Int. Acct. II Ch. 21 Accounting Changes and Error Analysis

direct effects

changes necessary to implement the change in accounting principle(could also include necessary changes to tax accounts)

indirect effects

changes to current or future cash flows that result from the change in accounting principle

financial statements that are not comparable from year to year...

violate the conceptual framework

when a firm decides to to change accounting methods, is this a mandatory or voluntary accounting change?

voluntary

changes in accounting principle can be...

voluntary or mandatory

when do companies tend to commonly change estimates?

when additional information becomes available

firms must provide footnote disclosure indicating...

why the new estimate is justifiable

what is specifically adjusted in the restated financial statements when using the retrospective method? (3)

-assets and liabilities as of the beginning of the first period presented to reflect the cumulative effect of the change on periods prior to those presented -retained earnings(or other appropriate components of equity) for the beginning of the first period presented to reflect the cumulative effect of the change on reported income for periods prior to those presented -financial statements for each period presented to reflect the effects of the change

accounting errors can impact...(2)

-balance sheet -income statement

three main types of accounting changes:

-changes in accounting principle -changes in accounting estimate -changes in the reporting entity

for any change in accounting principle, what are the 6 footnote disclosures that firms must provide in the year of the change?

-description of nature of the change -management's justification for the change, which indicates why the new method is preferable -the method of applying the change -a description of any adjusted prior-period information -the effect of the change on income from continuing operations, net income, per share amounts, and any other affected line item -the cumulative effect of the change on retained earnings for the balance sheet presented

firms must correct comparative financial statements on a...

retrospective basis

what are the two exceptions for when a firm does not have to report changes in accounting principle under the retrospective approach?

-in the case of a mandatory change required by a new accounting standard, an entity should follow the specific transition requirements provided within the new standard(it should specify retrospective or prospective application, if it doesn't, then use retrospective approach as normal) -it is impractical to use the retrospective approach if(3): the financial statement effects of the retrospective application are not determinable, retrospective application requires assumptions about management's intent in a prior period, or retrospective application requires significant estimates for a prior period and the availability of the necessary information to determine these estimates cannot be objectively verified

accounting standards may allow changes in accounting principle, but how often should they occur? do companies need to disclose these changes?

-infrequently -yes, and adequately

the financial statements for the year of change should disclose the...(3)

-nature of the change -reason for the change -effect of the change on income from continuing operations, net income, other comprehensive income, and related per share amounts for all periods presented

a change in the reporting entity primarily involves...(3)

-presenting consolidated/combined financial statements instead of individual financial statements -changing the specific subsidiaries that make up the group of entities for which consolidated financial statements are presented -changing the entities included in combined financial statements

changes in reporting entity disclosures are essential in...(2)

-restoring comparability -offsetting the violation of consistency resulting from an accounting change

after discovering a balance sheet error, what should the accountant do? what should the company do?

-the accountant should reclassify the item -the company should restate any comparative financial statements

2 primary issues in analyzing self-correcting errors that will be offset or corrected over two accounting periods:

-whether the error is discovered in the first or second year -whether the books have been closed for the fiscal year

when reporting a change in accounting principle, IFRS additionally requires a company to report...

3 years of balance sheets and 2 years of the other financial statements

firms generally account for and report changes in accounting principle on a...

retrospective basis

change in accounting estimate effected by a change in accounting principle

a change in estimate that is inseparable from the effect of a related change in accounting principle

Restated financial statements

adjust opening balance sheet accounts for the cumulative affect of applying the new principle in all prior years and present all subsequent financial statements as if the policy had always been used

if the error is not self-correcting within two accounting periods, correcting entries are...

always needed regardless of whether the closing entries for the period have been recorded

error vs. fraud: an error is unintentional, whereas a fraud is considered...

an intentional misrepresentation

error

an unintentional mistake often due to an incorrect application of an accounting policy or incorrect mathematical computation

income statement errors

are commonly caused by misclassification mistakes; only affect revenue, gain, expense, and loss accounts(do not affect the balance sheet and might not affect net income)

balance sheet errors

are typically the result of a misclassification of accounts in the recording of a transaction; they affect only asset, liability, and equity accounts

if a company discovers a material error, what must it do?

correct it

when an accountant discovers an error that it material in amount, it must be...

corrected

what are the two types of effects that changes in accounting principle can have?

direct and indirect effects

if a firm changes its method of costing inventory, how would this affect inventory and retained earnings balances?

directly

self-correcting errors

errors that will self-correct within 2 years

as discussed in the conceptual framework, financial reports are based on...

estimates, judgements, and models rather than exact depictions

when should companies disclose the effect of a change in estimate on income from continuing operations, net income, and related per share amounts of the current period?

if a change in estimate affects several periods

when firms use the prospective method to report changes in accounting estimates, they are...

