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Chapter 22 ACCOUNTING CHANGES AND ERROR analysis Sommers – Intermediate I

Chapter 22 ACCOUNTING CHANGES AND ERROR analysis Sommers – Intermediate I. Accounting Changes. For accounting purposes, we classify accounting changes into three categories. Accounting changes are categorized as:

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Chapter 22 ACCOUNTING CHANGES AND ERROR analysis Sommers – Intermediate I

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  1. Chapter 22 ACCOUNTING CHANGES AND ERROR analysisSommers – Intermediate I

  2. Accounting Changes For accounting purposes, we classify accounting changes into three categories. Accounting changes are categorized as: • Changes in policy (when companies switch from one acceptable accounting method to another) • Changes in estimate (when new information causes companies to revise estimates made previously) • Changes in reporting entity (the group of companies comprising the reporting entity changes) Correction of an error is NOT considered an accounting change

  3. Discussion Questions Q22-4 Identify and describe the approach the FASB requires for reporting changes in accounting principles.

  4. Change in Accounting Policy Change from one GAAP to another • Adopt a new FASB standard • Change methods of inventory costing • Change from cost method to equity method, or vice versa • Change from completed contract to percentage-of-completion, or vice versa

  5. Changes in Accounting Principle Retrospective Accounting Change Approach Company reporting the change • Adjusts its financial statements for each prior period presented to the same basis as the new accounting principle. • Adjusts the carrying amounts of assets and liabilities as of the beginning of the first year presented, plus the opening balance of retained earnings.

  6. Retrospective Approach Revise prior years’ statements (that are presented for comparative purposes) to reflect the impact of the change. • 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 never occurred. • Adjust the beginning balance of retained earnings for the earliest period reported. In the first set of financial statements after the change is made, a disclosure note is needed to: • Provide justification for the change. • Point out that comparative information has been revised. • Report any per share amounts affected for the current and all prior periods.

  7. Example 1 Rockwell Corporation uses a periodic inventory system and has used the FIFO cost method since inception of the company in 1976. In 2011, the company decided to switch to the average cost method. Data for 2011 are as follows: Beginning inventory, FIFO (5,000 units @ $30) $150,000 Purchases: 5,000 units @ $ 36 $180,000 5,000 units @ $ 40 200,000 380,000 Cost of goods available for sale $530,000 Sales for 2011 (8,000 units @ $70) $560,000 Additional Information: • The company’s effective income tax rate is 40% for all years. • If the company had used the average cost method prior to 2011, ending inventory for 2010 would have been $130,000. • 7,000 units remained in inventory at the end of 2011. Ignoring income taxes, prepare the 2011 journal entry to adjust the accounts to reflect the average cost method. What is the effect of the change in methods on 2011 net income?

  8. Example 1: Continued Ignoring income taxes, prepare the 2011 journal entry to adjust the accounts to reflect the average cost method. What is the effect of the change in methods on 2011 net income? The effect of the change for the year 2011 is a $14,000 increase in cost of goods sold ($272,000 - 258,000) resulting in a $14,000 decrease in income before tax and a $8,400 decrease in income after tax [$14,000 x (1 - .40)].

  9. Changes in Accounting Principle Impracticability Companies should not use retrospective application if one of the following conditions exists: • Company cannot determine the effects of the retrospective application. • Retrospective application requires assumptions about management’s intent in a prior period. • Retrospective application requires significant estimates that the company cannot develop. If any of the above conditions exists, the company prospectively applies the new accounting principle.

  10. Example 2: Aquatic Equipment Corporation decided to switch from the LIFO method of costing inventories to the FIFO method at the beginning of 2011. The inventory as reported at the end of 2010 using LIFO would have been $60,000 higher using FIFO. Retained earnings at the end of 2010 was reported as $780,000 (reflecting the LIFO method). The tax rate is 40%. • Calculate the balance in retained earnings at the time of the change (beginning of 2011) as it would have been reported if FIFO had been used in prior years. • Prepare the journal entry at the beginning of 2011 to record the change in accounting principle.

