Chapter 20
ACCOUNTING CHANGES
AND ERROR
CORRECTIONS
© 2009 The McGraw-Hill Companies, Inc.
Slide 2
Accounting Changes
Type of Change
Change in Accounting
Description
Replaces one GAAP
Examples
Adopt a new FASB standard.
Principle
with another GAAP
Change method of inventory costing.
Change from FV method to equity
method, or vice versa.
Change from completed contract to
percentage-of completion, or vice versa.
Change in Accounting
Revision of an estimate
Estimate
because of new information
or new experience
Change depreciation methods.
Change estimate of useful life of
depreciable asset.
Change estimate of residual value of
depreciable asset.
Change estimate of bad debt %
Change acturial estimates pertaining to
a pension plan.
Change in Reporting
Entity
Change from reporting as one Consolidate a subsidiary not
type of entity to
previously included in consolidated
another type of entity
financial statements.
Report consolidated financial statements
in place of individual statements.
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Slide 3
Accounting Changes and Error
Corrections
Retrospective
Two
Reporting
Approaches
Prospective
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Slide 4
Error Corrections and
Most Changes in Principle
Retrospective
ReviseTwo
prior years’ statements (that are
presented
for comparative purposes) to reflect
Reporting
the
impact of the change.
Approaches
•The balance in each account affected is revised to
appear as if the newly adopted accounted method
had been applied all along or that the error had
Prospective
never occurred.
•Adjust the beginning balance of retained earnings
for the earliest period reported.
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Slide 5
Changes in Estimates and Some
Changes in Principle
The change is implemented in the Retrospective
current
period, and its effects are reflected in the
financial statements of the current and
future Two
years only.
•Prior years’ statements are not revised.
Reporting
•Account balances are not revised.
Approaches
Prospective
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Slide 6
Change in Accounting Principle
Qualitative
Characteristics
Consistency
Comparability
Although consistency and comparability are desirable,
changing to a new method sometimes is appropriate.
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Slide 7
Motivation for Accounting Choices
Effect on
Compensation
Changing
Conditions
Motivations
for Change
Effect on Debt
Agreements
Effect on Union
Negotiations
New Standard
Issued
Effect on
Income Taxes
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Slide 8
Retrospective Approach
– Most Changes in Principle
Let’s look at an examples of a change from LIFO to FIFO.
At the beginning of 2009, Air Parts Corporation changed from
LIFO to FIFO. Air Parts has paid dividends of $40 million
each year since 2002. Its income tax rate is 40 percent.
Retained earnings on January 1, 2007, was $700 million;
inventory was $500 million. Selected income statement
amounts for 2009 and prior years are (in millions):
Cost of goods sold (LIFO)
Cost of goods sold (FIFO)
Difference
Revenues
Operating expenses
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Previous
2009
2008
2007
Years
$
430 $
420 $
405 $
2,000
370
365
360
1,700
$
60 $
55 $
45 $
300
$
950 $
230
900 $
210
875 $
205
4,500
1,000
Slide 9
Retrospective Approach
For each year reported, Air Parts makes the comparative
statements appear as if the newly adopted accounting
method (FIFO) had been in use all along.
Income Statements (Millions)
Revenues
Less: Cost of goods sold (FIFO)
Operating expenses
Income before tax
Less: Income tax expense (40%)
Net income
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2009
2008
2007
$
950 $
900 $
875
370
365
360
230
210
205
$
350 $
325 $
310
140
130
124
$
210 $
195 $
186
Slide 10
Retrospective Approach
For each year reported, Air Parts makes the comparative
statements appear as if the newly adopted accounting
method (FIFO) had been in use all along.
Cost of goods sold (LIFO)
Cost of goods sold (FIFO)
Difference
Previous
2009
2008
2007
Years
$
430 $
420 $
405 $
2,000
370
365
360
1,700
$
60 $
55 $
45 $
300
Comparative balance sheets will report 2007 inventory $345
million higher than it was reported in last year’s statements.
Retained earnings for 2007 will be $207 million higher.
[$345 million × (1 – 40% tax rate)]
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Slide 11
Retrospective Approach
For each year reported, Air Parts makes the comparative
statements appear as if the newly adopted accounting
method (FIFO) had been in use all along.
