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Prepared byCoby Harmon

University of California, Santa Barbara

IntermediateAccounting

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Intermediate Accounting

14th Edition

22 Accounting Changes andError Analysis

Kieso, Weygandt, and Warfield

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1. Identify the two types of accounting changes.

2. Describe the accounting for changes in accounting policies.

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. Describe the accounting for correction of errors.

7. Identify economic motives for changing accounting policies.

8. Analyze the effect of errors.

Learning Objectives

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Changes in accounting

policy

Changes in accounting

estimate

Change in reporting entity

Correction of errors

Summary

Motivations for change of

method

Accounting Changes Error Analysis

Balance sheet errors

Income statement errors

Balance sheet and income

statement effects

Comprehensive example

Preparation of statements

with error corrections

Accounting Changes and Error Analysis

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Types of Accounting Changes:

1. Change in Accounting Policy.

2. Changes in Accounting Estimate.

3. Change in Reporting Entity.

Errors are not considered an accounting change.

LO 1 Ident i fy the two types of account ing ch anges.

Accounting Alternatives:

Diminish the comparability of financial information.

Obscure useful historical trend data.

Accounting Changes

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Average cost to LIFO.

Completed-contract to percentage-of-completion.

Change from one accepted accounting policy to another.

Examples include:

Changes in Accounting Principle

LO 2 Descr ibe the account ing fo r changes in accoun t ing pol ic ies.

Adoption of a new policy in recognition of events that have occurred forthe first time or that were previously immaterial is not an accounting

change.

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Three approaches for reporting changes:

1) Currently.

2) Retrospectively.

3) Prospectively (in the future).

FASB requiresuse of the retrospectiveapproach.

Rationale- Users can then better compare results from one period to

the next.

LO 2 Descr ibe the account ing fo r changes in accoun t ing pol ic ies.


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Retrospective Accounting Change Approach

LO 3 Understand how to accou nt for retrospect ive accoun t ing changes.

Company reporting the change

1) Adjusts its financial statements for each prior period

presented to the same basis as the new accountingprinciple.

2) Adjusts the carrying amounts of assets and liabilities as

of the beginning of the first year presented, plus the

opening balance of retained earnings.


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Illustration: Denson Company has accounted for its income from

long-term construction contracts using the completed-contract

method. In 2012, the company changed to the percentage-of-completion method. Management believes this approach provides

a more appropriate measure of the income earned. For tax

purposes, the company uses the completed-contract method and

plans to continue doing so in the future. (Assume a 40 percentenacted tax rate.)


Retrospective Accounting Change: Long-Term Contracts


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Illustration 22-1



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Data for Retrospective Change Illustration 22-2

Construction in Process 220,000

Deferred Tax Liability 88,000

Retained Earnings 132,000


Journal entrybeginning of

2012


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Reporting a Change in Principle


Major disclosure requirements are as follows.

1. Nature of the change in accounting policy;

2. The method of applying the change, and:

a. A description of the prior period information that has been

retrospectively adjusted, if any.

b. The effect of the change on income from continuing operations,

net income (or other appropriate captions of changes in net assets

or performance indicators), any other affected line item.

c. The cumulative effect of the change on retained earnings or other

components of equity or net assets in the balance sheet as of the

beginning of the earliest period presented.


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22-13LO 3

Illustration 22-3Reporting a Change in policy


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Retained Earnings Adjustment


Illustration 22-4

Retained earnings balance is $1,360,000 at the beginning of 2010.

Before Change


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22-15LO 3 Understand how to accou nt for retrospect ive accoun t ing changes.

Illustration 22-5 After Change

Retained Earnings Adjustment


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E22-1 (Change in Principle

Long-Term Contracts): CherokeeConstruction Company changed from the completed-contract to the

percentage-of-completion method of accounting for long-term

construction contracts during 2012. For tax purposes, the company

employs the completed-contract method and will continue thisapproach in the future. (Hint:Adjust all tax consequences through

the Deferred Tax Liability account.)



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E22-1 (Change in policy

Long-Term Contracts):


Instructions: (assume a tax rate of 35%)

(b) What entry(ies) are necessary to adjust the accounting records for

the change in accounting principle?

(a) What is the amount of net income and retained earnings that would

be reported in 2012? Assume beginning retained earnings for 2011 to

be $100,000.


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Journal entry

2012 Construction in progress 170,000Deferred tax liability 59,500

Retained earnings 110,500


35%

Percentage- Completed- Tax Net of

Date of-Completion Contract Difference Effect Tax

2011 780,000$ 610,000$ 170,000 59,500 110,500$2012 700,000 480,000 220,000 77,000 143,000


E22-1: Pre-Tax Income from Long-Term Contracts

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Restated Previous

2012 2011 2011

Pre-tax income 700,000$ 780,000$ 610,000$

Income tax (35%) 245,000 273,000 213,500Net income 455,000$ 507,000$ 396,500$

Beg. Retained earnings 496,500$ 100,000$ 100,000$

Accounting change 110,500

Beg. R/Es restated 607,000$ 100,000 100,000Net income 455,000 507,000 396,500

End. Retained earnings 1,062,000$ 607,000$ 496,500$


Income

Statement

Statementof Retained

Earnings


E22-1: Comparative Statements

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22-20 LO 3 Understand how to accou nt for retrospect ive accoun t ing changes.

Direct Effects -FASB takes the position that

companies should retrospectively apply the direct

effects of a change in accounting principle.

Indirect Effectis any change to current or futurecash

flows of a company that result from making a change in

accounting principle that is applied retrospectively.

Direct and Indirect Effects of Changes


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Impracticability

LO 4 Understand how to accou nt for impract icable changes.

Companies 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 thatthe company cannot develop.


If any of the above conditions exists, the company prospectivelyapplies the newaccounting principle.

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Changes in Accounting Estimate

LO 5 Descr ibe the accou nt ing for changes in est imates.

Examples of 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.

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Prospective ReportingChanges in accounting estimates are reported prospectively.

Account for changes in estimates in

1. the period of change if the change affects that period only,or

2. the period of change and future periods if the change

affects both.

FASBviews changes in estimates as normal recurring corrections

and adjustments and prohibits retrospective treatment.

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Illustration: Arcadia High School purchased equipment for$510,000 which was estimated to have a useful life of 10 years

with a salvage value of $10,000 at the end of that time.

Depreciation has been recorded for 7 years on a straight-line

basis. In 2012 (year 8), it is determined that the total estimated lifeshould be 15 years with a salvage value of $5,000 at the end of

that time.

Required:

What is the journal entry to correctprior years depreciation expense?

Calculate depreciation expense for 2012.

No EntryRequired

Change in Estimate Example


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Equipment $510,000

Fixed Assets:

Accumulated depreciation 350,000

Net book value (NBV) $160,000

Balance Sheet (Dec. 31, 2011)

Change in Estimate Example After 7 years

Equipment cost $510,000Salvage value - 10,000

Depreciable base 500,000

Useful life (original) 10 years

Annual depreciation $ 50,000x 7 years =

$350,000

First, establish NBVat date of change in

estimate.


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Net book value $160,000Salvage value (if any) 5,000

Depreciable base 155,000

Useful life 8 years

Annual depreciation $ 19,375

Change in Estimate Example

Second, calculatedepreciation expense

for 2012.

Depreciation expense 19,375


Journal entry for 2012


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DisclosuresCompanies need not disclosechanges 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.

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Change in Reporting Entity

LO 6 Identi fy changes in a repor t ing enti ty.

Examples 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 financialstatements.

3. Changing the companies included in combined financial

statements.

4. Changing the cost, equity, or consolidation method ofaccounting for subsidiaries and investments.

Reported by changing the financial statements of all prior periods presented.

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Correction of Errors

LO 7 Descr ibe the account ing fo r correct ion of 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 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.

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All material errors must be corrected.

Record corrections of errorsfrom 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.


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Illustration: In 2013 the bookkeeper for Selectro Companydiscovered an error:

In 2012 the company failed to record $20,000of depreciation

expense on a newly constructed building. This building is the only

depreciable asset Selectro owns. The company correctly included

the depreciation expense in its tax return and correctly reported

its income taxes payable.


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Illustration: Selectros income statement for 2012 with andwithout the error.

Illustration 22-19

Show the entries that Selectro should have made and did make for

recording depreciation expense and income taxes.


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Illustration: Show the entries that Selectro should have made anddid make for recording depreciation expense and income taxes.

Illustration 22-18

CorrectingEntry in

2013


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Retained Earnings 12,000CorrectingEntry in

2013


Illustration 22-18

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CorrectingEntry in

2013

Reversal


Illustration 22-18

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Accumulated DepreciationBuildings 20,000

CorrectingEntry in

2013

Record


Illustration 22-18

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Illustration (Single-Period Statement): Assume that SelectroCompany has a beginning retained earnings balance at January 1,

2013, of $350,000. The company reports net income of $400,000 in

2013.Illustration 22-21


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Comparative Statements

Company should

1. make adjustments to correct the amounts for all affected

accounts reported in the statements for all periodsreported.

