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Accounting Changes

Accounting Alternatives:

Diminish the comparability of financial information.

Obscure useful historical trend data.

Types of Accounting Changes:


1. Change in Accounting Principles.
2. Changes in Accounting Estimate.
3. Change in Reporting Entity.
Errors are not considered an accounting change.
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LO 1

Changes in Accounting Principle


Change from one accepted accounting policy to another.
Examples include:

Average cost to LIFO.

Completed-contract to percentage-of-completion method.

Adoption of a new principle in recognition of events that have occurred


for the first time or that were previously immaterial is not an accounting
change.

22-2

LO 2

Changes in Accounting Principle


Three approaches for reporting changes:
1) Currently.
2) Retrospectively.
3) Prospectively (in the future).

FASB requires use of the retrospective approach.

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

22-3

LO 2

Changes in Accounting Principle


Retrospective Accounting Change Approach
Company reporting the change
1) Adjusts its financial statements for each prior period
presented to the same basis as the new accounting
principle.
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.

22-4

LO 3

Changes in Accounting Principle


Retrospective Accounting Change: Long-Term
Contracts
Illustration: Denson Company has accounted for its income from
long-term construction contracts using the completed-contract
method. In 2014, the company changed to the percentage-ofcompletion 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 percent
enacted tax rate.)

22-5

LO 3

Changes in Accounting Principle


Illustration 22-1

22-6

LO 3

Changes in Accounting Principle


Data for Retrospective Change
Illustration 22-2

Journal entry
beginning of
2014

22-7

Construction in Process
Deferred Tax Liability
Retained Earnings

220,000
88,000
132,000
LO 3

Changes in Accounting Principle


Reporting a Change in Principle
Major disclosure requirements are as follows.

22-8

1.

Nature of the change in accounting principle.

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.
LO 3

Changes in Accounting Principle


Reporting a Change in policy

22-9

Illustration 22-3

LO 3

Changes in Accounting Principle


Retained Earnings Adjustment
Retained earnings balance is $1,360,000 at the beginning of 2012.
Illustration 22-4

Before Change

22-10

LO 3

Changes in Accounting Principle


Retained Earnings Adjustment

Illustration 22-5

22-11

After Change

LO 3

Changes in Accounting Principle


E22-1 (Change in PrincipleLong-Term Contracts): Pam Erickson
Construction Company changed from the completed-contract to the
percentage-of-completion method of accounting for long-term
construction contracts during 2015. For tax purposes, the company
employs the completed-contract method and will continue this
approach in the future. (Hint: Adjust all tax consequences through the
Deferred Tax Liability account.)

22-12

LO 3

Changes in Accounting Principle


E22-1 (Change in PrincipleLong-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 2015? Assume beginning retained earnings for
2013 to be $100,000.
22-13

LO 3

Changes in Accounting Principle


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

Journal entry for 2014


Construction in Process
Deferred Tax Liability
Retained Earnings
22-14

190,000
66,500
123,500
LO 3

Changes in Accounting Principle


E22-1: Comparative Statements

Income
Statement

Statement
of Retained
Earnings

22-15

LO 3

Changes in Accounting Principle


Direct and Indirect Effects of Changes

22-16

Direct Effects - FASB takes the position that


companies should retrospectively apply the direct
effects of a change in accounting principle.

Indirect Effect is any change to current or future cash


flows of a company that result from making a change in
accounting principle that is applied retrospectively.

LO 3

Changes in Accounting Principle


Impracticability
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 that


the company cannot develop.

If any of the above conditions exists, the company prospectively applies the
new accounting principle.
22-17

LO 4

Changes in Accounting Estimate


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.

22-18

LO 5

Changes in Accounting Estimate


Prospective Reporting
Changes 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.
FASB views changes in estimates as normal recurring
corrections and adjustments and prohibits retrospective
treatment.
22-19

LO 5

Changes in Accounting Estimate


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 2014 (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 time.
Required:

22-20

What is the journal entry to correct


prior years depreciation expense?

