ch 20

reporting a change in principle: Prospective Approach

--APPLICATION IS IMPRACTICAL: A lack of information makes it impracticable to report a change retrospectively so the new method is simply applied prospectively --Mandated by the Standards: When authoritative literature requires prospective application for specific changes in accounting methods

reporting a change in principle: Modified Retrospective Approach

--Apply the new standard in the period of adoption --Adjust the balance of retained earnings at the beginning of the adoption period to capture the cumulative effects of prior periods (without adjusting the numbers in the prior periods reported)

Changes in reporting entity

--Change from reporting as one type of entity to another type of entity --Occurs as a result of: -Presenting consolidated financial statements in place of statements of individual companies, -Changing specific companies that constitute the group for which consolidated or combined statements are prepared, -Changes in accounting rules (requiring consolidations of certain entities), or -One company acquiring another --Reported by recasting all previous periods' financial statements as if the new reporting entity existed in those periods --A disclosure note should describe the nature of the change and the reason it occurred --entities differ on income statement

increase COGS

Net income decrease Retained earnings decrease inventory decreased

decrease in COGS

Net income increase Retained earnings increase inventory increased

prospective approach

No modification of prior years is necessary --Change is implemented in the period of the change and future periods

what is a change in accounting principle?

changes from one form of GAAP to another ex. FIFO to LIFO, revenue recognition *change in depreciation method is not a change in principle*

increase in warranty expense/ depreciation expense

decrease in Net Income

decrease in warranty expense/ depreciation expense

increase in Net Income

most voluntary changes in principle are reported...

retrospectively

Modified retrospective approach

when we adjust retained earnings you make it look like we used to new principle all along --Requires application of new standard only to the adoption period (i.e. current period) --Requires an adjustment to retained earnings in the current period to account for the cumulative effect of the change in prior periods

why might a company change their accounting principle?

--Economic Conditions - in the 70's companies changed from FIFO to LIFO due to inflation --Industry Changes - to be consistent with industry peers --Mandated by the FASB - standards require the change --Effect of change on management compensation, debt agreements, and union negotiations (managers at companies with bonus plans are more likely to select methods that maximize their bonuses) --Income smoothing investors and creditors should be alert for possible hidden motivations for the changes

changes in accounting estimate

--Revision of an estimate because of new information or new experience- Ex. change in depreciation, uncollectible accounts, etc. --Accounted for PROSPECTIVELY -Prior financials NOT revised -Incorporate the new estimate in the year of change, and future years -Disclosure note should describe the effect of a change in estimate on income from continuing operations, net income, and related per share amounts for the current period

Corrections of accounting errors

--requires a prior period adjustment--updated retained earnings

types of change in estimate

1. change in warranty expense 2. change in depreciation

Reporting Approaches

1. retrospective 2. modified retrospective 3. prospective

Error Affecting Prior Year's Net Income in 2018, it was discovered that a company had debited an expense account for $7 cost of sorting equipment purchased at the beginning of 2016. the equipment's useful life was expected to be five years with no residual value. straight line depreciation.

Both Income Statement and Balance Sheet are Affected --Both statements must be RETROSPECTIVLY restated --Retained earnings will require correction because the errors affected Net Income they did (already recorded): 2016 (dr.) expense = 7 (cr.) cash = 7 2016 closing- no entry 2017 no entry they should have (don't record): 2016 (dr.) equipment = 7 (cr.) cash = 7 2016 closing (dr.) depreciation expense = 1.4 (cr.) accumulated depreciation = 1.4 2017 (dr.) depreciation expense = 1.4 (cr.) accumulated depreciation = 1.4 STEP 1 adjusting for error (record): 2018 (dr.) equipment = 7 (cr.) retained earnings = 4.2 (cr.) accumulated depreciation = 2.8 STEP 3 (all this written out in word format not equations) 2018 is recorded for yrs 2016 and 2017 2017 is recorded for 2016: (dr.) equipment = 7 (cr.) retained earnings = 5.6 (cr.) accumulated depreciation = 1.4 2016 no adjustment necessary bc error was in 2016 STEP 4 disclosure note

Error Affecting Previous Financial Statements- Not Net Income company incorrectly recorded a $2 note receivable as accounts receivable.

