LEARNING OBJECTIVES
After studying this chapter, you should be able to:
The FASB's conceptual framework describes comparability (including consistency) as one of the qualitative characteristics that contribute to the usefulness of accounting information. Unfortunately, companies are finding it difficult to maintain comparability and consistency due to the numerous changes in accounting principles mandated by the FASB. In addition, a number of companies have faced restatements due to errors in their financial statements. For example, the table below shows types and numbers of recent accounting changes.
Although the percentage of companies reporting material changes or errors is small, readers of financial statements still must be careful. The reason: The amounts in the financial statements may have changed due to changing accounting principles and/or restatements. The chart below indicates the recent trends in restatements.
There is much good news in the chart. In 2007, restatements declined by 32.2 percent (from 1,790 to 1,213). In 2008, restatements declined another 24 percent (from 1,213 to 922). The declining trend continued in 2009, with restatements stabilized at pre-crisis levels in 2010 and 2011. However, investors can be in the dark when a company has an error that requires restatement. It may take some time for companies to sort out the source of an error, prepare corrected statements, and get auditor sign-off. Recent data indicate it takes on average about 3 months to resolve a restatement. The following table reports the range of periods when investors are in the dark due to a restatement.
CONCEPTUAL FOCUS
INTERNATIONAL FOCUS
While most companies (77%) resolve their errors within 3 months, 12 percent (or over 200 companies) take more than 9 months to file corrected statements.
These lengthy “dark periods” have caught the attention of policy-setters and were a topic of discussion of the Committee for Improvements in Financial Reporting (CIFR). As one member of CIFR noted, “The dark period is bad for users.” As a result, the committee is proposing that for some errors, companies might not need to go through the pain of restatement, but enhanced disclosures about errors are needed.
Sources: Accounting change data from Accounting Trends and Techniques—2011–2012 (New York: AICPA, 2011–2012). Restatement data from 2011 Financial Restatements: A Nine Year Comparison, Audit Analytics (April 2012), p. 3; M. Leone, “Materiality Debate Emerges from the Dark,” CFO.com (July 14, 2008); and B. Badertscher and J. Burks, “Accounting Restatements and the Timeliness of Disclosures,” Accounting Horizons (December 2011), pp. 609–629.
PREVIEW OF CHAPTER 22
As our opening story indicates, changes in accounting principles and errors in financial information have increased substantially in recent years. When these changes occur, companies must follow specific accounting and reporting requirements. In addition, to ensure comparability among companies, the FASB has standardized reporting of accounting changes, accounting estimates, error corrections, and related earnings per share information. In this chapter, we discuss these reporting standards, which help investors better understand a company's financial condition. The content and organization of the chapter are as follows.
Accounting alternatives diminish the comparability of financial information between periods and between companies; they also obscure useful historical trend data. For example, if Ford revises its estimates for equipment useful lives, depreciation expense for the current year will not be comparable to depreciation expense reported by Ford in prior years. Similarly, if OfficeMax changes to FIFO inventory pricing while Staples uses LIFO, it will be difficult to compare these companies' reported results. A reporting framework helps preserve comparability when there is an accounting change.
See the FASB Codification section (page 1381).
The FASB has established a reporting framework, which involves three types of accounting changes. [1] The three types of accounting changes are:
Underlying Concepts
While changes in accounting may enhance the qualitative characteristic of usefulness, these changes may adversely affect the enhancing characteristics of comparability and consistency.
A fourth category necessitates changes in accounting, though it is not classified as an accounting change.
4. Errors in financial statements. Errors result from mathematical mistakes, mistakes in applying accounting principles, or oversight or misuse of facts that existed when preparing the financial statements. For example, a company may incorrectly apply the retail inventory method for determining its final inventory value.
The FASB classifies changes in these categories because each category involves different methods of recognizing changes in the financial statements. In this chapter, we discuss these classifications. We also explain how to report each item in the accounts and how to disclose the information in comparative statements.
LEARNING OBJECTIVE
Describe the accounting for changes in accounting principles.
By definition, a change in accounting principle involves a change from one generally accepted accounting principle to another. For example, a company might change the basis of inventory pricing from average-cost to LIFO. Or, it might change its method of revenue recognition for long-term construction contracts from the completed-contract to the percentage-of-completion method.
Companies must carefully examine each circumstance to ensure that a change in principle has actually occurred. 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. For example, a change in accounting principle has not occurred when a company adopts an inventory method (e.g., FIFO) for newly acquired items of inventory, even if FIFO differs from that used for previously recorded inventory. Another example is certain marketing expenditures that were previously immaterial and expensed in the period incurred. It would not be considered a change in accounting principle if they become material and so may be acceptably deferred and amortized.
Finally, what if a company previously followed an accounting principle that was not acceptable? Or what if the company applied a principle incorrectly? In such cases, the profession considers a change to a generally accepted accounting principle a correction of an error. For example, a switch from the cash (income tax) basis of accounting to the accrual basis is a correction of an error. Or, if a company deducted salvage value when computing double-declining depreciation on plant assets and later recomputed depreciation without deducting estimated salvage value, it has corrected an error.
There are three possible approaches for reporting changes in accounting principles:
Advocates of this position argue that changing prior years' financial statements results in a loss of confidence in financial reports. How do investors react when told that the earnings computed three years ago are now entirely different? Changing prior periods, if permitted, also might upset contractual arrangements based on the old figures. For example, profit-sharing arrangements computed on the old basis might have to be recomputed and completely new distributions made, creating numerous legal problems. Many practical difficulties also exist. The cost of changing prior period financial statements may be excessive, or determining the amount of the prior period effect may be impossible on the basis of available data.
Advocates of this position argue that retrospective application ensures comparability. Think for a moment what happens if this approach is not used. The year previous to the change will be on the old method, the year of the change will report the entire cumulative adjustment, and the following year will present financial statements on the new basis without the cumulative effect of the change. Such lack of consistency fails to provide meaningful earnings-trend data and other financial relationships necessary to evaluate the business.
International Perspective
IFRS (IAS 8) generally requires retrospective application to prior years for accounting changes. However, IAS 8 permits the prospective method if a company cannot reasonably determine the amounts to which to restate prior periods.
Given these three possible approaches, which does the accounting profession prefer? The FASB requires that companies use the retrospective approach. Why? Because it provides financial statement users with more useful information than the cumulative-effect or prospective approaches. [2] The rationale is that changing the prior statements to be on the same basis as the newly adopted principle results in greater consistency across accounting periods. Users can then better compare results from one period to the next.1
The cumulative-effect approach results in a loss of comparability. Also, reporting the cumulative adjustment in the period of the change can significantly affect net income, resulting in a misleading income figure. For example, at one time Chrysler Corporation changed its inventory accounting from LIFO to FIFO. If Chrysler had used the cumulative-effect approach, it would have reported a $53,500,000 adjustment to net income. That adjustment would have resulted in net income of $45,900,000, instead of a net loss of $7,600,000.
A second case: In the early 1980s, the railroad industry switched from the retirement-replacement method of depreciating railroad equipment to more generally used methods such as straight-line depreciation. Using cumulative treatment, railroad companies would have made substantial adjustments to income in the period of change. Many in the industry argued that including such large cumulative-effect adjustments in the current year would distort the information and make it less useful.
Such situations lend support to retrospective application so that comparability is maintained.
LEARNING OBJECTIVE
Understand how to account for retrospective accounting changes.
A presumption exists that once a company adopts an accounting principle, it should not change. That presumption is understandable, given the idea that consistent use of an accounting principle enhances the usefulness of financial statements. However, the environment continually changes, and companies change in response. Recent standards on such subjects as stock options, exchanges of non-monetary assets, and derivatives indicate that changes in accounting principle will continue to occur.
Underlying Concepts
Retrospective application contributes to comparability.
When a company changes an accounting principle, it should report the change using retrospective application. In general terms, here is what it must do:
For example, assume that Target decides to change its inventory valuation method in 2014 from the retail inventory method (FIFO) to the retail inventory method (average-cost). It provides comparative information for 2012 and 2013 based on the new method. Target would adjust its assets, liabilities, and retained earnings for periods prior to 2012 and report these amounts in the 2012 financial statements, when it prepares comparative financial statements.
To illustrate the retrospective approach, assume that Denson Company has accounted for its income from long-term construction contracts using the completed-contract method. In 2014, 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% enacted tax rate.)
Illustration 22-1 shows portions of three income statements for 2012–2014—for both the completed-contract and percentage-of-completion methods (2012 was Denson's first year of operations in the construction business).
ILLUSTRATION 22-1 Comparative Income Statements for Completed-Contract versus Percentage-of-Completion Methods
To record a change from the completed-contract to the percentage-of-completion method, we analyze the various effects, as Illustration 22-2 shows.
The entry to record the change at the beginning of 2014 would be:
The Construction in Process account increases by $220,000 (as indicated in the first column under “Difference in Income” in Illustration 22-2). The credit to Retained Earnings of $132,000 reflects the cumulative income effects prior to 2014 (third column under “Difference in Income” in Illustration 22-2). The company credits Retained Earnings because prior years' income is closed to this account each year. The credit to Deferred Tax Liability represents the adjustment to prior years' tax expense. The company now recognizes that amount, $88,000, as a tax liability for future taxable amounts. That is, in future periods, taxable income will be higher than book income as a result of current temporary differences. Therefore, Denson must report a deferred tax liability in the current year.
Halliburton offers a case study in the importance of good reporting of an accounting change. Note that Halliburton uses percentage-of-completion accounting for its long-term construction-services contracts. The SEC questioned the company about its change in accounting for disputed claims.
Prior to the year of the change, Halliburton took a very conservative approach to its accounting for disputed claims. That is, the company waited until all disputes were resolved before recognizing associated revenues. In contrast, in the year of the change, the company recognized revenue for disputed claims before their resolution, using estimates of amounts expected to be recovered. Such revenue and its related profit are more tentative and subject to possible later adjustment. The accounting method adopted is more aggressive than the company's former policy but is within the boundaries of GAAP.
It appears that the problem with Halliburton's accounting stems more from how the company handled its accounting change than from the new method itself. That is, Halliburton did not provide in its annual report in the year of the change an explicit reference to its change in accounting method. In fact, rather than stating its new policy, the company simply deleted the sentence that described how it accounted for disputed claims. Then later, in its next year's annual report, the company stated its new accounting policy.
When companies make such changes in accounting, investors need to be informed about the change and about its effects on the financial results. With such information, investors and analysts can compare current results with those of prior periods and can make a more informed assessment about the company's future prospects.
Source: Adapted from “Accounting Ace Charles Mulford Answers Accounting Questions,” Wall Street Journal Online (June 7, 2002).
Reporting a Change in Principle. The disclosure of accounting changes is particularly important. Financial statement readers want consistent information from one period to the next. Such consistency ensures the usefulness of financial statements. The major disclosure requirements are as follows.
(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 (or other appropriate captions of changes in net assets or performance indicators), any other affected line item, and any affected per share amounts for the current period and for any prior periods retrospectively adjusted.
(c) 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.2
To illustrate, Denson will prepare comparative financial statements for 2013 and 2014 using the percentage-of-completion method (the new construction accounting method). Illustration 22-3 indicates how Denson presents this information.
As Illustration 22-3 shows, Denson Company reports net income under the newly adopted percentage-of-completion method for both 2013 and 2014. The company retrospectively adjusted the 2013 income statement to report the information on a percentage-of-completion basis. Also, the note to the financial statements indicates the nature of the change, why the company made the change, and the years affected.
In addition, companies are required to provide data on important differences between the amounts reported under percentage-of-completion versus completed-contract. When identifying the significant differences, some companies show the entire financial statements and line-by-line differences between percentage-of-completion and completed-contract. However, most companies will show only line-by-line differences. For example, Denson would show the differences in construction in process, retained earnings, gross profit, and net income for 2013 and 2014 under the completed-contract and percentage-of-completion methods.
Retained Earnings Adjustment. As indicated earlier, one of the disclosure requirements is to show the cumulative effect of the change on retained earnings as of the beginning of the earliest period presented. For Denson Company, that date is January 1, 2013. Denson disclosed that information by means of a narrative description (see Note A in Illustration 22-3). Denson also would disclose this information in its retained earnings statement. Assuming a retained earnings balance of $1,360,000 at the beginning of 2012, Illustration 22-4 shows Denson's retained earnings statement under the completed-contract method—that is, before giving effect to the change in accounting principle. (The income information comes from Illustration 22-1 on page 1347.)
If Denson presents comparative statements for 2013 and 2014 under percentage-of-completion, then it must change the beginning balance of retained earnings at January 1, 2013. The difference between the retained earnings balances under completed-contract and percentage-of-completion is computed as follows.