Calculate depreciation expense for 2014.

No Entry
Required

LO 5

Changes in Accounting Estimate


Equipment cost
Salvage value
Depreciable base
Useful life (original)
Annual depreciation

After 7
years

$510,000
First,
First,establish
establishNBV
NBV
- 10,000
at
atdate
dateof
ofchange
changeinin
estimate.
500,000
estimate.
10 years
$ 50,000 x 7 years = $350,000

Balance Sheet (Dec. 31, 2013)


Fixed Assets:

22-21

Equipment
Accumulated depreciation

$510,000
350,000

Net book value (NBV)

$160,000
LO 5

Changes in Accounting Estimate


Net book value
Salvage value (if any)
Depreciable base
Useful life
Annual depreciation

$160,000
5,000
155,000
8 years
$ 19,375

Second,
Second,calculate
calculate
depreciation
depreciationexpense
expense
for
for2014.
2014.

Journal entry for 2014


Depreciation expense
Accumulated depreciation

22-22

Advance slide in presentation


mode to reveal answers.

19,375
19,375

LO 5

Changes in Accounting Estimate


Disclosures
Companies need not disclose changes 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.

22-23

LO 5

Change in Reporting Entity


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 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 prior periods presented.
22-24

LO 6

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 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.
22-25

LO 7

Accounting Errors

Illustration 22-18
Accounting-Error Types

Accounting Category

Type of Restatement

Expense recognition

Recording expenses in the incorrect period or for an


incorrect amount.

Revenue recognition

Instances in which revenue was improperly recognized,


questionable revenues were recognized, or any other
number of related errors that led to misreported revenue.

Misclassification

Include restatements due to misclassification of short- or


long-term accounts or those that impact cash flows from
operations.

Equityother

Improper accounting for EPS, restricted stock, warrants,


and other equity instruments.

Reserves/Contingencies

Errors involving accounts receivables bad debts, inventory


reserves, income tax allowances, and loss contingencies.

Long-lived assets

Asset impairments of property, plant, and equipment;


goodwill; or other related items.

22-26

LO 7

Accounting Errors

Illustration 22-18
Accounting-Error Types

Accounting Category

Type of Restatement

Taxes

Includes instances in which revenue was improperly


recognized, questionable revenues were recognized, or
any other number of related errors that led to misreported
revenue.

Equityother
comprehensive income

Improper accounting for comprehensive income equity


transactions including foreign currency items, minimum
pension liability adjustments, unrealized gains and losses
on certain investments in debt, equity securities, and
derivatives.

Inventory

Inventory costing valuations, quantity issues, and cost of


sales adjustments.

Equitystock options

Improper accounting for employee stock options.

Other

Any restatement not covered by the listed categories.

22-27

Source: T. Baldwin and D. Yoo, RestatementsTraversing Shaky Ground, Trend Alert, Glass
Lewis & Co. (June 2, 2005), p. 8.

LO 7

Accounting Errors

22-28

All 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.

LO 7

Example of Error Correction


Illustration: In 2015 the bookkeeper for Selectro Company
discovered an error. In 2014 the company failed to record
$20,000 of 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.

22-29

LO 7

Example of Error Correction


Selectros income statement for 2014 with and without the error.
Illustration 22-19

What are the entries that Selectro should have made and did make
for recording depreciation expense and income taxes?
22-30

LO 7

Example of Error Correction


Illustration 22-19

Entries that Selectro should have made and did make for recording
depreciation expense and income taxes.

Illustration 22-20

22-31

Example of Error Correction


Illustration 22-20

Advance
slide in
presentation
mode to
reveal
complete
illustration.

