Intermediate
Financial Accounting
Accounting Changes and
Error Corrections
by Professor Hsieh
Objectives of the Chapter
I. To learn the types of accounting
changes.
II. To study the accounting treatments of
accounting changes.
III. To analyze the accounting errors and
to learn the accounting treatments of
errors.
Accounting Changes & Error Corrections
2
I. Types of Accounting Changes
A. Changes in Accounting Principle
(Method).
B. Changes in Accounting Estimate.
C. Changes in Reporting Entity.
Accounting Changes & Error Corrections
3
Examples of Changes in Accounting
Principle (Method)
Changes from one acceptable
accounting method to another
acceptable accounting method.
Examples:

adopting a new accounting standard.

changes in inventory method.

changes from P-O-C method to C-C
method for long-term construction
projects.
Accounting Changes & Error Corrections
4
Examples of Changes in Accounting
Estimates

Changes in the estimates of:
a. useful lives and salvage values of
depreciable assets;
b. uncollectible accounts expense;
c. liabilities for warranty costs, and
income taxes.
Note: Under SFAS 154,changes in
depreciation method is considered
as changes in accounting estimates.
Accounting Changes & Error Corrections
5
Examples of Changes in Reporting
Entity
1. Presenting consolidated statements for
the first time to replace individual
statements.
2. Changing subsidiaries that are
included in consolidated F/S.
Accounting Changes & Error Corrections
6
II. Accounting Treatments for
Accounting Changes


Three approaches had been suggested:
1.Current-Period Approach (eliminated
by SFAS 154).
2.Retrospective Approach (applied to
voluntary accounting method
changes and changes in reporting
entity).
3.Prospective approach (applicable
for accounting estimate change).
Accounting Changes & Error Corrections
7
1. Current-Period Approach
(Eliminated by SFAS 154)

The cumulative effect of all prior years
resulting from adoption of the new method is
reported in the current year’s income
statement.
F/S of prior years should not be restated.
Net income and earnings per share,
computed on a pro-forma basis (as if the
new method were adopted) are shown on
the I/S for all periods that appear on the I/S.

Accounting Changes & Error Corrections
8
Current Period Approach (Eliminated)


This approach has been eliminated by
SFAS 154.
SFAS 154 was issued in May 2005,
and became effective for fiscal years
beginning after 12/15/2005.
Accounting Changes & Error Corrections
9
Current-Period Approach (contd.)
(skip)


Advantages
a. Less costly.
b Will not affect the financial ratios of prior
years.
c. No change in prior years’ earnings.
Disadvantages
a. It has significant impact on current year’s
income.
b. Loss comparability among financial
statements (F/S) of different years.
Accounting Changes & Error Corrections
10
2. Retrospective Approach


A retrospective adjustment of the F/S
(i.e., restatement of F/S) is made for prior
years as if the new method were used.
Cumulative effect for the non-restated
prior years is reported in the statement of
retained earnings (not income statement)
as an adjustment.
Accounting Changes & Error Corrections
11
Retrospective Approach (contd.)


Advantages
a. It results in comparable F/S.
b. It has no significant impact in the
current year’s income statement.
Disadvantages
a. It is costly to restate F/S.
b. It has a potential in violating loan
covenant.
Accounting Changes & Error Corrections
12
3. Prospective Approach



No cumulative effect is reported in
any financial statements (F/S).
No prior statements are restated.
The new method is applied to the
f/S of the current year and future
years.
Accounting Changes & Error Corrections
13
The Treatments for Changes in
Accounting Method (skip)


Prior to APB Opinion No. 20
(Accounting Changes, effective
7/31/1971), all three approaches were
acceptable for changes in accounting
method.
APB 20 only allows the current period
approach and the retrospective
approach for accounting method
changes (except for five situations in which
the retrospective approach must be used).
Accounting Changes & Error Corrections
14
The Treatments for Changes in
Accounting Method (contd.)


Under SFAS 154 (effective 2006), the
only acceptable treatment for voluntary
accounting method changes is the
retrospective approach.
SFAS 154 eliminated the current period
approach except when proscribed by
new accounting standards.
Accounting Changes & Error Corrections
15
The Treatment for Changes in
Accounting Method (contd.)



