GAAP Updates
This document is an updated version of Chapter 21 of the 2006 Edition of Wiley GAAP in order to reflect the May 2005 issuance of FAS 154, Accounting Changes and Error Corrections.
21 ACCOUNTING POLICIES, CHANGES AND RESTATEMENTS
PERSPECTIVE AND ISSUES
Under US GAAP, management is granted the flexibility of choosing between or among certain alternative methods to account for the same economic transactions. Examples of this are provided in this publication in diverse areas such as the different cost-flow assumptions used to account for inventory and cost of sales, different methods of depreciating long-lived assets, and different methods of identifying operating segments. The professional literature (in the areas of accounting principles, auditing standards, quality control standards, and professional ethics) is emphatic that, in choosing from the various alternatives, management is to choose principles and apply them in a manner that results in financial statements that are representationally faithful to economic substance over form and fully transparent to the user.
Changes can occur over time due to changes in the assumptions and estimates underlying the application of accounting principles and methods of applying them, changes in the principles defined as acceptable by a standards-setting authority, or other types of changes.
The accounting for and disclosure of changes in accounting for given transactions are issues that have confronted the accounting profession for many years. The matter is particularly sensitive because of the impact on financial statement analysis of differing methods of accounting for specific transactions, and of disclosing the effects of those changes, This impact can have a profound influence on investing and operational decisions. Financial statement analysis presumes the consistency and comparability of financial statements across periods and among entities within industry groupings. Any type of accounting change potentially can create inconsistency, and since some change is inevitable, the challenge is to present the effects of the change in a manner that is most readily comprehended by users of financial statements, who may make various adjustments of their own to make the information comparable for analysis purposes.
This concern is exacerbated by the fact that events in the late 1900s and early 2000s have created a growing crisis of confidence about the accuracy of financial reports and the credibility of the parties associated with preparing and auditing them. The number and magnitude of restatements of previously issued financial statements, with reportedly as many as 10% of all publicly traded companies having at least one such restatement over a recent four-year period, has raised disturbing questions about management manipulation and the possible complicity, or at least negligence, of external auditors. The enactment of the Sarbanes-Oxley Act of 2002 and the restructuring of oversight of the auditing profession were two consequences of this series of unfortunate developments. The move to "converge" US GAAP and international accounting standards is a further indicator of the premium now being placed on accurate, transparent, and uniform financial reporting.
When contemplating a potential change in accounting principle, a primary focus of management should be to consider its effect on financial statement comparability.
In May 2005, as part of the joint FASB-IASB effort to converge US GAAP and International Financial Reporting Standards, FASB issued FAS 154, Accounting Changes and Error Corrections, which superseded APB 20 and essentially conformed US GAAP practice to that under international standards (IFRS). FAS 154 requires retrospective application of a newly adopted accounting policy for most changes in accounting principle, including changes in accounting principle required by newly issued pronouncements. FASB did, however, retain the right to require different transition provisions for changes in accounting principle mandated by the future issuance of new pronouncements, should it deem such differences to be appropriate. In another significant alteration, FAS 154 also requires the reporting of a change in depreciation, amortization, or depletion method as a change in an accounting estimate rather than a change in principle, as had been required under APB 20.
An accounting change is defined as a change in
- Accounting principle
- Accounting estimate
- Reporting entity
While the correction of an error in previously issued financial statements is not considered an accounting change, per se, this subject is also dealt with by FAS 154, which specifically restricts the use of the term "restatement" to corrections of prior period errors.
FAS 154 retains and restates the concept from the predecessor standard, APB 20, that in the preparation of financial statements there is an underlying presumption that an accounting principle, once adopted, should not be changed in accounting for events and transactions of a similar type. This consistent use of accounting principles is intended to enhance the utility of financial statements. The presumption that an enterprise should not change an accounting principle may be overcome only if management justifies the use of an alternative acceptable accounting principle on the basis that it is actually preferable.
FAS 154 does not provide a definition of preferability or criteria by which to make such assessments. Because there is no universally agreed-upon set of objectives for external financial reporting, what is preferable to one industry or company is not necessarily considered preferable to another. This may serve to perpetuate some of the same reporting inconsistencies that existed prior to the issuance of FAS 154 and prior to its predecessor standard, APB 20.
SAS 69 (discussed in Chapter 1) requires that an entity adopt the accounting principles set forth in pronouncements with effective dates after March 15, 1992. An entity initially applying an accounting principle after that date (including those making an accounting change) must follow the applicable GAAP hierarchy set forth in SAS 69. An entity following an established accounting principle that was effective on or before March 15, 1992, need not change its accounting until a new pronouncement is issued.
In February 2003, the FASB staff began issuing FASB Staff Positions (abbreviated in this publication as FSP and discussed more fully in Chapter 1) to provide guidance on the application of its authoritative literature. Unless otherwise specified, FSP will be effective for new transactions or arrangements entered into after the beginning of the first fiscal quarter following the date of final posting of the FSP to the FASB Web site (http://www.FASB.org). FSP are included in the FAS 154 definition of "accounting pronouncement" and, thus, in the rare instance that an FSP is silent regarding transition, the reporting entity will be required to retrospectively apply the new FSP to all prior periods.
|
DEFINITIONS OF TERMS
Accounting change. In the context of FAS 154, an accounting change is one of three types of modifications that affect a reporting entity's accounting principles and practices, or its application of them. The three types of accounting changes are: (1) a change in accounting principle from one generally accepted accounting principle to another alternative that is considered preferable, (2) a change in an accounting estimate, and (3) a change in the reporting entity. Although, technically, corrections of errors in prior periods' financial statements (referred to as "restatements"), are not accounting changes, their treatment is also governed by FAS 154.
Accounting principle. A methodology used to measure and report the monetary effects of economic events in financial statements. Acceptable accounting principles are either prescribed by a recognized standard-setting body in an authoritative pronouncement or, in the absence of a relevant pronouncement, are predominantly followed by entities that engage in transactions of a similar nature or operate in a particular industry or profession. In the context of FAS 154, accounting principles encompass both accounting practices and the methods of applying them.
