ASC 250, Accounting Changes and Error Corrections, contains one subtopic:
ASC 250-10, Overall, which:
ASC 250-10 also:
(ASC 250-10-5-5)
ASC 250 applies to all entities' financial statements and summaries of information that reflect an accounting period affected by accounting change or error.
Under U.S. GAAP, management is granted the flexibility of choosing between or among certain alternative methods of accounting for the same economic transactions. Examples of the availability of such choices are provided throughout this publication, in such diverse areas as alternative cost-flow assumptions used to account for inventory and cost of sales, different methods of depreciating long-lived assets, and varying 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 among the various alternatives, management is to select principles and apply them in a manner that results in financial statements that faithfully represent economic substance over form and that are fully transparent to the user.
Changes in accounting can be necessitated 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.
Changes in the accounting for given transactions can have a profound influence on investing and operational decisions. Financial statement analysts and management decision makers both generally presume the consistency and comparability of financial statements across periods and among entities within industry groupings. Any type of accounting change potentially can create inconsistency. 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 impose various adjustments of their own in their efforts to make the information comparable for analysis purposes.
When contemplating a potential change in accounting principle, a primary focus of management should be to consider its effect on financial statement comparability. This should not, however, dissuade preparers from adopting preferable accounting standards, where otherwise warranted.
ASC 250 contains the underlying presumption that in preparing financial statements 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 a reporting entity 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.
ASC 250 does not provide a definition of preferability or criteria by which to make such assessments, so this remains a matter of professional judgment. What is preferable for one industry or company is not necessarily considered preferable for another.
Source: ASC 250-10-20
Accounting Change. A change in an accounting principle, an accounting estimate, or the reporting entity. The correction of an error in previously issued financial statements is not an accounting change.
Change in Accounting Estimate. A change that has the effect of adjusting the carrying amount of an existing asset or liability or altering the subsequent accounting for existing or future assets or liabilities. A change in accounting estimate is a necessary consequence of the assessment, in conjunction with the periodic presentation of financial statements, of the present status and expected future benefits and obligations associated with assets and liabilities. Changes in accounting estimates result from new information. Examples of items for which estimates are necessary are uncollectible receivables, inventory obsolescence, service lives and salvage values of depreciable assets, and warranty obligations.
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. An example of a change in estimate effected by a change in principle is a change in the method of depreciation, amortization, or depletion for long-lived, nonfinancial assets.
Change in Accounting Principle. A change from one generally accepted accounting principle to another generally accepted accounting principle when there are two or more generally accepted accounting principles that apply or when the accounting principle formerly used is no longer generally accepted. A change in the method of applying an accounting principle also is considered a change in accounting principle.
Change in the Reporting Entity. A change that results in financial statements that, in effect, are those of a different reporting entity. A change in the reporting entity is limited mainly to the following:
Neither a business combination accounted for by the acquisition method nor the consolidation of a variable interest entity (VIE) pursuant to Topic 810 is a change in reporting entity.
Direct Effects of a Change in Accounting Principle. Those recognized changes in assets or liabilities necessary to effect a change in accounting principle. An example of a direct effect is an adjustment to an inventory balance to effect a change in inventory valuation method. Related changes, such as an effect on deferred income tax assets or liabilities or an impairment adjustment resulting from applying the lower-of-cost-or-market test to the adjusted inventory balance, also are examples of direct effects of a change in accounting principle.
Error in Previously Issued Financial Statements. An error in recognition, measurement, presentation, or disclosure in financial statements resulting from mathematical mistakes, mistakes in the application of generally accepted accounting principles (GAAP), or oversight or misuse of facts that existed at the time the financial statements were prepared. A change from an accounting principle that is not generally accepted to one that is generally accepted is a correction of an error.
Indirect Effects of a Change in Accounting Principle. Any changes to current or future cash flows of an entity that result from making a change in accounting principle that is applied retrospectively. An example of an indirect effect is a change in a nondiscretionary profit sharing or royalty payment that is based on a reported amount such as revenue or net income.
Restatement. The process of revising previously issued financial statements to reflect the correction of an error in those financial statements.
Retrospective Application. The application of a different accounting principle to one or more previously issued financial statements, or to the statement of financial position at the beginning of the current period, as if that principle had always been used, or a change to financial statements of prior accounting periods to present the financial statements of a new reporting entity as if it had existed in those prior years.
