NTI CHAPTER
22
ACCOU NG C HANG E S AN D ER ROR ANALYSIS
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 2 3 4 5 6 7 8 9
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.
In the Dark
The FASBs conceptual framework describes comparability (including consistency) as one of the qualitative characteristics that contribute to the usefulness of accounting information. Unfortunately, companies are finding it difficult to maintain comparability and consistency due to the numerous changes in accounting principles mandated by the FASB. In addition, a number of companies have faced restatements due to errors in their financial statements. For example, the table below shows types and numbers of recent accounting changes.
Stock-based compensation Defined-benefit pension and postretirement plans Asset retirement obligations Prior period financial statement misstatements 437 305 29 18 Inventories Goodwill and other intangibles Lease/rental costs Other (including servicing rights, exchanges of nonmonetary assets, and impairments) 8 5 5 34
Although the percentage of companies reporting material changes or errors is small, readers of financial statements still must be careful. The reason: The amounts in the financial statements may have changed due to changing accounting principles and/or restatements. The chart on the next page indicates the recent trends in restatements.
1180
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There is some good news in the chart. As indicated, the number of restatements declined in 2007 compared to the high of 2006. However, investors can be in the dark when a company has an error that requires restatement. It may take some time for companies to sort out the source of an error, prepare corrected statements, and get auditor sign-off. Recent data indicate it takes on average about 3 months to resolve a restatement. The following table reports the range of periods when investors are in the dark due to a restatement.
Time to File Restated Financial Statements Up to 3 Months 39 Months Greater than 9 Months % of All Restatements 77 11 12
Number of companies that restated
1,200 8.9% 800 4.5% 400 9.7% 8.7%
0 2004 2005 2006 2007
Note: Chart includes all U.S.-listed companies. The total number of companies is based on the number of unique companies that filed at least one annual report, quarterly report, or effective registration statement with the SEC during the year. In 2007, that number was 13,540 and in 2006 it was 13,899.
While most companies (77%) resolve their errors within 3 months, 12% (or over 200 companies) take more than 9 months to file corrected statements. These lengthy dark periods have caught the attention of policy-setters and were a topic of discussion of the Committee for Improvements in Financial Reporting (CIFR). As one member of CIFR noted, The dark period is bad for users. As a result, the committee is proposing that for some errors, companies might not need to go through the pain of restatement, but enhanced disclosures about errors are needed. Sources: Accounting change data from Accounting Trends and Techniques2007 (New York: AICPA, 2007). Restatement data from M. Grothe, The Tide is Turning, Trend Alert (January 15, 2008), Glass Lewis and Co., p. 2, and M. Leone, Materiality Debate Emerges from the Dark, CFO.com (July 14, 2008).
PREVIEW
OF
CHAPTER
22
As our opening story indicates, changes in accounting principles and errors in financial information have increased substantially in recent years. When these changes occur, companies must follow specific accounting and reporting requirements. In addition, to ensure comparability among companies, the FASB has standardized reporting of accounting changes, accounting estimates, error corrections, and related earnings per share information. In this chapter, we discuss these reporting standards, which help investors better understand a companys financial condition. The content and organization of the chapter are as follows.
ACCOUNTING CHANGES AND E R R O R A N A LY S I S
ACCOUNTING CHANGES
Changes in accounting principle Changes in accounting estimate Change in reporting entity Correction of errors Summary Motivations for change of method
E R R O R A N A LY S I S
Balance sheet errors Income statement errors Balance sheet and income statement effects Comprehensive example Preparation of statements with error corrections
1181
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1182 Chapter 22 Accounting Changes and Error Analysis
SECTION 1 ACCOU NTI NG C HANGES
Objective1 Identify the types of accounting changes.
See the FASB Codification section (page 1218).
Accounting alternatives diminish the comparability of financial information between periods and between companies; they also obscure useful historical trend data. For example, if Ford revises its estimates for equipment useful lives, depreciation expense for the current year will not be comparable to depreciation expense reported by Ford in prior years. Similarly, if Best Buy changes to FIFO inventory pricing while Circuit City uses LIFO, it will be difficult to compare these companies reported results. A reporting framework helps preserve comparability when there is an accounting change. The FASB has established a reporting framework, which involves three types of accounting changes. [1] The three types of accounting changes are:
Underlying Concepts While changes in accounting may enhance the qualitative characteristic of usefulness, these changes may adversely affect the characteristics of comparability and consistency.
1. Change in Accounting Principle. A change from one generally accepted accounting principle to another one. For example, a company may change its inventory valuation method from LIFO to average cost. 2. Change in Accounting Estimate. A change that occurs as the result of new information or additional experience. For example, a company may change its estimate of the useful lives of depreciable assets. 3. Change in Reporting Entity. A change from reporting as one type of entity to another type of entity. As an example, a company might change the subsidiaries for which it prepares consolidated financial statements.
A fourth category necessitates changes in accounting, though it is not classified as an accounting change.
4. Errors in Financial Statements. Errors result from mathematical mistakes, mistakes in applying accounting principles, or oversight or misuse of facts that existed when preparing the financial statements. For example, a company may incorrectly apply the retail inventory method for determining its final inventory value.
The FASB classifies changes in these categories because each category involves different methods of recognizing changes in the financial statements. In this chapter we discuss these classifications. We also explain how to report each item in the accounts and how to disclose the information in comparative statements.
CHANGES IN ACCOUNTING PRINCIPLE
Objective2 Describe the accounting for changes in accounting principles.
By definition, a change in accounting principle involves a change from one generally accepted accounting principle to another. For example, a company might change the basis of inventory pricing from average cost to LIFO. Or it might change its method of revenue recognition for long-term construction contracts from the completed-contract to the percentage-of-completion method. Companies must carefully examine each circumstance to ensure that a change in principle has actually occurred. Adoption of a new principle in recognition of events that have occurred for the first time or that were previously immaterial is not an accounting change. For example, a change in accounting principle has not occurred when a company adopts an inventory method (e.g., FIFO) for newly acquired items of inventory, even if FIFO differs from that used for previously recorded inventory. Another example is certain marketing expenditures that were previously immaterial and expensed in the period incurred. It would not be considered a change in accounting principle if they become material and so may be acceptably deferred and amortized. Finally, what if a company previously followed an accounting principle that was not acceptable? Or what if the company applied a principle incorrectly? In such cases,
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Changes in Accounting Principle 1183 the profession considers a change to a generally accepted accounting principle a correction of an error. For example, a switch from the cash (income tax) basis of accounting to the accrual basis is a correction of an error. Or, if a company deducted salvage value when computing double-declining depreciation on plant assets and later recomputed depreciation without deducting estimated salvage value, it has corrected an error. There are three possible approaches for reporting changes in accounting principles: Report changes currently. In this approach, companies report the cumulative effect of the change in the current years income statement as an irregular item. The cumulative effect is the difference in prior years income between the newly adopted and prior accounting method. Under this approach, the effect of the change on prior years income appears only in the current-year income statement. The company does not change prior-year financial statements. Advocates of this position argue that changing prior years financial statements results in a loss of confidence in financial reports. How do investors react when told that the earnings computed three years ago are now entirely different? Changing prior periods, if permitted, also might upset contractual arrangements based on the old figures. For example, profit-sharing arrangements computed on the old basis might have to be recomputed and completely new distributions made, creating numerous legal problems. Many practical difficulties also exist: The cost of changing prior-period financial statements may be excessive, or determining the amount of the prior-period effect may be impossible on the basis of available data. Report changes retrospectively. Retrospective application refers to the application of a different accounting principle to recast previously issued financial statements as if the new principle had always been used. In other words, the company goes back and adjusts prior years statements on a basis consistent with the newly adopted principle. The company shows any cumulative effect of the change as an adjustment to beginning retained earnings of the earliest year presented. Advocates of this position argue that retrospective application ensures comparability. Think for a moment what happens if this approach is not used: The year previous to the change will be on the old method; the year of the change will report the entire cumulative adjustment; and the following year will present financial statements on the new basis without the cumulative effect of the change. Such lack of consistency fails to provide meaningful earnings-trend data and other financial relationships necessary to evaluate the business. Report changes prospectively (in the future). In this approach, previously reported results remain. As a result, companies do not adjust opening balances to reflect the change in principle. Advocates of this position argue that once management presents financial statements based on acceptable accounting principles, they are final; management cannot change prior periods by adopting a new principle. According to this line of reasoning, the current-period cumulative adjustment is not appropriate, because that approach includes amounts that have little or no I NTERNATIONAL I NSIGHT relationship to the current years income or economic events. Given these three possible approaches, which does the accounting profession prefer? The FASB requires that companies use the retrospective approach. Why? Because it provides financial statement users with more useful information than the cumulative-effect or prospective approaches. [2] The rationale is that changing the prior statements to be on the same basis as the newly adopted principle results in greater consistency across accounting periods. Users can then better compare results from one period to the next.1
1
IAS 8 generally requires retrospective application to prior years for accounting changes. However, IAS 8 permits the cumulative-effect method or prospective method if a company cannot reasonably determine the amounts to which to restate prior periods.
Adoption of the retrospective approach contributes to international accounting convergence. The FASB and the IASB are collaborating on a project in which they have agreed to converge around high-quality solutions to resolve differences between U.S. GAAP and International Financial Reporting Standards (IFRS). By adopting the retrospective approach, which is the method used in IFRS, the FASB agreed that this approach is superior to the current approach.
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1184 Chapter 22 Accounting Changes and Error Analysis
QUITE A CHANGE
The cumulative-effect approach results in a loss of comparability. Also, reporting the cumulative adjustment in the period of the change can significantly affect net income, resulting in a misleading income figure. For example, at one time Chrysler Corporation changed its inventory accounting from LIFO to FIFO. If Chrysler had used the cumulative-effect approach, it would have reported a $53,500,000 adjustment to net income. That adjustment would have resulted in net income of $45,900,000, instead of a net loss of $7,600,000. A second case: In the early 1980s the railroad industry switched from the retirement-replacement method of depreciating railroad equipment to more generally used methods such as straight-line depreciation. Using cumulative treatment, railroad companies would have made substantial adjustments to income in the period of change. Many in the industry argued that including such large cumulative-effect adjustments in the current year would distort the information and make it less useful. Such situations lend support to retrospective application so that comparability is maintained.
What do the numbers mean?
Retrospective Accounting Change Approach
Objective3 Understand how to account for retrospective accounting changes.
A presumption exists that once a company adopts an accounting principle, it should not change. That presumption is understandable, given the idea that consistent use of an accounting principle enhances the usefulness of financial statements. However, the environment continually changes, and companies change in response. Recent standards on such subjects as stock options, exchanges of nonmonetary assets, and derivatives indicate that changes in accounting principle will continue to occur. When a company changes an accounting principle, it should report the change using retrospective application. In general terms, here is what it must do:
1. It adjusts its financial statements for each prior period presented. Thus, financial statement information about prior periods is on the same basis as the new accounting principle. 2. It adjusts the carrying amounts of assets and liabilities as of the beginning of the first year presented. By doing so, these accounts reflect the cumulative effect on periods prior to those presented of the change to the new accounting principle. The company also makes an offsetting adjustment to the opening balance of retained earnings or other appropriate component of stockholders equity or net assets as of the beginning of the first year presented.
For example, assume that Target decides to change its inventory valuation method in 2010 from the retail inventory method (FIFO) to the retail inventory (average cost). It provides comparative information for 2008 and 2009 based on the new method. Target would adjust its assets, liabilities, and retained earnings for periods prior to 2008 and report these amounts in the 2008 financial statements, when it prepares comparative financial statements.
Retrospective Accounting Change: Long-Term Contracts
To illustrate the retrospective approach, assume that Denson Company has accounted for its income from long-term construction contracts using the completed-contract 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. (We assume a 40 percent enacted tax rate.)
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Changes in Accounting Principle 1185 Illustration 22-1 shows portions of three income statements for 20082010for both the completed-contract and percentage-of-completion methods.
COMPLETED-CONTRACT METHOD DENSON COMPANY INCOME STATEMENT (PARTIAL) FOR THE YEARS ENDED DECEMBER 31 2008 Income before income tax Income tax (40%) Net income $400,000 160,000 $240,000 2009 $160,000 64,000 $ 96,000 2010 $190,000 76,000 $114,000
ILLUSTRATION 22-1 Comparative Income Statements for Completed-Contract versus Percentage-ofCompletion Methods
PERCENTAGE-OF-COMPLETION METHOD DENSON COMPANY INCOME STATEMENT (PARTIAL) FOR THE YEARS ENDED DECEMBER 31 2008 Income before income tax Income tax (40%) Net income $600,000 240,000 $360,000 2009 $180,000 72,000 $108,000 2010 $200,000 80,000 $120,000
To record a change from the completed-contract to the percentage-of-completion method, we analyze the various effects, as Illustration 22-2 shows.
Pretax Income from Year Prior to 2009 In 2009 Total at beginning of 2010 Total in 2010 Percentage-ofCompletion $600,000 180,000 $780,000 $200,000 CompletedContract $400,000 160,000 $560,000 $190,000 Difference $200,000 20,000 $220,000 $ 10,000
Difference in Income Tax Effect 40% $80,000 8,000 $88,000 $ 4,000 Income Effect (net of tax) $120,000 12,000 $132,000 $ 6,000
ILLUSTRATION 22-2 Data for Retrospective Change Example
The entry to record the change at the beginning of 2010 would be:
Construction in Process Deferred Tax Liability Retained Earnings 220,000 88,000 132,000
The Construction in Process account increases by $220,000 (as indicated in the first column under Difference in Income in Illustration 22-2). The credit to Retained Earnings of $132,000 reflects the cumulative income effects prior to 2010 (third column under Difference in Income in Illustration 22-2). The company credits Retained Earnings because prior years income is closed to this account each year. The credit to Deferred Tax Liability represents the adjustment to prior years tax expense. The company now recognizes that amount, $88,000, as a tax liability for future taxable amounts. That is, in future periods, taxable income will be higher than book income as a result of current temporary differences. Therefore, Denson must report a deferred tax liability in the current year.
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1186 Chapter 22 Accounting Changes and Error Analysis
CHANGE MANAGEMENT
Halliburton offers a case study in the importance of good reporting of an accounting change. Recall from Chapter 18 that Halliburton uses percentage-of-completion accounting for its long-term construction-services contracts. Recently, the SEC questioned the company about its change in accounting for disputed claims. Prior to 1998 Halliburton took a very conservative approach to its accounting for disputed claims. That is, the company waited until all disputes were resolved before recognizing associated revenues. In contrast, in 1998 the company recognized revenue for disputed claims before their resolution, using estimates of amounts expected to be recovered. Such revenue and its related profit are more tentative and subject to possible later adjustment. The accounting method adopted in 1998 is more aggressive than the companys former policy but is within the boundaries of GAAP. It appears that the problem with Halliburtons accounting stems more from how the company handled its accounting change than from the new method itself. That is, Halliburton did not provide in its 1998 annual report an explicit reference to its change in accounting method. In fact, rather than stating its new policy, the company simply deleted the sentence that described how it accounted for disputed claims. Then later, in its 1999 annual report, the company stated its new accounting policy. When companies make such changes in accounting, investors need to be informed about the change and about its effects on the financial results. With such information, investors and analysts can compare current results with those of prior periods and can make a more informed assessment about the companys future prospects.
Source: Adapted from Accounting Ace Charles Mulford Answers Accounting Questions, Wall Street Journal Online (June 7, 2002).
What do the numbers mean?
Reporting a Change in Principle. The disclosure of accounting changes is particularly important. Users of the financial statements want consistent information from one period to the next. Such consistency ensures the usefulness of financial statements. The major disclosure requirements are as follows.
1. The nature of and reason for the change in accounting principle. This must include an explanation of why the newly adopted accounting principle is preferable. 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 (or other appropriate captions of changes in net assets or performance indicators), any other affected line item, and any affected per-share amounts for the current period and for any prior periods retrospectively adjusted. c. The cumulative effect of the change on retained earnings or other components of equity or net assets in the statement of financial position as of the beginning of the earliest period presented.2
To illustrate, Denson will prepare comparative financial statements for 2009 and 2010 using the percentage-of-completion method (the new-construction accounting method). Illustration 22-3 (on page 1187) indicates how Denson presents this information.
2
Presentation of the effect on financial statement subtotals and totals other than income from continuing operations and net income (or other appropriate captions of changes in the applicable net assets or performance indicator) is not required. [3]
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Changes in Accounting Principle 1187
DENSON COMPANY INCOME STATEMENT (PARTIAL) FOR THE YEAR ENDED 2010 Income before income tax Income tax (40%) Net income $200,000 80,000 $120,000 2009 As adjusted (Note A) $180,000 72,000 $108,000
ILLUSTRATION 22-3 Comparative Information Related to Accounting Change (Percentage-ofCompletion)
Note A: Change in Method of Accounting for Long-Term Contracts. The company has accounted for revenue and costs for long-term construction contracts by the percentage-of-completion method in 2010, whereas in all prior years revenue and costs were determined by the completed-contract method. The new method of accounting for long-term contracts was adopted to recognize . . . [state justification for change in accounting principle] . . ., and financial statements of prior years have been restated to apply the new method retrospectively. For income tax purposes, the completed-contract method has been continued. The effect of the accounting change on income of 2010 was an increase of $6,000 net of related taxes and on income of 2009 as previously reported was an increase of $12,000 net of related taxes. The balances of retained earnings for 2009 and 2010 have been adjusted for the effect of applying retroactively the new method of accounting. As a result of the accounting change, retained earnings as of January 1, 2009, increased by $120,000 compared to that reported using the completed-contract method.
As Illustration 22-3 shows, Denson Company reports net income under the newly adopted percentage-of-completion method for both 2009 and 2010. The company retrospectively adjusted the 2009 income statement to report the information on a percentage-of-completion basis. Also, the note to the financial statements indicates the nature of the change, why the company made the change, and the years affected. In addition, companies are required to provide data on important differences between the amounts reported under percentage-of-completion versus completedcontract. When identifying the significant differences, some companies show the entire financial statements and line-by-line differences between percentage-of-completion and completed-contract. However, most companies will show only line-by-line differences. For example, Denson would show the differences in construction in process, retained earnings, gross profit, and net income for 2009 and 2010 under the completed-contract and percentage-of-completion methods. Retained Earnings Adjustment. As indicated earlier, one of the disclosure requirements is to show the cumulative effect of the change on retained earnings as of the beginning of the earliest period presented. For Denson Company, that date is January 1, 2009. Denson disclosed that information by means of a narrative description (see Note A in Illustration 22-3). Denson also would disclose this information in its retained earnings statement. Assuming a retained earnings balance of $1,360,000 at the beginning of 2008, Illustration 22-4 shows Densons retained earnings statement under the completedcontract methodthat is, before giving effect to the change in accounting principle. (The income information comes from Illustration 22-1 on page 1185.)
DENSON COMPANY RETAINED EARNINGS STATEMENT FOR THE YEAR ENDED 2010 Retained earnings, January 1 Net income Retained earnings, December 31 $1,696,000 114,000 $1,810,000 2009 $1,600,000 96,000 $1,696,000 2008 $1,360,000 240,000 $1,600,000
ILLUSTRATION 22-4 Retained Earnings Statement before Retrospective Change
If Denson presents comparative statements for 2009 and 2010 under percentage-ofcompletion, then it must change the beginning balance of retained earnings at January 1,
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1188 Chapter 22 Accounting Changes and Error Analysis 2009. The difference between the retained earnings balances under completed-contract and percentage-of-completion is computed as follows.
Retained earnings, January 1, 2009 (percentage-of-completion) Retained earnings, January 1, 2009 (completed-contract) Cumulative-effect difference $1,720,000 1,600,000 $ 120,000
The $120,000 difference is the cumulative effect. Illustration 22-5 shows a comparative retained earnings statement for 2009 and 2010, giving effect to the change in accounting principle to percentage-of-completion.
