Accounting Changes and Errors

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Accounting Changes and Errors
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Objectives

• 1. Identify the types of accounting changes.
• 2. Explain the methods of disclosing an
  accounting change.
• 3. Account for a change in accounting principle
  using the cumulative effect method.
• 4. Account for a change in accounting principle
  using a prior period restatement.
• 5. Account for a change in estimate.

Continued
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Objectives
6. Explain the conceptual issues regarding a
change in accounting principle and a change in
estimate. 7. Identify a change in a reporting
entity. 8. Account for a correction of an
error. 9. Summarize the methods for making
accounting changes and correcting errors.
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Types of Accounting Changes

• 1. Change in an Accounting Principle. This type
  of change occurs when a company adopts a
  generally accepted accounting principle different
  from the one used previously for reporting
  purposes.
• 2. Change in an Accounting Estimate. This type
  of change is required because an earlier estimate
  has proven to require modifying as additional
  information is obtained or circumstances change.
• 3 Change in a Reporting Entity. This type of
  change is the result of a change in the entity
  being reported.

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Methods of Disclosing an Accounting Change

• Retroactively adjust its past financial
  statements.
• Include the cumulative effect of the change in
  its income of the current period.
• Adjust for the change prospectively.

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Basic Principles
The basic principles of APB Opinion No. 20
requires that generally

• A change in an accounting principle is accounted
  for by the cumulative effect method.
• A change in an accounting estimate is accounted
  for prospectively.
• A change in a reporting entity is accounted for
  by prior period restatement (retroactively).
• An error is accounted for by prior period
  restatement (retroactively).

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Accounting for a Change in Accounting Principle
The general rule is that a company accounts for a
change in principle as a cumulative effect change
as follows
1. The financial statements for prior periods
included for comparative purposes are presented
as previously reported.
Continued
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Accounting for a Change in Accounting Principle
2. The cumulative effect of changing to the new
accounting principle (net of applicable income
taxes) on the amount of retained earnings at the
beginning of the period in which the change is
made is reported immediately before the caption
net income on the income statement of the
period of the change.
Continued
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Accounting for a Change in Accounting Principle
3. Income before extraordinary items and net
income computed on a pro forma basis (that is, as
if the new principle had been in effect for all
past periods) are shown on the face of the income
statement (below earnings per share) for all
periods presented.
Continued
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Accounting for a Change in Accounting Principle
4. A description of the change and the reason for
it, as well as the effect of the change on income
before extraordinary items and on net income (and
on related earnings per share amounts) of the
period of the change are disclosed in the notes
to the financial statements.
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Illustration of Cumulative Effect Method
Goddard Company has assets for which it has been
using straight-line depreciation for its
financial reporting, and MACRS depreciation for
its income tax reporting. At the beginning of
2005 it adopts an accelerated depreciation method
for financial reporting. The tax rate is 30.
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Change in Accounting Principle(Cumulative Effect
Method)
Straight-Line
Accelerated Difference Year
Depreciation Depreciation Net of Tax
(30)
Prior to 2004 240,000 300,000 42,000 2004
100,000 130,000 21,000 Total at begin-
ning of 2005 340,000 430,000 63,000
Partial Income Statement
Continued
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Change in Accounting Principle(Cumulative Effect
Method)
Income before cumulative effect of a change in
accounting principle 840,000 Cumulative effect
on prior years (to December 31, 2004) of
changing to a different depreciation method
(net of 27,000 income taxes) (63,000 ) Net
income 777,000 Earnings per share (100,000
shares outstanding) Income before cumulative
effect of a change in accounting
principle 8.40 Cumulative effect on prior
years (to December 31, 2,004) of changing to a
different depreciation method (0.63 ) Earnings
per share 7.77
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Change in Accounting Principle(Cumulative Effect
Method)
Straight-Line
Accelerated Difference Year
Depreciation Depreciation Net of Tax
(30)
Prior to 2004 240,000 300,000 42,000 2004
100,000 130,000 21,000 Total at begin-
ning of 2005 340,000 430,000 63,000
Loss on Cumulative Effect of a Change in
Depreciation Method 63,000 Deferred Tax
Liability 27,000 Accumulated Depreciation 90,000
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Exceptions to the General Rule for a Change in
Accounting Principle

• 1. Adoption of New Principle for Future Events.
  If a company adopts a new principle for future
  events, but does not change the method currently
  used, it does not make a cumulative effect change.

