Changes and Correction of Errors Journal Entry : Change on Accounting Principles

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 yearsIf 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:

Change In Accounting Principle Case

 

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):

Comparative Income Statement

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:

Comparative Retained Earning Statement

 

Another Example:

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:

T-Account Balance of Accounting Principle Change

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:

 

New Annual Depreciation

(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:

  1. 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).
  2. A change for which an authoritative pronouncement requires the prospective approach.
  3. 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.

Author: Lie Dharma Putra

Putra is a CPA. His last position, in the corporate world, was a controller for a corporation in Costa Mesa, CA. After spending 15 years as a nine-to-five employee, he decided to serve more companies, families and even individuals, as a trusted business advisor. He blogs about accounting, finance and tax, during his spare time, and helps accounting students (around the globe) to understand the subject matter easier , faster. Follow him on twitter @LieDharmaPutra or add him to your circle at Google Plus Lie+

11 thoughts on “Changes and Correction of Errors Journal Entry : Change on Accounting Principles”

  1. 1 )Pak putra, dalam contoh di atas apakah ada bedanya bila buku telah ditutp dan belum ditutup dan haruskah ada jurnal lain yang di buat untuk koreksiannya .
    2 )saya pernah dengan istilah ” counter balance ” sehingga kesalahan , tidak perlu dikoreksi dan akan benar sendiri, bagaiman mekanismenya karena saya kurang paham bentul tentang istilah tersebut.

    *******TERIMAKASIH*****

  2. @ekostrsn – Good question, Saya anjurkan untuk membaca kelanjutan article ini, yaitu: Change in accounting estimate and reporting dan Correction entries. Jika sudah membaca article “Journal Entry for Correction of Errors and counterbalancing” mudah-mudahan menjadi jelas ya, jika belum, silahkan disampaikan.

  3. Sebelumnya terima kasih atas kesediaan Bapak mmenjawab pertanyaan saya, tapi masih ada sesuatu hal yang masih mengganjal pikiran saya…. Apakah mungkin “Changes and Errors” tersebut dapat / sengaja digunakan pihak management untuk melakukan “earninng management” kalau mungkin bagaimana cara untuk mendeteksinya

    —————————————-
    ————–********——————
    TERIMAKASIH

  4. @ekostrsn – Sebagus apapun suatu “Financial Information System” dibangun. loop-holes tetap ada dan akan menjadi jalan bagi management melakukan over-ride (manipulations, cheats, illegal alterations, etc) yang tentunya dimaksudkan untuk self-benefit. Adjustment untuk change and error correction adalah salah satu area dimana maksud tersebut dilakukan. Itulah sebab-nya mengapa diperlukan otorisasi access bertingkat dan approval limit diperlukan, dimana hanya pihak-pihak tertentu (mostly: controller)yang boleh memberikan persetujuan terhadap “change” dan “error correction”. Tentu, pihak yang authorized hanya akan memberikan persetujuan bila semua kelengkapan dan bukti pendukung adjustment atau correction tersedia dan a proper verification telah dilakukan.

    Jika over-ride dilakukan oleh pihak-pihak yang memperoleh access, sudah pasti, there is no way to stop this illegal practices. Di sini lah peranan “External (independent) auditor” diperlukan, guna mem-verify apakah change and error correction dilakukan atas dasar yang masuk akal dan dibolehkan.

    How to verify? pastinya dengan auditing procedure.

