Advanced Financial Reporting Exam 3
Error Correction
-Caused by a transaction being recorded incorrectly or not recorded at all -Previous years' financial statements are retrospectively restated
Examples of Change in accounting estimate
-Change depreciation methods -Change estimate of useful life of depreciable asset -Change estimate of residual value of depreciable asset -Change estimate of periods benefited by intangible assets -Change actuarial estimates pertaining to a pension plan
Change in Reporting Entity
-Change from reporting as one type of entity to another type of entity -Occurs as a result of: *presenting consolidated financial statements in place of statements of individual companies or *changing specific companies that constitute the group for which consolidated or combined statements are prepared *changes in accounting rules -Reported by recasting all previous periods' financial statements as if the new reporting entity existed in those periods -A disclosure note should describe the nature of the change and the reason it occurred
The Prospective Approach: Changing Depreciation, Amortization, and Depletion Methods
-Considered to be a change in accounting estimate that is achieved by a change in accounting principle -Accounted for prospectively—precisely the way we account for changes in estimates
Examples of Change in reporting entity
-Consolidate a subsidiary not previously included in consolidated financial statements -Report consolidated financial statements in place of individual statements
Retrospective approach
-Financial statements issued in previous years are revised -Statements are made to appear as if the newly adopted accounting method had been applied all along or that the error had never occurred -Then, a journal entry is created to adjust all account balances affected
IFRS No. 1: "First-time Adoption of International Financial Reporting Standards." (Basic requirement)
-Full retrospective application of IFRS for the company's first IFRS financial statements -First IFRS financial statements must include: *at least three balance sheets *Two of each of the other financial statements
Examples of Error correction
-Mathematical mistakes -Inaccurate physical count of inventory -Change from the cash basis of accounting to the accrual basis -Failure to record an adjusting entry -Recording an asset as an expense, or vice versa -Fraud or gross negligence
Disclosure Notes
-Must be provided in the first set of financial statements after the change to justify the application of the new method -Note disclosure must: *Explain why the change was needed as well as its effects on items not reported on the face of the primary statements *Point out that comparative information has been revised *Report any per share amounts affected for the current period and all prior periods presented
First-time application of IFRS entails
-Recording some assets and liabilities not permitted under U.S. GAAP -Not recording (derecognizing) some assets and liabilities -Reclassifying items that are classified differently under the two sets of standards -Providing disclosures (in notes to the financial statements) required under IFRS -Providing extensive disclosures to explain how the transition to IFRS affected the company's financial position, financial performance, and cash flows *Providing explanations of material adjustments to the balance sheet, income statement, and cash flow statement *Reconciliations of equity and total comprehensive income reported under previous GAAP to equity under IFRS
Change in Accounting Estimate
-Revision of an estimate because of new information or new experience -Accounted prospectively -Disclosure note should describe the effect of a change in estimate on income from continuing operations, net income, and related per share amounts for the current period
Error Affecting Net Income— Recording an Asset as an Expense
-The effect of most errors is different -> Depending on when the error is discovered -If the error in our illustration is not discovered until 2019 or after -> No correcting entry at all would be needed -Most errors eventually self-correct -Even errors that eventually correct themselves cause financial statements to be misstated in the meantime.
Five exceptions cover areas in which retrospective application of IFRS is considered inappropriate and relate to
-Derecognition of financial assets and financial liabilities (mandatory) -Hedge accounting (mandatory) -Noncontrolling interests (mandatory) -Full-cost oil and gas assets (optional) -Determining whether an arrangement contains a lease (mandatory)
Decision Makers' Perspective—Motivation for Accounting Choices
-Effect of choices on management compensation, on existing debt agreements, and on union negotiations each can affect management's selection of accounting methods -Financial analysts must be aware that different accounting methods used by different firms and by the same firm in different years complicate comparisons -Investors and creditors must consider not only the effect on comparability but also possible hidden motivations for making the changes -Managers tend to prefer to report earnings that follow a regular, smooth trend from year to year. -Desire to do this is not always in the direction of higher income
Correction of Accounting Errors: Prior Period Adjustments
An addition to or reduction in the beginning retained earnings balance in a statement of shareholders' equity
Change in accounting principle
Change from one generally accepted accounting principle to another
Optional exemptions
Designed to allow companies to avoid excessive costs or difficulties expected for retrospective application of certain standards
Prospective approach
Effects of a change are reflected in the financial statements of only the current and future years
-Retrospective -Yes -as adjustment to retained earnings of earliest year reported -to correct any balances that are incorrect as a result of the error -Yes
Error: -method of accounting? -Restate prior years' statements? -cumulative effect on prior years' income reported: -Journal entry: -disclosure note?
