Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Accounting Changes and Error Corrections 20 Insert Book Cover Picture

20-2 Learning Objectives Differentiate between the three types of accounting changes and between the retrospective and prospective approaches to accounting for and reporting accounting changes.

20-3 Accounting Changes

20-4 Error corrections are...  Transactions that are either recorded incorrectly or not recorded at all.  Not actually accounting changes, but are accounted for similarly. Error corrections are...  Transactions that are either recorded incorrectly or not recorded at all.  Not actually accounting changes, but are accounted for similarly. Accounting Changes

20-5 Accounting Changes and Error Corrections Retrospective Two Reporting Approaches Prospective

20-6 Retrospective Two Reporting Approaches Prospective Revise prior year’s 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 year’s 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. Accounting Changes and Error Corrections

20-7 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. Accounting Changes and Error Corrections

20-8 Learning Objectives Describe how changes in accounting principle typically are reported.

20-9 ConsistencyComparability Qualitative Characteristics Although consistency and comparability are desirable, changing to a new method is sometimes appropriate. Change in Accounting Principle

20-10 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

20-11 Retrospective Approach Let’s look at an examples of a change from LIFO to FIFO that is reported using the retrospective approach. At the beginning of 2006, 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, 2004, was $700 million; inventory was $500 million. Selected income statement amounts for 2006 and prior years are (in millions): Let’s look at an examples of a change from LIFO to FIFO that is reported using the retrospective approach. At the beginning of 2006, 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, 2004, was $700 million; inventory was $500 million. Selected income statement amounts for 2006 and prior years are (in millions):

20-12 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.

20-13 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 2004 inventory $345 million higher than it was reported in last year’s statements. Retained earnings for 2004 will be $207 million higher. [$345 million × (1 – 40% tax rate)]

20-14 Retrospective Approach Comparative balance sheets will report 2005 inventory $400 million higher than it was reported in last year’s statements. Retained earnings for 2005 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.

20-15 Retrospective Approach Comparative balance sheets will report 2006 inventory $460 million higher than it would have been if the change from LIFO had not occurred. Retained earnings for 2006 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.

20-16 Retrospective Approach On January 1, 2006, the date of the change, the following journal entry would be made to record the change in principle: 40% of $400,000,000

20-17 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.

20-18 Learning Objectives Explain how and why some changes in accounting principle are reported prospectively. Explain how and why changes in estimates are treated prospectively.

20-19 The prospective approach is used when it is:  Impracticable to determine some period- specific effects.  Impracticable to determine the cumulative effect of prior years.  Mandated by authoritative pronouncements. The prospective approach is used when it is:  Impracticable to determine some period- specific effects.  Impracticable to determine the cumulative effect of prior years.  Mandated by authoritative pronouncements. FASB Statement Update Prospective Approach

20-20 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

20-21 Universal Semiconductors switched from SYD depreciation to straight-line depreciation in The asset was purchased at the beginning of 2004 for $63 million, has a useful life of 5 years and an estimated residual value of $3 million. Changing Depreciation Methods

20-22 Changing Depreciation Methods ÷

20-23 Depreciation adjusting entry for 2006, 2007, and Changing Depreciation Methods

20-24 Changing an Estimate Changes in accounting estimates are also accounted for prospectively. Let’s look at an example of a change in a depreciation estimate.

20-25 On January 1, 2002, Towing, Inc. purchased specialized equipment for $243,000. The equipment was depreciated using straight-line and had an estimated life of 10 years and salvage value of $3,000. In 2006 the total useful life of the equipment was revised to 6 years. The 2006 depreciation expense is a. $24,000 b. $48,000 c. $72,000 d. $73,500 On January 1, 2002, Towing, Inc. purchased specialized equipment for $243,000. The equipment was depreciated using straight-line and had an estimated life of 10 years and salvage value of $3,000. In 2006 the total useful life of the equipment was revised to 6 years. The 2006 depreciation expense is a. $24,000 b. $48,000 c. $72,000 d. $73,500 Changing an Estimate

20-26 On January 1, 2002, Towing, Inc. purchased specialized equipment for $243,000. The equipment was depreciated using straight-line and had an estimated life of 10 years and salvage value of $3,000. In 2006 the total useful life of the equipment was revised to 6 years. The 2006 depreciation expense is a. $24,000 b. $48,000 c. $72,000 d. $73,500 On January 1, 2002, Towing, Inc. purchased specialized equipment for $243,000. The equipment was depreciated using straight-line and had an estimated life of 10 years and salvage value of $3,000. In 2006 the total useful life of the equipment was revised to 6 years. The 2006 depreciation expense is a. $24,000 b. $48,000 c. $72,000 d. $73,500 $243,000 – $3,000 = $24,000 (2002 – 2005) 10 years $24,000 × 4 years = $96,000 Accum. Depr. $243,000 – $96,000 = $147,000 Book Value $147,000 – $3,000 = $72,000 (2006 – 2007) 2 years Changing an Estimate

20-27 I wonder why companies make accounting changes? It seems like a lot of trouble to me!

20-28 Learning Objectives Describe the situations that constitute a change in reporting entity.

20-29 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.

20-30 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.

20-31 Learning Objectives Understand and apply the four-step process of correcting and reporting errors, regardless of the type of error or the timing of its discovery.

20-32  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

20-33 Four-step process  Prepare a journal entry to correct any balances.  Retrospectively restate prior years’ financial statements that were incorrect.  Report error 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 error as a prior period adjustment if retained earnings is one of the incorrect accounts affected.  Include a disclosure note. Correction of Accounting Errors

20-34 Counterbalancing error discovered in the second year. Noncounterbalancing error discovered in any year. Use the retrospective approach. Prior Period Adjustment Required Prior Period Adjustments

20-35 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).

20-36 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. Error Not Affecting Prior Year’s Net Income

20-37 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. Error Affecting Prior Year’s Net Income

20-38 In 2006, the accountant at Orion, Inc. discovered the depreciation of $50,000 on a new asset purchased in 2005 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 2005 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 2005 to record income taxes was: Error Affecting Prior Year’s Net Income

20-39 This error affected the following accounts: Remember that the 2005 expense accounts have been closed. Error Affecting Prior Year’s Net Income

20-40 Let’s assume the following: Retained earning as 1/1/06 was $922,000. In 2006, the company paid $65,000 in dividends. Net income for 2006 is $184,000. The Statement of Retained Earnings would be as follows: Error Affecting Prior Year’s Net Income

20-41 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. Correction of Accounting Errors

20-42 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.

20-43 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

20-44 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

20-45 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

20-46 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

20-47 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

20-48 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

20-49 Summary of Accounting Changes and Errors

20-50 End of Chapter 20