Financial Accounting and Accounting Standards_10_

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					Chapter 11


       Accounting
Changes and Error Analysis
1.   Identify the types of accounting changes.
2.   Describe the accounting for changes in accounting principles.
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.   Identify changes in a reporting entity.
7.   Describe the accounting for correction of errors.
8.   Identify economic motives for changing accounting methods.
9.   Analyze the effect of errors.
              Accounting Changes
               Accounting Changes
          Reporting Issues & Approaches
          Reporting Issues & Approaches

Why are accounting changes made?
   New FASB pronouncements
  Changing economic conditions
  Changing internal circumstances
           Accounting Changes
            Accounting Changes
       Reporting Issues & Approaches
       Reporting Issues & Approaches
 Essential issues in reporting accounting changes:

¶ Whether an accounting change is allowed.

¶ Whether to restate prior years?financial statements.

¶ Whether to recognize the effect of the change in the
 current year’s net income or in the beginning
 retained earnings balance .
Accounting Changes
Accounting Changes
            Accounting Changes
            Accounting Changes




            Error corrections . . .
• Are not classified as accounting changes.
• Do affect the income of prior periods and
 require special treatment.
Objectives of Reporting Accounting Changes
Objectives of Reporting Accounting Changes



 Relevance
                     Consistency




                                 Public
                               Confidence
Accounting Principle Changes
Accounting Principle Changes
            Accounting Principle Changes
            Accounting Principle Changes

The following are not accounting principle changes:
   Initial adoption of an accounting principle
   Adopting an accounting principle for a new group
    of assets or liabilities
   Change from inappropriate accounting principle to
    GAAP
   Planned change to straight-line depreciation
   Change in accounting principle that cannot be
    distinguished from a change in accounting
    estimate
        Changes in Accounting Principle
        Changes in Accounting Principle


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

FASB requires use of the retrospective approach.
                     Basic Principles
                     Basic Principles

According to the provisions of FASB No. 154:
   A change in an accounting principle is accounted for by the
    retrospective application of the new accounting principle.
   A change in an accounting estimate is accounted for
    prospectively.
   A change in a reporting entity is accounted for by the
    retrospective application of the new accounting principle.
   A material error is accounted for by prior period restatement
    (adjustment).
        Retrospective Adjustment Method
        Retrospective Adjustment Method

A company accounts for a change in principle by the
retrospective application of the new accounting principle as
follows:

 •• The company computes the cumulative effect of the
     The company computes the cumulative effect of the
    change to the new accounting principle as of the
     change to the new accounting principle as of the
    beginning of the first period presented. That is, it
     beginning of the first period presented. That is, it
    computes the amounts that would have been in the
     computes the amounts that would have been in the
    financial statements if it had always used the new
     financial statements if it had always used the new
    principle.
     principle.

                                 Continued
                                 Continued
      Retrospective Adjustment Method
      Retrospective Adjustment Method


2. The company adjusts the carrying values of those assets
 2. The company adjusts the carrying values of those assets
    and liabilities (including income taxes) that are affected
     and liabilities (including income taxes) that are affected
    by the change. The company makes an offsetting
     by the change. The company makes an offsetting
    adjustment to the beginning balance of retained
     adjustment to the beginning balance of retained
    earnings to report the cumulative effect of the change
     earnings to report the cumulative effect of the change
    (net of taxes) for each period presented.
     (net of taxes) for each period presented.




                        Continued
                        Continued
      Retrospective Adjustment Method
      Retrospective Adjustment Method


3. The company adjusts the financial statements of each
 3. The company adjusts the financial statements of each
    prior period to reflect the specific effects of applying the
     prior period to reflect the specific effects of applying the
    new accounting principle. That is, each item in each
     new accounting principle. That is, each item in each
    financial statement that is affected by the change is
     financial statement that is affected by the change is
    restated to the appropriate amount under the new
     restated to the appropriate amount under the new
    accounting principle. The company uses the new
     accounting principle. The company uses the new
    accounting principle in its current financial statements.
     accounting principle in its current financial statements.




