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Intermediate Accounting

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Prepared by Coby Harmon University of California, Santa Barbara

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Accounting Changes and Error Analysis

Intermediate Accounting 14th Edition

Kieso, Weygandt, and Warfield


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Learning Objectives
1. 2. Identify the two types of accounting changes. Describe the accounting for changes in accounting policies.

3.
4. 5. 6. 7. 8.

Understand how to account for retrospective accounting changes.


Understand how to account for impracticable changes. Describe the accounting for changes in estimates. Describe the accounting for correction of errors. Identify economic motives for changing accounting policies. Analyze the effect of errors.

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Accounting Changes and Error Analysis

Accounting Changes

Error Analysis

Changes in accounting policy

Balance sheet errors Income statement errors Balance sheet and income statement effects Comprehensive example Preparation of statements with error corrections

Changes in accounting estimate


Change in reporting entity Correction of errors

Summary
Motivations for change of method
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Accounting Changes
Accounting Alternatives:

Diminish the comparability of financial information. Obscure useful historical trend data.

Types of Accounting Changes:


1. Change in Accounting Policy. 2. Changes in Accounting Estimate. 3. Change in Reporting Entity.

Errors are not considered an accounting change.


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LO 1 Identify the two types of accounting changes.

Changes in Accounting Principle


Change from one accepted accounting policy to another. Examples include:

Average cost to LIFO.

Completed-contract to percentage-of-completion.

Adoption of a new policy in recognition of events that have occurred for the first time or that were previously immaterial is not an accounting change.

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LO 2 Describe the accounting for changes in accounting policies.

Changes in Accounting Principle


Three approaches for reporting changes:
1) Currently.
2) Retrospectively. 3) Prospectively (in the future).

FASB requires use of the retrospective approach.

Rationale - Users can then better compare results from one period to the next.

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LO 2 Describe the accounting for changes in accounting policies.

Changes in Accounting Principle


Retrospective Accounting Change Approach
Company reporting the change
1) Adjusts its financial statements for each prior period presented to the same basis as the new accounting principle. 2) Adjusts the carrying amounts of assets and liabilities as of the beginning of the first year presented, plus the opening balance of retained earnings.

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LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle


Retrospective Accounting Change: Long-Term Contracts
Illustration: Denson Company has accounted for its income from long-term construction contracts using the completed-contract method. In 2012, the company changed to the percentage-ofcompletion method. Management believes this approach provides a more appropriate measure of the income earned. For tax purposes, the company uses the completed-contract method and

plans to continue doing so in the future. (Assume a 40 percent


enacted tax rate.)

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LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle


Illustration 22-1

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LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle


Data for Retrospective Change
Illustration 22-2

Journal entry beginning of 2012

Construction in Process

220,000

Deferred Tax Liability


Retained Earnings

88,000
132,000

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LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle


Reporting a Change in Principle
Major disclosure requirements are as follows. 1. 2. Nature of the change in accounting policy; The method of applying the change, and: a. A description of the prior period information that has been retrospectively adjusted, if any.

b. The effect of the change on income from continuing operations,


net income (or other appropriate captions of changes in net assets or performance indicators), any other affected line item. c. The cumulative effect of the change on retained earnings or other components of equity or net assets in the balance sheet as of the beginning of the earliest period presented.
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LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle


Reporting a Change in policy
Illustration 22-3

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LO 3

Changes in Accounting Principle


Retained Earnings Adjustment
Retained earnings balance is $1,360,000 at the beginning of 2010.
Illustration 22-4

Before Change

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LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle


Retained Earnings Adjustment

Illustration 22-5

After Change

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LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle


E22-1 (Change in PrincipleLong-Term Contracts): Cherokee Construction Company changed from the completed-contract to the percentage-of-completion method of accounting for long-term construction contracts during 2012. For tax purposes, the company employs the completed-contract method and will continue this

approach in the future. (Hint: Adjust all tax consequences through


the Deferred Tax Liability account.)

