CHAPTER 22 Accounting Changes and Error Analysis LEARNING OBJECTIVES 1. Discuss the types of accounting changes and the accounting for changes in accounting policies. 2. Describe the accounting and reporting for changes in estimates. 3. Describe the accounting for correction of errors. 4. Analyze the effect of errors. Copyright © 2018 John Wiley & Sons, Inc. Kieso Intermediate: IFRS 3e, Instructor’s Manual 22-1 CHAPTER REVIEW 1. Chapter 22 discusses the different procedures used to report accounting changes and error corrections. The use of estimates in accounting as well as the uncertainty that surrounds many of the events accountants attempt to measure may make adjustments to the financial reporting process necessary. The accurate reporting of these adjustments in a manner that facilitates analysis and understanding of financial statements is the focus of this chapter. Types of Accounting Changes 2. (L.O. 1) The IASB has established a reporting framework for reporting the two types of accounting changes: a. Change in Accounting Policy. A change from one accepted accounting policy to another one. b. Change in Accounting Estimate. A change that occurs as the result of new information or additional experience. An example is a change in the estimate of the useful lives of depreciable assets. Errors in Financial Statements 3. Errors necessitate changes in accounting, but errors are not considered accounting changes. Errors result from mathematical mistakes, mistakes in applying accounting policies, or oversight or misuse of facts that existed when preparing financial statements. Changes in Accounting Policy 4. A change in accounting policy is not a result of the adoption of a new policy in recognition of events that have occurred for the first time or that were previously immaterial. For example, implementing a credit sales policy when one had not previously existed is not considered a change in accounting policy. In addition, a change from an accounting policy that is not acceptable to an acceptable policy is considered a correction of an error. Thus, only those changes from one acceptable policy to another acceptable policy are defined as changes in accounting policy. 5. Three approaches are suggested for recording the effect of changes in accounting policies: (a) currently, (b) retrospectively, and (c) prospectively. The IASB requires that companies use the retrospective approach. 6. Treating a change in accounting policy currently requires computation of the cumulative effect of the change on financial statements in the current year’s income statement as an irregular item. Advocates of this method contend that investor confidence is lost by a retroactive adjustment of financial statements for prior periods. 22-2 Copyright © 2018 John Wiley & Sons, Inc. Kieso Intermediate: IFRS 3e, Instructor’s Manual 7. Retrospective Application refers to the application of a different accounting policy to recast previously issued financial statements as if the new policy had always been used. The company shows any cumulative effect of the change as an adjustment to beginning retained earnings of the earliest year presented. 8. Prospective treatment of a change in accounting policy requires no change in previously reported results. Opening balances are not adjusted and no attempt is made to compensate for prior events. Advocates of this position contend that financial statements based on acceptable accounting policies are final since management cannot change prior periods by subsequently adopting a new policy. Retrospective Changes 9. There is a presumption that once an accounting policy is selected, it should not change. The IASB permits companies to change accounting policies if: (a) it is required by IFRS; or (b) the new policy will result in financial statements that report information that is more relevant and reliable. A retrospective adjustment of the financial statements presented is made by recasting the statements of prior years on a basis consistent with the newly adopted policy. Any part of the cumulative effect attributable to years prior to those presented is treated as an adjustment of beginning retained earnings (or other appropriate component of equity) for the earliest year presented. 10. When a company makes a change in accounting policy, the major disclosure requirements include (a) nature of the change in policy, (b) reasons why the new policy provides reliable and more relevant information, (c) for the current and each prior period presented the amount of adjustment to each financial statement line item and EPS, and (d) the amount of the adjustment relating to periods prior to those presented. 11. A direct effect of a change in accounting policy should be retrospectively applied. An example of a direct effect is the change in the inventory balance as a result of changing methods of inventory valuation. Related changes, such as the deferred income tax effect, are also considered direct effects. An indirect effect is any change to current or future cash flows that result from the change in accounting policy (for example, a change in a profit-sharing distribution due to a change in revenue or net income). The IASB does not provide guidance regarding indirect effects, although U.S. GAAP requires that indirect effects do not change prior period amounts. 