Chapter 20

Change in Accounting Estimate: Changing Depreciation, Amortization, and Depletion Methods

(a change in the method of depreciation, amortization, or depletion is considered to be a change in estimate achieved by a change in accounting principle; these changes are treated as changes in estimate using the prospective method)

Errors

-Corrections of errors are not accounting changes but are accounting for similarly using the retrospective approach-see next section

ERROR CORRECTIONS

-Retrospective -Adj beginning retained earnings for the earliest reporting period

Error Affecting Previous Financial Statements, but Not Net Income

-could include (1) recording a balance sheet item in the wrong account, (2) recording an income statement item in the wrong account without affecting net income, (3) classifying a cash flow incorrectly in the statement of cash flows; since these errors do not affect income, no prior period adjustment would be needed

The Retrospective Approach: Most Changes in Accounting Principle 1. Revise Comparative Financial Statement

-income statement: appropriate amounts in the income statement will be adjusted as if the new method had been used in those prior years; -balance sheet: appropriate balances, including retained earnings, will be adjusted as if the new method had been used in those prior years; statement of shareholders' equity: the beginning retained earnings balance for the earliest period presented in the comparative statements must be adjusted for the cumulative effect of the change prior to that date

Prior Period Adjustments

-the prior period adjustment is applied to beginning retained earnings for the year following the error, or for the earliest year being reported in the comparative financial statements if the error occurred before then

What is the situation described and how is it reported? Change from LIFO inventory costing to the weighted-average inventory costing

Change in Principle reported retrospectively

What is the situation described and how is it reported? Change from determining lower of cost or net realizable value (LCNRV) for the inventories by the individual item approach to the aggregated approach

Change in Principle reported retrospectively

What is the situation described and how is it reported? Including in the consolidated financial statements a subsidiary acquired several years earlier that was appropriately not included in previous years

Change in reporting entity

What is the situation described and how is it reported? Change by a retail store reporting warranty expense on a pay-as-you-go basis to estimating the expense in the period of sale

Not an accounting change

Changes in Principle Retrospective Method

Restate prior periods under new principal for comparison

Flay Foods has always used the FIFO inventory costing method for both financial reporting and tax purposes. At the beginning of 2021, Flay decided to change to the LIFO method. As a result of the change, net income in 2021 was $80 million. If the company had used LIFO in 2020 its cost of goods sold would have been higher by $6 million year. Flay's records of inventory purchases and sales are not available for 2019 and several previous years. Last year, Flay reported the following net income amounts in its comparative income statements: 2018 - Net Income - $80 million 2019 - Net Income - $82 million 2020 - Net Income - $84 million 1. Will the correction be made prospectively or retrospectively

Use Prospective for a change to LIFO

The Prospective Approach: When Mandated by Authoritative Accounting Literature

the prospective method is applied if a mandated change in accounting principle requires it

Flay Foods has always used the FIFO inventory costing method for both financial reporting and tax purposes. At the beginning of 2021, Flay decided to change to the LIFO method. As a result of the change, net income in 2021 was $80 million. If the company had used LIFO in 2020 its cost of goods sold would have been higher by $6 million year. Flay's records of inventory purchases and sales are not available for 2019 and several previous years. Last year, Flay reported the following net income amounts in its comparative income statements: 2018 - Net Income - $80 million 2019 - Net Income - $82 million 2020 - Net Income - $84 million 1. What amounts will Flay report for net income in its 2019-2021 comparative statements?

