Accounting Changes and Errors

ACCOUNTING CHANGES AND ERROR ANALYSIS
Learning Objectives
Accounting Changes and Error Analysis
Accounting Changes
Changes in accounting principle Changes in accounting estimate Reporting in reporting entity Correction of errors Summary Motivations for change of method
Error Analysis
Balance sheet errors Income statement errors Balance sheet and income statement effects Comprehensive example Preparation of statements with error corrections
Accounting Changes
Accounting Alternatives:
1) Diminish the comparability of financial information.
2) Obscure useful historical trend data.
Types of Accounting Changes:

Change in Accounting Principle. Changes in Accounting Estimate.
Change in Reporting Entity.
Errors are not considered an accounting change.

LO 1 Identify the types of accounting changes.
Changes in Accounting Principle

A change from one generally accepted accounting principle to another. Examples include: Average cost to LIFO.
Completed-contract to percentage-of-completion.
Adoption of a new principle in recognition of events that have occurred for the first time or that were previously immaterial is not an accounting change.
LO 2 Describe the accounting for changes in accounting principles.

Three approaches for reporting changes:
1) Currently.
2) Retrospectively.
3) Prospectively (in the future).
FASB requires use of the retrospective approach.

Rationale - Users can then better compare results from one period to the next.
LO 2 Describe the accounting for changes in accounting principles.

Retrospective Accounting Change Approach
Company reporting the change
1) adjusts its financial statements for each prior period
presented to the same basis as the new accounting

principle.
2) adjusts the carrying amounts of assets and liabilities as
of the beginning of the first year presented, plus the

opening balance of retained earnings.
LO 3 Understand how to account for retrospective accounting changes.

Retrospective Accounting Change: Long-Term Contracts
Illustration: Denson Company has accounted for its income from long-term construction contracts using the completedcontract method. In 2010 the company changed to the percentage-of-completion method. Management believes this approach provides a more appropriate measure of the income earned. For tax purposes, the company uses the completed-
contract method and plans to continue doing so in the future.

(We assume a 40 percent enacted tax rate.)

Income statements for 20082010
Illustration 22-1
LO 3

Data for Retrospective Change Example
Illustration 22-2
Journal entry to record change at beginning of 2010:
Construction in Process
Deferred Tax Liability Retained Earnings
220,000
88,000 132,000

Reporting a Change in Principle
Major disclosure requirements are as follows. 1. Nature and reason for the change in accounting principle. a. A description of the prior-period information that has been retrospectively adjusted, if any. 2. The method of applying the change, and:
b. The effect of the change on income from continuing operations, net income, any other affected line items.
c.
The cumulative effect of the change on retained earnings or other components of equity or net assets as of the beginning of the earliest period presented.

Reporting a Change in Principle
Illustration 22-3

Retained Earnings Adjustment
Assuming a retained earnings balance of $1,360,000 at the beginning of 2008.
Illustration 22-4
Before Change

Retained Earnings Adjustment
Illustration 22-5
After Change

E22-1 (Change in PrincipleLong-Term Contracts):
Cherokee Construction Company changed from the

completed-contract to the percentage-of-completion method of accounting for long-term construction contracts during
2010. For tax purposes, the company employs the

completed-contract method and will continue this approach in the future. (Hint: Adjust all tax consequences through the Deferred Tax Liability account.) The appropriate information related to this change is as follows.

E22-1 (Change in PrincipleLong-Term Contracts):
Instructions: (assume a tax rate of 35%)
(b) What entry(ies) are necessary to adjust the accounting records

for the change in accounting principle? (a) What is the amount of net income and retained earnings that
would be reported in 2010? Assume beginning retained earnings for

2009 to be $100,000.

