Accounting Changes and Error Analysis

CHAPTER 22

Accounting Changes and Error Analysis

ASSIGNMENT CLASSIFICATION TABLE

Topics / Questions / Brief
Exercises / Exercises /
Problems / Cases
1. Differences between change in principle, change in estimate, change in entity, errors. / 2, 4, 5, 6, 7, 8, 11, 12, 13, 15, 16 / 3 / 1, 2, 3, 4, 5
2. Accounting changes:
a. Comprehensive. / 1, 2, 3, 7 / 1, 2, 4, 5, 6
b. Changes in estimate. / 4 / 2, 3, 4, 16 / 1, 2, 5 / 2, 3, 4, 5, 7
c. Changes in depreciation methods. / 9 / 1. 2 / 1, 2, 3, 5, 6, 10, 16, 17 / 1, 5, 6 / 1, 3, 4, 7
d. Changes in accounting for long-term construction contracts. / 7 / 6 / 1, 2, 5
e. Change from FIFO to average cost. / 8
f. Change from FIFO to LIFO. / 10 / 9 / 1, 2, 5
g. Change from LIFO. / 3 / 8 / 4
h. Miscellaneous. / 1, 3, 8 / 6 / 1, 6
3. Correction of an error.
a. Comprehensive. / 14, 17, 19 / 7 / 10, 12, 15, 16, 17, 18 / 5, 6, 8, 9, 10 / 2, 4, 5
b. Depreciation. / 18, 21 / 5, 6 / 1, 13, 14 / 1
c. Inventory. / 20 / 11, 13 / 2, 10 / 1, 2
*4. Changes between fair value and equity methods. / 8, 9 / 19, 20 / 11, 12

*This material is dealt with in an Appendix to the chapter.

ASSIGNMENT CHARACTERISTICS TABLE

Item / Description / Level of
Difficulty / Time
(minutes)
E22-1 / Error and change in principle—depreciation. / Simple / 15-20
E22-2 / Change in principle and change in estimate—depreciation. / Moderate / 30-35
E22-3 / Change in principle and change in estimate—depreciation. / Moderate / 20-25
E22-4 / Change in estimate—depreciation. / Simple / 10-15
E22-5 / Change in principle—depreciation. / Simple / 20-25
E22-6 / Change in principle—depreciation. / Moderate / 20-25
E22-7 / Change in principle—long-term contracts. / Simple / 10-15
E22-8 / Various changes in principle—inventory methods. / Moderate / 20-35
E22-9 / Change in principle—FIFO to LIFO. / Simple / 10-15
E22-10 / Error correction entries. / Simple / 15-20
E22-11 / Change in principle and error; financial statements. / Moderate / 25-35
E22-12 / Error analysis and correcting entry. / Simple / 10-15
E22-13 / Error analysis and correcting entry. / Simple / 10-15
E22-14 / Error analysis. / Moderate / 25-30
E22-15 / Error analysis; correcting entries. / Simple / 20-25
E22-16 / Error analysis. / Moderate / 20-25
E22-17 / Error analysis. / Moderate / 10-15
E22-18 / Error analysis. / Moderate / 5-10
*E22-19 / Change from fair value to equity. / Complex / 25-30
*E22-20 / Change from equity to fair value. / Moderate / 15-20
P22-1 / Change in estimate, principle, and error correction. / Moderate / 30-35
P22-2 / Comprehensive accounting change and error analysis problem. / Complex / 30-40
P22-3 / Comprehensive accounting change and error analysis problem. / Complex / 30-40
P22-4 / Change in principle (LIFO to average cost), income statements. / Moderate / 40-50
P22-5 / Error corrections. / Moderate / 30-35
P22-6 / Error corrections and changes in principle. / Moderate / 25-30
P22-7 / Comprehensive error analysis. / Moderate / 25-30
P22-8 / Error analysis. / Moderate / 20-25
P22-9 / Error analysis and correcting entries. / Moderate / 20-25
P22-10 / Error analysis and correcting entries. / Complex / 50-60
*P22-11 / Fair value to equity method with goodwill. / Moderate / 20-25
*P22-12 / Change from fair value to equity method. / Moderate / 20-25
C22-1 / Analysis of various accounting changes and errors. / Moderate / 25-35
C22-2 / Analysis of various accounting changes and errors. / Moderate / 20-30
C22-3 / Analysis of three accounting changes and errors. / Moderate / 30-35
C22-4 / Analysis of various accounting changes and errors. / Moderate / 20-30
C22-5 / Comprehensive accounting changes and error analysis. / Moderate / 30-40
C22-6 / Accounting changes. / Moderate / 20-30
C22-7 / Change in estimates, ethics / Moderate / 20-30

