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ACCOUNTING CHANGES

PERSPECTIVE AND ISSUES

Financial statements are the results of choices among different accounting principles and methodologies. Organizations select those principles and methods that they believe reflect, in their financial statements, the economic reality of their financial position, results of operations, and changes in financial position. Changes take place because of changes in the assumptions and estimates underlying the application of these principles and methods, changes in the acceptable principles by a promulgating authority, or other types of changes.

Accounting for and reporting of these changes is a problem that has faced the accounting profession for years. Much financial analysis is based on the consistency and comparability of annual financial statements. Any type of accounting change creates an inconsistency; thus, a primary focus of management in making the decision to change should be to consider its effect on financial statement comparability.

The FASB guidance for reporting accounting changes and error corrections is contained in FASB ASC 250-10. An accounting change is a change in (1) an accounting principle, (2) an accounting estimate, or (3) the reporting entity.

The FASB ASC Master Glossary defines the following relevant terms:

Changes 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. Neither (1) initial adoption of an accounting principle in recognition of events or transactions occurring for the first time or that previously were immaterial in their effect nor (2) adoption or modification of an accounting principle necessitated by transactions or events that are clearly different in substance from those previously occurring is a change in accounting principle.

Changes 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.

Changes 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 (1) presenting consolidated or combined financial statements in place of financial statements of individual entities, (2) changing specific subsidiaries that make up the group of entities for which consolidated financial statements are presented, and (3) changing the entities included in combined financial statements. Neither a business combination accounted for by the purchase method nor the consolidation of a variable-interest entity is a change in reporting entity.

The following paragraphs summarize the accounting and disclosure requirements for each of these types of accounting changes.

Change in Accounting Principle

FASB ASC 250-10 provides that a presumption exists that an accounting principle once adopted should not be changed in accounting for events and transactions of a similar type. Consistent use of the same accounting principle from one accounting period to another enhances the utility of financial statements for users by facilitating analysis and understanding of comparative accounting data.

A reporting entity is permitted to change an accounting principle only if (1) the change is required by a newly issued accounting pronouncement, or (2) the entity can justify the use of an allowable alternative accounting principle on the basis that the new principle is preferable to the old principle carried forward from the previous requirements.

FASB ASC 250-10 anticipates that accounting pronouncements normally will provide specific transition requirements. However, in the unusual instance that there are no transition requirements specific to a particular accounting pronouncement, a change in accounting principle effected to adopt the requirements of that accounting pronouncement should be reported in accordance with the following requirements.

Accounting requirements. An entity is required to report a change in accounting principle through retrospective application of the new accounting principle to all prior periods, unless it is impracticable to do so. Retrospective application is 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. Retrospective application also includes 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.

Retrospective application requires the following:

  1. The cumulative effect of the change to the new accounting principle on periods prior to those presented should be reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented.
  2. An offsetting adjustment, if any, is also to be made to the opening balance of the appropriate components of net assets in the statement of financial position for that period.
  3. Financial statements for each individual prior period presented should be adjusted to reflect the period-specific effects of applying the new accounting principle.

Note that retrospective application is a significant change to the previous requirements. The change in accounting principle is reflected in the opening balances of the earliest financial statement presented, meaning that prior year financial statements are restated.

FASB ASC 250-10 further provides that if the cumulative effect of applying a change in accounting principle to all prior periods can be determined, but it is impracticable to determine the period-specific effects of that change on all prior periods presented, the cumulative effect of the change to the new accounting principle should be applied to the carrying amounts of assets and liabilities as of the beginning of the earliest period to which the new accounting principle can be applied. An offsetting adjustment, if any, shall be made to the opening balance of the appropriate components of net assets in the statement of financial position for that period.

If it is impracticable to determine the cumulative effect of applying a change in accounting principle to any prior period, the new accounting principle should be applied as if the change was made prospectively as of the earliest date practicable.

