Accounting Changes and Error Corrections

1. Accounting Changes and Error Corrections

2. Learning Objectives • Understand the three different types of accounting changes that have been identified by accounting standard setters. • Recognize the difference between a change in accounting estimate and a change in accounting principle, and know how a change in accounting estimate is reflected in the financial statements.

3. Learning Objectives • Determine if a change in accounting principle requires a cumulative adjustment relating to its effect or a restatement of prior-periods’ financial statements, and be able to compute the necessary adjustment. • Determine when a change in reporting entity has occurred, and understand the disclosure requirements associated with this change.

4. Learning Objectives • Recognize the various type of errors that can occur in the accounting process, understand when errors counterbalance, and be able to correct errors when necessary. • Describe the differences between the U.S. approach to accounting changes and error corrections and the international standard found in IAS 8.

5. Why Are Accounting Changes Made? • A company, as a result of experience or new information may change its estimates of revenues or expenses. • Due to changes in economic conditions, companies may need to change methods of accounting to more clearly reflect the current economic situation. • Accounting standard-setting bodies may require the use of a new accounting method or principle.

6. Why Are Accounting Changes Made? • The acquisition or divestiture of companies may cause a change in the reporting entity. • Management may be pressured to report profitable performance. Making accounting changes can often result in higher net income, thereby reflecting favorably on management.

7. Effect of SFAS No. 106 One-Time Charge (in millions) Company IBM $2,263 Gen. Electric 1,799 Bell Atlantic 1,550 PepsiCo 357 The Coca-Cola Company 7 Tiffany & Co. 6

8. Categories of Accounting Changes • Change in accounting estimate • Change in accounting principle • Change in reporting entity

9. Change in Accounting Estimate • Employ current and prospective approach. • Report current and future financial statements on new basis. • Present prior periods as previously reported. • Make no adjustments to current period opening balances. • Present no pro-forma data.

10. Change in Accounting Estimate Examples of areas where changes in accounting estimates often are needed: • Uncollectible receivables. • Useful lives of depreciable or intangible assets. • Residual values for depreciable assets. • Warranty obligations. • Quantities of mineral reserves to be depleted. • Actuarial assumptions for pensions or other postemployment benefits. • Number of periods benefited by deferred costs.

11. Change in Accounting Principle • Report cumulative effect on income statement after extraordinary items. • Criteria for change: change only if the new principle is preferable: • provides more useful information. • is less costly per benefit.

12. Changes in Accounting Principle--Disclosure Requirements • Report current year’s income components on the new basis. • Report the cumulative effectof the adjustment, net of tax, on the income statement. • Present prior period financial statements as previously reported. • Include pro-forma information as if the change were retroactive--direct and indirect effects. • Present earnings per share data for all prior periods presented.

13. Change in Accounting Principle--Example: Basic Data • AlphaTronics, Inc. has decided to change depreciation methods from double-declining balance to straight-line. The income results are summarized as: • Net difference $173 • Tax effect (52) • Net effect on income $121

14. Change in Accounting Principle--Example: Income Statement AlphaTronics, Inc. Partial Income Statement Income from continuing operations $500 Cumulative effect of change in accounting principle (net of $52 income tax effect) 121 Net income $621 Note: pro-forma information should also be disclosed if available.

15. Sample Partial Income Statement Income from continuing operations $560,000 Extraordinary gain, net of income taxes of $30,000 70,000 Cumulative effect on prior years of change in accounting principle--change to the straight-line method of depreciation from double-declining-balance method, net of taxes of $39,300 91,750 Net income $721,700

16. Exceptions to GeneralRule--Situations • A change from LIFO method of inventory pricing to another method. • A change in the method of accounting for long-term construction contracts. • A change to or from the “full cost” method of accounting used in extractive industries. • Changes made at the time of an initial distribution of company stock.

17. Retroactive Restatement • Several FASB statements require retroactive restatement. • Adjust Retained Earnings and the prior year’s income for the effects of the change. • Pro-forma information is not required.

18. Exceptions to GeneralRule--Change to LIFO • Change to LIFO--past records often inadequate to prepare pro-formas. • Beginning inventory becomes first LIFO layer. • No cumulative effect adjustment is required.

19. Change of Principle andChange of Estimate If there is both a change in principle and a change in estimate for an item, the event is treated as a change in estimate.

20. Change in Reporting Entity • Employ retroactive approach. • Restate financial statements for all prior periods presented. • Disclose, in year of change, effect on income from continuing operations, net income, and earning per share data for all periods presented.

21. Error Correction--Types of Errors Errors discovered currently in the course of normal accounting procedures. • Math errors. • Posting to the wrong account. • Misstating an account. • Omitting an account from the trial balance.

22. Error Correction--Types of Errors Errors limited to balance sheet accounts. • Debiting Accounts Receivable instead of Notes Receivable. • Crediting Interest Payable instead of Notes Payable. • Debiting an investment account instead of Land when property was purchased for plant expansion.

23. Error Correction--Types of Errors Errors limited to income statement accounts. • Debiting Office Salaries instead of Sales Salaries. • Crediting Rent Revenue instead of Commissions Revenue.

24. Error Correction--Types of Errors Errors affecting both income statement accounts and balance sheet accounts. • Debiting Office Equipment instead of Repairs Expense. • Crediting Depreciation Expense instead of Accumulated Depreciation.

25. Errors--Automatically Counterbalanced Errors in the income statement that are not detected are automatically counterbalanced in the following fiscal period.

26. Errors--Not Automatically Counterbalanced Except for merchandise, errors in the balance sheet are inaccurately stated until such time as correcting entries are made.

27. Error Correction • If detected in current period, before books are closed: • Correct the account through normal accounting adjustment. • If detected in subsequent period, after books are closed: • adjust financial records for effect of material errors. • make adjustment directly to Retained Earnings.

28. Example: Error Correction • In 2001, the accountant for Jackman Enterprises, Inc. forgot to record $5,000 of depletion at an iron mine Jackman owns. • Record the 2003 correcting entry. Retained Earnings 5,000 Mineral Rights--Iron Mine 5,000

29. Error Correction--Disclosure • If comparative statements are provided, apply correction retroactively to prior years. • Restate beginning balance of Retained Earnings for first period presented if error extends beyond. • Disclose and explain error correction in notes.

30. The End