Module 13 - Changes, Estimates, Errors, and Error Analysis

What is a change in accounting principle?

changing from one generally accepted accounting method to another (for example, average-cost to FIFO).

What is a change in accounting estimate?

Revising an estimate because of new information or additional experience (for example, useful life, salvage value, warranty estimate).

What is a change in reporting entity?

Changing which companies or units are included in the financial statements (for example, changing from individual to consolidated statements).

Is correction of an error considered an accounting change?

No. Correction of an error is not an accounting change. Errors are handled separately and are corrected through restatement and prior period adjustment rules.

What is retrospective application?

A company goes back and adjusts prior financial statements as if the new accounting principle had always been used. It also adjusts beginning retained earnings for the earliest year presented.

What is prospective application?

The company applies the new estimate or method only to the current year and future years. Prior years are not restated, and there is no retained earnings adjustment.

What is current application (modified retrospective)?

Prior financial statements are not restated, but the cumulative effect of the change is recorded in the opening balance of retained earnings in the current year.

Which type of accounting change is usually accounted for retrospectively?

A change in accounting principle is usually accounted for retrospectively.

Which type of accounting change is accounted for prospectively?

A change in accounting estimate is accounted for prospectively.

How is a change in reporting entity usually accounted for?

A change in reporting entity is accounted for retrospectively, meaning prior statements are restated to reflect the new reporting entity for all periods shown.

What is a prior period adjustment?

A correction of an error from a prior period that is recorded as an adjustment to the beginning balance of retained earnings in the current period.

What is a restatement?

The revision of previously issued financial statements to correct an error. The term restatement is used for error corrections, while recast or revised is used more often for accounting principle changes.

What is the difference between a recast and a restatement?

A recast or revised statement usually refers to prior statements updated for a change in accounting principle.

A restatement refers to prior statements revised to correct an error.

What is the basic rule for changes in accounting estimate?

Changes in accounting estimate are handled prospectively.

Prior years are not adjusted, retained earnings is not changed, and the new estimate is used in the current and future periods.

What is the basic rule for corrections of accounting errors?

Corrections of accounting errors are handled retrospectively.

If the books are closed, the correction usually goes through Retained Earnings and affected balance sheet accounts.

What is a change in estimate effected by a change in accounting principle?

It is handled prospectively because it appears to involve a principle change (such as changing depreciation methods) but is treated as a change in estimate.

How is a change in depreciation method treated?

it is handled prospectively because it is treated as a change in estimate effected by a change in accounting principle.

If it is impossible to tell whether a change is a principle change or an estimate change, how should it be treated?

It should be treated as a change in accounting estimate.

How do you distinguish a change in estimate from an error?

A change in estimate results from new information or updated judgment.

An error results from a mistake, misuse of facts, poor faith, incorrect application, or omission of information that should have been used originally.

What are the three required disclosure elements for a change in accounting principle?

1. The nature and reason for the change, including why the new method is preferable.

2. The method of applying the change, including prior periods adjusted.

3. The effect on income, retained earnings, and other major line items, including per-share effects if relevant.

What must be disclosed for a change in accounting estimate if it is material?

The company should disclose the effect on current income from continuing operations and any related per-share amounts.

What must be disclosed for a change in reporting entity?

A company should disclose the nature of the change, the reason for it, and the effect on income from continuing operations, net income, and per-share data for all periods presented.

What must be disclosed when correcting an error?

A company should disclose the nature of the error, the effect on each affected financial statement line item, any per-share effects, and the cumulative effect on retained earnings for the earliest period presented.

What is the straight-line depreciation formula?

Depreciation = (Cost − Salvage Value) / Useful Life

What is the formula for book value?

Book Value = Cost − Accumulated Depreciation

What is the formula for remaining life after a useful life revision?

Remaining Life = New Total Useful Life − Years Already Used

What is the formula for revised annual depreciation after a change in estimate?

New Depreciation = (Book Value − New Salvage Value) / Remaining Life

What is the cost of goods sold formula?

COGS = Beginning Inventory + Purchases − Ending Inventory

How do you compute annual expense from a prepaid amount covering multiple years?

Annual Expense = Total Prepaid Amount / Number of Covered Years

How do you compute the after-tax effect of an error or retrospective accounting adjustment?

After-Tax Effect = Pre-Tax Effect × (1 − Tax Rate)

How do you compute the tax portion of an accounting correction or change?

Tax Portion = Pre-Tax Effect × Tax Rate

What is the SYD (sum-of-the-years’-digits) denominator formula?

n(n + 1) / 2

For example, if useful life is 5 years:

5(6)/2 = 15

What is the SYD depreciation formula?

