In this chapter we examine the way accounting changes and error corrections are handled in a variety of situations that might be encountered in practice. We see that most changes in accounting policies are reported retrospectively. Changes in estimates are accounted for prospectively.
Chapter 20 ACCOUNTING CHANGES AND ERROR McGrawHill/Irwin © 2013 The McGraw-Hill Companies, Inc Accounting Changes Type of Change Description Examples Change in Accounting Change from one generally Adopt a new IFRS standard accepted accounting policy to Change method of inventory costing Policy another Change from fair value accounting to equity method, or vice versa Change in Accounting Revision of an estimate Estimate because of new information or new experience Change from cost method to revaluation, or vice versa Change depreciation methods Change estimate of useful life of depreciable asset Change estimate of residual value of depreciable asset Change estimate of impairment loss Change actuarial estimates pertaining to a pension plan 20 - Correction of an Error Type of Change Error correction Description Correction of an error caused by a transaction being recorded incorrectly or not at all Examples Mathematical mistakes Inaccurate physical count of inventory Application of the cash basis of accounting in place of the accrual basis Failure to record an adjusting entry Recording an asset as an expense, or vice versa 20 - Accounting Changes and Error Corrections Retrospective Retrospective Two Reporting Approaches Prospective Prospective 20 - Error Corrections and Most Changes in Policies Retrospective Retrospective Revise prior Two Revise prior years’ years’ statements statements (that (that are are presented for Reporting presented for comparative comparative purposes) purposes) to to reflect reflect the impact Approaches the impact of of the the change change •• The The balance balance in in each each account account affected affected is is revised revised to to appear appear as as ifif the the newly newly adopted adopted accounting accounting policy policy had had been been applied applied all all along along or or that that the the error error had had Prospective Prospective never never occurred occurred •• Adjust Adjust the the beginning beginning balance balance of of retained retained earnings earnings for for the the earliest earliest period period reported reported 20 - The Retrospective Approach Prior period errors must be corrected retrospectively so as to produce correct comparative information in the current set of financial statements A retrospective application of a policy While a retrospective restatement of is a retrospective adjustment to effect the comparative information is used to a change in policy correct a prior period error In normal circumstances, only one year’s comparative information needs to be provided But, when a company makes one of the above two retrospective adjustments, it has to present an additional statement of financial position as at the beginning of the earliest period presented Since the earliest period presented in a normal situation is the previous period, the beginning of the earliest period would be two periods before the current period 20 - Changes in Estimates The change is implemented in the Retrospective current Retrospective period, and its effects are reflected in the financial statements of the current and future Two years only • Prior years’ statements are not revised Reporting • Account balances are not revised Approaches Prospective Prospective 20 - Change in Accounting Policy Qualitative Characteristics Consistency Comparability Although consistency and comparability are desirable, changing to a new policy sometimes is appropriate 20 - Change in Accounting Policy Accounting standards present some choices to companies with respect to accounting policies 20 - Motivation for Accounting Choices Effect on on Effect Compensation Compensation Changing Changing Conditions Conditions Motivations Motivations for Change Change for 20 - 10 Effect on on Debt Debt Effect Agreements Agreements Effect on on Union Union Effect Negotiations Negotiations New Accounting Accounting New Standard Issued Issued Standard Effect on on Effect Income Taxes Taxes Income Error Correction Errors Errors arise arise from from the the misuse misuse of of or or the the failure failure to to use use available information information that that could could have have been been reasonably reasonably available obtained as as of of the the date date when when the the financial financial statements statements obtained were authorized authorized for for issue issue were Examples Examples include: include: Use of of inappropriate inappropriate policies policies •• Use Mistakes in in applying applying IFRS IFRS •• Mistakes Arithmetic mistakes mistakes •• Arithmetic Fraud or or gross gross negligence negligence in in reporting reporting •• Fraud For For all all years years disclosed, disclosed, financial financial statements statements are are retrospectively restated restated to to reflect reflect the the error error correction correction retrospectively 20 - 28 Correction of Accounting Errors Four-step process process Four-step Prepare Prepare aa journal journal entry entry to to correct correct any any balances balances Retrospectively Retrospectively restate restate prior prior years’ years’ financial financial statements that that were were incorrect incorrect statements Report Report correction correction as as aa prior prior period period adjustment adjustment ifif retained earnings earnings is is one one of of the the incorrect incorrect retained accounts affected affected accounts Include Include aa disclosure disclosure note note that that should should describe describe the nature nature of of the the error error and and the the impact impact on on each each the line item item affected affected and and earnings earnings per per share share for for line each prior prior period period presented presented each 20 - 29 Correction of Accounting Errors … Retrospectively Retrospectively restate restate prior prior years’ years’ financial financial … statements that that were were incorrect incorrect statements 20 - 30 Errors Occurred and Discovered in the Same Period Corrected by by reversing reversing the the incorrect incorrect entry entry Corrected and then