Chapter 20 Review: Accounting Changes and Error Corrections

A change in reporting entity 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.

When a company changes the way it depreciates midstream, the change would be made to reflect:

(a) estimated future benefits from the assets (b) the pattern of receiving those benefits (c) the company's knowledge about those benefits

What are some examples of accounting tasks that require estimates?

- Depreciation - Uncollectible accounts receivable - Predicting warranty expenses - Amortizing intangible assets - Making actuarial assumptions for pension benefits

Sometimes, it is more practical for the prospective change to be used than the retrospective change. What are these situations?

- Lack of information of prior periods accounting records - If it's impracticable to adjust each year reported, the change is applied retrospectively as of the earliest year practical - If full retrospective application isn't possible, the new method is applied prospectively beginning in the earliest year practicable. - If accounting standards update specifically requires prospective accounting

Change in Estimate (including depreciation changes):

- Method of Accounting: Prospective - Restate prior years' statements? NO - Cumulative effect on prior years' income reported: Not Reported - Journal Entry: None, but subsequent accounting is affected by the new estimate - Disclosure Note: YES

Change in Reporting Entity:

- Method of Accounting: Retrospective - Restate prior years' statements? YES - Cumulative effect on prior years' income reported: As adjustment to retained earnings of earliest year reported - Journal Entry: Involves consolidated financial statements - Disclosure Note: YES

Error:

- Method of Accounting: Retrospective - Restate prior years' statements? YES - Cumulative effect on prior years' income reported: As adjustment to retained earnings of earliest year reported - Journal Entry: To correct any balances that are incorrect as a result of the error - Disclosure Note? YES

Change in Accounting Principle: Retrospective

- Restate prior years' statements? YES - Cumulative effect on prior years' income reported: As adjustment to retained earnings of earliest year reported - Journal Entry: To reflect affected balances to new method - Disclosure Note? YES

3 Ways to Report an Accounting Changes and Error Corrections:

1.) Retrospective Approach 2.) Modified Retrospective Approach 3.) Prospective Approach

Steps in the Retrospective Approach:

1.) Revise Comparative Financial Statements - I/S - B/S (Inventory, R/E) - Statements of Shareholders Equity (must adjust beginning balance of retained Earnings for the earliest period reported in the comparative statements of shareholders equity) 2) Adjust Accounts for the Change - make journal entires to change those balances from their current amounts to what they would have been using the newly adopted method. 3.) Disclosure Notes - explains why the change was needed as well as its effects on items not reported on the face of the primary statements

The correction of an error is treated as what?

A prior period adjustment

The allocation process for intangible assets? For natural resources?

Amortization; Depletion

When a company is changing its depreciation method to reflect changes in its estimates of future benefits, how is this change reported?

As a change in estimate rather than a change in accounting principle.

Revise 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 assets, Change actuarial estimates pertaining to a pension plan

Change in Accounting Estimate

Change from one generally accepted accounting principle to another Ex: Adopt a new Accounting Standard, Change methods of inventory costing, Change from cost method to equity method or vice versa

Change in Accounting Principle

Change from FIFO inventory costing to LIFO inventory costing

Change in Accounting Principle (prospective)

Change in actuarial assumptions for a defined benefit pension plan.

Change in Estimate

Change in the residual value of machinery

Change in Estimate

Change from FIFO inventory costing to average inventory costing.

Change in accounting principle (retrospective)

Change in estimate useful life of office equipment

Change in estimate

Change in the percentage used to determine warranty expense.

Change in estimate

Pension plan assets for a defined benefit pension plan achieving a rate of return in excess of the amount anticipated.

Change in estimate

Settling a lawsuit for less than the amount accrued previously as a loss contingency.

Change in estimate

Technological advance that renders worthless a patent with an unamortized cost of $45,000.

Change in estimate

For each of the following Inventory errors, determine the effect of the error on COGS, net income, and retained earnings: Understatement of ending inventory

Cost of Goods Sold: O Net Income: U Retained Earnings: U

For each of the following Inventory errors, determine the effect of the error on COGS, net income, and retained earnings: Freight-in-charges are understated

Cost of Goods Sold: U Net Income: O Retained Earnings: O

For each of the following Inventory errors, determine the effect of the error on COGS, net income, and retained earnings: Understatement of beginning inventory

Cost of Goods Sold: U Net Income: O Retained Earnings: O

For each of the following Inventory errors, determine the effect of the error on COGS, net income, and retained earnings: Understatement of purchases

Cost of Goods Sold: U Net Income: O Retained Earnings: O

For each of the following Inventory errors, determine the effect of the error on COGS, net income, and retained earnings: Overstatement of ending inventory

Cost of Goods Sold: U Net Income: O Retained Earnings: O

JE to record the change in principle:

DEBIT: Inventory CREDIT: Retained Earnings CREDIT: Income tax payable (inventory x %)

The allocation process used for assets such as buildings, equipment, or other tangible assets is called:

Depreciation

* Is not actually an accounting change** Correct 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.

