CH-20 Accounting Changes and Error Corrections – Intermediate Accounting : Book Guide

Chapter 20 Accounting Changes and Error Corrections 1 Chapter 20 Accounting Changes and Error Corrections QUESTIONS FOR REVIEW OF KEY TOPICS Question 20-1 Accounting changes are categorized as: 1. Changes in principle (when companies switch from one acceptable accounting method to another) 2. Changes in estimate (when new information causes companies to revise estimates made previously) 3. Changes in reporting entity (the group of companies comprising the reporting entity changes) Question 20-2 Accounting changes can be accounted for: 1. Retrospectively (prior years revised), or 2. Prospectively (only current and future years affected). Question 20-3 In general, we report voluntary changes in accounting principles retrospectively. This means revising all previous period’s financial statements as if the new method were used in those periods. In other words, for each year in the comparative statements reported, we revise the balance of each account affected. Specifically, we make those statements appear as if the newly adopted accounting method had been applied all along. Also, if retained earnings is one of the accounts whose balance requires adjustment (and it usually is), we revise the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders’ equity (or statements of retained earnings if they’re presented instead). Then we create a journal entry to adjust all account balances affected as of the date of the change. In the first set of financial statements after the change, a disclosure note would describe the change and justify the new method as preferable. It also would describe the effects of the change on all items affected, including the fact that the retained earnings balance was revised in the statement of shareholders’ equity. 2 Question 20-4 Lynch should report its change in depreciation method as a change in estimate, rather than as a change in accounting principle. This is because a change in depreciation method is considered a change in accounting estimate reflected by a change in accounting principle. In other words, a change in the depreciation method is adopted to reflect a change in (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the company’s knowledge about those benefits. The effect of the change in depreciation method is inseparable from the effect of the change in accounting estimate. Such changes frequently are related to the ongoing process of obtaining new information and revising estimates and, accordingly, are actually changes in estimates not unlike changing the estimated useful life of a depreciable asset. Logically, the two events should be reported the same way. Accordingly, Lynch reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from then on. The undepreciated cost remaining at the time of the change would be depreciated straight-line over the remaining useful life. A disclosure note should justify that the change is preferable and describe the effect of a change on any financial statement line items and per share amounts affected for all periods reported. Question 20-5 In general, we report voluntary changes in accounting principles retrospectively. This means Sugarbaker will revise all previous period’s financial statements, including 2005, as if the average cost method always had been used. Sugarbaker will revise cost of goods sold for 2005 as well as any other income statement amounts affected by that revision, including income taxes and net income. Since the change affects income, retained earnings also changes. Sugarbaker reflects the cumulative prior year difference in cost of goods sold (after tax) as a difference in prior years’ income and therefore in the balance in retained earnings. It also revises inventory in the balance sheet. The company also will revise deferred taxes. Income tax effect is reflected in the deferred income tax asset because retrospectively decreasing accounting income, but not taxable income, creates a temporary difference between the two that will reverse over time as the unsold inventory becomes cost of goods sold. When that happens, taxable income will become lower than accounting income – a future deductible amount, creating a deferred tax asset. Recall from Chapter 16 that in the meantime, the temporary difference is reflected in the deferred tax asset. . 3 Answers to Questions (continued) Question 20-6 Voluntary changes in accounting principles usually are reported retrospectively. We don’t report changes in depreciation method that way, though, because such changes are considered to be changes in estimate and thus reported prospectively. Also, it’s not practicable to report some changes in principle retrospectively because insufficient information is available. Revising balances in prior years means knowing what those balances should be. For instance, suppose we’re switching from the FIFO method of inventory costing to the LIFO method. Recall that LIFO inventory consists of “layers” added in prior years at costs existing in those years. So, if FIFO has been used, the company probably hasn’t kept track of those costs. Accounting records of prior years typically are inadequate to report the change retrospectively, so a company changing to LIFO usually reports the change prospectively. The beginning inventory in the year the LIFO method is adopted becomes the base year inventory for all future LIFO calculations. Another exception is when an FASB Statement or other authoritative pronouncement requires prospective application for specific changes in accounting methods. For example, when there’s a change from the equity method to another method of accounting for long-term investments, APBO No. 18 requires the prospective application of the new method. From Chapter 12, recall that if an investor's level of influence over an investee changes, it may be necessary to change from the equity method to another method. This might happen if a sale of shares causes the investor’s ownership interest to fall from, say, 20% to 10%, resulting in the equity method no longer being appropriate. In such a case, we make no adjustment to the carrying amount of the investment, but instead, simply discontinue the equity method and apply the new method applied from then on. The existing balance in the investment account when the equity method is discontinued serves as the new “cost” basis from then on. Question 20-7 Accounting records of prior years usually are inadequate to determine the cumulative income effect of the change for prior years when a company changes to the LIFO inventory method from another inventory method. For example, it would be necessary to make assumptions as to when specific LIFO inventory layers were created in years prior to the change. Accordingly, a company changing to LIFO generally does not revise the balance in retained earnings. Rather, the beginning inventory in the year the LIFO method is adopted becomes the base year inventory for all future LIFO calculations. A disclosure note would be included in the financial statements describing the nature of and justification for the change as well as an explanation as to why retrospective application was impracticable. 4 Answers to Questions (continued) Question 20-8 A change in estimate is accounted for prospectively. When a company revises an estimate, previous financial statements are not revised. Rather, the company simply incorporates the new estimate in any related accounting determinations from then on. The unamortized cost remaining after three years would be amortized over the new estimate of the useful life. A disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per share amounts for the current period. Question 20-9 When it’s not possible to distinguish between a change in principle and a change in estimate, the change should be treated as a change in estimate. Question 20-10 The situations deemed to constitute a change in reporting entity are (1) presenting consolidated financial statements in place of statements of individual companies and (2) changing the specific companies that comprise the group for which consolidated or combined statements are prepared. Question 20-11 Ford reported the situation as a change in reporting entity. This means recasting all previous period’s financial statements as if the new reporting entity existed in those periods. In the first set of financial statements after the change, a disclosure note describes the nature of the change and the reason it occurred. Also, the effect of the change on net income, income before extraordinary items, and related per share amounts is indicated for all periods presented. Question 20-12 When an error is discovered, previous years' financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. Any account balances that currently are incorrect as a result of the error should be corrected by a journal entry. Also, if retained earnings is one of the accounts whose balance is incorrect, the correction is reported as a “prior period adjustment” to the beginning balance in a Statement of Shareholders’ Equity (or Statement of Retained Earnings if that’s presented instead). A disclosure note is needed also to describe the nature of the error and the impact of its correction on operations. Question 20-13 If merchandise inventory is understated at the end of 2005, that year’s cost of goods sold would be overstated, causing 2005 net income to be understated. Because 2005 ending inventory is 2006 beginning inventory, the opposite effect on net income would occur in 2006. 2006 cost of goods sold would be understated, causing 2006 net income to be overstated by the same amount it was understated the year before. 5 Answers to Questions (concluded) Question 20-14 The error would have caused the previous year’s expenses to be overstated, and therefore its net income to be understated. Therefore, retained earnings would be understated as a result of the error. So, the correction to that account would be reported as a “prior period adjustment” (increase in this case) to the beginning retained earnings balance in the retained earnings column of the Statement of Shareholders’ Equity. Question 20-15 During the two-year period, insurance expense would have been overstated by $30,000, so net income during the period was understated by $30,000. This means retained earnings is currently understated by that amount. During the two-year period, prepaid insurance would have been understated, and continues to be understated by $30,000. So, a correcting entry would debit prepaid insurance and credit retained earnings. Also, the financial statements that were incorrect as a result of the error would be retrospectively restated to report the prepaid insurance acquired and reflect the correct amount of insurance expense when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported since retained earnings is one of the accounts incorrect as a result of the error. And, a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share. Question 20-16 If the error in the previous question is not discovered until the insurance coverage has expired, no correcting entry at all would be needed. By then, the sum of the omitted insurance expense amounts ($10,000 x 5 years) would equal the expense incorrectly recorded when the error occurred, so the retained earnings balance would be the same as if the error never had occurred. Also, the asset – prepaid insurance – would have expired so it also would not need to be recorded. Of course, any statements of prior years that were affected and are reported again in comparative statements still would be restated, and a footnote would describe the error. 6 BRIEF EXERCISES Brief Exercise 20-1 Requirement 1 To record the change: ($ in millions) Retained earnings ........................................................................................... 8.2 Inventory ($32 million – 23.8 million) ..................................... 8.2 Requirement 2 Carney applies the average cost method retrospectively; that is, to all prior periods as if it always had used that method. In other words, all financial statement amounts for individual periods that are included for comparison with the current financial statements are revised for period-specific effects of the change. Then, the cumulative effects of the new method on periods prior to those presented are reflected in the reported balances of the assets and liabilities affected as of the beginning of the first period reported and a corresponding adjustment is made to the opening balance of retained earnings for that period. Let’s say Carney reports 2006-2004 comparative statements of shareholders’ equity. The $8.2 million adjustment above is due to differences prior to the 2006 change. The portion of that amount due to differences prior to 2004 is subtracted from the opening balance of retained earnings for 2004. The effect of the change on each line item affected should be disclosed for each period reported as well as any adjustment for periods prior to those reported. Also, the nature of and justification for the change should be described in the disclosure notes. Brief Exercise 20-2 To record the change: ($ in millions) Inventory ($47.6 million – 64 million) ......................................... 16.4 Retained earnings ..................................................................................... 