                                               Continued
                                               Continued
      Retrospective Adjustment Method
      Retrospective Adjustment Method


4. The company’s disclosures include (a) the nature and
 4. The company’s disclosures include (a) the nature and
    reason for the change in accounting principle, including
     reason for the change in accounting principle, including
    an explanation of why the new principle is preferable,
     an explanation of why the new principle is preferable,
    (b) a description of the prior-period information that
     (b) a description of the prior-period information that
    has been retrospectively adjusted, (c) the effect of the
     has been retrospectively adjusted, (c) the effect of the
    change on income, earnings per share, and any other
     change on income, earnings per share, and any other
    financial statement line item for the current period and
     financial statement line item for the current period and
    the prior periods retrospectively adjusted, and (d) the
     the prior periods retrospectively adjusted, and (d) the
    cumulative effect of the change on retained earnings (or
     cumulative effect of the change on retained earnings (or
    other appropriate component of equity) at the beginning
     other appropriate component of equity) at the beginning
    of the earliest period presented.
     of the earliest period presented.
      Retrospective Adjustment Method
      Retrospective Adjustment Method

The following accounting principle changes are subject to the
retroactive approach:
¶ Change from LIFO to another inventory method
¶ Change in the method of accounting for long-term
  construction contracts
¶ Change to or from full-cost method in extractive industries
¶ Changes in accounting principle made in conjunction with an
  initial public offering of equity securities (exemption
  available only once)
      Retrospective Adjustment Method
      Retrospective Adjustment Method

The following accounting principle changes are subject to the
retroactive approach:
¶ Change from retirement/replacement accounting to
  depreciation accounting for railroad track structures
¶ Change to a principle required by a new pronouncement
  recognized as GAAP that requires retroactive application
¶ Change to the equity method of accounting for investments in
  common stock (sometimes classified as a change in reporting
  entity)
          Retrospective Change Example
          Retrospective Change Example

Example (Retrospective Change) Buildmore Construction
Company used the completed contract method to account for
long-term construction contracts for financial accounting
and tax purposes in 2007, its first year of operations. In 2008,
the company decided to change to the percentage-of-
completion method for financial accounting purposes.
Income before long-term contracts and taxes in 2007 and
2008 was $80,000 and $100,000. The tax rate is 40% and the
company will continue to use the completed contract method
for tax purposes.
        Retrospective Change Example
        Retrospective Change Example

Example Income from Long-Term Contracts
        Retrospective Change Example
        Retrospective Change Example

Example Comparative Income Statements
        Retrospective Change Example
        Retrospective Change Example

Example Retained Earnings Statement
        Changes in Accounting Principle
        Changes in Accounting Principle
Impracticability
Companies should not use retrospective application if one
of the following conditions exists:

•   Company cannot determine the effects of the
    retrospective application.
•   Retrospective application requires assumptions about
    management’s intent in a prior period.
•   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.
           Prospective Approach
           Prospective Approach

Summary of the Approach for Changes in Accounting
Estimates


                          Prior years’ results
                            remain unchanged.
No cumulative
 adjustment is made.
                          New estimates are
                           applied prospectively.
       Changes in Accounting Estimate
       Changes in Accounting Estimate

The following items require estimates.
•   Uncollectible receivables.
•   Inventory obsolescence.
•   Useful lives and salvage values of assets.
•   Periods benefited by deferred costs.
•   Liabilities for warranty costs and income taxes.
•   Recoverable mineral reserves.
•   Change in depreciation methods.
Companies report prospectively changes in accounting
estimates.
Arcadia HS, 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 2005 (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:
    ◦ What is the journal entry to correct
        the prior years’ depreciation?
                                                         No Entry
    ◦ Calculate the depreciation expense                 Required
        for 2005.
                                                  After 7 years

Equipment cost                $510,000       First, establish NBV
                                              First, establish NBV
Salvage value                 - 10,000       at date of change in
                                              at date of change in
Depreciable base                500,000            estimate.
                                                    estimate.
Useful life (original)         10 years
Annual depreciation            $ 50,000 x 7 years = $350,000


                          Balance Sheet (Dec. 31, 2004)
          Fixed Assets:
            Equipment                          $510,000
            Accumulated depreciation            350,000
               Net book value (NBV)            $160,000
                                           After 7 years

