Chapter 22 ACCOUNTING CHANGES AND ERROR analysis Sommers – ACCT 3311 Acct 3311 - Class 17 Chapter 22 ACCOUNTING CHANGES AND ERROR analysis Sommers – ACCT 3311 Chapter 1: Environment and Theoretical Structure of Financial Accounting.

Accounting Changes For accounting purposes, we classify accounting changes into three categories. Accounting changes are categorized as: Changes in policy (when companies switch from one acceptable accounting method to another) Changes in estimate (when new information causes companies to revise estimates made previously) Changes in reporting entity (the group of companies comprising the reporting entity changes) Correction of an error is NOT considered an accounting change

Discussion Questions Q22-4 Identify and describe the approach the FASB requires for reporting changes in accounting principles.

Change in Accounting Policy Change from one GAAP to another Adopt a new FASB standard Change methods of inventory costing Change from cost method to equity method, or vice versa Change from completed contract to percentage-of-completion, or vice versa

Changes in Accounting Principle Retrospective Accounting Change Approach Company reporting the change Adjusts its financial statements for each prior period presented to the same basis as the new accounting principle. Adjusts the carrying amounts of assets and liabilities as of the beginning of the first year presented, plus the opening balance of retained earnings.

Retrospective Approach 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. 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. 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 presented.

Example 1 Rockwell Corporation uses a periodic inventory system and has used the FIFO cost method since inception of the company in 1976. In 2011, the company decided to switch to the average cost method. Data for 2011 are as follows: Beginning inventory, FIFO (5,000 units @ $30) $150,000 Purchases: 5,000 units @ $ 36 $180,000 5,000 units @ $ 40 200,000 380,000 Cost of goods available for sale $530,000 Sales for 2011 (8,000 units @ $70) $560,000 Additional Information: The company’s effective income tax rate is 40% for all years. If the company had used the average cost method prior to 2011, ending inventory for 2010 would have been $130,000. 7,000 units remained in inventory at the end of 2011. Ignoring income taxes, prepare the 2011 journal entry to adjust the accounts to reflect the average cost method. What is the effect of the change in methods on 2011 net income?

Example 1: Continued Units FIFO $ Avg Cost $ 5,000 10,000 150,000 380,000 15,000 530,000 7,000 8,000

Changes in Accounting Principle Impracticability Companies should not use retrospective application if one of the following conditions exists: Company cannot determine the effects of the retrospective application. Retrospective application requires assumptions about management’s intent in a prior period. Retrospective application requires significant estimates that the company cannot develop. If any of the above conditions exists, the company prospectively applies the new accounting principle.

Example 2: Aquatic Equipment Corporation decided to switch from the LIFO method of costing inventories to the FIFO method at the beginning of 2011. The inventory as reported at the end of 2010 using LIFO would have been $60,000 higher using FIFO. Retained earnings at the end of 2010 was reported as $780,000 (reflecting the LIFO method). The tax rate is 40%. Calculate the balance in retained earnings at the time of the change (beginning of 2011) as it would have been reported if FIFO had been used in prior years. Prepare the journal entry at the beginning of 2011 to record the change in accounting principle.

Example 2: Continued

Discussion Questions Q22-6 Define a change in estimate and provide an illustration.

Changes in Accounting Estimate Examples of Estimates Uncollectible receivables. Inventory obsolescence. Useful lives and salvage values of assets. Periods benefited by deferred costs. Liabilities for warranty costs and income taxes. Recoverable mineral reserves. Change in depreciation methods.

Changes in Accounting Estimate Revision of an estimate because of new information or new experience Change depreciation methods (considered a change in estimate achieved by a change in accounting principle) Change estimate of useful life of depreciable asset Change estimate of bad debt percentage Change estimate of periods benefited by intangible assets Change actuarial estimates pertaining to a pension plan

Prospective Approach 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. Most changes in principle are reported by the retrospective approach, but 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. Change in Depreciation Estimate 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. The prospective approach is used instead of the retrospective approach when it is:  Impracticable to determine some period-specific effects.  Impracticable to determine the cumulative effect of prior years.  Mandated by Financial Accounting Standards Board or other authoritative pronouncements.

