ISU MODULE TEMPLATE

Subject: INTERMEDIATE ACCOUNTING III

Title of the Module

Accounting Changes
Learning Outcome
At the end of the chapter, the students should be able to:
 Identify the accounting changes
 Know the recognition and reporting of change in accounting estimate
 Know the recognition and reporting of a change in accounting policy
 Know the guideline when selecting accounting policy in the absence of an accounting standard
 To know the recognition and reporting of prior period errors

ACCOUNTING CHANGES

a. change in accounting estimate and errors

b. change in accounting policy
c. events after the reporting period

Related standards:
PAS 1 presentation of financial statements
PAS 8 accounting policies, change in estimates and errors
PAS 10 events after the reporting period
 Accounting changes can have a great impact on an entity’s reported earnings
 It is critically important that users of financial statements understand the nature and effect of accounting
changes and must not rely solely on the bottom line which is the net income or loss.

Notes (notes to the financial statements)

 Provides information in addition to those presented in the other financial statements. It is an integral part
of a complete set of financial statements.
 All other financial statements are intended to be read in conjunction with the notes.

PAS 1 requires an entity to present the notes in a systematic manner.

1. General information on the reporting entity.

2. statement of compliance with the PFRS and basis of preparation of financial statements.
3. summary of significant accounting policies.
4. disaggregation (breakdowns) of the line items in the other financial statements and other supporting
information.
5. other disclosures required by PFRS.
6. other disclosures not required by PFRS.

Accounting Policies

Accounting policies are “the specific principle, bases, conventions, rules and practices applied by an entity in
preparing and presenting financial statements.” (PAS 8.5)

Changes in Accounting Policies

 PAS 8 requires the consistent selection and application of accounting policies.

 PAS 8 permits a change in accounting policy only if the change:
a. is required by a PRFS; or
b. results in reliable and more relevant information

Examples of Change in Accounting Policies:

1. change from FIFO to weighted average cost formula for inventories

2. change from the cost model to the fair value model of measuring investment property
3. change from the cost model to the revaluation model of measuring property, plant and equipment and
intangible assets
4. change in business model for classifying financial assets
5. change in the method of recognizing revenue from long-term construction contracts
6. change to a new policy resulting from the requirement of a new PFRS
7. change in financial reporting framework, such as PFRS for SME’s to full PFRS
Illustration 1: (change in accounting policy)
An entity consistently applies cost model for its land classified as investment property. Due to sudden increase in
the fair value of the land, the entity considered that changing the accounting to fair value model will result to
more relevant information in its financial statements. The land’s fair value as of the end of each period can be
measured reliably.

Illustration 2: (Not a change in accounting policy)

An entity consistently applies cost model for its land classified as investment property. Due to lack of interested
lessees, the entity converted the land to be used as a site for its new office building. Consequently, the land was
reclassified as PPE and accounted for under revaluation model, which applied to the entity’s existing lands that
are classified as PPE.

Accounting for Changes in Accounting Policies

Change in accounting policies are accounted for using the following order of priority:
1. transitional provision in a PFRS, if any
2. retrospective application, in the absence of a transitional provision.
3. prospective application, if retrospective application is impracticable.

Retrospective Application is applying a new accounting policy to transactions, other events and conditions as
if that policy had always been applied.

The entity shall adjust the opening balance of each affected component of equity (usually, retained earnings)
for the earliest prior period presented and the other comparative amounts disclosed for each prior presented as if
the new accounting policy had been applied.

To illustrate, assume an entity reported the following cost of sales for the year ended December 31, 2022:
Inventory, January 1 100,000
Purchases, net 800,000
Total Goods available for sale 900,000
Less: Inventory, December 31 130,000
Cost of Sales 770,000

In 2023, the entity has decided to switch from using the FIFO method to the weighted average method.
Using the weighted average method for the year ended December 31, 2022, the cost of sales should have been

Inventory, January 1 120,000

Purchases, net 800,000
Total Goods available for sale 920,000
Less: Inventory, December 31 160,000
Cost of Sales 760,000

A change in inventory valuation method from FIFO to Weighted Average method is a change in accounting policy
that is accounted for retrospectively.
Specifically, the change is accounted for as follows:

