E23-1 Identification of Changes and Errors. (Easy) Indicate how to report various items, whether increases or decreases are to be expected.

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1 CHAPTER 23 ACCOUNTING FOR CHANGES AND ERRORS CONTENT ANALYSIS OF EXERCISES AND PROBLEMS Number Content Time Range (minutes) E23-1 Identification of Changes and Errors. (Easy) Indicate how to report various items, whether increases or decreases are to be expected. E23-2 Identification of Changes and Errors. (Easy) Indicate how to report various items, whether increases or decreases are to be expected. E23-3 Accounting Changes and Errors. (Easy) Identify correct accounting treatment for different events. E23-4 Change to Inventory Cost Flow Assumption. (Moderate) FIFO to average cost. Journal entry. Preparation of comparative income statements. E23-5 (AICPA adapted). Change in Inventory Cost Flow Assumption. (Easy) FIFO to LIFO. Effect on income taxes. E23-6 Change in Inventory Method. (Moderate) LIFO to FIFO. Journal entry. Preparation of comparative income statements and retained earnings statements. E23-7 Change in Accounting for Construction Contracts. (Moderate) Completed-contract to percentage-of-completion. Income statements, statement of retained earnings. E23-8 Changes and Corrections of Depreciation. (Moderate) Decreased asset life. Change in method. Residual value ignored. Journal entries. E23-9 Errors. (Moderate) Discovered year after made. Journal entries to correct several independent situations. E23-10 Errors. (Moderate) Discovered two years after made. Journal entries to correct several independent situations. E23-11 Effects of Errors. (Easy) On assets, liabilities, owners' equity, net income in year of error. E23-12 Errors. (Moderate) Discovered one or two years after made. Journal entries to correct several independent situations

2 Number Content Time Range (minutes) E23-13 Omission of Accruals and Prepayments. (Moderate) Computation of correct net income. Journal entries if error discovered after one year, after two years. P23-1 (AICPA adapted). Identification and Effects of Changes and Errors. (Easy) Indicate how to classify, and the accounting treatment for, 10 transactions. P23-2 Comprehensive: Change in Inventory Cost Flow Assumption. (Challenging) LIFO to FIFO, Journal entry, Comparative income statements. Comparative retained earnings statements. Note disclosures. Bonus. P23-3 Change in Inventory Cost Flow Assumption. (Challenging) FIFO to average cost. Journal entry. Comparative financial statements. P23-4 Change in Inventory Cost Flow Assumption. (Challenging) LIFO to average cost. Journal entry. Comparative financial statements. P23-5 Change in Accounting for Construction Contracts. (Challenging) Completed-contract to percentage-ofcompletion. Journal entry. Comparative financial statements. P23-6 Changes and Corrections of Depreciation. (Moderate) Increased service life. Change in method. Error in including residual value. Journal entries. P23-7 (AICPA adapted). Change in Accounting for Inventory. (Moderate) FIFO to LIFO. Computation of effect on income. P23-8 First Issuance of Financial Statements. (Challenging) Prepare financial statements for prior three years. Describe method to account for each item if statements had been issued publicly. P23-9 Error Correction. (Challenging) Discovered before books are closed, and after books are closed. Journal entries. P23-10 Error Correction. (Moderate) Determination of correct net income. Adjusting journal entry. P23-11 Error Correction. Worksheet to determine correct net income, adjusted balance sheet accounts. P23-12 Error Correction. Analysis of effect on income and ending balance sheet. P23-13 (AICPA adapted). Comprehensive. (Moderate) Change in estimate and principle, errors. Worksheet reconciling income. Computation of cumulative effect. P23-14 (AICPA adapted). Comprehensive: Errors. (Moderate) Discovered in same period. Journal entries. Computation of corrected net income

3 ANSWERS TO QUESTIONS Q23-1 GAAP defines three types of changes: a change in accounting principle, a change in accounting estimate, and a change in reporting entity. A change in accounting principle occurs when a company adopts a generally accepted accounting principle different from the one used previously for items currently reported, such as a change in an inventory cost flow assumption or depreciation method. Changes in accounting estimates occur because the preparation of financial statements requires estimation of the effects of future events, and such estimates sometimes must be changed as new events occur, more experience is acquired, or additional information is obtained. A change in reporting entity is caused by a change in the make-up of the entity being reported, such as an increase or decrease in the number of subsidiaries included in the reporting entity for consolidated financial statements. Q23-2 The three possible methods a company could use to disclose an accounting change in the financial statements are to (1) retroactively adjust past financial statements (prior period restatement), (2) include the cumulative effect of the change in the income of the current period, or (3) adjust for the change prospectively. The major argument in favor of prior period restatement is that all financial statements presented at a given date should be prepared on the basis of consistent accounting principles. An argument against prior period restatement is that users may be confused by the change in the reported results and that confidence in the accounting profession may be lost because "they change the numbers." The use of the cumulative effect adjustment is favored because it is consistent with the allinclusive income concept. The major argument against cumulative effect adjustments is that comparative financial statements are not being prepared on the basis of consistent application of accounting principles. An argument in favor of prospective adjustment is that the reporting of the effect of a change in estimate cumulatively or retroactively might cause a great deal of confusion for users of the financial statements because of the frequency of such changes. An argument against prospective adjustment is that the change may be seen as an event of the period, and would be more appropriately accounted for by a cumulative effect adjustment. Q23-3 A company could justify a change in accounting principle on the grounds that the new principle is preferable to the old. One example would be a change from FIFO to LIFO, because the change results in a more meaningful matching of costs with revenues. Another example would be a change from straight-line depreciation to sum-of-the-years'-digits depreciation, because the new method better reflects the pattern of benefits from the fixed assets. A different kind of example is the adoption of a new principle because of the issuance of new GAAP. Q23-4 A change in accounting principle occurs when one generally accepted accounting principle is adopted in place of the one used previously for reporting purposes. A change in estimate results from new events occurring, more experience being acquired, or additional information being obtained that necessitates a revision of an accounting estimate previously made. It is often difficult to distinguish between a change in principle and a change in estimate because they are interdependent. For example, a change in the estimated productive use of equipment may cause a change in the method of depreciating that equipment. A company accounts for a change in accounting principle as a cumulative effect in the year of change, with a few exceptions, and accounts for a change in estimate prospectively. A company accounts for a change in accounting principle that is associated with a change in estimate prospectively. 23-3