Example: Pre-Tax Income from Long-Term Contracts
PercentageDate of-Completion 2009 2010 $ 780,000 700,000 Completed Contract $ 610,000 480,000 35% Tax Effect 59,500 77,000 Net of Tax $ 110,500 143,000
Difference 170,000 220,000
Journal entry 2010 Construction in progress Deferred tax liability Retained earnings 170,000 59,500 110,500

Example: Comparative Statements
2010
Income Statement
Restated 2009 $ 780,000 273,000 $ 507,000 $ 100,000 110,500
Pre-tax income Income tax (35%) Net income
$ 700,000 245,000 $ 455,000
Statement of Retained Earnings
Beg. Retained earnings Accounting change Beg. R/Es restated Net income End. Retained earnings $ 717,500 455,000 $ 1,172,500
210,500 507,000 $ 717,500

Direct and Indirect Effects of Changes
Direct Effects - The FASB takes the position that
companies should retrospectively apply the direct

effects of a change in accounting principle. Indirect Effects do not change prior-period amounts.

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.
LO 4 Understand how to account for impracticable changes.
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.
LO 5 Describe the accounting for changes in estimates.

Prospective Reporting
Companies report prospectively changes in accounting estimates. They account for changes in estimates in 1. the period of change if the change affects that period only, or 2. the period of change and future periods if the change affects both.
The FASB views changes in estimates as normal recurring corrections and adjustments and prohibits retrospective treatment.
Change in Estimate Example

Illustration: Arcadia High School (Phoenix), 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 2008 (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 prior years depreciation expense? Calculate depreciation expense for 2008.
No Entry Required

Equipment cost Salvage value Depreciable base Useful life (original) Annual depreciation
After 7 years
$510,000 First, establish - 10,000 NBV at date of change in estimate. 500,000 10 years $ 50,000 x 7 years = $350,000
Balance Sheet (Dec. 31, 2007) Fixed Assets: Equipment Accumulated depreciation Net book value (NBV) $510,000 350,000 $160,000

Net book value Salvage value (if any) Depreciable base Useful life Annual depreciation $160,000 5,000 155,000 8 years $ 19,375
Second, calculate depreciation expense for 2008.
Journal entry for 2008
Depreciation expense
Accumulated depreciation
Solution on notes page
19,375
19,375

Disclosures
Companies need not disclose changes in accounting
estimate made as part of normal operations, such as bad debt allowances or inventory obsolescence, unless such
changes are material.

However, for a change in estimate that affects several periods (such as a change in the service lives of depreciable assets), companies should disclose the effect on income from continuing operations and related pershare amounts of the current period.
Change in Reporting 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.
LO 6 Identify changes in a reporting entity.
Correction of Errors
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.
LO 7 Describe the accounting for correction of errors.
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.
Illustration: In 2011 the bookkeeper for Selectro Company
discovered an error:
In 2010 the company failed to record $20,000 of depreciation expense on a newly constructed building. This
building is the only depreciable asset Selectro owns. The

company correctly included the depreciation expense in its tax return and correctly reported its income taxes payable.
Illustration: Selectros income statement for 2010 with
and without the error.

Illustration 22-19
Show the entries that Selectro should have made and did make for recording depreciation expense and income taxes.
Illustration: Show the entries that Selectro should have
made and did make for recording depreciation expense and

income taxes.
Illustration 22-20
Correcting Entry in 2011


income taxes.
Illustration 22-20
Retained Earnings
12,000

income taxes.
Illustration 22-20
Retained Earnings Deferred Tax Liability
12,000 8,000
Reversal

income taxes.
Illustration 22-20
Retained Earnings Deferred Tax Liability
12,000 8,000
Record 20,000
Accumulated DepreciationBuildings
Illustration (Single-Period Statement): Assume that
Selectro Company has a beginning retained earnings balance

at January 1, 2011, of $350,000. The company reports net income of $400,000 in 2011.
Illustration 22-21
Comparative Statements
A company should
1. make adjustments to correct the amounts for all affected accounts reported in the statements for all periods reported. 2. restate the data to the correct basis for each year
presented.
3. show any catch-up adjustment as a prior period adjustment to retained earnings for the earliest period it
reported.
Woods, Inc. Statement of Retained Earnings For the Year Ended December 31, 2010 Balance, January 1 Net income Dividends Balance, December 31 $ 1,050,000 360,000 (300,000) 1,110,000
Before issuing the report for the year ended December 31, 2010, you discover a $62,500 error that caused the 2009 inventory to be overstated (overstated inventory caused COGS to be lower and thus net income to be higher in 2009). Would this discovery have any impact on the reporting of the Statement of Retained Earnings for 2010? Assume a 20% tax rate.
Woods, Inc. Statement of Retained Earnings For the Year Ended December 31, 2010 Balance, January 1, as previously reported Prior period adjustment, net of tax Balance, January 1, as restated Net income Dividends Balance, December 31 $ 1,050,000 (50,000) 1,000,000 360,000 (300,000) 1,060,000
Summary of Accounting Changes and Errors

