Accounting Changes and Error Corrections Chapter 20 Power

Accounting Changes and Error Corrections Chapter 20 Power. Point Authors: Susan Coomer Galbreath, Ph. D. , CPA Charles W. Caldwell, D. B. A. , CMA Jon A. Booker, Ph. D. , CPA, CIA Cynthia J. Rooney, Ph. D. , CPA Copyright © 2013 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

20 -2 Accounting Changes

20 -3 Correction of an Error

20 -4 Accounting Changes and Error Corrections Retrospective Two Reporting Approaches Prospective

20 -5 Error Corrections and Most Changes in Principle Retrospective Revise. Two prior years’ statements (that are presented for comparative purposes) to reflect Reporting the impact of the change. Approaches }The balance in each account affected is revised to appear as if the newly adopted accounting method had been applied all along or that the error had Prospective never occurred. }Adjust the beginning balance of retained earnings for the earliest period reported.

20 -6 Changes in Estimates and Some Changes in Principle The change is implemented in the current Retrospective period, and its effects are reflected in the financial statements of the current and future. Two years only. Reporting }Prior years’ statements are not revised. Approaches }Account balances are not revised. Prospective

20 -7 Change in Accounting Principle Qualitative Characteristics Consistency Comparability Although consistency and comparability are desirable, changing to a new method sometimes is appropriate.

20 -8 Motivation for Accounting Choices Effect on Compensation Changing Conditions Motivations for Change Effect on Debt Agreements Effect on Union Negotiations New Accounting Standard Issued Effect on Income Taxes

Retrospective Approach: Most Changes in Accounting Principle Let’s look at an examples of a change from LIFO to FIFO. At the beginning of 2013, Air Parts Corporation changed from LIFO to FIFO. Air Parts has paid dividends of $40 million each year since 2006. Its income tax rate is 40 percent. Retained earnings on January 1, 2011, was $700 million; inventory was $500 million. Selected income statement amounts for 2013 and prior years are (in millions): 20 -9

20 -10 Revise Comparative Financial Statements For each year reported, Air Parts makes the comparative statements appear as if the newly adopted accounting method (FIFO) had been in use all along.

20 -11 Revise Comparative Financial Statements For each year reported, Air Parts makes the comparative statements appear as if the newly adopted accounting method (FIFO) had been in use all along. Comparative balance sheets will report 2011 inventory $345 million higher than it was reported in last year’s statements Retained earnings for 2011 will be $207 million higher. [$345 million × (1 – 40% tax rate)]

20 -12 Revise Comparative Financial Statements For each year reported, Air Parts makes the comparative statements appear as if the newly adopted accounting method (FIFO) had been in use all along. Comparative balance sheets will report 2012 inventory $400 million higher than it was reported in last year’s statements. Retained earnings for 2012 will be $240 million higher. [$400 million × (1 – 40% tax rate)]

20 -13 Revise Comparative Financial Statements For each year reported, Air Parts makes the comparative statements appear as if the newly adopted accounting method (FIFO) had been in use all along. Comparative balance sheets will report 2013 inventory $460 million higher than it would have been if the change from LIFO had not occurred. Retained earnings for 2013 will be $276 million higher. [$460 million × (1 – 40% tax rate)]

20 -14 Adjust Accounts for the Change On January 1, 2013, the date of the change, the following journal entry would be made to record the change in principle. January 1, 2013: Inventory. . . . Retained earnings. . . . Income tax payable ………. . …. 400, 000 240, 000 160, 000 To increase inventory, retained earnings, and income tax payable as a result of the change from LIFO to FIFO. 40% of $400, 000

20 -15 Disclosure Notes 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.

20 -16 U. S. GAAP vs. IFRS The changes to and from the LIFO method would not occur if international standards were being applied because LIFO is not a permissible method for accounting for inventory under IFRS.

20 -17 U. S. GAAP vs. IFRS Changing from U. S. GAAP to IFRS }The basic requirement is full retrospective application of IFRS for the company’s first IFRS financial statements, with several optional exemptions and five mandatory exceptions designed to allow companies to avoid excessive costs or difficulties. }A company’s first IFRS financial statements must include at least three balance sheets and two of each of the other financial statements. The date of transition to IFRS is the date of the opening balance sheet. }Almost all adjustments arising from the first-time application of IFRS

20 -18 Prospective Approach 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.

Prospective Approach: Change in Accounting 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. 20 -19

20 -20 Change in Accounting Estimate Changes in accounting estimates are accounted for prospectively. Let’s look at an example of a change in a depreciation estimate. On January 1, 2009, Towing Inc. purchased specialized equipment for $243, 000. The equipment has been depreciated using the straight-line method and had an estimated life of 10 years and salvage value of $3, 000. In 2013 the total useful life of the equipment was revised to 6 years. Calculate the 2013 depreciation expense. $243, 000 – $3, 000 = $24, 000 (2009 – 2012) 10 years $24, 000 × 4 years = $96, 000 Accum. Depr. $243, 000 – $96, 000 = $147, 000 Book Value $147, 000 – $3, 000 = $72, 000 (2013 & 2014) 2 years

20 -21 Changing Depreciation Methods Universal Semiconductors switched from SYD depreciation to straight-line depreciation in 2013. The asset was purchased at the beginning of 2011 for $63 million, has a useful life of five years, and an estimated residual value of $3 million.

