Module 19
Accounting Changes, Errors, and Derivatives
Change in Accounting Estimate
When it prepares the financial statements, management makes many estimates based on its best judgment. When more information is available later, estimates can change. For example, a company might estimate that a new machine will have a useful life of 10 years. After six years, however, information about new technologies might suggest that the machine will be useful for only two more years (for a total of eight). This is an example of the need for a change in accounting estimate.
Changes in accounting estimates can occur as the result of changes in the following:
· Uncollectible receivables (the percentages deemed uncollectible).
· Warranty obligations.
· Useful lives of intangible assets.
· Actuarial assumptions used in pension and other post-retirement benefits (settlement rate, long-term expected return rate, salary increase rate, expected mortality rates for retirees, medical cost increases, etc.).
The rules related to changes in accounting estimates are as follows:
1. Nothing from the past needs to be changed (that is, no retroactive changes are involved).
2. The change must be reflected in current and future financial statements.
Example
Williams Company purchased a machine on January 1, 2002, for $100,000. Its estimated useful life was determined to be 10 years, with zero salvage value. On January 1, 2006, the company revised its estimate. It now expects the machine to be useful for only another three years. If the company uses straight-line depreciation, what is the amount of the depreciation each year?
Depreciation based on initial estimates is $10,000 each year (= $100,000/10).
Thus, depreciation for the first four years (2002 through 2005) is $10,000 per year.
As of January 1, 2006, accumulated depreciation is $40,000 (= $10,000 x 4).
Therefore, the book value (amount left to depreciate) as of January 1, 2006, is $60,000
(= $100,000 - $40,000).
As of January 1, 2006, the revised remaining useful life is 3 years.
Hence, depreciation from 2006 (to 2008) is $20,000 per year (= $60,000/3).
Change in Accounting Principle
A change in accounting principle involves a change from one generally accepted accounting principle to another. The following are examples of changes in accounting principles:
· Change in the inventory method from LIFO to FIFO.
· Change in depreciation method from the straight-line method to the double-declining-balance method.
· Change in the method of accounting for long-term construction contracts from the percentage of completion method to the completed contract method.
The rules for changes in accounting principle are as follows:
1. Financial statements of prior periods are not changed.
2. The cumulative effect of the change in accounting principle (net of taxes) is included in the income statement for the period in which the change is made. This is shown after extraordinary items and before net income.
3. Income before extraordinary items and net income on the income statement is computed on a pro-forma basis (as if the new principle had been used in prior periods) for prior years and is shown on the income statement for all periods presented.
Example
Spencer Company purchased machinery worth $100,000 on January 1, 2002. Its estimated useful life was five years; the company uses the straight-line method of depreciation. On January 1, 2004, the company decided to change to the double-declining-balance method. Ignoring income tax effects, how will the change be reported on the income statement?
Straight-line depreciation schedule:
Straight-line depreciation is $20,000 each year (= $100,000/5).
Straight-line method of accumulated depreciation after two years is $40,000 (= $20,000 x 2).
Straight-line method book value after two years is $60,000 (= $100,000 – $40,000).
Double-declining-balance (DDB) depreciation schedule:
Straight-line rate each year is 20% (1/5).
Hence the DDB rate is 40%.
Year / Beginning Book Value / DDB Rate / DDB Depreciation / Accumulated Depreciation / Ending Book Value2002 / $100,000 / 0.40 / $ 40,000 / $ 40,000 / $60,000
2003 / 60,000 / 0.40 / 24,000 / 64,000 / 36,000
Excess depreciation as the result of using the DDB method, as of the end of 2003 (or January 1, 2004) is $24,000 (= $64,000 – $40,000).
If the company had used the DDB method throughout, depreciation in prior years would have been $24,000 higher. This means that the sum of the net income reported in prior years would have been $24,000 lower, causing retained earnings to be $24,000 lower. Furthermore, if the company had used the DDB method throughout, the accumulated depreciation would have been $24,000 higher. Hence, the retained earnings account must be reduced and the accumulated depreciation account must be increased.
