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CHAPTER 22
Accounting Changes and Error Analysis
ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)
Topics Questions
Brief Exercises Exercises Problems
Concepts for Analysis
- Differences between change in principle, change in estimate, change in entity, errors.
2, 4, 6, 7, 8, 9, 12, 13, 15, 21
8, 10 3, 5 1, 2, 3, 4
- Accounting changes: a. Comprehensive. 1, 3 10 3, 6 1, 2, 4, 5 b. Changes in estimate, changes in depreciation methods.
2, 3, 8, 18 4, 5, 9 8, 9, 11, 12, 13, 14
1, 2, 3, 4, 6, 7
1, 2, 3, 4, 5, 6
c. Changes in accounting for long-term construction contracts.
2, 10 1, 2, 10 1, 6 3 1, 2
d. Change from FIFO to average cost.
4, 7 3
e. Change from FIFO to LIFO. 2, 11 10 1, 2 f. Change from LIFO. 8 3 2, 3, 5, 7 3 g. Miscellaneous. 1, 3, 4, 5, 6, 7, 8, 10
8, 9, 10 1, 5
- Correction of an error. a. Comprehensive. 8, 14, 15, 17, 19
8, 9, 10 10, 15, 16, 18, 19, 20, 21
3, 4, 6, 7, 8, 9, 10
2, 3, 4
b. Depreciation. 2, 18, 21 6, 7 11, 15, 17, 18
2, 6, 8
c. Inventory. 9, 16, 20 10 9, 17, 18 8, 10 1, 2
*4. Changes between fair value and equity methods.
11, 12 22, 23 11, 12
*This material is dealt with in an Appendix to the chapter.
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)
Learning Objectives Questions
Brief Exercises Exercises Problems
Concepts for Analysis
- Identify types of accounting changes and understand the accounting for changes in accounting principles.
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11
1, 2, 3, 9, 10
1, 2, 3, 4, 5, 6, 7, 10
1, 2, 3, 4, 5, 6
1, 2, 3, 4, 5
- Describe the accounting for changes in estimates and changes in the reporting entity.
12, 13 4, 5, 9 8, 9, 10, 11, 12, 13, 14
2, 3, 4, 5 1, 2, 3, 4, 5, 6
- Describe the accounting for correction of errors.
15, 16, 17, 18, 19, 20, 21
6, 7, 8, 10 9, 10, 11, 15, 16, 17, 18, 19, 20, 21
2, 3, 4, 6, 7, 8, 9, 10
1, 2, 3, 4
- Analyze the effect of errors. 14 18, 19, 20, 21
6, 7, 8, 9, 10 *5. Make the computations and prepare the entries necessary to record a change from or to the equity method of accounting.
11, 12 22, 23 11, 12
ANSWERS TO QUESTIONS
- The major reasons why companies change accounting methods are: (a) Desire to show better profit picture. (b) Desire to increase cash flows through reduction in income taxes. (c) Requirement by Financial Accounting Standards Board to change accounting methods. (d) Desire to follow industry practices. (e) Desire to show a better measure of the company’s income. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- (a) Change in accounting principle; retrospective application is generally not made because it is impracticable to determine the effect of the change on prior years. The FIFO inventory amount is therefore generally the beginning inventory in the current period. (b) Correction of an error and therefore prior period adjustment; adjust the beginning balance of retained earnings. (c) Increase income for litigation settlement, assuming it was not accrued. (d) Change in accounting estimate; currently and prospectively. Part of operating section of income statement. (e) Reduction of accounts receivable and the allowance for doubtful accounts. (f) Change in accounting principle; retrospective application to prior period financial statements. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The three approaches suggested for reporting changes in accounting principles are: (a) Currently—the cumulative effect of the change is reported in the current year’s income as a special item. (b) Retrospectively—the cumulative effect of the change is reported as an adjustment to retained earnings. The prior year’s statements are changed on a basis consistent with the newly adopted principle. (c) Prospectively—no adjustment is made for the cumulative effect of the change. Previously reported results remain unchanged. The change shall be accounted for in the period of the change and in subsequent periods if the change affects future periods. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The FASB believes that the retrospective approach provides financial statement users the most useful information. Under this approach, the prior statements are changed on a basis consistent with the newly adopted standard; any cumulative effect of the change for prior periods is recorded as an adjustment to the beginning balance of retained earnings of the earliest period reported. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The indirect effect of a change in accounting principle reflects any changes in current or future cash flows resulting from a change in accounting principle that is applied retrospectively. An example is the change in payments to a profit-sharing plan that is based on reported net income. Indirect effects are not included in the retrospective application, but instead are reported in the period in which the accounting change occurs (current period). LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- 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 effected by a change in accounting principle occurs when a change in accounting estimate is inseparable from the effect of a related change in accounting principle. 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. LO: 1, Bloom: K, C, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 22 (Continued)
