Book cover for Intermediate Accounting

Intermediate Accounting

Donald E. Kieso, Jerry J. Weygandt, Terry D. Warfield

ISBN #9780470374948

13th Edition

695 Questions

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7,109 Students Helped

Homework Questions

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Summary
Learning Objectives
Key Concepts
Example Problems
Explanations
Common Mistakes

Summary

Chapter 22 focuses on the critical nature of accounting changes and error corrections, emphasizing the need for proper adjustments (retrospective for principle changes and prospective for estimate changes) to maintain the integrity and comparability of financial statements. Additionally, the chapter highlights the importance of understanding cash flow reporting methods (direct versus indirect) to assess a company’s financial health accurately. Proper disclosure of these adjustments ensures that stakeholders receive accurate and useful financial data.

Learning Objectives

1

Explain the importance of accounting changes and error corrections in ensuring the comparability and consistency of financial statements.

2

Differentiate between changes in accounting principles (retrospective adjustments) and changes in accounting estimates (prospective application).

3

Describe the significance of proper disclosure in financial reporting and how it benefits stakeholders.

4

Compare and contrast net income with net cash flows, and explain the differences between the direct and indirect methods for cash flow reporting.

Key Concepts

CONCEPT

DEFINITION

Accounting Changes

Modifications in accounting principles, procedures, or practices that have a significant impact on the preparation and presentation of financial statements.

Error Corrections

Adjustments made to correct mistakes or inaccuracies found in previously issued financial statements.

Retrospective Adjustments

Adjustments applied to prior periods when a change in accounting principle occurs to ensure comparability over time.

Prospective Application

The method of applying changes in accounting estimates and adjustments only to the current and future periods, without altering past financial statements.

Net Income

The company’s profit after all expenses, taxes, and costs have been deducted from total revenue; often reported on the income statement.

Net Cash Flows

The measure of a company’s liquidity determined by all cash inflows and outflows; reported on the cash flow statement.

Direct Method

A way to prepare the cash flow statement that reports cash receipts and cash payments during the period.

Indirect Method

A way to prepare the cash flow statement where net income is adjusted for changes in balance sheet accounts to arrive at net cash provided by operating activities.

Example Problems

Example 1

In recent years, the Wall Street Journal has indicated that many companies have changed their accounting principles. What are the major reasons why companies change accounting methods?

Example 2

State how each of the following items is reflected in the financial statements (a) Change from FIFO to LIFO method for inventory valuation purposes. (b) Charge for failure to record depreciation in a previous period. (c) Litigation won in current year, related to prior period. (d) Change in the realizability of certain receivables. (e) Write-off of receivables. (f) Change from the percentage-of-completion to the completed-contract method for reporting net income.

Example 3

Discuss briefly the three approaches that have been suggested for reporting changes in accounting principles.

Example 4

Identify and describe the approach the FASB requires for reporting changes in accounting principles.

Example 5

What is the indirect effect of a change in accounting principle? Briefly describe the reporting of the indirect effects of a change in accounting principle.
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Step-by-Step Explanations

QUESTION

How do accounting changes and error corrections differ in terms of their treatment in financial statements?

STEP-BY-STEP ANSWER:

Step [1]: Identify the nature of the adjustment. Accounting changes involve modifications to principles, policies, or estimates, while error corrections address mistakes from previous reporting periods.
Step [2]: Determine the method of application. Changes in accounting principles require retrospective adjustments (applying corrections to previously reported financial statements) whereas changes in estimates are recognized prospectively (only affecting future periods).
Step [3]: Assess the impact on comparability. Retrospective adjustments improve comparability over time, while error corrections ensure historical accuracy.
Final Answer: Accounting changes (especially in principles) require adjustments to prior periods using retrospective methods, whereas error corrections fix prior mistakes without changing the current accounting methodology.

Accounting Changes vs. Error Corrections

QUESTION

What are the main differences between the direct and indirect methods in preparing the cash flow statement?

STEP-BY-STEP ANSWER:

Step [1]: Understand the basic approach. The direct method lists actual cash inflows and outflows during the period, while the indirect method begins with net income and adjusts for non-cash transactions and changes in working capital.
Step [2]: Identify key components. The direct method includes detailed cash receipts and payments, whereas the indirect method reconciles net income with net cash provided by operating activities.
Step [3]: Analyze reporting implications. The direct method provides a clear picture of cash movements, whereas the indirect method is more widely used due to its ease of preparation using existing financial data.
Final Answer: The direct method provides a detailed breakdown of cash collections and payments, while the indirect method reconciles net income to net cash flows by adjusting for non-cash transactions and changes in working capital.

Direct versus Indirect Cash Flow Reporting Methods

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Common Mistakes

  • Misunderstanding the difference between retrospective adjustments for principle changes and prospective adjustments for estimate changes.
  • Assuming that all accounting corrections affect historical financial data in the same way.
  • Confusing net income with net cash flows, leading to misinterpretations of a company’s liquidity.
  • Overlooking the disclosure requirements and the impact of non-cash transactions on the cash flow statement.