StIce | StIce |Skousen
Accounting Changes and
Error Corrections
Chapter 20
Intermediate Accounting
16E
Prepared by: Sarita Sheth | Santa Monica College
COPYRIGHT © 2007
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
Learning Objectives
1. Understand the two different types of
accounting changes that have been
identified by accounting standard setters.
2. Recognize the difference between a
change in accounting estimate and a
change in accounting principle, and know
how a change in accounting estimate is
reflected in the financial statements.
3. Prepare the retrospective adjustment of
prior periods’ financial statements, and
any necessary cumulative adjustment,
associated with a change in accounting
principle.
Learning Objectives
4. Report pro forma results for prior
years following a business
combination.
5. Recognize the various types of errors
that can occur in the accounting
process understand when errors
counterbalance, and be able to correct
errors when necessary.
Effect of FASB
Statement No. 106
Company
One-Time Charge
(in millions)
IBM
Gen. Electric
Bell Atlantic
PepsiCo
The Coca-Cola Company
Tiffany & Co.
$2,263
1,799
1,550
357
7
6
Accounting Changes
•
Two main categories of accounting
changes:
1. Change in accounting estimate
2. Change in accounting principle
• Basic issue is if the changes should
be reported as adjustments of the
prior periods statements or only
affect current and future years.
Change in Accounting Estimate
• Accounting information can not be
measured precisely.
• Estimates may need to be revised to give a
better reflection of the business’s activities.
• Examples accounting estimate changes:
–
–
–
–
–
Uncollectible receivables
Useful lives of depreciation
Residual values of depreciable assets
Warranty obligations
Quantities of mineral reserves to be depleted
Stop and Think
Why aren’t changes in estimates
accounted for by restating prior
years’ financial statements?
Change in Accounting Estimate
All changes in estimates should be
reflected either in the current period
or in current and future periods.
No retroactive adjustments or pro
forma statements are to be prepared
for a change in estimate.
Change in Accounting Estimate
Assume Telestar Co, a telescope sales
and manufacturing firm, elected in 2008
to change from double-declining balance
method of depreciation to the straightline method to make it more consistent
with the majority of its competitors.
Depreciable assets have a cost of
$500,000 and they were all acquired on
1/1/2005 and have a useful life of 10
years with a zero salvage value. The
income tax rate is 30%.
Change of Accounting Estimate
Year
Double-DecliningBalance
Straight-Line
Depreciation Depreciation
Effect on
Difference Income
2005
$ 100,000
2006
80,000
50,000
30,000
21,000
2007
64,000
50,000
14,000
9,800
$150,000 $94,000
$65,800
$ 50,000 $ 50,000
$ 35,000
Cumulative before
2008
$244,000
Income would have been $94,000 higher leaving a net income
difference of $65,800.
No change to depreciation for 2005,2006, 2007.
Change in Accounting Principle
• A change in accounting principle
involves a change from one generally
accepted principle or method to
another.
• A change from a principle that is not
generally accepted to one that is
generally accepted is considered to be
an error correction rather than a
change in accounting principle.
Change in Accounting Principle
• Report current year’s income components on
the new basis.
• Report the cumulative effect of the
adjustment, net of tax, on the income
statement.
• Present prior period financial statements as
previously reported.
• Include pro-forma information as if the
change were retroactive—direct and indirect
effects.
• Present earnings per share data for all prior
periods presented.
Restatement for Prior Periods
for Change in Principle
• A change from LIFO method of inventory
pricing to another method.
• A change in the method of accounting for
long-term construction contracts.
• A change to or from the full cost method of
accounting used in extractive industries.
• Changes made at the time of an initial
distribution of company stock.
• A change from retirement-replacementbetterment accounting to depreciation
accounting for railroads.
Restatement for Prior Periods
for Change in Principle
• Change to LIFO—past
records often inadequate
to prepare pro-formas.
• Beginning inventory
becomes first LIFO layer.
• No cumulative effect
adjustment is required.
