Chapter 7: Accounting Changes and Error Analysis

After studying this chapter, you should be able to:

Learning Objectives

1. Identify the types of accounting changes.

2. Describe the accounting for changes in accounting principles.
3. Understand how to account for retrospective accounting changes.
4. Describe the accounting for changes in estimates.
5. Identify changes in a reporting entity.
6. Describe the accounting for correction of errors.
7. Identify economic motives for changing accounting methods.
8. Analyze the effect of errors.

Changes in accounting principles and errors in financial information have increased substantially in recent
years. When these changes occur, companies must follow specific accounting and reporting requirements. In
addition, to ensure comparability among companies, the FASB has standardized reporting of accounting
changes, accounting estimates, error corrections, and related earnings per share information. In this chapter,
we discuss these reporting standards, which help investors better understand a company’s financial condition.

7.1 Types of Accounting Changes

The FASB has established a reporting framework, which involves three types of accounting changes.
1. Change in accounting principle. A change from one generally accepted accounting principle to another
one. For example, a company may change its inventory valuation method from LIFO to average cost.
2. Change in accounting estimate. A change that occurs as the result of new information or additional
experience. For example, a company may change its estimate of the useful lives of depreciable assets.
3. Change in reporting entity. A change from reporting as one type of entity to another type of entity. As an
example, a company might change the subsidiaries for which it prepares consolidated financial
statements.

7.2 Approaches to Recording and Reporting Accounting Changes

7.2.1 Changes in Accounting Principle
By definition, a change in accounting principle involves a change from one generally accepted accounting
principle to another. Adoption of a new principle in recognition of events that have occurred for the first time
or that were previously immaterial is not an accounting change.

There are three possible approaches for reporting changes in accounting principles:
a) Report changes currently – In this approach, companies report the cumulative effect of the change in the
current year’s income statement as an irregular item. The cumulative effect is the difference in prior
years’ income between the newly adopted and prior accounting method. Under this approach, the effect
of the change on prior years’ income appears only in the current-year income statement. The company
does not change prior-year financial statements.
b) Report changes retrospectively – Retrospective application refers to the application of a different
accounting principle to recast previously issued financial statements as if the new principle had always
been used. In other words, the company “goes back” and adjusts prior years’ statements on a basis
consistent with the newly adopted principle. The company shows any cumulative effect of the change as
an adjustment to beginning retained earnings of the earliest year presented.
c) Report changes prospectively (in the future) – In this approach, previously reported results remain. As a
result, companies do not adjust opening balances to reflect the change in principle. Advocates of this

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 position argue that once management presents financial statements based on acceptable accounting
principles, they are final; management cannot change prior periods by adopting a new principle.
According to this line of reasoning, the current-period cumulative adjustment is not appropriate, because
that approach includes amounts that have little or no relationship to the current year’s income or
economic events.
IFRS (IAS 8) generally requires retrospective application to prior years for accounting changes.
However, IAS 8 permits the prospective method if a company cannot reasonably determine the
amounts to which to restate prior periods.

Given these three possible approaches, which does the accounting profession prefer? The FASB requires
that companies use the retrospective approach. Why? For the reason it provides financial statement users
with more useful information than the cumulative-effect or prospective approaches. The rationale is that
changing the prior statements to be on the same basis as the newly adopted principle results in greater
consistency across accounting periods. Users can then better compare results from one period to the next.

Retrospective Accounting Change: Inventory Methods

As a second illustration of the retrospective approach, assume that Lancer Company has accounted for its
inventory using the LIFO method. In 2012, the company changes to the FIFO method because management
believes this approach provides a more appropriate reporting of its inventory costs. Additional information
related to Lancer Company provided as follows.

Given the information about Lancer Company, its income statement, retained earnings statement, balance
sheet, and statement of cash flows for 2010–2012 under LIFO are shown below.

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Lancer’s income statement, retained earnings statement, balance sheet, and statement of cash flows for 2010–
2012 under FIFO are shown below. You can see that the cash flow statement under FIFO is the same as
under LIFO. Although the net in-comes are different in each period, there is no cash flow effect from these
differences in net income. (If we considered income taxes, a cash flow effect would result.)

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Compare the financial statements reported. You can see that, under retrospective application, the change to
FIFO inventory valuation affects reported inventories, cost of goods sold, net income, and retained earnings.

Given the above information, how to account for and report on the accounting change?

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First step is to adjust the financial records for the change from LIFO to FIFO. To do so, analysis is
performed as follows.

