IA Ch. 22 Accounting Changes and Error Analysis

Changes in Accounting principle journal entry

(Hint: Adjust all tax consequences through the Deferred Tax Liability account.) Dr. Construction in Process x Cr. Deferred tax liability x Cr. Retained earnings x

Retrospective accounting change approach for 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.

Three approaches for reporting changes in accounting principle

1) Currently. 2) Retrospectively. 3) Prospectively (in the future).

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.

Types of Accounting Changes:

1. Change in Accounting Policy. 2. Changes in Accounting Estimate. 3. Change in Reporting Entity. Errors are not considered an accounting change

Companies should not use retrospective application if one of the following conditions exists:

1. Company cannot determine the effects of the retrospective application. 2. Retrospective application requires assumptions about management's intent in a prior period. 3. Retrospective application requires significant estimates that the company cannot develop. If any of the above conditions exists, the company prospectively applies the new accounting principle.

Error analysis: 3 questions companies must answer

1. What type of error is involved? 2. What entries are needed to correct for the error? 3. After discovery of the error, how are financial statements to be restated?

In comparative statements for accounting errors, the 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.

Reporting a Change in Principle - Major Disclosure requirements

1.Nature of the change in accounting principle. 2.The method of applying the change, and: a.A description of the prior period information that has been retrospectively adjusted, if any. b.The effect of the change on income from continuing operations, net income (or other appropriate captions of changes in net assets or performance indicators), any other affected line item. c.The cumulative effect of the change on retained earnings or other components of equity or net assets in the balance sheet as of the beginning of the earliest period presented.

Examples of a change in reporting entity are:

1.Presenting consolidated statements in place of statements of individual companies. 2.Changing specific subsidiaries that constitute the group of companies for which the entity presents consolidated financial statements. 3.Changing the companies included in combined financial statements. 4.Changing the cost, equity, or consolidation method of accounting for subsidiaries and investments.

Examples of Estimates

1.Uncollectible receivables. 2.Inventory obsolescence. 3.Useful lives and salvage values of assets. 4.Periods benefited by deferred costs. 5.Liabilities for warranty costs and income taxes. 6.Recoverable mineral reserves. 7.Change in depreciation methods.

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.

How should accounting errors be reported?

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.

Balance Sheet Errors

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

Changes in Accounting Principle

Change from one accepted accounting policy to another. Examples include: -Average cost to LIFO. -Completed-contract to percentage-of-completion method. Adoption of a new principle` in recognition of events that have occurred for the first time or that were previously immaterial is not an accounting change.

Changes in Accounting Estimate Disclosures

Companies DO NOT need to disclose changes in accounting estimate made as part of normal operations, such as bad debt allowances or inventory obsolescence, unless such changes are material. HOWEVER, for a change in estimate that affects several periods (such as a change in the service lives of depreciable assets), companies should disclose the effect on income from continuing operations and related per-share amounts of the current period.

Interest receivable overstated 750 (books are not closed)

Dr. Interest revenue 750 Cr. Interest receivable 750

Supplies overstated 1100 (books have been closed)

Dr. Retained earnings 1100 Cr. supplies 1100

Accrued salaries and wages understated 2900 (books have not been closed)

Dr. Retained earnings 2900 Cr. Salary and wages payable 2900

Salary and wages payable are understated 2900 (books are not closed)

Dr. Salary and wages expense 2900 Cr. Salary and wages payable 2900

Prepaid insurance overstated 30k (books are not closed)

Dr. insurance expense 30k Cr. prepaid insurance 30k

No rental income recorded. $24,000 was received on January 1, 2018 for the rent of a building for both 2018 and 2019. The entire amount was credited to rental income. (books have not been closed)

Dr. retained earnings 12000 Cr. unearned rent revenue

Depreciation for the year was erroneously recorded as $5,000 rather than the correct figure of $50,000. (books have not been closed)

Dr. retained earnings 45000 Cr. Accumulated depreciation 45000

Supplies are overstated 1600 (books are not closed)

Dr. supplies expense 1600 Cr. supplies 1600

Summary of Changes in Accounting Estimate

Employ the current and prospective approach by: - Reporting current and future financial statements on the new basis - Presenting prior period financials as previously reported - Making no adjustments to current-period opening balances for the effects in prior periods

Summary of Changes due to error

Employ the restatement approach by: - Correcting all prior period statements presented - Restating the beginning balance of RE for the first period presented when the error effects occur in a period prior to the first period presented

Summary of Changes in accounting principle

Employ the retrospective approach by: - Changing the financial statements of all prior periods presented - Disclosing in the year of the change the effect on net income and EPS for all prior periods presented - Reporting an adjustment to the beginning retained earnings balance in the RE statement in the earlier year presented If impracticable to determine the prior period effect (e.g., change to LIFO): - Do not change prior years' income - Use opening inventory in the year the method is adopted as the base-year inventory for all subsequent LIFO computations - 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

Summary of Changes in Reporting Entity

Employ the retrospective approach by: - Restating the financial statements of all prior periods presented - Disclosing in the year of change the effect on N.I. and EPS data for all prior periods presented

Counterbalancing errors if Company HAS NOT closed the books

If error already counterbalanced, make entry to correct the error in the current period and to adjust the beginning balance of Retained Earnings. If error not yet counterbalanced, make entry to adjust the beginning balance of Retained Earnings.

Counterbalancing errors if Company HAS closed the books

If the error is already counterbalanced, no entry is necessary. If the error is not yet counterbalanced, make entry to adjust the present balance of retained earnings. For comparative purposes, restatement is necessary even if a correcting journal entry is not required.

Income Statement Errors

Improper classification of revenues or expenses.

B/S and I/S Noncounterbalancing Errors

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

How are changes in accounting estimates reported?

Prospectively

How are changes in reporting entity reported?

Reported by changing the financial statements of all prior periods presented

"cumulative adjustment"

Term when a new accounting pronouncement is adopted

Balance Sheet and I/S Counterbalancing Errors

Will be offset or corrected over two periods.

What is a self-correcting error to RE

inventory (counterbalances over two years)

Companies treat errors as ___________ and report them in the current year as adjustments to the _________________.

prior-period adjustments adjustments to the beginning balance of retained earnings

Change from sum-of-the-years'-digits to straight-line method of depreciation.

prospectively

Change in a patent's amortization period

prospectively

Change in the rate used to compute warranty costs

prospectively

How to adjust from one depreciation method to another

prospectively

change in a plant asset's salvage value

prospectively

Balance Sheet Current Year Error

reclassify item to its proper position.

Income statement current year error

reclassify item to its proper position.

Balance sheet prior year error

restate the balance sheet of the prior year for comparative purposes.

Income statement prior year error

restate the income statement of the prior year for comparative purposes.

FASB views changes in estimates as normal recurring corrections and adjustments and prohibits _______ treatment.

retrospective

Which approach is required by FASB?

retrospective approach because users can then better compare results from one period to the next

Change due to overstatement of inventory

retrospectively

Change from FIFO to average cost inventory method.

retrospectively

Change from LIFO to FIFO inventory method

retrospectively

Change from an unacceptable accounting principle to an acceptable accounting principle.

retrospectively

Change from completed-contract to percentage-of-completion method on construction contracts

retrospectively

Change from presenting unconsolidated to consolidated financial statements

retrospectively