CH - 22 - Accounting Changes and Error Analysis

Chapter
22-1
CHAPTER 22
ACCOUNTING CHANGES AND

ERROR ANALYSIS
Intermediate Accounting
13th Edition
Kieso, Weygandt, and Warfield
Chapter
22-2
Learning
Learning Objectives
Objectives
Chapter
22-3
Accounting
Accounting Changes
Changes and
and Error
Error Analysis
Analysis
Accounting Changes Error Analysis
Changes in accounting Balance sheet errors

principle Income statement errors
Changes in accounting Balance sheet and income
estimate statement effects
Reporting in reporting entity Comprehensive example
Correction of errors Preparation of statements
Summary with error corrections
Motivations for change of
method
Chapter
22-4
Accounting
Accounting Changes
Changes
Accounting Alternatives:
1) Diminish the comparability of financial information.
2) Obscure useful historical trend data.
Types of Accounting Changes:

Change in Accounting Principle.
Changes in Accounting Estimate.
Change in Reporting Entity.
Errors are not considered an accounting change.

Chapter
22-5 LO 1 Identify the types of accounting changes.
Changes
Changes in
in Accounting
Accounting Principle
Principle
A change from one generally accepted accounting

principle to another. Examples include:
 Average cost to LIFO.
 Completed-contract to percentage-of-completion.
Adoption of a new principle in recognition of events that have

occurred for the first time or that were previously immaterial
is not an accounting change.
Chapter
22-6 LO 2 Describe the accounting for changes in accounting principles.
Changes
Changes in
in Accounting
Principle
Three approaches for reporting changes:
1) Currently.
2) Retrospectively.
3) Prospectively (in the future).
FASB requires use of the retrospective approach.
Rationale - Users can then better compare results from one

period to the next.
Chapter
22-7 LO 2 Describe the accounting for changes in accounting principles.
Changes
Changes in
in Accounting
Principle
Retrospective Accounting Change Approach

Company reporting the change
1) adjusts its financial statements for each prior period
presented to the same basis as the new accounting
principle.
2) adjusts the carrying amounts of assets and liabilities as
of the beginning of the first year presented, plus the
opening balance of retained earnings.
Chapter
22-8 LO 3 Understand how to account for retrospective accounting changes.
Changes
Changes in
in Accounting
Principle
Retrospective Accounting Change: Long-Term Contracts
Illustration: Denson Company has accounted for its income

from long-term construction contracts using the completed-
contract method. In 2010 the company changed to the
percentage-of-completion method. Management believes this
approach provides a more appropriate measure of the income
earned. For tax purposes, the company uses the completed-
contract method and plans to continue doing so in the future.
(We assume a 40 percent enacted tax rate.)
Chapter
Changes
Changes in
in Accounting
Principle
Income statements for 2008–2010 Illustration 22-1
Chapter
22-10 LO 3
Changes
Changes in
in Accounting
Principle
Data for Retrospective Change Example
Illustration 22-2
Journal entry to record change at beginning of 2010:
Construction in Process 220,000

Deferred Tax Liability 88,000
Retained Earnings 132,000
Chapter
Changes
Changes in
in Accounting
Principle
Reporting a Change in Principle
Major disclosure requirements are as follows.
1. Nature and reason for the change in accounting principle.
2. The method of applying the change, and:
a. A description of the prior-period information that has
been retrospectively adjusted, if any.
b. The effect of the change on income from continuing
operations, net income, any other affected line items.
c. The cumulative effect of the change on retained
earnings or other components of equity or net assets
as of the beginning of the earliest period presented.
Chapter
Changes
Changes in
in Accounting
Principle
Reporting a Change in Principle Illustration 22-3
Chapter
Changes
Changes in
in Accounting
Principle
Retained Earnings Adjustment
Assuming a retained earnings balance of $1,360,000 at the
beginning of 2008.
Illustration 22-4
Before Change
Chapter
Changes
Changes in
in Accounting
Principle
Retained Earnings Adjustment
Illustration 22-5
After Change
Chapter
Changes
Changes in
in Accounting
Principle
E22-1 (Change in Principle—Long-Term Contracts):