Cost of goods sold (LIFO)
Cost of goods sold (FIFO)
Difference
Previous
2009
2008
2007
Years
$
430 $
420 $
405 $
2,000
370
365
360
1,700
$
60 $
55 $
45 $
300
Comparative balance sheets will report 2008 inventory $400
million higher than it was reported in last year’s statements.
Retained earnings for 2008 will be $240 million higher.
[$400 million × (1 – 40% tax rate)]
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Slide 12
Retrospective Approach
For each year reported, Air Parts makes the comparative
statements appear as if the newly adopted accounting
method (FIFO) had been in use all along.
Cost of goods sold (LIFO)
Cost of goods sold (FIFO)
Difference
Previous
2009
2008
2007
Years
$
430 $
420 $
405 $
2,000
370
365
360
1,700
$
60 $
55 $
45 $
300
Comparative balance sheets will report 2009
inventory $460 million higher than it would have
been if the change from LIFO had not occurred.
Retained earnings for 2009 will be $276 million higher.
[$460 million × (1 – 40% tax rate)]
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Slide 13
Retrospective Approach
On January 1, 2009, the date of the change,
the following journal entry would be made
to record the change in principle.
GENERAL JOURNAL
Date
Description
Inventory
PR
Debit
Page 4
Credit
400,000,000
Retained Earnings
240,000,000
Deferred Tax Liability
160,000,000
40% of $400,000,000
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Slide 14
Retrospective Approach
In the first set of financial statements after the
change is made, a disclosure note is needed to
Provide
justification
for the change.
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Point out that
comparative
information has
been revised.
Report any per
share amounts
affected for the
current and all
prior periods.
Slide 15
Prospective Approach
– Some Changes in Principle
Most changes in principle are reported by the
retrospective approach, but:
The prospective approach is used for changes in
principle when:
It is impracticable to determine some periodspecific effects.
It is impracticable to determine the cumulative
effect of prior years.
The change is mandated by authoritative
pronouncements.
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Slide 16
Prospective Approach
– Change in Accounting Estimate
A change in depreciation method
is considered to be a change in
accounting estimate that is
achieved by a change in
accounting principle. It is
accounted for prospectively as a
change in accounting estimate.
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Slide 17
Change in Accounting Estimate
Changes in accounting estimates are accounted for
prospectively. Let’s look at an example of a change in a
depreciation estimate.
On January 1, 2005, Towing, Inc. purchased specialized
equipment for $243,000. The equipment has been
depreciated using the straight-line method and had an
estimated life of 10 years and salvage value of $3,000.
In 2009 the total useful life of the equipment was
revised to 6 years. The 2009 depreciation expense is
a.
b.
c.
d.
$24,000
$48,000
$72,000
$73,500
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$243,000 – $3,000 = $24,000 (2005 – 2008)
10 years
$24,000 × 4 years = $96,000 Accum. Depr.
$243,000 – $96,000 = $147,000 Book Value
$147,000 – $3,000 = $72,000 (2009 – 2010)
2 years
Slide 18
Changing Depreciation Methods
Universal Semiconductors switched from SYD
depreciation to straight-line depreciation in 2009.
The asset was purchased at the beginning of 2007
for $63 million, has a useful life of 5 years and
an estimated residual value of $3 million.
Sum-of-the-Years-Digits Depreciaton (millions)
2007 depreciation
2008 depreciation
Accumulated depreciation
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$ 20
16
$ 36
($60 x 5/15)
($60 x 4/15)
Slide 19
Changing Depreciation Methods
÷
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Slide 20
Changing Depreciation Methods
Depreciation adjusting entry
for 2009, 2010, and 2011.
GENERAL JOURNAL
Date
Description
Depreciation Expense
Accumulated Depreciation
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PR
Debit
Page 4
Credit
8,000,000
8,000,000
Slide 21
Change in Reporting Entity
A change in reporting entity occurs as a result of:
 presenting consolidated financial statements
in place of statements of individual companies, or
 changing specific companies that constitute the
group for which consolidated statements are
prepared.
