Chapter 22 - Textbook Notes
Chapter 22 - Textbook Notes Acc 302
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Date Created: 04/13/16
Chapter 22 – Accounting Changes and Error Analysis Accounting alternatives diminish the comparability of financial information between periods and between companies; they also obscure useful historical trend data. A reporting framework helps preserve comparability when there is an accounting change. The three types of accounting changes are: o 1. Change in accounting principle. A change from one generally accepted accounting principle to another one. For example, a company may change its inventory valuation method from LIFO to average-cost. o 2. Change in accounting estimate. A change that occurs as the result of new information or additional experience. For example, a company may change its estimate of the useful lives of depreciable assets. o 3. Change in reporting entity. A change from reporting as one type of entity to another type of entity. As an example, a company might change the subsidiaries for which it prepares consolidated ﬁnancial statements. A fourth category necessitates changes in accounting, though it is not classified as an accounting change. o 4. 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. For example, a company may incorrectly apply the retail inventory method for determining its ﬁnal inventory value. A change in accounting principle involves a change from one generally accepted accounting principle to another. 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. Finally, what if a company previously followed an accounting principle that was not acceptable? Or what if the company applied a principle incorrectly? o In such cases, the profession considers a change to a generally accepted accounting principle a correction of an error. There are three possible approaches for reporting changes in accounting principles: o 1. Report changes currently. In this approach, companies report the cumulative effect of the change in the current year’s income statement as an irregular item. The cumulative effect is the difference in prior years’ income between the newly adopted and prior accounting method. Under this approach, the effect of the change on prior years’ income appears only in the current-year income statement. The company does not change prior year ﬁnancial statements. Advocates of this position argue that changing prior years’ ﬁnancial statements results in a loss of conﬁdence in ﬁnancial reports. How do investors react when told that the earnings computed three years ago are now entirely different? Changing prior periods, if permitted, also might upset contractual arrangements based on the old ﬁgures o 2. Report changes retrospectively. Retrospective application refers to the application of a different accounting principle to recast previously issued ﬁnancial statements— as if the new principle had always been used. In other words, the company “goes back” and adjusts prior years’ statements on a basis consistent with the newly adopted principle. The company shows any cumulative effect of the change as an adjustment to beginning retained earnings of the earliest year presented. Advocates of this position argue that retrospective application ensures comparability. Think for a moment what happens if this approach is not used. The year previous to the change will be on the old method, the year of the change will report the entire cumulative adjustment, and the following year will present ﬁnancial statements on the new basis without the cumulative effect of the change. Such lack of consistency fails to provide meaningful earnings-trend data and other ﬁnancial relationships necessary to evaluate the business. o 3. Report changes prospectively (in the future). In this approach, previously reported results remain. As a result, companies do not adjust opening balances to reﬂect the change in principle. Advocates of this position argue that once management presents ﬁnancial statements based on acceptable accounting principles, they are ﬁnal. Management cannot change prior periods by adopting a new principle. According to this line of reasoning, the current-period cumulative adjustment is not appropriate because that approach includes amounts that have little or no relationship to the current year’s income or economic events. Retrospective Accounting Change Approach o When a company changes an accounting principle, it should report the change using retrospective application. o In general terms, here is what it must do: 1. It adjusts its ﬁnancial statements for each prior period presented. Thus, ﬁnancial statement information about prior periods is on the same basis as the new accounting principle. 2. It adjusts the carrying amounts of assets and liabilities as of the beginning of the ﬁrst year presented. By doing so, these accounts reﬂect the cumulative effect on periods prior to those presented of the change to the new accounting principle. The company 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. Reporting a Change in Principle: o The disclosure of accounting changes is particularly important. o Financial statement readers want consistent information from one period to the next. o Such consistency ensures the usefulness of financial statements. o The major disclosure requirements are as follows. 