Cherokee Construction Company changed from the
completed-contract to the percentage-of-completion method
of accounting for long-term construction contracts during
2010. For tax purposes, the company employs the
completed-contract method and will continue this approach
in the future. (Hint: Adjust all tax consequences through
the Deferred Tax Liability account.) The appropriate
information related to this change is as follows.
Chapter
Changes
Changes in
in Accounting
Principle
E22-1 (Change in Principle—Long-Term Contracts):
Instructions: (assume a tax rate of 35%)

(b) What entry(ies) are necessary to adjust the accounting records
for the change in accounting principle?
(a) What is the amount of net income and retained earnings that
would be reported in 2010? Assume beginning retained earnings for
2009 to be $100,000.
Chapter
Changes
Changes in
in Accounting
Principle
Example: Pre-Tax Income from Long-Term Contracts
35%
Percentage- Completed Tax Net of
Date of-Completion Contract Difference Effect Tax
2009 $ 780,000 $ 610,000 170,000 59,500 $ 110,500
2010 700,000 480,000 220,000 77,000 143,000
Journal entry
2010 Construction in progress 170,000
Deferred tax liability 59,500
Retained earnings 110,500
Chapter
Changes
Changes in
in Accounting
Principle
Example: Comparative Statements
Restated
2010 2009
Income Pre-tax income $ 700,000 $ 780,000
Statement
Income tax (35%) 245,000 273,000
Net income $ 455,000 $ 507,000
Statement Beg. Retained earnings $ 100,000

of Accounting change 110,500
Retained
Earnings Beg. R/Es restated $ 717,500 210,500
Net income 455,000 507,000
End. Retained earnings $ 1,172,500 $ 717,500
Chapter
Changes
Changes in
in Accounting
Principle
Direct and Indirect Effects of Changes
Direct Effects - The FASB takes the position that

companies should retrospectively apply the direct
effects of a change in accounting principle.
Indirect Effects do not change prior-period amounts.
Chapter
Changes
Changes in
in Accounting
Principle
Impracticability
Companies should not use retrospective application if
one of the following conditions exists:
1. Company cannot determine the effects of the
retrospective application.
2. Retrospective application requires assumptions about
management’s intent in a prior period.
3. Retrospective application requires significant estimates
that the company cannot develop.
If any of the above conditions exists, the company prospectively

applies the new accounting principle.
Chapter
22-21 LO 4 Understand how to account for impracticable changes.
Changes
Changes in
in Accounting
Accounting Estimate
Estimate
The following items require estimates.

1. Uncollectible receivables.
2. Inventory obsolescence.
3. Useful lives and salvage values of assets.
4. Periods benefited by deferred costs.
5. Liabilities for warranty costs and income taxes.
6. Recoverable mineral reserves.
7. Change in depreciation methods.
Chapter
22-22 LO 5 Describe the accounting for changes in estimates.
Changes
Changes in
in Accounting
Accounting Estimate
Estimate
Prospective Reporting
Companies report prospectively changes in accounting
estimates. They account for changes in estimates in
1. the period of change if the change affects that period
only, or
2. the period of change and future periods if the change
affects both.
The FASB views changes in estimates as normal recurring

corrections and adjustments and prohibits retrospective treatment.
Chapter
Change
Change in
in Estimate
Estimate Example
Example
Illustration: Arcadia High School (Phoenix), purchased

equipment for $510,000 which was estimated to have a
useful life of 10 years with a salvage value of $10,000 at the
end of that time. Depreciation has been recorded for 7
years on a straight-line basis. In 2008 (year 8), it is
determined that the total estimated life should be 15 years
with a salvage value of $5,000 at the end of that time.
Required:
 What is the journal entry to correct No Entry
Required
prior years’ depreciation expense?
 Calculate depreciation expense for 2008.
Chapter
Change
Change in
in Estimate
Estimate Example
Example After 7 years
Equipment cost $510,000 First,

First,establish
establish
Salvage value - 10,000 NBV
NBVat atdate
dateofof
Depreciable base 500,000 change
changeininestimate.
estimate.
Useful life (original) 10 years
Annual depreciation $ 50,000 x 7 years = $350,000
Balance Sheet (Dec. 31, 2007)