Reasons of eliminating the current
period approach under SFAS 154:
Toward global convergence of
accounting standards;
Improve the comparability of financial
statements.
Accounting Changes & Error Corrections
16
The Treatment for Changes in
Accounting Estimates


The prospective approach is only
acceptable for changes in accounting
estimates, NOT for changes in
accounting method.
However, a deprecation method change
is treated as an estimate change under
SFAS 154. Thus, the prospective
approach is applied to deprecation
method change.
Accounting Changes & Error Corrections
17
Reasons for Changes in Accounting
Method

Reasons for changes in accounting
method:
1. Changes in economic environment.
2. Mandated by a new accounting standard
(i.e., recognition of post retirement
benefit expenses on an accrual basis);
3. Changes in technology.
4. Economical Reasons (see p66 for
details).
Accounting Changes & Error Corrections
18
Change in Accounting Method - An
Example



On 1/1 20x2, Doherty Corporation
purchased a machine for $110,000. A 10year economic life and zero residual value
were expected for this machine.
The sum-of-the-years’-digits method had
been used for depreciation purposes starting
20x2.
On 1/1/ 20x6, the depreciation method was
changed to straight line method. The income
tax rate is 30%.
Accounting Changes & Error Corrections
19
Change in Accounting Method
Example (contd.) – A Note



SFAS 154 requires that the changes in
depreciation methods be treated as an
estimate change.
Thus, a prospective approach should be
applied for such a change.
However, for illustration and comparison
purposes, the current period,
retrospective and the prospective
approaches are applied for this change.
Accounting Changes & Error Corrections
20
Example (contd.)-Depreciation Expense under
the Old Method (SYD) vs. New Method (S-L)
SYD
20x2
20x3
20x4
20x5
$20,000
18,000
16,000
14,000
$68,000
S-L
Diff.
$11,000
11,000
11, 000
11,000
44,000
Diff.(net) C.Eff.(net)
$9,000 6,300 6,300
7,000 4,900 11,200
5,000 3,500 14,700
3,000 2,100 16,800
$24,000 16,800
Diff (net).= difference, net of income tax ;C.Eff (net)=
cumulative effect, net of income tax.
For 20x6, the depre. Expense is $12,000 and
$11,000 under SYD and S-L, respectively. The
difference is $1000 (or $700 net of 30% tax)
Accounting Changes & Error Corrections
21
Example – A Current Period Approach
(this approach has been eliminated by SFAS 154)
Cumulative Effect= $68,000-44,000=$24,000
Net Cum. Effect = 24,000x (1-30%)= $16,800
JE to reflect this change applying the current
period approach (assuming a 30% income tax
rate):
Accumulated Depreciation 24,000
Cumulative Effect of
Change in Acct. Method-Depre. 16,800
Deferred Income Tax Lia.
7,200
Accounting Changes & Error Corrections
22
Example (contd.)- A Current Period Approach
Comparative Income Statements*
20x6
20x5
20x4
Revenues
$50,000 $50,000 $50,000
Depr. Exp. (Note A) (11,000) (14,000) (16,000)
Other expe.
(10,000) (10,000) (10,000)
Income taxes
(8,700)
(7,800)
(7,200)
Income before changes
in acct. principle
$20,300
Cumulative effect
16,800
Net income
$37,100 $18,200 $16,800
Earnings per share
$3.71
$1.82
$1.68
Pro Forma (Note A)
Net income
$20,300 $20,300 $20,300
Earnings per share
$2.03
$2.03
$2.03
*Assume a 30% tax rate and 10,000 shares outstanding.
Accounting Changes & Error Corrections
23
Comparative Retained Earnings
Assuming a retained earnings balance of $140,000
at the beginning of 20x4 and a dividends of $20,000
for years 20x4-20x6, the following statements of
retained earnings will be in the 20x6 annual report:
20x6
20x5
20x4
Balance at beg.(R/E) $135,000 136,800 140,000
Net income4
37,100 18,200 16,800
Cash dividens
(20,000) (20,000) (20,000)
Balance at end of year 152,100 135,000 136,800
Accounting Changes & Error Corrections
24
Example (contd.)-A Current Period
Approach

Note A:
Prior to 20x6, Doherty used sum-ofthe-years’-digits depreciation on its
plant assets. In 20x6 Doherty changed
to the straight-line method of
depreciation, which management felt
better represented the service
expiration of its plan assets..
Accounting Changes & Error Corrections
25
Example (contd.)-A Current Period
Approach

Note A (contd):
The cumulative effect of the change in
accounting principle of $16,800 (net of
I/T) has been included in 20x6 net
income. The effect of this change on
income of 20x6 was an increase of $700
(net of I/T). The pro forma data report
what would have been had the straightline method been used prior to 20x6.
Accounting Changes & Error Corrections
26
Example: A Retrospective Approach



The F/S of prior years (i.e., two years) are
restated on a basis consistent with the new
method.
The cumulative effect of the non-restated
prior years is reported in the statement of
retained earnings.
This part of cumulative effect is treated as
an adjustment of beginning retained
earnings of the earliest year presented.
Accounting Changes & Error Corrections
27
Example - A Retrospective Approach