  11. Example 2: Continued Balance at January 1, 2011, using LIFO $780,000 Prior to 2011, using FIFO: Inventory would have been higher by $60,000, so Cost of Goods Sold would have been lower by $60,000, so Pretax income would have been higherby: $60,000 Less: income tax at 40% (24,000) Cumulative net income and thus retained earnings would have been higher by: 36,000 Balance at January 1, 2011, using FIFO $816,000 January 1, 2011

  12. Discussion Questions Q22-6 Define a change in estimate and provide an illustration.

  13. Changes in Accounting Estimate Examples of Estimates • Uncollectible receivables. • Inventory obsolescence. • Useful lives and salvage values of assets. • Periods benefited by deferred costs. • Liabilities for warranty costs and income taxes. • Recoverable mineral reserves. • Change in depreciation methods.

  14. Changes in Accounting Estimate Revision of an estimate because of new information or new experience • Change depreciation methods (considered a change in estimate achieved by a change in accounting principle) • Change estimate of useful life of depreciable asset • Change estimate of bad debt percentage • Change estimate of periods benefited by intangible assets • Change actuarial estimates pertaining to a pension plan

  15. Prospective Approach The change is implemented in the current period, and its effects are reflected in the financial statements of the current and future years only. • Prior years’ statements are not revised. • Account balances are not revised. 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 period-specific effects. • It is impracticable to determine the cumulative effect of prior years. • The change is mandated by authoritative pronouncements. Change in Depreciation 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.

  16. Changes in Accounting Estimate Disclosures • Companies need not disclose changes in accounting estimate made as part of normal operations, such as bad debt allowances or inventory obsolescence, unless such changes are material. • However, for a change in estimate that affects several periods (such as a change in the service lives of depreciable assets), companies should disclose the effect on income from continuing operations and related per-share amounts of the current period.

  17. Example 3 The PerdotCompany purchased machinery on January 2, 2009, for $800,000. A five-year life was estimated and no residual value was anticipated. Perdotdecided to use the straight-line depreciation method and recorded $160,000 in depreciation in 2009 and 2010. Early in 2011, the company revised the total estimated life of the machinery to eight years. Briefly describe the accounting treatment for this change.

  18. Example 3: Continued The PerdotCompany purchased machinery on January 2, 2009, for $800,000. A five-year life was estimated and no residual value was anticipated. Perdotdecided to use the straight-line depreciation method and recorded $160,000 in depreciation in 2009 and 2010. Early in 2011, the company revised the total estimated life of the machinery to eight years. Determine depreciation for 2011. $800,000 Cost $160,000 Old annual deprec($800,000/5 yrs) x 2 years 320,000 Depreciation to date (2009-2010) 480,000 Book value ÷ 6 New estimated remaining life (8–2 yrs) $ 80,000 New annual depreciation

  19. Change in Reporting Entity Examples of a change in reporting entity are: • Presenting consolidated statements in place of statements of individual companies. • Changing specific subsidiaries that constitute the group of companies for which the entity presents consolidated financial statements. • Changing the companies included in combined financial statements. • Changing the cost, equity, or consolidation method of accounting for subsidiaries and investments. Reported by changing the financial statements of all prior periods presented.

  20. 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.

  21. Discussion Questions Q22-2 State how each of the following items is reflected in the financial statements. • Change from FIFO to LIFO method for inventory valuation purposes. • Charge for failure to record depreciation in a previous period. (c) Litigation won in current year, related to prior period.

  22. Discussion Questions Q22-2 State how each of the following items is reflected in the financial statements. • Change in the reliability of certain receivables. • Write-off of receivables. • Change from the percentage-of-completion to the completed-contract method for reporting new income.

  23. Classification of Accounting Changes Indicate with the appropriate letter the nature of each situation described below: • PR Change in principle reported retrospectively • PP Change in principle reported prospectively • E Change in estimate • EP Change in estimate resulting from a change in principle • R Change in reporting entity • CECorrection of an error • Change from declining balance depreciation to straight-line. • Change in the estimated useful life of office equipment. • Technological advance that renders worthless a patent with an unamortized cost of $45,000. • Change from determining lower of cost or market for the inventories by the individual item approach to the aggregate approach.