The entry to record the change to the FIFO method at the beginning of 2012 is as follows.
Inventory 5,000
Retained Earnings 5,000
The change increases the Inventory account by $5,000. This amount represents the difference between the
ending inventory at December 31, 2011, under LIFO ($20,000) and the ending inventory under FIFO
($25,000). The credit to Retained Earnings indicates the amount needed to change prior-year’s income,
assuming that Lancer had used FIFO in previous periods.

Second step is reporting a change in principle - Lancer Company will prepare comparative financial
statements for 2011 and 2012 using FIFO (the new inventory method) as follows.

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7.2.2 Changes in Accounting Estimate
To prepare financial statements, companies must estimate the effects of future conditions and events. For
example, the following items require estimates.
 Uncollectible receivables.
 Inventory obsolescence.
 Useful lives and salvage values of assets.
 Periods benefited by deferred costs.
 Liabilities for warranty costs and income taxes.
 Recoverable mineral reserves.
 Change in depreciation methods.
A company cannot perceive future conditions and events and their effects with certainty. Therefore,
estimation requires the exercise of judgment. Accounting estimates will change as new events occur, as a
company acquires more experience, or as it obtains additional information.

Prospective Reporting – Companies report prospectively changes in accounting estimates. That is,
companies should not adjust previously reported results for changes in estimates. Instead, they account for
the effects of all changes in estimates 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.
The FASB views changes in estimates as normal recurring corrections and adjustments, the natural result of
the accounting process. It prohibits retrospective treatment.
To illustrate, Beta Inc. purchased for $300,000 a building that it originally estimated to have a useful life of
15 years and no salvage value. It recorded depreciation for 5 years on a straight-line basis. On January 1,
2012, Beta Inc. revises the estimate of the useful life. It now considers the asset to have a total life of 25
years. (Assume that the useful life for financial reporting and tax purposes and depreciation method are the
same). The following computation shows the accounts at the beginning of the sixth year.
Buildings ……………………………………………………………. $300,000
Less: Accumulated depreciation – buildings (5 x $20,000) ………. 100,000
Book value of building ……………………………………………... $200,000

The company computes the $10,000 depreciation charge as shown below:

Beta Inc. records depreciation for the year 2012 as follows.

Depreciation Expense 10,000
Accumulated Depreciation—Buildings 10,000
Companies sometime find it difficult to differentiate between a change in estimate and a change in
accounting principle. If it is impossible to determine whether a change in principle or a change in estimate
has occurred, the rule is this: Consider the change as a change in estimate. This is often referred to as a
change in estimate affected by a change in accounting principle.

A similar problem occurs in differentiating between a change in estimate and a correction of an error,
although here the answer is more clear-cut. Proper classification is important because the accounting
treatment differs for corrections of errors versus changes in estimates.

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The general rule is this: Companies should consider careful estimates that later prove to be incorrect as
changes in estimate.

Disclosures – For the most part, companies need not disclose changes in accounting estimate made as part of
normal operations, such as bad debt allowances or inventory obsolescence, unless such changes are material.
However, for a change in estimate that affects several periods (such as a change in the service lives of
depreciable assets), companies should disclose the effect on income from continuing operations and related
per share amounts of the current period. When a company has a change in estimate affected by a change in
accounting principle, it must indicate why the new method is preferable. In addition, companies are subject
to all other disclosure guidelines established for changes in accounting principle.

7.2.3 Changes in Reporting Entity

Occasionally companies make changes that result in different reporting entities. In such cases, companies
report the change by changing the financial statements of all prior periods presented. The revised statements
show the financial information for the new reporting entity for all periods. Examples of a change in reporting
entity are:
 Presenting consolidated statements in place of statements of individual companies.
 Changing specific subsidiaries that constitute the group of companies for which the entity presents
consolidated financial statements.
 Changing the companies included in combined financial statements.
 Changing the cost, equity, or consolidation method of accounting for subsidiaries and investments. In
this case, a change in the reporting entity does not result from creation, cessation, purchase, or
disposition of a subsidiary or other business unit.
In the year in which a company changes a reporting entity, it should disclose in the financial statements the
nature of the change and the reason for it. It also should report, for all periods presented, the effect of the
change on income before extraordinary items, net income, and earnings per share. These disclosures need not
be repeated in subsequent periods’ financial statements.
7.3 Error Correction and Analysis
No business, large or small, is immune from errors. As the opening story discussed, the number of
accounting errors that lead to restatement are beginning to decline. However, without accounting and
disclosure guidelines for the reporting of errors, investors can be left in the dark about the effects of errors.
Certain errors, such as misclassifications of balances within a financial statement, are not as significant to
investors as other errors. Significant errors would be those resulting in overstating assets or income, for
example. However, investors should know the potential impact of all errors. Even “harmless”
misclassifications can affect important ratios. Also, some errors could signal important weaknesses in
internal controls that could lead to more significant errors.
In general, accounting errors include the following types:
1. A change from an accounting principle that is not generally accepted to an accounting principle that is acceptable.
The rationale is that the company incorrectly presented prior periods because of the application of an improper
accounting principle. For example, a company may change from the cash (income tax) basis of accounting to the
accrual basis.
2. Mathematical mistakes, such as incorrectly totaling the inventory count sheets when computing the inventory value.
3. Changes in estimates that occur because a company did not prepare the estimates in good faith. For example, a
company may have adopted a clearly unrealistic depreciation rate.
4. An oversight, such as the failure to accrue or defer certain expenses and revenues at the end of the period.

