Accounting Changes and Error Corrections
ACCOUNTING CHANGES
Types of Accounting Changes
1. Change in accounting principle-Change from one generally accepted accounting
principle to another.
2. Change in accounting estimate-Revision of an estimate because of new information or
new experience.
3. Change in reporting entity-Change from reporting as one type of entity to another type
of entity.
4. Correction of an error-Correction of an error caused by a transaction being recorded
incorrectly or not at all.
CHANGE IN ACCOUNTING PRINCIPLE
Changing from one acceptable accounting principle to another acceptable accounting principle is
accounted for as a change in accounting principle. This does not include the adoption of a new
accounting principle because the entity has entered into transactions for the first time that require
specific accounting treatment. It also does not include the change from an inappropriate
accounting principle to an acceptable accounting principle. The later would be classified as the
correction of an error.
The types of changes that might be included in a change in accounting principle are:
Adoption of a new FASB accounting standard
Change in the method of inventory costing
Change to, or from, the cost method to the equity method
Change to, or from, the completed contract to percentage-of-completion method
CHANGE IN ACCOUNTING ESTIMATE
At the end of each accounting period there are a number of estimates made in order to prepare
the financial statements. These estimates are based on the facts and circumstances that exist at
the time. These facts and circumstances will change from one accounting period to the next. It
is not practical to restate the financial statements every time there is new information that makes
the prior estimates incorrect. Therefore, on an ongoing basis management applies its best
judgment and modifies such estimates as the facts and circumstances change in each subsequent
accounting period. A change in accounting estimate is handled on a prospective basis.
CHANGE IN REPORTING ENTITY
Under certain circumstances management is required to restate the financial statements of all
prior periods. These circumstances relate to a change in the reporting entity. Such changes
include:
Presenting consolidated financial statements for the first time.
Changing specific subsidiaries for which consolidated financial statements are presented.
Changing companies included in combined financial statements
Change in the cost, equity, or consolidation method used for accounting for subsidiaries
and investments.
CORRECTION OF AN ERROR
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Accounting Changes and Error Corrections
The correction of an error must be handled as a prior period adjustment to the earliest period
reported in the financial statements. Some of the types of errors that might occur are as follows:
Change from an unacceptable accounting principle to an acceptable one.
Mathematical errors.
Changes in estimates that were not prepared in good faith.
Failure to accrue or defer expenses or revenues at the end of a period.
Misuse of facts.
Misclassification of costs as expenses and vice versa.
APPROACHES TO REPORTING ACCOUNTING CHANGES
1. Retrospective approach
The retroactive approach provides consistency and comparability between periods and across
entities. Comparative financial statements are recast to reflect the changes. The cumulative
effect (net of tax) of the change is reported as a prior period adjustment in the earliest period
reported. The accounting records are adjusted to reflect the cumulative effect (net of the
change) as of the beginning of the current period. The change and its effects on income and
balance sheet amounts is disclosed in the notes to the financial statements.
2. Prospective approach
The prospective approach is used when it is impractical to use the retrospective approach.
For example, a change from an acceptable inventory costing method to LIFO. It would be
impractical for management to attempt to estimate what inventory and cost of goods sold
would have been in prior years if the entity had been using LIFO. Under certain
circumstances the entity may be required to use the prospective approach because the FASB
has mandated such treatment in the adoption of a new accounting standard. Although
considered a change in accounting principle a change in depreciation, amortization or
depletion methods are to be reported on a prospective basis rather than retrospectively.
CHANGE IN ACCOUNTING PRINCIPLE-RETROSPECTIVE APPROACH
In applying the retrospective approach the financial statements are recast so that all prior periods
reported in comparative financial statement reflect the adoption of the change in accounting
principle.
