INTERMEDIATE
ACCOUNTING
Chapter 22
Accounting for Changes and Errors
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What Are the Types of Accounting Changes
and How Are They Reported?
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Changes in accounting principle represent a change from one generally
accepted accounting principle to another generally accepted accounting
principle. A change in the method of applying an accounting principle is
also a change in accounting principle.
Changes in accounting estimate are a revision of an estimate used in the
accounting process. This type of change is inherent in the periodic
presentation of financial statements and occurs as the result of new or
additional information and experience.
Changes in a reporting entity represent a change in the type of entity
being reported. Many companies operate in a consolidated manner in that
the parent company owns many subsidiaries. If a company acquires a
subsidiary or sells off a subsidiary, the reporting entity has changed.
Errors are the result of mathematical mistakes, mistakes in the application
of GAAP, or the oversight or misuse of facts that existed when the financial
statements were prepared. While errors are not accounting changes per se,
they are discussed in this chapter because the correction of an error
involves corrections to the reported financial statements similar to
accounting changes.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Method of Reporting Accounting Changes
and Errors (Slide 1 of 2)
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If a company makes an accounting change, GAAP
provides two possible methods of reporting the change:
The retrospective adjustment method requires that the
reported financial statements be revised as if the newly
adopted accounting principle had always been used.
 The prospective method does not require an adjustment to
previously issued financial statements. Instead, the
accounting change is accounted for in the current and future
periods.
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Additionally, if an error is discovered, a company will
correct the error by making a prior period adjustment.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Method of Reporting Accounting Changes
and Errors (Slide 2 of 2)
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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 a
retrospective adjustment so that all the financial
statements presented are for the same entity.
An error is accounted for as a prior period
adjustment (prior period restatement).
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
How Do We Account for a Change
in Accounting Principle? (Slide 1 of 2)
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A change in accounting principle includes:
 change
from one generally accepted accounting
principle to another generally accepted accounting
principle
 change in accounting principle because an Accounting
Standard Update has been issued and the former
principle is no longer generally accepted
 change in the method of applying an accounting
principle
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
How Do We Account for a Change
in Accounting Principle? (Slide 2 of 2)
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A change in accounting principle does not include:
 Initial
adoption of a generally accepted accounting
principle because of events or transactions occurring for
the first time or that were previously immaterial
 Adoption or modification of an accounting principle for
transactions or events that are clearly different in
substance from those previously occurring
 Change to a generally accepted accounting principle
from a principle that is not generally accepted. This
would be treated as a correction of an error
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Retrospective Adjustment Method
(Slide 1 of 2)
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A company accounts for a change in accounting principle by the
retrospective application of the new accounting principle to all prior
periods as follows:
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Step 1. Compute the cumulative effect of the change to the new
accounting principle as of the beginning of the first period presented.
Step 2. Prepare a journal entry to adjust the book values of the assets
and liabilities (including income taxes) that are affected by the change
so that their balances reflect the amounts that would have existed under
the newly adopted accounting principle. An offsetting adjustment is
made to the beginning balance of Retained Earnings for the cumulative
effect of the change (net of taxes).
Step 3. Adjust the financial statements of the current period and each
prior period to reflect the specific effects of applying the new
accounting principle. Therefore, the comparative financial statements
would appear as if the newly adopted accounting principle was used in
every period presented.
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Retrospective Adjustment Method
(Slide 2 of 2)
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Step 4. Disclose the following information:
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Nature and reason for the change in accounting principle, including
an explanation of why the new principle is preferable
Description of the prior-period information that has been
retrospectively adjusted
Effect of the change on income, earnings per share, and any other
financial statement line item for the current period and the prior
periods retrospectively adjusted
Cumulative effect of the change on retained earnings (or other
appropriate component of equity) at the beginning of the earliest
period presented
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Direct and Indirect Effects
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The direct effect of a change in accounting principle is the
amount by which a company’s prior years’ income is
increased or decreased specifically as a result of the
change in accounting principle.
An indirect effect of a change in accounting principle is
the amount by which the company’s prior years’ income is
affected by how the change in principle affects other
elements of income.
In situations in which a change in accounting principle has
both a direct and indirect effect on prior years’ income,
GAAP states that a company recognizes only the direct
effect (net of applicable income taxes) in determining the
amount of the retrospective adjustment.
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Impracticability of Retrospective Adjustment
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Sometimes, it may not be practicable to determine the effect
of applying a change in accounting principle to a prior
period. Retrospective adjustment is considered impracticable
if any of the following conditions exist:
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The company cannot, after reasonable effort, determine the
effect on prior periods.
Retrospective adjustments depend on management’s intent that
cannot be independently verified.
Significant estimates are required that cannot be objectively
verified.
If retrospective adjustment is impracticable, GAAP requires
a company to apply the new accounting principle
prospectively as of the earliest date practicable.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Accounting Changes in
Interim Financial Statements
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If a company makes a change in accounting principle in
an interim period, it reports the change using the
retrospective adjustment method in its interim financial
statements.
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For example, if a company changes its method of
accounting for long-term contracts during the third quarter
of its fiscal year, it must restate the prior interim periods (the
first and second quarters). The company does this by
applying the newly adopted accounting principle to those
interim periods and reporting the cumulative effect of the
change in retained earnings at the beginning of the year in
the restated net income of the first interim period.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
How Do We Account for a Change in Estimate?