Fixed Assets:
Equipment $510,000
Accumulated depreciation 350,000
Net book value (NBV) $160,000
Chapter
Change
Change in
in Estimate
Estimate Example
Example
Net book value $160,000 Second,
Second,calculate
calculate
Salvage value (if any) 5,000 depreciation
depreciation
Depreciable base 155,000 expense
expensefor
for2008.
2008.
Useful life 8 years
Annual depreciation $ 19,375
Journal entry for 2008
Depreciation expense 19,375

Chapter Solution on
22-26 notes page LO 5 Describe the accounting for changes in estimates.
Changes
Changes in
in Accounting
Accounting Estimate
Estimate
Disclosures
Companies need not disclose changes in accounting
estimate made as part of normal operations, such as bad
debt allowances or inventory obsolescence, unless such
changes are material.
However, for a change in estimate that affects several
periods (such as a change in the service lives of
depreciable assets), companies should disclose the effect
on income from continuing operations and related per-
share amounts of the current period.
Chapter
Change
Change in
in Reporting
Reporting Entity
Entity
Examples of a change in reporting entity are:
1. Presenting consolidated statements in place of statements
of individual companies.
2. Changing specific subsidiaries that constitute the group of
companies for which the entity presents consolidated
financial statements.
3. Changing the companies included in combined financial
statements.
4. Changing the cost, equity, or consolidation method of
accounting for subsidiaries and investments.
Reported by changing the financial statements of all prior periods presented.
Chapter
22-28 LO 6 Identify changes in a reporting entity.
Correction
Correction of
of Errors
Errors
Accounting errors include the following types:
1. A change from an accounting principle that is not
generally accepted to an accounting principle that is
acceptable.
2. Mathematical mistakes.
3. Changes in estimates that occur because a company did
not prepare the estimates in good faith.
4. Failure to accrue or defer certain expenses or revenues.
5. Misuse of facts.
6. Incorrect classification of a cost as an expense instead
of an asset, and vice versa.
Chapter
22-29 LO 7 Describe the accounting for correction of errors.
Correction
Correction of
of Errors
Errors
All material errors must be corrected.
Record corrections of errors from prior periods as an

adjustment to the beginning balance of retained
earnings in the current period.
Such corrections are called prior period adjustments.
For comparative statements, a company should restate

the prior statements affected, to correct for the
error.
Chapter
Correction
Correction of
of Errors
Errors
Illustration: In 2011 the bookkeeper for Selectro Company

discovered an error:
In 2010 the company failed to record $20,000 of
depreciation expense on a newly constructed building. This
building is the only depreciable asset Selectro owns. The
company correctly included the depreciation expense in its
tax return and correctly reported its income taxes payable.
Chapter
Correction
Correction of
of Errors
Errors
Illustration: Selectro’s income statement for 2010 with

and without the error.
Illustration 22-19
Show the entries that Selectro should have made and did make for
recording depreciation expense and income taxes.
Chapter
Correction
Correction of
of Errors
Errors
Illustration: Show the entries that Selectro should have

made and did make for recording depreciation expense and
income taxes.
Illustration 22-20
Correcting
Entry in
2011
Chapter
Correction
Correction of
of Errors
Errors

income taxes.
Illustration 22-20
Correcting Retained Earnings 12,000

Entry in
2011
Chapter
Correction
Correction of
of Errors
Errors

income taxes.
Illustration 22-20
Reversal
Entry in Deferred Tax Liability 8,000
2011
Chapter
Correction
Correction of
of Errors
Errors

income taxes.
Illustration 22-20

Entry in Record
Deferred Tax Liability 8,000
2011 Accumulated Depreciation—Buildings 20,000
Chapter
Correction
Correction of
of Errors
Errors
Illustration (Single-Period Statement): Assume that

Selectro Company has a beginning retained earnings balance
at January 1, 2011, of $350,000. The company reports net
income of $400,000 in 2011.
Illustration 22-21
Chapter
Correction
Correction of
of Errors
Errors
Comparative Statements
A company should
1. make adjustments to correct the amounts for all affected
accounts reported in the statements for all periods
reported.
2. restate the data to the correct basis for each year
presented.
3. show any catch-up adjustment as a prior period
adjustment to retained earnings for the earliest period it
reported.
Chapter
Correction
Correction of
of Errors
Errors
Woods, Inc.
Statement of Retained Earnings
For the Year Ended December 31, 2010
Balance, January 1 $ 1,050,000