Illustration 22-23
Summary of Accounting Changes and Errors

Illustration 22-23
Motivations for Change of Accounting Method

Why companies may prefer certain accounting methods. Some reasons are:
1. Political costs. 2. Capital Structure. 3. Bonus Payments.
4. Smooth Earnings.
LO 8 Identify economic motives for changing accounting methods.
Error Analysis
Companies must answer three questions:
1. What type of error is involved?
2. What entries are needed to correct for the error? 3. After discovery of the error, how are financial
statements to be restated? Companies treat errors as prior-period adjustments
and report them in the current year as adjustments to

the beginning balance of Retained Earnings.
LO 9 Analyze the effect of errors.
Balance Sheet Errors

Balance sheet errors affect only the presentation of an asset, liability, or stockholders equity account.
When the error is discovered in the error year, the company reclassifies the item to its proper position.
If the error is discovered in a prior year, the company should restate the balance sheet of the prior year for comparative purposes.
Income Statement Errors

Improper classification of revenues or expenses. A company must make a reclassification entry when it discovers the error in the error year. If the error is discovered in a prior year, the company should restate the income statement of the prior year for comparative purposes.
Balance Sheet and Income Statement Errors

Errors affecting both balance sheet and income statement. This type of error classified as: 1. Counterbalancing errors 2. Noncounterbalancing errors

Counterbalancing Errors
Will be offset or corrected over two periods. If company has closed the books:
a. If the error is already counterbalanced, no entry is necessary.
b. If the error is not yet counterbalanced, make entry to adjust the present balance of retained earnings. For comparative purposes, restatement is necessary even if a correcting journal entry is not required.

Counterbalancing Errors
Will be offset or corrected over two periods. If company has not closed the books:
a. If error already counterbalanced, make entry to correct the error in the current period and to adjust the beginning balance of Retained Earnings. b. If error not yet counterbalanced, make entry to adjust the beginning balance of Retained Earnings.

Noncounterbalancing Errors
Not offset in the next accounting period. Companies must make correcting entries, even if they have closed the books.
Error Analysis Example

E22-19 (Error Analysis; Correcting Entries): A partial trial balance of Dickinson Corporation is as follows on December 31, 2010.
Dr. Cr. Supplies on hand Accured salaries and wages Interest receivable Prepaid insurance Unearned rent Accured interest payable 5,100 90,000 0 15,000 $ 2,500 $ 1,500
Instructions (a) Assuming that the books have not been closed, what are the adjusting entries necessary at December 31, 2010?

(a) Assuming that the books have not been closed, what are the adjusting entries necessary at December 31, 2010?
1.
A physical count of supplies on hand on December 31, 2010, totaled $1,100.

Supplies expense Supplies on hand 1,400 1,400
2.
Accrued salaries and wages on December 31, 2010, amounted to $4,400.

Salaries and wages expense Accured salaries and wages
2,900 2,900

3.
Accrued interest on investments amounts to $4,350 on December 31, 2010.

Interest revenue Interest receivable 750 750
4.
The unexpired portions of the insurance policies totaled $65,000 as of December 31, 2010.
Insurance expense Prepaid insurance
25,000 25,000

5.
$24,000 was received on January 1, 2010 for the rent of a building for both 2010 and 2011. The entire amount was credited to rental income.
Rental income Unearned rent 12,000 12,000
6.
Depreciation for the year was erroneously recorded as $5,000 rather than the correct figure of $50,000.
Depreciation expense Accumulated depreciation
45,000 45,000

E22-19 (Error Analysis; Correcting Entries) A partial trial balance of Dickinson Corporation is as follows on December 31, 2010.
Dr. Cr. Supplies on hand Accured salaries and wages Interest receivable Prepaid insurance Unearned rent Accured interest payable 5,100 90,000 0 15,000 $ 2,500 $ 1,500
Instructions (b) Assuming that the books have been closed, what are the adjusting entries necessary at December 31, 2010?

