Financial Accounting And Accounting Standards
22-1
PREVIEW OF CHAPTER22Intermediate AccountingIFRS 2nd EditionKieso, Weygandt, and Warfield22-2
22Accounting Changesand Error AnalysisLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1. Identify the two types ofaccounting changes.5. Describe the accounting for changes inestimates.2. Describe the accounting for changes inaccounting policies.6. Describe the accounting for correctionof errors.3. Understand how to account forretrospective accounting changes.7. Identify economic motives for changingaccounting policies.4. Understand how to account forimpracticable changes.8. Analyze the effect of errors.22-3
ACCOUNTING CHANGESAccounting Alternatives: Diminish the comparability of financial information. Obscure useful historical trend data.Types of Accounting Changes:1. Change in Accounting Policy.2. Changes in Accounting Estimate.Errors are not considered an accounting change.22-4LO 1
22Accounting Changesand Error AnalysisLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1. Identify the two types of accountingchanges.5. Describe the accounting for changes inestimates.2. Describe the accounting forchanges in accounting policies.6. Describe the accounting for correctionof errors.3. Understand how to account forretrospective accounting changes.7. Identify economic motives for changingaccounting policies.4. Understand how to account forimpracticable changes.8. Analyze the effect of errors.22-5
CHANGES IN ACCOUNTING POLICYChange from one accepted accounting policy to another.Examples include: Average-cost to LIFO. Cost-recovery to percentage-of-completion method.Adoption of a new policy in recognition of events that haveoccurred for the first time or that were previously immaterial isnot an accounting change.22-6LO 2
CHANGES IN ACCOUNTING POLICYThree approaches for reporting changes:1) Currently.2) Retrospectively.3) Prospectively (in the future).IASB requires use of the retrospective approach.Rationale - Users can then better compare results from oneperiod to the next.22-7LO 2
22Accounting Changesand Error AnalysisLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1. Identify the two types of accountingchanges.5. Describe the accounting for changes inestimates.2. Describe the accounting for changes inaccounting policies.6. Describe the accounting for correctionof errors.3. Understand how to account forretrospective accounting changes.7. Identify economic motives for changingaccounting policies.4. Understand how to account forimpracticable changes.8. Analyze the effect of errors.22-8
CHANGES IN ACCOUNTING POLICYRetrospective Accounting Change ApproachCompany reporting the change1) Adjusts its financial statements for each prior periodpresented to the same basis as the new accountingpolicy.2) Adjusts the carrying amounts of assets and liabilities asof the beginning of the first year presented. Also makesan offsetting adjustment to the opening balance ofretained earnings or other appropriate component ofequity or net assets as of the beginning of the first yearpresented.22-9LO 3
CHANGES IN ACCOUNTING POLICYRetrospective Accounting Change: Long-TermContractsIllustration: Denson Company has accounted for its income fromlong-term construction contracts using the cost-recovery method. In2015, the company changed to the percentage-of-completionmethod. Management believes this approach provides a moreappropriate measure of the income earned. For tax purposes, thecompany uses the cost-recovery method and plans to continuedoing so in the future. (Assume a 40 percent enacted tax rate.)22-10LO 3
CHANGES IN ACCOUNTING POLICYILLUSTRATION 22-1Comparative IncomeStatements for CostRecovery versusPercentage-of-CompletionMethods22-11LO 3
CHANGES IN ACCOUNTING POLICYData for Retrospective Change ExampleJournal entrybeginning of201522-12Construction in ProcessDeferred Tax LiabilityRetained EarningsILLUSTRATION 22-2220,00088,000132,000LO 3
CHANGES IN ACCOUNTING POLICYReporting a Change in PolicyMajor disclosure requirements are as follows.1.Nature of the change in accounting principle.2.Reasons why applying the new accounting policy provides reliableand more relevant information;3.For the current period and each prior period presented, to theextent practicable, the amount of the adjustment:4.22-13a)For each financial statement line item affected; andb)Basic and diluted earnings per share.The amount of the adjustment relating to periods before thosepresented, to the extent practicable.LO 3
ILLUSTRATION 22-3Comparative Information Related to AccountingChange (Percentage-of-completion)22-14LO 3
CHANGES IN ACCOUNTING POLICYRetained Earnings AdjustmentRetained earnings balance is 1,360,000 at the beginning of 2016.Before Change22-15ILLUSTRATION 22-4LO 3
CHANGES IN ACCOUNTING POLICYRetained Earnings AdjustmentAfter Change22-16ILLUSTRATION 22-5LO 3