ILLUSTRATION 22-5 Retained Earnings Statement after Retrospective Application
DENSON COMPANY RETAINED EARNINGS STATEMENT FOR THE YEAR ENDED 2010 Retained earnings, January 1, as reported Add: Adjustment for the cumulative effect on prior years of applying retrospectively the new method of accounting for construction contracts Retained earnings, January 1, as adjusted Net income Retained earnings, December 31 2009 $1,600,000
120,000 $1,828,000 120,000 $1,948,000 1,720,000 108,000 $1,828,000
Denson adjusted the beginning balance of retained earnings on January 1, 2009, for the excess of percentage-of-completion net income over completed-contract net income in 2008. This comparative presentation indicates the type of adjustment that a company needs to make. It follows that this adjustment would be much larger if a number of prior periods were involved.
Retrospective Accounting Change: Inventory Methods
As a second illustration of the retrospective approach, assume that Lancer Company has accounted for its inventory using the LIFO method. In 2010, the company changes to the FIFO method because management believes this approach provides a more appropriate measure of its inventory costs. Illustration 22-6 provides additional information related to Lancer Company.
ILLUSTRATION 22-6 Lancer Company Information
1. Lancer Company started its operations on January 1, 2008. At that time stockholders invested $100,000 in the business in exchange for common stock. 2. All sales, purchases, and operating expenses for the period 20082010 are cash transactions. Lancers cash flows over this period are as follows. 2008 Sales Purchases Operating expenses Cash flow from operations $300,000 90,000 100,000 $110,000 2009 $300,000 110,000 100,000 $ 90,000 2010 $300,000 125,000 100,000 $ 75,000
3. Lancer has used the LIFO method for financial reporting since its inception. 4. Inventory determined under LIFO and FIFO for the period 20082010 is as follows. LIFO Method January 1, 2008 December 31, 2008 December 31, 2009 December 31, 2010 $ 0 10,000 20,000 32,000 FIFO Method $ 0 12,000 25,000 39,000 Difference $ 0 2,000 5,000 7,000
continued on next page
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Changes in Accounting Principle 1189
5. Cost of goods sold under LIFO and FIFO for the period 20082010 are as follows. Cost of Goods Sold LIFO 2008 2009 2010 $ 80,000 100,000 113,000 Cost of Goods Sold FIFO $ 78,000 97,000 111,000 Difference $2,000 3,000 2,000
6. Earnings per share information is not required on the income statement. 7. All tax effects for this illustration should be ignored.
Given the information about Lancer Company, Illustration 22-7 shows its income statement, retained earnings statement, balance sheet, and statement of cash flows for 20082010 under LIFO.
ILLUSTRATION 22-7 Lancer Financial Statements (LIFO)
2010 $300,000 113,000 100,000 $ 87,000
LANCER COMPANY INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31 2008 Sales Cost of goods sold (LIFO) Operating expenses Net income $300,000 80,000 100,000 $120,000 2009 $300,000 100,000 100,000 $100,000
LANCER COMPANY RETAINED EARNINGS STATEMENT FOR THE YEAR ENDED DECEMBER 31 2008 Retained earnings (beginning) Add: Net income Retained earnings (ending) $ 0 120,000 2009 $120,000 100,000 $220,000 2010 $220,000 87,000 $307,000
$120,000 LANCER COMPANY BALANCE SHEET AT DECEMBER 31 2008
2009 $300,000 20,000 $320,000 $100,000 220,000 $320,000
2010 $375,000 32,000 $407,000 $100,000 307,000 $407,000
Cash Inventory (LIFO) Total assets Common stock Retained earnings Total liabilities and stockholders equity
$210,000 10,000 $220,000 $100,000 120,000 $220,000
LANCER COMPANY STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31 2008 Cash flows from operating activities Sales Purchases Operating expenses Net cash provided by operating activities Cash flows from financing activities Issuance of common stock Net increase in cash Cash at beginning of year Cash at end of year $300,000 90,000 100,000 110,000 100,000 210,000 0 $210,000 2009 $300,000 110,000 100,000 90,000 90,000 210,000 $300,000 2010 $300,000 125,000 100,000 75,000 75,000 300,000 $375,000
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1190 Chapter 22 Accounting Changes and Error Analysis As Illustration 22-7 indicates, under LIFO Lancer Company reports $120,000 net income in 2008, $100,000 net income in 2009, and $87,000 net income in 2010. The amount of inventory reported on Lancers balance sheet reflects LIFO costing. Illustration 22-8 shows Lancers income statement, retained earnings statement, balance sheet, and statement of cash flows for 20082010 under FIFO. You can see that the cash flow statement under FIFO is the same as under LIFO. Although the net incomes are different in each period, there is no cash flow effect from these differences in net income. (If we considered income taxes, a cash flow effect would result.)
ILLUSTRATION 22-8 Lancer Financial Statements (FIFO)
Sales Cost of goods sold (FIFO) Operating expenses Net income LANCER COMPANY INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31 2008 $300,000 78,000 100,000 $122,000 2009 $300,000 97,000 100,000 $103,000 2010 $300,000 111,000 100,000 $ 89,000
LANCER COMPANY RETAINED EARNINGS STATEMENT FOR THE YEAR ENDED DECEMBER 31 2008 Retained earnings (beginning) Add: Net income Retained earnings (ending) $ 0 122,000 2009 $122,000 103,000 $225,000 2010 $225,000 89,000 $314,000
$122,000 LANCER COMPANY BALANCE SHEET AT DECEMBER 31 2008
2009 $300,000 25,000 $325,000 $100,000 225,000 $325,000
2010 $375,000 39,000 $414,000 $100,000 314,000 $414,000
Cash Inventory (FIFO) Total assets Common stock Retained earnings Total liabilities and stockholders equity
$210,000 12,000 $222,000 $100,000 122,000 $222,000
LANCER COMPANY STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31 2008 Cash flows from operating activities Sales Purchases Operating expenses Net cash provided by operating activities Cash flows from financing activities Issuance of common stock Net increase in cash Cast at beginning of year Cash at end of year $300,000 90,000 100,000 110,000 100,000 210,000 0 $210,000 2009 $300,000 110,000 100,000 90,000 90,000 210,000 $300,000 2010 $300,000 125,000 100,000 75,000 75,000 300,000 $375,000
Compare the financial statements reported in Illustration 22-7 and Illustration 22-8. You can see that, under retrospective application, the change to FIFO inventory valuation affects reported inventories, cost of goods sold, net income, and retained earnings. In the following sections we discuss the accounting and reporting of Lancers accounting change from LIFO to FIFO.
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Changes in Accounting Principle 1191 Given the information provided in Illustrations 22-6, 22-7, and 22-8, we now are ready to account for and report on the accounting change. Our first step is to adjust the financial records for the change from LIFO to FIFO. To do so, we perform the analysis in Illustration 22-9.
Net Income Year 2008 2009 Total at beginning of 2010 Total in 2010 LIFO $120,000 100,000 $220,000 $ 87,000 FIFO $122,000 103,000 $225,000 $ 89,000 $2,000 3,000 $5,000 $2,000 Difference in Income
ILLUSTRATION 22-9 Data for Recording Change in Accounting Principle
The entry to record the change to the FIFO method at the beginning of 2010 is as follows.
Inventory Retained Earnings 5,000 5,000
The change increases the inventory account by $5,000. This amount represents the difference between the ending inventory at December 31, 2009, under LIFO ($20,000) and the ending inventory under FIFO ($25,000). The credit to Retained Earnings indicates the amount needed to change prior-years income, assuming that Lancer had used FIFO in previous periods. Reporting a Change in Principle. Lancer Company will prepare comparative financial statements for 2009 and 2010 using FIFO (the new inventory method). Illustration 22-10 indicates how Lancer might present this information.
LANCER COMPANY INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31 2010 Sales Cost of goods sold Operating expenses Net income $300,000 111,000 100,000 $ 89,000 2009 As adjusted (Note A) $300,000 97,000 100,000 $103,000
ILLUSTRATION 22-10 Comparative Information Related to Accounting Change (FIFO)
Note A Change in Method of Accounting for Inventory Valuation On January 1, 2010, Lancer Company elected to change its method of valuing its inventory to the FIFO method; in all prior years inventory was valued using the LIFO method. The Company adopted the new method of accounting for inventory to better report cost of goods sold in the year incurred. Comparative financial statements of prior years have been adjusted to apply the new method retrospectively. The following financial statement line items for years 2010 and 2009 were affected by the change in accounting principle. 2010 Balance Sheet Inventory Retained earnings Income Statement Cost of goods sold Net income $113,000 87,000 $111,000 89,000 $2,000 2,000 $100,000 100,000 $ 97,000 103,000 $3,000 3,000 LIFO $ 32,000 307,000 FIFO $ 39,000 314,000 Difference $7,000 7,000 LIFO $ 20,000 220,000 2009 FIFO $ 25,000 225,000 Difference $5,000 5,000
Nature and reason for change Description of prior period information adjusted
Effect of change on key performance indicators
Statement of Cash Flows (no effect) As a result of the accounting change, retained earnings as of January 1, 2009, increased from $120,000, as originally reported using the LIFO method, to $122,000 using the FIFO method.
Cumulative effect on retained earnings
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1192 Chapter 22 Accounting Changes and Error Analysis As Illustration 22-10 shows, Lancer Company reports net income under the newly adopted FIFO method for both 2009 and 2010. The company retrospectively adjusted the 2009 income statement to report the information on a FIFO basis. In addition, the note to the financial statements indicates the nature of the change, why the company made the change, and the years affected. The note also provides data on important differences between the amounts reported under LIFO versus FIFO. (When identifying the significant differences, some companies show the entire financial statements and line-by-line differences between LIFO and FIFO.) Retained Earnings Adjustment. As indicated earlier, one of the disclosure requirements is to show the cumulative effect of the change on retained earnings as of the beginning of the earliest period presented. For Lancer Company, that date is January 1, 2009. Lancer disclosed that information by means of a narrative description (see Note A in Illustration 22-10). Lancer also would disclose this information in its retained earnings statement. Illustration 22-11 shows Lancers retained earnings statement under LIFO that is, before giving effect to the change in accounting principle. (This information comes from Illustration 22-7 on page 1189.)
ILLUSTRATION 22-11 Retained Earnings Statements (LIFO)
2010 Retained earnings, January 1 Net income Retained earnings, December 31 $220,000 87,000 $307,000
2009 $120,000 100,000 $220,000
2008 $ 0 120,000 $120,000
If Lancer presents comparative statements for 2009 and 2010 under FIFO, then it must change the beginning balance of retained earnings at January 1, 2009. The difference between the retained earnings balances under LIFO and FIFO is computed as follows.
Retained earnings, January 1, 2009 (FIFO) Retained earnings, January 1, 2009 (LIFO) Cumulative effect difference
$122,000 120,000 $ 2,000
The $2,000 difference is the cumulative effect. Illustration 22-12 shows a comparative retained earnings statement for 2009 and 2010, giving effect to the change in accounting principle to FIFO.
ILLUSTRATION 22-12 Retained Earnings Statements after Retrospective Application
2010 Retained earnings, January 1, as reported Add: Adjustment for the cumulative effect on prior years of applying retrospectively the new method of accounting for inventory Retained earnings, January 1, as adjusted Net income Retained earnings, December 31 $225,000 89,000 $314,000
2009 $120,000
2,000 122,000 103,000 $225,000
Lancer adjusted the beginning balance of retained earnings on January 1, 2009, for the excess of FIFO net income over LIFO net income in 2008. This comparative presentation indicates the type of adjustment that a company needs to make. It follows that the amount of this adjustment would be much larger if a number of prior periods were involved.
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Changes in Accounting Principle 1193
Direct and Indirect Effects of Changes
Are there other effects that a company should report when it makes a change in accounting principle? For example, what happens when a company like Lancer has a bonus plan based on net income and the prior years net income changes when FIFO is retrospectively applied? Should Lancer also change the reported amount of bonus expense? Or what happens if we had not ignored income taxes in the Lancer example? Should Lancer adjust net income, given that taxes will be different under LIFO and FIFO in prior periods? The answers depend on whether the effects are direct or indirect. Direct Effects. The FASB takes the position that companies should retrospectively apply the direct effects of a change in accounting principle. An example of a direct effect is an adjustment to an inventory balance as a result of a change in the inventory valuation method. For example, Lancer Company should change the inventory amounts in prior periods to indicate the change to the FIFO method of inventory valuation. Another inventory-related example would be an impairment adjustment resulting from applying the lower-of-cost-or-market test to the adjusted inventory balance. Related changes, such as deferred income tax effects of the impairment adjustment, are also considered direct effects. This entry was illustrated in the Denson example, in which the change to percentage-of-completion accounting resulted in recording a deferred tax liability. Indirect Effects. In addition to direct effects, companies can have indirect effects related to a change in accounting principle. An indirect effect is any change to current or future cash flows of a company that result from making a change in accounting principle that is applied retrospectively. An example of an indirect effect is a change in profit-sharing or royalty payment that is based on a reported amount such as revenue or net income. Indirect effects do not change prior-period amounts. For example, lets assume that Lancer has an employee profit-sharing plan I NTERNATIONAL based on net income. As Illustration 22-9 (on page 1191) showed, Lancer would I NSIGHT report higher income in 2008 and 2009 if it used the FIFO method. In addition, lets iGAAP does not explicitly assume that the profit-sharing plan requires that Lancer pay the incremental address the accounting and disclosure amount due based on the FIFO income amounts. In this situation, Lancer reports of indirect effects. this additional expense in the current period; it would not change prior periods for this expense. If the company prepares comparative financial statements, it follows that it does not recast the prior periods for this additional expense.3 If the terms of the profit-sharing plan indicate that no payment is necessary in the current period due to this change, then the company need not recognize additional profit-sharing expense in the current period. Neither does it change amounts reported for prior periods. When a company recognizes the indirect effects of a change in accounting principle, it includes in the financial statements a description of the indirect effects. In doing so, it discloses the amounts recognized in the current period and related per share information.
Impracticability
It is not always possible for companies to determine how they would have reported prior periods financial information under retrospective application of an accounting principle change. Retrospective application is considered impracticable if a company cannot determine the prior-period effects using every reasonable effort to do so.
3
Objective4 Understand how to account for impracticable changes.
The rationale for this approach is that companies should recognize, in the period the adoption occurs (not the prior period), the effect on the cash flows that is caused by the adoption of the new accounting principle. That is, the accounting change is a necessary past event in the definition of an asset or liability that gives rise to the accounting recognition of the indirect effect in the current period. [4]
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1194 Chapter 22 Accounting Changes and Error Analysis Companies should not use retrospective application if one of the following conditions exists:
1. The company cannot determine the effects of the retrospective application. 2. Retrospective application requires assumptions about managements intent in a prior period. 3. Retrospective application requires significant estimates for a prior period, and the company cannot objectively verify the necessary information to develop these estimates.
If any of the above conditions exists, it is deemed impracticable to apply the retrospective approach. In this case, the company prospectively applies the new accounting principle as of the earliest date it is practicable to do so. [5] For example, assume that Williams Company changed its inventory method from FIFO to LIFO, effective January 1, 2011. Williams prepares statements on a calendaryear basis and has used the FIFO method since its inception. Williams judges it impracticable to retrospectively apply the new method. Determining prior-period effects would require subjective assumptions about the LIFO layers established in prior periods. These assumptions would ordinarily result in the computation of a number of different earnings figures. As a result, the only adjustment necessary may be to restate the beginning inventory to a cost basis from a lower-of-cost-or-market approach. Williams must disclose only the effect of the change on the results of operations in the period of change. Also, the company should explain the reasons for omitting the computations of the cumulative effect for prior years. Finally, it should disclose the justification for the change to LIFO. [6]4 Illustration 22-13, from the annual report of Quaker Oats Company, shows the type of disclosure needed.
ILLUSTRATION 22-13 Disclosure of Change to LIFO
The Quaker Oats Company
Note 1 (In Part): Summary of Significant Accounting Policies Inventories. Inventories are valued at the lower of cost or market, using various cost methods, and include the cost of raw materials, labor and overhead. The percentage of year-end inventories valued using each of the methods is as follows: June 30 Average quarterly cost Last-in, first-out (LIFO) First-in, first-out (FIFO) Current Year 21% 65% 14% Prior Year 54% 29% 17%
Effective July 1, the Company adopted the LIFO cost flow assumption for valuing the majority of remaining U.S. Grocery Products inventories. The Company believes that the use of the LIFO method better matches current costs with current revenues. The cumulative effect of this change on retained earnings at the beginning of the year is not determinable, nor are the pro-forma effects of retroactive application of LIFO to prior years. The effect of this change on current-year fiscal results was to decrease net income by $16.0 million, or $.20 per share. If the LIFO method of valuing certain inventories were not used, total inventories would have been $60.1 million higher in the current year, and $24.0 million higher in the prior year.
4
In practice, many companies defer the formal adoption of LIFO until year-end. Management thus has an opportunity to assess the impact that a change to LIFO will have on the financial statements and to evaluate the desirability of a change for tax purposes. As indicated in Chapter 8, many companies use LIFO because of the advantages of this inventory valuation method in a period of inflation.
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Changes in Accounting Estimate 1195
CHANGES IN ACCOUNTING ESTIMATE
To prepare financial statements, companies must estimate the effects of future conditions and events. For example, the following items require estimates.
Objective5 Describe the accounting for changes in estimates.
1. 2. 3. 4. 5. 6. 7.
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.
A company cannot perceive future conditions and events and their effects with certainty. Therefore, estimating requires the exercise of judgment. Accounting estimates will change as new events occur, as a company acquires more experience, or as it obtains additional information.
Prospective Reporting
Companies report prospectively changes in accounting estimates. That is, companies should not adjust previously reported results for changes in estimates. Instead, they account for the effects of all 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, the natural result of the accounting process. It prohibits retrospective treatment. The circumstances related to a change in estimate differ from those for a change in accounting principle. If companies reported changes in estimates retrospectively, continual adjustments of prior years income would occur. It seems proper to accept the view that, because new conditions or circumstances exist, the revision fits the new situation (not the old one). Companies should therefore handle such a revision in the current and future periods. To illustrate, Underwriters Labs Inc. purchased for $300,000 a building that it originally estimated to have a useful life of 15 years and no salvage value. It recorded depreciation for 5 years on a straight-line basis. On January 1, 2010, Underwriters Labs revises the estimate of the useful life. It now considers the asset to have a total life of 25 years. (Assume that the useful life for financial reporting and tax purposes and depreciation method are the same.) Illustration 22-14 shows the accounts at the beginning of the sixth year.
Building Less: Accumulated depreciationbuilding (5 Book value of building $300,000 100,000 $200,000
$20,000)
ILLUSTRATION 22-14 Book Value after Five Years Depreciation
Underwriters Labs records depreciation for the year 2010 as follows:
Depreciation Expense Accumulated DepreciationBuilding 10,000 10,000
The company computes the $10,000 depreciation charge as shown in Illustration 22-15.
Depreciation charge Book value of asset Remaining service live $200,000 25 years 5 years $10,000
ILLUSTRATION 22-15 Depreciation after Change in Estimate
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1196 Chapter 22 Accounting Changes and Error Analysis Companies sometime find it difficult to differentiate between a change in estimate and a change in accounting principle. Is it a change in principle or a change in estimate when a company changes from deferring and amortizing marketing costs to expensing them as incurred because future benefits of these costs have become doubtful? If it is impossible to determine whether a change in principle or a change in estimate has occurred, the rule is this: Consider the change as a change in estimate. This is often referred to as a change in estimate effected by a change in accounting principle. Another example of a change in estimate effected by a change in principle is a change in depreciation (as well as amortization or depletion) methods. Because companies change depreciation methods based on changes in estimates about future benefits from longlived assets, it is not possible to separate the effect of the accounting principle change from that of the estimates. As a result, companies account for a change in depreciation methods as a change in estimate effected by a change in accounting principle. [7] A similar problem occurs in differentiating between a change in estimate and a correction of an error, although here the answer is more clear-cut. How does a company determine whether it overlooked the information in earlier periods (an error), or whether it obtained new information (a change in estimate)? Proper classification is important because the accounting treatment differs for corrections of errors versus changes in estimates. The general rule is this: Companies should consider careful estimates that later prove to be incorrect as changes in estimate. Only when a company obviously computed the estimate incorrectly because of lack of expertise or in bad faith should it consider the adjustment an error. There is no clear demarcation line here. Companies must use good judgment in light of all the circumstances.5
Disclosures
Illustration 22-16 shows disclosure of a change in estimated useful lives, which appeared in the annual report of AmpcoPittsburgh Corporation.
