Intermediate Accounting

Intermediate Accounting
Prepared by Coby Harmon University of California, Santa Barbara

22 Accounting Changes and Error Analysis Intermediate Accounting
14th Edition Kieso, Weygandt, and Warfield

Learning Objectives Identify the two types of accounting changes.
Describe the accounting for changes in accounting policies. Understand how to account for retrospective accounting changes. Understand how to account for impracticable changes. Describe the accounting for changes in estimates. Describe the accounting for correction of errors. Identify economic motives for changing accounting policies. Analyze the effect of errors.

Accounting Changes and Error Analysis
Changes in accounting policy Changes in accounting estimate Change in reporting entity Correction of errors Summary Motivations for change of method Balance sheet errors Income statement errors Balance sheet and income statement effects Comprehensive example Preparation of statements with error corrections

Accounting Changes Accounting Alternatives:
Diminish the comparability of financial information. Obscure useful historical trend data. Types of Accounting Changes: Change in Accounting Policy. Changes in Accounting Estimate. Change in Reporting Entity. Errors are not considered an accounting change. LO 1 Identify the two types of accounting changes.

Changes in Accounting Principle
Change from one accepted accounting policy to another. Examples include: Average cost to LIFO. Completed-contract to percentage-of-completion. Adoption of a new policy in recognition of events that have occurred for the first time or that were previously immaterial is not an accounting change. LO 2 Describe the accounting for changes in accounting policies.

Three approaches for reporting changes: Currently. Retrospectively. Prospectively (in the future). FASB requires use of the retrospective approach. Rationale - Users can then better compare results from one period to the next. LO 2 Describe the accounting for changes in accounting policies.

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. LO 3 Understand how to account for retrospective accounting changes.

Retrospective Accounting Change: Long-Term Contracts Illustration: Denson Company has accounted for its income from long-term construction contracts using the completed-contract method. In 2012, the company changed to the percentage-of-completion method. Management believes this approach provides a more appropriate measure of the income earned. For tax purposes, the company uses the completed-contract method and plans to continue doing so in the future. (Assume a 40 percent enacted tax rate.) LO 3 Understand how to account for retrospective accounting changes.

Illustration 22-1 LO 3 Understand how to account for retrospective accounting changes.

Data for Retrospective Change Illustration 22-2 Construction in Process 220,000 Deferred Tax Liability 88,000 Retained Earnings 132,000 Journal entry beginning of 2012 LO 3 Understand how to account for retrospective accounting changes.

Reporting a Change in Principle Major disclosure requirements are as follows. Nature of the change in accounting policy; The method of applying the change, and: A description of the prior period information that has been retrospectively adjusted, if any. The effect of the change on income from continuing operations, net income (or other appropriate captions of changes in net assets or performance indicators), any other affected line item. The cumulative effect of the change on retained earnings or other components of equity or net assets in the balance sheet as of the beginning of the earliest period presented. LO 3 Understand how to account for retrospective accounting changes.

Reporting a Change in policy Illustration 22-3 LO 3

Retained Earnings Adjustment Retained earnings balance is $1,360,000 at the beginning of 2010. Illustration 22-4 Before Change LO 3 Understand how to account for retrospective accounting changes.

Retained Earnings Adjustment After Change Illustration 22-5 LO 3 Understand how to account for retrospective accounting changes.

E22-1 (Change in Principle—Long-Term Contracts): Cherokee Construction Company changed from the completed-contract to the percentage-of-completion method of accounting for long-term construction contracts during For tax purposes, the company employs the completed-contract method and will continue this approach in the future. (Hint: Adjust all tax consequences through the Deferred Tax Liability account.) LO 3 Understand how to account for retrospective accounting changes.

E22-1 (Change in policy—Long-Term Contracts): Instructions: (assume a tax rate of 35%) (b) What entry(ies) are necessary to adjust the accounting records for the change in accounting principle? (a) What is the amount of net income and retained earnings that would be reported in 2012? Assume beginning retained earnings for 2011 to be $100,000. LO 3 Understand how to account for retrospective accounting changes.

E22-1: Pre-Tax Income from Long-Term Contracts LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle Statement of Retained Earnings
E22-1: Comparative Statements Income Statement Statement of Retained Earnings LO 3 Understand how to account for retrospective accounting changes.

Direct and Indirect Effects of Changes Direct Effects - FASB takes the position that companies should retrospectively apply the direct effects of a change in accounting principle. Indirect Effect is any change to current or future cash flows of a company that result from making a change in accounting principle that is applied retrospectively. LO 3 Understand how to account for retrospective accounting changes.

