Section 18 – Accounting Changes
& Error Corrections
3 types of accounting changes:
1. Change in accounting principle (slide 5)
2. Change in accounting estimate (slide 21)
3. Change in reporting entity (slide 27)
Type of Change
Accounting Changes
Description
Change in accounting
Change from one generally
accepted accounting principle
principle
to another.
Examples
Adopt a new FASB standard.
•
• 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 periods benefited by
intangible asset.
• Change acturial estimates pertaining to
a pension plan.
Change in reporting
entity
Change from reporting as one
type of entity to
another type of entity
• Consolidate a subsidiary not
previously included in consolidated
financial statements.
• Report consolidated financial statements
in place of individual statements.
Motivation for Accounting Choices
Changing
Conditions
Effect on mgt
Compensation
Motivations for Change
of Accounting Method
Effect on Debt Agreements
(no dividends if R/E fall below
a certain level)
Effect on Union
Negotiations
New Accounting
Standard Issued
Effect on
Income Taxes
Motivations for Change of Accounting Method, Cont’d
Additional reasons why companies may prefer certain
accounting methods:
1. Capital Structure.
2. Bonus Payments.
3. Smooth Earnings.
Changes in Accounting Principle
A change from one generally accepted accounting
principle to another. Examples include:
 Average cost to LIFO.
 Completed-contract to percentage-of-completion.
Adoption of a new principle in recognition of events that
have occurred for the 1st time or that were previously
immaterial is not an accounting change.
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.
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.
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.
(assumming a 40 percent enacted tax rate.)
Changes in Accounting Principle
Income statements for 2008–2010
Changes in Accounting Principle
Data for Retrospective Change Example
Journal entry to record change at beginning of 2010:
Construction in Process
Deferred Tax Liability
Retained Earnings
Both methods covered in Section 23
220,000
88,000
132,000
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.
Changes in Accounting Principle
Reporting a Change in Principle
Illustration 22-3
Changes in Accounting Principle
Retained Earnings Adjustment
Assuming a retained earnings balance of $1,360,000 at the
beginning of 2008.
Before Change
Changes in Accounting Principle
Retained Earnings Adjustment
After Change
Changes in Accounting Principle
Other effects that a co. should report when it
makes a change in accounting principle:
e.g., what happens when ABC corp. has a bonus
plan based on net income, and the prior year’s net
income changes when FIFO is retrospectively
applied? Should ABC adjust net income? The
answers depend on whether the effects are direct
or indirect.
Changes in Accounting Principle
Effects of a Change
1. Direct Effects: The direct effects of a change in accounting
principle are adjustments that would be necessary to restate the
financial statements of prior periods. The FASB takes the position
that companies should retrospectively apply the direct effects of
a change in accounting principle.
Example: ABC Corp. changed its inventory costing method from
LIFO to FIFO, resulting in an higher inventory value. ABC should
change the inventory amounts in prior periods to indicate the
change to the FIFO method.
Changes in Accounting Principle, Cont’d
2. Indirect Effects: The indirect effects of a change in accounting
principle are differences in nondiscretionary items based on earnings
(e.g., bonuses) that would have occurred if the new principle had been
used in prior years. They do not change prior-period amounts.
e.g., XYZ corp has an employee profit-sharing plan based on net
income. As explained earlier, XYZ would report higher income in
previous two years if it used the FIFO method. In addition, it is
assumed that the profit-sharing plan requires that XYZ pay the
incremental amount due based on the FIFO income amounts.
XYZ must report the incremental amount as additional expense in the
current period. If the co. prepares comparative financial statements, it
does not recast (change) amounts reported for prior periods.
The co. includes in the financial statements a description of the
indirect effects, i.e., it discloses the amounts recognized in the current
period and related per share info.
Changes in Accounting Principle, Cont’d
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.
Prospective Approach
The prospective approach is used for changes in
principle when:
 It is impracticable to determine some period-specific
effects, e.g. from FIFO to LIFO.
 It is impracticable to determine the cumulative effect
of prior years.
 The change is mandated by authoritative
pronouncements, e.g., from Accounting for Investment
to Investment as AFS (Available for Sale).
Note: Most changes in principle are reported by the
retrospective approach
Change to the LIFO Method
When a company elects to change to LIFO, it is usually
impossible to calculate the income effect on prior years. As a
result, the company does not report the change
retrospectively. Instead, the LIFO method is used from the
point of adoption forward.
The beginning inventory in the year the LIFO method is
adopted is the base year inventory.
A disclosure note is needed to explain:
(a) The nature of the change,
(b) the effect of the change on current year’s
income and earnings per share, and
(c) why retrospective application was impracticable.