Using the example on page 19 except applying the
retrospective approach, the following comparative
I/S will be reported on the 20x6 annual report:
20x6
Revenues
Depr. Exp.(Note A)
Other Expe.
Income Taxes
Net Income
Earnings per share
$50,000
(11,000)
(10,000)
(8,700)
$20,300
$2.03
20x5
20x4
(restated) (restated)
$50,000 $50,000
(11,000) (11,000)
(10,000) (10,000)
(8,700)
(8,700)
$20,300 $20,300
$2.03
$2.03
Accounting Changes & Error Corrections
.
28
A Retrospective Approach (contd.)
Note A:



Prior to 20x6, Doherty used sum-of- the-years’digits depreciation on its plant assets.
In 20x6 Doherty changed to the straight-line
method of depreciation, which management felt
better represented the service expiration of its
plan assets.
The financial statements of 20x4 and 20x5 have
been restated to reflect this change.
Accounting Changes & Error Corrections
29
A Retrospective Approach (Contd.)



Note A (contd.):
The effect of this change on income of 20x6
was an increase of $700 (net of income tax)
and on income of 20x5 and 20x4 was an
increase of $2,100 and $3,500 (net of
income tax), respectively.
The balances of retained earnings of 20x4
and 20x5 have been adjusted for the effect
of applying retrospectively the new method.
Accounting Changes & Error Corrections
30
Example (contd.)-Depreciation Expense under
the Old Method (SYD) vs. New Method (S-L)
SYD
20x2
20x3
20x4
20x5
$20,000
18,000
16,000
14,000
$68,000
S-L
Diff.
$11,000
11,000
11, 000
11,000
44,000
Diff.(net) C.Eff.(net)
$9,000 6,300 6,300
7,000 4,900 11,200
5,000 3,500 14,700
3,000 2,100 16,800
$24,000 16,800
Diff (net).= difference, net of income tax ;C.Eff (net)=
cumulative effect, net of income tax.
For 20x6, the depre. Expense is $12,000 and
$11,000 under SYD and S-L, respectively. The
difference is $1000 (or $700 net of 30% tax)
Accounting Changes & Error Corrections
31
A Retrospective Approach (contd.)

The entry to reflect this accounting change
under the retrospective approach of 20x6 is:
Accu. Depr.
24,000
Retained Earnings
16,800
Deferred Income tax Lia.
7,200
Accounting Changes & Error Corrections
32
A Retrospective Approach (contd.)
Assuming a retained earnings balance of $140,000
at the beginning of 20x4 and a dividends of $20,000
for years 20x4-20x6, the following statements of
retained earnings will be in the 20x6 annual report:
20x6
20x5
20x4
Balance at beg.(R/E) $135,0002 136,8001 140,000
Adjustment for the
Cum. effect 3
16,800 14,700 11,200
Adjusted balance
$151,800 151,500 151,200
Net income4
20,300 20,300 20,300
Cash dividens
(20,000) (20,000) (20,000)
Balance at end of year 152,100 151,800 151,500
Accounting Changes & Error Corrections
33
Example (contd.)
1. 140,000 + 16,800 - 20,000 = 136,800 (See
p23 for unadjusted net income of x4.)
2. 136,800 + 18,200 - 20,000 = 135,000 (See p
23 for unadjusted net income of x5)
3. Cumulative difference (effect), see p31.
4. Restated net income to reflect the change
of depreciation method made in 20x6, see
p28 for restated net income for 20x4 and
20x5.
Accounting Changes & Error Corrections
34
Change in Depreciation Method
A Prospective Approach
Under SFAS 154, a prospective approach
should be applied to a change in
depreciation method.
Thus, the change from a SYD depreciation
to a straight-line deprecation would not
result in any restatement of prior years’
financial statements.
The new depreciation method would only
be applied for years of 2006 - 2011.
Accounting Changes & Error Corrections
35
Change in Depreciation Method
A Prospective Approach (contd.)
The annual depreciation expense for 20062011 is:
($110,000-$68,000)/ (10-4) = $7,000
Note: Prior to 20x6, Doherty used sum-ofthe-years’-digits depreciation on its plant
assets. In 20x6 Doherty changed to the
straight-line method of depreciation, which
management felt better represented the
service expiration of its plan assets.
Accounting Changes & Error Corrections
36
Change in Depreciation Method
A Prospective Approach (contd.)
Note (contd): The effect of this change on
income of 20x6 is an increase of $3,500a
(net of 30% income taxes).
a. The depreciation expense of 2006 would
have been $12,000 under the SYD (the old
method) while it is $7,000 under the
straight-line method (the new method).
Accounting Changes & Error Corrections
37
Change in Accounting Method - Inventory
Cost Method Change Example (Example 20-1 of
Spiceland, etc. with some revisions)


Air Parts Corporation used the LIFO
inventory costing method. At the
beginning of 2006, Air Parts decided to
change to the FIFO method.
Under SFAS 154, the retrospective
approach is applied for all voluntary
accounting method change except for the
change in depreciation method.
Accounting Changes & Error Corrections
38
Changes in Inventory Cost Flow
Assumption (contd.)





