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Chapter 14-1Accounting Changes and Error AnalysisChapter 14Intermediate Accounting12th EditionKieso,Weygandt,and Warfield Prepared by Coby Harmon,University of California,Santa BarbaraChapter 14-21.Identify the types of accounting changes.2.Describe the accounting for changes in accounting principles.3.Understand how to account for retrospective accounting changes.4.Understand how to account for impracticable changes.5.Describe the accounting for changes in estimates.6.Identify changes in a reporting entity.7.Describe the accounting for correction of errors.8.Identify economic motives for changing accounting methods.9.Analyze the effect of errors.Learning ObjectivesLearning ObjectivesChapter 14-3Why are accounting changes made?Why are accounting changes made?New FASB pronouncementsNew FASB pronouncementsChanging economic conditionsChanging economic conditionsChanging internal circumstancesChanging internal circumstancesAccounting Changes Accounting Changes Reporting Issues&ApproachesReporting Issues&ApproachesChapter 14-4 Essential issues in reporting accounting changes:Essential issues in reporting accounting changes:Whether an accounting change is allowed.Whether an accounting change is allowed.Whether to restate prior Whether to restate prior years?financialyears?financial statements.statements.Whether to recognize the effect of the change in Whether to recognize the effect of the change in the current years net income or in the beginning the current years net income or in the beginning retained earnings balance.retained earnings balance.Accounting Changes Accounting Changes Reporting Issues&ApproachesReporting Issues&ApproachesChapter 14-5Accounting ChangesAccounting ChangesChapter 14-6Error corrections.Are not classified as accounting changes.Do affect the income of prior periods and require special treatment.Accounting ChangesAccounting ChangesChapter 14-7RelevanceConsistencyPublic ConfidenceObjectives of Reporting Accounting ChangesObjectives of Reporting Accounting ChangesChapter 14-8Accounting Principle ChangesAccounting Principle ChangesChapter 14-9The following are The following are notnot accounting principle changes:accounting principle changes:l lInitial adoption of an accounting principleInitial adoption of an accounting principlel lAdopting an accounting principle for a new group of Adopting an accounting principle for a new group of assets or liabilities assets or liabilities l lChange from inappropriate accounting principle to Change from inappropriate accounting principle to GAAPGAAPl lPlanned change to straight-line depreciationPlanned change to straight-line depreciationl lChange in accounting principle that cannot be Change in accounting principle that cannot be distinguished from a change in accounting estimatedistinguished from a change in accounting estimateAccounting Principle ChangesAccounting Principle ChangesChapter 14-10Three approaches for reporting changes:1)Currently(cumulative effect).2)Retrospectively.3)Prospectively(in the future).4)FASB requires use of the retrospective approach.Changes in Accounting PrincipleChanges in Accounting PrincipleChapter 14-11l lA change in anA change in an accounting principle accounting principle is accounted for by is accounted for by the retrospective application of the new accounting the retrospective application of the new accounting principle.principle.l lA change in an A change in an accounting estimateaccounting estimate is accounted for is accounted for prospectively.prospectively.l lA change in a A change in a reporting entityreporting entity is accounted for by the is accounted for by the retrospective application of the new accounting principle.retrospective application of the new accounting principle.l lA material A material errorerror is accounted for by prior period is accounted for by prior period restatement(adjustment).restatement(adjustment).According to the provisions of FASB No.154:Basic PrinciplesBasic PrinciplesChapter 14-12A company accounts for a change in principle by the retrospective application of the new accounting principle as follows:1.The company computes the cumulative effect of the change to the new accounting principle as of the beginning of the first period presented.That is,it computes the amounts that would have been in the financial statements if it had always used the new principle.ContinuedContinuedRetrospective Adjustment MethodRetrospective Adjustment MethodChapter 14-132.The company adjusts the carrying values of those assets and liabilities(including income taxes)that are affected by the change.The company makes an offsetting adjustment to the beginning balance of retained earnings to report the cumulative effect of the change(net of taxes)for each period presented.ContinuedContinuedRetrospective Adjustment MethodRetrospective Adjustment MethodChapter 14-143.The company