16.4 7 Brief Exercise 20-3 When a company changes to the LIFO inventory method from another inventory method, accounting records of prior years often are inadequate to determine the cumulative income effect of the change for prior years. For instance, it would be necessary to make assumptions as to when specific LIFO inventory layers were created in years prior to the change. So, a company changing to LIFO generally does not revise the balance in retained earnings. This is the case for Dorsey Markets. No entry is made. Instead, the beginning inventory in the year the LIFO method is adopted ($96 million for Dorsey) becomes the base year inventory for all future LIFO calculations. A disclosure note would be included in the financial statements describing the nature of and justification for the change as well as an explanation as to why retrospective application was impracticable. 8 Brief Exercise 20-4 A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. In other words, a change in the depreciation method is similar to changing the economic useful life of a depreciable asset, and therefore the two events should be reported the same way. Accordingly, Irwin reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from then on. The undepreciated cost remaining at the time of the change would be depreciated straight-line over the remaining useful life. ($ in millions) Asset’s cost $35.0 Accumulated depreciation to date (calculated below) (16.2) Undepreciated cost, Jan. 1, 2006 $18.8 Estimated residual value (2.0) To be depreciated over remaining 7 years $16.8 7 years Annual straight-line depreciation 2006-12 $ 2.4 Calculation of SYD depreciation (10+9+8) x [$35 -2] million) = $16.2 million 55* * n (n = 1) ÷ 2 = 10 (11) ÷ 2 = 55 Adjusting entry (2006 depreciation): ($ in millions) Depreciation expense (calculated above) ............................................. 2.4 Accumulated depreciation ............................................................ 2.4 9 Brief Exercise 20-5 A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. In other words, a change in the depreciation method is similar to changing the economic useful life of a depreciable asset, and therefore the two events should be reported the same way. Accordingly, Irwin reports the change prospectively; previous financial statements are not revised. Instead, the undepreciated cost remaining at the time of the change would be depreciated by the sum-of-the-years’-digits method over the remaining useful life. ($ in millions) Asset’s cost $35.0 Accumulated depreciation to date (calculated below) (9.9) Undepreciated cost, Jan. 1, 2006 $25.1 Estimated residual value (2.0) To be depreciated over remaining 7 years $23.1 Calculation of straight-line depreciation to date ($35 -2) ÷ 10 years = $3.3 x 3 years = $9.9 Adjusting entry (2006 depreciation): ($ in millions) Depreciation expense (calculated below) ............................................. 5.78 Accumulated depreciation ............................................................ 5.78 Calculation of SYD depreciation 7 x 23.1 million = $5.775 million 28* * n (n + 1) ÷ 2 = 7 (8) ÷ 2 = 28 10 Brief Exercise 20-6 When an estimate is revised as new information comes to light, accounting for the change in estimate is quite straightforward. We do not recast prior years' financial statements to reflect the new estimate. Instead, we merely incorporate the new estimate in any related accounting determinations from there on. If the effect of the change in estimate is material, the effect on net income and earnings per share must be disclosed in a note, along with the justification for the change. ($ in millions) Amortization expense (determined below) .. 5 Patent ................................................... 5 Calculation of annual amortization after the estimate change: ($ in millions) $18 Cost $2 Previous annual amortization ($18 ÷ 9 years) x 4 years 8 Amortization to date (2002-2005) $10 Unamortized cost (balance in the patent account) ÷ 2 Estimated remaining life (6 years – 4 years) $ 5 New annual amortization 11 Brief Exercise 20-7 To correct the error: Machinery ............................................................................... 65,000 Buildings ............................................................................. 65,000 Other step(s) that would be taken in connection with the error: When comparative balance sheets are reported that include 2005, the 2005 balance sheet would be restated to reflect the correction. A disclosure note should describe the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share. In this case, because the machine was purchased at the end of 2005, depreciation in 2005 is correct and net income for 2005 is not impacted by the error. 12 Brief Exercise 20-8 Requirement 1 Analysis: Correct Incorrect (Should Have Been Recorded) (As Recorded) 2003 Equipment 350,000 Expense 350,000 Cash 350,000 Cash 350,000 2003 Expense 70,000 depreciation entry omitted Accum. deprec. 70,000 2004 Expense 70,000 depreciation entry omitted Accum. deprec. 70,000 2005 Expense 70,000 depreciation entry omitted Accum. deprec. 70,000 During the three year period, depreciation expense was understated by $210,000, but other expenses were overstated by $350,000, so net income during the period was understated by $140,000, which means retained earnings is currently understated by that amount. During the three year period, accumulated depreciation was understated, and continues to be understated by $210,000. To correct incorrect accounts Equipment .......................................................... 350,000 Accumulated depreciation ($70,000 x 3 years) 210,000 Retained earnings ($350,000 – 140,000) ........ 140,000 Brief Exercise 20-9 No correcting entry would be required because, after five years, the accounts would show appropriate balances. 13 Brief Exercise 20-10 Error a 1. 2005 Income Statement: Expenses understated, net income overstated. 2005 Balance Sheet: Liabilities understated, retained earnings overstated. ($ in millions) Retained earnings .................................................................... 2 Wages expense .................................................................. 2 2. The 2005 financial statements that were incorrect as a result of the error would be retrospectively restated to reflect the correct wages expense, (income tax expense if taxes are considered), net income, and retained earnings when those statements are reported again for comparative purposes in the 2006 annual report. 3. Because retained earnings is one of the accounts incorrectly stated accounts, the correction to that account is reported as a prior period adjustment to the 2006 beginning retained earnings balance in the comparative statements of shareholders’ equity. 4. Also, a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share. 14 Brief Exercise 20-10 (concluded) Error b 1. To include the $3 million in year 2006 purchases and increase retained earnings to what it would have been if 2005 cost of goods sold had not included the $3 million purchases. Analysis: 2005 2006 Beginning inventory Beginning inventory Purchases O Purchases U Less: Ending inventory Cost of goods sold O Revenues Less: Cost of goods sold O U = Understated Less: Other expenses O = Overstated Net income U Ð Retained earnings U ($ in millions) Purchases .......................................................... 3 Retained earnings .......................................... 3 2. The 2005 financial statements that were incorrect as a result of the error would be retrospectively restated to reflect the correct cost of goods sold, (income tax expense if taxes are considered), net income, and retained earnings when those statements are reported again for comparative purposes in the 2006 annual report. 3. Because retained earnings is one of the accounts incorrectly stated accounts, the correction to that account is reported as a prior period adjustment to the 2005 retained earnings balance in the comparative statements of shareholders’ equity. 15 4. Also, a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share. 17 Exercise 20-1 Requirement 1 January 1, 2006 ($ in millions) Retained earnings .......................................................................... 30 Inventory (cumulative effect) * .................................................. 30 2005 2004 Total * Cost of goods sold (FIFO) ........................................................ 40 38 Cost of goods sold (average) .................................................... 56 52 Difference .............................................................................. 16 14 30 Since the cost of goods available for sale each period is the sum of the cost of goods sold and the cost of goods unsold (inventory), a $30 million difference ($16 + 14) in cost of goods sold due to using FIFO rather than Average means there also is a $30 million difference in inventory. The cumulative prior year difference in cost of goods sold is reflected as a difference in prior years’ income and therefore the balance in retained earnings. Requirement 2 COMPARATIVE INCOME STATEMENTS ($ in millions) 2006 2005 Revenues $420 $390 Cost of goods sold (average) (62) (56) Operating expenses (254) (250) Net income $104 $ 84 Requirement 3 Calculations ($ in millions): 2004 Revenues $380 Cost of goods sold (FIFO) (38) Operating expenses (242) Net income $100 Dividends (20) Retained earnings, Jan. 1, 2004 0 Retained earnings, Jan. 1, 2005 $ 80 EXERCISES 18 Exercise 20-1 (concluded) Requirement 4 Calculations ($ in millions): 2004 FIFO Average Difference Revenues $380 $380 Cost of goods sold (38) (52) Operating expenses (242) (242) Net income $100 $ 86 $14 Comparative Statements of Shareholders’ Equity (not required) ($ in millions) Common Stock Additional Paid-in Capital Retained Earnings Total Shareholders’ Equity Jan. 1, 2005* 66 Net income 84** Dividends (20) Jan. 1, 2006 130 Net income 104** Dividends (20) Jan. 1, 2007 214 * Decreased from $80 million to $66 million to reflect the effect of the change in inventory methods. **Calculations ($ in millions): 2006 2005 Revenues $420 $390 Cost of goods sold (average) (62) (56) Operating expenses (254) (250) Net income $104 $ 84 19 Exercise 20-2 Requirement 1 Balance at January 1, 2006, using LIFO $780,000 Prior to 2006, using FIFO: Inventory would have been higher by $60,000, so Cost of goods sold would have been lower by $60,000, so Pretax income would have been higher by: $60,000 Less: income tax at 40% (24,000) Cumulative net income and thus retained earnings would have been higher by: 36,000 Balance at January 1, 2006, using FIFO $816,000 Requirement 2 January 1, 2006 Inventory (additional inventory if FIFO had been used) ...................... 60,000 Retained earnings (additional net income if FIFO had been used) .. 36,000 Deferred tax liability (40% x $60,000) ...................................... 24,000 Exercise 20-3 Requirement 1 ($ in millions) Construction in process (additional amount due to the new method: $7 million + 3 million) ............................................ 10 Deferred tax liability ($10 million x 40%) ........................................ 4 Retained earnings (difference) ........................................................ 6 Retained earnings is increased by $6 million because the net income in years prior to 2006 would have been higher by that amount. Requirement 2 2006 2005 Income before income taxes $10.0 $8.0 Income tax expense (40%) (4.0) (3.2) Net Income $ 6.0 $4.8 20 Exercise 20-3 (continued) Requirement 3 Besides net income, which was reported in 2005 as $3 million ($5 million less tax) and now revised to $4.8 million, other amounts that would be revised to reflect accounting by the percentage - of - completion method are: Earnings per share Income tax expense (and income before income taxes) Construction in process (and total assets) Deferred tax liability (and total liabilities) Retained earnings (and total shareholders’ equity) The reason for the adjustment to deferred tax liability requires some explanation. Remember from Chapter 16 that when taxable income is less than pretax accounting income because of a “temporary difference,” a deferred tax liability is recorded. This liability reflects the tax that eventually will be paid when the difference later reverses and taxable income is higher than pretax accounting income. Here, construction income would have been higher during years prior to 2006 if accounting income had been based on the percentage-of- completion method. So, we need to increase the deferred tax liability from what it is now to what it would have been if percentage-of-completion had been used previously. Here’s another way to view it. For financial reporting purposes, but not for tax, we are now retrospectively recognizing income not previously recorded under the earlier completed contract method. In a future year, when the contract is completed and that income is recognized for tax purposes, taxable income will be higher than accounting income. When taxable income will be higher than accounting income as a temporary difference reverses, we a have “future taxable amount,” and record a deferred tax liability. If we were switching the other way, from percentage-of-completion to the completed contract method, we would record a deferred tax asset instead. For financial reporting purposes, but not for tax, we would be retrospectively eliminating income previously recorded under the percentage-of-completion method. In a future year, when the contract is completed and that income is recognized for financial reporting purposes, accounting income will be higher than taxable income. When taxable income will be less than accounting income as a temporary difference reverses, we have a “future deductible amount” and record a deferred tax asset. 