then recording recording the the correct correct entry entry (or (or and by making making an an entry entry to to correct correct the the account account by balances) balances) 20 - 31 Errors Not Affecting Prior Years’ Net Income Involves incorrect incorrect classification classification of of accounts accounts Involves Requires correction correction of of previously previously issued issued Requires statements (retrospective (retrospective approach) approach) statements Is not not classified classified as as aa prior prior period period adjustment adjustment Is since itit does does not not affect affect prior prior income income since Disclose nature nature of of error error Disclose 20 - 32 Error Affecting Prior Year’s Net Income Requires correction correction of of previously previously issued issued •• Requires statements (retrospective (retrospective approach) approach) statements All incorrect incorrect account account balances balances must must be be •• All corrected corrected Is classified classified as as aa prior prior period period adjustment adjustment since since itit •• Is does affect affect prior prior income income does Disclose nature nature of of error error •• Disclose 20 - 33 Error Affecting Prior Year’s Net Income In In 2012, 2012, internal internal auditors auditors discovered discovered that that Seidman Seidman Distribution Distribution Ltd Ltd had had debited debited an an expense expense account account for for the the $7 $7 million million cost cost of of sorting sorting equipment equipment purchased purchased at at the the beginning beginning of of 2010 2010 The The equipment’s equipment’s useful useful life life was was expected expected to to be be 55 years years with with no no residual residual value value StraightStraightline line depreciation depreciation is is used used by by Seidman Seidman Analysis ($ in millions): Correct December 31, 2010: Equipment 7.0 Cash 7.0 Expense … 1.4 Accum Depr 1.4 December 31, 2011: Expense … 1.4 Accum Depr 1.4 20 - 34 Correct December 31, 2010: Expense 7.0 Cash 7.0 Depreciation entry omitted December 31, 2011: Depreciation entry omitted Error Affecting Prior Year’s Net Income To correct incorrect accounts… 2011 ($ in millions): Equipment ……….………………………… Accumulated Depreciation….……… Retained Earnings … … ………………… 20 - 35 7.0 2.8 4.2 Error Affecting Prior Year’s Net Income Let’s assume the following for Orion Ltd: On Jan 1, 2011, the retained earnings balance was $922,000 In 2011, the company paid $65,000 in dividends Net income for 2011 was $184,000 Correction of error for 2010 was $50,000 The Statement of Retained Earnings (or RE column of the Statement of Shareholders’ Equity) would be as follows: Retained earnings, January 1, 2011 As previously reported Correction of error in depreciation Less: Income tax reduction $ 922,000 50,000 15,000 (35,000) Retained earnings as restated, January 1, 2011 887,000 Add: Net income 184,000 Less: Dividends (65,000) Retained earnings, December 31, 2011 20 - 36 $ $ 1,006,000 Correction of Accounting Errors Identify the the type type of of accounting accounting error error for for the the following following item: item: Identify Ending inventory inventory was was incorrectly incorrectly counted counted Ending Counterbalancing error affecting net income The ending inventory in one period will be incorrect and the beginning inventory in the next period will also be incorrect Since the inventory balance effects cost of goods sold, income will also be incorrect in the two periods, by the same amount At the end of the two periods, if no other errors are made, the balances in inventory and retained earnings are correct 20 - 37 Correction of Accounting Errors Identify the the type type of of accounting accounting error error for for the the following following item: item: Identify Loss on on sale sale of of furniture furniture was was incorrectly incorrectly Loss recorded as as depreciation depreciation expense expense recorded Error not affecting net income When the furniture sale transaction was recorded, depreciation expense was debited for the amount that should have been a debit to loss on sale Since both expenses and losses reduce income, the error does not effect income 20 - 38 Correction of Accounting Errors Identify the the type type of of accounting accounting error error for for the the following following item: item: Identify Depreciation expense expense was was understated understated Depreciation Noncounterbalancing error affecting net income An expense is understated, so income is understated The error affects only the year in which the error was made It is a noncounterbalancing error since only one period’s income is affected 20 - 39 Summary of Accounting Changes and Errors Change in Accounting Policy Most Prospective Changes Exceptions Method of accounting Retrospective Prospective Revise prior years? Yes No Cumulative effect on An adjustment to prior years' income earliest reported Not reported? retained earnings reported Journal entries? Adjust affected None balances to new policy Disclosure note? 20 - 40 Subsequent accounting is affected by change Yes Subsequent accounting is affected by change Yes Change in Estimate Prospective No Not reported None Subsequent accounting is affected by change Yes if material Error Retrospective Yes An adjustment to earliest reported retained earnings Involves any incorrect balances as a result of the error Yes IFRS versus U.S GAAP When correcting errors in previously issued financial statements, IFRS (IAS No 8), unlike U.S GAAP permits the effect of the error to be reported in the current period if it’s not considered practicable to report it retrospectively as is required by U.S GAAP 20 - 41 End of Chapter 20 ... CONDITIONS, AND EVENTS These should be accounted for prospectively… 20 - 26 APPLICATION OF ACCOUNTING POLICIES TO DIFFERENT OR NEW TRANSACTIONS, CONDITIONS, AND EVENTS 20 - 27 Error Correction Errors Errors... sometimes is appropriate 20 - Change in Accounting Policy Accounting standards present some choices to companies with respect to accounting policies 20 - Motivation for Accounting Choices Effect... restated to to reflect reflect the the error error correction correction retrospectively 20 - 28 Correction of Accounting Errors Four-step process process Four-step Prepare Prepare aa journal journal