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What are the 3 types of accounting changes?
- 1. Change in Accounting Principle- LIFO to FIFO
- 2. Change in Accounting Estimate- Estimate useful life
- 3. Change in Reporting Entity- subsidiaries for which it prepares consolidated financial statements
Name one category that necessitates changes in accounting that is not classified as an accounting change
Errors in Financial Statements- math mistakes, applying wrong accting principle, oversight or misuse of facts.
What are the 3 possible approaches for reporting changes in accounting principles?
- 1. Report changes currently- report the cumulative effect of the change in the current year's Inc. St. as an irregular item. Do NOT change prior-year financial statements.
- 2. Report changes retrospectively- Retrospective application. "goes back" and adjusts prior years' statements on a basis consistent w/ newly adopted principle. Company shows any cumulative effect of the change as an adjustment to beg. retained earnings of the earliest year presented. (Comparability)
- 3. Report Changes prospectively (in the future)-
Define: Cumulative Effect
the difference in prior years' income btwn the newly adopted and prior accounting method.
answers.com: Cumulative Effect of a Change in Accounting Principle- Income statement account reflecting the Net of Tax effect of switching from one principle to another. Cumulative effect equals the difference between the actual retained earnings reported at the beginning of the year using the old method and the retained earnings that would have been reported at the beginning of the year if the new method had been used in prior years. Assume in 2005 a company goes from straightline depreciation to sum-of-the-years'-digits depreciation. In 2005, the new method is used to determine depreciation expense. However, the cumulative on prior years of the difference between straight-line (e.g., $50) and sum-of-the-years'-digits (e.g., $65) must be noted. The difference is charged to the cumulative effect account. The entry is to debit cumulative effect $15 and credit accumulated depreciation $15.
Define: Retrospective Application
Application to recast previously issued financial statements- as if the new principle had always been used.
FASB requires which approach for reporting changes in accounting principles?
Retrospective approach because it provides financial statement users with more useful information.
How do you account for retrospective accounting changes?
- 1. Adjust financial statements for each prior period presented.
- 2. Adjusts the carrying amounts of assets and liabilities as of the beg. of the first year presented. Make offsetting adjustment to the opening balance of retained earnings or other appropriate component of stockh. equity or net assets as of the beg. of the first yr presented.
Direct Effect of changes
is an adjustment to an inventory balance as a result of a change in the inventory valuation method.
Indirect Effect Changes
is any change to current or future cash flows of a company that result from making a change in accounting principle that is applied retrospectively.
Does indirect effects change prior period amounts?
Companies should not use retrospective application if one of the following conditions exist:
- 1. Cannot determine the effects of the retrospective application.
- 2. Retrospective application requires assumptions about management's intent in a prior period
- 3. Retrospective application requires significant estimates for a prior period, and the company cannot objectively verify the necessary information to develop these estimates.
In the event it is deemed impracticable to apply the retrospective approach (the conditions) the company should apply which approach?
Prospectively apply the new accounting principle as of the earliest date it is practicable to do so.
Give examples of 7 items that require estimates
- 1. Uncollectible Receivables
- 2. Inventory obsolescence
- 3. Useful lives and salvage values of assets
- 4. periods benefited by deferred costs
- 5. liabilities for warranty costs and income taxes
- 6. recoverable mineral reserves
- 7. change in depreciation methods.
Changes in accounting estimates are reported using which approach?
Prospectively. N they acct for the effect in the period of change and future periods when it applies
How does FASB view changes in estimates?
As a normal recurring corrections and adjustments, natural result of the accounting process.
If it is impossible to determine whether a change in principle or a change in estimate has occurred, the rule is....
consider the change as a change in estimate. AKA "change in estimate effected by a change in accounting principle"
Changes in Depreciation, amortization or depletion use which method?
change in estimate effected by a change in accounting principle
What is the general rule when it is difficult to differentiate between a change in estimate and a correction of error?
Companies should consider careful estimates that later prove to be incorrect as changes in estimate.
Change in reporting entity report the change by....
Changing the financial statements of all prior periods presented.