This is accomplished through the following journal entries:
Account / Debit / CreditCumulative Effect of Change in Accounting Principle / 24,000
Accumulated Depreciation / 24,000
The cumulative effect is included in the income statement and reduces net income, thereby reducing the Retained Earnings account. The credit to the Accumulated Depreciation account increases its balance.
If the change had been from the DDB method to the straight-line method, the opposite effect occurs. The Cumulative Effect account would have been credited, thereby increasing net income and the Retained Earnings account. The Accumulated Depreciation account would have been debited, thereby reducing its balance.
Effect of Taxes
If taxes are considered, the accounting is substantively similar, but the debit or credit to the Cumulative Effect account is net of taxes. The balance relates to the impact of taxes, and the Deferred Tax Asset or Liability account is debited or credited as appropriate. (In some instances, the debit or credit is to Income Tax Receivable or Payable, as appropriate).
In the Spencer Company example, assume that the company has always used the DDB method for tax purposes (and continues to do so after the change for financial reporting purposes from straight-line to DDB).
Since the depreciation with DDB method is $24,000 higher than the depreciation with the straight-line method, the depreciation for tax purposes is higher than that for financial statement purposes.
That is, taxable income in the past has been lower than financial income.
This, in turn, means that future taxable income will be higher.
Therefore, the company must set up a deferred tax liability of $7,200 ($24,000 x 0.30).
Once the company decides to change the method from straight-line to DDB, the deferred tax liability is no longer applicable. Hence, the Deferred Tax Liability account is eliminated with a $7,200 debit. As before, the Accumulated Depreciation account is credited with the $24,000 difference in depreciation arising from the switch. The “plug” number is the debit to the Cumulative Effect account. Thus, the journal entry is as follows:
Account / Debit / CreditDeferred Tax Liability / 7,200
Cumulative Effect of Change in Accounting Principle / 16,800
Accumulated Depreciation / 24,000
Change to LIFO Method
Assume that a company changed its inventory method from FIFO to LIFO during 2002. Such a change is made effective with the beginning inventory for the period (as of January 1, 2002). This is because it is extremely difficult (if not impossible) to determine changes in prior-year LIFO layers or dollar-value pools.
Hence, the beginning inventory under LIFO as of January 1, 2002, is assumed to be the same as the ending inventory using FIFO as of December 31, 2001. Thus, when a company changes to the LIFO method, no cumulative effect adjustment is needed. The change is disclosed in the footnotes to the financial statements.
Prior-Period Restatement
In several specific situations, GAAP requires a retroactive treatment for accounting changes. In such instances, the financial statements of prior periods must be revised using the new accounting principle. The specific changes include the following:
· Change from LIFO to another inventory accounting method.
· Change to or from the full cost method used in extractive industries.
· Change in the method of accounting for long-term construction contracts.
· Changes made at the time of initial public offering of stock.
· Change from the fair value method to the equity method for investments.
Example
Dallas Company began operations in the year 2000 and used the LIFO method for inventory accounting. The company changed from LIFO to FIFO for both financial reporting and tax purposes in 2002. The following table gives the relevant details:
Year / LIFO Income before Taxes / FIFO Income before Taxes / Difference2000 / $ 50,000 / $ 60,000 / $ 10,000
2001 / 70,000 / 82,000 / 12,000
2002 / 80,000 / 95,000 / 15,000
Assuming a tax rate of 30%, prepare the necessary journal entry for the change in method.
Because both the previous and new methods were used simultaneously for financial and tax purposes, the change has no deferred tax consequences. However, additional taxes could be payable (or receivable) because of the change in method used for tax purposes.
In this case, the net income using the new method in the previous years is higher by $22,000 ($10,000 in 2000 and $12,000 in 2001). Hence, the income tax payable (relating to operations of prior years) is higher under the new method by $6,600 (30% of $22,000).
Furthermore, the value of the ending inventory as of December 31, 200,1 using FIFO would be higher than the corresponding value using LIFO: the same $22,000.