Change in accounting estimate. A revision of an accounting measurement based on the occurrence of new events, additional experience, subsequent developments, better insight, and improved judgment. Refining previously made estimates is an inherent part of the accounting process.
Change in accounting estimate effected by a change in accounting principle. A change in accounting estimate that is inseparable from the effect of a related change in accounting principle (for example, a change in depreciation method).
Change in accounting principle. A change from one generally accepted accounting principle to another generally accepted accounting principle, including the methods of applying the principles. This does not include selection and adoption of an accounting principle to account for the substance and/or form of events (1) occurring for the first time in the operations of a given reporting entity or (2) that had occurred in the past but that were previously considered immaterial. A change in accounting principle can also occur when an authoritative standards setter issues a new standard that renders an existing accounting principle no longer acceptable.
Change in reporting entity. A special type of change in accounting principle that results in financial statements that, in effect, are those of a different reporting entity. Financial statements are prepared for an entity that is different from the one reported on in previous financial statements. Specifically excluded from this type of accounting change are business combinations under FAS 141 and consolidation of variable interest entities under FIN 46R.
Comparability. The quality of information that enables users to identify similarities in and differences between two sets of economic circumstances. Normally, comparability is a quantitative assessment of a common characteristic.
Consistency. Conformity from period to period with unchanging policies and procedures. Consistency enhances the utility of financial statements to users by facilitating analysis and understanding of comparative accounting data.
Cumulative effect. The difference between the retained earnings balance at the beginning of the year in which a change is reported and the beginning retained earnings balance that would have been reported if the new principle had been applied retrospectively in all prior periods that would have been affected.
Errors. Mathematical mistakes, mistakes in applying accounting principles, oversight or misuse of available facts, and use of unacceptable GAAP.
Restatement. The revision of previously issued financial statements in order to correct an error made in preparing them (see definition of "errors" above). Under FAS 154, this term is only to be used in the context of error corrections and not to describe any other types of financial statement changes.
CONCEPTS, RULES, AND EXAMPLES
Initial Adoption Decisions
Upon formation of a business or nonprofit organization, management makes decisions regarding the adoption of accounting policies, based on the types of activities in which the entity engages and the industry and environment in which it operates. Certain types of events and transactions are subject to GAAP that permits choices to be made from among alternative, acceptable accounting treatments. The principles selected from among the available alternatives and the methods of applying those principles constitute the reporting entity's accounting policies.
Management initially adopts accounting principles at two distinct times
- Upon formation of the reporting entity.
- Upon the occurrence of a new type of event or transaction that had either not happened in the past or had previously been judged to be immaterial.
Once the initial adoption decisions are made, the users of the financial statements expect a reporting entity's financial statements to be prepared consistently over time. This facilitates comparisons across periods and among different reporting enterprises.
Accounting Changes
There are legitimate reasons why a reporting entity would change its accounting, either voluntarily or because it is required to do so.
- Changing to an existing alternative accounting principle that management deems to be preferable to the one it is currently following.
- Adopting a newly issued accounting principle.
- Refining an estimate made in the past as a result of further experience and better information.
- Correcting an error made in previously issued financial statements. Although technically not an "accounting change" as defined in GAAP literature, this involves restating previously issued financial statements and is governed by FAS 154, the same accounting pronouncement as 1. – 3. above.
To facilitate accurate analysis, it is important for management of the reporting entity to adequately inform the financial statement users when one or more of these changes is made, and to provide sufficient information to enable the reader to distinguish the effects of the change from other factors affecting results of operations.
FAS 154, Accounting Changes and Error Corrections, was issued in May 2005 in order to more closely conform the treatment of accounting changes under US GAAP to international financial reporting standards under IAS 8 (see Appendix B, International vs. US Accounting Standards). It applies to financial statements of commercial businesses and not-forprofit organizations as well as historical summaries and other presentations derived from them that include one or more periods reflecting an accounting change or error correction.
FAS 154 is effective for accounting changes and error corrections made in fiscal years beginning after December 15, 2005 (i.e., for calendar 2006 and later periods). Early adoption is permitted for changes occurring in fiscal years beginning on or after June 1, 2005.
Each of the types of accounting changes and the proper treatment prescribed for them is discussed in detail in the following sections.
Change in Accounting Principle
Management is permitted to change from one generally accepted accounting principle to another only when (1) it voluntarily decides to do so and can justify the use of the alternative accounting principle as being preferable to the principle currently being followed, or (2) it is required to make the change as a result of a newly issued accounting pronouncement. If the change is being made voluntarily, the financial statements of the period of change are to include disclosure of the nature of and reason for the change and an explanation of why management believes the newly adopted accounting principle is preferable. In accordance with FIN 1, this preferability assessment is required to be made from the perspective of financial reporting, and not solely from an income tax perspective. Thus, favorable income tax consequences alone do not justify making a change in financial reporting practices.
According to FAS 154, the term "accounting principle" includes the accounting principles and practices used by the reporting entity as well as its methods of applying them. FIN 1 elaborates on this by stating that a change in the components used to cost a firm's inventory is considered a change in accounting principle and, therefore, is only permitted when the new inventory costing method is preferable to the former method.
FAS 154 provides that changes in accounting principle be reflected in financial statements by retrospective application to all prior periods presented unless it is impracticable to do so. This is a significant departure from the predecessor standard, APB 20, which had required current accounting for such changes, using the cumulative effect method. FAS 154 points out, however, that in the future when new accounting principles are issued, those pronouncements will include specific provisions regarding transitioning to the new principles that are to be followed by adopting entities. Thus, future standards may still provide for adoption using cumulative effect adjustments, if FASB believes this to be the most beneficial method of transition. The new default method, however, will be retrospective restatement, whereas previously it was cumulative effect adjustment included in current results of operations.
Retrospective application. Retrospective application is accomplished by the following steps:
At the beginning of the first period presented in the financial statements,
Step 1 - Adjust the carrying amounts of assets and liabilities for the cumulative effect of changing to the new accounting principle on periods prior to those presented in the financial statements.
