Accounting Changes and Error Analysis

1. 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

2. 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.

3. Accounting Changes and Error Analysis Accounting Changes Error Analysis • Changes in accounting principle • Changes in accounting estimate • Reporting a change in entity • Reporting a correction of an error • Motivations for change of method • Balance sheet errors • Income statement errors • Balance sheet and income statement effects • Comprehensive example • Preparation of statements with error corrections

4. Restatements are common!

5. Accounting Changes & Corrections • SFAS No. 154 discusses 3 types of accounting changes plus correction of errors • Changes in Accounting Principle • Changes in Accounting Estimates • Changes in Reporting Entity • Errors in Financial Statements

6. 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.

7. 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)

8. 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 Indirect effects (if actually incurred) are recognized in the period during which the accounting change is made Direct effects include income tax impact

9. Earliest Year Presented (or affected by change) • Retained Earnings account is shown as follows: Balance at beginning of year $ XXX Adjustment for the cumulative effect on prior years (net of tax) $ XX Balance at beginning (as adjusted) $ XX Net Income $ XXX Less dividends declared - XX Balance at end of year $ XXX

10. 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

11. Motivations for Change • Managers and others may have a self- interest 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

12. Retrospective Change 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-of-completion 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.

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

14. Retrospective Change Example Example Comparative Income Statements LO 3 Understand how to account for retrospective accounting changes.

15. Retrospective Change Example Example Retained Earnings Statement LO 3 Understand how to account for retrospective accounting changes.

16. Changes in accounting estimates Current and prospective method

17. Many amounts on FS involve estimates, including: • Uncollectible receivables. • Inventory obsolescence. • Useful lives and salvage values of assets. • Periods benefited by deferred costs. • Liabilities for warranty costs and income taxes. • Recoverable mineral reserves. • Change in depreciation methods.

18. 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.

19. 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

20. 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

21. Depreciation Example • Consider these facts related to an asset acquired January 1, 2010: • 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?

22. 160,000 -10,000 = 6 Solution $240,000 - 40,000- 40,000 =$160,000Carrying Value new estimate $ 25,000 8 - 2

23. 240,000 -10,000 = $28,750 8 Alternate treatment • If we had originally known new facts: • 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

24. 240,000 -10,000 = $28,750 8 Alternate treatment 2012 Correcting JE: Acc’d Depr 22,500 Depr Exp 22,500 Record 2012 depreciation: Depr Exp 28,750 Acc’d Depr 28,750

25. Example - Coal Mine • Cost of property $9,000,000 • Cost to restore property $1,200,000* • Value after restoration $1,000,000 • Recoverable resources 4,000,000 tons • First year production 150,000 tons • Sold for $30 per ton * Present value (asset retirement obligation measured in accordance with SFAS No. 143) Statutory depletion rate for tax purposes = 10%

26. 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

27. 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

28. 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 new estimate of recoverable units (including 2nd year’s production) is 4,050,000 tons(3,800K left + 250K mined this year) The cost to restore is now $2,000,000 $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

29. 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

30. 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

31. Other Changes & Corrections Change in Entity Correction of Error

32. 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

33. 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

34. 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

35. Error Analysis in General • Firms do not correct errors that are insignificant. • Three questions must be answered in this regard: • What type of error is involved? • What correcting entries are needed? • 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

36. Accounting Changes A. Change in Accounting Estimate (prospectively) B. Change in Accounting Principle (retroactively or disclosed) C. Change in Accounting Entity (retroactively) D. 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

37. Accounting Changes A. Change in Accounting Estimate (prospectively) B. Change in Accounting Principle (retroactively or disclosed) C. Change in Accounting Entity (retroactively) D. 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