Intermediate accounting, Kieso, Chapter 22

Types of accounting changes

1. Change in accounting principle/policy

2. Changes in accounting estimate

3. Change in reporting entity

** Errors are not considered an accounting change

Changes in accounting principle

Change from one accepted accounting principle to another.

Examples include:

- average cost to LIFO

- completed-contract to percentage-of-completion method

Three approaches for reporting accounting changes

1. currently

2. retrospectively

3. prospectively (in the future)

** FASB requires use of retrospective approach for changes 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

3) plus the cumulative effect of the opening balance of retained earnings as of the beginning of the first period presented.

Reporting a change in principle

Major disclosure requirements are as follows.

1. Nature of the change in accounting principle

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.

c. The cumulative effect of the change on retained earnings or other components of equity or net assets in the balance sheet as of the beginning of the earliest period presented.

Direct effects of Changes

FASB takes the position that companies should retrospectively apply the direct effects of a change in accounting principle.

Indirect effects of change

any change to current or future cash flows of a company that result from making a change in accounting principle that is applied retrospectively.

Impracticability

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.

3. Retrospective application requires significant estimates that the company cannot develop.

** If any of the above exists, the company prospectively applies the new accounting principle

Examples of 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

Prospective reporting

FORWARD ONLY

Account for 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

FASB views changes in estimates as normal recurring corrections and adjustments and prohibits retrospective treatment.

Disclosures

Companies need not disclose changes in accounting estimate made as part of normal operations, such as bad debt allowances or inventory obsolescence, unless such changes are material.

However, for a change in estimate that affects several periods (such as a change in the service lives of depreciable assets) companies should disclose the effect on income from continuing operations and related per share amounts of the current period.

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.

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

Types of accounting errors:

1. A change from an accounting principle that is not generally accepted to an accounting policy that is acceptable.

2. Mathematical mistakes.

3. Changes in estimates that occur because a company did not prepare the estimate 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.

Accounting errors

- All material must be corrected.

- Record corrections of errors from prior periods as an adjustment to the beginning balance of retained earnings in the current period.

- Such corrections are called prior period adjustments.

- For comparative statements, a company should restate the prior statements affected, to correct for the error. (Kind of like retrospective).

- Reissue statements for earlier years if needed.

Error restatements - expense recognition

Recording expenses in the incorrect period or for an incorrect amount.

Error restatements - Revenue recognition

Instances in which revenue was improperly recognized, questionable revenues were recognized, or any other number of related errors that led to misreported revenues.

Error Restatements - Misclassification

Include restatements due to misclassification of short- or long-term accounts or those that impact cash flows from operations

Error Restatements - equity-other

Improper accounting for EPS, restricted stock, warrants, and other equity instruments.

Error Restatements - Allowances/contingencies

Errors involving accounts receivables' bad debts, inventory reserves, income tax allowances, and loss contingencies.

Error Restatements - long-lived assets

Asset impairments of property, plant, and equipment; goodwill; or other related items.

Error Restatements - Taxes

Errors involving correction of tax provision, improper treatment of tax liabilities, and other tax-related items.

Error Restatements - Equity-other comprehensive income

Improper accounting for comprehensive income equity transactions including foreign currency items, minimum pension liability adjustments, unrealized gains and losses on certain investments in debt, equity securities, and derivatives.

Error Restatements - Inventory

Inventory costing valuations, quantity issues, and cost of sales adjustments.

Error Restatements - equity-stock options

Improper accounting for employee stock options

Error Restatements - other

Any restatement not covered by the listed categories.

Comparative statements

Company should

1) make adjustments to correct the amounts for all affected accounts reported in the statements for all periods reported.

2) restate the data to the correct basis for each year presented.

3) show any catch-up adjustments as a prior period adjustment to retained earnings for the earliest period it reported.

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.

Balance sheet only errors

Balance sheet errors affect only the presentation of an asset, liability, or stockholders' equity account.

Example: classifying an account payable as a note payable

- current year error - reclassify item to its proper position

- Prior year error - restate the balance sheet of the prior year for comparative purposes

Income Statement only errors

Improper classification of revenues or expenses:

Example reporting depreciation expense as interest expense or interest revenue as sales revenue

- these errors have no impact on Net Income

- current year error - reclassify items to its proper position

- prior year error - restate the income statement of the prior year for comparative purposes.

Balance sheet and Income Statement Errors

Counterbalancing errors -

Will be offset or corrected over two periods (if it goes beyond 2 periods, then it's not counterbalancing)