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. LO 4 Understand how to account for impracticable changes.

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. LO 5 Describe the accounting for changes in estimates.

Prospective Reporting Changes in accounting estimates are reported prospectively. Account for changes in estimates in the period of change if the change affects that period only, or the period of change and future periods if the change affects both. FASB views changes in estimates as normal recurring corrections and adjustments and prohibits retrospective treatment. LO 5 Describe the accounting for changes in estimates.

Change in Estimate Example
Illustration: Arcadia High School purchased equipment for $510,000 which was estimated to have a useful life of 10 years with a salvage value of $10,000 at the end of that time. Depreciation has been recorded for 7 years on a straight-line basis. In 2012 (year 8), it is determined that the total estimated life should be 15 years with a salvage value of $5,000 at the end of that time. Required: What is the journal entry to correct prior years’ depreciation expense? Calculate depreciation expense for 2012. No Entry Required LO 5 Describe the accounting for changes in estimates.

After 7 years Equipment cost $510,000 Salvage value ,000 Depreciable base 500,000 Useful life (original) years Annual depreciation $ 50,000 First, establish NBV at date of change in estimate. x 7 years = $350,000 Balance Sheet (Dec. 31, 2011) Fixed Assets: Equipment $510,000 Accumulated depreciation 350,000 Net book value (NBV) $160,000 LO 5 Describe the accounting for changes in estimates.

Net book value $160,000 Salvage value (if any) ,000 Depreciable base 155,000 Useful life years Annual depreciation $ 19,375 Second, calculate depreciation expense for 2012. Journal entry for 2012 Depreciation expense 19,375 Accumulated depreciation 19,375 LO 5 Describe the accounting for changes in estimates.

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. LO 5 Describe the accounting for changes in estimates.

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. LO 6 Identify changes in a reporting entity.

Correction of Errors Types of Accounting Errors:
A change from an accounting principle that is not generally accepted to an accounting policy that is acceptable. Mathematical mistakes. Changes in estimates that occur because a company did not prepare the estimates in good faith. Failure to accrue or defer certain expenses or revenues. Misuse of facts. Incorrect classification of a cost as an expense instead of an asset, and vice versa. LO 7 Describe the accounting for correction of errors.

Correction of Errors All material errors must be corrected.
Record corrections of errors from prior periods as an adjustment to the beginning balance of retained earnings in the current period. Such corrections are called prior period adjustments. For comparative statements, a company should restate the prior statements affected, to correct for the error. LO 7 Describe the accounting for correction of errors.

Correction of Errors Illustration: In 2013 the bookkeeper for Selectro Company discovered an error: In 2012 the company failed to record $20,000of depreciation expense on a newly constructed building. This building is the only depreciable asset Selectro owns. The company correctly included the depreciation expense in its tax return and correctly reported its income taxes payable. LO 7 Describe the accounting for correction of errors.

Correction of Errors Illustration: Selectro’s income statement for 2012 with and without the error. Illustration 22-19 Show the entries that Selectro should have made and did make for recording depreciation expense and income taxes. LO 7 Describe the accounting for correction of errors.

Correction of Errors Illustration: Show the entries that Selectro should have made and did make for recording depreciation expense and income taxes. Illustration 22-18 Correcting Entry in 2013 LO 7 Describe the accounting for correction of errors.

Correction of Errors Illustration: Show the entries that Selectro should have made and did make for recording depreciation expense and income taxes. Illustration 22-18 Retained Earnings 12,000 Correcting Entry in 2013 LO 7 Describe the accounting for correction of errors.

Correction of Errors Illustration: Show the entries that Selectro should have made and did make for recording depreciation expense and income taxes. Illustration 22-18 Reversal Retained Earnings 12,000 Deferred Tax Liability 8,000 Correcting Entry in 2013 LO 7 Describe the accounting for correction of errors.

Correction of Errors Illustration: Show the entries that Selectro should have made and did make for recording depreciation expense and income taxes. Illustration 22-18 Retained Earnings 12,000 Deferred Tax Liability 8,000 Accumulated Depreciation—Buildings 20,000 Correcting Entry in 2013 Record LO 7 Describe the accounting for correction of errors.

Correction of Errors Illustration (Single-Period Statement): Assume that Selectro Company has a beginning retained earnings balance at January 1, 2013, of $350,000. The company reports net income of $400,000 in 2013. Illustration 22-21 LO 7 Describe the accounting for correction of errors.

Correction of Errors Comparative Statements Company should
make adjustments to correct the amounts for all affected accounts reported in the statements for all periods reported. restate the data to the correct basis for each year presented. show any catch-up adjustment as a prior period adjustment to retained earnings for the earliest period it reported. LO 7 Describe the accounting for correction of errors.