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LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle


E22-1 (Change in policyLong-Term Contracts):

Instructions: (assume a tax rate of 35%) (b) What entry(ies) are necessary to adjust the accounting records for the change in accounting principle? (a) What is the amount of net income and retained earnings that would be reported in 2012? Assume beginning retained earnings for 2011 to be $100,000.
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LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle


E22-1: Pre-Tax Income from Long-Term Contracts
Percentageof-Completion $ 780,000 700,000 CompletedContract $ 610,000 480,000 35% Tax Effect 59,500 77,000 Net of Tax $ 110,500 143,000

Date 2011 2012

Difference 170,000 220,000

Journal entry 2012 Construction in progress Deferred tax liability Retained earnings 170,000 59,500 110,500

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LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle


E22-1: Comparative Statements
Restated 2011 $ $ $ 780,000 273,000 507,000 100,000 100,000 507,000 $ 607,000 Previous 2011 $ 610,000 213,500 $ 396,500 $ 100,000 100,000 396,500 $ 496,500

2012

Income Statement

Pre-tax income Income tax (35%) Net income Beg. Retained earnings Accounting change Beg. R/Es restated Net income End. Retained earnings

$ $ $ $

700,000 245,000 455,000 496,500 110,500 607,000 455,000

Statement of Retained Earnings

$ 1,062,000

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LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle


Direct and Indirect Effects of Changes

Direct Effects - FASB takes the position that companies should retrospectively apply the direct

effects of a change in accounting principle.

Indirect Effect is any change to current or future cash flows of a company that result from making a change in accounting principle that is applied retrospectively.

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LO 3 Understand how to account for retrospective accounting changes.

Changes in Accounting Principle


Impracticability
Companies should not use retrospective application if one of the following conditions exists:
1. Company cannot determine the effects of the retrospective application. Retrospective application requires assumptions about managements intent in a prior period. Retrospective application requires significant estimates that the company cannot develop.

2.

3.

If any of the above conditions exists, the company prospectively applies the new accounting principle.
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LO 4 Understand how to account for impracticable changes.

Changes in Accounting Estimate


Examples of Estimates
1. Uncollectible receivables.
2. Inventory obsolescence. 3. Useful lives and salvage values of assets.

4. Periods benefited by deferred costs.


5. Liabilities for warranty costs and income taxes. 6. Recoverable mineral reserves. 7. Change in depreciation methods.

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LO 5 Describe the accounting for changes in estimates.

Changes in Accounting Estimate


Prospective Reporting
Changes in accounting estimates are reported prospectively. Account for changes in estimates in
1. the period of change if the change affects that period only, or 2. the period of change and future periods if the change affects both. FASB views changes in estimates as normal recurring corrections and adjustments and prohibits retrospective treatment.

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LO 5 Describe the accounting for changes in estimates.

Change in Estimate Example


Illustration: Arcadia High School purchased equipment for $510,000 which was estimated to have a useful life of 10 years with a salvage value of $10,000 at the end of that time. Depreciation has been recorded for 7 years on a straight-line basis. In 2012 (year 8), it is determined that the total estimated life should be 15 years with a salvage value of $5,000 at the end of that time. Required:

What is the journal entry to correct prior years depreciation expense? Calculate depreciation expense for 2012.

No Entry Required

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LO 5 Describe the accounting for changes in estimates.

Change in Estimate Example


Equipment cost Salvage value Depreciable base Useful life (original) Annual depreciation

After 7 years

$510,000 First, establish NBV - 10,000 at date of change in 500,000 estimate. 10 years $ 50,000 x 7 years = $350,000

Balance Sheet (Dec. 31, 2011) Fixed Assets: Equipment Accumulated depreciation Net book value (NBV)
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$510,000 350,000 $160,000

LO 5 Describe the accounting for changes in estimates.

