Accounting Changes, Errors, and Derivatives

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1 Change in Accounting Estimate

7

Counterbalancing Errors
2 Change in Accounting Principle

8

Derivatives
3 Effect of Taxes

9

Accounting for Futures Contracts
4 Change to LIFO Method

10

Accounting for Options
5 Prior-Period Restatement

11

Glossary
6 Accounting for Errors  

Change in Accounting Estimate

When preparing the financial statements, management makes many estimates based on its best judgment. When more information is available later, estimates can change. For example, a company might estimate that a new machine will have a useful life of 10 years. After six years, however, information about new technologies might suggest that the machine will be useful for only two more years (for a total of eight). This is an example of the need for a change in accounting estimate.

Changes in accounting estimates can occur as the result of changes in the following:

The rules related to changes in accounting estimates are as follows:
  1. Nothing from the past needs to be changed (that is, no retroactive changes are involved).
  2. The change must be reflected in current and future financial statements.
Example:
Williams Company purchased a machine on January 1, 2002, for $100,000. Its estimated useful life was determined to be 10 years, with zero salvage value. On January 1, 2006, the company revised its estimate. It now expects the machine to be useful for only another three years. If the company uses straight-line depreciation, what is the amount of the depreciation each year?

Depreciation based on initial estimates is $10,000 each year (= $100,000/10).
Thus, depreciation for the first four years (2002 through 2005) is $10,000 per year.
As of January 1, 2006, accumulated depreciation is $40,000 (= $10,000 x 4).
Therefore, the book value (amount left to depreciate) as of January 1, 2006, is $60,000
(= $100,000 - $40,000).
As of January 1, 2006, the revised remaining useful life is 3 years.
Hence, depreciation from 2006 (to 2008) is $20,000 per year (= $60,000/3).

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Change in Accounting Principle

A change in accounting principle involves a change from one generally accepted accounting principle to another. The following are examples of changes in accounting principles:

The rules for changes in accounting principle are as follows:
  1. Financial statements of prior periods are not changed.
  2. The cumulative effect of the change in accounting principle (net of taxes) is included in the income statement for the period in which the change is made. This is shown after extraordinary items and before net income.
  3. Income before extraordinary items and net income on the income statement is computed on a pro-forma basis (as if the new principle had been used in prior periods) for prior years and is shown on the income statement for all periods presented.
Example:
Spencer Company purchased machinery worth $100,000 on January 1, 2002. Its estimated useful life was five years; the company uses the straight-line method of depreciation. On January 1, 2004, the company decided to change to the double-declining-balance method. Ignoring income tax effects, how will the change be reported on the income statement?


Straight-line depreciation schedule:

Straight-line depreciation is $20,000 each year (= $100,000/5).
Straight-line method of accumulated depreciation after two years is $40,000 (= $20,000 x 2).
Straight-line method book value after two years is $60,000 (= $100,000 - $40,000).


Double-declining-balance (DDB) depreciation schedule:

Straight-line rate each year is 20% (1/5).
Hence the DDB rate is 40%.

Year

Beginning Book Value

DDB Rate

DDB
Depreciation

Accumulated Depreciation

Ending Book Value

2002

$100,000

0.40

$ 40,000

$ 40,000

$60,000

2003

60,000

0.40

24,000

64,000

36,000

Excess depreciation as the result of using the DDB method, as of the end of 2003 (or January 1, 2004) is $24,000 (= $64,000 - $40,000).

If the company had used the DDB method throughout, depreciation in prior years would have been $24,000 higher. This means that the sum of the net income reported in prior years would have been $24,000 lower, causing retained earnings to be $24,000 lower. Furthermore, if the company had used the DDB method throughout, the accumulated depreciation would have been $24,000 higher. Hence, the retained earnings account must be reduced and the accumulated depreciation account must be increased.

This is accomplished through the following journal entries:

Account

Debit

Credit

Cumulative Effect of Change in Accounting Principle

$ 24,000

 
    Accumulated Depreciation  

24,000

The cumulative effect is included in the income statement and reduces net income, thereby reducing the Retained Earnings account. The credit to the Accumulated Depreciation account increases its balance.

If the change had been from the DDB method to the straight-line method, the opposite effect occurs. The Cumulative Effect account would have been credited, thereby increasing net income and the Retained Earnings account. The Accumulated Depreciation account would have been debited, thereby reducing its balance.

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Effect of Taxes

If taxes are considered, the accounting is substantively similar, but the debit or credit to the Cumulative Effect account is net of taxes. The balance relates to the impact of taxes, and the Deferred Tax Asset or Liability account is debited or credited as appropriate. (In some instances, the debit or credit is to Income Tax Receivable or Payable, as appropriate).