(b) Assuming that the books have been closed, what are the adjusting entries necessary at December 31, 2010?
1.
A physical count of supplies on hand on December 31, 2010, totaled $1,100.

Retained earnings Supplies on hand 1,400 1,400
2.
Accrued salaries and wages on December 31, 2010, amounted to $4,400.

Retained earnings Accured salaries and wages
2,900 2,900

3.
Accrued interest on investments amounts to $4,350 on December 31, 2010.

Retained earnings Interest receivable 750 750
4.
The unexpired portions of the insurance policies totaled $65,000 as of December 31, 2010.
Retained earnings Prepaid insurance
25,000 25,000

5.
$24,000 was received on January 1, 2010 for the rent of a building for both 2010 and 2011. The entire amount was credited to rental income.
Retained earnings Unearned rent 12,000 12,000
6.
Depreciation for the year was erroneously recorded as $5,000 rather than the correct figure of $50,000.
Retained earnings Accumulated depreciation
45,000 45,000
One area in which iGAAP and U.S. GAAP differ is the reporting of error corrections in previously issued financial statements. While both GAAPs require restatement, U.S. GAAP is an absolute standardthat is, there is no exception to this rule.
The accounting for changes in estimates is similar between U.S. GAAP and iGAAP.
Under U.S. GAAP and iGAAP, if determining the effect of a change in accounting principle is considered impracticable, then a company should report the effect of the change in the period in which it believes it practicable to do so, which may be the current period.
Under iGAAP, the impracticality exception applies both to changes in accounting principles and to the correction of errors. Under U.S. GAAP, this exception applies only to changes in accounting principle. IAS 8 does not specifically address the accounting and reporting for indirect effects of changes in accounting principles. As indicated in the chapter, U.S. GAAP has detailed guidance on the accounting and reporting of indirect effects.

Accounting Changes and Errors

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ACCOUNTING CHANGES AND ERROR ANALYSIS

Accounting Changes and Error Analysis

Types of Accounting Changes:

Change in Reporting Entity.

Errors are not considered an accounting change.

Changes in Accounting Principle

LO 2 Describe the accounting for changes in accounting principles.

Changes in Accounting Principle

3) Prospectively (in the future).

FASB requires use of the retrospective approach.

Changes in Accounting Principle

presented to the same basis as the new accounting

of the beginning of the first year presented, plus the

LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle

contract method and plans to continue doing so in the future.

LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle

Changes in Accounting Principle

Journal entry to record change at beginning of 2010:

LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle

LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle

LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle

LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle

LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle

Cherokee Construction Company changed from the

2010. For tax purposes, the company employs the

LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle

Instructions: (assume a tax rate of 35%)

(b) What entry(ies) are necessary to adjust the accounting records

would be reported in 2010? Assume beginning retained earnings for

Changes in Accounting Principle

Difference 170,000 220,000

LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle

Restated 2009 $ 780,000 273,000 $ 507,000 $ 100,000 110,500

Pre-tax income Income tax (35%) Net income

$ 700,000 245,000 $ 455,000

Statement of Retained Earnings

210,500 507,000 $ 717,500

LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle

companies should retrospectively apply the direct

LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle

2. Retrospective application requires assumptions about managements intent in a prior period.

Changes in Accounting Estimate

4. Periods benefited by deferred costs.

LO 5 Describe the accounting for changes in estimates.

Changes in Accounting Estimate

Change in Estimate Example

LO 5 Describe the accounting for changes in estimates.

Change in Estimate Example

LO 5 Describe the accounting for changes in estimates.

Change in Estimate Example

Journal entry for 2008