The $120,000 difference is the cumulative effect. Illustration 22-5 shows a comparative retained earnings statement for 2013 and 2014, giving effect to the change in accounting principle to percentage-of-completion.
Denson adjusted the beginning balance of retained earnings on January 1, 2013, for the excess of percentage-of-completion net income over completed-contract net income in 2012. This comparative presentation indicates the type of adjustment that a company needs to make. It follows that this adjustment would be much larger if a number of prior periods were involved.
As a second illustration of the retrospective approach, assume that Lancer Company has accounted for its inventory using the LIFO method. In 2014, the company changes to the FIFO method because management believes this approach provides a more appropriate reporting of its inventory costs. Illustration 22-6 provides additional information related to Lancer Company.
Given the information about Lancer Company, Illustration 22-7 shows its income statement, retained earnings statement, balance sheet, and statement of cash flows for 2012–2014 under LIFO.
As Illustration 22-7 indicates, under LIFO Lancer Company reports $120,000 net income in 2012, $100,000 net income in 2013, and $87,000 net income in 2014. The amount of inventory reported on Lancer's balance sheet reflects LIFO costing.
Illustration 22-8 shows Lancer's income statement, retained earnings statement, balance sheet, and statement of cash flows for 2012–2014 under FIFO. You can see that the cash flow statement under FIFO is the same as under LIFO. Although the net incomes are different in each period, there is no cash flow effect from these differences in net income. (If we considered income taxes, a cash flow effect would result.)
Compare the financial statements reported in Illustration 22-7 and Illustration 22-8. You can see that under retrospective application, the change to FIFO inventory valuation affects reported inventories, cost of goods sold, net income, and retained earnings. In the following sections, we discuss the accounting and reporting of Lancer's accounting change from LIFO to FIFO.
Given the information provided in Illustrations 22-6, 22-7, and 22-8, we now are ready to account for and report on the accounting change.
Our first step is to adjust the financial records for the change from LIFO to FIFO. To do so, we perform the analysis in Illustration 22-9.
The entry to record the change to the FIFO method at the beginning of 2014 is as follows.
The change increases the Inventory account by $5,000. This amount represents the difference between the ending inventory at December 31, 2013, under LIFO ($20,000) and the ending inventory under FIFO ($25,000). The credit to Retained Earnings indicates the amount needed to change the prior year's income, assuming that Lancer had used FIFO in previous periods.
Reporting a Change in Principle. Lancer Company will prepare comparative financial statements for 2013 and 2014 using FIFO (the new inventory method). Illustration 22-10 indicates how Lancer might present this information.
As Illustration 22-10 shows, Lancer Company reports net income under the newly adopted FIFO method for both 2013 and 2014. The company retrospectively adjusted the 2013 income statement to report the information on a FIFO basis. In addition, the note to the financial statements indicates the nature of the change, why the company made the change, and the years affected. The note also provides data on important differences between the amounts reported under LIFO versus FIFO. (When identifying the significant differences, some companies show the entire financial statements and line-by-line differences between LIFO and FIFO.)
Retained Earnings Adjustment. As indicated earlier, one of the disclosure requirements is to show the cumulative effect of the change on retained earnings as of the beginning of the earliest period presented. For Lancer Company, that date is January 1, 2013. Lancer disclosed that information by means of a narrative description (see Note A in Illustration 22-10). Lancer also would disclose this information in its retained earnings statement. Illustration 22-11 shows Lancer's retained earnings statement under LIFO—that is, before giving effect to the change in accounting principle. (This information comes from Illustration 22-7 on page 1351.)
If Lancer presents comparative statements for 2013 and 2014 under FIFO, then it must change the beginning balance of retained earnings at January 1, 2013. The difference between the retained earnings balances under LIFO and FIFO is computed as follows.
The $2,000 difference is the cumulative effect. Illustration 22-12 shows a comparative retained earnings statement for 2013 and 2014, giving effect to the change in accounting principle to FIFO.
Lancer adjusted the beginning balance of retained earnings on January 1, 2013, for the excess of FIFO net income over LIFO net income in 2012. This comparative presentation indicates the type of adjustment that a company needs to make. It follows that the amount of this adjustment would be much larger if a number of prior periods were involved.
Are there other effects that a company should report when it makes a change in accounting principle? For example, what happens when a company like Lancer has a bonus plan based on net income and the prior year's net income changes when FIFO is retrospectively applied? Should Lancer also change the reported amount of bonus expense? Or what happens if we had not ignored income taxes in the Lancer example? Should Lancer adjust net income, given that taxes will be different under LIFO and FIFO in prior periods? The answers depend on whether the effects are direct or indirect.
The FASB takes the position that companies should retrospectively apply the direct effects of a change in accounting principle. An example of a direct effect is an adjustment to an inventory balance as a result of a change in the inventory valuation method. For example, Lancer Company should change the inventory amounts in prior periods to indicate the change to the FIFO method of inventory valuation. Another inventory-related example would be an impairment adjustment resulting from applying the lower-of-cost-or-market test to the adjusted inventory balance. Related changes, such as deferred income tax effects of the impairment adjustment, are also considered direct effects. This entry was illustrated in the Denson example, in which the change to percentage-of-completion accounting resulted in recording a deferred tax liability.
In addition to direct effects, companies can have indirect effects related to a change in accounting principle. An indirect effect is any change to current or future cash flows of a company that result from making a change in accounting principle that is applied retrospectively. An example of an indirect effect is a change in profit-sharing or royalty payment that is based on a reported amount such as revenue or net income. Indirect effects do not change prior period amounts.
International Perspective
IFRS does not explicitly address the accounting and disclosure of indirect effects.
For example, let's assume that Lancer has an employee profit-sharing plan based on net income. As Illustration 22-9 showed (on page 1353), Lancer would report higher income in 2012 and 2013 if it used the FIFO method. In addition, let's assume that the profit-sharing plan requires that Lancer pay the incremental amount due based on the FIFO income amounts. In this situation, Lancer reports this additional expense in the current period; it would not change prior periods for this expense. If the company prepares comparative financial statements, it follows that it does not recast the prior periods for this additional expense.3
If the terms of the profit-sharing plan indicate that no payment is necessary in the current period due to this change, then the company need not recognize additional profit-sharing expense in the current period. Neither does it change amounts reported for prior periods.
When a company recognizes the indirect effects of a change in accounting principle, it includes in the financial statements a description of the indirect effects. In doing so, it discloses the amounts recognized in the current period and related per share information.
It is not always possible for companies to determine how they would have reported prior periods' financial information under retrospective application of an accounting principle change. Retrospective application is considered impracticable if a company cannot determine the prior period effects using every reasonable effort to do so.
Companies should not use retrospective application if one of the following conditions exists:
If any of the above conditions exists, it is deemed impracticable to apply the retrospective approach. In this case, the company prospectively applies the new accounting principle as of the earliest date it is practicable to do so. [5]
For example, assume that Williams Company changed its inventory method from FIFO to LIFO, effective January 1, 2015. Williams prepares statements on a calendar-year basis and has used the FIFO method since its inception. Williams judges it impracticable to retrospectively apply the new method. Determining prior period effects would require subjective assumptions about the LIFO layers established in prior periods. These assumptions would ordinarily result in the computation of a number of different earnings figures.
As a result, the only adjustment necessary may be to restate the beginning inventory to a cost basis from a lower-of-cost-or-market approach (which establishes the beginning LIFO layer). Williams must disclose only the effect of the change on the results of operations in the period of change. Also, the company should explain the reasons for omitting the computations of the cumulative effect for prior years. Finally, it should disclose the justification for the change to LIFO. [6]4 Illustration 22-13, from the annual report of The Quaker Oats Company, shows the type of disclosure needed.
To prepare financial statements, companies must estimate the effects of future conditions and events. For example, the following items require estimates.
A company cannot perceive future conditions and events and their effects with certainty. Therefore, estimation requires the exercise of judgment. Accounting estimates will change as new events occur, as a company acquires more experience, or as it obtains additional information.
Companies report prospectively changes in accounting estimates. That is, companies should not adjust previously reported results for changes in estimates. Instead, they account for the effects of all 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, the natural result of the accounting process. It prohibits retrospective treatment.
The circumstances related to a change in estimate differ from those for a change in accounting principle. If companies reported changes in estimates retrospectively, continual adjustments of prior years' income would occur. It seems proper to accept the view that, because new conditions or circumstances exist, the revision fits the new situation (not the old one). Companies should therefore handle such a revision in the current and future periods.
To illustrate, Underwriters Labs Inc. purchased for $300,000 a building that it originally estimated to have a useful life of 15 years and no salvage value. It recorded depreciation for 5 years on a straight-line basis. On January 1, 2014, Underwriters Labs revises the estimate of the useful life. It now considers the asset to have a total life of 25 years. (Assume that the useful life for financial reporting and tax purposes and depreciation method are the same.) Illustration 22-14 shows the accounts at the beginning of the sixth year.
Underwriters Labs records depreciation for the year 2014 as follows.
The company computes the $10,000 depreciation charge as shown in Illustration 22-15.
Companies sometime find it difficult to differentiate between a change in estimate and a change in accounting principle. Is it a change in principle or a change in estimate when a company changes from deferring and amortizing marketing costs to expensing them as incurred because future benefits of these costs have become doubtful? If it is impossible to determine whether a change in principle or a change in estimate has occurred, the rule is this: Consider the change as a change in estimate. This is often referred to as a change in estimate effected by a change in accounting principle.
Another example of a change in estimate effected by a change in principle is a change in depreciation (as well as amortization or depletion) methods. Because companies change depreciation methods based on changes in estimates about future benefits from long-lived assets, it is not possible to separate the effect of the accounting principle change from that of the estimates. As a result, companies account for a change in depreciation methods as a change in estimate effected by a change in accounting principle. [7]
A similar problem occurs in differentiating between a change in estimate and a correction of an error, although here the answer is more clear-cut. How does a company determine whether it overlooked the information in earlier periods (an error), or whether it obtained new information (a change in estimate)? Proper classification is important because the accounting treatment differs for corrections of errors versus changes in estimates. The general rule is this: Companies should consider careful estimates that later prove to be incorrect as changes in estimate. Only when a company obviously computed the estimate incorrectly because of lack of expertise or in bad faith should it consider the adjustment an error. There is no clear demarcation line here. Companies must use good judgment in light of all the circumstances.5
Illustration 22-16 shows disclosure of a change in estimated useful lives, which appeared in the annual report of Ampco–Pittsburgh Corporation.
For the most part, companies need not disclose changes in accounting estimates 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. When a company has a change in estimate effected by a change in accounting principle, it must indicate why the new method is preferable. In addition, companies are subject to all other disclosure guidelines established for changes in accounting principle.
LEARNING OBJECTIVE
Identify changes in a reporting entity.
Occasionally, companies make changes that result in different reporting entities. In such cases, companies report the change by changing the financial statements of all prior periods presented. The revised statements show the financial information for the new reporting entity for all periods.
Examples of a change in reporting entity are:
In the year in which a company changes a reporting entity, it should disclose in the financial statements the nature of the change and the reason for it. It also should report, for all periods presented, the effect of the change on income before extraordinary items, net income, and earnings per share. These disclosures need not be repeated in subsequent periods' financial statements.
Illustration 22-17 shows a note disclosing a change in reporting entity, from the annual report of Hewlett-Packard Company.
LEARNING OBJECTIVE
Describe the accounting for correction of errors.
No business, large or small, is immune from errors. As the opening story discusses, the number of accounting errors that lead to restatement are beginning to decline. However, without accounting and disclosure guidelines for the reporting of errors, investors can be left in the dark about the effects of errors.
Certain errors, such as misclassifications of balances within a financial statement, are not as significant to investors as other errors. Significant errors would be those resulting in overstating assets or income, for example. However, investors should know the potential impact of all errors. Even “harmless” misclassifications can affect important ratios. Also, some errors could signal important weaknesses in internal controls that could lead to more significant errors.
In general, accounting errors include the following types:
Accounting errors occur for a variety of reasons. Illustration 22-18 indicates 11 major categories of accounting errors that drive restatements.
As soon as a company discovers an error, it must correct the error. Companies 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.7 [8]
If it presents comparative statements, a company should restate the prior statements affected, to correct for the error.8 The company need not repeat the disclosures in the financial statements of subsequent periods.
To illustrate, in 2015 the bookkeeper for Selectro Company discovered an error. In 2014, 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. Illustration 22-19 presents Selectro's income statement for 2014 (starting with income before depreciation expense) with and without the error.