(a) the 2022 financial statements are restated to reflect the retrospective application of the weighted average
method.
(b) the restated December 31, 2022 statement of financial position will report inventory at P160,000.
(c) the cost of sales for the years ended December 31, 2023 and 2022 will be computed using the weighted
average method as if the entity did not use the FIFO.
(d) the January 1, 2022 retained earnings balance is adjusted as follows:

Inventory, January 1 (WA) 120,000

Inventory, January 1 (FIFO) 100,000
Effect of Change in accounting policy 20,000

Retained earnings, January 1, 2022 xxxx

Effect of Change in accounting policy 14,000
Retained earnings, January 1 (as restated) xxxx

(e) since the effect of the change in inventory valuation method on the previous period’s ending inventory is
offset by the effect on the succeeding period’s beginning inventory, the cumulative effect of the change in
accounting policy as of January 1, 2023 is computed as follows:

Inventory, December 31, 2022 (WA) 160,000

Less Inventory, December 31, 2022 (FIFO) 130,000
Cumulative effect of change 30,000

Inventory 30,000
Retained Earnings 21,000
 Income Tax Payable 9,000
(f) the entity is required to present a third statement of financial position (dated January 1, 2022) in addition to
the minimum comparative financial statements if the retrospective application has a material effect on the
information in the statement of financial position as at January 1, 2022.

Illustration: change of cost formulas

During 2021, ABC Co. decided to change from average cost formula inventory valuation to the FIFO cost formula.
Inventory balances under each method are as follows:

Average FIFO
January 1 1,000,000.00 1,200,000.00
December 31 2,000,000.00 2,100,000.00
Income tax rate is 30%.

Requirement: what is the net cumulative effect of the accounting change in ABC’s opening retained earnings
balance?

Solution:
average inventory - January 1 1,000,000.00
FIFO inventory - January 1 1,200,000.00
cumulative effect - gross of tax 200,000.00
multiply by: (100% - tax rate) 70%
cumulative effect - net of tax 140,000.00

Inventory 200,000.00
Retained earnings 140,000.00
Deferred tax liability 60,000.00

PAS 12 Income Taxes requires the recognition of current or deferred taxes on adjustments to the opening
balance of the retained earnings resulting from either a change in accounting policy that is applied
retrospectively or the correction of an error.

Retrospective application of change in accounting policy will also result to present three statements of
financial position dated as follows:
a. the end of the current period;
b. the end of the preceding period;
c. the beginning of the preceding period

Illustration:
During 2023, an entity decided to change its inventory cost flow model assumption from FIFO method to Average
method. Relevant information is as follows:

Inventory balances Dec 31, 2021 Dec 31, 2022 Dec 31, 2023
Average method 3,000,000 4,500,000 5,200,000
FIFO method 2,700,000 4,250,000 5,050,000

On January 1, 2023, the following entry shall be made to record the P250,000 increase in beginning inventory
from P4,250,000 under FIFO method to P4,500,000 under average method.

Inventory Beginning 250,000

Retained earnings 250,000

The effects of the difference in inventory balance as of December 31, 2021 has been counterbalanced over the
two-year period from 2021-2022. Consequently, no separate journal entry shall be made for 2021.

In addition, the entity’s 2023 financial statements shall be affected as follows:

The statement of financial position shall be presented as of the following dates with the related inventory
balances under the Average Method:

Date Inventory Balances

Beginning of preceding period Jan 1, 2022 3,000,000
End of preceding period Dec 31, 2022 4,500,000
End of current period Dec 31, 2023 5,200,000
Limitations on Retrospective Application of a Change in Accounting Policy
When it is impracticable to determine the cumulative effect of the beginning of the current period of applying a
new accounting policy to all prior periods, the entity shall adjust the comparative information to apply the new
accounting policy prospectively from the earliest date of impracticable.

Change in Accounting Estimate

PAS 8, defines a change in accounting estimate as an adjustment of the carrying amount of an asset or a liability,
or the amount of the periodic consumption of an asset that results from the assessment of the present status and
expected future benefit and obligation associated with the asset and liability

 A change in accounting estimate is a normal recurring correction or adjustment of an asset or liability

which is the natural result of the use of an estimate.
 The use of reasonable estimate is an essential part of the preparation of financial statements and does not
undermine their reliability.

