Chapter 20 Accounting Changes and Error Corrections

Steps to correct 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 tat were incorrect as a result of the error are retrospectively restated to reflect the correction (for all years reported for comprative purposes). 3. If retained earnings is one of the accounts incorrect as a result of the error, the correction is reported as aprior period adjustment to the beginning balance in a statement of shareholders' 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. A statement of retained earnings the events that cause changes in retained earnings. The incorrect balance as previously reported is corrected by the prior period adjustment.

Change in Reporting Equity

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.

Prior Period Adjustments

A prior period adjustment refers to an addition to or reduction in the beginning retained earnings balance in a statement of shareholders' equity.

Change in Accounting Principle

Change from one generally accepted accounted principle to another. EX: adopt a new accounting standard codification; change methods of inventory costing; change from cost method to equity mehtod; change from completed contact to percentage of completiong

Correction of Errors

Correction of an error caused by a transaction being recorded incorrectly or not at all. EX: 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

Change in Accounting estimate

Revision of an estimate because of new information or new experience. EX: Change depreciation methods; change estimate of useful life of depreciable asset; change estimate of residual value of depreciable asset; change estimate of periods benefited by intangible asset; change actuarial estimates pertaining to a pension plan.

Error Correction

The correction of an error is not actually an accounting change but is accounted for similarly. It's accounted for retrospectively like a change in reporting entity and like most changes in accounting principle.

Change in reporting entity

Change from reporting as one type of entity to another type of entity. EX: consolidate a subsidiary not previously included in consolidated financial statements; report consolidated financial statements in place of individual statements.

Prospective Approach

The prospective approach requires neither a modification of prior years' financial statemetns nor a journal entry to adjust account balances. Instead, the change is simply implements now, and its effects are reflected in the financial statements of the current and future years only.

Change in Accounting Principle; The prospective approach

Although we ususally report voluntary changes in accounting principles retrospectively, its not always practical or applicable to do so. Sometimes a lack of information makes it impracticable to report a change retrospectively so the new method is applied prospectively. If its impractiable to adjust each year reported, the change is applied retrospectively as of the earliest year practiable. IF full retrospective application isn't possible, the new method is applied prospectively beginning in the earliest year practicable. When mandated by authoritative accounting literature; if a new accounting standards update specifically requires prospective accounting, that requirement is followed. A change in depreciation methods is considered to be a change in accounting estimate that is achieved by a change in accounting principle. We account for such a change prospectively.

Change in Accounting estimate

Changes in accounting estimates are accounted for prospectively. A change in estimate i reflected in the financial statements of the current period and future periods. Changing Depreciation, Amortization, and Depreciation Methods; When a company changes the way it describes an asset in midstream, then change wold be made to reflect a change in estimated future benefits from the asset, the pattern of receiving those benefits, or the company's knowledge about those benefits. An exception to retrospective application of a change in accounting principle is the method of depreciation (or amortization or depletion). A company must justify an change in principle as preferable to the previous method. When its not possible to distinguish between a change in principle and a change in estimate, the change should be treated as a change in estimate.

Retrospective Approach

The retrospective approach offers consistency and comparability. Using the 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. For each year reported in the comparative statements reported, the balance of each account affected is revised. Those statements are made to appear as if the newly adopted accounting method had been applied all along or that the error had never occurred. A journal entry is created to adjust all account balances affected to what those accounts would have been. If retained earnings is one of the accounts that requires adjustment, that adjustment is made to the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders' equity.

Change in Accounting Principle; The retrospective approach: Most changes in accounting principle

Although consistency and comparability are desirable, changing to a new method sometimes is appropriate. We report most voluntary changes in accounting principles retrospectively. 1. Revise Comparative Financial Statements (FIFO usually produces lower cost of goods sold and thus inventory than does LIFO. When costs are rising, FIFO produces lower cost of goods sold than does LIFO and thus higher net income and retained earnings. Retained Earnings is revised each year to reflect FIFO. By FIFO, cogs is lower. The cumulative income effect increases each year by the annual after-tax difference in COGS. INventory, pretax income, income taxes, net income, and retained earnings are all higher). 2. Adjust accounts for the change. 3. Disclosure notes; footnote disclosure explains why the change was needed as well as its effects on items not reported on the face of the primary statements.