There are legitimate reasons why a reporting entity would change its accounting:
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 are made, and to provide sufficient information to enable the reader to distinguish the effects of the change from other factors affecting results of operations.
Each of the types of accounting changes and the proper treatment prescribed for them is summarized in the following chart and discussed in detail in the following sections.
Treatment in financial statements, historical summaries, financial highlights, and other similar presentations of businesses and not-for-profit organizations | |||
Type and description of change or correction | Retrospective application to all periods presented1 | Affects period of change and, if applicable, future periods | Restatement of all prior period financial statements presented |
Accounting Changes Change in accounting principle New principle required to be preferable |
✓ | ||
Change in accounting estimate | ✓ | ||
Change in accounting estimate effected by a change in accounting principle New principle required to be preferable |
✓ | ||
Change in reporting entity2 | ✓ | ||
Restatements3 Correction of errors in previously issued financial statements |
✓ |
Management is permitted to change from one generally accepted accounting principle to another only when:
Per ASC 250-45-1, the following are not considered a change in accounting principle:
If a change in accounting principle is being made voluntarily, the financial statements of the period of change must 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. 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 ASC 250, the term accounting principle includes not only the accounting principles and practices used by the reporting entity, but also its methods of applying them. 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.
As stated, management is only permitted to voluntarily change the reporting entity's accounting principles when the newly employed principle is preferable to the principle it is replacing. The independent auditors are then charged with concurring with management's assessment. If the auditors do not believe management has provided reasonable justification for the change, AU-C §708.07 requires the auditors to express either a qualified or adverse opinion, depending on the materiality of the effects of the unacceptable accounting principle on the financial statements.
When management of a public company voluntarily changes the registrant's accounting principles, a letter from the registrant's independent public accountants is required to be filed with the Securities and Exchange Commission (SEC). This “preferability letter” is to be included as an exhibit in 10-Q and 10-K filings (Regulation S-K Item 601, Exhibit 18) and must indicate whether the change in principle or practice (or method of applying that principle or practice) is to an acceptable alternative that, in the auditors' judgment, is preferable under the circumstances. (ASC 250-10-S99-4)
ASC 250-10-45-5 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. ASC 250-45-3 points out that Accounting Standards Updates include specific provisions regarding transitioning to the new principles that are to be followed by adopting entities. The default method is retrospective restatement, whereas previously the default procedure was to recognize a cumulative effect adjustment in current results of operations. If FASB believes this to be the most beneficial method of transition, updates may still provide for adoption using cumulative effect adjustments.
Retrospective application is accomplished by the following steps:
At the beginning of the first period presented in the financial statements,
For each individual prior period that is presented in the financial statements,
(ASC 250-10-45-5)
In this example, the preparer refers to the previously issued 2011 financial statements presented above. Assume the following data regarding advertising costs at December 31, 20Y1/January 1, 20Y2:
Costs incurred during 20Y1 for advertising that will not take place for the first time until 20Y2 | $25,000 |
Deferred income tax liability that would have been recognized at December 31, 20Y1, computed at 40% of the temporary difference | (10,000) |
Net adjustment to beginning assets and liabilities | $15,000 |
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, 20Y2 retained earnings as previously reported at December 31, 20Y1.
