Accounting

Changes
and Error
Corrections
20

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.   

 20-2

Accounting Changes
Type of
Change Description Examples
 adopt a new FASB standard
Change in Change from  change methods of inventory costing
accounting one generally  change from cost method to equity
principle accepted method, or vice versa
accounting  change from completed contract to %-of-
principle to completion, or vice versa
another
 change depreciation methods
 change estimate of useful life of
Change in Revision of an depreciable asset
estimate estimate because  change estimate of residual value
of new  change estimate of bad debt percentage
information or  change estimate of periods benefited by
new experience intangible assets
 change actuarial estimates pertaining to a
pension plan
 consolidate a subsidiary not previously
Change in Change from included in consolidated financial
reporting reporting as one statements
entity type of entity to  report consolidated financial statements
another type of in place of individual statements
entity
© 2010 The McGraw-Hill Companies, Inc.
 20-3

Correction of an Error
Type Description Examples
 mathematical mistakes
 inaccurate physical count
Correction of an of inventory
Error error caused by  change from the cash basis
correction a transaction of accounting to the
being recorded accrual basis
incorrectly or  failure to record an
not at all adjusting entry
 recording an asset as an
expense, or vice versa
 fraud or gross negligence

© 2010 The McGraw-Hill Companies, Inc.

 20-4

Accounting Changes and

Error Corrections
Retrospective
Retrospective

Two
Reporting
Approaches

Prospective
Prospective

© 2010 The McGraw-Hill Companies, Inc.

 20-5

Accounting Changes and

Error Corrections
Retrospective
Retrospective

Revise
Revise prior
prior years’
years’ statements
statements that
that are
are
presented
presentedTwo
Two again
again for
for comparative
comparative purposes
purposes to to
Reporting
reflect the
the impact
impact of
Reporting
reflect of the
the change.
change.
Approaches
Revise
Revise the
the balance
Approaches balance in
in each
each account
account affected
affected is
is to
to
appear
appear as
as ifif the
the newly
newly adopted
adopted accounted
accounted method
method
had
had been
been applied
applied all
all along
along or
or that
that the
the error
error had
had
never
never occurred.
occurred.
Prospective
Prospective
Adjust
Adjust the beginning balance of retained earnings
the beginning balance of retained earnings
for
for the
the earliest
earliest period
period reported.
reported.
© 2010 The McGraw-Hill Companies, Inc.
 20-6

Accounting Changes and

Error Corrections
The change is implemented in the current
Retrospective
Retrospective
period and its effects are reflected in the
financial statements of the current and
futureTwo
years only.
Two
Prior years’ statements are not revised.
Reporting
Reporting
Account balances are not revised.
Approaches
Approaches

Prospective
Prospective

© 2010 The McGraw-Hill Companies, Inc.

 20-7

Change in Accounting Principle

Qualitative
Characteristics

Consistency Comparability

Although consistency and comparability are desirable,

changing to a new method is sometimes appropriate.
© 2010 The McGraw-Hill Companies, Inc.
 20-8

Motivation for Accounting Choices

Changing
Changing Effect on
Effect on
Conditions
Conditions Compensation
Compensation

Motivations
Motivations
for Change
for Change
Effect on
Effect on Debt
Debt Effect on
Effect on Union
Union
Agreements
Agreements Negotiations
Negotiations

New Standard
New Standard Effect on
Effect on
Issued
Issued Income Taxes
Income Taxes
© 2010 The McGraw-Hill Companies, Inc.
 20-9

Let’s look at an example of a change from LIFO to

FIFO that is reported using the retrospective approach.
Retrospective Approach
At the beginning of 2009, Air Parts Corporation changed
from LIFO to FIFO. Air Parts has paid dividends of $40 million
each year since 1999. Its income tax rate is 40 percent.
Retained earnings on Jan. 1, 2007, was $700 million;
inventory was $500 million. Selected income statement
amounts for 2009 and prior years are (in millions):

Previous
2006 2005 2004 Years
Cost of goods sold (LIFO) $ 430 $ 420 $ 405 $ 2,000
Cost of goods sold (FIFO) 370 365 360 1,700
Difference $ 60 $ 55 $ 45 $ 300

Revenues $ 950 $ 900 $ 875 $ 4,500

Operating expenses 230 210 205 1,000
© 2010 The McGraw-Hill Companies, Inc.
 20-10

Retrospective Approach
For
For each
each year
year reported,
reported, AirAir Parts
Parts makes
makes the
the comparative
comparative
statements
statements appear
appear as
as ifif the
the newly
newly adopted
adopted accounting
accounting
method
method (FIFO)
(FIFO) had
had been
been in
in use
use all
all along.
along.