Illustration 22-20 shows the entries that Selectro should have made and did make for recording depreciation expense and income taxes.
As Illustration 22-20 indicates, the $20,000 omission error in 2014 results in the following effects.
To make the proper correcting entry in 2015, Selectro should recognize that net income in 2014 is overstated by $12,000, the Deferred Tax Liability is overstated by $8,000, and Accumulated Depreciation—Buildings is understated by $20,000. The entry to correct this error in 2015 is as follows.
The debit to Retained Earnings results because net income for 2014 is overstated. The debit to Deferred Tax Liability is made to remove this account, which was caused by the error. The credit to Accumulated Depreciation—Buildings reduces the book value of the building to its proper amount. Selectro will make the same journal entry to record the correction of the error in 2015 whether it prepares single-period (noncomparative) or comparative financial statements.
To demonstrate how to show this information in a single-period statement, assume that Selectro Company has a beginning retained earnings balance at January 1, 2015, of $350,000. The company reports net income of $400,000 in 2015. Illustration 22-21 shows Selectro's retained earnings statement for 2015.
The balance sheet in 2015 would not have any deferred tax liability related to the building, and Accumulated Depreciation—Buildings is now restated at a higher amount. The income statement would not be affected.
If preparing comparative financial statements, a company should make adjustments to correct the amounts for all affected accounts reported in the statements for all periods reported. The company should restate the data to the correct basis for each year presented. It should show any catch-up adjustment as a prior period adjustment to retained earnings for the earliest period it reported. These requirements are essentially the same as those for reporting a change in accounting principle.
For example, in the case of Selectro, the error of omitting the depreciation of $20,000 in 2014, discovered in 2015, results in the restatement of the 2014 financial statements. Illustration 22-22 shows the accounts that Selectro restates in the 2014 financial statements.
Selectro prepares the 2015 financial statements in comparative form with those of 2014 as if the error had not occurred. In addition, Selectro must disclose that it has restated its previously issued financial statements, and it describes the nature of the error. Selectro also must disclose the following.
Having guidelines for reporting accounting changes and corrections has helped resolve several significant and long-standing accounting problems. Yet, because of diversity in situations and characteristics of the items encountered in practice, use of professional judgment is of paramount importance. In applying these guidelines, the primary objective is to serve the users of the financial statements. Achieving this objective requires accuracy, full disclosure, and an absence of misleading inferences.
Illustration 22-23 summarizes the main distinctions and treatments presented in the discussion in this chapter.
Changes in accounting principle are appropriate only when a company demonstrates that the newly adopted generally accepted accounting principle is preferable to the existing one. Companies and accountants determine preferability on the basis of whether the new principle constitutes an improvement in financial reporting, not on the basis of the income tax effect alone.9
But it is not always easy to determine an improvement in financial reporting. How does one measure preferability or improvement? Such measurement varies from company to company. Quaker Oats Company, for example, argued that a change in accounting principle to LIFO inventory valuation “better matches current costs with current revenues” (see Illustration 22-13, page 1356). Conversely, another company might change from LIFO to FIFO because it wishes to report a more realistic ending inventory. How do you determine which is the better of these two arguments? Determining the preferable method requires some “standard” or “objective.” Because no universal standard or objective is generally accepted, the problem of determining preferability continues to be difficult.
Initially, the SEC took the position that the auditor should indicate whether a change in accounting principle was preferable. The SEC has since modified this approach, noting that greater reliance may be placed on management's judgment in assessing preferability. Even though the preferability criterion is difficult to apply, the general guidelines have acted as a deterrent to capricious changes in accounting principles.10 If a FASB rule creates a new principle, expresses preference for, or rejects a specific accounting principle, a change is considered clearly acceptable.
When companies report restatements, investors usually lose money. What should investors do if a company misleads them by misstating its financial results? Join other investors in a class-action suit against the company and in some cases, the auditor.
Class-action activity has picked up in recent years, and settlements can be large. To find out about class actions, investors can go online to see if they are eligible to join any class actions. Below are some recent examples.
The amounts reported are before attorney's fees, which can range from 15 to 30 percent of the total. Also, investors may owe taxes if the settlement results in a capital gain on the investment. Thus, investors can get back some of the money they lost due to restatements, but they should be prepared to pay an attorney and the government first.
Sources: Adapted from C. Coolidge, “Lost and Found,” Forbes (October 1, 2001), pp. 124–125; data from www.lawyersandsettlements.com as of 11/13/12.
Difficult as it is to determine which accounting standards have the strongest conceptual support, other complications make the process even more complex. These complications stem from the fact that managers have self-interest in how the financial statements make the company look. They naturally wish to show their financial performance in the best light. A favorable profit picture can influence investors, and a strong liquidity position can influence creditors. Too favorable a profit picture, however, can provide union negotiators and government regulators with ammunition during bargaining talks. Hence, managers might have varying motives for reporting income numbers.
Research has provided additional insight into why companies may prefer certain accounting methods.11 Some of these reasons are as follows.
Management pays careful attention to the accounting it follows and often changes accounting methods, not for conceptual reasons, but for economic reasons. As indicated throughout this textbook, such arguments have come to be known as economic consequences arguments. These arguments focus on the supposed impact of the accounting method on the behavior of investors, creditors, competitors, governments, or managers of the reporting companies themselves.13
Underlying Concepts
Neutrality is an important element of faithful representation.
To counter these pressures, standard-setters such as the FASB have declared, as part of their conceptual framework, that they will assess the merits of proposed standards from a position of neutrality. That is, they evaluate the soundness of standards on the basis of conceptual soundness, not on the grounds of possible impact on behavior. It is not the FASB's place to choose standards according to the kinds of behavior it wishes to promote and the kinds it wishes to discourage. At the same time, it must be admitted that some standards often will have the effect of influencing behavior. Yet their justification should be conceptual, and not viewed in terms of their economic impact.
LEARNING OBJECTIVE
Analyze the effect of errors.
In this section, we show some additional types of accounting errors. Companies generally do not correct for errors that do not have a significant effect on the presentation of the financial statements. For example, should a company with a total annual payroll of $1,750,000 and net income of $940,000 correct its financial statements if it finds it failed to record accrued wages of $5,000? No—it would not consider this error significant or material.
Obviously, defining materiality is difficult, and managers and auditors must use experience and judgment to determine whether adjustment is necessary for a given error. We assume all errors discussed in this section to be material and to require adjustment. (Also, we ignore all tax effects in this section.)
Companies must answer three questions in error analysis:
As indicated earlier, companies treat errors as prior period adjustments and report them in the current year as adjustments to the beginning balance of Retained Earnings. If a company presents comparative statements, it restates the prior affected statements to correct for the error.
Balance sheet errors affect only the presentation of an asset, liability, or stockholders' equity account. Examples are the classification of a short-term receivable as part of the investment section, the classification of a note payable as an account payable, and the classification of plant assets as inventory.
When the error is discovered, the company reclassifies the item to its proper position. If the company prepares comparative statements that include the error year, it should correctly restate the balance sheet for the error year.
Income statement errors involve the improper classification of revenues or expenses. Examples include recording interest revenue as part of sales, purchases as bad debt expense, and depreciation expense as interest expense. An income statement classification error has no effect on the balance sheet and no effect on net income.
A company must make a reclassification entry when it discovers the error, if it makes the discovery in the same year in which the error occurs. If the error occurred in prior periods, the company does not need to make a reclassification entry at the date of discovery because the accounts for the current year are correctly stated. (Remember that the company has closed the income statement accounts from the prior period to retained earnings.) If the company prepares comparative statements that include the error year, it restates the income statement for the error year.
The third type of error involves both the balance sheet and income statement. For example, assume that the bookkeeper overlooked accrued wages payable at the end of the accounting period. The effect of this error is to understate expenses, understate liabilities, and overstate net income for that period of time. This type of error affects both the balance sheet and the income statement. We classify this type of error in one of two ways—counterbalancing or noncounterbalancing.
Counterbalancing errors are those that will be offset or corrected over two periods. For example, the failure to record accrued wages is a counterbalancing error because over a two-year period the error will no longer be present. In other words, the failure to record accrued wages in the previous period means: (1) net income for the first period is overstated, (2) accrued wages payable (a liability) is understated, and (3) wages expense is understated. In the next period, net income is understated, accrued wages payable (a liability) is correctly stated, and wages expense is overstated. For the two years combined: (1) net income is correct, (2) wages expense is correct, and (3) accrued wages payable at the end of the second year is correct. Most errors in accounting that affect both the balance sheet and income statement are counterbalancing errors.
Noncounterbalancing errors are those that are not offset in the next accounting period. An example would be the failure to capitalize equipment that has a useful life of five years. If we expense this asset immediately, expenses will be overstated in the first period but understated in the next four periods. At the end of the second period, the effect of the error is not fully offset. Net income is correct in the aggregate only at the end of five years because the asset is fully depreciated at this point. Thus, noncounterbalancing errors are those that take longer than two periods to correct themselves.
Only in rare instances is an error never reversed. An example would be if a company initially expenses land. Because land is not depreciable, theoretically the error is never offset, unless the land is sold.
We illustrate the usual types of counterbalancing errors on the following pages. In studying these illustrations, keep in mind a couple of points.
First, determine whether the company has closed the books for the period in which the error is found:
(a) If the error is already counterbalanced, no entry is necessary.
(b) If the error is not yet counterbalanced, make an entry to adjust the present balance of retained earnings.
(a) If the error is already counterbalanced, make an entry to correct the error in the current period and to adjust the beginning balance of Retained Earnings.
(b) If the error is not yet counterbalanced, make an entry to adjust the beginning balance of Retained Earnings.
Second, if the company presents comparative statements, it must restate the amounts for comparative purposes. Restatement is necessary even if a correcting journal entry is not required.
To illustrate, assume that Sanford's Cement Co. failed to accrue revenue in 2012 when it fulfilled its performance obligation, but recorded the revenue in 2013 when it received payment. The company discovered the error in 2015. It does not need to make an entry to correct for this error because the effects have been counterbalanced by the time Sanford discovered the error in 2015. However, if Sanford presents comparative financial statements for 2012 through 2015, it must restate the accounts and related amounts for the years 2012 and 2013 for financial reporting purposes.
The sections that follow demonstrate the accounting for the usual types of counterbalancing errors.
Failure to Record Accrued Wages. On December 31, 2014, Hurley Enterprises did not accrue wages in the amount of $1,500. The entry in 2015 to correct this error, assuming Hurley has not closed the books for 2015, is:
The rationale for this entry is as follows. (1) When Hurley pays the 2014 accrued wages in 2015, it makes an additional debit of $1,500 to 2015 Salaries and Wages Expense. (2) Salaries and Wages Expense—2015 is overstated by $1,500. (3) Because the company did not record 2014 accrued wages as Salaries and Wages Expense in 2014, the net income for 2014 was overstated by $1,500. (4) Because 2014 net income is overstated by $1,500, the Retained Earnings account is overstated by $1,500 (because net income is closed to Retained Earnings).
If Hurley has closed the books for 2015, it makes no entry because the error is counterbalanced.
Failure to Record Prepaid Expenses. In January 2014, Hurley Enterprises purchased a two-year insurance policy costing $1,000. It debited Insurance Expense, and credited Cash. The company made no adjusting entries at the end of 2014.
The entry on December 31, 2015, to correct this error, assuming Hurley has not closed the books for 2015, is:
If Hurley has closed the books for 2015, it makes no entry because the error is counterbalanced.
Understatement of Unearned Revenue. On December 31, 2014, Hurley Enterprises received $50,000 as a prepayment for renting certain office space for the following year. At the time of receipt of the rent payment, the company recorded a debit to Cash and a credit to Rent Revenue. It made no adjusting entry as of December 31, 2014. The entry on December 31, 2015, to correct for this error, assuming that Hurley has not closed the books for 2015, is:
If Hurley has closed the books for 2015, it makes no entry because the error is counterbalanced.
Overstatement of Accrued Revenue. On December 31, 2014, Hurley Enterprises accrued as interest revenue $8,000 that applied to 2015. On that date, the company recorded a debit to Interest Receivable and a credit to Interest Revenue. The entry on December 31, 2015, to correct for this error, assuming that Hurley has not closed the books for 2015, is:
If Hurley has closed the books for 2015, it makes no entry because the error is counterbalanced.
Overstatement of Purchases. Hurley's accountant recorded a purchase of merchandise for $9,000 in 2014 that applied to 2015. The physical inventory for 2014 was correctly stated. The company uses the periodic inventory method. The entry on December 31, 2015, to correct for this error, assuming that Harley has not closed the books for 2015, is:
If Hurley has closed the books for 2015, it makes no entry because the error is counterbalanced.