- This is an example of a situation in which it is difficult to differentiate between a change in account- ing 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. LO: 1, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- (a) Charge to expense—possibly separately disclosed. (b) Change in estimate that is effected by a change in accounting principle—currently and prospectively. (c) Charge to expense—possibly separately disclosed. (d) Correction of an error and reported as a prior period adjustment—adjust the beginning balance of retained earnings. (e) Change in accounting principle—retrospective application to all affected prior-period financial statements. (f) Change in accounting estimate—currently and prospectively. LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- This change is to be handled as a correction of an error. As such, the portion of the change attributable to prior periods ($23,000 = $52,000 − $29,000) should be reported as an adjustment to the beginning balance of retained earnings in the 2017 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 reported in the 2017 income statement as a reduction of materials cost. LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- 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 LIFO and FIFO. 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. LO: 1, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- 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. This assumes that prior years’ income is not changed because it would be too impractical to do so. The only adjustment necessary may be to adjust the beginning inventory from a lower-of-cost-or-market approach to a cost basis. This establishes the beginning LIFO layer. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- 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 from continuing operations, net income, and earnings per share amounts should be disclosed for all periods presented. LO: 2, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 22 (Continued)
- The amortization error decreases net income by $2,700 in 2017. Interest expense related to the discount should have been charged for $300 ($3,000 ÷ 10), but was charged for $3,000. The entry to correct for this error is as follows: Discount on Bonds Payable ....................................................................... 2, Interest Expense ................................................................................ 2, The entry to record accrued interest on the $100,000 of principal at 11% for 6 months is: Interest Expense........................................................................................ 5, Interest Payable ................................................................................. 5,
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- 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, Accounts Payable .............................................................................. 13, LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- This error increases net income by $2,400 in 2017. Depreciation should have been charged to net income. The entry to correct for this error is as follows: Depreciation Expense ($24,000 ÷ 10) ........................................................ 2, Accumulated Depreciation—Equipment ............................................. 2, LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 22-
Construction in Process ($120,000 – $80,000) ......... 40, Deferred Tax Liability [($120,000 – $80,000) X 35%] .......................... 14, Retained Earnings .............................................. 26, LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 22-
Difference in profit-sharing expense—prior years Pre-tax income—percentage-of-completion ............. $120, Pre-tax income—completed-contract ....................... 80, $ 40, X 1% Indirect effect .............................................................. $ 400
The indirect effect from prior years will be reported as a profit-sharing expense for year 2017.
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 22-
Inventory ..................................................................... 1,200, Deferred Tax Liability ($1,200,000 X 40%) ......... 480, Retained Earnings .............................................. 720, LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 22-
BEIDLER COMPANY
Retained Earnings Statement For the Year Ended December 31, 2017
Retained earnings, January 1, as previously reported ....... $2,000, Less: Correction of depreciation error, net of tax ......... 240,000* Retained earnings, January 1, as adjusted ..................... 1,760, Add: Net income ............................................................. 900, Less: Dividends ................................................................ 250, Retained earnings, December 31 ..................................... $2,410,
*$400,000 X (1 – .4) LO: 3, Bloom: AN, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 22-
a. Overstated Overstated b. Overstated Understated c. Understated Overstated d. Overstated Understated e. No effect Overstated
LO: 3, Bloom: AN, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 22-
- The change to a three-year remaining life for the purpose of computing depreciation on production equipment is a change in estimate due to a change in conditions.
