F1 - M6 Accounting Changes and Error Corrections

Applications to the "General Rule" of changes in an Accounting Principle

1st way. The amount of cumulative effects to be reported on the retained earnings statement is the difference between: • Retained earnings at the beginning of the earliest period presented net of tax and • Retained earnings that would have been reported at the beginning of the earliest period presented if the new accounting principle had been applied retrospectively for all prior periods, by recognizing only the direct effects and related income tax effect. 2nd way. The new accounting principle is used for all periods presented (prior periods are restated). 3rd way. If an accounting change is not considered material in the year of change but is reasonably expected to become material in later periods, it should be fully disclosed in the year of change.

Changes in Accounting Estimate (Prospective Application)

A change in accounting estimate occurs when it is determined that the estimate previously used by the company is incorrect. • Not an error • Do not restate prior years Events Resulting in "Estimate" Changes affect current and future income from continuing operations. • Changes in the lives of fixed assets • Adjustments of year-end accrual of officers' salaries and/or bonuses • Write-downs of obsolete inventory • Material, nonrecurring IRS adjustments • Settlement of literation • Changes in accounting principle that are "inseparable" from a change in estimates like changing to LIFO or a different depreciation method • Revisions of estimates regarding discontinued operations

Changes in Accounting Principle (Retrospective Application)

A change in accounting principle is a change in accounting from one accounting principle to another acceptable accounting principle (e.g., GAAP to GAAP). • Non-GAAP to GAAP accounting principles is an error, not a change in accounting principles Rule of "Preferability" (Justified): An accounting principle may be change "only" if required by GAAP (a newly issued codification update) or if the alternative principle is preferable and more fairly presents the information. • No income smoothing, cannot change accounting principles to benefit the entity. It must be a change that makes information more preferable to present the information more fairly.

"Error" Correction for Comparative Financial Statements Presented

Correct the Information if the Year is Presented: If comparative financial statements are presented and financial statements for the year with the error are presented, merely correct the error in those prior financial statements. Adjust Beginning Retained Earnings Net of Tax of the Earliest Year Presented (if the Year is Not Presented): If comparative financial statements are presented and financial statements for the year with the error are not presented (e.g., because it is too far back in years), adjust (net of tax) the opening retained earnings of the earliest year presented.

Effects of changes in Accounting Principle

Direct Effects: The direct effects of a change in accounting principle are adjustments that would be necessary to restate the financial statements of prior periods Indirect Effects: The indirect effects of a change in accounting principle are differences in non-discretionary items based on earnings (e.g., bonuses) that would have occurred if the new principle had need used in prior periods. Cumulative Effect: Adjust beginning retained earnings net of tax (i.e, Adj. RE × (1 - T) in the statement of stockholders' equity.

"Error" Correction (Prior Period Adjustment = Restatement)

Error corrections are not accounting changes. Error corrections include: • Corrections of errors in recognition, measurement, presentation, or disclosure in financial statements resulting from mathematical mistakes, mistakes in the application of U.S. GAAP, or oversight or misuse of facts that existed at the time the financial statements were prepared. • Changes from a non-GAAP method of accounting to a GAAP method of accounting (e.g., cash basis to accrual basis), which is a specific correction of an error.

"Error" Correction when Comparative Financial Statements are Not Presented

If comparative financial statements are not presented, the error correction should be reported as an adjustment to the opening balance of retained earnings net of tax.

Exceptions to the General Rule of changes in an Accounting Principle

Impracticable to Estimate: A change is "impractical" if an entity cannot calculate the cumulative-effect adjustment to beginning retained earnings, therefore the change in accounting principle will be done prospectively. • Change in inventory cost flow assumption to LIFO is a prime example, it would require regaining old inventory (most likely sold) and recalculating. Beginning inventory of the year of change will be handled prospectively, reflecting the change from then on. Change in Depreciation Method: A change in the method of depreciation, amortization, or depletion is considered to be both a change in accounting principle and a change in estimate. • These changes are accounted for as changes to estimate and are done prospectively to reflect the changes. • No changes to previous calculations and no adjustment to be made for retained earnings.

Reporting a change in Estimate

Prospectively reporting a change in estimate: Changes in accounting estimate are accounted for prospectively (i.e., implement in the current period and continue in future periods). • It does not affect previous periods (i.e., no effect on previously reported retained earnings) Change in Estimate Affecting Future Periods: If a change in accounting estimate affects several future periods (e.g., a revision of service lives of depreciable assets), the effect on income from continuing operations, net income, and the related per share information for the current year should be disclosed in the notes to the financial statements. • Changes in "ordinary accounting estimates" (e.g., uncollectible accounts and inventory adjustments) usually made each period do not have to be disclosed unless they are material (entity specific.

Reporting Changes in an Accounting Principle

The "General Rule" is that changes in accounting principle should • Be recognized by adjusting beginning retained earnings in the earliest period presented for the cumulative effect of the change, and • If prior period (comparative) financial statements are presented, they should be restated (retrospective application) using the new method.

Effect on the Statement of Retained Earnings due to "Error" Correction

The purpose of the statement of retained earnings is to reconcile the beginning balance of retained earnings with the ending balance. It is usually presented immediately following the income statement or as a component of the statement of stockholders' equity.

Changes in Accounting Entity (Retrospective Application)

Under U.S. GAAP, a change in accounting entity occurs when the entity being reported on has changed composition. Examples include: • Consolidated or combined financial statements that are presented in place (switched) of statements of individual companies and • Changes in the companies included in the consolidated or combined financial statements from year to year. Restatement to reflect information for the New Entity (if Comparative Financial Statements are Presented): If a change in accounting entity occurs in the current year, all previous financial statements that are presented in comparative financial statements along with the current year should be restated to reflect the information for the new entity. Full Disclosure: Full disclosure of the cause and nature of the change should be made, including changes in income from continuing operations, net income, and retained earnings.