Depreciation = (Remaining Life / SYD Denominator) × (Cost − Salvage)

What is the formula for effective-interest expense on bonds?

Interest Expense = Carrying Value × Effective Interest Rate

What is the formula for cash interest paid on bonds?

Cash Interest = Face Value × Stated Interest Rate

How do you compute net sales when the amount collected includes sales tax?

Net Sales = Gross Receipts / (1 + Sales Tax Rate)

How do you compute sales tax collected when the sales figure includes tax?

Sales Tax Collected = Gross Receipts − Net Sales

What are the step-by-step instructions for solving a straight-line depreciation estimate change problem (useful life and/or salvage value change)?

1. Identify it as a change in estimate.

2. Compute original annual depreciation if needed.

3. Compute accumulated depreciation through the date of change.

4. Compute book value at the date of change.

5. Compute remaining life using the new total life minus years already used.

6. Use the new salvage value if one is given.

7. Compute new depreciation prospectively:

   • (Book Value − New Salvage) / Remaining Life

8. Record current-year depreciation with a normal depreciation entry.

9. Do not restate prior years or adjust retained earnings.

What are the step-by-step instructions for solving a depreciation method change problem, such as SYD to straight-line?

1. Identify it as a change in estimate effected by a change in accounting principle.

2. Do not revise prior years.

3. Compute accumulated depreciation under the old method through the date of change.

4. Compute book value at the date of change.

5. Compute remaining life.

6. Compute depreciation prospectively using the new method based on book value, not original cost.

7. Record normal current-year depreciation expense.

What are the steps for correcting an error where equipment was expensed instead of capitalized?

1. Identify it as a noncounterbalancing error.

2. Compute how much depreciation should have been recorded in prior years.

3. Compute accumulated depreciation that should exist.

4. Compute the cumulative impact on prior-period income and retained earnings.

5. If taxes are included, split the correction into after-tax retained earnings and the tax portion.

6. Restore the asset at original cost.

7. Credit accumulated depreciation for the amount that should already exist.

8. Adjust retained earnings for the cumulative after-tax amount.

9. Use the tax account required by the problem/system for the tax portion.

What are the steps for solving a change in accounting principle problem involving inventory (for example, average-cost to FIFO)?

1. Identify it as a change in accounting principle.

2. Use retrospective application unless a specific exception applies.

3. Compute yearly differences: New method income − Old method income

4. Sum all prior-year differences to find the cumulative effect.

5. If no taxes apply, record:

   • Dr Inventory

         Cr Retained Earnings

6. If taxes apply, split retained earnings and tax effects.

7. Restate prior-year financial statements using the new method.

What are the steps for solving a cost-recovery to percentage-of-completion change in accounting principle problem with taxes?

1. Identify it as a retrospective change in accounting principle.

2. Use the new method income for book/pre-tax income.

3. Use the old tax method income to compute current tax.

4. Compute deferred tax on the difference between book and tax income.

5. Compute total tax expense as current tax plus deferred tax.

6. Compute net income using the new method.

7. For the cumulative adjustment entry, use only the prior-year difference, not the current-year difference.

8. Debit the affected asset account (for long-term contracts, often Construction In Process).

9. Credit Retained Earnings for the after-tax cumulative effect and the tax-related account for the tax portion.

What are the steps for solving a current-year adjusting entry problem?

1. Determine what the correct year-end balance should be.

2. Compare the correct balance to the existing balance.

3. Adjust only the difference.

4. If the item is an accrual, usually use expense/revenue with a payable/receivable.

5. If the item is a prepaid or unearned item, adjust the asset or liability and offset the related expense or revenue.

6. If books are not closed, use revenue and expense accounts.

7. If books are closed, use Retained Earnings instead of revenue and expense accounts.

What are the steps for solving a closed-books correction problem?

1. Identify whether books are closed.

2. If books are closed, do not use revenue or expense accounts.

3. Determine which balance sheet accounts are wrong.

4. Determine whether retained earnings is overstated or understated.

5. Debit or credit Retained Earnings for the cumulative after-tax or no-tax effect depending on the problem.

6. Adjust the affected asset or liability accounts.

7. If current-year income statement accounts have been closed, replace them with retained earnings.

What are the steps for solving a multi-error “effect on net income” problem?

1. Ignore everything except items that affect the income statement for the year asked about.

2. For each error, ask: does this increase or decrease current-year revenue, expense, gain, or COGS?

3. Mark each effect as overstating or understating net income.

4. Add the overstating effects and subtract the understating effects.

5. Match the Wiley logic for the specific problem if direct component additions are expected instead of netting internally.

What are the steps for solving a “working capital effect” problem?

