Chapter 21


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Chapter 21

  1. 1. Prepared by: Patricia Zima, CA Mohawk College of Applied Arts and Technology Chapter 21 Accounting Changes and Error Analysis
  2. 2. Accounting Changes and Error Analysis <ul><li>Changes in Accounting Policies and Estimates, and Errors </li></ul><ul><li>Introduction </li></ul><ul><li>Types of accounting changes </li></ul><ul><li>Alternative accounting methods </li></ul><ul><li>Accounting standards </li></ul><ul><li>Retrospective application – change in accounting policy </li></ul><ul><li>Retrospective restatement – correction of error </li></ul><ul><li>Prospective application </li></ul><ul><li>Summary of accounting changes </li></ul><ul><li>Error Analysis </li></ul><ul><li>Balance sheet errors </li></ul><ul><li>Income statement errors </li></ul><ul><li>Balance sheet and income statement errors </li></ul><ul><li>Comprehensive illustration: numerous errors </li></ul><ul><li>Preparation of comparative financial statements </li></ul><ul><li>Perspectives </li></ul><ul><li>Motivations for change </li></ul><ul><li>Interpreting accounting changes </li></ul><ul><li>International </li></ul>
  3. 3. Types of Accounting Changes <ul><li>Change in Accounting Policy </li></ul><ul><ul><li>Change in the choice of “specific principles, bases, rules, and practices applied by an entity in preparing and presenting financial statements” </li></ul></ul><ul><li>Change in Accounting Estimate </li></ul><ul><ul><li>Change occurs in circumstances on which a previous estimate was based or as the result of new information, more experience or subsequent developments </li></ul></ul>
  4. 4. Types of Accounting Changes (continued) <ul><li>Correction of an error in prior period financial statements </li></ul><ul><ul><li>Omissions from or mistakes in financial statements of prior periods caused by the misuse or failure to use reliable information that existed at the time financial statements were prepared </li></ul></ul><ul><ul><li>They may be intentional or an oversight </li></ul></ul>
  5. 5. Changes in Accounting Policy <ul><li>Handbook Section 1506.09: A change in an accounting policy is permitted only when the change: </li></ul><ul><ul><li>Is required by a primary source of GAAP , or </li></ul></ul><ul><ul><li>Results in portraying reliable and more relevant information about effects of transactions, events or conditions </li></ul></ul>
  6. 6. Changes in Accounting Policy <ul><li>Does not result from adoption of a: </li></ul><ul><ul><li>New policy that recognizes events that have occurred for the first time or that were previously immaterial </li></ul></ul><ul><ul><li>Different policy necessitated by events or transactions clearly different in substance from those previously occurring </li></ul></ul>
  7. 7. Changes in Accounting Policy <ul><li>Examples of situations that are not changes in accounting policy: </li></ul><ul><ul><li>Adopting interest capitalization during construction of own long-term assets, when company had not previously been involved in self-construction </li></ul></ul><ul><ul><li>Deferral of marketing expenses when previously these expenses were expensed as they were immaterial </li></ul></ul>
  8. 8. Changes in Accounting Estimates <ul><li>Future conditions and events and their effects cannot be known with certainty; therefore estimation requires exercise of judgement </li></ul><ul><li>Use of reasonable estimates is essential to the accounting process and does not undermine the reliability of financial statements </li></ul>
  9. 9. Changes in Accounting Estimates <ul><li>Examples of items requiring estimates include: </li></ul><ul><ul><li>Uncollectible receivables </li></ul></ul><ul><ul><li>Inventory obsolescence </li></ul></ul><ul><ul><li>Fair value of financial assets/liabilities </li></ul></ul><ul><ul><li>Useful lives and residual values of depreciable assets </li></ul></ul><ul><ul><li>Liabilities for warranty costs and income taxes </li></ul></ul><ul><ul><li>Asset retirement obligations </li></ul></ul><ul><ul><li>Recoverable mineral reserves </li></ul></ul>