Restatement for Prior Periods
for Change in Principle
In 2008 Forester Company changed
from the LIFO inventory costing
method to the FIFO method for both
financial reporting and income tax
purposes. At this time LIFO costing
provided a pretax income of
$335,000. By converting to FIFO,
this pretax income is $335,000 (an
$85,000 difference). Applying a tax
rate of 30%, the income tax effect is
$25,500.
Restatement for Prior Periods
for Change in Principle
The entry in 2008 to record the priorperiod effects of the change in accounting
principle follows:
Inventory
85,000
Income Taxes Payable
25,500
Retained Earnings
59,500
To adjust the
beginning 2008
inventory to its FIFO
cost.
Pro Forma Disclosures after a
Business Combination
On December 31, 2008, Sump
Pump Company acquired Rock
Wall Company for $500,000. This
amount exceeded the recorded
value of Rock Wall Company’s net
assets by $100,000. The entire
excess was attributed to a piece of
Rock Wall’s equipment that had a
remaining useful life of five years
as of the acquisition date.
Pro Forma Disclosures after a
Business Combination
Information reported on the two companies for
2007 and 2008 was as follows:
2008
2007
Sump Pump Company:
Revenue
$3,500,000$3,000,000
Net income
250,000
200,000
Rock Wall Company:
Revenue
$250,000 $400,000
Net income
40,000
75,000
Pro Forma Disclosures after a
Business Combination
The pro forma information included in the notes
to Sump Pump Company’s 2008 financial
statements is:
2008
Combined
Results
Revenue
Net income
$3,500,000
250,000
2007
Combined
Results
Revenue
Net income
$3,000,000
200,000
2008 Results
for Combined
Companies
$3,750,000
270,000
2007 Results
for Combined
Companies
$3,400,000
255,000
Error Corrections
Errors discovered currently in the
course of normal accounting
procedures.
• Math errors
• Posting to the wrong
account
• Misstating an account
• Omitting an account
from the trial balance
Error Corrections
Errors limited to balance sheet
accounts.
• Debiting Accounts Receivable
instead of Notes Receivable
• Crediting Interest Payable instead
of Notes Payable
• Debiting an investment account
instead of Land when property was
purchased for plant expansion
Error Corrections
Errors limited to income statement
accounts.
• Debiting Office Salaries instead of
Sales Salaries
• Crediting Rent Revenue instead of
Commissions Revenue
Error Corrections
Errors affecting both income
statement accounts and balance sheet
accounts.
• Debiting Office Equipment instead
of Repairs Expense
• Crediting Depreciation Expense
instead of Accumulated
Depreciation
Error Corrections
Errors affecting both income
statement accounts and balance sheet
accounts.
• Debiting Office Equipment instead
of Repairs Expense
• Crediting Depreciation Expense
instead of Accumulated
Depreciation
Error Corrections
Errors affecting both income statement accounts
and balance sheet accounts.
• There are errors in net income that, when not
detected, are not automatically
counterbalanced in the following fiscal period.
• There are also errors in net income that,
when not detected, are not automatically
counterbalanced in the following fiscal period:
•Recognition of capital expenditures as expenses.
•The omission of charges for depreciation and
amortization.
Error Corrections
• If detected in current period, before books
are closed:
– Correct the account through normal
accounting adjustment.
• If detected in subsequent period, after
books are closed:
– adjust financial records for effect of
material errors.
– make adjustment directly to Retained
Earnings.
Example of Error Corrections
(1) Understatement of Merchandise
Inventory:
Supply Masters, Inc., began operations
at the beginning of 2006. Before the
accounts are adjusted and closed for
2008, it was discovered that
merchandise inventory as of
December 31, 2006, was understated
by $1,000.
Because this type of error counterbalances after two
years, no correcting entry is required in 2008.
Example of Error Corrections
If this error had been discovered in
2007 instead of 2008, the following
entry would have to be made to
correct the account balances.
