Intermediate
Accounting
22-1
Prepared by
Coby Harmon
University of California, Santa Barbara
22
Accounting Changes and
Error Analysis
Intermediate Accounting
14th Edition
Kieso, Weygandt, and Warfield
22-2
Learning Objectives
22-3
1.
Identify the two types of accounting changes.
2.
Describe the accounting for changes in accounting policies.
3.
Understand how to account for retrospective accounting changes.
4.
Understand how to account for impracticable changes.
5.
Describe the accounting for changes in estimates.
6.
Describe the accounting for correction of errors.
7.
Identify economic motives for changing accounting policies.
8.
Analyze the effect of errors.
Accounting Changes and Error Analysis
Accounting Changes
Changes in accounting
policy
Balance sheet errors
Changes in accounting
estimate
Balance sheet and income
statement effects
Change in reporting entity
Comprehensive example
Correction of errors
Preparation of statements
with error corrections
Summary
Motivations for change of
method
22-4
Error Analysis
Income statement errors
Accounting Changes
Accounting Alternatives:

Diminish the comparability of financial information.

Obscure useful historical trend data.
Types of Accounting Changes:
1. Change in Accounting Policy.
2. Changes in Accounting Estimate.
3. Change in Reporting Entity.
Errors are not considered an accounting change.
22-5
LO 1 Identify the two types of accounting changes.
Changes in Accounting Principle
Change from one accepted accounting policy to another.
Examples include:

Average cost to LIFO.

Completed-contract to percentage-of-completion.
Adoption of a new policy in recognition of events that have occurred for
the first time or that were previously immaterial is not an accounting
change.
22-6
LO 2 Describe the accounting for changes in accounting policies.
Changes in Accounting Principle
Three approaches for reporting changes:
1) Currently.
2) Retrospectively.
3) Prospectively (in the future).
FASB requires use of the retrospective approach.
Rationale - Users can then better compare results from one period to
the next.
22-7
LO 2 Describe the accounting for changes in accounting policies.
Changes in Accounting Principle
Retrospective Accounting Change Approach
Company reporting the change
1) Adjusts its financial statements for each prior period
presented to the same basis as the new accounting
principle.
2) Adjusts the carrying amounts of assets and liabilities as
of the beginning of the first year presented, plus the
opening balance of retained earnings.
22-8
LO 3 Understand how to account for retrospective accounting changes.
Changes in Accounting Principle
Retrospective Accounting Change: Long-Term Contracts
Illustration: Denson Company has accounted for its income from
long-term construction contracts using the completed-contract
method. In 2012, the company changed to the percentage-ofcompletion method. Management believes this approach provides
a more appropriate measure of the income earned. For tax
purposes, the company uses the completed-contract method and
plans to continue doing so in the future. (Assume a 40 percent
enacted tax rate.)
22-9
LO 3 Understand how to account for retrospective accounting changes.
Changes in Accounting Principle
Illustration 22-1
22-10
LO 3 Understand how to account for retrospective accounting changes.
Changes in Accounting Principle
Data for Retrospective Change
Illustration 22-2
Journal entry
beginning of
2012
22-11
Construction in Process
Deferred Tax Liability
Retained Earnings
220,000
88,000
132,000
LO 3 Understand how to account for retrospective accounting changes.
Changes in Accounting Principle
Reporting a Change in Principle
Major disclosure requirements are as follows.
1.
Nature of the change in accounting policy;
2.
The method of applying the change, and:
a. A description of the prior period information that has been
retrospectively adjusted, if any.
b. The effect of the change on income from continuing operations,
net income (or other appropriate captions of changes in net assets
or performance indicators), any other affected line item.
c. The cumulative effect of the change on retained earnings or other
components of equity or net assets in the balance sheet as of the
beginning of the earliest period presented.
22-12
LO 3 Understand how to account for retrospective accounting changes.
Changes in Accounting Principle
Reporting a Change in policy
Illustration 22-3
22-13
LO 3
Changes in Accounting Principle
Retained Earnings Adjustment
Retained earnings balance is $1,360,000 at the beginning of 2010.
Illustration 22-4
Before Change
22-14
LO 3 Understand how to account for retrospective accounting changes.
Changes in Accounting Principle
Retained Earnings Adjustment
Illustration 22-5
22-15
After Change
LO 3 Understand how to account for retrospective accounting changes.
Changes in Accounting Principle
E22-1 (Change in Principle—Long-Term Contracts): Cherokee
Construction Company changed from the completed-contract to the
percentage-of-completion method of accounting for long-term
construction contracts during 2012. For tax purposes, the company
employs the completed-contract method and will continue this
approach in the future. (Hint: Adjust all tax consequences through
the Deferred Tax Liability account.)
22-16
LO 3 Understand how to account for retrospective accounting changes.
Changes in Accounting Principle
E22-1 (Change in policy—Long-Term Contracts):
Instructions: (assume a tax rate of 35%)
(b) What entry(ies) are necessary to adjust the accounting records for
the change in accounting principle?
(a) What is the amount of net income and retained earnings that would
be reported in 2012? Assume beginning retained earnings for 2011 to
be $100,000.
22-17
LO 3 Understand how to account for retrospective accounting changes.
Changes in Accounting Principle
E22-1: Pre-Tax Income from Long-Term Contracts
35%
Tax
Effect
Date
Percentageof-Completion
CompletedContract
Difference
2011
$
780,000
$ 610,000
170,000
59,500
$ 110,500
700,000
480,000
220,000
77,000
143,000
2012
Net of
Tax
Journal entry
2012
Construction in progress
Deferred tax liability
Retained earnings
22-18
170,000
59,500
110,500
LO 3 Understand how to account for retrospective accounting changes.
Changes in Accounting Principle
E22-1: Comparative Statements
Restated
2011
2012
Income
Statement
Statement
of Retained
Earnings
Pre-tax income
Income tax (35%)
700,000
$
245,000
780,000
$ 610,000
273,000
213,500
Net income
$
455,000
$
507,000
$ 396,500
Beg. Retained earnings
$
496,500
$
100,000
$ 100,000
607,000
100,000
100,000
455,000
507,000
396,500
607,000
$ 496,500
Accounting change
Beg. R/Es restated
Net income
End. Retained earnings
22-19
$
Previous
2011
110,500
$
$ 1,062,000
$
LO 3 Understand how to account for retrospective accounting changes.
Changes in Accounting Principle
Direct and Indirect Effects of Changes