Net income 360,000
Dividends (300,000)
Balance, December 31 $ 1,110,000
Before issuing the report for the year ended December 31, 2010, you
discover a $62,500 error that caused the 2009 inventory to be
overstated (overstated inventory caused COGS to be lower and thus
net income to be higher in 2009). Would this discovery have any impact
on the reporting of the Statement of Retained Earnings for 2010?
Assume a 20% tax rate.
Chapter
Correction
Correction of
of Errors
Errors
Woods, Inc.
Statement of Retained Earnings
For the Year Ended December 31, 2010
Balance, January 1, as previously reported $ 1,050,000

Prior period adjustment, net of tax (50,000)
Balance, January 1, as restated 1,000,000
Net income 360,000
Dividends (300,000)
Balance, December 31 $ 1,060,000
Chapter Solution on
22-40 notes page LO 7 Describe the accounting for correction of errors.
Summary
Summary of
of Accounting
Accounting Changes
Changes and
and Errors
Errors
Illustration 22-23
Chapter
Summary
Summary of
of Accounting
Accounting Changes
Changes and
and Errors
Errors
Illustration 22-23
Chapter
Motivations
Motivations for
for Change
Change of
of
Accounting
Accounting Method
Method
Why companies may prefer certain accounting

methods. Some reasons are:
1. Political costs.
2. Capital Structure.
3. Bonus Payments.
4. Smooth Earnings.
Chapter
22-43 LO 8 Identify economic motives for changing accounting methods.
Error
Error Analysis
Analysis
Companies must answer three questions:

1. What type of error is involved?
2. What entries are needed to correct for the error?
3. After discovery of the error, how are financial

statements to be restated?
Companies treat errors as prior-period adjustments

and report them in the current year as adjustments to
the beginning balance of Retained Earnings.
Chapter
22-44 LO 9 Analyze the effect of errors.
Balance
Balance Sheet
Sheet Errors
Errors
Balance sheet errors affect only the presentation of

an asset, liability, or stockholders’ equity account.
When the error is discovered in the error year, the

company reclassifies the item to its proper position.
If the error is discovered in a prior year, the company

should restate the balance sheet of the prior year for
comparative purposes.
Chapter
Income
Income Statement
Statement Errors
Errors
Improper classification of revenues or expenses.
A company must make a reclassification entry when

it discovers the error in the error year.
If the error is discovered in a prior year, the

company should restate the income statement of the
prior year for comparative purposes.
Chapter
Balance
Balance Sheet
Sheet and
and Income
Income Statement
Statement Errors
Errors
Errors affecting both balance sheet and income

statement.
This type of error classified as:
1. Counterbalancing errors
2. Noncounterbalancing errors
Chapter
Balance
Balance Sheet
Sheet and
and Income
Income Statement
Statement Errors
Errors
Counterbalancing Errors
Will be offset or corrected over two periods.
If company has closed the books:
a. If the error is already counterbalanced, no entry is
necessary.
b. If the error is not yet counterbalanced, make entry
to adjust the present balance of retained earnings.
For comparative purposes, restatement is necessary even

if a correcting journal entry is not required.
Chapter
Balance
Balance Sheet
Sheet and
and Income
Income Statement
Statement Errors
Errors
Counterbalancing Errors
Will be offset or corrected over two periods.
If company has not closed the books:
a. If error already counterbalanced, make entry to
correct the error in the current period and to
adjust the beginning balance of Retained Earnings.
b. If error not yet counterbalanced, make entry to
adjust the beginning balance of Retained Earnings.
Chapter
Balance
Balance Sheet
Sheet and
and Income
Income Statement
Statement Errors
Errors
Noncounterbalancing Errors
Not offset in the next accounting period.
Companies must make correcting entries, even if they
have closed the books.
Chapter
Error
Error Analysis
Analysis Example
Example
E22-19 (Error Analysis; Correcting Entries): A partial
trial balance of Dickinson Corporation is as follows on
December 31, 2010.
Dr. Cr.
Supplies on hand $ 2,500
Accured salaries and wages $ 1,500
Interest receivable 5,100
Prepaid insurance 90,000
Unearned rent 0
Accured interest payable 15,000
Instructions
(a) Assuming that the books have not been closed, what are
the adjusting entries necessary at December 31, 2010?
Chapter
Error
Error Analysis
Analysis Example
Example
1. A physical count of supplies on hand on December 31,

