Chap 20 Accounting Changes and Error Corrections

4 steps to correcting an error

1) A journal entry is made to correct any account balances that are incorrect as a result of the error 2) Previous years' financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction (for all years reported for comparative purposes) 3) If retained earnings is one of the accounts incorrect as a result of the error, the correction is reported as a prior period adjustment to the beginning balance in a statement of shareholder's equity (or statement of retained earnings if that's presented instead) 4) A disclosure note should describe the nature of the error and the impact of its correction on net income

Tax payers are given up to how many years to pay back taxes when switching from LIFO to FIFO

6 years

Change in depreciation is considered a change in

Accounting estimate and considered a change in principle We change it prospectively

Prior period adjustments refers to an

Addition or reduction in the beginning retained earnings balance in a statement of shareholders' equity (or statement of retained earnings)

Step 2 Retrospective revision

Adjust accounts for change Must adjust book balances of their affected accounts Journal entry to record the change in principle

Change in accounting principle

Although this disrupts consistency and comparability since they are desirable, however changing to new method is sometimes appropriate or mandated by FASB

Uncommon instance when a error doesn't correct itself

An expense account is debited for the cost of land, this will never reverse out since land is not depreciated

When it's not possible to distinguish between a change in principle and a change in estimate, the change should be treated as a change in

Estimate

Is a change in depreciation method a change in accounting principle or change in estimate?

Even though its considered to reflect a change in estimate and is accounted for as such, a change to a new depreciation method requires the company to justify the new method as being preferable to the previous method just as any other change in principle

Retrospective approach

Financial statements issued in previous years are revised to reflect the impact of the change whenever those statements are presented again for comparative purposes (Achieves comparability)

Retained earnings Retrospective revision

How does this affect retained earnings

The prospective approach: When mandated by authoritative pronouncements

If an authoritative pronouncement specifically requires prospective accounting that requirement is followed

When is impracticable to determine effects of prior years

If full retrospective application isn't possible, the new method is applied prospectively beginning in the earliest year practicable

Prior period adjustment

Refers to an addition to or a reduction in the beginning retained earnings balance in a statement of shareholder's equity

Prospective approach

Requires neither a modification of prior year's financial statements nor a journal entry to adjust account balances

2 Approaches to reporting accounting changes and error corrections are

Retrospective approach and Prospective approach

Report most voluntary changes in accounting principle

Retrospectively (all previous reporting periods as if the new method had been used in prior periods)

Step 1 of Retrospective approach

Revise comparative financial statements

Change in accounting estimate

Revisions are viewed as a natural consequence of making estimate Change in estimates is reflected in financial statements of current period and future periods Disclosure note should describe the effect of a change in estimate or income before net income and related per share amounts for current period

When is Retrospective application Impracticable

Sometimes a lack of information makes it impracticable to report a change retrospectively so the new method is simply applied prospectively

Balance Sheet Retrospective revision

Where any balance sheet accounts affected

A correction of an error is accounted for

retrospectively

Examples of accounting estimates

Anticipating uncollectible accounts, predicting warranty expenses, amortizing intangible assets, making accrual assumptions

If an accounting error was made and discovered in same accounting period, original erroneous entry should simply

Be reversed

Prospective (What type of changes and when)

Changes in estimate including changes in depreciation method, changes in accounting principle when retrospective application is impractical, and changes in accounting principle when prospective application is mandated. Occur in current year into future years

2 qualitative characteristics of accounting information that contribute to relevance and faithful representation are

Consistency and comparability

FIFO usually produces lower ______________ and thus higher______________ the LIFO does

Cost of Goods sold, Inventory

Step 3 Retrospective revision

Disclosure note Justification for change Point out the revision has been made retrospective or if not because it was impractacticable EPS restated

Income statement Retrospective revision

Earnings per share each year will have to be based on the revised net income

Prospective approach: When it is impracticable to determine some period-specific event

If it is impracticable to adjust each year reported, the change is applied retrospectively as of the earliest year practicable

Statement of shareholders' equity

If retained earnings requires adjustment due to change in accounting principles (usually is), we must adjust the beginning balance of retained earnings for earliest period reported in comparative Statements of shareholders' equity

Cumulative income effect ________________ each year by the annual after-tax difference in _______________

Increases, Cost of Goods sold

Any account balances that are incorrect as a result of the error are corrected by a

Journal entry

What should be included in the disclosure note for change in estimate

Justification, point out comparative information that has been revised, retrospective revision has not been made because its impracticable, report any share amounts affected by current period and all prior periods presented

Retrospective (What type of changes and when)

Most changes in accounting principle, Changes in reporting entity and Correction of errors. Changes made in previous years to current year

Retrospective approach 3

Offers consistency and comparability among the financial statements - all of the financials are presented on the same basis

A change in reporting entity occurs as a result of

Presenting consolidated financial statements of individual companies or changing specific companies that constitute the group for which consolidated or combined statements are prepared

If retained earnings is one of the incorrect accounts, then the correction is reported as a

Prior period adjustment to adjust beginning balance of statement of shareholder's equity

Prospective approach 3

The effects of a change are reflected in the financial statement of only the current and future years under this approach