Give some examples of a change in reporting entity (New reporting entity)
- Presenting consolidated statements in place of statements of individual companies
- Changing specific subsidiaries that constitute the group of companies for which the entity presents consolidated financial statements.
- Changing the companies included in combined financial statements
- Changing the cost, equity, or consolidation method of accounting for subsidiaries and investments.
In general accounting errors include the following types:
- 1. incorrectly presented prior periods because of the application of an improper accting principle. A change from an accounting principle that is NOT generally accepted to an accounting principle. Ex: company may change from the cash (income tax) basis of accting to the accrual basis.
- 2. Mathematical mistakes. Ex: incorrectly totaling inventory count sheets when computing the inventory value
- 3. Changes in estimates that occur cuz a company did not prepare the estimates in good faith. Ex: a company may have adopted a clearly unrealistic depreciation rate.
- 4. An oversight, such as the failure to accrue or defer certain expenses & revenues at the end of the period.
- 5. A misuse of facts, such as the failure to use salvage value in computing the depreciation base for the straigh-line approach.
- 6. The incorrect classification of a cost as an expense instead of an asset, and vice versa
What is prior period adjustments?
Recording corrections of errors from prior periods as an adjustment to the beginning balance of retained earnings in the current period
If it presents comparative statements, a company should ______ the prior statements affected, to correct for the error.
restate - the term restatement is used for the process of revising previously issued financial statements to reflect the correction of an error. This distinguishes an error correction from a change in accounting principle.
Comparative statements definition:
Financial statements that follow a consistent format but which cover different periods of time. Useful for spotting trends.
Changes in Accounting principle are appropriate ____ when a company demonstrates that the newly adopted generally accepted accounting principle is __________ to the existing one.
How do companies and accountants define preferability?
They determine preferability on the basis of whether the new principle constitutes an improvement in financial reporting, not on the basis of the income tax effect alone.
How do companies treat errors?
As prior-period adjustments and report them in the current year as adjustments to the beginning balance of Retained Earnings.
Companies treat errors as prior-period adjustments and report them in the current year as adjustments to the beginning balance of Retained Earnings... but when would a company restate the prior affected statements to correct for an error?
If a company presents comparative statements.
How are Balance Sheet Errors corrected?
- reclassifies the item to its proper position (When the error is discovered)
- OR- if company prepares comparative statements that include the error year, then correctly restate the balance sheet for the error year.
Why? BS errors affect ONLY the presentation of an asset, Liab, or Equity acct.
Ex: Classification of short-term receivable as part of the investment section OR note payable as an account payable OR plat assets as inventory
Income statement errors involve the improper classification of _________ or __________
revenues or expenses
- Ex: recording % revenue as part of sales, purchases as bad debt expense OR depr expense as % expense
- pg. 1205
How does a company make a correction when there is an income statement error?
- Reclassify entry when it is discovered, if it makes the discovery in the same year in which the error occurs.
- OR- If the company prepares comparative statements that include the error year, it restates the income statement for the error year.
Why? Because prior years I/S r already closed out to the Retained Earnings, so errors in prior yrs do not need to be reclassified at all cuz the accts for the current year are correctly stated.
Does the Income Statement classification error effect the balance sheet or the net income or both?
Neither. An income statement classification error has No effect on the balance sheet and NO effect on net income.
Error analysis: What 3 questions must be answered?
- 1. What type of error is it? B/S, I/S or both.
- 2. What entries are needed to correct for the error?
- 3. After the discovery of the error, how are financial statements to be restated?
Balance Sheet Errors effect income statement, equity or both?
Neither. B/S errors have improper classification and only effect the presentation of the B/S. So, to correct it reclassify it or for comparative statements restate the B/S if it involves the error yr.
If an error involves both a B/S and I/S error what do you do?
You classify either by Counterbalancing Errors OR Noncounterbalancing Errors
Define Counterbalancing Errors
Errors that will be offset or corrected over two periods.
Most errors fall under the counterbalancing errors.
Define Noncounterbalancing Error
Errors that take longer than two periods to correct themselves.