McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. ACCOUNTING CHANGES AND ERROR CORRECTIONS Chapter 20

Slide Accounting Changes

Slide Accounting Changes and Error Corrections Retrospective Two Reporting Approaches Prospective

Slide Error Corrections and Most Changes in Principle Retrospective Two Reporting Approaches Prospective Revise prior years’ statements (that are presented for comparative purposes) to reflect the impact of the change. The balance in each account affected is revised to appear as if the newly adopted accounted method had been applied all along or that the error had never occurred. Adjust the beginning balance of retained earnings for the earliest period reported. Revise prior years’ statements (that are presented for comparative purposes) to reflect the impact of the change. The balance in each account affected is revised to appear as if the newly adopted accounted method had been applied all along or that the error had never occurred. Adjust the beginning balance of retained earnings for the earliest period reported.

Slide Changes in Estimates and Some Changes in Principle Retrospective Two Reporting Approaches Prospective The change is implemented in the current period, and its effects are reflected in the financial statements of the current and future years only. Prior years’ statements are not revised. Account balances are not revised.

Slide ConsistencyComparability Qualitative Characteristics Although consistency and comparability are desirable, changing to a new method sometimes is appropriate. Change in Accounting Principle

Slide Motivation for Accounting Choices Changing Conditions New Standard Issued Effect on Compensation Effect on Debt Agreements Effect on Union Negotiations Motivations for Change Effect on Income Taxes

Slide Retrospective Approach – Most Changes in Principle Let’s look at an examples of a change from LIFO to FIFO. At the beginning of 2009, Air Parts Corporation changed from LIFO to FIFO. Air Parts has paid dividends of $40 million each year since Its income tax rate is 40 percent. Retained earnings on January 1, 2007, was $700 million; inventory was $500 million. Selected income statement amounts for 2009 and prior years are (in millions):

Slide Retrospective Approach For each year reported, Air Parts makes the comparative statements appear as if the newly adopted accounting method (FIFO) had been in use all along.

Slide Retrospective Approach For each year reported, Air Parts makes the comparative statements appear as if the newly adopted accounting method (FIFO) had been in use all along. Comparative balance sheets will report 2007 inventory $345 million higher than it was reported in last year’s statements. Retained earnings for 2007 will be $207 million higher. [$345 million × (1 – 40% tax rate)]

Slide Retrospective Approach Comparative balance sheets will report 2008 inventory $400 million higher than it was reported in last year’s statements. Retained earnings for 2008 will be $240 million higher. [$400 million × (1 – 40% tax rate)] For each year reported, Air Parts makes the comparative statements appear as if the newly adopted accounting method (FIFO) had been in use all along.

Slide Retrospective Approach Comparative balance sheets will report 2009 inventory $460 million higher than it would have been if the change from LIFO had not occurred. Retained earnings for 2009 will be $276 million higher. [$460 million × (1 – 40% tax rate)] For each year reported, Air Parts makes the comparative statements appear as if the newly adopted accounting method (FIFO) had been in use all along.

Slide Retrospective Approach On January 1, 2009, the date of the change, the following journal entry would be made to record the change in principle. 40% of $400,000,000

Slide Retrospective Approach In the first set of financial statements after the change is made, a disclosure note is needed to Provide justification for the change. Point out that comparative information has been revised. Report any per share amounts affected for the current and all prior periods.

Slide The prospective approach is used for changes in principle when:  It is impracticable to determine some period- specific effects.  It is impracticable to determine the cumulative effect of prior years.  The change is mandated by authoritative pronouncements. The prospective approach is used for changes in principle when:  It is impracticable to determine some period- specific effects.  It is impracticable to determine the cumulative effect of prior years.  The change is mandated by authoritative pronouncements. Prospective Approach – Some Changes in Principle Most changes in principle are reported by the retrospective approach, but:

Slide A change in depreciation method is considered to be a change in accounting estimate that is achieved by a change in accounting principle. It is accounted for prospectively as a change in accounting estimate. Prospective Approach – Change in Accounting Estimate

Slide On January 1, 2005, Towing, Inc. purchased specialized equipment for $243,000. The equipment has been depreciated using the straight-line method and had an estimated life of 10 years and salvage value of $3,000. In 2009 the total useful life of the equipment was revised to 6 years. The 2009 depreciation expense is a. $24,000 b. $48,000 c. $72,000 d. $73,500 Change in Accounting Estimate $243,000 – $3,000 = $24,000 (2005 – 2008) 10 years $24,000 × 4 years = $96,000 Accum. Depr. $243,000 – $96,000 = $147,000 Book Value $147,000 – $3,000 = $72,000 (2009 – 2010) 2 years Changes in accounting estimates are accounted for prospectively. Let’s look at an example of a change in a depreciation estimate.

Slide Universal Semiconductors switched from SYD depreciation to straight-line depreciation in The asset was purchased at the beginning of 2007 for $63 million, has a useful life of 5 years and an estimated residual value of $3 million. Changing Depreciation Methods

Slide Changing Depreciation Methods ÷

Slide Depreciation adjusting entry for 2009, 2010, and Changing Depreciation Methods

Slide Change in Reporting Entity A change in reporting entity occurs as a result of:  presenting consolidated financial statements in place of statements of individual companies, or  changing specific companies that constitute the group for which consolidated statements are prepared. A change in reporting entity occurs as a result of:  presenting consolidated financial statements in place of statements of individual companies, or  changing specific companies that constitute the group for which consolidated statements are prepared.

