Accounting Changes

• Preserve comparability of financial information.

• Otherwise, historical financial data loses relevance/trends.

3 Types of Accounting Changes:

1. Change in Accounting Principal.
Average Cost to LIFO
Completed contract to percentage of completion
2. Change in Accounting Estimate.
3. Change in Reporting Entity.
Errors are not considered an accounting change.
Adopting a new principle for an event occurred the first
Or the amount was previously immaterial
is not a change in accounting principle
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 Three approaches for reporting changes
1. Currently.
2. Retrospectively (changes in accounting principle)
Adjusts its financial statements for each prior period presented to the same basis as the
new accounting principle.
Adjusts the carrying amounts of assets and liabilities as of the beginning of the first year
presented, plus the opening balance of retained earnings.
3. Prospectively (in the future).
• Rationale –Preserve comparability from one period to the other

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• In 20X4, Adam Company changed to the percentage-of-completion method
from the completed contract method. Adam 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. (Assume a 20 percent enacted tax rate.)
Completed Contract Method (old)
20X2 20X3 20X4
Income before income tax $410,000 $170,000 $200,000
Income tax (20%) 82,000 34,000 40,000
Net income $328,000 $128,000 $160,000

Percentage of Completion Method (new)

20X2 20X3 20X4
Income before income tax $700,000 $200,000 $220,000
Income tax (20%) 140,000 40,000 44,000
Net income $560,000 $160,000 $176,000

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 Completed Contract Method Percentage of Completion Method

20X2 20X3 20X4 20X2 20X3 20X4

Income before income tax $410,000 $170,000 $200,000 Income before income tax $700,000 $200,000 $220,000
Income tax (20%) 82,000 34,000 40,000 Income tax (20%) 140,000 40,000 44,000
Net income $328,000 $128,000 $160,000 Net income $560,000 $160,000 $176,000

Pretax Income Pretax Income Difference Difference in

from from in Income Income
Percentage-of- Completed- Difference Tax Effect Income Effect
year Completion Contract in Income 20% (net of tax)
20X2 $700,000 $410,000 $290,000 $58,000 $232,000
20X3 200,000 170,000 30,000 6,000 24,000

Total at beginning of 20X4 $900,000 $580,000 $320,000 $64,000 $256,000

Total in 20X4 $220,000 $200,000 $ 20,000 $ 4,000 $ 8,000

Journal entry Construction in Process 320,000

beginning of Deferred Tax Liability 64,000
20X4 Retained Earnings 256,000

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 Disclosures
What do you need to disclose?
1. Nature of the change in accounting principle.
2. The method of applying the change
 A description of the prior period information that has been retrospectively adjusted, if any.
 The effect of the change on income from continuing operations, net income
 The cumulative effect of the change on retained earnings or other components of equity or net
assets in the statement of financial position as of the beginning of the earliest period presented.
20X4
Retained earnings, January 1, as reported $355,000
Add: Adjustment for the cumulative effect on prior years
of applying retrospectively the new revenue principle
256,000
Retained earnings, January 1, as adjusted 611,000
Net income 102,000
Retained earnings, December 31 713,000
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Changes In accounting Principles
• Need Inventory exam
 Accounting Changes
3 Types of Accounting Changes:
1. Change in Accounting Principal.
2. Change in Accounting Estimate
Bad Debit expense (allowance for uncollectible)
Warranty Expense
Periods benefits by deferred costs
Income tax expense
Inventory obsolescence.
Depreciation expense (TBD)
3. Change in Reporting Entity.
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 Three approaches for reporting changes
1. Currently.
2. Retrospectively (changes in accounting principle)
3. Prospectively (changes in estimates)
the period of change if the change affects that period only, or
the period of change and future periods if the change affects both.

No need for restatement or making changes to prior periods

NOT retrospective

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Adam Co. purchased for $500,000 a building that it originally estimated to have a useful life of 10 years and no salvage value.
It recorded depreciation for 4 years on a straight-line basis. On January 1, Y5, Adam revises the estimate of the useful life to
have 14 years in total

Accounts at the beginning of the fifth year:

Buildings $500,000
Less: Accumulated depreciation—buildings (4 × 50,000) 200,000
Book value of building $300,000

• Adam records depreciation for the Y 5 as follows.

Depreciation Expense 30,000

Accumulated Depreciation—Buildings 30,000

$ 3 00,000
=$3 0,000
(1 4   years − 4  years )

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 Change in Estimate Effected by a Change in
Principle
• Change in depreciation methods (SL to DDB) is based on changes in
estimates about future benefits from long-lived assets.
Depreciation expense :
 Life
 Residual life
 Method
• It is not possible to separate the effect of the accounting principle
change from that of the estimates  Change in estimate
• Companies account for a change in depreciation methods as a change in
estimate effected by a change in accounting principle:

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 Disclosure
No disclosure:
• Changes in accounting estimates made as part of normal operations
• Bad debt expense or
• Inventory obsolescence
 unless such changes are material.
Disclose:
Change in estimate that affects several periods
service lives of depreciable assets
Disclose the effect on income from continuing operations and related per-share
amounts of the current period.