1. Working Capital = Current Assets − Current Liabilities

2. Ignore revenues, expenses, gains, and losses unless they affect current assets or current liabilities.

3. Include only current assets and current liabilities at the date asked.

4. Ignore noncurrent assets like equipment and accumulated depreciation.

5. Add up the effects on current assets and current liabilities to determine whether working capital is overstated or understated.

What are the steps for solving a “retained earnings effect” problem?

1. Include all cumulative effects on net income through the date asked.

2. Include prior-year effects that have not reversed.

3. Exclude counterbalancing errors that have already fully reversed.

4. Include current-year effects that change net income.

5. Add the cumulative overstated and understated effects to determine the final effect on retained earnings.

What are the steps for solving a corrected income before tax schedule problem?

1. Start with reported income before tax for each year.

2. List each error separately.

3. Determine whether each error increases or decreases income in each year.

4. Enter each correction on its own line using the exact category Wiley expects (for example, “Sales Erroneously Included in 2025 Income”).

5. Add all corrections to the reported income to arrive at corrected income before tax.

6. Recheck arithmetic carefully.

What is the journal entry pattern for a change in accounting estimate?

Dr Depreciation Expense

    Cr Accumulated Depreciation

Use the new amount prospectively. No retained earnings adjustment is made.

What is the journal entry pattern for an inventory accounting principle change with no taxes?

Dr Inventory

    Cr Retained Earnings

The amount is the cumulative prior-year effect of the change.

What is the journal entry pattern for a long-term construction accounting principle change with taxes?

Dr Construction In Process (full pre-tax cumulative effect)

    Cr Deferred tax-type account (as required)

    Cr Retained Earnings (after-tax effect)

What is the journal entry pattern for a missed accrual in the current year when books are open?

Dr Expense

    Cr Payable

Examples: accrued wages, accrued vacation pay, accrued warranty costs.

What is the journal entry pattern for correcting prepaid insurance that was fully expensed when books are open?

Dr Prepaid Insurance (unexpired part that should remain as an asset)

    Cr Insurance Expense

What is the journal entry pattern for correcting revenue that should be unearned when books are open?

Dr Rent Revenues

    Cr Unearned Rent Revenue (part not yet earned at year end)

What is the journal entry pattern for a closed-books correction of an overstated asset tied to prior overstatement of revenue?

Dr Retained Earnings

    Cr Asset

Example from the worked problems: overstated Interest Receivable with books closed.

What is the journal entry pattern for a prior-period depreciation error when books are closed and no taxes are included?

Dr Retained Earnings

    Cr Accumulated Depreciation

What is the entry pattern for a closed-books depreciation correction with taxes?

Dr Retained Earnings

Dr Income Taxes Receivable

    Cr Accumulated Depreciation-Equipment

What is the journal entry pattern for correcting sales tax that was included in sales revenue?

Dr Sales Revenue

    Cr Sales Taxes Payable

This removes the sales tax from revenue and records it as a liability.

What is the journal entry for reversing the incorrect classification of sales tax as an expense?

Dr Sales Taxes Payable

    Cr Sales Tax Expense

This reverses the incorrect expense treatment and aligns the amount with the liability classification.

What important Wiley trap appeared in the books-closed problem?

When the books were closed, Wiley expected Retained Earnings instead of revenue and expense accounts — even for what would normally be current-year adjustments in a books-open setting.

How do you know if an error is counterbalancing?

It reverses itself over two periods, such as a missed accrual or an inventory error that flips in the next year.

How do you know if an error is noncounterbalancing?

It does not reverse quickly and continues affecting multiple future periods, such as expensing a capital asset or failing to record depreciation.

What is the pattern for a wages payable accrual error?

If wages payable are not recorded at year-end:

• Year 1: expense understated, income overstated

• Year 2: expense overstated, income understated
  This is a counterbalancing error.

What is the pattern for an ending inventory understatement?

• Current year: ending inventory understated → COGS overstated → income understated

• Next year: beginning inventory understated → COGS understated → income overstated
  This is a counterbalancing error.

What is the pattern for expensing equipment that should have been capitalized?

• Year of purchase: expense overstated → income understated

• Future years: no depreciation recorded → income overstated
  This is a noncounterbalancing error.

What is the pattern for failing to record amortization or depreciation in the current year?

If amortization or depreciation is not recorded in the current year, expense is understated and net income is overstated for that year.

In a useful life revision problem, why should book value be used instead of original cost?

Because a change in useful life is a prospective estimate change, so the company does not restart from original cost; it depreciates the remaining book value over the remaining life.

In a change in estimate problem, why is there no retained earnings adjustment?

Because a change in estimate is not a correction of the past — it is a change based on new information, so only current and future periods are affected.