Changes in Accounting Estimate Disclosures Companies need not disclose changes in accounting estimate made as part of normal operations, such as bad debt allowances or inventory obsolescence, unless such changes are material. However, for a change in estimate that affects several periods (such as a change in the service lives of depreciable assets), companies should disclose the effect on income from continuing operations and related per-share amounts of the current period.

Example 3 The Perdot Company purchased machinery on January 2, 2009, for $800,000. A five-year life was estimated and no residual value was anticipated. Perdot decided to use the straight-line depreciation method and recorded $160,000 in depreciation in 2009 and 2010. Early in 2011, the company revised the total estimated life of the machinery to eight years. Briefly describe the accounting treatment for this change.

Example 3: Continued The Perdot Company purchased machinery on January 2, 2009, for $800,000. A five-year life was estimated and no residual value was anticipated. Perdot decided to use the straight-line depreciation method and recorded $160,000 in depreciation in 2009 and 2010. Early in 2011, the company revised the total estimated life of the machinery to eight years. Determine depreciation for 2011.

Change in Reporting Entity Examples of a change in reporting entity are: Presenting consolidated statements in place of statements of individual companies. Changing specific subsidiaries that constitute the group of companies for which the entity presents consolidated financial statements. Changing the companies included in combined financial statements. Changing the cost, equity, or consolidation method of accounting for subsidiaries and investments. Reported by changing the financial statements of all prior periods presented.

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. A change in reporting entity requires that financial statements of prior periods be retrospectively revised to report the financial information for the new reporting entity in all periods presented. All previous periods’ financial statements that are presented are recasted 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. These two disclosures are not necessary in subsequent financial statements.

Discussion Questions Q22-2 State how each of the following items is reflected in the financial statements. Change from FIFO to LIFO method for inventory valuation purposes. Charge for failure to record depreciation in a previous period. (c) Litigation won in current year, related to prior period.

Discussion Questions Q22-2 State how each of the following items is reflected in the financial statements. Change in the reliability of certain receivables. Write-off of receivables. Change from the percentage-of-completion to the completed- contract method for reporting new income.

Classification of Accounting Changes Indicate with the appropriate letter the nature of each situation described below: PR Change in principle reported retrospectively PP Change in principle reported prospectively E Change in estimate EP Change in estimate resulting from a change in principle R Change in reporting entity CE Correction of an error Change from declining balance depreciation to straight-line. Change in the estimated useful life of office equipment. Technological advance that renders worthless a patent with an unamortized cost of $45,000. Change from determining lower of cost or market for the inventories by the individual item approach to the aggregate approach.

Classification of Accounting Changes Indicate with the appropriate letter the nature of each situation described below: PR Change in principle reported retrospectively PP Change in principle reported prospectively E Change in estimate EP Change in estimate resulting from a change in principle R Change in reporting entity CE Correction of an error Change from LIFO inventory costing to the weighted-average inventory costing. Settling a lawsuit for less than the amount accrued previously as a loss contingency. Including in the consolidated financial statements a subsidiary acquired several years earlier that was appropriately not included in previous years.

Classification of Accounting Changes Indicate with the appropriate letter the nature of each situation described below: PR Change in principle reported retrospectively PP Change in principle reported prospectively E Change in estimate EP Change in estimate resulting from a change in principle R Change in reporting entity CE Correction of an error Change by a retail store from reporting bad debt expense on a pay- as-you-go basis to the allowance method. A shift of certain manufacturing overhead costs to inventory that previously were expensed as incurred to more accurately measure cost of goods sold. (Either method is generally acceptable.)