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Slide 22
Change in Reporting Entity
Summary of the Retrospective Approach for
Changes in Reporting Entity
Recast all previous periods’ financial statements as if
the new reporting entity existed in those periods.
In the first financial statements after the change:
 A disclosure note should describe the nature of
and the reason for the change.
 The effect of the change on net income, income
before extraordinary items, and related per share
amounts should be shown for all periods
presented.
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Slide 23
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 retrospectively restated to reflect the error
correction.
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Slide 24
Correction of Accounting Errors
Four-step process
Prepare a journal entry to correct any balances.
Retrospectively restate prior years’ financial
statements that were incorrect.
Report correction as a prior period adjustment if
retained earnings is one of the incorrect
accounts affected.
Include a disclosure note.
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Slide 25
Prior Period Adjustments
Prior Period
Adjustment Required
Counterbalancing
error discovered in
the second year.
Noncounterbalancing
error discovered in
any year.
Use the retrospective approach
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Slide 26
Errors Occurred and Discovered in the
Same Period
Corrected by reversing the incorrect entry
and then recording the correct entry (or
by making an entry to correct the account
balances)
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Slide 27
Errors Not Affecting Prior Years’ Net
Income
Involves incorrect classification of accounts.
Requires correction of previously issued
statements (retrospective approach).
Is not classified as a prior period adjustment
since it does not affect prior income.
Disclose nature of error.
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Slide 28
Error Affecting Prior Year’s Net Income
Requires correction of previously issued
statements (retrospective 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.
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Slide 29
Error Affecting Prior Year’s Net Income
In 2009, the accountant at Orion, Inc. discovered the
depreciation of $50,000 on a new asset purchased in 2008
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 2008 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 2008 to record income taxes was
GENERAL JOURNAL
Date
Description
Dec 31 Income Tax Expense
2008
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PR
Debit
Page 6
Credit
82,500
Deferred Tax Liability (30% x $50,000)
15,000
Income Tax Payable (30% x $225,000)
67,500
Slide 30
Error Affecting Prior Year’s Net Income
This error affected the following accounts
Depreciation expense for 2008 - understated
$
50,000
Accumulated depreciation for 2008 - understated
50,000
Net income in 2008 - overstated ($50,000 x 70%)
35,000
Income tax expense in 2008 - overstated
15,000
Deferred tax liability for 2008 - overstated
15,000
Remember, the 2008 expense accounts were closed to RE.
GENERAL JOURNAL
Date
Description
2009
Retained Earnings
35,000
Deferred Tax Liability
15,000
Accumulated Depreciation
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PR
Debit
Page 6
Credit
50,000
Slide 31
Error Affecting Prior Year’s Net Income
Let’s assume the following:
On 1/1/09, the retained earnings balance was $922,000. In
2009, the company paid $65,000 in dividends. Net income
for 2009 was $184,000.
The Statement of Retained Earnings (or RE column of the
Statement of Shareholders’ Equity) would be as follows:
Retained earnings, January 1, 2009
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, 2009
887,000
Add: Net income
184,000
Less: Dividends
(65,000)
Retained earnings, December 31, 2009
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$
1,006,000
Slide 32
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.
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Slide 33
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.
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Slide 34
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.
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Slide 35
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.
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Slide 36
Summary of Accounting Changes and Errors
Change in Accounting Principle
Most
Prospective
Changes
Exceptions
Method of accounting
Retrospective
Prospective
Revise prior years?
Yes
No
Cumulative effect on An adjustment to
prior years' income
earliest reported
Not
reported?
retained earnings.
reported.
Journal entries?
Adjust affected
None
balances to new
method.
Disclosure note?
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Subsequent
accounting is
affected by
change.
Yes
Subsequent
accounting is
affected by
change.
Yes
Change in
Estimate
Change in
Reporting
Entity
Prospective
No
Retrospective
Yes
Not
reported.
None
Not
reported.
None
Subsequent
accounting is
affected by
change.
Yes
Consolidated
statements are
discussed in
other courses.
Yes
Error
Retrospective
Yes
An adjustment to
earliest reported
retained earnings.
Involves any
incorrect balances
as a result of the
error.
Yes
End of Chapter 20
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© 2008 The McGraw-Hill Companies, Inc.