Changes and Error Corrections

Introduction

  • Speaker: Derrick Bonyuet, Clinical Assistant Professor of Accounting at The University of Texas at Austin

  • Topic: Accounting Changes and Error Corrections

  • Course Level: Intermediate Accounting

Agenda

  • Overview

  • Types of Accounting Changes     - Retrospective Approach     - Prospective Approach

  • Problems

Overview

  • Importance of Accounting Alternatives:   - Diminish the comparability of financial information.   - Obscure useful historical trend data.

  • Types of Accounting Changes:   - Change in Accounting Principle.   - Change in Accounting Estimate.   - Change in Reporting Entity.

  • Errors:
      - Not considered an accounting change.   - Learning Objective 1 (LO 1).

Types of Accounting Changes

1. Change in Accounting Principle

  • Definition: A change from one generally accepted accounting principle to another.

  • Example: Switching from LIFO to average-cost for inventory cost allocation.

2. Change in Accounting Estimate

  • Definition: A change that results from new information or additional experience.

  • Examples:
      - Change in estimate of useful lives of depreciable assets.
      - Updating estimates on accrued warranty expenditures.
      - Change in actuarial estimates related to pension plans.

3. Change in Reporting Entity

  • Definition: Changing from reporting as one type of entity to another type.

  • Examples:
      - Switching from the cost method to the equity method, or vice versa.
      - Changing subsidiaries for which consolidated financial statements are prepared.

  • Important Note: When changing a reporting entity, previous periods' financial statements must be recast.

Accounting Treatment of Changes

Type of Change

Method

Restatement Requirement

Adjustment to Retained Earnings

Disclosure Note

Change in Accounting Principle

Retrospective

Yes

As adjustment to retained earnings of earliest year reported.

Yes

Change in Estimate

Prospective

No

Not reported.

Yes

Change in Reporting Entity

Retrospective

Yes

As adjustment to retained earnings of earliest year reported.

Yes

Error Correction

Retrospective

Yes

As adjustment to retained earnings of earliest year reported.

Yes

Important Exceptions

  • Changes in depreciation, amortization, and depletion methods are changes in estimates.

  • When retrospective application is impracticable, such as most changes to LIFO, certain mandated changes do not require it.

Regulatory Context

  • Regulators require recalibration of executive compensation if significant errors in financial statements are discovered, to enhance corporate accountability.

  • Companies must recover erroneously awarded compensation, regardless of misconduct, including smaller errors that only affect the current year's results.

The Retrospective Approach

  • Most voluntary changes in accounting principles are registered retrospectively.

  • Case Study: Lamar Corporation   - Change from LIFO to FIFO Inventory Costing Method (2024).   - Historical Financial Data (in millions):     - 2022: COGS (LIFO) = 418, Revenues = 950     - 2023: COGS (LIFO) = 409, Revenues = 900     - 2024: COGS (LIFO) = 400, Revenues = 875

  • Analysis includes revisions to income components based on the new FIFO method.

Adjusting Comparative Financial Statements

  • Revised Comparative Income Statements
      - 2022 Income Statement:     - Revenues: 950, COGS (FIFO): 370, Operating Expenses: 220, Income Tax Expense (25%): 90, Net Income: 231.   - 2023 and 2024 similar adjustments made accordingly.

Cumulative Effects of Switching to FIFO (Previous Years)

  • Cumulative differences result in an increase in both income and retained earnings over the applicable years:   - 2022: Net Income 225.   - 2023: Net Income 255.   - 2024: Net Income 288.

Adjusting Accounts for Change

  • Journal Entry on January 1, 2024 (in millions):
      - Debit: Inventory 384
      - Credit: Retained Earnings 288
      - Adjusted income tax payable calculated at 25%.

Disclosure Notes

  • Disclosure notes must:   - Justify the application of the new method.
      - Explain reasons for the changes and effects on primary financial statements.
      - Highlight any revised comparative information presented.

Change in Accounting Estimate

  • Example with Tivoli Networks:
      - Estimated warranty expense revised from 2% to 3% of sales.   - Sales figure of 400 million leads to warranty expenses adjusted to reflecting the new estimate.

  • Journal Entry for Warranty Expense
      - Warranty Expense (3% × 400 million) and a corresponding warranty liability estimated at the same amount.

Change in Depreciation Methods

  • Example with Tivoli Networks:
      - From sum-of-the-years’-digits to straight-line depreciation (2024)
      - Calculations detail the difference in depreciation across periods.
      - Annual straight-line depreciation calculated as 24 million over the remaining years.

Change in Reporting Entity

  • Definition: Change due to new combined or consolidated financial statement presentations.

  • Example: Hartford Life changed its reporting entity structure leading to stockholder equity increase of 1.3 billion.

Correction of Errors

  • Types of Accounting Errors:   - Mathematical mistakes.   - Oversight in preparing estimates.
      - Misuse of facts.   - Errors in classification.

  • Impact: Must correct prior financial statements to reflect the adjustments resulting from discovered errors.

Journal Entry Examples

  • Example of executing journal entries to correct prior inaccuracies in financial situations.

  • Specific cases highlight error handling within accounting practices.

Class Exercises

  • Several class exercises to reinforce learning on:   - Inventory valuation changes.   - Cumulative effect computations for accounting changes.   - Journal entries for adjustments in estimates or corrections of errors, including detailed calculations and reasoning about impacts on financial documents.