ANSWERS TO QUESTIONS

1. The major reasons are:

(1) Desire to show better profit picture.

(2) Desire to increase cash flows through reduction in income taxes.

(3) Recommendations by Financial Accounting Standards Board to change accounting methods.

(4) Desire to follow industry practices.

(5) Desire to show a better measure of the company’s income.

2. (a) Change in accounting principle; current or catch-up approach; the cumulative effect of the
adjustment should be reflected in the income statement between the captions “extraordinary items” and “net income.”

(b) Change in accounting principle; no restatement is made as the base-year inventory is the opening inventory of the period of change.

(c) Prior period adjustment; adjust the beginning balance of retained earnings.

(d) Credit to revenue—possibly separately disclosed.

(e) Change in accounting estimate; currently and prospectively. Part of operating section of income statement.

(f) Charge to expense; possibly separately disclosed.

(g) Change in accounting principle; retroactive restatement of all affected prior period financial statements.

3. The current or catch-up method has the following advantages:

(1) Prior periods are not restated and therefore investor confidence is not lost.

(2) Upsetting of legal conditions if restatement is permitted is avoided.

(3) All revenues and expenses are run through the income statement instead of being buried in restatements.

(4) Cost of restatement is high.

(5) Restatement may be difficult to compute.

4. Pro-forma amounts are reported whenever a company changes from one generally accepted accounting principle to another. These amounts permit financial statements users to determine the net income that would have been shown if the newly adopted principle had been in effect in earlier periods.

5. A change in an estimate is simply a change in the way an individual perceives the realizability of an asset or liability. Examples of changes in estimate are: (1) change in the realizability of trade receivables, (2) revisions of estimated lives, (3) changes in estimates of warranty costs, and (4) change in estimate of deferred charges or credits. A change in accounting estimate is considered affected by a change in accounting principle when a new accounting principle is adopted to reflect an expected change in future economic events. An example would be switching from capitalizing advertising expenditures to expensing them if the future benefit of the expenditures can no longer be estimated with reasonable certainty.

6. This is an example of a situation in which it is difficult to differentiate between a change in accounting principle and a change in estimate. In such a situation, the change should be considered a change in estimate, and accordingly, should be handled currently and prospectively. Thus, all costs presently capitalized and viewed as providing doubtful future values should be expensed immediately, and costs currently incurred should also be expensed immediately.

Questions Chapter 22 (Continued)

7. (a) Charge to expense—possibly separately disclosed.

(b) Change in accounting principle—current or catch-up approach; the cumulative effect of the adjustment should be reflected in the income statement between the captions “extraordinary items” and “net income.”

(c) Charge to expense—possibly separately disclosed.

(d) Prior period adjustment—adjust the beginning balance of retained earnings.

(e) Change in accounting principle—retroactive restatement of all affected prior-period financial statements.

(f) Change in accounting estimate—currently and prospectively.

8. This change is to be handled as a correction of an error. As such, the portion of the change attributable to prior periods ($33,000) should be reported as an adjustment to the beginning balance of retained earnings in the 2004 financial statements. If statements for previous years are presented for comparative purposes, these statements should be restated to correct for the error. The remainder of the inventory value ($29,000) should be reflected in the 2004 statements as a reduction of materials cost.