In the Spencer Company example, assume that the company has always used the DDB method for tax purposes. Note that for the company used the straight-line method for financial reporting before switching to the DDB method in 2004. (The accounting method used to calculate income taxes need not be the same as the method used for financial reporting.) Furthermore, assume that Spencer Company continues to use the DDB method for tax purposes after the change for financial reporting purposes from straight-line to DDB.

Since the depreciation with DDB method is $24,000 higher than the depreciation with the straight-line method, the depreciation for tax purposes is higher than that for financial statement purposes.
That is, taxable income in the past has been lower than financial income.
This, in turn, means that future taxable income will be higher.
Therefore, the company must set up a deferred tax liability of $7,200 ($24,000 x 0.30).

Once the company decides to change the method from straight-line to DDB, the deferred tax liability is no longer applicable. Hence, the Deferred Tax Liability account is eliminated with a $7,200 debit. As before, the Accumulated Depreciation account is credited with the $24,000 difference in depreciation arising from the switch. The "plug" number is the debit to the Cumulative Effect account. Thus, the journal entry is as follows:

Account

Debit

Credit

Deferred Tax Liability

$ 7,200

 
Cumulative Effect of Change in Accounting Principle

16,800

 
    Accumulated Depreciation  

24,000



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Change to LIFO Method

Assume that a company changed its inventory method from FIFO to LIFO during 2002. Such a change is made effective with the beginning inventory for the period (as of January 1, 2002). This is because it is extremely difficult (if not impossible) to determine changes in prior-year LIFO layers or dollar-value pools.

Hence, the beginning inventory under LIFO as of January 1, 2002, is assumed to be the same as the ending inventory using FIFO as of December 31, 2001. Thus, when a company changes to the LIFO method, no cumulative effect adjustment is needed. The change is disclosed in the footnotes to the financial statements.


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Prior-Period Restatement

In several specific situations, GAAP requires a retroactive treatment for accounting changes. In such instances, the financial statements of prior periods must be revised using the new accounting principle. The specific changes include the following:

Example:
Dallas Company began operations in the year 2000 and used the LIFO method for inventory accounting. The company changed from LIFO to FIFO for both financial reporting and tax purposes in 2002. The following table gives the relevant details:

Year

LIFO Income
Before Taxes

FIFO Income
Before Taxes

Difference

2000

$ 50,000

$ 60,000

$ 10,000

2001

70,000

82,000

12,000

2002

80,000

95,000

15,000

Assuming a tax rate of 30%, prepare the necessary journal entry for the change in method.

Because both the previous and new methods were used simultaneously for financial and tax purposes, the change has no deferred tax consequences. However, additional taxes could be payable (or receivable) because of the change in method used for tax purposes.

In this case, the net income using the new method in the previous years is higher by $22,000 ($10,000 in 2000 and $12,000 in 2001). Hence, the income tax payable (relating to operations of prior years) is higher under the new method by $6,600 (30% of $22,000).

Furthermore, the value of the ending inventory as of December 31, 2001 using FIFO would be higher than the corresponding value using LIFO by the same $22,000.
(Note: The company started with beginning inventory of zero, and the value of purchases is the same under both methods. Therefore, the difference in the Ending Inventory account under the two methods must equal the opposite of the difference in the Cost of Goods Sold account for the two methods or equal the difference in net income between the two methods.)

To account for the higher value of inventory under FIFO, the Inventory account must be debited for $22,000. To record the higher tax payable, the Income Tax Payable account must be credited for $6,600. The plug number is the increase to the Retained Earnings, representing the after-tax increase in net income of the previous periods and the resultant increase in Retained Earnings. (Note that the increase occurs in the beginning balance of the Retained Earnings account, as explained later.)

Hence, the journal entry in 2002 to account for the change is as follows:

Account

Debit

Credit

Inventory

$ 22,000

 
    Income Tax Payable  

6,600

    Retained Earnings  

15,400

The income statements for 2000 and 2001 must be restated, assuming that the FIFO method had been used. The net income for 2000 and 2001 would be higher by $7,000 and $8,400, respectively (after-tax amounts of the impact of the change). This means that the ending balance of the 2000 Retained Earnings account will be higher by $7,000. Since Retained Earnings is a permanent account, its 2001 ending balance (that is, the beginning balance of 2002 Retained Earnings) will be higher by $15,400 ($7,000 + $8,400).

(Note: Pro-forma information is not required with the retroactive approach because the financial statements for the prior years are restated directly.)

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Accounting for Errors

Accounting errors occur for a variety of reasons, including the following:

The different types of errors have different consequences:
  1. Errors affecting the balance sheet only. For example, a long-term receivable could be included as a current receivable. No correcting journal entries are required for such errors, which are usually detected and corrected in the period in which it occurs. However, if such an error is not found until a subsequent period, the prior period financial statements must be corrected by reclassifying the item.

