End of Chapter 20
Chapter 20: Accounting changes and Error Corrections.
In this chapter we examine the way accounting changes and error
corrections are handled in a variety of situations that might be
encountered in practice. We see that most changes in accounting
principle are reported retrospectively. Changes in estimates are
accounted for prospectively. A change in depreciation methods is
considered a change in estimate resulting from a change in
principle. Both changes in reporting entities and the correction of
errors are reported retrospectively.The three types of accounting
changes are a change in accounting principle, a change in
accounting estimate, and a change in reporting entity. A change in
accounting principle involves changing from one generally accepted
accounting principle to another generally accepted accounting
principle. A change in accounting estimate occurs when new
information becomes available that allows a new and better
estimate. A change in reporting entity is a change from reporting
as one type of entity to another type of entity. The correction of
an error is another adjustment sometimes made to financial
statements that is not actually an accounting change but is
accounted for similarly. Errors occur when transactions are either
recorded incorrectly or not recorded at all as shown in the table
on this screen.The correction of an error is necessary when a
transaction is recorded incorrectly or not recorded at all. An
error correction is not actually an accounting change, but it is
accounted for in a similar fashion.We use two approaches to
reporting accounting changes and error corrections, depending on
the situation. The retrospective approach involves the revision of
prior years financial statements, while the prospective approach
affects the financial statements in the current and future years
only.Using the retrospective approach, we restate prior years
statements that are presented for comparative purposes to reflect
the impact of the change. We adjust the balance in each account
affected to appear as if the newly adopted accounting method had
been applied all along or that the error had never occurred. If
retained earnings is one of the accounts whose balance must be
adjusted, we adjust beginning balance of retained earnings for the
earliest period reported in the comparative statements.Using the
prospective approach, we implement the change in the current period
and its effects are reflected in the financial statements of the
current and future years only. Prior years statements and account
balances are not revised.
Two of the qualitative characteristics of accounting information
are consistency and comparability. While accountants make every
effort to achieve these financial reporting attributes, they cannot
ignore the normal changes that continually occur in a dynamic
business environment. The accounting professions response to these
changes often involves the development of new or modified reporting
standards that are more appropriate for the changed
environment.Accounting changes are made by management for a variety
of reasons including: Changing business environment. Effect on
compensation, such as bonuses and stock options. Effect on debt
agreements. Effect on union negotiations. Issuance of new
accounting standards. Effect on income taxes.Management must
justify the change. Hopefully, changes are made in the best
interest of fair and consistent financial reporting, but that may
not always be the case.Lets look at an example of a change from the
last-in, first-out inventory costing method to the first-in,
first-out method. This accounting change is reported using the
retrospective approach.At the beginning of 2011, Air Parts
Corporation changed from last-in, first-out to first-in, first-out.
Air Parts has paid dividends of $40,000,000 each year since 2004.
Its income tax rate is forty percent. Retained earnings on January
1, 2009, was $700,000,000; inventory was $500,000,000.Selected
income statement amounts for 2011 and prior years can be seen in
the table on your screen. All amounts in the table are shown in
millions of dollars.For each year reported, Air Parts makes the
comparative statements appear as if the newly adopted accounting
method (first-in, first out) had been in use all along.Net income
using the first-in, first-out inventory method for years 2011,
2010, and 2009 is $210,000,000; $195,000,000; and $186,000,000
respectively.
The cost of goods sold difference for all years before 2009 is a
cumulative $300,000,000 lower using the first-in, first-out
inventory method. Cost of goods sold for the year 2009 is
$45,000,000 lower using the first-in, first-out method. As a
result, comparative balance sheets will report 2009 year-end
inventory $345,000,000 higher than it was reported in the 2009
balance sheet prepared using the last-in, first-out method.Retained
earnings for 2009 will be $207,000,000 higher, as a result of
multiplying $345,000,000 times one minus the forty percent tax
rate. Cost of goods sold for the year 2010 is $55,000,000 lower
using the first-in, first-out method. As a result, comparative
balance sheets will report 2010 year-end inventory $400,000,000
higher than it was reported in the 2010 balance sheet prepared
using the last-in, first-out method.Retained earnings for 2010 will
be $240,000,000 higher, as a result of multiplying $400,000,000
times one minus the forty percent tax rate.Cost of goods sold for
the year 2011 is $60,000,000 lower using the first-in, first-out
method. As a result, comparative balance sheets will report 2011
year-end inventory $460,000,000 higher than it would have been
reported if the change to first-in, first out had not been
made.Retained earnings for 2011 will be $276,000,000 higher, as a
result of multiplying $460,000,000 times one minus the forty
percent tax rate.