  24. Classification of Accounting Changes Indicate with the appropriate letter the nature of each situation described below: • PR Change in principle reported retrospectively • PP Change in principle reported prospectively • E Change in estimate • EP Change in estimate resulting from a change in principle • R Change in reporting entity • CE Correction of an error • Change from LIFO inventory costing to the weighted-average inventory costing. • Settling a lawsuit for less than the amount accrued previously as a loss contingency. • Including in the consolidated financial statements a subsidiary acquired several years earlier that was appropriately not included in previous years.

  25. Classification of Accounting Changes Indicate with the appropriate letter the nature of each situation described below: • PR Change in principle reported retrospectively • PP Change in principle reported prospectively • E Change in estimate • EP Change in estimate resulting from a change in principle • R Change in reporting entity • CE Correction of an error • Change by a retail store from reporting bad debt expense on a pay-as-you-go basis to the allowance method. • A shift of certain manufacturing overhead costs to inventory that previously were expensed as incurred to more accurately measure cost of goods sold. (Either method is generally acceptable.)

  26. Example 4: Described below are six independent and unrelated situations involving accounting changes. Each change occurs during 2011 before any adjusting entries or closing entries were prepared. Assume the tax rate for each company is 40% in all years. • Fleming Home Products introduced a new line of commercial awnings in 2010 that carry a one-year warranty against manufacturer’s defects. Based on industry experience, warranty costs were expected to approximate 3% of sales. Sales of the awnings in 2010 were $3,500,000. Accordingly, warranty expense and a warranty liability of $105,000 were recorded in 2010. In late 2011, the company’s claims experience was evaluated and it was determined that claims were far fewer than expected: 2% of sales rather than 3%. Sales of the awnings in 2011 were $4,000,000 and warranty expenditures in 2011 totaled $91,000. Identify the type of change. Prepare any journal entry necessary as a direct result of the change as well as any adjusting entry for 2011 related to the situation described. Briefly describe any other steps that should be taken to appropriately report the situation.

  27. Example 4: Continued • This is a change in estimate. No entry is needed to record the change 2011 adjusting entry: Warranty expense (2% x $4,000,000) 80,000 Estimated warranty liability 80,000 If the effect is material, a disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per share amounts for the current period.

  28. Example 4: Continued Each change occurs during 2011 before any adjusting entries or closing entries were prepared. Assume the tax rate for each company is 40% in all years. • On December 30, 2007, Rival Industries acquired its office building at a cost of $1,000,000. It was depreciated on a straight- line basis assuming a useful life of 40 years and no salvage value. However, plans were finalized in 2011 to relocate the company headquarters at the end of 2015. The vacated office building will have a salvage value at that time of $700,000. Identify the type of change. Prepare any journal entry necessary as a direct result of the change as well as any adjusting entry for 2011 related to the situation described. Briefly describe any other steps that should be taken to appropriately report the situation.

  29. Example 4: Continued • This is a change in estimate. No entry is needed to record the change. Calculation of annual depreciation after the estimate change: $1,000,000 Cost$25,000 Old depreciation ($1,000,000 ÷ 40 years) x 3 yrs (75,000) Depreciation to date (2008-2010) $ 925,000 Undepreciated cost (700,000) New estimated salvage value $ 225,000 To be depreciated ÷ 5 Estimated remaining life (5 years: 2011-2015)$ 45,000 New annual depreciation 2011 adjusting entry: Depreciation expense 45,000 Accumulated depreciation 45,000 A disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per share amounts for the current period.

  30. Example 4: Continued Each change occurs during 2011 before any adjusting entries or closing entries were prepared. Assume the tax rate for each company is 40% in all years. • Hobbs- Barto Merchandising, Inc., changed inventory cost methods to LIFO from FIFO at the end of 2011 for both financial statement and income tax purposes. Under FIFO, the inventory at January 1, 2012, is $690,000. Identify the type of change. Prepare any journal entry necessary as a direct result of the change as well as any adjusting entry for 2011 related to the situation described. Briefly describe any other steps that should be taken to appropriately report the situation.

  31. Example 4: Continued • This is a change in accounting principle that usually is reported prospectively. No entry is needed to record the change. When a company changes tothe LIFO inventorymethod from another inventory method, accounting records usually are insufficient to determine the cumulative income effect of the change necessary to retrospectively revise accounts. So, a company changing to LIFO usually reports the beginning inventory in the year the LIFO method is adopted ($690,000 in this case) as the base year inventory for all future LIFO calculations. The disclosure required is a footnote to the financial statements describing the nature of and justification for the change as well as an explanation as to why the retrospective application was impracticable.

