Reporting for Different Types of Accounting Changes
Changes in accounting are of three types. They are changes in accounting principle, changes in accounting estimates, and changes in reporting entity. Accounting errors result in accounting changes too. Changes in accounting principle and changes in reporting should be accounted for retrospectively, whereas changes in accounting estimates should be accounted for prospectively. Errors correction depends on the period they are recovered in and if comparative statements are issued.
To start off, changes in accounting principle come about when a company adopts a new generally accepted accounting principle for the prior yearsâ€™ generally accepted accounting principle. For example, a company might decide to account for its inventory based on FIFO instead of LIFO method or change its depreciation method from straight line to accelerated depreciation method. Even though switching from one generally accounting principle to another generally accounting principle is allowed, FASB requires companies to account for the changes retrospectively. Following this approach, companies adjust their prior yearsâ€™ financial statements as if they were prepared using the new principle. Beginning balance of the retained earnings of the earliest year presented is adjusted for any cumulative effects. In doing so, FASB contends that financial statements are easy to compare from one year to another, and thus, the information provided therein is more useful to the financial statement users.
In addition, changes in estimates are simply restatement of accounting assumptions. At end of year, companies make estimates to prepare their financial statements. These estimates are not always correct. For example, a company assumes at first that the life of an equipment would be five years and salvage value five thousands. After two years, the company might decide the life of the equipment to be seven years and salvage value only two thousands. Consequently, the company has to account for changes in estimate. Accounting for changes in estimate is done prospectively. Under this approach, the company need not restate its prior years financial states, rather it should account for the changes in current and future years. The rationale for adopting prospective approach for accounting changes in estimates is that estimates are normal and recurring corrections and adjustments.
Similarly, changes in reporting entity happen when two or more previously separate companies are combined together and reported as one entity. The companies have to restate their prior periods’ financial statements as if they were one entity in the near past. Additionally, the nature of the change in entity and the reasons for the change is disclosed in the note to the financial statements. Companies should also report in the year of change the effect of the change on income before extraordinary items, net income, other comprehensive income, and related earnings per share for all periods presented.
Furthermore, errors result in changes in accounting. No company is free from errors. They can occur in the form of mathematical mistakes in totaling the accounts, wrongly recording revenues as expenses, or leaving out an event from recording. How to account for errors then? Accounting for errors depends on when they are recovered and if comparative financial statements are being issued. If the errors have occurred in current period and came to attention before issuing the statements, the companies should correct them in the current year, but restatement is not needed. However, correction of errors from prior period requires companies to make adjustments to the beginning balance of retained earnings in the current period. In addition, if the companies are presenting comparative statements, then they should restate the prior periods’ statements that are affected by the errors.
In conclusion, accounting changes are inevitable. They are not against the accounting rules and regulations. Once they are adopted, accounting pronouncements should to be followed. FASB has set clear guidelines how to report changes in accounting. Retrospective approach is used to account for changes in principles and reporting entity, and prospective approach is followed for changes in estimates. Accounting changes resulting from errors are dependent on when the errors are found out and if comparative financial statements are to be reported. For companies, following these approaches to report changes in accounting can be burdensome and time consuming, but they provide very useful information to the financial statement users.
Kieso, Donald E., Jerry J. Weygandt, and Terry D. Warfield. â€œAccounting Changes and Error Analysis.â€ Intermediate Accounting. 14th ed. Hoboken, NJ: Wiley, 2012. 1366-1400. Print.
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A Bachelor of Science in Accounting student.