Additional information:
The company has paid dividends of $40
million each year beginning 1999.
The income tax rate is 40%.
Retained earnings on January 1, 2004
was $700 million.
$Inventory on January 1, 2004 was $500
million.
Accounting Changes & Error Corrections
39
Cost Flow Assumption Change
(Contd.)-A Retrospective Approach
The income statements of 2004, 2005 and 2006
are as follows (under LIFO assumption):
($ in millions)
20x6
20x5
20x4
Revenues
$950
$900
$875
CGS (LIFO)
(430)
(420)
(405)
Operating expenses (230)
(210)
(205)
Pre-tax Income
290
270
265
Income taxes
(116)
(108)
(106)
Net income
$174
$162
$159
.
Accounting Changes & Error Corrections
40
Cost Flow Assumption Change
(Contd.)-A Retrospective Approach
The statement of retained earnings of
2004 and and 2005 are as follows (under
(LIFO)) ($ in millions):
R/E (Beg. Bal.)
Net Income
Dividends
R/E (End. Bal.)
20x5
$819
162
(40)
$941
20x4
$700
159
(40)
$819
.
Accounting Changes & Error Corrections
41
Cost Flow Assumption Change (Contd.)
cost of Goods Sold ($ in millions)
LIFO FIFO
Diff. C. D.. Net.C.D.
PY $2,000 $1,700 $300 $ 300
180
20x4
405
360
45
345
207
20x5
420
365
55
400
240
$2,825 $ 2,425 $400
 PY = previous years.
C.D.=cumulative difference.
Net C.D.= cumulative difference, net of
income tax of 40%.
For
2006, The CGS is $430 million and $370
million under LIFO and FIFO, respectively. The
CGS difference is $60 million for 2006.
Accounting Changes & Error Corrections
42
Change in Cost Flow Assumption (contd.)

The cumulative difference of CGS
from the change of LIFO to FIFO
inventory method is equivalent to the
impact of this change on the inventory.
Accounting Changes & Error Corrections
43
Change in Cost Flow Assumption (contd.)

Since the cumulative difference of CGS
is $345 and $400 million lower for 20x4
and 20x5, respectively, the inventory for
2004 and 2005 would be $345 million and
$400 million higher under FIFO than
under LIFO, respectively.
Accounting Changes & Error Corrections
44
Change in Cost Flow Assumption (contd.)

For 2006, cumulative difference of CGS
would be $460 million lower (i.e., $400
million + $60 million), the inventory of
2006 would be $460 million higher under
FIFO than under LIFO.
Accounting Changes & Error Corrections
45
Cost Flow Assumption Change –A
Retrospective Approach
The cumulative difference of CGS up to 2005
equals:
$2,825-2,425 or 300+45+55 = 400
(million)
The journal entry to record the change from LIFO to
FIFO :
1/1 2006
Inventory
400
Retained Earnings
240
Deferred Income Tax Lia.
160
*assuming a 40% income tax rate
Accounting Changes & Error Corrections
46
Comparative Income Statements-A
Retrospective Approach
20x6
Revenues
$950
CGS (FIFO)
(370)
Operating expenses (230)
Pre-tax Income
350
Income taxes1
(140)
Net income
$210
20x5
20x4
restated restated
$900
$875
(365)
(360)
(210)
(205)
325
310
(130)
(124)
$195R $186R
1Assume a 40% tax rate.
R. Restated net income for 20x4 and 20x5.
Accounting Changes & Error Corrections
47
Comparative Retained Earnings
Statement -A Retrospective Approach
Assuming a retained earnings balance of $700
million at the beginning of 20x4, the following
statement of retained earnings will be in the 20x6
annual report ($ in millions):
20x6
20x5
20x4
Balance at beg.(R/E)1
$941
819
700
Adjustment for the
Cum. difference2
240
207
180
Adjusted Beg. Balance $1,181 $1,026
$880
Net income3
210
195
186
Dividens
(40)
(40)
(40)
Balance at end of year $1,351 $1,181 $1,026
Accounting Changes & Error Corrections
48
Comparative Retained Earnings
Statement (contd.)
Notes:
1.Begining Retained earnings under the old
method (i.e., the unadjusted), see p41.
2.Cumulative difference, net of income tax,
see p42.
3. Net income under the new method (i.e.,
LIFO) for 2006 and restated net income (i.e.,
under LIFO) for 2005 and 2004, see p47.
Accounting Changes & Error Corrections
49
Change to LIFO Method (An Exception)

When change from other inventory
method to LIFO, a prospective approach
is applied when a retrospective
adjustment is impractical.