21 Exercise 20-3 (concluded) Requirement 4 In the retained earnings column of the comparative statements of shareholders’ equity, the beginning balance of 2005 retained earnings is revised to include any portion of the cumulative income effect attributable to years prior to 2005. The adjusted balance is then followed by any increases or decreases to retained earnings during the year (net income, dividends, etc.). For example, if retained earnings had been reported at the end of 2004 as $9 million (reflecting the completed contract method) and dividends of $1 million were paid each year, retained earnings would be adjusted as follows (not required): Long Island Construction Company Statement of Shareholders’ Equity For the Years Ended Dec. 31, 2006 and 2005 ($ in millions) Common Stock Additional Paid-in Capital Retained Earnings Total Shareholders’ Equity Balance at Jan. 1 13.2* Net income 4.8 Cash dividends (1.0) Balance at Dec. 31, 2005 17.0 Net income 6.0 Cash dividends (1.0) Balance at Dec. 31, 2006 22.0 * $9 million increased by $4.2 million, the $7 million difference in income before 2005, less 40% income tax. 22 Exercise 20-4 EP 1. Change from declining balance depreciation to straight-line. E 2. Change in the estimated useful life of office equipment. E 3. Technological advance that renders worthless a patent with an unamortized cost of $45,000. PR 4. Change from determining lower of cost or market for inventories by the individual item approach to the aggregate approach. PR 5. Change from LIFO inventory costing to weighted-average inventory costing. E 6. Settling a lawsuit for less than the amount accrued previously as a loss contingency. R 7. Including in the consolidated financial statements a subsidiary acquired several years earlier that was appropriately not included in previous years. N * 8. Change by a retail store from reporting bad debt expense on a pay-as- you-go basis to the allowance method. PR 9. A shift of certain manufacturing overhead costs to inventory that previously were expensed as incurred to more accurately measure cost of goods sold. (Either method is generally acceptable.) E 10. Pension plan assets for a defined benefit pension plan achieving a rate of return in excess of the amount anticipated. *Error correction: change from an unacceptable method to GAAP. 23 Exercise 20-5 This is a change in accounting principle. ($ in millions) Common stock ($1 par x 4 million shares retired) ......................... 4 Paid-in capital – excess of par (average amount above par at which the retired shares originally sold: $800 million .................. ÷ 200 million shares = $4; $4 x 4 million shares retired) .............. 16 Retained earnings (difference) .................................................. 5 Treasury stock (cost of the shares retired) ................................ 25 UMC applies the new way of reporting reacquired shares retrospectively; that is, to all prior periods as if it always had used that method. In other words, all financial statement amounts for individual periods affected by the change and that are included for comparison with the current financial statements are revised. In each prior period reported, then, UMC would reduce Common stock by $4 million, Paid-in capital – excess of par by $16 million, Retained earnings by $5 million, and Treasury stock by $25 million. The effect of the change on each line item affected should be disclosed for each period reported as well as any adjustment for periods prior to those reported. Also, the nature of and justification for the change should be described in the disclosure notes. 24 Exercise 20-6 Requirement 1 ($ in millions) Investment in equity securities ($48 million – 31 million) ........... 17 Retained earnings (investment revenue from the equity method) . 17 Requirement 2 Financial statements would be recast to reflect the equity method for each year reported for comparative purposes. A disclosure note also should describe the change, justify the switch, and indicate its effects on all financial statement items. Requirement 3 When a company changes from the equity method, no adjustment is made to the carrying amount of the investment. Instead, the equity method is simply discontinued, and the new method is applied from then on. The balance in the investment account when the equity method is discontinued would serve as the new “cost” basis for writing the investment up or down to market value in the next set of financial statements. There also would be no revision of prior years, but the change should be described in a disclosure note. 25 Exercise 20-7 Requirement 1 To record the change: ($ in millions) Retained earnings (cost of goods sold higher; 2005 net income lower) 6 Inventory (cost of goods sold higher; inventory lower) ............... 6 Requirement 2 Moulton is unable to apply the LIFO cost method retrospectively. It does, however, have sufficient information to apply the new method prospectively beginning in 2005. So, the company reports numbers for years beginning in 2005 as if it had carried forward the 2004 ending balance in inventory (measured on the FIFO inventory costing basis) and then had begun applying LIFO as of January 1, 2005. A journal entry is needed to revise retained earnings and inventory to balances that would have resulted from using LIFO beginning in 2005 (requirement 1). Information available doesn’t allow recording and reporting the cumulative effects of the new method on periods prior to 2005. The effect of the change on each line item affected should be disclosed for each period reported. Also, the nature of and justification for the change should be described, as well as the reasons full retrospective application was impracticable. Requirement 3 ($ in millions) 2006 2005 2004 Net income $80 $78 $82 LIFO LIFO (revised) FIFO 26 Exercise 20-8 Requirement 1 To record the change: ($ in millions) Retained earnings ($23 million plus $7 million)........................... 30 Inventory (cost of goods sold higher; inventory lower) ............... 30 Requirement 2 If it is impracticable to revise all specific years reported, a change is applied retrospectively as of the earliest year practicable. Wolfgang has information that would allow it to revise all assets and liabilities on the basis of LIFO for 2005 in its comparative statements, but not for 2004. So, the company should report 2005 statement amounts (revised) and 2006 statement amounts (reported for the first time) based on LIFO, but not revise 2004 numbers. Then, it should revise reported account balances retrospectively as of the beginning of 2005 since that’s the earliest date it’s practicable to do so. A journal entry is needed at the beginning of 2006 to adjust retained earnings and inventory to balances that would have resulted from using LIFO all along. This is the cumulative income effects prior to 2005 ($23 million), plus the income effects of 2005 ($7 million). The effect of the change on each line item affected should be disclosed for each period reported. Also, the nature of and justification for the change should be described, as well as the reasons full retrospective application was impracticable. Requirement 3 ($ in millions) 2006 2005 2004 Net income $90 $87 $92 LIFO LIFO (revised) FIFO 27 Exercise 20-9 Requirement 1 In general, we report voluntary changes in accounting principles retrospectively. However, a change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. In other words, a change in the depreciation method reflects a change in the (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the company’s knowledge about those benefits, and therefore the two events should be reported the same way. Accordingly, Clinton reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change would be depreciated straight-line over the remaining useful life. A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported. Requirement 2 Asset’s cost $2,560,000 Accumulated depreciation to date (given) (1,650,000) Undepreciated cost, Jan. 1, 2006 $ 910,000 Estimated residual value (160,000) To be depreciated over remaining 3 years $ 750,000 3 years Annual straight-line depreciation 2006-5 $ 250,000 Adjusting entry: Depreciation expense (calculated above) .......................... 250,000 Accumulated depreciation ....................................... 250,000 28 Exercise 20-10 Requirement 1 In general, we report voluntary changes in accounting principles retrospectively. However, a change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. In other words, a change in the depreciation method reflects a change in the (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the company’s knowledge about those benefits, and therefore the two events should be reported the same way. Accordingly, Canliss reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the SYD method from now on. The undepreciated cost remaining at the time of the change would be depreciated by the SYD method over the remaining useful life (3 years). A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported. Requirement 2 Asset’s cost $800,000 Accumulated depreciation to date ($160,000 x 2) (320,000) To be depreciated over remaining 3 years $ 480,000 2006 SYD depreciation: 3 x $480,000 = $240,000 (3 + 2 + 1) Adjusting entry: Depreciation expense (calculated above) .......................... 240,000 Accumulated depreciation ....................................... 240,000 Not required: 2007 SYD depreciation: 2 x $480,000 = $160,000 (3 + 2 + 1) 2008 SYD depreciation: 1 x $480,000 = $80,000 (3 + 2 + 1) 29 Exercise 20-11 1. d 2. b Exercise 20-12 Requirement 1 April 1, 2006 Cash ........................................................................................ 36,000 Receivable - royalty revenue ............................................. 31,000 Royalty revenue ................................................................. 5,000 October 1, 2006 Cash ........................................................................................ 40,000 Royalty revenue ................................................................. 40,000 December 31, 2006 Receivable - royalty revenue ................................................. 50,000 Royalty revenue ($500,000 x 10%) ........................................ 50,000 Requirement 2 The fact that more royalty revenue was received in April than anticipated in December represents a change in estimate. No adjustments are made to any 2005 financial statements. 30 Exercise 20-13 1. This is a change in estimate. To revise the liability on the basis of the new estimate: Liability - litigation ($1,000,000 – 600,000) ................... 400,000 Gain – litigation ...................................................... 400,000 2. A disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per-share amounts for the current period. Exercise 20-14 Requirement 1 Accrued liability and expense Warranty expense (3% x $3,600,000) ............................................... 108,000 Estimated warranty liability ............................................... 108,000 Actual expenditures (summary entry) Estimated warranty liability ................................................... 88,000 Cash, wages payable, parts and supplies, etc. .................... 88,000 Requirement 2 Actual expenditures (summary entry) Estimated warranty liability ($50,000 – $23,000) ...................... 27,000 Loss on product warranty (3% – 2%] x $2,500,000) ................... 25,000 Cash, wages payable, parts and supplies, etc. .................... 52,000* *(3% x $2,500,000) – $23,000 = $52,000 31 Exercise 20-15 A deferred tax liability is established using the currently enacted tax rate for the year(s) a temporary difference is expected to reverse. In this case that rate was 40%. The change in the tax law in 2007 constitutes a change in estimate. The deferred tax liability is simply revised to reflect the new rate. ($ in millions) Income tax expense (to balance) ................................................ 10 Deferred tax liability ($20 million x [40% – 30%]) ....................... 2 Income tax payable ($30 million x 40%) ................................. 12 When a company revises a previous estimate, prior financial statements are not revised. No adjustment is made to existing accounts. A disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per-share amounts for the current period. Exercise 20-16 Requirement 1 This is a change in accounting estimate. Requirement 2 When an estimate is revised as new information comes to light, accounting for the change in estimate is quite straightforward. We do not recast prior years' financial statements to reflect the new estimate. Instead, we merely incorporate the new estimate in any related accounting determinations from there on. If the after- tax income effect of the change in estimate is material, the effect on net income and earnings per share must be disclosed in a note, along with the justification for the change. Requirement 3 $800,000 Cost $160,000 Old annual depreciation ($800,000 ÷ 5 years) x 2 years 320,000 Depreciation to date (2004-2005) 480,000 Book value ÷ 6 New estimated remaining life (8 years - 2 years) $ 80,000 New annual depreciation 32 Exercise 20-17 Requirement 1 Depreciation expense (determined below) ... 