In this case, the following adjustments are necessary to adjust the 20Y2 financial statements for the period-specific effects of the change in accounting principle:
Cost incurred in | Year the advertising was first run | |
20Y1 | 20Y2 | $ 25,000 |
20Y2 | 20Y3 | (45,000) |
Pretax, period-specific adjustment to advertising costs at 12/31/Y1 | (20,000) | |
× 40% income tax effect | 8,000 | |
Effect on 20Y2 net income | $(12,000) |
Adjustments to the 20Y2 financial statements for the period-specific effects of retrospective application of the new accounting principle are:
Deferred advertising costs | Deferred income tax liability | Advertising expense | Income tax expense | |
Balance at 12/31/Y2 prior to adjustment | $ – | $ – | $65,000 | $404,000 |
Adjustment to opening balances from retrospective application to 20Y2 | 25,000 | 10,000 | – | – |
Advertising costs incurred in 2010, first run in 20Y2 | (25,000) | – | 25,000 | – |
Advertising costs incurred in 2011, first run in 20Y3 | 45,000 | – | (45,000) | – |
(20,000) | ||||
Income tax effect of net adjustment to 20Y2 advertising expense (40%) | – | 8,000 | – | 8,000 |
Adjusted amounts for 20Y2 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, 20Y3 and 20Y2 | ||
20Y3 | 20Y2 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 | ||
Statements of Financial Position | ||
Reflecting Retrospective Application of Change in Accounting Principle | ||
Years Ended December 31, 20Y3 and 20Y2 | ||
20Y2 | ||
Assets | 20Y3 | as adjusted |
Current assets | ||
Cash and cash equivalents | $ 2,382,000 | $ 2,200,000 |
Deferred advertising costs | 16,000 | 45,000 |
Prepaid expenses | 123,000 | 125,000 |
Other current assets | 21,000 | 22,000 |
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, 20Y3 and 20Y2 | ||
20Y2 | ||
Operating activities | 20Y3 | as adjusted |
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) |
20Y3 | 20Y2 as adjusted | |
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 20Y2, the caption “as adjusted” is included in the column heading. Prior to ASC 250, many preparers used the caption “as restated.” ASC 250 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 are to 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 20Y2 | $25,000 | 15% | $3,750 |
20Y2 | (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 20Y2 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.
ASC 250 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 2013 in the example above.
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. (ASC 250-10-45-9) FASB recognizes 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.
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:
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, ASC 250-10-45-6 requires the following steps to adopt the new accounting principle:
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, ASC 250-10-45-7 requires that the new principle be 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:
The following is an example of the required disclosure in this circumstance:
The accounting principles used in the reporting entity's financial statements may comply with GAAP as of the reporting date, but those principles may become unacceptable at a specified future date due to the issuance of a new accounting standard that is not yet effective. If the new GAAP, when adopted, is expected to materially affect the future financial statements, it is necessary to inform the users of the current financial statements about the future change. The objective of such a disclosure is to ensure that the financial statements are not misleading and that the users are provided with adequate information to assess the significance of adopting the new GAAP on the reporting entity's future financial statements.
In some cases, the effect of the future change will be so pervasive as to necessitate the presentation of pro forma financial data to supplement the historical financial statements. The pro forma data would present the effects of the future adoption as if it had occurred at the date of the statement of financial position. The pro forma data may be presented in a column next to the historical data, in the notes to the financial statements, or separately accompanying the basic historical financial statements. Disclosure may also be needed of other future effects that may be triggered by the adoption of the new GAAP, such as adverse effects on the reporting entity's compliance with its debt covenants.
The best source of guidance in determining the form and content of these disclosures is ASC 250-10-S99. While this guidance is applicable to public companies, it also can be interpreted to apply to nonpublic companies as “practices that are widely recognized and prevalent.” Under this requirement management is to disclose:
The SEC staff also encourages the following additional disclosures:
There is no requirement under GAAP or under SEC rules to disclose the potential effects of standards that have been proposed but not yet issued. If management wishes to voluntarily disclose information that it believes will provide the financial statement users with useful, meaningful information, the SEC provides guidance (§501.11 of the Codification of Financial Reporting Policies) on how to present this information, either in narrative form or as pro forma information, in a manner that “is reasonable, balanced and not misleading.” In its guidance, the SEC notes that it may be reasonable to cover only those proposals where, based on the standard setter's published agenda, adoption appears imminent. When management chooses to make these disclosures, the disclosures should:
Occasionally, a company will choose to change the way it applies an accounting principle, resulting 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, including:
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:
The preparation of financial statements requires frequent use of estimates for such items as asset service lives, salvage values, lease residuals, asset impairments, collectability of accounts receivable, warranty costs, pension costs, and the like. 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. ASC 250-10-45-17 requires that changes in estimates be recognized currently and prospectively. 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.
Accounting for long-term construction contracts under the percentage-of-completion method necessarily involves ongoing revisions to estimates of total contract revenue, total contract cost, and extent of progress toward project completion. These revisions represent changes in accounting estimate and, in accordance with ASC 605-35, the change in estimate is accounted for using the cumulative catch-up method. This is applied by:
This approach results in the effect of the change in accounting estimate being reflected in the current period statement of income, and prospectively accounting for the contract using the revised assumptions.
Note that an impairment of a long-lived asset, as described by ASC 360-10-35, 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 in this volume on ASC 360.)