  32. Example 4: Continued Each change occurs during 2011 before any adjusting entries or closing entries were prepared. Assume the tax rate for each company is 40% in all years. • At the beginning of 2008, the Hoffman Group purchased office equipment at a cost of $330,000. Its useful life was estimated to be 10 years with no salvage value. The equipment was depreciated by the sum-of-the-years’-digits method. On January 1, 2011, the company changed to the straight-line method. Identify the type of change. Describe all journal entry(s) necessary as a direct result of the change as well as any adjusting entry for 2011 related to the situation described. Briefly describe any other steps that should be taken to appropriately report the situation.

  33. Example 4: Continued • This is a change in accounting estimate resulting from a change in accounting principle. No entry is needed to record the change 2011 adjusting entry: Depreciation expense New amount Accumulated depreciation New amount A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. Accordingly, the Hoffman Group reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change is depreciated straight-line over the remaining useful life.

  34. Example 4: Continued Each change occurs during 2011 before any adjusting entries or closing entries were prepared. Assume the tax rate for each company is 40% in all years. • In November 2009, the State of Minnesota filed suit against Huggins Manufacturing Company, seeking penalties for violations of clean air laws. When the financial statements were issued in 2010, Huggins had not reached a settlement with state authorities, but legal counsel advised Huggins that it was probable the company would have to pay $200,000 in penalties. Accordingly, the following entry was recorded: Loss— litigation .................................. 200,000 Liability— litigation .............................. 200,000Late in 2011, a settlement was reached with state authorities to pay a total of $350,000 in penalties. Identify the type of change. Prepare any journal entry necessary as a direct result of the change as well as any adjusting entry for 2011 related to the situation described. Briefly describe any other steps that should be taken to appropriately report the situation.

  35. Example 4: Continued • This is a change in estimate. To revise the liability on the basis of the new estimate: Loss – litigation 150,000 Liability – litigation ($350,000 – 200,000) 150,000 A disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per share amounts for the current period.

  36. Example 4: Continued Each change occurs during 2011 before any adjusting entries or closing entries were prepared. Assume the tax rate for each company is 40% in all years. • At the beginning of 2011, Jantzen Specialties, which uses the sum-of-the-years’-digits method, changed to the straight-line method for newly acquired buildings and equipment. The change increased current year net earnings by $445,000. Identify the type of change. Prepare any journal entry necessary as a direct result of the change as well as any adjusting entry for 2011 related to the situation described. Briefly describe any other steps that should be taken to appropriately report the situation.

  37. Example 4: Continued • This is a change in accounting principle accounted for prospectively. Because the change will be effective only for assets placed in service after the date of change, the change doesn’t affect assets depreciated in prior periods. The nature of and justification for the change should be described in the disclosure notes. Also, the effect of the change on the current period’s financial statements should be disclosed.

  38. Correction of Errors Types of Accounting Errors: • A change from an accounting principle that is not generally accepted to an accounting policy that is acceptable. • Mathematical mistakes. • Changes in estimates that occur because a company did not prepare the estimates in good faith. • Failure to accrue or defer certain expenses or revenues. • Misuse of facts. • Incorrect classification of a cost as an expense instead of an asset, and vice versa.

  39. Correction of Errors • All material errors must be corrected. • Record corrections of errors from prior periods as an adjustment to the beginning balance of retained earnings in the current period. • Such corrections are called prior period adjustments. • For comparative statements, a company should restate the prior statements affected, to correct for the error.

  40. Error Analysis • Balance sheet errors affect only the presentation of an asset, liability, or stockholders’ equity account. • Current year error - reclassify item to its proper position. • Prior year error - restate the balance sheet of the prior year for comparative purposes. • Income Statement errors cause the improper classification of revenues or expenses. • Current year error - reclassify item to its proper position. • Prior year error - restate the income statement of the prior year for comparative purposes.