ILLUSTRATION 22-16 Disclosure of Change in Estimated Useful Lives
AmpcoPittsburgh Corporation
Note 11: Change in Accounting Estimate. The Corporation revised its estimate of the useful lives of certain machinery and equipment. Previously, all machinery and equipment, whether new when placed in use or not, were in one class and depreciated over 15 years. The change principally applies to assets purchased new when placed in use. Those lives are now extended to 20 years. These changes were made to better reflect the estimated periods during which such assets will remain in service. The change had the effect of reducing depreciation expense and increasing net income by approximately $991,000 ($.10 per share).
For the most part, 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 per-share
5
In evaluating reasonableness, the auditor should use one or a combination of the following approaches. (a) Review and test the process used by management to develop the estimate. (b) Develop an independent expectation of the estimate to corroborate the reasonableness of managements estimate. (c) Review subsequent events or transactions occurring prior to completion of fieldwork. Auditing Accounting Estimates, Statement on Auditing Standards No. 57 (New York: AICPA, 1988).
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Correction of Errors 1197 amounts of the current period. When a company has a change in estimate effected by a change in accounting principle, it must indicate why the new method is preferable. In addition, companies are subject to all other disclosure guidelines established for changes in accounting principle.
CHANGE IN REPORTING ENTITY
Occasionally companies make changes that result in different reporting entities. In such cases, companies report the change by changing the financial statements of all prior periods presented. The revised statements show the financial information for the new reporting entity for all periods. Examples of a change in reporting entity are:
Objective6 Identify changes in a reporting entity.
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.6 In this case, a change in the reporting entity does not result from creation, cessation, purchase, or disposition of a subsidiary or other business unit.
In the year in which a company changes a reporting entity, it should disclose in the financial statements the nature of the change and the reason for it. It also should report, for all periods presented, the effect of the change on income before extraordinary items, net income, and earnings per share. These disclosures need not be repeated in subsequent periods financial statements. Illustration 22-17 shows a note disclosing a change in reporting entity, from the annual report of Hewlett-Packard Company.
Hewlett-Packard Company
Note: Accounting and Reporting Changes (In Part) Consolidation of Hewlett-Packard Finance Company. The company implemented a new accounting pronouncement on consolidations. With the adoption of this new pronouncement, the company consolidated the accounts of Hewlett-Packard Finance Company (HPFC), a wholly owned subsidiary previously accounted for under the equity method, with those of the company. The change resulted in an increase in consolidated assets and liabilities but did not have a material effect on the companys financial position. Since HPFC was previously accounted for under the equity method, the change did not affect net earnings. Prior years consolidated financial information has been restated to reflect this change for comparative purposes.
ILLUSTRATION 22-17 Disclosure of Change in Reporting Entity
CORRECTION OF ERRORS
No business, large or small, is immune from errors. As the opening story discussed, the number of accounting errors that lead to restatement are beginning to decline. However, without accounting and disclosure guidelines for the reporting of errors, investors can be left in the dark about the effects of errors. Certain errors, such as misclassifications of balances within a financial statement, are not as significant to investors as other errors. Significant errors would
6
Objective7 Describe the accounting for correction of errors.
An exception to retrospective application occurs when changing from the equity method. We provide an expanded illustration of the accounting for a change from or to the equity method in Appendix 22A.
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1198 Chapter 22 Accounting Changes and Error Analysis be those resulting in overstating assets or income, for example. However, investors should know the potential impact of all errors. Even harmless misclassifications can affect important ratios. Also, some errors could signal important weaknesses in internal controls that could lead to more significant errors. In general, accounting errors include the following types:
1. A change from an accounting principle that is not generally accepted to an accounting principle that is acceptable. The rationale is that the company incorrectly presented prior periods because of the application of an improper accounting principle. For example, a company may change from the cash (income tax) basis of accounting to the accrual basis. 2. Mathematical mistakes, such as incorrectly totaling the inventory count sheets when computing the inventory value. 3. Changes in estimates that occur because a company did not prepare the estimates in good faith. For example, a company may have adopted a clearly unrealistic depreciation rate. 4. An oversight, such as the failure to accrue or defer certain expenses and revenues at the end of the period. 5. A misuse of facts, such as the failure to use salvage value in computing the depreciation base for the straight-line approach. 6. The incorrect classification of a cost as an expense instead of an asset, and vice versa.
ILLUSTRATION 22-18 Accounting-Error Types
Accounting Category Expense recognition Revenue recognition
Accounting errors occur for a variety of reasons. Illustration 22-18 indicates 11 major categories of accounting errors that drive restatements.
Type of Restatement Recording expenses in the incorrect period or for an incorrect amount Improper revenue accounting. This category includes instances in which revenue was improperly recognized, questionable revenues were recognized, or any other number of related errors that led to misreported revenue. Misclassifying significant accounting items on the balance sheet, income statement, or statement of cash flows. These include restatements due to misclassification of short- or long-term accounts or those that impact cash flows from operations Improper accounting for EPS, restricted stock, warrants, and other equity instruments Errors involving accounts receivables bad debts, inventory reserves, income tax allowances, and loss contingencies Asset impairments of property, plant, and equipment, goodwill, or other related items. Errors involving correction of tax provision, improper treatment of tax liabilities, and other tax-related items Improper accounting for comprehensive income equity transactions including foreign currency items, minimum pension liability adjustments, unrealized gains and losses on certain investments in debt, equity securities, and derivatives. Inventory costing valuations, quantity issues, and cost of sales adjustments Improper accounting for employee stock options Any restatement not covered by the listed categories including those related to improper accounting for acquisitions or mergers
Misclassification
Equityother Reserves/Contingencies Long-lived assets Taxes Equityother comprehensive income Inventory Equitystock options Other
Source: T. Baldwin and D. Yoo, RestatementsTraversing Shaky Ground, Trend Alert, Glass Lewis & Co. (June 2, 2005), p. 8.
As soon as a company discovers an error, it must correct the error. Companies 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.7 [8]
7
See Mark L. DeFord and James Jiambalvo, Incidence and Circumstances of Accounting Errors, The Accounting Review (July 1991) for examples of different types of errors and why these errors might have occurred.
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Correction of Errors 1199 If it presents comparative statements, a company should restate the prior statements affected, to correct for the error.8 The company need not repeat the disclosures in the financial statements of subsequent periods.
Example of Error Correction
To illustrate, 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. Illustration 22-19 presents Selectros income statement for 2010 (starting with income before depreciation expense) with and without the error.
SELECTRO COMPANY INCOME STATEMENT FOR THE YEAR ENDED, DECEMBER 31, 2010 Without Error Income before depreciation expense Depreciation expense Income before income tax Current Deferred Net income $32,000 0 $100,000 20,000 80,000 32,000 $ 48,000 $ 32,000 8,000 With Error $100,000 0 100,000 40,000 $ 60,000
ILLUSTRATION 22-19 Error Correction Comparison
Illustration 22-20 shows the entries that Selectro should have made and did make for recording depreciation expense and income taxes.
Entries Company Should Have Made (Without Error) Depreciation Expense Accumulated Depreciation Buildings Income Tax Expense Income Tax Payable 20,000 20,000 32,000 32,000 Income Tax Expense Deferred Tax Liability Income Tax Payable 40,000 8,000 32,000 Entries Company Did Make (With Error) No entry made for depreciation
ILLUSTRATION 22-20 Error Entries
As Illustration 22-20 indicates, the $20,000 omission error in 2010 results in the following effects. Income Statement Effects Depreciation expense (2010) is understated $20,000. Income tax expense (2010) is overstated $8,000 ($20,000 40%). Net income (2010) is overstated $12,000 ($20,000 $8,000). Balance Sheet Effects Accumulated depreciationbuildings is understated $20,000. Deferred tax liability is overstated $8,000 ($20,000 40%). To make the proper correcting entry in 2011, Selectro should recognize that net income in 2010 is overstated by $12,000, the Deferred Tax Liability is overstated by $8,000,
8 The term restatement is used for the process of revising previously issued financial statements to reflect the correction of an error. This distinguishes an error correction from a change in accounting principle. [9]
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1200 Chapter 22 Accounting Changes and Error Analysis and Accumulated DepreciationBuildings is understated by $20,000. The entry to correct this error in 2011 is as follows:
Retained Earnings Deferred Tax Liability Accumulated DepreciationBuildings 12,000 8,000 20,000
The debit to Retained Earnings results because net income for 2010 is overstated. The debit to the Deferred Tax Liability is made to remove this account, which was caused by the error. The credit to Accumulated DepreciationBuildings reduces the book value of the building to its proper amount. Selectro will make the same journal entry to record the correction of the error in 2011 whether it prepares single-period (noncomparative) or comparative financial statements.
Single-Period Statements
To demonstrate how to show this information in a 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. Illustration 22-21 shows Selectros retained earnings statement for 2011.
ILLUSTRATION 22-21 Reporting an Error Single-Period Financial Statement
SELECTRO COMPANY RETAINED EARNINGS STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2011 Retained earnings, January 1, as reported Correction of an error (depreciation) Less: Applicable income tax reduction Retained earnings, January 1, as adjusted Add: Net income Retained earnings, December 31 $350,000 $20,000 8,000 (12,000) 338,000 400,000 $738,000
The balance sheet in 2011 would not have any deferred tax liability related to the building, and Accumulated DepreciationBuildings is now restated at a higher amount. The income statement would not be affected.
Comparative Statements
If preparing comparative financial statements, a company should make adjustments to correct the amounts for all affected accounts reported in the statements for all periods reported. The company should restate the data to the correct basis for each year presented. It should show any catch-up adjustment as a prior period adjustment to retained earnings for the earliest period it reported. These requirements are essentially the same as those for reporting a change in accounting principle. For example, in the case of Selectro, the error of omitting the depreciation of $20,000 in 2010, discovered in 2011, results in the restatement of the 2010 financial statements. Illustration 22-22 shows the accounts that Selectro restates in the 2010 financial statements.
ILLUSTRATION 22-22 Reporting an Error Comparative Financial Statements
In the balance sheet: Accumulated depreciationbuildings Deferred tax liability Retained earnings, ending balance In the income statement: Depreciation expensebuildings Income tax expense Net income In the retained earnings statement: Retained earnings, ending balance (due to lower net income for the period) $12,000 decrease $20,000 increase $ 8,000 decrease $12,000 decrease $20,000 increase $ 8,000 decrease $12,000 decrease
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Summary of Accounting Changes and Correction of Errors 1201 Selectro prepares the 2011 financial statements in comparative form with those of 2010 as if the error had not occurred. In addition, Selectro must disclose that it has restated its previously issued financial statements, and it describes the nature of the error. Selectro also must disclose the following:
1. The effect of the correction on each financial statement line item and any per-share amounts affected for each prior period presented. 2. The cumulative effect of the change on retained earnings or other appropriate components of equity or net assets in the statement of financial position, as of the beginning of the earliest period presented. [10]
SUMMARY OF ACCOUNTING CHANGES AND CORRECTION OF ERRORS
Having guidelines for reporting accounting changes and corrections has helped resolve several significant and long-standing accounting problems. Yet, because of diversity in situations and characteristics of the items encountered in practice, use of professional judgment is of paramount importance. In applying these guidelines, the primary objective is to serve the users of the financial statements. Achieving this objective requires accuracy, full disclosure, and an absence of misleading inferences. Illustration 22-23 summarizes the main distinctions and treatments presented in the discussion in this chapter.
ILLUSTRATION 22-23 Summary of Guidelines for Accounting Changes and Errors
Changes in accounting principle Employ the retrospective approach by: a. Changing the financial statements of all prior periods presented. b. Disclosing in the year of the change the effect on net income and earnings per share for all prior periods presented. c. Reporting an adjustment to the beginning retained earnings balance in the statement of retained earnings in the earliest year presented. If impracticable to determine the prior period effect (e.g., change to LIFO): a. Do not change prior years income. b. Use opening inventory in the year the method is adopted as the base-year inventory for all subsequent LIFO computations. c. Disclose the effect of the change on the current year, and the reasons for omitting the computation of the cumulative effect and pro forma amounts for prior years. Changes in accounting estimate. Employ the current and prospective approach by: a. Reporting current and future financial statements on the new basis. b. Presenting prior period financial statements as previously reported. c. Making no adjustments to current-period opening balances for the effects in prior periods. Changes in reporting entity. Employ the retrospective approach by: a. Restating the financial statements of all prior periods presented. b. Disclosing in the year of change the effect on net income and earnings per share data for all prior periods presented. Changes due to error. Employ the restatement approach by: a. Correcting all prior period statements presented. b. Restating the beginning balance of retained earnings for the first period presented when the error effects occur in a period prior to the first period presented.
Changes in accounting principle are appropriate only when a company demonstrates that the newly adopted generally accepted accounting principle is preferable to the existing one. Companies and accountants determine preferability on the basis of
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1202 Chapter 22 Accounting Changes and Error Analysis whether the new principle constitutes an improvement in financial reporting, not on the basis of the income tax effect alone.9 But it is not always easy to determine an improvement in financial reporting. How does one measure preferability or improvement? Such measurement varies from company to company. Quaker Oats Company, for example, argued that a change in accounting principle to LIFO inventory valuation better matches current costs with current revenues (see Illustration 22-13, page 1194). Conversely, another company might change from LIFO to FIFO because it wishes to report a more realistic ending inventory. How do you determine which is the better of these two arguments? Determining the preferable method requires some standard or objective. Because no universal standard or objective is generally accepted, the problem of determining preferability continues to be difficult. Initially the SEC took the position that the auditor should indicate whether a change in accounting principle was preferable. The SEC has since modified this approach, noting that greater reliance may be placed on managements judgment in assessing preferability. Even though the preferability criterion is difficult to apply, the general guidelines have acted as a deterrent to capricious changes in accounting principles.10 If a FASB rule creates a new principle, expresses preference for, or rejects a specific accounting principle, a change is considered clearly acceptable.
CAN I GET MY MONEY BACK?
When companies report restatements, investors usually lose money. What should investors do if a company misleads them by misstating its financial results? Join other investors in a class-action suit against the company and in some cases, the auditor. Class-action activity has picked up in recent years, and settlements can be large. To find out about class actions, investors can go online to see if they are eligible to join any class actions. Below are some recent examples.
Company Xerox Transamerica HomeFirst Tommy Hilfiger Corp. Settlement Amount $670 million $ 8 million $ 6 million Contact for Claim www.gilardi.com www.gilardi.com www.gilardi.com
What do the numbers mean?
The amounts reported are before attorneys fees, which can range from 15 to 30 percent of the total. Also, investors may owe taxes if the settlement results in a capital gain on the investment. Thus, investors can get back some of the money they lost due to restatements, but they should be prepared to pay an attorney and the government first.
Source: Adapted from C. Coolidge, Lost and Found, Forbes (October 1, 2001), pp. 124125; data from www.gilardi.com as of 8/14/08.
9
A change in accounting principle, a change in the reporting entity (special type of change in accounting principle), and a correction of an error require an explanatory paragraph in the auditors report discussing lack of consistency from one period to the next. A change in accounting estimate does not affect the auditors opinion relative to consistency; however, if the change in estimate has a material effect on the financial statements, disclosure may still be required. Error correction not involving a change in accounting principle does not require disclosure relative to consistency.
10
If management has not provided reasonable justification for the change in accounting principle, the auditor should express a qualified opinion. Or, if the effect of the change is sufficiently material, the auditor should express an adverse opinion on the financial statements. Reports on Audited Financial Statements, Statement on Auditing Standards No. 58 (New York: AICPA, 1988).
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Motivations for Change of Accounting Method 1203
MOTIVATIONS FOR CHANGE OF ACCOUNTING METHOD
Difficult as it is to determine which accounting standards have the strongest conObjective8 ceptual support, other complications make the process even more complex. These Identify economic motives for complications stem from the fact that managers have self-interest in how the changing accounting methods. financial statements make the company look. They naturally wish to show their financial performance in the best light. A favorable profit picture can influence investors, and a strong liquidity position can influence creditors. Too favorable a profit picture, however, can provide union negotiators and government regulators with ammunition during bargaining talks. Hence, managers might have varying motives for reporting income numbers. Research has provided additional insight into why companies may prefer certain accounting methods.11 Some of these reasons are as follows:
1. Political Costs. As companies become larger and more politically visible, politicians and regulators devote more attention to them. The larger the firm, the more likely it is to become subject to regulation such as antitrust, and the more likely it is to be required to pay higher taxes. Therefore, companies that are politically visible may seek to report low income numbers, to avoid the scrutiny of regulators. In addition, other constituents, such as labor unions, may be less willing to ask for wage increases if reported income is low. Researchers have found that the larger the company, the more likely it is to adopt income-decreasing approaches in selecting accounting methods. 2. Capital Structure. A number of studies have indicated that the capital structure of the company can affect the selection of accounting methods. For example, a company with a high debt-to-equity ratio is more likely to be constrained by debt covenants. The debt covenant may indicate that the company cannot pay dividends if retained earnings fall below a certain level. As a result, such a company is more likely to select accounting methods that will increase net income. 3. Bonus Payments. Studies have found that if compensation plans tie managers bonus payments to income, management will select accounting methods that maximize their bonus payments. 4. Smooth Earnings. Substantial earnings increases attract the attention of politicians, regulators, and competitors. In addition, large increases in income are difficult to achieve in following years. Further, executive compensation plans would use these higher numbers as a baseline and make it difficult for managers to earn bonuses in subsequent years. Conversely, investors and competitors might view large decreases in earnings as a signal that the company is in financial trouble. Also, substantial decreases in income raise concerns on the part of stockholders, lenders, and other interested parties about the competency of management. For all these reasons, companies have an incentive to manage or smooth earnings. In general, management tends to believe that a steady 10 percent growth a year is much better than a 30 percent growth one year and a 10 percent decline the next.12 In other words, managers usually prefer a gradually increasing income report and sometimes change accounting methods to ensure such a result.
Management pays careful attention to the accounting it follows and often changes accounting methods, not for conceptual reasons, but for economic reasons. As indicated
11
See Ross L. Watts and Jerold L. Zimmerman, Positive Accounting Theory: A Ten-Year Perspective, The Accounting Review (January 1990) for an excellent review of research findings related to management incentives in selecting accounting methods. O. Douglas Moses, Income Smoothing and Incentives: Empirical Tests Using Accounting Changes, The Accounting Review (April 1987). The findings provide evidence that earnings smoothing is associated with firm size, the existence of bonus plans, and the divergence of actual earnings from expectations.
12
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1204 Chapter 22 Accounting Changes and Error Analysis throughout this textbook, such arguments have come to be known as economic consequences arguments. These arguments focus on the supposed impact of the accounting method on the behavior of investors, creditors, competitors, governments, or managers of the reporting companies themselves.13 To counter these pressures, standard-setters such as the FASB have declared, as part of their conceptual framework, that they will assess the merits of proposed standards from a position of neutrality. That is, they evaluate the soundness of standards on the basis of conceptual soundness, not on the grounds of possible impact on behavior. It is not the FASBs place to choose standards according to the kinds of behavior it wishes to promote and the kinds it wishes to discourage. At the same time, it must be admitted that some standards often will have the effect of influencing behavior. Yet their justification should be conceptual, and not viewed in terms of their economic impact.
SECTION 2 ER ROR ANALYSIS
Objective9 Analyze the effect of errors.
In this section, we show some additional types of accounting errors. Companies generally do not correct for errors that do not have a significant effect on the presentation of the financial statements. For example, should a company with a total annual payroll of $1,750,000 and net income of $940,000 correct its financial statements if it finds it failed to record accrued wages of $5,000? Noit would not consider this error significant. Obviously, defining materiality is difficult, and managers and auditors must use experience and judgment to determine whether adjustment is necessary for a given error. We assume all errors discussed in this section to be material and to require adjustment. (Also, we ignore all tax effects in this section.) Companies must answer three questions in error analysis:
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?