adjusts the financial statements of each prior period to reflect the specific effects of applying the new accounting principle.That is,each item in each financial statement that is affected by the change is restated to the appropriate amount under the new accounting principle.The company uses the new accounting principle in its current financial statements.ContinuedContinuedRetrospective Adjustment MethodRetrospective Adjustment MethodChapter 14-154.The companys disclosures include(a)the nature and reason for the change in accounting principle,including an explanation of why the new principle is preferable,(b)a description of the prior-period information that has been retrospectively adjusted,(c)the effect of the change on income,earnings per share,and any other financial statement line item for the current period and the prior periods retrospectively adjusted,and(d)the cumulative effect of the change on retained earnings(or other appropriate component of equity)at the beginning of the earliest period presented.Retrospective Adjustment MethodRetrospective Adjustment MethodChapter 14-16The following accounting principle changes are subject to the The following accounting principle changes are subject to the retroactive approach:retroactive approach:Change from LIFO to another inventory methodChange from LIFO to another inventory methodChange in the method of accounting for long-term Change in the method of accounting for long-term construction contractsconstruction contractsChange to or from full-cost method in extractive Change to or from full-cost method in extractive industriesindustriesChanges in accounting principle made in conjunction with Changes in accounting principle made in conjunction with an initial public offering of equity securities(exemption an initial public offering of equity securities(exemption available only once)available only once)Retrospective Adjustment MethodRetrospective Adjustment MethodChapter 14-17The following accounting principle changes are subject to the The following accounting principle changes are subject to the retroactive approach:retroactive approach:Change from retirement/replacement accounting to Change from retirement/replacement accounting to depreciation accounting for railroad track structuresdepreciation accounting for railroad track structuresChange to a principle required by a new pronouncement Change to a principle required by a new pronouncement recognized as GAAP that requires retroactive applicationrecognized as GAAP that requires retroactive applicationChange to the equity method of accounting for Change to the equity method of accounting for investments in common stock(sometimes classified as a investments in common stock(sometimes classified as a change in reporting entity)change in reporting entity)Retrospective Adjustment MethodRetrospective Adjustment MethodChapter 14-18Example(Retrospective Change)Buildmore Construction Company used the completed contract method to account for long-term construction contracts for financial accounting and tax purposes in 2007,its first year of operations.In 2008,the company decided to change to the percentage-of-completion method for financial accounting purposes.Income before long-term contracts and taxes in 2007 and 2008 was$80,000 and$100,000.The tax rate is 40%and the company will continue to use the completed contract method for tax purposes.Retrospective Change ExampleRetrospective Change ExampleChapter 14-19Example Income from Long-Term ContractsRetrospective Change ExampleRetrospective Change ExampleChapter 14-20Example Comparative Income StatementsRetrospective Change ExampleRetrospective Change ExampleChapter 14-21Example Retained Earnings StatementRetrospective Change ExampleRetrospective Change ExampleChapter 14-22ImpracticabilityChanges in Accounting PrincipleChanges in Accounting PrincipleCompanies should not use retrospective application if one of the following conditions exists:1.Company cannot determine the effects of the retrospective application.2.Retrospective application requires assumptions about managements intent in a prior period.3.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.Chapter 14-23No cumulative adjustment No cumulative adjustment is made.is made.Prior years results Prior years results remain unchanged.remain unchanged.New estimates are applied New estimates are applied prospectively.prospectively.Summary of the Approach for Changes in Accounting EstimatesProspective ApproachProspective ApproachChapter 14-24Changes in Accounting EstimateChanges in Accounting EstimateThe following items require estimates.1.Uncollectible receivables.2.Inventory obsolescence.3.Useful lives and salvage values of assets.4.Periods benefited by deferred costs.5.Liabilities for warranty costs and income taxes.6.Recoverable mineral reserves.7.Change in depreciation methods.Companies report prospectively changes in accounting