These lectures discuss the different procedures used to report accounting changes and accounting error corrections, and changes in accounting principles.
[vc_row][vc_column][vc_video link=”https://youtu.be/5Q1bYncNNCg” title=”Changes in Accounting Principles”]
[vc_video link=”https://youtu.be/1ib-MPswJjQ” title=”Changes in Accounting Estimates”][/vc_column][/vc_row][vc_row][vc_column][vc_video link=”https://youtu.be/2I9TA8g4MTE” title=”Changes in Reporting Entity “][vc_video link=”https://youtu.be/JO-5an8ZW5g” title=”Accounting for Correction of Errors “][/vc_column][/vc_row][vc_row][vc_column][vc_video link=”https://youtu.be/84Onf9rY7-o” title=”Accounting Error Analysis”][/vc_column][/vc_row]
Chapter 22 discusses the different procedures used to report accounting changes and error corrections. The use of estimates in accounting as well as the uncertainty that surrounds many of the events accountants attempt to measure may require adjustments in the financial reporting process. The accurate reporting of these adjustments in a manner that facilitates analysis and understanding of financial statements is the focus of this chapter.
The FASB requires that changes in estimates (for example, uncollectible receivables, useful lives, and salvage values of assets) should be handled prospectively. Opening balances are not adjusted and no attempt is made to “catch up” for prior periods. The effects of all changes in estimates are accounted for in (a) the period of change if the change affects that period only, or (b) the period of change and future periods if the change affects both.
Example: If an asset with a cost of $250,000 and no salvage value was originally depreciated on a straight-line basis for the first 7 years of its 25 year useful life, the book value of the asset at the end of year 7 would be $180,000 ($250,000 – $70,000). If the estimated useful life was revised at the end of year 7, and the asset was assumed to have a remaining useful life of 9 years, the following journal entry would be made for depreciation at the end of year 8:
Depreciation Expense…………………………………………. 20,000*
Accumulated Depreciation…………………………….. 20,000
*($180,000 ÷ 9)
The FASB has standardized the manner in which accounting changes are reported. The three types of accounting changes are:
- Change in accounting principle. A change from one generally accepted accounting principle to another one. An example is the change from LIFO to average cost.
- Change in accounting estimate. A change that occurs as the result of new information or additional experience. An example is a change in the estimate of the useful lives of depreciable assets.
- Change in reporting entity. A change from reporting as one type of entity to another type of entity. An example is the change of specific subsidiaries comprising the group of companies for which consolidated financial statements are prepared.
Changes in Accounting Principle
Changes from one GAAP to another GAAP are defined as a change in accounting principle. A company wishing to change from one GAAP to another GAAP must disclose the nature of and reasons for the change in principle and an explanation of why the newly adopted accounting principle is preferable.
A change in accounting principle is not considered to result from the adoption of a new principle in recognition of events that have occurred for the first time or that were previously immaterial. For example, implementing a credit sales policy when one had not previously existed is not considered a change in accounting principle. Also, a change from an accounting principle that is not acceptable to a principle that reflects GAAP is considered a correction of an error.
Three possible approaches exist for recording the effect of changes in accounting principles: (a) report changes currently, (b) report changes retrospectively, and (c) report changes prospectively. The FASB requires that companies use the retrospective approach.
Reporting a change in accounting principle currently requires reporting the cumulative effect of the change on financial statements in the current year’s income statement as an irregular item. Advocates of this method contend that investor confidence is lost by a retroactive adjustment of financial statements for prior periods.
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. The company shows any cumulative effect of the change as an adjustment to beginning retained earnings of the earliest year presented
Prospective treatment of a change in accounting principle requires no change in previously reported results. Opening account balances are not adjusted and no attempt is made to compensate for prior events. Advocates of this position contend that financial statements based on acceptable accounting principles are final since management cannot change prior periods by subsequently adopting a new principle.