Ch. 20: Accounting Changes and Error Corrections

Accounting changes and error corrections U.S. GAAP

- U.S. GAAP and International standards are largely converged regarding accounting changes and error corrections, but one difference concerns error corrections. - When correcting errors in previously issued financial statements, IFRS (IAS No. 8) permits the effect of the error to be reported in the current period if it's not considered practicable to report it retrospectively, as is required by U.S. GAAP.

Prior period adjustment

- addition to or reduction in the beginning retained earnings balance in a statement of shareholders' equity due to a correction of an error. - applied to beginning retained earnings for the year following the error, or for the earliest year being reported in the comparative financial statements when the error occurs prior to the earliest year presented

Change in accounting principle

- change from one generally accepted accounting principle to another. - revise comparative financial statements, adjust accounts for the change, and add disclosure notes. - the modified retrospective approach or prospective approach - ex. adopt a new Accounting Standard. - ex. change methods of inventory costing. - ex. change from cost method to equity method, or vice versa.

Change in depreciation method (or amortization or depletion)

- change in accounting principle and change in estimate. - accounted for prospectively - a disclosure note should justify that the change is preferable and describe the effect of a change on any financial statement line items and per share amounts affected for all periods reported.

Error correction

- correct an error caused by a transaction being recorded incorrectly or not at all. - ex. mathematical mistakes. - ex. inaccurate physical count of inventory. - ex. change from the cash basis of accounting to the accrual basis. - ex. failure to record an adjusting entry. - ex. recording an asset as an expense, or vice versa. - ex. fraud or gross negligence.

Accounting for change in principle

- debit inventory (additional if FIFO had been used) - credit retained earnings (additional net income if FIFO had been used) - credit income tax payable (cumulative difference x % change in taxes)

Errors

- previous years' financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. - any account balances that are incorrect as a result of the error are corrected by a journal entry. - if retained earnings is one of the incorrect accounts, 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). - as for accounting changes, a disclosure note is needed to describe the nature of the error and the impact of its correction on operations

Statement of retained earnings

- reports the events that cause changes in retained earnings. - the incorrect balance as previously reported is corrected by the prior period adjustment.

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. - a disclosure note should indicate reasons why retrospective application was impracticable. - prospective changes usually are accounted for as of the beginning of the year of change.

Switching from LIFO to FIFO

- usually produces lower cost of goods sold and thus higher inventory, net income, and retained earnings than does LIFO. - 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 all are higher.

Steps to correct an accounting 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.

Error affecting previous financial statements, but not net income

Step 1: Correct incorrect accounts. Step 2: When reported for comparative purposes in the current year's annual report, last year's balance sheet would be restated to report the note as it should have been reported last year. Step 3: Since last year's net income was not affected by the error, the balance in retained earnings was not incorrect. So no prior period adjustment to that account is necessary. Step 4: A disclosure note would describe the nature of the error, but there would be no impact on net income, income from continuing operations, and earnings per share to report.

Correction of an error

an adjustment a company makes due to an error made.

Most errors

eventually self-correct.

Retrospective approach

financial statements issued in previous years are revised to reflect the impact of an accounting change whenever those statements are presented again for comparative purpose.

Modified retrospective approach

the accounting change is applied only to the adoption period with adjustment of the balance of retained earnings at the beginning of the adoption period to capture the cumulative effects of prior periods.

Prospective approach

the accounting change is implemented in the present, and its effects are reflected in the financial statements of the current and future years only.

When it's not possible to distinguish between a change in principle and a change in estimate

the change should be treated as a change in estimate.

If full retrospective application isn't possible

the new method is applied prospectively beginning in the earliest year practicable.

Error discovered in same reporting period that it occurred

the original erroneous entry should simply be reversed and the appropriate entry recorded.

Change in accounting estimate

- revise an estimate because of new information or new experience. - ex. change depreciation methods (prospectively). - ex. change estimate of useful life of depreciable asset. - ex. change estimate of residual value of depreciable asset. - ex. change estimate of periods benefited by intangible assets. - ex. change actuarial estimates pertaining to a pension plan.

Error affecting net income: failure to record sales revenue

Step 1: Correct incorrect accounts. Step 2: The 2017 financial statements that were incorrect as a result of the error are retroactively restated to reflect the correct amount of sales revenue and accounts receivable when those statements are reported again for comparative purposes in the 2018 annual report. Step 3: Because retained earnings is one of the accounts incorrect as a result of the error, the correction to that account is reported as a prior period adjustment to the 2018 beginning retained earnings balance in the company's comparative statements of shareholders' equity. Step 4: A disclosure note in the company's 2018 annual report should describe the nature of the error and the impact of its correction on each year's net income, income from continuing operations, and earnings per share.

Error affecting a prior year's net income

Step 1: Correct incorrect accounts. Step 2: The previous financial statements that were incorrect as a result of the error are retrospectively restated to report the correct accounts, assuming statements are reported again for comparative purposes in the annual report. Step 3: Because retained earnings is one of the accounts that is incorrect as a result of the error, a correction to that account is reported as a prior period adjustment to the current beginning retained earnings balance in comparative statements of shareholders' equity. A correction would be made also to the previous beginning retained earnings balance. That prior period adjustment, though, would be for the pre-last year's difference. If two years ago's statements also are included in the comparative report, no adjustment would be necessary for that period because the error didn't occur until after the beginning of the year. Step 4: A disclosure note accompanying current financial statements should describe the nature of the error and the impact of its correction on each year's net income, income from continuing operations (same as net income), and earnings per share.

Inventory

goods acquired, manufactured, or in the process of being manufactured for sale.

First-time adoption of IFRS

- Recording some assets and liabilities not permitted under U.S. GAAP, such as some provisions (contingent liabilities) permitted under IFRS but not U.S. GAAP. - Not recording (derecognizing) some assets and liabilities, for example, an intangible asset for research expenditures, permitted under U.S. GAAP but not IFRS. - Reclassifying items that are classified differently under the two sets of standards, for instance, reclassifying some preferred shares from shareholder equity classification under U.S. GAAP to liability classification under IFRS. - Providing disclosures (in notes to the financial statements) required under IFRS but not U.S. GAAP. - Providing extensive disclosures to explain how the transition to IFRS affected the company's financial position, financial performance, and cash flows. These disclosures include (a) providing explanations of material adjustments to the balance sheet, income statement, and cash flow statement; and (b) reconciliations of equity and total comprehensive income reported under previous GAAP to equity under IFRS.

Change in reporting entity

- change from reporting as one type of entity to another type of entity. - presenting consolidated financial statements in place of statements of individual companies. - changing specific companies that constitute the group for which consolidated or combined statements are prepared. - most frequently occurs when one company acquires another one. - requires that financial statements of prior periods be retrospectively revised to report the financial information for the new reporting entity in all periods. - the supplemental pro forma information should display revenue, income from continuing operations, net income, and earnings per share. - ex. consolidate a subsidiary not previously included in consolidated financial statements. - ex. report consolidated financial statements in place of individual statements.