Incom e Sta te m e nts (Millions)

2006 2005 2004

Re ve nue s $ 950 $ 900 $ 875
Le ss: Cost of goods sold (FIFO) 370 365 360
Opera ting e x pe nse s 230 210 205
Incom e be fore ta x $ 350 $ 325 $ 310
Le ss: Incom e ta x e xpe nse (40%) 140 130 124
Ne t incom e $ 210 $ 195 $ 186
© 2010 The McGraw-Hill Companies, Inc.
 20-11

Retrospective Approach
For
For each
each year
year reported,
reported, AirAir Parts
Parts makes
makes the
the comparative
comparative
statements
statements appear
appear as
as ifif the
the newly
newly adopted
adopted accounting
accounting
method
method (FIFO)
(FIFO) had
had been
been in
in use
use all
all along.
along.

Previous
2006 2005 2004 Ye a rs
Cost of goods sold (LIFO) $ 430 $ 420 $ 405 $ 2,000
Cost of goods sold (FIFO) 370 365 360 1,700
Diffe re nce $ 60 $ 55 $ 45 $ 300

Comparative balance sheets will report 2007 inventory $345

million higher than it was reported in last year’s statements.
Retained earnings for 2007 will be $207 million higher.
[$345 less 40% of $345]
© 2010 The McGraw-Hill Companies, Inc.
 20-12

Retrospective Approach
For
For each
each year
year reported,
reported, AirAir Parts
Parts makes
makes the
the comparative
comparative
statements
statements appear
appear as
as ifif the
the newly
newly adopted
adopted accounting
accounting
method
method (FIFO)
(FIFO) had
had been
been in
in use
use all
all along.
along.

Pre vious
2006 2005 2004 Ye a rs
Cost of goods sold (LIFO) $ 430 $ 420 $ 405 $ 2,000
Cost of goods sold (FIFO) 370 365 360 1,700
Diffe re nce $ 60 $ 55 $ 45 $ 300

Comparative balance sheets will report 2008 inventory $400

million higher than it was reported in last year’s statements.
Retained earnings for 2008 will be $240 million higher.
[$400 less 40% of $400]
© 2010 The McGraw-Hill Companies, Inc.
 20-13

Retrospective Approach
For
For each
each year
year reported,
reported, AirAir Parts
Parts makes
makes the
the comparative
comparative
statements
statements appear
appear as
as ifif the
the newly
newly adopted
adopted accounting
accounting
method
method (FIFO)
(FIFO) had
had been
been in
in use
use all
all along.
along.

Pre vious
2006 2005 2004 Ye a rs
Cost of goods sold (LIFO) $ 430 $ 420 $ 405 $ 2,000
Cost of goods sold (FIFO) 370 365 360 1,700
Diffe re nce $ 60 $ 55 $ 45 $ 300

Comparative balance sheets will report 2009

inventory $460 million higher than it would have
been if the change from LIFO had not occurred.
Retained earnings for 2009 will be $276 million higher.
[$460 million less 40% of $460]
© 2010 The McGraw-Hill Companies, Inc.
 20-14

Retrospective Approach

The Internal Revenue Code requires that taxes saved

On
previously January
On ($160
January 1,
1, 2009,
million in thisthe
2009, the date
date
case) of
of the
from the change,
change,
having used
the
the following
following
another inventory methodjournal
mustentry
journal entry would
now bewould be
repaid made
be (over
madeno
to record the change in
in principle:
longer than 6 to record
years). Inthe
the change
meantime, principle:
there is temporary
difference, reflected in the deferred tax liability.

