Change in Accounting Principle

1
Change in Accounting Principle
Involves a change from one set of GAAP rules to
another.
Involves changes made to existing accounts, not
for simply adopting new GAAP for a new account.
e.g. Switch from LIFO to FIFO for existing
inventory is a change in accounting principle.
Choosing FIFO for a completely separate set of
new inventory is not a change in accounting
principle (even if the old inventory is accounted
under LIFO).
2
Change in Accounting Principle
Three ways to handle change in accounting
principle
Record the Cumulative Effect Go back and
collect all changes from prior years and then
report as an item, net of tax, in the income
statement. Do not restate prior years income
statements.
Record the Retroactive Effect Go back and
restate prior years income statements.
Make no adjustments at all. The past is the past
and only future net income will be affected by
the change in principle.
GAAP has generally adopted cumulative effect,
except under special circumstances.
3
Change in Accounting Principle
Special Circumstances
When a cumulative effect adjustment would result
in unreasonably dramatic changes in net income
for the current year, GAAP allows for a
retroactive adjustment.

• A change from LIFO to another method

• A change in method on long term construction
  contracts

• A new company prior to an initial stock sale
  (IPO)

• A change to or from full-cost method for
  extractive firms.

• A FASB pronouncement requiring retroactive
  adjustment

Make adjustments directly to Retained Earnings
for prior years.
4
Change in Accounting Estimates
We often have to update our estimates

• Amount of Receivables estimated not collectable

• Amount of Inventory that will be obsolete

• Assets useful lives and salvage values

• Amount of liabilities for estimated contingencies

• Amount of recoverable mineral or oil reserves

Changes in estimates happen prospectively there
are no prior period or cumulative adjustments
made.
The effects of these changes will occur in
current or future periods.
5
Change in Accounting Estimates
Example of change in estimate
Joe bought a car on Jan 1, 2000 for 24,000.
Estimated useful life on purchase date 7 years
Estimated Salvage value on purchase date 3,000
On Jan 1, 2001, he revised the useful life down
to 5 years.
Depreciation Exp. (purchase date estimates, SL)
(24,000 - 3,000) / 7 years 3,000 per year
Accumulated Depreciation as of change of estimate
date 3,000
After change of estimate, depreciate remaining
book value-salvage value over remaining useful
life
(24,000 - 3,000 - 3,000) / (5-1) years
4,500 per year
6
Change in Accounting Entity
If there is a change in accounting entity, the
new entity must restate all prior financial
statements as if they were under the new entity
status.

• Consolidating two or more companies into one
• Changing the companies covered within
  consolidation
• Accounting for a pooling of interests
  merger/acquisition

Note this does not include simply shutting down,
creating or purchasing another business (which is
a change in real business entity).
7
Error Corrections
Error corrections for prior financial statements
are adjusted directly to the beginning balance of
Retained Earnings in the current year.

• Change from non-GAAP to GAAP
• Mathematical errors
• Changes due to poor or improper estimates
• Misuse of facts

8
Types of Errors
Counterbalancing Errors
Errors that correct themselves, or offset in the
following period.
e.g. Failing to record accrued wages
payable/wages expense.
Overstates net income in current period and
understates net income in next period (when
corrected).
Non-Counterbalancing Errors
Errors that take more than one period to correct
themselves.
e.g. Immediately expensing construction project
avoidable interest instead of capitalizing into
the asset.
Understates net income in current period and
overstates net income over depreciable life of
asset. Finally corrects when asset is fully
depreciated.
9
Types of Errors
Counterbalancing Errors
Assume we discover the error in the second, or
offsetting, period.
If the second year books are already closed, do
nothing, since the error has already reversed
itself.
If the second year books have not already closed,
make an adjustment to the Beginning value of
retained earnings.
1st Determine what effect the error had on 1st
period Retained Earnings (same as 1st
period Net Income)
2nd Create the journal entry to undo the effect
in the 2nd pd. This will restate Beginning
Retained Earnings back to its appropriate
level.
10
Types of Errors
Counterbalancing Errors
Example Beaver Stadium ticket office notices in
2001 that it had accidentally credited ticket
revenue instead of unearned ticket revenue for
160 at the end of 2000 when it received
prepayment for season tickets. 2001 books are
not closed.
1st Effect on 1st period is overstated revenue
and Retained Earnings. Therefore, 2nd
period Beginning Retained Earnings is
overstated.
2nd Create the journal entry to undo the effect
in the 2nd pd.
Retained Earnings 160 Ticket Revenue 160
11
Types of Errors
Counterbalancing Errors
Example Paterno Corp. forgot to recognize
accrued salary expense and accrued salary
liability of 200,000 at the end of 2000. The
error is discovered in 2001 before the books are
closed.
1st Effect on 1st period is understated expense
which makes Retained Earnings overstated.
Therefore, 2nd period Beginning Retained
Earnings is overstated.
2nd Create the journal entry to undo the effect
in the 2nd pd.
Retained Earnings 200,000 Salary
Expense 200,000
12
Types of Errors
Counterbalancing Errors
Example Abercrombie and Fitch undercounted its
ending inventory for 1999 by 10,000. It
discovered this error in 2000 before its books
were closed.
1st Effect on 1st period is overstated COGS
which makes Retained Earnings understated.
Therefore, 2nd period Beginning Retained
Earnings is understated.
2nd Create the journal entry to undo the effect
in the 2nd pd.
Merch. Inventory 10,000 Retained
Earnings 10,000
13
Types of Errors
Non-Counterbalancing Errors
Since these errors do not automatically correct
in the next period, an adjustment must be made
regardless of whether the books are closed.
Computing the adjustment requires more
complicated analysis and depends on whether the
books have been closed.
14
Types of Errors
Non-Counterbalancing Errors
Books not yet closed
Basically do the same adjustment as before.
Books already closed
Basically do the adjustment as before, except
back out a correction for the current year.
15
Types of Errors
Non-Counterbalancing Errors
Example Jones Corp. bought a truck for 10,000
with a 5 year useful life, no salvage value, SL
depreciation on Jan 1, 2000.
The company inadvertently recorded the 10,000 as
an expense instead of an asset on the date of
sale.
The error was discovered in 2001 and the books
were not closed for that year.
Effect of error in 2000
Truck expense overstated by 10,000 Depreciation
expense understated by 2,000 Net effect
overstated expenses (understated RE) by 8,000
Correction in 2001
Truck 10,000 Retained Earnings (Prior Pd.
Adj.) 8,000 Accum Depr. Truck 2,000
16
Types of Errors
Non-Counterbalancing Errors
Same example, yet the error was discovered in
2001 and the books were closed for that year.
The effect of error in 2000 has not changed
Truck expense overstated by 10,000 Depreciation
expense understated by 2,000 Net effect
overstated expenses (understated RE) by 8,000
However, we must now also consider the additive
effect of the error on 2001
Depreciation expense understated by another
2,000 Net effect overstated expenses
(understated RE) by only 6,000
Correction in 2001
Truck 10,000 Retained Earnings 6,000 Accum
Depr. Truck 4,000