Accounting Changes and Error Corrections INTERMEDIATE ACCOUNTING II CHAPTER 20 1

Accounting changes fall into one of three categories  Changes in principle  Changes in estimates  Changes in reporting entity ACCOUNTING CHANGES 2

Type of Change DescriptionExamples Change in accounting principle Change from one generally accepted accounting principle to another  adopt a new FASB standard  change methods of inventory costing  change from cost method to equity method (investments), or vice versa  change from completed contract to %-of-completion (constructed assets), or vice versa Change in estimate Revision of an estimate because of new information or new experience  change depreciation methods  change estimate of useful life of depreciable asset  change estimate of residual value  change estimate of warranty expense percentage  change estimate of periods benefited by intangible assets  change actuarial estimates pertaining to a pension plan Change in reporting entity Change from reporting as one type of entity to another type of entity  consolidate a subsidiary not previously included in consolidated financial statements  report consolidated financial statements in place of individual statements 3

Accounting changes can be accounted for in one of two ways depending on the nature of the change.  Retrospectively (prior years revised)  Prospectively (only current and future years affected) ACCOUNTING CHANGES 4

Although consistency and comparability are desirable, changing to a new method sometimes is appropriate. We report most voluntary changes in accounting principles retrospectively on previous period’s financial statements which are included with comparative statements. The prior period statements are reported as if the new method had been used in all prior periods. Additionally, the cumulative effect of the change should be reflected in the carrying amounts of assets and liabilities as of the beginning of the first period in which you are presenting financial statements; and an offsetting amount will be recorded in the beginning retained earnings balance of the first period in which you are presenting financial statements. CHANGE IN ACCOUNTING PRINCIPLE The prospective approach is used when it is impractical to use the retrospective approach. 5

During 2011 (its first year of operations) and 2012, Batali Foods used the FIFO inventory costing method for both financial and tax purposes. At the beginning of 2013, Batali decided to change to the average method for both financial reporting and tax purposes. The following information is available for 2011 & Retained earnings30 Inventory30 Change in Inventory Methods - Example Cost of Goods Sold – FIFO4038 Cost of Goods Sold – Average5658 Difference1614 Total 30 Prepare the journal entry at the beginning of 2013 to record the change in accounting pricinple, ignoring income taxes. 6

Brief Exercise 20-1, page 1220 In 2016, the Barton and Barton Company changed its method of valuing inventory from the FIFO method to the average cost method. At December 31, 2015, B & B’s inventory valuation was $32 million under FIFO. B & B’s records indicated that the inventories would have totaled $23.8 million at December 31, 2015, if determined on an average cost basis. Ignoring income taxes, what journal entry will B & B use to record the adjustment in 2013? Retained earnings8.2 Inventory8.2 Explanation: The difference in inventory valuation for the two methods is $32 - $23.8 = 8.2 (millions). Applying the new inventory method (average cost), inventory would be lower than previously reported under LIFO. To make this adjustment, credit the inventory account (to reduce the balance to $23.8). Retained Earnings is also reduced to reflect the higher cost of goods sold that would have been reported using the average cost method.. Because cost of goods sold by FIFO is less than by LIFO, income and therefore retained earnings by FIFO are greater than by LIFO. 7

When switching from FIFO to the average cost method, we would record a deferred tax asset. For financial reporting purposes, we would be retrospectively decreasing accounting income, but not taxable income. A temporary difference between accounting and taxable income is created that will reverse over time as the unsold inventory (now restated) becomes cost of goods sold. As the temporary difference reverses, taxable income will be less than accounting income. When taxable income will be less than accounting income as a temporary difference reverses, we have a “future deductible amount” and record a deferred tax asset. When switching from FIFO to LIFO, the income tax effect is reflected in the income tax payable account. The rationale for this is that income taxes cannot be retrospectively restated for prior years. The Internal Revenue Code requires that taxes previously saved under another inventory method must now be repaid (over no longer than six years). Since the amount must be repaid immediately, there is no deferred tax liability. EFFECT ON INCOME TAX AS A RESULT OF CHANGE IN INVENTORY COSTING METHOD 8

