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Chapter 22 ACCOUNTING CHANGES AND ERROR analysis Sommers – ACCT 3311. Discussion Questions. Q22–12 How should consolidated financial statements be reported this year when statements of individual companies were presented last year?. Correction of Errors. Types of Accounting Errors:
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Chapter 22 ACCOUNTING CHANGES AND ERROR analysisSommers – ACCT 3311
Discussion Questions Q22–12 How should consolidated financial statements be reported this year when statements of individual companies were presented last year?
Correction of Errors Types of Accounting Errors: • A change from an accounting principle that is not generally accepted to an accounting policy that is acceptable. • Mathematical mistakes. • Changes in estimates that occur because a company did not prepare the estimates in good faith. • Failure to accrue or defer certain expenses or revenues. • Misuse of facts. • Incorrect classification of a cost as an expense instead of an asset, and vice versa.
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.
Error Analysis • Balance sheet errors affect only the presentation of an asset, liability, or stockholders’ equity account. • Current year error - reclassify item to its proper position. • Prior year error - restate the balance sheet of the prior year for comparative purposes. • Income Statement errors cause the improper classification of revenues or expenses. • Current year error - reclassify item to its proper position. • Prior year error - restate the income statement of the prior year for comparative purposes.
Counterbalancing Errors • Will be offset or corrected over two periods. • If company has closed the books: • If the error is already counterbalanced, no entry is necessary. • 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. • If company has not closed the books: • If error already counterbalanced, make entry to correct the error in the current period and to adjust the beginning balance of Retained Earnings. • If error not yet counterbalanced, make entry to adjust the beginning balance of Retained Earnings.
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. • Include a disclosure note.
Example 5 Goddard Company has used the FIFO method of inventory valuation since it began operations in 2008. Goddard decided to change to the average cost method for determining inventory costs at the beginning of 2011. The following schedule shows year-end inventory balances under the FIFO and average cost methods: YearFIFOAverage Cost 2008 $45,000 $54,000 2009 78,000 71,000 2010 83,000 78,000 Ignoring income taxes, prepare the 2011 journal entry to adjust the accounts to reflect the average cost method. How much higher or lower would cost of goods sold be in the 2010 revised income statement?
Example 5: Continued Ignoring income taxes, prepare the 2011 journal entry to adjust the accounts to reflect the average cost method. How much higher or lower would cost of goods sold be in the 2010 revised income statement?
Example 6: Classifying Accounting Changes Type of ChangeReporting Approach P. Change in accounting principle R. Retrospective approach E. Change in accounting estimate P. Prospective approach EP. Change in estimate resulting from a change in principle X. Correction of an error N. Neither an accounting change nor an accounting error. • Wagner changed its method of depreciating computer equipment from the DDB method to the straight-line method. • Wagner determined that a liability insurance premium it both paid and expensed in 2010 covered the 2010–2012 period.
Example 6: Classifying Accounting Changes Type of ChangeReporting Approach P. Change in accounting principle R. Retrospective approach E. Change in accounting estimate P. Prospective approach EP. Change in estimate resulting from a change in principle X. Correction of an error N. Neither an accounting change nor an accounting error. • Wagner custom-manufactures farming equipment on a contract basis. Wagner switched its accounting for these long-term contracts from the completed-contract method to the percentage-of-completion method. • Due to an unexpected relocation, Wagner determined that its office building, previously depreciated using a 45-year life, should be depreciated using an 18-year life. • Wagner offers a three-year warranty on the farming equipment it sells. Manufacturing efficiencies caused Wagner to reduce its expectation of warranty costs from 2% of sales to 1% of sales.
Example 6: Classifying Accounting Changes Type of ChangeReporting Approach P. Change in accounting principle R. Retrospective approach E. Change in accounting estimate P. Prospective approach EP. Change in estimate resulting from a change in principle X. Correction of an error N. Neither an accounting change nor an accounting error. • Wagner changed from LIFO to FIFO to account for its materials and work-in-process inventories. • Wagner changed from FIFO to average cost to account for its equipment inventory. • Wagner sells extended service contracts on some of its equipment sold. Wagner performs services related to these contracts over several years, so in 2011 Wagner changed from recognizing revenue from these service contracts on a cash basis to the accrual basis.
Example 7: Error Analysis You have been hired as the new controller for the Ralston Company. Shortly after joining the company in 2011, you discover the following errors related to the 2009 and 2010 financial statements: • Inventory at 12/31/09 was understated by $6,000. • Inventory at 12/31/10 was overstated by $9,000. • On 12/31/10, inventory was purchased for $3,000. The company did not record the purchase until the inventory was paid for early in 2011. At that time, the purchase was recorded by a debit to purchases and a credit to cash. The company uses a periodic inventory system. Required: • Assuming that the errors were discovered after the 2010 financial statements were issued, analyze the effect of the errors on 2010 and 2009 cost of goods sold, net income, and retained earnings. ( Ignore income taxes.) • Prepare a journal entry to correct the errors. • What other step( s) would be taken in connection with the error?
IFRS • The accounting for changes in estimates is similar between GAAP and IFRS. • Under GAAP and IFRS, if determining the effect of a change in accounting policy 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.
IFRS • One area in which GAAP and IFRS differ is the reporting of error corrections in previously issued financial statements. While both sets of standards require restatement, GAAP is an absolute standard—that is, there is no exception to this rule. • Under IFRS, the impracticality exception applies both to changes in accounting principles and to the correction of errors. Under GAAP, this exception applies only to changes in accounting principle. • IFRS (IAS 8) does not specifically address the accounting and reporting for indirect effects of changes in accounting principles. As indicated in the chapter, GAAP has detailed guidance on the accounting and reporting of indirect effects.
Summary of Accounting Changesand Errors Illustration 22-23
Summary of Accounting Changesand Errors Illustration 22-23
Example 8: During 2011, WMC Corporation discovered that its ending inventories reported on its financial statements were misstated by the following amounts: 2009 understated by $120,000 2010 overstated by 150,000 WMC uses the periodic inventory system and the FIFO cost method. • Determine the effect of these errors on retained earnings at January 1, 2011, before any adjustments. (Ignore income taxes.) • Prepare a journal entry to correct the error. • What other step(s) would be taken in connection with the error?
Example 8: Continued Book style answer: The 2009 error caused 2009 net income to be understated, but since 2009 ending inventory is 2010 beginning inventory, 2010 net income was overstated by the same amount. So, the income statement was misstated for 2009 and 2010, but the balance sheet (retained earnings) was incorrect only for 2009 with regard to this error. After that, no account balances are incorrect due to the 2009 error. However, the 2010 error has not yet self-corrected. Both retained earnings and inventory still are overstated as a result of the second error.
Example 9: Below are three independent and unrelated errors. • On December 31, 2010, Wolfe Corp failed to accrue office supplies expense of $1,800. In January 2011, when it received the bill from its supplier, Wolfe made the following entry: Office supplies expense......1,800 Cash...................................1,800 • On the last day of 2010, MW Importers received a $90,000 prepayment from a tenant for 2011 rent of a building. MW recorded the receipt as rent revenue. • At the end of 2010, Dinkins failed to accrue interest of $8,000 on a note receivable. At the beginning of 2011, when the company received the cash, it was recorded as interest revenue. For each error, what would be the effect of each error on the income statement and the balance sheet in the 2010 financial statements? Prepare any journal entries each company should record in 2011 to correct the errors.
