Accounting Changes

Methods of accounting for changes

Appropriate method for specific situations

Accounting Changes

“The only constant in this world is change”

Accounting is no different. How do changes affect financial

statements? How should decision makers respond to

accounting changes?

Accounting Change Events

Error - books are wrong Change in principle - LIFO to FIFO Change in estimate - useful life of assets Change in entity - firms merge

Three Methods to Account for Changes

Retrospective method Current method Prospective method

Retrospective method

completely restate the financial statements as if the new method or information had been used from the day the company first opened for business

adjust beginning Retained Earnings and permanent accounts for earliest year presented

Current method

change current period’s financial statements but leave the prior statements alone

cumulative effect of change appears as nonrecurring item in financial statements

prior year statements are not changed; however, pro forma disclosure may be required (for disclosure only - no formal entry)

Prospective method

use the new information or new method in preparing current and future financial statements

no entry to adjust for cumulative effect no adjustment to prior statements for

comparative purposes

Which method should be used?

Correction of an error retrospective method

Change in estimate prospective method

Change in principle retrospective method if change due to new FASB - the standard

will tell which method to use

Examples

(1) Decide which type of change is involved.

(2) Determine the method to be used for the change.

Accounting Changes/Errors

Change in plant asset’s salvage value. Estimate – prospective

Change due to overstatement of inventory. Error – retrospective

Change from FIFO to LIFO inventory Principle – retrospective

Change to consolidation of subsidiaries Entity – retrospective

Accounting Changes/Errors

Change from SYD to SL depreciation method. Estimate effected by principle change –

prospective

Change in rate used to compute warranty costs. Estimate – prospective

Change from an unacceptable accounting principle to an acceptable principle Error - retrospective

Company A

Acquired asset in 2006 for $500,000 Used SL depreciation, 10 yr life, no

salvage In 2009, change to SYD depreciation

Type of Change and Approach

switch from SL to SYD change in estimate prospective approach

Change in Depreciation Method

Method 2006 200720082009

SL Depr 50 50 50 50

Bal, A/D 50 100 150

Book Value (2009)=500,000-150,000

= 350,000

SYD Depr (2009) = 350,000 x 7/28

= 87,500

Record $87,500 in depreciation in 2009

Company B

In 2008, switched inventory method from FIFO to Average Cost

Net income under both methods is:

FIFO Average Cost

2005 26,000 24,000

2006 30,000 25,000

2007 28,000 27,000

2008 34,000 30,000

Type of Change and Approach

Switch from FIFO to Average Cost Change in accounting principle Retrospective approach

Journal Entry in 2008

2005 26,000 – 24,000 = 2,000 2006 30,000 – 25,000 = 5,000 2007 28,000 – 27,000 = 1,000

8,000

Retained Earnings 8,000 Inventory 8,000

Reported Net Income

2008 2007 2006 2005

Net income 30,000 27,000 25,000 24,000

Company C

Acquired asset in January 2005 for $140,000

$140,000 was debited to expense rather than PPE

In 2009, begin using SL depreciation, 10 yr life, no salvage

Type of Change and Approach

expensed purchase of machine in 2006 correction of an error retrospective approach

Correction of an Error

Machine should have a balance of $140,000

A/D should have a balance of

4 x 14,000 = $56,000 Adjust Retained Earnings and accounts

Machine 140,000

A/D 56,000

Ret Earnings 84,000