Example 4: Described below are six independent and unrelated situations involving accounting changes. Each change occurs during 2011 before any adjusting entries or closing entries were prepared. Assume the tax rate for each company is 40% in all years. Fleming Home Products introduced a new line of commercial awnings in 2010 that carry a one-year warranty against manufacturer’s defects. Based on industry experience, warranty costs were expected to approximate 3% of sales. Sales of the awnings in 2010 were $3,500,000. Accordingly, warranty expense and a warranty liability of $105,000 were recorded in 2010. In late 2011, the company’s claims experience was evaluated and it was determined that claims were far fewer than expected: 2% of sales rather than 3%. Sales of the awnings in 2011 were $4,000,000 and warranty expenditures in 2011 totaled $91,000. Identify the type of change. Prepare any journal entry necessary as a direct result of the change as well as any adjusting entry for 2011 related to the situation described. Briefly describe any other steps that should be taken to appropriately report the situation.

Example 4: Continued

Example 4: Continued Each change occurs during 2011 before any adjusting entries or closing entries were prepared. Assume the tax rate for each company is 40% in all years. On December 30, 2007, Rival Industries acquired its office building at a cost of $1,000,000. It was depreciated on a straight- line basis assuming a useful life of 40 years and no salvage value. However, plans were finalized in 2011 to relocate the company headquarters at the end of 2015. The vacated office building will have a salvage value at that time of $700,000. Identify the type of change. Prepare any journal entry necessary as a direct result of the change as well as any adjusting entry for 2011 related to the situation described. Briefly describe any other steps that should be taken to appropriately report the situation.

Example 4: Continued

Example 4: Continued Each change occurs during 2011 before any adjusting entries or closing entries were prepared. Assume the tax rate for each company is 40% in all years. Hobbs- Barto Merchandising, Inc., changed inventory cost methods to LIFO from FIFO at the end of 2011 for both financial statement and income tax purposes. Under FIFO, the inventory at January 1, 2012, is $690,000. Identify the type of change. Prepare any journal entry necessary as a direct result of the change as well as any adjusting entry for 2011 related to the situation described. Briefly describe any other steps that should be taken to appropriately report the situation.

Example 4: Continued

Example 4: Continued Each change occurs during 2011 before any adjusting entries or closing entries were prepared. Assume the tax rate for each company is 40% in all years. At the beginning of 2008, the Hoffman Group purchased office equipment at a cost of $330,000. Its useful life was estimated to be 10 years with no salvage value. The equipment was depreciated by the sum-of-the-years’-digits method. On January 1, 2011, the company changed to the straight-line method. Identify the type of change. Describe all journal entry(s) necessary as a direct result of the change as well as any adjusting entry for 2011 related to the situation described. Briefly describe any other steps that should be taken to appropriately report the situation.

Example 4: Continued

Example 4: Continued Each change occurs during 2011 before any adjusting entries or closing entries were prepared. Assume the tax rate for each company is 40% in all years. In November 2009, the State of Minnesota filed suit against Huggins Manufacturing Company, seeking penalties for violations of clean air laws. When the financial statements were issued in 2010, Huggins had not reached a settlement with state authorities, but legal counsel advised Huggins that it was probable the company would have to pay $200,000 in penalties. Accordingly, the following entry was recorded: Loss— litigation .................................. 200,000 Liability— litigation .............................. 200,000 Late in 2011, a settlement was reached with state authorities to pay a total of $350,000 in penalties. Identify the type of change. Prepare any journal entry necessary as a direct result of the change as well as any adjusting entry for 2011 related to the situation described. Briefly describe any other steps that should be taken to appropriately report the situation.

Example 4: Continued

Example 4: Continued Each change occurs during 2011 before any adjusting entries or closing entries were prepared. Assume the tax rate for each company is 40% in all years. At the beginning of 2011, Jantzen Specialties, which uses the sum-of-the-years’-digits method, changed to the straight-line method for newly acquired buildings and equipment. The change increased current year net earnings by $445,000. Identify the type of change. Prepare any journal entry necessary as a direct result of the change as well as any adjusting entry for 2011 related to the situation described. Briefly describe any other steps that should be taken to appropriately report the situation.

Example 4: Continued