4 Q23-5 The four exceptions to the normal method of accounting for a change in accounting principle are 1. When a company adopts a new accounting principle for future events and does not change the accounting for past events of the same nature, it discloses a description of the nature of the change, its effect on income before extraordinary items and net income of the period of the change, and its effect on the earnings per share amounts. 2. When the cumulative effect is not determinable, a company discloses the effect of the change on the results of operations for the period of change, including earnings per share data, as well as an explanation for the omission of cumulative effect data and pro forma amounts for prior years. 3. When a company makes an initial public sale of common stock, it retroactively restates the financial statements for all prior periods presented. 4. When the advantages of retroactive treatment in prior periods outweigh the disadvantages, prior period restatement (adjustment) is required. This applies to a change from LIFO to another inventory flow method, a change in the method of accounting for long-term construction contracts, a change to or from the "full cost" method of accounting (which is used in the extractive industries), a change from the retirement-replacement-betterment accounting to depreciation accounting (for railroad track structures), and a change from the fair value method to the equity method for investments in common stock. Q23-6 The cumulative effect may not be determinable when the accounting system does not include sufficient information; for example, when a company changes to LIFO from another inventory cost flow assumption, it probably would not have records of the costs of the additions to and reductions in the LIFO layers that would have occurred if it had used LIFO in the past. In this situation, its disclosure is limited to showing the effect of the change on the results of operations of the period of change (including per share data) and explaining the reason for omitting the cumulative effect and disclosure of pro forma amounts for prior years. Q23-7 A change in depreciation method is accounted for as a change in accounting estimate effected by a change in accounting principle. Thus, it is accounted for prospectively. This approach is used because the change in depreciation method is the result of a change in the estimate of the pattern of future benefits, so that the change in accounting principle is inseparable from the change in estimate. Q23-8 A company only recognizes the direct effects (net of applicable income taxes) of a change in accounting principle in determining the amount of the retrospective adjustment to its financial statements. Therefore, the indirect effects that would have been recognized if the newly adopted principle had been used in prior periods are not included in the retrospective adjustment. However, if a company actually incurs and recognizes indirect effects, they are reported in the year in which the accounting change is made. Q23-9 A company accounts for the adoption of a new accounting principle for future events by describing the nature of the change and its effect on net income of the period of the change, together with the earnings per share amounts, in the notes to its financial statements. 23-4

5 Q23-10 If a company makes a cumulative effect type of accounting change during the first interim period, it includes the cumulative effect of the change on retained earnings at the beginning of the year in the net income of the first interim period. However, if a company makes a cumulative effect type of change in other than the first interim period, it restates the prior interim periods by applying the newly adopted principle to those interim periods, and reports the cumulative effect of the change on retained earnings at the beginning of the year in the restated net income of the first interim period. For those changes in accounting principle for which the cumulative effect cannot be determined, disclosure of the change is necessary but no adjustments are required if the change occurs in the first interim period. If a company makes the change in other than the first interim period, it restates the financial statements of the prechange interim periods by applying the newly adopted accounting principle to those prechange interim periods. Q23-11 A change in a reporting entity occurs mainly when (a) consolidated or combined statements are presented in place of the statements of individual companies, (b) there is a change in the specific subsidiaries that make up the group of companies for which consolidated financial statements are presented, and (c) the companies included in combined financial statements change. When a change in a reporting entity occurs, the company reports it as a prior period adjustment. Additionally, the company includes a description of the nature of the change and the reason for it in the notes to the financial statements of the period in which the change is made. Furthermore, in the period of the change, the company discloses the effect of the change on income before extraordinary items, net income, and related earnings per share amounts for all periods presented. The company need not repeat the disclosures in the financial statements of future periods. Q23-12 A material error of a prior period that is discovered in the current period is accounted for as a prior period adjustment (restatement) and therefore is excluded from net income. On the current period financial statements, the company reports the error (net of related income tax effects) as an adjustment to the beginning balance of retained earnings. When comparative statements are presented, it makes adjustments to the affected items on the income statements and to the retained earnings balances, as well as the balances of the affected balance sheet accounts for all periods reported. In addition, the company discloses the nature of the error in previously issued financial statements and the effect of its correction on income before extraordinary items, net income, and the related earnings per share amounts for each year reported. Q23-13 Errors that affect only a company's balance sheet are mainly classification errors. These include classifying a long-term note receivable as a current receivable and failing to include the current portion of long-term debt in current liabilities. Q23-14 Errors that affect only a company's income statement usually result from misclassification of items. Examples of this include combining interest revenue with sales revenue and including selling expenses in cost of goods sold. 23-5

