Chapter 22: Accounting Changes and Error Analysis

Which of the following is a reason why companies prefer certain accounting methods? A. Bonus payments. B. Asset structure. C. Comparability. D. Asset allocation

A. Bonus payments.

True or False: When changing from the equity method to the fair-value method, the investor must change the financial statements of all prior periods presented.

False. When changing from the equity method to the fair-value method, the investor applies the new method in its entirety once the equity method is no longer appropriate.

Statements regarding IFRS and U.S. GAAP accounting and reporting for changes in accounting principles

A. While both IFRS and U.S. GAAP require restatement of previously issued financial statements for error corrections, U.S. GAAP is an absolute standard, with no exception to this rule. B. Under U.S. GAAP and IFRS, if determining the effect of a change in accounting principle is considered impracticable, then a company should report the effect of the change in the period in which it believes it practicable to do so, which may be the current period. C. The FASB has issued guidance on changes in accounting principles, changes in estimates, and corrections of errors, which essentially converges U.S. GAAP to IAS 8.

A change to LIFO inventory valuation from any other acceptable inventory valuation method: A. requires restatement of all prior years' income. B. requires no restatement of prior years' income. C. is not allowed by FASB. D. is accounted for as an adjustment to beginning retained earnings.

B. requires no restatement of prior years' income (because it is impractical).

Retrospective accounting change: inventory method

Changes from LIFO to FIFO (and vice versa) affects inventories, cost of goods sold, net income, and retained earnings. The statement of cash flow's does not change. If net income increases: Dr. Inventory Cr. Retained Earnings (for the cumulative change from the earliest period presented until the beginning of the current year when the change takes place)

How to account for changes in accounting estimates

Changes in accounting estimates should be accounted for prospectively. The effects of all changes in estimates are reported in the period of change if the change affects that period only, or in the period of change and future periods if the change affects both. The FASB views changes in estimates as normal recurring corrections and adjustments. It prohibits retrospective treatment. If a company cannot determine whether a change is a change in estimate or a change in principle, it should look at it as a change in estimate.

Disclosures for changes in estimates

Changes made as part of normal operations, or that are not material, do not need to be disclosed. However, for changes and estimates that affect several periods - like depreciation - companies need to disclose the effect on income from continuing operations and related per-share amounts of the current period. The company must disclose why the new method is preferable. The company is also subject to all other disclosure guidelines for changes in accounting principle.

True or false: IFRS and GAAP both require the companies apply the direct effects of changes in accounting policies retrospectively.

True. Both IFRS and GAAP require retrospective application of the direct effects of changes in accounting policies.

True or false: Understating ending inventory will understate the current year's net income.

True. If you understated ending inventory, then cost of goods is overstated, and gross profit and net income are understated.

Examples of accounting errors

1. A change from an accounting principle that is not generally excepted to one that is 2. Mathematical mistakes, oversight, or misuse of facts 3. Changes in estimates that occur because a company did not prepare the estimates in good faith 4. Incorrect classification of a cost as an expense instead of an asset, and vice versa 5. Failure to record depreciation expense in a prior period

Four types of accounting changes

1. Change in accounting principle 2. Change in accounting estimate 3. Change in reporting entity 4. Errors in financial statements

Steps for using a retrospective accounting change approach

1. Company adjusts its financial statements for each prior period presented 2. Company adjusts the carrying amount of assets and liabilities as of the beginning of the first year presented (and to the opening balance of retained earnings or other components of stockholders equity or net assets)

Retrospective applications for changes in accounting principles: 1. Direct vs. 2. Indirect

1. FASB states that company should retrospectively apply the direct effects of a change in accounting principle. 2. An indirect effect is any change to current or future cash flows that results from making a change in accounting principle that is applied retrospectively. Ex: profit sharing as a percentage of revenue or net income. Indirect effects do not change prior period amounts, as changes are shown in the current period. Companies disclose when they recognize indirect effects of a change in accounting principle.

Accounting for corrections of errors

Corrections are posted as PPAs, which reflect in the beginning balance of retained earnings in the current period. The company should make adjustments to correct all affected accounts reported in the statements for all periods reported. The company should also show any catch-up adjustment as a PPA to retained earnings for the earliest period reported.

Questions to ask when analyzing errors

1. What type of error is involved? 2. What entries are needed to correct the error? 3. After discovery of the error, how are financial statements to be restated? (Errors are posted as PPAs and reported in the current year as adjustments to the beginning balance of retained earnings. If the company presents comparative statements, the company restates them.)

1. Balance sheet errors 2. Income statement errors

1. Balance sheet errors affect only the presentation of assets, liabilities, or stockholders equity. Errors must be corrected when they are discovered. 2. Income statement errors involve improper classification of revenues or expenses. They do not affect net income. If the error occurred in a prior period, the company does not re-classify (because these errors do not affect income, and income is closed to retained earnings).

Examples of a changes in reporting entity

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 Note: during the year in which a company changes a reporting entity, it should disclose the nature of the change and the reason for it, and the effect of the change on income from continuing operations, net income, and earnings per share for all periods presented.

Conditions where companies should not use retrospective application (impracticability)

1. The company cannot determine the effects of the retrospective application 2. Assumptions about management's intent in a prior period are required 3. Retrospective application requires significant estimates and the company cannot objectively verify the information needed to develop these estimates If any of these conditions exists, it is deemed impracticable to apply the retrospective approach, and the company prospectively applies the new accounting principle as of the earliest date it is practicable to do so.

Disclosures for changes in accounting principle

1. The nature and reason for the change and explanation of why the newly-adopted principle is preferable 2. The method of applying the change 3. Description of the prior period information that has been retrospectively adjusted (if any) 4. The effect of the change in income from continuing operations, net income, any other affected line item, and any affected per-share amounts for current and prior periods adjusted 5. The cumulative effect of the change on retain earnings or other components of equity or net assets as of the beginning of the EARLIEST periods presented

Balance sheet and income statement errors: Counterbalancing

Most errors that affect the balance sheet and income statement are counterbalancing. These errors will be offset or corrected over two periods. Ex: accrued wages payable. If a company prepares comparative statements, it must re-state amounts even if a correcting journal entry is not required. If The company has closed the books in the error year, and the error is not already counterbalanced, make an entry to adjust the present balance of retained earnings. If the error is already counterbalanced, no entry is necessary. If the company has not closed the books in the error year, and the error is not already counterbalanced, make an entry to adjust the beginning balance of retained earnings. If the air is already counterbalanced, make an entry to correct the error in the current and to adjust the beginning balance of retained earnings.

Balance sheet and income statement errors: non-counterbalancing

Non-counterbalancing errors take more than two periods to correct themselves. Ex: failure to capitalize equipment that has a useful life of five years (the error is fully corrected at the end of five years), or recording a depreciable asset as an expense. Even if the company has closed its books, they must make correcting entries. When creating journal entries to correct these errors, determine the revenues and expenses that have been closed to retain earnings.

Accounting for a change from the equity method (to fair value)

Prospective application. Earnings previously recognized under the equity method should remain as part of the carrying amount of the investment. The cost basis for accounting purposes is the carrying amount of the investment at the date of change. The investor recognizes an unrealized holding gain or loss if there is a difference in fair value. Future dividends in excess of earnings reduce the investment's carrying amount (not recognized as revenue).

Accounting for a change to the equity method

Retrospective application. The company adjusts the accounts to be on the same basis as if the equity method had always been used. P. 1301-1302