  2. Errors affecting the income statement only. For example, sales commission could be included with manufacturing salaries. This error does not affect net income, so if it is found in a subsequent period, no correcting journal entries are required. However, the financial statements of prior periods must be reclassified and presented using the correct classification.

  3. Errors affecting both the income statement and the balance sheet.
Some of these errors are
counterbalancing. That is, an error that understates an item in one period will automatically overstate it in the next period, but no further consequences occur after the end of the second period. An example is a mistake in inventory count at the end of one year but correct counts in previous and subsequent years.

Other errors do not balance over two periods. Examples are (1) capitalizing and amortizing an item that must be expensed in one period, and (2) incorrectly expensing the purchase of a machine that must be capitalized and depreciated in future periods.


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Counterbalancing Errors

Assume that Olson Company, which uses the periodic system for inventory, made an error in counting the ending inventory as of December 31, 2001. This error led to understating the inventory amount by $600 on December 31, 2001. The inventory counts at the end of 2000 and 2002 were correct. (Income taxes are ignored in this example.)

In this case, the understatement of inventory as of December 31, 2001, leads to overstating the Cost of Goods Sold account for the year ended December 31, 2001, by $600.
(Explanation: Assume beginning inventory of zero and purchases of $10,000. If the correct amount of ending inventory is $2,000, the cost of goods sold is $8,000. However, if the ending inventory is counted to be only $1,400, the cost of goods sold is calculated to be $8,600.)
This, in turn, leads to understating net income for the year ended December 31, 2001, by $600.

However, because the inventory for December 31, 2001, also is the beginning inventory for 2002, this error also leads to understating the cost of goods sold and overstating the net income for the year ended December 31, 2002 by $600.

Thus, as of the end of 2002, the two errors have canceled, or counterbalanced, each other. The ending Inventory and Retained Earnings accounts as of December 31, 2002, are correct.

If a counterbalancing error is discovered in the next year (in this case, some time during 2002), an adjustment is made to the Retained Earnings account and the other affected account. In this example (if the error is discovered sometime before the end of 2002), the correcting journal entry is as follows.

The understatement error at the end of 2001 led to understating the balance in the Inventory account. Correcting this requires increasing the Inventory account, with a debit.

Because the inventory for 2001 was understated, the net income for 2001 was understated. Hence, the beginning balance of Retained Earnings also is understated. Correcting this requires increasing the Retained Earnings account with a credit.

Account

Debit

Credit

Inventory

$ 600

 
    Retained Earnings  

600

However, if a counterbalancing error is discovered only after the subsequent year (that is, sometime in 2003 in the example), no correcting journal entry would be needed.

Other examples of counterbalancing errors include the following:
  1. Incorrectly recording year-end sales made at the end of one year in the second year.
    If a $3,000 sale should have been recorded at the end of 2003 but was recorded in January 2004 and was discovered in 2004, the correcting journal entry is as follows:

    Account

    Debit

    Credit

    Sales

    $ 2,000

     
        Retained Earnings  

    2,000

    The debit to Sales reverses the incorrect increase to 2004 sales, and the credit to Retained Earnings increases its beginning balance in 2004.
    If the error was not discovered in 2004 but later, no correcting journal entry is needed.

  2. Incorrectly recording inventory purchases in the next year.
    The logic for correcting this error is the same as the one to correct sales incorrectly posted to the wrong year. If such an error in the amount of $1,200 relating to the end of 2003 is discovered in 2004, the correcting journal entry is as follows:

    Account

    Debit

    Credit

    Sales

    $ 1,200

     
        Retained Earnings  

    1,200

  3. Failure to record accrued expenses or revenues.

  4. Failure to account for prepaid expenses or unearned revenue.

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Derivatives

A derivative is a financial instrument that derives its value from changes in its price or any other feature (such as interest rate) of some other asset or financial instrument. There are many types of derivatives, and they can be used to protect against various types of risk. Some of the common types of derivatives are swaps, futures, and options.

A
swap is a contract in which two parties agree to exchange payments in the future based on the price or value of some item. In an interest rate swap, two companies agree to exchange the interest payments related to a given loan amount over a specified period in the future. Usually, one party pays interest based on a fixed interest rate and the other pays interest based on a rate that varies over time.

A
futures contract permits a company to buy a specified amount of a commodity (such as corn, wheat, coffee, or oil) at a specified price on a specified date in the future. An option gives the holder the right, but not the obligation, to sell or buy an item at a specified price any time before a specified period in the future. A call option gives the owner the right to buy; a put option gives the owner the right to sell.