6 Q23-15 One example of an error that is counterbalanced in the following period is the failure to accrue an interest liability in the current period when the interest is to be paid in the next period. The effect of this error in the current period is to understate interest expense and thus overstate net income and retained earnings, and to understate interest payable. In the following period when the interest is paid and treated as an expense, interest expense is overstated and net income is understated by the same amount as it was overstated in the previous period. Therefore, at the end of the second period, retained earnings is correctly stated. Another example of an error that is counterbalanced in the following period is the overstatement of ending inventory under a periodic inventory system. In the current period, cost of goods sold is understated, which results in net income and retained earnings being overstated. In the following period, however, beginning inventory is overstated, so cost of goods sold is overstated and net income is understated, which results in retained earnings being correctly stated at the end of the second period. Q23-16 One error that is not counterbalanced in the following period is the expensing of a depreciable fixed asset in the period it is purchased. In the year of purchase, expenses are overstated, assets are understated, depreciation expense is understated, and accumulated depreciation is understated. The understatement of the asset and depreciation expense will continue over the life of the asset. The balance sheet accounts (Asset, Accumulated Depreciation, and Retained Earnings) will only be correct upon the disposal of the asset. Another noncounterbalancing error is the failure to record properly a bond discount or premium. This causes interest expense to be incorrectly reported and liabilities and net income to be incorrect for the life of the bonds. Q23-17 A company corrects errors even after they have counterbalanced whenever it presents for comparative purposes financial statements affected by the error. Otherwise, the errors may cause financial statements to be misleading to users by distorting trends and financial ratios. Q23-18 Under IFRS, if an error is discovered and it is impracticable to restate the financial statements for all prior periods, a company may choose to restate the financial statements for the earliest period practicable. This may be the current period which would effectively result in a prospective adjustment. Under U.S. GAAP, there is no impracticability exception for errors. Therefore, U.S. GAAP would require that the financial statements for all prior periods be restated. Q23-19 Under IFRS, the accounting for the indirect effects of a change in accounting principle is not specified. Therefore, a company may recognize these indirect effects either retrospectively or in the year in which the accounting change is made. Under U.S. GAAP, the indirect effects of a change in accounting principle are not included in the retrospective adjustment. However, if a company actually incurs and recognizes indirect effects, they are reported in the year in which the accounting change is made. ANSWERS TO MULTIPLE CHOICE 1. a 3. a 5. c 7. c 9. a 2. d 4. b 6. d 8. d 10. b 23-6

7 SOLUTIONS TO REVIEW EXERCISES RE Change in reporting entity (a) 2. Change in accounting principle (a) 3. Change in accounting estimate (b) RE23-2 RE23-3 RE23-4 RE23-5 Cost of goods sold under LIFO, Year 1 $300,000 Cost of goods sold under FIFO, Year 1 (250,000) Increase in pretax income, Year 1 $ 50,000 X 1 Income tax rate x 0.70 = Cumulative effect adjustment $ 35,000 Inventory ($300,000 - $250,000) 50,000 Income Taxes Payable ($50,000 x 0.30) 15,000 Retained Earnings 35,000 HELLER COMPANY Income statements (Partial) Year 1 Year 2 As Adjusted Sales $650,000 $510,000 Cost of goods sold (360,000) (250,000) Gross profit $290,000 $260,000 Beginning unadjusted retained earnings $400,000 Plus: Adjustment for the cumulative effect on prior years of retrospectively applying the FIFO inventory method (net of tax) 28,000 Adjusted beginning retained earnings $428,000 Net income 150,000 Less: Dividends (30,000) Ending retained earnings $548,

8 RE23-6 RE23-7 RE23-8 RE23-9 RE23-10 RE23-11 RE23-12 The change will be accounted for prospectively. Current and future annual depreciation expense = $200, years = $10,000 per year. Blake Company would recognize an expense in the amount of $5,000 ($100,000 x 5%) in the year it adopted the new principle. Retained Earnings 8,000 Rent Revenue 8,000 Interest Revenue 3,200 Retained Earnings 3,200 Insurance Expense 6,000 Retained Earnings 6,000 Inventory 50,000 Retained Earnings 50,000 Retained Earnings 13,500 Allowance for Doubtful Accounts 13,

9 SOLUTIONS TO EXERCISES E23-1 The cited items are reported as follows: 1. Change in accounting principle; retrospective adjustment; at the beginning of the period, increase retained earnings and inventory; assuming rising costs during the period, net income and assets are higher than they otherwise would have been. 2. Change in accounting estimate; revise periodic depreciation charge based on current book value, estimated residual value, and new estimate of remaining service life for current and future periods; no effect at the beginning of the period; depreciation expense is higher and net income and assets are lower than they otherwise would have been in the current period. 3. Change in accounting estimate effected by a change in accounting principle; revise periodic depreciation charge based on current book value, estimated residual value, and new depreciation method for current and future periods; no effect at beginning of the period; depreciation expense is higher (or lower) and net income and assets are lower (or higher) than they otherwise would have been in the current period, depending on the remaining life of the asset. 4. Change in accounting estimate; charge to income in current period; decrease income and current assets. 5. Included in income of the current period; therefore, income and assets increase. 6. Correction of accounting error; prior period restatement (adjustment); increase assets and retained earnings at the beginning of the period; during the period, more depreciation is charged than otherwise would have been. 7. Change in accounting estimate; impairment charge to current income; decrease assets and net income. 8. Change in accounting principle; retrospective adjustment; probably increase assets and retained earnings at the beginning of the period; during the period, assets and net income probably are higher than they otherwise would be. 23-9

10 E23-2 The cited items are reported as follows: 1. Change in accounting principle; cumulative effect impractical to determine; disclosure of the effect of the change on results of operations (including per share data) for the period of change. 2. Change in accounting estimate; charge to income in current period; decrease net income and assets. 3. Include in income of the current period; decrease net income and assets. 4. Change in accounting estimate; charge to income in current and future periods; decreases net income and current assets in the current period. 5. Change in accounting estimate effected by a change in accounting principle; revise periodic depreciation charge based on current book value, estimated residual value, and new depreciation method for current and future periods; no effect at beginning of the period; depreciation expense is higher (or lower) and net income and assets are lower (or higher) than they otherwise would have been in the current period, depending on the remaining life of the asset. 6. Change in accounting estimate (contingency); impairment charge to current income; decrease assets and net income. 7. Change in accounting principle; retrospective restatement; probably decrease retained earnings and assets at the beginning of the period; during the period, net income and assets are probably lower than they otherwise would have been. E23-3 Accounting treatment for the cited events: 1. Change in accounting principle; financial statements from all prior periods are retrospectively restated since they have never been available to the public. 2. Correction of an accounting error; prior period restatement (adjustment)

