Chapter 20

Change in accounting principle

Change from one generally accepted accounting principle to another. •Adopt a new Accounting Standard. •Change methods of inventory costing. •Change from cost method to equity method, or vice verso.

Change in reporting entity

Change from reporting as one type of entity to another type of entity. •Consolidate a subsidiary not previously included in consolidated financial statements. •Report consolidated financial statements in place of Individual statements.

Types of Accounting Changes

Change in accounting principle Change in accounting estimate Change in reporting entity

The effect of most errors is different.

Depending on whenthe error is discovered.

If a new accounting standards update specifically requires prospective accounting, that requirement is followed.

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.

If the error in our illustration is not discovered until 2024 or after.

No correcting entry at all would be needed.

Three Approaches: Error Corrections

Retrospective Approach Modified Retrospective Approach Prospective Approach

Change in accounting estimate

Revise an estimate because of new information or new experience. •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.

It is significantly more complicated to deal with an error if:

it affected net income in the reporting period in which it occurred it is not discovered until a later period

Most errors eventually__________

self-correct •Even errors that eventually correct themselves cause financial statements to be misstated in the meantime.

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.

Modified Retrospective Approach

•New standard applied only to the currentperiod. •Adjust retained earnings balance at beginning of year.

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 each financial statement line item and any per-share amounts affected for each prior period presented.

Change in Reporting Entity

Change from reporting as one type of entity to another type of entity. Occurs as a result of: •Presentingconsolidated financial statementsin place of statements of individual companies, •Changing specific companies that constitute the group for which consolidated or combined statements are prepared, •Changes in accounting rules,or •One company acquiring another. Reported by recasting all previous periods' financial statements as if the new reporting entity existed in those periods. Adisclosure note should describe the nature of the change and the reason it occurred.

Error correction

Correct an error caused by a transaction being recorded incorrectly or not at all. •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.

Error Affecting a Prior Year's Net Income

Most errors affect net income. •When they do, they affect the balance sheet as well. Both statements must be retrospectively restated. Thestatement 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.

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 financial statements. •Point out that comparative information has been revised. •Report any per share amounts affected for the current period and all prior periods presented.

The Modified Retrospective Approach

The FASB sometimes allows a modified retrospective approach. •Applythe new standard onlyto the adoption period (the current period). •Adjust the balance of retained earnings at the beginning of the adoption periodto capture the cumulative effects of prior periods withoutactuallyadjustingthe numbers inthe prior periods reported.

Errors

•Caused by a transaction being recorded incorrectly or not recorded at all. •Previous years' financial statements are retrospectively restated. Retrospective: -most changes in accounting principle -change in reporting entity -corrections of errors Prospective: -changes in estimate including changes in depreciation method -changes in accounting principle when retrospective application is impracticable -changes in accounting principle when prospective application is mandated

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. •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. •Changes that might be mandated when the FASB codifies a new accounting standard.

Prospective Approach

•Effects of a change are reflected in the financial statements of only the current and future years.

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.

Change in Accounting Estimate

•Revision of an estimate may result from new information or new experience. •They are accounted for prospectively. •Disclosure note should describe the effect of a change in estimate on income from continuing operations,net income,and related per share amountsfor the current period.