L06, L07: Error Correction Notes

Change in Depreciation, Amortization, and Depletion Methods

• Nature of Method Change: A change in the method used for depreciation, amortization, or depletion is categorized as both a change in accounting estimate and a change in accounting principle.

  • Justification for Categorization: The change involves elements that are historical facts and elements that are estimates. For example, while the cost of a machine (e.g., $250,000$) is a known fact, the determination of its useful life and residual value relies entirely on estimates.

  • Requirement for Change: Any shift in accounting method must be accompanied by a clear justification. Entities cannot change methods arbitrarily; they must disclose a valid reason for the transition in their financial reports.

Case Study: Hogan Manufacturing Company Method Change

• Asset Detail: The company owns a machine with a cost basis of $250,000$.

• Method Transition: The scenario involves Switching from the Double Declining Balance (DDB) depreciation method to the Straight-Line (SL) method.

• Procedural Requirements:

  • Performing this change requires a refresher on calculating DDB depreciation for the periods prior to the change.

  • The transition is handled similarly to changes in useful life or residual value estimates, where the remaining book value is depreciated over the remaining life using the new method.

Principles and Procedures for Correcting Accounting Errors (Learning Objective 7)

• Materiality and Significance: Error correction is required when a discovered error is significant or material.

  • Examples of Significance: An error of $14$ is typically considered insignificant (immaterial), whereas errors of $140,000$ or $1,400,000$ are significant and necessitate formal correction.

• Retrospective Restatement: If a computational or clerical error is found from a prior year, the company must retrospectively restate its financial statements. This involves adjusting the prior period figures to what they would have been had the error never occurred.

• Accounting Adjustments:

  • Account Balances: Current account balances must be corrected to reflect accurate values.

  • Retained Earnings: If the error impacted prior period income, the correction is reported as a Prior Period Adjustment to the beginning balance of Retained Earnings.

  • Note Disclosure: Financial statements must include a note that describes the nature of the error and the financial impact of the subsequent correction.

Case Analysis: Hathaway Corporation Patent Error Correction

• Background of the Error: In $2021$, the controller of Hathaway Corporation discovered an error originating in $2019$.

• Nature of the Transaction: The company paid $300,000$ in legal fees to defend a patent.

• Incorrect Accounting (2019): The company accidentally debited the entire $300,000$ to "Legal Fee Expense" and credited Cash. This resulted in an immediate reduction of net income and Retained Earnings in $2019$.

• Correct Accounting Treatment:

  • The legal fees should have been capitalized to the Patent asset account.

  • The capitalized amount should have been amortized over the asset's remaining life.

• Amortization Calculation:

  • Remaining useful life: $5$ years.

  • Annual amortization expense: $\frac{300,000}{5} = 60,000$ per year.

• Impact Over Time (2019–2020):

  • Amortization that should have been recorded: $60,000$ in $2019$ and $60,000$ in $2020$, totaling $120,000$ in expenses.

  • Actual expense recorded: A one-time charge of $300,000$ in $2019$.

• Net Correction to Retained Earnings:

  • Retained earnings were overcharged (understated) by the original $300,000$ expense.

  • Retained earnings were undercharged (overstated) by the missed amortization of $120,000$ (for the years $2019$ and $2020$).

  • The net adjustment required to Retained Earnings is an increase of $180,000$ ($300,000 - 120,000 = 180,000$).

• Correction Entry Components:

  1. Credit Retained Earnings: $180,000$ to fix the cumulative understatement of equity.

  2. Debit Patent Account: For the remaining unamortized portion of the legal fees ($180,000$).

• Reporting Requirements: This correction requires the restatement of the financial statements for $2019$ and $2020$ and a detailed note disclosure regarding the error.