11 E23-3 (continued) 3. Change in accounting estimate effected by a change in accounting principle; revise periodic depreciation charge based on current book value, estimated residual value, and new depreciation method for current and future periods; no effect at beginning of the period; depreciation expense is higher (or lower) and net income and assets are lower (or higher) than they otherwise would have been in the current period, depending on the remaining life of the asset. 4. Change in accounting principle; exception to general rule; the adoption of a new principle for future events without changing the principle used for past events does not require a retrospective adjustment but the company should disclose the nature of the change and its effect on income before extraordinary items and net income of the period of the change (including earnings per share data). 5. Correction of an accounting error; prior period restatement (adjustment). (Note to Instructor: This is not discussed in Chapter 8 but Research Simulation 8-2 addresses this issue in depth.) E The total increase in cost of goods sold prior to 2011 of $180,000 ($130,000 + $50,000) decreases the reported income before income taxes and the value of the inventory by that amount. Retained earnings at the beginning of 2011 is decreased by the "cumulative effect loss" of $126,000 ($180,000, net of 30% income tax credit) and since the company filed amended tax returns, the remaining $54,000 is debited to Income Taxes Receivable for the amount of the income tax refund. The journal entry is: Retained Earnings 126,000 Income Taxes Receivable 54,000 Inventory 180, Comparative Income Statements As Adjusted Revenues $1,750,000 $1,500,000 Expenses (1,050,000) b (950,000) a Income before income taxes $ 700,000 $ 550,000 Income tax expense (210,000) (165,000) Net income $ 490,000 $ 385,000 Earnings per share $4.90 $3.85 a $1,500,000 - $550,000 b $1,750,000 - $700,

12 E23-4 (continued) 3. Comparative Retained Earnings Statements Beginning unadjusted retained earnings $1,540,000 $1,120,000 Less: Adjustment for the cumulative effect on prior years of retrospectively applying the average cost inventory method (net of income tax credits of $54,000 in 2011 and $39,000 in 2010) (126,000) b (91,000) a Adjusted beginning retained earnings $1,414,000 $1,029,000 Add: Net income 490, ,000 Ending retained earnings $1,904,000 $1,414,000 a $130,000 x 0.70 b ($130,000 + $50,000) x 0.70 E23-5 (AICPA adapted solution) E23-6 A change to the LIFO method is one of the exceptions to the retrospective application of a change in accounting principle (assuming sufficient information is not available, as in this example). Because of the impracticality of determining the prior inventory amount under LIFO, the company would apply the change prospectively. Therefore, the FIFO beginning inventory for 2011 is used for LIFO. Since the LIFO ending inventory is $60,000 less than the FIFO inventory, LIFO income before income taxes is $60,000 less than FIFO income and is $110, Inventory 8,000 Retained Earnings ($8,000 x 0.70) 5,600 Income Taxes Payable ($8,000 x 0.30) 2,

13 E23-6 (continued) 2. Comparative Income Statements As adjusted Revenues $300,000 $270,000 Cost of goods sold (55,000) (37,000) Other expenses (70,000) (75,000) Income before income taxes $175,000 $158,000 Income tax expense (52,500) (47,400) Net income $122,500 $110,600 Earnings per share (15,000 shares) $8.17 $ Comparative Retained Earnings Statements Beginning unadjusted retained earnings $105,000 a $ 0 Plus: Adjustment for the cumulative effect on Prior year s of retrospectively applying the FIFO inventory method (net of income taxes of $2,400) 5,600 b 0 Adjusted beginning retained earnings $110,600 $ 0 Add: Net income 122, ,600 Ending retained earnings $233,100 $110,600 E23-7 a ($270,000 - $120,000) x 0.70 b $8,000 x 0.70 Condensed Comparative Income Statements As adjusted As adjusted Construction revenue $900,000 $420,000 $200,000 Construction expense (420,000) (182,000) (80,000) Other expenses (80,000) (70,000) (50,000) Income before income taxes $400,000 $168,000 $ 70,000 Income tax expense (120,000) (50,400) (21,000) Net income $280,000 $117,600 $ 49,000 Earnings per share $2.80 $1.18 $

14 E23-7 (continued) Comparative Statements of Retained Earnings Balance at beginning of year, as previously reported $ 77,000 $ 7,000 0 Add: Adjustment for the cumulative effect on prior years of applying retrospectively the new method of accounting for long-term contracts (net of income taxes of $38,400 in 2010 and $18,000 in 2009) 89,600 d 42,000 b 0 Balance at beginning of year, as adjusted $166,600 $ 49,000 0 Net income 280, ,600 c $49,000 a Balance at end of year $446,600 $166,600 $49,000 a $200,000 - $80,000 - $50,000 = $70,000 x 0.70 b $49,000 - $7,000 c $420,000 - $182,000 - $70,000 = $168,000 x 0.70 d ($49,000 + $117,600) - ($7,000 + $70,000) E Change in estimate--accounted for prospectively: $520,000 - $20,000 Straight-line depreciation = = $25,000 per year 20 Book value at beginning of 2011 = $520,000 ($25,000 x 6) = $370,000 Depreciation = Remaining book value Residual value Remaining life $370,000 - $20,000 $350,000 = = = $35,000 Depreciation Expense 35,000 Accumulated Depreciation 35,000 To record depreciation for

