ACC 318 Module 7 Project Two Example

Wrong Then or Different Now? Classifying and Reporting an Estimate Change and an Error at a Composite Trampoline Park Chain

[Student Name]

Southern New Hampshire University

ACC 318: Intermediate Accounting II

Project Two

[Instructor Name]

[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

Wrong Then or Different Now? Classifying and Reporting an Estimate Change and an Error at a Composite Trampoline Park Chain

Introduction

When the books closed in January, the park operator faced two surprises. Its maintenance director reported that the trampoline courts installed three years ago, made with a new spring design, are wearing out faster than expected and will need replacement two years earlier than planned. And the auditors, testing December revenue, found that deposits for birthday and corporate parties to be held the following January had been recorded as revenue when received. Both reduce reported profit. They are not, however, reported the same way. This project classifies each under GAAP, applies the required treatment and drafts the disclosures. The company's combined tax rate is 25 percent.

The Three Categories

GAAP separates accounting changes from error corrections and assigns each a reporting method (Financial Accounting Standards Board, 2005). A change in accounting principle, a move from one acceptable method to another, is applied retrospectively, as if the new method had always been used. A change in accounting estimate, a revision of a judgment because of new information or experience, is applied prospectively, in the current and future periods only. A correction of an error, a mistake in recognition, measurement or presentation, including misuse of facts that existed when the statements were prepared, is reported by restating the prior statements. The deciding question is whether the information was available and should have been used at the time.

Situation 1: Courts That Wear Out Sooner

The courts cost $2,800,000 and were placed in service at the start of the year three years ago, on a seven-year life with nothing expected at the end, which put annual straight-line depreciation at $400,000, so after three years accumulated depreciation is $1,200,000 and book value is $1,600,000. The new spring design was untested when the courts were bought; three years of wear data now show a total life of five years, leaving two years.

This is a change in estimate. The original seven-year life was a reasonable judgment with the information available then, and the new estimate comes from experience gained since. Kieso et al. (2019) note that estimates are an inherent part of accounting and that revising them is not evidence of error. Nothing in the prior statements changes.

Table 1. Revised Depreciation

This year's adjusting entry therefore books $800,000 of depreciation. Income before tax this year is $400,000 lower than it would have been, and the effect will repeat next year. The notes should disclose the change, the reason for it and its effect on income from continuing operations and net income for the current year, $400,000 before tax and $300,000 after tax.

Situation 2: Revenue From Parties Not Yet Held

In December of the prior year, the company received $310,000 in deposits for parties held in January. Under ASC 606, revenue is recognized when the service is provided, so those deposits should have been recorded as a contract liability and recognized in January. The company's revenue policy already said so; the December entries were made by a newly hired bookkeeper who coded deposits to revenue. Since both the policy and the party dates were known when last year's statements were closed, the item falls in the error category.

The effect on the prior year was to overstate revenue and pretax income by $310,000, overstate income tax expense by $77,500 and overstate net income by $232,500. In the current year, the same parties' revenue was never recognized in January, because the cash had already been booked, so current-year revenue is understated by $310,000. Since the current year's books are still open, the correction is recorded now.

Table 2. Correction Entry in the Current Year

The opening retained earnings adjustment removes the prior year's overstatement net of tax; the revenue credit places the parties' revenue in January, when they were held. The prior year's income statement, presented for comparison, is restated: revenue falls by $310,000 and net income by $232,500, and its balance sheet shows a $310,000 contract liability instead of extra equity.

Disclosures

For the error, the notes must state that the prior year has been restated, describe the nature of the error, show the effect on each affected line and on per-share amounts, and show the cumulative effect on retained earnings at the start of the earliest period presented. The word restated should appear in the column heading for the prior year. For the estimate change, a short note describing the revised useful life and its effect on the current year is enough. The auditor's report will refer to the restatement.

Why the Label Matters

The two items have nearly the same effect on this year's pretax income, but users read them differently. A change in estimate signals that management learned something; a restatement signals that the books were wrong. Palmrose et al. (2004) found that restatement announcements produce significantly negative market reactions, larger when the restatement involves fraud or reduces income. Hennes et al. (2008) showed that the distinction between errors and deliberate irregularities matters: executive turnover is far more likely after irregularities. Here the revenue error was a coding mistake by a new employee, and the correction should say so plainly. The temptation to describe it as a change in estimate, to avoid the word restated, should be resisted; the facts existed and were misapplied.

The private equity investor and the bank will also ask about controls. A recurring revenue cut-off error suggests a gap in review of December entries, and the remediation, a monthly review of deposits coded to revenue, should be described to them even if the notes do not require it.

Conclusion

The shorter life of the trampoline courts is a change in estimate, applied prospectively by spreading the $1,600,000 book value over two years and raising depreciation by $400,000 this year and next. The party deposits are an error, corrected by restating the prior year and reducing opening retained earnings by $232,500 net of tax, with the revenue placed in the year the parties happened. Getting the label right is as important as getting the numbers right, because users treat a restatement as information about the reliability of the books.

References

Financial Accounting Standards Board. (2005). Accounting changes and error corrections (Statement of Financial Accounting Standards No. 154). Author.

Hennes, K. M., Leone, A. J., & Miller, B. P. (2008). The importance of distinguishing errors from irregularities in restatement research: The case of restatements and CEO/CFO turnover. The Accounting Review, 83(6), 1487-1519. https://doi.org/10.2308/accr.2008.83.6.1487

Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2019). Intermediate accounting (17th ed.). Wiley.

Palmrose, Z.-V., Richardson, V. J., & Scholz, S. (2004). Determinants of market reactions to restatement announcements. Journal of Accounting and Economics, 37(1), 59-89. https://doi.org/10.1016/j.jacceco.2003.06.003