As indicated earlier, companies treat errors as prior-period adjustments and report them in the current year as adjustments to the beginning balance of Retained Earnings. If a company presents comparative statements, it restates the prior affected statements to correct for the error.
BALANCE SHEET ERRORS
Balance sheet errors affect only the presentation of an asset, liability, or stockholders equity account. Examples are the classification of a short-term receivable as part of the investment section, the classification of a note payable as an account payable, and the classification of plant assets as inventory. When the error is discovered, the company reclassifies the item to its proper position. If the company prepares comparative statements that include the error year, it should correctly restate the balance sheet for the error year.
13
Lobbyists use economic consequences argumentsand there are many of themto put pressure on standard-setters. We have seen examples of these arguments in the oil and gas industry about successful efforts versus full cost, in the technology area with the issue of mandatory expensing of research and developmental costs and stock options.
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Balance Sheet and Income Statement Errors 1205
INCOME STATEMENT ERRORS
Income statement errors involve the improper classification of revenues or expenses. Examples include recording interest revenue as part of sales, purchases as bad debt expense, and depreciation expense as interest expense. An income statement classification error has no effect on the balance sheet and no effect on net income. A company must make a reclassification entry when it discovers the error, if it makes the discovery in the same year in which the error occurs. If the error occurred in prior periods, the company does not need to make a reclassification entry at the date of discovery because the accounts for the current year are correctly stated. (Remember that the company has closed the income statement accounts from the prior period to retained earnings.) If the company prepares comparative statements that include the error year, it restates the income statement for the error year.
BALANCE SHEET AND INCOME STATEMENT ERRORS
The third type of error involves both the balance sheet and income statement. For example, assume that the bookkeeper overlooked accrued wages payable at the end of the accounting period. The effect of this error is to understate expenses, understate liabilities, and overstate net income for that period of time. This type of error affects both the balance sheet and the income statement. We classify this type of error in one of two wayscounterbalancing or noncounterbalancing. Counterbalancing errors are those that will be offset or corrected over two periods. For example, the failure to record accrued wages is a counterbalancing error because over a two-year period the error will no longer be present. In other words, the failure to record accrued wages in the previous period means: (1) net income for the first period is overstated; (2) accrued wages payable (a liability) is understated, and (3) wages expense is understated. In the next period, net income is understated; accrued wages payable (a liability) is correctly stated; and wages expense is overstated. For the two years combined: (1) net income is correct; (2) wages expense is correct; and (3) accrued wages payable at the end of the second year is correct. Most errors in accounting that affect both the balance sheet and income statement are counterbalancing errors. Noncounterbalancing errors are those that are not offset in the next accounting period. An example would be the failure to capitalize equipment that has a useful life of five years. If we expense this asset immediately, expenses will be overstated in the first period but understated in the next four periods. At the end of the second period, the effect of the error is not fully offset. Net income is correct in the aggregate only at the end of five years, because the asset is fully depreciated at this point. Thus, noncounterbalancing errors are those that take longer than two periods to correct themselves. Only in rare instances is an error never reversed. An example would be if a company initially expenses land. Because land is not depreciable, theoretically the error is never offset, unless the land is sold.
Counterbalancing Errors
We illustrate the usual types of counterbalancing errors on the following pages. In studying these illustrations, keep in mind a couple of points, discussed below. First, determine whether the company has closed the books for the period in which the error is found:
1. If the company has closed the books in the current year: (a) If the error is already counterbalanced, no entry is necessary. (b) If the error is not yet counterbalanced, make an entry to adjust the present balance of retained earnings.
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1206 Chapter 22 Accounting Changes and Error Analysis
2. If the company has not closed the books in the current year: (a) If the error is already counterbalanced, make an entry to correct the error in the current period and to adjust the beginning balance of Retained Earnings. (b) If the error is not yet counterbalanced, make an entry to adjust the beginning balance of Retained Earnings.
Second, if the company presents comparative statements, it must restate the amounts for comparative purposes. Restatement is necessary even if a correcting journal entry is not required. To illustrate, assume that Sanfords Cement Co. failed to accrue revenue in 2008 when earned, but recorded the revenue in 2009 when received. The company discovered the error in 2011. It does not need to make an entry to correct for this error because the effects have been counterbalanced by the time Sanford discovered the error in 2011. However, if Sanford presents comparative financial statements for 2008 through 2011, it must restate the accounts and related amounts for the years 2008 and 2009 for financial reporting purposes. The sections that follow demonstrate the accounting for the usual types of counterbalancing errors.
Failure to Record Accrued Wages
On December 31, 2010, Hurley Enterprises did not accrue wages in the amount of $1,500. The entry in 2011 to correct this error, assuming Hurley has not closed the books for 2011, is:
Retained Earnings Wages Expense 1,500 1,500
The rationale for this entry is as follows: (1) When Hurley pays the 2010 accrued wages in 2011, it makes an additional debit of $1,500 to 2011 Wages Expense. (2) Wages Expense2011 is overstated by $1,500. (3) Because the company did not record 2010 accrued wages as Wages Expense in 2010, the net income for 2010 was overstated by $1,500. (4) Because 2010 net income is overstated by $1,500, the Retained Earnings account is overstated by $1,500 (because net income is closed to Retained Earnings). If Hurley has closed the books for 2011, it makes no entry, because the error is counterbalanced.
Failure to Record Prepaid Expenses
In January 2010 Hurley Enterprises purchased a two-year insurance policy costing $1,000. It debited Insurance Expense, and credited Cash. The company made no adjusting entries at the end of 2010. The entry on December 31, 2011, to correct this error, assuming Hurley has not closed the books for 2011, is:
Insurance Expense Retained Earnings 500 500
If Hurley has closed the books for 2011, it makes no entry, because the error is counterbalanced.
Understatement of Unearned Revenue
On December 31, 2010, Hurley Enterprises received $50,000 as a prepayment for renting certain office space for the following year. At the time of receipt of the rent payment, the company recorded a debit to Cash and a credit to Rent Revenue. It made no adjusting entry as of December 31, 2010. The entry on December 31, 2011, to correct for this error, assuming that Hurley has not closed the books for 2011, is:
Retained Earnings Rent Revenue 50,000 50,000
If Hurley has closed the books for 2011, it makes no entry, because the error is counterbalanced.
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Balance Sheet and Income Statement Errors 1207
Overstatement of Accrued Revenue
On December 31, 2010, Hurley Enterprises accrued as interest revenue $8,000 that applied to 2011. On that date, the company recorded a debit to Interest Receivable and a credit to Interest Revenue. The entry on December 31, 2011, to correct for this error, assuming that Hurley has not closed the books for 2011, is:
Retained Earnings Interest Revenue 8,000 8,000
If Hurley has closed the books for 2011, it makes no entry, because the error is counterbalanced.
Overstatement of Purchases
Hurleys accountant recorded a purchase of merchandise for $9,000 in 2010 that applied to 2011. The physical inventory for 2010 was correctly stated. The company uses the periodic inventory method. The entry on December 31, 2011, to correct for this error, assuming that Harley has not closed the books for 2011, is:
Purchases Retained Earnings 9,000 9,000
If Hurley has closed the books for 2011, it makes no entry, because the error is counterbalanced.
Noncounterbalancing Errors
The entries for noncounterbalancing errors are more complex. Companies must make correcting entries, even if they have closed the books.
Failure to Record Depreciation
Assume that on January 1, 2010, Hurley Enterprises purchased a machine for $10,000 that had an estimated useful life of five years. The accountant incorrectly expensed this machine in 2010, but discovered the error in 2011. If we assume that Hurley uses straight-line depreciation on this asset, the entry on December 31, 2011, to correct for this error, given that Hurley has not closed the books, is:
Machinery Depreciation Expense Retained Earnings Accumulated Depreciation (20% 10,000 2,000 $10,000 2) 8,000* 4,000
*Computations: Retained Earnings Overstatement of expense in 2010 Proper depreciation for 2010 (20%
$10,000)
$10,000 (2,000) $ 8,000
Retained earnings understated as of Dec. 31, 2010
If Hurley has closed the books for 2011, the entry is:
Machinery Retained Earnings Accumulated Depreciation *Computations: Retained Earnings Retained earnings understated as of Dec. 31, 2010 Proper depreciation for 2011 (20% $10,000) Retained earnings understated as of Dec. 31, 2011 10,000 6,000* 4,000
$ 8,000 (2,000) $ 6,000
Failure to Adjust for Bad Debts
Companies sometimes use a specific charge-off method in accounting for bad debt expense when a percentage of sales is more appropriate. They then make adjustments to change from the specific write-off to some type of allowance method. For example,
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1208 Chapter 22 Accounting Changes and Error Analysis assume that Hurley Enterprises has recognized bad debt expense when it has the following uncollectible debts.
2010 From 2010 sales From 2011 sales $550 2011 $690 700
Hurley estimates that it will charge off an additional $1,400 in 2012, of which $300 is applicable to 2010 sales and $1,100 to 2011 sales. The entry on December 31, 2011, assuming that Hurley has not closed the books for 2011, is:
Bad Debt Expense Retained Earnings Allowance for Doubtful Accounts 410 990 1,400
Allowance for doubtful accounts: Additional $300 for 2010 sales and $1,100 for 2011 sales. Bad debts and retained earnings balance: 2010 Bad debts charged for Additional bad debts anticipated in 2012 Proper bad debt expense Charges currently made to each period Bad debt adjustment
*$550 $690 $1,240
2011 $ 700 1,100 1,800 (1,390) $ 410
$1,240* 300 1,540 (550) $ 990
If Hurley has closed the books for 2011, the entry is:
Retained Earnings Allowance for Doubtful Accounts 1,400 1,400
COMPREHENSIVE EXAMPLE: NUMEROUS ERRORS
In some circumstances a combination of errors occurs. The company therefore prepares a worksheet to facilitate the analysis. The following problem demonstrates use of the worksheet. The mechanics of its preparation should be obvious from the solution format. The income statements of Hudson Company for the years ended December 31, 2009, 2010, and 2011 indicate the following net incomes.
2009 2010 2011 $17,400 20,200 11,300
An examination of the accounting records for these years indicates that Hudson Company made several errors in arriving at the net income amounts reported:
1. The company consistently omitted from the records wages earned by workers but not paid at December 31. The amounts omitted were:
December 31, 2009 December 31, 2010 December 31, 2011 $1,000 $1,400 $1,600
When paid in the year following that in which they were earned, Hudson recorded these amounts as expenses. 2. The company overstated merchandise inventory on December 31, 2009, by $1,900 as the result of errors made in the footings and extensions on the inventory sheets. 3. On December 31, 2010, Hudson expensed unexpired insurance of $1,200, applicable to 2011. 4. The company did not record on December 31, 2010, interest receivable in the amount of $240.
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Comprehensive Example: Numerous Errors 1209
5. On January 2, 2010, Hudson sold for $1,800 a piece of equipment costing $3,900. At the date of sale the equipment had accumulated depreciation of $2,400. The company recorded the cash received as Miscellaneous Income in 2010. In addition, the company continued to record depreciation for this equipment in both 2010 and 2011 at the rate of 10 percent of cost.
The first step in preparing the worksheet is to prepare a schedule showing the corrected net income amounts for the years ended December 31, 2009, 2010, and 2011. Each correction of the amount originally reported is clearly labeled. The next step is to indicate the balance sheet accounts affected as of December 31, 2011. Illustration 22-24 shows the completed worksheet for Hudson Company.
ILLUSTRATION 22-24 Worksheet to Correct Income and Balance Sheet Errors
Worksheet to Correct Income and Balance Sheet Errors
HUDSON COMPANY
Worksheet Analysis of Changes in Net Income
2009 2010 $20,200 1,000 (1,400) 1,400 (1,600) (1,900) 1,900 1,200 240 (1,500) (1,200) (240) 2011 $11,300 Totals $48,900 0 0 (1,600) 0 0 0 (1,500) $2,400 Debit
Balance Sheet Correction at December 31, 2011
Credit Account
Net income as reported Wages unpaid, 12/31/09 Wages unpaid, 12/31/10 Wages unpaid, 12/31/11 Inventory overstatement, 12/31/09 Unexpired insurance, 12/31/10 Interest receivable, 12/31/10 Correction for entry made upon sale of equipment, 1/2/10a Overcharge of depreciation, 2010 Overcharge of depreciation, 2011 Corrected net income
a
$17,400 (1,000)
$ 1,600
Wages Payable
3,900 390 390 $14,500 $ 3,900 2,400 1,500 1,800 300 (1,800) $ (1,500) $22,030 $10,050 390 390 $46,580 390 390
Accumulated Depreciation Machinery Accumulated Depreciation Accumulated Depreciation
Cost Accumulated depreciation Book value Proceeds from sale Gain on sale Income reported Adjustment
Assuming that Hudson Company has not closed the books, correcting entries on December 31, 2011, are:
Retained Earnings Wages Expense (To correct improper charge to Wages Expense for 2011) Wages Expense Wages Payable (To record proper wages expense for 2011) Insurance Expense Retained Earnings (To record proper insurance expense for 2011) Interest Revenue Retained Earnings (To correct improper credit to Interest Revenue in 2011) 240 240 1,400 1,400 1,600 1,600 1,200 1,200
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1210 Chapter 22 Accounting Changes and Error Analysis
Retained Earnings Accumulated Depreciation Machinery (To record write-off of machinery in 2010 and adjustment of Retained Earnings) Accumulated Depreciation Depreciation Expense Retained Earnings (To correct improper charge for depreciation expense in 2010 and 2011) 780 390 390 1,500 2,400 3,900
If Hudson Company has closed the books for 2011, the correcting entries are:
Retained Earnings Wages Payable (To record proper wage expense for 2011) Retained Earnings Accumulated Depreciation Machinery (To record write-off of machinery in 2010 and adjustment of Retained Earnings) Accumulated Depreciation Retained Earnings (To correct improper charge for depreciation expense in 2010 and 2011) 1,600 1,600 1,500 2,400 3,900
780 780
PREPARATION OF FINANCIAL STATEMENTS WITH ERROR CORRECTIONS
Up to now, our discussion of error analysis has focused on identifying the type of error involved and accounting for its correction in the records. We have noted that companies must present the correction of the error on comparative financial statements. The following example illustrates how a company would restate a typical years financial statements, given many different errors. Dick & Wallys Outlet is a small retail outlet in the town of Holiday. Lacking expertise in accounting, the company does not keep adequate records, and numerous errors occurred in recording accounting information.
1. The bookkeeper inadvertently failed to record a cash receipt of $1,000 on the sale of merchandise in 2011. 2. Accrued wages expense at the end of 2010 was $2,500; at the end of 2011, $3,200. The company does not accrue for wages; all wages are charged to Administrative Expenses. 3. The company had not set up an allowance for estimated uncollectible receivables. Dick and Wally decided to set up such an allowance for the estimated probable losses, as of December 31, 2011, for 2010 accounts of $700, and for 2011 accounts of $1,500. They also decided to correct the charge against each year so that it shows the losses (actual and estimated) relating to that years sales. The company has written off accounts to bad debt expense (selling expense) as follows.
In 2010 2010 accounts 2011 accounts $400 In 2011 $2,000 1,600
4. Unexpired insurance not recorded at the end of 2010 was $600, and at the end of 2011, $400. All insurance is charged to Administrative Expenses. 5. An account payable of $6,000 should have been a note payable.
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Preparation of Financial Statements with Error Corrections 1211
6. During 2010, the company sold for $7,000 an asset that cost $10,000 and had a book value of $4,000. At the time of sale Cash was debited, and Miscellaneous Income was credited for $7,000. 7. As a result of the last transaction, the company overstated depreciation expense (an administrative expense) in 2010 by $800 and in 2011 by $1,200.
Illustration 22-25 presents a worksheet that begins with the unadjusted trial balance of Dick & Wallys Outlet. You can determine the correcting entries and their effect on the financial statements by examining the worksheet.
DICK & WALLYS OUTLET
ILLUSTRATION 22-25 Worksheet to Analyze Effect of Errors in Financial Statements
Worksheet Analysis to Adjust Financial Statements for the Year 2011
Trial Balance Unadjusted Debit Cash Accounts Receivable Notes Receivable Inventory Property, Plant, and Equipment Accumulated Depreciation Investments Accounts Payable Notes Payable Capital Stock Retained Earnings 24,300 14,500 10,000 43,500 20,000 (3) (6) (2) Sales Cost of Goods Sold Selling Expenses Administrative Expenses 21,000 22,000 23,000 (2) (4) Totals Wages Payable Allowance for Doubtful Accounts Unexpired Insurance Net Income Totals (4) 265,500 265,500 94,000 (5) 3,100 17,600 8,500 34,000 112,000 83,500 (6) (7) Credit (1)
Adjustments Debit 1,000 Credit
Income Statement Adjusted Debit Credit
Balance Sheet Adjusted Debit 4,100 17,600 8,500 34,000 Credit
(6) 6,000 2,000
a
10,000a
102,000 75,500 24,300
6,000 (5) 2,700b 4,000 2,500
a
8,500 6,000 16,000 43,500 (4) (7) (1) (3) 600 800 1,000 21,000 500b 400 1,200 21,500 22,700 95,000 12,200
700 600
(4) (7)
(2) (3) 400
3,200 2,200
b
3,200 2,200 400 29,800 29,800 95,000 190,900 190,900
25,900
25,900
95,000
Computations: a Machinery Proceeds from sale Book value of machinery Gain on sale Income credited Retained earnings adjustment $7,000 4,000 3,000 7,000 $4,000
b
Bad Debts
2010 $2,400 700 3,100 (400) $2,700
2011 $1,600 1,500 3,100 (3,600) $ (500)
Bad debts charged for Additional bad debts anticipated Charges currently made to each year Bad debt adjustment
You will want to read the
CONVERGENCE CORNER on page 1212 For discussion of how international convergence efforts relate to accounting changes and errors.
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CONVERGENCE
CORNER
ACCOUNTING CHANGES AND ERRORS
The iGAAP standard addressing accounting and reporting for changes in accounting principles, changes in estimates, and errors is IAS 8 (Accounting Policies, Changes in Accounting Estimates and Errors). Various presentation issues related to restatements are addressed in IAS 1 (Presentation of Financial Statements). As indicated in the chapter, the FASB has issued guidance on changes in accounting principles, changes in estimates, and corrections of errors, which essentially converges U.S. GAAP to IAS 8.
R E L E VA N T FA C T S
One area in which iGAAP and U.S. differ GAAP is
the reporting of error corrections in previously issued financial statements. While both GAAPs require restatement, U.S. GAAP is an absolute standardthat is, there is no exception to this rule.
ABOUT THE NUMBERS
An interesting sidelight to our discussion of accounting changes involves how companies that follow iGAAP report financial information related to the equity method of accounting. Under the equity method of accounting, the investor increases its investment for the pro-rata share of the net income of the investee (often referred to as an associated company under iGAAP). On the other hand, the investor reduces its investment for any dividends received from the investee. Both iGAAP and U.S. GAAP follow this accounting approach. However, there is a subtle difference between iGAAP and U.S. GAAP related to how the investor evaluates the accounting policies of the investee. To illustrate, assume that Kirkland Company (the investor company) uses the FIFO inventory method, and Margo Company (the investee company) uses average cost for its inventory valuation. If Kirkland follows iGAAP, Kirkland must conform the accounting policies of Margo to its own accounting policies. Therefore Kirkland adjusts the net income of Margo so its net income is reported on the FIFO basis. This procedure is not used under U.S. GAAP. Under U.S. GAAP Kirkland ignores the fact that Margo uses a different method of inventory valuation. Kirkland records its pro-rata share of the net income of Margo without adjusting for the fact that Margo uses a different inventory valuation method. As a result, there is a lack of comparability in the inventory methods used to report net income for Kirkland Company under U.S. GAAP.
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.
ON TH E HORIZON
For the most part, iGAAP and U.S. GAAP are similar in the area of accounting changes and reporting the effects of errors. Thus, there is no active project in this area. A related development involves the presentation of comparative data. Under iGAAP, when a company prepares financial statements on a new basis, 2 years of comparative data are reported. U.S. GAAP requires comparative information for a 3-year period. Use of the shorter comparative data period must be addressed before U.S. companies can adopt iGAAP.
