ACCOUNTING CHANGES Types of Accounting Changes
1. Change in accounting principle-Change from one generally accepted accounting principle to another.
2. Change in accounting estimate-Revision of an estimate because of new information or new experience.
3. Change in reporting entity-Change from reporting as one type of entity to another type of entity.
4. Correction of an error-Correction of an error caused by a transaction being recorded incorrectly or not at all.
CHANGE IN ACCOUNTING PRINCIPLE
Changing from one acceptable accounting principle to another acceptable accounting principle is accounted for as a change in accounting principle. This does not include the adoption of a new accounting principle because the entity has entered into transactions for the first time that require specific accounting treatment. It also does not include the change from an inappropriate
accounting principle to an acceptable accounting principle. The later would be classified as the correction of an error.
The types of changes that might be included in a change in accounting principle are: Adoption of a new FASB accounting standard
Change in the method of inventory costing
Change to, or from, the cost method to the equity method
Change to, or from, the completed contract to percentage-of-completion method CHANGE IN ACCOUNTING ESTIMATE
At the end of each accounting period there are a number of estimates made in order to prepare the financial statements. These estimates are based on the facts and circumstances that exist at the time. These facts and circumstances will change from one accounting period to the next. It is not practical to restate the financial statements every time there is new information that makes the prior estimates incorrect. Therefore, on an ongoing basis management applies its best judgment and modifies such estimates as the facts and circumstances change in each subsequent accounting period. A change in accounting estimate is handled on a prospective basis.
CHANGE IN REPORTING ENTITY
Under certain circumstances management is required to restate the financial statements of all prior periods. These circumstances relate to a change in the reporting entity. Such changes
The correction of an error must be handled as a prior period adjustment to the earliest period reported in the financial statements. Some of the types of errors that might occur are as follows:
Change from an unacceptable accounting principle to an acceptable one. Mathematical errors.
Changes in estimates that were not prepared in good faith.
Failure to accrue or defer expenses or revenues at the end of a period. Misuse of facts.
Misclassification of costs as expenses and vice versa.
APPROACHES TO REPORTING ACCOUNTING CHANGES 1. Retrospective approach
The retroactive approach provides consistency and comparability between periods and across entities. Comparative financial statements are recast to reflect the changes. The cumulative effect (net of tax) of the change is reported as a prior period adjustment in the earliest period reported. The accounting records are adjusted to reflect the cumulative effect (net of the change) as of the beginning of the current period. The change and its effects on income and balance sheet amounts is disclosed in the notes to the financial statements.
2. Prospective approach
The prospective approach is used when it is impractical to use the retrospective approach. For example, a change from an acceptable inventory costing method to LIFO. It would be impractical for management to attempt to estimate what inventory and cost of goods sold would have been in prior years if the entity had been using LIFO. Under certain
circumstances the entity may be required to use the prospective approach because the FASB has mandated such treatment in the adoption of a new accounting standard. Although considered a change in accounting principle a change in depreciation, amortization or depletion methods are to be reported on a prospective basis rather than retrospectively. CHANGE IN ACCOUNTING PRINCIPLE-RETROSPECTIVE APPROACH
In applying the retrospective approach the financial statements are recast so that all prior periods reported in comparative financial statement reflect the adoption of the change in accounting principle.
Example: Spencer Company changed from the LIFO cost flow assumption to the FIFO cost flow assumption in 2004. The company’s federal income tax rate is 20%. The original
comparative income statements for the two years ended December 31, 2003 and all years prior to 2002 are presented below:
2003 2002
Years Prior to
2002
Revenue $1,050 $980 $3,800
Cost of goods sold (LIFO) 683 637 2,470
Gross profit 368 343 1,330
Operating expenses 231 216 836
Income before tax 137 127 494
Income tax 27 25 99
Net income $109 $102 $395
Income Statements
The following are the inventory amounts reported in the balance sheet at the end of each of the years 2001 through 2003.
2003 2002 2001
Inventory (LIFO) $150 $130 $120
Balance Sheets
The cumulative effect of the change from LIFO to FIFO for the two years ended December 31, 2003, and all years prior to 2002 is presented below.
2003 2002
Years Prior to
2002
Cost of goods sold (LIFO) $683 $637 $2,470
Cost of goods sold (FIFO) 478 446 1,729
Differences $205 $191 $741
Cumulative effect of change:
Inventory/cost of goods sold $1,137 $932 $741
2004 2003 2002
Revenue $1,200 $1,050 $980
Cost of goods sold (FIFO) 624 478 446
Gross profit 576 572 534
Operating expenses 264 231 216
Income before tax 312 341 319
Income tax 62 68 64
Net income $250 $273 $255
Income Statements (Recast)
The change in inventory method will result in changes in the balance sheet amounts as well. Inventory, deferred income taxes and retained earnings are all effected by this change in accounting principle.
The adjusted inventory and the cumulative effect of changes on deferred income taxes and retained earnings are presented below.