Example: Spencer Company changed from the LIFO cost flow assumption to the FIFO cost
flow assumption in 2004. The company’s federal income tax rate is 20%. The original
comparative income statements for the two years ended December 31, 2003 and all years prior to
2002 are presented below:
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Accounting Changes and Error Corrections
Income Statements
2003
$1,050
683
368
231
137
27
$109
Revenue
Cost of goods sold (LIFO)
Gross profit
Operating expenses
Income before tax
Income tax
Net income
2002
$980
637
343
216
127
25
$102
Years
Prior to
2002
$3,800
2,470
1,330
836
494
99
$395
The following are the inventory amounts reported in the balance sheet at the end of each of the
years 2001 through 2003.
Balance Sheets
2003
$150
Inventory (LIFO)
2002
$130
2001
$120
The cumulative effect of the change from LIFO to FIFO for the two years ended December 31,
2003, and all years prior to 2002 is presented below.
2003
$683
478
$205
2002
$637
446
$191
Years
Prior to
2002
$2,470
1,729
$741
$1,137
227
$909
$932
186
$746
$741
148
$593
Cost of goods sold (LIFO)
Cost of goods sold (FIFO)
Differences
Cumulative effect of change:
Inventory/cost of goods sold
Income taxes
Net income/retained earnings
The company adopted the change in accounting principle in 2004 so therefore the financial
statements must be recast for 2003 and 2002, assuming that three year comparative financial
statements are going to be presented. We assume that the change took effect on January 1, 2004
so there is no recasting of the 2004 financial statements but rather they reflect the results of the
change. The following are the recast income statements for the three years.
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Accounting Changes and Error Corrections
Income Statements (Recast)
Revenue
Cost of goods sold (FIFO)
Gross profit
Operating expenses
Income before tax
Income tax
Net income
2004
$1,200
624
576
264
312
62
$250
2003
$1,050
478
572
231
341
68
$273
2002
$980
446
534
216
319
64
$255
The change in inventory method will result in changes in the balance sheet amounts as well.
Inventory, deferred income taxes and retained earnings are all effected by this change in
accounting principle.
The adjusted inventory and the cumulative effect of changes on deferred income taxes and
retained earnings are presented below.
Balance Sheets (Recast)
Inventory (LIFO)
AJE (cumulative effect of changes)
Adjusted inventory (FIFO)
2003
$150
1,137
$1,287
2002
$130
932
$1,062
Change to deferred income taxes
Change to retained earnings
Cumulative effect of changes
$227
909
$1,137
$186
746
$932
Because we assume that the change in accounting principle took place on the first day of 2004 an
adjusting journal entry is required to bring the accounting records into alignment with this
change. The following adjusting journal entry reflects the adjustment to the accounting records.
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Accounting Changes and Error Corrections
Account
Inventory
Retained earnings
Deferred income taxes
Debit
$1,137
Credit
$909
227
To record the cumulative effect of the change from LIFO to FIFO
inventory cost method on January 1, 2004
Although this is the adjusting journal entry to correct the general ledger accounts, a prior period
adjustment is also required to adjust the January 1, 2002 retained earnings balance. If we assume
that original retained earnings was $1,900 the following prior period adjustment will have to be
made as of January 1, 2002 to reflect the change in accounting principal.
Retained earnings, January 1, 2002
Prior period adjustment
Corrected balance
$1,900
593
$2,493
CHANGE IN ACCOUNTING PRINCIPLE-PROSPECTIVE APPROACH
A change in depreciation, amortization or depletion method is a change in accounting estimate as
a result of a change accounting principle and is reported on a prospective basis.
Example: In 2004 Spencer Company decided to change from accelerated depreciation to
straight-line for financial reporting purposes. The only asset involved is equipment that
originally cost $500,000 on January 1, 2001. The equipment was expected to have a ten year
service life, a salvage value of $50,000 and was depreciated using the double declining method.
The change in depreciation method is assumed to be effective as of the beginning of 2004. The
following is a depreciation schedule on this piece of equipment for the four years that it has been
in service.