22-32

LO 7

Example of Error Correction


Prepare the proper correcting entry in 2015, that should be made
by Selectro.
Illustration 22-20

Correcting
Entry in
2015

22-33

Retained Earnings

12,000

LO 7

Example of Error Correction


Prepare the proper correcting entry in 2015, that should be made
by Selectro.
Illustration 22-20

Correcting
Entry in
2015

22-34

Retained Earnings
Deferred Tax Liability

12,000

Reversal

8,000

LO 7

Example of Error Correction


Prepare the proper correcting entry in 2015, that should be made
by Selectro.
Illustration 22-20

Correcting
Entry in
2015

22-35

Retained Earnings
Deferred Tax Liability

12,000
8,000

Accumulated DepreciationBuildings

20,000
LO 7

Example of Error Correction


Single-Period Statements
Illustration: Selectro Company has a beginning retained earnings
balance at January 1, 2015, of $350,000. The company reports net
income of $400,000 in 2015.
Illustration 22-21

22-36

LO 7

Accounting Errors
Comparative Statements
Company should
1. make adjustments to correct the amounts for all affected
accounts reported in the statements for all periods
reported.
2. restate the data to the correct basis for each year
presented.
3. show any catch-up adjustment as a prior period
adjustment to retained earnings for the earliest period it
reported.
22-37

LO 7

Accounting Errors

Before issuing the report for the year ended December 31, 2014, you discover
a $62,500 error that caused the 2013 inventory to be overstated (overstated
inventory caused COGS to be lower and thus net income to be higher in
2013). Would this discovery have any impact on the reporting of the
Statement of Retained Earnings for 2014? Assume a 20% tax rate.
22-38

LO 7

Accounting Errors

22-39

Advance slide in presentation


mode to reveal answers.

LO 7

Accounting Errors
Summary of Accounting Changes and
Correction of Errors
Illustration 22-23

22-40

LO 7

Summary of Changes and Errors


Illustration 22-23

22-41

LO 7

Accounting Errors
Motivations for Changes of Accounting
Method
Why companies may prefer certain accounting methods.
Some reasons are:
1. Political costs.
2. Capital Structure.
3. Bonus Payments.
4. Smooth Earnings.

22-42

LO 8

Error Analysis
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 to
be restated?
Companies treat errors as prior-period adjustments and report
them in the current year as adjustments to the beginning
balance of Retained Earnings.

22-43

LO 9

Error Analysis
Balance Sheet Errors
Balance sheet errors affect only the presentation of an asset,
liability, or stockholders equity account.

22-44

Current year error - reclassify item to its proper position.

Prior year error - restate the balance sheet of the prior year
for comparative purposes.

LO 9

Error Analysis
Income Statement Errors
Improper classification of revenues or expenses.

22-45

Current year error - reclassify item to its proper position.

Prior year error - restate the income statement of the prior


year for comparative purposes.

LO 9

Error Analysis
Balance Sheet and Income Statement Errors
Counterbalancing Errors
Will be offset or corrected over two periods.
1. If company has closed the books:
a. If the error is already counterbalanced, no entry is necessary.
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.
22-46

LO 9

Error Analysis
Balance Sheet and Income Statement Errors
Counterbalancing Errors
Will be offset or corrected over two periods.
2. If company has not closed the books:
a. If error already counterbalanced, make entry to correct the
error 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.

22-47

LO 9

Error Analysis
Balance Sheet and Income Statement Errors
Noncounterbalancing Errors
Not offset in the next accounting period.
Companies must make correcting entries, even if they have
closed the books.

22-48

LO 9

Error Analysis
E22-19 (Error Analysis; Correcting Entries): A partial trial balance of
Julie Hartsack Corporation is as follows on December 31, 2015.

Instructions: (a) Assuming that the books have not been closed, what
are the adjusting entries necessary at December 31, 2015?
22-49

LO 9

Error Analysis
(a) Assuming that the books have not been closed, what are the
adjusting entries necessary at December 31, 2015?
1.

A physical count of supplies on hand on December 31, 2015, totaled


$1,100.
Supplies Expense ($2,700 $1,100)

1,600

Supplies on Hand
2.