January 1, 2009 ($ in millions)

Inventory (additional inventory if FIFO had been used) 400
Retained earnings (additional NI if FIFO had been used) 240
Deferred tax liability ($400 x 40%) 160

© 2010 The McGraw-Hill Companies, Inc.

 20-15

Retrospective Approach

In
In the
the first
first set
set of
of financial
financial statements
statements after
after the
the
change
change isis made
made aa disclosure
disclosure note
note is
is needed
needed to:
to:

Report any per

Point out that
Provide share amounts
comparative
justification affected for the
information has
for the change. current and all
been revised.
prior periods.

© 2010 The McGraw-Hill Companies, Inc.

 20-16

Prospective Approach
The prospective
The prospective approach
approach is
is used
used for
for
accounting changes
accounting changes when
when it
it is:
is:

Impracticable to
 Impracticable
 to determine
determine some
some period-
period-
specific effects.
specific effects.

Impracticable to
 Impracticable
 to determine
determine the
the cumulative
cumulative
effect of
effect of prior
prior years.
years.

Mandated by
 Mandated
 by authoritative
authoritative pronouncements.
pronouncements.

© 2010 The McGraw-Hill Companies, Inc.

 20-17

Change in Depreciation Method

A change in depreciation
method is considered to be
a change in accounting
estimate that is achieved by
a change in accounting
principle. It is accounted for
prospectively as a change in
accounting estimate.

© 2010 The McGraw-Hill Companies, Inc.

 20-18

Changing Depreciation Methods

Universal
Universal Semiconductors
Semiconductors switched
switched fromfrom SYD
SYD
depreciation
depreciation toto straight-line
straight-line depreciation
depreciation in in 2009.
2009.
The
The asset
asset was
was purchased
purchased at at the
the beginning
beginning of of 2007
2007
for
for $63
$63 million,
million, has
has aa useful
useful life
life of
of 55 years
years and
and
an
an estimated
estimated residual
residual value
value of of $3
$3 million.
million.
n x (n+1) / 2 = 5 x (5+1) / 2 = 15

Sum-of-the-Years-Digits
Sum-of-the-Years-DigitsDepreciaton
Depreciaton ($
($ in
in millions)
millions)
2004
2004depreciation
depreciation $$ 20
20 ($60
($60 xx 5/15)
5/15)
2005
2005depreciation
depreciation 16
16 ($60
($60 xx 4/15)
4/15)
Accumulated
Accumulated depreciation
depreciation $$ 36
36
$63 - 3 = $60
© 2010 The McGraw-Hill Companies, Inc.
 20-19

Changing Depreciation Methods

SYD depreciation from previous slide

© 2010 The McGraw-Hill Companies, Inc.

 20-20

Changing an Estimate
When a company revises a
previous estimate, prior financial
statements are not revised.
Instead, the company merely
incorporates the new estimate in
any related accounting
determinations from then on.

A disclosure note should

describe the effect of a change in
estimate on income before
extraordinary items, net income,
and related per-share amounts for
the current period.
© 2010 The McGraw-Hill Companies, Inc.
 20-21

CHANGE IN ACCOUNTING ESTIMATE

 Universal Semiconductors estimates bad debt expense as
2% of credit sales. After a review during 2009, Universal
determined that 3% of credit sales is a more realistic estimate
of its collection experience. Credit sales in 2009 are $300
million. The effective income tax rate is 40%.
 Neither bad debt expense nor the allowance for uncollectible
accounts reported in prior years is restated.
 No account balances are adjusted.

 In 2009 and later years, the adjusting entry to record bad

debt expense simply will reflect the new percentage. In
2009, the entry would be: ($ in millions)

Bad debt expense (3% x $300 million) 9

Allowance for uncollectible accounts 9
 The effect of a change in estimate is described in a footnote
to the financial statements. © 2010 The McGraw-Hill Companies, Inc.
 20-22