Examples of accounting estimate

a. doubtful accounts / bad debts
b. inventory obsolescence / net realizable value of inventories
c. useful life, residual value, and expected pattern of consumption of benefit of depreciable asset
d. warranty cost / provisions
e. fair value of financial asset and financial liabilities

Accounting for changes in accounting estimates

Changes in accounting estimates are accounted for by prospective application. Prospective application means
recognizing the effects of the change in profit or loss, either in:
a. the period of change
b. the period of change and future periods if both are affected.

Illustration: change in depreciation method, estimated useful life and residual value

On January 1, 2016, DEF Co. acquired equipment for P1,000,000. The equipment will be depreciated using the
straight line method over 20 years. The estimated residual value is P100,000.

In 2021, following a reassessment of the realization of the expected economic benefits from the equipment, DEF
Co. changed its depreciation method to sum of the years digits (SYD). The remaining useful life of the asset is
estimated to be 4 years and the residual value is changed to P50,000.

Requirement: compute for the depreciation expense in 2021? 290,000

Illustration: change in provisions

On December 31, 2020, GHI Co. recognized the following provisions:

Dec 31, 2020 Warranty Expense 50,000.00

Estimated warranty obligation 50,000.00

Dec 31, 2020 Probable loss on litigation 100,000.00

Estimated liability on pending
litigation 100,000.00

In 2022, GHI incurred P65,000 in discharging its warranty obligation and settled pending lawsuit for P90,000.
Requirement: provide the entries made in 2021
Warranty Expense 15,000.00
Estimated warranty obligation 50,000.00
Cash in Bank 65,000.00

Estimated liability on pending litigation 100,000.00

Gain on settlement of litigation 10,000.00
Cash in Bank 90,000.00
Illustration: Bad Debts
During the prior periods, an entity consistently estimated it allowance for bad debts as equal to 5% of its
accounts receivable balance. However, during 2023, an entity changed its estimate to 3% of its accounts
receivable. As of December 31, 2023, the entity reported accounts receivable and unadjusted allowance for bad
debts amounted to P5,000,000 and P90,000, respectively.

No Change Change to 3%
Required ending balance of allowance 250,000 150,000
less: unadjusted balance of allowance (90,000) (90,000)
required bad debt expense 160,000 60,000

For the year 2023, the entity shall recognize bad debt expense of P60,000.

Change in Accounting Policy Change in Accounting Estimate

Normally results from a Normally results from changes on

change in measurement how the expected inflows or
basis (e.g., FIFO to Weighted outflows of economic benefits
Average, Cost to Fair Value, are realized from assets or
etc.) incurred liabilities

Errors
Errors include misapplication of accounting policies, mathematical mistakes, oversight or misinterpretations of
facts, and fraud.

Financial statements do not comply with PFRS if they contain either material errors or immaterial errors made
intentionally to achieve a particular presentation of an entity’s financial position, financial performance or cash
flows. (PAS 8.41)

Material errors are those that cause the financial statements to be misstated. Intentional errors are fraud.

The types of errors according to the period of occurrence:

a. current period errors – are errors in the current period that were discovered either during the current period
or after the current period but before the financial statements were authorized for issue. These are corrected
simply by correcting entries.

b. prior period errors – are errors in one or more prior periods that were only discovered either during the
current period or after the current period but before the financial statements were authorized for issue. These are
corrected by retrospective restatement.

Illustration: current period error

On January 10, 2022, prior to authorization of ABC Co.’s December 31, 2021 financial statements for issue, the
accountant of ABC Co. received a bill for an advertisement made in the month of December 2021 amounting to
P400,000. This expense was not accrued as of December 31, 2021.

Requirement: prepare the correcting entries assuming (a) books are still open and (b) books are already
closed.

a. advertising expenses 400,000

advertising payable 400,000
b. retained earnings 400,000
advertising payable 400,000

Illustration: prior period error

On January 15, 2022 while finalizing its 2021 financial statements, ABC Co. discovered that depreciation expense
recognized in 2020 is overstated by P400,000.

Accumulated depreciation 400,000

Retained earnings 400,000

Types of Accounting Errors

1. Error in principle – these arise from lack of knowledge of accounting standards or procedures, misuse of
available information, or misinterpretation of accounting standards, whether intentional or unintentional.

