Changes in accounting principle, changes in estimates, and corrections of errors require unique reporting provisions.
Changes in Accounting Principle
Changes in accounting occur frequently in practice because important events or conditions may be in dispute or uncertain at the statement date. One type of ac- counting change results when a company adopts a different accounting princi- ple. Changes in accounting principle include a change in the method of inventory pricing from FIFO to average-cost, or a change in accounting for construction con- tracts from the percentage-of-completion to the completed-contract method. [6]14 A company recognizes a change in accounting principle by making a retro- spective adjustment to the financial statements. Such an adjustment recasts the prior years’ statements on a basis consistent with the newly adopted principle.
The company records the cumulative effect of the change for prior periods as an adjustment to beginning retained earnings of the earliest year presented.
To illustrate, Gaubert Inc. decided in March 2015 to change from FIFO to weighted- average inventory pricing. Gaubert’s income before income tax, using the new weighted- average method in 2015, is $30,000. Illustration 4-17 presents the pretax income data for 2013 and 2014 for this example.
14In Chapter 22, we examine in greater detail the problems related to accounting changes, and changes in estimates (discussed in the next section).
7 LEARNING OBJECTIVE Understand the reporting of accounting changes and errors.
Underlying Concepts Companies can change principles, but they must demonstrate that the newly adopted principle is preferable to the old one. Such changes result in lost consistency from period to period.
Excess of
Weighted- FIFO
Average over Weighted-
Year FIFO Method Average Method
2013 $40,000 $35,000 $5,000
2014 30,000 27,000 3,000
Total $8,000
ILLUSTRATION 4-17 Calculation of a Change in Accounting Principle
Illustration 4-18 shows the information Gaubert presented in its comparative income statements, based on a 30 percent tax rate.
Thus, under the retrospective approach, the company recasts the prior years’ income numbers under the newly adopted method. This approach therefore preserves compa- rability across years.
Changes in Accounting Estimates
Changes in accounting estimates are inherent in the accounting process. For example, companies estimate useful lives and residual values of depreciable assets, uncollectible receivables, inventory obsolescence, and the number of periods expected to benefit from a particular expenditure. Not infrequently, due to time, circumstances, or new informa- tion, even estimates originally made in good faith must be changed. A company ac- counts for such changes in the period of change if they affect only that period, or in the period of change and future periods if the change affects both.
To illustrate a change in estimate that affects only the period of change, assume that DuPage Materials Corp. consistently estimated its bad debt expense at 1 percent of credit sales. In 2015, however, DuPage determines that it must revise upward the esti- mate of bad debts for the current year’s credit sales to 2 percent, or double the prior years’ percentage. The 2 percent rate is necessary to reduce accounts receivable to net realizable value. Using 2 percent results in a bad debt charge of CHF240,000, or double the amount using the 1 percent estimate for prior years. DuPage records the bad debt expense and related allowance at December 31, 2015, as follows.
Bad Debt Expense 240,000
Allowance for Doubtful Accounts 240,000
DuPage includes the entire change in estimate in 2015 income because the change does not affect future periods. Companies do not handle changes in estimate retro- spectively. That is, such changes are not carried back to adjust prior years. (We examine changes in estimate that affect both the current and future periods in greater detail in Chapter 22.) Changes in estimate are not considered errors.
Corrections of Errors
Errors occur as a result of mathematical mistakes, mistakes in the application of ac- counting principles, or oversight or misuse of facts that existed at the time financial statements were prepared. In recent years, many companies have corrected for errors in their financial statements. The errors involved such items as improper reporting of rev- enue, accounting for share options, allowances for receivables, inventories, and other provisions.
Companies correct errors by making proper entries in the accounts and reporting the corrections in the financial statements. Corrections of errors are treated as prior period adjustments, similar to changes in accounting principles. Companies record a correction of an error in the year in which it is discovered. They report the error in the financial statements as an adjustment to the beginning balance of retained earnings. If a company prepares comparative financial statements, it should restate the prior state- ments for the effects of the error.
2015 2014 2013
Income before income tax $30,000 $27,000 $35,000
Income tax 9,000 8,100 10,500
Net income $21,000 $18,900 $24,500
ILLUSTRATION 4-18 Income Statement Presentation of a Change in Accounting Principle
Other Reporting Issues 155 To illustrate, in 2015, Tsang Co. determined that it incorrectly overstated its accounts
receivable and sales revenue by NT$100,000 in 2014. In 2015, Tsang makes the following entry to correct for this error (ignore income taxes).
Retained Earnings 100,000
Accounts Receivable 100,000
Retained Earnings is debited because sales revenue, and therefore net income, was overstated in a prior period. Accounts Receivable is credited to reduce this overstated balance to the correct amount.
Summary
The impact of changes in accounting principle and error corrections are debited or cred- ited directly to retained earnings, if related to a prior period. Illustration 4-19 summarizes the basic concepts related to these two items, as well as the accounting and reporting for changes in estimates. Although simplified, the chart provides a useful framework for determining the treatment of special items affecting the income statement.
Retained Earnings Statement
Net income increases retained earnings. A net loss decreases retained earnings.
Both cash and share dividends decrease retained earnings. Changes in account- ing principle (generally) and prior period adjustments may increase or decrease retained earnings. Companies charge or credit these adjustments (net of tax) to the opening balance of retained earnings.
Companies may show retained earnings information in different ways. For example, some companies prepare a separate retained earnings statement, as Illustration 4-20 shows.
ILLUSTRATION 4-19 Summary of Accounting Changes and Errors
Change from one generally accepted accounting principle to another.
Normal, recurring corrections and adjustments.
Mistake, misuse of facts.
Change in the basis of inventory pricing from FIFO to
average-cost.
Changes in the realizability of receivables and inventories;
changes in estimated lives of equipment, intangible assets;
changes in estimated liability for warranty costs, income taxes, and salary payments.
Error in reporting income and expense.
Recast prior years’ income statements on the same basis as the newly adopted principle.
Show change only in the affected accounts (not shown net of tax) and disclose the nature of the change.
Restate prior years’ income statements to correct for error.
Type of Situation Criteria Examples Placement on Income Statement
Changes in accounting principle Changes in
accounting estimates
Corrections of errors
8 LEARNING OBJECTIVE Prepare a retained earnings statement.
ILLUSTRATION 4-20 Retained Earnings Statement
CHOI INC.
RETAINED EARNINGS STATEMENT
FORTHE YEAR ENDED DECEMBER 31, 2015
Retained earnings, January 1, as reported W1,050,000 Correction for understatement of net income in prior period
(inventory error) 50,000
Retained earnings, January 1, as adjusted 1,100,000
Add: Net income 360,000
1,460,000
Less: Cash dividends W100,000
Share dividends 200,000 300,000
Retained earnings, December 31 W1,160,000
The reconciliation of the beginning to the ending balance in retained earnings pro- vides information about why net assets increased or decreased during the year. The association of dividend distributions with net income for the period indicates what management is doing with earnings: It may be “plowing back” into the business part or all of the earnings, distributing all current income, or distributing current income plus the accumulated earnings of prior years.
Restrictions of Retained Earnings
Companies often restrict retained earnings to comply with contractual requirements, board of directors’ policy, or current necessity. Generally, companies disclose in the notes to the financial statements the amounts of restricted retained earnings. In some cases, companies transfer the amount of retained earnings restricted to an account titled Appropriated Retained Earnings. The retained earnings section may therefore report two separate amounts: (1) retained earnings free (unrestricted) and (2) retained earn- ings appropriated (restricted). The total of these two amounts equals the total retained earnings.