1.W HEN R ETROSPECTIVE A PPLICATION I S I MPRACTICABLE Sometimes a lack of information makes it impracticable to report a change retrospectively so the new method is simply applied prospectively. If it’s impracticable to adjust each year reported, the change is applied retrospectively as of the earliest year practicable. If full retrospective application isn’t possible, the new method is applied prospectively beginning in the earliest year practicable. Footnote disclosure should indicate reasons why retrospective application was impracticable. EXCEPTIONS NECESSITATING THE PROSPECTIVE APPROACH 2. W HEN M ANDATED B Y A UTHORITATIVE P RONOUNCEMENTS Another exception to retrospective application is when a new authoritative pronouncement requires prospective application for specific changes in accounting methods. 3.C HANGING D EPRECIATION, A MORTIZATION, D EPLETION M ETHODS We account for a change in depreciation method as a change in accounting estimate that is achieved by a change in accounting principle. Therefore, we account for such a change prospectively; that is, precisely the way we account for changes in estimates. 9

. SPECIFIC EXCEPTIONS TO RETROSPECTIVE APPLICATION  A change from another inventory method to LIFO.  A change in the method of depreciation, amortization, or depletion. 10

Ex 20-11, page 1224 – Change in Depreciation Methods Requirement 2 Asset’s cost$800,000 Accumulated depreciation to date ($160,000 x 2) (320,000) Book Value - To be depreciated over remaining 3 years$ 480, SYD depreciation: 3 x $480,000 = $240,000 sum-of-years-digits( ) Depreciation Expense240,000 Accumulated Depreciation240,000 11

 Changes in estimates are accounted for prospectively. When a company revises a previous estimate, prior financial statements are not revised. Instead, the company merely incorporates the new estimate in any related accounting determinations from then on.  A disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per-share amounts for the current period. CHANGE IN ACCOUNTING ESTIMATE 12

CHANGE IN ACCOUNTING ESTIMATE - Example Universal Semiconductors estimates warranty expense as 2% of credit sales. After a review during 2015, Universal determined that 3% of credit sales is a more realistic estimate of its payment experience. Credit sales in 2015 are $300 million. The effective income tax rate is 40%. Warranty Expense9,000,000 Estimated Warranty Liability9,000,000 Calculation: 300,000,000 X.03 = $9,000,000 This is a change in accounting estimate, therefore:  Warranty expense reported in prior years is not restated.  No account balances are adjusted (including income tax).  In 2015 and later years, the adjusting entry to record warranty expense simply will reflect the new percentage.  The effect of a change in estimate is described in a footnote to the financial statements. 13

Brief Exercise 20-7, page 1221 In 2015, Quapau Products introduced a new line of hot water heaters that carry a one-year warranty against manufacturer’s defects. Based on industry experience, warranty costs were expected to approximate 5% of sales revenue. First-year sales of the heaters were $300,000. An evaluation of the company’s claims experience in late 2016 indicated that actual claims were less that expected – 4% of sales rather than 5%. Assuming sales of the heaters in 2016 were $350,000 and warranty expenditures in 2016 totaled $12,000, what is the 2016 warranty expense? Warranty Expense14,000 Estimated Warranty Liability14,000 Calculation: $350,000 X.04 = $14,000 14

ERROR CORRECTIONS Errors occur when transactions either are recorded incorrectly or not recorded at all. 15

 A journal entry is made to correct any account balances that are incorrect as a result of the error.  Errors occurring and discovered in the current accounting period do not require any restatements.  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).  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), for the earliest year being reported in the comparative financial statements. Prior period errors affecting revenue or expense accounts will flow through to retained earnings.  A disclosure note should describe the nature of the error and the impact of its correction on net income, income before extraordinary items, and earnings per share. ERROR CORRECTION 16

