University:
California State University, Northridge
Course:
ACCT 352 | Intermediate Financial Accounting III
Academic year:

2020
Views:

62

Pages:

38
Author:

Eddie Mcgee

Accounting Changes and Errors Accounting Changes Type of Change Change in Accounting Principle Description Change from one generally accepted accounting principle to another. Examples Adopt a new FASB standard. Change method of inventory costing. Change from FV method to equity method, or vice versa. Change from completed contract to percentage-of completion, or vice versa. Change in Accounting Estimate Revision of an estimate because of new information or new experience Change depreciation methods. Change estimate of useful life of depreciable asset. Change estimate of residual value of depreciable asset. Change estimate of bad debt % Change acturial estimates pertaining to a pension plan. Change in Reporting Entity Change from reporting as one type of entity to another type of entity 20 - 2 Consolidate a subsidiary not previously included in consolidated financial statements. Report consolidated financial statements in place of individual statements. Correction of an Error Type of Change Error correction Description Examples Correction of an error caused Mathematical mistakes. by a transaction being recorded Inaccuract physical count of inventory. incorrectly or not at all Change from the cash basis of accounting to the accrual basis. Failure to record an adjusting entry. Recording an asset as an expense, or vice versa. 20 - 3 Accounting Changes and Error Corrections Retrospective Two Reporting Approaches Prospective 20 - 4 Error Corrections and Most Changes in Principle Retrospective ReviseTwo prior years’ statements (that are presented for comparative purposes) to reflect Reporting the impact of the change. Approaches •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 Prospective never occurred. •Adjust the beginning balance of retained earnings for the earliest period reported. 20 - 5 Changes in Estimates and Some Changes in Principle The change is implemented in the Retrospective current period, and its effects are reflected in the financial statements of the current and future Two years only. Reporting •Prior years’ statements are not revised. •Account balances are not revised. Approaches Prospective 20 - 6 Change in Accounting Principle Qualitative Characteristics Consistency Comparability Although consistency and comparability are desirable, changing to a new method sometimes is appropriate. 20 - 7 Motivation for Accounting Choices Effect on Compensation Changing Conditions Motivations for Change 20 - 8 Effect on Debt Agreements Effect on Union Negotiations New Accounting Standard Issued Effect on Income Taxes Retrospective Approach Most Changes in Accounting Principle Let’s look at an examples of a change from LIFO to FIFO. At the beginning of 2011, Air Parts Corporation changed from LIFO to FIFO. Air Parts has paid dividends of $40 million each year since 2004. Its income tax rate is 40 percent. Retained earnings on January 1, 2009, was $700 million; inventory was $500 million. Selected income statement amounts for 20011 and prior years are (in millions): Cost of goods sold (LIFO) Cost of goods sold (FIFO) Difference 20 - 9 Revenues Operating expenses 2011 $ 430 370 $ 60 2010 $ 420 365 $ 55 2009 $ 405 360 $ 45 Previous Years $ 2,000 1,700 $ 300 $ $ $ $ 950 230 900 210 875 205 4,500 1,000 Revise Comparative Financial Statements 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. Income Statements ($ in millions) Revenues Cost of goods sold (FIFO) Operating expenses Income before tax Less: Income tax expense (40%) Net income 20 - 10 2011 $ 950 370 230 $ 350 140 $ 210 2010 $ 900 365 210 $ 325 130 $ 195 2009 $ 875 360 205 $ 310 124 $ 186 Revise Comparative Financial Statements 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. Cost of goods sold (LIFO) Cost of goods sold (FIFO) Difference 2011 $ 430 370 $ 60 2010 $ 420 365 $ 55 2009 $ 405 360 $ 45 Previous Years $ 2,000 1,700 $ 300 Comparative balance sheets will report 2009 inventory $345 million higher than it was reported in last year’s statements. Retained earnings for 2009 will be $207 million higher. [$345 million × (1 – 40% tax rate)] 20 - 11 Revise Comparative Financial Statements 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. Cost of goods sold (LIFO) Cost of goods sold (FIFO) Difference 2011 $ 430 370 $ 60 