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. Hist Cost – Accum Depr. – Salv. Value Useful life – years already used 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. Credits Revenue to appropriate period Reduces Beg. Ret Earns 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. Reduces the expense that was shifted to 2nd period due to error. Reduces Beg. Ret Earns 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. Corrects the understate- ment in Beg. Ret. Earns Corrects the undercount in Merchandise inventory 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. Adjust RE for understatement Add the truck accts. to the books at the Correct balances 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. Adjust RE for understatement Add the truck accts. to the books This now adjusts for 2 years of accum. depr. 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