  10. 10. Changes in Accounting Estimates <ul><li>Differentiating a change in policy and a change in estimate can be difficult </li></ul><ul><li>For example, is a change in amortization method a change in policy or a change in estimate? </li></ul><ul><ul><li>At first glance, a change in amortization method appears to be a change in accounting policy </li></ul></ul><ul><ul><li>However, it is a change in estimate if it is a change in estimate of the pattern in which company benefits from the asset </li></ul></ul><ul><li>Where it is not clear, treat the change as a change in estimate </li></ul>
  11. 11. Correction of an Error in Prior Period Financial Statements <ul><li>Examples of accounting errors include: </li></ul><ul><ul><li>Change from non-GAAP to GAAP </li></ul></ul><ul><ul><ul><li>e.g. change from cash basis of accounting to accrual basis </li></ul></ul></ul><ul><ul><li>Mathematical mistakes </li></ul></ul><ul><ul><ul><li>e.g. incorrect totaling of inventory count sheets </li></ul></ul></ul><ul><ul><li>Oversight </li></ul></ul><ul><ul><ul><li>e.g. failure to defer expenses or revenues </li></ul></ul></ul><ul><ul><li>Misappropriation of assets </li></ul></ul><ul><ul><ul><li>e.g. discovery of inventory theft </li></ul></ul></ul>
  12. 12. Correction of an Error <ul><li>Distinguishing between correction of an error and a change in estimate can be difficult </li></ul><ul><li>Example: a lack of a previous year’s accrual of reassessed income taxes – was the information overlooked (i.e. an error) or do we have more information or was there subsequent developments (i.e. an estimate)? </li></ul><ul><li>General rule: if an estimate was calculated incorrectly due to lack of expertise, it is considered an error; </li></ul><ul><li>If a careful estimate was made in a previous year which is later determined as incorrect, it is considered a change in estimate </li></ul>
  13. 13. Alternative Accounting Methods <ul><li>Three approaches have been suggested for reporting changes in the accounts </li></ul><ul><ul><li>Retrospectively </li></ul></ul><ul><ul><li>Currently </li></ul></ul><ul><ul><li>Prospectively </li></ul></ul>
  14. 14. Retrospective Treatment <ul><li>Also know as retroactive application </li></ul><ul><li>Requires calculating the cumulative effect of the change on the financial statements at the beginning of the period as if the new method or estimate had always been used </li></ul><ul><li>An adjustment is made to the financial statements equal to this cumulative effect </li></ul><ul><li>Results in restating all affected prior years’ financial statements on a basis consistent with the newly adopted policy (i.e. as if the new accounting policy had always been used) </li></ul>
  15. 15. Current Treatment <ul><li>New accounting method or estimate’s cumulative effect on the financial statements at the beginning of the period is calculated </li></ul><ul><li>An adjustment is reported in current year’s income statement </li></ul><ul><li>Prior years’ financial statements are not restated </li></ul>
  16. 16. Prospective Treatment <ul><li>Previously reported results remain; no change is made </li></ul><ul><li>Opening balances are not adjusted and no attempt is made to correct or change past periods </li></ul><ul><li>New policy or estimate is adopted for current and future periods only and applied to balances existing at the date of the change </li></ul>
  17. 17. Accounting Changes and Related Accounting Methods Apply retrospectively. Correction of an error Apply prospectively. Change in accounting estimate Apply retrospectively. If impractical, apply prospectively Voluntary change in accounting policy Apply method approved in transitional provisions section of the primary source; if none, then use retrospective application. Adoption of primary source of GAAP (Change in Accounting Policy) Accounting Method Applied Type of Accounting Change
