Chapter 22: Accounting Changes and Error Analysis

1
Chapter 22 Accounting Changes and Error Analysis
2
Types of Accounting Changes

• SFAS No. 154
• Types of accounting changes
• Changes in Accounting Principle
• Changes in Accounting Estimates
• Changes in Reporting Entity
• Errors in Financial Statements

3
Changes in Accounting Principle

• From one generally accepted principle to another
• Does not result from the adoption of a new
  accounting principle
• Previously immaterial
• Events for first time
• A change to a generally accepted principle (from
  an incorrect principle) correction of an error

4
Changes in Accounting Principle

• Currently
• Retrospectively
• Prospectively

5
Changes in Accounting Principle Retroactive
Reporting

• Cumulative effect new determined
• Prior period FS recast based on new
• Cumulative effect for periods prior to
  presentation adjusted to beginning retained
  earnings
• Leads to comparable consistent FS

6
Changes in Accounting Principle Retroactive
Reporting

• Impracticable to retrospectively apply principle
  change (i.e. FIFO to LIFO)
• Prospective reporting at earliest practicable
  date
• Effects of retro application not determinable
• Requires assumptions re management intent in
  prior periods
• Significant estimates for prior period required
  AND unable to objectively verify info needed to
  develop retro adjustment

7
Changes in Accounting Principle Retroactive
Reporting

• Impracticable to retrospectively apply principle
  change (i.e. FIFO to LIFO)
• Disclose
• Effect of change in operations for change period
• Reasons for omitting computations
• Pro forma amounts for PY should be explained
• Justification for change
• Illustration 22-10 Page 1163

8
Changes in Estimate

• FS require estimates re future conditions
  events
• Lack of certainty
• Judgment required
• Examples
• CHANGES IN DEPRECIATION METHOD
• Change in life of depreciable assets
• Salvage values of assets
• Estimates of bad debts

9
Changes in Estimate

• Prospective basis
• Considered normal recurring corrections
  adjustments
• Estimates later determined incorrect
• Change in estimates
• Impossible to determine
• Principle vs. estimate estimate
• Error vs. estimate estimate for careful
  estimates
• Judgment required

10
Reporting a Change in Entity

• Financial statements restated for all prior
  periods presented
• Examples
• Consolidated statements in lieu of individual FS
• Changes in subsidiaries in a consolidated group
• Change in method for accounting for subsidiaries
  investments

11
Reporting the Correction of an Error

• Prior period adjustments
• Adjust beginning RE for earliest period presented
• Examples
• Change from an accounting principle that is not
  generally accepted to one that is accepted
• Mathematical errors
• Changes in estimates that were not prepared in
  good faith
• Failure to properly accrue/defer
  expenses/revenues
• Misapplication or omission of relevant facts

12
When is a Change in Accounting Principle
Appropriate?

• New principle preferable to existing accounting
  principle
• New principle should result in improved financial
  reporting
• Not solely for income tax effect
• Considered preferable if SFAS
• Creates new accounting principle, or
• Expresses preference for a new principle, or
• Rejects a specific accounting principle

13
Motivations for Change

• Self interest
• Managers standards to maximize bonuses
• Political cost
• Less politically visible to avoid regulation
• Capital structure
• High debt/equity
• Smooth earnings
• To avoid notice (regulators, competitors, etc.)

14
Error Analysis in General

• Firms do not correct errors that are
  insignificant
• Considerations
• What type of error is involved?
• What correcting entries are needed?
• How are financial statements to be restated?
• Reported as PPEs

15
Types of Errors

• Balance sheet
• Classifications
• Income statement
• Classifications
• Balance sheet income statement
• Types a MUST KNOW for entry level positions
• Counterbalancing (or self-correcting over two
  accounting periods)
• Accrued payroll
• Non-counterbalancing (more than two periods
  needed)
• Expense vs. capitalization
• Examples pages 1177 - 1178

16
Counterbalancing Errors

• Questions to be considered are
• Are the books closed?
• Are comparative statements presented?
• Adjust beginning RE
• Books are closed error is not counterbalanced,
  or
• Books are not closed company is in the second
  year error is already counterbalanced

17
Changing From and to the Equity Method

• Requires restatement of all prior period FS
• From equity method to FV method must be made
  when
• Investors level of influence falls below
  required percentage of ownership
• A change from fair value method to the equity
  method must be made when
• Investors level of influence rises above
  required ownership

18
Changing to the Equity Method

• Retroactive adjustments/reporting
• Carrying value of investment
• Results of current prior period operations
• Retained earnings of investor
• Any balances in unrealized holding gains losses
  are eliminated
• Available-for-sale classification also removed

19
Class Exercises

• E22-8 E22-2
• E22-4 E22-9
• E22-19

20
Chapter 24 Full Disclosure in Financial Reporting
21
Types of Financial Information
22
Full Disclosure

• Full disclosure at heart of high quality
  financial reporting
• MANAGEMENTS responsibility
• Standards overload
• GAAP hierarchy
• Differential disclosure
• Public vs. nonpublic companies
• AICPA study
• Profession still developing guidelines
• Whether given transaction should be disclosed
• What format disclosure should take

23
The Full Disclosure Principle

• Full disclosure principle
• Financial reporting of significant facts
  affecting the judgment of an informed reader
• Objective of financial reporting
• Info useful for decision making
• Problems of implementing
• Costs of disclosure
• Information overload

24
Increase in Reporting Requirements

• Reasons for increased reporting requirements
• Complexity of business environment (derivatives,
  business combinations, pensions)
• Necessity for timely information (interim data,
  forecasts)
• Accounting used as a control and monitoring
  device