Year
2001
2002
2003
2004
Beginning
Ending
Book
Accumulated
Book
Value DDB % Depreciation Depreciation Value
$500,000 20%
$100,000
$100,000 $400,000
400,000 20%
80,000
180,000 320,000
320,000 20%
64,000
244,000 256,000
256,000 20%
51,200
295,200 204,800
Using the prospective approach the following reflects the depreciation that will be taken in 2004
and in subsequent years.
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Accounting Changes and Error Corrections
Original cost
Accumulated depreciation
Book value
Salvage value
Depreciable base
Serivce life remaining
Annual depreciation
$500,000
244,000
256,000
50,000
206,000
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$29,429
CHANGES IN ACCOUNTING ESTIMATE-PROSPECTIVE APPROACH
At the end of each accounting period there are a number of estimates made in order to prepare
the financial statements. These estimates are based on the facts and circumstances that exist at
the time. These facts and circumstances will change from one accounting period to the next. It
is not practical to restate the financial statements every time there is new information that makes
the prior estimates incorrect. Therefore, on an ongoing basis management applies its best
judgment and modifies such estimates as the facts and circumstances change in each subsequent
accounting period. Changes in accounting estimates are handled on a prospective basis.
Example: On January 1, 2000 Spencer Company purchased machinery which cost $60,000.
The machinery has an estimated salvage value of $18,000 and service life of 7 years. On
January 1, 2002 it was determined that the salvage life would be approximately $10,000 and the
service life would be 4 years. The journal entry to record the depreciation expense for year
ended December 31, 2002 is as follows.
DATE
ACCOUNT
12/31/2002 Depreciation expense
Accumulated depreciation
Analysis of revised depreciation expense:
Original cost
Original salvage value
Depreciable base
Original service life
Annual depreciation
Years in service before change in estimate
Accumulated deprecation
Book value
Revised salvage value
Depreciable base
Revised service life (4 total, 2 left)
Revised annual depreciation expense
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DEBIT
$19,000
CREDIT
$19,000
$60,000
$18,000
42,000
7
6,000
2
12,000
48,000
10,000
38,000
2
$19,000
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Accounting Changes and Error Corrections
REPORTING A CHANGE IN ENTITY-RETROSPECTIVE APPROACH
Under certain circumstances management is required to restate the financial statements of all
prior periods. These circumstances relate to a change in the reporting entity. All such changes
are reported on a retrospective basis. Such changes include:
(1) Presenting consolidated financial statements for the first time.
(2) Changing specific subsidiaries for which consolidated financial statements are presented.
(3) Changing companies included in combined financial statements
(4) Change in the cost, equity, or consolidation method used for accounting for subsidiaries and
investments.
REPORTING A CORRECTION OF AN ERROR-RETROSPECTIVE APPROACH
The correction of an error must be handled as a prior period adjustment to the earliest period
reported in the financial statements. All such corrections are reported on a retrospective basis.
Some of the types of errors that might occur are as follows:
(1) Change from an unacceptable accounting principle to an acceptable one.
(2) Mathematical errors.
(3) Changes in estimates that were not prepared in good faith.
(4) Failure to accrue or defer expenses or revenues at the end of a period.
(5) Misuse of facts.
(6) Misclassification of costs as expenses and vice versa.
Example: Spencer Company purchased a piece of equipment on January 1, 2000 for $75,000.
The bookkeeper incorrectly expensed the purchase as operating expenses in 2000. The
equipment had no estimated salvage value and a service life of 5 years. The company has an
average income tax rate of 35%. In 2002 the company discovered the error and prepared the
following journal entry to make the correction.
DATE
ACCOUNT
1/1/2002 Equipment
Accumulated deprecation
Deferred tax liability
Retained earnings
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DEBIT
$75,000
CREDIT
$30,000
13,500
31,500
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Accounting Changes and Error Corrections
Analysis of adjustment to retained earnings:
Cost of equipment
Salvage value
Depreciable base
Service life
Annual depreciation
Years of service
Accumulated deprecation
Book value
Income tax rate
Deferred tax liability
Retained earnings
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$75,000
0
75,000
5
15,000
2
$75,000
30,000
45,000
30%
13,500
$31,500
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