Step 2 - Offset the effect of the adjustment in Step 1 (if any) by adjusting the opening balance of retained earnings (or other components of equity or net assets, as applicable to the reporting entity).
For each individual prior period that is presented in the financial statements,
Step 3 - Adjust the financial statements for the effects of applying the new accounting principle to that specific period.
Example of retrospective application of a new accounting principle
In 1998, upon the incorporation of Newburger Company, its management elected to recognize advertising costs as incurred. Newburger has been consistently following that policy in its financial statements. In 2007, Newburger's management reviewed its accounting policies and concluded that application of its current policy was resulting in substantial costs associated with the production of television advertising being recognized in financial reporting periods that preceded the periods in which the related revenues were earned. Consequently, management decided to change Newburger's policy to elect to expense advertising costs the first time the advertising takes place as permitted by SOP 93-7, Reporting on Advertising Costs. Additional assumptions follow:
- As has been its policy in the past, Newburger plans to issue comparative financial statements presenting two years, 2007 and 2006.
- Newburger does not engage in direct-response advertising activities (SOP 93-7)
- A combined federal and state income tax rate of 40% was in effect for all relevant periods.
- Prior to the change in accounting principle, there were no temporary differences or loss carryforwards and, thus, there were no deferred income tax assets or liabilities
- Advertising costs are deductible for income tax purposes when incurred and, therefore, upon adoption of the new accounting policy, Newburger will have a temporary difference between the book and income tax bases of its asset, deferred advertising costs. These advertising costs that are being recognized in the financial statements in the year after they are deducted on Newburger's income tax return represent a taxable temporary difference that will give rise to a deferred income tax liability.
- The financial statements originally issued as of and for the years ended December 31, 2006 and 2005, prior to the adoption of the new accounting principle are presented below with advertising-related captions shown separately for illustrative purposes
Newburger Company
Statements of Income and Retained Earnings
Prior to Change in Accounting Principle
Years Ended December 31, 2006 and 20052006 2005 Sales $ 2,300,000 $ 2,000,000 Cost of sales
(850,000) (750,000) Gross profit
1,450,000 1,250,000 Advertising expense
(65,000) (55,000) Other selling, general and administrative expenses
(385,000)
450,000(445,000)
500,000Income from operations
1,000,000 750,000 Other income (expense)
11,000 10,000 Income before income taxes
1,011,000 760,000 Income taxes
(404,000) (304,000) Net income
607,000 456,000 Retained earnings, beginning of year
13,756,000 14,500,000 Dividends
(1,400,000) (1,200,000) Retained earnings, end of year $12,963,000 $13,756,000
Newburger Company Balance Sheets Prior to Change in Accounting Principle December 31, 2006 and 2005 |
||||
---|---|---|---|---|
2006 | 2005 | |||
Assets | ||||
Current assets |
||||
Cash and cash equivalents |
$ 2,200,000 | $ 2,400,000 | ||
Deferred advertising cost |
||||
Prepaid expenses |
125,000 | 120,000 | ||
Other current assets |
22,000 | 20,000 | ||
Total current assets | 2,347,000 | 2,540,000 | ||
Property and equipment | 10,729,000 | 11,311,000 | ||
Total assets | $13,076,000 | $13,851,000 | ||
Liabilities and Stockholders' Equity | ||||
Deferred income taxes | $ -- | $ -- | ||
Other current liabilities | 35,000 | 12,000 | ||
Total current liabilities | 35,000 | 12,000 | ||
Noncurrent liabilities | 65,000 | 70,000 | ||
Total liabilities | 100,000 | 82,000 | ||
Stockholders' equity | ||||
Common stock |
13,000 | 13,000 | ||
Retained earnings |
12,963,00 | 13,756,000 | ||
Total stockholders' equity | 12,976,000 | 13,769,000 | ||
Total liabilities and stockholders' equity | $13,076,000 | $13,851,000 |
Newburger Company Statements of Cash Flows Prior to Change in Accounting Principle Years Ended December 31, 2006 and 2005 |
||||
---|---|---|---|---|
2006 | 2005 | |||
Operating activities | ||||
Net income | $ 607,000 | $ 456,000 | ||
Depreciation | 715,000 | 715,000 | ||
Deferred income taxes | ||||
Gain on sale of property and equipment | ||||
Changes in | ||||
Deferred advertising costs | ||||
Prepaid expenses | (5,000) | 1,000 | ||
Other current assets | (2,000) | 1,500 | ||
Other current liabilities | 23,000 | 900 | ||
Net cash provided by operating activities | 1,338,000 | 1,174,400 | ||
Investing activities | ||||
Property and equipment | ||||
Acquisition | (133,000) | (120,000) | ||
Proceeds from sale | ---------- | ---------- | ||
Net cash used for investing activities | (133,000) | (120,000) | ||
Financing activities | ||||
Dividends paid to stockholders | (1,400,000) | (1,200,000) | ||
Long-term debt | ||||
Borrowed | ||||
Repaid | (5,000) | (5,000) | ||
Net cash used for financing activities | (1,405,000) | (1,205,000) | ||
Decrease in cash and cash equivalents | (200,000) | (150,600) | ||
Cash and cash equivalents, beginning of year | 2,400,000 | 2,550,600 | ||
Cash and cash equivalents, end of year | $2,200,000 | $2,400,000 |
Step 1 - Adjust the carrying amounts of assets and liabilities at the beginning of the first period presented in the financial statements for the cumulative effect of changing to the new accounting principle on periods prior to those presented in the financial statements.
In this example, the preparer refers to the previously issued 2005 financial statements presented above. Assume the following data regarding advertising costs at December 31, 2005/January 1, 2006.
Costs incurred during 2005 for advertising that will not take place
for the first time until 2006$25,000 Deferred income tax liability that would have been recognized at
December 31, 2005, computed at 40% of the temporary difference(10,000) Net adjustment to beginning assets and liabilities $15,000 Step 2 - Offset the effect of the adjustment in Step 1 by adjusting the opening balance of retained earnings (or other components of equity or net assets, as applicable to the reporting entity).