CHANGES IN ACCOUNTING POLICYIllustration: Cherokee Construction Company changed from the costrecovery to the percentage-of-completion method of accounting forlong-term construction contracts during 2015. For tax purposes, thecompany employs the cost-recovery method and will continue thisapproach in the future. (Hint: Adjust all tax consequences through theDeferred Tax Liability account.) The appropriate information related tothis change is as follows.22-17LO 3
CHANGES IN ACCOUNTING POLICYInstructions: (assume a tax rate of 35%)(a) What entry(ies) are necessary to adjust the accounting recordsfor the change in accounting principle?(b) What is the amount of net income and retained earnings thatwould be reported in 2015? Assume beginning retained earningsfor 2014 to be 100,000.22-18LO 3
CHANGES IN ACCOUNTING POLICYPre-Tax Income from Long-Term ContractsDatePercentageof-Completion2014 2015CostRecoveryDifference35%TaxEffectNet ofTax780,000 610,000170,00059,500 110,500700,000480,000220,00077,000143,000Journal entry (recorded in 2015)Construction in ProcessDeferred Tax LiabilityRetained Earnings22-19170,00059,500110,500LO 3
CHANGES IN ACCOUNTING POLICYComparative of RetainedEarningsPre-tax incomeIncome tax (35%)700,000 245,000780,000 610,000273,000213,500Net income 455,000 507,000 396,500Beg. Retained earnings 496,500 100,000 100,000Accounting change123,500Beg. R/Es restated607,000100,000100,000Net income455,000507,000396,500607,000 496,500End. Retained earnings22-20 Previous2014 1,062,000 LO 3
CHANGES IN ACCOUNTING POLICYDirect and Indirect Effects of Changes Direct Effects - IASB takes the position that companiesshould retrospectively apply the direct effects of achange in accounting policy. Indirect Effect is any change to current or future cashflows of a company that result from making a change inaccounting principle that is applied retrospectively.22-21LO 3
22Accounting Changesand Error AnalysisLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1. Identify the two types of accountingchanges.5. Describe the accounting for changes inestimates.2. Describe the accounting for changes inaccounting policies.6. Describe the accounting for correctionof errors.3. Understand how to account forretrospective accounting changes.7. Identify economic motives for changingaccounting policies.4. Understand how to account forimpracticable changes.8. Analyze the effect of errors.22-22
CHANGES IN ACCOUNTING POLICYImpracticabilityCompanies should not use retrospective application if one of thefollowing conditions exists:1.Company cannot determine the effects of the retrospectiveapplication.2.Retrospective application requires assumptions aboutmanagement’s intent in a prior period.3.Retrospective application requires significant estimates thatthe company cannot develop.If any of the above conditions exists, the company prospectively appliesthe new accounting principle.22-23LO 4
22Accounting Changesand Error AnalysisLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1. Identify the two types of accountingchanges.5. Describe the accounting forchanges in estimates.2. Describe the accounting for changes inaccounting policies.6. Describe the accounting for correctionof errors.3. Understand how to account forretrospective accounting changes.7. Identify economic motives for changingaccounting policies.4. Understand how to account forimpracticable changes.8. Analyze the effect of errors.22-24
CHANGES IN ACCOUNTING ESTIMATEExamples of Estimates1. Bad debts.2. Inventory obsolescence.3. Useful lives and residual 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 estimates.8. Fair value of financial assets or financial liabilities.22-25LO 5
CHANGES IN ACCOUNTING ESTIMATEProspective ReportingChanges in accounting estimates are reported prospectively.Account for changes in estimates in1. the period of change if the change affects that period only,or2. the period of change and future periods if the changeaffects both.IASB views changes in estimates as normal recurringcorrections and adjustments and prohibits retrospectivetreatment.22-26LO 5
CHANGES IN ACCOUNTING ESTIMATEIllustration: Arcadia HS purchased equipment for 510,000which was estimated to have a useful life of 10 years with asalvage value of 10,000 at the end of that time. Depreciation hasbeen recorded for 7 years on a straight-line basis. In 2015 (year8), it is determined that the total estimated life should be 15 yearswith a salvage value of 5,000 at the end of that time.Required:22-27 What is the journal entry to correctprior years’ depreciation expense? Calculate depreciation expense for 2015.No EntryRequiredLO 5
After 7yearsCHANGES IN ESTIMATEEquipment costResidual valueDepreciable baseUseful life (original)Annual depreciation 510,000First, establish book- 10,000value at date of500,000change in estimate.10 years 50,000 x 7 years 350,000Statement of financial position (Dec. 31, 2014)Property, Plant, and Equipment:EquipmentAccumulated depreciationBook value (BV)22-28 510,000350,000 160,000LO 5