Slide Change in Reporting Entity Summary of the Retrospective Approach for Changes in Reporting Entity Recast all previous periods’ financial statements as if the new reporting entity existed in those periods. In the first financial statements after the change:  A disclosure note should describe the nature of and the reason for the change.  The effect of the change on net income, income before extraordinary items, and related per share amounts should be shown for all periods presented. Recast all previous periods’ financial statements as if the new reporting entity existed in those periods. In the first financial statements after the change:  A disclosure note should describe the nature of and the reason for the change.  The effect of the change on net income, income before extraordinary items, and related per share amounts should be shown for all periods presented.

Slide Examples include: Use of inappropriate principle Mistakes in applying GAAP Arithmetic mistakes Fraud or gross negligence in reporting For all years disclosed, financial statements are retrospectively restated to reflect the error correction. Examples include: Use of inappropriate principle Mistakes in applying GAAP Arithmetic mistakes Fraud or gross negligence in reporting For all years disclosed, financial statements are retrospectively restated to reflect the error correction. Error Correction

Slide Four-step process  Prepare a journal entry to correct any balances.  Retrospectively restate prior years’ financial statements that were incorrect.  Report correction as a prior period adjustment if retained earnings is one of the incorrect accounts affected.  Include a disclosure note. Four-step process  Prepare a journal entry to correct any balances.  Retrospectively restate prior years’ financial statements that were incorrect.  Report correction as a prior period adjustment if retained earnings is one of the incorrect accounts affected.  Include a disclosure note. Correction of Accounting Errors

Slide Counterbalancing error discovered in the second year. Noncounterbalancing error discovered in any year. Use the retrospective approach Prior Period Adjustment Required Prior Period Adjustments

Slide Errors Occurred and Discovered in the Same Period Corrected by reversing the incorrect entry and then recording the correct entry (or by making an entry to correct the account balances)

Slide Errors Not Affecting Prior Years’ Net Income Involves incorrect classification of accounts. Requires correction of previously issued statements (retrospective approach). Is not classified as a prior period adjustment since it does not affect prior income. Disclose nature of error. Involves incorrect classification of accounts. Requires correction of previously issued statements (retrospective approach). Is not classified as a prior period adjustment since it does not affect prior income. Disclose nature of error.

Slide Error Affecting Prior Year’s Net Income Requires correction of previously issued statements (retrospective approach). All incorrect account balances must be corrected. Is classified as a prior period adjustment since it does affect prior income. Disclose nature of error. Requires correction of previously issued statements (retrospective approach). All incorrect account balances must be corrected. Is classified as a prior period adjustment since it does affect prior income. Disclose nature of error.

Slide In 2009, the accountant at Orion, Inc. discovered the depreciation of $50,000 on a new asset purchased in 2008 had not been recorded on the books. However, the amount was properly reported on the tax return. This is the only difference between book and tax income. Accounting income for 2008 was $275,000 and taxable income was $225,000. Orion, Inc. is subject to a 30% tax rate and prepares current period statements only. The entry made in 2008 to record income taxes was Error Affecting Prior Year’s Net Income

Slide This error affected the following accounts Remember, the 2008 expense accounts were closed to RE. Error Affecting Prior Year’s Net Income

Slide Let’s assume the following: On 1/1/09, the retained earnings balance was $922,000. In 2009, the company paid $65,000 in dividends. Net income for 2009 was $184,000. Error Affecting Prior Year’s Net Income The Statement of Retained Earnings (or RE column of the Statement of Shareholders’ Equity) would be as follows:

Slide Correction of Accounting Errors Identify the type of accounting error for the following item: Ending inventory was incorrectly counted. a. Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above. Identify the type of accounting error for the following item: Ending inventory was incorrectly counted. a. Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above.

Slide Identify the type of accounting error for the following item: Loss on sale of furniture was incorrectly recorded as depreciation expense. a. Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above. Identify the type of accounting error for the following item: Loss on sale of furniture was incorrectly recorded as depreciation expense. a. Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above. Correction of Accounting Errors

Slide Identify the type of accounting error for the following item: Depreciation expense was understated. a. Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above. Identify the type of accounting error for the following item: Depreciation expense was understated. a. Counterbalancing error affecting net income. b. Noncounterbalancing error affecting net income. c. Error not affecting net income. d. None of the above. Correction of Accounting Errors

Slide A prior period adjustment is not required for a a. Counterbalancing error affecting net income discovered in the second year. b. Counterbalancing error affecting net income discovered after the second year. c. Noncounterbalancing error affecting net income. d. None of the above. A prior period adjustment is not required for a a. Counterbalancing error affecting net income discovered in the second year. b. Counterbalancing error affecting net income discovered after the second year. c. Noncounterbalancing error affecting net income. d. None of the above. Correction of Accounting Errors

Slide Summary of Accounting Changes and Errors

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