---Use Prospective method from 2020 Net Income 2019: 82 million under FIFO - No change Net Income 2020: 84 million FIFO - 6 million COGS = 78 million Net Income 2021: 80 million LIFO

Changes in Principle Prospective Approach

-Use when mandated by FASB -You do not restate prior periods --**You don't have the numbers to be able to --**Example - Switching to LIFO -You may restate prior periods as far back as you can

The Retrospective Approach: Most Changes in Accounting Principle 2. Adjust Accounts for the Change

-a journal entry needs to be made to adjust accounts to the correct balances reflecting the new principle as of the beginning of the year of the change

Accounting Changes

-changes in accounting principle (a change from one generally accepted accounting principle to another) -changes in accounting estimate (a revision in estimate because of new information)

Change in Accounting Estimate

-changes in estimate are treated using the prospective method; -prior period amounts are not restated, but the new estimate is used for current and future period calculations

The Prospective Approach: When Retrospective Application is Impracticable

-if it is impracticable to use the retrospective method, the prospective method may be used; for example, if a company switches to the LIFO method of inventory valuation, it is unlikely the records exist to determine prior years' LIFO layers; -in the case, the new method is simply applied to the current and future periods, and prior period comparative statements are not restated; -if some, but not all, prior period effects can be calculated or if the cumulative effect on prior years cannot be determined, retrospective adjustment would take place in the earliest year practicable-not a big focus in our class

Error Affecting a Prior Year's Net Income

-most errors affect net income and therefore affect the balance sheet also; -they may also affect the statement of cash flows; -most errors that affect income will also have tax effects, either taxes payable or refundable or deferred tax assets or liabilities; we will mostly look at errors without their tax effects, but we need to realize that many error corrections will have tax consequences; -the effect of an error and the necessary correction may depend on when the error is discovered; -many errors self correct, at least over a period of years, sometimes within the next year; -even if they self correct, errors may need correcting journal entries and/or restatement of prior years' numbers in comparative statements

The Retrospective Approach: Most Changes in Accounting Principle

-most voluntary changes in accounting principle are treated retrospectively; -this means we report all prior period financial statements (at least those which will be presented as comparative statements) as if the new method had been used in those prior periods; -when a change in principle is made any time during a fiscal year, it is treated as having been made as of the beginning of that year

Error Discovered in the Same Reporting Period That It Occurred

-simply reverse the incorrect entry and make the correct entry; -or make a correcting entry to get to the correct account balances

The Modified Retrospective Approach

-when a new accounting standard mandates a change in accounting principle, the FASB may specify the approach for handling the change or may give companies a choice of how to handle the change: --using the retrospective method, the prospective method, or a modified retrospective method; -the modified retrospective method applies the new principle only to the adoption period (not to prior periods for comparative statements) and adjusts the beginning retained earnings for the current period; -numbers reported in comparative statements are not adjusted)

Correction of Accounting Errors

-when errors are discovered, they need to be corrected; they are corrected using the retrospective method: (1) a journal entry is made to correct any incorrect amounts, (2) previous years' financial statements presented for comparison are changed to reflect the correct amounts, (3) if retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to beginning retained earnings, (4) a disclosure note should describe the error and the impact of its correction)

Change in Accounting Principle

-while consistency in the application of accounting principles leads to increased comparability, it is sometimes appropriate to change accounting principles; -sometimes companies have arbitrary choices between or among different accounting principles; -in other cases, the circumstances, which can change, dictate between competing accounting principles to be applied; -if circumstances change such that a change in accounting principle is either dictated or preferred to enhance the accounting information provided, we need to know how to account for the change; -of course, we would not expect to see a lot of accounting changes, as they reduce comparability; -we would also not expect companies to switch back and forth, as there would not be justification for doing so

The Prospective Approach: Changing Depreciation, Amortization, and Depletion Methods

1) Change in Accounting Est. 2) Change in Reporting Entity

These inventory errors errors were discovered. 2019 - understated by $120,000 2020 - overstated by $ 150,000 1. What is the effect on 2021 retained earnings at Jan 1, 2021? 2. What is the journal entry to correct it? 3. Will the error be accounted for prospectively or retrospectively?

1. 2019 error - self corrected in 2020 2021 error - Retained earnings is overstated 2. Retained earnings 150,000 ---Inventory 150,000 3. Retrospective

At the end of 2020, Dinkins-Lowery Corporation failed to accrue interest of $8,000 on a note receivable. At the beginning of 2021, when the company received the cash, it was recorded as interest revenue. 1. What is the effect on the income statement and the balance sheet for 2020? 2. What is the journal entry to correct the error?