(Note: The company started with beginning inventory of zero, and the value of purchases is the same under both methods. Therefore, the difference in the Ending Inventory account under the two methods must equal the opposite of the difference in the Cost of Goods Sold account for the two methods or equal the difference in net income between the two methods.)
To account for the higher value of inventory under FIFO, the Inventory account must be debited for $22,000. To record the higher tax payable, the Income Tax Payable account must be credited for $6,600. The plug number is the increase to the Retained Earnings, representing the after-tax increase in net income of the previous periods and the resultant increase in Retained Earnings. (Note that the increase occurs in the beginning balance of the Retained Earnings account, as explained later.)
Hence, the journal entry in 2002 to account for the change is as follows:
Account / Debit / CreditInventory / 22,000
Income Tax Payable / 6,600
Retained Earnings / 15,400
The income statements for 2000 and 2001 must be restated, assuming that the FIFO method had been used. The net income for 2000 and 2001 would be higher by $7,000 and $8,400 (after-tax amounts of the impact of the change), respectively. This means that the ending balance of the 2000 Retained Earnings account will be higher by $7,000. Since Retained Earnings is a permanent account, its 2001 ending balance (that is, the beginning balance of 2002 Retained Earnings) will be higher by $15,400 ($7,000 + $8,400).
(Note: Pro-forma information is not required with the retroactive approach because the financial statements for the prior years are restated directly.)
Accounting for Errors
Accounting errors occur for a variety of reasons, including the following:
· Calculation mistakes (e.g., inventory counting mistakes).
· Classification (e.g., including items in wrong categories, such as classifying a current liability as a noncurrent liability).
· Omission of an accrual or deferral (e.g., failure to accrue warranty costs).
· Use of an accounting principle not in conformity with GAAP.
The different types of errors have different consequences:
1. Errors affecting the balance sheet only. For example, a long-term receivable could be included as a current receivable. No correcting journal entries are required for such errors, which are usually detected and corrected in the period in which it occurs. However, if such an error is not found until a subsequent period, the prior period financial statements must be corrected by reclassifying the item.
2. Errors affecting the income statement only. For example, sales commission could be included with manufacturing salaries. This error does not affect net income, so if it is found in a subsequent period, no correcting journal entries are required. However, the financial statements of prior periods must be reclassified and presented using the correct classification.
3. Errors affecting both the income statement and the balance sheet.
Some of these errors are counterbalancing. That is, an error that understates an item in one period will automatically overstate it in the next period, but, for example, no further consequences occur after the end of the second period. An example is a mistake in inventory count at the end of one year but correct counts in previous and subsequent years.
Other errors do not balance over two periods. Examples are (1) capitalizing and amortizing an item that must be expensed in one period (2) and incorrectly expensing the purchase of a machine that must be capitalized and depreciated in future periods.
Counterbalancing Errors
Assume that Olson Company, which uses the periodic system for inventory, made an error in counting the ending inventory as of December 31, 2001. This error led to understating the inventory amount by $600 on December 31, 2001. The inventory counts at the end of 2000 and 2002 were correct. (Income taxes are ignored in this example.)
In this case, the understatement of inventory as of December 31, 2001, leads to overstating the Cost of Goods Sold account for the year ended December 31, 2001, by $600.
(Explanation: Assume beginning inventory of zero and purchases of $10,000. If the correct amount of ending inventory is $2,000, the cost of goods sold is $8,000. However, if the ending inventory is counted to be only $1,400, the cost of goods sold is calculated to be $8,600.)
This, in turn, leads to understating net income for the year ended December 31, 2001, by $600.
However, because the inventory for December 31, 2001, also is the beginning inventory for 2002, this error also leads to understating the cost of goods sold and overstating the net income for the year ended December 31, 2002 by $600.
Thus, as of the end of 2002, the two errors have canceled, or counterbalanced, each other. The ending Inventory and Retained Earnings accounts as of December 31, 2002, are correct.
If a counterbalancing error is discovered in the next year (in this case, some time during 2002), an adjustment is made to the Retained Earnings account and the other affected account. In this example, if the error is discovered sometime before the end of 2002, the correcting journal entries are as follows.