implementing the new estimate in the year of the change and in all future years as appropriate

the impact on cash flows related to profit sharing and bonus plans or from violating restrictive debt covenants are what type of effects?

indirect effects

if accountants discover income statement errors after financial statements have been prepared...

no correcting entry is made(but the company should restate the incorrect amounts from the financial statements that have already been issued in any future comparative financial statements)

changes in the reporting entity

occur when a company reports financial statements, that are, in effect, financial statements for a different reporting entity

companies are not required to disclose changes in accounting estimates made as part of normal operations, such as bad debt allowances or inventory obsolescence, unless...

the changes are material

if the firm discovers the error after the books are closed for the first year but before the books are closed for the second year, is an entry needed?

yes, an entry is needed to correct beginning retained earnings and other balance sheet accounts as well as make any necessary adjustments to the accounts for the second year

if the firm discovers the error in the first year and the books have not been closed, is an entry required?

yes, to correct accounts for the first year

how do firms classify all changes affecting retained earnings due to error corrections?

as prior-period adjustments

accounting changes due to revisions of underlying estimates involve areas such as...

bad debt expense, depreciation expense, inventory obsolescence, and pensions

changes in accounting principle

changes from one generally accepted accounting method to another generally accepted accounting method

do changes in accounting estimates or principles occur more frequently?

changes in accounting estimates

the accounting standards permit accounting changes only when...

companies provide adequate disclosures to assist financial statement users in restoring comparability with prior-years financial information

retrospective method

companies restate all prior year financial statements presented in the annual report as if the newly adopted principle had always been used

a company's disclosure of both a change in principle and estimate must enable the financial statement user to...

compare the year of the change with all prior periods

for financial information to be a faithful representation of the underlying position and performance of the firm, it must be...

free from error

changes in accounting estimate

involve revisions of estimates used in accounting

a firm should voluntarily change accounting principles only if...

it can justify use of the new principle on the basis that it more accurately portrays its financial position and performance

how does changing accounting principles and estimates from period to period affect comparability?

it detracts from it

if the error is immaterial...

the firm does not need to apply the correction process

although the conceptual framework does not specify consistency as a qualitative characteristic of useful financial information, it does help achieve...

the goal of comparability

financial information is considered to be free from error when...

the process used to produce the information is selected and applied with no errors and the description of the transaction is free from error

firms must report changes in accounting estimates using which method?

the prospective method

inventory errors are self-correcting within...

two accounting periods

materiality is a matter of...

judgement

prospective method

make the accounting change in the current year(year of the change) and all future years, but do not make adjustments to previously issued financial statements(treats all information as final and does not change previously issued financial information)

changes in estimates are expected, especially as...

management becomes more experienced and as new information becomes available

are newly issued accounting standards mandatory or voluntary accounting changes?

mandatory

is the acquisition of a business considered a change in the reporting entity?

no

is the adoption of a new principle in recognition of events that have occurred for the first time considered a change in accounting principle?

no

if the firm discovers the error after closing the books for the second year, is an entry needed?

no, the error has self-corrected and the books are closed, so retained earnings is correctly stated, thus all permanent accounts are correctly stated

Change in reporting entity

occurs when a company reports financial statements, that are, in effect, financial statements for a different reporting entity

the conceptual framework states that financial information is material if...

omitting it or misstating it would impact a user's decisions

Comparability

one of the conceptual framework's enhancing qualitative characteristics; it enhances the usefulness of relevant and faithfully represented information by helping users to identify and understand the similarities and differences in items reported

firms apply indirect effects using which of the two methods for reporting accounting changes?

prospective approach

firms generally account for and report changes in accounting estimate on a...

prospective basis

firms account for a change in accounting estimate effected by a change in accounting principle the same way as a change in accounting estimate, so which method is used?

prospective method

Consistency

refers to the firm's use of the same accounting methods for the same transactions from period to period

two approaches for reporting accounting changes:

retrospective and prospective methods

firms apply direct effects using which of the two methods for reporting accounting changes?

retrospective approach(unless it is impractical to do so)

firms account for a change in the reporting entity by using which method for reporting accounting changes?

retrospective method(by adjusting all financial statements presented from prior periods to reflect the change)

when a company changes an accounting estimate effected by a change in accounting principle, what is required?

the disclosure requirements for a change in accounting principle

generally, firms are required to report all changes in accounting principle using which approach?

the retrospective approach

which method for reporting accounting changes do firms use to account for error corrections?

the retrospective method

how are a company's financial statements affected if it changes its accounting method/estimate for a particular transaction?

they are not consistent from year to year

how do all three accounting changes affect the financial statements?

they make them inconsistent from period to period

if accountants discover income statement errors in the year the error occurred...

they must be corrected