Accrued salaries and wages on December 31, 2015, amounted to


$4,400.
Salary and Wages Expense
Accrued Salaries and Wages

22-50

1,600

2,900
2,900
LO 9

Error Analysis
(a) Assuming that the books have not been closed, what are the
adjusting entries necessary at December 31, 2015?
3.

Accrued interest on investments amounts to $4,350 on December 31,


2015.
Interest Revenue ($5,100 $4,350)

750

Interest Receivable
4.

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


of December 31, 2015.
Insurance Expense
Prepaid Insurance

22-51

750

25,000
25,000
LO 9

Error Analysis
(a) Assuming that the books have not been closed, what are the
adjusting entries necessary at December 31, 2015?
5.

$28,000 was received on January 1, 2015 for the rent of a building for
both 2015 and 2016. The entire amount was credited to rental
income.
Rental Income ($28,000 2)

14,000

Unearned Rent
6.

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


than the correct figure of $50,000.
Depreciation Expense
Accumulated Depreciation

22-52

14,000

45,000
45,000
LO 9

Error Analysis
E22-19 (Error Analysis; Correcting Entries) A partial trial balance of
Dickinson Corporation is as follows on December 31, 2015.

Instructions: (b) Assuming that the books have been closed, what are
the adjusting entries necessary at December 31, 2015?
22-53

LO 9

Error Analysis
(b) Assuming that the books have been closed, what are the adjusting
entries necessary at December 31, 2015?
1.

A physical count of supplies on hand on December 31, 2015, totaled


$1,100.
Retained Earnings

1,600

Supplies
2.

Accrued salaries and wages on December 31, 2015, amounted to


$4,400.
Retained Earnings
Accrued Salaries and Wages

22-54

1,600

2,900
2,900
LO 9

Error Analysis
(b) Assuming that the books have been closed, what are the adjusting
entries necessary at December 31, 2015?
3.

Accrued interest on investments amounts to $4,350 on December 31,


2015.
Retained Earnings ($5,100 $4,350)

750

Interest Receivable
4.

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


of December 31, 2015.
Retained Earnings
Prepaid Insurance

22-55

750

25,000
25,000
LO 9

Error Analysis
(b) Assuming that the books have been closed, what are the adjusting
entries necessary at December 31, 2015?
5.

$24,000 was received on January 1, 2015 for the rent of a building for
both 2015 and 2016. The entire amount was credited to rental
income.
Retained Earnings

14,000

Unearned Rent
6.

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


than the correct figure of $50,000.
Retained Earnings
Accumulated Depreciation

22-56

14,000

45,000
45,000
LO 9

APPENDIX

22A

CHANGING FROM OR TO THE EQUITY METHOD

Change From The Equity Method


Change from the equity method to the fair-value method.

22-57

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.
LO 10 Make the computations and prepare the entries necessary to
record a change from or to the equity method of accounting.

APPENDIX

22A

CHANGING FROM OR TO THE EQUITY METHOD

Dividends in Excess of Earnings


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
liquidating dividend with this excess then accounted for as a
________________

reduction of the equity investment.

22-58

LO 10

APPENDIX

22A

CHANGING FROM OR TO THE EQUITY METHOD

Dividends in Excess of Earnings


Illustration: On January 1, 2013, 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 2013, Investor reported its investment in
Investee Company at $8,780,000 at December 31, 2013. On January 2,
2014, 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.

22-59

LO 10

APPENDIX

22A

CHANGING FROM OR TO THE EQUITY METHOD

Dividends in Excess of Earnings


Illustration 22A-1

22-60

LO 10

APPENDIX

22A

CHANGING FROM OR TO THE EQUITY METHOD

Impact on Investment Carrying Amount

2014 and
2015
2016

22-61

Illustration 22A-2

Cash
Dividend Revenue

400,000

Cash
Equity Investments (AFS)
Dividend Revenue

210,000

400,000
60,000
150,000
LO 10

APPENDIX

22A

CHANGING FROM OR TO THE EQUITY METHOD

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 investor
are 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.

22-62

LO 10