Unit 03 - Accounting Changes and Error Analysis - Ch 22

Change in Principle: Retrospective: Two Steps

(1) *Adjust prior periods*: The company must adjust its financial statements for each prior period presented to show them as if using the new principle. // (2) *Adjust the carrying amounts of Assets and Liabilities as of the beginning of the first year presented*. Also makes an offsetting adjustment to the opening balance of retained earnings or other appropriate component of stockholders' equity or net assets as of the beginning of the first year presented.

Error Analysis: Companies Must Answer Three Questions

(1) What type of error is involved? (2) What entries are needed to correct for the error? (3) After discovery of the error, how are financial statements to be restated? /// Companies treat errors as prior period adjustments and *report them in the current year as adjustments to the beginning balance of Retained Earnings*. If a company presents comparative statements, it restates the prior affected statements to correct for the error.

Types of Accounting Changes: Change in Accounting Principle

A change from one *generally accepted accounting principle to another one*. // Example: A company may change its inventory valuation method from LIFO to average-cost.

Types of Accounting Changes: Change in Accounting Estimate

A change that occurs as the result of *new information or additional experience*. // Example: A company may change its estimate of the useful lives of depreciable assets.

Changes in Principle: Adoption of a New Principle

Companies must carefully examine each circumstance to ensure that a change in principle has actually occurred. Adoption of a new principle in *recognition of events that have occurred for the first time or that were previously immaterial is not an accounting change*. //// Example: A change in accounting principle has not occurred when a company adopts an inventory method (e.g., FIFO) for newly acquired items of inventory, even if FIFO differs from that used for previously recorded inventory. //// Example: Certain marketing expenditures that were previously immaterial and expensed in the period incurred. It would not be considered a change in accounting principle if they become material and so may be acceptably deferred and amortized.

Change in Estimates: When and Reporting

Companies report prospectively changes in accounting estimates. That is, companies should not adjust previously reported results for changes in estimates. Instead, they account for the effects of all changes in estimates in (1) the period of change if the change affects that period only, or (2) the period of change and future periods if the change affects both. The FASB views changes in estimates as normal recurring corrections and adjustments, the natural result of the accounting process. It prohibits retrospective treatment. // Was the change made because of incompetents or bad faith then it is an error. If it is new data then it is a chance in estimate. // As a result, companies account for a change in depreciation methods as a change in estimate effected by a change in accounting principle. // Don't need to report changes in estimates unless they are material or affects several periods. Companies should disclose the effect on income from continuing operations and related per share amounts of the current period.

Guidelines for Changes Due to Error

Employ the restatement approach by: (a) *Correcting all prior period statements* presented. (b) *Restating the beginning balance* of *retained earnings* for the *first period* presented when the error effects occur in a period prior to the first period presented.

Guidelines for Changes in Reporting Entity

Employ the retrospective approach by: (a) *Restating* the financial statements of *all prior periods* presented. (b) Disclosing *in the year of change* the effect on *net income and earnings per share data* for *all prior periods* presented.

Types of Accounting Changes: Errors in financial statements

Errors result from *mathematical mistakes, mistakes in applying accounting principles, or oversight or misuse of facts* that existed when preparing the financial statements. // Example: A company may incorrectly apply the retail inventory method for determining its final inventory value.

Error Analysis: Balance Sheet and Income Statement Errors

These errors affect both the bal sheet and the income stmt. Classified in two ways: *COUNTERBALANCING*: Errors that will be offset or corrected over two periods. The natural process in the second year will negate the error in the first year and the combined total of the two periods are correct. This is the most common. If the error is not yet counterbalanced, make an entry to adjust the present balance of retained earnings. /// *NONCOUNTERBALANCING*: Errors that are not offset in the next accounting period. These take more than two periods to correct themselves. /// If the error is discovered after the counterbalancing has completed then no changes are needed unless a mutli-year comparative statement is created in which case adjustments will be needed.

Error Analysis: Income Statement Errors

These errors affect only revenue and expenses. An income stmt classification error has no effect on the bal sheet and no effect on net income. // If the error occurred in prior periods, the company does not need to make a reclassification entry at the date of discovery because the accounts for the current year are correctly stated. ///// Examples: recording interest revenue as part of sales, purchases as bad debt expense, and depreciation expense as interest expense.

Motivations for Change of Accounting Method

*POLITICAL*: The bigger the co is the more it is in the public eye for regulators, taxes, labor unions, ect. More likely to use income-decreasing approaches. // *CAPITAL STRUCTURE*: If the capital is based on high debt to equity ratio they are more likely to have debt covenants to drive them. More likely to use methods that will increase net income. // *BONUS PAYMENTS*: Management will choose income promoting methods if their bonus is tied to income. // *SMOOTH EARNINGS*: Smooth steady increase is better than large increases or decreases. Both draw negative attention. Often efforts are made to smooth the income between periods.

Types of Accounting Changes: Change in Reporting Entity

A change from reporting as *one type of entity to another type of entity*. // Example: A company might change the subsidiaries for which it prepares consolidated financial statements.

Guidelines for Changes in Accounting Estimate

Employ the current and prospective approach by: (a) *Reporting current and future financial statements on the new basis*. (b) Presenting prior period financial statements *as previously reported*. (c) Making *no adjustments* to current-period *opening balances* for the effects in prior periods.

IFRS Differences

GAAP requires that financials be restated for all errors, IFRS has some leniency. // IFRS impracticality applies to both changes in principle and correction of errors. GAAP only allows impracticability under changes in principle. // IFRS does not require reporting of indirect effects of changes in principle, GAAP does require it.

