as a “prior period adjustment.” o A disclosure note describes the error and the impact of its

correction.

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INVENTORY MISSTATEDIn early 2009, a company discovered that $1 million of inventory had been inadvertently excluded from its 2007 ending inventory count. Analysis: U = Understated

O = Overstated 2004 2005 Beginning inventory Beginning inventory U Plus: Net purchases Plus: Net purchases Less: Ending inventory U Less: Ending inventory Cost of goods sold O Cost of goods sold U

Revenues Revenues Less: COGS O Less: Cost of goods sold U Less: Other expenses Less: Other expenses Net income U Net income O Retained earnings U Retained earnings corrected

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INVENTORY MISSTATED(continued)

If discovered in 2008 (before closing):($ in millions)

Inventory 1Retained earnings 1

If discovered in 2009 or later: No correcting entry needed

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Change in Change in Reporting

Change in Accounting Principle Estimate Entity ErrorMost Prospective

Changes ExceptionsMethod of accounting Retrospective Prospective Prospective Retrospective RetrospectiveRestate prior years? Yes No No Yes YesPro forma disclosureof income and EPS? No No No No NoCumulative effect on An adjustment to An adjustment to prior years' income earliest reported Not Not Not earliest reportedreported? retained earnings. reported. reported. reported. retained earnings.Journal entries? Adjust affected None None None Involves any

balances to new incorrect balancesmethod. as a result of the

error.Subsequent Subsequent Subsequent Consolidated

accounting is accounting is accounting is statements are affected by affected by affected by discussed in

change. change. change. other courses.Disclosure note? Yes Yes Yes Yes Yes

Summary of Accounting Changes and Errors

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End of Chapter 20