Air Parts will report retained earnings using FIFO each year as
well. Retained earnings is different because the two inventory
methods affect income differently. Because cost of goods sold using
FIFO is less than cost of goods sold using LIFO, income and
therefore retained earnings using FIFO are greater than income and
retained earnings using LIFO.
On January 1, 2011, the date of the change, we make a journal
entry adjusting the accounts for the effect of the change. We
increase inventory by $400,000,000, increase retained earnings by
$240,000,000, and increase income tax payable by $160,000,000.
Notice that the income tax effect increases income tax payable.
An accounting method used for tax purposes cannot be changed
retrospectively for prior years. 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 six years). As a result, this liability has both current
(portion payable within one year) and noncurrent (payable after one
year).In the first set of financial statements after the change is
made, a disclosure note is needed to: Provide justification for the
change. Point out that comparative information has been revised.
Report any per share amounts affected for the current and all prior
periods presented.
The prospective approach is used instead of the retrospective
approach when it is: Impracticable to determine some
period-specific effects. Impracticable to determine the cumulative
effect of prior years. Mandated by Financial Accounting Standards
Board or other authoritative pronouncements.
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.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, the same way that we account for a
change in accounting estimate.
Part I.Changes in accounting estimates are also accounted for
prospectively. Lets look at an example of a change in a
depreciation estimate.
Lets examine the accounting for a change in accounting estimate
with a multiple choice question.On January 1, 2007, Towing, Inc.
purchased specialized equipment for $243,000. The equipment was
depreciated using the straight-line method and had an estimated
life of ten years and salvage value of $3,000. In 2011 the total
useful life of the equipment was revised to six years. How much is
the depreciation expense for 2011 using the revised estimated
useful life?
Part II.The depreciation expense for each of the first four
years is $24,000 ($243,000 minus $3,000, divided by the original
estimated useful life of ten years). The accumulated depreciation
for the first four years is $96,000, computed by multiplying the
$24,000 of depreciation each year times four years. The
undepreciated cost (book value) of the equipment on January 1, 2011
is $147,000, computed by subtracting $96,000 of accumulated
depreciation from the $243,000 cost.To calculate the amount of
straight-line depreciation for each of the remaining two years of
the equipments life, we divide the $147,000 book value of the
equipment, less the $3,000 by two years. The resulting
straight-line depreciation is $72,000 per year for 2011 and
2012.Note that the prospective approach used for this change in
estimate affected only 2011, the year of the change, and 2012.
There was no restatement of depreciation for the prior years.I
think you would agree that accounting changes involve a good deal
of additional work. They should only be made in the best interest
of fair and consistent financial reporting.
Lets consider an example of a change in depreciation
method.Universal Semiconductors switched from
sum-of-the-years-digits depreciation to straight-line depreciation
in 2011. The change affects precision equipment purchased at the
beginning of 2009 for $63,000,000. The equipment has an expected
useful life of five years and an estimated residual value of
$3,000,000.Sum-of-the-years-digits depreciation for 2009 was
$20,000,000, and $16,000,000 for 2010, resulting in a total of
$36,000,000 of accumulated depreciation.
The undepreciated cost (book value) of the equipment on January
1, 2011, the date of the change, is $27,000,000, computed by
subtracting $36,000,000 of accumulated depreciation from the
$63,000,000 cost of the equipment.To calculate the amount of
straight-line depreciation for each of the remaining three years of
the equipments life, we divide the $27,000,000 book value of the
equipment, less the $3,000,000 estimated residual value, by three
years. The resulting straight-line depreciation is $8,000,000 per
year.
For each of the remaining three years of the equipments life
(2011, 2012, 2015), the adjusting entry for depreciation is the
same. We debit depreciation expense and credit accumulated
depreciation for $8,000,000.Note that the prospective approach used
for this accounting change affected only 2011, the year of the
change, and 2012 and 2013. There was no restatement of prior years
depreciation for 2009 and 2010.A reporting entity can be a single
company or a group of companies that reports a single set of
consolidated financial statements. 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.