The $15,000 net effect of the adjustment in Step 1 is presented in the statement of income and retained earnings as an adjustment to the January 1, 2006 retained earnings as previously reported at December 31, 2005.
Step 3 - Adjust the financial statements of each individual prior period presented for the effects of applying the new accounting principle to that specific period.
In this case, the following adjustments are necessary to restate the 2006 financial statements for the period-specific effects of the change in accounting principle
Cost incurred in Year the advertising
was first run2005 2006 $ 25,000 2006 2004 (45,000) Pretax, period-specific adjustment to advertising costs at 12/31/06 (20,000) × 40% income tax effect 8,000 Effect on 2006 net income $(12, 000)
Adjustments to the 2006 financial statements for the period-specific effects of retrospective application of the new accounting principle are
Adjustmenst to 2006 financial statements | ||||||||
Deferred advertising costs |
Deferred income tax liability |
Advertising expense |
Income tax expense |
|||||
Balance at 12/31/06 prior to adjustment | $ -- | $ -- | $65,000 | $404,000 | ||||
Adjustment to opening balances from retrospective application to 2005 | 25,000 | 10,000 | -- | -- | ||||
Advertising costs incurred in 2005, first run in 2006 | (25,000) | -- | 25,000 | -- | ||||
Advertising costs incurred in 2006, first run in 2007 | 45,000 | -- | (45,000) | -- | ||||
(20,000) | ||||||||
Income tax effect of net adjustment to 2006 advertising expense (40%) | -- | 8,000 | -- | 8,000 | ||||
Adjusted amounts for 2006 financial statements | $45,000 | $18,000 | $45,000 | $412,000 |
The adjusted comparative financial statements, reflecting the retrospective application of the new accounting principle, follow.
Newburger Company Statements of Income and Retained Earnings Reflecting Retrospective Application of Change in Accounting Principle Years Ended December 31, 2007 and 2006 |
||||
---|---|---|---|---|
2007 | 2006 as adjusted |
|||
Sales | $ 2,700,000 | $ 2,300,000 | ||
Cost of sales | 995,000 | 850,000 | ||
Gross profit | 1,705,000 | 1,450,000 | ||
Advertising expense | 66,000 | 45,000 | ||
Other selling, general, and administrative expenses | 423,000 | 385,000 | ||
489,000 | 430,000 | |||
Income from operations | 1,216,000 | 1,020,000 | ||
Other income (expense) | 9,000 | 11,000 | ||
Income before income taxes | 1,225,000 | 1,031,000 | ||
Income taxes | 490,400 | 412,000 | ||
Net income | 734,600 | 619,000 | ||
Retained earnings, beginning of year, as originally reported | 13,756,000 | |||
Adjustment for retrospective application of new accounting principle (Note X) | 15,000 | |||
Retained earnings, beginning of year, as adjusted | 12,990,000 | 13,771,000 | ||
Dividends | 1,600,000 | 1,400,000 | ||
Retained earnings, end of year | $12,124,600 | $12,990,000 |
Newburger Company Balance Sheets Reflecting Retrospective Application of Change in Accounting Principle Years Ended December 31, 2007 and 2006 |
||||
---|---|---|---|---|
2007 | 2006 as adjusted |
|||
Assets | ||||
Current assets | $ 2,382,000 | $ 2,200,000 | ||
Cash and cash equivalents | 16,000 | 45,000 | ||
Deferred advertising costs | 123,000 | 125,000 | ||
Prepaid expenses | 21,000 | 22,000 | ||
Other current assets | ||||
Total current assets | 2,542,000 | 2,392,000 | ||
Property and equipment | 9,800,000 | 10,729,000 | ||
Total assets | $12,342,000 | $13,121,000 | ||
Liabilities and stockholders' equity | ||||
Deferred income taxes | $ 6,000 | $ 18,000 | ||
Other current liabilities | 36,000 | 35,000 | ||
Total current liabilities | 42,400 | 53,000 | ||
Noncurrent liabilities | 162,000 | 65,000 | ||
Total liabilities | 204,400 | 118,000 | ||
Stockholders' equity | ||||
Common stock | 13,000 | 13,000 | ||
Retained earnings | 12,124,600 | 12,990,000 | ||
Total stockholders' equity | 12,137,600 | 13,003,000 | ||
Total liabilities and stockholders' equity | $12,342,000 | $13,121,000 |
Newburger Company Statements of Cash Flows Reflecting Retrospective Application of Change in Accounting Principle Years Ended December 31, 2007 and 2006 |
||||
---|---|---|---|---|
2007 | 2006 as adjusted |
|||
Operating activities | ||||
Net income | $ 734,600 | $ 619,000 | ||
Depreciation | 725,000 | 715,000 | ||
Deferred income taxes | (11,600) | 8,000 | ||
Gain on sale of property and equipment | (1,200,000) | -- | ||
Changes in | ||||
Deferred advertising costs | 29,000 | (20,000) | ||
Prepaid expenses | 2,000 | (5,000) | ||
Other current assets | 1,000 | (2,000) | ||
Other current liabilities | 1,000 | 23,000 | ||
Net cash provided by operating activities | $ 281,000 | $1,338,000 | ||
Investing activities | ||||
Property and equipment | ||||
Acquisition | (1,096,000) | (133,000) | ||
Proceeds from sale | 2,500,000 | -- | ||
Net cash provided by (used for) investing activities | 1,404,000 | (133,000) | ||
Financing activities | ||||
Dividends paid to stockholders | (1,600,000) | (1,400,000) | ||
Long-term debt | ||||
Borrowed | 105,000 | -- | ||
Repaid | (8,000) | (5,000) | ||
Net cash used for financing activities | (1,503,000) | (1,405,000) | ||
Increase (decrease) in cash and cash equivalents | 182,000 | (200,000) | ||
Cash and cash equivalents, beginning of year | 2,200,000 | 2,400,000 | ||
Cash and cash equivalents, end of year | $2,382,000 | $2,200,000 |
It is important to note that, in presenting the previously issued financial statements for 2006, the caption "as adjusted" is included in the column heading. Prior to the issuance of FAS 154, many preparers used the caption "as restated." FAS 154 explicitly defines a restatement as a revision to previously issued financial statements to correct an error. Therefore, to avoid misleading the financial statement reader, use of the terms restatement or restated should be limited to prior period adjustments to correct errors as discussed later in this chapter.