Changing an Estimate
On January
On January 1, 1, 2005,
2005, Towing,
Towing, Inc.Inc. purchased
purchased
specialized equipment
specialized equipment for for $243,000.
$243,000. The The
equipment was
equipment was depreciated
depreciated usingusing straight-line
straight-line
and had
and had anan estimated
estimated life
life of
of 10
10 years
years andand
salvage value
salvage value ofof $3,000.
$3,000. In In 2009
2009 thethe total
total useful
useful
life of
life of the
the equipment
equipment was was revised
revised to to 66 years.
years. The
The
2009 depreciation
2009 depreciation expense
expense is is
a. $24,000
a. $24,000 $243,000 – $3,000 = $24,000 (2005 – 2008)
b. $48,000
b. $48,000 10 years
$24,000 × 4 years = $96,000 Accum. Depr.
c. $72,000
c. $72,000 $243,000 – $96,000 = $147,000 Book Value
d. $73,500
d. $73,500 $147,000 – $3,000 = $72,000 (2009 – 2010)
2 years
© 2010 The McGraw-Hill Companies, Inc.
 20-23

Change in Reporting Entity

AA change
change in in reporting
reporting entity
entity occurs
occurs as
as aa result
result of:
of:
 presenting
presenting consolidated
consolidated financial
financial statements
statements
in
in place
place of
of statements
statements ofof individual
individual companies,
companies, or or
 changing
changing specific
specific companies
companies that that constitute
constitute thethe
group
group for
for which
which consolidated
consolidated statements
statements areare
prepared.
prepared.

© 2010 The McGraw-Hill Companies, Inc.

 20-24

Change in Reporting Entity

Recast
Recast all all previous
previous periods’
periods’ financial
financial statements
statements
as
as ifif the
the new
new reporting
reporting entity
entity existed
existed in
in those
those
periods
periods..
AA disclosure
disclosure note note should
should describe
describe the
the nature
nature of
of
and
and the
the reason
reason for for the
the change
change and
and the
the effect
effect of
of
the
the change
change on on net
net income,
income, income
income before
before
extraordinary
extraordinary items,
items, andand related
related per
per share
share
amounts
amounts forfor all
all periods
periods presented.
presented.

© 2010 The McGraw-Hill Companies, Inc.

 20-25

Error Correction
Examples include:
 Examples
 include:
Use of
Use
 of inappropriate
inappropriate principle
principle
Mistakes in
Mistakes
 in applying
applying GAAP
GAAP
Arithmetic mistakes
Arithmetic
 mistakes
Fraud or
Fraud
 or gross
gross negligence
negligence in
in reporting
reporting

For all
 For
 all years
years disclosed,
disclosed, financial
financial
statements are
statements are retrospectively
retrospectively restated
restated
to reflect
to reflect the
the error
error correction.
correction.

© 2010 The McGraw-Hill Companies, Inc.

 20-26

Correction of Accounting Errors

Four-step process
Four-step process
Prepare
 Prepare aa journal
journal entry
entry toto correct
correct any
any
balances.
balances.
Retrospectively
 Retrospectively restate
restate prior
prior years’
years’
financial statements
financial statements that that were
were incorrect.
incorrect.
Report
 Report error
error as
as aa prior
prior period
period adjustment
adjustment
ifif retained
retained earnings
earnings is is one
one of
of the
the incorrect
incorrect
accounts affected.
accounts affected.

 Include
toInclude aa disclosure
disclosure
the beginning note.
balance in anote.
statement of shareholders’
equity
Note (or statement
should of retained
describe the nature ofearnings
the errorif and
that’s presented
the
instead),
impact of itsforcorrection
the earliest
on year being reported
net income, income in the
before
comparativeitems,
extraordinary financial
andstatements.
earnings per share.© 2010 The McGraw-Hill Companies, Inc.
 20-27

Errors Occurred and Discovered

in the Same Period
Corrected by
Corrected by reversing
reversing the
the incorrect
incorrect
entry and
entry and then
then recording
recording the
the correct
correct
entry (or
entry (or by
by making
making an
an entry
entry to
to
correct the
correct the account
account balances).
balances).

© 2010 The McGraw-Hill Companies, Inc.

 20-28

ERROR DISCOVERED IN THE SAME

REPORTING PERIOD THAT IT OCCURRED
 If an accounting error is made and discovered in the same
accounting period, the original erroneous entry should
simply be reversed and the appropriate entry recorded.

G.H. Little, Inc. paid $3 million for replacement computers

and recorded the expenditure as maintenance expense.
The error was discovered a week later.