3,088 Accumulated depreciation .................. 3,088 Calculation of annual depreciation after the estimate change: $40,000 Cost $7,200 Old annual depreciation ($36,000 ÷ 5 years) x 2 years 14,400 Depreciation to date (2004-2005) $25,600 Book value 900 Revised residual value $24,700 Revised depreciable base ÷ 8 Estimated remaining life (10 years - 2 years) $ 3,088 New annual depreciation Requirement 2 Depreciation expense (determined below) ... 3,889 Accumulated depreciation ................... 3,889 Calculation of annual depreciation after the estimate change: $40,000 Cost Previous depreciation: $12,000 2004: ($36,000 x 5/15) 9,600 2005: ($36,000 x 4/15) 21,600 Depreciation to date (2004-2005) $18,400 Book value 900 Revised residual value $17,500 Revised depreciable base x 8/36* Estimated remaining life - 8 years $ 3,889 2006 depreciation * n (n + 1) / 2 = 8 (9) / 2 = 36 33 Exercise 20-18 Requirement 1 The 2004 error caused 2004 net income to be understated, but since 2004 ending inventory is 2005 beginning inventory, 2005 net income was overstated the same amount. So, the income statement was misstated for 2004 and 2005, but the balance sheet (retained earnings) was incorrect only for 2004. After that, no account balances are incorrect due to the 2004 error. Analysis: U = Understated O = Overstated 2004 2005 Beginning inventory → Beginning inventory U Plus: net purchases ↑ Plus: net purchases Less: ending inventory U → Less: ending inventory Cost of goods sold O Cost of goods sold U Revenues Revenues Less: cost of goods sold O Less: cost of goods sold U Less: other expenses Less: other expenses Net income U Net income O È È Retained earnings U Retained earnings corrected 34 Exercise 20-18 (concluded) However, the 2005 error has not yet self-corrected. Both retained earnings and inventory still are overstated as a result of the second error. Analysis: U = Understated O = Overstated 2005 Beginning inventory Plus: net purchases Less: ending inventory O Cost of goods sold U Revenues Less: cost of goods sold U Less: other expenses Net income O È Retained earnings O Requirement 2 Retained earnings (overstatement of 2005 income) ........................ 150,000 Inventory (overstatement of 2006 beginning inventory) .............. 150,000 Requirement 3 The financial statements that were incorrect as a result of both errors (effect of one error in 2004 and effect of two errors in 2005) would be retrospectively restated to report the correct inventory amounts, cost of goods sold, income, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share. 35 Exercise 20-19 1. Error discovered before the books are adjusted or closed in 2006. Investments ($100,000 – 80,000) ........................................................ 20,000 Gain on sale of investments ................................................ 20,000 2. Error not discovered until early 2007. Investments ($100,000 – 80,000) ........................................................ 20,000 Retained earnings ................................................................ 20,000 36 Exercise 20-20 Requirement 1 The error caused both 2004 net income and 2005 net income to be overstated, so retained earnings is overstated by a total of $85,000. Also, the note payable would be understated by the same amount. Remember, the entry to record interest is: Interest expense ................................................................................. xxx Note payable (difference) .......................................................... xxx Cash .................................................................................... xxx So, if interest expense is understated, the reduction in the note will be too much, causing the balance in that account to be understated. Requirement 2 Retained earnings (overstatement of 2004-05 income) .................. 85,000 Note payable (understatement determined above) ..................... 85,000 Requirement 3 The financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct interest amounts, income, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share. Exercise 20-21 1. c 2. a 3. a 37 Exercise 20-22 The 2006 interest expense is overstated by the extra interest recorded in February. Similarly, retained earnings is overstated the same amount because 2005 interest expense was understated when the accrued interest was not recorded. To correct the error: Retained earnings ........................................................... 61,000 Interest expense ($73,200 – $12,200*) ....................... 61,000 2006 adjusting entry: Interest expense (5/6 x $73,200) ................................. 61,000 Discount on bonds payable (5/6 x $1,200).............. 1,000 Interest payable (5/6 x $72,000) .............................. 60,000 *ENTRIES THAT SHOULD HAVE BEEN RECORDED: 2005 adjusting entry: Interest expense (5/6 x $73,200) .............................. 61,000 Discount on bonds payable (5/6 x $1,200) ........... 1,000 Interest payable (5/6 x $72,000) ........................... 60,000 February 1, 2006: Interest expense (1/6 x $73,200) .............................. 12,200 Interest payable (5/6 x $72,000) ............................... 60,000 Discount on bonds payable (1/6 x $1,200) ........... 200 Cash ( gi 38 Exercise 20-23 Error a Income Statement: Expenses understated, net income overstated. Balance Sheet: Liabilities understated, retained earnings overstated. Retained earnings .................................................................... 1,800 Office supplies expense .................................................... 1,800 Error b Income Statement: Revenue overstated, net income overstated. Balance Sheet: Liabilities understated, retained earnings overstated. Retained earnings .................................................................... 90,000 Rent revenue ....................................................................... 90,000 Error c Income Statement: Revenue understated, net income understated. Balance Sheet: Assets understated, retained earnings understated. Interest revenue ....................................................................... 8,000 Retained earnings ................................................................ 8,000 39 Exercise 20-24 U = understated O = overstated NE = no effect Cost of Net Retained Goods Sold Income Earnings 1. Overstatement of ending inventory U O O 2. Overstatement of purchases O U U 3. Understatement of beginning inventory U O O 4. Freight-in charges are understated U O O 5. Understatement of ending inventory O U U 6. Understatement of purchases U O O 7. Overstatement of beginning inventory O U U 8. Understatement of purchases + understatement of ending inventory by the same amount NE NE NE 40 Exercise 20-25 F 1. Change from expensing extraordinary repairs to capitalizing the expenditures. C 2. Change in the residual value of machinery. B 3. Change from FIFO inventory costing to LIFO inventory costing. C 4. Change in the percentage used to determine bad debts. A 5. Change from LIFO inventory costing to FIFO inventory costing. B 6. Change from reporting an investment by the equity method to another method due to a reduction in the percentage of shares owned. E 7. Change in the composition of a group of firms reporting on a consolidated basis. D 8. Change from sum-of-the-years’-digits depreciation to straight-line. A 9. Change from the percentage-of-completion method by a company in the long-term construction industry. C 10. Change in actuarial assumptions for a defined benefit pension plan. 41 Exercise 20-26 1. a. Prior-period adjustments (error corrections) are to be accounted for through retained earnings, not the income statement. Thus, the beginning balance of retained earnings should be credited for revenue that was erroneously not accrued in a prior period. The amount of the credit at May 31, 2007 is $91,800 (2006 accrued interest revenue).. 2. d. A change in the liability is merely a change in an estimate; it is not a change in principle. A change in estimate should be accounted for prospectively, that is, in the current and future periods. 3. c. The correction of an error in the financial statements of a prior period is accounted for and reported as a prior-period adjustment and excluded from the determination of net income for the current period (SFAS 16, Prior Period Adjustment). 42 Problem 20-1 Requirement 1 To record the change: Inventory ($155,000 – $120,000) ................................................ 35,000 Deferred tax liability ($35,000 x 40%) .................................. 14,000 Retained earnings (net effect) .............................................. 21,000 Note: For financial reporting purposes, but not for tax, the company is retrospectively increasing accounting income, but not taxable income. This creates a temporary difference between the two that will reverse over time as the unsold inventory becomes cost of goods sold. When that happens, taxable income will be higher than accounting income. When taxable income will be higher than accounting income as a temporary difference reverses, we have a “future taxable amount” and record a deferred tax liability. Requirement 2 COMPARATIVE INCOME STATEMENTS 2006 2005 Income before taxes $525,000 $399,000* Income tax expense (40%) (210,000) (159,600) Net income $315,000 $239,400 Earnings per share: Earnings per common share $3.15 $2.39 *$400,000 less 1,000‡ = $399,000 if FIFO had been used ‡ Calculation of decrease in 2005 pretax income: $160,000 – $124,000 = $36,000 increase in 2005 beginning inventory $155,000 – $120,000 = (35,000) increase in 2005 ending inventory ↑ ↑ $ 1,000 increase in cost of goods sold/ FIFO average decrease in income PROBLEMS 43 Problem 20-2 Requirement 1 Construction in process (additional amount due to the new method) 39,000 Deferred tax liability ($39,000* x 40%) ................................. 15,600 Retained earnings (difference) .............................................. 23,400 * Since the method used for tax purposes cannot be changed retrospectively for prior years, the switch for financial reporting purposes will cause a temporary difference between taxable income and pretax financial income in prior years when the method of determining pretax financial income in those years is changed – regardless of whether the tax method is changed for future years or not. When the temporary difference reverses, taxable income will be higher than accounting income. When taxable income will be higher than accounting income as a temporary difference reverses, we have a “future taxable amount” and record a deferred tax liability. Retained earnings is increased by $23,400 because the net income for 2004 and 2005 would have been higher by that amount, and net income increases retained earnings. Requirement 2 2006 2005 Income before income taxes $51,000 $45,000 Income tax expense (40%) (20,400) (18,000) Net Income $30,600 $27,000 Earnings per share: (50,000 shares) $.61 $.54 44 Problem 20-2 (concluded) Requirement 3 Pyramid Construction Company Statement of Shareholders’ Equity For the Years Ended Dec. 31, 2006 and 2005 Common Stock Additional Paid-in Capital Retained Earnings Total Shareholders’ Equity Balance at Jan. 1 * 50,000 180,000 54,000 284,000 Net income 27,000 27,000 Cash dividends (10,000) (10,000) Balance at Dec. 31, 2005 50,000 180,000 71,000 301,000 Net income 30,600 30,600 Cash dividends (10,000) (10,000) Balance at Dec. 31, 2006 50,000 180,000 91,600 321,600 * Retained earnings at the beginning of 2005 (end of 2004) is increased by $18,000 because the net income for 2004 would have been higher by that amount, and net income increases retained earnings. 45 Problem 20-3 1. This is a change in accounting principle to be recorded retrospectively. ($ in 000s) Retained earnings ($3,550 – 3,140) ........................................... 410 Inventory (reduction to Average) ............................................ 410 Weihrich will recast its financial statements to appear as if the average method always had been used. It also will reduce retained earnings to the balance it would have had if the average method had been used previously; that is, by the cumulative income difference between the average and FIFO methods. Simultaneously, inventory is reduced to the balance it would have had if the average method had always been used. A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported. 2. This is a change in accounting principle to be recorded retrospectively. ($ in 000s) Inventory (increase to average cost) ................................................ 730 Retained earnings ($3,550 – 2,820) ....................................... 