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Intermediate Accounting

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					Gonzalez
Intermediate Accounting II / ACNT 2304
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.

Correction of Errors

       Error correction-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.

A. Current Approach: Cumulative-Effect Type of Accounting Change
   (1) The catch-up or current approach requires that the cumulative effect of the change
       in accounting principle be reported net of tax, in the income statement between
       extraordinary items and net income.
   (2) If the entity prepares comparative financial statement, the statements for prior
       years are not restated.
   (3) Pro-forma amounts should be reported on the face of the income statement for all
       periods as if the new accounting principle had been used in prior periods.

Example: At the beginning of 2002 Spencer Company decided to change from
accelerated depreciation to straight-line for financial reporting purposes. The company
will continue to use the accelerated method in computing federal income taxes. The
company is in the 35% tax bracket. The following schedule shows depreciation under the
accelerated method and the straight-line method for 2000 and 2001.

            Accelerated Straight-Line                                    Effect on Income
    Year    Depreciation Depreciation Difference              Tax Effect    (net of tax)
       2000      80,000       40,000      40,000                  14,000            26,000
       2001      48,000       40,000        8,000                  2,800             5,200
                128,000       80,000      48,000                  16,800            31,200




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Gonzalez
Intermediate Accounting II / ACNT 2304
To record the cumulative effect of a change in accounting principle Spencer Company
would record the following journal entry on January 1, 2002.

 DATE                         ACCOUNT                             DEBIT       CREDIT
  1/1/02 Accumulated depreciation                                   48,000
           Deferred tax liability                                                 16,800
           Cumulative effect of chang in accounting principle                     31,200
         To record the change from accelerated to straight-
         line depreciation for financial reporting purposes

Spencer Company prepares comparative financial statements. Income before
extraordinary item and cumulative effect of a change in accounting principle was
$150,000 in 2002 and $122,000 in 2001. Extraordinary items net of tax for the two years
were $29,000 in 2002 and ($10,000) in 2001. There were 100,000 shares of common
stock outstanding during the year. The comparative income statement for the year ended
December 31, 2002 is as follows:

                                                       2002           2001
Income before extraordinary item and cumulative
effect of a change in accounting principle              150,000       122,000
Extraordinary item, net of tax                           29,000       (10,000)
Cumulative effect of prio years retroactive
application of new depreciation method, net of tax       31,200
Net income                                              210,200       112,000

Earnings per share
Income before extraordinary item and cumulative
effect of a change in accounting principle                 1.50           1.22
Extraordinary item, net of tax                             0.29          (0.10)
Cumulative effect of prio years retroactive
application of new depreciation method, net of tax         0.31
Net income                                                 2.10          1.12

Also, on the face of the 2002 comparative financial statements Spencer Company needs
to present pro-forma amounts as if the change to straight-line had taken place
retroactively. The following would be included in Spencer Company’s income
statement.




                                                                                       2
Gonzalez
Intermediate Accounting II / ACNT 2304
Pro-forma amounts, assuming retroactive application of new depreciation method
                                                       2002          2001
Income before extraordinary item                        150,000       148,000
Earnings per common share                                  1.50          1.48
 Net income                                             210,200       138,000
Earnings per common share                                  2.10          1.38

B. Retroactive Approach: Retroactive-Effect Type Accounting Change

   In applying the retroactive-type accounting change we essentially go back and recast
   the financial statements so they are consistently presented based on the newly adopted
   accounting principle. If there is a cumulative effect at the beginning of the last period
   presented it is handled as a prior period adjustment to the earliest period presented.
   There are five situations that require the retroactive-effect type of restatement.
   (1) Change from LIFO inventory valuation method to another method.
   (2) Change in the method of accounting for long-term construction-type contracts.
   (3) Change to or from the “full-cost” method of accounting in extractive industries.
   (4) First time issuance of financial statements to obtain equity capital, effect a
         business combination or register securities.
   (5) FASB pronouncement recommends that the change in accounting principle be
         accounted for on a retroactive basis.

Example: Spencer Company changed from the LIFO cost flow assumption to the FIFO
cost flow assumption in 2002. The company’s federal income tax rate is 40%. The
increase in prior year’s income is reflected in the schedule below.