Indirect effects. The example above only reflects the direct effects of the change in accounting principle, net of the effect of income taxes. Changing accounting principles sometimes results in indirect effects from legal or contractual obligations of the reporting entity, such as profit sharing or royalty arrangements that contain monetary formulas based on amounts in the financial statements. In the preceding example, if Newburger Company had an incentive compensation plan that required it to contribute 15% of its pretax income to a pool to be distributed to its employees, the adoption of the new accounting policy would potentially require Newburger to provide additional contributions to the pool computed as
Pretax effect of retroactive application |
Contractual rate |
Indirect effect |
||||
Prior to 2006 | $25,000 | 15% | $3,750 | |||
2006 | (20,000) | 15% | (3,000) | |||
$ 750 |
Contracts and agreements are often silent regarding how such a change might affect amounts that were computed (and distributed) in prior years. Management of Newburger Company might have discretion over whether to make the additional contributions. Further, it would probably consider it undesirable to reduce the 2006 incentive compensation pool because of an accounting change of this nature, and it might thus decide for valid business reasons not to reduce the pool under these circumstances.
FAS 154 specifies that irrespective of whether the indirect effects arise from an explicit requirement in the agreement or are discretionary, if incurred they are to be recognized in the period in which the reporting entity makes the accounting change, which is 2007 in the example above.
Impracticability exception. All prior periods presented in the financial statements are required to be adjusted for the retroactive application of the newly adopted accounting principle, unless it is impracticable to do so. FASB recognized that there are certain circumstances when there is a change in accounting principle when it will not be feasible to compute (1) the retroactive adjustment to the prior periods affected or (2) the period-specific adjustments relative to periods presented in the financial statements presented.
In order for management to assert that it is impracticable to retrospectively apply the new accounting principle, one or more of the following conditions must be present:
- Management has made a reasonable effort to determine the retrospective adjustment and is unable to do so.
- If it were to apply the new accounting principle retrospectively, management would be required to make assumptions regarding its intent in a prior period that would not be able to be independently substantiated.
- If it were to apply the new accounting principle retrospectively, management would be required to make significant estimates of amounts for which it is impossible to develop objective information that would have been available at the time the original financial statements for the prior period (or periods) were issued to provide evidence of circumstances that existed at that time regarding the amounts to be measured, recognized, and/or disclosed by retrospective application.
Inability to determine period-specific effects. If management is able to determine the adjustment to beginning retained earnings for the cumulative effect of applying the new accounting principle to periods prior to those presented in the financial statements, but is unable to determine the period-specific effects of the change on all of the prior periods presented in the financial statements, FAS 154 requires the following steps to adopt the new accounting principle:
- Adjust the carrying amounts of the assets and liabilities for the cumulative effect of applying the new accounting principle at the beginning of the earliest period presented for which it is practicable to make the computation.
- Any offsetting adjustment required by applying step 1. is made to beginning retained earnings (or other applicable components of equity or net assets) of that period.
Inability to determine effects on any prior periods. If it is impracticable to determine the cumulative effect of adoption of the new accounting principle on any prior periods, the new principle is applied prospectively as of the earliest date that it is practicable to do so. The most common example of this occurs when management of a reporting entity decides to change its inventory costing assumption from first-in, first-out (FIFO) to last-in, first-out (LIFO), as illustrated in the following example:
Example of change from FIFO to LIFO
During 2007 Warady Inc. decided to change the method used for pricing its inventories from FIFO to LIFO. The inventory values are as listed below using both FIFO and LIFO methods.
Sales for the year were $15,000,000 and the company's total purchases were $11,000,000. Other expenses were $1,200,000 for the year. The company had 1,000,000 shares of common stock outstanding throughout the year.
Inventory values | ||||||
FIFO | LIFO | Difference | ||||
12/31/06 Base year | $ 2,000,000 | $2,000,000 | $ -- | |||
12/31/07 | 4,000,000 | 1,800,000 | 2,200,000 | |||
Variation | $ 2,000,000 | $ ( 200,000) | $ 2,200,000 |
The computations for 2007 would be as follows:
FIFO | LIFO | Difference | ||||
Sales | $15,000,000 | $15,000,000 | $ -- | |||
Cost of goods sold | ||||||
Beginning inventory | 2,000,000 | 2,000,000 | -- | |||
Purchases | 11,000,000 | 11,000,000 | -- | |||
Goods available for sale | 13,000,000 | 13,000,000 | -- | |||
Ending inventory | 4,000,000 | 1,800,000 | 2,200,000 | |||
9,000,000 | 11,200,000 | (2,200,000) | ||||
Gross profit | 6,000,000 | 3,800,000 | 2,200,000 | |||
Other expenses | 1,200,000 | 1,200,000 | -- | |||
Net income | $ 4,800,000 | $ 2,600,000 | $2,200,000 |
The following is an example of the required disclosure in this circumstance:
Note A: Change in Method of Accounting for Inventories
During 2007, the company changed its method of accounting for all of its inventories from first-in, first-out (FIFO) to last-in, first-out (LIFO). The change was made because management believes that the LIFO method provides a better matching of costs and revenues. In addition, the adoption of LIFO conforms the company's inventory pricing policy to the one that is predominant in the industry. The change and its effect on net income ($000 omitted except for per share amounts) and earnings per share for 2007 are as follows:
Net income | Earnings per share | |||
Net income before the change | $4,800 | $4.80 | ||
Reduction of net income due to the change | 2,200 | 2.20 | ||
Net income as adjusted | $2,600 | $2.60 |
Management has not retrospectively applied this change to prior years' financial statements because beginning inventory on January 1, 2007, using LIFO is the same as the amount reported on a FIFO basis at December 31, 2006. As a result of this change, the current period's financial statements are not comparable with those of any prior periods. The FIFO cost of inventories exceeds the carrying amount valued using LIFO by $2,200,000 at December 31, 2007.
