Intermediate
Accounting
13 Canadian
th
Edition, Volume 2
Kieso ● Weygandt ● Warfield ● Wiecek ● McConomy
Chapter 21
Accounting Changes and Error
Analysis
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CHAPTER 21: Accounting Changes and
Error Analysis
1. types of accounting changes.
2. accounting for accounting changes.
3. Apply the retrospective method
4. Apply the prospective method
Types of Accounting Changes
1. Change in Accounting Policy
– Change in the choice of “specific principles,
bases, conventions, rules, and practices
applied by an entity in preparing and
presenting financial statements”
2. Change in Accounting Estimate
– Adjustment based on a change in
circumstances on which a previous estimate
was based or as the result of new information,
more experience or subsequent
developments
Types of Accounting Changes
3. Correction of an error in prior period financial
statements
– Omissions from or mistakes in financial
statements of prior periods caused by the
misuse or failure to use reliable information
that existed at the time financial statements
were prepared
– They may be intentional or an oversight
Changes in Accounting Policies
• Under IFRS, changes in accounting
policies are permitted only when the
change:
1. Is required by a primary source of GAAP, or
2. Results in portraying reliable and more
relevant information about effects of
transactions, events or conditions (voluntary)
Changes in Accounting Estimates
• Future conditions and events and their effects
cannot be known with certainty; therefore
estimation requires exercise of judgment
• Use of reasonable estimates is essential to the
accounting process and does not undermine the
reliability of financial statements
Changes in Accounting Estimates
• Examples of items requiring estimates
include:
– Uncollectible receivables
– Inventory obsolescence
– Fair value of financial assets/liabilities
– Useful lives and residual values of
depreciable assets
– Liabilities for warranty costs
– Impairment losses
Changes in Accounting Estimates
• Differentiating a change in policy and a change in
estimate can be difficult
• For example, is a change in depreciation method a
change in policy or a change in estimate?
– At first glance, a change in depreciation method appears to be a
change in accounting policy
– However, it is a change in estimate if it is a change in estimate of
the pattern in which company benefits from the asset
• Where it is not clear, treat the change as a change in
estimate
Correction of a Prior Period Error
• Examples of accounting errors include:
– Change to an acceptable method from a non-
GAAP method
• change from immediate recognition of bad debts to
the allowance method
– Mathematical mistakes
• e.g. incorrect totaling of inventory count sheets
– Oversight
• Missed a necessary year-end adjustment
– Misappropriation of assets
• discovery of inventory theft
Correction of a Prior Period Error
• Distinguishing between correction of an error and a
change in estimate can be difficult
• Example: a lack of a previous year’s accrual of reassessed
income taxes – was the information overlooked (i.e. an
error) or do we have more information or were there
subsequent developments (i.e. an estimate)?
• General rule: if an estimate was calculated incorrectly due
to lack of expertise, it is considered an error;
• If a careful estimate was made in a previous year which is
later determined as incorrect, it is considered a change in
estimate
Alternative Accounting Methods
• Three approaches have been suggested
for reporting changes in the accounts:
1. Retrospective
2. Current
3. Prospective
Retrospective Treatment
• Also known as retroactive application
• Requires calculating the cumulative effect of the change on
the financial statements at the beginning of the period as if
the new method or estimate had always been used
• An adjustment is made to the financial statements including
all affected accounts equal to this cumulative effect
• Results in restating all affected prior years’ financial
statements on a basis consistent with the newly adopted
policy (i.e. as if the new accounting policy had always been
used)
Current Treatment
• New accounting method or estimate’s
cumulative effect on the financial
statements as of the beginning of the
period is calculated
• An adjustment is reported in the current
year’s income statement
• Prior years’ financial statements are not
restated
Prospective Treatment
• Previously reported results remain; no
change is made
• Opening balances are not adjusted and no
attempt is made to correct or change past
periods
• New policy or estimate is adopted for
current and future periods only and applied
to balances existing at the date of the
change
Accounting Standards
Type of Accounting Change Accounting Method Applied
Change in Accounting Policy – Apply method approved in
Adoption of primary source of transitional provisions section of
GAAP the primary source; if none, then
use retrospective application (if
impractical, apply prospectively).
Change in Accounting Policy – Apply retrospectively to the extent
Voluntary practicable.
Change in accounting estimate Apply prospectively.
Correction of an error Apply retrospectively.
Retrospective-with-Restatement
Requirements of this method include:
1. Retroactive application of the new method,
including income tax effects using an
accounting entry
2. Prior-period financial statements included for
comparative purposes are restated
3. Description of the change and effect on current
and prior period financial statements disclosed
so that statements remain comparable
Retrospective-with-Restatement - Example
Given:
• Voluntary change to capitalizing all avoidable
interest costs on self-constructed assets
• Cumulative effects at January 1, 2017:
• Capitalizing interest: $20,000 + $200,000 =
$220,000
• Income tax effect: $6,000 + $60,000 = $66,000
Retrospective-with-Restatement - Example
January 1, 2017: To record retroactive change
Buildings 220,000
Deferred Tax Liability 66,000
Retained Earnings 154,000
Note: You capitalized interest that was previously an
expense. No longer a deduction. NI increases, so
increase RE net of tax.