730 In its comparative 2006-2005 financial statements, Weihrich should report numbers for 2005 as if it had carried forward the 2004 ending balance in inventory (measured on the previous FIFO inventory costing basis) and then had begun applying LIFO as of January 1, 2005. There would be no adjustment to accounts for the cumulative income effect of not using LIFO prior to that. 3. This is a change in accounting principle that usually is reported prospectively. No entry is needed to record the change. When a company changes to the LIFO inventory method from another inventory method, it usually does not report the change retrospectively. Instead, the base year inventory for all future LIFO calculations is the beginning inventory in the year the LIFO method is adopted. A footnote should describe the nature of and justification for the change as well as an explanation as to why retrospective application was impracticable. 46 Problem 20-4 Requirement 1 To record the change: Retained earnings (net effect) .................................................. 12,000 Deferred tax asset ($20,000 x 40%) ........................................... 8,000 Inventory ($150,000 – $130,000) ............................................ 20,000 Note: For financial reporting purposes, but not for tax, the company is retrospectively decreasing accounting income, but not taxable income. This creates a temporary difference between the two that will reverse over time as the unsold inventory becomes cost of goods sold. When that happens, taxable income will be lower than accounting income. When taxable income will be lower than accounting income as a temporary difference reverses, we have a “future deductible amount” and record a deferred tax asset. Requirement 2 Rockwell will recast its financial statements to appear as if the average method always had been used. This will include reporting cost of goods sold in the income statement and inventory in the balance sheet for 2006 using the newly adopted average method. Average cost method cost of goods sold: Beginning inventory (5,000 units) $130,000 Purchases: 5,000 units @ $36 $180,000 5,000 units @ $40 200,000 380,000 Cost of goods available for sale (15,000 units) 510,000 Less ending inventory (below) (238,000) Cost of goods sold $272,000 Cost of ending inventory: $510,000 Weighted average unit cost = = $34 15,000 units Inventory: 7,000 units x $34 = $238,000 47 Problem 20-5 Requirement 1 January 1, 2006 ($ in millions) Inventory (additional inventory if FIFO had been used) ...................... 20 Retained earnings (additional net income if FIFO had been used) .. 12* Deferred tax payable (40% x $20 million) .................................. 8 * Prior to 2006, using FIFO: Inventory would have been higher by $20, so Cost of goods sold would have been lower by $20, so Pretax income would have been higher by: $20 Less: income tax at 40% (8) Cumulative net income and thus retained earnings would have been higher by: $12 For financial reporting purposes, but not for tax, the company is retrospectively increasing accounting income, but not taxable income. This creates a temporary difference between the two that will reverse over time as the unsold inventory becomes cost of goods sold. When that happens, taxable income will be higher than accounting income. When taxable income will be higher than accounting income as a temporary difference reverses, we have a “future taxable amount” and record a deferred tax liability. Requirement 2 Net income, which was reported in 2005 as $28 million would be revised to $30 million in the 2006-2005 comparative income statements. Net income in 2006 would simply be reported at $36 million, the amount resulting from using the new method (FIFO). The comparative income statements and balance sheets also would be recast to reflect the balances as if the FIFO method had been used in prior years. 48 Problem 20-5 (concluded) Requirement 3 Fantasy Fashions Statement of Shareholders’ Equity For the Years Ended Dec. 31, 2006 and 2005 ($ in millions) Common Stock Additiona l Paid-in Capital Retained Earnings Total Shareholders’ Equity Balance at Jan. 1, 2005 2501 Net income (revised to FIFO) 30 2 Cash dividends (8) Balance at Dec. 31, 2005 272 Net income (using FIFO) 36 2 Cash dividends (8) Balance at Dec. 31, 2006 300 1 $240 million plus the difference in net income before 2005: $250 - 240 2 given A disclosure note would describe the change and justify the new method as preferable. It also would describe the effects of the change on all items affected, including the fact that the January 1, 2005, balance in the statement of shareholders’ equity was revised by $10 million due to the change from the LIFO to the FIFO method of accounting for inventories. If three-year comparative statements were provided, it would be the balance in retained earnings at the beginning of 2004 that would be revised for any portion of the cumulative income effect attributable to years prior to 2004. Retained earnings is revised for the earliest year reported in the comparative statements. 49 Problem 20-6 Requirement 1 A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. In other words, a change in the depreciation method is similar to changing the economic useful life of a depreciable asset, and therefore the two events should be reported the same way. Accordingly, Faulkner reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from then on. The undepreciated cost remaining at the time of the change would be depreciated straight-line over the remaining useful life. Asset’s cost $21,000 Accumulated depreciation (SYD) to date (given) (6,000) Undepreciated cost, Jan. 1, 2006 $15,000 Estimated residual value (1,000) To be depreciated over remaining 8 years $14,000 8 years Annual straight-line depreciation 2006-13 $ 1,750 Adjusting entry (2006 depreciation): Depreciation expense (calculated above) ............................................. 1,750 Accumulated depreciation ............................................................ 1,750 A disclosure note should justify that the change is preferable and describe the effect of a change on any financial statement line items and per share amounts affected for all periods reported. 50 Problem 20-6 (concluded) Requirement 2 If Faulkner switched to sum-of-the-years’-digits with 8 years remaining, it reports the change prospectively; previous financial statements are not revised. Instead, the company employs the SYD method from then on. The undepreciated cost remaining at the time of the change would be depreciated by the SYD method over the remaining useful life. Asset’s cost $21,000 Accumulated depreciation (S-L) to date (given) (4,000) Undepreciated cost, Jan. 1, 2006 $17,000 Estimated residual value (1,000) To be depreciated over remaining 8 years $16,000 x 8 / 36* SYD depreciation 2006 $ 3,556 * n (n + 1) / 2 = 8 (9) / 2 = 36 Adjusting entry (2006 depreciation): Depreciation expense (calculated above) ............................................. 3,556 Accumulated depreciation ............................................................ 3,556 A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported. 51 Problem 20-7 Requirement 1 Cost of mineral mine: Purchase price $1,600,000 Development costs 600,000 $2,200,000 Depletion: $2,200,000 - 100,000 Depletion per ton = = $5.25 per ton 400,000 tons 2006 depletion = $5.25 x 50,000 tons = $262,500 2007 depletion: Revised depletion rate = ($2,200,000 - 262,500) - 100,000 = $4.20 487,500 - 50,000 tons 2007 depletion = $4.20 x 80,000 tons = $336,000 Depreciation: Structures: $150,000 Depreciation per ton = = $.375 per ton 400,000 tons 2006 depreciation = $.375 x 50,000 tons = $18,750 2007 depreciation: Revised depreciation rate = $150,000 - 18,750 = $.30 487,500 - 50,000 tons 2007 depreciation = $.30 x 80,000 tons = $24,000 52 Problem 20-7 (concluded) Equipment: $80,000 - 4,000 Depreciation per ton = = $.19 per ton 400,000 tons 2006 depreciation = $.19 x 50,000 tons = $9,500 2007 depreciation: Revised depreciation rate = ($80,000 - 9,500) - 4,000 = $.152 487,500 - 50,000 tons 2007 depreciation = $.152 x 80,000 tons = $12,160 Requirement 2 Mineral mine: Cost $ 2,200,000 Less accumulated depletion: 2006 depletion $262,500 2007 depletion 336,000 598,500 Book value, 12/31/07 $1,601,500 Structures: Cost $ 150,000 Less accumulated depreciation: 2006 depreciation $18,750 2007 depreciation 24,000 42,750 Book value, 12/31/07 $107,250 Equipment: Cost $ 80,000 Less accumulated depreciation: 2006 depreciation $ 9,500 2007 depreciation 12,160 21,660 Book value, 12/31/07 $58,340 53 Problem 20-8 a. This is a change in estimate. No entry is needed to record the change 2006 adjusting entry: Warranty expense (2% x $4,000,000) ................................... 80,000 Estimated warranty liability .................................... 80,000 If the effect is material, a disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per share amounts for the current period. b. This is a change in estimate. No entry is needed to record the change 2006 adjusting entry: Depreciation expense (determined below) ..................... 45,000 Accumulated depreciation ...................................... 45,000 Calculation of annual depreciation after the estimate change: $1,000,000 Cost $25,000 Old depreciation ($1,000,000 ÷ 40 years) x 3 yrs (75,000) Depreciation to date (2003-2005) $ 925,000 Undepreciated cost (700,000) New estimated salvage value $ 225,000 To be depreciated ÷ 5 Estimated remaining life (5 years: 2006-2010) $ 45,000 New annual depreciation A disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per share amounts for the current period. 54 Problem 20-8 (continued) c. This is a change in accounting principle that usually is reported prospectively. No entry is needed to record the change. When a company changes to the LIFO inventory method from another inventory method, accounting records usually are insufficient to determine the cumulative income effect of the change necessary to retrospectively revise accounts. So, a company changing to LIFO usually reports the beginning inventory in the year the LIFO method is adopted ($690,000 in this case) as the base year inventory for all future LIFO calculations. The disclosure required is a footnote to the financial statements describing the nature of and justification for the change as well as an explanation as to why the retrospective application was impracticable. d. This is a change in accounting estimate resulting from a change in accounting principle. No entry is needed to record the change 2006 adjusting entry: Depreciation expense (determined below) ..................... 24,000 Accumulated depreciation ...................................... 24,000 55 Problem 20-8 (concluded) A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. Accordingly, the Hoffman Group reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change is depreciated straight-line over the remaining useful life. ($ in 000s) Asset’s cost $330 Accumulated depreciation to date (calculated below) (162) Undepreciated cost, Jan. 1, 2006 $168 Estimated residual value (0) To be depreciated over remaining 7 years $168 7 years Annual straight-line depreciation 2006-12 $ 24 Calculation of SYD depreciation: (10+9+8) x $330,000) = $162,000 55 e. This is a change in estimate. To revise the liability on the basis of the new estimate: Loss – litigation .................................................................. 150,000 Liability - litigation ($350,000 – 200,000) .......................... 150,000 A disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per share amounts for the current period. f. This is a change in accounting principle accounted for prospectively. Because the change will be effective only for assets placed in service after the date of change, the change doesn’t affect assets depreciated in prior periods. The nature of and justification for the change should be described in the disclosure notes. Also, the effect of the change on the current period’s financial statements should be disclosed. 56 Problem 20-9 P R 1. By acquiring additional stock, Wagner increased its investment in Wise, Inc. from a 12% interest to 25% and changed its method of accounting for the investment from an available-for-sale investment to the equity method. N P 2. Wagner instituted a postretirement benefit plan for its employees in 2006 and adopted SFAS No. 106, “Accounting for Postretirement Benefit Plans Other than Pensions.” Wagner had not previously had such a plan. EP P 3. Wagner changed its method of depreciating computer equipment from the SYD method to the straight-line method. X R 4. Wagner determined that a liability insurance premium it both paid and expensed in 2005 covered the 2005-2007 period. P R 5. Wagner custom-manufactures farming equipment on a contract basis. Wagner switched its accounting for these long-term contracts from the completed-contract method to the percentage- of-completion method. E P 6. Due to an unexpected relocation, Wagner determined that its office building previously to be depreciated over 45 years should be depreciated over 18 years. E P 7. Wagner offers a three-year warranty on the farming equipment it sells. Manufacturing efficiencies caused Wagner to reduce its expectation of warranty costs from 2% of sales to 1% of sales. P R 8. Wagner changed from LIFO to FIFO to account for its materials and work in process inventories. P R 9. Wagner changed from FIFO to average cost to account for its equipment inventory. X R 10. Wagner sells extended service contracts on some of its equipment sold. Wagner performs services related to these contracts over several years, so in 2006 Wagner changed from recognizing revenue from these service contracts on a cash basis to the accrual basis. 