9. Preferability is a difficult concept to apply. The problem is that there are no basic objectives to indicate which is the most preferable method, assuming a selection between two generally accepted accounting practices is possible, such as accelerated and straight-line depreciation. If a FASB standard creates a new principle or expresses preference for or rejects a specific accounting principle, a change is considered clearly acceptable. A more appropriate matching of revenues and expenses is often given as the justification for a change in accounting principle.

10. When a company changes to the LIFO method, the base-year inventory for all subsequent LIFO calculations is the beginning inventory in the year the method is adopted. Prior years’ income is not restated because it would be too impractical. The only adjustment necessary may be to restate the beginning inventory from a lower of cost or market approach to a cost basis.

11. Where individual company statements were reported in prior years and consolidated financial statements are to be prepared this year, the following reporting and disclosure practices should be implemented:

(1) The financial statements of all prior periods presented should be restated to show the financial information for the new reporting entity for all periods.

(2) The financial statements of the year in which the change in reporting entity is made should describe the nature of the change and the reason for it.

(3) The effect of the change on income before extraordinary items, net income, and earnings per share amounts should be disclosed for all periods presented.

12. This change represents a change in reporting entity. This type of change 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. The financial statements of the year in which the change in reporting entity is made should describe the nature of the change and the reason for it.

13. This change represents a change in accounting principle for which retroactive restatement is required. As such, this change would be reported in the financial statements by the restatement of all prior periods presented to reflect the newly adopted depreciation method. The statements for the current year would, of course, reflect the newly adopted method. (This procedure of restatement upon the issuance of securities may be used only by closely held companies and then only once.)

14. Counterbalancing errors are errors that will be offset or corrected over two periods. Non-counterbalancing errors are errors that are not offset in the next accounting period. An example of a counterbalancing error is the failure to record accrued wages or prepaid expenses. Failure to capitalize equipment and record depreciation is an example of a non-counterbalancing error.

Questions Chapter 22 (Continued)

15. A correction of an error in previously issued financial statements should be handled as a prior-period adjustment. Thus, such an error should be reported in the year that it is discovered as an adjustment to the beginning balance of retained earnings. And, if comparative statements are presented, the prior periods affected by the error should be restated. The disclosures need not be repeated in the financial statements of subsequent periods.

As an illustration, assume that sales of $40,000 were inadvertently overlooked at the end of 2004. When the error was discovered in a subsequent period, the appropriate entry to record the correction of the error would have been:

Accounts Receivable 40,000

Retained Earnings 40,000

16. This change represents a change from an accounting principle that is not generally accepted to an accounting principle that is acceptable. As such, this change should be handled as a correction of an error. Thus, in the 2005 statements, the cumulative effect of the change should be reported as an adjustment to the beginning balance of retained earnings. If 2004 statements are presented for comparative purposes, these statements should be restated to correct for the accounting error.

17. Retained earnings is correctly stated at December 31, 2005. Failure to accrue salaries in earlier years is a counterbalancing error that has no effect on 2005 ending retained earnings.

18. December 31, 2005

Machinery 8,000

Accumulated Depreciation—Machinery 800

Retained Earnings 7,200

(To correct for the error of expensing installation costs on

machinery acquired in January, 2004)

Depreciation Expense [($38,000 – $3,800) ÷ 20] 1,710

Accumulated Depreciation—Machinery 1,710

(To record depreciation on machinery for 2005 based on a

20-year useful life)

19. The amortization error decreases net income by $2,850 in 2004. Interest expense related to the discount should have been charged for $150, but was charged for $3,000. The entry to correct for this error is as follows:

Discount on Bonds Payable 2,850

Interest Expense 2,850

The entry to record accrued interest on the $100,000 of principal at 11% for 6 months is:

Interest Expense 5,500

Interest Payable 5,500

20. This error has no effect on net income because both purchases and inventory were understated. The entry to correct for this error, assuming a periodic inventory system, is:

Purchases 13,000

Accounts Payable 13,000

21. This error increases net income by $1,800 in 2004. Depreciation should have been charged to net income. The entry to correct for this error is as follows: