Intermediate Accounting - mcgrawhill.ca · EXHIBIT 22-3 Sunset Corporation ... The fact that the FS of prior periods have not been restated The fact that an accounting policy has

b a c k n e x th o m e

Thomas H. BeechySchulich School of Business,

York University

Joan E. D. ConrodFaculty of Management,

Dalhousie University

PowerPoint slides by:Bruce W. MacLean,Bruce W. MacLean,

Faculty of Management,Faculty of Management,

Dalhousie UniversityDalhousie University

Copyright 1998 McGraw-Hill Ryerson Limited, Canada

Intermediate Accounting


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Chapter 22

Accounting Changes


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Introduction

■ Accounting requires many choiceschoices, both of accounting policy and ofaccounting measurements or estimates

■ Management may decide that a company�s reporting, ownershipstructure or economic circumstances have changed circumstances have changed sufficiently towarrant changing their previous choices, either by changing one ormore accounting policies accounting policies or by changing their accountingaccountingestimatesestimates.

■ AcSB regulations, legal statute, FASB, or International accountingstandards may require changes to mademay require changes to made.

■ Accounting changes are necessary when a company discovers that ithas made an accounting error accounting error in previous accounting periods

■ All types of accounting changes affect reported resultschanges affect reported results, but notnecessarily in the same way.


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Types Of Accounting Changes

■ There are three general types ofaccounting changes:

� Changes in accounting policyaccounting policy✜✜ VoluntaryVoluntary, at the option of management

or at the request of a user

✜✜ involuntaryinvoluntary, to comply with new CICAHandbook recommendations

� Changes in accounting estimatesaccounting estimates

�� Correction of an error Correction of an error in previousperiods� financial statements

■ The general nature of each of thesetypes of changes is discussed below.


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Changes In Policy

■ A change in accounting policychange in accounting policy is achange in the wayway that a companyaccounts for a particular type oftransaction or event, or for theresulting asset or liability.

■ A changechange in accounting policy mustnot be confused with adopting a newnewaccounting policy

■■ voluntaryvoluntary

■ tax minimization to net incomemaximization

■ conform with new parent company

■ investor may purchase shares oncondition of new reporting method

•• InvoluntaryInvoluntary - AcSBAcSB issues a newor revised recommendation in theCICACICA Handbook Handbook which requires aGAAP-constrained company toalter its policy to conform to thenew recommendations.

•• previously accepted methodpreviously accepted methodbecomes unacceptableunacceptable(pension costs )

•• new approachnew approach isrecommended that was notpreviously used in practice(income taxes: the change fromthe deferral method to theliability method )


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Changes In Estimate

■■ Changes in accounting estimatesChanges in accounting estimatesare common. Change in theapplicationapplication of an accounting policy toa specific transaction or event

■ Accounting measurements are basedextensively on future expectations.We can never predict never predict futureoutcomes with certainty

■ Examples:

�� UncollectibleUncollectible accountsreceivable;

�� RecoverableRecoverable value of an asset,

�� Criteria Criteria for capitalizingdevelopment costs

■■ Several reasons, changes:Several reasons, changes:

• the company�s economiceconomicenvironment,

•• auditorsauditors have raisedquestions

• the company�s reportingobjectivesobjectives, (e.g., agreater emphasis onconservatism); or

• there has been a shift inthe nature of thenature of thecompany�s businesscompany�s businessoperations


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Correction Of An Error

■ On occasion, a company (or its auditors) discovers that there was anaccounting error in a prior period. If the error was materialerror was material, the errormust be corrected even if it has washed out over the long run

� Inventory overlooked when the physical count was taken.

� Failed to accrue commission liabilities that had not been paid by theend of the fiscal year.

� Routine repairs were capitalized instead of being expensed.

� The company treasurer fraudulent transfer of substantial sums intopersonal account hidden by fake purchase invoices

■ Errors do not arise from a change in estimate or a change in policy. Theyare simply mistakesmistakes.

■ Accounting errors require restatement of prior periods resultsrestatement of prior periods results, in orderto comply with the qualitative criteria of comparability and consistency,even if there is no impact on the period in which the error was discovered


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Summary: Types Of Changes

■ Basically, then, we can summarize an accountingchange as being:� a change in estimate if it is the result of new informationchange in estimate if it is the result of new information

that was not known previously;

� a change in policy if the change was motivated bychange in policy if the change was motivated bydifferent reporting circumstances different reporting circumstances of the enterprise andthere has been no material change in economiccircumstances;

�� application of a new policy application of a new policy if the transactions or events arematerially different from those reported previously; or

�� correction of an accounting error correction of an accounting error if information has cometo light that was reasonably determinable in the period inwhich the transaction or event was initially reported.


