Accounting Changes: Error Correction

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Accounting Analysis II: Accounting for Liabilities and Equity

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University of Illinois at Urbana-Champaign

Accounting Analysis II: Accounting for Liabilities and Equity

8 notes

Cours 4 sur 5 dans Specialization Financial Reporting

This course is the fourth course in a five-course Financial Reporting Specialization. This course focuses on the recognition, measurement and subsequent accounting for equity, pensions, share-based compensation and cash flows utilizing the FASB Accounting Standards Codification and other resources.

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Module 6 Accounting Changes

In this module, you will be introduced to the accounting for changes in accounting principles, changes in accounting estimates, and correction of errors from a previous period. The module will discuss the three techniques used when a new standard is adopted: retrospective, modified retrospective, and prospective.

Accounting Changes: Error Correction10:05

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John Hepp
Clinical Assistant Professor of Accountancy
Department of Accountancy

Welcome back. In this lesson,

we're going to talk about correcting errors.

Now, recall that in the beginning of this module,

we talked about how a correction of an error is not really an accounting change,

it's not a change in accounting principle,

it's not a change in accounting estimates.

It's correction of an error.

In 1,000 previously issued financial statements,

this could result from mathematical mistakes,

mistakes in the application of GAP.

This is getting more and more common, by the way,

as GAP financial statements get more complicated,

as the rules get more complicated,

or oversight or misuse of the facts

that existed at the time the statements were appeared.

A change from an accounting principle that is not generally

accepted also is correction of an error.

An example of some of this might be that if you were applying hedge accounting,

for example, in the prior period,

but you didn't properly document the hedge or tested on a timely basis for effectiveness,

you may have to go back and correct your financial statements by

accounting for those hedges as if they had just simply been the purchase of a derivative.

So, if I have an error in recognition measurement, presentation,

or disclosure resulting from these,

I'm going to have to restate.

The dreaded R word.

This is a big deal.

Companies hate to restate their financial statements.

So, you're always going to look first to see whether it's material.

Error corrections in a single period statement

reflected as adjustment of the opening balance of retained earnings.

So, if I don't have comparatives,

again, think back to how we did a change in accounting principle.

I'm going to recount for it as a comparative

or I'm going to adjust the kind of net income and retained earnings

for all comparative purposes to reflect

the retroactive application of the error corrections.

So, I'm only going to make these changes that they're material.

And in determining materiality for the purpose of reporting correction of error,

amounts show they're related to estimated income for the full fiscal year

and also to the effect on the trend of earnings.

Now, interim materiality may be a little different than full period materiality.

Changes that are material respect to an interim period but

not material with respect to the full period or the trend of earnings,

those gets separately disclosed in the interim period.

They may not necessarily be restated.

There's two methods that are generally used

to evaluate materiality and they test different things.

So, most of the time,

you're going to do both if they apply to your particular situation.

Let's talk about them briefly.

Those are the Rollover method and the Iron Curtain approach.

Now, you'll find these in the codification but if you look

at the citation here at the bottom of this slide,

you'll notice that there's an S99-2 encoded at the end.

What does that mean?

The S99 means that this is coming actually from the SCC.

Now, the fact that it's coming from the SCC means it's technically

not generally accepted accounting principles as applied by

the ASCPA code of ethics but most accounting firms are going to apply this to

both public and private companies because it's the best technique available.

The rollover approach quantifies a misstatement

based upon the amount of air originating in the current period.

It ignores the carry over effects of prior period misstatements.

So, I'm going to look at it and say,

was it material in the current period?

And if it wasn't, then I don't necessarily have to make a correction.

If it is, I do.

The shortcoming with that is it can result in the accumulation of

immaterial misstatements that are immaterial in one period

and immaterial the next period and immaterial in the next period.

But something on the balance sheet is

accumulating over that period and what happens is eventually,

you're going to get the material misstatement on

the balance sheet that can come up even though

the amount on the income statement in

each individual year was quantitatively

small or maybe immaterial on the balance sheet itself.