  41. Counterbalancing Errors • Will be offset or corrected over two periods. • If company has closed the books: • If the error is already counterbalanced, no entry is necessary. • If the error is not yet counterbalanced, make entry to adjust the present balance of retained earnings. For comparative purposes, restatement is necessary even if a correcting journal entry is not required. • If company has not closed the books: • If error already counterbalanced, make entry to correct the error in the current period and to adjust the beginning balance of Retained Earnings. • If error not yet counterbalanced, make entry to adjust the beginning balance of Retained Earnings.

  42. 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.

  43. Example 5 Goddard Company has used the FIFO method of inventory valuation since it began operations in 2008. Goddard decided to change to the average cost method for determining inventory costs at the beginning of 2011. The following schedule shows year-end inventory balances under the FIFO and average cost methods: YearFIFOAverage Cost 2008 $45,000 $54,000 2009 78,000 71,000 2010 83,000 78,000 Ignoring income taxes, prepare the 2011 journal entry to adjust the accounts to reflect the average cost method. How much higher or lower would cost of goods sold be in the 2010 revised income statement?

  44. Example 5: Continued Ignoring income taxes, prepare the 2011 journal entry to adjust the accounts to reflect the average cost method. How much higher or lower would cost of goods sold be in the 2010 revised income statement?

  45. Example 6: Classifying Accounting Changes Type of ChangeReporting Approach P. Change in accounting principle R. Retrospective approach E. Change in accounting estimate P. Prospective approach EP. Change in estimate resulting from a change in principle X. Correction of an error N. Neither an accounting change nor an accounting error. • Wagner changed its method of depreciating computer equipment from the DDB method to the straight-line method. • Wagner determined that a liability insurance premium it both paid and expensed in 2010 covered the 2010–2012 period.

  46. Example 6: Classifying Accounting Changes Type of ChangeReporting Approach P. Change in accounting principle R. Retrospective approach E. Change in accounting estimate P. Prospective approach EP. Change in estimate resulting from a change in principle X. Correction of an error N. Neither an accounting change nor an accounting error. • Wagner custom-manufactures farming equipment on a contract basis. Wagner switched its accounting for these long-term contracts from the completed-contract method to the percentage-of-completion method. • Due to an unexpected relocation, Wagner determined that its office building, previously depreciated using a 45-year life, should be depreciated using an 18-year life. • Wagner offers a three-year warranty on the farming equipment it sells. Manufacturing efficiencies caused Wagner to reduce its expectation of warranty costs from 2% of sales to 1% of sales.

  47. Example 6: Classifying Accounting Changes Type of ChangeReporting Approach P. Change in accounting principle R. Retrospective approach E. Change in accounting estimate P. Prospective approach EP. Change in estimate resulting from a change in principle X. Correction of an error N. Neither an accounting change nor an accounting error. • Wagner changed from LIFO to FIFO to account for its materials and work-in-process inventories. • Wagner changed from FIFO to average cost to account for its equipment inventory. • Wagner sells extended service contracts on some of its equipment sold. Wagner performs services related to these contracts over several years, so in 2011 Wagner changed from recognizing revenue from these service contracts on a cash basis to the accrual basis.

  48. Example 7: Error Analysis You have been hired as the new controller for the Ralston Company. Shortly after joining the company in 2011, you discover the following errors related to the 2009 and 2010 financial statements: • Inventory at 12/31/09 was understated by $6,000. • Inventory at 12/31/10 was overstated by $9,000. • On 12/31/10, inventory was purchased for $3,000. The company did not record the purchase until the inventory was paid for early in 2011. At that time, the purchase was recorded by a debit to purchases and a credit to cash. The company uses a periodic inventory system. Required: • Assuming that the errors were discovered after the 2010 financial statements were issued, analyze the effect of the errors on 2010 and 2009 cost of goods sold, net income, and retained earnings. ( Ignore income taxes.) • Prepare a journal entry to correct the errors. • What other step( s) would be taken in connection with the error?

  49. Example 7: Error Analysis The financial statements that were incorrect as a result of both errors (effect of one error in 2009 and effect of three errors in 2010) would be retrospectively restated to report the correct inventory amounts, cost of goods sold, income, and retained earnings when those statements are reported again for comparative purposes in the 2011 annual report. A prior period adjustment to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share.

  50. Summary of Accounting Changes and Errors

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