2010, totaled $1,100.
Supplies expense 1,400
Supplies on hand 1,400
2. Accrued salaries and wages on December 31, 2010,

amounted to $4,400.
Salaries and wages expense 2,900

Accured salaries and wages 2,900
Chapter Solution on
22-52 notes page LO 9 Analyze the effect of errors.
Error
Error Analysis
Analysis Example
Example
3. Accrued interest on investments amounts to $4,350 on

December 31, 2010.
Interest revenue 750
Interest receivable 750
4. The unexpired portions of the insurance policies totaled $65,000 as of December

31, 2010.
Insurance expense 25,000

Chapter Solution on
Error
Error Analysis
Analysis Example
Example
5. $24,000 was received on January 1, 2010 for the rent of a

building for both 2010 and 2011. The entire amount was
credited to rental income.
Rental income 12,000
Unearned rent 12,000
6. Depreciation for the year was erroneously recorded as

$5,000 rather than the correct figure of $50,000.
Depreciation expense 45,000
Chapter Solution on
Error
Error Analysis
Analysis Example
Example
E22-19 (Error Analysis; Correcting Entries) A partial trial
balance of Dickinson Corporation is as follows on December
31, 2010.
Dr. Cr.
Supplies on hand $ 2,500
Accured salaries and wages $ 1,500
Interest receivable 5,100
Unearned rent 0
Accured interest payable 15,000
Instructions
(b) Assuming that the books have been closed, what are the
adjusting entries necessary at December 31, 2010?
Chapter
Error
Error Analysis
Analysis Example
Example
1. A physical count of supplies on hand on December 31,

2010, totaled $1,100.
Supplies on hand 1,400
2. Accrued salaries and wages on December 31, 2010,

amounted to $4,400.

Accured salaries and wages 2,900
Chapter Solution on
Error
Error Analysis
Analysis Example
Example
3. Accrued interest on investments amounts to $4,350 on

December 31, 2010.
Retained earnings 750
Interest receivable 750
4. The unexpired portions of the insurance policies totaled

$65,000 as of December 31, 2010.
Chapter Solution on
Error
Error Analysis
Analysis Example
Example
5. $24,000 was received on January 1, 2010 for the rent of a

building for both 2010 and 2011. The entire amount was
credited to rental income.
Unearned rent 12,000
6. Depreciation for the year was erroneously recorded as

$5,000 rather than the correct figure of $50,000.
Chapter Solution on
 One area in which iGAAP and U.S. GAAP differ is the reporting of
error corrections in previously issued financial statements. While
both GAAPs require restatement, U.S. GAAP is an absolute
standard—that is, there is no exception to this rule.
 The accounting for changes in estimates is similar between U.S.

GAAP and iGAAP.
 Under U.S. GAAP and iGAAP, if determining the effect of a change

in accounting principle is considered impracticable, then a company
should report the effect of the change in the period in which it
Chapter believes it practicable to do so, which may be the current period.
22-59
 Under iGAAP, the impracticality exception applies both to changes
in accounting principles and to the correction of errors. Under U.S.
GAAP, this exception applies only to changes in accounting principle.
 IAS 8 does not specifically address the accounting and reporting

for indirect effects of changes in accounting principles. As
indicated in the chapter, U.S. GAAP has detailed guidance on the
accounting and reporting of indirect effects.
Chapter
22-60
Change From The Equity Method
Change from the equity method to the fair-value method.
 Earnings or losses previously recognized under the equity
method should remain as part of the carrying amount of the
investment.
 The cost basis is the carrying amount of the investment at
the date of the change.
 The investor applies the new method in its entirety.
 At the next reporting date, the investor should record the
unrealized holding gain or loss to recognize the difference
between the carrying amount and fair value.
Chapter LO 10 Make the computations and prepare the entries necessary to

22-61 record a change from or to the equity method of accounting.
Dividends in Excess of Earnings
Accounted for such dividends as a reduction of the

investment carrying amount, rather than as revenue.
Reason: Dividends in excess of earnings are viewed as a

liquidating dividend
________________with this excess then accounted for as
a reduction of the equity investment.