15 E23-8 (continued) 2. Change in estimate effected by change in accounting principle accounted for prospectively: Book value at beginning of 2011 = $370,000 (from #1) n(n+1) 14*(15) Sum-of-the-years digits = = = *14 year remaining life Depreciation = (Remaining book value Residual value) x SYD fraction = ($370,000 - $20,000) x 14/105 = $46,667 Depreciation Expense 46,667 Accumulated Depreciation 46,667 To record depreciation for Error accounted for as a prior period restatement (adjustment): $520,000 Depreciation without residual value = = $26,000 per year 20 Incorrect accumulated depreciation = $156,000 ($26,000 x 6) Correct depreciation = $520,000 - $20, = $25,000 per year Correct accumulated depreciation = $150,000 ($25,000 x 6) Accumulated Depreciation 6,000 Retained Earnings 6,000 Prior period adjustment for error ($150,000 - $156,000). Depreciation Expense 25,000 Accumulated Depreciation 25,000 To record depreciation for E Purchases 10,000 Retained Earnings 10, Machinery 2,000 Retained Earnings 1,500 Accumulated Depreciation: Machinery 500 or 23-15

16 E23-9 (continued) 2. (continued) Machinery 2,000 Retained Earnings 2,000 Retained Earnings 500 Accumulated Depreciation: Machinery Retained Earnings 2,000 Wages Payable 2,000 If the error is discovered after the first wage payment for the year, which is most likely, the entry would be: Retained Earnings 2,000 Wages Expense 2, Rent Expense 4,000 Retained Earnings 4, If discovered during the following year: Retained Earnings 5,000 Allowance for Doubtful Accounts 5,000 If discovered after the accrual for uncollectibles is made at the end of the following year: Retained Earnings 5,000 Bad Debt Expense 5, Retained Earnings 15,960 Discount on Note Receivable 15,960 or Retained Earnings 29,960 a Discount on Note Receivable 29,960 a To correct sale. Discount on Note Receivable 14,000 b Retained Earnings 14,000 To correct interest revenue in the first year. a $129,960 - ($129,960 x ) b 14% x ($129,960 - $29,960) 23-16

17 E No journal entry is needed because the error is counterbalanced after the second year. If financial statements are presented for comparative purposes, however, the effects of the error will have to be corrected in each of the 2 years affected. 2. Machinery 2,000 Accumulated Depreciation: Machinery 1,000 Retained Earnings 1,000 or Machinery 2,000 Retained Earnings 2,000 Retained Earnings 1,000 Accumulated Depreciation: Machinery 1,000 To record depreciation for two years at $500 per year. 3. No journal entry is needed because the error is counterbalanced at the end of the second year. If financial statements for the year in which the error occurred and the following year are presented for comparative purposes, however, the effects of the error will have to be corrected for those years. 4. No journal entry is needed because the error is counterbalanced at the end of the second year. However, since rent expense is overstated for the year in which the error occurred and understated for the following year, these amounts will have to be corrected if the financial statements for those years are presented for comparative purposes. 5. Assuming that an accrual for bad debts was made at the end of the previous year, no journal entry is needed because the error is counterbalanced at the end of the second year. However, since bad debt expense and the allowance for doubtful accounts are understated for the year in which the error occurred, and overstated for the following year, these amounts will have to be corrected if the financial statements for those years are presented for comparative purposes. If no accrual for bad debts was made at the end of the previous year, it would be necessary to debit Retained Earnings and credit Allowance for Doubtful Accounts for the total of the estimated bad debts for 2 years

18 E23-10 (continued) 6. No journal entry is needed because the error has been counterbalanced. That is, the overstatement of the gain in the first year has been offset by an understatement of interest revenue in each of the two years. If financial statements for the year in which the error occurred and the following year are presented for comparative purposes, however, the effects of the error will have to be corrected for those years. E23-11 E23-12 Assets Liabilities Owners' Equity Net Income NE NE 2. - NE NE NE NE NE NE NE Retained Earnings 8,100 Accumulated Depreciation: Machinery 900 Machinery 9,000 or Retained Earnings 9,000 Machinery 9,000 Accumulated Depreciation: Machinery 900 Retained Earnings Construction in Progress 22,000 Retained Earnings 22,000 Note to Instructor: This assumes that no physical inventory was taken, which is consistent with the discovery of the error in Inventory 8,000 a Retained Earnings 8,000 a (3,000 15,000) x $40,

19 E Computation of correct income: Reported pretax income $20,000 $25,000 $23,000 Prepaid Expenses: Add back expense in year paid ,100 Deduct expense in year incurred (500) (900) Accrued Expenses: Deduct expense in year incurred (800) (700) (950) Add back expense in year paid Revenue Received in Advance (Unearned): Deduct revenue from year received (300) (400) (1,300) Add revenue in year earned Revenue Earned but not Received (Accrued): Deduct revenue from year received (600) (1,000) Add revenue in year earned 600 1,000 1,200 Correct pretax income $20,000 $25,800 $22, The following individual journal entries may be used to correct the errors. Prepaid expenses: Prepaid Expense 1,100 Expense 1,100 Expense 900 Retained Earnings 900 Accrued expenses: Expense 950 Accrued Expense 950 Retained Earnings 700 Expense 700 Revenue received in advance (unearned): Revenue 1,300 Unearned Revenue 1,300 Retained Earnings 400 Revenue