1212
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Summary of Learning Objectives 1213
SUMMARY OF LEARNING OBJECTIVES
1 Identify the types of accounting changes. The three different types of accounting changes are: (1) Change in accounting principle: a change from one generally accepted accounting principle to another generally accepted accounting principle. (2) Change in accounting estimate: a change that occurs as the result of new information or as additional experience is acquired. (3) Change in reporting entity: a change from reporting as one type of entity to another type of entity.
KEY TERMS
change in accounting estimate, 1182, 1195 change in accounting principle, 1182 change in accounting estimate effected by a change in accounting principle, 1196 change in reporting entity, 1182 correction of an error, 1198 counterbalancing errors, 1205 cumulative effect, 1183 direct effects of change in accounting principle, 1193 economic consequences, 1204 impracticable, 1193 indirect effects of change in accounting principle, 1193 noncounterbalancing errors, 1205 prior period adjustments, 1198 prospectively, 1183 restatement, 1199(n) retrospective application, 1183
Describe the accounting for changes in accounting principles. A change in accounting principle involves a change from one generally accepted accounting principle to another. A change in accounting principle is not considered to result from the adoption of a new principle in recognition of events that have occurred for the first time or that were previously immaterial. If the accounting principle previously followed was not acceptable or if the principle was applied incorrectly, a change to a generally accepted accounting principle is considered a correction of an error.
2 3 Understand how to account for retrospective accounting changes. The general requirement for changes in accounting principle is retrospective application. Under retrospective application, companies change prior years financial statements on a basis consistent with the newly adopted principle. They treat any part of the effect attributable to years prior to those presented as an adjustment of the earliest retained earnings presented.
Understand how to account for impracticable changes. Retrospective application is impracticable if the prior period effect cannot be determined using every reasonable effort to do so. For example, in changing to LIFO, the base-year inventory for all subsequent LIFO calculations is generally the opening inventory in the year the company adopts the method. There is no restatement of prior years income because it is often too impractical to do so.
4 5 Describe the accounting for changes in estimates. Companies report changes in estimates prospectively. That is, companies should make no changes in previously reported results. They do not adjust opening balances nor change financial statements of prior periods.
Identify changes in a reporting entity. An accounting change that results in financial statements that are actually the statements of a different entity should be reported by restating the financial statements of all prior periods presented, to show the financial information for the new reporting entity for all periods.
6 7 Describe the accounting for correction of errors. Companies must correct errors as soon as they discover them, by proper entries in the accounts, and report them in the financial statements. The profession requires that a company treat corrections of errors as prior-period adjustments, record them in the year in which it discovered the errors, and report them in the financial statements in the proper periods. If presenting comparative statements, a company should restate the prior statements affected to correct for the errors. The company need not repeat the disclosures in the financial statements of subsequent periods.
Identify economic motives for changing accounting methods. Managers might have varying motives for income reporting, depending on economic times and whom they seek to impress. Some of the reasons for changing accounting methods are: (1) political costs, (2) capital structure, (3) bonus payments, and (4) smoothing of earnings.
8
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1214 Chapter 22 Accounting Changes and Error Analysis
9 Analyze the effect of errors. Three types of errors can occur: (1) Balance sheet errors, which affect only the presentation of an asset, liability, or stockholders equity account. (2) Income statement errors, which affect only the presentation of revenue, expense, gain, or loss accounts in the income statement. (3) Balance sheet and income statement errors, which involve both the balance sheet and income statement. Errors are classified into two types: (1) Counterbalancing errors are offset or corrected over two periods. (2) Noncounterbalancing errors are not offset in the next accounting period and take longer than two periods to correct themselves.
As an aid to understanding accounting changes, we provide the following glossary.
KEY TERMS RELATED TO ACCOUNTING CHANGES
ACCOUNTING CHANGE. A change in (1) an accounting principle, (2) an accounting estimate, or (3) the reporting entity. The correction of an error in previously issued financial statements is not an accounting change. CHANGE IN ACCOUNTING PRINCIPLE. A change from one generally accepted accounting principle to another generally accepted accounting principle when two or more generally accepted accounting principles apply or when the accounting principle formerly used is no longer generally accepted. CHANGE IN ACCOUNTING ESTIMATE. A change that has the effect of adjusting the carrying amount of an existing asset or liability or altering the subsequent accounting for existing or future assets or liabilities. Changes in accounting estimates result from new information. CHANGE IN ACCOUNTING ESTIMATE EFFECTED BY A CHANGE IN ACCOUNTING PRINCIPLE. A change in accounting estimate that is inseparable from the effect of a related change in accounting principle. CHANGE IN THE REPORTING ENTITY. A change that results in financial statements that, in effect, are those of a different reporting entity (see page 1197). DIRECT EFFECTS OF A CHANGE IN ACCOUNTING PRINCIPLE. Those recognized changes in assets or liabilities necessary to effect a change in accounting principle. ERROR IN PREVIOUSLY ISSUED FINANCIAL STATEMENTS. An error in recognition, measurement, presentation, or disclosure in financial statements resulting from mathematical mistakes, mistakes in the application of GAAP, or oversight or misuse of facts that existed at the time the financial statements were prepared. A change from an accounting principle that is not generally accepted to one that is generally accepted is a correction of an error. INDIRECT EFFECTS OF A CHANGE IN ACCOUNTING PRINCIPLE. Any changes to current or future cash flows of an entity that result from making a change in accounting principle that is applied retrospectively. RESTATEMENT. The process of revising previously issued financial statements to reflect the correction of an error in those financial statements. RETROSPECTIVE APPLICATION. The application of a different accounting principle to one or more previously issued financial statements, or to the statement of financial position at the beginning of the current period, as if that principle had always been used, or a change to financial statements of prior accounting periods to present the financial statements of a new reporting entity as if it had existed in those prior years. [11]
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Appendix: Changing from or to the Equity Method 1215
APPENDIX
22A
CHANGING FROM OR TO THE EQUITY METHOD
As noted in the chapter, companies generally should report an accounting change that results in financial statements for a different entity by changing the financial statements of all prior periods presented. An example of a change in reporting entity is when a companys level of ownership or influence changes, such as when it changes from or to the equity method. When changing to the equity method, companies use retrospective application. Companies treat a change from the equity method prospectively. We present examples of these changes in entity in the following two sections.
CHANGE FROM THE EQUITY METHOD
If the investor level of influence or ownership falls below that necessary for conObjective10 tinued use of the equity method, a company must change from the equity method Make the computations and to the fair value method. The earnings or losses that the investor previously recprepare the entries necessary to ognized under the equity method should remain as part of the carrying amount record a change from or to the of the investment, with no retrospective application to the new method. equity method of accounting. When a company changes from the equity method to the fair value method, the cost basis for accounting purposes is the carrying amount of the investment at the date of the change. The investor applies the new method in its entirety once the equity method is no longer appropriate. At the next reporting date, the investor should record the unrealized holding gain or loss to recognize the difference between the carrying amount and fair value.14
Dividends in Excess of Earnings
In subsequent periods, dividends received by the investor company may exceed its share of the investees earnings for such periods (all periods following the change in method). To the extent that they do so, the investor company should account for such dividends as a reduction of the investment carrying amount, rather than as revenue. The reason: dividends in excess of earnings are viewed as a liquidating dividend with this excess then accounted for as a reduction of the equity investment. To illustrate, assume that on January 1, 2009, Investor Company purchased 250,000 shares of Investee Companys 1,000,000 shares of outstanding stock for $8,500,000. Investor correctly accounted for this investment using the equity method. After accounting for dividends received and investee net income, in 2009, Investor reported its investment in Investee Company at $8,780,000 at December 31, 2009. On January 2, 2010, Investee Company sold 1,500,000 additional shares of its own common stock to the public, thereby reducing Investor Companys ownership from 25 percent to 10 percent. Illustration 22A-1 shows the net income (or loss) and dividends of Investee Company for the years 2010 through 2012.
Investors Share of Investee Income (Loss) $600,000 350,000 0 Totals $950,000 Investee Dividends Received by Investor $ 400,000 400,000 210,000 $1,010,000
Year 2010 2011 2012
ILLUSTRATION 22A-1 Income Earned and Dividends Received
14
A retrospective application for this type of change is impracticable in many cases. Determining fair values on a portfolio basis for securities in previous periods may be quite difficult. As a result, prospective application is used.
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1216 Chapter 22 Accounting Changes and Error Analysis Assuming a change from the equity method to the fair value method as of January 2, 2010, Investor Companys reported investment in Investee Company and its reported income would be as shown in Illustration 22A-2.
ILLUSTRATION 22A-2 Impact on Investment Carrying Amount
Cumulative Excess of Share of Earnings Over Dividends Received $200,000a 150,000b (60,000)c
Year 2010 2011 2012
a
Dividend Revenue Recognized $400,000 400,000 150,000
$400,000 $200,000 $400,000) $200,000 $210,000 $(60,000)
Investment at December 31 $8,780,000 8,780,000 $8,780,000 $60,000 $8,720,000
$600,000 ($350,000 c $150,000
b
$150,000
Investor Company would record the dividends and earnings data for the three years subsequent to the change in methods as shown by the following entries.
2010 and 2011 Cash Dividend Revenue (To record dividend received from Investee Company) 2012 Cash Available-for-Sale Securities Dividend Revenue (To record dividend revenue from Investee Company in 2012 and to recognize cumulative excess of dividends received over share of Investee earnings in periods subsequent to change from equity method) 210,000 60,000 150,000 400,000 400,000
CHANGE TO THE EQUITY METHOD
When converting to the equity method, companies use retrospective application. Such a change involves adjusting the carrying amount of the investment, results of current and prior operations, and retained earnings of the investor as if the equity method has been in effect during all of the previous periods in which this investment was held. [12] When changing from the fair value method to the equity method, companies also must eliminate any balances in the Unrealized Holding Gain or LossEquity account and the Securities Fair Value Adjustment account. In addition, they eliminate the available-for-sale classification for this investment, and they record the investment under the equity method. For example, on January 2, 2010, Amsted Corp. purchased, for $500,000 cash, 10 percent of the outstanding shares of Cable Company common stock. On that date, the net identifiable assets of Cable Company had a fair value of $3,000,000. The excess of cost over the underlying equity in the net identifiable assets of Cable Company is goodwill. On January 2, 2012, Amsted Corp. purchased an additional 20 percent of Cable Companys stock for $1,200,000 cash when the fair value of Cables net identifiable assets was $4,000,000. The excess of cost over fair value related to this additional investment is goodwill. Now having a 30 percent interest, Amsted Corp. must use the equity method. From January 2, 2010, to January 2, 2012, Amsted Corp. used the fair value method and categorized these securities as available-for-sale. At January 2, 2012, Amsted has a credit balance of $92,000 in its Unrealized Holding Gain or LossEquity account and a debit balance in its Securities Fair Value Adjustment account of the same amount. This change in fair value occurred in 2010 (Income tax effects are ignored.) Illustration 22A-3 (page 1217) shows the net income reported by Cable Company and the Cable Company dividends received by Amsted during the period 2010 through 2012.
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Appendix: Changing from or to the Equity Method 1217
ILLUSTRATION 22A-3 Income Earned and Dividends Received
Year 2010 2011 2012
Cable Company Net Income $ 500,000 1,000,000 1,200,000
Cable Co. Dividends Paid to Amsted $ 20,000 30,000 120,000
Amsted makes the following journal entries from January 2, 2010, through December 31, 2012, relative to Amsted Corp.s investment in Cable Company, reflecting the data above and a change from the fair value method to the equity method.15
January 2, 2010 Available-for-Sale Securities Cash (To record the purchase of a 10% interest in Cable Company) December 31, 2010 Cash Dividend Revenue (To record the receipt of cash dividends from Cable Company) Securities Fair Value Adjustment (Available-for-Sale) Unrealized Holding Gain or LossEquity (To record increase in fair value of securities) December 31, 2011 Cash Dividend Revenue (To record the receipt of cash dividends from Cable Company) January 2, 2012 Investment in Cable Stock Cash Retained Earnings (To record the purchase of an additional interest in Cable Company and to reflect retrospectively a change from the fair value method to the equity method of accounting for the investment. The $100,000 adjustment is computed as follows:) 2010 Amsted Corp. equity in earnings of Cable Company (10%) Dividend received Retrospective application $50,000 (20,000) $30,000 January 2, 2012 Investment in Cable Stock Available-for-Sale Securities (To reclassify initial 10% interest to equity method) January 2, 2012 Unrealized Holding Gain or LossEquity Securities Fair Value Adjustment (Available-for-Sale) (To eliminate fair value accounts for change to equity method) 92,000 92,000 500,000 500,000 1,300,000 1,200,000 100,000 30,000 30,000 20,000 20,000 500,000 500,000
92,000 92,000
2011 $100,000 (30,000) $ 70,000
Total $150,000 (50,000) $100,000
15
Adapted from Paul A. Pacter, Applying APB Opinion No. 18Equity Method, Journal of Accountancy (September 1971), pp. 5960.
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1218 Chapter 22 Accounting Changes and Error Analysis
December 31, 2012 Investment in Cable Stock Revenue from Investment [To record equity in earnings of Cable Company (30% of $1,200,000)] Cash Investment in Cable Stock (To record the receipt of cash dividends from Cable Company) 360,000 360,000
120,000 120,000
Companies change to the equity method by placing the accounts related to and affected by the investment on the same basis as if the equity method had always been the basis of accounting for that investment. Thus, they report the effects of this accounting change using the retrospective approach.16
SUMMARY OF LEARNING OBJECTIVES FOR APPENDIX 22A
Make the computations and prepare the entries necessary to record a change from or to the equity method of accounting. When changing from the equity method to the
10
fair value method, the cost basis for accounting purposes is the carrying amount used for the investment at the date of change. The investor company applies the new method in its entirety once the equity method is no longer appropriate. When changing to the equity method, the company adjusts the accounts to be on the same basis as if the equity method had always been used for that investment.
FASB CODIFICATION
FASB Codification References
[1] FASB ASC 250-10-05-1. [Predecessor literature: Accounting Changes and Error Corrections, Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005).] [2] FASB ASC 250-10-05-2. [Predecessor literature: Accounting Changes and Error Corrections, Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005).] [3] FASB ASC 250-10-50-1. [Predecessor literature: Accounting Changes and Error Corrections, Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), par. 17.] [4] FASB ASC 250-10-50-1. [Predecessor literature: Accounting Changes and Error Corrections, Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), par. B19.] [5] FASB ASC 250-10-45-6. [Predecessor literature: Accounting Changes and Error Corrections, Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), pars. 811.] [6] FASB ASC 250-10-50-1. [Predecessor literature: Accounting Changes and Error Corrections, Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), par. 17.] [7] FASB ASC 250-10-45-18. [Predecessor literature: Accounting Changes and Error Corrections, Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), par. 20.] [8] FASB ASC 250-10-45-24. [Predecessor literature: Prior Period Adjustments, Statement of Financial Accounting Standards No. 16 (Stamford, Conn.: FASB, 1977), p. 5.]
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The change to the equity method illustration assumes that the fair value and the book value of the net identifiable assets of the investee are the same. However, the fair value of the net identifiable assets of the investee may be greater than their book value. In this case, this excess (if depreciable or amortizable) reduces the net income reported by the investor from the investee. For example, assume that the fair value of an investees building is $1,000,000 and its book value is $800,000 at the time of change to the equity method. In that case, this difference of $200,000 is depreciated over the useful life of the building, thereby reducing the amount of investees net income reported on the investors books.
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Questions 1219 [9] FASB ASC 250-10-50-4. [Predecessor literature: Accounting Changes and Error Corrections, Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), par. 2.] [10] FASB ASC 250-10-50-7. [Predecessor literature: Accounting Changes and Error Corrections, Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), par. 26.] [11] FASB ASC 250-10-50-1. [Predecessor literature: Accounting Changes and Error Corrections, Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), par. 2.] [12] FASB ASC 323-10-35-33. [Predecessor literature: The Equity Method of Accounting for Investments in Common Stock, Opinions of the Accounting Principles Board No. 18 (New York: AICPA, 1971), par. 17.]
Exercises
Access the FASB Codification at http://asc.fasb.org/home to prepare responses to the following exercises. Provide Codification references for your responses. CE22-1 Access the glossary (Master Glossary) to answer the following. (a) (b) (c) (d) What What What What is is is is a change in accounting estimate? a change in accounting principle? a restatement? the definition of retrospective application?
CE22-2 When a company has to restate its financial statements to correct an error, what information must the company disclose? CE22-3 What reporting requirements does retrospective application require? CE22-4 If a company registered with the SEC justifies a change in accounting method as preferable under the circumstances, and the circumstances change, can that company switch back to its prior method of accounting before the change? Why or why not? An additional Codification case can be found in the Using Your Judgment section, on page 1240.
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Be sure to check the companion website for a Review and Analysis Exercise, with solution.
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Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.
QUESTIONS
1. In recent years, the Wall Street Journal has indicated that
many companies have changed their accounting principles. What are the major reasons why companies change accounting methods? (e) Write-off of receivables. (f) Change from the percentage-of-completion to the completed-contract method for reporting net income.
3. Discuss briefly the three approaches that have been suggested for reporting changes in accounting principles.
2. State how each of the following items is reflected in the
financial statements. (a) Change from FIFO to LIFO method for inventory valuation purposes. (b) Charge for failure to record depreciation in a previous period. (c) Litigation won in current year, related to prior period. (d) Change in the realizability of certain receivables.
4. Identify and describe the approach the FASB requires
for reporting changes in accounting principles.
5. What is the indirect effect of a change in accounting principle? Briefly describe the reporting of the indirect effects of a change in accounting principle.
6. Define a change in estimate and provide an illustration.
When is a change in accounting estimate effected by a change in accounting principle?
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1220 Chapter 22 Accounting Changes and Error Analysis 7. Lenexa State Bank has followed the practice of capitalizing certain marketing costs and amortizing these costs over their expected life. In the current year, the bank determined that the future benefits from these costs were doubtful. Consequently, the bank adopted the policy of expensing these costs as incurred. How should the bank report this accounting change in the comparative financial statements? inventory. These costs have been expensed as incurred. In 2010, the company decided to change its accounting methods for manufacturing inventories to full costing by including these costs as product costs. Assuming that these costs are material, how should this change be reflected in the financial statements for 2009 and 2010?
17. Elliott Corp. failed to record accrued salaries for 2009,
$2,000; 2010, $2,100; and 2011, $3,900. What is the amount of the overstatement or understatement of Retained Earnings at December 31, 2012?
8. Indicate how the following items are recorded in the accounting records in the current year of Coronet Co. (a) Impairment of goodwill. (b) A change in depreciating plant assets from accelerated to the straight-line method. (c) Large write-off of inventories because of obsolescence. (d) Change from the cash basis to accrual basis of accounting. (e) Change from LIFO to FIFO method for inventory valuation purposes. (f) Change in the estimate of service lives for plant assets.
18. In January 2010, installation costs of $6,000 on new machinery were charged to Repair Expense. Other costs of this machinery of $30,000 were correctly recorded and have been depreciated using the straight-line method with an estimated life of 10 years and no salvage value. At December 31, 2011, it is decided that the machinery has a remaining useful life of 20 years, starting with January 1, 2011. What entry(ies) should be made in 2011 to correctly record transactions related to machinery, assuming the machinery has no salvage value? The books have not been closed for 2011 and depreciation expense has not yet been recorded for 2011.
9. Whittier Construction Co. had followed the practice of
expensing all materials assigned to a construction job without recognizing any salvage inventory. On December 31, 2010, it was determined that salvage inventory should be valued at $52,000. Of this amount, $29,000 arose during the current year. How does this information affect the financial statements to be prepared at the end of 2010?
19. On January 2, 2010, $100,000 of 11%, 10-year bonds were
issued for $97,000. The $3,000 discount was charged to Interest Expense. The bookkeeper, Mark Landis, records interest only on the interest payment dates of January 1 and July 1. What is the effect on reported net income for 2010 of this error, assuming straight-line amortization of the discount? What entry is necessary to correct for this error, assuming that the books are not closed for 2010?
