Intermediate Accounting Chapter 22 Accounting for Changes and Errors © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

What Are the Types of Accounting Changes and How Are They Reported? Changes in accounting principle represent a change from one generally accepted accounting principle to another generally accepted accounting principle. A change in the method of applying an accounting principle is also a change in accounting principle. Changes in accounting estimate are a revision of an estimate used in the accounting process. This type of change is inherent in the periodic presentation of financial statements and occurs as the result of new or additional information and experience. Changes in a reporting entity represent a change in the type of entity being reported. Many companies operate in a consolidated manner in that the parent company owns many subsidiaries. If a company acquires a subsidiary or sells off a subsidiary, the reporting entity has changed. Errors are the result of mathematical mistakes, mistakes in the application of GAAP, or the oversight or misuse of facts that existed when the financial statements were prepared. While errors are not accounting changes per se, they are discussed in this chapter because the correction of an error involves corrections to the reported financial statements similar to accounting changes. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Method of Reporting Accounting Changes and Errors (Slide 1 of 2) If a company makes an accounting change, GAAP provides two possible methods of reporting the change: The retrospective adjustment method requires that the reported financial statements be revised as if the newly adopted accounting principle had always been used. The prospective method does not require an adjustment to previously issued financial statements. Instead, the accounting change is accounted for in the current and future periods. Additionally, if an error is discovered, a company will correct the error by making a prior period adjustment. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Method of Reporting Accounting Changes and Errors (Slide 2 of 2) A change in an accounting principle is accounted for by the retrospective application of the new accounting principle. A change in an accounting estimate is accounted for prospectively. A change in a reporting entity is accounted for by a retrospective adjustment so that all the financial statements presented are for the same entity. An error is accounted for as a prior period adjustment (prior period restatement). © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

How Do We Account for a Change in Accounting Principle? (Slide 1 of 2) A change in accounting principle includes: change from one generally accepted accounting principle to another generally accepted accounting principle change in accounting principle because an Accounting Standard Update has been issued and the former principle is no longer generally accepted change in the method of applying an accounting principle © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

How Do We Account for a Change in Accounting Principle? (Slide 2 of 2) A change in accounting principle does not include: Initial adoption of a generally accepted accounting principle because of events or transactions occurring for the first time or that were previously immaterial Adoption or modification of an accounting principle for transactions or events that are clearly different in substance from those previously occurring Change to a generally accepted accounting principle from a principle that is not generally accepted. This would be treated as a correction of an error © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Retrospective Adjustment Method (Slide 1 of 2) A company accounts for a change in accounting principle by the retrospective application of the new accounting principle to all prior periods as follows: Step 1. Compute the cumulative effect of the change to the new accounting principle as of the beginning of the first period presented. Step 2. Prepare a journal entry to adjust the book values of the assets and liabilities (including income taxes) that are affected by the change so that their balances reflect the amounts that would have existed under the newly adopted accounting principle. An offsetting adjustment is made to the beginning balance of Retained Earnings for the cumulative effect of the change (net of taxes). Step 3. Adjust the financial statements of the current period and each prior period to reflect the specific effects of applying the new accounting principle. Therefore, the comparative financial statements would appear as if the newly adopted accounting principle was used in every period presented. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Retrospective Adjustment Method (Slide 2 of 2) Step 4. Disclose the following information: Nature and reason for the change in accounting principle, including an explanation of why the new principle is preferable Description of the prior-period information that has been retrospectively adjusted Effect of the change on income, earnings per share, and any other financial statement line item for the current period and the prior periods retrospectively adjusted Cumulative effect of the change on retained earnings (or other appropriate component of equity) at the beginning of the earliest period presented © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Direct and Indirect Effects The direct effect of a change in accounting principle is the amount by which a company’s prior years’ income is increased or decreased specifically as a result of the change in accounting principle. An indirect effect of a change in accounting principle is the amount by which the company’s prior years’ income is affected by how the change in principle affects other elements of income. In situations in which a change in accounting principle has both a direct and indirect effect on prior years’ income, GAAP states that a company recognizes only the direct effect (net of applicable income taxes) in determining the amount of the retrospective adjustment. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Impracticability of Retrospective Adjustment Sometimes, it may not be practicable to determine the effect of applying a change in accounting principle to a prior period. Retrospective adjustment is considered impracticable if any of the following conditions exist: The company cannot, after reasonable effort, determine the effect on prior periods. Retrospective adjustments depend on management’s intent that cannot be independently verified. Significant estimates are required that cannot be objectively verified. If retrospective adjustment is impracticable, GAAP requires a company to apply the new accounting principle prospectively as of the earliest date practicable. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Accounting Changes in Interim Financial Statements If a company makes a change in accounting principle in an interim period, it reports the change using the retrospective adjustment method in its interim financial statements. For example, if a company changes its method of accounting for long-term contracts during the third quarter of its fiscal year, it must restate the prior interim periods (the first and second quarters). The company does this by applying the newly adopted accounting principle to those interim periods and reporting the cumulative effect of the change in retained earnings at the beginning of the year in the restated net income of the first interim period. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