- This is an expense classification change arising from a change in the use of the building for a different purpose. Thus, it is not a change in principle, a change in estimate, or an error.
- The change to expensing preproduction costs (writing the costs off in one year as opposed to several years) is a change in estimate due to a change in conditions. LO: 1, 2, Bloom: AN, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 22-
- Both FIFO and LIFO are generally accepted accounting principles; thus, this item is a change in accounting principle.
- This oversight is a mistake that should be corrected. Such a correction is considered a change due to error.
- Since the change from one GAAP method to another was required due to a new accounting standard, such a change is a change in accounting principle. LO: 1, 3, Bloom: AN, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*BRIEF EXERCISE 22-
Cash ($95,000 X 10%) ..................................................... 9, Equity Investments ................................................. 1, Dividend Revenue ($80,000 X 10%) ....................... 8, LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*BRIEF EXERCISE 22-
Equity Investments (Conrad Corporation) ($475,000 + $33,000) .................................................. 508, Cash......................................................................... 475, Retained Earnings .................................................. 33,
Equity Investments (Conrad Corporation) ................... 185, Equity Investments ................................................. 185,
Retained Earnings .......................................................... 34, Fair Value Adjustment ............................................ 34, LO: 4, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 22-3 (25–30 minutes)
(a) TAVERAS CO. Income Statement For the Year Ended December 31
LIFO 2015 2016 2017 Sales ....................................................... $3,000 $3,000 $3, Cost of goods sold ................................. 800 1,000 1, Operating expenses ............................... 1,000 1,000 1, Net income ....................................... $1,200 $1,000 $ 870
Income Statement For the Year Ended December 31
FIFO 2015 2016 2017 Sales ....................................................... $3,000 $3,000 $3, Cost of goods sold ................................. 820 940 1, Operating expenses ............................... 1,000 1,000 1, Net income ....................................... $1,180 $1,060 $ 900
(b) TAVERAS CO. Income Statement For the Year Ended December 31
2017 2016 As adjusted (Note A) Sales ....................................................... $3,000 $3, Cost of goods sold ................................. 1,100 940 Operating expenses ............................... 1,000 1, Net income ....................................... $ 900 $1,
EXERCISE 22-3 (Continued)
(c) Note A:
Change in Method of Accounting for Inventory Valuation
On January 1, 2017, Taveras elected to change its method of valuing its inventory to the FIFO method, whereas in all prior years inventory was valued using the LIFO method. The new method of accounting for inventory was adopted because it better reflects the current cost of the inventory on the balance sheet and comparative financial statements of prior years have been adjusted to apply the new method retrospectively. The following financial statement line items for fiscal years 2017 and 2016 were affected by the change in accounting principle.
2017 2016 Balance Sheet LIFO FIFO Difference LIFO FIFO Difference Inventory $ 320 $ 390 $70 $ 200 $ 240 $ Retained Earnings 3,070 3,140 70 2,200 2,240 40
Income Statement Cost of Goods Sold $1,130 $1,100 $30 $1,000 $940 $ Net Income 870 900 30 1,000 1,060 60
Statement of Cash Flows (no effect)
(d) Retained earnings statements after retrospective application.
Retained earnings, January 1, as reported $1, Less: Adjustment for cumulative effect of applying new accounting method (FIFO) 20 Retained earnings, January 1, as adjusted $2,240 1, Net Income 900 1, Retained earnings, December 31 $3,140 $2, LO: 1, Bloom: AP, Difficulty: Complex, Time: 25-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
EXERCISE 22-5 (30–35 minutes)
(a) KENSETH COMPANY Income Statement For the Year Ended
2017 2016 Sales................................................................. $3,000 $3, Cost of goods sold .......................................... 1,100 940 Operating expenses 1,000 1, Income before profit sharing ................... $ 900 $1, Profit sharing expense .................................... 96 100 Net income ................................................ $ 804 $ 960
Under GAAP , Kenseth Company should report $100 as the profit sharing expense in 2016, even though the profit sharing expense would be $106 if FIFO had been used in 2016.