                  Pretax Income from
                                                                        Effect on Income
    Year           LIFO           FIFO        Difference     Tax Effect    (net of tax)
Prior to 2001     1,100,000      1,900,000       800,000       320,000           480,000
          2001    1,800,000      2,000,000       200,000         80,000          120,000
          2002    4,000,000      4,200,000       200,000         80,000          120,000

The change in inventory cost flow assumption took place in 2002 so the effect of the
change will be recorded as of January 1, 2002. This will include all years prior to 2002
but not the year of 2002. The following provides an analysis of the effect of the change
as of January 1, 2002.




                                                                                           3
Gonzalez
Intermediate Accounting II / ACNT 2304
                   Pretax Income from
                                                                         Effect on Income
    Year           LIFO           FIFO         Difference     Tax Effect    (net of tax)
Prior to 2001     1,100,000      1,900,000        800,000       320,000           480,000
          2001    1,800,000      2,000,000        200,000         80,000          120,000
                  2,900,000      3,900,000      1,000,000       400,000           600,000


To effect this change in accounting principle the following journal entry is entered into
the accounting records.

  DATE                        ACCOUNT                                DEBIT        CREDIT
   1/1/02 Inventory                                                  1,000,000
           Deferred tax liability                                                   400,000
           Retained earnings                                                        600,000
          To record the change from LIFO to FIFO cost flow
          ssumption in valuing inventory.

Spencer Company has no irregular items to report in either 2001 or 2002. The company
has 1,000,000 shares of common stock outstanding for the entire year. The following is a
partial presentation of the comparative income statement for the years ended December
31, 2001 and 2002.

                                                          2002           2001
Income before income tax                                 4,200,000      2,000,000
Income tax expense                                       1,680,000        800,000
Net income                                               2,520,000      1,200,000

Earnings per share
Net income                                                    2.52           1.20

There is no need to prepare pro-forma amounts because the income statements for the
two years have been recast to reflect the change from LIFO to FIFO. The remaining
cumulative effect of the change must be shown in the statement of retained earnings as
presented below.




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Gonzalez
Intermediate Accounting II / ACNT 2304
                                                          2002           2001
Beginning retained earnings as previously reported       5,580,000      4,500,000
Add: Adjustment for the cumulative effect on prior
years of applying retroactively the FIFO cost flow
assumption in valuing inventory.                           600,000        480,000
Beginning retained earnings, as adjusted                 6,180,000      4,980,000
Net income                                               2,520,000      1,200,000
Ending retained earnings                                 8,700,000      6,180,000

C. Prospective Approach: Change to LIFO Method
A change in accounting for inventory using an acceptable cost flow assumption to LIFO
is a special situation. It would be impossible to calculate prior year LIFO layers as a
result of the change in accounting principle. Therefore the change is accounted for on a
prospective basis. The opening inventory in the year that LIFO is adopted becomes the
base-year inventory. There is no restatement to recognize the cumulative effect.

CHANGES 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. Changes in
accounting estimates are handled on a prospective basis. management at the time

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.




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Gonzalez
Intermediate Accounting II / ACNT 2304
  DATE                     ACCOUNT                             DEBIT         CREDIT
  12/31/02 Depreciation expense                                  19,000
            Accumulated depreciation                                             19,000

            Analysis of revised depreciation expense:
            Original cost                                                        60,000
            Original salvage value                                18,000
            Depreciable base                                      42,000
            Original service life                                      7
            Annual depreciation                                    6,000
            Years in service before change in estimate                 2
            Accumulated deprecation                                              12,000
            Book value                                                           48,000
            Revised salvage value                                                10,000
            Depreciable base                                                     38,000
            Revised service life (4 total, 2 left)                                    2
            Revised depreciation expense                                         19,000

REPORTING A CHANGE IN 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:
(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
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:
(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.


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Gonzalez
Intermediate Accounting II / ACNT 2304


  DATE                     ACCOUNT       DEBIT      CREDIT
   1/1/02 Equipment                        75,000
           Accumulated deprecation                    30,000
           Deferred tax liability                     13,500
           Retained earnings                          31,500

          Analysis of correction:
          Cost of equipment                75,000     75,000
          Salvage value                         0
          Depreciable base                 75,000
          Service life                          5
          Annual depreciation              15,000
          Years of service                      2
          Accumulated deprecation                     30,000
          Book value                       45,000
          Income tax rate                     30%
          Deferred tax liability                      13,500
          Retained earnings                           31,500




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