20 E23-13 (continued) Revenue earned but not received (accrued): Accounts Receivable 1,200 Revenue 1,200 Revenue 1,000 Retained Earnings 1,000 Alternatively, the following combined journal entry could be made (assuming the expense account corrections can be offset). Prepaid Expenses 1,100 Accounts Receivable 1,200 Expenses 50 Revenue 700 Accrued Expenses 950 Unearned Revenue 1,300 Retained Earnings The following individual journal entries may be used to correct the errors. Expense 1,100 Retained Earnings 1,100 Retained Earnings 950 Expense 950 Retained Earnings 1,300 Revenue 1,300 Revenue 1,200 Retained Earnings 1,200 Alternatively, the following combined journal entry could be made (assuming the expense account corrections can be offset). Expenses 150 Revenue 100 Retained Earnings

21 SOLUTIONS TO PROBLEMS P23-1 (AICPA adapted solution) (1) (2) Transaction Classification Accounting Treatment 1 Change in accounting principle Retrospective adjustment 2 Change in accounting estimate Prospective 3 Change in accounting estimate Prospective 4 Change in accounting principle Retrospective adjustment 5 Correction of an error Prior period restatement 6 Correction of an error Prior period restatement 7 Change in accounting principle Prospective effected by a change in accounting estimate 8 Neither accounting change nor Prospective accounting error 9 Change in accounting principle Retrospective adjustment P Inventory ($42,000 + $18,000) 60,000 Retained Earnings ($60,000 x 0.70) 42,000 Income Taxes Payable ($60,000 x 0.30) 18, Comparative Income Statements As adjusted Revenues $230,000 $225,000 Cost of goods sold (120,000) b (95,000) a Gross profit $110,000 $130,000 Operating expenses (40,000) (32,000) Income before income taxes $ 70,000 $ 98,000 Income tax expense (21,000) (29,400) Net income $ 49,000 $ 68,600 Earnings per share $4.90 $6.86 a ($225,000 revenues - $32,000 operating expenses - $80,000 reported income before income taxes under LIFO) - $18,000 decrease in cost of goods sold b $230,000 revenues - $40,000 operating expenses - $70,000 reported income before income taxes under FIFO 23-21

22 P23-2 (continued) 3. Comparative Statements of Retained Earnings Balance at beginning of year, as previously reported $224,000 $168,000 c Add: Adjustment for the cumulative effect on prior years of retrospectively applying the FIFO method of inventory valuation (net of income taxes of $18,000 in 2011 and $12,600 in 2010) 42,000 e 29,400 d Balance at beginning of year, as adjusted $266,000 $197,400 Net income 49,000 68,600 Balance at end of year $315,000 $266,000 c ($240,000) x (1-0.30) d ($42,000) x (1-0.30) e ($42,000 + $18,000) x (1-0.30) 4. Note to the Financial Statements (partial): On January 1, 2011, the company changed its method of valuing its inventory and cost of goods sold to the FIFO method from the LIFO method used in all previous years. The new method of accounting for inventory and cost of goods sold was adopted to recognize (state justification for the change in accounting principle) and financial statements of prior years have been retrospectively adjusted to apply the new method. The effect on retained earnings at January 1, 2010 was an increase of $29,400. The following income statement line items for 2011 and 2010 were affected by the change in accounting principle. Income Statement For Year Ended 12/31/2010 As Originally Reported under LIFO As Adjusted to FIFO Effect of Change Sales $225,000 $225,000 0 Cost of goods sold (113,000) a (95,000) $18,000 Operating expenses (32,000) (32,000) 0 Income before income taxes $ 80,000 $ 98,000 $18,000 Income tax expense (24,000) (29,400) (5,400) Net income $ 56,000 $ 68,600 $12,600 Earnings per share $5.60 $6.86 $1.26 a $225,000 revenues - $32,000 operating expenses - $80,000 reported income before income taxes under LIFO 23-22

23 P23-2 (continued) 4. (continued) Income Statement For Year Ended 12/31/2011 As Computed under LIFO As Reported under FIFO Effect of Change Sales $230,000 $230,000 0 Cost of goods sold (136,000) b (120,000) $16,000 Operating expenses (40,000) (40,000) 0 Income before income taxes $ 54,000 $ 70,000 $16,000 Income tax expense (16,200) (21,000) (4,800) Net income $ 37,800 $ 49,000 $11,200 Earnings per share $3.78 $4.90 $1.12 b $120,000 + $16,000 excess cost of goods sold 5. If employees received a bonus of 10% of income before deducting the bonus and income taxes, the change in accounting principle would affect the amount of that bonus in 2011, but it has already been given effect in the reported net income for The company would also recognize an additional expense of $6,000 [($42,000 + $18,000) x 0.10] in 2011, the year it adopted the new principle and paid the prior years bonuses. P Retained Earnings ($16,000 - $4,800) 11,200 Deferred Tax Liability ($16,000 x 0.30) 4,800 Inventory ($7,000 from $9,000 from 2010) 16,

24 P23-3 (continued) 2. KOOPMANN COMPANY Comparative Income Statements For Years Ended December As adjusted Revenues $130,000 $100,000 Cost of goods sold (80,000) (69,000) Gross profit $ 50,000 $ 31,000 Operating expenses (30,000) (25,000) Income before income taxes $ 20,000 $ 16,000 Income tax expense (30%) (6,000) (1,800) Net income 14,000 $ 4,200 Earnings per share $1.40 $0.42 KOOPMANN COMPANY Comparative Retained Earnings Statements For Years Ended December Beginning unadjusted retained earnings $19,500 $15,000 Less: Adjustment for the cumulative effect on prior years of retrospectively applying the average cost inventory method (net of income tax credits of $4,800 in 2011 and $2,100 in 2010) (11,200) b (4,900) a Adjusted beginning retained earnings $ 8,300 $10,100 Add: Net Income 14,000 4,200 $22,300 $14,300 Less: Dividends (10,000) (6,000) Ending retained earnings $12,300 $ 8,300 a ($7,000) x 0.70 b ($7,000 + $9,000) x