57 Problem 20-10 Requirement 1 Analysis: U = Understated O = Overstated 2004 2005 Beginning inventory → Beginning inventory U-6,000 Plus: Net purchases ↑ Plus: Net purchases U-3,000 Less: Ending inventory U-6,000 Less: Ending inventory O-9,000 Cost of goods sold O-6,000 Cost of goods sold U-18,000 Revenues Revenues Less: Cost of goods sold O-6,000 Less: Cost of goods sold U-18,000 Less: Other expenses Less: Other expenses Net income U-6,000 Net income O-18,000 Ð Ð Retained earnings U-6,000 Retained earnings O-12,000 Requirement 2 Retained earnings ..................................... 12,000 Inventory .............................................. 9,000 Purchases ............................................. 3,000 Requirement 3 The financial statements that were incorrect as a result of both errors (effect of one error in 2004 and effect of three errors in 2005) would be retrospectively restated to report the correct inventory amounts, cost of goods sold, income, and retained earnings when those statements are reported again for comparative purposes in the 2006 annual report. A prior period adjustment to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share. 58 Problem 20-11 Requirement 1 Analysis: Correct Incorrect (Should Have Been Recorded) (As Recorded) 2004 Equipment 1,900,000 Equipment 2,000,000 Expense 100,000 Cash 2,000,000 Cash 2,000,000 2004 Expense 475,000 [1] Expense 500,000 [2] Accum. deprec. 475,000 Accum. deprec. 500,000 2005 Expense 356,250 [3] Expense 375,000 [4] Accum. deprec. 356,250 Accum. deprec. 375,000 [1] $1,900,000 x 25% (2 times the straight-line rate of 12.5%) [2] $2,000,000 x 25% [3] ($1,900,000 - 475,000) x 25% [4] ($2,000,000 - 500,000 ) x 25% During the two-year period, depreciation expense was overstated by $43,750, but other expenses were understated by $100,000, so net income during the period was overstated by $56,250, which means retained earnings is currently overstated by that amount. During the two-year period, accumulated depreciation was overstated, and continues to be overstated by $43,750. To correct incorrect accounts Retained earnings .................................................. 56,250 Accumulated depreciation ................................... 43,750 Equipment ......................................................... 100,000 59 Problem 20-11 (concluded) Requirement 2 This is a change in accounting estimate resulting from a change in accounting principle. No entry is needed to record the change 2006 adjusting entry: Depreciation expense (determined below) ..................... 178,125 Accumulated depreciation ...................................... 178,125 A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. Accordingly, the Collins Corporation reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change is depreciated straight-line over the remaining useful life. Asset’s cost (after correction) $1,900,000 Accumulated depreciation to date ($475,000 + 356,250) (831,250) Undepreciated cost, Jan. 1, 2006 $1,068,750 Estimated residual value (0) To be depreciated over remaining 6 years $1,068,750 6 years Annual straight-line depreciation 2006-11 $ 178,125 60 Problem 20-12 a. This is a correction of an error. To correct the error: Prepaid insurance ($35,000 ÷ 5 yrs x 3 yrs: 2006-2008) ........... 21,000 Retained earnings* ................................................................ 21,000 *$35,000 – [$35,000 ÷ 5 years x 2 years: 2004-05] 2006 adjusting entry: Insurance expense ($35,000 ÷ 5 years) ...................................... 7,000 Prepaid insurance ........................................................... 7,000 The financial statements that were incorrect as a result of the error would be retrospectively restated to report the prepaid insurance acquired and reflect the correct amount of insurance expense when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share. b. This is a change in estimate. No entry is needed to record the change 2006 adjusting entry: Depreciation expense (determined below) ............................ 15,000 Accumulated depreciation ............................................. 15,000 Calculation of annual depreciation after the estimate change: $600,000 Cost $12,500 Old depreciation ([$600,000 – $100,000] ÷ 40 years) x 10 yrs (125,000) Depreciation to date (1996-2005) $475,000 Undepreciated cost (25,000) New estimated salvage value $450,000 To be depreciated ÷ 30 Estimated remaining life (40 years – 10 years) $ 15,000 New annual depreciation 61 Problem 20-12 (continued) A disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per share amounts for the current period. c. This is a correction of an error. To correct the error: Retained earnings ....................................................................... 25,000 Inventory .................................................................................. 25,000 The financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct inventory amounts, cost of goods sold, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share. d. This is a change in accounting principle and is reported retrospectively. To record the change: Inventory (given) .................................................................. 960,000 Retained earnings ................................................................... 960,000 Most changes in accounting principle are accounted for retrospectively. Prior years' financial statements are recast to reflect the use of the new accounting method. The company should increase retained earnings to the balance it would have been if the FIFO method had been used previously; that is, by the cumulative income difference between the LIFO and FIFO methods. Simultaneously, inventory is increased to the balance it would have been if the FIFO method had always been used. A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported. 62 Problem 20-12 (continued) e. This is a correction of an error. To correct the error: Retained earnings ....................................................................... 15,500 Compensation expense ......................................................... 15,500 The 2005 financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct compensation expense, net income, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share. f. This is a change in estimate resulting from a change in accounting principle and is accounted for prospectively. No entry is needed to record the change 2006 adjusting entry: Depreciation expense (calculated below) .................................. 57,600 Accumulated depreciation ............................................ 57,600 A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. Accordingly, the Williams-Santana reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change is depreciated straight-line over the remaining useful life. Undepreciated cost, Jan. 1, 2006 (given) $460,800 Estimated residual value (0) To be depreciated over remaining 8 years $460,800 8 years Annual straight-line depreciation 2006-13 $ 57,600 63 Problem 20-12 (concluded) g. This is a change in estimate. No entry is needed to record the change 2006 adjusting entry: Bad debt expense (.75% x $4,000,000) ................................. 30,000 Allowance for uncollectible accounts ............................ 30,000 If the effect is material, a disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per share amounts for the current period. h. This is a correction of an error. To correct the error: Equipment (cost) .................................................................. 1,000,000 Accumulated depreciation ([$1,000,000 ÷ 10] x 3 years) ..... 300,000 Retained earnings ($1,000,000 – [$100,000 x 3 years]) ......... 700,000 2006 adjusting entry: Depreciation expense ($1,000,000 ÷ 10) .............................. 100,000 Accumulated depreciation .............................................. 100,000 The financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct depreciation, assets, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share. 64 Problem 20-13 a. This is a correction of an error. To correct the error: Prepaid insurance ($35,000 ÷ 5 yrs x 3 yrs: 2006-2008) ........... 21,000 Income tax payable ($21,000 x 40%) ............................... 8,400 Retained earnings* ................................................................ 12,600 *($35,000 – [$35,000 ÷ 5 years x 2 years: 2004-05]) less $8,400 tax 2006 adjusting entry: Insurance expense ($35,000 ÷ 5 years) ...................................... 7,000 Prepaid insurance ........................................................... 7,000 The financial statements that were incorrect as a result of the error would be retrospectively restated to report the prepaid insurance acquired and reflect the correct amount of insurance expense when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share. b. This is a change in estimate. No entry is needed to record the change 2006 adjusting entry: Depreciation expense (determined below) ............................ 15,000 Accumulated depreciation ............................................. 15,000 Calculation of annual depreciation after the change: $600,000 Cost $12,500 Old depreciation ([$600,000 – $100,000] ÷ 40 years) x 10 yrs (125,000) Depreciation to date (1996-2005) $475,000 Undepreciated cost (25,000) New estimated salvage value $450,000 To be depreciated ÷ 30 Estimated remaining life (40 years – 10 years) $ 15,000 New annual depreciation 65 Problem 20-13 (continued) A disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per share amounts for the current period. c. This is a correction of an error. To correct the error: Retained earnings (net effect) ..................................................... 15,000 Refund - income tax ($25,000 x 40%) ................................. 10,000 Inventory .................................................................................. 25,000 The financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct inventory amounts, cost of goods sold, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share. d. This is a change in accounting principle and is reported retrospectively. To record the change: Inventory (given) .................................................................. 960,000 Deferred tax liability ($960,000 x 40%) ............................ 384,000 Retained earnings (net effect) ................................................ 576,000 Most changes in accounting principle are accounted for retrospectively. Prior years' financial statements are recast to reflect the use of the new accounting method. The company should increase retained earnings to the balance it would have been if the FIFO method had been used previously; that is, by the cumulative net income difference between the LIFO and FIFO methods. Simultaneously, inventory is increased to the balance it would have been if the FIFO method had always been used. A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported. 66 Problem 20-13 (continued) For financial reporting purposes, but not for tax, the company is retrospectively increasing accounting income, but not taxable income. This creates a temporary difference between the two that will reverse over time as the unsold inventory becomes cost of goods sold. When that happens, taxable income will be higher than accounting income. When taxable income will be higher than accounting income as a temporary difference reverses, we have a “future taxable amount” and record a deferred tax liability. e. This is a correction of an error. To correct the error: Retained earnings (net effect) ..................................................... 9,300 Refund - income tax ($15,500 x 40%) .................................. 6,200 Compensation expense ......................................................... 15,500 The 2005 financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct compensation expense, net income, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share. 67 Problem 20-13 (continued) f. This is a change in estimate resulting from a change in accounting principle and is accounted for prospectively. No entry is needed to record the change 2006 adjusting entry: Depreciation expense (calculated below) .................................. 57,600 Accumulated depreciation ............................................ 57,600 A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. Accordingly, the Williams-Santana reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change is depreciated straight-line over the remaining useful life. Undepreciated cost, Jan. 1, 2006 (given) $460,800 Estimated residual value (0) To be depreciated over remaining 8 years $460,800 8 years Annual straight-line depreciation 2006-13 $ 57,600 g. This is a change in estimate. No entry is needed to record the change. 2006 adjusting entry: Bad debt expense (.75% x $4,000,000) ................................. 30,000 Allowance for uncollectible accounts ............................ 30,000 If the effect is material, a disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per share amounts for the current period. 68 Problem 20-13 (concluded) h. This is a correction of an error. To correct the error: Equipment (cost) .................................................................. 