So, the second approach that is used

often in conjunction with the rollover approach is the Iron Curtain,

and this quantifies a misstatement may stem the effects of correcting

the misstatement existing in the balance sheet at the end of the current year.

And this is regardless of the misstatements' impact in the year of origination.

So, even if it was immaterial in previous years,

small amounts, small amounts,

small amounts, if it's built up to a large enough amount,

I'm going to consider it material.

The shortcoming with that is that it doesn't really consider a correction

of prior years' misstatements in the current year to be errors.

So, the staff believes that

the registrant should quantify the current year misstatement using

both the Iron Curtain approach and

the rollover approach in order to assess the materiality of an error.

So, let's look at an example of that.

So, we'll go back to Faux Sentiment Jewelers and they discover an error in

the accounting for an arrangement involving variable rate debt and an interest rate swap.

You don't really need to know what that is.

You just need to know that that's something that can build up over a period of years.

Let's see how we evaluate it.

Under the rollover method,

you've got $5,000 of losses on the swap,

were improperly classified as other comprehensive income in 2015,

and there was 4,000 in 2016,

and 3,000 in 2017,

and those are not yet issued.

So, we're assessing materiality at 7,000.

Does this qualify?

Well, under the rollover method,

a 3,000 correction for the current period

would be immaterial based upon the rollover method.

Under the Iron Curtain method, of course,

the correction to income would not be considered in

errors as long as the ending balance sheet is correct.

But the ending balance sheet here would be incorrect.

It would be 9,000 for previous amounts

recorded in the AOCI and 3,000 for the current period.

So, you would have a cumulative effect of

$12,000 of error in AOCI at the end of the period.

So, error is material.

But it could be corrected by a reclassification from a AOCI to retained earnings.

So, if we're doing a single year,

we would report the effect from

the prior years which would be the 9,000 from the prior years,

there would be a correction to retained earnings net of tax.

Remember AOCI is net of tax.

So, we're going to have that correction on there for 7,200 and then the tax effect,

the tax schedule, we'll work on all of that.

But remember that the AOCI is always net of tax.

The amount for the current year, of course,

since they haven't been issued yet,

we would make the correction in the current year.

Now, what if there's been interim statements issued?

We would make that interim assessment using interim materiality.

So, if we haven't issued any material interim financial statements,

then we'll just going to make the amount in the final entry for the current year.

And since they haven't been issued yet,

it's not an error.

So, we're just going to record that normally.

So, the error correction would just be for

the previous periods that were already issued or

possibly for any material impact

on interim financial statements that have already been issued.

If there's comparative balance sheets and a comparative income statement,

the amounts are restated.

Again, this is exactly the same as what we did with

the change in accounting principle. We're going to go back.

We'll change the first year.

So, for 2016, we have to take into

account both the income statement impacts and the balance sheet impacts.

So, we would reverse the amount that was classified in OCI as

a reclassification and the deferred tax and we would put in the loss in the swap,

now becomes an item measured in net income,

and the deferred tax as a regular income deferred tax.

So, there's also would be a closing entry where you would close the income statement,

again, to retained earnings so there would be an impact on retained earnings.

So, remember that error corrections are like

a change in accounting principle, only they're involuntary.

If it's material, you have to do it.

You're evaluating from materiality and there's two methods,

one that catches the current period impact mainly which is the rollover,

and another which captures the cumulative effect which is the Iron Curtain method.

And then those material errors are corrected by restatement of the financial statements.

So, this is a situation that you never want to see.

If you're a financial reporting professional,

you don't want to go back and restate your financial statements.

In some countries, actually,

you're not allowed to do so,

but it's an embarrassing and it's an expensive proposition.

The idea is to get it right the first time.

But if it happens,

it happens, and this is the method that you would use. Thank you.

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