CHANGES IN ACCOUNTING ESTIMATEBook valueResidual value (if any)Depreciable baseUseful lifeAnnual depreciation 160,0005,000155,0008 years 19,375Second, calculatedepreciation expensefor 2015.Journal entry for 2015Depreciation expenseAccumulated depreciation22-2919,37519,375LO 5
CHANGES IN ACCOUNTING ESTIMATEDisclosuresA company should disclose the nature and amount of a change inan accounting estimate that has an effect in the current period oris expected to have an effect in future periods (unless it isimpracticable to estimate that effect).Companies need not disclose changes in accounting estimatemade as part of normal operations, such as bad debt allowancesor inventory obsolescence, unless such changes are material.22-30LO 5
22Accounting Changesand Error AnalysisLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1. Identify the two types of accountingchanges.5. Describe the accounting for changes inestimates.2. Describe the accounting for changes inaccounting policies.6. Describe the accounting forcorrection of errors.3. Understand how to account forretrospective accounting changes.7. Identify economic motives for changingaccounting policies.4. Understand how to account forimpracticable changes.8. Analyze the effect of errors.22-31
ACCOUNTING ERRORSTypes of Accounting Errors:1. A change from an accounting principle that is not generallyaccepted to an accounting policy that is acceptable.2. Mathematical mistakes.3. Changes in estimates that occur because a company didnot 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 ofan asset, and vice versa.22-32LO 6
ACCOUNTING ERRORSILLUSTRATION 22-16Accounting-Error TypesAccounting CategoryType of RestatementExpense recognitionRecording expenses in the incorrect period or for anincorrect amount.Revenue recognitionInstances in which revenue was improperly recognized,questionable revenues were recognized, or any othernumber of related errors that led to misreported revenue.MisclassificationInclude restatements due to misclassification of short- orlong-term accounts or those that impact cash flows fromoperations.Equity—otherImproper accounting for EPS, restricted stock, warrants,and other equity instruments.Reserves/ContingenciesErrors involving accounts receivables’ bad debts, inventoryreserves, income tax allowances, and loss contingencies.Long-lived assetsAsset impairments of property, plant, and equipment;goodwill; or other related items.22-33LO 6
ACCOUNTING ERRORSILLUSTRATION 22-16Accounting-Error TypesAccounting CategoryType of RestatementTaxesErrors involving correction of tax provision, impropertreatment of tax liabilities, and other tax-related items.Equity—othercomprehensive incomeImproper accounting for comprehensive income equitytransactions including foreign currency items, revaluationsof plant assets, unrealized gains and losses on certaininvestments in debt, equity securities, and derivatives.InventoryInventory costing valuations, quantity issues, and cost ofsales adjustments.Equity—share optionsImproper accounting for employee share options.OtherAny restatement not covered by the listed categories,including those related to improper accounting foracquisitions or mergers.Source: T. Baldwin and D. Yoo, “Restatements—Traversing Shaky Ground,” Trend Alert, Glass Lewis & Co.(June 2, 2005), p. 8.; and “2012 Financial Restatements,” Audit Analytics (March 2013).22-34LO 6
ACCOUNTING ERRORS All material errors must be corrected. Record corrections of errors from prior periods as anadjustment to the beginning balance of retained earnings inthe current period. Such corrections are called prior period adjustments. For comparative statements, a company should restate theprior statements affected, to correct for the error.22-35LO 6
Example of Error CorrectionIllustration: In 2016 the bookkeeper for Selectro Companydiscovered an error. In 2015 the company failed to record 20,000 of depreciation expense on a newly constructed building.This building is the only depreciable asset Selectro owns. Thecompany correctly included the depreciation expense in its taxreturn and correctly reported its income taxes payable.22-36LO 6
Example of Error CorrectionSelectro’s income statement for 2015 with and without the error.ILLUSTRATION 22-17What are the entries that Selectro should have made and did makefor recording depreciation expense and income taxes?22-37LO 6
Example of Error CorrectionILLUSTRATION 22-1722-38ILLUSTRATION 22-18LO 6
Example of Error CorrectionILLUSTRATION 22-1822-39LO 6
Example of Error CorrectionPrepare the proper correcting entry in 2016, that should bemade by Selectro.ILLUSTRATION 22-18CorrectingEntry in201622-40Retained Earnings12,000LO 6
Example of Error CorrectionPrepare the proper correcting entry in 2016, that should bemade by Selectro.ILLUSTRATION 22-18CorrectingEntry in201622-41Retained EarningsDeferred Tax Liability12,000Reversal8,000LO 6
