Prospective Application
Accounting for Estimate Changes - Prospective Application
A Change in Accounting Estimate : Derived from new information and is a change that causes the carrying amount of an asset or liability to change, or that changes the subsequent accounting for an asset or liability. Estimate changes are the most frequent type of accounting change.
On January 1, 2003, Warren Co. purchases a $600,000 machine, with a five-year useful life and no salvage value. The machine is depreciated by the accelerated method for book and tax purposes. The machine's carrying amount is $240,000 on December 31, 2004. On January 1, 2005, Warren changes to the straight-line method for financial-statement purposes. Warren can justify the change. Warren's income tax rate is 30%. In its 2005 financial statements, what amount should Warren report as the cumulative effect of this change?
A change in depreciation method is treated as a change in estimate with the remaining book value at the beginning of the year of change being subject to the new method for the remainder of the asset's life. No cumulative effect is reported.
What disclosures are required for estimate changes?
Effect of the change on income from continuing operations and net income for the year of change.
What is the most frequent type of accounting change?
Estimate change.
For 2003, Pac Co. estimates its two-year equipment warranty costs based on $100 per unit sold in 2003. Experience during 2004 indicates that the estimate should have been based on $110 per unit. The effect of this $10 difference from the estimate is reported
In 2004 income from continuing operations. This is a change in accounting estimate, because experience in the current period implies that a different estimate should be used. This new information does not invalidate the good-faith estimate made in 2003, because the new information was not known at that time. These changes are treated currently and prospectively; that is, in the current and future periods, if affected. They are not applied retroactively. In this instance, the $10 increase in warranty costs per unit is recognized as an increase in warranty expense of 2004. Therefore, income from continuing operations will reflect this increase.
What is the amount of cumulative effect recorded for change in depreciation method?
None (prospective approach is applied).
How is a change in depletion method accounted for?
Prospective approach (same as estimate change).
(Start of CPAexcel Flashcards) What accounting approach is applied to changes in depreciation method?
Prospective.
Item: Correction of error in previous period balance sheet; prior year income is unaffected
Reporting -current period - Not applicable Reporting -previous period - Corrected
Item: Change from corridor amortization to SL amortization for defined benefit pensions
Reporting -current period - Use new accounting principle Reporting -previous period - Use new accounting principle
Belle Co. determined after four years that the estimated useful life of its labeling machine should be ten, rather than 12 years. The machine originally cost $46,000 and had an estimated salvage value of $1,000. Belle uses straight-line depreciation. What amount should Belle report as depreciation expense for the current year?
The asset has a depreciable base of $46,000-$1,000=$45,000. The depreciation expense for years one through four is $45,000/12=$3,750. Accumulated depreciation after four years is $3,750 X 4 =$15,000. The carrying value after four years is $46,000-$15,000=$31,000. Depreciation based on the new estimated useful life is $31,000-$1,000 = $30,000 for the depreciable base. The remaining useful life is 10-4=6 years. Depreciation for the current year is $30,000/6 = $5,000.
Disclosures for Estimate Changes
C. Disclosures for Estimate Changes -- For the current period, the following are required: 1. Effect of the change on income from continuing operations, net income, and related per share amounts for the period of change for estimate changes affecting current and future periods; 2. For estimate changes affecting only the period of change, the above disclosures are required only if material.
Numerical Example - Change in Depreciation Method
Example: Book value at 1/1/x6 = $22,000 - $22,000(2/5) = $13,200 Depreciation for 20x6 = ($13,200 - $200)/(9 - 1) = $1,625 (at the beginning of 20x6, eight years remain in the asset's useful life) Journal entry for depreciation, 12/31/x6 Dr:Depreciation expense 1,625 Cr:Accumulated depreciation 1,625 The same entry would be recorded for the remaining seven years of the asset's life after 20x6 unless additional estimate or method changes were made
On January 1, 2003, Lane, Inc. acquires equipment for $100,000 with an estimated ten-year useful life. Lane estimates a $10,000 salvage value and uses the straight-line method of depreciation. During 2007, after its 2006 financial statements have been issued, Lane determines that, owing to obsolescence, this equipment's remaining useful life was only four more years and its salvage value would be $4,000. In Lane's December 31, 2007 balance sheet, what was the carrying amount of this asset?