There are specific requirements that must be met in order for it to be “impracticable” to retrospectively apply a change in accounting principle. It is deemed to be impracticable to apply the effects of a change in accounting principle retrospectively only if any of the following conditions exist:

  1. After making every reasonable effort to do so, the entity is unable to apply the requirement.
  2. Retrospective application requires assumptions about management's intent in a prior period that cannot be independently substantiated.
  3. Retrospective application requires significant estimates of amounts, and it is impossible to distinguish objectively information about those estimates that:
    1. Provides evidence of circumstances that existed on the date(s) at which those amounts would be recognized, measured, or disclosed under retrospective application;
    2. Would have been available when the financial statements for that prior period were issued.

Retrospective application only includes the direct effects of a change in accounting principle, including any related income tax effects. The direct effects of a change in accounting principle are 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.

Indirect effects that would have been recognized if the newly adopted accounting principle had been followed in prior periods should not be included in the retrospective application. The indirect effects of a change in accounting principle are 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 royalty payment that is based on a reported amount such as revenue or net income.

If indirect effects are actually incurred and recognized, they shall be reported in the period in which the accounting change is made.

Justification for a change in accounting principle. As mentioned above, in the preparation of financial statements, once an accounting principle is adopted, it shall be used consistently in accounting for similar events and transactions.

An entity may change an accounting principle only if it justifies the use of an allowable alternative accounting principle on the basis that it is preferable. However, a method of accounting that was previously adopted for a type of transaction or event that is being terminated or that was a single, nonrecurring event in the past should not be changed. Additionally, the method of transition elected at the time of adoption of an accounting pronouncement shall not be subsequently changed. However, a change in the estimated period to be benefited by an asset, if justified by the facts, shall be recognized as a change in accounting estimate.

The issuance of an accounting pronouncement that requires use of a new accounting principle, interprets an existing principle, expresses a preference for an accounting principle, or rejects a specific principle may require an entity to change an accounting principle. The issuance of such a pronouncement constitutes sufficient support for making such a change provided that the hierarchy established for GAAP is followed.

The burden of justifying other changes in accounting principle rests with the entity making the change.

Reporting a change in accounting principle made in an interim period. A change in accounting principle made in an interim period shall be reported by retrospective application in accordance with the above requirements. However, the impracticability exception may not be applied to prechange interim periods of the fiscal year in which the change is made. When retrospective application to prechange interim periods is impracticable, the desired change may only be made as of the beginning of a subsequent fiscal year.

Disclosure requirements. FASB ASC 250-10-50 requires an entity to disclose the following in the fiscal period in which a change in accounting principle is made:

  1. The nature and reason for the change in accounting principle, including an explanation of why the newly adopted accounting principle is preferable.
  2. The method of applying the change; and
    1. A description of the prior period information that has been retrospectively adjusted, if any.
    2. The effect of the change on income from continuing operations, the appropriate captions of changes in the applicable net assets, any other affected financial statement line item for the current period, and any prior periods retrospectively adjusted. Presentation of the effect on financial statement subtotals and totals other than income from continuing operations and other appropriate captions of changes in the applicable net assets is not required.
    3. The cumulative effect of the change on the components of net assets in the statement of financial position as of the beginning of the earliest period presented.
    4. If retrospective application to all prior periods is impracticable, disclosure of the reasons therefor, and a description of the alternative method used to report the change.
  3. If indirect effects of a change in accounting principle are recognized:
    1. A description of the indirect effects of a change in accounting principle, including the amounts that have been recognized in the current period.
    2. Unless impracticable, the amount of the total recognized indirect effects of the accounting change that are attributable to each prior period presented.

Financial statements of subsequent periods need not repeat these disclosures. If a change in accounting principle has no material effect in the period of change but is reasonably certain to have a material effect in later periods, these disclosures should be provided whenever the financial statements of the period of change are presented.

In the fiscal year in which a new accounting principle is adopted, financial information reported for interim periods after the date of adoption should disclose the effect of the change on income from continuing operations or other appropriate captions of changes in the applicable net assets for those postchange interim periods.