Change in Estimate Example


Net book value Salvage value (if any) Depreciable base Useful life Annual depreciation $160,000 5,000 155,000 8 years $ 19,375 Second, calculate depreciation expense for 2012.

Journal entry for 2012 Depreciation expense Accumulated depreciation 19,375 19,375

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LO 5 Describe the accounting for changes in estimates.

Changes in Accounting Estimate


Disclosures
Companies need not disclose changes in accounting estimate made as part of normal operations, such as bad debt allowances or inventory obsolescence, unless such changes are material. However, for a change in estimate that affects several periods (such as a change in the service lives of depreciable assets), companies should disclose the effect on income from continuing operations and related per-share amounts of the current period.

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LO 5 Describe the accounting for changes in estimates.

Change in Reporting Entity


Examples of a change in reporting entity are:
1. Presenting consolidated statements in place of statements of individual companies.

2. Changing specific subsidiaries that constitute the group of companies for which the entity presents consolidated financial statements.
3. Changing the companies included in combined financial statements. 4. Changing the cost, equity, or consolidation method of accounting for subsidiaries and investments.
Reported by changing the financial statements of all prior periods presented.
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LO 6 Identify changes in a reporting entity.

Correction of Errors
Types of Accounting Errors:
1. A change from an accounting principle that is not generally accepted to an accounting policy that is acceptable. 2. Mathematical mistakes. 3. Changes in estimates that occur because a company did not prepare the estimates in good faith. 4. Failure to accrue or defer certain expenses or revenues. 5. Misuse of facts. 6. Incorrect classification of a cost as an expense instead of an asset, and vice versa.
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LO 7 Describe the accounting for correction of errors.

Correction of Errors

All material errors must be corrected.

Record corrections of errors from prior periods as an


adjustment to the beginning balance of retained earnings in the current period.

Such corrections are called prior period adjustments.


For comparative statements, a company should restate the prior statements affected, to correct for the error.

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LO 7 Describe the accounting for correction of errors.

Correction of Errors
Illustration: In 2013 the bookkeeper for Selectro Company discovered an error: In 2012 the company failed to record $20,000of depreciation expense on a newly constructed building. This building is the only depreciable asset Selectro owns. The company correctly included the depreciation expense in its tax return and correctly reported its income taxes payable.

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LO 7 Describe the accounting for correction of errors.

Correction of Errors
Illustration: Selectros income statement for 2012 with and without the error.
Illustration 22-19

Show the entries that Selectro should have made and did make for
recording depreciation expense and income taxes.
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LO 7 Describe the accounting for correction of errors.

Correction of Errors
Illustration: Show the entries that Selectro should have made and did make for recording depreciation expense and income taxes.
Illustration 22-18

Correcting Entry in 2013


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LO 7 Describe the accounting for correction of errors.

Correction of Errors
Illustration: Show the entries that Selectro should have made and did make for recording depreciation expense and income taxes.
Illustration 22-18

Correcting Entry in 2013


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Retained Earnings

12,000

LO 7 Describe the accounting for correction of errors.

Correction of Errors
Illustration: Show the entries that Selectro should have made and did make for recording depreciation expense and income taxes.
Illustration 22-18

Correcting Entry in 2013


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Retained Earnings
Deferred Tax Liability

12,000
8,000

Reversal

LO 7 Describe the accounting for correction of errors.

Correction of Errors
Illustration: Show the entries that Selectro should have made and did make for recording depreciation expense and income taxes.
Illustration 22-18

Correcting Entry in 2013


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Retained Earnings
Deferred Tax Liability

12,000
8,000 Record 20,000

Accumulated DepreciationBuildings

LO 7 Describe the accounting for correction of errors.

Correction of Errors
Illustration (Single-Period Statement): Assume that Selectro Company has a beginning retained earnings balance at January 1, 2013, of $350,000. The company reports net income of $400,000 in 2013.
Illustration 22-21

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LO 7 Describe the accounting for correction of errors.