Companies seeking to protect themselves against future changes in price use futures and options. That is, they use these derivatives to hedge against future risks (
hedging refers to actions taken to reduce risk).

A company need not actually purchase the specified item when executing a futures contract or an option. The parties to the contract simply exchange the necessary payment.

Example:
Assume that Company X has entered into a futures contract with Company Y to buy some item in the future for $50. The actual price on the date the contract is executed is $40. In this case, Company X will pay Company Y the difference ($10), and the contract is deemed to be completed.


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Accounting for Futures Contracts

Example:
On September 1, 2002, Texas Bakery entered into a futures contract to purchase 20,000 pounds of sugar at $0.50 per pound on January 1, 2003. The price of sugar was $0.50 per pound on September 1, 2002, but was $0.53 per pound on December 31, 2002, and on January 1, 2003. The contract was duly completed. Prepare the necessary journal entries on:

1) September 1, 2002.
2) December 31, 2002.
3) January 1, 2003.
1. No entry is required on September 1, 2002, because as of that date, the fair value of the future is zero.

2. On December 31, 2002, the price had changed to $0.53 per pound. Since this is higher than the contracted price at which Texas Bakery contracted to purchase ($0.50 per pound), as of December 31, 2002, Texas Bakery expects to receive a payment of $600 ([$0.53 - $0.50] x 20,000). Because this amount is expected to offset any changes in the price of the item to be purchased in January 2003, the gain on the futures contract is not recognized during 2002 but is deferred to 2003. The journal entry on December 31 is as follows:

Account

Debit

Credit

Futures Contract (asset)

$ 600

 
    Other Comprehensive Income  

600

The credit to Other Comprehensive Income means that the expected gain is temporarily reported as an increase in equity without including it in the income statement.

3. On January 1, 2003, when the price is $0.53 per pound, the contract is executed. The journal entries are as follows:
  1. To purchase 20,000 pounds of sugar at $0.53 per pound:

    Account

    Debit

    Credit

    Sugar Inventory

    $ 10,600

     
        Cash  

    10,600

  2. To settle the futures contract:

    Account

    Debit

    Credit

    Cash

    $ 600

     
        Futures Contract (Asset)  

    600

  3. To recognize the gain on the contract (by moving the gain from temporary holding in Other Comprehensive Income to the income statement):

    Account

    Debit

    Credit

    Other Comprehensive Income

    $ 600

     
        Gain on Futures Contract  

    600


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Accounting for Options

Example:
On October 1, 2002, Boston Cookies entered into a call option to purchase 10,000 pounds of sugar at $0.50 per pound on January 1, 2003. The price of sugar was $0.50 per pound on September 1, 2002, but was $0.53 per pound on December 31, 2002, and on January 1, 2003. Boston Cookies paid $100 to purchase the option, and the contract was duly completed. Prepare the necessary journal entries on

1) October 1, 2002.
2) December 31, 2002.
3) January 1, 2003.
1. Because $100 cash was paid to purchase the option on October 1, 2002, the journal entry is as follows:
Account

Debit

Credit

Sugar Call Option (asset)

$ 100

 
    Cash  

100

2. On December 31, 2002, the price is $0.53 per pound. Since this is higher than the contracted price at which Texas Bakery is obligated to purchase ($0.50 per pound), as of December 31, 2002, the call option is valuable.
At this price, Boston Cookies expects to receive $300 ([$0.53 - $0.50] x 10,000) from settling the call option.
Hence, the value of the option as of December 31, 2002, is $300. Because the option is currently on the books at $100, the $200 increase in the asset's value must be recorded. The journal entry on December 31 is as follows:
Account

Debit

Credit

Sugar Call Option (asset)

$ 200

 
    Other Comprehensive Income  

200

The debit increases the Sugar Call Option account from $100 to $300.
The credit to Other Comprehensive Income means that the expected gain is temporarily reported as an increase in equity without including it in the 2002 income statement.

3. On January 1, 2003, the contract is executed. The journal entries are as follows:
  1. To purchase 10,000 pounds of sugar at $0.53 per pound:

    Account

    Debit

    Credit

    Sugar Inventory

    $ 5,300

     
        Cash  

    5,300

  2. To settle the call option:

    Account

    Debit

    Credit

    Cash

    $ 300

     
        Sugar Call Option (asset)  

    300

  3. To recognize the gain on the contract (by moving the gain from the temporary holding in Other Comprehensive Income to the income statement):

    Account

    Debit

    Credit

    Other Comprehensive Income

    $ 200

     
        Gain on Call Option  

    200


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Glossary

Accounting errors Hedging
Call options Interest rate swap
Change in accounting estimate Options
Change in accounting principle Pro forma bases
Counterbalancing Put options
Derivative Retroactive changes
Futures contracts Swap

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