The entries for noncounterbalancing errors are more complex. Companies must make correcting entries, even if they have closed the books.
Failure to Record Depreciation. Assume that on January 1, 2014, Hurley Enterprises purchased a machine for $10,000 that had an estimated useful life of five years. The accountant incorrectly expensed this machine in 2014, but discovered the error in 2015. If we assume that Hurley uses straight-line depreciation on this asset, the entry on December 31, 2015, to correct for this error, given that Hurley has not closed the books, is:
If Hurley has closed the books for 2015, the entry is:
Failure to Adjust for Bad Debts. Companies sometimes use a specific charge-off method in accounting for bad debt expense when a percentage of sales is more appropriate. They then make adjustments to change from the specific write-off to some type of allowance method. For example, assume that Hurley Enterprises has recognized bad debt expense when it has the following uncollectible debts.
Hurley estimates that it will charge off an additional $1,400 in 2016, of which $300 is applicable to 2014 sales and $1,100 to 2015 sales. The entry on December 31, 2015, assuming that Hurley has not closed the books for 2015, is:
If Hurley has closed the books for 2015, the entry is:
In some circumstances a combination of errors occurs. The company therefore prepares a worksheet to facilitate the analysis. The following problem demonstrates use of the worksheet. The mechanics of its preparation should be obvious from the solution format. The income statements of Hudson Company for the years ended December 31, 2013, 2014, and 2015, indicate the following net incomes.
An examination of the accounting records for these years indicates that Hudson Company made several errors in arriving at the net income amounts reported:
When paid in the year following that in which they were earned, Hudson recorded these amounts as expenses.
The first step in preparing the worksheet is to prepare a schedule showing the corrected net income amounts for the years ended December 31, 2013, 2014, and 2015. Each correction of the amount originally reported is clearly labeled. The next step is to indicate the balance sheet accounts affected as of December 31, 2015. Illustration 22-24 shows the completed worksheet for Hudson Company.
Assuming that Hudson Company has not closed the books, correcting entries on December 31, 2015, are:
If Hudson Company has closed the books for 2015, the correcting entries are:
Restatements sometimes occur because of financial fraud. Financial frauds involve the intentional misstatement or omission of material information in the organization's financial reports. Common methods of financial fraud manipulation include recording fictitious revenues, concealing liabilities or expenses, and artificially inflating reported assets. Financial frauds made up around 8 percent of the frauds in a recent study on occupational fraud but caused a median loss of more than $1 million in 2012 ($4 million in 2010)—by far the most costly category of fraud. The following chart compares loss amounts for 2012 versus 2010 for financial statement fraud, corruption, and asset misappropriation.
While the trend in the dollar amount of losses is going in the right direction, another study indicates that the number of fraud reports at 1,400 companies in the “Quarterly Corporate Fraud Index” is on the climb—with 2,348 reported frauds in the 2nd quarter of 2005 to over 7,800 in the 2nd quarter of 2012. While there is some debate about whether the reporting of fraud has increased with regulation that provides whistleblower protections (i.e., the incidence of fraud is not increasing as much as the reporting of fraud), companies must increase their efforts to protect their statements from the negative effects of fraud.
Sources: Report to the Nations on Occupational Fraud and Abuse, 2012 Global Fraud Study, Association of Certified Fraud Examiners (2012), p. 11; and C. McDonald, “Fraud Reports Climb Still Higher,” CFO.com (September 26, 2012).
Up to now, our discussion of error analysis has focused on identifying the type of error involved and accounting for its correction in the records. We have noted that companies must present the correction of the error on comparative financial statements.
The following example illustrates how a company would restate a typical year's financial statements, given many different errors.
Dick & Wally's Outlet is a small retail outlet in the town of Holiday. Lacking expertise in accounting, the company does not keep adequate records, and numerous errors occurred in recording accounting information.
Illustration 22-25 (page 1374) presents a worksheet that begins with the unadjusted trial balance of Dick & Wally's Outlet. You can determine the correcting entries and their effect on the financial statements by examining the worksheet.
You will want to read IFRS INSIGHTS on pages 1404–1408 for discussion of IFRS related to accounting changes and errors.
KEY TERMS
change in accounting estimate, 1344, 1357
change in accounting estimate effected by a change in accounting principle, 1358
change in accounting principle, 1344
change in reporting entity, 1344
correction of an error, 1360
counterbalancing errors, 1367
cumulative effect, 1345
direct effects of change in accounting principle, 1355
economic consequences, 1366
errors in financial statements, 1344
impracticable, 1356
indirect effects of change in accounting principle, 1355
noncounterbalancing errors, 1367
prior period adjustments, 1360
prospectively, 1345
restatement, 1361(n)
retrospective application, 1345
SUMMARY OF LEARNING OBJECTIVES
Identify the types of accounting changes. The three different types of accounting changes are as follows. (1) Change in accounting principle: a change from one generally accepted accounting principle to another generally accepted accounting principle. (2) Change in accounting estimate: a change that occurs as the result of new information or as additional experience is acquired. (3) Change in reporting entity: a change from reporting as one type of entity to another type of entity.
Describe the accounting for changes in accounting principles. A change in accounting principle involves a change from one generally accepted accounting principle to another. A change in accounting principle is not considered to result from the adoption of a new principle in recognition of events that have occurred for the first time or that were previously immaterial. If the accounting principle previously followed was not acceptable or if the principle was applied incorrectly, a change to a generally accepted accounting principle is considered a correction of an error.
Understand how to account for retrospective accounting changes. The general requirement for changes in accounting principle is retrospective application. Under retrospective application, companies change prior years' financial statements on a basis consistent with the newly adopted principle. They treat any part of the effect attributable to years prior to those presented as an adjustment of the earliest retained earnings presented.
Understand how to account for impracticable changes. Retrospective application is impracticable if the prior period effect cannot be determined using every reasonable effort to do so. For example, in changing to LIFO, the base-year inventory for all subsequent LIFO calculations is generally the opening inventory in the year the company adopts the method. There is no restatement of prior years' income because it is often too impractical to do so.
Describe the accounting for changes in estimates. Companies report changes in estimates prospectively. That is, companies should make no changes in previously reported results. They do not adjust opening balances nor change financial statements of prior periods.
Identify changes in a reporting entity. An accounting change that results in financial statements that are actually the statements of a different entity should be reported by restating the financial statements of all prior periods presented, to show the financial information for the new reporting entity for all periods.
Describe the accounting for correction of errors. Companies must correct errors as soon as they discover them, by proper entries in the accounts, and report them in the financial statements. The profession requires that a company treat corrections of errors as prior period adjustments, record them in the year in which it discovered the errors, and report them in the financial statements in the proper periods. If presenting comparative statements, a company should restate the prior statements affected to correct for the errors. The company need not repeat the disclosures in the financial statements of subsequent periods.
Identify economic motives for changing accounting methods. Managers might have varying motives for income reporting, depending on economic times and whom they seek to impress. Some of the reasons for changing accounting methods are (1) political costs, (2) capital structure, (3) bonus payments, and (4) smoothing of earnings.
Analyze the effect of errors. Three types of errors can occur. (1) Balance sheet errors, which affect only the presentation of an asset, liability, or stockholders' equity account. (2) Income statement errors, which affect only the presentation of revenue, expense, gain, or loss accounts in the income statement. (3) Balance sheet and income statement errors, which involve both the balance sheet and income statement. Errors are classified into two types. (1) Counterbalancing errors are offset or corrected over two periods. (2) Noncounterbalancing errors are not offset in the next accounting period and take longer than two periods to correct themselves.
As an aid to understanding accounting changes, we provide the following glossary.
KEY TERMS RELATED TO ACCOUNTING CHANGES
ACCOUNTING CHANGE. A change in (1) an accounting principle, (2) an accounting estimate, or (3) the reporting entity. The correction of an error in previously issued financial statements is not an accounting change.
CHANGE IN ACCOUNTING PRINCIPLE. A change from one generally accepted accounting principle to another generally accepted accounting principle when two or more generally accepted accounting principles apply or when the accounting principle formerly used is no longer generally accepted.
CHANGE IN ACCOUNTING ESTIMATE. A change that has the effect of adjusting the carrying amount of an existing asset or liability or altering the subsequent accounting for existing or future assets or liabilities. Changes in accounting estimates result from new information.
CHANGE IN ACCOUNTING ESTIMATE EFFECTED BY A CHANGE IN ACCOUNTING PRINCIPLE. A change in accounting estimate that is inseparable from the effect of a related change in accounting principle.
CHANGE IN THE REPORTING ENTITY. A change that results in financial statements that, in effect, are those of a different reporting entity (see page 1359).
DIRECT EFFECTS OF A CHANGE IN ACCOUNTING PRINCIPLE. Those recognized changes in assets or liabilities necessary to effect a change in accounting principle.
ERROR IN PREVIOUSLY ISSUED FINANCIAL STATEMENTS. An error in recognition, measurement, presentation, or disclosure in financial statements resulting from mathematical mistakes, mistakes in the application of GAAP, or oversight or misuse of facts that existed at the time the financial statements were prepared. A change from an accounting principle that is not generally accepted to one that is generally accepted is a correction of an error.
INDIRECT EFFECTS OF A CHANGE IN ACCOUNTING PRINCIPLE. Any changes to current or future cash flows of an entity that result from making a change in accounting principle that is applied retrospectively.
RESTATEMENT. The process of revising previously issued financial statements to reflect the correction of an error in those financial statements.
RETROSPECTIVE APPLICATION. The application of a different accounting principle to one or more previously issued financial statements, or to the statement of financial position at the beginning of the current period, as if that principle had always been used, or a change to financial statements of prior accounting periods to present the financial statements of a new reporting entity as if it had existed in those prior years. [11]
LEARNING OBJECTIVE
Make the computations and prepare the entries necessary to record a change from or to the equity method of accounting.
As noted in the chapter, companies generally should report an accounting change that results in financial statements for a different entity by changing the financial statements of all prior periods presented.
An example of a change in reporting entity is when a company's level of ownership or influence changes, such as when it changes from or to the equity method. When changing to the equity method, companies use retrospective application. Companies treat a change from the equity method prospectively. We present examples of these changes in entity in the following two sections.
If the investor level of influence or ownership falls below that necessary for continued use of the equity method, a company must change from the equity method to the fair value method. The earnings or losses that the investor previously recognized under the equity method should remain as part of the carrying amount of the investment, with no retrospective application to the new method.
When a company changes from the equity method to the fair value method, the cost basis for accounting purposes is the carrying amount of the investment at the date of the change. The investor applies the new method in its entirety once the equity method is no longer appropriate. 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.14
In subsequent periods, dividends received by the investor company may exceed its share of the investee's earnings for such periods (all periods following the change in method). To the extent that they do so, the investor company should account for such dividends as a reduction of the investment carrying amount, rather than as revenue. The 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.
To illustrate, assume that on January 1, 2013, 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 2013 Investor reported its investment in Investee Company at $8,780,000 at December 31, 2013. On January 2, 2014, 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 (page 1378) shows the net income (or loss) and dividends of Investee Company for the years 2014 through 2016.
Assuming a change from the equity method to the fair value method as of January 2, 2014, Investor Company's reported investment in Investee Company and its reported income would be as shown in Illustration 22A-2.
Investor Company would record the dividends and earnings data for the three years subsequent to the change in methods as shown by the following entries.
When converting to the equity method, companies use retrospective application. Such a change involves adjusting the carrying amount of the investment, results of current and prior operations, and retained earnings of the investor as if the equity method has been in effect during all of the previous periods in which this investment was held. [12] When changing from the fair value method to the equity method, companies also must eliminate any balances in the Unrealized Holding Gain or Loss—Equity account and the Fair Value Adjustment account. In addition, they eliminate the available-for-sale classification for this investment, and they record the investment under the equity method.
For example, on January 2, 2014, Amsted Corp. purchased, for $500,000 cash, 10 percent of the outstanding shares of Cable Company common stock. On that date, the net identifiable assets of Cable Company had a fair value of $3,000,000. The excess of cost over the underlying equity in the net identifiable assets of Cable Company is goodwill. On January 2, 2016, Amsted Corp. purchased an additional 20 percent of Cable Company's stock for $1,200,000 cash when the fair value of Cable's net identifiable assets was $4,000,000. The excess of cost over fair value related to this additional investment is goodwill. Now having a 30 percent interest, Amsted Corp. must use the equity method.