Changes in Entity

If a change results from different reporting entities then the reporting is to change the financial statements of all prior periods presented. The revised statements show the financial information for the new reporting entity for all periods. /// It also should report, for all periods presented, the effect of the change on income before extraordinary items, net income, and earnings per share. ///// Examples: 1. Presenting consolidated statements in place of statements of individual companies. 2. Changing specific subsidiaries that constitute the group of companies for which the entity presents consolidated financial statements. 3. Changing the companies included in combined financial statements. 4. Changing the cost, equity, or consolidation method of accounting for subsidiaries and investments.6 In this case, a change in the reporting entity does not result from creation, cessation, purchase, or disposition of a subsidiary or other business unit.

Change in Principle: Correction of an Error

If a company previously followed an accounting principle that was not acceptable or if they applied a principle incorrectly. Then it is not a change in generally accepted accounting principle. It is a correction of an error.

Accounting Errors: Prior Period Adjustments

Corrections of errors from prior periods are recorded as an adjustment to the beginning balance of retained earnings in the current period.

Types of Accounting Changes: Name All Three

The FASB classifies changes in these categories because each category involves different methods of recognizing changes in the financial statements. *Change in accounting principle. Change in accounting estimate. Change in reporting entity.* //// A fourth category necessitates changes in accounting, though it is not classified as an accounting change. *Errors in financial statements.*

Change in Principle: Cumulative Effect

The difference in prior years; income between the newly adopted and prior accounting method.

Error Analysis: Balance Sheet Errors

These errors affect only the assets, liabilities, or equity accounts. When discovered company reclassifies the item to its proper position and restate the bal sheet for the error year. ///// Examples: the classification of a short-term receivable as part of the investment section, the classification of a note payable as an account payable, and the classification of plant assets as inventory.

Change in Principle: Three Possible Approaches

*Report changes currently*: Companies report the *cumulative effect* of the change in the current year's income statement as an irregular item. The effect of the change on prior years' income appears only in the current-year income statement. No changes to prior year financial statements. // *Report changes retrospectively*: The principle change is applied to prior periods and new financials are created as if the principle had always been used. Adjusts prior years' statements. Any cumulative effect is an adjustment to beginning retained earnings of the earliest year presented.. // *Report changes prospectively (future)*: Previously reported results are not changed. Do not adjust opening balances to reflect the change in principle. // THE FASB REQUIRES that companies use the RETROSPECTIVE APPROACH. // IFRS generally requires retrospective unless the company cannot reasonably restate prior periods.

Accounting Errors: Reporting Requirements

Must disclose the following. (1) The effect of the correction on each financial statement line item and any per share amounts affected for each prior period presented. (2) The cumulative effect of the change on retained earnings or other appropriate components of equity or net assets in the statement of financial position, as of the beginning of the earliest period presented.

Change in Principle: Retained Earning Adjustment

One of the disclosure requirements is to show the cumulative effect of the change on retained earnings as of the beginning of the earliest period presented.

Change in Principle: Impracticability

Retrospective application is considered impracticable if a company cannot determine the prior period effects using every reasonable effort to do so. /// Companies should not use retrospective application if one of the following conditions exists: (1) The company cannot determine the effects of the retrospective application. (2) Retrospective application requires assumptions about management's intent in a prior period. (3) Retrospective application requires significant estimates for a prior period, and the company cannot objectively verify the necessary information to develop these estimates. /// In this case the company prospectively applies it as of the earliest date it is practicable to do so.

Change in Principle: Direct and Indirect Effects

The FASB takes the position that companies should *retrospectively apply the direct effects* of a change in accounting principle. // *Direct Effect*: Example: the change in inventory balance as a result of a change in inventory valuation method. Including lower-of-cost-or-market impairment. Deferred income tax effects. // *Indirect Effects*: Any change to current or future cash flows of a company that results from making the change in principle. Indirect effects do not change prior period amounts. Example: profit-sharing or royalty payments based on revenue or net income. Any new or additional expenses due to higher net income would be expensed in the current period and a note added to the financial statements.

IFRS Similarities

The accounting for changes in estimates. // If determining the effect of the change in the period it started is impracticable then they can use a period after that or the current period.

Change in Principle: Reporting Requirements

The major disclosure requirements are as follows. (1) The nature of and reason for the change in accounting principle. Including an explanation of why the newly adopted accounting principle is preferable. (2) The method of applying the change, and: (a) A description of the prior period information that has been retrospectively adjusted, if any. (b) The effect of the change on income from continuing operations, net income, any other affected line item, and any affected per share amounts for the current period and for any prior periods retrospectively adjusted. (c) The cumulative effect of the change on retained earnings or other components of equity or net assets in the statement of financial position as of the beginning of the earliest period presented.

Guidelines for Changes in Accounting Principle

These are *only appropriate* when a company demonstrates that the newly adopted *principle is preferable* to the existing one. An *improvement in financial reporting*, not necessarily just income tax effect. /// RETROSPECTIVE Approach: (a) *Change financial statements* of all prior periods presented. (b) Disclosing in the year of the change the *effect on net income and earnings per share* for all prior periods presented. (c) Reporting an *adjustment to the beginning retained earnings balance* in the retained earnings statement in the earliest year presented. /// IF IMPRACTICABLE: If impracticable to determine the prior period effect: (a) *Do not change prior years' income*. (b) Use *opening inventory in the year the method is adopted* as the base-year inventory for all subsequent LIFO computations. (c) Disclose the *effect of the change on the current year*, and the *reasons for omitting* the computation of the cumulative effect and pro forma amounts for prior years.

Change of Accounting Method: Economic Consequences Argument

These arguments focus on the supposed impact of the accounting method on the behavior of investors, creditors, competitors, governments, or managers of the reporting companies themselves.