Correction of Errors Before issuing the report for the year ended December 31, 2012, you discover a $62,500 error that caused the 2011 inventory to be overstated (overstated inventory caused COGS to be lower and thus net income to be higher in 2011). Would this discovery have any impact on the reporting of the Statement of Retained Earnings for 2012? Assume a 20% tax rate. LO 7 Describe the accounting for correction of errors.

Correction of Errors LO 7 Describe the accounting for correction of errors.

Summary of Accounting Changes and Errors
Illustration 22-23 LO 7

Motivations for Change of Accounting Method
Why companies may prefer certain accounting methods. Some reasons are: Political costs. Capital Structure. Bonus Payments. Smooth Earnings. LO 8 Identify economic motives for changing accounting policies.

Error Analysis Companies must answer three questions:
What type of error is involved? What entries are needed to correct for the error? After discovery of the error, how are financial statements to be restated? Companies treat errors as prior-period adjustments and report them in the current year as adjustments to the beginning balance of Retained Earnings. LO 9 Analyze the effect of errors.

Balance Sheet Errors Balance sheet errors affect only the presentation of an asset, liability, or stockholders’ equity account. Current year error - reclassify item to its proper position. Prior year error - restate the balance sheet of the prior year for comparative purposes. LO 9 Analyze the effect of errors.

Income Statement Errors
Improper classification of revenues or expenses. Current year error - reclassify item to its proper position. Prior year error - restate the income statement of the prior year for comparative purposes. LO 9 Analyze the effect of errors.

Balance Sheet and Income Statement Errors
Counterbalancing Errors Will be offset or corrected over two periods. If company has closed the books: If the error is already counterbalanced, no entry is necessary. If the error is not yet counterbalanced, make entry to adjust the present balance of retained earnings. For comparative purposes, restatement is necessary even if a correcting journal entry is not required. LO 9 Analyze the effect of errors.

Counterbalancing Errors Will be offset or corrected over two periods. If company has not closed the books: If error already counterbalanced, make entry to correct the error in the current period and to adjust the beginning balance of Retained Earnings. If error not yet counterbalanced, make entry to adjust the beginning balance of Retained Earnings. LO 9 Analyze the effect of errors.

Non-Counterbalancing Errors Not offset in the next accounting period. Companies must make correcting entries, even if they have closed the books. LO 9 Analyze the effect of errors.

Error Analysis Example
E22-19 (Error Analysis; Correcting Entries): A partial trial balance of Dickinson Corporation is as follows on December 31, 2012. Instructions: (a) Assuming that the books have not been closed, what are the adjusting entries necessary at December 31, 2012? LO 9 Analyze the effect of errors.

(a) Assuming that the books have not been closed, what are the adjusting entries necessary at December 31, 2012? 1. A physical count of supplies on hand on December 31, 2012, totaled $1,100. 2. Accrued salaries and wages on December 31, 2012, amounted to $4,400. LO 9 Analyze the effect of errors.

(a) Assuming that the books have not been closed, what are the adjusting entries necessary at December 31, 2012? 3. Accrued interest on investments amounts to $4,350 on December 31, 2012. 4. The unexpired portions of the insurance policies totaled $65,000 as of December 31, 2012. LO 9 Analyze the effect of errors.

(a) Assuming that the books have not been closed, what are the adjusting entries necessary at December 31, 2012? 5. $24,000 was received on January 1, 2012 for the rent of a building for both 2012 and The entire amount was credited to rental income. 6. Depreciation for the year was erroneously recorded as $5,000 rather than the correct figure of $50,000. LO 9 Analyze the effect of errors.

E22-19 (Error Analysis; Correcting Entries) A partial trial balance of Dickinson Corporation is as follows on December 31, 2012. Instructions: (b) Assuming that the books have been closed, what are the adjusting entries necessary at December 31, 2012? LO 9 Analyze the effect of errors.

(b) Assuming that the books have been closed, what are the adjusting entries necessary at December 31, 2012? 1. A physical count of supplies on hand on December 31, 2012, totaled $1,100. 2. Accrued salaries and wages on December 31, 2012, amounted to $4,400. LO 9 Analyze the effect of errors.

(b) Assuming that the books have been closed, what are the adjusting entries necessary at December 31, 2012? 3. Accrued interest on investments amounts to $4,350 on December 31, 2012. 4. The unexpired portions of the insurance policies totaled $65,000 as of December 31, 2012. LO 9 Analyze the effect of errors.