12. When a company cannot determine the prior period effects using every reasonable effort to do so, it is considered impracticable and the company should not use retrospective application. If any one of the following conditions exists, a company should not use retrospective application (a) The company cannot determine the effects of the retrospective application; (b) Retrospective application requires assumptions about management’s intent in a prior period or (c) Retrospective application requires significant estimates for a prior period and the company cannot objectively verify the necessary information to develop these estimates. Copyright © 2018 John Wiley & Sons, Inc. Kieso Intermediate: IFRS 3e, Instructor’s Manual 22-3 Changes in Estimates 13. (L.O. 2) The IASB requires that changes in estimates (for example, uncollectible receivables, useful lives, and salvage values of assets) should be handled prospectively. Opening balances are not adjusted and no attempt is made to “catch up” for prior periods. The effects of all changes in estimates are accounted for in (a) the period of change if the change affects that period only or (b) the period of change and future periods if the change affects both. 14. For example, if an asset with a cost of £250,000 and no salvage value were originally depreciated on a straight-line basis for the first 7 years of its 25-year useful life, the book value of the asset at the end of year 7 would be £180,000 (£250,000 – £70,000). If the estimated useful life was revised at the end of year 7, and the asset was assumed to have a remaining useful life of 9 years, the following journal entry would be made for depreciation at the end of year 8: Depreciation Expense ............................................. Accumulated Depreciation .............................. 20,000* 20,000 *(£180,000/9) Whenever it is impossible to determine whether a change in policy or a change in estimate has occurred, the change should be considered a change in estimate. In addition, some problems arise in differentiating between a change in an estimate and a correction of an error. The general rule is that careful estimates that later prove to be incorrect should be considered changes in estimates. Corrections of Errors 15. (L.O. 3) The IASB requires that corrections of errors be (a) treated as prior period adjustments, (b) recorded in the year in which the error was discovered, and (c) reported in the financial statements as an adjustment to the beginning balance of retained earnings. If comparative statements are presented, the prior statements affected should be restated to correct for the error. 16. Errors include: 22-4 a. A change from an accounting policy that is not generally accepted to an accounting policy that is acceptable. b. Mathematical mistakes. c. Changes in estimates that occur because a company did not prepare the estimates in good faith. d. An oversight or a misuse of facts. e. The incorrect classification of a cost as an expense instead of an asset, and vice versa. Copyright © 2018 John Wiley & Sons, Inc. Kieso Intermediate: IFRS 3e, Instructor’s Manual 17. The text includes a Summary of Guidelines for Accounting Changes and Errors (Illustration 22-21). This summary indicates the accounting to be accorded an accounting change or changes due to an error along with the financial statement presentation to be considered. This summary is an effective way to review the major concepts and to assess your understanding of the manner in which accounting changes and errors should be handled in the financial statements. Motivations for Change of Accounting Policy 18. Managers might have varying motives for reporting income numbers. Research shows some of these reasons involve political costs, capital structure, bonus payments, and to smooth earnings. To counter these pressures, the IASB has declared they will assess proposed standards from a position of neutrality. Error Analysis 19. (L.O. 4) Errors occurring in the accounting process can result from mathematical mistakes, bad faith accounting estimates, misapplication of accounting policies, as well as numerous other causes. As indicated earlier, the profession requires that errors be treated as prior period adjustments and be reported in the current year as adjustments to the beginning balance of Retained Earnings. 20. Counterbalancing errors are errors that occur in one period and correct themselves in the next period. Noncounterbalancing errors take longer than two periods to correct themselves and sometimes may exist until the item in error is no longer a part of the entity’s financial statements. In the case of counterbalancing errors found at the end of the first period, the necessity for preparing a correcting journal entry depends on whether or not the books have been closed. If the books have been closed, no correcting entry is needed. Noncounterbalancing errors should always be corrected if discovered before they correct themselves, even if the books have been closed. The following indicates the accounting treatment for counterbalancing errors based on whether or not the books are closed. 