  18. 18. Retrospective-with-Restatement <ul><li>Requirements of this method include: </li></ul><ul><ul><li>Retroactive application of the new method, including income tax effects – an accounting entry is made </li></ul></ul><ul><ul><li>Prior-period financial statements included for comparative purposes are restated </li></ul></ul><ul><ul><li>Description of the change and effect on current and prior period financial statements disclosed so that statements remain comparable </li></ul></ul>
  19. 19. Retrospective-with-Restatement Example Given: Voluntary change to capitalizing all avoidable interest costs on self-constructed assets
  20. 20. Retrospective-with-Restatement Example <ul><li>January 1, 2008: To record retroactive change </li></ul><ul><li>Property, Plant and Equip (net) 220,000 </li></ul><ul><li>Future Income Tax Liability 88,000 </li></ul><ul><li>Retained Earnings – </li></ul><ul><li>Change in Accounting Policy 132,000 </li></ul>
  21. 21. Retrospective-with-Restatement Example
  22. 22. Retrospective-with-Restatement Example
  23. 23. Retrospective-with-Restatement Example
  24. 24. Retrospective with Partial Restatement <ul><li>Retroactively restating prior years’ financial statements requires information that may be impractical to obtain on a cost-benefit basis </li></ul><ul><li>The transitional provision under CICA Handbook Section 3461 for example, allows for a partial retrospective application </li></ul><ul><li>The change in policy is applied at the beginning of the earliest period for which restatement is possible </li></ul>
  25. 25. Retrospective with Partial Restatement - Example <ul><li>Assume that it was impractical for Denson Ltd. to determine the effects of the change in policy on specific years any further back than 2007. The journal entry to record the change in policy is the same as the one made for full restatement: </li></ul><ul><li>January 1, 2008: To record change </li></ul><ul><li>Property, Plant and Equip (net) 220,000 </li></ul><ul><li>Future Income Tax Liability 88,000 </li></ul><ul><li>Retained Earnings – </li></ul><ul><li>Change in Accounting Policy 132,000 </li></ul><ul><li>However, years prior to 2007 are not restated </li></ul>
  26. 26. Retrospective with Partial Restatement <ul><li>Any comparative financial statements prior to 2007 are not restated </li></ul><ul><li>Without restatement, leaves the comparative financial statements as originally reported and </li></ul><ul><li>The change’s cumulative effect prior to Jan. 1, 2007 is presented as an adjustment to Jan. 1, 2007 Retained Earnings </li></ul>
  27. 27. Disclosures – Changes in Accounting Policy <ul><li>For changes in policy resulting from initial application of a primary source of GAAP or from a voluntary change, the following must be disclosed: </li></ul><ul><ul><li>The nature of the change in accounting policy </li></ul></ul><ul><ul><li>The amount of the adjustment for each financial statement line item that is affected and the basic and fully diluted EPS, for current and prior periods </li></ul></ul><ul><ul><li>The amount of the adjustment that relates to periods before those that are presented </li></ul></ul><ul><ul><li>The reasons it was not practicable for restatement of particular periods, with a description of how the change was applied and from what date </li></ul></ul>
  28. 28. Disclosures – Changes in Accounting Policy <ul><li>For voluntary changes in accounting policy that affect current or prior periods presented, or may have an effect in future periods: </li></ul><ul><ul><li>Explanation of the change and justification why the new policy provides reliable and a more relevant presentation of the entity’s financial position, financial performance or cash flows </li></ul></ul>
  29. 29. Disclosures – Changes in Accounting Policy <ul><li>For an initial application of a primary source of GAAP : </li></ul><ul><ul><li>The title of the primary source, and </li></ul></ul><ul><ul><li>If in accordance with transitional provisions, provide a description of transitional provisions including those that affect future periods </li></ul></ul>
