Accounting Changes
and Error Analysis
Chapter 22
Intermediate Accounting
12th & 13th Editions
Kieso, Weygandt, and Warfield
KWW slides Prepared by Coby Harmon, University of California,
Santa Barbara as modified by Teresa Gordon, University of Idaho
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Restatements are common!
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Accounting Changes &
Corrections

ASC Topic 250 (SFAS No. 154) discusses
3 types of accounting changes plus
correction of errors
1. Changes in Accounting Principle
2. Changes in Accounting Estimates
3. Changes in Reporting Entity
4. Errors in Financial Statements
5
Change in accounting
principle

A change from one generally accepted
principle to another generally accepted
accounting principle



Only possible where GAAP permits more than
one acceptable choice
Definition includes a change in the method of
applying an accounting principle
Must be applied consistently after adopted
IMPORTANT NOTE: The change must be justified on the
basis that it is preferable to the principle previously
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followed.
Change in accounting
principle

A change in accounting principle does NOT
include



Initial adoption of an accounting principle for a
new event or transaction
Modification of an accounting principle made
necessary by transactions clearly different in
substance from those previously occurring
A change to a generally accepted principle from
an incorrect principle (This is considered the
correction of an error)
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Reporting a change in
principle

Retrospective application to all prior periods unless
this is impracticable



Cumulative DIRECT effect of the change on periods prior
to those presented is reflected on the balance sheet in the
amounts reported for assets and liabilities
The offsetting adjustment (if any) is made to the beginning
balance of retained earnings for the earliest period
presented
Financial statements will be re-stated as though the new
principle had been in use
Direct effects include
income tax impact
Indirect effects (if actually incurred) are
recognized in the period during which the
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accounting change is made
Earliest Year Presented (or
affected by change)

Retained Earnings account is shown as follows:
Balance at beginning of year
Adjustment for the cumulative
effect on prior years (net of tax)
Balance at beginning (as adjusted)
Net Income
Less dividends declared
Balance at end of year
$ XXX
$ XX
$ XX
$ XXX
- XX
$ XXX
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When is a Change in Accounting
Principle Appropriate?



Changes are appropriate when the new principle is
preferable to the existing accounting principle.
The new principle should result in improved financial
reporting.
A change is considered preferable if a FASB
standard:



creates a new accounting principle, or
expresses preference for a new principle, or
rejects a specific accounting principle
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Motivations for Change

Managers and others may have a selfinterest in adopting principles or standards:




Companies may want to be less politically visible
to avoid regulation
A company’s capital structure may affect its
selection of accounting standards
Managers may select accounting standards to
maximize their performance-related bonuses
Companies have an incentive to manage or
smooth earnings
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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 completedcontract method. In 2010 the company changed to the
percentage-of-completion 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.
(We assume a 40 percent enacted tax rate.)
LO 3 Understand how to account for retrospective accounting changes.
Changes in Accounting Principle
Income statements for 2008–2010
Illustration 22-1
LO 3
Changes in Accounting Principle
Data for Retrospective Change Example
Illustration 22-2
Journal entry to record change at beginning of 2010:
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 and reason for the change in accounting principle.
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, any other affected line items.
c.
The cumulative effect of the change on retained earnings
or other components of equity or net assets as of the
beginning of the earliest period presented.
LO 3 Understand how to account for retrospective accounting changes.
Changes in Accounting Principle
Reporting a Change in Principle
Illustration 22-3
LO 3 Understand how to account for retrospective accounting changes.
Changes in Accounting Principle
Retained Earnings Adjustment
Assuming a retained earnings balance of $1,360,000 at the
beginning of 2008.
Illustration 22-4
Before Change
LO 3 Understand how to account for retrospective accounting changes.
Changes in Accounting Principle
Retained Earnings Adjustment
Illustration 22-5
After Change
LO 3 Understand how to account for retrospective accounting changes.
Changes in
accounting estimates
Current and prospective method
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Many amounts on FS involve
estimates, including:
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.
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Change in Estimate

Estimates that are later determined to be
incorrect should be corrected as changes in
estimates

Result from availability of new or additional
information
Companies report prospectively changes in
accounting estimates.
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Change in Estimate

Sometimes effected in the form of a change
in accounting principle


Bad debt accounting – change from percentage of
sales method to aging of accounts receivable
(allowance) method
Fixed assets – change from sum-of-year’s-digits
depreciation to straight-line depreciation
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Changes in Accounting
Estimates

Are handled with what used to be called the
current and prospective method



This means that we do not go back and change
previously reported numbers on the financial
statements (no retroactive restatement)
We make changes to current and future years
only
Two numeric examples


Depreciation expense
Depletion expense
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Depreciation Example

Consider these facts related to an asset acquired
January 1, 2010:
Asset cost
Estimated residual value
Estimated service life




$240,000
$40,000
5 years
The company uses straight-line depreciation
Assume that after 2 years, it becomes obvious that the
asset will be used for a total of 8 years
At the end of 8 years, it will be worth $10,000
What depreciation expense should be recorded for 2012?
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Solution
$240,000 - 40,000
- 40,000 =
$160,000
Carrying Value
160,000 -10,000
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Year
2010
2011
2012
2013
2014
2015
2016
2017
=
Depreciation
$
$
$
$
$
$
$
$
40,000
40,000
25,000
25,000
25,000
25,000
25,000
25,000
$240,000
Book value at
end of year
$200,000
$160,000
$135,000
$110,000
$85,000
$60,000
$35,000
$10,000
$ 25,000
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Alternate treatment