1,000,000 Accumulated depreciation ([$1,000,000 ÷ 10] x 3 years) ..... 300,000 Deferred tax liability ([$1,000,000 - $300,000] x 40%) ....... 280,000 Retained earnings ($1,000,000 – [$100,000 x 3 years]) less $280,000 tax ........... 420,000 2006 adjusting entry: Depreciation expense ($1,000,000 ÷ 10) .............................. 100,000 Accumulated depreciation .............................................. 100,000 The financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct depreciation, assets, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share. 69 Problem 20-14 Requirement 1 a. ($ in millions) Inventory (understatement of 2006 beginning inventory) ................ 10 Retained earnings (understatement of 2005 income) .................. 10 Note: The 2004 error requires no adjustment because it has self-corrected by 2006. b. Liability – litigation (original estimate) ............................................ 7 Gain – litigation ($7 million – 4 million) ...................................... 3 Cash (actual settlement) ................................................................. 4 c. Retained earnings (2004-05 patent amortization) ............................. 6 Patent ([$18 million ÷ 6 yrs.] x 2) .................................................. 6 2006 adjusting entry: Patent amortization expense ($18 million ÷ 6 years) ................ 3 Patent ................................................................................ 3 d. No entry to record the change 2006 adjusting entry: Depreciation expense (determined below) ................................. 4 Accumulated depreciation ................................................. 4 Calculation of annual depreciation after the change: $30 Cost (18) Previous depreciation (calculated below*) $12 Undepreciated cost (0) Estimated residual value $12 To be depreciated ÷ 3 yrs Estimated remaining life $ 4 New annual depreciation *SYD: 2004 depreciation $10 ($30 x 5/15) 2005 depreciation 8 ($30 x 4/15) Accumulated depreciation $18 70 Problem 20-14 (concluded) Requirement 2 Shareholders’ Net Assets Liabilities Equity Income Expenses 2004 $740 $330 $410 $210 $150 2004 inventory (12) (12) (12) 12 Loss contingency no adjustments to prior years Patent amortization (3) (3) (3) 3 Depreciation no adjustments to prior years ____ ____ ____ ____ ____ $725 $330 $395 $195 $165 2005 $820 $400 $420 $230 $175 2004 inventory 12 (12) 2005 inventory 10 10 10 (10) Loss contingency no adjustments to prior years Patent amortization (6) (6) (3) 3 Depreciation no adjustments to prior years ____ ____ ____ ____ ____ $824 $400 $424 $249 $156 71 Problem 20-15 1a. To correct the error: Equipment (cost) .................................................................... 45,000 Accumulated depreciation ([$45,000 ÷ 5] x 2 years) ............. 18,000 Retained earnings ($45,000 – [$9,000 x 2 years]) ..................... 27,000 2006 adjusting entry: Depreciation expense ($45,000 ÷ 5) ...................................... 9,000 Accumulated depreciation ................................................ 9,000 b. To reverse erroneous entry: Cash ..................................................................................... 17,000 Office supplies ................................................................. 17,000 To record correct entry: Tools .................................................................................... 17,000 Cash ................................................................................. 17,000 Note: These entries can, of course, be combined. c. To correct the error: Inventory .......................................................................................... 78,000 Retained earnings ...................................................................... 78,000 d. To correct the error: Retained earnings ([$12 x 2,000 shares] – $2,000) ..................... 22,000 Paid-in capital – excess of par .......................................... 22,000 Note: A “small” stock dividend (<25%) requires that the market value of the additional shares be “capitalized.”. 72 Problem 20-15 (concluded) e. To correct the error: Retained earnings (overstatement of 2005 income) ....................... 104,000 Interest expense (overstatement of 2006 interest) .................. 104,000 2006 adjusting entry: Interest expense (4/6 x $156,000)............................................. 104,000 Interest payable (4/6 x $156,000) ......................................... 104,000 f. To correct the error: Prepaid insurance ($72,000 ÷ 3 yrs x 2 years: 2006-2007) .......... 48,000 Retained earnings ($72,000 – [$72,000 ÷ 3 years]) .............. 48,000 2006 adjusting entry: Insurance expense ($72,000 ÷ 3 years) ......................................... 24,000 Prepaid insurance ............................................................. 24,000 73 CASES Judgment Case 20-1 Situation I 1. A change in the depreciable lives of fixed assets is a change in accounting estimate. 2. The change in estimate should be reflected in the current period and in future periods. Unlike a change in accounting principle, the change in accounting estimate should not be applied retrospectively. 3. This change in accounting estimate will affect the balance sheet in that the accumulated depreciation in the current and future years will increase at a different rate than previously reported, and this will also be reflected in depreciation expense in the income statement in the current and future years. 4. A footnote should disclose the effect of the change in accounting estimate on income before extraordinary items, net income, and related per share amounts for the current period. Situation II 1. The change from reporting the investment in Allen to using a consolidated financial statement basis is a change in reporting entity. 2. A change in reporting entity is effected and disclosed by recasting all prior- period financial statements in accordance with the method of presenting the current financial statements of the new reporting entity. In the initial set of financial statements occurring after the change, the nature of and reason for the change must be disclosed by footnote, but subsequent financial statements need not repeat the disclosures. 3. The balance sheet will be affected by this change in that the investment account of the parent and the equity section of the subsidiary will be eliminated, intercompany accounts will be eliminated, and a goodwill account may arise. The income statement will be affected in that intercompany transactions will be eliminated. 74 Case 20-1 (concluded) 4. The financial statements of the period of the change in the reporting entity should describe by footnote disclosure the nature of the change and the reason for it. In addition, the effect of the change in earnings before extraordinary items, net earnings, and related per share amounts should be disclosed for all periods presented. Financial statements of subsequent periods need not repeat the disclosures. Situation III 1. The change in the method of computing depreciation represents a change in estimate resulting from a change in accounting principle. This is because a change in the depreciation method is adopted to reflect a change in (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the company’s knowledge about those benefits. The effect of the change in depreciation method is inseparable from the effect of the change in accounting estimate. Such changes frequently are related to the ongoing process of obtaining new information and revising estimates and, accordingly, are actually changes in estimates not unlike changing the estimated useful life of a depreciable asset. Logically, the two events should be reported the same way. Accordingly, the company reports the change prospectively; previous financial statements are not recast. Instead, the company simply employs the straight- line method from then on. The undepreciated cost remaining at the time of the change would be depreciated straight-line over the remaining useful life. 2. The change should be reflected in the current period and in future periods. Unlike most changes in accounting principle, the change in accounting estimate should not be applied retrospectively. 3. This change will affect the balance sheet in that the accumulated depreciation in the current and future years will increase at a different rate than previously reported, and this will also be reflected in depreciation expense in the income statement in the current and future years. 4. Additionally, a disclosure note should justify that the change is preferable and describe the effect of a change on any financial statement line items and per share amounts affected for all periods reported. 75 Analysis Case 20-2 Requirement 1 DRS's change in depreciation method for computers represents a change in estimate resulting from a change in accounting principle. This is because a change in the depreciation method is adopted to reflect a change in (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the company’s knowledge about those benefits. Accordingly, the company reports the change prospectively; previous financial statements are not recast. Instead, the company simply employs the straight-line method from then on. The undepreciated cost remaining at the time of the change would be depreciated using the straight-line method over the remaining useful life The change in residual value for the office building is a change in accounting estimate. The company reports the change prospectively; previous financial statements are not recast. Instead, the company simply employs the new residual value estimate from then on. The undepreciated cost remaining at the time of the change would be reduced by the new estimate of residual value and the resulting amount would be depreciated over the remaining useful life of the building. DRS's change in the specific subsidiaries constituting the group of companies for which consolidated financial statements are presented is a change in reporting entity. A change in reporting entity is effected and disclosed by recasting all prior-period financial statements in accordance with the method of presenting the current financial statements of the new reporting entity. In the initial set of financial statements occurring after the change, the nature of and reason for the change must be disclosed by footnote, but subsequent financial statements need not repeat the disclosures. Requirement 2 Applying the same accounting principles from one reporting period to another enhances the comparability of accounting information across accounting periods. The FASB’s conceptual framework describes consistency as one of the important qualitative characteristics of accounting information. When accounting changes occur, the usefulness of the comparative financial statements is enhanced with retrospective application of those changes, especially when assessing trends. 76 If a change in accounting principle occurs, the nature and effect of a change should be disclosed. Disclosure is desirable because of the presumption that an accounting principle once adopted will not change. 77 Analysis Case 20-3 The change from cash basis recognition for service contract revenue to the accrual basis is a change from an unacceptable accounting principle to one that is generally accepted. So the change is considered an error correction. Ray should restate prior periods’ financial statements and adjust retained earnings for the effect on January 1, 2006. Ray also should disclose the nature and details of the corrections in disclosure notes. The change from accelerated depreciation for all future acquisitions is a change in accounting principle. Ray should disclose the nature and justification for the change in depreciation methods in the disclosure notes to the 2006 financial statements, along with the effect of the change on current year’s income. There is no retrospective application because the change was made only for equipment acquired after January 1, 2006. Ray’s change from LIFO to FIFO is a change in accounting principle for which Ray should recast prior periods’ financial statements to appear as if FIFO had been used all along. It also should state the nature and justification for the change in inventory method along with the effects of the change on financial statement components for all periods presented. 78 Integrating Case 20-4 1. Webster's dollar-value LIFO inventory at December 31, 2007 and 2008, is calculated as follows: Year Inventory Divided Inventory Layers at by At Base At Base Times Inventory FIFO Index Year Cost Year Cost Index at DVL 2006 $300,000 1.00 $300,000 $300,000 1.00 $300,000 2007 $412,500 1.25 $330,000 $300,000 1.00 $300,000 30,000 1.25 37,500 $337,500 2008 $585,000 1.50 $390,000 $300,000 1.00 $300,000 30,000 1.25 37,500 60,000 1.50 90,000 $427,500 2. When a company changes to the LIFO inventory method from another inventory method, accounting records usually are insufficient to determine the cumulative income effect of the change required to apply the new method retrospectively. So, a company changing to LIFO usually applies the change prospectively. The base year inventory for all future LIFO calculations is the beginning inventory in the year the LIFO method is adopted ($300,000 in this case). Disclosure required includes a footnote to the financial statements describing the nature of and justification for the change as well as an explanation as to why retrospective application was impracticable. 