Original cost $100,000 Less depreciation 2003-06 (four years): 4[($100,000 - $10,000)/10] ($36,000) Book value January 1, 2007 $64,000 Less depreciation, 2007: ($64,000 - $4,000)/4 ($15,000) Equals carrying value, December 31, 2007 $49,000 This is a change in estimate. The new salvage and useful life estimates are used starting at the beginning of the year of the estimate change. Estimate changes are not applied retroactively.
Item: Change from indirect method of reporting cash flows to the direct method
Reporting -current period - Use new accounting principle Reporting -previous period - Use new accounting principle
Item: Capitalizing advertising costs for the first time on new transactions; previously advertising costs were expensed
Reporting -current period - Use new accounting principle Reporting -previous period - Use old accounting principle
Item: Change in method of depreciation
Reporting -current period - Use new accounting principle Reporting -previous period - Use old accounting principle
Item: Change to LIFO; computation of prior year income effects impracticable
Reporting -current period - Use new accounting principle Reporting -previous period - Use old accounting principle
Item: Change in Useful life of plant assets
Reporting -current period - Use new estimate Reporting -previous period - Use old estimate
At December 31, 2004, Off-Line Co. changes its method of accounting for demo costs from writing off the costs over two years to expensing the costs immediately. Off-Line makes the change in recognition of an increasing number of demos placed with customers that did not result in sales. Off-Line has deferred demo costs of $500,000 at December 31, 2003, $300,000 of which were to be written off in 2004 and the remainder in 2005. Off-Line's income tax rate is 30%. In its 2004 retained-earnings statement, what amount should Off-Line report as cumulative effect of change in accounting principle?
The change in accounting principle is indistinguishable from a change in accounting estimate. This change can be effected by changing the useful life of the demo costs to zero - a change in estimate. The firm should write off the remaining unamortized costs at the beginning of the year of change. Earnings in 2004 will be reduced by $500,000 before tax as a result.
Matt Co. included a foreign subsidiary in its 2008 consolidated financial statements. The subsidiary was acquired in 2002 and was excluded from previous consolidations. The change was caused by the elimination of foreign-exchange controls. Including the subsidiary in the 2008 consolidated financial statements results in an accounting change that should be reported
The elimination of foreign-currency controls would legitimately change the status of the foreign sub from non-consolidated to consolidated. This causes a change in the reporting entity, since both companies must now be reported together. A change in reporting entity utilizes the retrospective method.
On January 2, 2005, to better reflect the variable use of its only machine, Holly, Inc. elects to change its method of depreciation from the straight-line method to the units-of-production method. The original cost of the machine on January 2, 2003, is $50,000, and its estimated life is ten years. Holly estimates that the machine's total life is 50,000 machine hours. Machine-hour usage was 8,500 during 2004 and 3,500 during 2003. Machine-hour usage for 2005 is 3,800. Holly's income tax rate is 30%. Holly should report the accounting change in its 2005 financial statements as a(an)
A change in depreciation method is accounted for as an estimate change. The remaining book value at the beginning of the year of change is allocated over the remaining useful life using the new method. Book value January 1, 2005 = $50,000 - ($50,000/10)2 = $40,000. Estimated remaining machine hours at January 1, 2005 = $50,000 - $8,500 - $3,500 = $38,000. Depreciation expense for 2005 = $3,800($40,000/$38,000) = $4,000.
Accounting for Estimate Changes - Prospective Application
A. Recall that this category of accounting change - estimate changes - now also includes changing a method of depreciation, amortization, or depletion. Such a principle change cannot be distinguished from a change in estimate, because the method change reflects a change in the expected pattern of benefits to be received from the asset in the future. Therefore, a change in depreciation method is considered to be a change in estimate effected by a change in accounting principle. 1. In general, when a change in principle cannot be distinguished from a change in estimate, the change is treated as a change in estimate (prospectively). For example, a cost that has been capitalized and amortized in the past is now expensed immediately because future benefits are no longer probable. The change to immediate expensing is treated as a change in estimate (no future periods are expected to benefit).