The Prospective Approach: When Mandated by Authoritative Accounting Literature
If a new accounting standards update specifically requires prospective accounting, that requirement is followed
-it affected net income in the reporting period in which it occurred -it is not discovered until a later period
It is significantly more complicated to deal with an error if (2):
Error Correction Illustrated
Learn the process needed to analyze whatever errors encounter
Change in accounting estimate
Revision of an estimate because of new information or new experience
Steps to Correct an Error
Step 1: a journal entry is made to correct any account balances that are incorrect as a result of the error Step 2: previous years' financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction (for all years reported for comparative purposes) Step 3: If retained earnings is one of the accounts incorrect as a result of the error, the correction is reported as a prior period adjustment to the beginning balance in a statement of shareholders' equity (or statement of retained earnings if that's presented instead) Step 4: a disclosure note should describe the nature of the error and the impact of its correction on net income
1. Retrospective approach 2. Prospective approach
Two approaches to report accounting changes and error corrections:
Retrospectively
We report most voluntary changes in accounting principles ______________________________. This means reporting all previous period's financial statements as if the new method had been used in all prior periods
IFRS - Accounting Changes and Error Corrections
When correcting errors in previously issued financial statements, IFRS ( IAS No. 8 17 ) permits the effect of the error to be reported in the current period.
U.S. GAAP - Accounting Changes and Error Corrections
When correcting errors in previously issued financial statements, it is considered practicable to report retrospectively.
-Prospective -No -Not reported -None, but subsequent accounting is affected by the change -Yes
change in accounting principle - exceptions: -method of accounting? -Restate prior years' statements? -cumulative effect on prior years' income reported: -Journal entry: -disclosure note?
-Retrospective -Yes -as adjustment to retained earnings of earliest year reported -to adjust affected balances to new method -Yes
change in accounting principle - most changes: -method of accounting? -Restate prior years' statements? -cumulative effect on prior years' income reported: -Journal entry: -disclosure note?
-Prospective -No -Not reported -None, but subsequent accounting is affected by the new estimate -Yes
change in estimate (including depreciation changes): -method of accounting? -Restate prior years' statements? -cumulative effect on prior years' income reported: -Journal entry: -disclosure note?
Examples of Change in Accounting Principle
-A switch by hundreds of companies from FIFO to LIFO in the mid-1970s, for example—was a result of heightened inflation -Changes within a specific industry or -Changes that might be mandated when the FASB codifies a new accounting standard
Examples of Change in Accounting principle
-Adopt a new Accounting Standard -Change methods of inventory costing -Change from cost method to equity method, or vice versa.
There are several optional exemptions and five mandatory exceptions to the requirement for retrospective application
-Business combinations -Fair value or revaluation as deemed cost for property, plant and equipment and other assets -Employee benefits -Cumulative translation differences -Compound financial instruments -Assets and liabilities of subsidiaries -Associates and joint ventures -Designation of previously recognized financial instruments -Share-based payment transactions -Insurance contracts -Decommissioning liabilities -Arrangements containing leases -Fair value measurement of no-active market financial instruments at initial recognition -Service concession arrangements -Borrowing cost
Error Affecting a Prior Year's Net Income
-affect net income *When they do, they affect the balance sheet as well -Both statements must be retrospectively restated -The statement of cash flows sometimes is affected, too -Incorrect account balances must be corrected -Income taxes often are affected by income errors *Amended tax returns are prepared: -Either to pay additional taxes; or -To claim a tax refund for taxes overpaid
-changes in estimate including changes in depreciation method -changes in accounting principle when retrospective application is impractical -changes in accounting principle when prospective application is mandated
Approaches to Reporting Accounting changes and error corrections - Prospective (3):
-most changes in accounting principle -change in reporting entity -corrections of errors
Approaches to Reporting Accounting changes and error corrections - Retrospective (3):
Change in Accounting Principle
Change from one generally accepted accounting principle to another -Though accounting choices once made should be consistently followed from year to year -Changing circumstances might make a new method more appropriate
Change in reporting entity
Change from reporting as one type of entity to another type of entity
Error Correction
Correction of an error caused by a transaction being recorded incorrectly or not at all
The Prospective Approach: When Mandated by Authoritative Accounting Literature Example
For a change from the equity method to another method of accounting for long-term investments, GAAP requires the prospective application of the new method
Change is applied retrospectively
Impracticable to determine some period-specific effects --> _____________________________________ -->Beginning in the earliest year practicable
Change is applied prospectively
Impracticable to determine the cumulative effect of prior years --> __________________________________ --> Beginning in the earliest year practicable
The Prospective Approach: When Retrospective Application is Impracticable
Sometimes a lack of information makes it impracticable to report a change retrospectively so the new method is simply applied prospectively
1. Revise Comparative Financial Statements 2. Adjust Accounts for the Change 3. Disclosure Notes
The Retrospective Approach: Most Changes in Accounting Principle Steps (3):
-Retrospective -Yes -Not reported -Involves consolidated financial statements discussed in other courses -Yes
change in reporting entity: -method of accounting? -Restate prior years' statements? -cumulative effect on prior years' income reported: -Journal entry: -disclosure note?