25 P23-3 (continued) 2. (continued) P23-4 KOOPMANN COMPANY Comparative Balance Sheets December As adjusted Assets Cash $ 10,000 $ 9,000 Inventory 24,000 22,000 a Other assets 70,800 64,100 Total assets $104,800 $ 95,100 Liabilities and Stockholders' Equity Accounts payable $ 4,500 c $ 3,000 Income taxes payable 6,000 b 1,800 Common stock, no par 82,000 82,000 Retained earnings 12,300 8,300 Total liabilities and stockholders' equity $104,800 $ 95,100 a $38,000 - $16,000 decrease from journal entry in Requirement 1. b $6,000 income tax expense. c Balancing amount. 1. Inventory ($6,000 from $9,000 from 2010) 15,000 Retained Earnings ($15,000 x 0.70) 10,500 Income Taxes Payable ($15,000 x 0.30) 4, SCHMIDT COMPANY Comparative Income Statements For Years Ended December As adjusted Revenues $130,000 $128,000 Cost of goods sold (80,000) (69,000) Gross profit $ 50,000 $ 59,000 Operating expenses (30,000) (25,000) Income before income taxes $ 20,000 $ 34,000 Income tax expense (6,000) (10,200) Net income $ 14,000 $ 23,800 Earnings per share $1.40 $

26 P23-4 (continued) 2. (continued) SCHMIDT COMPANY Comparative Retained Earnings Statements For Years Ended December Beginning unadjusted retained earnings $38,500 $27,000 Plus: Adjustment for the cumulative effect on prior years of retrospectively applying the average-cost inventory method (net of income taxes of $4,500 in 2011 and $1,800 in 2010) 10,500 b 4,200 a Adjusted beginning retained earnings $49,000 $31,200 Add: Net income 14,000 23,800 $63,000 $55,000 Less: Dividends (10,000) (6,000) Ending retained earnings $53,000 $49,000 a For 2009: $6,000 x (1-0.30) b For 2010 and 2009: [$9,000 x (1-0.30)] + $4,200 SCHMIDT COMPANY Comparative Balance Sheets Assets December As adjusted Cash $ 12,000 $ 8,000 Inventory 34,000 57,000 a Other assets 76,000 60,000 Total assets $122,000 $125,000 Liabilities and Stockholders' Equity Accounts payable $ 3,000 c $ 4,000 Income taxes payable 6,000 12,000 b Common stock, no par 60,000 60,000 Retained earnings 53,000 49,000 Total liabilities and stockholders' equity $122,000 $125,000 a $42,000 + $15,000 (reduction in cost of goods sold for 2009 and 2010) b $7,500 + $4,500 (from Requirement 1) c Balancing amount 23-26

27 P Jan. 1 Construction in Progress 70,000 a Retained Earnings [$70,000 x (1-0.30)] 49,000 Deferred Tax Asset 21,000 a [($100,000 + $120,000) + ($125,000 + $75,000)] - ($100,000 + $250,000) 2. GOODE CONSTRUCTION COMPANY Comparative Income Statements (Partial) As adjusted As adjusted Income before income taxes $400,000 $200,000 $220,000 Income taxes at 30% (120,000) (60,000) (66,000) Net income $280,000 $140,000 $154,000 Earnings per common share (100,000 shares) $2.80 $1.40 $1.54 Comparative Statements of Retained Earnings Balance at beginning of year as previously reported $245,000 c $ 70,000 b 0 Add: Adjustment for the cumulative effect on prior years of retrospectively applying the percentage-of-completion method of accounting for longterm contracts (net of income taxes of $21,000 in 2011 and $36,000 in ,000 e 84,000 d 0 Balance at beginning of year, as adjusted $294,000 $154,000 0 Net income 280, ,000 $154,000 Balance at end of year $574,000 $294,000 $154,000 b $100,000 x (1-0.30) c $250,000 x (1-0.30) + $70,000 d [($100,000 + $120,000) - $100,000] x (1-0.30) e [($100,000 + $120,000 + $125,000 + $75,000) - ($100,000 + $250,000)] x (1-0.30) 23-27

28 P23-5 (continued) 3. Items Restated: On the 2009 and 2010 income statements, construction revenues and expenses would be restated to the appropriate amounts for the percentage of completion method. On the December 31, 2009 and 2010 balance sheets, the construction in progress, deferred income taxes, and retained earnings amounts would also be restated. P Change in estimate accounted for prospectively: Depreciation base $90,000 Original life = = = 10 years Annual depreciation $ 9,000* *$45,000 5 years Remaining life = (10-5) years + 1 year = 6 years Book value Residual value $55,000 - $10,000 $7,500 per Depreciation = = = Remaining life 6 year Depreciation Expense 7,500 Accumulated Depreciation: Machine X 7,500 To record depreciation for Change in accounting estimate effected by change in accounting principle accounted for prospectively: Previous depreciation amount 2009: ($40,000 - $4,000) x 8/36* = $ 8, : ($40,000 - $4,000) x 7/36 = 7,000 $15,000 *n(n+1) 8(9) = = Book value = $40,000 - $15,000 = $25,000 Book value Residual value $25,000 - $4,000 $3,500 per Depreciation = = = Remaining life 6 year Depreciation Expense 3,500 Accumulated Depreciation: Machine Y 3,500 To record depreciation for

29 P23-6 (continued) 3. Error accounted for as a prior period restatement (adjustment): Previous 2010 depreciation erroneously calculated: ($80,000 - $8,000) x [2 x (100% 5)] = $28,800 Correct 2010 depreciation: $80,000 x 40% = $32,000 Correct 2011 depreciation: ($80,000 - $32,000) x 40% = $19,200 Retained Earnings 3,200 Accumulated Depreciation: Machine Z 3,200 Prior period adjustment for error ($32,000 - $28,800) Depreciation Expense 19,200 Accumulated Depreciation: Machine Z 19,200 To record depreciation for