Retrospective-with-Restatement - Example
See next page for explanation
Income Statement BEFORE Retroactive Change
2017 2016
Income before tax $ 190,000 $ 160,000
Income tax expense 57,000 48,000
Net income $ 133,000 $ 112,000
EPS (100,000 shares) $ 1.33 $ 1.12
Income Statement AFTER Retroactive Change
2017 2016
Income before tax $ 200,000 $ 180,000
Income tax expense 60,000 54,000
Net income $ 140,000 $ 126,000
EPS (100,000 shares) $ 1.40 $ 1.26
• This change increases EBT by the 20,000
interest for 2016 and then increases tax by
the 6,000 related to the 20,000 of interest
capitalized.
• NI increases 14,000
Corrections of Errors
• Counterbalancing errors are errors that
occur in one period and correct
themselves in the next period. Non-
counterbalancing errors take longer than
the next year to correct themselves and
sometimes may exist until the item in error
is no longer a part of the entity's financial
statements.
Counterbalancing errors
• Failure to record accrued revenues or expenses.
•
• Failure to record prepaid revenues or expenses.
•
• Overstatement or understatement of purchases.
•
• Overstatement or understatement of ending
inventory.
Non-counterbalancing errors
• Failure to record amortization.
•
• Recording a depreciable asset as an expense.
•
• Recording the purchase of land as an expense.
•
• Recording the discount on bonds as interest
expense in the year of issue
• Assume a building owner received a rent payment for the 2018 rent of
$24,000 on December 31, 2017. The following entry was made on Dec. 31,
2017 and no adjustment was recorded:
•
• Cash........................................................24,000
• Rent Revenue.............................................. 24,000
•
• This would cause Rent Revenue to be overstated in 2017. If the error was
found in 2018, the following entry would be made:
•
• Retained Earnings .............................24,000
• Rent Revenue........................................ 24,000
• (ignores tax)
• This entry would reduce Retained Earnings for
the overstatement of Rent Revenue in 2017 and
properly state the Rent Revenue account for
2018. If this error were discovered after the
books were closed in 2018, no entry would be
made because the error is counterbalanced.
• (the scenario ignores tax effects)
Retrospective with Partial Restatement
• Retroactively restating prior years’ financial
statements requires information that may
be impractical to obtain on a cost-benefit
basis
• Some standards allow for a partial
retrospective application
• The change in policy is applied at the
beginning of the earliest period for which
restatement is possible
Disclosures – Changes in Accounting Policy
• For changes in policy resulting from initial application of a primary source
of GAAP or from a voluntary change, the following must be disclosed:
• For first-time application of IFRS or primary source, its title, nature of
change and that made in accordance with transitional provisions, and
what provisions are (including those that affect future periods)
• The nature of any voluntary change in accounting policy, and why the
new policy results in reliable and more relevant information (under
ASPE, some voluntary changes are exempt from this requirement)
• The amount of the adjustment for each financial statement line item
that is affected for current and prior periods
• The reasons it was not practicable for restatement of particular
periods, with a description of how the change was applied and from
what date
Disclosures – Changes in Accounting Policy
• IFRS also requires disclosures for new
primary sources of GAAP that are not yet
effective and have not been applied:
1. Disclose the fact that new primary source has
been issued, and
2. Any reasonably reliable information useful in
assessing possible impact on financial
statement in the period in which it will be first
applied
Correction of an Error
• Under ASPE, full retrospective
adjustment is required
• Under IFRS, partial retrospective
adjustment is allowed if full retrospective
restatement is impracticable
Disclosures –Correction of an Error
• Where a change is the result of an accounting
error, companies must disclose that an error
occurred in a prior period(s) and disclose, in the
year of the correction:
• The nature of the error;
• The amount of the correction to each line item on the
financial statements presented for comparative
purposes;
• The amount of the correction made at the beginning
of the earliest prior period presented.
Disclosures –Error Correction
• IFRS requires additional disclosures:
– Where partial retrospective restatement is
made on grounds of impracticability, additional
information relating to impracticability and
adjustment is required
– Effect of correction on basic and diluted EPS
for each period presented
Prospective Application
• Effects of changes in estimates are handled
prospectively
• No changes are made to previously reported results
– Changes in estimates are viewed as normal recurring
corrections and adjustments
• Effect of a change in estimate is accounted for by
including it in net income or comprehensive income as
appropriate in:
– The period of change if the change affects that period only
– The period of change and future periods if the change affects
both
Disclosure – Change in Estimate
• Minimum disclosures are as follows:
1. The nature of the change in estimate
2. The amount of the change in estimate
affecting the current period
• IFRS also requires disclosure of the
nature and amount of any change
expected to impact future periods
– If it is not practicable to estimate effect, this fact is
disclosed
Interpreting Accounting Changes
• Accounting changes often make it difficult
to develop trend data
– Users of the financial statements should look
at accounting changes closely when they
occur and adjust trend data as appropriate
