978-1259722660 Chapter 20 Lecture Note Part 1

Unlock access to all the studying documents.

View Full Document

CHAPTER 20

ACCOUNTING CHANGES AND ERROR CORRECTIONS

Overview

Chapter 4 provided a brief overview of accounting changes and error correction. Later, we

discussed changes encountered in connection with specific assets and liabilities as we dealt with

those topics in subsequent chapters.

Now, in this chapter, we revisit accounting changes and error correction with the intent to

synthesize the way these are handled in a variety of situations that might be encountered in practice.

We see that most changes in accounting principle are recorded and reported retrospectively.

Changes in estimates are accounted for prospectively. Both changes in reporting entities and the

correction of errors are reported retrospectively.

Learning Objectives

After studying this chapter, you should be able to:

LO20–1 Differentiate among the three types of accounting changes and distinguish among the

retrospective, modified retrospective, and prospective approaches to accounting for

and reporting accounting changes.

LO20–2 Describe how changes in accounting principle typically are reported.

LO20–3 Explain how and why some changes in accounting principle are reported

prospectively.

LO20–4 Explain how and why changes in estimates are reported prospectively.

LO20–5 Describe the situations that constitute a change in reporting entity.

LO20–6 Understand and apply the four-step process of correcting and reporting errors,

regardless of the type of error or the timing of its discovery.

LO20–7 Discuss the primary differences between U.S. GAAP and IFRS with respect to

accounting changes and error corrections.

Instructors Resource Manual 20-1

McGraw-Hill Education.

Lecture Outline

Part A: Accounting Changes

I. Overview

A. Accounting changes fall into one of three categories.

1. Changes in principle.

2. Changes in estimate.

3. Changes in reporting entity.

B. Errors occur when transactions are either recorded incorrectly or not recorded at all.

C. Accounting changes and error corrections can be accounted for in one of three ways

depending on the nature of the change.

1. Retrospective approach (prior years revised)

2. Modified retrospective approach

3. Prospective approach (only current and future years affected)

II. Change in Accounting Principle

A. Most voluntary changes in accounting principles are recorded and reported

retrospectively. This means reporting all previous periods’ financial statements as if the

new method had been used in all prior periods.

B. For each year reported in the comparative statements, we revise those statements to

appear as if the newly adopted accounting method had been applied all along.

C. In addition to reporting revised amounts in the comparative financial statements, we must

also adjust the book balances of affected accounts. This means creating a journal entry to

change those balances from their current amounts (from using the previous method) to

what those balances would have been using the newly adopted method.

D. In the first set of financial statements after the change, a disclosure note is needed to

provide that justification that the new method is clearly more appropriate. The footnote

also should point out that comparative information has been revised, or that retrospective

revision has not been made because it is impracticable, and report any per share amounts

affected for the current period and all prior periods presented.

III. The Prospective Approach

A. Sometimes a lack of information makes it impracticable to report a change

retrospectively so the new method is simply applied prospectively.

1. If it’s impracticable to adjust each year reported, the change is applied

retrospectively as of the earliest year practicable.

2. If full retrospective application isn’t possible, the new method is applied

prospectively beginning in the earliest year practicable.

Instructors Resource Manual 20-2

McGraw-Hill Education.

3. Footnote disclosure should indicate reasons why retrospective application was

impracticable.

B. Another exception to retrospective application is when an FASB Statement or another

authoritative pronouncement requires prospective application for specific changes in

accounting methods.

C. We account for a change in depreciation method as a change in accounting estimate that

is achieved by a change in accounting principle. Therefore, we account for such a change

prospectively; that is, precisely the way we account for changes in estimates.

IV. Change in Accounting Estimate

A. Changes in estimates are accounted for prospectively.

1. When a company revises a previous estimate, prior financial statements are not

revised.

2. Rather, the company merely incorporates the new estimate in any related

accounting determinations from then on.

V. Change in Reporting Entity

A.A change in reporting entity requires that financial statements of prior periods be

retrospectively revised to report the financial information for the new reporting entity in

all periods.

Part B: Correction of Accounting Errors

I. Overview

A. When errors are discovered, they should be corrected and accounted for retrospectively.

B. A journal entry is made to correct any account balances that are incorrect as a result of

the error.

C. Previous years’ financial statements that were incorrect as a result of an error are

retrospectively restated.

D. If retained earnings is one of the incorrect accounts, the correction is reported as a

“prior period adjustment” to the beginning balance in a statement of shareholders’

equity.