2. Clerical or similar errors – these include mathematical mistakes, oversights or misinterpretations of facts.
 a. transplacement error – committed when the number of digits in an amount is incorrectly increased or
decreased.
b. transposition error – is committed when the digits in an amount are interchanged.
c. errors of omission – the accountant forgot to record a transaction.
d. errors of commission – the accountant recorded a transaction twice or partially.
e. compensating errors – P500 overstatement in the sales account is compensated by P500 overstatement
in expense account.
f. accounting system error – there is a “bug” in the computer program.

effect in Net
Scenario Income Correction
Understated income Understatement Addition to Net income
Deduction from net
Overstated income Overstatement income
Understated Deduction from net
expenses Overstatement income
Overstated expenses Understatement Addition to Net income

TYPES of Errors
Balance sheet errors – errors affecting only balance sheet accounts. For example, PPE items were classified as
investment properties

Income statement errors – errors affecting only income statement accounts. From example, administrative
expenses classified as selling expenses

Mixed errors – errors affecting at least one balance sheet and at least one income stamen account

Illustration:
During the year, an entity reported net income of P1,500,000. Upon looking closer in its records, the following
errors were noted:
 Utilities expense was understated by P240,000
 Interest income was overstated by P120,000
 Salaries expense was overstated by P320,000
 Gain on sale was understated by P90,000

Unadjusted net income P1,500,000

Add: understated gain on sale 90,000
overstated salaries expense 320,000
Less: overstated interest income (120,000)
understated utilities expense (240,000)
Adjusted Net Income P1,550,000

MISSTATEMENTS IN THE ENDING INVENTORY

The ending inventory affects the amounts of cost of goods sold, gross profit, and ultimately, net income.
Misstatements on the ending inventory shall affect these amounts, not just during the current period, but also in
the immediately succeeding period.

The effects of misstatements of ending inventory during the current period are exactly the opposite of its
effects in the immediately succeeding period, making this misstatement a counter balancing error.

Illustration:
An entity reported the following condensed income statement for the years 2023 and 2024
2023 2024
Net sales 7,500,000 8,800,000
Less: cost of goods sold (4,200,000) (5,050,000)
Gross profit 3,300,000 3,750,000
Less: operating expenses (2,400,000) (2,800,000)
Net Income 900,000 950,000

The cost of goods sold for each year was determined as follows:
2023 2024
Beginning inventory 1,200,000 1,500,000
Add: purchases 4,500,000 5,300,000
Less: ending inventory (1,500,000) 1,750,000)
Cost of goods sold 4,200,000 5,050,000

Required; under each of the following independent scenarios, determine the correct amount of net income for
2023 and 2024
1. the correct amount of 2023 ending inventory was P1,380,000
2. the correct amount of 2023 ending inventory was P1,720,000

In this scenario, the 2023 ending inventory is said to be overstated by P120,000 (P1,500,000 – 1,380,000). The
correct amounts of cost of goods sold and net income for 2023 and 2024 are determined as follows:

2023 2024
Beginning inventory 1,200,000 1,380,000
Add: purchases 4,500,000 5,300,000
Less: ending inventory (1,380,000) (1,750,000)
Corrected Cost of goods sold 4,320,000 4,930,000

2023 2024
Net sales 7,500,000 8,800,000
Less: cost of goods sold (4,320,000) (4,930,000)
Gross profit 3,180,000 3,870,000
Less: operating expenses (2,400,000) (2,800,000)
Corrected Net Income 780,000 1,070,000

Net income Under or

amounts Reported Corrected overstatement
2023 COGS 4,200,000.00 4,320,000.00 understated by P120,000
2023 Gross Profit 3,300,000.00 3,180,000.00 Overstated by P120,000
2023 Net Income 900,000.00 780,000.00 Overstated by P120,000
2024 COGS 5,050,000.00 4,930,000.00 Overstated by P120,000
2024 Gross Profit 3,750,000.00 3,870,000.00 understated by P120,000
2024 Net Income 950,000.00 1,070,000.00 understated by P120,000

Take note that in computing cost of goods sold for 2024, the ending inventory of 2023 is the beginning inventory
of 2024.
In addition, retained earnings as of December 31, 2023 is overstated by P120,000 since the net income for 2023
is overstated by the same amount.
On the other hand, retained earnings as of December 31, 2024 is correctly stated since the P120,000 net income
in 2023 was fully match by the understatement for the year 2024. This only shows that this error is indeed a
counterbalancing one.

