Intermediate Accounting, 10th Edition
Kieso, Weygandt, and Warfield
Chapter 23: Accounting Changes
and Error Analysis
Prepared by
Krishnan Ranganathan
, Angelo State University,
San Angelo, Texas
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Types of Accounting Changes
APB Opinion No 20 limits the flexibility in
accounting treatments for similar situations
The types of accounting changes are:
Changes in Accounting Principle
Changes in Accounting Estimates
Changes in Reporting Entity
Errors in Financial Statements
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Changes in Accounting Principle
A changes in principle involves a change from one
generally accepted principle to another
A change in principle does not result from the
adoption of a new accounting principle
A change to a generally accepted principle (from
an incorrect principle) is a correction of an
error
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Changes in Accounting Principle
Changes in accounting principle are classified
into:
Cumulative-effect type of accounting change
Retroactive-effect type of accounting change
Change to the LIFO method of inventory
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Cumulative-Effect Type of Accounting
Change
The catch up method should be used to account
for these changes
Financial statements for prior periods are not
restated
For all prior periods, the following items are
shown on an as-if basis (as if the new principle
had been applied):
income before extraordinary items
net income
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Cumulative-Effect Type of Accounting
Change
The adjusting entry is effective as of the beginning
of the year
Pro forma information is shown only as
supplementary information
Such information may be reported:
in the income statement
in a separate schedule
in the notes to the financial statements
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Cumulative Effect: Example
• XYZ company changes from the sum-of-the-
years’ digits method to the straight line method of
depreciation.
• The depreciation amounts are:
Year SYD ST.LINE
2000 $15,000 $8,000
2001 $14,000 $8,000
• The company’s tax rate is 40%
• Record the change as of the beginning of 2002
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Cumulative Effect: Example
• Year SYD SL Tax Diff
Effect
• 2000 $15,000 $8,000 $7,000 $2,800
• 2001 $14,000 $8,000 $6,000 $2,400
-------- --------
$13,000 $5,200
-------- --------
• Tax liability increases by $5,200
• Tax effect is the difference times the tax rate
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Cumulative Effect: Example
• Journal Entry:
• Accumulated Depreciation $13,000
Deferred Tax Asset $5,200
Cumulative Effect of
Change in Principle $7,800
The debit to accumulated depreciation restores the
account balance on a straight line basis
The credit to Cumulative Effect is the income
effect (net of tax effect)
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Income Statement Presentation
The following information must be presented in
whole dollar amounts and as per share amounts:
Income before Extraordinary Item
and Cumulative Effect of Change :$ XXX
Extraordinary Item (Net of Tax) :$ XX
Cumulative Effect on Prior Years
of Retroactive Application :$ XX
Net Income :$ XX
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Retroactive-Effect Type of Accounting Change
The cumulative effect of the new method at the
beginning of the period is determined
Prior period statements are recast based on the
new principle
Any cumulative effect of prior periods is adjusted
to the beginning retained earnings balance
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Retroactive-Effect Type of Accounting Change
The five situations requiring restatement of all prior
period statements are:
A change from the LIFO inventory method to another
method
A change in the method of accounting for long term
construction type contracts
A change from or to the full cost method in extractive
industries
Issue of financials to obtain first time financing
A pronouncement recommending retroactive adjustment
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Income Statement Presentation
• Retained Earnings account is shown as follows:
• Balance at beginning of year :$ XXX
• Adjustment for the Cumulative
Effect on Prior Years :$ XX
• Balance at beginning (as adjusted) :$ XX
• Net Income :$ XXX
• Balance at end of year :$ XXX
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Reporting a Change in Entity
Changes in estimates are accounted for on a prospective
basis
Such changes are viewed as normal, recurrent adjustments
When uncertainty exists as to whether a change in
principle or a change in estimate has occurred:
the change should be treated as a change in estimate
Estimates that are later determined to be incorrect should
be corrected as changes in estimates
Examples of changes in estimates involve:
inventory obsolescence; salvage values of assets
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Reporting a Change in Entity
An accounting change may result in a different reporting
entity
Financial statements are then restated for all prior periods
presented
Examples of a change in reporting entity are:
consolidated statements in lieu of individual financials
changes in subsidiaries in a consolidated group
accounting for pooling of interests
a change in method for accounting for subsidiaries and
investments
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Reporting the Correction of an Error
Corrections are treated as prior period adjustments to
retained earnings for the earliest period being reported
Examples of accounting errors are:
A change from an accounting principle that is not
generally accepted to one that is accepted
Mathematical errors
Changes in estimates that were not prepared in good faith
A failure to properly accrue or defer expenses or
revenues
A misapplication or omission of relevant facts
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When is a Change in Accounting Principle Appropriate?
Changes are appropriate when the new principle is
preferable to the existing accounting principle
The new principle should result in improved
financial reporting
A change is considered preferable if a FASB
standard:
creates a new accounting principle, or
expresses preference for a new principle, or
rejects a specific accounting principle
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Motivations for Change
Managers and others may have a self interest in adopting
principles or standards:
Companies may want to be less politically visible to
avoid regulation;
A company’s capital structure may affect its selection of
accounting standards;
Managers may select accounting standards to maximize
their performance-related bonuses;
Companies have an incentive to manage or smooth
earnings
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Error Analysis in General
Firms do not correct errors that are insignificant
Three questions must be answered in this regard:
What type of error is involved?
What correcting entries are needed?
How are financial statements to be restated?
Error corrections are reported as prior period
adjustments to the beginning retained earnings
balance in the current year
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Types of Errors
Errors can occur in the following financial
statements:
Balance sheet
Income statement
Balance sheet and the income statement
Errors can be:
Counterbalancing (or self-correcting over two
accounting periods)
Non-counterbalancing (more than two periods needed)
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Counterbalancing Errors
Questions to be considered are:
Are the books closed?
Are comparative statements presented?
An entry is needed to adjust the beginning
retained earnings balance if:
the books are closed, and the error is not
counterbalanced, or
the books are not closed, and
the company is in the second year, and
the error is already counterbalanced
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Changing from and to the Equity Method
For a change to or from the Equity method,
restatement of all prior period statements is
required
A change from the equity method to the fair value
method must be made when:
the investor’s level of influence falls below the required
percentage of ownership
A change from the fair value method to the equity
method must be made when:
the investor’s level of influence rises above the required
percentage of ownership
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Changing from the Equity Method
The cost basis for accounting purposes is the
carrying amount of the investment at the date of
the change
The earnings and losses (previously recognized) remain
part of the carrying value
Any amortization previously needed under the equity
method ceases
To the extent that dividends received by investor
exceed investor’s share of investee’s earnings in
subsequent periods:
such excesses are reductions of the investment carrying
amount
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Changing to the Equity Method
The following amounts are retroactively adjusted
(as if the investor had held the investment during
all prior periods)
a the carrying value of the investment
b the results of current and prior period operations
c the retained earnings of the investor
Any balances in unrealized holding gains and
losses are eliminated
The available-for-sale classification is also
removed.
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