2. restate the data to the correct basis for each year

presented.

3. show any catch-up adjustmentas a prior period

adjustment to retained earnings for the earliest period it

reported.


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Woods, Inc.

Statement of Retained EarningsFor the Year Ended December 31, 2012

Balance, January 1 1,050,000$

Net income 360,000Dividends (300,000)

Balance, December 31 1,110,000$

Before issuing the report for the year ended December 31, 2012, you

discover a $62,500 error that caused the 2011 inventory to be overstated(overstated inventory caused COGS to be lower and thus net income to be

higher in 2011). Would this discovery have any impact on the reporting of the

Statement of Retained Earnings for 2012? Assume a 20% tax rate.



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Woods, Inc.

Statement of Retained EarningsFor the Year Ended December 31, 2012

Balance, January 1, as previously reported 1,050,000$

Prior period adjustment, net of tax (50,000)Balance, January 1, as restated 1,000,000

Net income 360,000

Dividends (300,000)

Balance, December 31 1,060,000$



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Summary of Accounting Changes and Errors

Illustration 22-23

LO 7

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Summary of Accounting Changes and Errors

Illustration 22-23

LO 7

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Motivations for Change ofAccounting Method

LO 8 Ident i fy econ om ic mot ives for changing accou nt ing pol ic ies.

Why companies may prefer certain accounting

methods. Some reasons are:

1. Political costs.

2. Capital Structure.

3. Bonus Payments.

4. Smooth Earnings.

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Error Analysis

LO 9 An alyze the effect of error s.

Companies 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 asprior-period adjustmentsand report

them in the current year as adjustments to the beginning

balance of Retained Earnings.

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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 yearfor comparative purposes.

Balance Sheet Errors


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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.

Income Statement Errors


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Counterbalancing Errors

Will be offset or corrected over two periods.

If company has closedthe books:

a. If the error is already counterbalanced, no entry isnecessary.

b. 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.

Balance Sheet and Income Statement Errors

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Will be offset or corrected over two periods.

If company has not closedthe books:

a. If error already counterbalanced, make entry to correct theerror in the current period and to adjust the beginning

balance of Retained Earnings.

b. If error not yet counterbalanced, make entry to adjust the

beginning balance of Retained Earnings.



Counterbalancing Errors

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Non-Counterbalancing Errors

Not offset in the next accounting period.

Companies must make correcting entries, even if they have

closed the books.



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E22-19 (Error Analysis; Correcting Entries):A partial trial balance of

Dickinson Corporation is as follows on December 31, 2012.

Error Analysis Example

Dr. Cr.

Supplies 2,500$

Salaries and wages payable 1,500$Interest receivable 5,100

Prepaid insurance 90,000

Unearned rent 0

Interest payable 15,000


Instructions: (a)Assuming that the books have not been closed, what

are the adjusting entries necessary at December 31, 2012?

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Salaries and wages expense 2,900

Salaries and wages payable 2,900

Supplies expense 1,400

Supplies 1,400



1. A physical count of supplies on hand on December 31, 2012, totaled

$1,100.

2. Accrued salaries and wages on December 31, 2012, amounted to

$4,400.

(a) Assuming that the books have not been closed, what are the

adjusting entries necessary at December 31, 2012?

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Interest revenue 750

Interest receivable 750

Insurance expense 25,000




3. Accrued interest on investments amounts to $4,350 on December

31, 2012.

4. The unexpired portions of the insurance policies totaled $65,000 as

of December 31, 2012.



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Depreciation expense 45,000


Rental income 12,000

Unearned rent 12,000



5. $24,000 was received on January 1, 2012 for the rent of a building

for both 2012 and 2013. The entire amount was credited to rental

income.

6. Depreciation for the year was erroneously recorded as $5,000 rather

than the correct figure of $50,000.



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E22-19 (Error Analysis; Correcting Entries)A partial trial balance of

Dickinson Corporation is as follows on December 31, 2012.



Instructions: (b)Assuming that the bookshave been closed, what are

the adjusting entries necessary at December 31, 2012?

Dr. Cr.

Supplies 2,500$

Salaries and wages payable 1,500$Interest receivable 5,100


Unearned rent 0

Interest payable 15,000

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Salaries and wages payable 2,900

Retained earnings 1,400Supplies 1,400



(b) Assuming that the books have been closed, what are the adjusting

entries necessary at December 31, 2012?

