Intermediate Accounting Thomas H. Beechy Schulich School of Business, York University Joan E. D. Conrod Faculty of Management, Dalhousie University PowerPoint slides by: Bruce W. MacLean, Faculty of Management, Dalhousie University
Chapter 22 Accounting Changes
Introduction Accounting requires many choices, both of accounting policy and of accounting measurements or estimates Management may decide that a company s reporting, ownership structure or economic circumstances have changed sufficiently to warrant changing their previous choices, either by changing one or more accounting policies or by changing their accounting estimates. AcSB regulations, legal statute, FASB, or International accounting standards may require changes to made. Accounting changes are necessary when a company discovers that it has made an accounting error in previous accounting periods All types of accounting changes affect reported results, but not necessarily in the same way.
Types Of Accounting Changes There are three general types of accounting changes: Changes in accounting policy Voluntary, at the option of management or at the request of a user involuntary, to comply with new CICA Handbook recommendations Changes in accounting estimates Correction of an error in previous periods financial statements The general nature of each of these types of changes is discussed below.
Changes In Policy A change in accounting policy is a change in the way that a company accounts for a particular type of transaction or event, or for the resulting asset or liability. A change in accounting policy must not be confused with adopting a new accounting policy voluntary tax minimization to net income maximization conform with new parent company investor may purchase shares on condition of new reporting method Involuntary - AcSB issues a new or revised recommendation in the CICA Handbook which requires a GAAP-constrained company to alter its policy to conform to the new recommendations. previously accepted method becomes unacceptable (pension costs ) new approach is recommended that was not previously used in practice (income taxes: the change from the deferral method to the liability method )
Changes In Estimate Changes in accounting estimates are common. Change in the application of an accounting policy to a specific transaction or event Accounting measurements are based extensively on future expectations. We can never predict future outcomes with certainty Examples: Uncollectible accounts receivable; Recoverable value of an asset, Criteria for capitalizing development costs Several reasons, changes: the company s economic environment, auditors have raised questions the company s reporting objectives, (e.g., a greater emphasis on conservatism); or there has been a shift in the nature of the company s business operations
Correction Of An Error On occasion, a company (or its auditors) discovers that there was an accounting error in a prior period. If the error was material, the error must be corrected even if it has washed out over the long run Inventory overlooked when the physical count was taken. Failed to accrue commission liabilities that had not been paid by the end of the fiscal year. Routine repairs were capitalized instead of being expensed. The company treasurer fraudulent transfer of substantial sums into personal account hidden by fake purchase invoices Errors do not arise from a change in estimate or a change in policy. They are simply mistakes. Accounting errors require restatement of prior periods results, in order to comply with the qualitative criteria of comparability and consistency, even if there is no impact on the period in which the error was discovered
Summary: Types Of Changes Basically, then, we can summarize an accounting change as being: a change in estimate if it is the result of new information that was not known previously; a change in policy if the change was motivated by different reporting circumstances of the enterprise and there has been no material change in economic circumstances; application of a new policy if the transactions or events are materially different from those reported previously; or correction of an accounting error if information has come to light that was reasonably determinable in the period in which the transaction or event was initially reported.
Summary: Types Of Changes Discerning the nature of the change is important for two reasons: the reporting approach for changes in accounting estimates is different from that for changes in accounting policies and corrections of errors, and changes in accounting estimates and error corrections normally are not disclosed and, in effect, are buried in the financial statements, while changes in accounting policies must be disclosed in the notes to the financial statements. When there is doubt as to whether a change is a change in policy or a change in estimate, the CICA Handbook suggests that the change should be treated as a change in estimate
Accounting For Changes 1.Retroactive application with restatem entofprior periods 2.Retroactive application withoutrestatem ent 3.Prospective application
Exhibit 22-1 Summary of Accounting Changes and Reporting Approaches EXHIBIT 22-1 Summary of Accounting Changes and Reporting Approaches Click for Hyperlink
Retroactive Approach, With Restatement The information necessary to make the change in the current and prior periods must be obtained from the underlying accounting records. Account balances that affect the prior year s comparative financial statements must be recalculated using the new policy, including all affected balance sheet and income statement accounts. The comparative statements must be restated to reflect the changed amounts in the full financial statements. Summary comparative information (e.g., earnings per share, total assets) presented publicly, (annual report), must be recalculated using the new policy. The cumulative impact of the change on the beginning balances of the current year must be calculated. The cumulative impact of the accounting policy change on prior year s net income is recorded as an GJ entry adjustment to the beginning balance of retained earnings.