If we had originally known new facts:
240,000 -10,000
8



=
$28,750
We would have had $57,500 in accumulated
depreciation at end of 2011.
Actually in acc’d depreciation = $80,000
Make adjusting JE and then continue with
$28,750 depreciation for remaining useful life
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Alternate treatment
240,000 -10,000
8
=
$28,750
2012
Correcting JE:
Acc’d Depr
22,500
Depr Exp
22,500
Record 2012 depreciation:
Depr Exp
28,750
Acc’d Depr
28,750
Year
2010
2011
2012
2013
2014
2015
2016
2017
Depreciation
$
$
$
$
$
$
$
$
40,000
40,000
6,250
28,750
28,750
28,750
28,750
28,750
$240,000
Book value at
end of year
$200,000
$160,000
$153,750
$125,000
$96,250
$67,500
$38,750
$10,000
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Example - Coal Mine






Cost of property
Cost to restore property
Value after restoration
Recoverable resources
First year production
Sold for
Statutory depletion rate
for tax purposes = 10%
$9,000,000
$1,200,000*
$1,000,000
4,000,000 tons
150,000 tons
$30 per ton
* Present value (asset
retirement obligation
measured in accordance
with SFAS No. 143)
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Coal mine example:
Cost basis + cost to restore - residual value after restoration
Total estimated recoverable units
$9,000,000 + 1,200,000 - 1,000,000
4,000,000 tons
=
$2.30
per ton
Sold 150,000 tons, therefore cost depletion
= 150,000 * 2.30 = $345,000
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Coal mine example, continued



Assume that 250,000 tons of coal were produced
and sold during the second year of operation
However, new EPA regulations increased the
projected restoration costs to $2,000,000 (asset
retirement obligation)
At the beginning of the second year of production,
geologist estimate 4,050,000 tons remain
We start over estimating the depletion rate per ton
-- using the current BOOK VALUE instead of cost
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Coal Mine Example
Cost basis + cost to restore - residual value after restoration
Remaining recoverable units (estimated)
Cost basis is now
$9,000,000 - $345,000
= $8,655,000
The cost to restore is
now $2,000,000
The new estimate of
recoverable units (including
2nd year’s production) is
4,050,000 tons
(3,800K left + 250K mined
this year)
$8,655,000 + $2,000,000 - $1,000,000 = $2.38 per ton
4,050,000
250,000 tons * $2.38 = $595,000 depletion expense
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Statutory Depletion




Note that the tax deduction would be much higher
using statutory depletion allowance (a permanent
difference between accounting and tax return)
Year 1 - 150,000 tons * $30 per ton = $4,500,000
revenue * 10% statutory rate = $450,000 on tax
deduction vs. $345,000 on income statement
Year 2 - 250,000 tons * $33 per ton =
$8,250,000 Revenue * 10% statutory rate =
$825,000 tax deduction vs. $595,000 on income
statement
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Disclosure of Changes in
Estimate

Not required for routine changes in estimate
that happen every year




Allowance for uncollectible accounts
Inventory obsolescence
Warranty obligations
UNLESS material

If material, the change in estimate should be
discussed in footnotes to financial statements with
per share disclosures
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Other Changes &
Corrections
Change in Entity
Correction of Error
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Reporting a Change in Entity



The reporting entity changes
Financial statements are restated for all prior
periods presented
Examples of a change in reporting entity are:



Consolidated statements in lieu of individual
financials
Loss in control of formerly consolidated subsidiary
Acquisition or sale of subsidiaries
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Reporting the
Correction of an Error


Corrections are treated as prior period adjustments
to retained earnings for the earliest period being
reported
Examples of accounting errors include:





A change from an accounting principle that is not generally
accepted to one that is accepted
Mathematical errors
Changes in estimates that were not prepared in good faith
A failure to properly accrue or defer expenses or revenues
A misapplication or omission of relevant facts
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Restatement Example



ASC 250-10-55-2 (SFAS No. 154, Appendix A)
Illustration 1 - detailed example of a change
from LIFO to FIFO inventory method
Shows extensive disclosures that would be
needed to communicate impact on balance
sheet, income statement, and statement of
cash flows
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Error Analysis in General



Firms do not correct errors that are insignificant.
Three questions must be answered in this regard:
1. What type of error is involved?
2. What correcting entries are needed?
3. How are financial statements to be restated?
Error corrections are reported as prior period
adjustments to the beginning retained earnings
balance in the current year
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Accounting Changes
A.
B.
C.
D.
Change in Accounting Estimate (prospectively)
Change in Accounting Principle (retroactively or disclosed)
Change in Accounting Entity (retroactively)
Correction of an Error (retroactively)
1. Change in a plant asset’s salvage value.
2. Change due to overstatement of inventory
3. Change from sum-of-years’-digits to straight-line
depreciation method
4. Change from presenting unconsolidated financial
statements to consolidated financial statements
5. Change from LIFO to FIFO inventory method
6. Change in rate used to compute warranty costs
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Accounting Changes
A.
B.
C.
D.
Change in Accounting Estimate (prospectively)
Change in Accounting Principle (retroactively or disclosed)
Change in Accounting Entity (retroactively)
Correction of an Error (retroactively)
7. Change from an unacceptable to an acceptable
accounting principle
8. Change in a patent’s amortization period
9. Change from completed contract to percentage of
completion accounting for long-term contracts
10. Change from FIFO to LIFO inventory method
11. Change from allowance method to the percentage of
sales method to account for bad debt expense
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