estimates.Chapter 14-25Arcadia HS,purchased equipment for$510,000 which was Arcadia HS,purchased equipment for$510,000 which was estimated to have a useful life of 10 years with a salvage estimated to have a useful life of 10 years with a salvage value of$10,000 at the end of that time.Depreciation has value of$10,000 at the end of that time.Depreciation has been recorded for 7 years on a straight-line basis.In 2005 been recorded for 7 years on a straight-line basis.In 2005(year 8),it is determined that the total estimated life should(year 8),it is determined that the total estimated life should be 15 years with a salvage value of$5,000 at the end of that be 15 years with a salvage value of$5,000 at the end of that time.time.Required:Required:l lWhat is the journal entry to correct What is the journal entry to correct the prior years depreciation?the prior years depreciation?l lCalculate the depreciation expense Calculate the depreciation expense for 2005.for 2005.No Entry No Entry RequiredRequiredChange in Estimate ExampleChange in Estimate ExampleChapter 14-26EquipmentEquipment$510,000$510,000Fixed Assets:Fixed Assets:Accumulated depreciationAccumulated depreciation 350,000350,000 Net book value(NBV)Net book value(NBV)$160,000$160,000Balance SheetBalance Sheet (Dec.31,2004)(Dec.31,2004)Change in Estimate ExampleChange in Estimate ExampleAfter 7 yearsAfter 7 yearsEquipment cost Equipment cost$510,000$510,000Salvage valueSalvage value -10,000 -10,000Depreciable baseDepreciable base500,000500,000Useful life(original)Useful life(original)10 years 10 yearsAnnual depreciationAnnual depreciation$50,000$50,000 x 7 years =x 7 years =$350,000$350,000 First,establish NBV First,establish NBV at date of change in at date of change in estimate.estimate.Chapter 14-27Change in Estimate ExampleChange in Estimate ExampleAfter 7 yearsAfter 7 yearsNet book value Net book value$160,000$160,000Salvage value(new)Salvage value(new)5,0005,000Depreciable baseDepreciable base155,000155,000Useful life remainingUseful life remaining 8 years 8 yearsAnnual depreciationAnnual depreciation$19,375$19,375Second,calculate Second,calculate depreciation expense depreciation expense for 2005.for 2005.Depreciation expense 19,375Accumulated depreciation 19,375Journal entry for 2005Chapter 14-28Reporting a Change in EntityReporting a Change in EntityExamples of a change in reporting entity are:1.Presenting consolidated statements in place of statements of individual companies.2.Changing specific subsidiaries that constitute the group of companies for which the entity presents consolidated financial statements.3.Changing the companies included in combined financial statements.4.Changing the cost,equity,or consolidation method of accounting for subsidiaries and investments.Reported by changing the financial statements of all priorperiods presented.Chapter 14-29No cumulative adjustment No cumulative adjustment is made.is made.Prior years results are Prior years results are restated.restated.Summary of the Approach for Changes in Reporting EntityReporting a Change in EntityReporting a Change in EntityChapter 14-30l lNew principle must be preferable.New principle must be preferable.l lNature of change and justification Nature of change and justification disclosed in notes.disclosed in notes.JustificationsJustificationsImproved matchingImproved matchingEnhanced asset valuationEnhanced asset valuationNew informationNew informationChanging conditionsChanging conditionsCompliance with new reporting Compliance with new reporting standards standards Justification for Accounting ChangesJustification for Accounting ChangesChapter 14-31I wonder why companies make accounting changes?It seems like a lot of trouble to me!Chapter 14-32Reporting a Correction of an ErrorReporting a Correction of an ErrorAccounting errors include the following types:1.A change from an accounting principle that is not generally accepted to an accounting principle that is acceptable.2.Mathematical mistakes.3.Changes in estimates that occur because a company did not prepare the estimates in good faith.4.Failure to accrue or defer certain expenses or revenues.5.Misuse of facts.6.Incorrect classification of a cost as an expense instead of an asset,and vice versa.Chapter 14-33Reporting a Correction of an ErrorReporting a Correction of an ErrorAll 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.Chapter 14-341.1.The company computes the cumulative effect of The company computes the cumulative effect of the error correction on prior period financial the error correction on prior period financial statements.That is,it computes the amounts that statements.That is,it computes the amounts that would have been in the financial statements if it would have been in the financial statements if it had not made the error.had not made the error.ContinuedContinuedA company accounts for a change in accounting principle by prior