chapter 20
Accounting
Changes and
Error Corrections
1
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.
Continued
2
Learning Objectives
3.
4.
5.
6.
Determine if a change in accounting principle requires a
cumulative adjustment relating to its effect or a restatement
of prior-periods’ financial statements, and be able to
compute the necessary adjustment.
Report pro forma results for prior years following a
business combination.
Recognize the various type of errors that can occur in the
accounting process, understand when errors counterbalance,
and be able to correct errors when necessary.
Describe the differences between the U.S. approach to
accounting changes and error corrections and the
international standard found in IFRS 8.
3
Why Are Accounting
Changes Made?
1.
2.
3.
4.
A company, as a result of experience or new
information, may change its estimates of
revenues or expenses.
Due to changes in economic conditions,
companies may need to change methods of
accounting to more clearly reflect the current
economic situation.
Accounting standard-setting bodies may require
the use of a new accounting method or
principle.
Management may be pressured to report
profitable performance. Making accounting
changes can often result in higher net income,
thereby reflecting favorably on management.
4
Effect of SFAS No. 106 –
Employers' Accounting for Postretirement Benefits Other
Than Pensions
Company
IBM
Gen. Electric
Bell Atlantic
PepsiCo
The Coca-Cola Company
Tiffany & Co.
One-Time Charge
(in millions)
$2,263
1,799
1,550
357
7
6
5
6
Accounting Changes
^ Change in accounting estimate
^ Change in accounting principle
Several alternatives have been suggested for
reporting accounting changes.
1. Restate the financial statements presented for
prior periods to reflect the effect of the
change.
2. Make no adjustment to statements prepared
for prior periods.
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Accounting Changes
3. Same as (2), except report the cumulative
effect of the change as a special item in the
income statement instead of directly to
Retained Earnings.
4. Report the cumulative effect in the current
year as in (3) but also present limited pro
forma information for all prior periods
included in the financial statements reporting
“what might have been” if the change had
been made in the prior year.
Continued
8
Accounting Changes
5. Make the change effective only for current
and future periods with no catch-up
adjustment.
Change in Accounting Estimate –
Applied Prospectively i.e. #5 on slide 8
Examples of areas where changes in accounting
estimates often are needed:
• Uncollectible receivables
• Useful lives of depreciable or intangible assets
• Residual values for depreciable assets
• Warranty obligations
• Quantities of mineral reserves to be depleted
• Actuarial assumptions for pensions or other
postemployment benefits
• Number of periods benefited by deferred costs
9
Changes in Accounting Principle
Uses approach #4 on slide 8
A change in accounting
principle involves a change
from one generally accepted
principle or method to another.
10
11
Changes in Accounting Principle
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.
12
Changes in Accounting Principle
If an asset if affected by both a
change in principle and a
change in estimation during the
same period…
…APB Opinion No. 20 requires
that the change be treated as a
change in estimation rather than a
change in principle.
Changes in Accounting Principle
Recall that approach #4 on slide 8 is used
 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.
13
14
Changes in Accounting Principle
• Telstar Company elected in 2005 to change
depreciation methods from double-declining
balance to straight-line. The income results
are summarized as:
– Net difference
$131,000
– Tax effect
(39,300)
– Net effect on income
$91,700
Continued
15
Changes in Accounting Principle
Base on these data, the journal entry to record
the cumulative effect adjustment and to
eliminate the previously recorded deferred taxes
is as follows:
Accumulated Depreciation
131,000
Deferred Tax Asset
Cumulative Effect of Change
in Accounting Principle
Continued
39,300
91,700
16
Changes in Accounting Principle
Telstar Company
Pro Forma Income Statement for 2003
Income from continuing operations $450,000
Effect of change in accounting
principle (net of tax)
19,600
Pro forma income (restated)
$469,600
Depreciation (DDB)
Depreciation (S/L)
Difference
Assume tax effect (30%)
Effect on income
Continued
$60,000
(32,000)
$28,000
(8,400)
$19,600
17
Changes in Accounting Principle
Telstar Company
Pro Forma Income Statement for 2004
Income from continuing operations $500,000
Effect of change in accounting
principle (net of tax)
21,000
Pro forma income (restated)
$521,000
Depreciation (DDB)
Depreciation (S/L)
Difference
Assume tax effect (30%)
Effect on income
Continued
$65,000
(32,000)
$30,000
(9,000)
$21,000
18
Changes in Accounting Principle
Since the release of the
SEC’s SAB 101 on
revenue recognition,
many companies have
changed their revenue
recognition practices to
be in accord with the
SEC guidelines.
SAFB No. 142
mandated the cessation
of amortization of
goodwill. This
standard also requires
firms to test for asset
impairment annually.
Restatement of Prior Periods for
Change in Principle (approach #1 on slide 8
Restatement required in the following five
circumstances:
1. A change from LIFO method of inventory
pricing to another method.
2. A change in the method of accounting for
long-term construction contracts.
3. A change to or from the full cost method of
accounting used in extractive industries.
Continued
19
Restatement of Prior Periods for
Change in Principle
4. Changes made at the time of an initial
distribution of company stock.
5. A change from retirement-replacementbetterment accounting to depreciation
accounting for railroads.
20
Restatement of 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.
21
Restatement of Prior Periods for
Change in Principle
In 2005 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 $420,000 (an $85,000
difference). Applying a tax rate of 30%,
the income tax effect is $25,500.