10. Parsons Inc. wishes to change from the completed-contract
to the percentage-of-completion method for financial reporting purposes. The auditor indicates that a change would be permitted only if it is to a preferable method. What difficulties develop in assessing preferability?
20. An entry to record Purchases and related Accounts Payable
of $13,000 for merchandise purchased on December 23, 2011, was recorded in January 2012. This merchandise was not included in inventory at December 31, 2011. What effect does this error have on reported net income for 2011? What entry should be made to correct for this error, assuming that the books are not closed for 2011?
11. Discuss how a change to the LIFO method of inventory
valuation is handled when it is impracticable to determine previous LIFO inventory amounts.
12. How should consolidated financial statements be reported
this year when statements of individual companies were presented last year?
21. Equipment was purchased on January 2, 2010, for $24,000,
but no portion of the cost has been charged to depreciation. The corporation wishes to use the straight-line method for these assets, which have been estimated to have a life of 10 years and no salvage value. What effect does this error have on net income in 2010? What entry is necessary to correct for this error, assuming that the books are not closed for 2010?
13. Simms Corp. controlled four domestic subsidiaries and
one foreign subsidiary. Prior to the current year, Simms Corp. had excluded the foreign subsidiary from consolidation. During the current year, the foreign subsidiary was included in the financial statements. How should this change in accounting entity be reflected in the financial statements?
22. Where can authoritative iGAAP related to accounting
changes be found?
14. Distinguish between counterbalancing and noncounterbalancing errors. Give an example of each.
23. Briefly describe some of the similarities and differences
between U.S. GAAP and iGAAP with respect to reporting accounting changes.
15. Discuss and illustrate how a correction of an error in previously issued financial statements should be handled.
24. How might differences in presentation of comparative
data under U.S. and iGAAP affect adoption of iGAAP by U.S. companies?
16. Prior to 2010, Heberling Inc. excluded manufacturing
overhead costs from work in process and finished goods
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Brief Exercises 1221
BRIEF EXERCISES
3
BE22-1 Wertz Construction Company decided at the beginning of 2010 to change from the completedcontract method to the percentage-of-completion method for financial reporting purposes. The company will continue to use the completed-contract method for tax purposes. For years prior to 2010, pre-tax income under the two methods was as follows: percentage-of-completion $120,000, and completedcontract $80,000. The tax rate is 35%. Prepare Wertzs 2010 journal entry to record the change in accounting principle. BE22-2 Refer to the accounting change by Wertz Construction Company in BE22-1. Wertz has a profitsharing plan, which pays all employees a bonus at year-end based on 1% of pre-tax income. Compute the indirect effect of Wertzs change in accounting principle that will be reported in the 2010 income statement, assuming that the profit-sharing contract explicitly requires adjustment for changes in income numbers. BE22-3 Shannon, Inc., changed from the LIFO cost flow assumption to the FIFO cost flow assumption in 2010. The increase in the prior years income before taxes is $1,200,000. The tax rate is 40%. Prepare Shannons 2010 journal entry to record the change in accounting principle. BE22-4 Tedesco Company changed depreciation methods in 2010 from double-declining-balance to straight-line. Depreciation prior to 2010 under double-declining-balance was $90,000, whereas straightline depreciation prior to 2010 would have been $50,000. Tedescos depreciable assets had a cost of $250,000 with a $40,000 salvage value, and an 8-year remaining useful life at the beginning of 2010. Prepare the 2010 journal entries, if any, related to Tedescos depreciable assets. BE22-5 Sesame Company purchased a computer system for $74,000 on January 1, 2009. It was depreciated based on a 7-year life and an $18,000 salvage value. On January 1, 2011, Sesame revised these estimates to a total useful life of 4 years and a salvage value of $10,000. Prepare Sesames entry to record 2011 depreciation expense. BE22-6 In 2010, Bailey Corporation discovered that equipment purchased on January 1, 2008, for $50,000 was expensed at that time. The equipment should have been depreciated over 5 years, with no salvage value. The effective tax rate is 30%. Prepare Baileys 2010 journal entry to correct the error. BE22-7 At January 1, 2010, Beidler Company reported retained earnings of $2,000,000. In 2010, Beidler discovered that 2009 depreciation expense was understated by $400,000. In 2010, net income was $900,000 and dividends declared were $250,000. The tax rate is 40%. Prepare a 2010 retained earnings statement for Beidler Company. BE22-8 Indicate the effectUnderstate, Overstate, No Effectthat each of the following errors has on 2010 net income and 2011 net income.
2010 (a) (b) (c) (d) (e) Equipment purchased in 2009 was expensed. Wages payable were not recorded at 12/31/10. Equipment purchased in 2010 was expensed. 2010 ending inventory was overstated. Patent amortization was not recorded in 2011. 2011
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5
5
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BE22-9 Roundtree Manufacturing Co. is preparing its year-end financial statements and is considering the accounting for the following items. 1. The vice president of sales had indicated that one product line has lost its customer appeal and will be phased out over the next 3 years. Therefore, a decision has been made to lower the estimated lives on related production equipment from the remaining 5 years to 3 years. The Hightone Building was converted from a sales office to offices for the Accounting Department at the beginning of this year. Therefore, the expense related to this building will now appear as an administrative expense rather than a selling expense on the current years income statement. Estimating the lives of new products in the Leisure Products Division has become very difficult because of the highly competitive conditions in this market. Therefore, the practice of deferring and amortizing preproduction costs has been abandoned in favor of expensing such costs as they are incurred.
2.
3.
Identify and explain whether each of the above items is a change in principle, a change in estimate, or an error.
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1222 Chapter 22 Accounting Changes and Error Analysis
3 7
BE22-10 1. 2.
Palmer Co. is evaluating the appropriate accounting for the following items.
3.
Management has decided to switch from the FIFO inventory valuation method to the LIFO inventory valuation method for all inventories. When the year-end physical inventory adjustment was made for the current year, the controller discovered that the prior years physical inventory sheets for an entire warehouse were mislaid and excluded from last years count. Palmers Custom Division manufactures large-scale, custom-designed machinery on a contract basis. Management decided to switch from the completed-contract method to the percentage-ofcompletion method of accounting for long-term contracts.
Identify and explain whether each of the above items is a change in accounting principle, a change in estimate, or an error.
10
*BE22-11 Simmons Corporation owns stock of Armstrong, Inc. Prior to 2010, the investment was accounted for using the equity method. In early 2010, Simmons sold part of its investment in Armstrong, and began using the fair value method. In 2010, Armstrong earned net income of $80,000 and paid dividends of $95,000. Prepare Simmonss entries related to Armstrongs net income and dividends, assuming Simmons now owns 10% of Armstrongs stock.
10
*BE22-12 Oliver Corporation has owned stock of Conrad Corporation since 2007. At December 31, 2010,
its balances related to this investment were:
Available-for-Sale Securities Securities Fair Value Adj (AFS) Unrealized Holding Gain or LossEquity $185,000 34,000 Dr. 34,000 Cr.
On January 1, 2011, Oliver purchased additional stock of Conrad Company for $475,000 and now has significant influence over Conrad. If the equity method had been used in 20072010, income would have been $33,000 greater than dividends received. Prepare Olivers journal entries to record the purchase of the investment and the change to the equity method.
EXERCISES
3
E22-1 (Change in PrincipleLong-Term Contracts) Cherokee Construction Company changed from the completed-contract to the percentage-of-completion method of accounting for long-term construction contracts during 2010. For tax purposes, the company employs the completed-contract method and will continue this approach in the future. (Hint: Adjust all tax consequences through the Deferred Tax Liability account.) The appropriate information related to this change is as follows.
Pretax Income from: Percentage-of-Completion 2009 2010 $780,000 700,000 Completed-Contract $610,000 480,000 Difference $170,000 220,000
Instructions (a) Assuming that the tax rate is 35%, what is the amount of net income that would be reported in 2010? (b) What entry(ies) are necessary to adjust the accounting records for the change in accounting principle?
3
E22-2 (Change in PrincipleInventory Methods) Whitman Company began operations on January 1, 2008, and uses the average cost method of pricing inventory. Management is contemplating a change in inventory methods for 2011. The following information is available for the years 20082010.
Net Income Computed Using Average Cost Method 2008 2009 2010 $16,000 18,000 20,000 FIFO Method $19,000 21,000 25,000 LIFO Method $12,000 14,000 17,000
Instructions (Ignore all tax effects.) (a) Prepare the journal entry necessary to record a change from the average cost method to the FIFO method in 2011.
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Exercises 1223
(b) Determine net income to be reported for 2008, 2009, and 2010, after giving effect to the change in accounting principle. (c) Assume Whitman Company used the LIFO method instead of the average cost method during the years 20082010. In 2011, Whitman changed to the FIFO method. Prepare the journal entry necessary to record the change in principle.
3
E22-3 (Accounting Change) Ramirez Co. decides at the beginning of 2010 to adopt the FIFO method of inventory valuation. Ramirez had used the LIFO method for financial reporting since its inception on January 1, 2008, and had maintained records adequate to apply the FIFO method retrospectively. Ramirez concluded that FIFO is the preferable inventory method because it reflects the current cost of inventory on the balance sheet. The table presents the effects of the change in accounting principle on inventory and cost of goods sold.
Inventory Determined by Date January 1, 2008 December 31, 2008 December 31, 2009 December 31, 2010 LIFO Method $0 100 200 320 FIFO Method $ 0 80 240 390 Cost of Goods Sold Determined by LIFO Method $ 0 800 1,000 1,130 FIFO Method $ 0 820 940 1,100
Retained earnings reported under LIFO are as follows:
Retained Earnings Balance December 31, 2008 December 31, 2009 December 31, 2010 $2,200 4,200 6,070
Other information: 1. 2. For each year presented, sales are $4,000 and operating expenses are $1,000. Ramirez provides two years of financial statements. Earnings per share information is not required.
Instructions (a) Prepare income statements under LIFO and FIFO for 2008, 2009, and 2010. (b) Prepare income statements reflecting the retrospective application of the accounting change from the LIFO method to the FIFO method for 2010 and 2009. (c) Prepare the note to the financial statements describing the change in method of inventory valuation. In the note, indicate the income statement line items for 2010 and 2009 that were affected by the change in accounting principle. (d) Prepare comparative retained earnings statements for 2009 and 2010 under FIFO.
3
E22-4 (Accounting Change) Linden Company started operations on January 1, 2006, and has used the FIFO method of inventory valuation since its inception. In 2012, it decides to switch to the average cost method. You are provided with the following information.
Net Income Under FIFO 2006 2007 2008 2009 2010 2011 $100,000 70,000 90,000 120,000 300,000 305,000 Under Average Cost $ 92,000 65,000 80,000 130,000 293,000 310,000 Retained Earnings (Ending balance) Under FIFO $100,000 160,000 235,000 340,000 590,000 780,000
Instructions (a) What is the beginning retained earnings balance at January 1, 2008, if Linden prepares comparative financial statements starting in 2008? (b) What is the beginning retained earnings balance at January 1, 2011, if Linden prepares comparative financial statements starting in 2011? (c) What is the beginning retained earnings balance at January 1, 2012, if Linden prepares singleperiod financial statements for 2012? (d) What is the net income reported by Linden in the 2011 income statement if it prepares comparative financial statements starting with 2009?
3
E22-5 (Accounting Change) Presented on page 1224 are income statements prepared on a LIFO and FIFO basis for Carlton Company, which started operations on January 1, 2009. The company presently uses the LIFO method of pricing its inventory and has decided to switch to the FIFO method in 2010. The FIFO income statement is computed in accordance with GAAP requirements. Carltons profit-sharing agreement
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1224 Chapter 22 Accounting Changes and Error Analysis
with its employees indicates that the company will pay employees 5% of income before profit sharing. Income taxes are ignored.
LIFO Basis 2010 Sales Cost of goods sold Operating expenses Income before profit sharing Profit sharing expense Net income $3,000 1,130 1,000 870 44 $ 826 2009 $3,000 1,000 1,000 1,000 50 $ 950 FIFO Basis 2010 $3,000 1,100 1,000 900 45 $ 855 2009 $3,000 940 1,000 1,060 53 $1,007
Instructions Answer the following questions. (a) If comparative income statements are prepared, what net income should Carlton report in 2009 and 2010? (b) Explain why, under the FIFO basis, Carlton reports $50 in 2009 and $48 in 2010 for its profitsharing expense. (c) Assume that Carlton has a beginning balance of retained earnings at January 1, 2010, of $8,000 using the LIFO method. The company declared and paid dividends of $2,500 in 2010. Prepare the retained earnings statement for 2010, assuming that Carlton has switched to the FIFO method.
5
E22-6 (Accounting ChangesDepreciation) of 2007.
Robillard Inc. acquired the following assets in January
$465,000 $780,000
Equipment, estimated service life, 5 years; salvage value, $15,000 Building, estimated service life, 30 years; no salvage value
The equipment has been depreciated using the sum-of-the-years-digits method for the first 3 years for financial reporting purposes. In 2010, the company decided to change the method of computing depreciation to the straight-line method for the equipment, but no change was made in the estimated service life or salvage value. It was also decided to change the total estimated service life of the building from 30 years to 40 years, with no change in the estimated salvage value. The building is depreciated on the straight-line method. Instructions (a) Prepare the journal entry to record depreciation expense for the equipment in 2010. (b) Prepare the journal entry to record depreciation expense for the building in 2010. (Round to nearest dollar.)
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E22-7 (Change in Estimate and Error; Financial Statements) Presented below are the comparative income statements for Pannebecker Inc. for the years 2009 and 2010.
2010 Sales Cost of sales Gross profit Expenses Net income Retained earnings (Jan. 1) Net income Dividends Retained earnings (Dec. 31) $340,000 200,000 140,000 88,000 $ 52,000 $125,000 52,000 (30,000) $147,000 2009 $270,000 142,000 128,000 50,000 $ 78,000 $ 72,000 78,000 (25,000) $125,000
The following additional information is provided: 1. In 2010, Pannebecker Inc. decided to switch its depreciation method from sum-of-the-years-digits to the straight-line method. The assets were purchased at the beginning of 2009 for $90,000 with an estimated useful life of 4 years and no salvage value. (The 2010 income statement contains depreciation expense of $27,000 on the assets purchased at the beginning of 2009.) In 2010, the company discovered that the ending inventory for 2009 was overstated by $20,000; ending inventory for 2010 is correctly stated.
2.
Instructions Prepare the revised retained earnings statement for 2009 and 2010, assuming comparative statements. (Ignore income taxes.)
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Exercises 1225
3 5 7
E22-8 (Accounting for Accounting Changes and Errors) Listed below are various types of accounting changes and errors. ______ ______ ______ ______ ______ ______ ______ ______ ______ ______ 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Change from FIFO to average cost inventory method. Change due to overstatement of inventory. Change from sum-of-the-years-digits to straight-line method of depreciation. Change from presenting unconsolidated to consolidated financial statements. Change from LIFO to FIFO inventory method. Change in the rate used to compute warranty costs. Change from an unacceptable accounting principle to an acceptable accounting principle. Change in a patents amortization period. Change from completed-contract to percentage-of-completion method on construction contracts. Change in a plant assets salvage value.
Instructions For each change or error, indicate how it would be accounted for using the following code letters: (a) Accounted for prospectively. (b) Accounted for retrospectively. (c) Neither of the above.
5 7
E22-9 (Error and Change in EstimateDepreciation) Tarkington Co. purchased a machine on January 1, 2007, for $440,000. At that time it was estimated that the machine would have a 10-year life and no salvage value. On December 31, 2010, the firms accountant found that the entry for depreciation expense had been omitted in 2008. In addition, management has informed the accountant that the company plans to switch to straight-line depreciation, starting with the year 2010. At present, the company uses the sumof-the-years-digits method for depreciating equipment. Instructions Prepare the general journal entries that should be made at December 31, 2010 to record these events. (Ignore tax effects.)
5
E22-10 (Depreciation Changes) On January 1, 2006, McElroy Company purchased a building and equipment that have the following useful lives, salvage values, and costs.
Building, 40-year estimated useful life, $50,000 salvage value, $1,200,000 cost Equipment, 12-year estimated useful life, $10,000 salvage value, $130,000 cost
The building has been depreciated under the double-declining balance method through 2009. In 2010, the company decided to switch to the straight-line method of depreciation. McElroy also decided to change the total useful life of the equipment to 9 years, with a salvage value of $5,000 at the end of that time. The equipment is depreciated using the straight-line method. Instructions (a) Prepare the journal entry(ies) necessary to record the depreciation expense on the building in 2010. (b) Compute depreciation expense on the equipment for 2010.
5
E22-11 (Change in EstimateDepreciation) Thurber Co. purchased equipment for $710,000 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 entered for 7 years on a straight-line basis. In 2011, it is determined that the total estimated life should be 15 years with a salvage value of $4,000 at the end of that time. Instructions (a) Prepare the entry (if any) to correct the prior years depreciation. (b) Prepare the entry to record depreciation for 2011.
5
E22-12 (Change in EstimateDepreciation) Frederick Industries changed from the double-declining balance to the straight-line method in 2010 on all its plant assets. There was no change in the assets salvage values or useful lives. Plant assets, acquired on January 2, 2007, had an original cost of $2,400,000, with a $100,000 salvage value and an 8-year estimated useful life. Income before depreciation expense was $370,000 in 2009 and $300,000 in 2010. Instructions (a) Prepare the journal entry(ies) to record the change in depreciation method in 2010. (b) Starting with income before depreciation expense, prepare the remaining portion of the income statement for 2009 and 2010.
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1226 Chapter 22 Accounting Changes and Error Analysis
3
E22-13 (Change in PrincipleLong-Term Contracts) Bryant Construction Company changed from the completed-contract to the percentage-of-completion method of accounting for long-term construction contracts during 2010. For tax purposes, the company employs the completed-contract method and will continue this approach in the future. The appropriate information related to this change is as follows.
Pretax Income from Percentage-of-Completion 2009 2010 $980,000 900,000 Completed-Contract $730,000 480,000 Difference $250,000 420,000
Instructions (a) Assuming that the tax rate is 40%, what is the amount of net income that would be reported in 2010? (b) What entry(ies) are necessary to adjust the accounting records for the change in accounting principle?
3
E22-14 (Various Changes in PrincipleInventory Methods) Below is the net income of Benchley Instrument Co., a private corporation, computed under the three inventory methods using a periodic system.
FIFO 2008 2009 2010 2011 $26,000 30,000 29,000 34,000 Average Cost $23,000 25,000 27,000 30,000 LIFO $20,000 21,000 24,000 26,000
Instructions (Ignore tax considerations.) (a) Assume that in 2011 Benchley decided to change from the FIFO method to the average cost method of pricing inventories. Prepare the journal entry necessary for the change that took place during 2011, and show net income reported for 2008, 2009, 2010, and 2011. (b) Assume that in 2011 Benchley, which had been using the LIFO method since incorporation in 2008, changed to the FIFO method of pricing inventories. Prepare the journal entry necessary to record the change in 2011 and show net income reported for 2008, 2009, 2010, and 2011.
7
E22-15 (Error Correction Entries) The first audit of the books of Fenimore Company was made for the year ended December 31, 2010. In examining the books, the auditor found that certain items had been overlooked or incorrectly handled in the last 3 years. These items are: 1. At the beginning of 2008, the company purchased a machine for $510,000 (salvage value of $51,000) that had a useful life of 5 years. The bookkeeper used straight-line depreciation, but failed to deduct the salvage value in computing the depreciation base for the 3 years. At the end of 2009, the company failed to accrue sales salaries of $45,000. A tax lawsuit that involved the year 2008 was settled late in 2010. It was determined that the company owed an additional $85,000 in taxes related to 2008. The company did not record a liability in 2008 or 2009 because the possibility of loss was considered remote, and debited the $85,000 to a loss account in 2010 and credited Cash for the same amount. Fenimore Company purchased a copyright from another company early in 2008 for $50,000. Fenimore had not amortized the copyright because its value had not diminished. The copyright has a useful life at purchase of 20 years. In 2010, the company wrote off $87,000 of inventory considered to be obsolete; this loss was charged directly to Retained Earnings and credited to Inventory.