(Start of TBS)
Accounting changes made in the current year may or may not affect prior year financial statements shown comparatively with the current year statements. When comparative statements are altered, the previously published statements no longer agree with the newly reported statements for the same year. Assume that a firm reports the current year's results along with the preceding year's results in the current year annual report. For each item in the first column, choose the appropriate reporting for the current year's statements, and for the previous year's statements shown comparatively with the current period
Accounting for Estimate Changes - Prospective Application
B. Prospective Application -- Changes in accounting estimate are accounted for in the current and future periods (if affected). Prior period statements are not affected in anyway nor are there disclosures with respect to prior statements. The new information prompting the change was not known until the current year and is not relevant to prior periods. 1. There is no "cumulative effect" account for estimate changes; 2. For estimate changes affecting only the current period, the new estimate is used and the usual accounting procedure applies; 3. For changes affecting current and future periods, the book value of the relevant account at the beginning of the current year is used as the basis for applying the new estimate; 4. For changes in method of depreciation, amortization, or depletion, the book value at the beginning of the current period is used as the basis for expense recognition over the asset's remaining useful life, along with new estimates of salvage value and useful life if necessary. The new method is applied as of the beginning of the period of change.
On January 2, 2002, Union Co. purchases a machine for $264,000 and depreciated it by the straight-line method, using an estimated useful life of eight years with no salvage value. On January 2, 2005, Union determines that the machine has a useful life of six years from the date of acquisition and will have a salvage value of $24,000. An accounting change was made in 2005 to reflect the additional data. The accumulated depreciation for this machine should have a balance at December 31, 2005, of
Book value, January 2, 2005, date of accounting change: $264,000(5/8 years) = (as of January 2, 2005, five years of useful life remain) $165,000 Accumulated depreciation January 2, 2005, date of accounting change: $264,000(3/8 years) = (as of January 2, 2005, three years of the asset's life have been used) $99,000 Plus 2005 depreciation: ($165,000 - $24,000)/(6 - 3 years) = \$47,000 Equals accumulated depreciation balance, December 31, 2005 $146,000 As of January 2, 2005, the equipment has been used for three years. The new estimate of total life is six years. Therefore, 6-3 = three years remain. This remaining number of years is the basis for depreciating the asset, as well as the remaining book value at the beginning of the year of the accounting change ($165,000).
What is the first computation in accounting for an estimate change involving a depletable resource?
Compute book value at the beginning of the year of change.
Numerical Example - Change in Estimate of Useful Life
D. Numerical Example - Change in Estimate of Useful Life -- In 20x8, a firm using the sum-of-years-digits (SYD) method of depreciation changed the total useful life of a plant asset (cost $19,000; residual value $4,000) from ten years to five years. The revised estimate of residual value is $1,000. The asset was purchased 1/1/x5. Example: Original SYD = 1 + 2 + ... + 9 + 10 = 55 Revised SYD = 1 + 2 = 3 (only two years remain in revised useful life at 1/1/x8) Book value at 1/1/x8 = $19,000 - ($19,000 - $4,000)[(10+9+8)/55] = $11,636 Depreciation for 20x8 = ($11,636 - $1,000)/[(2/3)] = $7,091 Journal entry for depreciation, 12/31/x8 Dr:Depreciation expense 7,091 Cr:Accumulated depreciation 7,091 If the estimates were not changed, depreciation in 20x8 would have been: ($19,000 - $4,000)(7/55) = $1,909. The increase in depreciation is $7,091 - $1,909 = $5,182. Assume a 30% tax rate. The decrease in income for the current year due to the estimate change is .70($5,182) = $3,627. Footnote: During the current year, the useful life and salvage value of equipment were reduced resulting in a decrease in current year income of $3,627.
Numerical Example - Change in Depreciation Method
E. Numerical Example - Change in Depreciation Method -- In 20x6, management changes from the double-declining balance method (DDB) to the straight-line method (SL) to reflect new information suggesting that the asset will provide more uniform benefits and for a longer period of time than originally expected. The affected asset was purchased at the beginning of 20x5 for $22,000. Original estimates were: 5-year total useful life; $2,000 residual value. As of the beginning of 20x6, the revised estimates are: 9-year total useful life; $200 residual value.
Example: Accounting for Estimate Changes - Prospective Application
Example: Most areas within financial accounting are subject to estimation. Bad debts, warranties, depreciation, pension accounting, lower of cost or market, asset impairment, and many others are examples.
Item: Change in percentage of credit sales for bad debt expense recognition
Reporting -current period - Use new estimate Reporting -previous period - Use old estimate
Item: Correction of error in computing depreciation in previous period
Reporting -current period - Not applicable Reporting -previous period - Corrected
Item: Change from FIFO to weighted average method of inventory valuation
Reporting -current period - Use new accounting principle Reporting -previous period - Use new accounting principle
Mellow Co. depreciates a $12,000 asset over five years, using the straight-line method with no salvage value. At the beginning of the fifth year, it is determined that the asset will last another four years. What amount should Mellow report as depreciation expense for year five?