  30. 30. Disclosures – Changes in Accounting Policy <ul><li>For new primary sources of GAAP that are not yet effective and have not been applied: </li></ul><ul><ul><li>Disclose the fact that new primary source has been issued, and </li></ul></ul><ul><ul><li>Any reasonably reliable information useful in assessing possible impact on financial statement in the period in which it will be first applied </li></ul></ul>
  31. 31. Disclosures –Error Correction <ul><li>Where a change is the result of an accounting error , companies must disclose that an error occurred in a prior period(s) and disclose, in the year of the correction: </li></ul><ul><ul><li>The nature of the error; </li></ul></ul><ul><ul><li>The amount of the correction to basic and fully diluted earnings per share and to each line item on the financial statements presented for comparative purposes; </li></ul></ul><ul><ul><li>The amount of the correction made at the beginning of the earliest prior period presented. </li></ul></ul>
  32. 32. Prospective Application <ul><li>Effects of changes in estimates are handled prospectively </li></ul><ul><li>No changes are made to previously reported results </li></ul><ul><ul><li>Changes in estimates are viewed as normal recurring corrections and adjustments </li></ul></ul><ul><li>Effect of a change in estimate is accounted for by including it in net income or comprehensive income as appropriate in: </li></ul><ul><ul><li>The period of change if the change affects that period only </li></ul></ul><ul><ul><li>The period of change and future periods if the change affects both </li></ul></ul>
  33. 33. Disclosure – Change in Estimate <ul><li>Minimum disclosures are as follows: </li></ul><ul><ul><li>The nature of the change in estimate </li></ul></ul><ul><ul><li>The amount of the change in estimate affecting the current period or future periods </li></ul></ul><ul><ul><ul><ul><li>- If it is not practicable to estimate effect, this fact is disclosed </li></ul></ul></ul></ul>
  34. 34. Motivations for Change <ul><li>Political costs – larger firms, larger profits, may become political targets; select policies to reduce profits </li></ul><ul><li>Capital structure – debt/equity structure will impact accounting policies due to debt covenants </li></ul><ul><li>Bonus payments – when bonuses attached to income, managers may select methods that maximize income </li></ul><ul><li>Smooth earnings – gradual increase (decrease) in income to shift attention </li></ul>
  35. 35. Error Analysis <ul><li>Balance Sheet Errors </li></ul><ul><ul><li>Affect only the presentation of an asset, liability or shareholders’ equity account </li></ul></ul><ul><ul><ul><li>e.g. classifying short-term receivable as long-term </li></ul></ul></ul><ul><ul><li>Reclassify when error is discovered </li></ul></ul><ul><ul><li>If comparatives, balance sheet for error year is restated correctly </li></ul></ul><ul><ul><li>No further corrections required </li></ul></ul>
  36. 36. Error Analysis <ul><li>Income Statement Errors </li></ul><ul><ul><li>Affect only the presentation of nominal accounts in the income statement </li></ul></ul><ul><ul><ul><li>Involve improper classification of revenues or expenses, such as recording purchases as bad debts expense </li></ul></ul></ul><ul><ul><li>No effect on balance sheet or net income </li></ul></ul><ul><ul><li>Reclassification entry required if error discovered in the year it is made </li></ul></ul><ul><ul><li>If error occurred in prior period, no entry required as accounts have all been closed </li></ul></ul><ul><ul><li>If comparatives prepared, restate error year </li></ul></ul>
  37. 37. Error Analysis <ul><li>Balance Sheet and Income Statement Errors </li></ul><ul><ul><li>Involve both balance sheet and income statement </li></ul></ul><ul><ul><ul><li>e.g. accrued wages payable was overlooked at year end </li></ul></ul></ul><ul><ul><li>Counterbalancing (self-correcting over two periods) </li></ul></ul><ul><ul><li>Non-counterbalancing (takes more than two periods to self-correct) </li></ul></ul>