From January 2, 2014, to January 2, 2016, Amsted Corp. used the fair value method and categorized these securities as available-for-sale. At January 2, 2016, Amsted has a credit balance of $92,000 in its Unrealized Holding Gain or Loss—Equity account and a debit balance in its Fair Value Adjustment account of the same amount. This change in fair value occurred in 2014. (Income tax effects are ignored.) Illustration 22A-3 shows the net income reported by Cable Company and the Cable Company dividends received by Amsted during the period 2014 through 2016.
Amsted makes the following journal entries from January 2, 2014, through December 31, 2016, relative to Amsted Corp.'s investment in Cable Company, reflecting the data above and a change from the fair value method to the equity method.15
Companies change to the equity method by placing the accounts related to and affected by the investment on the same basis as if the equity method had always been the basis of accounting for that investment. Thus, they report the effects of this accounting change using the retrospective approach.16
SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 22A
Make the computations and prepare the entries necessary to record change from or to the equity method of accounting. When changing from the equity method to the fair value method, the cost basis for accounting purposes is the carrying amount used for the investment at the date of change. The investor company applies the new method in its entirety once the equity method is no longer appropriate. When changing to the equity method, the company adjusts the accounts to be on the same basis as if the equity method had always been used for that investment.
DEMONSTRATION PROBLEM
Wangerin Company is in the process of adjusting and correcting its books at the end of 2014. In reviewing its records, the following information is compiled.
Instructions
Prepare the journal entries necessary at December 31, 2014, to record the above corrections and changes. The books are still open for 2014. The income tax rate is 40%. Wangerin has not yet recorded its 2014 income tax expense and payable amounts so current-year tax effects may be ignored. Prior-year tax effects must be considered in item 2.
FASB Codification References
[1] FASB ASC 250-10-05-1. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005).]
[2] FASB ASC 250-10-05-2. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005).]
[3] FASB ASC 250-10-50-1. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), par. 17.]
[4] FASB ASC 250-10-50-1. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), par. B19.]
[5] FASB ASC 250-10-45-6. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), paras. 8–11.]
[6] FASB ASC 250-10-50-1. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), par. 17.]
[7] FASB ASC 250-10-45-18. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), par. 20.]
[8] FASB ASC 250-10-45-24. [Predecessor literature: “Prior Period Adjustments,” Statement of Financial Accounting Standards No. 16 (Stamford, Conn.: FASB, 1977), p. 5.]
[9] FASB ASC 250-10-50-4. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), par. 2.]
[10] FASB ASC 250-10-50-7. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), par. 26.]
[11] FASB ASC 250-10-50-1. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Accounting Standards No. 154 (Stamford, Conn.: FASB, 2005), par. 2.]
[12] FASB ASC 323-10-35-33. [Predecessor literature: “The Equity Method of Accounting for Investments in Common Stock,” Opinions of the Accounting Principles Board No. 18 (New York: AICPA, 1971), par. 17.]
Exercises
If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses.
CE22-1 | Access the glossary (“Master Glossary”) to answer the following.
(a) What is a change in accounting estimate? (b) What is a change in accounting principle? (c) What is a restatement? (d) What is the definition of “retrospective application”? |
CE22-2 | When a company has to restate its financial statements to correct an error, what information must the company disclose? |
CE22-3 | What reporting requirements does retrospective application require? |
CE22-4 | If a company registered with the SEC justifies a change in accounting method as preferable under the circumstances, and the circumstances change, can that company switch back to its prior method of accounting before the change? Why or why not? |
An additional Codification case can be found in the Using Your Judgment section, on page 1404.
Be sure to check the book's companion website for a Review and Analysis Exercise, with solution.
Brief Exercises, Exercises, Problems, and many more learning and assessment tools and resources are available for practice in WileyPLUS.
Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.
QUESTIONS
(a) Change from FIFO to LIFO method for inventory valuation purposes.
(b) Charge for failure to record depreciation in a previous period.
(c) Litigation won in current year, related to prior period.
(d) Change in the realizability of certain receivables.
(e) Write-off of receivables.
(f) Change from the percentage-of-completion to the completed-contract method for reporting net income.
(a) Impairment of goodwill.
(b) A change in depreciating plant assets from accelerated to the straight-line method.
(c) Large write-off of inventories because of obsolescence.
(d) Change from the cash basis to accrual basis of accounting.
(e) Change from LIFO to FIFO method for inventory valuation purposes.
(f) Change in the estimate of service lives for plant assets.
BRIEF EXERCISES
BE22-1 Wertz Construction Company decided at the beginning of 2014 to change from the completed-contract method to the percentage-of-completion method for financial reporting purposes. The company will continue to use the completed-contract method for tax purposes. For years prior to 2014, pretax income under the two methods was as follows: percentage-of-completion $120,000, and completed-contract $80,000. The tax rate is 35%. Prepare Wertz's 2014 journal entry to record the change in accounting principle.
BE22-2 Refer to the accounting change by Wertz Construction Company in BE22-1. Wertz has a profit-sharing plan, which pays all employees a bonus at year-end based on 1% of pretax income. Compute the indirect effect of Wertz's change in accounting principle that will be reported in the 2014 income statement, assuming that the profit-sharing contract explicitly requires adjustment for changes in income numbers.
BE22-3 Shannon, Inc., changed from the LIFO cost flow assumption to the FIFO cost flow assumption in 2014. The increase in the prior year's income before taxes is $1,200,000. The tax rate is 40%. Prepare Shannon's 2014 journal entry to record the change in accounting principle.
BE22-4 Tedesco Company changed depreciation methods in 2014 from double-declining-balance to straight-line. Depreciation prior to 2014 under double-declining-balance was $90,000, whereas straight-line depreciation prior to 2014 would have been $50,000. Tedesco's depreciable assets had a cost of $250,000 with a $40,000 salvage value, and an 8-year remaining useful life at the beginning of 2014. Prepare the 2014 journal entries, if any, related to Tedesco's depreciable assets.
BE22-5 Sesame Company purchased a computer system for $74,000 on January 1, 2013. It was depreciated based on a 7-year life and an $18,000 salvage value. On January 1, 2015, Sesame revised these estimates to a total useful life of 4 years and a salvage value of $10,000. Prepare Sesame's entry to record 2015 depreciation expense.
BE22-6 In 2014, Bailey Corporation discovered that equipment purchased on January 1, 2012, for $50,000 was expensed at that time. The equipment should have been depreciated over 5 years, with no salvage value. The effective tax rate is 30%. Prepare Bailey's 2014 journal entry to correct the error.
BE22-7 At January 1, 2014, Beidler Company reported retained earnings of $2,000,000. In 2014, Beidler discovered that 2013 depreciation expense was understated by $400,000. In 2014, net income was $900,000 and dividends declared were $250,000. The tax rate is 40%. Prepare a 2014 retained earnings statement for Beidler Company.
BE22-8 Indicate the effect—Understate, Overstate, No Effect—that each of the following errors has on 2014 net income and 2015 net income.
BE22-9 Roundtree Manufacturing Co. is preparing its year-end financial statements and is considering the accounting for the following items.
Identify and explain whether each of the above items is a change in principle, a change in estimate, or an error.
BE22-10 Palmer Co. is evaluating the appropriate accounting for the following items.
Identify and explain whether each of the above items is a change in accounting principle, a change in estimate, or an error.
*BE22-11 Simmons Corporation owns stock of Armstrong, Inc. Prior to 2014, the investment was accounted for using the equity method. In early 2014, Simmons sold part of its investment in Armstrong, and began using the fair value method. In 2014, Armstrong earned net income of $80,000 and paid dividends of $95,000. Prepare Simmons's entries related to Armstrong's net income and dividends, assuming Simmons now owns 10% of Armstrong's stock.
*BE22-12 Oliver Corporation has owned stock of Conrad Corporation since 2011. At December 31, 2014, its balances related to this investment were:
On January 1, 2015, Oliver purchased additional stock of Conrad Company for $475,000 and now has significant influence over Conrad. If the equity method had been used in 2011–2014, Oliver's share of income would have been $33,000 greater than dividends received. Prepare Oliver's journal entries to record the purchase of the investment and the change to the equity method.
EXERCISES
E22-1 (Change in Principle—Long-Term Contracts) Pam Erickson Construction Company changed from the completed-contract to the percentage-of-completion method of accounting for long-term construction contracts during 2015. 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.
Instructions
(a) Assuming that the tax rate is 35%, what is the amount of net income that would be reported in 2015?
(b) What entry(ies) are necessary to adjust the accounting records for the change in accounting principle?
E22-2 (Change in Principle—Inventory Methods) Holder-Webb Company began operations on January 1, 2012, and uses the average-cost method of pricing inventory. Management is contemplating a change in inventory methods for 2015. The following information is available for the years 2012–2014.
(Ignore all tax effects.)
(a) Prepare the journal entry necessary to record a change from the average-cost method to the FIFO method in 2015.
(b) Determine net income to be reported for 2012, 2013, and 2014, after giving effect to the change in accounting principle.
(c) Assume Holder-Webb Company used the LIFO method instead of the average-cost method during the years 2012–2014. In 2015, Holder-Webb changed to the FIFO method. Prepare the journal entry necessary to record the change in principle.
E22-3 (Accounting Change) Taveras Co. decides at the beginning of 2014 to adopt the FIFO method of inventory valuation. Taveras had used the LIFO method for financial reporting since its inception on January 1, 2012, and had maintained records adequate to apply the FIFO method retrospectively. Taveras concluded that FIFO is the preferable inventory method because it reflects the current cost of inventory on the balance sheet. The following table presents the effects of the change in accounting principles on inventory and cost of goods sold.
Other information:
Instructions
(a) Prepare income statements under LIFO and FIFO for 2012, 2013, and 2014.
(b) Prepare income statements reflecting the retrospective application of the accounting change from the LIFO method to the FIFO method for 2014 and 2013.
(c) Prepare the note to the financial statements describing the change in method of inventory valuation. In the note, indicate the income statement line items for 2014 and 2013 that were affected by the change in accounting principle.
(d) Prepare comparative retained earnings statements for 2013 and 2014 under FIFO. Retained earnings reported under LIFO are as follows:
E22-4 (Accounting Change) Gordon Company started operations on January 1, 2009, and has used the FIFO method of inventory valuation since its inception. In 2015, it decides to switch to the average-cost method. You are provided with the following information.
Instructions
(a) What is the beginning retained earnings balance at January 1, 2011, if Gordon prepares comparative financial statements starting in 2011?
(b) What is the beginning retained earnings balance at January 1, 2014, if Gordon prepares comparative financial statements starting in 2014?
(c) What is the beginning retained earnings balance at January 1, 2015, if Gordon prepares single-period financial statements for 2015?
(d) What is the net income reported by Gordon in the 2014 income statement if it prepares comparative financial statements starting with 2012?
E22-5 (Accounting Change) Presented below are income statements prepared on a LIFO and FIFO basis for Kenseth Company, which started operations on January 1, 2013. The company presently uses the LIFO method of pricing its inventory and has decided to switch to the FIFO method in 2014. The FIFO income statement is computed in accordance with the requirements of GAAP. Kenseth's profit-sharing agreement with its employees indicates that the company will pay employees 10% of income before profit-sharing. Income taxes are ignored.
Instructions
Answer the following questions.
(a) If comparative income statements are prepared, what net income should Kenseth report in 2013 and 2014?
(b) Explain why, under the FIFO basis, Kenseth reports $100 in 2013 and $96 in 2014 for its profit-sharing expense.
(c) Assume that Kenseth has a beginning balance of retained earnings at January 1, 2014, of $8,000 using the LIFO method. The company declared and paid dividends of $500 in 2014. Prepare the retained earnings statement for 2014, assuming that Kenseth has switched to the FIFO method.
E22-6 (Accounting Changes—Depreciation) Kathleen Cole Inc. acquired the following assets in January of 2012.
The equipment has been depreciated using the sum-of-the-years'-digits method for the first 3 years for financial reporting purposes. In 2015, the company decided to change the method of computing depreciation to the straight-line method for the equipment, but no change was made in the estimated service life or salvage value. It was also decided to change the total estimated service life of the building from 30 years to 40 years, with no change in the estimated salvage value. The building is depreciated on the straight-line method.
Instructions
(a) Prepare the general journal entry to record depreciation expense for the equipment in 2015.
(b) Prepare the journal entry to record depreciation expense for the building in 2015. (Round all computations to two decimal places.)
E22-7 (Change in Estimate and Error; Financial Statements) Presented below are the comparative income and retained earnings statements for Denise Habbe Inc. for the years 2014 and 2015.
The following additional information is provided:
Prepare the revised retained earnings statement for 2014 and 2015, assuming comparative statements. (Ignore income taxes.)
E22-8 (Accounting for Accounting Changes and Errors) Listed below are various types of accounting changes and errors.