No cumulative effect will be reported in
the income statement and no
restatement of prior years’ F/S.
Accounting Changes & Error Corrections
50
Change to LIFO Method –contd.

The base-year inventory for all
subsequent LIFO calculations is the cost
of opening inventory in the year the
method is adopted.

The base-year inventory needs to be
adjusted back to the cost.
Accounting Changes & Error Corrections
51
Examples of Changes in Accounting
Estimates

Changes in:
a. useful lives and salvage values of
depreciable assets;
b. uncollectible accounts expense;
c. liabilities for warranty costs, and
income taxes;
d. periods benefited by deferred costs;
Accounting Changes & Error Corrections
52
Examples of Changes in Accounting
Estimates (contd.)

e. inventory obsolescence;
f . liabilities of employee related benefits;
Note (an exception): Under SFAS
154,changes in depreciation method is
considered as an estimate change.
Accounting Changes & Error Corrections
53
Changes in Accounting Estimate
Accounting Treatment



A prospective approach is applied for
changes in accounting estimates.
The effect of the change on current
year’s income will be disclosed in the
footnotes.
SFAS 154 requires to apply the
prospective approach for the changes
in depreciation method.
Accounting Changes & Error Corrections
54
How to Distinguish Changes In
Estimates from an Error?

Changes in estimate are changes made
based on new information not available
before, Not based on information
overlooked in prior period (i.e., an error).
Accounting Changes & Error Corrections
55
Changes in Estimates
Example of Changes in Estimates

Change the bad debt exp. estimation from 2%
to 4% of the net sale in 20x6. The net sale of
20x6 amounts to $50,000.
12/31/x6 Bad debt exp.
2,000
Allow. for bad debt
2,000
Note: Due to the accounting estimate change,
the bad debt expense is increased from
$1,000 (at 2%) to $2,000 (at 4%). The net
impact (net of income tax credit) from this
change is a $700 decrease in net income of
20x6.
Accounting Changes & Error Corrections
56
Changes in Estimates
Example of Changes in Estimates (contd.)

Machine costing $15,000 was purchased on
1/1/x4 with estimated life of 5 years and zero
residual value. The straight-line method was
used for depreciation. On 1/1/x6, the estimated
life of the machine had been changed to 6
years and the residual value had been changed
to $1,000 due to new information available.
 Book value of the machine on 1/1/x6:
(15,000-6000) =9,000
 Depreciation expense for 20x6, 20x7,20x8,
and 20x9:
($9,000 -$1,000) / (6-2) = $2,000
Accounting Changes & Error Corrections
57
Example B (contd.)
12/31/x6
Depr. Exp.
2,000
Acc. Depr.
2,000
Note: Due to the accounting estimate changes
on the estimated life and the salvage value of
machine purchased on 1/1/x4, the
depreciation expense of 20x 6 is decreased
by $1,000. The net of income tax effect is a
$700 increase in net income of 20x6.
Accounting Changes & Error Corrections
58
Changes In Reporting Entity

The treatment is to restate the F/S of
all prior periods presented (for
comparability).
Accounting Changes & Error Corrections
59
Examples of Changes in Reporting
Entity
1. Presenting consolidated statements for the
first time to replace individual statements.
2. Changing subsidiaries that are included in
consolidated F/S (i.e. with new mergers or
spin offs).
3. A change in the accounting for investments
(i.e., change to the equity method or
change from equity to consolidation).
Accounting Changes & Error Corrections
60
Examples of Changes in Reporting
Entity (contd.)
An example of changes in reporting entity:
In adopting SFAS 94 (“Consolidation of All
Majority-Owned Subsidiaries”), HewlettPackard Company (HP) consolidated the
accounts of its wholly owned subsidiary,
Hewlett-Packard Finance Company,
previously accounted for under the equity
method, with accounts of HP. HP restated its
prior years’ consolidated financial statements
to reflect this change for comparative
purposes.
Accounting Changes & Error Corrections
61
Motivations for Changes and
Income Management

Management often changes accounting
methods not for conceptual reasons (i.e.,
to improve the fairness of financial
statements), but rather for economic
reasons (for economic consequence).
Accounting Changes & Error Corrections
62
Motivations for Changes and
Income Management

The followings are possible reasons
suggested by academic research in
explaining why companies prefer certain
accounting methods:
1. Political Costs.
2. Capital Structure (maintain D/E ratio).
3. Bonus Payments.
4. Income Smoothing.
5. Labor Renegotiation Costs.
Accounting Changes & Error Corrections
63
III. Error Analysis