20 -22 Changing Depreciation Methods ÷

20 -23 Changing Depreciation Methods Depreciation adjusting entry for 2013, 2014, and 2015. Depreciation expense. . . . . Accumulated depreciation. . . . To record depreciation expense. 8, 000, 000

20 -24 Change in Reporting Entity A change in reporting entity occurs as a result of presenting consolidated financial statements in place of statements of individual companies, or changing specific companies that constitute the group for which consolidated statements are prepared.

20 -25 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 revenue, net income, income before extraordinary items, and related per share amounts should be shown for all periods presented.

20 -26 Error Correction Examples include: } } Use of inappropriate principle Mistakes in applying GAAP Arithmetic mistakes Fraud or gross negligence in reporting For all years presented, financial statements are retrospectively restated to reflect the error correction.

20 -27 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.

20 -28 Prior Period Adjustments Prior Period Adjustment Required Counterbalancing error discovered in the second year. Noncounterbalancing error discovered in any year. Use the retrospective approach

Errors Occurred and Discovered in the Same Period Corrected by reversing the incorrect entry and then recording the correct entry (or by making an entry to correct the account balances) 20 -29

Errors Not Affecting Prior Years’ Net Income Involves incorrect classification of accounts. Requires correction of previously issued statements (retrospective approach). Is not classified as a prior period adjustment since it does not affect prior income. Disclose nature of error. 20 -30

20 -31 Error Affecting Prior Year’s Net Income } Requires correction of previously issued statements (retrospective approach). } All incorrect account balances must be corrected. } Is classified as a prior period adjustment since it does affect prior income. } Disclose nature of error.

20 -32 Error Affecting Prior Year’s Net Income In 2013, the accountant at Orion, Inc. discovered the depreciation of $50, 000 on a new asset purchased in 2012 had not been recorded on the books. However, the amount was properly reported on the tax return. This is the only difference between book and tax income. Accounting income for 2012 was $275, 000 and taxable income was $225, 000. Orion, Inc. is subject to a 30% tax rate and prepares current period statements only. The entry made in 2012 to record income taxes was December 31, 2012: Income tax expense (30% of $275, 000). . . . . Deferred tax liability (30% of $50, 000). . . Income tax payable (30% of $225, 000) ……. . … To record income tax expense. 82, 500 15, 000 67, 500

20 -33 Error Affecting Prior Year’s Net Income This error affected the following accounts: Remember, the 2012 expense accounts were closed to RE. 2013: Retained earnings ……………. . . . . Deferred tax liability ………………. . . Accumulated depreciation …………………. . … To correct recording error. 35, 000 15, 000 50, 000

20 -34 Error Affecting Prior Year’s Net Income Let’s assume the following for Orion, Inc. : On 1/1/13, the retained earnings balance was $922, 000. In 2013, the company paid $65, 000 in dividends. Net income for 2013 was $184, 000. The Statement of Retained Earnings (or RE column of the Statement of Shareholders’ Equity) would be as follows:

20 -35 Correction of Accounting Errors Identify the type of accounting error for the following item: Ending inventory was incorrectly counted. Counterbalancing error affecting net income The ending inventory in one period will be incorrect and the beginning inventory in the next period will also be incorrect. Since the inventory balance effects cost of goods sold, income will also be incorrect in the two periods, by the same amount. At the end of the two periods, if no other errors are made, the balances in inventory and retained earnings are correct.

20 -36 Correction of Accounting Errors Identify the type of accounting error for the following item: Loss on sale of furniture was incorrectly recorded as depreciation expense. Error not affecting net income. When the furniture sale transaction was recorded, depreciation expense was debited for the amount that should have been a debit to loss on sale. Since both expenses and losses reduce income, the error does not affect income.

20 -37 Correction of Accounting Errors Identify the type of accounting error for the following item: Depreciation expense was understated. Noncounterbalancing error affecting net income. An expense is understated, so income is understated. The error affects only the year in which the error was made. It is a noncounterbalancing error since only one period’s income is affected.

Reporting Accounting Changes and Error Corrections 20 -38

20 -39 Summary of Accounting Changes and Errors

20 -40 U. S. GAAP vs. IFRS When correcting errors in previously issued financial statements, IFRS (IAS No. 8) permits the effect of the error to be reported in the current period if it’s not considered practicable to report it retrospectively as is required by U. S. GAAP.

20 -41 End of Chapter 20