______ 1. | Change in a plant asset's salvage value. |
______ 2. | Change due to overstatement of inventory. |
______ 3. | Change from sum-of-the-years'-digits to straight-line method of depreciation. |
______ 4. | Change from presenting unconsolidated to consolidated financial statements. |
______ 5. | Change from LIFO to FIFO inventory method. |
______ 6. | Change in the rate used to compute warranty costs. |
______ 7. | Change from an unacceptable accounting principle to an acceptable accounting principle. |
______ 8. | Change in a patent's amortization period. |
______ 9. | Change from completed-contract to percentage-of-completion method on construction contracts. |
______ 10. | Change from FIFO to average-cost inventory method. |
Instructions
For each change or error, indicate how it would be accounted for using the following code letters:
(a) Accounted for prospectively.
(b) Accounted for retrospectively.
(c) Neither of the above.
E22-9 (Error and Change in Estimate—Depreciation) Joy Cunningham Co. purchased a machine on January 1, 2012, for $550,000. At that time, it was estimated that the machine would have a 10-year life and no salvage value. On December 31, 2015, the firm's accountant found that the entry for depreciation expense had been omitted in 2013. In addition, management has informed the accountant that the company plans to switch to straight-line depreciation, starting with the year 2015. At present, the company uses the sum-of-the-years'-digits method for depreciating equipment.
Instructions
Prepare the general journal entries that should be made at December 31, 2015, to record these events. (Ignore tax effects.)
E22-10 (Depreciation Changes) On January 1, 2011, Jackson Company purchased a building and equipment that have the following useful lives, salvage values, and costs.
The building has been depreciated under the double-declining-balance method through 2014. In 2015, the company decided to switch to the straight-line method of depreciation. Jackson also decided to change the total useful life of the equipment to 9 years, with a salvage value of $5,000 at the end of that time. The equipment is depreciated using the straight-line method.
Instructions
(a) Prepare the journal entry(ies) necessary to record the depreciation expense on the building in 2015.
(b) Compute depreciation expense on the equipment for 2015.
E22-11 (Change in Estimate—Depreciation) Peter M. Dell Co. 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 entered for 7 years on a straight-line basis. In 2015, 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.
Instructions
(a) Prepare the entry (if any) to correct the prior years' depreciation.
(b) Prepare the entry to record depreciation for 2015.
E22-12 (Change in Estimate—Depreciation) Gerald Englehart Industries changed from the double-declining-balance to the straight-line method in 2015 on all its plant assets. There was no change in the assets' salvage values or useful lives. Plant assets, acquired on January 2, 2012, had an original cost of $1,600,000, with a $100,000 salvage value and an 8-year estimated useful life. Income before depreciation expense was $270,000 in 2014 and $300,000 in 2015.
Instructions
(a) Prepare the journal entry(ies) to record depreciation expense in 2015.
(b) Starting with income before depreciation expense, prepare the remaining portion of the income statement for 2014 and 2015.
E22-13 (Change in Principle—Long-Term Contracts) Cullen Construction Company, which began operations in 2014, changed from the completed-contract to the percentage-of-completion method of accounting for long-term construction contracts during 2015. For tax purposes, the company employs the completed-contract method and will continue this approach in the future. The appropriate information related to this change is as follows.
Instructions
(a) Assuming that the tax rate is 40%, what is the amount of net income that would be reported in 2015?
(b) What entry(ies) are necessary to adjust the accounting records for the change in accounting principle?
E22-14 (Various Changes in Principle—Inventory Methods) Below is the net income of Anita Ferreri Instrument Co., a private corporation, computed under the three inventory methods using a periodic system.
Instructions
(Ignore tax considerations.)
(a) Assume that in 2015 Ferreri decided to change from the FIFO method to the average-cost method of pricing inventories. Prepare the journal entry necessary for the change that took place during 2015, and show net income reported for 2012, 2013, 2014, and 2015.
(b) Assume that in 2015 Ferreri, which had been using the LIFO method since incorporation in 2012, changed to the FIFO method of pricing inventories. Prepare the journal entry necessary to record the change in 2015 and show net income reported for 2012, 2013, 2014, and 2015.
E22-15 (Error Correction Entries) The first audit of the books of Bruce Gingrich Company was made for the year ended December 31, 2015. In examining the books, the auditor found that certain items had been overlooked or incorrectly handled in the last 3 years. These items are:
Instructions
Prepare the journal entries necessary in 2015 to correct the books, assuming that the books have not been closed. Disregard effects of corrections on income tax.
E22-16 (Error Analysis and Correcting Entry) You have been engaged to review the financial statements of Gottschalk Corporation. In the course of your examination, you conclude that the bookkeeper hired during the current year is not doing a good job. You notice a number of irregularities as follows.
Instructions
Prepare the necessary correcting entries, assuming that Gottschalk uses a calendar-year basis.
E22-17 (Error Analysis and Correcting Entry) The reported net incomes for the first 2 years of Sandra Gustafson Products, Inc., were as follows: 2014, $147,000; 2015, $185,000. Early in 2016, the following errors were discovered.
Instructions
Prepare the correcting entry necessary when these errors are discovered. Assume that the books are closed. (Ignore income tax considerations.)
E22-18 (Error Analysis) Peter Henning Tool Company's December 31 year-end financial statements contained the following errors.
An insurance premium of $66,000 was prepaid in 2014 covering the years 2014, 2015, and 2016. The entire amount was charged to expense in 2014. In addition, on December 31, 2015, fully depreciated machinery was sold for $15,000 cash, but the entry was not recorded until 2016. There were no other errors during 2014 or 2015, and no corrections have been made for any of the errors. (Ignore income tax considerations.)
Instructions
(a) Compute the total effect of the errors on 2015 net income.
(b) Compute the total effect of the errors on the amount of Henning's working capital at December 31, 2015.
(c) Compute the total effect of the errors on the balance of Henning's retained earnings at December 31, 2015.
E22-19 (Error Analysis; Correcting Entries) A partial trial balance of Julie Hartsack Corporation is as follows on December 31, 2015.
Additional adjusting data:
(a) Assuming that the books have not been closed, what are the adjusting entries necessary at December 31, 2015? (Ignore income tax considerations.)
(b) Assuming that the books have been closed, what are the adjusting entries necessary at December 31, 2015? (Ignore income tax considerations.)
(c) Repeat the requirements for items 6 and 7, taking into account income tax effects (40% tax rate) and assuming that the books have been closed.
E22-20 (Error Analysis) The before-tax income for Lonnie Holdiman Co. for 2014 was $101,000 and $77,400 for 2015. However, the accountant noted that the following errors had been made:
The bonds have a face value of $250,000 and pay a stated interest rate of 6%. They were issued at a discount of $15,000 on January 1, 2014, to yield an effective-interest rate of 7%. (Assume that the effective-yield method should be used.)
Instructions
Prepare a schedule showing the determination of corrected income before taxes for 2014 and 2015.
E22-21 (Error Analysis) When the records of Debra Hanson Corporation were reviewed at the close of 2015, the errors listed below were discovered. For each item, indicate by a check mark in the appropriate column whether the error resulted in an overstatement, an understatement, or had no effect on net income for the years 2014 and 2015.
*E22-22 (Change from Fair Value to Equity) On January 1, 2014, Beyonce Co. purchased 25,000 shares (a 10% interest) in Elton John Corp. for $1,400,000. At the time, the book value and the fair value of John's net assets were $13,000,000.
On July 1, 2015, Beyonce paid $3,040,000 for 50,000 additional shares of John common stock, which represented a 20% investment in John. The fair value of John's identifiable assets net of liabilities was equal to their carrying amount of $14,200,000. As a result of this transaction, Beyonce owns 30% of John and can exercise significant influence over John's operating and financial policies.
John reported the following net income and declared and paid the following dividends.
Instructions
(Any excess fair value is attributed to goodwill.)
Determine the ending balance that Beyonce Co. should report as its investment in John Corp. at the end of 2015.
*E22-23 (Change from Equity to Fair Value) Dan Aykroyd Corp. was a 30% owner of Steve Martin Company, holding 210,000 shares of Martin's common stock on December 31, 2013. The investment account had the following entries.
On January 2, 2014, Aykroyd sold 126,000 shares of Martin for $3,440,000, thereby losing its significant influence. During the year 2014, Martin experienced the following results of operations and paid the following dividends to Aykroyd.
At December 31, 2014, the fair value of Martin shares held by Aykroyd is $1,570,000. This is the first reporting date since the January 2 sale.
Instructions
(a) What effect does the January 2, 2014, transaction have upon Aykroyd's accounting treatment for its investment in Martin?
(b) Compute the carrying amount of the investment in Martin as of December 31, 2014 (prior to any fair value adjustment).
(c) Prepare the adjusting entry on December 31, 2014, applying the fair value method to Aykroyd's long-term investment in Martin Company securities.
EXERCISES SET B
See the book's companion website, at www.wiley.com/college/kieso, for an additional set of exercises.
PROBLEMS
P22-1 (Change in Estimate and Error Correction) Holtzman Company is in the process of preparing its financial statements for 2014. Assume that no entries for depreciation have been recorded in 2014. The following information related to depreciation of fixed assets is provided to you.
Instructions
(a) Prepare the journal entries to record depreciation expense for 2014 and correct any errors made to date related to the information provided. (Ignore taxes.)
(b) Show comparative net income for 2013 and 2014. Income before depreciation expense was $300,000 in 2014, and was $310,000 in 2013. (Ignore taxes.)
P22-2 (Comprehensive Accounting Change and Error Analysis Problem) Botticelli Inc. was organized in late 2012 to manufacture and sell hosiery. At the end of its fourth year of operation, the company has been fairly successful, as indicated by the following reported net incomes.
The company has decided to expand operations and has applied for a sizable bank loan. The bank officer has indicated that the records should be audited and presented in comparative statements to facilitate analysis by the bank. Botticelli Inc. therefore hired the auditing firm of Check & Doublecheck Co. and has provided the following additional information.
(a) The company incorrectly overstated the ending inventory (under both LIFO and FIFO) by $14,000 in 2014.
(b) A dispute developed in 2013 with the Internal Revenue Service over the deductibility of entertainment expenses. In 2012, the company was not permitted these deductions, but a tax settlement was reached in 2015 that allowed these expenses. As a result of the court's finding, tax expenses in 2015 were reduced by $60,000.
Instructions
(a) Indicate how each of these changes or corrections should be handled in the accounting records. (Ignore income tax considerations.)
(b) Present comparative income statements for the years 2012 to 2015, starting with income before extraordinary items. (Ignore income tax considerations.)
P22-3 (Error Corrections and Accounting Changes) Penn Company is in the process of adjusting and correcting its books at the end of 2014. In reviewing its records, the following information is compiled.
Penn has already made an entry that established the incorrect December 31, 2014, inventory amount.
Instructions
Prepare the journal entries necessary at December 31, 2014, to record the above corrections and changes. The books are still open for 2014. The income tax rate is 40%. Penn has not yet recorded its 2014 income tax expense and payable amounts so current-year tax effects may be ignored. Prior-year tax effects must be considered in item 4.
P22-4 (Accounting Changes) Aston Corporation performs year-end planning in November of each year before its calendar year ends in December. The preliminary estimated net income is $3 million. The CFO, Rita Warren, meets with the company president, J. B. Aston, to review the projected numbers. She presents the following projected information.
Estimated fair value at December 31, 2014:
Other information at December 31, 2014:
The corporation has never used robotic equipment before, and Warren assumed an accelerated method because of the rapidly changing technology in robotic equipment. The company normally uses straight-line depreciation for production equipment.
Aston explains to Warren that it is important for the corporation to show a $7,000,000 income before taxes because Aston receives a $1,000,000 bonus if the income before taxes and bonus reaches $7,000,000. Aston also does not want the company to pay more than $3,000,000 in income taxes to the government.
Instructions
(a) What can Warren do within GAAP to accommodate the president's wishes to achieve $7,000,000 in income before taxes and bonus? Present the revised income statement based on your decision.
(b) Are the actions ethical? Who are the stakeholders in this decision, and what effect do Warren's actions have on their interests?
P22-5 (Change in Principle—Inventory—Periodic) The management of Utrillo Instrument Company had concluded, with the concurrence of its independent auditors, that results of operations would be more fairly presented if Utrillo changed its method of pricing inventory from last-in, first-out (LIFO) to average-cost in 2014. Given below is the 5-year summary of income under LIFO and a schedule of what the inventories would be if stated on the average-cost method.
Instructions
Prepare comparative statements for the 5 years, assuming that Utrillo changed its method of inventory pricing to average-cost. Indicate the effects on net income and earnings per share for the years involved. Utrillo Instruments started business in 2009. (All amounts except EPS are rounded up to the nearest dollar.)