2. 3.
4.
5.
Instructions Prepare the journal entries necessary in 2010 to correct the books, assuming that the books have not been closed. Disregard effects of corrections on income tax.
7
E22-16 (Error Analysis and Correcting Entry) You have been engaged to review the financial statements of Longfellow Corporation. In the course of your examination you conclude that the bookkeeper hired during the current year is not doing a good job. You notice a number of irregularities as follows. 1. 2. 3. Year-end wages payable of $3,400 were not recorded because the bookkeeper thought that they were immaterial. Accrued vacation pay for the year of $31,100 was not recorded because the bookkeeper never heard that you had to do it. Insurance for a 12-month period purchased on November 1 of this year was charged to insurance expense in the amount of $3,300 because the amount of the check is about the same every year.
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Exercises 1227
4. Reported sales revenue for the year is $1,908,000. This includes all sales taxes collected for the year. The sales tax rate is 6%. Because the sales tax is forwarded to the states Department of Revenue, the Sales Tax Expense account is debited. The bookkeeper thought that the sales tax is a selling expense. At the end of the current year, the balance in the Sales Tax Expense account is $103,400.
Instructions Prepare the necessary correcting entries, assuming that Longfellow uses a calendar-year basis.
7
E22-17 (Error Analysis and Correcting Entry) The reported net incomes for the first 2 years of Sinclair Products, Inc., were as follows: 2010, $147,000; 2011, $185,000. Early in 2012, the following errors were discovered. 1. 2. 3. 4. Depreciation of equipment for 2010 was overstated $19,000. Depreciation of equipment for 2011 was understated $38,500. December 31, 2010, inventory was understated $50,000. December 31, 2011, inventory was overstated $14,200.
Instructions Prepare the correcting entry necessary when these errors are discovered. Assume that the books for 2011 are closed. (Ignore income tax considerations.)
7 9
E22-18 (Error Analysis) Emerson Tool Companys December 31 year-end financial statements contained the following errors.
December 31, 2009 Ending inventory Depreciation expense $9,600 understated $2,300 understated December 31, 2010 $7,100 overstated
An insurance premium of $60,000 was prepaid in 2009 covering the years 2009, 2010, and 2011. The entire amount was charged to expense in 2009. In addition, on December 31, 2010, fully depreciated machinery was sold for $15,000 cash, but the entry was not recorded until 2011. There were no other errors during 2009 or 2010, and no corrections have been made for any of the errors. (Ignore income tax considerations.) Instructions (a) Compute the total effect of the errors on 2010 net income. (b) Compute the total effect of the errors on the amount of Emersons working capital at December 31, 2010. (c) Compute the total effect of the errors on the balance of Emersons retained earnings at December 31, 2010.
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E22-19 (Error Analysis and Correcting Entries) A partial trial balance of Dickinson Corporation is as follows on December 31, 2010.
Dr. Supplies on hand Accrued salaries and wages Interest receivable Prepaid insurance Unearned rent Accrued interest payable $ 2,500 $ 1,500 5,100 90,000 0 15,000 Cr.
Additional adjusting data: 1. 2. 3. 4. 5. 6. 7. A physical count of supplies on hand on December 31, 2010, totaled $1,100. Through oversight, the Accrued Salaries and Wages account was not changed during 2010. Accrued salaries and wages on December 31, 2010, amounted to $4,400. The Interest Receivable account was also left unchanged during 2010. Accrued interest on investments amounts to $4,350 on December 31, 2010. The unexpired portions of the insurance policies totaled $65,000 as of December 31, 2010. $24,000 was received on January 1, 2010 for the rent of a building for both 2010 and 2011. The entire amount was credited to rental income. Depreciation for the year was erroneously recorded as $5,000 rather than the correct figure of $50,000. A further review of depreciation calculations of prior years revealed that depreciation of $7,200 was not recorded. It was decided that this oversight should be corrected by a prior period adjustment.
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1228 Chapter 22 Accounting Changes and Error Analysis
Instructions (a) Assuming that the books have not been closed, what are the adjusting entries necessary at December 31, 2010? (Ignore income tax considerations.) (b) Assuming that the books have been closed, what are the adjusting entries necessary at December 31, 2010? (Ignore income tax considerations.)
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E22-20 (Error Analysis) The before-tax income for Fitzgerald Co. for 2010 was $101,000 and $77,400 for 2011. However, the accountant noted that the following errors had been made: 1. 2. 3. Sales for 2010 included amounts of $38,200 which had been received in cash during 2010, but for which the related products were delivered in 2011. Title did not pass to the purchaser until 2011. The inventory on December 31, 2010, was understated by $8,640. The bookkeeper in recording interest expense for both 2010 and 2011 on bonds payable made the following entry on an annual basis.
Interest Expense Cash 15,000 15,000
4.
The bonds have a face value of $250,000 and pay a stated interest rate of 6%. They were issued at a discount of $10,000 on January 1, 2010, to yield an effective interest rate of 7%. (Assume that the effective-interest method should be used.) Ordinary repairs to equipment had been erroneously charged to the Equipment account during 2010 and 2011. Repairs in the amount of $8,000 in 2010 and $9,400 in 2011 were so charged. The company applies a rate of 10% to the balance in the Equipment account at the end of the year in its determination of depreciation charges.
Instructions Prepare a schedule showing the determination of corrected income before taxes for 2010 and 2011.
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E22-21 (Error Analysis) When the records of Archibald Corporation were reviewed at the close of 2011, the errors listed below were discovered. For each item indicate by a check mark in the appropriate column whether the error resulted in an overstatement, an understatement, or had no effect on net income for the years 2010 and 2011.
2010 Item 1. Failure to reflect supplies on hand on balance sheet at end of 2010. Overstatement Understatement No Effect Overstatement
2011 Understatement No Effect
2. Failure to record the correct amount of ending 2010 inventory. The amount was understated because of an error in calculation. 3. Failure to record merchandise purchased in 2010. Merchandise was also omitted from ending inventory in 2010 but was not yet sold. 4. Failure to record accrued interest on notes payable in 2010; that amount was recorded when paid in 2011. 5. Failure to record amortization of patent in 2011.
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Problems 1229
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*E22-22 (Change from Fair Value to Equity) On January 1, 2010, Sandburg Co. purchased 25,000 shares
(a 10% interest) in Yevette Corp. for $1,400,000. At the time, the book value and the fair value of Yevettes net identifiable assets were $13,000,000. On July 1, 2011, Sandburg paid $3,040,000 for 50,000 additional shares of Yevette common stock, which represented a 20% investment in Yevette. The fair value of Yevettes identifiable assets net of liabilities was equal to their carrying amount of $14,200,000. As a result of this transaction, Sandburg owns 30% of Yevette and can exercise significant influence over Yevettes operating and financial policies. Any excess of the cost over the fair value of the identifiable net assets is attributed to goodwill. Yevette reported the following net income and declared and paid the following dividends.
Net Income Year ended 12/31/10 Six months ended 6/30/11 Six months ended 12/31/11 $900,000 500,000 815,000 Dividend per Share None None $1.40
Instructions Determine the ending balance that Sandburg Co. should report as its investment in Yevette Corp. at the end of 2011.
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*E22-23 (Change from Equity to Fair Value) Gamble Corp. was a 30% owner of Sabrina Company, holding 210,000 shares of Sabrinas common stock on December 31, 2010. The investment account had the following entries.
Investment in Sabrina 1/1/09 Cost 12/31/09 Share of income 12/31/10 Share of income $3,180,000 390,000 510,000 12/6/09 Dividend received 12/5/10 Dividend received $150,000 200,000
On January 2, 2011, Gamble sold 126,000 shares of Sabrina for $3,440,000, thereby losing its significant influence. During the year 2011 Sabrina experienced the following results of operations and paid the following dividends to Gamble.
Sabrina Income (Loss) 2011 $350,000 Dividends Paid to Gamble $50,400
At December 31, 2011, the fair value of Sabrina shares held by Gamble is $1,570,000. This is the first reporting date since the January 2 sale. Instructions (a) What effect does the January 2, 2011, transaction have upon Gambles accounting treatment for its investment in Sabrina? (b) Compute the carrying amount in Sabrina as of December 31, 2011. (c) Prepare the adjusting entry on December 31, 2011, applying the fair value method to Gambles long-term investment in Sabrina Company securities.
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PROBLEMS
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P22-1 (Change in Estimate and Error Correction) Holtzman Company is in the process of preparing its financial statements for 2010. Assume that no entries for depreciation have been recorded in 2010. The following information related to depreciation of fixed assets is provided to you: 1. Holtzman purchased equipment on January 2, 2007, for $85,000. At that time, the equipment had an estimated useful life of 10 years with a $5,000 salvage value. The equipment is depreciated on a straight-line basis. On January 2, 2010, as a result of additional information, the company determined that the equipment has a remaining useful life of 4 years with a $3,000 salvage value. During 2010 Holtzman changed from the double-declining balance method for its building to the straight-line method. The building originally cost $300,000. It had a useful life of 10 years and a
2.
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ile
y. c o m /
1230 Chapter 22 Accounting Changes and Error Analysis
salvage value of $30,000. The following computations present depreciation on both bases for 2008 and 2009.
2009 Straight-line Declining-balance $27,000 48,000 2008 $27,000 60,000
3.
Holtzman purchased a machine on July 1, 2008, at a cost of $120,000. The machine has a salvage value of $16,000 and a useful life of 8 years. Holtzmans bookkeeper recorded straight-line depreciation in 2008 and 2009 but failed to consider the salvage value.
Instructions (a) Prepare the journal entries to record depreciation expense for 2010 and correct any errors made to date related to the information provided. (b) Show comparative net income for 2009 and 2010. Income before depreciation expense was $300,000 in 2010, and was $310,000 in 2009. Ignore taxes.
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P22-2 (Comprehensive Accounting Change and Error Analysis Problem) Botticelli Inc. was organized in late 2008 to manufacture and sell hosiery. At the end of its fourth year of operation, the company has been fairly successful, as indicated by the following reported net incomes.
2008 2009
a b
$140,000a 160,000b
2010 2011
$205,000 276,000
Includes a $10,000 increase because of change in bad debt experience rate. Includes extraordinary gain of $30,000.
The company has decided to expand operations and has applied for a sizable bank loan. The bank officer has indicated that the records should be audited and presented in comparative statements to facilitate analysis by the bank. Botticelli Inc. therefore hired the auditing firm of Check & Doublecheck Co. and has provided the following additional information. 1. In early 2009, Botticelli Inc. changed its estimate from 2% to 1% on the amount of bad debt expense to be charged to operations. Bad debt expense for 2008, if a 1% rate had been used, would have been $10,000. The company therefore restated its net income for 2008. In 2011, the auditor discovered that the company had changed its method of inventory pricing from LIFO to FIFO. The effect on the income statements for the previous years is as follows.
2008 Net income unadjustedLIFO basis Net income unadjustedFIFO basis $140,000 155,000 $ 15,000 2009 $160,000 165,000 $ 5,000 2010 $205,000 215,000 $ 10,000 2011 $276,000 260,000 ($ 16,000)
2.
3.
In 2011 the auditor discovered that: a. The company incorrectly overstated the ending inventory by $14,000 in 2010. b. A dispute developed in 2009 with the Internal Revenue Service over the deductibility of entertainment expenses. In 2008, the company was not permitted these deductions, but a tax settlement was reached in 2011 that allowed these expenses. As a result of the courts finding, tax expenses in 2011 were reduced by $60,000.
Instructions (a) Indicate how each of these changes or corrections should be handled in the accounting records. Ignore income tax considerations. (b) Present comparative income statements for the years 2008 to 2011, starting with income before extraordinary items. Ignore income tax considerations.
3 5 7
P22-3 (Error Corrections and Accounting Changes) Penn Company is in the process of adjusting and correcting its books at the end of 2010. In reviewing its records, the following information is compiled. 1. Penn has failed to accrue sales commissions payable at the end of each of the last 2 years, as follows.
December 31, 2009 December 31, 2010 $3,500 $2,500
2.
In reviewing the December 31, 2011, inventory, Penn discovered errors in its inventory-taking procedures that have caused inventories for the last 3 years to be incorrect, as follows.
December 31, 2008 December 31, 2009 December 31, 2010 Understated Understated Overstated $16,000 $19,000 $ 6,700
Penn has already made an entry that established the incorrect December 31, 2010, inventory amount.
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Problems 1231
3. At December 31, 2010, Penn decided to change the depreciation method on its office equipment from double-declining balance to straight-line. The equipment had an original cost of $100,000 when purchased on January 1, 2008. It has a 10-year useful life and no salvage value. Depreciation expense recorded prior to 2010 under the double-declining balance method was $36,000. Penn has already recorded 2010 depreciation expense of $12,800 using the double-declining balance method. Before 2010, Penn accounted for its income from long-term construction contracts on the completedcontract basis. Early in 2010, Penn changed to the percentage-of-completion basis for accounting purposes. It continues to use the completed-contract method for tax purposes. Income for 2010 has been recorded using the percentage-of-completion method. The following information is available.
Pretax Income Percentage-of-Completion Prior to 2010 2010 $150,000 60,000 Completed-Contract $105,000 20,000
4.
Instructions Prepare the journal entries necessary at December 31, 2010, to record the above corrections and changes. The books are still open for 2010. The income tax rate is 40%. Penn has not yet recorded its 2010 income tax expense and payable amounts so current-year tax effects may be ignored. Prior-year tax effects must be considered in item 4.
5
P22-4 (Accounting Changes) Aston Corporation performs year-end planning in November of each year before their calendar year ends in December. The preliminary estimated net income is $3 million. The CFO, Rita Warren, meets with the company president, J. B. Aston, to review the projected numbers. She presents the following projected information.
ASTON CORPORATION PROJECTED INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2010 Sales Cost of goods sold Depreciation Operating expenses Income before income tax Income tax Net income $14,000,000 2,600,000 6,400,000 $29,000,000
23,000,000 6,000,000 3,000,000 $ 3,000,000
ASTON CORPORATION SELECTED BALANCE SHEET INFORMATION AT DECEMBER 31, 2010 Estimated cash balance Available-for-sale securities (at cost) Security fair value adjustment account (1/1/10) $ 5,000,000 10,000,000 200,000
Estimated market value at December 31, 2010:
Security A B C D Total Cost $ 2,000,000 4,000,000 3,000,000 1,000,000 $10,000,000 Estimated Market $ 2,200,000 3,900,000 3,000,000 1,800,000 $10,900,000
Other information at December 31, 2010:
Equipment Accumulated depreciation (5-year SL) New robotic equipment (purchased 1/1/10) Accumulated depreciation (5-year DDB) $ 3,000,000 1,200,000 5,000,000 2,000,000
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1232 Chapter 22 Accounting Changes and Error Analysis
The corporation has never used robotic equipment before, and Warren assumed an accelerated method because of the rapidly changing technology in robotic equipment. The company normally uses straightline depreciation for production equipment. Aston explains to Warren that it is important for the corporation to show a $7,000,000 income before taxes because Aston receives a $1,000,000 bonus if the income before taxes and bonus reaches $7,000,000. Aston also does not want the company to pay more than $3,000,000 in income taxes to the government. Instructions (a) What can Warren do within GAAP to accommodate the presidents wishes to achieve $7,000,000 in income before taxes and bonus? Present the revised income statement based on your decision. (b) Are the actions ethical? Who are the stakeholders in this decision, and what effect do Warrens actions have on their interests?
3
P22-5 (Change in PrincipleInventoryPeriodic) The management of Utrillo Instrument Company had concluded, with the concurrence of its independent auditors, that results of operations would be more fairly presented if Utrillo changed its method of pricing inventory from last-in, first-out (LIFO) to average cost in 2010. Given below is the 5-year summary of income under LIFO and a schedule of what the inventories would be if stated on the average cost method.
UTRILLO INSTRUMENT COMPANY STATEMENT OF INCOME AND RETAINED EARNINGS FOR THE YEARS ENDED MAY 31 2006 Salesnet Cost of goods sold Beginning inventory Purchases Ending inventory Total Gross profit Administrative expenses Income before taxes Income taxes (50%) Net income Retained earningsbeginning Retained earningsending Earnings per share $13,964 1,000 13,000 (1,100) 12,900 1,064 700 364 182 182 1,206 $ 1,388 $1.82 2007 $15,506 1,100 13,900 (1,000) 14,000 1,506 763 743 372 371 1,388 $ 1,759 $3.71 2008 $16,673 1,000 15,000 (1,115) 14,885 1,788 832 956 478 478 1,759 $ 2,237 $4.78 2009 $18,221 1,115 15,900 (1,237) 15,778 2,443 907 1,536 768 768 2,237 $ 3,005 $7.68 2010 $18,898 1,237 17,100 (1,369) 16,968 1,930 989 941 471 470 3,005 $ 3,475 $4.70
SCHEDULE OF INVENTORY BALANCES USING AVERAGE COST METHOD FOR THE YEARS ENDED MAY 31 2005 $1,010 2006 $1,124 2007 $1,101 2008 $1,270 2009 $1,500 2010 $1,720
Instructions Prepare comparative statements for the 5 years, assuming that Utrillo changed its method of inventory pricing to average cost. Indicate the effects on net income and earnings per share for the years involved. Utrillo Instruments started business in 2005. (All amounts except EPS are rounded up to the nearest dollar.)
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P22-6 (Accounting Change and Error Analysis) On December 31, 2010, before the books were closed, the management and accountants of Madrasa Inc. made the following determinations about three depreciable assets. 1. Depreciable asset A was purchased January 2, 2007. It originally cost $540,000 and, for depreciation purposes, the straight-line method was originally chosen. The asset was originally expected to be useful for 10 years and have a zero salvage value. In 2010, the decision was made to change the depreciation method from straight-line to sum-of-the-years-digits, and the estimates relating to useful life and salvage value remained unchanged. Depreciable asset B was purchased January 3, 2006. It originally cost $180,000 and, for depreciation purposes, the straight-line method was chosen. The asset was originally expected to be useful for 15 years and have a zero salvage value. In 2010, the decision was made to shorten the total life of this asset to 9 years and to estimate the salvage value at $3,000.
2.
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Problems 1233
3. Depreciable asset C was purchased January 5, 2006. The assets original cost was $160,000, and this amount was entirely expensed in 2006. This particular asset has a 10-year useful life and no salvage value. The straight-line method was chosen for depreciation purposes.
Additional data: 1. 2. 3. 4. 5. Income in 2010 before depreciation expense amounted to $400,000. Depreciation expense on assets other than A, B, and C totaled $55,000 in 2010. Income in 2009 was reported at $370,000. Ignore all income tax effects. 100,000 shares of common stock were outstanding in 2009 and 2010.
Instructions (a) Prepare all necessary entries in 2010 to record these determinations. (b) Prepare comparative retained earnings statements for Madrasa Inc. for 2009 and 2010. The company had retained earnings of $200,000 at December 31, 2008.
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P22-7 (Error Corrections) You have been assigned to examine the financial statements of Zarle Company for the year ended December 31, 2010. You discover the following situations. 1. Depreciation of $3,200 for 2010 on delivery vehicles was not recorded. 2. The physical inventory count on December 31, 2009, improperly excluded merchandise costing $19,000 that had been temporarily stored in a public warehouse. Zarle uses a periodic inventory system. 3. A collection of $5,600 on account from a customer received on December 31, 2010, was not recorded until January 2, 2011. 4. In 2010, the company sold for $3,700 fully depreciated equipment that originally cost $25,000. The company credited the proceeds from the sale to the Equipment account. 5. During November 2010, a competitor company filed a patent-infringement suit against Zarle claiming damages of $220,000. The companys legal counsel has indicated that an unfavorable verdict is probable and a reasonable estimate of the courts award to the competitor is $125,000. The company has not reflected or disclosed this situation in the financial statements. 6. Zarle has a portfolio of trading securities. No entry has been made to adjust to market. Information on cost and market value is as follows.