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5. A misuse of facts, such as the failure to use salvage value in computing the depreciation base for the straight-line
approach.
6. The incorrect classification of a cost as an expense instead of an asset, and vice versa.

Accounting errors occur for a variety of reasons. The following table indicates 11 major categories of
accounting errors that drive restatements.
Accounting Category Type of Restatement
Expense recognition Recording expenses in the incorrect period or for an incorrect amount.
Improper revenue accounting. This category includes instances in which revenue
Revenue recognition was improperly recognized, questionable revenues were recognized, or any other
number of related errors that led to misreported revenue.
Misclassifying significant accounting items on the balance sheet, income
statement, or statement of cash flows. These include restatements due to
Misclassification
misclassification of short- or long-term accounts or those that impact cash flows
from operations.
Improper accounting for EPS, restricted stock, warrants, and other equity
Equity—other
instruments.
Errors involving accounts receivables bad debts, inventory reserves, income tax
Reserves/Contingencies
allowances, and loss contingencies.
Asset impairments of property, plant, and equipment; goodwill; or other related
Long-lived assets
items.
Errors involving correction of tax provision, improper treatment of tax liabilities,
Taxes
and other tax-related items.
Improper accounting for comprehensive income equity transactions including
Equity—other foreign currency items, income minimum pension liability adjustments,
comprehensive unrealized gains, and losses on certain investments in debt, equity securities, and
derivatives.
Inventory Inventory costing valuations, quantity issues, and cost of sales adjustments.
Equity—stock options Improper accounting for employee stock options.
Any restatement not covered by the listed categories including those related to
Other
improper accounting for acquisitions or mergers.
Source: T. Baldwin and D. Yoo “Restatements—Traversing Shaky Ground”, Trend Alert, Glass Lewis & Co. (June 2, 2005), p. 8.

As soon as a company discovers an error, it must correct the error. Companies record corrections of errors
from prior periods as an adjustment to the beginning balance of retained earnings in the current period. Such
corrections are called prior period adjustments.
If it presents comparative statements, a company should restate the prior statements affected, to correct for
the error. The company need not repeat the disclosures in the financial statements of subsequent periods.

Example of Error Correction

To illustrate, in 2013 the bookkeeper for Selector Company discovered an error: In 2012, the company failed
to record $20,000 of depreciation expense on a newly constructed building. This building is the only
depreciable asset Selector owns. The company correctly included the depreciation expense in its tax return
and correctly reported its income taxes payable. Presented below is Selector's income statement for 2012
(starting with income before depreciation expense) with and without the error.

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 Selector Company
Income statement
For The Year Ended, December 31, 2012

The error entries that Selector should have made and did make for recording depreciation expense and
income taxes are as follows.

The $20,000 omission error in 2012 results in the following effects.

Income Statement Effects
Depreciation expense (2012) is understated by $20,000.
Income tax expense (2012) is overstated by $8,000 ($20,000 x 40%).
Net income (2012) is overstated by $12,000 ($20,000 – $8,000).
Balance Sheet Effects
Accumulated depreciation – buildings is understated by $20,000.
Deferred tax liability is overstated by $8,000 ($20,000 x 40%).

To make the proper correcting entry in 2013, Selector should recognize that net in-come in 2012 is
overstated by $12,000; the Deferred Tax Liability is overstated by $8,000, and Accumulated Depreciation -
Buildings is understated by $20,000. The entry to correct this error in 2013 is as follows.
Retained Earnings 12,000
Deferred Tax Liability 8,000
Accumulated Depreciation—Buildings 20,000
The debit to Retained Earnings results because net income for 2012 is overstated. The debit to Deferred Tax
Liability is made to remove this account, which was caused by the error. The credit to Accumulated
Depreciation – Buildings reduces the book value of the building to its proper amount. Selector will make the
same journal entry to record the correction of the error in 2013 whether it prepares single-period (non-
comparative) or comparative financial statements.

