1. Prepared by Gabriela H. Schneider, CMA; Grant MacEwan College INTERMEDIATE ACCOUNTING INTERMEDIATE ACCOUNTING Sixth Canadian Edition KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK

2. C H A P T E R 22 Accounting Changes and Error Analysis

3. Learning Objectives 1.Identify the types of accounting changes. 1. Identify the types of accounting changes. 2. Describe a change in accounting policy. 3. Understand how to account for retroactive-with- restatement type of accounting changes. 4. Understand how to account for retroactive- without-restatement type of accounting changes. 5. Understand how to account for prospective-type accounting changes.

4. Learning Objectives 6. Describe the accounting for changes in estimates. 7. Describe the accounting for correction of errors. 8. Identify changes in a reporting entity. 9. Identify economic motives for changing accounting methods. 10. Analyse the effect of errors.

5. Accounting Changes and Error Analysis Accounting Changes Types of accounting changes Change in accounting policy Change in accounting estimate Correction of an error Change in the reporting entity Summary Motivations for change Illustrations of reporting changes Error Analysis Balance sheet errors Income statement errors Balance sheet and income statement errors Comprehensive illustration Preparation of comparative statements

6. TypeDescriptionGeneral Rule Change inChange from oneApplied retroactively Accounting PolicyGAAP to anotherwith restatement 1 Change inChange resultingApplied prospectively Accounting Estimatefrom new information 2 Correction of errorMathematical orApplied retroactively in prior periodapplication errorwith restatement 3 Change in Change from business Applied prospectively Reporting entity combination or disposal with disclosure 4 Types of Accounting Changes

7. Change in Accounting Policy Change from one GAAP currently in practice to another Does not include: Adoption of a policy for new events or for events previously deemed immaterial Adoption of a policy for events that are substantially different from previous events Adoption of an acceptable GAAP practice in place of one which was previously not generally accepted This would be an example of an error correction

8. Change in Accounting Policy CICA Handbook, Section 1506 outlines three methods of accounting for accounting changes 1.Retroactive-with-restatement Used when there is a choice between two or more acceptable practices 2.Retroactive-without-restatement Used when information required for restatement is difficult to obtain 3.Prospective Used when information required for retroactive calculation difficult to obtain

9. Retroactive-with- Restatement Requirements of this method include: 1.Retroactive application of the new method, including income tax effects 2.Prior-period financial statements included for comparative purposes 3.Description of the change and effect on current and prior period financial statements disclosed

10. Retroactive-with- Restatement - Example Given: Change in amortization method Effect on Prior Periods: YearOriginal Revised Difference Tax @ Net Effect Amort. Amort. 40% on Income 2001 $12,000 $11,000 $ 1,000 $ 400 $ 600 2002 $21,600 $11,000 $10,600 $4,240 $6,360 Cumulative Effect $11,600 $4,640 $6,960 Effect on Current Periods: Year Original Revised Difference Tax @ Net Effect Amort. Amort. 40% on Income 2003 $17,280 $11,000 $6,280 $2,512 $3,768

11. Retroactive-with- Restatement - Example The effect on prior periods must now be recorded Use only Balance Sheet accounts for this entry Accumulated Amortization11,600 Future Income Tax Liability 4,640 Retained Earnings – Cumulative Effect of Change in Policy 6,960 Effect on Prior Periods: Difference Tax @ Net Effect 40% on Income Cumulative Effect $ 11,600 $4,640 $6,960

12. Retroactive-with- Restatement Restatement of the prior period Net income is the restated amount Retained earnings opening balance is the amount originally reported Restate the opening balance, with the cumulative effect of the accounting change to prior period Current period Retained earnings opening balance is the opening balance as originally stated in prior period Restate the opening balance for the cumulative effect on retained earnings

13. Retroactive-without- Restatement All appropriate calculations are made Entries made to account for the cumulative effect of the accounting change Only difference between retroactive-with- restatement and retroactive-without- restatement is the financial statement information Retained earnings will still show an effect of the accounting change

14. Change in Accounting Estimate Accounting estimates made are based on the best information available at the time New information becomes available, but does not invalidate the previous estimate calculations Therefore, all changes in accounting estimates are treated prospectively Examples include: 1.Estimating uncollectible receivables 2.Estimating useful lives and residual values of assets 3.Liabilities for warranty costs

15. Change in Accounting Estimate - Example Given: Building cost$300,000 Original useful life15 years Original salvage-0- AmortizedStraight-line Fiscal year endDecember 31 st Amortization recorded for five years; January 1, 2003 estimate of useful life changed to a total useful life of 25 years

16. Change in Accounting Estimate - Example Calculate the book value to the date of change (300,000 – 0)  15 =20,000 * 5 years = $100,000 Book Value = 300,000 – 100,000 = $200,000 The book value becomes the basis for the revised amortization calculation. Revised annual amortization (200,000 – 0)  (25 – 5) = $10,000 The 2003 and subsequent financial statements will report $10,000 amortization expense.

17. Correction of an Error in Prior Period Accounting errors that affect prior period financial statements accounted for retroactively in the year the error is discovered Reported in the current years’ financial statement as an adjustment to opening balance of Retained Earnings If comparative statements are prepared, all affected accounts in the prior periods are restated and cumulative adjustment made to opening Retained Earnings balance Disclosure in subsequent periods not required

18. Error Correction - Example Effects of the Error: Amortization expense understated by$20,000 Accumulated Amortization understated by$20,000 Income Tax Expense overstated by$ 8,000 Net Income overstated by$12,000 Future Tax Liability overstated by$ 8,000 If closing process is complete, an entry to only Balance Sheet accounts is made.

19. Error Correction - Example Future Tax Liability 8,000 Retained Earnings12,000 Accumulated Amortization20,000 The debit to Retained Earnings reflects the cumulative effect of the error on Net Income.

20. Error Correction - Example Retained Earnings (with error) Retained Earnings (without error) 150,000130,000Net Income Current Year Income Taxes ($110,000 * 40%) $44,000 Future Tax Liability ($130,000 - $110,000)*40% 8,000 Income Tax Expense$52,000 60,000 52,000Income Tax Expense 90,00078,000Ending Balance Adjustment to Retained Earnings: 90,000 – 78,000 = $8,000 Dr.

21. Change in Reporting Entity Current-period financial statements are reporting on an operation that is a different operation than in the previous period Disclosure requirements to provide sufficient information for user assessment Business combinations Discontinuing, disposal of a segment

22. Business Combination Disclosure includes: 1.Description of enterprise acquired, including percentage of voting shares 2.Date from which income from the acquired entity is included in the statements 3.Cost of the purchase; how cost is allocated to asset classes and liabilities assumed Pro-forma information may also be reported

23. Segment Disposal/Discontinuance When a segment is discontinued, or formal plans to do so are made, required disclosure includes: 1.Income statement reporting on the continuing and discontinued operations for current and prior periods 2.Description of discontinued operation with date of disposal 3.Description and carrying value of major assets and liabilities of discontinued segment

24. Motivations for Change 1.Political costs Larger firms, larger profits, may become political targets Accounting policies selected to reduce profits 2.Capital structure Debt/equity structure will impact accounting policies based on EPS impact, debt restraints 3.Bonus payments When bonuses attached to income, managers may select methods that maximize income 4.Smooth earnings Gradual increase (decrease) in income to shift attention

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