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Accounting Changes and Error Corrections ACCOUNTING CHANGES Types of Accounting Changes 1. Change in accounting principle-Change from one generally accepted accounting principle to another. 2. Change in accounting estimate-Revision of an estimate because of new information or new experience. 3. Change in reporting entity-Change from reporting as one type of entity to another type of entity. 4. Correction of an error-Correction of an error caused by a transaction being recorded incorrectly or not at all. CHANGE IN ACCOUNTING PRINCIPLE Changing from one acceptable accounting principle to another acceptable accounting principle is accounted for as a change in accounting principle. This does not include the adoption of a new accounting principle because the entity has entered into transactions for the first time that require specific accounting treatment. It also does not include the change from an inappropriate accounting principle to an acceptable accounting principle. The later would be classified as the correction of an error. The types of changes that might be included in a change in accounting principle are:
Adoption of a new FASB accounting standard
Change in the method of inventory costing
Change to, or from, the cost method to the equity method
Change to, or from, the completed contract to percentage-of-completion method CHANGE IN ACCOUNTING ESTIMATE At the end of each accounting period there are a number of estimates made in order to prepare the financial statements. These estimates are based on the facts and circumstances that exist at the time. These facts and circumstances will change from one accounting period to the next. It is not practical to restate the financial statements every time there is new information that makes the prior estimates incorrect. Therefore, on an ongoing basis management applies its best judgment and modifies such estimates as the facts and circumstances change in each subsequent accounting period. A change in accounting estimate is handled on a prospective basis. CHANGE IN REPORTING ENTITY Under certain circumstances management is required to restate the financial statements of all prior periods. These circumstances relate to a change in the reporting entity. Such changes include:
Presenting consolidated financial statements for the first time.
Changing specific subsidiaries for which consolidated financial statements are presented.
Changing companies included in combined financial statements
Change in the cost, equity, or consolidation method used for accounting for subsidiaries and investments. CORRECTION OF AN ERROR D:\Teaching\3322\web\post\module4\c20\tnotes\c20a.doc 11/29/2007 1 Accounting Changes and Error Corrections The correction of an error must be handled as a prior period adjustment to the earliest period reported in the financial statements. Some of the types of errors that might occur are as follows:
Change from an unacceptable accounting principle to an acceptable one.
Mathematical errors.
Changes in estimates that were not prepared in good faith.
Failure to accrue or defer expenses or revenues at the end of a period.
Misuse of facts.
Misclassification of costs as expenses and vice versa. APPROACHES TO REPORTING ACCOUNTING CHANGES 1. Retrospective approach The retroactive approach provides consistency and comparability between periods and across entities. Comparative financial statements are recast to reflect the changes. The cumulative effect (net of tax) of the change is reported as a prior period adjustment in the earliest period reported. The accounting records are adjusted to reflect the cumulative effect (net of the change) as of the beginning of the current period. The change and its effects on income and balance sheet amounts is disclosed in the notes to the financial statements. 2. Prospective approach The prospective approach is used when it is impractical to use the retrospective approach. For example, a change from an acceptable inventory costing method to LIFO. It would be impractical for management to attempt to estimate what inventory and cost of goods sold would have been in prior years if the entity had been using LIFO. Under certain circumstances the entity may be required to use the prospective approach because the FASB has mandated such treatment in the adoption of a new accounting standard. Although considered a change in accounting principle a change in depreciation, amortization or depletion methods are to be reported on a prospective basis rather than retrospectively. CHANGE IN ACCOUNTING PRINCIPLE-RETROSPECTIVE APPROACH In applying the retrospective approach