Continued
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Exceptions to the General Rule for a Change in
Accounting Principle
2. Cumulative Effect Not Determinable. If the
cumulative effect is not determinable, the
company does not make a cumulative effect change.
Continued
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Exceptions to the General Rule for a Change in
Accounting Principle
3. Initial Public Sale of Common Stock. If a
company makes accounting changes when it makes an
initial public distribution, it restates
retroactively the financial statements for all
prior periods.
Continued
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Exceptions to the General Rule for a Change in
Accounting Principle
4. Prior Period Restatement (Retroactive
Adjustment) More Useful. For certain changes in
accounting principles, the APB requires the
company to make a prior period restatement
instead of a cumulative effect adjustment.
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Examples of Item 4
- A change from the LIFO inventory cost flow
method to another method. - A change in the
method of accounting for long-term
construction-type contracts. - A change to or
from the full cost method of accounting that is
used in the extractive industries. - A change
from retirement-replacement-betterment accounting
for railroad track structures. - A change from
the fair value method to the equity method for
investments in common stock.
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Prior Period Restatement Method
A company accounts for a change in accounting
principle by prior period restatement as follows

• 1. The revenues and expenses (including
  applicable income taxes) affected by the changes
  are restated in the income statements of previous
  years included for comparative purposes.

Continued
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Prior Period Restatement Method
2. The aggregate change in income (net of
applicable income taxes) at the beginning of each
year is added to (or subtracted from) retained
earnings as a prior period adjustment on
comparative statements of retained earnings.
Continued
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Prior Period Restatement Method
3. The related assets and liabilities, including
income taxes, are restated in the comparative
balance sheets of previous years.
4. A description of the change and the reason for
it, as well as the effect of the change on income
before extraordinary items and on net income (and
on related earnings per amounts) for all periods,
are disclosed in notes to the financial
statements.
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Prior Period Restatement Method
Werner Company changes from the LIFO to the FIFO
inventory method at the beginning of 2005, and it
presents comparative financial statements for
2005 and 2004.
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Prior Period Restatement Method
Comparative Statements of Retained Earnings
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Prior Period Restatement Method
LIFO
FIFO Inventory
Inventory Difference Year
Method Method
Net of Tax (30)
Prior to 2004 550,000 850,000 210,000
2004 650,000 600,000
(35,000 ) Total at begin- ning of
2005 1,200,000 1,450,000 175,000 2005
500,000 700,000 140,000
Total 1,700,000 2,150,000 315,000
Inventory 250,000 Retained Earnings 175,000 Inc
ome Taxes Payable 75,000
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Transition Method
Transition rules define the accounting method a
company uses when it changes an accounting
principle to conform to a new principle required
by the issuance of a new statement.
When a statement specifies a method, the
transition rule usually requires retroactive
restatement.
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Accounting For a Change in an Estimate
and future periods if the change affects both.
A change in accounting estimate does not result
in a cumulative change or a prior period
adjustment.
APB Opinion Number 20 requires that a company
account for a change in an accounting estimate in
the period of change if the change affects that
period only,...
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Accounting For a Change in an Estimate
A company uses an asset with an original cost of
100,000, an estimated life of 20 years, and an
estimated residual value of zero (the company
uses the straight-line method for depreciation).
When adjusting entries are made in the ninth
year, a new estimation of the total life of the
asset is 23 years. Depreciation expense is
determined as follows
100,000 (8 x 5,000)
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Additional Issues
A change in accounting estimate that is related
in whole or in part to a change in accounting
principle is reported as a change in estimate.
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Additional Issues
A change in the amortization or depreciation
method is considered a change in accounting
principle under the provision of APB Opinion
Number 20.
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Accounting for a Change in a Reporting Entity
Ill fax you this list of situations where a
change in a reporting entity occurs.
A company accounts for a change in reporting
entity as a prior period adjustment.
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1. When a company presents consolidated or
combined financial statements in place of the
statements of individual companies. 2. When there
is a change in the specific subsidiaries that
make up the group of companies for which
consolidated financial statements are
presented. 3. When the companies included in
combined financial statements change.
FAX Machine
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Accounting For a Correction of An Error
Examples of errors that a company might make
include
1. The use of an accounting principle that is not
generally accepted. 2. The use of an estimate
that was not made in good faith. 3. Mathematical
miscalculations. 4. The omission of a deferral or
accrual.
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Accounting For a Correction of An Error
Error Affecting Only the Balance Sheet
Slider Company issued a bond for 100,000 due in
five years. The liability was incorrectly
recorded as a long-term notes payable. Interest
was paid and correctly recorded as interest
expense on December 31.
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Accounting For a Correction of An Error
Error Affecting Only the Balance Sheet
The error can be corrected in the following year
by charging a balance sheet account, Long-Term
Notes Payable, and crediting Bonds Payable.
Since both accounts are real accounts, there is
no prior period adjustment.
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Accounting For a Correction of An Error
Error Affecting Only the Income Statement
Slider Company recorded interest revenue as
revenue from sales. Discovery of this error in
the succeeding year does not require a correcting
entry. If Slider presents comparative financial
statements in the current year, it corrects the
financial statements of the prior period by
reclassifying the item.
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Accounting For a Correction of An Error
Errors Affecting Both the Income Statement and
Balance Sheet
Income Taxes Payable is overstated by 600.
Interest Expense is understated by 2,000.
Income before income taxes is overstated by
2,000.
Slider Company fails to accrue interest of
2,000. Assuming a tax rate of 30, the effects
of the error on Sliders financial statements in
the period of the errors are
Retained Earnings is overstated by 1,400.
Income Tax Expense is overstated by 600.
Net income is overstated by 1,400.
Interest Payable is understated by 2,000.
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Accounting For a Correction of An Error
Errors Affecting Both the Income Statement and
Balance Sheet
Interest Expense is overstated by 2,000.
In the next period, when the company pays the
interest and records the entire payment as an
expense, these additional errors occur
Income before income taxes is understated by
2,000.
Net income is understated by 1,400.
Income Tax Expense is understated by 600.
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Error Correction
Error Recording Building Improvement Expenditure
Handel Company spent 20,000 on building
improvements that the company incorrectly
recorded as Repair Expense rather than
capitalizing the item. A single comprehensive
journal entry to correct the error when it is
discovered is
Note that this entry ignores income taxes and
depreciation considerations.
Building 20,000 Retained Earnings 20,000
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Error Correction
Error Recording Building Improvement Expenditure
Assuming the building improvements are expected
to last 10 years and have no residual value, a
depreciation entry for 2,000 should have been
made (assuming straight-line depreciation). The
necessary correcting entry is
Retained Earnings 2,000 Accumulated
Depreciation 2,000
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Error Correction
Steps in Analyzing and Correction Errors

• 1. Analyze the original erroneous journal entry
  and determine all the debits and credits that
  were recorded.
• 2. Determine the correct journal entry and the
  appropriate debits and credits.
• 3. Evaluate whether the error has caused
  additional errors in other accounts.
• 4. Prepare the correcting entry(ies).

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Error Correction
Omission of Unearned Revenue
In December 2004 the Huggins Company received
10,000 as a prepayment for renting a building to
another company for all of 2005. The company
debited Cash and credited Rent Revenue. This
error was discovered in 2005. The correcting
entry is
Retained Earnings 10,000 Rent Revenue 10,000
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Error Correction
Failure to Accrue Revenue
On December 31, 2004 the Huggins Company failed
to accrue interest revenue of 500 that it had
earned but not received on an outstanding note
receivable. When the cash was received the
company debited Cash and credited Interest
Revenue. The correcting entry needed is--
Interest Revenue 500 Retained Earnings 500
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Error Correction
Omission of Prepaid Expense
On December 31, 2004 the Huggins Company paid
1,000 for insurance coverage for the year 2005.
It recorded the original entry as a debit to
Insurance Expense and a credit to Cash. The
error was discovered at the end of 2005, and the
company makes the following correcting entry
Insurance Expense 1,000 Retained Earnings 1,000
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Error Correction
Error in Ending Inventory
On December 31, 2004 the Huggins Company recorded
its ending inventory at 50,000. During 2005 it
discovered that the correct inventory value
should have been 55,000. The following
correcting entry is needed.
Inventory 5,000 Retained Earnings 5,000
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Error Correction
Error in Purchases
During December 4, Huggins Company made a
purchase on credit that it had not paid at years
end. It recorded this transaction incorrectly at
17,000 although the invoice price was 27,000.
In 2005, Huggins made the following correcting
entry
Retained Earnings 10,000 Accounts Payable 10,000
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Error Correction
Failure to Accrue Estimated Bad Debts
Huggins Company failed to accrue an allowance for
doubtful accounts of 7,000 in its 2004 financial
statements. The discovery of the error in 2005
requires the following entry
Retained Earnings 7,000 Allowance for Doubtful
Accounts 7,000
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This electronic presentation was prepared by
Douglas Cloud, Professor of Accounting,
Pepperdine University