Reclassifications
Occasionally, a company will choose to change the way it applies an accounting principle that results in a change in the way that a particular financial statement caption is displayed or in the individual general ledger accounts that comprise a caption. These reclassifications may occur for a variety of reasons that include
- In management's judgment, the revised methodology more accurately reflects the economics of a type or class of transaction.
- An amount that was immaterial in previous periods and combined with another number has become material and warrants presentation as a separately captioned line item.
- Due to changes in the business or the manner in which the financial statements are used to make decisions, management deems a different form of presentation to be more useful or informative.
In order to maintain comparability of financial statements when such changes are made, the financial statements of all periods presented must be reclassified to conform to the new presentation.
Such reclassifications, which usually affect only the statement of income, do not affect reported net income or retained earnings for any period since they result in simply recasting amounts that were previously reported. Normally a reclassification will result in an increase in one or more reported numbers with a corresponding decrease in one or more other numbers. In addition, these changes reflect changes in the application of accounting principles either for which there are multiple alternative treatments, or for which GAAP is silent and thus management has discretion in presentation.
Reclassifications are not explicitly dealt with in GAAP but nevertheless do commonly occur in practice. The following examples are adapted from actual notes that appeared in the summary of significant accounting policies of publicly held companies:
Example 1
Effective January 1, 2007, the company removed the impact of intellectual property income, gains and losses on sales and other-than-temporary declines in market value of certain investments, realized gains and losses on certain real estate activity, and foreign currency transaction gains and losses from the caption, "Selling, General and Administrative Expenses" in the Consolidated Statement of Income. Custom development income was also removed from the "Research, Development, and Engineering" caption on the Consolidated Statement of Income. Intellectual property and custom development income are now presented in a separate caption in the Consolidated Statement of Income. The other items listed above are now included as part of "Other Income and Expense." Results of prior periods have been reclassified to conform to the current year presentation.
Example 2
Effective January 1, 2007, management has elected to reclassify certain expenses in its consolidated statements of income. Costs of the order entry function and certain accounting and information technology services have been reclassified from cost of sales to selling, general, and administrative expense. Costs related to order fulfillment have been reclassified from selling, general, and administrative expense to cost of sales. These reclassifications resulted in a decrease to cost of sales and an increase to selling, general, and administrative expense of $31.8 million, and $36.2 million for the years ended December 31, 2006 and 2005, respectively.
Change in Accounting Estimate
The preparation of financial statements requires frequent use of estimates for such items as asset service lives, salvage values, lease residuals, asset impairments, collectibility of accounts receivable, warranty costs, pension costs, etc. Future conditions and events that affect these estimates cannot be estimated with certainty. Therefore, changes in estimates will be inevitable as new information and more experience is obtained. FAS 154 requires that changes in estimates be recognized currently and prospectively, as did predecessor standard APB 20. The effect of the change in accounting estimate is accounted for in "(a) the period of change if the change affects that period only or (b) the period of change and future periods if the change affects both." The reporting entity is precluded from retrospective application, restatement of prior periods, or presentation of pro forma amounts as a result of a change in accounting estimate.
For example, on January 1, 2007, a machine purchased for $10,000 was originally estimated to have a ten-year useful life and a salvage value of $1,000. On January 1, 2012 (five years later), the asset is expected to last another ten years and have a salvage value of $800. As a result, both the current period (the year ending December 31, 2007) and subsequent periods are affected by the change. Annual depreciation expense over the estimated remaining useful life is computed as follows:
Original cost | $10,000 | |||
Less estimated salvage (residual) value | (1,000) | |||
Depreciable amount | 9,000 | |||
Accumulated depreciation, based original assumptions (10-year life) | ||||
2007 | 900 | |||
2008 | 900 | |||
2009 | 900 | |||
2010 | 900 | |||
2011 | 900 | |||
4,500 | ||||
Carrying value at 1/1/2012 | 5,500 | |||
Revised estimate of salvage value | (800) | |||
Depreciable amount | 4,700 | |||
Remaining useful life at 1/1/2012 | 10 | years | ||
$ 470 | depreciation per year | |||
Effect on 2012 net income | $470 – $900 = $430 increase |
Note A: Change in Accounting Estimate.
During 2012, management assessed its estimates of the useful lives and residual values of the Company's machinery and equipment. Management revised its original estimates and currently estimates that its production equipment acquired in 2007 and originally estimated to have a 10year useful life and a residual value of $1,000 will have a 15-year useful life and a residual value of $800. The effects of reflecting this change in accounting estimate on the 2012 financial statements are as follows:
Increase in | ||
Income from continuing operations and net income | $430.00 | |
Earnings per share (for public companies)* | $ 0.02 | |
* Assuming 25,000 shares were outstanding for all of 2012 |
As another example, the industry in which ABC Company operates suffers a significant downturn, resulting in a decline in the financial condition of its customers, and a noticeable worsening of the days required to collect its accounts receivable. ABC had formerly provided an amount equal to 2% of its credit sales as an increment to the bad debt allowance, resulting in a current balance in the allowance of $105,000. However, the new economic conditions mandate an immediate change to a 4% allowance. Accordingly, ABC provides an additional $105,000 in the current period to increase the previously recorded allowance to meet the new 4% estimate, and also begins providing 4% in the bad debt allowance on all new credit sales. Both these adjustments are reflected in current period expense, even though the increased allowance on existing receivables pertains to sales made (in part) in a prior reporting period, because the change in estimate was made in the current period based on new circumstances that arose in that period.
An impairment of a long-lived asset, as described by FAS 144, is not a change in accounting estimate. Rather, it is an event that is to be treated as an operating expense of the period in which it is recognized, in effect as additional depreciation. (See further discussion in Chapter 9.)