the financial statements are recast so that all prior periods reported in comparative financial statement reflect the adoption of the change in accounting principle. Example: Spencer Company changed from the LIFO cost flow assumption to the FIFO cost flow assumption in 2004. The company’s federal income tax rate is 20%. The original comparative income statements for the two years ended December 31, 2003 and all years prior to 2002 are presented below: D:\Teaching\3322\web\post\module4\c20\tnotes\c20a.doc 11/29/2007 2 Accounting Changes and Error Corrections Income Statements 2003 $1,050 683 368 231 137 27 $109 Revenue Cost of goods sold (LIFO) Gross profit Operating expenses Income before tax Income tax Net income 2002 $980 637 343 216 127 25 $102 Years Prior to 2002 $3,800 2,470 1,330 836 494 99 $395 The following are the inventory amounts reported in the balance sheet at the end of each of the years 2001 through 2003. Balance Sheets 2003 $150 Inventory (LIFO) 2002 $130 2001 $120 The cumulative effect of the change from LIFO to FIFO for the two years ended December 31, 2003, and all years prior to 2002 is presented below. 2003 $683 478 $205 2002 $637 446 $191 Years Prior to 2002 $2,470 1,729 $741 $1,137 227 $909 $932 186 $746 $741 148 $593 Cost of goods sold (LIFO) Cost of goods sold (FIFO) Differences Cumulative effect of change: Inventory/cost of goods sold Income taxes Net income/retained earnings The company adopted the change in accounting principle in 2004 so therefore the financial statements must be recast for 2003 and 2002, assuming that three year comparative financial statements are going to be presented. We assume that the change took effect on January 1, 2004 so there is no recasting of the 2004 financial statements but rather they reflect the results of the change. The following are the recast income statements for the three years. D:\Teaching\3322\web\post\module4\c20\tnotes\c20a.doc 11/29/2007 3 Accounting Changes and Error Corrections Income Statements (Recast) Revenue Cost of goods sold (FIFO) Gross profit Operating expenses Income before tax Income tax Net income 2004 $1,200 624 576 264 312 62 $250 2003 $1,050 478 572 231 341 68 $273 2002 $980 446 534 216 319 64 $255 The change in inventory method will result in changes in the balance sheet amounts as well. Inventory, deferred income taxes and retained earnings are all effected by this change in accounting principle. The adjusted inventory and the cumulative effect of changes on deferred income taxes and retained earnings are presented below. Balance Sheets (Recast) Inventory (LIFO) AJE (cumulative effect of changes) Adjusted inventory (FIFO) 2003 $150 1,137 $1,287 2002 $130 932 $1,062 Change to deferred income taxes Change to retained earnings Cumulative effect of changes $227 909 $1,137 $186 746 $932 Because we assume that the change in accounting principle took place on the first day of 2004 an adjusting journal entry is required to bring the accounting records into alignment with this change. The following adjusting journal entry reflects the adjustment to the accounting records. D:\Teaching\3322\web\post\module4\c20\tnotes\c20a.doc 11/29/2007 4 Accounting Changes and Error Corrections Account Inventory Retained earnings Deferred income taxes Debit $1,137 Credit $909 227 To record the cumulative effect of the change from LIFO to FIFO inventory cost method on January 1, 2004 Although this is the adjusting journal entry to correct the general ledger accounts, a prior period adjustment is also required to adjust the January 1, 2002 retained earnings balance. If we assume that original retained earnings was $1,900 the following prior period adjustment will have to be made as of January 1, 2002 to reflect the change in accounting principal. Retained earnings, January 1, 2002 Prior period adjustment Corrected balance $1,900 593 $2,493 CHANGE IN ACCOUNTING PRINCIPLE-PROSPECTIVE APPROACH A change in depreciation, amortization or depletion method is a change in accounting estimate as a result of a change accounting principle and is reported on a prospective basis. Example: In 2004 Spencer Company decided to change from accelerated depreciation to straight-line for financial reporting purposes. The only asset involved is equipment that originally cost $500,000 on January 1, 2001. The equipment was expected to have a ten year service life, a salvage value of $50,000 and was depreciated using the double declining method. The change in depreciation method is assumed to be effective as of the beginning of 2004. The following is a depreciation schedule on this piece of equipment for the four years that it has been in