Chapter 9 (Unit 8) Accounting Changes and Error Analysis

Question 1

What are the three types of accounting changes?

What is the fourth category that is not an accounting change but does necessitate change?

Answer 1

1. Change in accounting principle (ex. changing inventory valuation from LIFO to average cost)
2. Change in accounting estimate (ex. a company changing its estimate of the useful lives of depreciable assets)
3. Change in reporting entity (ex. a company changing might change the subsidiaries for which it prepares consolidated financial statements)
4. Errors in financial statements

Question 2

When is the adoption of a new accounting principle not considered an accounting change?

Answer 2

Adoption of a new principle in recognition of events that have occurred for the first time or that were previously immaterial is not an accounting change.

ex. a change in accounting principle has not occurred when a company adopts an inventory method (e.g. FIFO) for newly acquired items of inventory, even if FIFO differs from that used for previously recorded inventory

ex. certain marketing expenditures that were previously immaterial and expensed in the period incurred. It would not be considered a change in accounting principle if they become material and so may be acceptably deferred and amortized.

Question 3

What are the three possible approaches for reporting changes in accounting principles?

Answer 3

1. Report changes currently
2. Report changes retrospectively
3. Report changes prospectively

Question 4

What approach does IFRS require for reporting changes in accounting principles?

Answer 4

IFRS generally requires retrospective application to prior years for accounting changes. However, IFRS permits the prospective method if a company cannot reasonably determine the amounts to which to reinstate prior periods.

Question 5

What is the accounting approach used for a change in estimate?

Answer 5

Report changes prospectively

Question 6

What is the accounting approach used for a change in accounting principle/method?

Answer 6

Report changes retrospectively

Question 7

What is the accounting approach used for an error in the financial statement

Answer 7

Restate any financial statements with the error

Question 8

At the end of year 6 of an asset’s life, the estimated life is changed from 10 years to 8 years. The asset’s cost was $10,000 with no salvage value.

What is the change in depreciation expense for the remaining years?

Answer 8

Depreciation taken: 10,000 / 10 years = 1,000 per year x 6 = 6,000
Net book value = 10,000 - 6,000 = 4,000

Remaining life: at the end of year 6, only 2 years of the asset’s life remains

New depreciation: $4,000 / 2 years = $2,000 depreciation expense in year 7 and year 8

Question 9

What is the exception to change in accounting principle?

Answer 9

A change to equity method accounting is a prospective application (not retrospectively) even though it is a change in accounting principle.

Question 10

If an offsetting adjustment is required in a retrospective application, how is that handled?

Answer 10

An offsetting adjustment, if any, shall be made to the opening balance of retained earnings for the earliest period presented.

Question 11

What is the Impracticability Exception for Retrospective Application?

Answer 11

Retrospective application is impracticable if:

1. the entity has made every effort but is unable to make a reasonable estimate of the impact of the change, and
2. it requires unsubstantiated assumptions about management’s intent in a prior period, or
3. it requires significant estimates that cannot be objectively made for the prior periods.

Question 12

Whenever it is impossible to determine whether a change in an accounting estimate or a change in an accounting principle has occurred, which is used?

Answer 12

The change should be considered a change in estimate.

Question 13

Cuthbert Industrials, Inc. prepares three-year comparative financial statements. In year 3, Cuthbert discovered an error in the financial statements for year 1. The effort affects the financial statements that were issued in years 1 and 2. How should the error be reported?

Answer 13

The financial statements for years 1 and 2 should be reinstated; the cumulative effect of the error on years 1 and 2 should be reflected in the carrying amounts of assets and liabilities as of the beginning of year 3.

Question 14

Wertz Construction Company decided at the beginning of 2014 to change from the completed-contract method to the percentage-of-completion method for financial reporting purposes. The company will continue to use the completed-contract method for tax purposes. For years prior to 2014, pretax income under the two methods was as follows: percentage-of-completion $102,300 and completed-contract $81,300. The tax rate is 33%.

Prepare Wertz’s 2014 journal entry to record the change in accounting principle.

Answer 14

D: Construction in Process 21,000 (102,300 - 81,300)
C: Deferred Tax Liability 6,930 (21,000 x 33%)
C: Retained Earnings 14,070 (plug)

Question 15

Pam Erickson Construction Company changed from the completed-contract to the percentage-of-completion method of accounting for long-term construction contracts during 2015. For tax purposes, the company employs the completed-contract method and will continue this approach in the future.

2014:
Percentage-of-Completion 775,900
Completed-Contract 593,600
Difference 182,300

2015:
Percentage-of-Completion 655,500
Completed-Contract 462,700
Difference 192,800

a) Assuming that the tax rate is 33%, what is the amount of net income that would be reported in 2015?

b) What entry is necessary to adjust the account records for the change in accounting principle?

Answer 15

a) Net Income = 655,500 x (1-33%) = 439,185

b)
D: Construction in Process 182,300 (difference is provided in question)
C: Deferred Tax Liability 60,159 (182,300 x 33%)
C: Retained Earnings 122,141 (plug)

Question 16

Wildhorse Cole Inc., aquired the following assets in January of 2015.

Equipment, estimated service life 5 years; salvage value $15,400 = 568,900
Building, estimated service life 30 years; no salvage value = $639,000

The equipment has been depreciated using the sum-of-the-years’-digits method for the first 3 years for financial reporting purposes. In 2018, the company decided to change the method of computing depreciation to the straight-line method for the equipment, but no change was made in the estimated service life or salvage life. It was also decided to change the total estimated service life of the building from 30 years to 40 years, with no change in the estimated salvage value. The building is depreciated on the straight-line method.

a) Prepare the general journal entry to record depreciation expense for the equipment in 2018.

b) Prepare the journal entry to record depreciation expense for the building in 2018.

Answer 16

1) Calculate book values as of 1/1/2018
2) Calculate 2018 (and future) depreciation expense using new method/estimates

Equipment Depreciation Expense, 2015-2017
Depreciable Base = 568,900 - 15,400 = 553,500
5 year service life = 1 + 2 + 3 + 4 + 5 = 15 SOYD denominator

2015: 553,500 x (5/15) = 184,500
2016: 553,500 x (4/15) = 147,600
2017: 553,500 x (3/15) = 110,700
Accumulated Depreciation = 442,800

Book Value as of 1/1/2018 = 568,900 - 442,800 = 126,100
Depreciable Base = 126,100 - 15,400 = 110,700
Remaining Life = 2 years
2018 Depreciation Expense = 110,700 / 2 years = 55,350

a)
D: Depreciation Expense 55,350
C: Accumulated Dep - Equipment 55,350

Building Depreciation Expense, 2015-2017
Depreciable Base = 639,000

Straight Line Method:
2015: 21,300
2016: 21,300
2017: 21,300
Accumulated Depreciation = 63,900

Book Value as of 1/1/2018 = 639,000 - 63,900 = 575,100
Remaining Life = 37 years
2018 Depreciation Expense = 575,100 / 37 years = 15,543

D: Depreciation Expense 15,543
C: Accumulated Dep - Building 15,543

Question 17

On January 2, year 2, Air Inc. agreed to pay its former president $300,000 under a deferred compensation arrangement. Air should have recorded this expense in year 1 but did not do so. Air’s reported income tax expense would have been $70,000 lower in year 1 had it properly accrued this deferred compensation. In its December 31, year 2 financial statements, how should Air adjust the beginning balance of its retained earnings?

Answer 17

300,000 - 70,000 = 230,000

By not recording this expense in year 1, the net income was overstated.

230,000 debit