Chapter 21
Accounting Changes and
Error Corrections
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-2
Accounting Changes
Type of Accounting
Change
Change in Accounting
Principle
Change in Accounting
Estimate
Change in Reporting
Entity
McGraw-Hill/Irwin
Definition
Replaces one GAAP with
another GAAP
Revision of an estimate
because of new
information or new
experience
Change from reporting as
one type of entity to
another type of entity
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-3
Accounting Changes
Error corrections . . .
• Are not classified as accounting
changes.
• Do affect the income of prior
periods and require special
treatment.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-4
Accounting Changes and Error
Corrections
Retroactive
Treatment
Three Reporting
Approaches
Prospective
Treatment
McGraw-Hill/Irwin
Current
Treatment
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-5
Accounting Changes and Error
Corrections
1. Cumulative effect
of using
Retroactive
the new principle
is
Treatment
computed as of the
beginningThree
of theReporting
period
and is included
on the
Approaches
income
statement.
Prospective
2.Treatment
No restatements.
3. Report pro-forma
information.
McGraw-Hill/Irwin
Current
Treatment
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-6
Accounting Changes and Error
Corrections
1.No
restatements.
Retroactive
Treatment
2.No pro forma
statements.
Three
Reporting
Approaches
Prospective
Treatment
McGraw-Hill/Irwin
3.Effects of change is
Current
reflected in current
Treatment
and future financial
statements.
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-7
Accounting Changes and Error
Corrections
Retroactive
Treatment
Three Reporting
1.Restate prior years’ financial
Approaches
statements on a basis consistent
Prospective
Current
with
new
principle.
Treatment
Treatment
2.Cumulative effect reported in R/E
of earliest year presented.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-8
Accounting Changes
Types of Accounting Changes
Accounting Changes:
1. Changes in accounting principle
a. Most principle changes
b. Specified exceptions
Reporting Approach
Required
Current Approach
Retroactive Approach
or
Prospective Approach
2. Changes in accounting estimates Prospective Approach
3. Changes in reporting entity
Retroactive Approach*
* For changes in reporting entity, an adjustment to current beginning
Retained Earnings is not required.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-9
Change in Accounting Principle
Qualitative
Characteristics
Consistency
Comparability
Although consistency and comparability are desirable,
changing to a new method is sometimes
appropriate.
© 2004 The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
Slide
21-10
Motivation for Accounting
Choices
Effect on
Compensation
Changing
Conditions
Motivations
for Change
Effect on Debt
Agreements
New Standard
Issued
McGraw-Hill/Irwin
Effect on Union
Negotiations
Effect on
Income Taxes
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-11
Current Approach
Summary of the Current Approach
Cumulative adjustment
is reported as a
separate income
statement item below
income from
continuing operations.
McGraw-Hill/Irwin
Prior years’ results
remain unchanged.
Pro forma income
amounts are disclosed.
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-12
Current Approach
During 2005, XYZ Company made a change
from the straight-line method to the doubledeclining balance method for depreciation.
The following schedule illustrates the effect of
this change.
Depreciation
Method
2002
SL
$
30,000 $
DDB
60,000
Difference $
30,000 $
McGraw-Hill/Irwin
Expense Per Year
2003
2004
Total
30,000 $
30,000 $ 90,000
48,000
38,400 146,400
18,000 $
8,400 $ 56,400
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-13
Current Approach
A partial income statement for XYZ is as follows:
2005
Income before extraordinary items and
and accounting change
Extraordinary gain (loss), net of tax
2004
$ 81,000 $90,000
(3,000)
5,000
The company has 100,000 shares of common
stock
is taxed at 30%.
Earnings
peroutstanding
share (100,000 and
shares)
Income before extraordinary items and
How would the change in depreciation
and accounting change
$ 0.81 $ 0.90
method gain
appear
comparative
income
Extraordinary
(loss),on
netthe
of tax
(0.03)
0.05
Effect of accounting
changefor 2005 and 2004?
0.00
statements
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-14
Current Approach
Decrease in 2005 Net Income
Less: Tax Benefit [($56,400) × 30%]
$
(56,400)
(16,920)
Net Decrease in 2005
$
(39,480)
Prepare the journal
entry to record the
accounting change in
2005.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-15
Current Approach
GENERAL JOURNAL
Date
Description
Page 77
Post.
Ref.