(b) The profit sharing expense reflects an indirect effect of the change in accounting principle. Under GAAP , indirect effects from periods before the change are recorded in the year of the change. In this case, profit sharing expense recorded in 2017 is composed of:
$900 X 10% = $90 (2017 under FIFO) $ 60 X 10% = 6 (difference in profit sharing for 2016) $96 (profit sharing expense for FIFO in 2017)
(c) Retained Earnings Statement 2017 Retained earnings, January 1, as reported ................. $8, Cumulative effect of change to FIFO ($960 – $900) ...... 60 Retained earnings, January 1, as adjusted ................. 8, Add: Net Income ........................................................... 804 Deduct: Dividends ........................................................ 500 Retained earnings, December 31 ................................. $8, LO: 1, Bloom: AP, Difficulty: Complex, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 22-6 (10–15 minutes)
(a) The net income to be reported in 2018, using the retrospective approach, would be computed as follows: Income before income tax $900, Income tax (40% X $900,000) 360, Net income $540,
(b) Construction in Process ...................................... 290, Deferred Tax Liability (40% X $290,000) ...... 116, Retained Earnings......................................... 174,000*
*($290,000 X 60% = $174,000) LO: 1, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 22-7 (20–25 minutes)
(a) Retained Earnings ..................................................... 8, Inventory ............................................................. 8,000*
*2015 $2,000 ($26,000 – $24,000) *2016 5,000 ($30,000 – $25,000) *2017 1,000 ($28,000 – $27,000) $8,
2018 2017 2016 2015 Net income ($30,000 $27,000 $25,000 $24,
(b) Inventory .................................................................... 19, Retained Earnings.............................................. 19,000*
*2015 $ 6,000 ($26,000 – $20,000) *2016 9,000 ($30,000 – $21,000) *2017 4,000 ($28,000 – $24,000) $19,
2018 2017 2016 2015 Net income ($34,000 $28,000 $30,000 $26, LO: 1, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 22-9 (25–30 minutes)
Change from sum-of-the-years digit to straight-line
Cost of depreciable assets ................................. $100, Less: Depreciation in 2017 ($100,000 X 4/10) .... 40, Book value at December 31, 2017 ...................... $ 60,
Depreciation for 2018 using straight-line depreciation
Book value at December 31, 2017 ...................... $60, Estimated useful life ............................................ 3 years Depreciation for 2018 ($60,000 ÷ 3) .................... $20,
DENISE HABBE INC. Retained Earnings Statement For the Year Ended
2018 2017 Retained earnings, January 1, unadjusted ......... $125, Less: Correction of error for inventory overstatement ................................................ 24, Retained earnings, January 1, adjusted ............. 101,000 $ 72, Add: Net income 86,000 54, Less: Dividends.................................................... 30,000 25, Retained earnings, December 31 ........................ $157,000 $101,
Note to instructor:
- 2017 Cost of sales increased $24,000; 2018 cost of sales decreased $24,000. As a result, net income for 2017 is overstated $24,000 and net income for 2018 is understated $24,000 as a result of the inventory error.
- 2017 expenses remained unchanged.
- 2018 expenses decreased $10,000 ($30,000 – $20,000). Net income in 2018 is therefore $86,000 ($52,000 + $24,000 + $10,000).
- Additional disclosures would be a necessitated as indicated in the chapter. LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 22-10 (5–10 minutes)
- a. 6. a.
- b. 7. b.
- a. 8. a.
- b. 9. b.
- b. 10. b. LO: 1, 2, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 22-11 (15–20 minutes)
December 31, 2018 Retained Earnings ($550,000 X 9/55) ............................ 90, Accumulated Depreciation—Equipment .............. 90, (To correct for the omission of depreciation expense in 2016)
Cost of Machine $550, Less: Depreciation prior to 2018 2015 ($550,000 X 10/55) $100, 2016 ($550,000 X 9/55) 90, 2017 ($550,000 X 8/55) 80,000 270, Book Value at January 1, 2018 $280,
Depreciation for 2018: $280,000 ÷ 7 = $40,
Depreciation Expense ................................................... 40, Accumulated Depreciation—Equipment .............. 40, (To record depreciation expense for 2018) LO: 2, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
