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Accounting Changes and Error Corrections

Accounting Changes and Error Corrections. Objectives of the Chapter. I. To learn the types of accounting changes. II. To study the accounting treatments of accounting changes. III. To analyze the accounting errors and to learn the accounting treatments of errors.

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Accounting Changes and Error Corrections

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  1. Accounting Changes and Error Corrections

  2. Objectives of the Chapter • I. To learn the types of accounting changes. • II. To study the accounting treatments of accounting changes. • III. To analyze the accounting errors and to learn the accounting treatments of errors. Accounting Changes & Error Corrections

  3. I. Types of Accounting Changes • A. Changes in Accounting Principle (Method). • B. Changes in Accounting Estimate. • C. Changes in Reporting Entity. Accounting Changes & Error Corrections

  4. Examples of Changes in Accounting Principle (Method) • Changes from one acceptable accounting method to another acceptable accounting method. Examples: • adopting a new accounting standard. • changes in inventory method. • changes from P-O-C method to C-C method for long-term construction projects. Accounting Changes & Error Corrections

  5. Examples of Changes in Accounting Estimates • Changes in the estimates of: • a. useful lives and salvage values of depreciable assets; • b. uncollectible accounts expense; • c. liabilities for warranty costs, and income taxes. • Note: Under SFAS 154,changes in depreciation method is considered as changes in accounting estimates. Accounting Changes & Error Corrections

  6. Examples of Changes in Reporting Entity • 1. Presenting consolidated statements for the first time to replace individual statements. • 2. Changing subsidiaries that are included in consolidated F/S. Accounting Changes & Error Corrections

  7. II. Accounting Treatments for AccountingChanges • Three approaches had been suggested: • 1.Current-Period Approach (eliminatedby SFAS 154). • 2.Retrospective Approach (applied to voluntary accounting method changes and changes in reporting entity). • 3.Prospective approach (applicable for accounting estimate change). Accounting Changes & Error Corrections

  8. 1. Current-Period Approach (Eliminated by SFAS 154) • The cumulative effect of all prior years resulting from adoption of the new method is reported in the current year’s income statement. • F/S of prior years should not be restated. • Net income and earnings per share, computed on a pro-forma basis (as if the new method were adopted) are shown on the I/S for all periods that appear on the I/S. Accounting Changes & Error Corrections

  9. Current Period Approach (Eliminated) • This approach has been eliminated by SFAS 154. • SFAS 154 was issued in May 2005, and became effective for fiscal years beginning after 12/15/2005. Accounting Changes & Error Corrections

  10. Current-Period Approach (contd.) (skip) • Advantages • a. Less costly. • b Will not affect the financial ratios of prior years. • c. No change in prior years’ earnings. • Disadvantages • a. It has significant impact on current year’s income. • b. Loss comparability among financial statements (F/S) of different years. Accounting Changes & Error Corrections

  11. 2. Retrospective Approach • A retrospective adjustment of the F/S (i.e., restatement of F/S) is made for prior years as if the new method were used. • Cumulative effect for the non-restated prior years is reported in the statement of retained earnings (not income statement) as an adjustment. Accounting Changes & Error Corrections

  12. Retrospective Approach (contd.) • Advantages • a. It results in comparable F/S. • b. It has no significant impact in the current year’s income statement. • Disadvantages • a. It is costly to restate F/S. • b. It has a potential in violating loan covenant. Accounting Changes & Error Corrections

  13. 3. Prospective Approach • No cumulative effect is reported in any financial statements (F/S). • No prior statements are restated. • The new method is applied to the f/S of the current year and future years. Accounting Changes & Error Corrections

  14. The Treatments for Changes in Accounting Method (skip) • Prior to APB Opinion No. 20 (Accounting Changes, effective 7/31/1971), all three approaches were acceptable for changes in accounting method. • APB 20 only allows the current period approach and the retrospective approach for accounting method changes(except for five situations in which the retrospective approach must be used). Accounting Changes & Error Corrections

  15. The Treatments for Changes in AccountingMethod (contd.) • Under SFAS 154 (effective 2006), the only acceptable treatment for voluntary accounting method changes is the retrospective approach. • SFAS 154 eliminated the current period approach except when proscribed by new accounting standards. Accounting Changes & Error Corrections

  16. The Treatment for Changes in Accounting Method (contd.) • Reasons of eliminating the current period approach under SFAS 154: • Toward global convergence of accounting standards; • Improve the comparability of financial statements. Accounting Changes & Error Corrections

  17. The Treatment for Changes in AccountingEstimates • The prospective approach is only acceptable for changes in accounting estimates, NOTfor changes in accounting method. • However, a deprecation method change is treated as an estimate change under SFAS 154. Thus, theprospective approach is applied to deprecation method change. Accounting Changes & Error Corrections