Debit
Credit
Cumulative Effect of Change in
Accounting Principle
Deferred Tax Liability
39,480
16,920
Accumulated Depreciation
56,400
To record change in methods
Now let’s look at the impact of this
change on the income statement.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-16
Current Approach
2005
2004
Income before extraordinary items and
and accounting change
Extraordinary gain (loss), net of tax
Effect of accounting change
$ 81,000 $90,000
(3,000)
5,000
(39,480)
-
Net income
$ 38,520
Earnings per share (100,000 shares)
Income before extraordinary items and
and accounting change
Extraordinary gain (loss), net of tax
Effect of accounting change
$
Net income
$
McGraw-Hill/Irwin
$95,000
0.81 $
(0.03)
(0.39)
0.39
$
0.90
0.05
0.95
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-17
Current Approach
2005
Pro Forma Income under DDB
Income before extraordinary items and
and accounting change
2004: $90,000 - [($38,400 DDB$30,000 SL) × 70%]
2005: Actual and pro forma same
Earnings per share
Net income
2004: $95,000 - [($38,400 DDB$30,000 SL) × 70%]
2005: $38,520 + $39,480
Earnings per share
McGraw-Hill/Irwin
2004
$84,120
$ 81,000
$ 0.81
$
0.84
$89,120
$ 78,000
$ 0.78
$
0.89
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-18
Any
questions?
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-19
Retroactive Approach
Summary of the Retroactive Approach
for Specified Exceptions
Cumulative adjustment
is reported as an
adjustment to retained
earnings, beginning
balance.
McGraw-Hill/Irwin
In comparative financial
statements, prior
years’ results are
restated to reflect new
principle.
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-20
Retroactive Approach
The following accounting principle changes are
subject to the retroactive approach:
 Change to a principle required by a new pronouncement
recognized as GAAP that requires retroactive application.
 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 made when a closely held corporation first issues
financial statements to obtain equity financing for
registering securities or for effecting a business
combination.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-21
Retroactive Approach
Pro forma income amounts are required
under the retroactive approach.
a. True
b. False
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-22
Retroactive Approach
Pro forma income amounts are required
under the retroactive approach.
a. True
b. False
McGraw-Hill/Irwin
Since the retroactive approach
requires restatement of prior
years’ financial statements to
conform to the new accounting
principle, pro forma income
amounts are not required.
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-23
Prospective Approach
Summary of the Prospective Approach for
Specified Exceptions and Changes in Estimates
Prior years’ results
remain unchanged.
No cumulative
adjustment is made.
McGraw-Hill/Irwin
New estimates are
applied prospectively.
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-24
Prospective Approach
Specified exceptions that require use of the
prospective approach:
Change to LIFO from another inventory
method.
Mandated by new accounting standard.
FASB
Statement
Update
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-25
Prospective Approach
On January 1, 2002, Towing, Inc. purchased
specialized equipment for $243,000. The equipment
was depreciated using straight-line and had an
estimated life of 10 years and salvage value of
$3,000. In 2006 the total useful life of the equipment
was revised to 6 years. The 2006 depreciation
expense is
a.
b.
c.
d.
$24,000
$48,000
$72,000
$73,500
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-26
Prospective Approach
On January 1, 2002, Towing, Inc. purchased
specialized equipment for $243,000. The equipment
was depreciated using straight-line and had an
estimated life of 10 years and salvage value of
$3,000. In 2006 the total useful life of the equipment
was revised to 6 years. The 2006 depreciation
expense is
a.
b.
c.
d.
$24,000
$48,000
$72,000
$73,500
McGraw-Hill/Irwin
$243,000 – $3,000 = $24,000 (2002 – 2005)
10 years
$24,000 × 4 years = $96,000 Accum. Depr.
$243,000 – $96,000 = $147,000 Book Value
$147,000 – $3,000 = $72,000 (2006 – 2007)
2 years
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-27
I wonder why
companies make
accounting changes?
It seems like a lot of
trouble to me!
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-28
Change in Reporting Entity
Summary of the Retroactive Approach
for Changes in Reporting Entity
Prior years’ results are
restated.
No cumulative
adjustment is made.
McGraw-Hill/Irwin
Present consolidated
financial statements.
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-29
Error Correction
Examples include:
Use of inappropriate principle
 Mistakes in applying GAAP
 Arithmetic mistakes
 Fraud or gross negligence in reporting

For all years disclosed, financial statements
are retroactively restated to reflect the error
correction.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-30
Correction of Accounting Errors
Prepare a journal entry to correct any
balances.
Retroactively restate prior years’ financial
statements that were incorrect.
Report error as a prior period adjustment if
retained earnings is one of the incorrect
accounts affected.
Include a disclosure note.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-31
Prior Period Adjustments
Prior Period
Adjustment Required
Counterbalancing
error discovered in
the second year.
Noncounterbalancing
error discovered in
any year.