Net book value               $160,000      Second, calculate
                                           Second, calculate
Salvage value (new)              5,000   depreciation expense
                                         depreciation expense
Depreciable base               155,000         for 2005.
                                                for 2005.
Useful life remaining          8 years
Annual depreciation           $ 19,375


    Journal entry for 2005

      Depreciation expense               19,375
         Accumulated depreciation                  19,375
           Reporting a Change in Entity
           Reporting a Change in Entity
Examples of a change in reporting entity are:
•   Presenting consolidated statements in place of statements of
    individual companies.
•   Changing specific subsidiaries that constitute the group of
    companies for which the entity presents consolidated financial
    statements.
•   Changing the companies included in combined financial
    statements.
•   Changing the cost, equity, or consolidation method of accounting
    for subsidiaries and investments.
Reported by changing the financial statements of all prior
periods presented.
         Reporting a Change in Entity
         Reporting a Change in Entity

Summary of the Approach for Changes in Reporting
Entity




    No cumulative          Prior years’ results are
  adjustment is made.              restated.
        Justification for Accounting Changes
        Justification for Accounting Changes

   New principle must be preferable.
   Nature of change and justification
    disclosed in notes.
          Justifications
      Improved matching
      Enhanced asset valuation
      New information
      Changing conditions
      Compliance with new reporting
        standards
     I wonder why
   companies make
accounting changes?
 It seems like a lot of
     trouble to me!
      Reporting a Correction of an Error
      Reporting a Correction of an Error

Accounting errors include the following types:
•   A change from an accounting principle that is not generally
    accepted to an accounting principle that is acceptable.
•   Mathematical mistakes.
•   Changes in estimates that occur because a company did not
    prepare the estimates in good faith.
•   Failure to accrue or defer certain expenses or revenues.
•   Misuse of facts.
•   Incorrect classification of a cost as an expense instead of an
    asset, and vice versa.
   Reporting a Correction of an Error
   Reporting a Correction of an Error

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.
              Prior Period Restatement
              Prior Period Restatement
A company accounts for a change in accounting principle by
prior period restatement as follows:

   1.
    1.   The company computes the cumulative effect of the
          The company computes the cumulative effect of the
         error correction on prior period financial statements.
          error correction on prior period financial statements.
         That is, it computes the amounts that would have
          That is, it computes the amounts that would have
         been in the financial statements if it had not made the
          been in the financial statements if it had not made the
         error.
          error.




                            Continued
                            Continued
          Prior Period Restatement
          Prior Period Restatement


2. The company adjusts the carrying values of those
 2. The company adjusts the carrying values of those
    assets and liabilities (including income taxes) that
     assets and liabilities (including income taxes) that
    are affected by the error. The company makes an
     are affected by the error. The company makes an
    offsetting entry to the beginning balance of
     offsetting entry to the beginning balance of
    retained earnings to report the cumulative effect of
     retained earnings to report the cumulative effect of
    the error correction (net of taxes) for each period
     the error correction (net of taxes) for each period
    presented.
     presented.



                      Continued
                      Continued
           Prior Period Restatement
           Prior Period Restatement

3.
 3.   The company adjusts the financial statements of
       The company adjusts the financial statements of
      each prior period to reflect the specific effects of
       each prior period to reflect the specific effects of
      correcting the error.
       correcting the error.



4.
 4.   The company’s disclosures include (a) that its
       The company’s disclosures include (a) that its
      previously issued financial statements have been
       previously issued financial statements have been
      restated, along with a description of the nature of
       restated, along with a description of the nature of
      the error,
       the error,


                        Continued
                        Continued
           Prior Period Restatement
           Prior Period Restatement



4.
 4.    b) the effect of the correction of each financial
      ((b)the effect of the correction of each financial
      statement line item, and any per share amounts
       statement line item, and any per share amounts
      affected for each prior period presented, and
       affected for each prior period presented, and