Change in Accounting Estimate Effected by a Change in Accounting Principle
In order to change certain accounting estimates, management must adopt a new accounting principle or change the method it uses to apply an accounting principle. In contemplating such a change, management would not be able to separately determine the effects of changing the accounting principle from the effects of changing its estimate. The change in estimate is accomplished by changing the method.
Under FAS 154, a change in accounting estimate that is effected by a change in accounting principle is to be accounted for in the same manner as a change in accounting estimate, that is, prospectively in the current and future periods affected. However, because management is changing the company's accounting principle or method of applying it, the new accounting principle, as previously discussed, must be preferable to the accounting principle being superseded.
Management may decide, for example, to change its depreciation method for certain types of assets from straight-line to an accelerated method such as double-declining balance to recognize the fact that those assets are more productive in their earlier years of service because they require less downtime and do not require repairs as frequently. Such a change is permitted by FAS 154 only if management justifies it based on the fact that using the new method is preferable to the old one, in this case because it more accurately matches the costs of production to periods in which the units are produced.
A distinction is made in FAS 154, however, for entities that elect to apply a depreciation method that results in accelerated depreciation until the period during the useful life of the depreciable asset when straight-line depreciation of the remaining carrying value would equal or exceed the amount computed using the accelerated method. At this point, the remaining carrying value (net book value) is depreciated using the straight-line method over its remaining useful life. FAS 154 (as did the predecessor standard, APB 20) provides that, if this method is consistently followed by the reporting entity, the changeover to straight-line depreciation is not considered to be an accounting change.
Change in Reporting Entity
An accounting change resulting in financial statements that are, in effect, of a different reporting entity than previously reported on, is retrospectively applied to the financial statements of all prior periods presented in order to show financial information for the new reporting entity for all periods. The change is also retrospectively applied to previously issued interim financial information.
The following qualify as changes in reporting entity:
- Consolidated or combined financial statements in place of individual entities' statements
- A change in the members of the group of subsidiaries that comprise the consolidated financial statements
- A change in the companies included in combined financial statements
Specifically excluded from qualifying as a change in reporting entity are
- A business combination accounted for by the purchase method and
- Consolidation of a variable interest entity under FIN 46R.
Error Corrections
Errors are sometimes discovered after financial statements have been issued. Errors result from mathematical mistakes, mistakes in the application of GAAP, or the oversight or misuse of facts known or available to the accountant at the time the financial statements were prepared. Errors can occur in recognition, measurement, presentation, or disclosure. A change from an unacceptable (or incorrect) accounting principle to a correct principle is also considered a correction of an error, and thus not as a change in accounting principle. Such a change should not be confused with the preferability determination discussed earlier that involves two or more acceptable principles. An error correction pertains to the recognition that a previously used method was not an acceptable method at the time it was employed.
The essential distinction between a change in estimate and the correction of an error depends upon the availability of information. An estimate requires revision because by its nature it is based upon incomplete information. Later data will either confirm or contradict the estimate and any contradiction will require revision of the estimate. An error results from the misuse of existing information available at the time and is discovered at a later date. However, this discovery is not as a result of additional information or subsequent developments.
FAS 154 specifies that, when correcting an error in prior period financial statements, the term "restatement" is to be used. That term is exclusively reserved for this purpose so as to effectively communicate to users of the financial statements the reason for a particular change in previously issued financial statements.
Restatement consists of the following steps:
Step 1 - Adjust the carrying amounts of assets and liabilities at the beginning of the first period presented in the financial statements for the cumulative effect of correcting the error on periods prior to those presented in the financial statements.
Step 2 - Offset the effect of the adjustment in Step 1 (if any) by adjusting the opening balance of retained earnings (or other components of equity or net assets, as applicable to the reporting entity) for that period.
Step 3 - Adjust the financial statements of each individual prior period presented for the effects of correcting the error on that specific period (referred to as the period-specific effects of the error).
Example of prior period adjustment
Assume that Truesdell Company had overstated its depreciation expense by $50,000 in 2005 and $40,000 in 2006, both due to mathematical mistakes. The errors affected both the financial statements and the income tax returns in 2005 and 2006 and are discovered in 2007.
Truesdell's balance sheets and statements of income and retained earnings as of and for the year ended December 31, 2006, prior to the restatement were as follows:
Truesdell Company Statement of Income and Retained Earnings Prior to Restatement Year Ended December 31, 2006 |
||
---|---|---|
2006 | ||
Sales | $2,000,000 | |
Cost of sales | ||
Depreciation | 750,000 | |
Other | 390,000 | |
1,140,000 | ||
Gross profit | 860,000 | |
Selling, general, and administrative expenses | 450,000 | |
Income from operations | 410,000 | |
Other income (expense) | 10,000 | |
Income before income taxes | 420,000 | |
Income taxes | 168,000 | |
Net income | 252,000 | |
Retained earnings, beginning of year | 6,463,000 | |
Dividends | (1,200,000) | |
Retained earnings, end of year | $5,515,000 |
Truesdell Company Balance Sheet Prior to Restatement December 31, 2006 |
||
---|---|---|
2006 | ||
Assets | ||
Current assets | $2,540,000 | |
Property and equipment | ||
Cost | 3,500,000 | |
Accumulated depreciation and amortization | (430,000) | |
3,070,000 | ||
Total assets | $5,610,000 | |
Liabilities and stockholders' equity | ||
Income taxes payable | $ -- | |
Other current liabilities | 12,000 | |
Total current liabilities | 12,000 | |
Noncurrent liabilities | 70,000 | |
Total liabilities | 82,000 | |
Stockholders' equity | ||
Common stock | 13,000 | |
Retained earnings | 5,515,000 | |
Total stockholders' equity | 5,528,000 | |
Total liabilities and stockholders' equity | $5,610,000 |
The following steps are followed to restate Truesdell's prior period financial statements:
Step 1 - Adjust the carrying amounts of assets and liabilities at the beginning of the first period presented in the financial statements for the cumulative effect of correcting the error on periods prior to those presented in the financial statements.