How Do We Account for a Change in Estimate? The application of GAAP requires a company to make estimates for items such as uncollectible accounts receivable, inventory obsolescence, service lives and residual values of depreciable assets, recoverable mineral reserves, warranty costs, pension costs, and the periods that it expects to be benefited by a deferred cost. In fact, virtually every number on the balance sheet involves an estimate. Because estimating future events is an inherently uncertain process, changes in estimates are inevitable as new events occur, as more experience is acquired, or as additional information is obtained. GAAP requires that a company account for a change in an accounting estimate in the period of the change and future periods if affected. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

A Change in Principle Distinguished from a Change in an Estimate Sometimes it is difficult for a company to distinguish between a change in an accounting principle and a change in an estimate. For example, a company may change from capitalizing and amortizing a cost to recording it as an expense when incurred because future benefits associated with the cost have become doubtful. The company adopted the new accounting method because of the change in estimated benefits, and therefore, the change in method is inseparable from the change in estimate. The company is required to account for such a change as a change in estimate. This is often referred to as a change in accounting estimate affected by a change in accounting principle. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

How Do We Account for a Change in Reporting Entity? The third type of change defined by GAAP is a change in a reporting entity which results in financial statements that, in effect, are those of a different reporting entity. A change in an accounting entity is limited mainly to presenting consolidated or combined financial statements in place of the statements of individual companies, changing specific subsidiaries that make up the group of companies for which consolidated financial statements are presented, or changing the companies included in combined financial statements. A company accounts for a change in reporting entity as a retrospective adjustment so that all the financial statements it presents are for the same entity. In addition, a company includes in the notes to its financial statements of the period in which it makes the change a description of the change as well as the reason for it, and the effect of the change on income before extraordinary items, net income, other comprehensive income, and related earnings per share amounts for all periods presented. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

How Do We Account for the Correction of an Error? (Slide 1 of 3) If a company makes a material error, it must correct the error as soon as it is discovered in the current period. The correction of an error is not an accounting change under GAAP. A company accounts for the correction of a material error of a past period that it discovers in the current period as a prior period adjustment (prior period restatement). Some of the more common issues involved in restatements in 2010 included: Revenue recognition Expense recognition Deferred, stock-based, or executive compensation Liabilities, payables, reserves and accrual estimate failures Debt, quasi-debt, and other equity issues Accounts/loans receivable, investments, and cash Cash flow statement classification errors © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

How Do We Account for the Correction of an Error? (Slide 2 of 3) A prior period adjustment requires a company to perform the following steps: Step 1. Compute the cumulative effect of the error on prior period financial statements. This represents the amounts that would have been in the financial statements if an error had not been made. Step 2. Prepare a journal entry to adjust the book values of those assets and liabilities (including income taxes) affected by the error. An offsetting adjustment is made to the beginning balance of Retained Earnings to report the cumulative effect of the error correction (net of taxes) for each period presented. Step 3. Adjust the financial statements of each prior period to reflect the specific effects of correcting the error. Each item in each financial statement that is affected by the error must be restated to the appropriate amount. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

How Do We Account for the Correction of an Error? (Slide 3 of 3) Step 4. Disclose the following information: A statement that the previously issued financial statements have been restated because of an error, along with a description of the nature of the error The effect of the correction of the error on each financial statement line item and any per share amounts for each prior period presented The cumulative effect of the change on retained earnings (or other appropriate component of equity) at the beginning of the earliest period presented © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Error Analysis Errors can be categorized according to the effect they have on the financial statements: Errors affecting only the balance sheet Errors affecting only the income statement Errors affecting both the income statement and balance sheet © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Errors Affecting Only the Balance Sheet A company may include a note receivable as an account receivable or it may incorrectly record a journal entry (e.g., a company may have debited Accounts Receivable when it should have debited Investments). Because the correction of these errors only affects the balance sheet, the company does not need to make a correcting journal entry. Instead, it reclassifies the affected accounts and restates any comparative financial statements presented. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Errors Affecting Only the Income Statement Errors that affect only income statement accounts usually result from the misclassification of items. For example, a company may include interest revenue with sales revenue. Errors of this kind require reclassification but do not affect the total amount reported as net income. Therefore, if the error occurred in a prior period, the company does not make a correcting journal entry. Instead, it reclassifies the affected accounts and restates any comparative financial statements presented. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Errors Affecting Both the Income Statement and Balance Sheet An error may affect both an income statement account and a balance sheet account, such as the failure to accrue a liability at the end of the period. These types of errors can be classified as counterbalancing or noncounterbalancing. Counterbalancing errors are those that that are automatically corrected in the next accounting period, even if they are not discovered. Noncounterbalancing errors are those that are not offset in the next accounting period. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Error Correction The following steps provide a basic framework for the analysis and correction of an error: Step 1. Analyze the original erroneous journal entry and determine what accounts and/or amounts were recorded in error. Step 2. Determine the journal entry that should have been recorded. Step 3. Evaluate whether the error has caused additional errors in other accounts. Step 4. Prepare the correcting entry (or entries). Any corrections of the revenues and expenses for prior years are recorded as adjustments to Retained Earnings. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.