Cost December 31, 2009 December 31, 2010 $95,000 $84,000 Market $95,000 $82,000
At December 31, 2010, an analysis of payroll information shows accrued salaries of $12,200. The Accrued Salaries Payable account had a balance of $16,000 at December 31, 2010, which was unchanged from its balance at December 31, 2009. 8. A large piece of equipment was purchased on January 3, 2010, for $40,000 and was charged to Repairs Expense. The equipment is estimated to have a service life of 8 years and no residual value. Zarle normally uses the straight-line depreciation method for this type of equipment. 9. A $12,000 insurance premium paid on July 1, 2009, for a policy that expires on June 30, 2012, was charged to insurance expense. 10. A trademark was acquired at the beginning of 2009 for $50,000. No amortization has been recorded since its acquisition. The maximum allowable amortization period is 10 years. 7. Instructions Assume the trial balance has been prepared but the books have not been closed for 2010. Assuming all amounts are material, prepare journal entries showing the adjustments that are required. (Ignore income tax considerations.)
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P22-8 (Comprehensive Error Analysis) On March 5, 2011, you were hired by Hemingway Inc., a closely held company, as a staff member of its newly created internal auditing department. While reviewing the companys records for 2009 and 2010, you discover that no adjustments have yet been made for the items listed below. Items 1. Interest income of $14,100 was not accrued at the end of 2009. It was recorded when received in February 2010.
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1234 Chapter 22 Accounting Changes and Error Analysis
2. A computer costing $4,000 was expensed when purchased on July 1, 2009. It is expected to have a 4-year life with no salvage value. The company typically uses straight-line depreciation for all fixed assets. Research and development costs of $33,000 were incurred early in 2009. They were capitalized and were to be amortized over a 3-year period. Amortization of $11,000 was recorded for 2009 and $11,000 for 2010. On January 2, 2009, Hemingway leased a building for 5 years at a monthly rental of $8,000. On that date, the company paid the following amounts, which were expensed when paid.
Security deposit First months rent Last months rent $20,000 8,000 8,000 $36,000
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The company received $36,000 from a customer at the beginning of 2009 for services that it is to perform evenly over a 3-year period beginning in 2009. None of the amount received was reported as unearned revenue at the end of 2009. Merchandise inventory costing $18,200 was in the warehouse at December 31, 2009, but was incorrectly omitted from the physical count at that date. The company uses the periodic inventory method.
Instructions Indicate the effect of any errors on the net income figure reported on the income statement for the year ending December 31, 2009, and the retained earnings figure reported on the balance sheet at December 31, 2010. Assume all amounts are material, and ignore income tax effects. Using the following format, enter the appropriate dollar amounts in the appropriate columns. Consider each item independent of the other items. It is not necessary to total the columns on the grid.
Net Income for 2009 Item Understated Overstated Retained Earnings at 12/31/10 Understated Overstated
(CIA adapted)
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P22-9 (Error Analysis) Lowell Corporation has used the accrual basis of accounting for several years. A review of the records, however, indicates that some expenses and revenues have been handled on a cash basis because of errors made by an inexperienced bookkeeper. Income statements prepared by the bookkeeper reported $29,000 net income for 2009 and $37,000 net income for 2010. Further examination of the records reveals that the following items were handled improperly. 1. Rent was received from a tenant in December 2009. The amount, $1,000, was recorded as income at that time even though the rental pertained to 2010. 2. Wages payable on December 31 have been consistently omitted from the records of that date and have been entered as expenses when paid in the following year. The amounts of the accruals recorded in this manner were:
December 31, 2008 December 31, 2009 December 31, 2010 $1,100 1,200 940
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Invoices for office supplies purchased have been charged to expense accounts when received. Inventories of supplies on hand at the end of each year have been ignored, and no entry has been made for them.
December 31, 2008 December 31, 2009 December 31, 2010 $1,300 940 1,420
Instructions Prepare a schedule that will show the corrected net income for the years 2009 and 2010. All items listed should be labeled clearly. (Ignore income tax considerations.)
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P22-10 (Error Analysis and Correcting Entries) You have been asked by a client to review the records of Roberts Company, a small manufacturer of precision tools and machines. Your client is interested in buying the business, and arrangements have been made for you to review the accounting records. Your examination reveals the information shown on page 1235.
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Problems 1235
1. Roberts Company commenced business on April 1, 2008, and has been reporting on a fiscal year ending March 31. The company has never been audited, but the annual statements prepared by the bookkeeper reflect the following income before closing and before deducting income taxes.
Year Ended March 31 2009 2010 2011 Income Before Taxes $ 71,600 111,400 103,580
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A relatively small number of machines have been shipped on consignment. These transactions have been recorded as ordinary sales and billed as such. On March 31 of each year, machines billed and in the hands of consignees amounted to:
2009 2010 2011 $6,500 none 5,590
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Sales price was determined by adding 25% to cost. Assume that the consigned machines are sold the following year. On March 30, 2010, two machines were shipped to a customer on a C.O.D. basis. The sale was not entered until April 5, 2010, when cash was received for $6,100. The machines were not included in the inventory at March 31, 2010. (Title passed on March 30, 2010.) All machines are sold subject to a 5-year warranty. It is estimated that the expense ultimately to be incurred in connection with the warranty will amount to 12 of 1% of sales. The company has charged an expense account for warranty costs incurred. Sales per books and warranty costs were as follows.
Warranty Expense for Sales Made in Sales $ 940,000 1,010,000 1,795,000 2009 $760 360 320 2010 $1,310 1,620 2011 Total $ 760 1,670 3,850
Year Ended March 31 2009 2010 2011
$1,910
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Bad debts have been recorded on a direct write-off basis. Experience of similar enterprises indicates that losses will approximate 14 of 1% of sales. Bad debts written off were:
Bad Debts Incurred on Sales Made in 2009 2009 2010 2011 $750 800 350 2010 $ 520 1,800 2011 Total $ 750 1,320 3,850
$1,700
6.
The bank deducts 6% on all contracts financed. Of this amount, 12% is placed in a reserve to the credit of Roberts Company that is refunded to Roberts as finance contracts are paid in full. The reserve established by the bank has not been reflected in the books of Roberts. The excess of credits over debits (net increase) to the reserve account with Roberts on the books of the bank for each fiscal year were as follows.
2009 2010 2011 $ 3,000 3,900 5,100 $12,000
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Commissions on sales have been entered when paid. Commissions payable on March 31 of each year were as follows.
2009 2010 2011 $1,400 900 1,120
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A review of the corporate minutes reveals the manager is entitled to a bonus of 1% of the income before deducting income taxes and the bonus. The bonuses have never been recorded or paid.
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1236 Chapter 22 Accounting Changes and Error Analysis
Instructions (a) Present a schedule showing the revised income before income taxes for each of the years ended March 31, 2009, 2010, and 2011. Make computations to the nearest whole dollar. (b) Prepare the journal entry or entries you would give the bookkeeper to correct the books. Assume the books have not yet been closed for the fiscal year ended March 31, 2011. Disregard correction of income taxes. (AICPA adapted)
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*P22-11 (Fair Value to Equity Method with Goodwill) On January 1, 2010, Millay Inc. paid $700,000
for 10,000 shares of Genso Companys voting common stock, which was a 10% interest in Genso. At that date the net assets of Genso totaled $6,000,000. The fair values of all of Gensos identifiable assets and liabilities were equal to their book values. Millay does not have the ability to exercise significant influence over the operating and financial policies of Genso. Millay received dividends of $1.50 per share from Genso on October 1, 2010. Genso reported net income of $550,000 for the year ended December 31, 2010. On July 1, 2011, Millay paid $2,325,000 for 30,000 additional shares of Genso Companys voting common stock which represents a 30% investment in Genso. The fair values of all of Genso identifiable assets net of liabilities were equal to their book values of $6,550,000. As a result of this transaction, Millay has the ability to exercise significant influence over the operating and financial policies of Genso. Millay received dividends of $2.00 per share from Genso on April 1, 2011, and $2.50 per share on October 1, 2011. Genso reported net income of $650,000 for the year ended December 31, 2011, and $350,000 for the 6 months ended December 31, 2011. Instructions (a) Prepare a schedule showing the income or loss before income taxes for the year ended December 31, 2010, that Millay should report from its investment in Genso in its income statement issued in March 2011. (b) During March 2012, Millay issues comparative financial statements for 2010 and 2011. Prepare schedules showing the income or loss before income taxes for the years ended December 31, 2010 and 2011, that Millay should report from its investment in Genso. (AICPA adapted)
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*P22-12 (Change from Fair Value to Equity Method) On January 3, 2009, Martin Company purchased
for $500,000 cash a 10% interest in Renner Corp. On that date the net assets of Renner had a book value of $3,700,000. The excess of cost over the underlying equity in net assets is attributable to undervalued depreciable assets having a remaining life of 10 years from the date of Martins purchase. The fair value of Martins investment in Renner securities is as follows: December 31, 2009, $560,000, and December 31, 2010, $515,000. On January 2, 2011, Martin purchased an additional 30% of Renners stock for $1,545,000 cash when the book value of Renners net assets was $4,150,000. The excess was attributable to depreciable assets having a remaining life of 8 years. During 2009, 2010, and 2011 the following occurred.
Renner Net Income 2009 2010 2011 $350,000 450,000 550,000 Dividends Paid by Renner to Martin $15,000 20,000 70,000
Instructions On the books of Martin Company prepare all journal entries in 2009, 2010, and 2011 that relate to its investment in Renner Corp., reflecting the data above and a change from the fair value method to the equity method.
CONCEPTS FOR ANALYSIS
CA22-1 (Analysis of Various Accounting Changes and Errors) Joblonsky Inc. has recently hired a new independent auditor, Karen Ogleby, who says she wants to get everything straightened out. Consequently, she has proposed the accounting changes shown on page 1237 in connection with Joblonsky Inc.s 2010 financial statements.
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Concepts for Analysis 1237
1. At December 31, 2009, the client had a receivable of $820,000 from Hendricks Inc. on its balance sheet. Hendricks Inc. has gone bankrupt, and no recovery is expected. The client proposes to write off the receivable as a prior period item. The client proposes the following changes in depreciation policies. (a) For office furniture and fixtures it proposes to change from a 10-year useful life to an 8-year life. If this change had been made in prior years, retained earnings at December 31, 2009, would have been $250,000 less. The effect of the change on 2010 income alone is a reduction of $60,000. (b) For its equipment in the leasing division the client proposes to adopt the sum-of-the-yearsdigits depreciation method. The client had never used SYD before. The first year the client operated a leasing division was 2010. If straight-line depreciation were used, 2010 income would be $110,000 greater. In preparing its 2009 statements, one of the clients bookkeepers overstated ending inventory by $235,000 because of a mathematical error. The client proposes to treat this item as a prior period adjustment. In the past, the client has spread preproduction costs in its furniture division over 5 years. Because its latest furniture is of the fad type, it appears that the largest volume of sales will occur during the first 2 years after introduction. Consequently, the client proposes to amortize preproduction costs on a per-unit basis, which will result in expensing most of such costs during the first 2 years after the furnitures introduction. If the new accounting method had been used prior to 2010, retained earnings at December 31, 2009, would have been $375,000 less. For the nursery division the client proposes to switch from FIFO to LIFO inventories because it believes that LIFO will provide a better matching of current costs with revenues. The effect of making this change on 2010 earnings will be an increase of $320,000. The client says that the effect of the change on December 31, 2009, retained earnings cannot be determined. To achieve a better matching of revenues and expenses in its building construction division, the client proposes to switch from the completed-contract method of accounting to the percentage-ofcompletion method. Had the percentage-of-completion method been employed in all prior years, retained earnings at December 31, 2009, would have been $1,075,000 greater.
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Instructions (a) For each of the changes described above decide whether: (1) The change involves an accounting principle, accounting estimate, or correction of an error. (2) Restatement of opening retained earnings is required. (b) What would be the proper adjustment to the December 31, 2009, retained earnings? CA22-2 (Analysis of Various Accounting Changes and Errors) Various types of accounting changes can affect the financial statements of a business enterprise differently. Assume that the following list describes changes that have a material effect on the financial statements for the current year of your business enterprise. 1. 2. 3. A change from the completed-contract method to the percentage-of-completion method of accounting for long-term construction-type contracts. A change in the estimated useful life of previously recorded fixed assets as a result of newly acquired information. A change from deferring and amortizing preproduction costs to recording such costs as an expense when incurred because future benefits of the costs have become doubtful. The new accounting method was adopted in recognition of the change in estimated future benefits. A change from including the employer share of FICA taxes with payroll tax expenses to including it with Retirement benefits on the income statement. Correction of a mathematical error in inventory pricing made in a prior period. A change from presentation of statements of individual companies to presentation of consolidated statements. A change in the method of accounting for leases for tax purposes to conform with the financial accounting method. As a result, both deferred and current taxes payable changed substantially. A change from the FIFO method of inventory pricing to the LIFO method of inventory pricing.
4. 5. 6. 7. 8.
Instructions Identify the type of change that is described in each item above and indicate whether the prior years financial statements should be retrospectively applied or restated when presented in comparative form with the current years financial statements.
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1238 Chapter 22 Accounting Changes and Error Analysis
CA22-3 (Analysis of Three Accounting Changes and Errors) unrelated sets of facts relating to accounting changes. Listed below are three independent,
Situation 1 Sanford Company is in the process of having its first audit. The company has used the cash basis of accounting for revenue recognition. Sanford president, B. J. Jimenez, is willing to change to the accrual method of revenue recognition. Situation 2 Hopkins Co. decides in January 2011 to change from FIFO to weighted-average pricing for its inventories. Situation 3 Marshall Co. determined that the depreciable lives of its fixed assets are too long at present to fairly match the cost of the fixed assets with the revenue produced. The company decided at the beginning of the current year to reduce the depreciable lives of all of its existing fixed assets by 5 years. Instructions For each of the situations described, provide the information indicated below. (a) Type of accounting change. (b) Manner of reporting the change under current generally accepted accounting principles including a discussion, where applicable, of how amounts are computed. (c) Effect of the change on the balance sheet and income statement. CA22-4 (Analysis of Various Accounting Changes and Errors) Katherine Irving, controller of Lotan Corp., is aware that a pronouncement on accounting changes has been issued. After reading the pronouncement, she is confused about what action should be taken on the following items related to Lotan Corp. for the year 2010. In 2010, Lotan decided to change its policy on accounting for certain marketing costs. Previously, the company had chosen to defer and amortize all marketing costs over at least 5 years because Lotan believed that a return on these expenditures did not occur immediately. Recently, however, the time differential has considerably shortened, and Lotan is now expensing the marketing costs as incurred. 2. In 2010, the company examined its entire policy relating to the depreciation of plant equipment. Plant equipment had normally been depreciated over a 15-year period, but recent experience has indicated that the company was incorrect in its estimates and that the assets should be depreciated over a 20-year period. 3. One division of Lotan Corp., Hawthorne Co., has consistently shown an increasing net income from period to period. On closer examination of their operating statement, it is noted that bad debt expense and inventory obsolescence charges are much lower than in other divisions. In discussing this with the controller of this division, it has been learned that the controller has increased his net income each period by knowingly making low estimates related to the writeoff of receivables and inventory. 4. In 2010, the company purchased new machinery that should increase production dramatically. The company has decided to depreciate this machinery on an accelerated basis, even though other machinery is depreciated on a straight-line basis. 5. All equipment sold by Lotan is subject to a 3-year warranty. It has been estimated that the expense ultimately to be incurred on these machines is 1% of sales. In 2010, because of a production breakthrough, it is now estimated that 12 of 1% of sales is sufficient. In 2008 and 2009, warranty expense was computed as $64,000 and $70,000, respectively. The company now believes that these warranty costs should be reduced by 50%. 6. In 2010, the company decided to change its method of inventory pricing from average cost to the FIFO method. The effect of this change on prior years is to increase 2008 income by $65,000 and increase 2009 income by $20,000. 1. Instructions Katherine Irving has come to you, as her CPA, for advice about the situations above. Prepare a report, indicating the appropriate accounting treatment that should be given each of these situations. CA22-5 (Change in Principle, Estimate) As a certified public accountant, you have been contacted by Joe Davison, CEO of Sports-Pro Athletics, Inc., a manufacturer of a variety of athletic equipment. He has asked you how to account for the following changes. 1. Sports-Pro appropriately changed its depreciation method for its production machinery from the double-declining balance method to the production method effective January 1, 2010.
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Using Your Judgment 1239
2. 3. Effective January 1, 2010, Sports-Pro appropriately changed the salvage values used in computing depreciation for its office equipment. On December 31, 2010, Sports-Pro appropriately changed the specific subsidiaries constituting the group of companies for which consolidated financial statements are presented.
Instructions Write a 11.5 page letter to Joe Davison explaining how each of the above changes should be presented in the December 31, 2010, financial statements. CA22-6 (Change in Estimate) Mike Crane is an audit senior of a large public accounting firm who has just been assigned to the Frost Corporations annual audit engagement. Frost has been a client of Cranes firm for many years. Frost is a fast-growing business in the commercial construction industry. In reviewing the fixed asset ledger, Crane discovered a series of unusual accounting changes, in which the useful lives of assets, depreciated using the straight-line method, were substantially lowered near the midpoint of the original estimate. For example, the useful life of one dump truck was changed from 10 to 6 years during its fifth year of service. Upon further investigation, Mike was told by Kevin James, Frosts accounting manager, I dont really see your problem. After all, its perfectly legal to change an accounting estimate. Besides, our CEO likes to see big earnings! Instructions Answer the following questions. (a) What are the ethical issues concerning Frosts practice of changing the useful lives of fixed assets? (b) Who could be harmed by Frosts unusual accounting changes? (c) What should Crane do in this situation?
USING YOUR JUDGMENT
F I NANCIAL REPORTI NG
Financial Reporting Problem
The Procter & Gamble Company (P&G)
The financial statements of P&G are provided in Appendix 5B or can be accessed at the books companion website, www.wiley.com/college/kieso.
Instructions
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Refer to P&Gs financial statements and the accompanying notes to answer the following questions. (a) Were there changes in accounting principles reported by P&G during the three years covered by its income statements (20042007)? If so, describe the nature of the change and the year of change. (b) What types of estimates did P&G discuss in 2007?
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Comparative Analysis Case
The Coca-Cola Company and PepsiCo, Inc.
Instructions
Go to the books companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo Inc. (a) Identify the changes in accounting principles reported by Coca-Cola during the 3 years covered by its income statements (20052007). Describe the nature of the change and the year of change. (b) Identify the changes in accounting principles reported by PepsiCo during the 3 years covered by its income statements (20052007). Describe the nature of the change and the year of change. (c) For each change in accounting principle by Coca-Cola and PepsiCo, identify, if possible, the cumulative effect of each change on prior years and the effect on operating results in the year of change.
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1240 Chapter 22 Accounting Changes and Error Analysis
BRI DGE TO TH E PROFESSION
Professional Research: FASB Codification
As part of the year-end accounting process and review of operating policies, Cullen Co. is considering a change in the accounting for its equipment from the straight-line method to an accelerated method. Your supervisor wonders how the company will report this change in principle. He read in a newspaper article that the FASB has issued a standard in this area and has changed GAAP for a change in estimate that is effected by a change in accounting principle. (Thus, the accounting may be different from that he learned in intermediate accounting.) Your supervisor wants you to research the authoritative guidance on a change in accounting principle related to depreciation methods.
Instructions
Access the FASB Codification at http://asc.fasb.org/home to conduct research using the Codification Research System to prepare responses to the following items. Provide Codification references for your responses. (a) What are the accounting and reporting guidelines for a change in accounting principle related to depreciation methods? (b) What are the conditions that justify a change in depreciation method, as contemplated by Cullen Co.? (c) What guidance does the SEC provide concerning the impact that recently issued accounting standards will have on the financial statements in a future period?
Professional Simulation
Go to the books companion website, at www.wiley.com/college/kieso, to find an interactive problem that simulates the computerized CPA exam. The professional simulation for this chapter asks you to address questions related to changes in accounting principles.
KWW_Professional _Simulation Changes in Accounting Principle Time Remaining 1 hour 20 minutes
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Remember to check the books companion website to find additional resources for this chapter.
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