The first period presented in the financial statements is 2006. At the beginning of that year, $50,000 of the mistakes had been made and reflected on both the income tax return and financial statements. Assuming a flat 40% income tax rate and ignoring the effects of penalties and interest that would be assessed on the amended income tax returns, the following adjustment would be made to assets and liabilities at January 1, 2006:
Decrease in accumulated depreciation | $50,000 | |
Increase in income taxes payable | (20,000) | |
$30,000 |
Step 2 - Offset the effect of the adjustment in Step 1 by adjusting the opening balance of retained earnings (or other components of equity or net assets, as applicable to the reporting entity) for that period.
Retained earnings at the beginning of 2006 will increase by $30,000 as the offsetting entry resulting from Step 1.
Step 3 - Adjust the financial statements of each individual prior period presented for the effects of correcting the error on that specific period (referred to as the period-specific effects of the error).
The 2006 prior period financial statements will be corrected for the period-specific effects of the restatement as follows:
Decrease in depreciation expense and accumulated depreciation | $40,000 | |
Increase in income tax expense and income taxes payable | (16,000) | |
Increase 2006 net income | $24,000 |
The restated financial statements are presented below.
Truesdell Company Statements of Income and Retained Earnings As Restated Years Ended December 31, 2007 and 2006 |
||
---|---|---|
2006 restated |
||
Sales | $2,000,000 | |
Cost of sales | ||
Depreciation | 710,000 | |
Other | 390,000 | |
1,100,000 | ||
Gross profit | 900,000 | |
Selling, general, and administrative expenses | 450,000 | |
Income from operations | 450,000 | |
Other income (expense) | 10,000 | |
Income before income taxes | 460,000 | |
Income taxes | 184,000 | |
Net income | 276,000 | |
Retained earnings, beginning of year, as originally reported | 6,463,000 | |
Restatement to reflect correction of depreciation (Note X) | 30,000 | |
Retained earnings, beginning of year, as restated | 6,493,000 | |
Dividends | (1,200,000) | |
Retained earnings, end of year | $5,569,000 |
Truesdell Company Balance Sheet As Restated December 31, 2007 and 2006 |
||
---|---|---|
2006 restated |
||
Assets | ||
Current assets | $2,540,000 | |
Property and equipment | ||
Cost | 3,500,000 | |
Accumulated depreciation and amortization | (340,000) | |
3,160,000 | ||
Total assets | $5,700,000 | |
Liabilities and stockholders' equity | ||
Income taxes payable | $ 36,000 | |
Other current liabilities | 12,000 | |
Total current liabilities | 48,000 | |
Noncurrent liabilities | 70,000 | |
Total liabilities | 118,000 | |
Stockholders' equity | ||
Common stock | 13,000 | |
Retained earnings | 5,569,000 | |
Total stockholders' equity | 5,582,000 | |
Total liabilities and stockholders' equity | $5,700,000 |
When restating previously issued financial statements, management is to disclose
- The fact that the financial statements have been restated
- The nature of the error
- The effect of the restatement on each line item in the financial statements
- The cumulative effect of the restatement on retained earnings (or other applicable components of equity or net assets)
- At the beginning of the earliest period presented in comparative financial statements or
- At the beginning of the period in single-period financial statements
- The effect on net income, both gross and net of income taxes
- For each prior period presented in comparative financial statements or
- For the period immediately preceding the period presented in single-period financial statements
- For public companies (or others electing to report earnings per share data), the effect of the restatement on affected per-share amounts for each prior period presented.
These disclosures need not be repeated in subsequent periods.
The correction of an error in the financial statements of a prior period discovered subsequent to their issuance is reported as a prior period adjustment in the financial statements of the subsequent period. In some cases, however, this situation necessitates the recall or withdrawal of the previously issued financial statements and their revision and reissuance.
Interim Reporting Considerations
If a change in accounting principle is made in an interim period, the change is made using the same methodology for retrospective application discussed and illustrated earlier in this chapter. Management is precluded from using the impracticability exception to avoid retrospective application to prechange interim periods of the same fiscal year in which the change is made. Thus, if it is impracticable to apply the change to those prechange interim periods, the change can only be made as of the beginning of the following fiscal year. FASB believes this situation will rarely occur in practice.
Interim financial reports are required by APB 28 to disclose any changes in accounting principles or the methods of applying them from those that were followed in
- The prior fiscal year;
- The comparable interim period of the prior fiscal year; and
- The preceding interim periods of the current fiscal year.
The disclosures required by FAS 154 for changes in accounting principle are to be made, in full, in the financial statements of the interim period in which the change is made.
Public companies. A special disclosure rule applies to a public company that
- Changes accounting principles in the fourth quarter of a fiscal year;
- Regularly reports interim financial information; and
- Does not separately disclose in its annual report (or in a separate report) the minimum summarized information required by APB 28 for the fourth quarter of the fiscal year.
When all three of these conditions are present, management is required to disclose in a note to the annual financial statements the effects of the change on interim period results.
Summary of Accounting Changes and Error Corrections
Type and description of change or correction | Treatment in financial statements, historical summaries, financial highlights, and other similar presentations of businesses and not-for-profit organizations | ||||||||
Retrospective application to all periods presented1 | Affects period of change and, if applicable, future periods | Restatement of all prior period financial statements presented | |||||||
|
X | ||||||||
Change in accounting estimate | X | ||||||||
|
X | ||||||||
Change in reporting entity2 | X | ||||||||
|
X |
1 FAS 154 provides an exception to the requirement for retroactive restatement when it is impracticable to make the restatement. This exception is only permitted to be used under specified conditions.
2 This is generally limited to (a) presentation of consolidated or combined financial statements instead of financial statements of individual entities, (b) a change in the specific subsidiaries making up a group of entities for which consolidated financial statements are presented, and (c) changing the entities included in combined financial statements. Neither a business combination under FAS 141 nor consolidation of a variable interest entity under FIN 46R is considered a change in reporting entity.
3 The word "restatement" is only to be used for corrections of prior period errors.