Chapter 20 Accounting Changes and Error Corrections

Change in accounting principle

Change from one generally accepted accounting principle to another - Changes from revenue recognition - Changes from Lease Accounting Examples: 1) Adopt a new Accounting Standard - Sometimes forced by FASB to change 2) Change from methods of inventory costing 3) Change from cost method to equity method, or vice versa. *Most voluntary changes in accounting principles are reported retrospectively* A disclosure note is needed to justify the change and purpose. - Change must be preferable with reasoning

Change in reporting entity

Change from reporting as one type of entity to another type of entity - Economic entity, like buying a new company resulting in no longer being a single company but two or more companies. *Accounted retrospectively, causes an adjustment to retained earnings of earliest year reported.* Journal Entries involves consolidated financial statements Occurs as a result of: 1) Presenting consolidated financial statements in place of statements of individual companies 2) Changing specific companies that constitute the group for which consolidated or combined statements are prepared 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

To do an Error Correction or not

Error Corrections should be done if: 1) If errors affect net income in the reporting period in which it occurred and will not self-correct 2) Error is the type to be not discoverable until a later period, should always correct when discovered

The Prospective Approach: When Mandated by Authoritative Accounting Literature

If a new accounting standards update specifically requires prospective accounting, that requirement is followed Example: For a change from the equity method to another method of accounting for long-term investments, GAAP requires the prospective application of the new method

Error Discovered in the Same Reporting Period That It Occurred

If an accounting error is made and discovered in the same accounting period, the original wrong entry should simply be reversed and the appropriate entry recorded. If an error did not affect net income in the year it occurred, it's relatively easy to correct. Examples are: 1) Incorrectly recording salaries payable as accounts payable 2) Recording a loss as an expense 3) Classifying a cash flow as an investing activity rather than a financing activity on the statement of cash flows. The disclosure note is needed.

Disclosure Notes for Changes in Accounting Principle

To achieve consistency and comparability, accounting choices once made should be consistently followed from year to year. Any change, then, requires that the new method be justified as clearly more appropriate. In the first set of financial statements after the change, a disclosure note is needed to provide that justification. Note disclosure must: 1) Explain why the change was needed as well as its effects on items not reported on the face of the primary statements 2) Point out that comparative information has been revised 3) Report any per share amounts affected for the current period and all prior periods presented

Periodic Inventory Equition

Beginning Inventory Plus: Purchases = Goods Available for Sale (GAOS) Less: Ending Inventory *= Cost of Goods Sold (COGS)*

Decision Makers' Perspective—Motivation for Accounting Choices

Effect of choices on management compensation, on existing debt agreements, and on union negotiations each can affect management's selection of accounting methods Financial analysts must be aware that different accounting methods used by different firms and by the same firm in different years complicate comparisons Investors and creditors must consider not only the effect on comparability but also possible hidden motivations for making the changes Managers tend to prefer to report earnings that follow a regular, smooth trend from year to year. Desire to do this is not always in the direction of higher income

Prospective Approach

Effects of a change are reflected in the financial statements of only the current and future years Occurs when: 1) When Retrospective Application is Impracticable 2) When Mandated by Authoritative Accounting Literature 3) Changing Depreciation, Amortization, and Depletion Methods, or *any change in Estimate* *A prospective approach is used for when Retrospective Application is Impracticable*

Error Affecting a Prior Year's Net Income

Most errors affect net income, but when they do, they affect the balance sheet as well Both statements must be retrospectively restated The statement of cash flows sometimes is affected, too Incorrect account balances must be corrected Income taxes often are affected by income errors causing amended tax returns to be prepared to: 1) either to pay additional taxes or 2) to claim a tax refund for taxes overpaid

Modified Retrospective Approach

New standard applied only to the current period Adjust retained earnings balance at beginning of year to capture the cumulative effects of prior periods without actually adjusting the numbers in the prior periods reported.

Retrospective Approach

Financial statements issued in previous years are revised Statements are made to appear as if the newly adopted accounting method had been applied all along or that the error had never occurred Then, a journal entry is created to adjust all account balances affected

Error Correction

Correct an error caused by a transaction being recorded incorrectly or not at all *Previous years' financial statements are retrospectively restated* The error causes an adjustment to retained earnings of the earliest year reported. Journal entries are needed to correct any balances that are incorrect due to the error. Requires a disclosure note when discovered and resolved. Examples of Errors: 1) Mathematical mistakes 2) Inaccurate physical count of inventory 3) Change from the cash basis of accounting to the accrual basis 4) Failure to record an adjusting entry 5) Recording an asset as an expense, or vice versa. 6) Fraud or gross negligence

Error Affecting Net Income—Inventory Unstated

Current Year: Inventory when Understated causes: 1) Overstated in COGS 2) Understated of Net Income and Retained earnings Next Year: 1) Beginning Inventory is Understated 2) Cost of Good Sold Understated 3) Net Income Overstated 4) Retained earnings corrected Error correct itself

Correction of Accounting Errors: Prior Period Adjustments

Prior Period Adjustment: An addition to or reduction in the beginning retained earnings balance in a statement of shareholders' equity Steps to Correct an Error: Step 1: A journal entry is made to correct any account balances that are incorrect as a result of the error. Step 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). Step 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 shareholders' equity (or statement of retained earnings if that's presented instead). Step 4: A disclosure note should describe the nature of the error and the impact of its correction on net income. Do this for: *1) Error Affecting Previous Financial Statements, but Not Net Income* *2) Error Affecting Net Income—Recording an Asset as an Expense * *3) Error Affecting Net Income—Failure to Record Sales Revenue*

Change in Accounting Estimate

Revise an estimate because of new information or new experience *Accounted prospectively* 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 Examples: 1) Change depreciation methods 2) Change estimate of the useful life of depreciation asset 3) Change estimate of periods benefited by intangible asset 4) Change actuarial estimates pertaining to a pension plan 5) Change of Contingent Liability whether it has increased, decrease or upheld that it wasn't the company fault and can effectively eliminate it.

The Prospective Approach: When Retrospective Application is Impracticable:

Sometimes a lack of information makes it impracticable to report a change retrospectively so the new method is simply applied prospectively *Such as Impracticable to determine the cumulative effect of prior years* If full retrospective application isn't possible, the new method is applied prospectively beginning in the earliest year practicable. No journal entries required to account for the change. *A prospective approach is used for Inventory Method if you go to LIFO from FIFO, an exception to retrospective approach. * - Under FIFO, inventory brought in first is sold first. - Therefore, they are gone from inventory already and you can't find them - Would cost more to retrospectively find the inventory is already gone. *A prospective approach is used for Inventory Method if you go to from Equity method to any other methods*

Self-Correcting Errors

The effect of most errors is different, depending on when the error is discovered. However, most errors eventually self-correct like understating or overstating inventory. Even errors that eventually correct themselves cause financial statements to be misstated in the meantime *If the error is not discovered until 2021 or after, then no correcting entry at all would be needed* *An error never self-corrects would be an expense account debited for the cost of land. Because land doesn't depreciate, the error would continue until the land is sold.*