Correction of Errors
Comparative Statements
Company should
1. make adjustments to correct the amounts for all affected accounts reported in the statements for all periods reported. 2. restate the data to the correct basis for each year

presented.
3. show any catch-up adjustment as a prior period adjustment to retained earnings for the earliest period it

reported.
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LO 7 Describe the accounting for correction of errors.

Correction of Errors
Woods, Inc. Statement of Retained Earnings For the Year Ended December 31, 2012 Balance, January 1 Net income Dividends Balance, December 31 $ 1,050,000 360,000 (300,000) 1,110,000

Before issuing the report for the year ended December 31, 2012, you discover a $62,500 error that caused the 2011 inventory to be overstated (overstated inventory caused COGS to be lower and thus net income to be higher in 2011). Would this discovery have any impact on the reporting of the Statement of Retained Earnings for 2012? Assume a 20% tax rate.
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LO 7 Describe the accounting for correction of errors.

Correction of Errors
Woods, Inc. Statement of Retained Earnings For the Year Ended December 31, 2012 Balance, January 1, as previously reported Prior period adjustment, net of tax Balance, January 1, as restated Net income Dividends Balance, December 31 $ 1,050,000 (50,000) 1,000,000 360,000 (300,000) 1,060,000

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LO 7 Describe the accounting for correction of errors.

Summary of Accounting Changes and Errors


Illustration 22-23

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LO 7

Summary of Accounting Changes and Errors


Illustration 22-23

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LO 7

Motivations for Change of Accounting Method


Why companies may prefer certain accounting methods. Some reasons are:
1. Political costs.
2. Capital Structure. 3. Bonus Payments. 4. Smooth Earnings.

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LO 8 Identify economic motives for changing accounting policies.

Error Analysis
Companies must answer three questions:
1. What type of error is involved? 2. What entries are needed to correct for the error? 3. After discovery of the error, how are financial statements to

be restated?
Companies treat errors as prior-period adjustments and report them in the current year as adjustments to the beginning

balance of Retained Earnings.

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LO 9 Analyze the effect of errors.

Balance Sheet Errors


Balance sheet errors affect only the presentation of an asset, liability, or stockholders equity account.

Current year error - reclassify item to its proper position. Prior year error - restate the balance sheet of the prior year for comparative purposes.

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LO 9 Analyze the effect of errors.

Income Statement Errors


Improper classification of revenues or expenses.

Current year error - reclassify item to its proper position. Prior year error - restate the income statement of the prior year for comparative purposes.

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LO 9 Analyze the effect of errors.

Balance Sheet and Income Statement Errors


Counterbalancing Errors
Will be offset or corrected over two periods. If company has closed the books: a. If the error is already counterbalanced, no entry is necessary. b. If the error is not yet counterbalanced, make entry to adjust the present balance of retained earnings. For comparative purposes, restatement is necessary even if a correcting journal entry is not required.

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LO 9 Analyze the effect of errors.

Balance Sheet and Income Statement Errors


Counterbalancing Errors
Will be offset or corrected over two periods. If company has not closed the books: a. If error already counterbalanced, make entry to correct the error in the current period and to adjust the beginning balance of Retained Earnings. b. If error not yet counterbalanced, make entry to adjust the beginning balance of Retained Earnings.

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LO 9 Analyze the effect of errors.

Balance Sheet and Income Statement Errors


Non-Counterbalancing Errors
Not offset in the next accounting period. Companies must make correcting entries, even if they have closed the books.

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LO 9 Analyze the effect of errors.

Error Analysis Example


E22-19 (Error Analysis; Correcting Entries): A partial trial balance of Dickinson Corporation is as follows on December 31, 2012.

Dr. Supplies Salaries and wages payable Interest receivable Prepaid insurance Unearned rent Interest payable 5,100 90,000 $ 2,500 $

Cr. 1,500

0 15,000

Instructions: (a) Assuming that the books have not been closed, what are the adjusting entries necessary at December 31, 2012?
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LO 9 Analyze the effect of errors.