To reverse erroneous entry ($ in millions)

Cash 3
Maintenance expense 3

To record correct entry

Equipment 3
Cash 3 © 2010 The McGraw-Hill Companies, Inc.
 20-29

ERROR AFFECTING PREVIOUS FINANCIAL

STATEMENTS, BUT NOT NET INCOME

 Example: Incorrectly recording salaries payable as

accounts payable, recording a loss as an expense, or
classifying a cash flow as an investing activity rather
than a financing activity on the statement of cash flows.

MDS Transportation incorrectly recorded a $2 million

note receivable as accounts receivable. The error was
discovered a year later.

To correct incorrect accounts ($ in millions)

Note receivable 2
Accounts receivable 2
© 2010 The McGraw-Hill Companies, Inc.
 20-30

RECORDING AN ASSET AS AN EXPENSE

In 2009, internal auditors discovered that Seidman Distribution, Inc. had
debited an expense account for the $7 million cost of sorting equipment
purchased at the beginning of 2007. The equipment’s useful life was
expected to be 5 years with no residual value. Straight-line depreciation
is used by Seidman.
Analysis:
($ in millions)
Correct Incorrect
(Should Have Been Recorded) (As Recorded)
2007 Equipment 7.0 Expense 7.0
Cash 7.0 Cash 7.0

2007 Expense 1.4 Depreciation entry omitted

Accum. depr. 1.4

2008 Expense 1.4 Depreciation entry omitted

Accum. depr. 1.4
© 2010 The McGraw-Hill Companies, Inc.
 20-31

RECORDING AN ASSET AS AN EXPENSE

(Illustration continued)

 During the two-year period, depreciation expense was understated

by $2.8 million, but other expenses were overstated by $7 million,
so net income during the period was understated by $4.2 million.
This means retained earnings is currently understated by that
amount.
Accumulated depreciation is understated by $2.8 million.

To correct incorrect accounts ($ in millions)

Equipment 7.0
Accumulated depreciation 2.8
Retained earnings 4.2

o The 2007 and 2008 financial statements are retrospectively

restated.
o The correction is reported as a “prior period adjustment.”
o A disclosure note describes the error and the impact of its
correction. © 2010 The McGraw-Hill Companies, Inc.
 20-32

INVENTORY MISSTATED
In early 2009, a company discovered that $1 million of inventory had been
inadvertently excluded from its 2007 ending inventory count.
Analysis: U = Understated
O = Overstated
2004 2005
Beginning inventory Beginning inventory U
Plus: Net purchases Plus: Net purchases
Less: Ending inventory U Less: Ending inventory
Cost of goods sold O Cost of goods sold U

Revenues Revenues
Less: COGS O Less: Cost of goods sold U
Less: Other expenses Less: Other expenses
Net income U Net income O
 
Retained earnings U Retained earnings corrected
© 2010 The McGraw-Hill Companies, Inc.
 20-33

INVENTORY MISSTATED
(continued)
If discovered in 2008 (before closing):
($ in millions)

Inventory 1
Retained earnings 1

If discovered in 2009 or later:

No correcting entry needed

© 2010 The McGraw-Hill Companies, Inc.

 20-34

Summary of Accounting
Changes and Errors
Change in
Change in Reporting
Change in Accounting Principle Estimate Entity Error
Most Prospective
Changes Exceptions
Method of accounting Retrospective Prospective Prospective Retrospective Retrospective
Restate prior years? Yes No No Yes Yes
Pro forma disclosure
of income and EPS? No No No No No
Cumulative effect on An adjustment to An adjustment to
prior years' income earliest reported Not Not Not earliest reported
reported? retained earnings. reported. reported. reported. retained earnings.
Journal entries? Adjust affected None None None Involves any
balances to new incorrect balances
method. as a result of the
error.
Subsequent Subsequent Subsequent Consolidated
accounting is accounting is accounting is statements are
affected by affected by affected by discussed in
change. change. change. other courses.
Disclosure note? Yes Yes Yes Yes Yes
© 2010 The McGraw-Hill Companies, Inc.
 20-35

End of Chapter 20

© 2010 The McGraw-Hill Companies, Inc.