Continued
22
Restatement of Prior Periods for
Change in Principle
The entry in 2005 to record the prior-period
effects of the change in accounting principle
follows:
Inventory
85,000
Income Taxes Payable
25,500
Retained Earnings
59,500
To adjust the beginning
2005 inventory to its
FIFO cost.
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24
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
25
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
26
Error Corrections
Errors limited to income statement accounts.
 Debiting Office Salaries
instead of Sales Salaries
 Crediting Rent Revenue
instead of Commissions
Revenue
27
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
28
Error Corrections
Errors affecting both income statement
accounts and balance sheet accounts.
There are errors in net income
that are not detected, such as
misstatement of inventories, that
are automatically counterbalanced
in the following fiscal period.
Error Corrections
Errors affecting both income statement
accounts and balance sheet accounts.
And then, there are 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
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30
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.
31
Example of Error Correction
(1) Supply Masters, Inc., began
operations at the beginning of 2003.
Before the accounts are adjusted and
closed for 2005, it was discovered that
merchandise inventory as of December
31, 2003, was understated by $1,000.
Because this type of error counterbalances
after two years, no correcting entry is
required in 2005.
Continued
32
Example of Error Correction
If this error had been discovered in
2004 instead of 2005, the following
entry would have to be made to correct
the account balances.
Merchandise Inventory
Retained Earnings
1,000
1,000
33
Example of Error Correction
(2) It is discovered that purchase
invoices of December 31, 2003, for
$850 had not been recorded until 2004.
The goods had been included in the
inventory at the end of 2003.
Because this type of error counterbalances
after two years, no correcting entry is
required in 2005.
Continued
34
Example of Error Correction
If this error had been discovered in
2004 instead of 2005, the following
entry would have to be made to correct
the account balances.
Periodic System:
Retained Earnings
Purchases
Perpetual System:
Retained Earnings
Inventory
850
850
850
850
35
Example of Error Correction
(3) It is discovered that sales on account
of $1,800 for the last week of
December 2004 had not been recorded
until 2005. The goods were included in
the inventory at the end of 2004. The
following correcting entry would be
required in 2005.
Sales
Retained Earnings
1,800
1,800
36
Example of Error Correction
(4) Accrued sales salaries of $450 as of
December 31, 2003, 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 2005.
Continued
37
Example of Error Correction
If this error had been discovered in
2004 instead of 2005, the following
entry would have to be made to correct
the account balances.
Retained Earnings
Sales Salaries
450
450
38
Example of Error Correction
(5) It is discovered that Miscellaneous
General Expense for 2003 included
taxes of $275 that should have been
deferred in adjusting the accounts on
December 31, 2003.
Because this type of error counterbalances
after two years, no correcting entry is
required in 2005.
Continued
39
Example of Error Correction
If this error had been discovered in
2004 instead of 2005, the following
entry would have to be made to correct
the account balances.
Miscellaneous General Expense
Retained Earnings
275
275
40
Example of Error Correction
(6) Accrued interest on notes receivable
of $150 was overlooked in adjusting
the accounts on December 31, 2003.
The revenue was recognized when the
interest was collected in 2004.
Because this type of error counterbalances
after two years, no correcting entry is
required in 2005.
Continued
41
Example of Error Correction
If this error had been discovered in
2004 instead of 2005, the following
entry would have to be made to correct
the account balances.
Interest Revenue
Retained Earnings
150
150
42
Example of Error Correction
(7) Fees of $225 received in advance for
miscellaneous services as of December 31,
2004, were overlooked in adjusting the
accounts. Miscellaneous Revenue had
been credited when fees were received.
The correcting entry in 2005 is:
Retained Earnings
Miscellaneous Revenue
225
225
43
Example of Error Correction
(8) Delivery equipment was acquired at the
beginning of 2003 at a cost of $6,000. The
equipment has an estimated five-year life.
Its depreciation of $1,200 was overlooked
at the end of 2003 and 2004.
Misstatements arising from the failure to
record depreciation are not counterbalanced
in the succeeding year.
Continued
44
Example of Error Correction
When the omission is recognized, Retained
Earnings must be decreased by the net
income overstatements and Accumulated
Depreciation—Delivery Equipment must
be increased. The 2005 correcting entry is:
Retained Earnings
2,400
Accumulated Depreciation—
Delivery Equipment
2,400
$1,200 per
year x 2
45
Example of Error Correction
(9) Operating expenses of $2,000 were paid in
cash at the beginning of 2003. 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 2003 and
2004. The required correcting entry is:
Retained Earnings
Accumulated Depreciation—
Equipment
Equipment
1,200
800
2,000
Additional Thoughts About Error
Corrections
• 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.
46
Accounting Changes and Error
Corrections Under IFRS 8
Change in Accounting Estimate
The treatment under
IFRS 8 is consistent
with U.S. GAAP.
However, a change
in depreciation
method is classified
as a change in
estimate under IFRS
8 rather than a
change in principle.
Under IFRS 8, a change in
accounting principle that
results from prior periods
should be restated. This
approach is followed under
U.S. GAAP for only a
small set of accounting
changes.
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Accounting Changes and Error
Corrections Under IFRS 8
Error Corrections
The benchmark treatment for accounting for
significant error corrections under IFRS 8 is the
same as that required under U.S. GAAP.
However, IFRS 8 allows an alternative—the error
correction can be accounted for by reflecting the
effect of the error correction in income of the
period in which the error was discovered without
restating previously reported results.
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