Retroactive Approach, Without Restatement - Exhibit 22-2 EXHIBIT 22-2 Sunset Corporation Data for Change in Accounting Policy Change from Average Cost (AC) to FIFO for Inventory 1. During 20x5, Sunset Corporation decides to change its inventory cost method from AC to FIFO for accounting purposes only, effective for fiscal year 20x5. The reporting year ends on 31 December, and the company s income tax rate is 40%. 2. From its records, the company determines the following information relating to the change: 20x5 20x4 FIFO AC FIFO AC a. Beginning inventory (from prior 31 December) $ 60,000 $ 50,000 $ 47,000 $ 45,000 b. Ending inventory 80,000 65,000 60,000 50,000 c. Income before extraordinary items 176,000* 160,000 d. Extraordinary gains (losses), net of tax (2,000) 3,000 e. Retained earnings, beginning balance 169,000 86,000 f. Dividends declared and paid 88,000 80,000 * Reflects FIFO policy.
Retroactive Approach, Without Restatement If the cumulative impact of a change of accounting policy can be determined but the impact on individual prior years cannot, then the change should be accounted for retroactively, but without restating prior years results. Instead, a catch-up adjustment is recorded and reported in retained earnings in the year of the change. AcSB sometimes permits a change to be applied without restatement of prior years results AcSB - set the effective date for a new standard that is more than one year after the release of the standard Prior financial statements and summary information remains unchanged. The cumulative impact is reported as an adjustment to opening retained earnings. The current year s financial statements reflect the new policy; the prior year s comparative statements reflect the old policy. The cumulative impact on all of the relevant beginning balances for the current year is computed and recorded
Retroactive Approach, Without Restatement Exhibit 3, 4 EXHIBIT 22-3 Sunset Corporation Selected Amounts from Comparative Financial Statements Change from Average Cost to FIFO for Inventory Click for Hyperlink EXHIBIT 22-4 Change in Accounting Policy Change from Completed-Contract to Percentage-of- Completion
Prospective Approach If the cumulative impact of an accounting policy change cannot be determined, the change in policy can be implemented prospectively. The new policy is used for events and transactions occurring in and after the year of the change, but beginning balances are not adjusted and prior years results are not revised. Changes in accounting estimates are always accounted for prospectively. If there is doubt as to whether a change is a change in estimate or a change in policy, it should be assumed to be a change in estimate. The financial statement effects of using the new estimate usually are not disclosed, nor is the fact of the change usually disclosed. Exceptions may arise when the change in estimate has a particularly substantial effect on the reported results, particularly when the change results in a loss that can be separately disclosed as an unusual item. Some estimates are valid for one year only
Disclosure Requirements Accounting changes affect the consistency and comparability of financial statements, and therefore their reliability. CICA Handbook recommends specific disclosures for accounting policy changes:cica 1506.16-1506.21 - see popup box The CICA Handbook contains no italicized recommendations for the disclosure of changes in accounting estimates.