1. A physical count of supplies on hand on December 31, 2012, totaled

$1,100.

2. Accrued salaries and wages on December 31, 2012, amounted to

$4,400.

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Retained earnings 750Interest receivable 750



3. Accrued interest on investments amounts to $4,350 on December

31, 2012.

4. The unexpired portions of the insurance policies totaled $65,000 as

of December 31, 2012.



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Unearned rent 12,000



5. $24,000 was received on January 1, 2012 for the rent of a building

for both 2012 and 2013. The entire amount was credited to rental

income.

6. Depreciation for the year was erroneously recorded as $5,000 rather

than the correct figure of $50,000.



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22-58LO 10 Make the comp utat ions and prepare the entr ies necessary to

record a change from or to the equi ty m ethod of accoun t ing.

Change From The Equity MethodChange from the equity method to the fair-value method.

Earnings or losses previously recognized under the equity method

should remain as part of the carrying amount of the investment.

The cost basis is the carrying amount of the investment at the date

of the change.

The investor applies the new method in its entirety.

At the next reporting date, the investor should record the unrealized

holding gain or loss to recognize the difference between the

carrying amount and fair value.

APPENDIX22A CHANGING FROM OR TO THE EQUITY METHOD

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Accounted for such dividends as a reduction of the

investment carrying amount, rather than as revenue.

Reason: Dividends in excess of earnings are viewed as a________________ with this excess then accounted for as a

reduction of the equity investment.

liquidating dividend


LO 10 Make the comp utat ions and prepare the entr ies necessary to


Dividends in Excess of Earnings

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Illustration: On January 1, 2011, Investor Company purchased

250,000 shares of Investee Companys 1,000,000 shares of outstanding

stock for $8,500,000. Investor correctly accounted for this investment

using the equity method. After accounting for dividends received and

investee net income, in 2011, Investor reported its investment in

Investee Company at $8,780,000 at December 31, 2011. On January 2,

2012, Investee Company sold 1,500,000 additional shares of its own

common stock to the public, thereby reducing Investor Companys

ownership from 25 percent to 10 percent.





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Illustration 22A-1





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Illustration 22A-2Impact on Investment Carrying Amount

Cash 400,000

Dividend Revenue 400,000

Cash 210,000Equity Investments (AFS) 60,000Dividend Revenue 150,000

2012 &

2013

2014


LO 10

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Change To The Equity Method Companies use retrospective application.

The carrying amount of the investment, results of current

and prior operations, and retained earnings of the investorare adjusted as if the equity method has been in effect

during all of the previous periods.

Companies also eliminate any balances in the Unrealized

Holding Gain or LossEquity account and the Securities

Fair Value Adjustment account.




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RELEVANT FACTS One area in which GAAP and IFRS differ is the reporting of error

corrections in previously issued financial statements. While both sets

of standards require restatement, GAAP is an absolute standard

that is, there is no exception to this rule.

The accounting for changes in estimates is similar between GAAP

and IFRS.

Under GAAP and IFRS, if determining the effect of a change in

accounting policy is considered impracticable, then a company

should report the effect of the change in the period in which it

believes it practicable to do so, which may be the current period.

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RELEVANT FACTS Under IFRS, the impracticality exception applies both to changes in

accounting principles and to the correction of errors. Under GAAP,

this exception applies only to changes in accounting principle.

IFRS (IAS 8) does not specifically address the accounting andreporting for indirect effects of changes in accounting principles. As

indicated in the chapter, GAAP has detailed guidance on the

accounting and reporting of indirect effects.

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Which of the following is false?

a. GAAP and IFRS have the same absolute standard regarding

the reporting of error corrections in previously issued financial

statements.

b. The accounting for changes in estimates is similar between

GAAP and IFRS.

c. Under IFRS, the impracticality exception applies both tochanges in accounting principles and to the correction of errors.

d. GAAP has detailed guidance on the accounting and reporting of

indirect effects; IFRS does not.

IFRS SELF-TEST QUESTION

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Which of the following is not classified as an accounting change by

IFRS?

a. Change in accounting policy.

b. Change in accounting estimate.

c. Errors in financial statements.

d. None of the above.


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IFRS requires companies to use which method for reporting changes

in accounting policies?

a. Cumulative effect approach.

b. Retrospective approach.

c. Prospective approach.

d. Averaging approach.


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