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 ASC 250-10-45-18, a change in accounting estimate that is effected by a change in accounting principle is 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 ASC 250-10-45-19 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 ASC 250-10-45-20, however, for entities that elect to apply a depreciation method that results in accelerated depreciation until the point during the useful life of the depreciable asset when it is useful to change to straight-line depreciation in order to fully depreciate the asset over the remaining term. At this point, the remaining carrying value (net book value) is depreciated using the straight-line method over its remaining useful life. ASC 250 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.
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 (ASC 250-10-45-21). The change is also retrospectively applied to previously issued interim financial information.
The following qualify as changes in reporting entity:
Specifically excluded from qualifying as a change in reporting entity are:
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 not 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 which is discovered at a later date. However, this discovery is not as a result of additional information or subsequent developments.
ASC 250 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:
The restated financial statements are presented below.
Truesdell Company | ||
Statements of Income and Retained Earnings | ||
As Restated | ||
Years Ended December 31, 20X3 and 20X2 | ||
20X3 | 20X2 restated | |
Sales | $2,100,000 | $2,000,000 |
Cost of sales | ||
Depreciation | 740,000 | 710,000 |
Other | 410,000 | 390,000 |
1,150,000 | 1,100,000 | |
Gross profit | 950,000 | 900,000 |
Selling, general, and administrative expenses | 460,000 | 450,000 |
Income from operations | 490,000 | 450,000 |
Other income (expense) | (5,000) | 10,000 |
Income before income taxes | 485,000 | 460,000 |
Income taxes | 200,000 | 184,000 |
Net income | 285,000 | 276,000 |
Retained earnings, beginning of year, as originally reported | 5,569,000 | 6,463,000 |
Restatement to reflect correction of depreciation (Note X) | – | 30,000 |
Retained earnings, beginning of year, as restated | 5,569,000 | 6,493,000 |
Dividends | (800,000) | (1,200,000) |
Retained earnings, end of year | $5,054,000 | $5,569,000 |
Truesdell Company | ||
Statements of Financial Position | ||
As Restated | ||
December 31, 20X3 and 20X2 | ||
20X3 | 20X2 restated | |
Assets | ||
Current assets | $2,840,000 | $2,540,000 |
Property and equipment | ||
Cost | 3,750,000 | 3,500,000 |
Accumulated depreciation and amortization | (1,050,000) | (340,000) |
2,700,000 | 3,160,000 | |
Total assets | $5,540,000 | $5,700,000 |
Liabilities and stockholders' equity | ||
Income taxes payable | $50,000 | $ 36,000 |
Other current liabilities | 110,000 | 12,000 |
Total current liabilities | 160,000 | 48,000 |
Noncurrent liabilities | 313,000 | 70,000 |
Total liabilities | 473,000 | 118,000 |
Stockholders' equity | ||
Common stock | 13,000 | 13,000 |
Retained earnings | 5,054,000 | 5,569,000 |
Total stockholders' equity | 5,067,000 | 5,582,000 |
Total liabilities and stockholders' equity | $5,540,000 | $5,700,000 |
When restating previously issued financial statements, management is to disclose
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.
Misstatements, particularly if detected after the financial statements have been produced and distributed, may under certain circumstances be left uncorrected. This decision is directly impacted by judgments about materiality, an important concept discussed in Chapter 1. The financial statement preparer is expected to exercise professional judgment in determining the level of materiality to apply in order to cost-effectively prepare full, complete, and accurate financial statements in a timely manner. However, there have been instances where the materiality concept has been used to rationalize the noncorrection of errors that should have been dealt with, and indeed even to excuse errors known when first committed. The fact that the concept of materiality has sometimes been abused led to the promulgation of further guidance relative to error corrections.
Although independent auditors are charged with obtaining sufficient evidence to enable them to provide the financial statement user with reasonable assurance that management's financial statements are free of material misstatement, the financial statements are primarily the responsibility of the preparers. Certain auditing literature is therefore germane to the preparers' consideration of matters such as error corrections and application of materiality guidelines. These matters are further explored in the following paragraphs.
