Lecture Intermediate accounting (IFRS/e) - Chapter 20: Accounting changes and error

In this chapter we examine the way accounting changes and error corrections are handled in a variety of situations that might be encountered in practice. We see that most changes in accounting policies are reported retrospectively. Changes in estimates are accounted for prospectively.

ACCOUNTING CHANGES AND ERROR

Chapter 20

Type of Change Description Examples

Change from fair value accounting to equity method, or vice versa.

Change from cost method to revaluation,

or vice versa.

Change in Accounting Revision of an estimate Change depreciation methods

Estimate because of new information Change estimate of useful life of

or new experience depreciable asset.

Change estimate of residual value of depreciable asset.

Change estimate of impairment loss Change actuarial estimates pertaining to

Type of Change Description Examples

Error correction Mathematical mistakes.

Inaccurate physical count of inventory Application of the cash basis of

accounting in place of the accrual basis Failure to record an adjusting entry Recording an asset as an expense, or vice versa.

Correction of an error caused

by a transaction being recorded incorrectly or not at

all

Correction of an Error

Accounting Changes and Error Corrections

Retrospective

Two Reporting Approaches

Two Reporting Approaches

Prospective

Error Corrections and Most Changes in Policies

Retrospective

Two Reporting Approaches

Two Reporting Approaches

Prospective

Revise prior years’ statements (that are

presented for comparative purposes) to reflect the impact of the change.

• The balance in each account affected is revised to appear as if the newly adopted accounting policy had been applied all along or that the error had never occurred

• Adjust the beginning balance of retained earnings for the earliest period reported

Revise prior years’ statements (that are

presented for comparative purposes) to reflect the impact of the change.

• The balance in each account affected is revised to appear as if the newly adopted accounting policy had been applied all along or that the error had never occurred

• Adjust the beginning balance of retained earnings for the earliest period reported

The Retrospective Approach

Prior period errors must be corrected retrospectively so as to produce correct comparative information in the current set of

financial statements

A retrospective application of a policy

is a retrospective adjustment to effect

a change in policy

While a retrospective restatement of the comparative information is used to

correct a prior period error

In normal circumstances, only one year’s comparative information needs to be provided But, when a company makes one of the above two retrospective adjustments, it has to present an additional statement of financial position as

at the beginning of the earliest period presented

Since the earliest period presented in a normal situation is the previous period, the beginning of the earliest period would be two periods before the

current period

Changes in Estimates

Retrospective

Two Reporting Approaches

Two Reporting Approaches

Prospective

The change is implemented in the current

period, and its effects are reflected in the

financial statements of the current and

future years only.

• Prior years’ statements are not revised

• Account balances are not revised

Qualitative Characteristics

Although consistency and comparability are desirable, changing to a new policy sometimes is appropriate.

Change in Accounting Policy

Accounting standards present some choices to companies with respect to accounting policies.

Change in Accounting Policy

Motivation for Accounting Choices

Changing Conditions

Changing Conditions

New Accounting Standard Issued

New Accounting Standard Issued

Effect on Compensation Effect on Compensation

Effect on Debt Agreements

Effect on Debt Agreements

Effect on Union Negotiations

Effect on Union Negotiations

Motivations for Change

Motivations for Change

Effect on Income Taxes Effect on Income Taxes

Revenues $ 950 $ 900 $ 875 $ 4,500 Operating expenses 230 210 205 1,000

Let’s look at an examples of a change from Weighted Average (WA) costing method to the FIFO method.

At the beginning of 2012, Air Parts Corporation changed from

WA to FIFO Air Parts has paid dividends of $40 million each year since 2004 Its income tax rate is 20 percent Retained earnings on January 1, 2010, was $700 million; inventory was $500 million Selected income statement amounts for

2012 and prior years are (in millions):

Revise Comparative Financial

Income Statements ($ in millions)

For each year reported, Air Parts makes the comparativestatements appear as if the newly adopted accounting

method (FIFO) had been in use all along

For each year reported, Air Parts makes the comparativestatements appear as if the newly adopted accounting

method (FIFO) had been in use all along

Note: only two periods need to be reported for statements, with the exception

of the statement of financial position.

