Accounting Principles and Errors Overview

These flashcards cover key concepts related to accounting principles, changes, estimates, and error corrections as discussed in the lecture.

Change in Accounting Principle

The act of switching from one acceptable accounting method to another acceptable method within GAAP, such as from FIFO to LIFO.

Not a Change in Accounting Principle

Adopting a new accounting principle for first-time events or for items previously deemed immaterial.

Retrospective Change

An adjustment that requires a company to change its financial statements as if the new accounting method had been used since the inception of the firm.

Impracticable

A situation where a company cannot reasonably determine the application of a new accounting principle due to the inability to estimate prior financial data.

Disclosure Requirements after Accounting Change

A firm must include the nature and reason for the change, the method of applying it, and the net effect on income and retained earnings.

Change in Accounting Estimate

A modification in the estimated useful life or salvage value of an asset, or expected uncollectible receivables, which is accounted for prospectively.

Correcting Errors in Financial Statements

The process of adjusting financial statements when errors, such as improper application of GAAP or math mistakes, are discovered.

Material Error

An error significant enough to affect the decision of users of financial statements, requiring a restatement of the prior period's financials.

Why do we care if a firm changes accounting principles?

For consistency and comparability of financial statements, it helps users understand trends and the impact on financial performance.

What are the two key issues with retrospective changes?

Recording a journal entry to adjust balance sheet accounts for prior periods and restating all years that are practicable.

When is the JE made for a retrospective change?

in the year of the change

for a retrospective change what account is adjusted to capture prior period income statement amounts?

Retained Earnings

For retrospective changes, what type of effects do we look at? (Direct/Indirect)

Direct - tax effects but not executive compensation

What is a retained earnings roll forward when dealing with retrospective changes?

A retained earnings roll forward shows the adjustments made to retained earnings from prior periods due to retrospective changes, outlining the beginning balance, adjustments, and ending balance for the reporting period.

What does a firm disclose?

The nature and reason for the change, the method of applying the change, a description of prior period information that has been adjusted retrospectively, the net effect of the change on income and any other line item (like EPS), and the cumulative effect on retained earnings as of the beginning of the earliest period presented.

Example of change in accounting principle

LIFO to FIFO

which is a change in accounting estimates: changing from cash to accrual basis or change in depreciation method?

Changing from cash basis to accrual basis accounting is a change in accounting principle, whereas changes in depreciation method are changes in estimates.

For changees in accounting estimates, what type of change are we dealing with?

Prospective

Prospective Change

A change in accounting estimates that is applied to future periods without restating prior financial statements. No material disclosures required.

Sum of Years Digits Formula

(RUL/sum of ALL years Digits) * (Cost of Asset - Salvage Value)

Double Declining Balance Formula

2 * SLD rate

When doing double declining balance do you deduct Salvage value when calculating depreciable base?

No

When doing DDB, what is the depreciable base

Cost of asset - Accumulated depreciation

When must a company correct an error

as soon as it is discovered

how do firms correct an error?

with journal entries that deal with both direct and indirect effects with no impracticability exemption

what type of document must a firm publish if there is a material error

8-K

How to handle Balance Sheet classification errors

reclassify the item when the error is discerned, if presenting the error year in the financial statements, correctly restate the balance

how to handle Income Statement classification errors

reclassify the item, if the error is discovered in the same year in which it occurred. If the error occurred in prior periods, no need to make reclassification entry. If presenting the error year in the financial statements, restate the Income Statement for the error year.

Example of an error that has Balance Sheet and Income Statement Effects

the accountant didn’t accrue for wages payable at the end of the year

How to handle errors that have B/S and I/S effects?

Find out if it is a counterbalancing error and find out when the error was discovered

universal method to correct errors

1. what entry did the company record

2. what entry should have been recorded

3. check accounts affected:

   • Balance Sheet

   • Current Period Income Statement

   • Retained Earnings (prior period Income Statement effects)

Depreciation error

record too much / not enough depreciation, wrong salvage value, etc.

Expense error

you “use” something but fail to record the expense

Prepaid error

failure to record a prepaid (you incorrectly put it all in expense)

Revenue error

you earn revenue but fail to record it

unearned revenue error

you receive cash for services to be rendered in the future but fail to record unearned revenue (you put it all in revenue)

% of Completion / Completed Contract errors

using the wrong method or the wrong percent of completion