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 Accounting Changes
3 Types of Accounting Changes:
1. Change in Accounting Principal (retrospectively)
2. Change in Accounting Estimate (prospectively)
3. Change in Reporting Entity.
1. Changes to consolidated or combined financial statements
(retrospectively if comparative presented)
2. Removing a sub from a consolidated or combined financial
statements (retrospective if comparative presented)
3. Changing from cost to equity (TBD)
4. Changing from equity to cost (TBD)

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 Change from Equity (no Retrospective)
• Go from equity to fair value
• Change to Fair value method
• All previously gains and losses recognized under the equity method are part
of the carrying amount of the investment.
• Cost basis is the carrying amount of the investment at the date of the change.
• NO RETROSPECTIVE APPLICATION
• No change of prior period
• Apply the new method when the equity method no longer applicable.
• Next reporting date:
• Record unrealized gains/looses as the difference between the carrying value and fair
value.
• Life is good.

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 Change TO Equity (no retrospective)
• From Cost to equity
• No prior adjustment
• Instead, account for the effects of the change in
the period of change and future periods if the change affects both.
• The investor company add the cost of acquiring the additional interest in the
investee company to the cost basis of their previously held interest.
• Best to illustrate in an example

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 On January 1, 20X1, Adam Company purchases a 10% stock interest in Avi’s Company for $900,000.

Equity Investment 900,000

Cash 900,000
On December 31, 20X1, the fair value of then investment in Avi’s company is 1,025,000.
Fair Value Adjustment 125,000
Unrealized Holding G/L-Income 125,000

On December 31, 20X1, Adam Company purchases an additional 20 % stock interest in Avi’s Company for $5,000,000
Equity Investment (Avi)
5,000,000
Cash 5,000,000
Reclassify the equity investment of 900,000 Equity Investment (Avi)

Equity Investment (Avi) 900,000 5,000,000

Equity Investment 900,000 900,000
Eliminate the fair value as we are using the equity method
Retained Earnings 125,000
Fair Value Adjustment 125,000

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 Accounting Errors
What is an accounting error?
Computational (Mathematical) mistakes.
Misapplication/Misuse of facts.
Switching from non-GAAP to a GAAP method
Estimates (Change) that were NOT prepared in good faith
(Waste Management)
Failure to book accrual or deferral (expenses or revenues)
Misclassification: Expensing a capitalized assets or vice
versa (world Com)
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 Category & Type of Restatement
• Expense Recognition:
• Recording expenses for incorrect amount or wrong period
• Revenue Recognition:
• Improperly recognized, questionable revenues, or any other number of related errors that led to
misreported revenue
• Misclassification:
• ST Vs Long Term
• Equity:
• Improper accounting for EPS, restricted stock, warrants, and other equity instruments (options)
• Allowances/ contingencies:
• Estimating bad debts, inventory reserves, income tax allowances, and loss contingencies.
• Long-lived assets
• Asset impairments of PPE
• Inventory Student or CPA Candidate?
• Costing valuations, quantity, and cost ofwww.farhatlectures.com
goods sold adjustments.
 How to handle Accounting
Retrospective!
• All material errors must be corrected.
• For comparative statements, a company should restate the prior financial
statements affected for each year presented.
• Show any catch-up adjustment as a prior period adjustment to retained earnings for
the earliest period it reported.
• One year Presented:
• Record corrections of errors from prior periods as an adjustment to the beginning
balance of retained earnings prior period adjustments in the current period
• Example

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In 20X1 Adam Co. discovered an error. In 20X0 the company failed to record $10,000 of depreciation expense on a newly
constructed building. The company correctly included the depreciation expense in its tax return and correctly reported its
income taxes payable. Adam Company
Income Statement
For the Year Ended December 31, 20X0
Without Error With Error
Income before depreciation expense $100,000 $100,000
Depreciation expense 10,000 –0–
Income before income tax 90,000 100,000
Current income tax expense $18,000 $18,000
Deferred income tax expense –0– 18,000 2,000 20,000
Net income $ 72,000 $ 80,000

If no error was made Entries Adam Actually Made

Depreciation Expense 10,000 No entry made for depreciation
Accumulated Depreciation— Income Tax Expense 20,000
Buildings 10,000
Deferred Tax Liability 2,000
Income Tax Expense 18,000
Income Taxes Payable 18,000
Income Taxes Payable 18,000
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 If no error was made Entries Adam Actually Made

