Chapter 22: Accounting Changes and Error Analysis

Accounting ChangesAccounting alternatives:

1. Diminish the comparability of financial information. 2. Obscure useful historical trends.

Three Types of Accounting Changes: Change in Accounting Principle: Retrospectively. Change in Accounting Estimate: Prospectively. Change in Reporting Entity: Retrospectively.

Errors are not considered an accounting change.

Change in Accounting PrincipleA change from one generally accepted accounting principle to another is accounted for Retrospectively.

Examples include: o Average cost to LIFO. o Completed-contract to percentage-of-completion.

Exception: A Change in Accounting Principle that involves switching depreciation methods (or amortization or depletion methods), is accounted for Prospectively. The FASB defines this special case as a “Change in Accounting Estimate effected through a Change in Accounting Principle.”

Retrospective Accounting Change Approach Company reporting the change

1. adjusts its financial statements for each prior period presented to the same basis as the new accounting principle.

2. adjusts the carrying amounts of assets and liabilities as of the beginning of the first year presented, plus the opening balance of retained earnings.

Changes in Accounting PrincipleImpracticability Companies should not use retrospective application if one of the following conditions exists:

1. Company cannot determine the effects of the retrospective application. 2. Retrospective application requires assumptions about management’s intent in a prior period (e.g. LIFO

layer assumptions). 3. Retrospective application requires significant estimates that the company cannot develop. 4. If any of the above conditions exists, the company prospectively applies the new accounting

principle.

Change in Accounting Estimate 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.

Companies Prospectively report changes in accounting estimates.

Reporting a Change in EntityExamples of a change in reporting entity are:

1. Presenting consolidated statements (own > 50%) 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 (fair value), equity, or consolidation method of accounting for subsidiaries

and investments.

Reported Retrospectively by changing the financial statements of all prior periods presented.

Reporting a Correction of an ErrorAccounting Errors include the following types: 1. A change from an accounting principle that is not GAAP to an accounting principle that is acceptable. 2. Mathematical mistakes.

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3. Changes in estimates that occur because a company did not prepare the estimates in good faith. 4. Failure to accrue or defer certain expenses or revenues. 5. Misuse of facts. 6. Incorrect classification of a cost as an expense instead of an asset, and vice versa.

All material errors from prior periods must be corrected as a Prior Period Adjustment. Record corrections of errors from prior periods as an adjustment to the beginning balance of

retained earnings in the current period. For comparative statements, a company should restate the prior statements affected, to correct

for the error.

Ending Inventory Error If EI is too high, then COGS is too low:

BI Add net Purchases Goods Available for Sale Less EI COGS

Justification for Accounting Changes Changes in accounting principle are appropriate only when a company demonstrates that

the newly adopted generally accepted accounting principle constitutes an improvement in financial reporting.

Motivations for Changes in Accounting Methods Managers and others may have self-interests in adopting accounting standards:

Preference for less political visibility to avoid regulation. Managers may select accounting standards to maximize their performance-related bonuses. Incentive to manage or smooth earnings to give perception of less risk.

Error AnalysisBalance Sheet and Income Statement Errors

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Errors affecting both the balance sheet and the income statement can be: 1. Counterbalancing errors (or self-correcting over two accounting periods; e.g. EI error). 2. Noncounterbalancing errors (not self-correcting; e.g. depreciation expense error).

Ending Inventory Counter Balancing ErrorEI error in the previous year becomes a BI error of the current year:

BI Add net Purchases Goods Available for Sale Less EI COGS

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