Motivations for Change of Accounting Methods

Managers might have varying motives for reporting income numbers. Research has provided additional
insight into why companies may prefer certain accounting methods. Some of these reasons are as follows.

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Political costs – As companies become larger and more politically visible, politicians and regulators devote
more attention to them. The larger the firm, the more likely it is to become subject to regulation such as
antitrust, and the more likely it is to be required to pay higher taxes. Therefore, companies that are politically
visible may seek to report low income numbers, to avoid the scrutiny of regulators.
Capital structure – A number of studies have indicated that the capital structure of the company can affect
the selection of accounting methods. For example, a company with a high debt to equity ratio is more likely
to be constrained by debt covenants. The debt covenant may indicate that the company cannot pay dividends
if retained earnings fall below a certain level. As a result, such a company is more likely to select accounting
methods that will increase net income.
Bonus payments – Studies have found that if compensation plans tie managers’ bonus payments to income,
management will select accounting methods that maximize their bonus payments.
Smooth earnings – Substantial earnings increases attract the attention of politicians, regulators, and
competitors. In addition, large increases in income are difficult to achieve in following years. Further,
executive compensation plans would use these higher numbers as a baseline and make it difficult for
managers to earn bonuses in subsequent years. Conversely, investors and competitors might view large
decreases in earnings as a signal that the company is in financial trouble. Also, substantial decreases in
income raise concerns on the part of stockholders, lenders, and other interested parties about the competency
of management.

7.4 Summary of Guidelines for Accounting Changes and Errors

Having guidelines for reporting accounting changes and corrections has helped resolve several significant
and long-standing accounting problems. Yet, because of diversity in situations and characteristics of the
items encountered in practice, use of professional judgment is of paramount importance. In applying these
guidelines, the primary objective is to serve the users of the financial statements. Achieving this objective
requires accuracy, full disclosure, and an absence of misleading inferences.

The main distinctions and treatments presented in this chapter are summarized as follows.
Changes in Accounting Principle
Employ the retrospective approach by:
a) Changing the financial statements of all prior periods presented.
b) Disclosing in the year of the change the effect on net income and earnings per share for all prior periods
presented.
c) Reporting an adjustment to the beginning retained earnings balance in the retained earnings statement in
the earliest year presented.

If impracticable to determine the prior period effect (e.g., change to LIFO):

a) Do not change prior years’ income.
b) Use opening inventory in the year the method is adopted as the base-year inventory for all subsequent
LIFO computations.
c) Disclose the effect of the change on the current year, and the reasons for omitting the computation of
the cumulative effect and pro forma amounts for prior years.

Changes in Accounting Estimate

Employ the current and prospective approach by:
a) Reporting current and future financial statements on the new basis.
b) Presenting prior period financial statements as previously reported.
c) Making no adjustments to current-period opening balances for the effects in prior periods.

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Changes in Reporting Entity
Employ the retrospective approach by:
a) Restating the financial statements of all prior periods presented.
b) Disclosing in the year of change the effect on net income and earnings per share data for all prior
periods presented.

Changes Due to Error

Employ the restatement approach by:
a) Correcting all prior period statements presented.
b) Restating the beginning balance of retained earnings for the first period presented when the error effects
occur in a period prior to the first period presented.

Chapter Review Questions

Say "True" if the statement is correct, otherwise "False".
1. A change in accounting principle is a change that occurs as the result of new information or additional
experience.
2. Errors in financial statements result from mathematical mistakes or oversight or misuse of facts that
existed when preparing the financial statements.
3. Adoption of a new principle in recognition of events that have occurred for the first time or that were
previously immaterial is treated as an accounting change.
4. Retrospective application refers to the application of a different accounting principle to recast previously
issued financial statements—as if the new principle had always been used.
5. When a company changes an accounting principle, it should report the change by reporting the
cumulative effect of the change in the current year’s income statement.
Which of the following is treated as a change in accounting principle or not?
6. A change from LIFO to FIFO for inventory valuation.
7. A change to a different method of depreciation for plant assets.
8. A change from full-cost to successful efforts in the extractive industry.
9. A change from completed-contract to percentage-of-completion.
10. A change in the estimated useful life of plant assets.
11. A change from the cash basis of accounting to the accrual basis of accounting.
12. A change in inventory valuation from average cost to FIFO.
Which of the following is a retrospective-type accounting change or not?
13. Completed-contract method to the percentage-of-completion method for long-term contracts
14. LIFO method to the FIFO method for inventory valuation
15. Sum-of-the-years'-digits method to the straight-line method
16. "Full cost" method to another method in the extractive industry

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