Illustration: On January 1, 2009, Investor Company purchased

250,000 shares of Investee Company’s 1,000,000 shares of
outstanding stock for $8,500,000. Investor correctly accounted
for this investment using the equity method. After accounting
for dividends received and investee net income, in 2009, Investor
reported its investment in Investee Company at $8,780,000 at
December 31, 2009. On January 2, 2010, Investee Company sold
1,500,000 additional shares of its own common stock to the
public, thereby reducing Investor Company’s ownership from 25
percent to 10 percent.

Illustration 22A-1

Impact on Investment Carrying Amount Illustration 22A-2
2010 & Cash 400,000

2011 Dividend Revenue 400,000
2012 Cash 210,000

Available-for-Sale Securities 60,000
Dividend Revenue 150,000
Chapter Solution on LO 10 Make the computations and prepare the entries necessary to
22-65 notes page record a change from or to the equity method of accounting.
Change To The Equity Method
 Companies use retrospective application.
 The carrying amount of the investment, results of

current and prior operations, and retained earnings of
the investor are adjusted as if the equity method has
been in effect during all of the previous periods.
 Companies also eliminate any balances in the Unrealized

Holding Gain or Loss—Equity account and the Securities
Fair Value Adjustment account.

Copyright
Copyright
Copyright © 2009 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted
in Section 117 of the 1976 United States Copyright Act
without the express written permission of the copyright owner
is unlawful. Request for further information should be
addressed to the Permissions Department, John Wiley & Sons,
Inc. The purchaser may make back-up copies for his/her own
use only and not for distribution or resale. The Publisher
assumes no responsibility for errors, omissions, or damages,
caused by the use of these programs or from the use of the
information contained herein.
Chapter
22-67

CH - 22 - Accounting Changes and Error Analysis

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Chapter

ACCOUNTING CHANGES AND

Accounting Changes Error Analysis

Changes in accounting Balance sheet errors

2) Obscure useful historical trend data.

Types of Accounting Changes:

Errors are not considered an accounting change.

A change from one generally accepted accounting

Adoption of a new principle in recognition of events that have

Three approaches for reporting changes:

3) Prospectively (in the future).

FASB requires use of the retrospective approach.

Rationale - Users can then better compare results from one

Retrospective Accounting Change Approach

Retrospective Accounting Change: Long-Term Contracts

Illustration: Denson Company has accounted for its income

Journal entry to record change at beginning of 2010:

Construction in Process 220,000

E22-1 (Change in Principle—Long-Term Contracts):

E22-1 (Change in Principle—Long-Term Contracts):

Instructions: (assume a tax rate of 35%)

Statement Beg. Retained earnings $ 100,000

Direct Effects - The FASB takes the position that

Indirect Effects do not change prior-period amounts.

If any of the above conditions exists, the company prospectively

The following items require estimates.

The FASB views changes in estimates as normal recurring

Illustration: Arcadia High School (Phoenix), purchased

Equipment cost $510,000 First,

Balance Sheet (Dec. 31, 2007)

Journal entry for 2008

Depreciation expense 19,375

Reported by changing the financial statements of all prior periods presented.

All material errors must be corrected.

Record corrections of errors from prior periods as an

Such corrections are called prior period adjustments.

For comparative statements, a company should restate

Illustration: In 2011 the bookkeeper for Selectro Company

Illustration: Selectro’s income statement for 2010 with

Illustration: Show the entries that Selectro should have

Illustration: Show the entries that Selectro should have

Correcting Retained Earnings 12,000

Illustration: Show the entries that Selectro should have

Illustration: Show the entries that Selectro should have

Correcting Retained Earnings 12,000

Illustration (Single-Period Statement): Assume that

Balance, January 1 $ 1,050,000

Balance, January 1, as previously reported $ 1,050,000

Why companies may prefer certain accounting

Companies must answer three questions:

2. What entries are needed to correct for the error?

3. After discovery of the error, how are financial

Companies treat errors as prior-period adjustments

Balance sheet errors affect only the presentation of

When the error is discovered in the error year, the

If the error is discovered in a prior year, the company

Improper classification of revenues or expenses.

A company must make a reclassification entry when

If the error is discovered in a prior year, the

Errors affecting both balance sheet and income

For comparative purposes, restatement is necessary even

1. A physical count of supplies on hand on December 31,

2. Accrued salaries and wages on December 31, 2010,