Direct Effects - FASB takes the position that
companies should retrospectively apply the direct
effects of a change in accounting principle.

Indirect Effect is any change to current or future cash
flows of a company that result from making a change in
accounting principle that is applied retrospectively.
22-20
LO 3 Understand how to account for retrospective accounting changes.
Changes in Accounting Principle
Impracticability
Companies should not use retrospective application if one of the
following conditions exists:
1.
Company cannot determine the effects of the retrospective
application.
2.
Retrospective application requires assumptions about
management’s intent in a prior period.
3.
Retrospective application requires significant estimates that
the company cannot develop.
If any of the above conditions exists, the company prospectively applies the new
accounting principle.
22-21
LO 4 Understand how to account for impracticable changes.
Changes in Accounting Estimate
Examples of Estimates
1. Uncollectible receivables.
2. Inventory obsolescence.
3. Useful lives and salvage values of assets.
4. Periods benefited by deferred costs.
5. Liabilities for warranty costs and income taxes.
6. Recoverable mineral reserves.
7. Change in depreciation methods.
22-22
LO 5 Describe the accounting for changes in estimates.
Changes in Accounting Estimate
Prospective Reporting
Changes in accounting estimates are reported prospectively.
Account for changes in estimates in
1. the period of change if the change affects that period only,
or
2. the period of change and future periods if the change
affects both.
FASB views changes in estimates as normal recurring corrections
and adjustments and prohibits retrospective treatment.
22-23
LO 5 Describe the accounting for changes in estimates.
Change in Estimate Example
Illustration: Arcadia High School purchased equipment for
$510,000 which was estimated to have a useful life of 10 years
with a salvage value of $10,000 at the end of that time.
Depreciation has been recorded for 7 years on a straight-line
basis. In 2012 (year 8), it is determined that the total estimated life
should be 15 years with a salvage value of $5,000 at the end of
that time.
Required:
22-24

What is the journal entry to correct
prior years’ depreciation expense?