  5. Mencoba menambahkan jawaban pak Putra, banyak jalan dapat digunakan oleh manajemen demi kepentingan laporan keuangan perusahaan-nya. Tentu saja jalan yang dimaksud disini adalah cara-cara yang menyalahi praktik akuntansi yang baik dan berlaku umum. Namun perlu dicermati bahwa sebenarnya ada dua macam hal yang sering terjadi yaitu kesalahan angka laporan keuangan karena eror (tidak disengaja) dan kesalahan karena fraud (disengaja). Nah, prosedur audit umumnya tidak dirancang sedemikian rupa untuk menemukan kesalahan berbentuk fraud. Audit umum yang dilakukan umumnya hanya menemukan kesalahan yang cenderung sebagai eror saja, mengapa? Karena untuk menemukan fraud merupakan hal cukup sulit dan audit umum tidak diarahkan untuk menemukan fraud. Dalam audit umum, fraud ditemukan lebih karena ketidak sengajaan auditor yang menemukan bukti yang mencurigakan yang mengarah kepada adanya fraud.
    Untuk menemukan fraud, prosedur audit harus berbeda dengan audit secara umum, nah, dewasa ini ada audit yang disebut Fraud Investigation, yang secara khusus diarahkan untuk menemukan fraud yang terjadi. Jadi, audit umum sangat sulit dan jarang untuk menemukan adanya fraud. Perlu diingat bahwa secanggih apapun metode audit yang dilakukan pasti akan kalah dengan adanya Kolusi, inilah mengapa audit umum belum tentu dapat menemukan adanya fraud yang salah satunya berupa earning management atau window dressing.
    Bila dikaitkan dengan “changes and error” maka manajemen bisa beralasan bahwa yang mereka lakukan karena alasan yang memang benar dan cukup kuat, tapi apakah bisa dipastikan bahwa perubahan tersebut wajar tanpa ada indikasi mengarah kepadanya fraud dengan memanfaatkan momen perubahan agar laporan keuangan tampak lebih baik. Jadi sekali lagi bahwa audit secara umum tidak ditujukan untuk menemukan adanya fraud, tetapi kalau ada indikasi mengarah ke fraud selama audit dilakukan maka harus menjadi pertimbangan si auditor, apakah dilanjutkan audit-nya atau bahkan menarik diri dari ikatan audit.

    Regards,

  6. Thanks abdi_oke for the detail opinion. Anda membuat topic ini menjadi makin menarik untuk dibahas. Saya tambahkan lagi sedikit ya…..

    Well, fraudulence detection is one of an internal auditor’s work main scoop. If any company does not include this task in their internal auditor’s job scoop, then they should add it, otherwise company will miss the opportunity.

    As for auditing conducted by external auditor……………

    Actually, an external auditor should perform audit tests that provide a reasonable expectation of uncovering fraud that has a material affect on the financial statements, although it is not their prime objective to uncover fraud.

    Many problems are caused by differing perceptions by external audit and users of financial statements audited by the external auditors. This is commonly known as the ‘Expectations gap’. Many users (including institutional and other shareholders) feel that the external auditor has verified the accounts to ensure they are correct.

    They expect the auditor to perform a 100% examination of the underlying transactions that go to produce the resultant figures—an unqualified audit opinion meaning that the accounts are reliable and the financial statements show a true and fair view, and that there are no major frauds in the company.

    The true position is that the external auditor uses samples for testing and the external audit can only provide a reasonable expectation that frauds, errors, insolvency, abuse and problems that have a material affect on the accounts may be uncovered.

    However, it depends on the “Audit Charter” when the auditing arranged between the company and the auditor. You can find “whether fraudulence is included on the auditing assignment or not” on the “Responsibility scoop” part of the audit charter.

    Just to enrich this topic……. Let’s talk about fraudulence a bit more……

    Indicators of Fraud

    Frauds are normally found through luck or third-party information while some are discovered during audit reviews, or through controls or by line management. Indicators of fraud are:

    • Strange trends where comparative figures move in an unexplained fashion.

    • Rewritten and/or amended documents may be evidence of unauthorized alteration to cover up fraud.

    • Missing documents may signal a fraud where items are sensitive such as unused checks or order forms.

    • Tipp-Ex (erasing fluid) applied to documents may indicate unauthorized alterations.

    • Photocopies substituted for originals can be readily tampered with since the photocopy may make it impossible to uncover alterations to the original.

    • Complaints from suppliers that do not tie in with the records should alert one to a potential problem.

    • Social habits of staff are sometimes used as an example of a fraud indicator particularly where they appear to be living beyond their means.

    • Other unusual situations or trends.

    Many indicators go unnoticed and the problem arises when, after a fraud has been uncovered, there are criticisms that there was obviously something wrong that should have been spotted. There are employees who are alert to these signs and as long as the organization promotes alert behavior this becomes an additional control. The only real remedy is effective controls.

    Fraud Detection

    The ACFE 2002 Report to the Nation suggests that the main sources of detection in the USA (percentage shown in brackets) come from:

    1. tip from employees (26%).
    2. by accident (19%).
    3. internal audit (18%).
    4. internal control (15%).
    5. external audit (11%)
    6. tip from customer (9%).
    7. anonymous tip (6%).
    8. tip from vendor (5%).
    9. notification by law enforcement (2%).

  7. Hi,

    If there is a change of inventory costing system, from FIFO to weighted average method, it is a change of accounting policy and PROSPECTIVE approach should be used?

    Thanks.

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