(1.1) Types of Changes and Accounting Approaches

Accounting Changes and Error Corrections -- GAAP specifies how to account for changes in accounting. The four items addressed:

1. Accounting principle changes (example: change from FIFO to weighted-average method); 2. Accounting estimate changes (example: change the useful life of a plant asset); 3. Changes in reporting entity (example: change in the composition of the subsidiary group in a consolidated enterprise); 4. Corrections of errors in prior financial statements (example: discover that an item expensed in a prior year should have been capitalized and amortized).

Accounting For Principle Changes - Retrospective Application - Changes in depreciation method,

Changes in depreciation method, amortization method, and depletion method are treated as estimate changes.

Litigation settlements

Litigation settlements from lawsuits initiated in previous years but paid or received in the current year are also not treated retrospectively. They are considered an event of the period of settlement and included in that period's earnings.

Direct and Indirect Effects --

Retrospective application of a change in accounting principle is limited to the direct effects of the change and related tax effects. Direct effects are those recognized changes in assets or liabilities necessary to effect the change (for example, the change to inventory due to change in cost flow assumption). Related effects on deferred tax accounts, or an impairment adjustment resulting from applying LCM valuation to the new inventory balance are also examples of direct effects.

Accounting Approaches are Specified for Accounting Changes and Errors - Retrospective

application of a principle to prior periods as if that principle had always been used. The procedure records the effect of the change on prior years as an adjustment to the beginning balance in retained earnings for the year of change rather than in income; prior year financial statements reported comparatively with the current year statements are adjusted to reflect the new method. The result is that the financial statements of all periods presented reflect the same (new) accounting principle. Retrospective application enhances comparability (a quality from the conceptual framework) across the financial statements of different years reported comparatively. Therefore the term "retrospective application" implies that the company applied the new standard it adopted to all periods shown unless it was impracticable to determine the cumulative effect or the period-specific change. When there is retrospective application the entity must disclose the effects on income and income taxes.

Accounting Approaches are Specified for Accounting Changes and Errors - Prospective

apply the change to current and future periods only; prior year statements are unaffected.

Indirect effects are changes in current or future cash flows resulting

from making a change in accounting principle applied retrospectively. Such changes are recognized in the period of change. Prior period financial statements are not adjusted although a description of the effects, amounts and per share amounts are disclosed in the footnotes. Example: A change in a nondiscretionary profit-sharing plan resulting from a principle change affecting earnings causes the firm to increase profit-sharing payments in the current period as a result of restating prior period income. The payments are recognized as expense in the current year, not retrospectively.

Error corrections are not considered an accounting change but....

the procedures for recording are the same as for accounting principle changes and thus are covered in this set of lessons.

The following are not accounting principle changes:

1. Initial adoption of a new principle to new events for the first time or for events that were immaterial in their effect in the past; 2. Adoption or modification of a principle for transactions that are clearly different in substance from those in the past; 3. A change in method that is a planned procedure as part of the normal application of a method (example: the change to the straight-line method late in the life of an asset depreciated on the double-declining balance method); 4. The change from a principle that is not generally accepted to one that is accepted (treat as an error correction). Example: Capitalizing interest for the first time because in the past the firm was not involved in construction activities to a significant extent. This is not an accounting principle change.

Disclosures for Principle Changes -- Disclosures in the year of change and also the interim period of change include the following. Subsequent financial statements need not repeat these disclosures.

1. Nature and reason for the change including why the new change is preferable (a change caused by the adoption of a new standard is sufficient justification). 2. Method of applying the change. 3. For current and prior periods retrospectively adjusted, the effect of the change on income from continuing operations and net income, and all other affected line items (for income statement, balance sheet and statement of cash flows), and any affected per share amounts. A firm may provide only the line item information, or may disclose the entire statements as adjusted, in the notes. 4. The cumulative effect on retained earnings (or other relevant equity accounts) as of the beginning of the earliest period presented. 5. If it was not practicable to apply the retrospective method to all periods, the reasons why and a description of the alternative method used report the change. 6. Summaries of financial results (such as major financial statement subtotals for the previous ten years) as reported in the notes are also retrospectively adjusted for the change.

Retrospective Application -- The following steps are performed to implement retrospective application of an accounting principle change.

1. The cumulative effect of the change on periods before those presented is reflected in the carrying amounts of affected assets and liabilities as of the beginning of the earliest period presented, along with an offsetting adjustment to the opening balance of retained earnings for that period. 2. The financial statements for prior periods presented comparatively are recast to reflect the period-specific effects of applying the new principle. Each account affected by the change is adjusted as if the new method had been used in those periods. 3.Through a journal entry, the beginning balance of retained earnings in the year of the change is adjusted to reflect the use of the new principle through that date. The amount of this cumulative effect is generally not the same amount as that for step 1 above because different periods are covered in each.

Accounting For Principle Changes - Retrospective Application - Definition

A Change in Accounting Principle : A change from one generally accepted accounting principle to another when there are at least two acceptable principles, or when the current principle used is no longer generally accepted. A change in the method of applying a principle is also considered a change in accounting principle. Example: Changing inventory cost flow assumption (LIFO to FIFO); changing the accounting for long-term construction contracts (completed contract to percentage of completion), change in method of applying LCM to inventory (individual, group, aggregate).

Summary of Accounting: The following summarizes the types of items found in the accounting changes area, and the associated accounting approach.

Accounting Change or Item Accounting Approach -Accounting principle change = Retrospective -Accounting principle change - determining prior year effects impracticable = Prospective -Accounting estimate change* = Prospective - Change in reporting entity = Retrospective - Correction of accounting error = Restatement** *includes changes in depreciation, amortization and depletion methods which are treated as a change in estimate effected by a change in accounting principle. **this is the same accounting procedure as retrospective but the difference in terminology highlights the distinction between a voluntary accounting principle change and the correction of an error, called a "prior period adjustment."

Justification for Principle Change

An accounting principle change can be made only if the change is required by a new pronouncement, or if the entity can justify the use of an allowable new principle on the basis that it is preferable in terms of financial reporting. The allowable new principle must improve financial reporting given the environment of the firm. Common justifications include changing business conditions, and better matching of revenues and expenses. Caution: When new accounting standards are adopted, retrospective application may not be required, even though the standard may require that a new accounting principle or method be applied. In such cases, the transitional guidance of the new standard is to be followed.

Retrospective Application - Example

In 20x5, a firm changes from the weighted-average (WA) method of accounting for inventory to FIFO. The 20x3 and 20x4 reports reissued comparatively with 20x5 will now reflect the FIFO method even though in those prior years the WA had been used. The journal entry to record the change will adjust beginning 20x5 inventory and retained earnings to the amounts that would have been in those accounts at that date had FIFO always been used (this is the cumulative effect recorded in the entry - through 1/1/x5). In the retained earnings statement, the beginning balance in retained earnings for 20x3 will be adjusted for the effects of the change on income for all years before 20x3 (this is the cumulative effect reported in the retained earnings statement - through 1/1/x3). The two cumulative effect amounts cover different numbers of years.

Accounting Approaches are Specified for Accounting Changes and Errors - Restatement is the term reserved specifically for

error changes. Restatement requires correcting the comparative financial information presented along with correcting the opening retained earnings balance. The entity must disclose the nature of the error and the effect on current and prior periods.