E. A disclosure note should describe the nature of the error and the impact of its correction

on operations.

Instructors Resource Manual 20-3

McGraw-Hill Education.

PowerPoint Slides

Three PowerPoint presentations of the chapter are available in the Connect Library:

1. With “Concept Checks” useful for classroom presentation, permitting the

instructor to intersperse in the presentation short exercises students can be asked

to solve individually or in small groups before the solution is “revealed” by the

instructor. {These are available only within Instructor Resources.}

2. Without the “Concept Checks” so students don’t have the solutions before being

asked to solve individually or in small groups.

3. Accessible PowerPoint Presentations. Accessibility is becoming even more

important in the education marketplace. Students and instructors with

disabilities use many different assistive technologies, and McGraw-Hill

Education is working to increase compatibility and access that will not only

help those with disabilities achieve better learning outcomes, but also serve the

institutions that are teaching these students. Accessible PowerPoint allows slide

content to be read by a screen reader and provides alternative text descriptions

for any image files used that enrich the learning experience. Accessible

PowerPoint is also designed with high-contrast color palettes and uses texture

when possible, instead of color to denote different aspects of the imagery used

within the slide.

Note: The slides are intended to provide comprehensive coverage of the chapter, but

they can be easily edited to allow instructors to change numbers and content in

illustrations or to delete slides pertaining to topics they choose to omit or

deemphasize. (Using your students’ names for company names in the Concept

Checks or Illustrations can be fun.)

Instructors Resource Manual 20-4

McGraw-Hill Education.

Suggestions for Class Activities

1. Critical Thinking Activity

It is alleged that not all accounting choices made by management are in the best interest of fair and

consistent financial reporting.

Suggestion:

Ask students to speculate on other motives that might influence the choices among accounting

methods and whether to change methods.

Points to note:

Your students should come up with a wide variety of motives. Among them will likely be the

effect of choices on:

Reported income

Stock prices

Management compensation

Existing debt agreements

Union negotiations

2. Real World Activity

The following February 22, 2013, report in Wallst.com described a change in the way

Abercrombie & Fitch accounts for inventories:

Abercrombie & Fitch Co. (NYSE: ANF) reported fourth-quarter and full-year 2012

earnings before markets opened this morning.

For the quarter, the specialty retailer posted adjusted diluted earnings per share (EPS)

of $2.21 on revenues of $1.47 billion. In the same period a year ago, the company

reported adjusted EPS of $1.12 on revenues of $1.33 billion. Fourth-quarter results

also compare to the Thomson Reuters consensus estimates for EPS of $1.96 and

$1.49 billion in revenues.

For the full year, A&F reported EPS of $3.22 on revenues of $4.51 billion. Analysts

were expecting EPS of $2.98 on revenues of $4.53 billion.

The company announced a change in its way of valuing inventory, from

the retail accounting method to a cost accounting method. The change will take effect

with A&F’s annual report and prior year figure will be “restated accordingly.” The

switch added $0.20 to adjusted EPS in the fourth quarter and $0.31 to full-year EPS.

Instructors Resource Manual 20-5

McGraw-Hill Education.

Suggestion:

Ask students to consult the footnotes to the financials of Abercrombie & Fitch Co. and describe

the details of the change and to speculate on the motivation for the original method and the change.

Points to note:

The details are in the footnotes to financials, which state in part:

INVENTORIES

During the fourth quarter of Fiscal 2012, the Company elected to change its inventory valuation

method from the lower of cost or market utilizing the retail method to the lower of cost or market under the

weighted average cost method. The Company believes the new method is preferable as it is consistent with

the practices of other specialty retailers and better aligns with the way the Company manages its business

with a focus on the actual margin realized. See Note 4, “CHANGE IN ACCOUNTING PRINCIPLE ,” for

further details on the accounting change.

Inventories are principally valued at the lower of cost or market on a weighted-average cost basis.

The Company writes down inventory through a lower of cost or market adjustment, the impact of which is

reflected in cost of goods sold in the Consolidated Statements of Operations and Comprehensive Income.

This adjustment is based on management’s judgment.