1. 2020 Reveue was understated, 2020 Retained earnings was understated, 2021 retained earnings was overstated 2021 Revenue was overstated 2. Reduce int revenue. Increase retained earnings. Journal Entry Interest Revenue 8,000 --Retained earnings 8,000

On December 31, 2012, Wolfe-Bache Corporation failed to accrue office supplies expense of $1,800. In January, when it received the bill from its supplier Wolfe Bache made the following entry: © Dr. Chula King All Rights Received bill from its supplier, Wolfe-Bache made the following entry: Office supplies expense 1,800 ---Cash 1,800 1. What is the effect on the income statement and the balance sheet for 2020? 2. What is the journal entry to correct the error?

1. 2020 Salary exp. Is understated by 1800 2021 Salary Exp. is overstated 2021 begin Retained Earnings is overstated 2. Reduce 2021 beginning retained earnings, and reduce 2021 Salary exp Journal Entry Retained earnings 1,800 --Salary Exp. 1,800

On the last day of 2020, Midwest Importers received a $90,000 prepayment from a tenant for 2021 rent of a building. Midwest recorded the receipt as rent revenue. The error was discovered midway through 2021 1. What is the effect on the income statement and the balance sheet for 2020? 2. What is the journal entry to correct the error?

1. 2020 revenue is overstated by 90,000, Retained Earnings is overstated, Rent liability is understated 2. Reduce 2021 beginning retained earnings by 90,000, split up revenue because we are midway through the year Journal Entry Retained earnings 90,000 --Rent Revenue 45,000 --Deferred Rent Revenue 45,000

Wilkins Food Products, Inc., acquired a packaging machine from Lawrence Specialists Corporation. Lawrence completed construction on the machine on January 1, 2019. In payment for the machine, Wilkins issued a three-year installment note to be paid in three equal payments at the end of each year. The payments include interest at the rate of 10%. Lawrence made a conceptual error in preparing the amortization schedule, which Wilkins failed to discover until 2021. The error had © Dr. Chula King All Rights Received , caused Wilkins to understate interest expense by $45,000 in 2019 and $40,000 in 2020 1. Determine which accounts are incorrect as a result of these errors at January 1, 2021 2. What is the journal entry to correct the error? 3. Account for the error retrospectively or prospectively?

1. Because cash payment was misapplied we paid too much to principle. This causes our expenses to be understated. Notes Payable - Understated Retained earnings - Overstated 2. Journal Entry Retained earnings 85,000 ---Notes Payable 85,000 3. Retrospective

Wardell Corporation purchased a mini computer on January 1, 2019, at a cost of $40,000. The computer has been depreciated using the straight-line method over an estimated five-year useful life with an estimated residual value of $4,000. On January 1, 2021, the estimated useful life was changed to a total of 10 years, and the estimate of residual value was changed to $900. 1. Prepare the adjusting entry for depreciation

1. Originally 5 year life Originally 4,000 residual 2 years years in change in EST. (Cost-Residual)/Usefule life (40,000-4,000)/5=7,200/ per year 7,200 * 2 years = 14,400 40,000 - 14,400 = 25,600 remaining life (25,600 - 900)/(10-2)=3087.50/per year Journal Entry Depreciation Exp. 3,087.50 ---Accumulated Depreciation 3,087.50

Flay Foods has always used the FIFO inventory costing method for both financial reporting and tax purposes. At the beginning of 2021, Flay decided to change to the LIFO method. As a result of the change, net income in 2021 was $80 million. If the company had used LIFO in 2020 its cost of goods sold would have been higher by $6 million year. Flay's records of inventory purchases and sales are not available for 2019 and several previous years. Last year, Flay reported the following net income amounts in its comparative income statements: 2018 - Net Income - $80 million 2019 - Net Income - $82 million 2020 - Net Income - $84 million 1. Prepare the journal entry to record the change in accounting principle.