1. The nature of and reason for the change in accounting principle. This must include 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 (or other appropriate captions of changes in net assets or performance indicators), 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. Retained Earnings Adjustment o 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. Direct and Indirect Changes o The FASB takes the position that companies should retrospectively apply the direct effects of a change in accounting principle. An example of a direct effect is an adjustment to an inventory balance as a result of a change in the inventory valuation method. o Indirect effects, companies can have indirect effects related to a change in accounting principle. o An indirect effect is any change to current or future cash flows of a company that result from making a change in accounting principle that is applied retrospectively. o Indirect effects do not change prior period adjustments. An example of an indirect effect is a change in profit-sharing or royalty payment that is based on a reported amount such as revenue or net income. Indirect effects do not change prior period amounts. Impracticability o Retrospective application is considered impracticable if a company cannot determine the prior period effects using every reasonable effort to do so. o 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. o If any of the above conditions exists, it is deemed impracticable to apply the retrospective approach. Changes in Accounting and Estimates o To prepare financial statements, companies must estimate the effects of future conditions and events. o For example, the following items require estimates: 1. Uncollectible receivables. 2. Inventory obsolescence. 3. Useful lives and salvage values of assets. 4. Periods beneﬁted by deferred costs. 5. Liabilities for warranty costs and income taxes. 6. Recoverable mineral reserves. 7. Change in depreciation methods. o A company cannot perceive future conditions and events and their effects with certainty. o Therefore, estimation requires the exercise of judgment. o Accounting estimates will change as new events occur, as a company acquires more experience, or as it obtains additional information. Companies report prospectively changes in accounting estimates. o That is, companies should not adjust previously reported results for changes in estimates. o 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. o The FASB views changes in estimates as normal recurring corrections and adjustments, the natural result of the accounting process. o It prohibits retrospective treatment. o The circumstances related to a change in estimate differ from those for a change in accounting principle. o If companies reported changes in estimates retrospectively, continual adjustments of prior years’ income would occur. o It seems proper to accept the view that, because new conditions or circumstances exist, the revision fits the new situation (not the old one). o Companies should therefore handle such a revision in the current and future periods. Companies sometime find it difficult to differentiate between a change in estimate and a change in accounting principle. o Is it a change in principle or a change in estimate when a company changes from deferring and amortizing marketing costs to expensing them as incurred because future benefits of these costs have become doubtful? o If it is impossible to determine whether a change in principle or a change in estimate has occurred, the rule is this: Consider the change as a change in estimate. o This is often referred to as a change in estimate effected by a change in accounting principle. o Companies account for a change in depreciation methods as a change in estimate effected by a change in accounting principle. Changes in Reporting Entity Companies make changes that result in different reporting entities. In such cases, companies report the change by changing the financial statements of all prior periods presented. o The revised statements show the financial information for the new reporting entity for all periods. o Examples of a change in reporting entity are: 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. o 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. o In the year in which a company changes a reporting entity, it should disclose in the financial statements the nature of the change and the reason for it. o It also should report, for all periods presented, the effect of the change on income before extraordinary items, net income, and earnings per share. o These disclosures need not be repeated in subsequent periods’ financial statements. Accounting Errors o 1. A change from an accounting principle that is not generally accepted to an accounting principle that is acceptable. The rationale is that the company incorrectly presented prior periods because of the application of an improper accounting principle. For example, a company may change from the cash (income tax) basis of accounting to the accrual basis. o 2. Mathematical mistakes, such as incorrectly totaling the inventory count sheets when computing the inventory value. o 3. Changes in estimates that occur because a company did not prepare the estimates in good faith. o For example, a company may have adopted a clearly unrealistic depreciation rate. o 4. An oversight, such as the failure to accrue or defer certain expenses and revenues at the end of the period. o 5. A misuse of facts, such as the failure to use salvage value in computing the depreciation base for the straight-line approach. o 6. The incorrect classiﬁcation of a cost as an expense instead of an asset, and vice versa. As soon as a company discovers an error, it must correct the error. Companies record corrections of errors from prior periods as an adjustment to the beginning balance of retained earnings in the current period. o Such corrections are called prior period adjustments. Three types of errors can occur: o (1) Balance sheet errors , which affect only the presentation of an asset, liability, or stockholders’ equity account. o (2) Income statement errors , which affect only the presentation of revenue, expense, gain, or loss accounts in the income statement. o (3) Balance sheet and income statement errors , which involve both the balance sheet and income statement. Errors are classified into two types: o (1) Counterbalancing errors are offset or corrected over two periods. o (2) Noncounterbalancing errors are not offset in the next accounting period and take longer than two periods to correct themselves.
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