Problem 26 - Accounting

Question

Discuss whether Baxter Company correctly reported the following items in the financial statements: a. In 2010, the company discovered a clerical error in the prior year's accounting records. As a result, the reported net income for 2009 was overstated by \(\$ 20,000\). The company corrected this error by restating the prior-year financial statements. b. In 2010 , the company voluntarily changed its method of accounting for long-term construction contracts from the percentage of completion method to the completed contract method. Both methods are acceptable under generally acceptable accounting principles. The cumulative effect of this change was reported as a separate component of income in the 2010 income statement.

Step-by-Step Solution

Answer

Baxter correctly restated prior financials for the clerical error. The accounting change should've been applied retrospectively, not as a separate component of income.

Step 1: Analyze Prior Period Error Correction

When a clerical error is discovered that affects a prior period's financial statements, it should be corrected by restating the prior-year financial statements. Baxter Company corrected the $20,000 error by restating the 2009 financial statements, which is the correct treatment according to Generally Accepted Accounting Principles (GAAP). This ensures that the financial statements for prior periods are accurate and comparable.

Step 2: Analyze Change in Accounting Principle

When a company voluntarily changes an accounting method, such as from the percentage of completion method to the completed contract method for long-term construction contracts, the cumulative effect of the change should not be reported as a separate component of income for the year. GAAP requires that such a change be applied retrospectively, adjusting prior period financial statements if practical. Instead of reflecting it as a distinct income component in 2010, the prior years' financials should be restated to reflect the new accounting method as if it had always been used.

Step 3: Conclusion

Baxter Company correctly handled the clerical error in the prior year's records by restating the financial statements. However, the change in accounting method was incorrectly reported as a separate component of income for the year rather than retrospectively applying the new method to prior periods, which is required by GAAP.

Key Concepts

Generally Accepted Accounting Principles (GAAP)

GAAP serves as the foundation for financial accounting practices. These are a compilation of principles, rules, and standards that companies in the United States must follow when preparing their financial statements. GAAP provides consistency, ensuring that companies report financial data in a way that stakeholders can rely on and compare across different companies and time periods.

Following GAAP not only ensures legal compliance but also enhances the credibility of your financial statements. This consistency is important when businesses report their income, expenses, assets, and liabilities. It allows investors and other stakeholders to have a clear view of the company's financial health. If you deviate from GAAP, it may result in financial misstatements, which can mislead stakeholders and lead to legal penalties.

Accounting Principle Change

An accounting principle change occurs when a company switches from one accepted accounting method to another, such as changing how they recognize revenue. Companies might switch methods to better reflect their financial reality. For example, if Baxter Company switches its accounting method for long-term construction contracts, it impacts financial statements.

Such changes require careful consideration and documentation. They must be disclosed in the financial statements to inform stakeholders of how the change affects financial results. GAAP requires that new method applications should improve the representation of a company's financial position and results. However, switching methods isn't casual, as any changes need to be justified and should represent a better approach compared to previous methods.

Prior Period Error Correction

Prior period errors occur when there are mistakes in financial statements of previous years, like overstating income. According to GAAP, these errors should be corrected by restating the affected prior period financial statements. Baxter Company, for example, had to revise its 2009 statement because of a $20,000 clerical mistake.

This restatement helps ensure that financial information is accurate and reliable. Correcting errors this way ensures comparability across periods, helping stakeholders make informed decisions. Handling prior period errors appropriately prevents misaligned bookkeeping and maintains transparency.

Long-term Construction Contracts

Accounting for long-term construction contracts can be tricky, as it involves recognizing revenue over the duration of a project. The percentage of completion method matches revenue and expenses as they are incurred, while the completed contract method recognizes revenue at the end of a project.

Companies like Baxter can choose either method under GAAP, but consistency is crucial. The method chosen affects financial statements greatly, as seen in how income and expenses are reported. Switching methods requires clear communication of the impact to stakeholders. It's essential to ensure that the new method better reflects the company's operations and provides a clearer financial picture.

Retrospective Application

Retrospective application is used when applying an accounting principle change. It involves updating previous financial statements as if the new principle had always been used. This method provides a consistent financial record over time.

For instance, if Baxter Company changes its recognition method for long-term contracts, it must adjust past financial statements according to the new method. This isn't just changing this year's results but revising past reports for consistency. Retrospective application ensures that stakeholders see a true reflection of the company's finances over time, improving transparency and comparability.