Example of Error CorrectionPrepare the proper correcting entry in 2016, that should bemade by Selectro.ILLUSTRATION 22-18CorrectingEntry in201622-42Retained EarningsDeferred Tax Liability12,0008,000Accumulated Depreciation—Buildings20,000LO 6
Example of Error CorrectionSingle-Period StatementsIllustration: Selectro Company has a beginning retained earningsbalance at January 1, 2016, of 350,000. The company reports netincome of 400,000 in 2016.22-43ILLUSTRATION 22-19Reporting an Error—Single-Period FinancialStatementLO 6
Example of Error CorrectionComparative StatementsCompany should1. make adjustments to correct the amounts for all affectedaccounts reported in the statements for all periodsreported.2. restate the data to the correct basis for each yearpresented.3. show any catch-up adjustment as a prior periodadjustment to retained earnings for the earliest period itreported.22-44LO 6
ACCOUNTING ERRORSWoods, Inc.Statement of Retained EarningsFor the Year Ended December 31, 2015Balance, January 1Net incomeDividendsBalance, December 31 1,050,000360,000(300,000)1,110,000Before issuing the report for the year ended December 31, 2014, youdiscover a 62,500 error that caused the 2013 inventory to be overstated(overstated inventory caused COGS to be lower and thus net income to behigher in 2013). Would this discovery have any impact on the reporting of theStatement of Retained Earnings for 2014? Assume a 20% tax rate.22-45LO 6
ACCOUNTING ERRORSWoods, Inc.Statement of Retained EarningsFor the Year Ended December 31, 2015Balance, January 1Prior period adjustment, net of taxBalance, January 1, as restatedNet incomeDividendsBalance, December 3122-46 0LO 6
ACCOUNTING ERRORSSummary of Accounting Changes andCorrection of ErrorsILLUSTRATION 22-2122-47LO 6
Summary of Changes and ErrorsILLUSTRATION 22-2122-48LO 6
22Accounting Changesand Error AnalysisLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1. Identify the two types of accountingchanges.5. Describe the accounting for changes inestimates.2. Describe the accounting for changes inaccounting policies.6. Describe the accounting for correctionof errors.3. Understand how to account forretrospective accounting changes.7. Identify economic motives forchanging accounting policies.4. Understand how to account forimpracticable changes.8. Analyze the effect of errors.22-49
ACCOUNTING ERRORSMotivations for Changes of AccountingMethodWhy companies may prefer certain accounting methods.Some reasons are:1. Political costs.2. Capital Structure.3. Bonus Payments.4. Smooth Earnings.22-50LO 7
22Accounting Changesand Error AnalysisLEARNING OBJECTIVESAfter studying this chapter, you should be able to:1. Identify the two types of accountingchanges.5. Describe the accounting for changes inestimates.2. Describe the accounting for changes inaccounting policies.6. Describe the accounting for correctionof errors.3. Understand how to account forretrospective accounting changes.7. Identify economic motives for changingaccounting policies.4. Understand how to account forimpracticable changes.8. Analyze the effect of errors.22-51
ERROR ANALYSISCompanies must answer three questions:1. What type of error is involved?2. What entries are needed to correct for the error?3. After discovery of the error, how are financial statements tobe restated?Companies treat errors as prior-period adjustments and reportthem in the current year as adjustments to the beginningbalance of Retained Earnings.22-52LO 8
ERROR ANALYSISStatement of Financial Position ErrorsStatement of financial position errors affect only thepresentation of an asset, liability, or equity account.22-53 Current year error - reclassify item to its proper position. Prior year error - restate the statement of financial positionof the prior year for comparative purposes.LO 8
ERROR ANALYSISIncome Statement ErrorsImproper classification of revenues or expenses.22-54 Current year error - reclassify item to its proper position. Prior year error - restate the income statement of the prioryear for comparative purposes.LO 8
ERROR ANALYSISStatement of Financial Position and IncomeStatement ErrorsCounterbalanceing errors will be offset or corrected overtwo periods.1. If company has closed the books in the current year:a. If the error is already counterbalanced, no entry is necessary.b. If the error is not yet counterbalanced, make entry to adjustthe present balance of retained earnings.For comparative purposes, restatement is necessary even if acorrecting journal entry is not required.22-55LO 8
ERROR
ACCOUNTING ERRORS Types of Accounting Errors: 1. A change from an accounting principle that is not generally accepted to an accounting policy 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
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