1. The books have been closed. a. If the error has already counterbalanced, no entry is necessary. b. If the error has not yet counterbalanced, an entry is necessary to adjust the beginning balance of Retained Earnings. 2. The books have not been closed. a. If the error has already counterbalanced and we are in the second year, an entry is necessary to correct the current period and to adjust the beginning balance of Retained Earnings. b. If the error is not yet counterbalanced, an entry is necessary to adjust the beginning balance of Retained Earnings and correct the current period. Copyright © 2018 John Wiley & Sons, Inc. Kieso Intermediate: IFRS 3e, Instructor’s Manual 22-5 21. Some examples of counterbalancing and noncounterbalancing errors are presented here: Counterbalancing Errors a. Failure to record accrued revenues or expenses. b. Failure to record prepaid revenues or expenses. c. Overstatement or understatement of purchases. d. Overstatement or understatement of ending inventory. Noncounterbalancing Errors a. Failure to record depreciation. b. Recording a depreciable asset as an expense. c. Recording the purchase of land as an expense. d. Failure to adjust for bad debts. 22. To demonstrate a counterbalancing error assume a building owner received a rent payment for the 2019 rent of €24,000 on December 31, 2018. The following entry was made on 12/31/18 and no adjustment was recorded: Cash ................................................................. Rent Revenue.............................................. 24,000 24,000 This would cause Rent Revenue to be overstated in 2018. If the error were found in 2019, the following entry would be made assuming the books had not been closed for 2019: Retained Earnings ............................................ Rent Revenue.............................................. 24,000 24,000 This entry would reduce Retained Earnings for the overstatement of Rent Revenue in 2018 and properly state the Rent Revenue account for 2019. If this error were discovered after the books were closed in 2019, no entry would be made because the error is counterbalanced. 23. In situations where a great many errors are encountered, use of a worksheet, as demonstrated in the text, can facilitate analysis and ultimate correction of account balances. When numerous accounting errors are encountered, it is important to have an organized approach in deciding on the account balances in need of adjustment. The work sheet provides the organization necessary to provide an orderly approach to error correction. Review of the comprehensive illustration on error correction at the end of the chapter will benefit the student’s understanding of the work sheet and the suggested approach to error analysis and correction. 22-6 Copyright © 2018 John Wiley & Sons, Inc. Kieso Intermediate: IFRS 3e, Instructor’s Manual LECTURE OUTLINE The material in this chapter can be covered in two class periods. Students are better able to differentiate the various types of accounting changes if the journal entries and reporting of each type are demonstrated. A. (L.O.1) Two Types of Accounting Changes. 1. Change in Accounting Policy. 2. Change in Accounting Estimate. B. Changes in Accounting Policy. 1. Involves a change from one accepted accounting policy to another accepted accounting policy. Example: Change the basis of inventory pricing from average cost to FIFO. 2. A change is not a result of the adoption of a new policy in recognition of events that have occurred for the first time or that were previously immaterial. Example: Capitalizing leases whereas previously leases were not capitalized because they were not material. 3. If the accounting policy previously followed was not acceptable, or if the policy was applied incorrectly, the change is considered a correction of an error. Example: Change from capitalizing all research and development expenditures to expensing those not eligible for capitalization. 4. Changes in accounting policy are considered appropriate only when the enterprise demonstrates that the alternative accepted accounting policy is preferable to the existing one. 5. Three approaches for reporting such changes have been considered: a. Report changes currently. The cumulative effect of the change is reported in the current year’s income statement as an irregular item. (1) Cumulative effect is difference between prior years’ income using the old method and the new method. (2) Company does not change prior year financial statements. b. Report changes retrospectively. (1) Prior years’ statements are restated as if the new policy had always been used. (2) Cumulative effect of the change is an adjustment to beginning retained earnings of the earliest year presented. Copyright © 2018 John Wiley & Sons, Inc. Kieso Intermediate: IFRS 3e, Instructor’s Manual 22-7 c. Report changes prospectively. Previous periods’ statements are not adjusted to reflect the change in policy. 6. IASB requires the use of the retrospective approach. a. Provides information that is more useful to statement users. b. Changing prior years’ statements to reflect the change in policy results in greater consistency across periods. C. Retrospective Accounting Change Approach. 