Disclosure Requirements Disclosure of the nature and effect on the current period may be desirable for a change in an accounting estimate that is rare or unusual and that may affect the financial results of both current and future periods, such as a change in the estimated service life of a fixed asset. CICA 1506.25 The AcSB s recommendations for reporting an error correction are similar to those for a change in accounting policy All Accounting Policy changes Disclose if material to future periods Description of the change Effect of the change on the financial statements of the current period Applied Retroactively Prior Periods Restated The fact that FS have been restated Effect on those prior periods Applied Retroactively Prior Periods Not restated The fact that the FS of prior periods have not been restated Cumulative adjustment to the opening balance of the retained earnings Prospective Application Prior Periods Not restated The fact that an accounting policy has not been applied retroactively Disclosure of particulars, including dollar amounts, applies to each change in an accounting policy
Exhibit 22-6 Disclosure of a Change in Accounting Policy MacMillan Bloedel Limited Change in Accounting Policy During the year, the Company adopted, on a retroactive basis, the new Canadian accounting requirements related to the presentation of financial instruments. Under this new accounting policy, the present value of the interest payments on the convertible subordinated debentures is presented as long term debt with the remaining portion of the principal amount included in shareholders equity. The interest related to the equity component of the convertible subordinated debentures is reflected as a charge to retained earnings. Effect of Change in Accounting Policy on the Financial Statements 1996 1995 Increase in long term debt $ 45 $ 47 Increase in equity component of convertible subordinated debentures 105 103 Elimination of previous classification of Convertible subordinated debentures (150) (150) Increase in net earnings 1 1
Exhibit 22-7 Summary of Recommended Disclosures for Accounting Changes Type of Change CICA Reference Disclosure Required Changes in policy for each change that has a material effect or is likely to have a material effect in future periods 1506.16 1506.20 1506.21 a description of the change the effect of the change on the financial statements of the current period, without netting offsetting amounts Plus, for changes in policy applied: Retroactively, with restatement 1506.17 the fact that prior years statements have been restated Retroactively, without restatement 1506.18 the fact that prior periods have not been restated the cumulative adjustment to retained earnings Prospectively 1506.19 the fact that the change has not been applied retroactively 1506.25 none required; optional if the change is rare and unusual Change in estimate, applied prospectively Correction of an accounting error 1506.30 a description of the error the effect of the correction on current and prior periods financial statements the fact that prior periods financial statements have been restated
Cash Flow Statement A change in accounting policy does not change cash flows, but it can affect the way that cash flows are reported. Indeed, the efficient markets hypothesis maintains that the public securities markets are not fooled by accounting policy changes because the market sees through changes in reporting that do not result from a change in cash flows While a change in accounting policy will not affect the net change in cash the bottom line of the cash flow statement it can affect the classification of amounts in the cash flow statement.
Prior Period Adjustments Prior to 1996, companies were permitted, under certain circumstances, to make prior period adjustments. A prior period adjustment was a gain or a loss that was credited or charged directly to retained earnings instead of appearing in the income statement. Prior period adjustments were permitted under the AcSB s recommendation if four criteria were satisfied. The only adjustments that can be made directly to retained earnings are for retroactively applied changes in accounting policy and for corrections of errors in prior periods. Other types of prior period adjustments must flow through the income statement Financial Reporting in Canada 1995, for example, found that of 42 prior period adjustments reported by its sample of 300 companies between 1991 and 1994, 38 were debit items and only 4 were credit items.
USA Perspective The U.S. approach for accounting policy changes is sharply at variance with the approach used in Canada. The preferred U.S. practice for changes in accounting policy is not only to use the prospective approach instead of the retroactive approach, but also to report the cumulative impact of a policy change as a component of net income in the period in which the change is made. Retroactive treatment is prohibited, except for a short list of specific changes (e.g., a change from LIFO to another inventory method), and except when retroactive application is specifically required in any new standard issued by the FASB The U.S. approach is consistent with the all-inclusive income concept The U.S. approach is generally out of step with other countries
International Perspective International Accounting Standard IAS 8 (revised in 1993), recommends that a change in accounting policy be applied retrospectively
Accounting Changes: An Evaluation Many people believe that all changes in accounting policy should be applied retroactively. They worry about the effect of changes on comparability. Accounting changes, even those applied retroactively, may cause confusion and reduce the predictive ability of accounting information. For example, at least one study has found that the accuracy of analysts earnings forecasts declined when accounting changes are made One criticism of the retroactive approach is that the cumulative effect on prior years income cannot be accurately computed Another concern is that three approaches to reporting accounting changes are endorsed in current Canadian standards Some contend that both of the retroactive approaches (with and without restatement) are inappropriate and believe that once an income item is reported, it is final