period restatement as follows:Prior Period RestatementPrior Period RestatementChapter 14-352.The company adjusts the carrying values of those assets and liabilities(including income taxes)that are affected by the error.The company makes an offsetting entry to the beginning balance of retained earnings to report the cumulative effect of the error correction(net of taxes)for each period presented.ContinuedContinuedPrior Period RestatementPrior Period RestatementChapter 14-363.3.The company adjusts the financial statements of The company adjusts the financial statements of each prior period to reflect the specific effects of each prior period to reflect the specific effects of correcting the error.correcting the error.4.4.The companys disclosures include(a)that its The companys disclosures include(a)that its previously issued financial statements have been previously issued financial statements have been restated,along with a description of the nature of restated,along with a description of the nature of the error,the error,ContinuedContinuedPrior Period RestatementPrior Period RestatementChapter 14-374.4.(b)the effect of the correction of each financial b)the effect of the correction of each financial statement line item,and any per share amounts statement line item,and any per share amounts affected for each prior period presented,and affected for each prior period presented,and(c)the cumulative effect of the change on retained(c)the cumulative effect of the change on retained earnings(or other appropriate component of earnings(or other appropriate component of equity)at the beginning of the earliest period equity)at the beginning of the earliest period presented.presented.Prior Period RestatementPrior Period RestatementChapter 14-38Before issuing the report for the year ended December 31,2007,you discover a$62,500 error that caused the 2006 inventory to be overstated(overstated inventory caused COGS to be lower and thus net income to be higher in 2006).Would this discovery have any impact on the reporting of the Statement of Retained Earnings for 2007?Assume a 20%tax rate.Retained Earnings StatementRetained Earnings StatementChapter 14-39Retained Earnings StatementRetained Earnings StatementChapter 14-40I.I.Errors occurred and discovered in theErrors occurred and discovered in the same accounting period.same accounting period.II.Errors occurred in previous period.II.Errors occurred in previous period.A.Errors did not affect prior period netA.Errors did not affect prior period net income.income.B.Errors did affect prior period net B.Errors did affect prior period net income.income.1.Counterbalancing errors1.Counterbalancing errors2.2.NoncounterbalancingNoncounterbalancing errors errorsAccounting ErrorsAccounting ErrorsClassificationsClassificationsChapter 14-41 Corrected by reversing the incorrect entry and then Corrected by reversing the incorrect entry and then recording the correct entry(or by making an entry to recording the correct entry(or by making an entry to correct the account balances)correct the account balances)Errors Occurred and Discovered in Same Errors Occurred and Discovered in Same PeriodPeriodChapter 14-42l lInvolves incorrect classification of accounts.Involves incorrect classification of accounts.l lRequires correction of previously issued statements Requires correction of previously issued statements(retroactive approachretroactive approach).l lIs Is notnot classified as a prior period adjustment since it does classified as a prior period adjustment since it does not affect prior income.not affect prior income.l lDisclose nature of error.Disclose nature of error.Previous Period Errors Not Affecting Net Previous Period Errors Not Affecting Net IncomeIncomeChapter 14-43l lCounterbalancing errors discovered after two or more Counterbalancing errors discovered after two or more years years do not requiredo not require a correcting entry.a correcting entry.l lCounterbalancing errors discovered in the second year of Counterbalancing errors discovered in the second year of the cycle the cycle require require a correcting entry.a correcting entry.-Treated as a prior period adjustment(net of tax)to-Treated as a prior period adjustment(net of tax)to beginning Retained Earnings balance.beginning Retained Earnings balance.Counterbalancing Errors Affecting Prior Net Counterbalancing Errors Affecting Prior Net IncomeIncomeChapter 14-44l lThese errors do These errors do notnot automatically correct themselves after automatically correct themselves after two years.two years.l lCorrection of a Correction of a noncounterbalancingnoncounterbalancing error usually error usually requires a prior period adjustment requires a prior period adjustment(retroactive approachretroactive approach).NoncounterbalancingNoncounterbalancing Errors Affecting Prior Errors Affecting Prior Net Inc
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