1. Procedures required: a. Adjust financial statements for each prior period presented. b. Adjust the carrying amounts of assets and liabilities as of the beginning of the first year presented. c. Make an offsetting adjustment to the opening balance of retained earnings (or other appropriate component of equity) as of the beginning of the first year presented. 2. Major disclosure requirements: a. The nature of the change in policy and reasons why the new policy provides reliable and more relevant information. b. For the current and each prior period presented the amount of adjustment to each financial statement line item and EPS. c. The amount of the adjustment relating to periods prior to those presented. 3. Direct and indirect effects of changes in accounting policy a. Direct effects should be presented retrospectively; for example, the adjustment to an inventory balance because of a change in the inventory valuation method. b. The IASB does not provide guidance regarding indirect effects, however, U.S. GAAP requires that indirect effects do not change prior period amounts. D. (L.O.4) How to Account for Impracticable Changes. 1. The retrospective approach should not be used if any one of the following conditions exists: a. The company cannot determine the effects of the retrospective approach. b. Application of the retrospective approach requires assumptions about management’s intent in a prior period. 22-8 Copyright © 2018 John Wiley & Sons, Inc. Kieso Intermediate: IFRS 3e, Instructor’s Manual c. The company cannot verify the necessary information needed to develop any estimates for a prior period under the retrospective approach. 2. Apply the prospective approach as of the earliest date practicable, if the retrospective approach is deemed impracticable. 3. Disclosures. a. The effect of the change on the results of operations in the period of change. b. An explanation of the reasons for omitting the computations of the cumulative effect for prior years. c. Justification for the change in method. E. (L.O. 2) Changes in Accounting Estimate. 1. Changes in accounting estimates are reported prospectively. 2. When it is impossible to tell whether a change in policy or a change in estimate has occurred, the change is considered a change in estimate. 3. Careful estimates that later prove to be incorrect should be considered changes in estimate, not errors. 4. Disclosures. A company should disclose the nature and amount of a change in an accounting estimate that has an effect in the current period or is expected to have an effect in future periods (unless it is impracticable to estimate that effect). F. (L.O. 3) Correction of an Error. 1. Record and report as prior period adjustments. 2. Types of errors include: a. A change from an accounting policy that is not acceptable to an accounting policy that is acceptable. b. Mathematical mistakes. c. Changes in estimates that occur because a company did not prepare the estimates in good faith. d. An oversight or a misuse of facts. Copyright © 2018 John Wiley & Sons, Inc. Kieso Intermediate: IFRS 3e, Instructor’s Manual 22-9 e. The incorrect classification of a cost as an expense instead of an asset, and vice versa. G. Management’s Motivation for Accounting Changes. 1. Political costs: Companies with high political visibility may be more inclined to adopt accounting methods that will decrease net income. 2. Capital structure: Companies with high debt-to-equity ratios are more likely to select accounting methods that will increase net income. 3. Bonus payments: Management will select accounting methods that maximize income, if their bonuses are tied to income. 4. Smooth earnings: In order to avoid the attention of politicians, regulators, and competitors, companies sometimes chose accounting methods that provide gradual increases in income. H. (L.O. 4) Error Analysis. 1. Statement of Financial Position Errors. Only affect assets, liabilities, and/or equity: Example: A misclassification of an asset. 2. Income Statement Errors. Only affect revenues and/or expenses. Example: misclassification of a revenue account a 3. Statement of Financial Position and Income Statement Effect. a. Counterbalancing errors are those that will be offset or corrected over two periods. Example: Errors with respect to inventory. (1) If the books have been closed: (a) No entry necessary, if error already counterbalanced. (b) If error not yet counterbalanced, need entry to adjust retained earnings. (2) If the books have not been closed: (a) If error already counterbalanced and company is in second year, need entry to adjust the beginning retained earnings balance and to correct the current year. (b) If error not yet counterbalanced, also need entry to correct beginning retained earnings balance and correct the current period. (3) If comparative statements presented, restatement of the amounts is necessary even if a correcting entry is not required. 22-10 Copyright © 2018 John Wiley & Sons, Inc. Kieso Intermediate: IFRS 3e, Instructor’s Manual b. Noncounterbalancing errors are those that take longer than two periods to correct themselves or never correct themselves. Example: Errors with respect to depreciation. Correcting entries are needed, even if the books have been closed. Copyright © 2018 John Wiley & Sons, Inc. Kieso Intermediate: IFRS 3e, Instructor’s Manual 22-11