2023 2024
Beginning inventory 1,200,000 1,720,000
Add: purchases 4,500,000 5,300,000
Less: ending inventory (1,720,000) (1,750,000)
Corrected Cost of goods sold 3,980,000 5,270,000

2023 2024
Net sales 7,500,000 8,800,000
Less: cost of goods sold (3,980,000) (5,270,000)
Gross profit 3,520,000 3,530,000
Less: operating expenses (2,400,000) (2,800,000)
Corrected Net Income 1,120,000 730,000

Net income
amounts Reported Corrected Under or overstatement
2023 COGS 4,200,000.00 3,980,000.00 overstated by P220,000
2023 Gross Profit 3,300,000.00 3,520,000.00 understated by P220,000
2023 Net Income 900,000.00 1,120,000.00 understated by P220,000
2024 COGS 5,050,000.00 5,270,000.00 understated by P220,000
2024 Gross Profit 3,750,000.00 3,530,000.00 overstated by P220,000
2024 Net Income 950,000.00 730,000.00 overstated by P220,000

SUMMARY FOR ERRORS:

1. accounting errors may arise from the unintentional misapplication of accounting principles or incorrect
recording of transactions and fraudulent financial reporting.
2. as to accounts affected, errors can be classified as balance sheet errors, income statement errors, or mixed
errors.
3. as to the ability to self-correct, errors are classified as counter balancing (i.e. can self-correct) or non-counter
balancing (i.e. cannot self-correct)
4. the following are considered as counter balancing
 Errors involving ending inventory
  Errors involving purchases recorded during the wrong period
 Errors involving non-accrual or income or expense
 Errors involving prepayments that were initially recorded using expense method, but no adjusting entries
were made
 Errors involving advances from customers that were initially recorded using income/revenue method , but
no adjusting were made
 Errors involving acquisition of a capitalize long-term assets that was charge to expense outright
5. generally, counter balancing errors have an equal but opposing effects in the net income of the current year
and the succeeding year.

Events after the Reporting Period

Events after the reporting period are “those events, favorable and unfavorable, that occur between the
end of the reporting period and the date when the financial statements are authorized for issue.” (PAS 10.3)

It should be noted that by default, transactions happening after the reporting period are not recorded as
of the reporting date. Transactions shall be recorded in the period during they occur. This makes the
non-adjusting events as the general rule, while the adjusting events are the exceptions

For example, an entity acquired a building on January 5, 2024. The acquisition shall not be reflected in the 2023
statement of financial position, even if it happened during the period when the entity is currently finalizing its
2023 financial statements. The same is also true for the sales and purchases made during 2024, which shall also
be excluded from the 2023 financial statements.

ADJUSTING EVENTS AFTER THE REPORTING PERIOD

These events include, but are not limited to, the following examples:
a. the settlement after the reporting period of a court case that confirms the entity had a present
obligation at the end of the reporting period.
b. the receipt of information after the reporting period which indicates the assets net realizable value or its
recoverable amount, for example
 The bankruptcy of a customer that occurs after the reporting period usually confirms that the customer
was credit-impaired at the end of the reporting period.
 The sale of inventories after the reporting period may give evidence about their net realizable value at
the end of the reporting period
c. the determination after the reporting period of the cost of assets purchased or the proceeds from assets
sold before the end of the reporting period.
d. the determination after the reporting period of the amount of profit-sharing or bonus payments if the entity
had a present legal or constructive obligation at the end of the reporting period.
e. the discovery of fraud or errors that show that the financial statements are incorrect.
f. going concern issues arising after the reporting date, but before the financial statements are authorized for
issue.

Illustration:

ABC Co. completes the draft of its December 31,2021 year-end financial statements on January 31, 2022. On
February 5, 2022, the board of directors reviews the financial statements and authorizes them for issue. The
entity announces its profit and selected other financial information on February 23, 2022. The financial
statements are made available to shareholders and others on March 1, 2022. The shareholders approve the
financial statements at their annual meeting on March 18, 2022 and the approved financial statements are then
filed with the regulatory body on April 1, 2022.

Two types of events after the reporting period.

1. adjusting events after the reporting period – are events that provide evidence of conditions that existed at the
end of the reporting period.
2. Non-adjusting events after the reporting period – are events that are indicative of conditions that arose after
the reporting period.