Accounting Changes

and Error Analysis

Chapter 22

Intermediate Accounting
12th Edition
Kieso, Weygandt, and Warfield
Prepared by Coby Harmon, University of California, Santa Barbara
as modified by Teresa Gordon, University of Idaho

Learning Objectives

Identify the types of accounting changes.

Describe the accounting for changes in accounting principles.
Understand how to account for retrospective accounting
changes.
Understand how to account for impracticable changes.
Describe the accounting for changes in estimates.
Identify changes in a reporting entity.
Describe the accounting for correction of errors.
Identify economic motives for changing accounting methods.
Analyze the effect of errors.

Accounting Changes and

Error Analysis
Accounting
Changes
Changes in
accounting
principle
Changes in
accounting estimate
Reporting a change
in entity
Reporting a
correction of an
error
Motivations for
change of method

Error Analysis
Balance sheet
errors
Income statement
errors
Balance sheet and
income statement
effects
Comprehensive
example
Preparation of
statements with
error corrections

Restatements are common!

Accounting Changes &

Corrections

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
followed.
6

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)
7

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
accounting change is made
8

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
9

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

10

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 companys 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
11

Retrospective
Retrospective Change
Change Example
Example
Example (Retrospective Change) Buildmore
Construction Company used the completed contract
method to account for long-term construction
contracts for financial accounting and tax purposes in
2006, its first year of operations. In 2008, the
company decided to change to the percentage-ofcompletion method for financial accounting purposes.
Income before long-term contracts and taxes in 2006,
2007, and 2008 was $50,000, $80,000 and $100,000.
The tax rate is 40% and the company will continue to
use the completed contract method for tax purposes.
12

Retrospective
Retrospective Change
Change Example
Example
Example Income from Long-Term Contracts

13

Retrospective
Retrospective Change
Change Example
Example
Example Comparative Income Statements

Income before LT contracts

2008

Restated
2007

Previous
2007

$ 100,000

$ 80,000

$ 80,000

60,000

40,000

25,000

160,000

120,000

105,000

64,000

48,000

42,000

96,000

$ 72,000

$ 63,000

Income from LT contracts

Income before tax
Income tax
Net income

14
LO 3 Understand how to account for retrospective accounting changes.

Retrospective
Retrospective Change
Change Example
Example
Example Retained Earnings Statement

15
LO 3 Understand how to account for retrospective accounting changes.

Changes in
accounting estimates
Current and prospective method

16

Many
Many amounts
amounts on
on FS
FS involve
involve
estimates,
estimates, including:
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.

17

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.
18

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-years-digits
depreciation to straight-line depreciation

19

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
20

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?

21

Solution
$240,000 - 40,000
- 40,000 =
$160,000
Carrying Value
new
estimate

160,000 -10,000
6

=
8-2

$ 25,000
22

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 accd depreciation = $80,000
Make adjusting JE and then continue with
$28,750 depreciation for remaining useful life
23

Alternate treatment
240,000 -10,000
8

$28,750

2012
Correcting JE:
Accd Depr
22,500
Depr Exp
22,500
Record 2012 depreciation:
Depr Exp
28,750
Accd Depr
28,750

24

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)

25

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

26

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
27

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 years 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

28

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
29

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
30

Other Changes &

Corrections
Change in Entity
Correction of Error

31

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
32

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

33

Restatement Example
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

34

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

35

Accounting
Accounting Changes
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 assets 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

36

Accounting
Accounting Changes
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 patents 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

37