FA3 Lesson 8. Accounting changes 1.Types of accounting changes 2.Dealing with accounting changes 3.Framework for analyzing accounting changes 4.Correcting accounting errors

1. Types of accounting changes 1.Changes in accounting policy (e. g., FIFO to average cost) 2.Changes in accounting estimate (e. g., bad debt expense, useful life of long-lived assets) 3.Change in reporting entity (e. g., business segment is discontinued) 4.Reporting the correction of an error

Policy change vs. new accounting policy A change in accounting policy is said to occur if the change is motivated by different reporting circumstances, and not by any material change in economic circumstances A new accounting policy is applied if transactions/events are materially different from those reported previously, or if a new standard is adopted by AcSB

Policy change vs. change in estimate A change in accounting policy is said to occur if the change is motivated by different reporting circumstances, and not by any material change in economic circumstances A change in estimate is deemed to occur if new information comes to light that was not known previously If unsure, assume a change in estimate EXAMPLE: A22-1

2. Dealing with accounting changes 1.Retroactive-with-restatement 2.Retroactive-without-restatement 3.Prospective

2.1. Retroactive-with-restatement This method should be used to account for changes in accounting policy, changes in accounting entity (discontinued operations) and correction of errors. a)New policy/correction should be applied retroactively. b)Prior period financial statements included for comparison should be restated to reflect new policy/correction. c)Change and its effect on key financial statement variables should be disclosed.

2.2. Retroactive-without-restatement This method should be used to account for changes in accounting policy if cumulative effect can be determined, but effect on individual periods cannot. a)Cumulative effect of policy change shown in adjustment to opening retained earnings. b)Prior period financial statements included for comparison are not restated. c)Change and its effect on key financial statement variables should be disclosed.

2.3. Prospective This method should be used to account for changes in accounting policy if even cumulative effect cannot be determined, and for changes in accounting estimates. a)New policy/estimates are used in current and future periods only. b)Prior period financial statements included for comparison are not restated. c)Note disclosure of the nature of the change.

Example: Accounting change I 2000 (current) Revenue Expenses Net income $ $70 $ $40 $ $30 Retained earnings, Jan. 1 Net income Retained earnings, Dec. 31 $70 70 $140 $30 40 $70 $ - 30 $30 At Dec. 31, 2000, after preparing the above statements, the company decided to make an accounting policy change. This change would have lowered expenses by $20 (1998), $30 (1999) and $40 (2000).

Example: Accounting change II 2000 (current) Revenue Expenses Net income $ $70 $ $40 $ $30 Retained earnings, Jan. 1 Net income Retained earnings, Dec. 31 $70 70 $140 $30 40 $70 $ - 30 $30 At Dec. 31, 2000, after preparing the above statements, the company decided to make an accounting policy change. This change would have lowered 2000 expenses by $40; and total expenses for 1998 and 1999 together by $50.

Example: Accounting change III 2000 (current) Revenue Expenses Net income $ $70 $ $40 $ $30 Retained earnings, Jan. 1 Net income Retained earnings, Dec. 31 $70 70 $140 $30 40 $70 $ - 30 $30 At Dec. 31, 2000, after preparing the above statements, the company changed its estimate of the service life of its fixed assets. This change would have lowered 2000 amortization by $40.

3. Framework for analyzing accounting changes (retroactive with restatement) Framework for analyzing effects of acctg changes Balance sht End last yr + Income stmt This year = Balance sht End this yr Assets = Liabilities *other *tax + Equity *RE Revenue - Expenses *other *tax = Net income Assets = Liabilities *other *tax + Equity *RE

EXAMPLES A22-17 A22-23

4. Correcting accounting errors Three questions must be addressed: 1.What kind of error is involved? (income statement, balance sheet, both) 2.Is a journal entry necessary to correct the error? 3.Do any of the financial statements to be published in this year’s annual report need to be restated?

4. Correcting accounting errors 1.What kind of error is involved? (income statement, balance sheet, both) Income statement OR balance sheet (not both) – usually just a presentation error; restate statements properly Both I/S and B/S – usually a revenue/expense and associated asset/liability that are misstated; restate statements and perhaps a correcting journal entry is necessary

4. Correcting accounting errors 2.Is a journal entry necessary to correct the error? Books are closed –Error counterbalanced: no entry required –Error not counterbalanced: must adjust RE and other affected B/S account Books are not closed –Error counterbalanced: in year after error, must adjust current period I/S item and beginning RE –Error not counterbalanced: must adjust beginning RE, I/S item and affected B/S account

4. Correcting accounting errors 3.Do any of the financial statements to be published in this year’s annual report need to be restated? Restatement is always necessary, whether or not a journal entry is required, if any of the past financial statements affected by the error are presented in current or future financial statements for comparison purposes

Error correction: Gabby Ltd. How it should be Revenue Salaries Net income Retained earnings, Jan. 1 Retained earnings, Dec. 31 $1, $1,080 $1, $720 $1, $360 Revenues are $100 per month, billed at the end of the month and collected the following month. Salaries for the month ($70) are paid the first of the following month books are still open.

Error correction: Gabby Ltd. What was reported Revenue Salaries Net income Retained earnings, Jan. 1 Retained earnings, Dec. 31 $1, $1,080 $1, $790 $1, $ ’s December revenues were mistakenly recorded in January, As well, Gabby forgot to accrue the salaries payable ($70) on December 31, books are still open.

EXAMPLE A22-27