If an accounting error is made and discovered in the same accounting period, the original erroneous entry should simply be reversed and the appropriate entry recorded. Example: G.H. Little, Inc. paid $300,000 for replacement computers and recorded the expenditure as maintenance expense. The error was discovered a week later. Cash300,000 Maintenance Expense300,000 To reverse the erroneous entry Equipment300,000 Cash300,000 To record the correct entry ERROR DISCOVERED IN THE SAME ACCOUNTING PERIOD THAT IT OCCURRED - Example 17

Other examples of errors affecting previous financial statements, but not net income:  Incorrectly recording salaries payable as accounts payable  Recording a loss as an expense or a gain as a revenue  Classifying a cash flow as an investing activity rather than a financing activity on the statement of cash flows. Any affected financial statements included with comparative financial statements would be retrospectively restated. Since net income was not affected, no prior period adjustment is required for retained earnings. A disclosure note would be included to describe the nature of the error. Example: MDS Transportation incorrectly recorded a $2 million note receivable as accounts receivable. The error was discovered a year later. Notes Receivable2,000,000 Accounts Receivable2,000,000 To correct incorrect accounts ERROR AFFECTING PREVIOUS FINANCIAL STATEMENTS BUT NOT NET INCOME - Example 18

RECORDING AN ASSET AS AN EXPENSE When an asset is incorrectly recorded as an expense, net income will be affected. The following steps should be taken to correct the error.  The prior period financial statements are retrospectively restated.  The corrections is reported as a “prior period adjustment”.  A disclosure note describes the error and the impact of its correction. 19

ERROR AFFECTING NET INCOME ON PREVIOUS FINANCIAL STATEMENTS - Example Analysis: ($ in millions) Incorrect (As Recorded) Correct (Should Have Been Recorded) 2014 Expense7.0Equipment7.0 Cash7.0 Cash DepreciationDep Expense1.4 Entry Omitted Accum Dep DepreciationDep Expense1.4 Entry Omitted Accum Dep In 2016, internal auditors discovered that Seidman Distribution, Inc. had debited an expense account for the $7 million cost of sorting equipment purchased at the beginning of The equipment’s useful life was expected to be 5 years with no residual value. Straight-line depreciation is used by Seidman

ERROR AFFECTING NET INCOME ON PREVIOUS FINANCIAL STATEMENTS - Explanation 21 During the two-year period, depreciation expense and accumulated depreciation were understated by $2.8 million, but other expenses were overstated by $7 million, so net income during the period was understated by a net difference of $4.2 million. This means retained earnings is currently understated by that amount. Equipment7,000,000 Accumulated Depreciation2,800,000 Retained Earnings4,200,000 To correct incorrect accounts

ERROR AFFECTING NET INCOME ON PREVIOUS FINANCIAL STATEMENTS 22  The 2014 and 2015 financial statements are retrospectively restated.  The correction is reported as a “prior period adjustment.”  A disclosure note describes the error and the impact of its correction.

INVENTORY MISSTATED In early 2013, Overseas Wholesale Supply discovered that $1 million of inventory had been inadvertently excluded from its 2011 ending inventory count. Analysis:U = Understated O = Overstated Beginning inventory  Beginning inventoryU Plus: Net purchases  Plus: Net purchases Less: Ending inventoryU   Less: Ending inventory Cost of goods soldOCost of goods sold U RevenuesRevenues Less: COGSOLess: Cost of goods sold U Less: Other expensesLess: Other expenses Net incomeUNet income O   Retained earningsURetained earnings corrected If discovered in 2012 (before closing) : ($ in millions) Inventory1 Retained earnings 1 If discovered in 2013 or later: No correcting entry needed

Accounting Changes and Error Corrections INTERMEDIATE ACCOUNTING II – CHAPTER 20 END OF PRESENTATION 24