1. -COGS is higher by 6 million -Making Retained Earning lower by 6 million Journal Entry Retained earnings 6 million ---COGS6 million

For financial reporting, Clinton Poultry Farms has used the declining-balance method of depreciation for conveyor equipment acquired at the beginning of 2018 for $2,560,000. Its useful life was estimated to be six years with a $160,000 residual value. At the beginning of 2021, Clinton decides to change to the straight-line method. The effect of this change on depreciation for each year is as follows ($in 000s) :Year Straight-Line Declining Balance Difference 2013 $400 $853 $453 2014 400 569 169 2015 400 379 (21) Totals $1,200 $1,801 $601 1. Retrospective or Prospective? 2. Prepare the journal entry to account for the change

1. Change in Est. - Prospectively 2. -Already depreciated - 1,801,000 -Use remaining amount for straight line -Remaining cost = 2,560,000-1,801,000 = 759,000 (759,000-160,000)/ 3 remaining years = 199,667 Journal Entry Depreciation Expense 199,667 ---Accumulated Depreciation 199,667

During 2011 (its first year of operations) and 2020, Batali Foods used the FIFO inventory costing method for both financial reporting and tax purposes. At the beginning of 2013, Batali decided to change to the average method for both financial reporting and tax purposes. Income components before income tax for 2019, 2020 and 2021 are as follows ($ in millions): 2019 2020 2021 Revenues $420 $390 $380 Cost of Goods Sold (FIFO) (46) (40) (38) Cost of Goods Sold (average) (62) (56) (52) Operating Expenses (254) (250) (242) Dividends of $20 million were paid each year. Batali's fiscal year ends December 3 1. Determine the balance in retained earnings at Jan 1, 2020 as Fieri reported prevously using the FIFO

2019 Rev 380 Cogs Lifo (38) Op Exp. (242) Net Income 100 Retained Earnings 2019 Beginning R/E $0 Net Income $100 Dividends ($20) R/E $80

During 2011 (its first year of operations) and 2020, Batali Foods used the FIFO inventory costing method for both financial reporting and tax purposes. At the beginning of 2013, Batali decided to change to the average method for both financial reporting and tax purposes. Income components before income tax for 2019, 2020 and 2021 are as follows ($ in millions): 2019 2020 2021 Revenues $420 $390 $380 Cost of Goods Sold (FIFO) (46) (40) (38) Cost of Goods Sold (average) (62) (56) (52) Operating Expenses (254) (250) (242) Dividends of $20 million were paid each year. Batali's fiscal year ends December 3 1. Prepare the 2021-2020 comparative income statements

2021 2020 Rev. $420 $390 Cogs Av. (62) (56) Op. Exp. (254) (250) Net Income 104 84

During 2011 (its first year of operations) and 2020, Batali Foods used the FIFO inventory costing method for both financial reporting and tax purposes. At the beginning of 2013, Batali decided to change to the average method for both financial reporting and tax purposes. Income components before income tax for 2019, 2020 and 2021 are as follows ($ in millions): 2019 2020 2021 Revenues $420 $390 $380 Cost of Goods Sold (FIFO) (46) (40) (38) Cost of Goods Sold (average) (62) (56) (52) Operating Expenses (254) (250) (242) Dividends of $20 million were paid each year. Batali's fiscal year ends December 3 1. Determine the adjustment to the January 1, 2020, balance in retained earnings that Batali would include in the 2021-2020 comparative statements of retained earnings or retained earnings column of the statements of shareholders' equity to revise it to the amount it would have been if Batali had used the average method

Beginning Balance = $80 million under Fifo Under Ave. there is in increase 14 million exp. 80 - 14 = 66 million adj. R/E

Determine the effects of the error on COGS Net Income Retained Earnings Overstatement of purchases