Calculate depreciation expense for 2012.
No Entry
Required
LO 5 Describe the accounting for changes in estimates.
Change in Estimate Example
Equipment cost
Salvage value
Depreciable base
Useful life (original)
Annual depreciation
After 7 years
$510,000
First, establish NBV
- 10,000
at date of change in
500,000
estimate.
10 years
$ 50,000 x 7 years = $350,000
Balance Sheet (Dec. 31, 2011)
Fixed Assets:
22-25
Equipment
Accumulated depreciation
$510,000
350,000
Net book value (NBV)
$160,000
LO 5 Describe the accounting for changes in estimates.
Change in Estimate Example
Net book value
Salvage value (if any)
Depreciable base
Useful life
Annual depreciation
$160,000
5,000
155,000
8 years
$ 19,375
Second, calculate
depreciation expense
for 2012.
Journal entry for 2012
Depreciation expense
Accumulated depreciation
22-26
19,375
19,375
LO 5 Describe the accounting for changes in estimates.
Changes in Accounting Estimate
Disclosures
Companies need not disclose changes in accounting estimate
made as part of normal operations, such as bad debt allowances
or inventory obsolescence, unless such changes are material.
However, for a change in estimate that affects several periods
(such as a change in the service lives of depreciable assets),
companies should disclose the effect on income from continuing
operations and related per-share amounts of the current period.
22-27
LO 5 Describe the accounting for changes in estimates.
Change in Reporting Entity
Examples of a change in reporting entity are:
1. Presenting consolidated statements in place of statements of
individual companies.
2. Changing specific subsidiaries that constitute the group of
companies for which the entity presents consolidated financial
statements.
3. Changing the companies included in combined financial
statements.
4. Changing the cost, equity, or consolidation method of
accounting for subsidiaries and investments.
Reported by changing the financial statements of all prior periods presented.
22-28
LO 6 Identify changes in a reporting entity.
Correction of Errors
Types of Accounting Errors:
1. A change from an accounting principle that is not generally
accepted to an accounting policy that is acceptable.
2. Mathematical mistakes.
3. Changes in estimates that occur because a company did not
prepare the estimates in good faith.
4. Failure to accrue or defer certain expenses or revenues.
5. Misuse of facts.
6. Incorrect classification of a cost as an expense instead of an
asset, and vice versa.
22-29
LO 7 Describe the accounting for correction of errors.
Correction of Errors

All material errors must be corrected.

Record corrections of errors from prior periods as an
adjustment to the beginning balance of retained earnings
in the current period.

Such corrections are called prior period adjustments.