30 P23-7 (AICPA adapted solution) THE KRAFT MANUFACTURING COMPANY Effect on Income Before Income Taxes - Change from FIFO to LIFO Inventory Method For Year Ended December 31, 2011 Inventory at December 31, 2011 if on FIFO Inventory Method: Mult - 16,000 units x $8.00 (October 15, 2011 unit cost) $128,000 Tran - 13,000 units x $3.50 (December 24, 2011 unit cost) 45,500 $173,500 Inventory at December 31, 2011 on LIFO Inventory Method: Mult Beginning inventory: 5,000 units x $5.00 (November 9, 2010 unit cost) $ 25,000 10,000 units x $6.00 (December 14, 2010 unit cost) 60,000 $ 85,000 Layer added in 2011: 1,000 units x $7.00 (February 12, 2011 unit cost) 7,000 $ 92,000 Tran Beginning inventory: 14,500 units x $2.50 (November 9, 2010 unit cost) $ 36,250 Layer liquidated in 2011: 1,500 units x $2.50 (November 9, 2010 unit cost) (3,750) 32,500 $124,500 Decrease in income before income taxes - change from FIFO to LIFO inventory method $ 49,

31 P JACKSON COMPANY Comparative Income Statements For Years Ended December Sales $100,000 $130,000 $180,000 Cost of goods sold (35,000) (45,000) (65,000) Gross profit $ 65,000 $ 85,000 $115,000 Other expenses a (59,500) (60,300) (77,800) Income before income taxes $ 5,500 $ 24,700 $ 37,200 Income tax expense (30%) (1,650) (7,410) (11,160) Net income $ 3,850 $ 17,290 $ 26,040 Comparative Balance Sheets December Cash $ 5,500 $ 12,500 $ 9,960 Accounts receivable (net) b 29,000 47,700 58,900 Income tax refund receivable e 2,100 4,290 6,630 Inventory 40,000 60,000 65,000 Equipment d 100, , ,000 Less: Accumulated depreciation (10,000) (20,000) (34,000) $166,600 $204,490 $246,490 Current liabilities $ 19,250 $ 27,250 $ 33,250 Notes payable 50,000 50,000 50,000 Interest payable c 6,000 12,000 18,000 Deferred tax liability f 3,000 9,600 13,560 Common stock 84,500 84,500 84,500 Retained earnings 3,850 21,140 47,180 $166,600 $204,490 $246,490 a Other expenses: Additional bad debt expense: % x $100,000 = $1, % x $130,000 = $1, % x $180,000 = $1,800 Additional interest expense each year = 12% x $50,000 = $6,000 Reduced depreciation expense (see footnote d for calculation) 2008 $10,000 ($20,000 - $10,000) 2009 $22,000 ($32,000 - $10,000) 2010 $13,200 ($19,200 - $10,000) + ($ 8,000 - $ 4,000) 23-31

32 P23-8 (continued) 1. (continued) Total increase (decrease) in other expenses: 2008 $1,000 + $6,000 - $10,000 = $(3,000) 2009 $1,300 + $6,000 - $22,000 = $(14,700) 2010 $1,800 + $6,000 - $13,200 = $(5,400) Other expenses: 2008 $62,500 - $3,000 = $59, $75,000 - $14,700 = $60, $83,200 - $5,400 = $77,800 b Accounts receivable (net): Deduction for allowance for uncollectibles: % x $100,000 = $1, $1,000 + (1% x $130,000) = $2, $2,300 + (1% x $180,000) - $630 = $3,470 Ending accounts receivable (net): 2008 $30,000 - $1,000 = $29, $50,000 - $2,300 = $47, $63,000 - $630 - $3,470 = $58,900 c Interest payable: % x $50,000 = $6, $6,000 + (12% x $50,000) = $12, $12,000 + (12% x $50,000) = $18,000 d Equipment: Amount Correct Computed 1 Amount Balance, January 1, 2008 $100,000 $100,000 Depreciation expense, 2008 (20,000) (20%) (10,000) (10%) Balance, December 31, 2008 $ 80,000 $ 90,000 Depreciation expense, 2009 (32,000) (32%) (10,000) (10%) Balance, December 31, 2009 $ 48,000 $ 80,000 Depreciation expense, 2010 (19,200) (19.20%) (10,000) (10%) Balance, December 31, 2010 $ 28,800 $ 70,000 Addition, 2010 $ 40,000 $ 40,000 Depreciation expense, 2010 (8,000) 2 (4,000) (10%) Balance, December 31, 2010 $ 32,000 $ 36,

33 P23-8 (continued) 1. (continued) 1 The depreciation expense each year is computed from the change in the balance of Accumulated Depreciation. The amounts are consistent with the applicable MACRS percentages in $40,000 x 20% (applicable MACRS depreciation in 2010) e Income tax refund receivable: Decrease in Taxable Income* x Tax Rate = Refund Cumulative Refund 2008 $7, $2,100 $2, , ,190 4, , ,340 6,630 *From footnote a, increase in other expenses except no change in depreciation. f Deferred tax liability: Increase in Tax Accounting Temporary Tax Deferred Tax Depreciation* - Depreciation = Difference x Rate = Liability Cumulative 2008 $20,000 $10,000 $10, $3,000 $ 3, ,000 10,000 22, ,600 9, ,200 14,000 13, ,960 13,560 *From footnote d 2. The omission of the allowance for uncollectibles, the non-accrual of interest, and the use of MACRS depreciation would all be considered errors and therefore would be accounted for by prior period restatements (adjustments). The omission of the allowance for uncollectibles could be considered a change in accounting estimate if the company had expected to collect all its credit sales and had a reasonable basis for making such an estimate. In that case, it would be accounted for prospectively