(c) Why: It would require assumptions as to when specific LIFO inventory layers were
created in years prior to the change.
Change in Accounting Estimate (Prospective Approach)
A change in depreciation method, residual value &
lives estimate (amortization, collectability of
accounts receivable, warranty expense, actuarial
assumptions for pension benefits) is considered to
be a change in accounting estimate that is achieved
by a change in accounting principle.
1.It is accounted for prospectively as a change in
accounting estimate.
2.A disclosure note is required to describe:
the effect of a change on income before
extraordinary items, net income, and related EPS
Changes in Accounting Estimate
The following items require 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.
Changes in Accounting Estimate
Prospective Reporting
Companies report prospectively changes in accounting
estimates. They 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.
The FASB views changes in estimates as normal recurring
corrections and adjustments and prohibits retrospective treatment.
Change in Estimate Example
Illustration: Arcadia High School (Phoenix), 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 2008 (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:
–
What is the journal entry to correct
prior years’ depreciation expense?
–
Calculate depreciation expense for 2008.
No Entry
Required
Change in Estimate Example After 7 years
Equipment cost
Salvage value
Depreciable base
Useful life (original)
Annual depreciation
$510,000
First, establish NBV at
- 10,000
date of change in
estimate.
500,000
10 years
$ 50,000 x 7 years = $350,000
Balance Sheet (Dec. 31, 2007)
Fixed Assets:
Equipment
Accumulated depreciation
$510,000
350,000
Net book value (NBV)
$160,000
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 pershare amounts of the current period.
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.
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 revenue, net income,
income before extraordinary items, and related per
share amounts should be shown for all periods
presented.
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.
Error Corrections
Error correction is not an accounting change but
it is treated similarly.
Examples include:




Use of inappropriate principle
Mistakes in applying GAAP
Arithmetic mistakes
Fraud or gross negligence in reporting
For all years presented, financial statements are
retrospectively restated to reflect the error
correction.
Error Corrections
Type of Change
Error correction
Description
Types/Examples
Correction of an error caused • Mathematical mistakes.
by varying reasons (see
• Inaccuract physical count of inventory.
types/examples)
• Change from the cash basis of
accounting to the accrual basis.
• Failure to record an adjusting entry.
• Recording an asset as an expense, or
vice versa.
• Fraud or gross negligence.
Error Corrections
Additional types/examples:
1. A change from an accounting principle that is not generally
accepted (cash basis) to an accounting principle that is
acceptable (accrual basis).
2. Changes in estimates that occur because a company did not
prepare the estimates in good faith.
3. Failure to accrue or defer certain expenses or revenues.
4. Misuse of facts.
5. Incorrect classification of a cost as an expense instead of an
asset, and vice versa.
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. Prior Period Adjustment refers to an
addition to or reduction in the beginning retained
earnings balance.
Include a disclosure note.
Prior Period Adjustments
Prior Period
Adjustment
Required
Counterbalancing error
discovered in the second
year.
Noncounterbalancing
error discovered in any
year.
Use the retrospective approach
Inventory Errors
Beginning inventory
Plus: Net purchases
Less: Ending inventory
Cost of goods sold
Revenues
Less: Cost of goods sold
Less: Other expenses
Net income
Beginning retained earnings
Plus: net income
Less: Dividends
Ending retained earnings
When analyzing inventory errors, it’s helpful to
visualize the way cost of goods sold, net income,
and retained earnings are determined.
Inventory Errors
 Overstatement of ending inventory
◦ Understates cost of goods sold &
◦ Overstates pretax income.
 Understatement of ending inventory
◦ Overstates cost of goods sold &
◦ Understates pretax income.
Inventory Errors
 Overstatement of beginning inventory
◦ Overstates cost of goods sold &
◦ Understates pretax income.
 Understatement of beginning inventory
◦ Understates cost of goods sold &
◦ Overstates pretax income.
Inventory Errors
When the Inventory Error is Discovered the Following Year
If an error was made in 2013, but not discovered until 2014, the 2013
financial statements were incorrect as a result of the error. The error
should be retrospectively restated to reflect the correct inventory amount,
cost of goods sold, net income, and retained earnings when the
comparative 2014 and 2013 financial statements are issued for 2014.
Dr. Retained Earnings
Cr. Inventory
When the Inventory Error is Discovered Subsequent
to the Following Year
If an error was made in 2013, but not discovered until 2015, all previous
years’ financial statements that were incorrect as a result of the error
also are retrospectively restated to reflect the correct inventory, cost of
goods sold, retained earnings, and net income even though no correcting
entry is needed in 2015. The error has self-corrected and no prior
period adjustment is needed.
