Chapter 22: Accounting Changes and Errors

*Inventory* -> most common

Inventory costing valuations, quantity issues, and cost of sales adjustments.

Change examples:

-Average cost to LIFO. -Completed-contract to percentage-of-completion method.

Accounting Errors:

-Expense recognition -Revenue recognition -Misclassification -Equity-other -Allowances/contingencies -Long-lived assets -Taxes -Equity-other comprehensive income -Inventory -Equity-stock options -Other

Noncounterbalancing Errors

-Not offset in the next accounting period. -Companies must make correcting entries, even if they have closed the books.

Types of Accounting Errors:

1. A change from an accounting principle that is not generally accepted to an accounting policy 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.

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. + they change the operating balance of R/E.

Three approaches for reporting changes:

1. Currently. 2. Retrospectively. 3. Prospectively *FASB requires* use of the *retrospective approach*.

Other

Any restatement not covered by the listed categories

Long-lived assets

Asset impairments of property, plant, and equipment ; goodwill; or other related items

Expense recognition

Recording expenses in the incorrect period or for an incorrect amount ex-> comapny buys equipment and expenses at once instead of over time

Changes due to error: Employ the restatement approach by:

a. Correcting all propr period statements presented. b. Restating the begging balance of R/E for the first period presented when the error effects occur in a period prior to the first period presented

Balance Sheet Errors

affect only the presentation of an asset, liability, or stockholders' equity account.

Errors (small)

are not considered an accounting change

Noncounterbalancing Errors examples:

depreciation, bad debts

Counterbalancing Errors Examples:

failure to accrue an expense, misstatement of unearned revenue, misstatement of COGS

Change (large)

one accepted accounting policy to another

Current year error - Balance Sheet

reclassify item to its proper position

Prior year error - Balance Sheet

restate the balance sheet of the prior year for comparative purposes

Prospective Reporting

*Changes in accounting estimates (smaller)* are reported *prospectively*. 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. *FASB* views changes in estimates *as normal recurring corrections and adjustments* and prohibits retrospective treatment.

ACCOUNTING 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.

Types of Accounting Changes:

-Change in Accounting Policy. -Changes in Accounting Estimate. -Change in Reporting Entity.

Comparative Statements: 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.

Accounting Alternatives:

Diminish the comparability of financial information. Obscure useful historical trend data.

Allowances/contingencies

Errors involving accounting receivables' bad debts, inventory reserves, income tax allowances, and loss contingencies

Taxes

Errors involving correction of tax provision, improper treatment of tax liabilities, and other tax-related items

Equity-other

Improper accounting for EPS, restricted stock, warrants, and other equity instruments

Equity-other comprehensive income

Improper accounting for comprehensive income equity transactions including foreign currency items, minimum pension liability adjustments, unrealized gains and losses on certain investments in debt, equity securities, and derivatives.

Equity-stock options

Improper accounting for employee stock options

Income Statement Errors

Improper classification of revenues or expenses.

Misclassification

Include restatements due to misclassification of short- or long- term accounts or those that impact cash flows from operations

Revenue recognition

Instances in which revenue was improperly recognized, questionable revenues were recognized, or any other number of related errors that led to misreported revenue.

Balance Sheet and Income Statement Errors: Counterbalancing Errors:

Will be offset or corrected over two periods. 1. If company *has closed* the books: 2. If company *has not closed* the books: *For comparative purposes, restatement is necessary even if a correcting journal entry is not required.*

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.

Changes in accounting principle: Employ the retrospective approach by

a. Changing the financial statements of all prior periods presented b. Disclosing in the year of change the effect on net income and EPS for all prior periods c. Reporting an adjustment to the beginning retained earnings balance in the retained earnings statement in the earliest year presented.

Changes in accounting principle: If impracticable to determine the prior period effect (e.g., change to LIFO)

a. Do not change prior years' income b. Use opening inventory in the year the method is adopted as the base-year inventory for all subsequent LIFO computations. c. Disclose the effect of the change on the current year, and the reasons for omitting the computation of the cumulative effect and pro forma amounts for prior years.

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.

Changes in accounting estimate: Employ the current and prospective approach by:

a. Reporting current and future financial statements on the new basis b. Presenting prior period financial statements as previously reported c. Making no adjustments to current-period opening balances for the effects in prior periods

Changes in reporting entity: Employ the retrospective approach by:

a. restating the financial statements of all prior periods presented b. Disclosing in the year of change the effect on net income and earnings per share data for all proper periods presented