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ACCOUNTING CHANGES AND ERROR ANALYSIS Sommers – ACCT 3311 BEST STUDY GUIDE

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Q22–12 How should consolidated financial statements be reported this year when statements of individual companies were presented last year? Where individual company statements were reported in pri... or years and consolidated financial statements are to be prepared this year, the following reporting and disclosure practices should be implemented: 1. The financial statements of all prior periods presented should be restated to show the financial information for the new reporting entity for all periods. 2. The financial statements of the year in which the change in reporting entity is made should describe the nature of the change and the reason for it. 3. The effect of the change on income before extraordinary items, net income, and earnings per share amounts should be disclosed for all periods presented. Correction of Errors Types of Accounting Errors: • A change from an accounting principle that is not generally accepted to an accounting policy that is acceptable. • Mathematical mistakes. • Changes in estimates that occur because a company did not prepare the estimates in good faith. • Failure to accrue or defer certain expenses or revenues. • Misuse of facts. • Incorrect classification of a cost as an expense instead of an asset, and vice versa. Correction of Errors • All material errors must be corrected. • Record corrections of errors from prior periods as an adjustment to the beginning balance of retained earnings in the current period. • Such corrections are called prior period adjustments. • For comparative statements, a company should restate the prior statements affected, to correct for the error. Balance sheet errors affect only the presentation of an asset, liability, or stockholders’ equity account. u Current year error - reclassify item to its proper position. u Prior year error - restate the balance sheet of the prior year for comparative purposes. Error Analysis Income Statement errors cause the improper classification of revenues or expenses. u Current year error - reclassify item to its proper position. u Prior year error - restate the income statement of the prior year for comparative purposes. Will be offset or corrected over two periods. If company has closed the books: a. If the error is already counterbalanced, no entry is necessary. b. If the error is not yet counterbalanced, make entry to adjust the present balance of retained earnings. For comparative purposes, restatement is necessary even if a correcting journal entry is not required. Counterbalancing Errors If company has not closed the books: a. If error already counterbalanced, make entry to correct the error in the current period and to adjust the beginning balance of Retained Earnings. b. If error not yet counterbalanced, make entry to adjust the beginning balance of Retained Earnings. Correction of Accounting Errors Four-step process 1. Prepare a journal entry to correct any balances. 2. Retrospectively restate prior years’ financial statements that were incorrect. 3. Report correction as a prior period adjustment if retained earnings is one of the incorrect accounts affected. 4. Include a disclosure note. Example 5 Goddard Company has used the FIFO method of inventory valuation since it began operations in 2008. Goddard decided to change to the average cost method for determining inventory costs at the beginning of 2011. The following schedule shows year-end inventory balances under the FIFO and average cost methods: Year FIFO Average Cost 2008 $45,000 $54,000 2009 78,000 71,000 2010 83,000 78,000 Ignoring income taxes, prepare the 2011 journal entry to adjust the accounts to reflect the average cost method. How much higher or lower would cost of goods sold be in the 2010 revised income statement? Example 5: Continued 2008 2009 2010 +9 Example 5: Continued 2008 2009 2010 0 0 0 +9 Example 5: Continued 2008 2009 2010 0 0 0 +9 –9 Example 5: Continued 2008 2009 2010 0 0 +9 0 0 +9 –9 Example 5: Continued 2008 2009 2010 0 0 +9 0 0 +9 +9 –9 –7 Example 5: Continued 2008 2009 2010 0 0 +9 0 0 +9 +9 –9 –7 +16 Example 5: Continued 2008 2009 2010 0 0 +9 0 –7 0 0 +9 –7 +9 –9 –7 +16 Example 5: Continued 2008 2009 2010 0 0 +9 0 –7 0 0 +9 –7 +9 –9 –7 +16 –5 Example 5: Continued 2008 2009 2010 0 0 +9 0 –7 0 0 +9 –7 +9 –9 –7 +16 –5 –2 Ignoring income taxes, prepare the 2011 journal entry to adjust the accounts to reflect the average cost method. Retained earnings 5,000 Inventory ($83,000 – 78,000) 5,000 How much higher or lower would cost of goods sold be in the 2010 revised income statement? $2,000 lower Example 6: Classifying Accounting Changes Type of Change Reporting Approach P. Change in accounting principle R. Retrospective approach E. Change in accounting estimate P. Prospective approach EP. Change in estimate resulting from a change in principle X. Correction of an error N. Neither an accounting change nor an accounting error. 1. Wagner changed its method of depreciating computer equipment from the DDB method to the straight-line method. 2. Wagner determined that a liability insurance premium it both paid and expensed in 2010 covered the 2010–2012 period. Example 6: Classifying Accounting Changes Type of Change Reporting Approach P. Change in accounting principle R. Retrospective approach E. Change in accounting estimate P. Prospective approach EP. Change in estimate resulting from a change in principle X. Correction of an error N. Neither an accounting change nor an accounting error. 3. 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 percentageof-completion method. 4. Due to an unexpected relocation, Wagner determined that its office building, previously depreciated using a 45-year life, should be depreciated using an 18-year life. 5. 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. Example 6: Classifying Accounting Changes Type of Change Reporting Approach P. Change in accounting principle R. Retrospective approach E. Change in accounting estimate P. Prospective approach EP. Change in estimate resulting from a change in principle X. Correction of an error N. Neither an accounting change nor an accounting error. 6. Wagner changed from LIFO to FIFO to account for its materials and work-in-process inventories. 7. Wagner changed from FIFO to average cost to account for its equipment inventory. 8. Wagner sells extended service contracts on some of its equipment sold. Wagner performs services related to these contracts over several years, so in 2011 Wagner changed from recognizing revenue from these service contracts on a cash basis to the accrual basis. Example 7: Error Analysis You have been hired as the new controller for the Ralston Company. Shortly after joining the company in 2011, you discover the following errors related to the 2009 and 2010 financial statements: a. Inventory at 12/31/09 was understated by $6,000. b. Inventory at 12/31/10 was overstated by $9,000. c. On 12/31/10, inventory was purchased for $3,000. The company did not record the purchase until the inventory was paid for early in 2011. At that time, the purchase was recorded by a debit to purchases and a credit to cash. The company uses a periodic inventory system. Required: 1. Assuming that the errors were discovered after the 2010 financial statements were issued, analyze the effect of the errors on 2010 and 2009 cost of goods sold, net income, and retained earnings. ( Ignore income taxes.) 2. Prepare a journal entry to correct the errors. 3. What other step( s) would be taken in connection with the error? Example 7: Error Analysis 2009 2010 –3,000 –6,000 +9,000 Example 7: Error Analysis 2009 2010 0 0 –3,000 0 –6,000 +6,000 +9,000 Example 7: Error Analysis Retained earnings 12,000 Inventory 9,000 Purchases 3,000 The financial statements that were incorrect as a result of both errors (effect of one error in 2009 and effect of three errors in 2010) 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 2011 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. 2009 2010 0 0 –6,000 –3,000 0 –9,000 –6,000 +6,000 +9,000 –18,000 Summary of Accounting Ch [Show More]

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