4. CHANGE IN ACCOUNTING PRINCIPLE

The Company elected to change its method of accounting for inventory from the lower of cost or

market utilizing the retail method to the weighted average cost method effective February 2, 2013. In

accordance with generally accepted accounting principles, all periods have been retroactively adjusted to

reflect the period-specific effects of the change to the weighted average cost method. The Company believes

that accounting under the weighted average cost method is preferable as it better aligns with the Company’s

focus on realized selling margin and improves the comparability of the Company’s financial results with

those of its competitors. Additionally, it will improve the matching of cost of goods sold with the related net

sales and reflect the acquisition cost of inventory outstanding at each balance sheet date. The cumulative

adjustment as of January 30, 2010, was an increase in its inventory of $73.6 million and an increase in

retained earnings of $47.3 million.

Instructors Resource Manual 20-6

McGraw-Hill Education.

As a result of the retroactive application of the change in accounting for inventory, the following items

in the Company’s Consolidated Statements of Operations and Comprehensive Income and Consolidated

Statements of Cash Flows have been restated:

Fiscal Year Ended January 28, 2012 (in thousands, except per share data)

As Reported Effect of Change As Restated

Net Sales $ 4,158,058 $ — $ 4,158,058

Cost of Goods Sold 1,639,188 (31,354) 1,607,834

Gross Profit 2,518,870 31,354 2,550,224

Operating Income 190,030 31,354 221,384

Income from Continuing Operations Before

Taxes 186,453 31,354 217,807

Tax Expense for Continuing Operations 59,591 15,078 74,669

Net Income from Continuing Operations 126,862 16,276 143,138

Net Income 127,658 16,276 143,934

Net Income Per Share from Continuing

Operations:

Basic $ 1.46 $ 0.19 $ 1.65

Diluted $ 1.42 $ 0.18 $ 1.60

Net Income Per Share:

Basic $ 1.47 $ 0.19 $ 1.66

Diluted $ 1.43 $ 0.18 $ 1.61

Foreign Currency Translation Adjustments (8,655) (3) (8,658)

Other Comprehensive Income (Loss) 12,971 (3) 12,968

Comprehensive Income 140,629 16,273 156,902

As Reported Effect of Change As Restated

Cash flow from operating activities:

Net Income $ 127,658 $ 16,276 $ 143,934

Deferred Taxes (46,330) 15,078 (31,252)

Inventories (184,784) (31,349) (216,133)

Instructors Resource Manual 20-7

McGraw-Hill Education.

Fiscal Year Ended January 29, 2011 (in thousands, except per share data)

As Reported Effect of Change As Restated

Net Sales $ 3,468,777 $ — $ 3,468,777

Cost of Goods Sold 1,256,596 (5,248) 1,251,348

Gross Profit 2,212,181 5,248 2,217,429

Operating Income 231,932 5,248 237,180

Income from Continuing Operations Before

Taxes 228,570 5,248 233,818

Tax Expense for Continuing Operations 78,287 (178) 78,109

Net Income from Continuing Operations 150,283 5,426 155,709

Net Income 150,283 5,426 155,709

Net Income Per Share from Continuing

Operations:

Basic $ 1.71 $ 0.06 $ 1.77

Diluted $ 1.67 $ 0.06 $ 1.73

Net Income Per Share:

Basic $ 1.71 $ 0.06 $ 1.77

Diluted $ 1.67 $ 0.06 $ 1.73

Foreign Currency Translation Adjustments 3,399 $ (161) $ 3,238

Other Comprehensive Income (Loss) 2,457 $ (161) $ 2,296

Comprehensive Income 152,740 $ 5,265 $ 158,005

As Reported Effect of Change As Restated

Cash flow from operating activities:

Net Income $ 150,283 $ 5,426 $ 155,709

Deferred Taxes (27,823) (178) (28,001)

Inventories (74,689) (5,180) (79,869)

Instructors Resource Manual 20-8

McGraw-Hill Education.

As a result of the retroactive application of the change in accounting for inventories, the following items in

the Company’s Consolidated Balance Sheets have been restated:

January 28, 2012 (in thousands):

As Reported Effect of Change As Restated

Inventories $ 569,818 $ 110,117 $ 679,935

Deferred Income Taxes 77,120 (41,238) 35,882

Total Current Assets 1,488,775 68,879 1,557,654

Total Assets 3,048,153 68,879 3,117,032

Retained Earnings 2,320,571 69,043 2,389,614

Total Stockholders’ Equity 1,862,456 68,879 1,931,335

Total Liabilities and Stockholders’ Equity 3,048,153 68,879 3,117,032

Instructors Resource Manual 20-9

McGraw-Hill Education.