M6 Accounting Changes and Error Corrections
How should the effect of a change in accounting estimate be accounted for? a. By restating amounts reported in financial statements of prior periods. b. By reporting pro forma amounts for prior periods. c. In the period of change and future periods if the change affects both. d. As a prior period adjustment to beginning retained earnings.
Choice "c" is correct, a "change in accounting estimate" affects only the current and subsequent (future) periods, if the change affects both. It does not affect "prior periods," nor "retained earnings." Choice "a" is incorrect. Restating prior years' financial statements is required when comparative financial statements are shown for prior period adjustments of "corrections of errors," "changes in entities," and changes in accounting principle. Choices "b" and "d" are incorrect. A "change in accounting estimate" does not affect prior periods.
How should the effect of a change in accounting principle that is inseparable from the effect of a change in accounting estimate be reported? a. By restating the financial statements of all prior periods presented. b. By footnote disclosure only. c. As a correction of an error. d. As a component of income from continuing operations.
D. As a component of income from continuing operations. When the effect of a change in accounting principle is inseparable from the effect of a change in accounting estimate, the reporting treatment for the overall effect is as a change in estimate. Thus, the effect is reported prospectively as a component of income from continuing operations. Restatement of all prior periods is the retroactive accounting treatment that is applied to the correction of an error and the retrospective accounting treatment given to changes in accounting principle. However, a change in accounting principle that is inseparable from the effect of a change in accounting estimate is now treated as a change in accounting estimate. Correction of an error is given retroactive treatment as a prior period adjustment to retained earnings with restatement of prior periods. This is not the treatment appropriate for the effect of a change in accounting principle that is inseparable from the effect of a change in accounting estimate. While footnote disclosure is always appropriate for an accounting change, such disclosure alone is never the appropriate accounting treatment.
Lore Co. changed from the cash basis of accounting to the accrual basis of accounting during the current year. The cumulative effect of this change should be reported in Lore's current year financial statements as a: a. Component of income before extraordinary item. b. Prior period adjustment resulting from the correction of an error. c. Component of income after extraordinary item. d. Prior period adjustment resulting from the change in accounting principle.
b. Prior period adjustment resulting from the correction of an error. The cash basis for financial reporting is not a generally accepted accounting basis of accounting (GAAP); therefore, it is an error. Correction of an error from a prior period is a reported as prior period adjustment to retained earnings. Cash basis reporting is not an accounting principle under accrual accounting principles. Thus, the change from cash basis is not reported as a change in accounting principle. In addition, changes in accounting principle are not prior period adjustments; instead, they are treated retrospectively. Correction of prior period errors has no effect on the current year's income statement.
During Year 2, Orca Corp. decided to change from the FIFO method of inventory valuation to the weighted-average method. Inventory balances under each method were as follows: FIFO average January 1, Year2 $71,000 $77,000 December 31, Year 2 79,000 83,000 Orca's income tax rate is 30%. Orca should report the cumulative effect of this accounting change as a(n): a. Extraordinary item. b. Component of income from continuing operations. c. Adjustment to beginning retained earnings. d. Component of income after extraordinary items.
c. Adjustment to beginning retained earnings. The cumulative effect of a change in accounting principle is shown as an adjustment to beginning retained earnings. The cumulative effect of a change in accounting principle is now presented as a separate category on the retained earnings statement and is not a component of net income. Extraordinary items are unusual and infrequent in nature. Extraordinary items have nothing to do with changes in accounting principle. A change in accounting principle affects retained earnings, not the income statement.