Error Analysis Example


(a) Assuming that the books have not been closed, what are the adjusting entries necessary at December 31, 2012?

1.

A physical count of supplies on hand on December 31, 2012, totaled $1,100.


Supplies expense Supplies 1,400 1,400

2.

Accrued salaries and wages on December 31, 2012, amounted to $4,400.


Salaries and wages expense Salaries and wages payable 2,900 2,900
LO 9 Analyze the effect of errors.

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Error Analysis Example


(a) Assuming that the books have not been closed, what are the adjusting entries necessary at December 31, 2012?

3.

Accrued interest on investments amounts to $4,350 on December 31, 2012.


Interest revenue Interest receivable 750 750

4.

The unexpired portions of the insurance policies totaled $65,000 as of December 31, 2012.
Insurance expense Prepaid insurance 25,000 25,000
LO 9 Analyze the effect of errors.

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Error Analysis Example


(a) Assuming that the books have not been closed, what are the adjusting entries necessary at December 31, 2012?

5.

$24,000 was received on January 1, 2012 for the rent of a building for both 2012 and 2013. The entire amount was credited to rental income.
Rental income Unearned rent 12,000 12,000

6.

Depreciation for the year was erroneously recorded as $5,000 rather than the correct figure of $50,000.
Depreciation expense Accumulated depreciation 45,000 45,000
LO 9 Analyze the effect of errors.

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Error Analysis Example


E22-19 (Error Analysis; Correcting Entries) A partial trial balance of Dickinson Corporation is as follows on December 31, 2012.

Dr. Supplies Salaries and wages payable Interest receivable Prepaid insurance Unearned rent Interest payable 5,100 90,000 $ 2,500 $

Cr. 1,500

0 15,000

Instructions: (b) Assuming that the books have been closed, what are the adjusting entries necessary at December 31, 2012?
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LO 9 Analyze the effect of errors.

Error Analysis Example


(b) Assuming that the books have been closed, what are the adjusting entries necessary at December 31, 2012?

1.

A physical count of supplies on hand on December 31, 2012, totaled $1,100.


Retained earnings Supplies 1,400 1,400

2.

Accrued salaries and wages on December 31, 2012, amounted to $4,400.


Retained earnings Salaries and wages payable 2,900 2,900

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LO 9 Analyze the effect of errors.

Error Analysis Example


(b) Assuming that the books have been closed, what are the adjusting entries necessary at December 31, 2012?

3.

Accrued interest on investments amounts to $4,350 on December 31, 2012.


Retained earnings Interest receivable 750 750

4.

The unexpired portions of the insurance policies totaled $65,000 as of December 31, 2012.
Retained earnings Prepaid insurance 25,000 25,000

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LO 9 Analyze the effect of errors.

Error Analysis Example


(b) Assuming that the books have been closed, what are the adjusting entries necessary at December 31, 2012?

5.

$24,000 was received on January 1, 2012 for the rent of a building for both 2012 and 2013. The entire amount was credited to rental income.
Retained earnings Unearned rent 12,000 12,000

6.

Depreciation for the year was erroneously recorded as $5,000 rather than the correct figure of $50,000.
Retained earnings Accumulated depreciation 45,000 45,000
LO 9 Analyze the effect of errors.

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APPENDIX

22A

CHANGING FROM OR TO THE EQUITY METHOD

Change From The Equity Method


Change from the equity method to the fair-value method.

Earnings or losses previously recognized under the equity method should remain as part of the carrying amount of the investment.

The cost basis is the carrying amount of the investment at the date of the change.

The investor applies the new method in its entirety.


At the next reporting date, the investor should record the unrealized holding gain or loss to recognize the difference between the

carrying amount and fair value.


LO 10 Make the computations and prepare the entries necessary to record a change from or to the equity method of accounting.