  18. Reasons for Changes in Accounting Method • Reasons for changes in accounting method: • 1. Changes in economic environment. • Mandated by a new accounting standard (i.e., recognition of post retirement benefit expenses on an accrual basis); • Changes in technology. • Economical Reasons (see p66 for details). Accounting Changes & Error Corrections

  19. Change in Accounting Method - An Example • On 1/1 20x2, Doherty Corporation purchased a machine for $110,000. A 10-year economic life and zero residual value were expected for this machine. • The sum-of-the-years’-digits method had been used for depreciation purposes starting 20x2. • On 1/1/ 20x6, the depreciation method was changed to straight line method. The income tax rate is 30%. Accounting Changes & Error Corrections

  20. Change in Accounting MethodExample (contd.) – A Note • SFAS 154 requires that the changes in depreciation methods be treated as an estimate change. • Thus,a prospective approachshould be applied for such a change. • However, for illustration and comparison purposes, the current period, retrospective and the prospective approaches are applied for this change. Accounting Changes & Error Corrections

  21. Example (contd.)-Depreciation Expense under the Old Method (SYD) vs. New Method (S-L) • SYD S-L Diff.Diff.(net) C.Eff.(net) • 20x2 $20,000 $11,000 $9,000 6,300 6,300 • 20x3 18,000 11,000 7,000 4,900 11,200 • 20x4 16,000 11, 000 5,000 3,50014,700 • 20x5 14,00011,0003,000 2,10016,800 • $68,00044,000$24,00016,800 • Diff (net).= difference, net of income tax ;C.Eff (net)= cumulative effect, net of income tax. • For 20x6, the depre. Expense is $12,000 and $11,000 under SYD and S-L, respectively. The difference is $1000 (or $700 net of 30% tax) Accounting Changes & Error Corrections

  22. Example – A Current Period Approach (this approach has been eliminated by SFAS 154) • Cumulative Effect= $68,000-44,000=$24,000 • Net Cum. Effect = 24,000x (1-30%)= $16,800 • JE to reflect this change applying the current period approach (assuming a 30% income tax rate): • Accumulated Depreciation 24,000 • Cumulative Effect of • Change in Acct. Method-Depre. 16,800 • Deferred Income Tax Lia. 7,200 Accounting Changes & Error Corrections

  23. Example (contd.)- A Current Period ApproachComparative Income Statements* • 20x6 20x5 20x4 • Revenues $50,000 $50,000 $50,000 • Depr. Exp. (Note A) (11,000) (14,000) (16,000) • Other expe. (10,000) (10,000) (10,000) • Income taxes (8,700) (7,800) (7,200) • Income before changes • in acct. principle $20,300 • Cumulative effect 16,800 • Net income $37,100 $18,200 $16,800 • Earnings per share $3.71 $1.82 $1.68 • Pro Forma (Note A) • Net income $20,300 $20,300 $20,300 • Earnings per share $2.03 $2.03 $2.03 • *Assume a 30% tax rate and 10,000 shares outstanding. Accounting Changes & Error Corrections

  24. Comparative Retained Earnings • Assuming a retained earnings balance of $140,000 at the beginning of 20x4 and a dividends of $20,000 for years 20x4-20x6, the following statements of retained earnings will be in the 20x6 annual report: • 20x6 20x5 20x4 • Balance at beg.(R/E) $135,000 136,800 140,000 • Net income4 37,100 18,20016,800 • Cash dividens (20,000) (20,000) (20,000) • Balance at end of year 152,100 135,000 136,800 Accounting Changes & Error Corrections

  25. Example (contd.)-A Current Period Approach • Note A: • Prior to 20x6, Doherty used sum-of- the-years’-digits depreciation on its plant assets. In 20x6 Doherty changed to the straight-line method of depreciation, which management felt better represented the service expiration of its plan assets.. Accounting Changes & Error Corrections

  26. Example (contd.)-A Current Period Approach • Note A (contd): • The cumulative effect of the change in accounting principle of $16,800 (net of I/T) has been included in 20x6 net income. The effect of this change on income of 20x6 was an increase of $700 (net of I/T). The pro forma data report what would have been had the straight-line method been used prior to 20x6. Accounting Changes & Error Corrections

  27. Example: A Retrospective Approach • The F/S of prior years (i.e., two years) are restated on a basis consistent with the new method. • The cumulative effect of the non-restated prior years is reported in the statement of retained earnings. • This part of cumulative effect is treated as an adjustment of beginning retained earnings of the earliest year presented. Accounting Changes & Error Corrections