25
Notes to the Financial Statements

• Amplify/explain items presented in FS body
• A statement that identifies the accounting
  policies of the entity must be disclosed
• GAAP choices footnote
• Summary of Significant Accounting Policies
• Page 1286 - 1287
• Common notes
• Inventory
• Deferred taxes
• PPE
• Credit claims
• Contingencies and commitments

26
Disclosure of Special Transactions or Special
Issues

• Related party transactions
• Not arms-length
• Special audit concerns
• Required disclosures
• Nature of relationship
• Description of transactions
• Dollar amounts of transactions
• Amounts due from/to related parties at balance
  sheet date
• Example page 1290

27
Post-Balance Sheet Events

• Notes to FS must explain any significant
  financial events that occurred after the BS date
  but before issuance of the FS

28
Types of Subsequent event Transactions to be
Disclosed

• Events providing additional evidence about
  conditions existing at the BS date that require
  adjustments
• Changes to estimated amounts
• Events arising subsequent to the BS date that do
  not require adjustments
• Examples page 1292

29
Reporting by Conglomerates

• Investors need information
• Regarding IS, BS, SC
• About segments to assess profitability
• Segmented information may harm reporting firms
• Disclosure of data useful to competitors
• WDW Universal re park attendance

30
Reporting by Conglomerates

• Objectives of reporting segment info provide
  info re
• Different types of business activities
• Different economic environments in which entities
  operate
• Operating segment component that
• Engages in business activities
• Revenues expenses
• Is reviewed by conglomerates chief operating
  officer
• Assess performance allocate resources
• Produces discrete financial information from the
  internal financial reporting system

31
Aggregation of Operating Segments

• May aggregate if have same basic characteristics
  in
• Products services rendered
• Production process
• Type/class of customer
• Methods of product/service distribution
• Regulatory environment

32
Reportable Segments

• Reportable segment if it satisfies one or more of
  the following criteria
• Revenue criterion
• Profit or loss criterion
• Identifiable assets criterion

33
Reportable Segments
Criterion
Thresholds

• Segment revenue
• Segment profit or loss
• Identifiable assets

• Is more than 10 of the combined revenue of all
  operating segments
• Is 10 or more of the greater of
• Combined profit of all operating segments not
  showing a loss OR
• Combined loss of all operating segments reporting
  a loss
• 10 or more of the combined assets of all
  operating segments

34
Required Segmented Information

• General information about operating segments
• Segment profit loss related information
• Segment assets
• Reconciliation of segment revenues, profits
  losses, segment assets
• Information about products services
  geographical areas
• Major customers
• Example page 1297

35
Interim Reporting Requirements

• Cover less than one year
• Public quarterly (10Q)
• Two approaches
• Integral each interim period integral part of
  annual report
• Discrete each interim period stands alone
• Most companies employ both approaches for various
  transactions
• Reporting requirements
• Use of same accounting principles
• Some exceptions page 1299
• Period costs often charged as incurred
• Not required to publish BS or SCF

36
Problems of Interim Reporting

• Advertising and similar costs
• Defer if benefit other periods
• Expenses subject to YE adjustments
• Best estimate allocation
• Income taxes
• Estimated annual effective rate
• Extraordinary items
• Charge in period occurs
• Changes in accounting principles
• Restate first quarter (consider NEW GAAP)
• Earnings per share
• Shares for each period stand alone
• Seasonality
• Examples pages 1301 1302

37
Auditors Reports

• Auditors reporting standards
• States whether FS are in conformity with GAAP
• Identifies circumstances in which GAAP have not
  been consistently applied
• Disclosures in FS are deemed adequate unless
  otherwise stated
• An opinion on the FS, if possible
• Example page 1304

38
Auditors Opinion

• Types of opinions
• Unqualified opinion
• Additional explanatory paragraphs
• Uncertainties
• Lack of consistency
• Emphasis of a matter
• Qualified opinion
• Scope
• Lack of conformity with GAAP
• Inadequate disclosure
• Example page 1306
• Adverse opinion
• Circumstances
• Disclaimer

39
Managements Report

• Managements Discussion and Analysis (MDA)
• Liquidity
• Capital resources
• Results of operations
• Identifies
• Favorable/unfavorable trends
• Any significant events uncertainties that
  affect the three aspects
• Example pages 1306 - 1307
• Report on Managements Responsibilities
• Example page 1308

40
Financial Forecasts and Projections

• Investing public needs wants more better
  information about corporate expectations
• Forms of disclosures
• Financial forecast of an entitys expected
  financial position
• Financial projection based on hypothetical
  assumptions (what might happen)

41
Internet Financial Reporting

• Advantages
• Reach more users
• Make traditional reports more useful
• Report more timely information
• Report disaggregated data
• Concern about security

42
Fraudulent Financial Reporting

• Auditing definition SAS No. 99
• Accounting vs. legal fraud
• Intentional/reckless conduct
• Act or omission
• Results in materially misleading FS
• Gross deliberate distortions
• Misapplication of accounting principles
• Failure to properly disclose material items

43
Fraudulent Financial Reporting Causes

• Impacted by internal external environments
• Opportunities increase in certain situations
• Weak board of directors or audit committee
• Weak internal controls
• Unusual or complex transactions
• Accounting issues requiring significant
  subjective judgments
• Ineffective internal audit function

44
Criteria for Making Accounting and Reporting
Choices

• Accounting is greatly influenced by its
  environment.
• Alternative presentations of certain transactions
  will continue to exist.
• FASBs Conceptual Framework will hopefully
  eliminate unneeded diversity in reporting
  practices.
• New oversight environment will impact accounting
  choices.

45
Class Exercises

• E24-2 E24-3