Preparers of financial statements need to have control procedures to reduce the risk of accounting errors being committed and not detected. From the auditors' perspective, it is required that the examination be conducted in a manner that will provide reasonable assurance of detecting material misstatements, including those resulting from errors. Known misstatements arise from:
Likely misstatements arise from:
Management, in assessing the impact of uncorrected misstatements, is required to assess materiality both quantitatively and qualitatively from the standpoint of whether a financial statement user would be misled if a misstatement were not corrected or if, in the case of informative disclosure errors, full disclosure was not made. Qualitative considerations include (but are not limited to) whether the misstatement:
Management may have decided to not correct misstatements that occurred in one or more prior years because, in their judgment at the time, the financial statements were not materially misstated. Two methods of making that materiality assessment—sometimes referred to as the “rollover” and the “iron curtain” methods—have been widely used in practice. These are described and illustrated in the following paragraphs.
The rollover method quantifies a misstatement as its originating or reversing effect on the current period's statement of income, irrespective of the potential effect on the statement of financial position of one or more prior periods' accumulated uncorrected misstatements.
The iron curtain method, on the other hand, quantifies a misstatement based on the accumulated uncorrected amount included in the current, end-of-period statement of financial position, irrespective of the year (or years) in which the misstatement originated.
Each of these methods, when considered separately, has strengths and weaknesses, as follows:
Method | Focuses on | Strength | Weakness |
Rollover | Current period income statement | Focuses on whether the income statement of the current period is materially misstated, assuming that the statement of financial position is not materially misstated | Material misstatement of the statement of financial position can accumulate over multiple periods |
Iron curtain | End of period statement of financial position | Focuses on ensuring that the statement of financial position is not materially misstated, irrespective of the year or years in which a misstatement originated | Does not consider whether the effect of correcting a statement of financial position misstatement that arose in one or more periods is material to the current period income statement |
The SEC staff issued Staff Accounting Bulletin (SAB) 108, Considering the Effects of Prior Year Misstatements in Current Year Financial Statements, to address how registrants (i.e., publicly held corporation) are to evaluate misstatements. SAB 108 prescribes that if a misstatement is material to either the income statement or the statement of financial position, it is to be corrected in a manner set forth in the bulletin and illustrated in the example and diagram below.
If the cumulative effect adjustment occurs in an interim period other than the first interim period, the SEC waived the requirement that previously filed interim reports for that fiscal year be amended. Instead, comparative information presented for interim periods of the first year subsequent to initial application is to be adjusted to reflect the cumulative effect adjustment as of the beginning of the fiscal year of initial application. The adjusted results are also required to be included in the disclosures of selected quarterly information that are required by Regulation S-K, Item 302.
Entities that do not meet the criteria to use the cumulative effect adjustment are required to follow the provisions of ASC 250 that require restatement of all prior periods presented in the filing.
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.
ASC 270 requires that interim financial reports disclose any changes in accounting principles or the methods of applying them from those that were employed in:
The disclosures required by ASC 250 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.
When a public company adopts a new standard in an interim period, the ASC 270 disclosures cited above are to be supplemented, as applicable, with all disclosures required by the newly adopted standard to be included in annual financial statements. If the change is made in a period other than the first quarter, prior filings are not required to be amended; however, adjustment of each prior quarter's results is to be included in the filing for the quarter in which the new principle is being adopted. If the newly adopted standard requires retrospective application to all prior periods, the prior interim quarters are also to be presented on an adjusted basis.
In addition, a special disclosure rule applies to a public company that:
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.
Financial statements prepared in accordance with GAAP presume that the reporting entity is expected to remain in operation for the foreseeable future. This “going concern” assumption is important, since in its absence many accounting conventions and practices (e.g., depreciation of long-lived assets over expected economic lives) would not be sensible, as the ability to realize the economic benefits of such assets would be in doubt.
US auditing standards have long required auditors to affirmatively evaluate whether there was substantial doubt about the ability of the reporting entity to continue as a going concern for a reasonable period following the date of the financial statements, but not for longer than one year from that date. When substantial doubt was found to exist, this was cited in the auditors' report, and the financial statements were required to include, as footnote disclosure, information about the reasons for such doubts, as well as about management's plans to cope with the circumstances. (When such informative disclosures were not provided by management, the auditors were generally required to qualify their opinions due to lack of adequate disclosure, notwithstanding inclusion of “going concern” language in the auditors' report itself.)
See ASC Location – Wiley GAAP Chapter | For information on… |
ASC 260-10-55-15 through 55-16 | The effect of restatements expressed in per-share terms |
ASC 323-10-45-1 through 45-2. | The classification of an investor's share of error corrections reported in the financial statements of the investee |
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