Depreciation Expense 10,000 No entry made for depreciation

Accumulated Depreciation— Income Tax Expense 20,000
Buildings 10,000
Deferred Tax Liability 2,000
Income Tax Expense 18,000
Income Taxes Payable 18,000
Income Taxes Payable 18,000

• Income Statement Effects

 Depreciation expense (20X0) is understated $10,000. Adam Company
 Income tax expense (20X0) is overstated $2,000 ($10,000 × .20). Retained Earnings Statement
 Net income (20X0) is overstated $8,000 ($80,000 − $72,000). For the Year Ended December 31, 20X1
• Balance Sheet Effects Retained earnings, January 1, as reported $400,000
 Accumulated depreciation—buildings is understated $10,000. Correction of an error (depreciation) $10,000
 Deferred tax liability is overstated $2,000 ($10,000 × .20). Less: Applicable income tax reduction 2,000 (8,000)
Retained earnings, January 1, as adjusted 392,000
Retained Earnings 8,000 Add: Net income 220,000
Deferred Tax Liability 2,000 Retained earnings, December 31 $612,000
Accumulated Depreciation—Buildings 10,000

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Accounting Error Analysis (counterbalancing
and noncouterbalancing
• Prior session:
• Treat errors as prior-period adjustments and report the error in the
current year as adjustments to the beginning balance of Retained
Earnings.
• For comparative purposes: Restate the balance sheet and income
statement
• Current year error - reclassify item (fix)

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 Counter Balancing Errors
• Errors that correct over two periods.
• If Books Closed:
 If the error is already counterbalanced no entry is necessary.
 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.
If books not closed:
 If the error is already counterbalanced, no entry is necessary.
 f the error is not yet counterbalanced  make entry to adjust the present balance of
retained earnings.

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 Noncounterbalancing Errors

• Not offset in the next accounting period.

• Companies must make correcting entries, even if they have closed the
books.
• Examples

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 Dr. Cr.
Supplies $ 2,900
Salaries and wages payable $ 1,500
Interest receivable 4,000
Prepaid insurance 90,000
Unearned rent 0
Interest payable 15,000
Supplies on hand on December 31, 20X1 totaled $1,000 (revealed by a physical
count).
Supplies Expense ($2,900 – $1,000) 1,900
Supplies 1,900
If the books were already closed:
Retained Earnings 1,900
1,900
Supplies

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 Dr. Cr.
Supplies $ 2,900
Salaries and wages payable $ 1,500
Interest receivable 4,000
Prepaid insurance 90,000
Unearned rent 0
Interest payable 15,000

Accrued salaries and wages on December 31, 20X1, should be $3,500.

Salary and Wages Expense 2,000
Salaries and Wages Payable 2,000
If the books were already closed:
Retained Earnings 2,000
Salaries and Wages Payable 2,000
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 Dr. Cr.
Supplies $ 2,900
Salaries and wages payable $ 1,500
Interest receivable 4,000
Prepaid insurance 90,000
Unearned rent 0
Interest payable 15,000

Accrued interest on investments amounts to $5,000 on December 31, 20X1.

Interest Receivable 1,000
Interest Revenue ($5,000 – $4,000) 1,000

If the books were already closed:

Interest Receivable 1,000

Retained Earnings ($5,000 – $4,000) 1,000

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 Dr. Cr.
Supplies $ 2,900
Salaries and wages payable $ 1,500
Interest receivable 4,000
Prepaid insurance 90,000
Unearned rent 0
Interest payable 15,000

The unexpired portions of the insurance policies totaled $60,000 as of December 31,
20X1
Insurance Expense 30,000
Prepaid Insurance 30,000
If the books were already closed:

Retained Earnings 30,000

Prepaid Insurance 30,000
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 Dr. Cr.
Supplies $ 2,900
Salaries and wages payable $ 1,500
Interest receivable 5,000
Prepaid insurance 90,000
Unearned rent 0
Interest payable 15,000

$30,000 was received on January 1, 20X1 for the rent of a building for both 20X1 and
20X2. The entire amount was credited to rental income.
Rental Income ($30,000 ÷ 2) 15,000
Unearned Rent Revenue 15,000

If the books were already closed:

Retained Earnings 15,000
Unearned Rent Revenue 15,000

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 Dr. Cr.
Supplies $ 2,900
Salaries and wages payable $ 1,500
Interest receivable 5,000
Prepaid insurance 90,000
Unearned rent 0
Interest payable 15,000

Depreciation for the year was erroneously recorded as $10,000 rather than the correct
figure of $40,000.
Depreciation Expense 30,000
Accumulated Depreciation 30,000
If the books were already closed:
Retained Earnings 30,000
Accumulated Depreciation 30,000
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