4. Accounting Changes and Correction of Accounting Errors

What are the three categories of accounting changes?

1. Change in an accounting principle

2. Change in estimate

3. Change in reporting entity

What is the retrospective approach?

• Prior years' financial statements are revised to reflect the impact of the change whenever those statements are reported again in comparative statements. Thus, it appears as if the new accounting method had been used in those years.

• A journal entry is created to adjust all account balances affected to what those amounts would have been.

• An adjustment is made to the earliest retained earnings beginning balance to reflect the cumulative income effect of changing to the new accounting principle.

What is the modified retrospective approach?

• The new standard is applied to the adoption year only. Prior years’ financial statements are not restated.

• The cumulative effect of the change on prior period’s net income is shown as an adjustment to the beginning balance of retained earnings in the adoption year.

What is the prospective approach?

• The change is only applied to the current year and future years.

• There is neither a modification of prior years' financial statements nor a journal entry to adjust to account balances.

What is a voluntary change in accounting principles and how is it accounted for?

It is when companies occasionally elect to change principles, but they must demonstrate that the newly adopted principle is preferable to the old one.

Accounted for using the retrospective approach.

What are some changes in accounting estimate examples?

1.  Estimated useful lives and salvage values of depreciable assets changes

2.  Allowance for uncollectible receivables changes

3.  Inventory obsolescence

How are changes in estimates accounted for?

Prospectively (the change is only applied to current and future years)

1.  If the change only affects the present period, then they account for the change in only in that period.

2.  If the change affects both present and future periods, then they account for the change in both the period of change and future periods.

What needs to be done if the effect of the change in estimate is material?

A disclosure note is needed to describe the change and its effect on both net income and earnings per share.

What is a change in depreciation, amortization, or depletion method considered to be?

It is considered to be a change in accounting estimate that is achieved by a change in accounting principle.

How is a change in depreciation, amortization, or depletion method accounted for?

Prospectively (just like any other change in estimate)

What is the difference between a normal change in estimate and a change in depreciation, amortization, or depletion method?

Most changes in estimate don't require a company to justify the change. However, this change in estimate is a result of changing an accounting principle and therefore requires a clear justification as to why the new method is preferable

How are errors corrected?

The original erroneous journal entry is reversed and the appropriate entry is recorded.

In which year do companies record a correction of an error?

In the same year it is discovered.

How is the error reported in the financial statements?

As an adjustment to the beginning balance of retained earnings.

The impact of error corrections and changes in accounting principle are debited/credited directly to retained earnings for the amounts related to prior periods.

What should a company do if they prepare comparative financial statements and there is an error?

The company should retrospectively restate the prior statements for the effects of the error.

Also, a disclosure note communicates the impact of the error on prior periods' net income.

How should correction for prior period adjustments be accounted for (correction of errors)?

Companies charge or credit these adjustments (net of tax) to the opening balance of retained earnings.