Error journal entry occurs often and you want to correct them. Companies also often change the use of accounting principles, occasionally. How do you make journal entry (and probably correction entry too) to reflect the correct entry properly? This post address the question.
Companies often make changes the use of accounting principles or accounting estimates. For example:
- A company may decide to change its depreciation method to another, or it may decide that an original estimate of the life of equipment was incorrect and should be revised. Such changes, accounting literature, are referred to as “accounting changes”.
- And, occasionally, a company discovers that errors were made in a previous accounting period and it now wishes to correct them. These are referred to as “error corrections”.
Both accounting changes and error corrections are discussed in this post. Let us start with the accounting changes.
A. Accounting Changes
There are three types of accounting changes:
1. Change in accounting principle – It involves changing from one generally accepted accounting principle to another. Example: A change in most inventory costing methods.
[Info_Box]If the accounting principle previously followed was not acceptable OR was incorrectly applied, it is not considered a change in principle but rather a “correction of an error“. [/Info_Box]
2. Change in accounting estimate – It arises as a result of new information obtained regarding certain estimations. For example: A change in the estimated useful life or residual value of a fixed asset would fall under this category.
[Info_Box]If the original estimate was made either in bad faith or with poor judgment, the change is not considered to be a change in estimate BUT rather a “correction of an error“. [/Info_Box].
3. A change in reporting entity – It involves organizations whose identity has evolved from one form to another. For example: preparation of consolidated statements instead of individual statements for a parent and its subsidiary.
B. Error Corrections
Error corrections involve the discovery of errors that took place in prior periods. For example: omissions, mathematical mistakes, double counting and improper application of accounting rules and principles.
1. Changes In Accounting Principle – As I have stated on the previous section, these changes involve a change from one generally accepted accounting method to another.
- A change in inventory methods (except to LIFO)
- A change in construction methods
- A change from the cost method to the equity method or vice versa
And there are two approaches you can use to take care of these changes:
(a) The retrospective approach – It corrects and revises the past, requires a journal entry to correct and revise previous years. If the correction involves revenue or expense it is referred to as a “prior period adjustment.” This adjustment would be shown on the current year’s Retained Earnings Statement as a correction of the January 1 balance:
- A revision of prior year financial statements that are presented alongside the current year’s statements.
- A footnote in the year of the change describing and justifying the change, and showing its effects.
Here is a good example:
During 19X1 and 19X2, the Royal Bali Corp. used the completed-contract method of accounting for construction contracts. At the beginning of 19X3, it decides to change to the percentage-of-completion method, for both tax and book purposes. The tax rate for all years is 40%, and there are 1,000 shares of common stock outstanding. The following table presents the relevant information for the years 19X1, 19X2, and 19X3:
The entry in 19X3 to record this change is:
[Debit]. Construction in Process = 130,000
[Credit]. Taxes Payable = 52,000
[Credit]. Retained Earnings = 78,000
Retained earnings is increased by $78,000 because the net income after taxes for 19X1 and 19X2 has risen by this amount, and net income increases retained earnings.
The 19X3 comparative income statement would show the following (assuming 19X3 income before tax of $170,000):
The above figures are based upon the new, retroactive, percentage-of-completion figures.
Let’s assume the beginning retained earnings balances for 19X3 and 19X2 were $800,000 and $680,000, respectively, and that no dividends were declared during these years. The comparative retained earnings statements for these years would appear as follows:
Royal Bali Corp. purchases a machine on January 1, 2005 for $11,000. This machine has an estimated life of 10 years and an estimated salvage of $1,000. During 2005 and 2006 Royal Bali Corp. used the sum-of-the years’ digits method of depreciation, resulting in the following t-account balances:
At the beginning of 2007 Royal Bali decides to change to the straight-line method, without changing the estimated life or salvage value.
Royal Bali would make no journal entry to revise the past, nor would it revise its comparative financial statements. The only thing Royal Bali would do is change its depreciation calculation prospectively (for 2007 and onward), as follows:
(b) The prospective approach – It does not correct or revise the past, it merely applies the new principle to the correct and future periods. Thus no journal entries or revision of prior financial statements are necessary.
Most changes in accounting principles use the retrospective approach. However, there are three exceptions:
- A change in depreciation methods (since these changes are often rooted in a change in the asset’s estimated future cash flows, they are treated as a change in accounting estimate, which as we will discuss later on, uses the prospective approach).
- A change for which an authoritative pronouncement requires the prospective approach.
- A change where the retrospective approach would be impractical, Example: a change to the LIFO method of inventory.
Up-coming post is Change In Accounting Estimates & Reporting Entity. There are a number of situations that require the use of estimates, such as un-collectability of account receivable, liabilities for estimated warranty costs, salvage values and lives of plant assets.