Changes in Accounting Estimate

A change in accounting estimate should be accounted for in (1) the period of change if the change affects that period only, or (2) the period of change and future periods if the change affects both. A change in accounting estimate shall not be accounted for by restating or retrospectively adjusting amounts reported in financial statements of prior periods or by reporting pro forma amounts for prior periods.

Distinguishing between a change in accounting principle and a change in an accounting estimate is sometimes difficult. In some cases, a change in accounting estimate is effected by a change in accounting principle. One example of this type of change is a change in method of depreciation, amortization, or depletion for long-lived, nonfinancial assets (hereinafter referred to as a depreciation method). The new depreciation method is adopted in partial or complete recognition of a change in the estimated future benefits inherent in the asset, the pattern of consumption of those benefits, or the information available to the entity about those benefits. The effect of the change in accounting principle, or the method of applying it, may be inseparable from the effect of the change in accounting estimate. Changes of that type are often related to the continuing process of obtaining additional information and revising estimates and, therefore, are considered changes in estimates.

As with other changes in accounting principle, a change in accounting estimate that is effected by a change in accounting principle may be made only if the new accounting principle is justifiable on the basis that it is preferable.

Disclosures. FASB ASC 250-10-50 requires that the effect on income from continuing operations and the other appropriate captions of changes in the applicable net assets of the current period be disclosed for a change in estimate that affects several future periods, such as a change in service lives of depreciable assets. Disclosure of those effects is not necessary for estimates made each period in the ordinary course of accounting for items such as uncollectible accounts or inventory obsolescence; however, disclosure is required if the effect of a change in the estimate is material. When an entity effects a change in estimate by changing an accounting principle, the disclosures required for a change in accounting principle also are required. If a change in estimate does not have a material effect in the period of change but is reasonably certain to have a material effect in later periods, the nature of and reason for the change shall be disclosed whenever the financial statements of the period are presented.

Change in the Reporting Entity

When an accounting change results in financial statements that are, in effect, the statements of a different reporting entity, the change shall be retrospectively applied to the financial statements of all prior periods presented to show financial information for the new reporting entity for those periods. Previously issued interim financial information should also be presented on a retrospective basis. However, the amount of interest cost previously capitalized through investments accounted for by the equity method (FASB ASC 835-20) should not be changed when retrospectively applying the accounting change to the financial statements of prior periods.

Disclosures. FASB ASC 250-10-50 requires that when there has been a change in the reporting entity, the financial statements of the period of the change describe the nature of the change and the reason for it. In addition, the effect of the change on income before extraordinary items and the appropriate captions of changes in the applicable net assets should be disclosed for all periods presented. Financial statements of subsequent periods need not repeat the disclosures required by this paragraph. If a change in reporting entity does not have a material effect in the period of change but is reasonably certain to have a material effect in later periods, the nature of and reason for the change shall be disclosed whenever the financial statements of the period of change are presented.

Correction of an Error in Previously Issued Financial Statements

An error in the financial statements of a prior period discovered subsequent to their issuance should be reported as a prior period adjustment by restating the prior period financial statements. Restatement requires that:

  1. The cumulative effect of the error on periods prior to those presented should be reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented.
  2. An offsetting adjustment, if any, should be made to the opening balance of the appropriate components of net assets in the statement of financial position for that period.
  3. Financial statements for each individual prior period presented should be adjusted to reflect correction of the period-specific effects of the error.

Disclosures. When financial statements are restated to correct an error, the entity should disclose that its previously issued financial statements have been restated, along with a description of the nature of the error. The entity also is required to disclose the following:

  1. The effect of the correction on each financial statement line item affected for each prior period presented;
  2. The cumulative effect of the change on the appropriate components of net assets in the statement of financial position, as of the beginning of the earliest period presented.

In addition, the entity shall make the disclosures of prior period adjustments and restatements required by FASB ASC 250-10-50. Financial statements of subsequent periods need not repeat the disclosures required by this paragraph.

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