For comparative statements, a company should restate
the prior statements affected, to correct for the error.
22-30
LO 7 Describe the accounting for correction of errors.
Correction of Errors
Illustration: In 2013 the bookkeeper for Selectro Company
discovered an error:
In 2012 the company failed to record $20,000of depreciation
expense on a newly constructed building. This building is the only
depreciable asset Selectro owns. The company correctly included
the depreciation expense in its tax return and correctly reported
its income taxes payable.
22-31
LO 7 Describe the accounting for correction of errors.
Correction of Errors
Illustration: Selectro’s income statement for 2012 with and
without the error.
Illustration 22-19
Show the entries that Selectro should have made and did make for
recording depreciation expense and income taxes.
22-32
LO 7 Describe the accounting for correction of errors.
Correction of Errors
Illustration: Show the entries that Selectro should have made and
did make for recording depreciation expense and income taxes.
Illustration 22-18
Correcting
Entry in
2013
22-33
LO 7 Describe the accounting for correction of errors.
Correction of Errors
Illustration: Show the entries that Selectro should have made and
did make for recording depreciation expense and income taxes.
Illustration 22-18
Correcting
Entry in
2013
22-34
Retained Earnings
12,000
LO 7 Describe the accounting for correction of errors.
Correction of Errors
Illustration: Show the entries that Selectro should have made and
did make for recording depreciation expense and income taxes.
Illustration 22-18
Correcting
Entry in
2013
22-35
Retained Earnings
Deferred Tax Liability
12,000
Reversal
8,000
LO 7 Describe the accounting for correction of errors.
Correction of Errors
Illustration: Show the entries that Selectro should have made and
did make for recording depreciation expense and income taxes.
Illustration 22-18
Correcting
Entry in
2013
22-36
Retained Earnings
Deferred Tax Liability
12,000
8,000
Accumulated Depreciation—Buildings
Record
20,000
LO 7 Describe the accounting for correction of errors.
Correction of Errors
Illustration (Single-Period Statement): Assume that Selectro
Company has a beginning retained earnings balance at January 1,
2013, of $350,000. The company reports net income of $400,000 in
2013.
Illustration 22-21
22-37
LO 7 Describe the accounting for correction of errors.
Correction of Errors
Comparative Statements
Company should
1. make adjustments to correct the amounts for all affected
accounts reported in the statements for all periods
reported.
2. restate the data to the correct basis for each year
presented.
3. show any catch-up adjustment as a prior period
adjustment to retained earnings for the earliest period it
reported.
22-38
LO 7 Describe the accounting for correction of errors.
Correction of Errors
Woods, Inc.
Statement of Retained Earnings
For the Year Ended December 31, 2012
Balance, January 1
Net income
Dividends
Balance, December 31
$
$
1,050,000
360,000
(300,000)
1,110,000
Before issuing the report for the year ended December 31, 2012, you
discover a $62,500 error that caused the 2011 inventory to be overstated
(overstated inventory caused COGS to be lower and thus net income to be
higher in 2011). Would this discovery have any impact on the reporting of the
Statement of Retained Earnings for 2012? Assume a 20% tax rate.
22-39
LO 7 Describe the accounting for correction of errors.
Correction of Errors
Woods, Inc.
Statement of Retained Earnings
For the Year Ended December 31, 2012
Balance, January 1, as previously reported
Prior period adjustment, net of tax
Balance, January 1, as restated
Net income
Dividends
Balance, December 31
22-40
$
$
1,050,000
(50,000)
1,000,000
360,000
(300,000)
1,060,000
LO 7 Describe the accounting for correction of errors.
Summary of Accounting Changes and Errors
Illustration 22-23
22-41
LO 7
Summary of Accounting Changes and Errors
Illustration 22-23
22-42
LO 7
Motivations for Change of
Accounting Method
Why companies may prefer certain accounting
methods. Some reasons are:
1. Political costs.
2. Capital Structure.
3. Bonus Payments.
4. Smooth Earnings.
22-43
LO 8 Identify economic motives for changing accounting policies.
Error Analysis
Companies must answer three questions:
1. What type of error is involved?
2. What entries are needed to correct for the error?
3. After discovery of the error, how are financial statements to
be restated?
Companies treat errors as prior-period adjustments and report
them in the current year as adjustments to the beginning
balance of Retained Earnings.
22-44
LO 9 Analyze the effect of errors.
Balance Sheet Errors
Balance sheet errors affect only the presentation of an asset,
liability, or stockholders’ equity account.
22-45

Current year error - reclassify item to its proper position.

Prior year error - restate the balance sheet of the prior year
for comparative purposes.
LO 9 Analyze the effect of errors.
Income Statement Errors
Improper classification of revenues or expenses.
22-46

Current year error - reclassify item to its proper position.