Previous

2012 2011 2010 Years Cost of goods sold (WA) $ 430 $ 420 $ 405 $ 2,000 Cost of goods sold (FIFO) 370 365 360 1,700 Difference $ 60 $ 55 $ 45 $ 300

Comparative statements will report 2010 inventory $345

million higher than it was reported in last year’s statements

Retained earnings for 2010 will be $276 million higher

[$345 million × (1 – 20% tax rate)]

Revise Comparative Financial

Statements

For each year reported, Air Parts makes the comparativestatements appear as if the newly adopted accounting

method (FIFO) had been in use all along

For each year reported, Air Parts makes the comparativestatements appear as if the newly adopted accounting

method (FIFO) had been in use all along

Previous

2012 2011 2010 Years Cost of goods sold (WA) $ 430 $ 420 $ 405 $ 2,000 Cost of goods sold (FIFO) 370 365 360 1,700 Difference $ 60 $ 55 $ 45 $ 300

Comparative statements will report 2011 inventory $400

million higher than it was reported in last year’s statements

Retained earnings for 2011 will be $320 million higher

[$400 million × (1 – 20% tax rate)]

For each year reported, Air Parts makes the comparativestatements appear as if the newly adopted accounting

method (FIFO) had been in use all along

For each year reported, Air Parts makes the comparativestatements appear as if the newly adopted accounting

method (FIFO) had been in use all along

Revise Comparative Financial

Statements

Previous

2012 2011 2010 Years Cost of goods sold (WA) $ 430 $ 420 $ 405 $ 2,000 Cost of goods sold (FIFO) 370 365 360 1,700 Difference $ 60 $ 55 $ 45 $ 300

Comparative statements will report 2012 inventory $460 million higher than it would havebeen if the change from WA had not occurred

Retained earnings for 2012 will be $368 million higher

[$460 million × (1 – 20% tax rate)]

For each year reported, Air Parts makes the comparativestatements appear as if the newly adopted accounting

method (FIFO) had been in use all along

For each year reported, Air Parts makes the comparativestatements appear as if the newly adopted accounting

method (FIFO) had been in use all along

Revise Comparative Financial

Statements

January 1, 2011:

Inventory 400,000,000

Retained earnings 320,000,000 Deferred tax liability……….……… … 80,000,000

To increase inventory, retained earnings, and deferred tax liability

as a result of the change from weighted average to FIFO.

Adjust Accounts for the Change

On January 1, 2012, the date of the change,the following journal entry would be made

to record the change in Policy

On January 1, 2012, the date of the change,the following journal entry would be made

to record the change in Policy

20% of $400,000,000

Disclosure Notes

Prospective Approach

Some Changes in Policies

Sometimes a lack of information makes it impracticable to report a change retrospectively so the new policy is

simply applied prospectively For example:

•A US company switching from FIFO to LIFO may not have kept records of the required information to restate past periods.

•A company adopting the fair value option for an amortized cost debt

instrument would not be able to fathom the manager’s intent in past

periods.

•A company moving to adopt the fair value model for its investment

properties (which are thinly traded) would not be able to guess what their discounted cash flow projections would have been like in the past periods.

Sometimes a lack of information makes it impracticable to report a change retrospectively so the new policy is

simply applied prospectively For example:

•A US company switching from FIFO to LIFO may not have kept records of

the required information to restate past periods.

• A company adopting the fair value option for an amortized cost debt

instrument would not be able to fathom the manager’s intent in past

periods.

•A company moving to adopt the fair value model for its investment

properties (which are thinly traded) would not be able to guess what their discounted cash flow projections would have been like in the past periods.

Most changes in policies are reported by the retrospective

approach, but:

Prospective Approach

Some Changes in Policies

Prospective Approach

Some Changes in Policies

There is another exception to retrospective application That is when an IASB Statement or another authoritative pronouncement requires prospective application for

specific changes in accounting policies:

• The entity is required to follow the IFRS prescribed transitional

provisions when it first applies the changes in a new or amended

standard

• In certain instances, prospective application of the new IFRS is

required An example would be the implementation of IFRS No 3,

“Business Combinations”.

There is another exception to retrospective application That is when an IASB Statement or another authoritative pronouncement requires prospective application for

specific changes in accounting policies:

• The entity is required to follow the IFRS prescribed transitional

provisions when it first applies the changes in a new or amended

standard

• In certain instances, prospective application of the new IFRS is

required An example would be the implementation of IFRS No 3,

“Business Combinations”.