2003 2002
Inventory (LIFO) $150 $130
AJE (cumulative effect of changes) 1,137 932
Adjusted inventory (FIFO) $1,287 $1,062
Change to deferred income taxes $227 $186
Change to retained earnings 909 746
Cumulative effect of changes $1,137 $932
Balance Sheets (Recast)
Because we assume that the change in accounting principle took place on the first day of 2004 an adjusting journal entry is required to bring the accounting records into alignment with this
Account Debit Credit
Inventory $1,137
Retained earnings $909
Deferred income taxes 227
To record the cumulative effect of the change from LIFO to FIFO inventory cost method on January 1, 2004
Although this is the adjusting journal entry to correct the general ledger accounts, a prior period adjustment is also required to adjust the January 1, 2002 retained earnings balance. If we assume that original retained earnings was $1,900 the following prior period adjustment will have to be made as of January 1, 2002 to reflect the change in accounting principal.
Retained earnings, January 1, 2002 $1,900
Prior period adjustment 593
Corrected balance $2,493
CHANGE IN ACCOUNTING PRINCIPLE-PROSPECTIVE APPROACH
A change in depreciation, amortization or depletion method is a change in accounting estimate as a result of a change accounting principle and is reported on a prospective basis.
Example: In 2004 Spencer Company decided to change from accelerated depreciation to straight-line for financial reporting purposes. The only asset involved is equipment that originally cost $500,000 on January 1, 2001. The equipment was expected to have a ten year service life, a salvage value of $50,000 and was depreciated using the double declining method. The change in depreciation method is assumed to be effective as of the beginning of 2004. The following is a depreciation schedule on this piece of equipment for the four years that it has been in service. Year Beginning Book Value DDB % Depreciation Accumulated Depreciation Ending Book Value 2001 $500,000 20% $100,000 $100,000 $400,000 2002 400,000 20% 80,000 180,000 320,000 2003 320,000 20% 64,000 244,000 256,000 2004 256,000 20% 51,200 295,200 204,800
Original cost $500,000 Accumulated depreciation 244,000
Book value 256,000
Salvage value 50,000
Depreciable base 206,000
Serivce life remaining 7
Annual depreciation $29,429
CHANGES IN ACCOUNTING ESTIMATE-PROSPECTIVE APPROACH
At the end of each accounting period there are a number of estimates made in order to prepare the financial statements. These estimates are based on the facts and circumstances that exist at the time. These facts and circumstances will change from one accounting period to the next. It is not practical to restate the financial statements every time there is new information that makes the prior estimates incorrect. Therefore, on an ongoing basis management applies its best judgment and modifies such estimates as the facts and circumstances change in each subsequent accounting period. Changes in accounting estimates are handled on a prospective basis.
Example: On January 1, 2000 Spencer Company purchased machinery which cost $60,000. The machinery has an estimated salvage value of $18,000 and service life of 7 years. On January 1, 2002 it was determined that the salvage life would be approximately $10,000 and the service life would be 4 years. The journal entry to record the depreciation expense for year ended December 31, 2002 is as follows.
DATE ACCOUNT DEBIT CREDIT
12/31/2002 Depreciation expense $19,000
Accumulated depreciation $19,000 Analysis of revised depreciation expense:
Original cost $60,000
Original salvage value $18,000
Depreciable base 42,000
Original service life 7
Annual depreciation 6,000
Years in service before change in estimate 2
Accumulated deprecation 12,000
Book value 48,000
Revised salvage value 10,000
Depreciable base 38,000
Revised service life (4 total, 2 left) 2 Revised annual depreciation expense $19,000
REPORTING A CHANGE IN ENTITY-RETROSPECTIVE APPROACH
Under certain circumstances management is required to restate the financial statements of all prior periods. These circumstances relate to a change in the reporting entity. All such changes are reported on a retrospective basis. Such changes include:
(1) Presenting consolidated financial statements for the first time.
(2) Changing specific subsidiaries for which consolidated financial statements are presented. (3) Changing companies included in combined financial statements
(4) Change in the cost, equity, or consolidation method used for accounting for subsidiaries and investments.
REPORTING A CORRECTION OF AN ERROR-RETROSPECTIVE APPROACH The correction of an error must be handled as a prior period adjustment to the earliest period reported in the financial statements. All such corrections are reported on a retrospective basis. Some of the types of errors that might occur are as follows:
(1) Change from an unacceptable accounting principle to an acceptable one. (2) Mathematical errors.
(3) Changes in estimates that were not prepared in good faith.
(4) Failure to accrue or defer expenses or revenues at the end of a period. (5) Misuse of facts.
(6) Misclassification of costs as expenses and vice versa.
Example: Spencer Company purchased a piece of equipment on January 1, 2000 for $75,000. The bookkeeper incorrectly expensed the purchase as operating expenses in 2000. The
equipment had no estimated salvage value and a service life of 5 years. The company has an average income tax rate of 35%. In 2002 the company discovered the error and prepared the following journal entry to make the correction.
DATE ACCOUNT DEBIT CREDIT
1/1/2002 Equipment $75,000
Accumulated deprecation $30,000
Deferred tax liability 13,500
Analysis of adjustment to retained earnings: Cost of equipment $75,000 $75,000 Salvage value 0 Depreciable base 75,000 Service life 5 Annual depreciation 15,000 Years of service 2 Accumulated deprecation 30,000 Book value 45,000
Income tax rate 30%
Deferred tax liability 13,500