COGS - Overstated Net Income - Understated Retained earnings - Understated

Determine the effects of the error on COGS Net Income Retained Earnings Understatement of ending inventory

COGS - Overstated Net Income - Understated Retained earnings - Understated

Determine the effects of the error on COGS Net Income Retained Earnings Overstatement of beginning inventory

COGS - Overstated - from prior period Net Income - no effect Retained earnings - no effect

Determine the effects of the error on COGS Net Income Retained Earnings Understatement of purchases Understatement of ending inventory by the same amount

COGS - The difference cancels out - No effect Net Income - The difference cancels out - No effect Retained earnings - The difference cancels out - No effect

Determine the effects of the error on COGS Net Income Retained Earnings Freight-in charges are understated

COGS - Understated Net Income - Overstated Retained earnings - Overstated

Determine the effects of the error on COGS Net Income Retained Earnings Overstatement of ending inventory

COGS - Understated Net Income - Overstated Retained earnings - Overstated

Determine the effects of the error on COGS Net Income Retained Earnings Understatement of purchases

COGS - Understated Net Income - Overstated Retained earnings - Overstated

Determine the effects of the error on COGS Net Income Retained Earnings Understatement of beginning inventory

COGS - Understated from prior period Net Income - No effect Retained earnings - No effect

What is the situation described and how is it reported? Change in the estimated useful life of office equipment

Change in Est. Reported prospectively

What is the situation described and how is it reported? Pension plan assets for a defined benefit pension plan achieving a rate of return in excess of the amount anticipated

Change in Est. Reported prospectively

What is the situation described and how is it reported? Setting a lawsuit for less than the amount accrued previously as a loss contignecy

Change in Est. Reported prospectively

What is the situation described and how is it reported? Technological advance that renders worthless a patent with an amortized cost of $45,000

Change in Est. Reported prospectively

What is the situation described and how is it reported? Change from declining depreciation to Straight-line

Change in Est. resulting from a change in principle Reported prospectively

What is the situation described and how is it reported? A shift of certain manufacturing overhead costs to inventory that previously were expensed as incurred to more accurately measure cost of good sold

Change in Principle reported retrospectively

Conrad Playground Supply underwent a restructuring in 2021. The company conducted a thorough internal audit, during which the following facts were discovered. The audit occurred during 2021 before any adjusting entries or closing entries are prepared. Additional computers were acquired at the beginning of 2019 and added to the company's office network. The $45,000 cost of the computers was inadvertently recorded as maintenance expense. Computers have five-year useful lives and no material salvage

Cost was expensed all at once --This cause Retained earnings to be understated No equip was recorded No Depreciation was recorded Depreciation = 45,000/5=9,000 per year 2 years = 18,0000 accumulated depreciation 45,000 - 18,000 = 27,000 remaining amount to go back into retained earnings Journal entries Equipment 45,000 ---Accumulated depreciation 18,000 ---Retained earnings 27,000

During 2011 (its first year of operations) and 2020, Batali Foods used the FIFO inventory costing method for both financial reporting and tax purposes. At the beginning of 2013, Batali decided to change to the average method for both financial reporting and tax purposes. Income components before income tax for 2019, 2020 and 2021 are as follows ($ in millions): 2019 2020 2021 Revenues $420 $390 $380 Cost of Goods Sold (FIFO) (46) (40) (38) Cost of Goods Sold (average) (62) (56) (52) Operating Expenses (254) (250) (242) Dividends of $20 million were paid each year. Batali's fiscal year ends December 3 1. Prepare the journal entry at the begining of 2021 to record the change in accounting principle

FIFO Average 2019 - 38 40 2020 - 40 56 Diif 14 16 Average = 14+16 = 30 million more than LIFO Higher COGS = Reduce ending inventory Lower Net Income Lower Retained Earnings Journal Entry Retained Earnings 30 million --Inventory 30 million

Changes in Est.

Use prospective method Do not change prior periods