Financial Accounting Part - Accounting changes and error analysis

Comparable

• across companies at a point in time
• over time for a specific company

However, companies often make changes in their: 

• Accounting policies; AND
• Accounting estimates

OR companies correct errors in prior financial statements.

Change from one text-decorationaccepted method to another

• Inventory valuation method
• Method for actuarial gains/losses on pensions

1. Report changes currently

• Report the cumulative effect of the change year's income
• No change in prior-year financial statement

2. Report changes retrospectively

• Recast prior financial statements as if new method was always applied
• Cumulative effect of the change reported as adjustment to beginning retained earning of the earliest year presented

3. Report changes prospectively

• No change to historic information

Difference in sums of income under each approach over the past years.

IASB advises to use option 2 (retrospective method) because of more useful information: better consistency across accounting periods (comparability).

Why not option 1? Because cumulative effects can be extremely large and the net income figure can be distorted by using option 2. The retrospective application has no effect on income in the year of change (except for current year effect).

• Changes in the business environment or profil of the company
• Changes in accounting standards
• Changes are allowed if IFRS requirements are fulfilled and new financial statements are more relevant and reliable for users

For all prior periods presented in the current annual report, make adjustments to financial statements --> prior financial statements presented as if new method had always been applied.

Adjust the carrying amounts of assets and liabilities as of the beginning of the first year presented in the current annual report

• Reflect the cumulative effect on periods prior to those presented
• Adjustment to opening balance of retained earnings

• Bad debts
• Warranty expenses
• Inventory obsolescence
• Useful lives and residual values of assets
• Periods benefited by deferred costs
• Fair value of financial assets/liabilities

Judgement is required, new information may result in revised estimates and expectations.

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

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

If it is possible to determine whether a change in policy or a change in estimate has occured, the rule is: 

Consider the change as a change in estimate. Companies account for changes in depreciation methods as a change in estimate.

Answer depends on the average current life of the assets. 

1. A change from an accounting policy 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 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 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 adjustment.

For comparative statements, a company should restate the prior statements affected, to correct for the error.

Why companies may prefer certain accounting methods. Some reasons are:

• Political costs
• Capital structure
• Bonus payments
• Smooth earnings

A change from one generally accepted accounting principle to another one. For example, a company may change its inventory valuation method from LIFO to average cost.

A change that occurs as the result of new information or additional experience. For example, a company may change its estimate of the useful lives of depreciable assets.

A change from reporting as one type of entity to another type of entity. As an example, a company might change the subsidiaries for which it prepares consolidated financial statements.

Errors in financial statements.

The FASB classifies changes in these categories because each catefory involves different methods of recognizing changes in the financial statements.

A change in accounting principle involves a change from one generally accepted accounting principle to another. A change in accounting principle is not considered to result from the adoption of a new principle in recognition of events that have occured for the first time or that were previously immaterial. If the accounting principle previously followed was not acceptable of if the principle was applied incorrectly, a change to a generally accepted accounting principle is considered as a correction of an error.

Under retrospective application, companies change prior years' financial statements on a basis consistent with the newly adopted principle.

Companies report changes in estimates prospectively. That is, companies should make no changes in previously reported results.They do not adjust opening balances nor change financial statements of prior periods.

Companies must correct errors as soon as they discover them, by proper entries in the accounts, and report them in the financial statements.

The profession requires that a company treat corrections of errors as prior period adjustments, record them in the year in which it discovered the errors, and report them in the financial statements of the proper period.

If presenting comparative statements, a company should restate the prior statements affected to correct for the errors. The company need not to repeat the disclosures in the financial statements.

A change in accounting estimate that is inseparable from the effect of a related change in accounting principle.

Those recognized changes in assets or liabilities necessary to effect a change in accounting principle.

Any changes to current or future cash flows of an entity that result from making a change in accounting principle that is applied retrospectively.

The process of changing/correcting previously issued financial statements to reflect the correction of an error in those financial statements.