In a principle change problem, why do prior years get restated?

Because retrospective application assumes the new method had always been used, so prior comparative statements must be recast for consistency and comparability.

In an error correction problem, why is retained earnings used when books are closed?

Because prior revenue and expense accounts have already been closed into retained earnings, so the correction must flow through Retained Earnings instead of those closed income statement accounts.

Why was the sales-tax-in-revenue correction handled separately from the sales-tax-expense correction?

Because one correction removed tax from Sales Revenue and established the liability, while the second correction reversed the incorrect classification of sales tax as an expense.

In the prepaid insurance problems, why was the current-year expense often much smaller than the total cash paid?

Because prepaid insurance covers future periods, so only the amount related to the current year is expense; the rest remains an asset as Prepaid Insurance.

In the long-term contract principle change problem, why was Construction In Process the asset adjusted?

Because under percentage-of-completion, previously recognized profit accumulates in the Construction In Process account, so the asset balance has to be brought up to the amount that would have existed under the new method.

Why did the equipment error problem require both Equipment and Accumulated Depreciation in the correction entry?

Because correcting the error required restoring the asset at original cost and separately recognizing the depreciation that should already have been recorded.

Why did the bond interest correction problem use effective-interest expense instead of the cash paid?

Because the bonds were issued at a discount, so the correct interest expense under the effective-interest method includes amortization of the discount and is based on the carrying value, not just the cash interest paid.

Why did the repairs-capitalized-in-error problem require both removing the repairs from equipment and adjusting depreciation?

Because if ordinary repairs were incorrectly capitalized, they should have been expensed immediately, and any depreciation recorded on those capitalized repairs must also be reversed or adjusted.

If a problem says “revised useful life” or “revised salvage value,” what should you immediately think?

Change in estimate → Prospective → Use book value

If a problem says “changed from one inventory method to another generally accepted method,” what should you immediately think?

Change in accounting principle → Usually retrospective

If a problem says “equipment was expensed when purchased,” what should you immediately think?

Error → Noncounterbalancing → Restore asset + record depreciation + adjust retained earnings

If a problem asks for the effect on working capital, what should you immediately ignore?

Ignore noncurrent assets and noncurrent liabilities, such as equipment, accumulated depreciation, buildings, and long-term debt effects.

If a problem says “books have been closed,” what is the first adjustment rule you should remember?

Do not use revenue or expense accounts for corrections that affect already-closed income statement items; use Retained Earnings instead.

If a problem gives a tax rate and asks for a correction entry, what should you check first?

Check whether the problem/system expects:

• a tax liability/temporary difference type account, or

• a current tax correction account such as Income Taxes Receivable.
  Then split the correction into the after-tax retained earnings effect and the tax portion.

If a problem asks for corrected comparative net income after a change in accounting principle, what should you usually report?

Report the net income amounts under the new method, because retrospective application means prior years are shown as if the new principle had always been used.

If a problem asks for a prior period adjustment and taxes are ignored, what journal entry pattern is common?

Dr or Cr Retained Earnings

    Cr or Dr affected asset/liability

No tax split is needed when taxes are ignored.

If a problem asks whether an amount is overstated or understated, what is the fastest way to decide?

Ask whether the error caused:

• too much expense (income understated),

• too little expense (income overstated),

• too much revenue (income overstated), or

• too little revenue (income understated).

What is a common mistake in change-in-estimate problems?

Using original cost instead of current book value. For estimate changes, always recompute from book value at the date of change.

What is a common mistake in closed-books correction problems?

Using expense or revenue accounts when the books are closed. Wiley often expects Retained Earnings instead.

What is a common mistake in inventory principle change problems?

Using only one year’s difference instead of summing all prior-year differences to get the cumulative retained earnings adjustment.

What is a common mistake in inventory error analysis questions?

Forgetting that a prior-year ending inventory error becomes a current-year beginning inventory error and reverses the effect on income.

What is a common mistake in tax-effect correction problems?

Assuming the tax account name from theory instead of using the exact Wiley account name or accepted account structure in the system.

What is a common mistake in compared-year corrected income schedules?

Getting all adjustment lines right but making an arithmetic error in the final corrected income total. Always re-add line by line.

What is the shortest possible summary of Chapter 21 treatment rules?

• Estimate → go forward

• Principle → usually go back

• Entity change → go back

• Error → fix the past

What is the shortest memory rule for books open versus books closed?

• Books open → use revenue/expense accounts

• Books closed → use Retained Earnings

What is the shortest memory rule for current-year effect vs retained earnings effect questions?

• Net income question → current year only

• Retained earnings question → cumulative effects through the date asked

What is the shortest memory rule for working capital questions?

Only current assets and current liabilities matter.