Questions need to be addressed:
1. What type of error is involved?
2. What entries needed to correct the
error?
3. How would the financial statements
be restated when the error is
discovered?
Accounting Changes & Error Corrections
64
Correction of an Error Made in Prior
Years (prior period adjustments, SFAS No. 16):
Examples of accounting errors:
1. A change from an incorrect accounting
principle (not GAAP) to a GAAP.
2. Mathematical mistakes.
3. Changes in estimates which were not
prepared in good faith.
4. A misuse of facts (i.e., failure to
consider salvage value in depreciation).
Accounting Changes & Error Corrections
65
Correction of an Error Made in Prior
Years (contd.)
Examples of accounting errors (contd.):
5. An oversight (i.e., failure to accrue
expense at year end).
6. An incorrect classification of a cost as
an expense (i.e., improper
capitalization).
Accounting Changes & Error Corrections
66
General Treatments for Prior Years’
Errors
The corrections of errors in previously
issued financial statements are referred
to as prior period adjustments.
 The corrections are made to Retained
Earnings and are reported as
adjustments to the beginning balance of
current year’s retained earnings.
Accounting Changes & Error Corrections
67
General Treatments for Prior Years’
Errors (contd.)
 If comparative F/S are presented, the
prior affected statements should be
restated to correct the errors.
Accounting Changes & Error Corrections
68
Types of Errors
1. Balance Sheet Errors.
2. Income Statement (I/S) Errors.
3. Balance Sheet and Income
Statement Effects.
Accounting Changes & Error Corrections
69
1. Balance Sheet Errors

Errors affect only the presentation of
accounts on the B/S statement (i.e.,
classification of notes payable as accounts
payable or inventory as plant assets).
Procedures of correction:
a. reclassification of the item to its proper
position.
b. If comparative statements that include the
error year are presented, the B/S of the
error year is restated correctly.
Accounting Changes & Error Corrections
70
2. Income Statement (I/S) Errors

Errors affect only accounts on the I/S
(i.e, recording interest revenue as
sales revenue, depre. exp. as interest
exp., etc.)
Impact: no impact on the net income
or the B/S.
Accounting Changes & Error Corrections
71
2. Income Statement (I/S) Errors (contd.)

Accounting Treatment:
a.If the error is discovered in the year it is
made, just do a reclassification.
b.If the error occurred in prior years, no
entry is needed at the date of discovery
because all accounts for the current
year is correctly stated including the
beg. balance of the retained earnings.
.
Accounting Changes & Error Corrections
72
2. Income Statement (I/S) Errors (contd.)

Accounting Treatment (contd.):
If comparative statements that include
the error year are presented, the I/S
for the error year is restated correctly.
Accounting Changes & Error Corrections
73
3. Balance Sheet and
Income Statement Effects


The errors involve both B/S and I/S
accounts (i.e., the accrued wages were
overlooked at the end of the year).
This type of errors can be further
classified as:
a. Counterbalancing errors.
b. Noncounterbalancing errors.
Accounting Changes & Error Corrections
74
a. Counterbalancing Errors



Errors that will be offset or corrected over
two periods.
If books of the second year (the year
following the error year) were closed, no
adjustments are needed for the correction
because the error has already been
corrected in the second year.
Most of B/S and I/S effect type of errors are
counterbalancing errors.
Accounting Changes & Error Corrections
75
b. Noncounterbalancing Errors


These errors do not counterbalance
over 2-year period (no self-correction
in two years).
Therefore, entries are needed even if
the books have been closed for the
year following the error.
Accounting Changes & Error Corrections
76
Example 1

Counterbalancing Errors
Failure to record accrued wages of $5,000
in 20x5. This error was discovered in 20x6.
Impact of this error on wages expense, net
income (N/I) and wages liabilities of 20x5
and 20x6 assuming this liability of $5,000
has been paid in 20x6:
Wages Exp.
N/I
Wages Lib.
20x5
under
over
under
20x6
over
under correctly stated
2-year
correct
correct correctly stated
combined
at end of 20x6
Accounting Changes & Error Corrections
77
Example 1 (contd.)

Accounting Treatment:
a. If the books of 20x6 have been closed,
no entry is necessary.
b. If the books of 20x6 have not been
closed, the entry in 20x6 to correct the
error is:
12/31/x6 Retained Earnings
5,000
Wages Expense
5,000
Accounting Changes & Error Corrections
78
Example 1 (contd.)