(b) Assuming that the books have been closed, what are the adjusting entries necessary at December 31, 2012? 5. $24,000 was received on January 1, 2012 for the rent of a building for both 2012 and The entire amount was credited to rental income. 6. Depreciation for the year was erroneously recorded as $5,000 rather than the correct figure of $50,000. LO 9 Analyze the effect of errors.

Change From The Equity Method
APPENDIX 22A CHANGING FROM OR TO THE EQUITY METHOD Change From The Equity Method Change from the equity method to the fair-value method. Earnings or losses previously recognized under the equity method should remain as part of the carrying amount of the investment. The cost basis is the carrying amount of the investment at the date of the change. The investor applies the new method in its entirety. At the next reporting date, the investor should record the unrealized holding gain or loss to recognize the difference between the carrying amount and fair value. LO 10 Make the computations and prepare the entries necessary to record a change from or to the equity method of accounting.

Dividends in Excess of Earnings
APPENDIX 22A CHANGING FROM OR TO THE EQUITY METHOD Dividends in Excess of Earnings Accounted for such dividends as a reduction of the investment carrying amount, rather than as revenue. Reason: Dividends in excess of earnings are viewed as a ________________ with this excess then accounted for as a reduction of the equity investment. liquidating dividend LO 10 Make the computations and prepare the entries necessary to record a change from or to the equity method of accounting.

APPENDIX 22A CHANGING FROM OR TO THE EQUITY METHOD Dividends in Excess of Earnings Illustration: On January 1, 2011, Investor Company purchased 250,000 shares of Investee Company’s 1,000,000 shares of outstanding stock for $8,500,000. Investor correctly accounted for this investment using the equity method. After accounting for dividends received and investee net income, in 2011, Investor reported its investment in Investee Company at $8,780,000 at December 31, On January 2, 2012, Investee Company sold 1,500,000 additional shares of its own common stock to the public, thereby reducing Investor Company’s ownership from 25 percent to 10 percent. LO 10 Make the computations and prepare the entries necessary to record a change from or to the equity method of accounting.

APPENDIX 22A CHANGING FROM OR TO THE EQUITY METHOD Dividends in Excess of Earnings Illustration 22A-1 LO 10 Make the computations and prepare the entries necessary to record a change from or to the equity method of accounting.

Impact on Investment Carrying Amount
APPENDIX 22A CHANGING FROM OR TO THE EQUITY METHOD Impact on Investment Carrying Amount Illustration 22A-2 2012 & 2013 Cash 400,000 Dividend Revenue 400,000 Cash 210,000 Equity Investments (AFS) 60,000 Dividend Revenue 150,000 2014 LO 10

Change To The Equity Method
APPENDIX 22A CHANGING FROM OR TO THE EQUITY METHOD Change To The Equity Method Companies use retrospective application. The carrying amount of the investment, results of current and prior operations, and retained earnings of the investor are adjusted as if the equity method has been in effect during all of the previous periods. Companies also eliminate any balances in the Unrealized Holding Gain or Loss—Equity account and the Securities Fair Value Adjustment account. LO 10 Make the computations and prepare the entries necessary to record a change from or to the equity method of accounting.

RELEVANT FACTS One area in which GAAP and IFRS differ is the reporting of error corrections in previously issued financial statements. While both sets of standards require restatement, GAAP is an absolute standard—that is, there is no exception to this rule. The accounting for changes in estimates is similar between GAAP and IFRS. Under GAAP and IFRS, if determining the effect of a change in accounting policy is considered impracticable, then a company should report the effect of the change in the period in which it believes it practicable to do so, which may be the current period.

RELEVANT FACTS Under IFRS, the impracticality exception applies both to changes in accounting principles and to the correction of errors. Under GAAP, this exception applies only to changes in accounting principle. IFRS (IAS 8) does not specifically address the accounting and reporting for indirect effects of changes in accounting principles. As indicated in the chapter, GAAP has detailed guidance on the accounting and reporting of indirect effects.

IFRS SELF-TEST QUESTION
Which of the following is false? GAAP and IFRS have the same absolute standard regarding the reporting of error corrections in previously issued financial statements. The accounting for changes in estimates is similar between GAAP and IFRS. Under IFRS, the impracticality exception applies both to changes in accounting principles and to the correction of errors. GAAP has detailed guidance on the accounting and reporting of indirect effects; IFRS does not.

Which of the following is not classified as an accounting change by IFRS? Change in accounting policy. Change in accounting estimate. Errors in financial statements. None of the above.

IFRS requires companies to use which method for reporting changes in accounting policies? Cumulative effect approach. Retrospective approach. Prospective approach. Averaging approach.

Copyright Copyright © 2012 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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