The book value at the beginning of the year of the change in estimated useful life is used as the base for subsequent depreciation. After four years, the book value remaining is one-fifth of its original cost, because there is no salvage value and the firm uses SL depreciation. That remaining book value is spread equally over four more years, yielding $600 of depreciation in each of those years. Book value at the beginning of year five = $12,000 - 4($12,000/5) = $2,400. Depreciation expense for year five = $2,400/4 = $600. The four years remaining include year five.
During 2005, Krey Co. increased the estimated quantity of copper recoverable from its mine. Krey uses the units-of-production-depletion method. Which of the following statements correctly describes the appropriate accounting for this change?
The change in estimate is applied as of the beginning of 2005 for current and future periods. This is an accounting-estimate change. These accounting changes are handled currently and prospectively by applying the new estimate to the current and future periods, if affected. The effect of the change on prior years' earnings is not computed, because the new information causing the estimate change was not known at that time. Cumulative effects are reported for accounting principle changes, not estimate changes, because the effect of the change on prior years is computed and reported for accounting principle changes only.
When a company changes the expected service life of an asset because additional information has been obtained, which of the following should be reported? Cumulative effect of accounting principle change and or Deferred income tax adjustment?
The change in expected service life is an accounting-estimate change. These are handled currently and prospectively. No attempt is made to compute the effect of the change on prior years' income, because the new information was not available at that time. With no catch-up adjustment, there is no change in deferred taxes, because future differences between book and tax depreciation have not been changed.
Oak Co. offers a three-year warranty on its products. Oak previously estimated warranty costs to be 2% of sales. Owing to a technological advance in production at the beginning of 2005, Oak now believes 1% of sales to be a better estimate of warranty costs. Warranty costs of $80,000 and $96,000 were reported in 2003 and 2004, respectively. Sales for 2005 were $5mn. What amount should be disclosed in Oak's 2005 financial statements as warranty expense?
The modification of the warranty-cost percentage is a change in estimate. Therefore, the new estimate is applied to 2005 and later years. There is no retroactive adjustment for changes in estimates, because the new information could not possibly have been known in the past. Therefore, warranty expense, which is a direct percentage of sales, is $50,000, or 1% of $5mn.
What is the rationale for applying the prospective method to estimate changes?
The new information triggering the change is not applicable to prior years.
On January 1, 2004, Taft Co. purchases a patent for $714,000. The patent is being amortized over its remaining legal life of 15 years, expiring on January 1, 2019. During 2007, Taft determined that the economic benefits of the patent would not last longer than ten years from the date of acquisition. What amount should be reported in the balance sheet for the patent, net of accumulated amortization, at December 31, 2007?
This is a change in accounting estimate. The beginning 2007 patent balance is $714,000(12/15) = $571,200, because three years of amortization would have been recorded as of that date, based on 15 years. Amortization in 2007, therefore, is $571,200(1/7) = $81,600. As of the beginning of 2007, only seven years remain in the useful life, because the total useful life as of that date was changed to ten years, and the patent had been used for three years as of that date. Therefore, the ending net balance in the patent is $571,200 - $81,600 = $489,600.
(Start of CPAexcel Exam Questions) On January 1, 2002, Flax Co. purchased a machine for $528,000 and depreciated it by the straight-line method using an estimated useful life of eight years with no salvage value. On January 1, 2005, Flax determines that the machine had a useful life of six years from the date of acquisition and will have a salvage value of $48,000. An accounting change is made in 2005 to reflect these additional data. The accumulated depreciation for this machine should have a balance at December 31, 2005 of
This is a change in estimate. The new estimated useful life and salvage value are applied to the book value at the beginning of the year of the estimate change. Accumulated depreciation, January 1, 2005 = $528,000(3/8) = $198,000 Book value, January 1, 2005 = $528,000 - $198,000 = $330,000 Depreciation, 2005 = ($330,000 - $48,000)/(6 - 3) = $94,000 Accumulated depreciation, 31 December 2005 $292,000 The denominator of the 2005 depreciation calculation (6 - 3) is the new total useful life of six years, less the three years for which the asset has been used as of January 1, 2005.