Rational: When the accrued wages of 20x5
are paid in 20x6, an additional debit of $5,000
is made to 20x6 wage expense (i.e., instated
of debit to wages payable, it was debited to
wages expense). Thus, the wages exp. of
20x6 is overstated by $5,000.
Also, because accrued wages expense of
$5,000 was not recorded in 20x5, the net
income of 20x5 was overstated by $5,000 and
the retained earnings accounting of 20x5 were
overstated by $5,000.
Accounting Changes & Error Corrections
79
Counterbalancing Errors
Example 2

Sanbor has failed to accrued wages payable
at the end of the last three years as follows:
12/31/20x4
12/31/20x5
12/31/20x6
$1,600
$3,000
$2,400
Impact of these errors on net income of 20x4,
20x5, and 20x6:
20x4
20x5
20x6
Beg.
---(1,600)
(3,000)
Ending
$1,600
3,000
2,400
Cum. Effect
$1,600
1,400
600
Accounting Changes & Error Corrections
80
Example 2 (contd.)

Entries to correct the errors of the last three
years assuming the books of 20x6 are still
open:
12/31/x6
a. No entry is necessary for the error of 20x4
because it has been counterbalanced by the
end of 20x5 when the books of 20x5 were
closed.
b. To correct the error of 20x5 when the books of
20x6 have not been closed:
Retained Earnings
3,000
Wages Expense
3,000
Accounting Changes & Error Corrections
81
Example 2 (contd.)

Entries to correct the error of the last three
years assuming the books of 20x6 are still
open: (contd.)
12/31/20x6
c. To correct the error of 20x6 (the current year’s
error):
Wages Exp.
2,400
Wages Payable
2,400
a, b and c combined:
Retained Earnings
3,000
Wages Exp.
600
Wages Payable
2,400
Accounting Changes & Error Corrections
82
Example 3

Counterbalancing Errors
Failure to Record Prepaid Expense
In 20x5, Hurley Enterprise purchased a 2year insurance policy costing $1,000.
Insurance expense was debited and cash
was credited. No adjusting entry was made
at the end of 20x5. Assuming the books of
20x6 have not been closed, the entry on
12/31/20x6 to correct the error on 12/31/20x6
as follows is :
Accounting Changes & Error Corrections
83
Example 3 (contd.)
Insurance Exp.
Retained Earnings
500
500
OR (1) + (2)
(1)Prepaid Insurance
Retained Earnings
500
(2)Insurance Exp.
Prepaid Insurance
500
500
500
If the books of 20x6 have been closed, no
entry is necessary to correct the error.
Accounting Changes & Error Corrections
84
Example 4

Counterbalancing Errors
Understatement of Unearned Revenue:
On 12/31/20x5, Hurley received $50,000
as a prepayment for renting office space
for the next year. A rent revenue account
was credited on 12/31/20x5. No adjusting
entry was made in 20x5. If the books of
20x6 are still open, the entry to correct the
error is:
Accounting Changes & Error Corrections
85
Example 4 (contd.)
Retained Earnings
Rent Revenue
50,000
50,000
OR (1) + (2)
(1)Retained Earnings
Unearned Rent
50,000
(2)
50,000
Unearned Rent
Rent Revenue
50,000
50,000
If the books of 20x6 have been closed, no
entry is necessary to correct the error.
Accounting Changes & Error Corrections
86
Example 5

Counterbalancing Errors
Overstatement of Accrued Revenue
On 12/31/20x5, Hurley accrued interest revenue
$8,000 that applied to 20x6. The entry made in
12/31/20x5 was:
Interest Receivable
8,000
Interest Revenue
8,000
If the books of 20x6 have not been closed, the
entry to correct the error is :
Retained Earnings
8,000
Interest Revenue
8,000
If the books of 20x6 have been closed, no entry
is necessary.
Accounting Changes & Error Corrections
87
Example 6

Counterbalancing Errors
Understatement of Ending Inventory
On 12/31/20x5, the physical count of the
inventory was understated by $25,000.
Assuming the books of 20x6 are still open, the
entry on 12/31/20x6 to correct the error is :
Inventory (beg.)
25,000
Retained Earnings
25,000
OR
Cost of Goods Sold
25,000*
Retained Earnings
25,000
* if the beg. inv. has already been closed to
cost of goods sold.
Accounting Changes & Error Corrections
88
Example 6 (contd.)

The impact of the understatement of ending
inventory of 20x5 on the income of 20x5 and
20x6:
Beg. inv.
End. Inv.
Net Effect
20x5
-------(25,000)
(25,000)
20x6
25,000
------25,000
2-year comb.
------------0
• Thus, if the books of 20x6 have been closed, no
entry is necessary. When the books of 20x6 are
still open, the beg. inv. of 20x6 is understated for
$25,000 and the beg. balance of 20x6 retained
earnings is understated for $25,000 (due to the
net income of 20x5 was understated for $25,000).
Accounting Changes & Error Corrections
89
Example 7

Counterbalancing Errors
Overstatement of ending inventory
On 12/31/20x5, the ending inv. was overstated
by $10,000. Assuming the books of 20x6 have
not been closed, the following entry is to correct
the error of 20x5:
12/31/20x6
Retained Earnings
10,000
Inventory (beg.)
10,000
OR
Retained Earnings
10,000 *
Cost of Goods Sold
10,000
* if the beg. inv. has been closed to cost of
goods sold.
Accounting Changes & Error Corrections
90
Example 7 (contd.)