  38. 38. Counterbalancing Errors <ul><ul><li>If books are closed when error is discovered: </li></ul></ul><ul><ul><ul><li>If error is already counterbalanced, no entry is required </li></ul></ul></ul><ul><ul><ul><li>If error is not yet counterbalanced, entry required to adjust retained earnings and any other balance sheet accounts affected </li></ul></ul></ul>
  39. 39. Counterbalancing Errors <ul><ul><li>If books are still open: </li></ul></ul><ul><ul><ul><li>If error is counterbalanced and company is in second year, an entry required to adjust current income statement and beginning retained earnings </li></ul></ul></ul><ul><ul><ul><li>If error not yet counterbalanced, an entry required to adjust beginning retained earnings and to adjust affected current income statement and balance sheet accounts </li></ul></ul></ul>
  40. 40. Counterbalancing Errors - Example <ul><li>Example: Accrued wages of $3,000 were not recorded on December 31, 2008. Assume a 40% tax rate. </li></ul><ul><li>If error discovered in 2009 when books for 2009 have not yet been closed, entry required: </li></ul><ul><ul><li>Dr Retained Earnings (3,000 x 60%) 1,800 </li></ul></ul><ul><ul><li>Dr Future Tax Asset (3,000 x 40%) 1,200 </li></ul></ul><ul><ul><li>Cr Wages Expense 3,000 </li></ul></ul><ul><ul><li>Reason for this entry: </li></ul></ul><ul><ul><li>Wages Expense in 2008 is understated by $3,000, therefore 2008 Net Income and 2009 Opening Retained Earnings are overstated by $1,800 (net of tax) </li></ul></ul><ul><ul><li>Wages Expense in 2009 is overstated by $3,000 </li></ul></ul>
  41. 41. Counterbalancing Errors - Example <ul><li>Example continued: </li></ul><ul><li>If books have already been closed in 2009 when error is discovered, no entry is required </li></ul><ul><li>Rationale: </li></ul><ul><ul><li>2008 Net Income and 2008 Ending Retained Earnings is overstated </li></ul></ul><ul><ul><li>2009 Net Income is understated </li></ul></ul><ul><ul><li>Therefore, ending Retained Earnings in 2009 is correct – i.e. error has counterbalanced </li></ul></ul>
  42. 42. Non-Counterbalancing Errors - Example <ul><li>Example: A machine that was purchased for $10,000 in 2008 was expensed in error. Ignore taxes. </li></ul><ul><li>Assume straight-line amortization for 5 year life applies (i.e. Amortization Expense = $2,000 per year) </li></ul><ul><li>The error results in 2008 expenses being overstated by $8,000; 2008 Net Income and 2009 Opening Retained Earnings is understated by $8,000 </li></ul><ul><li>In 2009, Machinery is understated by $10,000 and Accumulated Amortization is understated by $4,000 </li></ul><ul><li>If discovered in 2009 before books closed, entry is: </li></ul><ul><ul><li>Machinery 10,000 </li></ul></ul><ul><ul><li>Amortization Expense (2009) 2,000 </li></ul></ul><ul><ul><li>Retained Earnings 8,000 </li></ul></ul><ul><ul><li> Accumulated Amortization (2008,2009) 4,000 </li></ul></ul>
  43. 43. Non-Counterbalancing Errors - Example <ul><li>Example continued: </li></ul><ul><li>If error discovered in 2009 after books closed, entry required: </li></ul><ul><ul><li>Machinery 10,000 </li></ul></ul><ul><ul><li>Retained Earnings 6,000 </li></ul></ul><ul><ul><li>Accumulated Amortization 4,000 </li></ul></ul><ul><li>Retained Earnings understated at Dec. 31, 2008 $ 8,000 </li></ul><ul><li>Correct amortization for 2009 (2,000) </li></ul><ul><li>Retained earnings understated as at Dec. 31, 2009 $ 6,000 </li></ul>
  44. 44. International <ul><li>The current accounting Canadian standard for accounting changes is based directly on the international standard, IAS 8. </li></ul><ul><li>Minor differences exist, such as international standards permit the partial retrospective application for the correction of an accounting error, while Canadian standards do not permit this treatment </li></ul>
  45. 45. COPYRIGHT Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.