Prior year error - restate the income statement of the prior
year for comparative purposes.
LO 9 Analyze the effect of errors.
Balance Sheet and Income Statement Errors
Counterbalancing Errors
Will be offset or corrected over two periods.
If company has closed the books:
a. If the error is already counterbalanced, no entry is
necessary.
b. If the error is not yet counterbalanced, make entry to adjust
the present balance of retained earnings.
For comparative purposes, restatement is necessary even if a
correcting journal entry is not required.
22-47
LO 9 Analyze the effect of errors.
Balance Sheet and Income Statement Errors
Counterbalancing Errors
Will be offset or corrected over two periods.
If company has not closed the books:
a. If error already counterbalanced, make entry to correct the
error in the current period and to adjust the beginning
balance of Retained Earnings.
b. If error not yet counterbalanced, make entry to adjust the
beginning balance of Retained Earnings.
22-48
LO 9 Analyze the effect of errors.
Balance Sheet and Income Statement Errors
Non-Counterbalancing Errors
Not offset in the next accounting period.
Companies must make correcting entries, even if they have
closed the books.
22-49
LO 9 Analyze the effect of errors.
Error Analysis Example
E22-19 (Error Analysis; Correcting Entries): A partial trial balance of
Dickinson Corporation is as follows on December 31, 2012.
Dr.
Supplies
$
Cr.
2,500
Salaries and wages payable
$
Interest receivable
5,100
Prepaid insurance
90,000
Unearned rent
Interest payable
1,500
0
15,000
Instructions: (a) Assuming that the books have not been closed, what
are the adjusting entries necessary at December 31, 2012?
22-50
LO 9 Analyze the effect of errors.
Error Analysis Example
(a) Assuming that the books have not been closed, what are the
adjusting entries necessary at December 31, 2012?
1.
A physical count of supplies on hand on December 31, 2012, totaled
$1,100.
Supplies expense
1,400
Supplies
2.
Accrued salaries and wages on December 31, 2012, amounted to
$4,400.
Salaries and wages expense
Salaries and wages payable
22-51
1,400
2,900
2,900
LO 9 Analyze the effect of errors.
Error Analysis Example
(a) Assuming that the books have not been closed, what are the
adjusting entries necessary at December 31, 2012?
3.
Accrued interest on investments amounts to $4,350 on December
31, 2012.
Interest revenue
750
Interest receivable
4.
The unexpired portions of the insurance policies totaled $65,000 as
of December 31, 2012.
Insurance expense
Prepaid insurance
22-52
750
25,000
25,000
LO 9 Analyze the effect of errors.
Error Analysis Example
(a) Assuming that the books have not been closed, what are the
adjusting entries necessary at December 31, 2012?
5.
$24,000 was received on January 1, 2012 for the rent of a building
for both 2012 and 2013. The entire amount was credited to rental
income.
Rental income
12,000
Unearned rent
6.
Depreciation for the year was erroneously recorded as $5,000 rather
than the correct figure of $50,000.
Depreciation expense
Accumulated depreciation
22-53
12,000
45,000
45,000
LO 9 Analyze the effect of errors.
Error Analysis Example
E22-19 (Error Analysis; Correcting Entries) A partial trial balance of
Dickinson Corporation is as follows on December 31, 2012.
Dr.
Supplies
$
Cr.
2,500
Salaries and wages payable
$
Interest receivable
5,100
Prepaid insurance
90,000
Unearned rent
Interest payable
1,500
0
15,000
Instructions: (b) Assuming that the books have been closed, what are
the adjusting entries necessary at December 31, 2012?
22-54
LO 9 Analyze the effect of errors.
Error Analysis Example
(b) Assuming that the books have been closed, what are the adjusting
entries necessary at December 31, 2012?
1.
A physical count of supplies on hand on December 31, 2012, totaled
$1,100.
Retained earnings
1,400
Supplies
2.
Accrued salaries and wages on December 31, 2012, amounted to
$4,400.
Retained earnings
Salaries and wages payable
22-55
1,400
2,900
2,900
LO 9 Analyze the effect of errors.
Error Analysis Example
(b) Assuming that the books have been closed, what are the adjusting
entries necessary at December 31, 2012?
3.
Accrued interest on investments amounts to $4,350 on December
31, 2012.
Retained earnings
750
Interest receivable
4.
The unexpired portions of the insurance policies totaled $65,000 as
of December 31, 2012.
Retained earnings
Prepaid insurance
22-56
750
25,000
25,000
LO 9 Analyze the effect of errors.
Error Analysis Example
(b) Assuming that the books have been closed, what are the adjusting
entries necessary at December 31, 2012?
5.
$24,000 was received on January 1, 2012 for the rent of a building
for both 2012 and 2013. The entire amount was credited to rental
income.
Retained earnings
12,000
Unearned rent
6.
Depreciation for the year was erroneously recorded as $5,000 rather
than the correct figure of $50,000.
Retained earnings
Accumulated depreciation
22-57
12,000
45,000
45,000
LO 9 Analyze the effect of errors.
APPENDIX
22A
CHANGING FROM OR TO THE EQUITY METHOD
Change From The Equity Method
Change from the equity method to the fair-value method.

Earnings or losses previously recognized under the equity method
should remain as part of the carrying amount of the investment.

The cost basis is the carrying amount of the investment at the date
of the change.

The investor applies the new method in its entirety.

