Accounting Changes and Error Corrections

Transcription

1 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 D:\Teaching\3322\web\post\module4\c20\tnotes\c20a.doc 11/29/2007 1

2 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 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: D:\Teaching\3322\web\post\module4\c20\tnotes\c20a.doc 11/29/2007 2

3 Income Statements Years Prior to 2002 Revenue $1,050 $980 $3,800 Cost of goods sold (LIFO) ,470 Gross profit ,330 Operating expenses Income before tax Income tax Net income $109 $102 $395 The following are the inventory amounts reported in the balance sheet at the end of each of the years 2001 through Balance Sheets Inventory (LIFO) $150 $130 $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 Years Prior to 2002 Cost of goods sold (LIFO) $683 $637 $2,470 Cost of goods sold (FIFO) ,729 Differences $205 $191 $741 Cumulative effect of change: Inventory/cost of goods sold $1,137 $932 $741 Income taxes Net income/retained earnings $909 $746 $593 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. D:\Teaching\3322\web\post\module4\c20\tnotes\c20a.doc 11/29/2007 3

4 Income Statements (Recast) Revenue $1,200 $1,050 $980 Cost of goods sold (FIFO) Gross profit Operating expenses Income before tax Income tax Net income $250 $273 $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) $150 $130 AJE (cumulative effect of changes) 1, Adjusted inventory (FIFO) $1,287 $1,062 Change to deferred income taxes $227 $186 Change to retained earnings Cumulative effect of changes $1,137 $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. D:\Teaching\3322\web\post\module4\c20\tnotes\c20a.doc 11/29/2007 4

5 Account Debit Credit Inventory $1,137 Retained earnings $909 Deferred income taxes 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 $1,900 Prior period adjustment 593 Corrected balance $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, 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 The following is a depreciation schedule on this piece of equipment for the four years that it has been in service. Beginning Book Value Ending Book Value Accumulated Year DDB % Depreciation Depreciation 2001 $500,000 20% $100,000 $100,000 $400, ,000 20% 80, , , ,000 20% 64, , , ,000 20% 51, , ,800 Using the prospective approach the following reflects the depreciation that will be taken in 2004 and in subsequent years. D:\Teaching\3322\web\post\module4\c20\tnotes\c20a.doc 11/29/2007 5

6 Original cost $500,000 Accumulated depreciation 244,000 Book value 256,000 Salvage value 50,000 Depreciable base 206,000 Serivce life remaining 7 Annual depreciation $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 DEBIT CREDIT 12/31/2002 Depreciation expense $19,000 Accumulated depreciation $19,000 Analysis of revised depreciation expense: Original cost $60,000 Original salvage value $18,000 Depreciable base 42,000 Original service life 7 Annual depreciation 6,000 Years in service before change in estimate 2 Accumulated deprecation 12,000 Book value 48,000 Revised salvage value 10,000 Depreciable base 38,000 Revised service life (4 total, 2 left) 2 Revised annual depreciation expense $19,000 D:\Teaching\3322\web\post\module4\c20\tnotes\c20a.doc 11/29/2007 6

7 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 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 DEBIT CREDIT 1/1/2002 Equipment $75,000 Accumulated deprecation $30,000 Deferred tax liability 13,500 Retained earnings 31,500 D:\Teaching\3322\web\post\module4\c20\tnotes\c20a.doc 11/29/2007 7

8 Analysis of adjustment to retained earnings: Cost of equipment $75,000 $75,000 Salvage value 0 Depreciable base 75,000 Service life 5 Annual depreciation 15,000 Years of service 2 Accumulated deprecation 30,000 Book value 45,000 Income tax rate 30% Deferred tax liability 13,500 Retained earnings $31,500 D:\Teaching\3322\web\post\module4\c20\tnotes\c20a.doc 11/29/2007 8