The impact of overstatement of end. inv. of
20x5 on the net income of 20x5 and 20x6:
20x5
20x6 2-year Comb.
Beg. Inv.
---(10,000)
------End. Inv.
10,000
-----------Net Effect
10,000 (10,000)
0
• Thus, if the books of 20x6 have been closed,
no entry is needed to correct the error.
• When the books of 20x6 are still open, the
beg. inv. of 20x6 is overstated for $10,000 and
the beg. balance of the 20x6 retained earnings
is also overstated for $10,000 (because the
net income of 20x5 was overstated).
Accounting Changes & Error Corrections
91
Example 8

Counterbalancing Errors
Over or Understatement of End. Inv.
Assuming inv. at the end of 20x4 was
overstated $11,000. At the end of 20x5, it
was overstated for $20,000 and at the end
of 20x6, it was understated for $19,000.
20x4
Beg. Inv.
End. Inv.
Net Effect
20x5
20x6
(11,000) (20,000)
11,000 20,000 (19,000)
11,000
9,000 (39,000)
Accounting Changes & Error Corrections
92
Example 8 (contd.)
If the books for 20x6 have not been closed, the
entries to correct the error are as follows:
12/31/20x6
for the inv. error of 20x4: no entry
for the inv. error of 20x5:
Retained Earnings
20,000 *
Cost of Goods Sold
20,000
for the inv. error of 20x6:
Inventory
19,000 *
Cost of Goods Sold
19,000
*Assuming inventory has been closed to the
cost of goods sold account.
Accounting Changes & Error Corrections
93
Example 8 (contd.)

Thus, the combined entry is (when the books
of 20x6 are still open):
12/31/20x6
Inventory
19,000
Retained Earnings
20,000
Cost of Goods Sold*
39,000
*or Income Summary if cost of goods sold has been
closed to the income summary account.
If the books of 20x6 are closed, the entry to
correct the errors is :
12/31/20x6 Inventory
19,000
Cost of Goods Sold
19,000
Accounting Changes & Error Corrections
94
Example 9

Counterbalancing Errors
Overstatement of Purchase
Hurley’s accountant recorded a purchase of
$9,000 in 20x5 which applied to 20x6. The
inventory account of 20x5 was correctly stated.
The entry on 12/31/20x6 to correct this error
(assuming the books of 20x6 are still open):
12/31/20x6
Purchases
9,000
Retained Earnings
9,000
If the books of 20x6 are closed, no entry is
needed to correct the error.
Accounting Changes & Error Corrections
95
Example 10

Counterbalancing Errors
Overstatement of Purchases and
Inventories
Assuming the purchases of 20x5 are
overstated by $9,000 and the ending
inv. is overstated by $7,000.
Accounting Changes & Error Corrections
96
Example 10 (contd.)
If the books of 20x6 are not closed, the entries
to correct the error:
12/31/20x6
Purchases
9,000
Retained Earnings
9,000
Retained Earnings
7,000
Inventory (Beg.)
7,000
(or Cost of Goods sold)
Combined Entry:
Purchases
9,000
Retained Earnings
2,000
Inventory
7,000
If the books of 20x6 are closed, no entry is needed.
Accounting Changes & Error Corrections
97
Noncounterbalancing Errors

These errors do not counterbalance
over 2-year period. The correcting
entries are needed even if the books of
the year in which the error is
discovered have been closed.
Accounting Changes & Error Corrections
98
Example

Assume that on 1/1/20x5, Hurley
purchased a machine for $10,000 that
had an estimated life of 5 years. The
accountant incorrectly expensed this
machine in 20x5. The error was
discovered in 20x6. Assume the
company uses straight line depreciation
on the asset, the entry to correct this error
given that the books of 20x6 have not
99
been closed: Accounting Changes & Error Corrections
Example (contd.)
12/31/20x6
Machine
10,000
Retained Earnings
10,000
Retained Earnings
2,000
Accu. Depre.
2,000
Depre. Exp.
2,000
Accu. Depre.
2,000
Combined:
Machine
10,000
Depre. Exp.
2,000
Retained earnings
8,000
Accu. Depre.
4,000
If the books of 20x6 have been closed, the entry is:
Machine
10,000
Retained Earnings
6,000
Accu. Depre. Accounting Changes & Error Corrections 4,000
100