At the next reporting date, the investor should record the unrealized
holding gain or loss to recognize the difference between the
carrying amount and fair value.
22-58
LO 10 Make the computations and prepare the entries necessary to
record a change from or to the equity method of accounting.
APPENDIX
22A
CHANGING FROM OR TO THE EQUITY METHOD
Dividends in Excess of Earnings
Accounted for such dividends as a reduction of the
investment carrying amount, rather than as revenue.
Reason: Dividends in excess of earnings are viewed as a
liquidating dividend with this excess then accounted for as a
________________
reduction of the equity investment.
22-59
LO 10 Make the computations and prepare the entries necessary to
record a change from or to the equity method of accounting.
APPENDIX
22A
CHANGING FROM OR TO THE EQUITY METHOD
Dividends in Excess of Earnings
Illustration: On January 1, 2011, Investor Company purchased
250,000 shares of Investee Company’s 1,000,000 shares of outstanding
stock for $8,500,000. Investor correctly accounted for this investment
using the equity method. After accounting for dividends received and
investee net income, in 2011, Investor reported its investment in
Investee Company at $8,780,000 at December 31, 2011. On January 2,
2012, Investee Company sold 1,500,000 additional shares of its own
common stock to the public, thereby reducing Investor Company’s
ownership from 25 percent to 10 percent.
22-60
LO 10 Make the computations and prepare the entries necessary to
record a change from or to the equity method of accounting.
APPENDIX
22A
CHANGING FROM OR TO THE EQUITY METHOD
Dividends in Excess of Earnings
Illustration 22A-1
22-61
LO 10 Make the computations and prepare the entries necessary to
record a change from or to the equity method of accounting.
APPENDIX
22A
CHANGING FROM OR TO THE EQUITY METHOD
Impact on Investment Carrying Amount
2012 &
2013
2014
22-62
Illustration 22A-2
Cash
Dividend Revenue
400,000
Cash
Equity Investments (AFS)
Dividend Revenue
210,000
400,000
60,000
150,000
LO 10
APPENDIX
22A
CHANGING FROM OR TO THE EQUITY METHOD
Change To The Equity Method

Companies use retrospective application.

The carrying amount of the investment, results of current
and prior operations, and retained earnings of the investor
are adjusted as if the equity method has been in effect
during all of the previous periods.

Companies also eliminate any balances in the Unrealized
Holding Gain or Loss—Equity account and the Securities
Fair Value Adjustment account.
22-63
LO 10 Make the computations and prepare the entries necessary to
record a change from or to the equity method of accounting.
RELEVANT FACTS
22-64

One area in which GAAP and IFRS differ is the reporting of error
corrections in previously issued financial statements. While both sets
of standards require restatement, GAAP is an absolute standard—
that is, there is no exception to this rule.

The accounting for changes in estimates is similar between GAAP
and IFRS.

Under GAAP and IFRS, if determining the effect of a change in
accounting policy is considered impracticable, then a company
should report the effect of the change in the period in which it
believes it practicable to do so, which may be the current period.
RELEVANT FACTS
22-65

Under IFRS, the impracticality exception applies both to changes in
accounting principles and to the correction of errors. Under GAAP,
this exception applies only to changes in accounting principle.

IFRS (IAS 8) does not specifically address the accounting and
reporting for indirect effects of changes in accounting principles. As
indicated in the chapter, GAAP has detailed guidance on the
accounting and reporting of indirect effects.
IFRS SELF-TEST QUESTION
Which of the following is false?
a. GAAP and IFRS have the same absolute standard regarding
the reporting of error corrections in previously issued financial
statements.
b. The accounting for changes in estimates is similar between
GAAP and IFRS.
c.
Under IFRS, the impracticality exception applies both to
changes in accounting principles and to the correction of errors.
d. GAAP has detailed guidance on the accounting and reporting of
indirect effects; IFRS does not.
22-66
IFRS SELF-TEST QUESTION
Which of the following is not classified as an accounting change by
IFRS?
a. Change in accounting policy.
b. Change in accounting estimate.
c.
Errors in financial statements.
d. None of the above.
22-67
IFRS SELF-TEST QUESTION
IFRS requires companies to use which method for reporting changes
in accounting policies?
a. Cumulative effect approach.
b. Retrospective approach.
c.
Prospective approach.
d. Averaging approach.
22-68
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22-69