Most changes in policies are reported by the retrospective

approach, however:

A change in depreciation method is not a

change in policy but a change in the expected pattern of consumption of benefits of an asset, therefore, we

account for such a change

way we account for changes in

estimates.

Note: A disclosure note should describe

the nature and effect of the change in the

accounting estimate in the current as

well as future periods affected by the

change If the amount of effect in future

periods could not be determined, the

company should disclose that fact.

Prospective Approach

Change in Accounting Estimate

On January 1, 2008, Towing Ltd purchased specialized

equipment for $243,000 The equipment has been depreciated using the straight-line method and had an estimated life of 10 years and salvage value of $3,000 At the end of 2011 the total useful life of the equipment was revised to 6 years Calculate the 2012 depreciation expense.

Change in Accounting Estimate

Universal Semiconductors switched from SYD depreciation to straight-line depreciation in 2012 The asset was purchased at the beginning of 2010 for $63 million, has a useful life of 5 years and

an estimated residual value of $3 million.

Universal Semiconductors switched from SYD depreciation to straight-line depreciation in 2012 The asset was purchased at the beginning of 2010 for $63 million, has a useful life of 5 years and

an estimated residual value of $3 million.

Sum-of-the-Years-Digits Depreciation (millions)

Calculation of Straight-Line Depreciation ($ in millions)

Asset's cost $ 63

Less accumulated depreciation to date of change 36

Undepreciated cost on January 1, 2012 $ 27

Less estimated residual value 3

To be depreciated over remaining three years $ 24

Remaining life years 3 Annual straight-line depreciation (2012-2014) $ 8

Changing Depreciation Methods

÷

Depreciation adjusting entry for 2012, 2013, and 2014.

Depreciation adjusting entry for 2012, 2013, and 2014.

Changing Depreciation Methods

Depreciation expense 8,000,000

Accumulated depreciation 8,000,000

To record depreciation expense.

APPLICATION OF ACCOUNTING POLICIES TO

DIFFERENT OR NEW TRANSACTIONS,

CONDITIONS, AND EVENTS These should be accounted for prospectively…

APPLICATION OF ACCOUNTING POLICIES TO

DIFFERENT OR NEW TRANSACTIONS,

CONDITIONS, AND EVENTS

Error Correction

Errors arise from the misuse of or the failure to use available information that could have been reasonably obtained as of the date when the financial statements were authorized for issue

Examples include:

• Use of inappropriate policies

• Mistakes in applying IFRS

• Arithmetic mistakes

• Fraud or gross negligence in reporting

For all years disclosed, financial statements are

retrospectively restated to reflect the error correction

Errors arise from the misuse of or the failure to use

available information that could have been reasonably obtained as of the date when the financial statements were authorized for issue

Examples include:

• Use of inappropriate policies

• Mistakes in applying IFRS

• Arithmetic mistakes

• Fraud or gross negligence in reporting

For all years disclosed, financial statements are

retrospectively restated to reflect the error correction

Correction of Accounting Errors

Four-step process

statements that were incorrect.

retained earnings is one of the incorrect accounts affected.

the nature of the error and the impact on each line item affected and earnings per share for each prior period presented

Four-step process

statements that were incorrect.

retained earnings is one of the incorrect

accounts affected.

the nature of the error and the impact on each line item affected and earnings per share for

each prior period presented

Correction of Accounting Errors

… Retrospectively restate prior years’ financial statements that were incorrect.

statements that were incorrect.

Errors Occurred and Discovered

in the Same Period

Corrected by reversing the incorrect entry and then recording the correct entry (or

by making an entry to correct the account

Errors Not Affecting Prior Years’ Net Income

Involves incorrect classification of accounts.

Requires correction of previously issued

statements (retrospective approach).

since it does not affect prior income.

Disclose nature of error.

Involves incorrect classification of accounts.

Requires correction of previously issued

since it does not affect prior income.

Disclose nature of error.

Error Affecting Prior Year’s Net Income

• Requires correction of previously issued

statements (retrospective approach).

• All incorrect account balances must be

corrected.

• Is classified as a prior period adjustment since it does affect prior income.

• Disclose nature of error.

corrected.

does affect prior income.