P22-6 (Accounting Change and Error Analysis) On December 31, 2014, before the books were closed, the management and accountants of Madrasa Inc. made the following determinations about three pieces of equipment.
Additional data:
Instructions
(a) Prepare all necessary entries in 2014 to record these determinations.
(b) Prepare comparative retained earnings statements for Madrasa Inc. for 2013 and 2014. The company had retained earnings of $200,000 at December 31, 2012.
P22-7 (Error Corrections) You have been assigned to examine the financial statements of Zarle Company for the year ended December 31, 2014. You discover the following situations.
Instructions
Assume the trial balance has been prepared but the books have not been closed for 2014. Assuming all amounts are material, prepare journal entries showing the adjustments that are required. (Ignore income tax considerations.)
P22-8 (Comprehensive Error Analysis) On March 5, 2015, you were hired by Hemingway Inc., a closely held company, as a staff member of its newly created internal auditing department. While reviewing the company's records for 2013 and 2014, you discover that no adjustments have yet been made for the items listed on the next page.
Instructions
Indicate the effect of any errors on the net income figure reported on the income statement for the year ending December 31, 2013, and the retained earnings figure reported on the balance sheet at December 31, 2014. Assume all amounts are material, and ignore income tax effects. Using the following format, enter the appropriate dollar amounts in the appropriate columns. Consider each item independent of the other items. It is not necessary to total the columns on the grid.
P22-9 (Error Analysis) Lowell Corporation has used the accrual basis of accounting for several years. A review of the records, however, indicates that some expenses and revenues have been handled on a cash basis because of errors made by an inexperienced bookkeeper. Income statements prepared by the bookkeeper reported $29,000 net income for 2013 and $37,000 net income for 2014. Further examination of the records reveals that the following items were handled improperly.
Instructions
Prepare a schedule that will show the corrected net income for the years 2013 and 2014. All items listed should be labeled clearly. (Ignore income tax considerations.)
P22-10 (Error Analysis and Correcting Entries) You have been asked by a client to review the records of Roberts Company, a small manufacturer of precision tools and machines. Your client is interested in buying the business, and arrangements have been made for you to review the accounting records. Your examination reveals the following information.
Sales price was determined by adding 25% to cost. Assume that the consigned machines are sold the following year.
Sales per books and warranty costs were as follows.
Instructions
(a) Present a schedule showing the revised income before income taxes for each of the years ended March 31, 2013, 2014, and 2015. (Make computations to the nearest whole dollar.)
(b) Prepare the journal entry or entries you would give the bookkeeper to correct the books. Assume the books have not yet been closed for the fiscal year ended March 31, 2015. Disregard correction of income taxes.
(AICPA adapted)
*P22-11 (Fair Value to Equity Method with Goodwill) On January 1, 2014, Millay Inc. paid $700,000 for 10,000 shares of Genso Company's voting common stock, which was a 10% interest in Genso. At that date, the net assets of Genso totaled $6,000,000. The fair values of all of Genso's identifiable assets and liabilities were equal to their book values. Millay does not have the ability to exercise significant influence over the operating and financial policies of Genso. Millay received dividends of $1.50 per share from Genso on October 1, 2014. Genso reported net income of $550,000 for the year ended December 31, 2014.
On July 1, 2015, Millay paid $2,325,000 for 30,000 additional shares of Genso Company's voting common stock which represents a 30% investment in Genso. The fair values of all of Genso's identifiable assets net of liabilities were equal to their book values of $6,550,000. As a result of this transaction, Millay has the ability to exercise significant influence over the operating and financial policies of Genso. Millay received dividends of $2.00 per share from Genso on April 1, 2015, and $2.50 per share on October 1, 2015. Genso reported net income of $650,000 for the year ended December 31, 2015, and $350,000 for the 6 months ended December 31, 2015.
Instructions
(For both purchases, assume any excess of cost over book value is due to goodwill.)
(a) Prepare a schedule showing the income or loss before income taxes for the year ended December 31, 2014, that Millay should report from its investment in Genso in its income statement issued in March 2015.
(b) During March 2016, Millay issues comparative financial statements for 2014 and 2015. Prepare schedules showing the income or loss before income taxes for the years ended December 31, 2014 and 2015, that Millay should report from its investment in Genso.
(AICPA adapted)
*P22-12 (Change from Fair Value to Equity Method) On January 3, 2013, Martin Company purchased for $500,000 cash a 10% interest in Renner Corp. On that date, the net assets of Renner had a book value of $3,700,000. The excess of cost over the underlying equity in net assets is attributable to undervalued depreciable assets having a remaining life of 10 years from the date of Martin's purchase.
The fair value of Martin's investment in Renner securities is as follows: December 31, 2013, $560,000, and December 31, 2014, $515,000.
On January 2, 2015, Martin purchased an additional 30% of Renner's stock for $1,545,000 cash when the book value of Renner's net assets was $4,150,000. The excess was attributable to depreciable assets having a remaining life of 8 years.
During 2013, 2014, and 2015, the following occurred.
Instructions
On the books of Martin Company, prepare all journal entries in 2013, 2014, and 2015 that relate to its investment in Renner Corp., reflecting the data above and a change from the fair value method to the equity method.
PROBLEMS SET B
See the book's companion website, at www.wiley.com/college/kieso, for an additional set of problems.
CONCEPTS FOR ANALYSIS
CA22-1 (Analysis of Various Accounting Changes and Errors) Mathys Inc. has recently hired a new independent auditor, Karen Ogleby, who says she wants “to get everything straightened out.” Consequently, she has proposed the following accounting changes in connection with Mathys Inc.'s 2014 financial statements.
(a) For office furniture and fixtures, it proposes to change from a 10-year useful life to an 8-year life. If this change had been made in prior years, retained earnings at December 31, 2013, would have been $250,000 less. The effect of the change on 2014 income alone is a reduction of $60,000.
(b) For its new equipment in the leasing division, the client proposes to adopt the sum-of-the-years'-digits depreciation method. The client had never used SYD before. The first year the client operated a leasing division was 2014. If straight-line depreciation were used, 2014 income would be $110,000 greater.
Instructions
(a) For each of the changes described above, decide whether:
(1) The change involves an accounting principle, accounting estimate, or correction of an error.
(2) Restatement of opening retained earnings is required.
(b) What would be the proper adjustment to the December 31, 2013, retained earnings?
CA22-2 (Analysis of Various Accounting Changes and Errors) Various types of accounting changes can affect the financial statements of a business enterprise differently. Assume that the following list describes changes that have a material effect on the financial statements for the current year of your business enterprise.
Identify the type of change that is described in each item above and indicate whether the prior year's financial statements should be recast when presented in comparative form with the current year's financial statements.
CA22-3 (Analysis of Three Accounting Changes and Errors) The following are three independent, unrelated sets of facts relating to accounting changes.
Situation 1: Sanford Company is in the process of having its first audit. The company has used the cash basis of accounting for revenue recognition. Sanford president, B. J. Jimenez, is willing to change to the accrual method of revenue recognition.
Situation 2: Hopkins Co. decides in January 2015 to change from FIFO to weighted-average pricing for its inventories.
Situation 3: Marshall Co. determined that the depreciable lives of its fixed assets are too long at present to fairly match the cost of the fixed assets with the revenue produced. The company decided at the beginning of the current year to reduce the depreciable lives of all of its existing fixed assets by 5 years.
Instructions
For each of the situations described, provide the information indicated below.
(a) Type of accounting change.
(b) Manner of reporting the change under current generally accepted accounting principles, including a discussion where applicable of how amounts are computed.
(c) Effect of the change on the balance sheet and income statement.
CA22-4 (Analysis of Various Accounting Changes and Errors) Katherine Irving, controller of Lotan Corp., is aware of a pronouncement on accounting changes. After reading the pronouncement, she is confused about what action should be taken on the following items related to Lotan Corp. for the year 2014.
Instructions
Katherine Irving has come to you, as her CPA, for advice about the situations above. Prepare a report, indicating the appropriate accounting treatment that should be given for each of these situations.
CA22-5 (Change in Principle, Estimate) As a certified public accountant, you have been contacted by Joe Davison, CEO of Sports-Pro Athletics, Inc., a manufacturer of a variety of athletic equipment. He has asked you how to account for the following changes.
Instructions
Write a 1–1.5 page letter to Joe Davison explaining how each of the above changes should be presented in the December 31, 2014, financial statements.
CA22-6 (Change in Estimate) Mike Crane is an audit senior of a large public accounting firm who has just been assigned to the Frost Corporation's annual audit engagement. Frost has been a client of Crane's firm for many years. Frost is a fast-growing business in the commercial construction industry. In reviewing the fixed asset ledger, Crane discovered a series of unusual accounting changes, in which the useful lives of assets, depreciated using the straight-line method, were substantially lowered near the midpoint of the original estimate. For example, the useful life of one dump truck was changed from 10 to 6 years during its fifth year of service. Upon further investigation, Mike was told by Kevin James, Frost's accounting manager, “I don't really see your problem. After all, it's perfectly legal to change an accounting estimate. Besides, our CEO likes to see big earnings!”
Instructions
Answer the following questions.
(a) What are the ethical issues concerning Frost's practice of changing the useful lives of fixed assets?
(b) Who could be harmed by Frost's unusual accounting changes?
(c) What should Crane do in this situation?
USING YOUR JUDGMENT
FINANCIAL REPORTING
Financial Reporting Problem
The Procter & Gamble Company (P&G)
The financial statements of P&G are presented in Appendix 5B. The company's complete annual report, including the notes to the financial statements, can be accessed at the book's companion website, www.wiley.com/college/kieso.
Instructions
Refer to P&G's financial statements and the accompanying notes to answer the following questions.
(a) Were there changes in accounting principles reported by P&G during the three years covered by its income statements (2009–2011)? If so, describe the nature of the change and the year of change.
(b) What types of estimates did P&G discuss in 2011?
Comparative Analysis Case
The Coca-Cola Company and PepsiCo, Inc.
Instructions
Go to the book's companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc.
(a) Identify the changes in accounting principles reported by Coca-Cola during the 3 years covered by its income statements (2009–2011). Describe the nature of the change and the year of change.
(b) Identify the changes in accounting principles reported by PepsiCo during the 3 years covered by its income statements (2009–2011). Describe the nature of the change and the year of change.
(c) For each change in accounting principle by Coca-Cola and PepsiCo, identify, if possible, the cumulative effect of each change on prior years and the effect on operating results in the year of change.
Accounting, Analysis, and Principles
In preparation for significant expansion of its international operations, ABC Co. has adopted a plan to gradually shift to the same accounting methods as used by its international competitors. Part of this plan includes a switch from LIFO inventory accounting to FIFO (recall that IFRS does not allow LIFO). ABC decides to make the switch to FIFO at January 1, 2014. The following data pertains to ABC's 2014 financial statements (in millions of dollars).
All sales and purchases were with cash. All of 2014's compensation expense was paid with cash. (Ignore taxes.) ABC's property, plant, and equipment cost $400 million and has an estimated useful life of 10 years with no salvage value.
ABC Co. reported the following for fiscal 2013 (in millions of dollars):
Accounting
Prepare ABC's December 31, 2014, balance sheet and an income statement for the year ended December 31, 2014. In columns beside 2014's numbers, include 2013's numbers as they would appear in the 2014 financial statements for comparative purposes.
Analysis
Compute ABC's inventory turnover for 2013 and 2014 under both LIFO and FIFO. Assume averages are equal to year-end balances where necessary. What causes the differences in this ratio between LIFO and FIFO?
Principles
Briefly explain, in terms of the principles discussed in Chapter 2, why GAAP requires that companies that change accounting methods recast prior year's financial statement data.
Professional Research: FASB Codification
As part of the year-end accounting process and review of operating policies, Cullen Co. is considering a change in the accounting for its equipment from the straight-line method to an accelerated method. Your supervisor wonders how the company will report this change in principle. He read in a newspaper article that the FASB has issued a standard in this area and has changed GAAP for a “change in estimate that is effected by a change in accounting principle.” (Thus, the accounting may be different from what he learned in intermediate accounting.) Your supervisor wants you to research the authoritative guidance on a change in accounting principle related to depreciation methods.
Instructions
If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses.
(a) What are the accounting and reporting guidelines for a change in accounting principle related to depreciation methods?
(b) What are the conditions that justify a change in depreciation method, as contemplated by Cullen Co.?
(c) What guidance does the SEC provide concerning the impact that recently issued accounting standards will have on the financial statements in a future period?