2010 $ 420 365 $ 55 2009 $ 405 360 $ 45 Previous Years $ 2,000 1,700 $ 300 Comparative balance sheets will report 2010 inventory $400 million higher than it was reported in last year’s statements. Retained earnings for 2010 will be $240 million higher. [$400 million × (1 – 40% tax rate)] 20 - 12 Revise Comparative Financial Statements 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. Cost of goods sold (LIFO) Cost of goods sold (FIFO) Difference 2011 $ 430 370 $ 60 2010 $ 420 365 $ 55 2008 $ 405 360 $ 45 Previous Years $ 2,000 1,700 $ 300 Comparative balance sheets will report 2011 inventory $460 million higher than it would have been if the change from LIFO had not occurred. 20 - 13 Retained earnings for 2011 will be $276 million higher. [$460 million × (1 – 40% tax rate)] Adjust Accounts for the Change On January 1, 2011, the date of the change, the following journal entry would be made to record the change in principle. January 1, 2011: Inventory ....................................................... Retained earnings ............................... Income tax payable ……….………..…. To increase inventory, retained earnings, and income tax payable as a result of the change from LIFO to FIFO. 400,000,000 240,000,000 160,000,000 40% of $400,000,000 20 - 14 Disclosure Notes In the first set of financial statements after the change is made, a disclosure note is needed to Provide justification for the change. 20 - 15 Point out that comparative information has been revised. Report any per share amounts affected for the current and all prior periods. Prospective Approach Some Changes in Principle 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 periodspecific effects.  It is impracticable to determine the cumulative effect of prior years.  The change is mandated by authoritative pronouncements. 20 - 16 U. S. GAAP vs. IFRS The changes to and from the LIFO method would not occur if international standards were being applied because LIFO is not a permissible method for accounting for inventory under IFRS. 20 - 17 Prospective Approach Change in Accounting 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. 20 - 18 Change in Accounting Estimate Changes in accounting estimates are accounted for prospectively. Let’s look at an example of a change in a depreciation estimate. On January 1, 2007, Towing, Inc. purchased specialized equipment for $243,000. The equipment has been depreciated using the straight-line method and had an estimated life of 10 years and salvage value of $3,000. In 2010 the total useful life of the equipment was revised to 6 years. Calculate the 2011 depreciation expense. $243,000 – $3,000 = $24,000 (2006 – 2009) 10 years $24,000 × 4 years = $96,000 Accum. Depr. $243,000 – $96,000 = $147,000 Book Value $147,000 – $3,000 = $72,000 (2011 & 2012) 2 years 20 - 19 Changing Depreciation Methods Universal Semiconductors switched from SYD depreciation to straight-line depreciation in 2011. The asset was purchased at the beginning of 2009 for $63 million, has a useful life of 5 years and an estimated residual value of $3 million. Sum-of-the-Years-Digits Depreciaton (millions) 2009 depreciation 2010 depreciation Accumulated depreciation 20 - 20 $ 20 16 $ 36 ($60 x 5/15) ($60 x 4/15) Changing Depreciation Methods ÷ 20 - 21 Changing Depreciation Methods Depreciation adjusting entry for 2011, 2012, and 2013. Depreciation expense ................................... Accumulated depreciation .................. To record depreciation expense. 20 - 22 8,000,000 8,000,000 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. 20 - 23 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. 20 - 24 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. 20 - 25 Correction of Accounting Errors Four-step process Prepare a journal entry to correct any balances. Retrospectively restate prior years’ financial statements that were incorrect. Report correction as a prior period adjustment if retained earnings is one of the incorrect accounts affected. Include a disclosure note. 20 - 26 Prior Period Adjustments Prior Period Adjustment Required Counterbalancing error discovered in the second year. Noncounterbalancing error discovered in any year. Use the retrospective approach 20 - 27 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 - 28 Errors Not Affecting Prior Years’ Net Income 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. 