Only affects Balance Sheet --Record the entry to correct the accounts --When comparative financial statements are presented, restate prior year's balance sheet and include a disclosure note --No prior period adjustment needed (bc it doesn't impact net income) Examples- recording a loss as an expense, recording salaries payable as accounts payable they did (already recorded): (dr.) accounts recievable = 2 (cr.) cash = 2 correct entry (record): (dr.) notes recievable = 2 (cr.) cash = 2 restate last yrs b/s disclosure note

Error Discovered in the Same Reporting Period that it Occurred company paid $3 for replacement computers and recorded the expenditure as maintenance expense. the error was found a week later.

reverse the erroneous entry and record the correct entry they did (already recorded): (dr.) maintenance exp = 3 (cr.) cash = 3 reverse error (don't record): (dr.) Cash = 3 (cr.) maintenance expense = 3 correct entry (record): (dr.) equipment = 3 (cr.) cash = 3

reporting a change in principle: retrospective approach steps

1. revise comparative financial statements (I/S and B/S) 2. Adjust accounting records for the change (journal entry) 3. disclosure notes: --Any accounting change must be justified as more appropriate --Disclosure is required in the first set of financials after the change -Should note comparative information has been revised or the retrospective revision has not been made because it is impractical -Report per share amounts affected for the current period and all prior periods presented

Error Affecting Prior Year's Net Income in 2018, a company discovered that $3 of merchandise (credit) sales the last week of 2017 were not recorded until the first week of 2018. the merchandise sold was appropriately excluded from 2017 ending inventory.

Both Income Statement and Balance Sheet are Affected --Both statements must be RETROSPECTIVLY restated --Retained earnings will require correction because the errors affected Net Income they did (already recorded): 2017- no entry 2018- (dr.) accounts receivable = 3 (cr.) sales revenue = 3 they should have (don't record): 2017 (dr.) accounts receivable = 3 (cr.) sales revenue = 3 2018- no entry adjusting for error/ correcting (record): 2018 (dr.) sales revenue = 3 (cr.) retained earnings = 3

retrospective approach

update old records --When presenting multiple years of financial statements, financial statements issued prior to the change are adjusted to reflect the change --Retained earnings is adjusted for the earliest period reported It is made to look like the newly adopted method had been applied all along of that the error never occurred --Advantage- All statements presented are on the same basis --Disadvantage- When previously reported numbers are superseded, public confidence in the integrity of the financial data suffers

change in depreciation a. whats the journal entry b. what effect would the change have on Net Income, after tax?

~change in estimate~ A. 1. cost of equipment - residual value= depreciation base 2. depreciation base- depreciation taken(add the depr. under the old method)= remaining depreciation base 3. remaining depreciation base /(divided by) remaining life= depreciation expense 4. Journal entry - (dr.) depreciation expense -------- (cr.) accumulated depreciation B. old depr. exps. = 12 new depr. exps. = 8 difference = 4 4*.4(tax)= 1.2 4-1.2= 2.8 Net Income increases by by 2.8

change in warranty expense ex. old warranty expense 2% of sales, and new one is 3%. total sales are $300. tax rate is 40% a. what is the journal entry b. what effect would the change have on net income, after tax?

~change in estimate~ warranty expense= if company gives warranties they have to estimate how much they have to pay when people use their warranties A. journal entry for new warranty expense: -(dr.) warranty expense (.03*300)= 9 ---- (cr.) warranty liability= 9 B. -old warranty expense= 6 -new warranty expense= 9 -difference=3 (this info does not go on the books) - 3*.4= 1.2 - 3- 1.2= 1.8 -after tax effect of the change in estimate is 1.8 decrease in net income