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APPENDIX

22A

CHANGING FROM OR TO THE EQUITY METHOD

Dividends in Excess of Earnings


Accounted for such dividends as a reduction of the
investment carrying amount, rather than as revenue. Reason: Dividends in excess of earnings are viewed as a
liquidating dividend with this excess then accounted for as a ________________

reduction of the equity investment.

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LO 10 Make the computations and prepare the entries necessary to record a change from or to the equity method of accounting.

APPENDIX

22A

CHANGING FROM OR TO THE EQUITY METHOD

Dividends in Excess of Earnings


Illustration: On January 1, 2011, Investor Company purchased 250,000 shares of Investee Companys 1,000,000 shares of outstanding stock for $8,500,000. Investor correctly accounted for this investment using the equity method. After accounting for dividends received and investee net income, in 2011, Investor reported its investment in Investee Company at $8,780,000 at December 31, 2011. On January 2,

2012, Investee Company sold 1,500,000 additional shares of its own


common stock to the public, thereby reducing Investor Companys ownership from 25 percent to 10 percent.

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LO 10 Make the computations and prepare the entries necessary to record a change from or to the equity method of accounting.

APPENDIX

22A

CHANGING FROM OR TO THE EQUITY METHOD

Dividends in Excess of Earnings


Illustration 22A-1

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LO 10 Make the computations and prepare the entries necessary to record a change from or to the equity method of accounting.

APPENDIX

22A

CHANGING FROM OR TO THE EQUITY METHOD

Impact on Investment Carrying Amount

Illustration 22A-2

2012 & 2013 2014

Cash Dividend Revenue Cash Equity Investments (AFS) Dividend Revenue

400,000 400,000 210,000 60,000 150,000


LO 10

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APPENDIX

22A

CHANGING FROM OR TO THE EQUITY METHOD

Change To The Equity Method


Companies use retrospective application. The carrying amount of the investment, results of current and prior operations, and retained earnings of the investor are adjusted as if the equity method has been in effect during all of the previous periods.

Companies also eliminate any balances in the Unrealized Holding Gain or LossEquity account and the Securities Fair Value Adjustment account.
LO 10 Make the computations and prepare the entries necessary to record a change from or to the equity method of accounting.

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RELEVANT FACTS

One area in which GAAP and IFRS differ is the reporting of error corrections in previously issued financial statements. While both sets of standards require restatement, GAAP is an absolute standard that is, there is no exception to this rule. The accounting for changes in estimates is similar between GAAP and IFRS. Under GAAP and IFRS, if determining the effect of a change in accounting policy is considered impracticable, then a company should report the effect of the change in the period in which it believes it practicable to do so, which may be the current period.

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RELEVANT FACTS

Under IFRS, the impracticality exception applies both to changes in accounting principles and to the correction of errors. Under GAAP, this exception applies only to changes in accounting principle. IFRS (IAS 8) does not specifically address the accounting and reporting for indirect effects of changes in accounting principles. As indicated in the chapter, GAAP has detailed guidance on the accounting and reporting of indirect effects.

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IFRS SELF-TEST QUESTION


Which of the following is false?
a. GAAP and IFRS have the same absolute standard regarding the reporting of error corrections in previously issued financial statements. b. The accounting for changes in estimates is similar between GAAP and IFRS. c. Under IFRS, the impracticality exception applies both to changes in accounting principles and to the correction of errors.

d. GAAP has detailed guidance on the accounting and reporting of indirect effects; IFRS does not.
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IFRS SELF-TEST QUESTION


Which of the following is not classified as an accounting change by IFRS?
a. Change in accounting policy. b. Change in accounting estimate. c. Errors in financial statements.

d. None of the above.

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IFRS SELF-TEST QUESTION


IFRS requires companies to use which method for reporting changes in accounting policies?
a. Cumulative effect approach. b. Retrospective approach. c. Prospective approach.

d. Averaging approach.

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