Merchandise Inventory
Retained Earnings
1,000
1,000
Example of Error Corrections
(2) Failure to Record Merchandise
Purchases
It is discovered that purchase invoices of
December 31, 2006, for $850 had not
been recorded until 2007. The goods had
been included in the inventory at the end
of 2006.
Because this type of error counterbalances after
two years, no correcting entry is required in 2008.
Example of Error Corrections
If this error had been discovered in
2007 instead of 2008, the following
entry would have to be made to
correct the account balances.
Periodic System:
Retained Earnings
Purchases
850
Perpetual System:
Retained Earnings
Inventory
850
850
850
Example of Error Corrections
(3) Failure to Record Merchandise
Sales
It is discovered that sales on account of
$1,800 for the last week of December 2007
had not been recorded until 2008. The
goods were included in the inventory at the
end of 2007. The following correcting entry
would be required in 2008.
Sales
Retained Earnings
1,800
1,800
Example of Error Corrections
(4) Failure to Record Accrued Expense
Accrued sales salaries of $450 as of
December 31, 2006, were overlooked
in adjusting the accounts. Sales
Salaries is debited for salary
payments.
Because this type of error counterbalances
after two years, no correcting entry is required
in 2008.
Example of Error Corrections
If this error had been discovered in
2007 instead of 2008, the following
entry would have to be made to
correct the account balances.
Retained Earnings
Sales Salaries
450
450
Example of Error Corrections
(5) Failure to Record Prepaid Expense
It is discovered that Miscellaneous
General Expense for 2006 included
taxes of $275 that should have been
deferred in adjusting the accounts on
December 31, 2006.
Because this type of error counterbalances
after two years, no correcting entry is required
in 2008.
Example of Error Corrections
If this error had been discovered in
2007 instead of 2008, the following
entry would have to be made to
correct the account balances.
Miscellaneous General Expense 275
Retained Earnings
275
Example of Error Corrections
(6) Failure to Record Accrued Revenue
Accrued interest on notes receivable of $150
was overlooked in adjusting the accounts
on December 31, 2006. The revenue was
recognized when the interest was collected
in 2007.
Because this type of error counterbalances
after two years, no correcting entry is required
in 2008.
Example of Error Corrections
If this error had been discovered in
2007 instead of 2008, the following
entry would have to be made to
correct the account balances.
Interest Revenue
Retained Earnings
150
150
Example of Error Corrections
(7) Failure to Record Unearned
Revenue
Fees of $225 received in advance for
miscellaneous services as of December
31, 2007, were overlooked in adjusting
the accounts. Miscellaneous
Revenue had been credited when fees
were received. The correcting entry in
2007 is:
Retained Earnings
Miscellaneous Revenue
225
225
Example of Error Corrections
(8) Failure to Record Depreciation
Delivery equipment was acquired at the
beginning of 2006 at a cost of $6,000.
The equipment has an estimated fiveyear life. Its depreciation of $1,200 was
overlooked at the end of 2006 and 2007.
Misstatements arising from the failure to
record depreciation are not
counterbalanced in the succeeding year.
Example of Error Corrections
When the omission is recognized, Retained
Earnings must be decreased by the net
income overstatements and Accumulated
Depreciation—Delivery Equipment must
be increased. The 2008 correcting entry is:
Retained Earnings
2,400
Accumulated Depreciation—
Delivery Equipment
2,400
$1,200 per
year x 2
Example of Error Corrections
(9) Incorrectly Capitalizing an
Expenditure Operating expenses of $2,000
were paid in cash at the beginning of 2006.
The payment was incorrectly debited to
Equipment. The “equipment” was assumed
to have a five-year life and no residual value;
thus, depreciation of $400 was recognized at
the end of 2006 and 2007. The required
correcting entry is:
Retained Earnings
Accumulated Depreciation—
Equipment
Equipment
1,200
800
2,000
Required Disclosure for Error
Restatements
• If comparative
statements are provided,
apply correction
retroactively to prior
years.
• Restate beginning
balance of Retained
Earnings for first period
presented if error
extends beyond.
• Disclose and explain
error correction in notes.