Physical Goods Included in Inventory
Effect of Inventory Errors
Ending
Inventory
Misstated
The effect of an error on net income in one year (2011) will be counterbalanced in
the next (2012), however the income statement will be misstated for both years.
Effect of Inventory Errors
Illustration: Jay Weiseman Corp. understates its ending inventory by
$10,000 in 2011; all other items are correctly stated.
Illustration 8-8
Physical Goods Included in Inventory
Effect of Inventory Errors
Purchases not
recorded &
not counted as
ending Inventory
The understatement does not affect cost of goods sold and net income because the
errors offset one another.
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.
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.
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.
Correction of Errors
Illustration: In 2011 the bookkeeper for Selectro Company
discovered an error:
In 2010 the company failed to record $20,000 of
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.
Correction of Errors
Illustration: Selectro’s income statement for 2010 with and
without the error.
Show the entries that Selectro should have made and did make for
recording depreciation expense and income taxes.
Correction of Errors
Illustration: Show the entries that Selectro should have
made and did make for recording depreciation expense and
income taxes.
Correcting
Entry in
2011
Correction of Errors
Illustration: Show the entries that Selectro should have
made and did make for recording depreciation expense and
income taxes.
Correcting
Entry in
2011
Retained Earnings
12,000
Correction of Errors
Illustration: Show the entries that Selectro should have
made and did make for recording depreciation expense and
income taxes.
Correcting
Entry in
2011
Retained Earnings
Deferred Tax Liability
12,000
8,000
Reversal
Correction of Errors
Illustration: Show the entries that Selectro should have
made and did make for recording depreciation expense and
income taxes.
Correcting
Entry in
2011
Retained Earnings
Deferred Tax Liability
12,000
8,000
Accumulated Depreciation—Buildings
Record
20,000
Correction of Errors
Illustration (Single-Period Statement): Assume that
Selectro Company has a beginning retained earnings balance
at January 1, 2011, of $350,000. The company reports net
income of $400,000 in 2011.
Correction of Errors
Comparative Statements
A 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.
Correction of Errors
Woods, Inc.
Statement of Retained Earnings
For the Year Ended December 31, 2010
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, 2010, you discover a
$62,500 error that caused the 2009 inventory to be overstated (overstated
inventory caused COGS to be lower and thus net income to be higher in 2009).
This discovery have an impact on the reporting of the Statement of Retained
Earnings for 2010.
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.
Balance Sheet Errors
Balance sheet errors affect only the presentation of
an asset, liability, or stockholders’ equity account.
When the error is discovered in the error year, the
company reclassifies the item to its proper position.
If the error is discovered in a prior year, the company
should restate the balance sheet of the prior year for
comparative purposes.
Income Statement Errors
Improper classification of revenues or expenses.
A company must make a reclassification entry when
it discovers the error in the error year.
If the error is discovered in a prior year, the
company should restate the income statement of the
prior year for comparative purposes.
Balance Sheet and Income Statement Errors
Errors affecting both balance sheet and income
statement.
This type of error classified as:
1. Counterbalancing errors
2. Noncounterbalancing 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.
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.
Balance Sheet and Income Statement Errors
Noncounterbalancing Errors
Not offset in the next accounting period.
Companies must make correcting entries, even if they
have closed the books.
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
retained earnings.
reported.
reported?
Journal entries?
Adjust affected
None
balances to new
method.
Disclosure note?
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
Summary of Accounting Changes and Errors
Summary of Accounting Changes and Errors
LO 7 Describe the accounting for correction of errors.
Reporting Accounting Changes and
Error Corrections
Disclosure Notes
In the first set of financial statements after the
change is made, a disclosure note is needed to
Provide
justification
for the change.
Point out that
comparative
information has
been revised.
Report any per
share amounts
affected for the
current and all
prior periods.
 One area in which iGAAP and U.S. GAAP differ is the reporting
of error corrections in previously issued financial statements.
While both GAAPs require restatement, U.S. GAAP is an
absolute standard—that is, there is no exception to this rule.
 The accounting for changes in estimates is similar between U.S.
GAAP and iGAAP.
 Under U.S. GAAP and iGAAP, if determining the effect of a
change in accounting principle 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.
 Under iGAAP, the impracticality exception applies both to
changes in accounting principles and to the correction of
errors. Under U.S. GAAP, this exception applies only to
changes in accounting principle.
 IAS 8 does not specifically address the accounting and
reporting for indirect effects of changes in accounting
principles. As indicated in the chapter, U.S. GAAP has
detailed guidance on the accounting and reporting of
indirect effects.