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The application of GAAP requires a company to make estimates for
items such as uncollectible accounts receivable, inventory
obsolescence, service lives and residual values of depreciable
assets, recoverable mineral reserves, warranty costs, pension costs,
and the periods that it expects to be benefited by a deferred cost.
In fact, virtually every number on the balance sheet involves an
estimate.
Because estimating future events is an inherently uncertain process,
changes in estimates are inevitable as new events occur, as more
experience is acquired, or as additional information is obtained.
GAAP requires that a company account for a change in an
accounting estimate in the period of the change and future periods
if affected.
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A Change in Principle Distinguished from
a Change in an Estimate
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Sometimes it is difficult for a company to distinguish
between a change in an accounting principle and a change
in an estimate.
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For example, a company may change from capitalizing and
amortizing a cost to recording it as an expense when incurred
because future benefits associated with the cost have become
doubtful.
The company adopted the new accounting method because of the
change in estimated benefits, and therefore, the change in
method is inseparable from the change in estimate.
The company is required to account for such a change as a
change in estimate. This is often referred to as a change in
accounting estimate affected by a change in accounting
principle.
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How Do We Account for a
Change in Reporting Entity?
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The third type of change defined by GAAP is a change in a reporting
entity which results in financial statements that, in effect, are those of a
different reporting entity.
A change in an accounting entity is limited mainly to presenting
consolidated or combined financial statements in place of the statements of
individual companies, changing specific subsidiaries that make up the group
of companies for which consolidated financial statements are presented, or
changing the companies included in combined financial statements.
A company accounts for a change in reporting entity as a retrospective
adjustment so that all the financial statements it presents are for the same
entity. In addition, a company includes in the notes to its financial statements
of the period in which it makes the change a description of the change as
well as the reason for it, and the effect of the change on income before
extraordinary items, net income, other comprehensive income, and related
earnings per share amounts for all periods presented.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
How Do We Account for the
Correction of an Error? (Slide 1 of 3)
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If a company makes a material error, it must correct the error as
soon as it is discovered in the current period.
The correction of an error is not an accounting change under GAAP.
A company accounts for the correction of a material error of a past
period that it discovers in the current period as a prior period
adjustment (prior period restatement).
Some of the more common issues involved in restatements in 2010
included:
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Revenue recognition
Expense recognition
Deferred, stock-based, or executive compensation
Liabilities, payables, reserves and accrual estimate failures
Debt, quasi-debt, and other equity issues
Accounts/loans receivable, investments, and cash
Cash flow statement classification errors
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
How Do We Account for the
Correction of an Error? (Slide 2 of 3)
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A prior period adjustment requires a company to perform
the following steps:
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Step 1. Compute the cumulative effect of the error on prior
period financial statements. This represents the amounts that
would have been in the financial statements if an error had not
been made.
Step 2. Prepare a journal entry to adjust the book values of
those assets and liabilities (including income taxes) affected by
the error. An offsetting adjustment is made to the beginning
balance of Retained Earnings to report the cumulative effect of
the error correction (net of taxes) for each period presented.
Step 3. Adjust the financial statements of each prior period to
reflect the specific effects of correcting the error. Each item in
each financial statement that is affected by the error must be
restated to the appropriate amount.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
How Do We Account for the
Correction of an Error? (Slide 3 of 3)
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Step 4. Disclose the following information:
A statement that the previously issued financial statements have
been restated because of an error, along with a description of
the nature of the error
 The effect of the correction of the error on each financial
statement line item and any per share amounts for each prior
period presented
 The cumulative effect of the change on retained earnings (or
other appropriate component of equity) at the beginning of
the earliest period presented
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Error Analysis
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Errors can be categorized according to the effect
they have on the financial statements:
 Errors
affecting only the balance sheet
 Errors affecting only the income statement
 Errors affecting both the income statement and balance
sheet
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Errors Affecting Only the Balance Sheet
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A company may include a note receivable as an
account receivable or it may incorrectly record a
journal entry (e.g., a company may have debited
Accounts Receivable when it should have debited
Investments).
Because the correction of these errors only affects
the balance sheet, the company does not need to
make a correcting journal entry.
Instead, it reclassifies the affected accounts and
restates any comparative financial statements
presented.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Errors Affecting Only the Income Statement
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Errors that affect only income statement accounts
usually result from the misclassification of items.
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example, a company may include interest revenue
with sales revenue.
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Errors of this kind require reclassification but do not
affect the total amount reported as net income.
 Therefore,
if the error occurred in a prior period, the
company does not make a correcting journal entry.
 Instead, it reclassifies the affected accounts and
restates any comparative financial statements
presented.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Errors Affecting Both the Income Statement
and Balance Sheet
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An error may affect both an income statement
account and a balance sheet account, such as the
failure to accrue a liability at the end of the period.
These types of errors can be classified as
counterbalancing or noncounterbalancing.
Counterbalancing errors are those that that are
automatically corrected in the next accounting
period, even if they are not discovered.
Noncounterbalancing errors are those that are not
offset in the next accounting period.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Error Correction
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The following steps provide a basic framework for the
analysis and correction of an error:
Step 1. Analyze the original erroneous journal entry and
determine what accounts and/or amounts were recorded in
error.
 Step 2. Determine the journal entry that should have been
recorded.
 Step 3. Evaluate whether the error has caused additional
errors in other accounts.
 Step 4. Prepare the correcting entry (or entries). Any
corrections of the revenues and expenses for prior years
are recorded as adjustments to Retained Earnings.
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© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.