Additional Professional Resources
See the book's companion website, at www.wiley.com/college/kieso, for professional simulations as well as other study resources.
ACCOUNTING CHANGES AND ERRORS
LEARNING OBJECTIVE
Compare the procedures for accounting changes and error analysis under GAAP and IFRS.
The IFRS addressing accounting and reporting for changes in accounting principles, changes in estimates, and errors is IAS 8 (“Accounting Policies, Changes in Accounting Estimates and Errors”). Various presentation issues related to restatements are addressed in IAS 1 (“Presentation of Financial Statements”). As indicated in the chapter, the FASB has issued guidance on changes in accounting principles, changes in estimates, and corrections of errors, which essentially converges GAAP to IAS 8.
RELEVANT FACTS
Following are the key similarities and differences between GAAP and IFRS related to the procedures for accounting changes.
Similarities
Differences
ABOUT THE NUMBERS
Direct and Indirect Effects of Changes
Are there other effects that a company should report when it makes a change in accounting policy? For example, what happens when a company like Lancer (see pages 1350–1354) has a bonus plan based on net income and the prior year's net income changes when FIFO is retrospectively applied? Should Lancer also change the reported amount of bonus expense? Or, what happens if we had not ignored income taxes in the Lancer example? Should Lancer adjust net income, given that taxes will be different under average-cost and FIFO in prior periods? The answers depend on whether the effects are direct or indirect.
Direct Effects
Similar to GAAP, IFRS indicates that companies should retrospectively apply the direct effects of a change in accounting policy. An example of a direct effect is an adjustment to an inventory balance as a result of a change in the inventory valuation method. For example, referring to Lancer Company on pages 1350–1354, Lancer should change the inventory amounts in prior periods to indicate the change to the FIFO method of inventory valuation. Another inventory-related example would be an impairment adjustment resulting from applying the lower-of-cost-or-net realizable value test to the adjusted inventory balance. Related changes, such as deferred income tax effects of the impairment adjustment, are also considered direct effects. This entry was illustrated in the Denson example on page 1349, in which the change to percentage-of-completion accounting resulted in recording a deferred tax liability.
Indirect Effects
In addition to direct effects, companies can have indirect effects related to a change in accounting policy. An indirect effect is any change to current or future cash flows of a company that results from making a change in accounting policy that is applied retrospectively. An example of an indirect effect is a change in profit-sharing or royalty payment that is based on a reported amount such as revenue or net income. The IASB is silent on what to do in this situation. GAAP (likely because its standard in this area was issued after IAS 8) requires that indirect effects do not change prior period amounts.
For example, let's assume that Lancer Company has an employee profit-sharing plan based on net income and it changed from the weighted-average inventory method to FIFO in 2014. Lancer reports higher income in 2013 and 2014 if it used the FIFO method. In addition, let's assume that the profit-sharing plan requires that Lancer pay the incremental amount due based on the FIFO income amounts. In this situation, Lancer reports this additional expense in the current period; it would not change prior periods for this expense. If the company prepares comparative financial statements, it follows that it does not recast the prior periods for this additional expense. If the terms of the profit-sharing plan indicate that no payment is necessary in the current period due to this change, then the company need not recognize additional profit-sharing expense in the current period. Neither does it change amounts reported for prior periods.
When a company recognizes the indirect effects of a change in accounting policy, it includes in the financial statements a description of the indirect effects. In doing so, it discloses the amounts recognized in the current period and related per share information.
Impracticability
It is not always possible for companies to determine how they would have reported prior periods' financial information under retrospective application of an accounting policy change. Retrospective application is considered impracticable if a company cannot determine the prior period effects using every reasonable effort to do so.
Companies should not use retrospective application if one of the following conditions exists:
If any of the above conditions exists, it is deemed impracticable to apply the retrospective approach. In this case, the company prospectively applies the new accounting policy as of the earliest date it is practicable to do so.
For example, assume that Williams Company changed its accounting policy for depreciable assets so as to more fully apply component depreciation under revaluation accounting. Unfortunately, the company does not have detailed accounting records to establish a basis for the components of these assets. As a result, Williams determines it is not practicable to account for the change to full component depreciation using the retrospective application approach. It therefore applies the policy prospectively, starting at the beginning of the current year.
Williams must disclose only the effect of the change on the results of operations in the period of change. Also, the company should explain the reasons for omitting the computations of the cumulative effect for prior years. Finally, it should disclose the justification for the change to component depreciation.
ON THE HORIZON
For the most part, IFRS and GAAP are similar in the area of accounting changes and reporting the effects of errors. Thus, there is no active project in this area. A related development involves the presentation of comparative data. Under IFRS, when a company prepares financial statements on a new basis, two years of comparative data are reported. GAAP requires comparative information for a three-year period. Use of the shorter comparative data period must be addressed before U.S. companies can adopt IFRS.
IFRS SELF-TEST QUESTIONS
(a) GAAP and IFRS have the same absolute standard regarding the reporting of error corrections in previously issued financial statements.
(b) The accounting for changes in estimates is similar between GAAP and IFRS.
(c) Under IFRS, the impracticability exception applies both to changes in accounting principles and to the correction of errors.
(d) GAAP has detailed guidance on the accounting and reporting of indirect effects; IFRS does not.
(a) Change in accounting policy.
(b) Change in accounting estimate.
(c) Errors in financial statements.
(d) None of the above.
(a) Cumulative effect approach.
(b) Retrospective approach.
(c) Prospective approach.
(d) Averaging approach.
(a) retrospective application requires assumptions about management's intent in a prior period.
(b) the company does not have trained staff to perform the analysis.
(c) the effects of the change have counterbalanced.
(d) the effects of the change have not counterbalanced.
IFRS CONCEPTS AND APPLICATION
IFRS22-1 Where can authoritative IFRS related to accounting changes be found?
IFRS22-2 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to reporting accounting changes.
IFRS22-3 How might differences in presentation of comparative data under GAAP and IFRS affect adoption of IFRS by U.S. companies?
IFRS22-4 What is the indirect effect of a change in accounting policy? Briefly describe the approach to reporting the indirect effects of a change in accounting policy under IFRS.
IFRS22-5 Discuss how a change in accounting policy is handled when it is impracticable to determine previous amounts.
IFRS22-6 Joblonsky Inc. has recently hired a new independent auditor, Karen Ogleby, who says she wants “to get everything straightened out.” Consequently, she has proposed the following accounting changes in connection with Joblonsky Inc.'s 2014 financial statements.
(a) For office furniture and fixtures, it proposes to change from a 10-year useful life to an 8-year life. If this change had been made in prior years, retained earnings at December 31, 2013, would have been $250,000 less. The effect of the change on 2014 income alone is a reduction of $60,000.
(b) For its new equipment in the leasing division, the client proposes to adopt the sum-of-the-years'-digits depreciation method. The client had never used SYD before. The first year the client operated a leasing division was 2014. If straight-line depreciation were used, 2014 income would be $110,000 greater.
Instructions
(a) For each of the changes described above, decide whether:
(1) The change involves an accounting policy, accounting estimate, or correction of an error.
(2) Restatement of opening retained earnings is required.
(b) What would be the proper adjustment to the December 31, 2013, retained earnings?
Professional Research
IFRS22-7 As part of the year-end accounting process and review of operating policies, Cullen Co. is considering a change in the accounting for its equipment from the straight-line method to an accelerated method. Your supervisor wonders how the company will report this change in accounting. It has been a few years since he took intermediate accounting, and he cannot remember whether this change would be treated in a retrospective or prospective manner. Your supervisor wants you to research the authoritative guidance on a change in accounting policy related to depreciation methods.
Instructions
Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.)
(a) What are the accounting and reporting guidelines for a change in accounting policy related to depreciation methods?
(b) What are the conditions that justify a change in depreciation method, as contemplated by Cullen Co.?
International Financial Reporting Problem
Marks and Spencer plc
IFRS22-8 The financial statements of Marks and Spencer plc (M&S) are available at the book's companion website or can be accessed at http://annualreport.marksandspencer.com/assets/downloads/Marks-and-Spencer-Annual-report-and-financial-statements-2012 pdf.
Instructions
Refer to M&S's financial statements and the accompanying notes to answer the following questions.
(a) Were there changes in accounting policies reported by M&S during the two years covered by its income statements (2011–2012)? If so, describe the nature of the change and the year of change.
(b) What types of estimates did M&S discuss in 2012?
ANSWERS TO IFRS SELF-TEST QUESTIONS
Remember to check the book's companion website to find additional resources for this chapter.
1Adoption of the retrospective approach contributes to international accounting convergence. As discussed throughout the textbook, the FASB and the IASB are collaborating on a project in which they have agreed to converge around high-quality solutions to resolve differences between GAAP and IFRS. By adopting the retrospective approach, which is the method used in IFRS, the FASB agreed that this approach is superior to the current approach.
2Presentation of the effect on financial statement subtotals and totals other than income from continuing operations and net income (or other appropriate captions of changes in the applicable net assets or performance indicator) is not required. [3]
3The rationale for this approach is that companies should recognize, in the period the adoption occurs (not the prior period), the effect on the cash flows that is caused by the adoption of the new accounting principle. That is, the accounting change is a necessary “past event” in the definition of an asset or liability that gives rise to the accounting recognition of the indirect effect in the current period. [4]
4In practice, many companies defer the formal adoption of LIFO until year-end. Management thus has an opportunity to assess the impact that a change to LIFO will have on the financial statements and to evaluate the desirability of a change for tax purposes. As indicated in Chapter 8, many companies use LIFO because of the advantages of this inventory valuation method in a period of inflation.
5In evaluating reasonableness, the auditor should use one or a combination of the following approaches.
(a) Review and test the process used by management to develop the estimate.
(b) Develop an independent expectation of the estimate to corroborate the reasonableness of management's estimate.
(c) Review subsequent events or transactions occurring prior to completion of fieldwork.
“Auditing Accounting Estimates,” Statement on Auditing Standards No. 57 (New York: AICPA, 1988).
6An exception to retrospective application occurs when changing from the equity method. We provide an expanded illustration of the accounting for a change from or to the equity method in Appendix 22A.
7See Mark L. Defond and James Jiambalvo, “Incidence and Circumstances of Accounting Errors,” The Accounting Review (July 1991) for examples of different types of errors and why these errors might have occurred.
8The term restatement is used for the process of revising previously issued financial statements to reflect the correction of an error. This distinguishes an error correction from a change in accounting principle. [9]
9A change in accounting principle, a change in the reporting entity (special type of change in accounting principle), and a correction of an error require an explanatory paragraph in the auditor's report discussing lack of consistency from one period to the next. A change in accounting estimate does not affect the auditor's opinion relative to consistency. However, if the change in estimate has a material effect on the financial statements, disclosure may still be required. Error correction not involving a change in accounting principle does not require disclosure relative to consistency.
10If management has not provided reasonable justification for the change in accounting principle, the auditor should express a qualified opinion. Or, if the effect of the change is sufficiently material, the auditor should express an adverse opinion on the financial statements. “Reports on Audited Financial Statements,” Statement on Auditing Standards No. 58 (New York: AICPA, 1988).
11See Ross L. Watts and Jerold L. Zimmerman, “Positive Accounting Theory: A Ten-Year Perspective,” The Accounting Review (January 1990) for an excellent review of research findings related to management incentives in selecting accounting methods.
12O. Douglas Moses, “Income Smoothing and Incentives: Empirical Tests Using Accounting Changes,” The Accounting Review (April 1987). The findings provide evidence that earnings smoothing is associated with firm size, the existence of bonus plans, and the divergence of actual earnings from expectations.
13Lobbyists use economic consequences arguments—and there are many of them—to put pressure on standard-setters. We have seen examples of these arguments in the oil and gas industry about successful-efforts versus full-cost in the technology area, with the issue of mandatory expensing of research and developmental costs and stock options.
14A retrospective application for this type of change is impracticable in many cases. Determining fair values on a portfolio basis for securities in previous periods may be quite difficult. As a result, prospective application is used.
15Adapted from Paul A. Pacter, “Applying APB Opinion No. 18—Equity Method,” Journal of Accountancy (September 1971), pp. 59–60.
16The change to the equity method illustration assumes that the fair value and the book value of the net identifiable assets of the investee are the same. However, the fair value of the net identifiable assets of the investee may be greater than their book value. In this case, this excess (if depreciable or amortizable) reduces the net income reported by the investor from the investee. For example, assume that the fair value of an investee's building is $1,000,000 and its book value is $800,000 at the time of change to the equity method. In that case, this difference of $200,000 is depreciated over the useful life of the building, thereby reducing the amount of investee's net income reported on the investor's books.