UTEP ACCT 3322 - Accounting Changes and Error Corrections

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Accounting Changes and Error Corrections D:\Teaching\3322\web\post\module4\c20\tnotes\c20a.doc 11/29/2007 1 ACCOUNTING CHANGES Types of Accounting Changes 1. Change in accounting principle-Change from one generally accepted accounting principle to another. 2. Change in accounting estimate-Revision of an estimate because of new information or new experience. 3. Change in reporting entity-Change from reporting as one type of entity to another type of entity. 4. Correction of an error-Correction of an error caused by a transaction being recorded incorrectly or not at all. CHANGE IN ACCOUNTING PRINCIPLE Changing from one acceptable accounting principle to another acceptable accounting principle is accounted for as a change in accounting principle. This does not include the adoption of a new accounting principle because the entity has entered into transactions for the first time that require specific accounting treatment. It also does not include the change from an inappropriate accounting principle to an acceptable accounting principle. The later would be classified as the correction of an error. The types of changes that might be included in a change in accounting principle are:  Adoption of a new FASB accounting standard  Change in the method of inventory costing  Change to, or from, the cost method to the equity method  Change to, or from, the completed contract to percentage-of-completion method CHANGE IN ACCOUNTING ESTIMATE At the end of each accounting period there are a number of estimates made in order to prepare the financial statements. These estimates are based on the facts and circumstances that exist at the time. These facts and circumstances will change from one accounting period to the next. It is not practical to restate the financial statements every time there is new information that makes the prior estimates incorrect. Therefore, on an ongoing basis management applies its best judgment and modifies such estimates as the facts and circumstances change in each subsequent accounting period. A change in accounting estimate is handled on a prospective basis. CHANGE IN REPORTING ENTITY Under certain circumstances management is required to restate the financial statements of all prior periods. These circumstances relate to a change in the reporting entity. Such changes include:  Presenting consolidated financial statements for the first time.  Changing specific subsidiaries for which consolidated financial statements are presented.  Changing companies included in combined financial statements  Change in the cost, equity, or consolidation method used for accounting for subsidiaries and investments. CORRECTION OF AN ERRORAccounting Changes and Error Corrections D:\Teaching\3322\web\post\module4\c20\tnotes\c20a.doc 11/29/2007 2 The correction of an error must be handled as a prior period adjustment to the earliest period reported in the financial statements. Some of the types of errors that might occur are as follows:  Change from an unacceptable accounting principle to an acceptable one.  Mathematical errors.  Changes in estimates that were not prepared in good faith.  Failure to accrue or defer expenses or revenues at the end of a period.  Misuse of facts.  Misclassification of costs as expenses and vice versa. APPROACHES TO REPORTING ACCOUNTING CHANGES 1. Retrospective approach The retroactive approach provides consistency and comparability between periods and across entities. Comparative financial statements are recast to reflect the changes. The cumulative effect (net of tax) of the change is reported as a prior period adjustment in the earliest period reported. The accounting records are adjusted to reflect the cumulative effect (net of the change) as of the beginning of the current period. The change and its effects on income and balance sheet amounts is disclosed in the notes to the financial statements. 2. Prospective approach The prospective approach is used when it is impractical to use the retrospective approach. For example, a change from an acceptable inventory costing method to LIFO. It would be impractical for management to attempt to estimate what inventory and cost of goods sold would have been in prior years if the entity had been using LIFO. Under certain circumstances the entity may be required to use the prospective approach because the FASB has mandated such treatment in the adoption of a new accounting standard. Although considered a change in accounting principle a change in depreciation, amortization or depletion methods are to be reported on a prospective basis rather than retrospectively. CHANGE IN ACCOUNTING PRINCIPLE-RETROSPECTIVE APPROACH In applying the retrospective approach the financial statements are recast so that all prior periods reported in comparative financial statement reflect the adoption of the change in accounting principle. Example: Spencer Company changed from the LIFO cost flow assumption to the FIFO cost flow assumption in 2004. The company’s federal income tax rate is 20%. The original comparative income statements for the two years ended December 31, 2003 and all years prior to 2002 are presented below:Accounting Changes and Error Corrections D:\Teaching\3322\web\post\module4\c20\tnotes\c20a.doc 11/29/2007 3 2003 2002Years Prior to 2002Revenue$1,050$980$3,800 Cost of goods sold (LIFO)6836372,470Gross profit3683431,330 Operating expenses231216836Income before tax137127494 Income tax272599Net income$109$102$395Income Statements The following are the inventory amounts reported in the balance sheet at the end of each of the years 2001 through 2003. 200320022001 Inventory (LIFO)$150$130$120Balance Sheets The cumulative effect of the change from LIFO to FIFO for the two years ended December 31, 2003, and all years prior to 2002 is presented below. 2003 2002Years Prior to 2002Cost of goods sold (LIFO) $683 $637 $2,470Cost of goods sold (FIFO) 478 446 1,729 Differences $205 $191 $741Cumulative effect of change:Inventory/cost of goods sold $1,137 $932 $741Income taxes 227 186 148Net income/retained earnings $909 $746 $593 The company adopted the change in accounting principle in 2004 so therefore the financial statements must be recast for 2003 and 2002, assuming that three year comparative financial statements are going to be presented. We assume that the change took effect on January 1, 2004 so there is no


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UTEP ACCT 3322 - Accounting Changes and Error Corrections

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