  28. Example - A Retrospective Approach • Using the example on page 19 except applying the retrospective approach, the following comparative I/S will be reported on the 20x6 annual report: • 20x6 20x5 20x4 . • (restated)(restated) • Revenues $50,000 $50,000 $50,000 • Depr. Exp.(Note A) (11,000) (11,000) (11,000) • Other Expe. (10,000) (10,000) (10,000) • Income Taxes (8,700)(8,700)(8,700) • Net Income $20,300$20,300$20,300 • Earnings per share $2.03 $2.03 $2.03 Accounting Changes & Error Corrections

  29. A Retrospective Approach (contd.) • Note A: • Prior to 20x6, Doherty used sum-of- the-years’-digits depreciation on its plant assets. • In 20x6 Doherty changed to the straight-line method of depreciation, which management felt better represented the service expiration of its plan assets. • The financial statements of 20x4 and 20x5 have been restated to reflect this change. Accounting Changes & Error Corrections

  30. A Retrospective Approach (Contd.) • Note A (contd.): • The effect of this change on income of 20x6 was an increase of $700 (net of income tax) and on income of 20x5 and 20x4 was an increase of $2,100 and $3,500 (net of income tax), respectively. • The balances of retained earnings of 20x4 and 20x5 have been adjusted for the effect of applying retrospectively the new method. Accounting Changes & Error Corrections

  31. Example (contd.)-Depreciation Expense under the Old Method (SYD) vs. New Method (S-L) • SYD S-L Diff.Diff.(net) C.Eff.(net) • 20x2 $20,000 $11,000 $9,000 6,300 6,300 • 20x3 18,000 11,000 7,000 4,900 11,200 • 20x4 16,000 11, 000 5,000 3,50014,700 • 20x5 14,00011,0003,000 2,10016,800 • $68,00044,000$24,00016,800 • Diff (net).= difference, net of income tax ;C.Eff (net)= cumulative effect, net of income tax. • For 20x6, the depre. Expense is $12,000 and $11,000 under SYD and S-L, respectively. The difference is $1000 (or $700 net of 30% tax) Accounting Changes & Error Corrections

  32. A Retrospective Approach (contd.) • The entry to reflect this accounting change under the retrospective approach of 20x6 is: • Accu. Depr. 24,000 • Retained Earnings 16,800 • Deferred Income tax Lia. 7,200 Accounting Changes & Error Corrections

  33. A Retrospective Approach (contd.) • Assuming a retained earnings balance of $140,000 at the beginning of 20x4 and a dividends of $20,000 for years 20x4-20x6, the following statements of retained earnings will be in the 20x6 annual report: • 20x6 20x5 20x4 • Balance at beg.(R/E) $135,0002 136,8001 140,000 • Adjustment for the • Cum. effect 3 16,800 14,700 11,200 • Adjusted balance $151,800 151,500 151,200 • Net income4 20,300 20,30020,300 • Cash dividens (20,000) (20,000) (20,000) • Balance at end of year 152,100 151,800 151,500 Accounting Changes & Error Corrections

  34. Example (contd.) • 1. 140,000 + 16,800 - 20,000 = 136,800 (See p23 for unadjusted net income of x4.) • 2. 136,800 + 18,200 - 20,000 = 135,000 (See p 23 for unadjusted net income of x5) • 3. Cumulative difference (effect), see p31. • 4. Restated net income to reflect the change of depreciation method made in 20x6, see p28 for restated net income for 20x4 and 20x5. Accounting Changes & Error Corrections

  35. Change in Depreciation MethodA Prospective Approach • Under SFAS 154, a prospective approach should be applied to a change in depreciation method. • Thus, the change from a SYD depreciation to a straight-line deprecation would not result in any restatement of prior years’ financial statements. • The new depreciation method would only be applied for years of 2006 - 2011. Accounting Changes & Error Corrections

  36. Change in Depreciation MethodA Prospective Approach (contd.) • The annual depreciation expense for 2006-2011 is: • ($110,000-$68,000)/ (10-4) = $7,000 • Note: Prior to 20x6, Doherty used sum-of- the-years’-digits depreciation on its plant assets. In 20x6 Doherty changed to the straight-line method of depreciation, which management felt better represented the service expiration of its plan assets. Accounting Changes & Error Corrections

  37. Change in Depreciation MethodA Prospective Approach (contd.) • Note (contd): The effect of this change on income of 20x6 is an increase of $3,500a (net of 30% income taxes). • a. The depreciation expense of 2006 would have been $12,000 under the SYD (the old method) while it is $7,000 under the straight-line method (the new method). Accounting Changes & Error Corrections

  38. Change in Accounting Method - Inventory Cost Method Change Example (Example 20-1 of Spiceland, etc. with some revisions) • Air Parts Corporation used the LIFO inventory costing method. At the beginning of 2006, Air Parts decided to change to the FIFO method. • Under SFAS 154, the retrospective approach is applied for all voluntary accounting method change except for the change in depreciation method. Accounting Changes & Error Corrections

  39. Changes in Inventory Cost Flow Assumption (contd.) • Additional information: • The company has paid dividends of $40 million each year beginning 1999. • The income tax rate is 40%. • Retained earnings on January 1, 2004 was $700 million. • $Inventory on January 1, 2004 was $500 million. Accounting Changes & Error Corrections

  40. Cost Flow Assumption Change (Contd.)-A Retrospective Approach • The income statements of 2004, 2005 and 2006 are as follows (under LIFO assumption): • ($ in millions) • 20x6 20x5 20x4 • Revenues $950 $900 $875 • CGS (LIFO) (430) (420) (405) • Operating expenses (230)(210)(205) • Pre-tax Income 290 270 265 • Income taxes (116) (108) (106) • Net income $174$162$159 • . Accounting Changes & Error Corrections

  41. Cost Flow Assumption Change (Contd.)-A Retrospective Approach • The statement of retained earnings of 2004 and and 2005 are as follows (under (LIFO)) ($ in millions): • 20x5 20x4 • R/E (Beg. Bal.) $819$700 • Net Income 162 159 • Dividends (40)(40) • R/E (End. Bal.) $941$819 • . Accounting Changes & Error Corrections

  42. Cost Flow Assumption Change (Contd.) • cost of Goods Sold ($ in millions) • LIFOFIFO Diff.C. D.. Net.C.D. • PY $2,000 $1,700 $300 $ 300 180 • 20x4 405 360 45 345 207 • 20x5 420 365 55 400 240 • $2,825 $ 2,425 $400 • PY = previous years. • C.D.=cumulative difference. • Net C.D.= cumulative difference, net of income tax of 40%. • For 2006, The CGS is $430 million and $370 million under LIFO and FIFO, respectively. The CGS difference is $60 million for 2006. Accounting Changes & Error Corrections

  43. Change in Cost Flow Assumption (contd.) • The cumulative difference of CGS from the change of LIFO to FIFO inventory method is equivalent to the impact of this change on the inventory. Accounting Changes & Error Corrections

  44. Change in Cost Flow Assumption (contd.) • Since the cumulative difference of CGS is $345 and $400 million lower for 20x4 and 20x5, respectively, the inventory for 2004 and 2005 would be $345 million and $400 million higher under FIFO than under LIFO, respectively. Accounting Changes & Error Corrections

  45. Change in Cost Flow Assumption (contd.) • For 2006, cumulative difference of CGS would be $460 million lower (i.e., $400 million + $60 million), the inventory of 2006 would be $460 million higher under FIFO than under LIFO. Accounting Changes & Error Corrections

  46. Cost Flow Assumption Change –A Retrospective Approach • The cumulative difference of CGS up to 2005 equals: • $2,825-2,425 or 300+45+55 = 400 (million) • The journal entry to record the change from LIFO to FIFO : • 1/1 2006 • Inventory 400 • Retained Earnings 240 • Deferred Income Tax Lia. 160 • *assuming a 40% income tax rate Accounting Changes & Error Corrections

  47. Comparative Income Statements-A Retrospective Approach • 20x6 20x5 20x4 • restated restated • Revenues $950 $900 $875 • CGS (FIFO) (370) (365) (360) • Operating expenses (230)(210)(205) • Pre-tax Income 350 325 310 • Income taxes1 (140) (130) (124) • Net income $210$195R$186R • 1Assume a 40% tax rate. • R. Restated net income for 20x4 and 20x5. Accounting Changes & Error Corrections

  48. Comparative Retained Earnings Statement -A Retrospective Approach • Assuming a retained earnings balance of $700 million at the beginning of 20x4, the following statement of retained earnings will be in the 20x6 annual report ($ in millions): • 20x6 20x5 20x4 • Balance at beg.(R/E)1 $941 819 700 • Adjustment for the • Cum. difference2 240 207 180 • Adjusted Beg. Balance$1,181$1,026 $880 • Net income3 210 195 186 • Dividens (40)(40)(40) • Balance at end of year $1,351$1,181$1,026 Accounting Changes & Error Corrections

  49. Comparative Retained Earnings Statement (contd.) • Notes: • 1.Begining Retained earnings under the old method (i.e., the unadjusted), see p41. • 2.Cumulative difference, net of income tax, see p42. • 3. Net income under the new method (i.e., LIFO) for 2006 and restated net income (i.e., under LIFO) for 2005 and 2004, see p47. Accounting Changes & Error Corrections

  50. Change to LIFO Method(An Exception) • When change from other inventory method to LIFO, a prospective approach is applied when a retrospective adjustment is impractical. • No cumulative effect will be reported in the income statement and no restatement of prior years’ F/S. Accounting Changes & Error Corrections

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