20 - 29 Error Affecting Prior Year’s Net Income • 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. 20 - 30 Error Affecting Prior Year’s Net Income In 2011, the accountant at Orion, Inc. discovered the depreciation of $50,000 on a new asset purchased in 2010 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 2010 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 2010 to record income taxes was December 31, 2010: Income tax expense (30% of $275,000) ..................... Deferred tax liability (30% of $50,000) .............. Income tax payable (30% of $225,000) ……..… To record income tax expense. 20 - 31 82,500 15,000 67,500 Error Affecting Prior Year’s Net Income This error affected the following accounts: Depreciation expense for 2010 - understated $ 50,000 Accumulated depreciation for 2010 - understated 50,000 Net income in 2010 - overstated ($50,000 x 70%) 35,000 Income tax expense in 2010 - overstated 15,000 Deferred tax liability for 2010 - overstated 15,000 Remember, the 2010 expense accounts were closed to RE. 2011: Retained earnings …………………………................... Deferred tax liability ……………………………............. Accumulated depreciation …………………....… To correct recording error. 20 - 32 35,000 15,000 50,000 Error Affecting Prior Year’s Net Income Let’s assume the following for Orion, Inc.: On 1/1/11, the retained earnings balance was $922,000. In 2011, the company paid $65,000 in dividends. Net income for 2011 was $184,000. The Statement of Retained Earnings (or RE column of the Statement of Shareholders’ Equity) would be as follows: Retained earnings, January 1, 2011 As previously reported Correction of error in depreciation Less: Income tax reduction $ 922,000 50,000 15,000 (35,000) Retained earnings as restated, January 1, 2011 887,000 Add: Net income 184,000 Less: Dividends (65,000) Retained earnings, December 31, 2011 20 - 33 $ $ 1,006,000 Correction of Accounting Errors Identify the type of accounting error for the following item: Ending inventory was incorrectly counted. Counterbalancing error affecting net income The ending inventory in one period will be incorrect and the beginning inventory in the next period will also be incorrect. Since the inventory balance effects cost of goods sold, income will also be incorrect in the two periods, by the same amount. At the end of the two periods, if no other errors are made, the balances in inventory and retained earnings are correct. 20 - 34 Correction of Accounting Errors Identify the type of accounting error for the following item: Loss on sale of furniture was incorrectly recorded as depreciation expense. Error not affecting net income. When the furniture sale transaction was recorded, depreciation expense was debited for the amount that should have been a debit to loss on sale. Since both expenses and losses reduce income, the error does not effect income. 20 - 35 Correction of Accounting Errors Identify the type of accounting error for the following item: Depreciation expense was understated. Noncounterbalancing error affecting net income. An expense is understated, so income is understated. The error affects only the year in which the error was made. It is a noncounterbalancing error since only one period’s income is affected. 20 - 36 Summary of Accounting Changes and Errors Change in Accounting Principle Most Prospective Changes Exceptions Method of accounting Retrospective Prospective Revise prior years? Yes No Cumulative effect on An adjustment to prior years' income earliest reported Not retained earnings. reported. reported? Journal entries? Adjust affected None balances to new method. Disclosure note? 20 - 37 Subsequent accounting is affected by change. Yes Subsequent accounting is affected by change. Yes Change in Estimate Change in Reporting Entity Prospective No Retrospective Yes Not reported. None Not reported. None Subsequent accounting is affected by change. Yes Consolidated statements are discussed in other courses. Yes Error Retrospective Yes An adjustment to earliest reported retained earnings. Involves any incorrect balances as a result of the error. Yes U. S. GAAP vs. IFRS When correcting errors in previously issued financial statements, IFRS (IAS No. 8) permits the effect of the error to be reported in the current period if it’s not considered practicable to report it retrospectively as is required by U.S. GAAP. 20 - 38

Accounting Changesand and Errors

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