A change in reporting entity requires that financial statements
of prior periods be retrospectively revised to report the financial
information for the new reporting entity in all periods presented.
All previous periods financial statements that are presented are
recasted 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.These two disclosures are not necessary in
subsequent financial statements.
Accounting errors can occur for any of the following reasons:
Use of an inappropriate accounting principle Mistakes in applying
generally accepted accounting principles Arithmetic mistakes Fraud
or gross negligence in reportingAn error correction may involve the
restatement of prior years account balances. If so, financial
statements for all years presented for comparative purposes are
retrospectively restated to reflect the effects of the error
correction.The correction of accounting errors involves four steps:
Prepare a journal entry to correct any balances that are incorrect
as a result of the error. Retrospectively restate all prior years
financial statements that were incorrect and presented for
comparative purposes. Report the correction as a prior period
adjustment if retained earnings is one of the incorrect accounts
affected. Include a disclosure note describing the nature of the
error and the impact of its correction on net income.A prior period
adjustment is required for: Counterbalancing errors discovered in
the second year. Noncounterbalancing errors discovered in any year
after the year of the error.Remember that we use the retrospective
approach for error corrections.
If an error is discovered in the same year that it was made, we
can correct it by reversing the incorrect entry and then recording
the correct entry, or by making a correcting entry to adjust the
incorrect account balances to the correct amounts. If an error is
discovered that does not affect the income of prior years, a prior
period adjustment to retained earnings is not necessary since
income for prior years and retained earnings are correct.We still
use the retrospective approach to correct the incorrect account
balances and restate all financial statements that are presented
for comparative purposes. A disclosure note is included to describe
the nature of the error.The correction of errors affecting the
income of prior years requires the retrospective approach: All
incorrect account balances are corrected. A prior period adjustment
to retained earnings is necessary since the income of prior periods
is incorrect. All financial statements presented for comparative
purposes are restated. A disclosure note is included to describe
the nature of the error.
Consider this example of an error affecting a prior years
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 thirty
percent tax rate and prepares current period statements only.The
journal entry made in 2010 to record income taxes included a debit
to income tax expense for $82,500, a credit to deferred tax
liability for $15,000, and a credit to income tax payable for
$67,500.The depreciation expense error affected the following
accounts in 2010: depreciation expense is understated by $50,000.
accumulated depreciation is understated by $50,000. net income is
overstated by $35,000 ($50,000 times one minus the thirty percent
tax rate). income tax expense is overstated by $15,000 ($50,000
times the thirty percent tax rate). deferred tax liability is
overstated by $15,000.The entry to correct the error reduces
retained earnings by $35,000, reduces deferred tax liability by
$15,000, and increases accumulated depreciation by $50,000.The
entry to correct the error does not include income tax expense and
depreciation expense because those accounts were closed at the end
of 2010. The statement of retained earnings reports a prior period
adjustment for $35,000 ($50,000 less the $15,000 tax effect).Part
I.Identify the type of accounting error for the following item:
Ending inventory was incorrectly counted.
Part II.If ending inventory is incorrectly counted, 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. For example, if
the error overstates ending inventory in the current period, cost
of goods sold will be understated and income will be overstated in
the current period. The error will result in an overstatement of
beginning in the next period, which will cause an overstatement of
cost of goods sold and an understatement of income in that period.
Since the income is overstated in the current period and
understated in the next period, this is called a counterbalancing
error. At the end of the two periods, if no other errors are made,
the balances in inventory and retained earnings are correct.
Part I.Identify the type of accounting error for the following
item: Loss on sale of furniture was incorrectly recorded as
depreciation expense.
Part II.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.
Part I.Identify the type of accounting error for the following
item: Depreciation expense was understated.
Part II.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 periods income is
affected.
The table on this screen summarizes the accounting and reporting
for accounting changes and error corrections. The highly summarized
information presented here should provide you with a quick
reference and a very useful study guide for the material in this
chapter.U.S. GAAP and International standards are largely converged
regarding accounting changes and error corrections, but one
difference concerns error corrections. 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 its
not considered practicable to report it retrospectively as is
required by U.S. GAAP.End of chapter 20.