79 Communication Case 20-5 Suggested Grading Concepts and Grading Scheme: Content (80% ) 20 Identifies the situation as a change in estimate. The liability was originally (appropriately) estimated as $750,000. The final settlement indicates the estimate should be revised. 40 Describes the journal entry related to the change in amounts. The liability must be reduced (a debit). A gain should be recorded (a credit). The amount of the gain should be $275,000 ($750,000 – $475,000). 20 Indicates that additional disclosure is necessary. Bonus (4) Provides detail regarding the disclosure note. A disclosure note should describe the effect of a change in estimate on key items. The effect on income before extraordinary items, net income, and related per share amounts for the current period should be indicated. 80-84 points Writing (20%) 5 Terminology and tone appropriate to the audience of a Vice President. 6 Organization permits ease of understanding. Introduction that states purpose. Paragraphs separate main points. 9 English. Word selection. Spelling. Grammar. 20 points 80 Analysis Case 20-6 Larry apparently is referring to the fact that because the company now believes the useful lives of the assets are longer than before that depreciation calculated assuming the shorter 16 year life was overstated. Now by not recalculating a lower depreciation for earlier years, the undepreciated cost to allocate to future years is less than it would have been had depreciation been based on 20 years all along. The result is that depreciation following the change in estimate is less than it would have been had depreciation been based on 20 years all along. In other words, depreciation was “too high” before the change and “too low” after the change. Larry is right if we accept his premise that depreciation was, in fact, “too high” before the change. That perspective enjoys the benefit of hindsight. When the original estimate was made, 16 years was considered the appropriate useful life. The accounting profession argues that as conditions change, estimates change, and that resulting inconsistencies are unavoidable. Therefore, changes in estimates are accounted for prospectively. When a company revises a previous estimate, prior financial statements are not revised. Instead, the company merely incorporates the new estimate in any related accounting determinations from then on. The result, however, is as Larry describes: the depreciation before the change is higher and the depreciation after the change is lower than it would have been if the new estimate had been used throughout. 81 Ethics Case 20-7 Discussion should include these elements. How would the actions suggested contribute toward “softening” the bad news? The choice of inventory method will affect earnings. FIFO will increase reported net income in a period of rising prices. However, FIFO also will cause an increase in taxes paid. Less obvious would be a change in LIFO pools. By drastically increasing the number of LIFO pools, the company may be able to cause some LIFO liquidations. If so, cost of goods sold would be forced to include much older, lower costs, thereby increasing net income. Changing estimates on depreciable lives, salvage values, pension assumptions, and others also can influence reported profits. Academic research performed in this area would indicate that accounting changes that merely increase reported earnings without any real economic (or cash flow) effect will not produce the desired effect of increasing share price. Most research suggests that the stock market “sees through” purely cosmetic accounting changes. Quite a bit of evidence, though, at least anecdotal evidence, indicates that managers attempt to fool the market. Some efforts to manage earnings may not be an attempt to affect share prices, but to avoid violating terms of contracts based on earnings or related balance sheet items. Some may be to favorably affect terms of compensation agreements. 82 Case 20-7 (concluded) Ethical Dilemma: Is the auditor’s obligation to challenge the questionable change in methods greater than the obligation to the financial interests of the CPA firm and its client? Who is affected?: You, the auditor Managers CPA firm (lost fees? reputation? legal action?) Shareholders Potential shareholders The employees The creditors Company managers, particularly the president, stand to benefit from the suggested actions. The auditor risks negative consequences if the changes occur and are challenged. 83 Research Case 20-8 The results students report will vary somewhat depending on the firms chosen. However, disclosures of changes in actuarial assumptions for benefit plans are quite similar, following SFAS No. 132, “Employers' Disclosures About Pensions and Other Postretirement Benefits.” A recent disclosure for Delta Airlines follows: We used the following actuarial assumptions to determine the actuarial present value of our APBO: Sept. 30, Sept. 30, March 31, 2001 2000 2000 ---------------------------------------------------------------------------------------------------- -- Weighted average discount rate 7.75% 8.25% 8.25% Assumed health care cost trend rate(*) 6.25% 7.00% 7.00% ---------------------------------------------------------------------------------------------------- -- (*) The assumed healthcare cost trend rate is assumed to decline gradually to 5.50% in 2003 and remain level thereafter. A 1% change in the health care cost rate used in measuring the APBO at September 30, 2001 would have the following effects: (In Millions) 1% Increase 1% Decrease Increase (decrease) in the total service and interest cost $ 17 $ (15) Increase (decrease) in the APBO 112 (111) Under SFAS 132, this is typical. Delta did not disclose the specific effect of changing from 8.25% to 7.75% in 2001. Instead, regardless of the actual change, the effect of a 1% change in either direction is reported. 84 Analysis Case 20-9 For changes not involving LIFO or changes from the LIFO method to another, the event is accounted for as a normal change in accounting principle. In general, we report voluntary changes in accounting principles retrospectively. This means revising all previous period’s financial statements as if the new method were used in those periods. In other words, for each year in the comparative statements reported, we revise the balance of each account affected. More specifically, we make those statements appear as if the newly adopted accounting method had been applied all along. Also, if retained earnings is one of the accounts whose balance requires adjustment (and it usually is), we make an adjustment to the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders’ equity (or statements of retained earnings if they’re presented instead). Then we create a journal entry to adjust all account balances affected as of the date of the change. The advantage of retrospective application is to enhance comparability of the statements from year to year. The recast statements appear as if the newly adopted accounting method had been applied in all previous years. Consistency and comparability suggest that accounting choices once made should be consistently followed from year to year. So, any change requires that the new method be justified as clearly more appropriate. In the first set of financial statements after the change, a disclosure note is needed to provide that justification. The footnote also should point out that comparative information has been revised and report any per share amounts affected for the current period and all prior periods presented. When a company changes to the LIFO inventory method from any other method, it usually is impracticable to calculate the cumulative effect of the change. Revising balances in prior years would require knowing what those balances should be. LIFO inventory, though, consists of “layers” added in prior years at costs existing in those years. If another method has been used, the company probably hasn’t kept a record of those costs. Accordingly, accounting records of prior years usually are inadequate to report the change retrospectively. Because of this difficulty, a company changing to LIFO usually does not report the change retrospectively. Instead, the base year inventory for all future LIFO calculations is the beginning inventory in the year the LIFO method is adopted. Then, the LIFO method is applied prospectively from that point on. The disclosure note must include an explanation as to why retrospective application was impracticable. 85 Real World Case 20-10 Requirement 1 We report most voluntary changes in accounting principles retrospectively. This means recasting all previous period’s financial statements as if the new method were used in those periods. For each year in the comparative statements reported, we revise the balance of each account affected so that those statements appear as if the newly adopted accounting method had been applied all along. Then we create a journal entry to adjust all account balances affected as of the date of the change. GAAP requires retrospective application to enhance comparability of the statements from year to year. The revised statements are made to appear as if the newly adopted accounting method (FIFO inventory costing in this case) had been applied in all previous years. Requirement 2 The note reports that the switch to the FIFO cost method caused a decrease in earnings per share of 2 cents for the first nine months of 2003. In order for FIFO to result in lower earnings (higher cost of goods sold) than LIFO (assuming the quantity of inventory did not change), the cost of inventory must have decreased during the year. 86 Communication Case 20-11 Requirement 1 Change in Inventory Method During 2006, the Company changed the method of valuing its inventories from the first-in, first-out (FIFO) method, to the last-in, first-out (LIFO) method, determined by the retail method. To estimate the effects of changing retail prices on inventories, the Company utilizes internally developed price indexes. The impact of the change was to decrease 2006 net income by $13.2 million and to decrease earnings per share by $0.13. Management has determined that retrospective application of the change is impracticable because the cumulative effect of the change on prior years was not determinable. The Company believes that the change to the LIFO method provides a more consistent matching of merchandise costs with sales revenue and also provides a more comparable basis of accounting with competitors. Note: Because cost of goods sold would have been $22 million lower if the change had not been made, income before tax would have been $22 million higher, and net income would have been $13.2 million higher ($22 million multiplied by 60% [1 - .40]). Requirement 2 It usually is impracticable to calculate the cumulative effect of a change to LIFO. To do so would require assumptions as to when specific LIFO inventory layers were created in years prior to the change. Accounting records usually are inadequate for a company to create the appropriate LIFO inventory layers. That’s why a change to LIFO usually can’t be applied retrospectively. 87 Judgment Case 20-12 Despite the self-correcting feature of certain inventory errors, the errors cause the financial statements of the year of the error as well as the financial statements in the subsequent year to be incorrect. For example, an overstatement of ending inventory at the end of 2005 will correct itself in 2006 and retained earnings at the end of 2006 will be correct. However, cost of goods sold and net income will be incorrect in both years. In addition, inventory and retained earnings on the 2005 balance sheet will be incorrect. If a material inventory error is discovered in an accounting period subsequent to the period in which the error is made, previous years’ financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. And, of course, any account balances that are incorrect as a result of the error are corrected by journal entry. If retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to the beginning balance of retained earnings in the statement of shareholders’ equity. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary item, and earnings per share. Ethics Case 20-13 Requirement 1 Bonuses will be negatively affected because if the error is corrected, a lower ending inventory results in higher cost of goods sold and lower pre-tax income. The effect of the error would be an overstatement of income by $665,000 ($3,265,000 - 2,600,000). Requirement 2 It will be reported as a prior period adjustment to the beginning retained earnings balance for the year beginning July 1, 2006. Financial statements for the year ending June 30, 2006, will be restated to reflect the correct inventory amount, cost of goods sold, net income, and retained earnings. Requirement 3 Ethical Dilemma: Should John recognize his obligation to disclose the inventory error to Danville shareholders, the local bank, auditors, and taxing authorities or remain 88 quiet, enabling him and other company employees to receive originally computed year-end bonuses? Solution Manual for Intermediate Accounting David J. Spiceland, James F. Sepe, Lawrence A. Tomassini 9780072994025, 9780072524482