Error Correction

Change from sum-of-year's-digits depreciation to straight-line depreciation

Estimate resulting from a change in principle

By __________, cost of goods sold is lower.

FIFO

What is an advantage of the Retrospective Approach?

It achieves comparability among financial statements.

Explain a reporting entity.

It can be a single company or it can be a group of companies that reports a single set of financial statements.

Requires application of the new standard ONLY to the adoption period (current period) as well as adjustments of the balance of retained earnings at the beginning of the adoption period to capture the cumulative effects of prior periods without actually adjusting the numbers of prior periods reported.

Modified Retrospective Approach

Change by a retail store from reporting warranty expense on pay-as-you-go basis to estimating the expense in the period of sale.

Not an accounting change

Requires NEITHER a modification of prior years' financial statements nor a journal entry to adjust account balances - The change is simply implemented in the period of the change, and its effects are reflected in the F/S of the period of the change and the future periods only.

Prospective Approach

A change in error is accounted for using what method?

Retrospective Approach

Financial Statements issued prior to the change are adjusted to reflect the impact of the change whenever those statements are presented again for comparative purposes. - Those statements are made to appear as if the accounting method had been applied all along or that the error had never occurred.

Retrospective Approach

Most voluntary changes in accounting principles are reported using which method?

Retrospective Approach

A change in reporting entity is revised by using what method?

Retrospective Approach - to report the financial information for the new reporting entity in all periods

What happens when one entity acquires another?

The financial statements of the acquirer include the acquiree of the date of acquisition, and the acquirer's prior period financial statements that are presented for comparative purposes are NOT restated.

YAY YOU'RE ALMOST DONE!!!

YOU CAN DO THIS!!!

LIFO usually produced higher _____________ than does FIFO because more recently purchased goods (usually higher priced) are assumed sold first.

cost of goods sold

The ______________________ increases each year by the annual after-tax difference in COGS.

cumulative income effect

FIFO usually produced lower cost of goods sold and thus higher __________ than does LIFO.

inventory

When costs are rising, FIFO produces lower cost of goods sold than does LIFO and thus higher ____________ and _____________.

net income and retained earnings

Change in Accounting Principle: Prospective

- Restate prior years' statements? NO - Cumulative effect on prior years' income reported: Not Reported - Journal Entry: None, but subsequent accounting is affected by the change - Disclosure Note: YES

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

Change in Reporting Entity

Change from LIFO inventory costing to FIFO inventory costing

Change in accounting principle (Retrospective)

Change from reporting an investment by the equity method to another method due to a reduction in the percentage of shares owned.

Change in accounting principle (prospective)

Change from declining balance depreciation to straight-line.

Change in estimate resulting from a change in principle

A shift of certain manufacturing overhead to cost inventory that previously were expensed as incurred to more accurately measure cost of goods sold.

Change in principle reported retrospectively

Change from LIFO inventory costing to the weighted-average inventory costing.

Change in principle reported retrospectively

Change from determining lower of cost or net realizable value (LCNRV) for the inventories by the individual item approach to the aggregate approach.

Change in principle reported retrospectively

Change in the composition of a group of firms reporting on a consolidated basis.

Change in reporting entity

Including in the consolidated financial statements a subsidiary acquired several years earlier that was appropriately not included in previous years.

Change in reporting entity

Change from expensing extraordinary repairs to capitalizing the expenditures.

Correction of an Error

For each of the following Inventory errors, determine the effect of the error on COGS, net income, and retained earnings: Understatement of purchases and understatement of ending inventory, by the same amount.

Cost of Goods Sold: NE (No Effect) Net Income: NE Retained Earnings: NE

For each of the following Inventory errors, determine the effect of the error on COGS, net income, and retained earnings: Overstatement of beginning inventory

Cost of Goods Sold: O Net Income: U Retained Earnings: U

For each of the following Inventory errors, determine the effect of the error on COGS, net income, and retained earnings: Overstatement of purchases

Cost of Goods Sold: O Net Income: U Retained Earnings: U

Changes in estimates are made how?

Prospectively - the company merely incorporates the new estimate in any related accounting determinations from then on.

What is a Prior Period Adjustment?

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

____________ is revised EACH year to reflect FIFO.

Retained Earnings