Use the retroactive approach.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-32
Errors Occurred and Discovered
in Same Period
Corrected by reversing the incorrect entry and
then recording the correct entry (or by
making an entry to correct the account
balances).
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-33
Previous Period Error Not
Affecting Net 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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-34
Previous Period Error Affecting
Net Income
Requires correction of previously issued
statements (retroactive approach).
All incorrect account balances must be
corrected.
Is classified as a prior period adjustment
since it does affect prior income.
Disclose nature of error.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-35
Previous Period Error Affecting
Net Income
In 2005, the accountant at Orion, Inc. discovered the depreciation
of $50,000 on a new asset purchased in 2004 had not been
recorded on the books. However, the amount was properly
reported on the tax return. This is the only difference between
book and tax income. Accounting income for 2004 was $275,000
and taxable income was $225,000. Orion, Inc. is subject to a 30%
tax rate and prepares current period statements only.
The entry made in 2004 to record income taxes was:
General Journal
Date
2004
Dec. 31
McGraw-Hill/Irwin
Description
Income tax expense
Deferred tax liability
Income tax payable
Debit
Credit
82,500
15,000
67,500
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-36
Previous Period Error Affecting
Net Income
This error affected the following accounts:
Depreciation expense for 2004 - understated
$
50,000
Accumulated depreciation for 2004 - understated
50,000
Net income in 2004 - overstated ($50,000 x 70%)
35,000
Income tax expense in 2004 - overstated
15,000
Deferred tax liability for 2004 - overstated
15,000
Remember that the 2004 expense
accounts have been closed.
General Journal
Description
Debit
Retained earnings
35,000
Deferred tax liability
15,000
Accumulated depreciation
McGraw-Hill/Irwin
Credit
50,000
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-37
Previous Period Error Affecting
Net Income
Let’s assume the following:
Retained earning as 1/1/05 was $922,000. In 2005, the
company paid $65,000 in dividends. Net income for 2005
is $184,000.
The Statement of Retained Earnings would be as follows:
Retained earnings, January 1, 2005
As previously reported
Correction of error in depreciation
Less: Income tax reduction
$
922,000
$ 50,000
15,000
(35,000)
Retained earnings as restated, January 1, 2005
887,000
Add: Net income
184,000
Less: Dividends
(65,000)
Retained earnings, December 31, 2005
McGraw-Hill/Irwin
$ 1,006,000
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-38
Correction of Accounting Errors
Identify the type of accounting error for the
following item:
Ending inventory was incorrectly counted.
a. Counterbalancing error affecting net income.
b. Noncounterbalancing error affecting net
income.
c. Error not affecting net income.
d. None of the above.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-39
Correction of Accounting Errors
Identify the type of accounting error for the
following item:
Ending inventory was incorrectly counted.
a. Counterbalancing error affecting net income.
b. Noncounterbalancing error affecting net
income.
c. Error not affecting net income.
d. None of the above.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-40
Correction of Accounting Errors
Identify the type of accounting error for the
following item:
Loss on sale of furniture was incorrectly recorded
as depreciation expense.
a. Counterbalancing error affecting net income.
b. Noncounterbalancing error affecting net
income.
c. Error not affecting net income.
d. None of the above.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-41
Correction of Accounting Errors
Identify the type of accounting error for the
following item:
Loss on sale of furniture was incorrectly recorded
as depreciation expense.
a. Counterbalancing error affecting net income.
b. Noncounterbalancing error affecting net
income.
c. Error not affecting net income.
d. None of the above.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-42
Correction of Accounting Errors
Identify the type of accounting error for the
following item:
Depreciation expense was understated.
a. Counterbalancing error affecting net income.
b. Noncounterbalancing error affecting net
income.
c. Error not affecting net income.
d. None of the above.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-43
Correction of Accounting Errors
Identify the type of accounting error for the
following item:
Depreciation expense was understated.
a. Counterbalancing error affecting net income.
b. Noncounterbalancing error affecting net
income.
c. Error not affecting net income.
d. None of the above.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-44
Correction of Accounting Errors
A prior period adjustment is not required for a
a. Counterbalancing error affecting net income
discovered in the second year.
b. Counterbalancing error affecting net income
discovered after the second year.
c. Noncounterbalancing error affecting net
income.
d. None of the above.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
21-45
Correction of Accounting Errors
A prior period adjustment is not required for a
a. Counterbalancing error affecting net income
discovered in the second year.
b. Counterbalancing error affecting net income
discovered after the second year.
c. Noncounterbalancing error affecting net
income.
d. None of the above.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
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End of Chapter 21
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.