      (c) the cumulative effect of the change on retained
       (c) the cumulative effect of the change on retained
      earnings (or other appropriate component of
       earnings (or other appropriate component of
      equity) at the beginning of the earliest period
       equity) at the beginning of the earliest period
      presented.
       presented.
Before issuing the report for the year ended December 31, 2007, you discover a
$62,500 error that caused the 2006 inventory to be overstated (overstated
inventory caused COGS to be lower and thus net income to be higher in 2006).
Would this discovery have any impact on the reporting of the Statement of
Retained Earnings for 2007? Assume a 20% tax rate.
                   Accounting Errors
                   Accounting Errors
                    Classifications
                     Classifications
I. Errors occurred and discovered in the
  same accounting period.
II. Errors occurred in previous period.
  A. Errors did not affect prior period net
     income.
  B. Errors did affect prior period net
     income.
      1. Counterbalancing errors
      2. Noncounterbalancing errors
 Errors Occurred and Discovered in Same
 Errors Occurred and Discovered in Same
                 Period
                  Period

 Corrected by reversing the incorrect entry and
then recording the correct entry (or by making an
entry to correct the account balances)
     Previous Period Errors Not Affecting Net
     Previous Period Errors Not Affecting Net
                     Income
                      Income
   Involves incorrect classification of accounts.

   Requires correction of previously issued statements
    (retroactive approach).

   Is not classified as a prior period adjustment since it does not
    affect prior income.

   Disclose nature of error.
    Counterbalancing Errors Affecting Prior Net
    Counterbalancing Errors Affecting Prior Net
                     Income
                      Income

   Counterbalancing errors discovered after two or more years do
    not require a correcting entry.

   Counterbalancing errors discovered in the second year of the
    cycle require a correcting entry.
    -- Treated as a prior period adjustment (net of tax) to beginning
      Retained Earnings balance.
    Noncounterbalancing Errors Affecting Prior
    Noncounterbalancing Errors Affecting Prior
                  Net Income
                  Net Income

   These errors do not automatically correct themselves after two
    years.

   Correction of a noncounterbalancing error usually requires a
    prior period adjustment (retroactive approach).
E22-19 (Error Analysis; Correcting Entries) A partial trial balance of Julie
Hartsack Corporation is as follows on December 31, 2008.




Instructions
(a) Assuming that the books have not been closed, what are the adjusting
     entries necessary at December 31, 2008?
(a) Assuming that the books have not been closed, what are the
    adjusting entries necessary at December 31, 2008?

1.   A physical count of supplies on hand on December 31, 2008, totaled
     $1,100.




2.   Accrued salaries and wages on December 31, 2008, amounted to
     $4,400.
(a) Assuming that the books have not been closed, what are the
    adjusting entries necessary at December 31, 2008?

3.   Accrued interest on investments amounts to $4,350 on December 31,
     2008.




4.   The unexpired portions of the insurance policies totaled $65,000 as
     of December 31, 2008.
(a) Assuming that the books have not been closed, what are the
    adjusting entries necessary at December 31, 2008?

5.   $28,000 was received on January 1, 2008 for the rent of a building for both
     2008 and 2009. 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.
E22-19 (Error Analysis; Correcting Entries) A partial trial balance of Julie
Hartsack Corporation is as follows on December 31, 2008.




Instructions
(b) Assuming that the books have been closed, what are the adjusting entries
     necessary at December 31, 2008?
(b) Assuming that the books have been closed, what are the adjusting
    entries necessary at December 31, 2008?

1.   A physical count of supplies on hand on December 31, 2008, totaled
     $1,100.




2.   Accrued salaries and wages on December 31, 2008, amounted to
     $4,400.
(b) Assuming that the books have been closed, what are the adjusting
     entries necessary at December 31, 2008?

3.   Accrued interest on investments amounts to $4,350 on December 31,
     2008.




4.   The unexpired portions of the insurance policies totaled $65,000 as of
     December 31, 2008.
(b) Assuming that the books have been closed, what are the adjusting
     entries necessary at December 31, 2008?

5.   $28,000 was received on January 1, 2008 for the rent of a building
     for both 2008 and 2009. 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.
        All-Inclusive Concept of Income
        All-Inclusive Concept of Income


Comprehensive income is defined as the net of all changes in
equity except those resulting from investments by and
distributions to owners.
   Hang in there!
We’re coming down
 the home stretch!

                     Yeah, that’s
                     easy for you
                       to say!
Chapter11



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