service. Year 2001 2002 2003 2004 Beginning Ending Book Accumulated Book Value DDB % Depreciation Depreciation Value $500,000 20% $100,000 $100,000 $400,000 400,000 20% 80,000 180,000 320,000 320,000 20% 64,000 244,000 256,000 256,000 20% 51,200 295,200 204,800 Using the prospective approach the following reflects the depreciation that will be taken in 2004 and in subsequent years. D:\Teaching\3322\web\post\module4\c20\tnotes\c20a.doc 11/29/2007 5 Accounting Changes and Error Corrections Original cost Accumulated depreciation Book value Salvage value Depreciable base Serivce life remaining Annual depreciation $500,000 244,000 256,000 50,000 206,000 7 $29,429 CHANGES IN ACCOUNTING ESTIMATE-PROSPECTIVE APPROACH At the end of each accounting period there are a number of estimates made in order to prepare the financial statements. These estimates are based on the facts and circumstances that exist at the time. These facts and circumstances will change from one accounting period to the next. It is not practical to restate the financial statements every time there is new information that makes the prior estimates incorrect. Therefore, on an ongoing basis management applies its best judgment and modifies such estimates as the facts and circumstances change in each subsequent accounting period. Changes in accounting estimates are handled on a prospective basis. Example: On January 1, 2000 Spencer Company purchased machinery which cost $60,000. The machinery has an estimated salvage value of $18,000 and service life of 7 years. On January 1, 2002 it was determined that the salvage life would be approximately $10,000 and the service life would be 4 years. The journal entry to record the depreciation expense for year ended December 31, 2002 is as follows. DATE ACCOUNT 12/31/2002 Depreciation expense Accumulated depreciation Analysis of revised depreciation expense: Original cost Original salvage value Depreciable base Original service life Annual depreciation Years in service before change in estimate Accumulated deprecation Book value Revised salvage value Depreciable base Revised service life (4 total, 2 left) Revised annual depreciation expense D:\Teaching\3322\web\post\module4\c20\tnotes\c20a.doc 11/29/2007 DEBIT $19,000 CREDIT $19,000 $60,000 $18,000 42,000 7 6,000 2 12,000 48,000 10,000 38,000 2 $19,000 6 Accounting Changes and Error Corrections REPORTING A CHANGE IN ENTITY-RETROSPECTIVE APPROACH Under certain circumstances management is required to restate the financial statements of all prior periods. These circumstances relate to a change in the reporting entity. All such changes are reported on a retrospective basis. Such changes include: (1) Presenting consolidated financial statements for the first time. (2) Changing specific subsidiaries for which consolidated financial statements are presented. (3) Changing companies included in combined financial statements (4) Change in the cost, equity, or consolidation method used for accounting for subsidiaries and investments. REPORTING A CORRECTION OF AN ERROR-RETROSPECTIVE APPROACH The correction of an error must be handled as a prior period adjustment to the earliest period reported in the financial statements. All such corrections are reported on a retrospective basis. Some of the types of errors that might occur are as follows: (1) Change from an unacceptable accounting principle to an acceptable one. (2) Mathematical errors. (3) Changes in estimates that were not prepared in good faith. (4) Failure to accrue or defer expenses or revenues at the end of a period. (5) Misuse of facts. (6) Misclassification of costs as expenses and vice versa. Example: Spencer Company purchased a piece of equipment on January 1, 2000 for $75,000. The bookkeeper incorrectly expensed the purchase as operating expenses in 2000. The equipment had no estimated salvage value and a service life of 5 years. The company has an average income tax rate of 35%. In 2002 the company discovered the error and prepared the following journal entry to make the correction. DATE ACCOUNT 1/1/2002 Equipment Accumulated deprecation Deferred tax liability Retained earnings D:\Teaching\3322\web\post\module4\c20\tnotes\c20a.doc 11/29/2007 DEBIT $75,000 CREDIT $30,000 13,500 31,500 7 Accounting Changes and Error Corrections Analysis of adjustment to retained earnings: Cost of equipment Salvage value Depreciable base Service life Annual depreciation Years of service Accumulated deprecation Book value Income tax rate Deferred tax liability Retained earnings D:\Teaching\3322\web\post\module4\c20\tnotes\c20a.doc 11/29/2007 $75,000 0 75,000 5 15,000 2 $75,000 30,000 45,000 30% 13,500 $31,500 8