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Summary: Types Of Changes

Discerning the nature of the change is important for two reasons:important for two reasons:� the reporting approach reporting approach for changes in accounting estimates isdifferent from that for changes in accounting policies andcorrections of errors, and� changes in accounting estimates estimates and error correctionserror correctionsnormally are not disclosednot disclosed and, in effect, are �buried� in thefinancial statements, while changes in accounting policiespolicies mustmustbe disclosedbe disclosed in the notes to the financial statements.

When there is doubt as to whether a change is a change in policy ora change in estimate, the CICACICA Handbook Handbook suggests that the changeshould be treated as a change in estimatechange in estimate


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Accounting For Changes

1. Retroactive application with restatem ent of priorperiods2. Retroactive application without restatem ent3. Prospective application


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Exhibit 22-1 Summary of Accounting Changesand Reporting Approaches

EXHIBIT 22-1Summary of Accounting Changes and

Reporting Approaches

Click forHyperlink


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Retroactive Approach, WithRestatement

■ The information necessary tomake the change in the currentin the currentand prior periods and prior periods must beobtained from the underlyingaccounting records.

■■ Account balances Account balances that affect theprior year�s comparative financialstatements must be recalculatedrecalculatedusing the new policy, including allaffected balance sheet andincome statement accounts. Thecomparative statements comparative statements must berestated restated to reflect the changedamounts in the full financialstatements.

■■ Summary comparativeSummary comparativeinformation information (e.g., earnings pershare, total assets) presentedpublicly, (annual report), must berecalculated using the new policy.

■ The cumulativecumulative impact of thechange on the beginningbeginning balancesof the current year must becalculated.

■ The cumulative impact cumulative impact of theaccounting policy change on prioryear�s net income is recorded as anGJ entry adjustment to theGJ entry adjustment to thebeginning balance of retainedbeginning balance of retainedearnings.earnings.

Retroactive Approach, Without Restatement - Exhibit 22-2

EXHIBIT 22-2Sunset Corporation −−−− Data for Change in Accounting Policy

Change from Average Cost (AC) to FIFO for Inventory

1. During 20x5, Sunset Corporation decides to change its inventory cost method from AC to FIFO foraccounting purposes only, effective for fiscal year 20x5. The reporting year ends on 31 December, and thecompany�s income tax rate is 40%.

2. From its records, the company determines the following information relating to the change:

20x5 20x4FIFO AC FIFO AC

a. Beginning inventory (from prior 31 December) $ 60,000 $ 50,000 $ 47,000 $ 45,000b. Ending inventory 80,000 65,000 60,000 50,000c. Income before extraordinary items 176,000* 160,000d. Extraordinary gains (losses), net of tax (2,000) 3,000e. Retained earnings, beginning balance 169,000 86,000f. Dividends declared and paid 88,000 80,000

* Reflects FIFO policy.


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Retroactive Approach, WithoutRestatement

■ If the cumulative impact cumulative impact of a changeof accounting policy can be determinedbut the impact on individual priorimpact on individual prioryears cannotyears cannot, then the change shouldbe accounted for retroactively, butwithout restating prior years� results.Instead, a catch-up adjustment catch-up adjustment isrecorded and reported in retainedearnings in the year of the change.

■ AcSB sometimes permits a change tobe applied without restatement applied without restatement ofprior years� results

■ AcSB - set the effective date for a newstandard that is more than one yearone yearafterafter the release of the standard

■■ Prior financial statements Prior financial statements andsummary information remainsunchanged.

■ The cumulative impact isreportedreported as an adjustment toopening retained earnings opening retained earnings .

■ The current year�s financialcurrent year�s financialstatements statements reflect the newpolicy; the prior year�scomparative statements reflectthe old policy.

■ The cumulative impact on all ofthe relevant beginningrelevant beginningbalances balances for the current year iscomputed computed and recordedrecorded


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Retroactive Approach, WithoutRestatement Exhibit 3, 4

EXHIBIT 22-3Sunset Corporation −−−− Selected Amountsfrom Comparative Financial StatementsChange from Average Cost to FIFO for

Inventory

EXHIBIT 22-4Change in Accounting Policy Change from

Completed-Contract to Percentage-of-Completion

Click forHyperlink


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Prospective Approach

■■ IfIf the cumulative impact cumulative impact of anaccounting policy change cannot cannot bedetermined, the change in policy canbe implemented prospectivelyprospectively. Thenew policy is used for events andtransactions occurring in and after theyear of the change, but beginningbeginningbalances are not adjusted and priorbalances are not adjusted and prioryears� results are not revisedyears� results are not revised.

■ Changes in accounting estimates accounting estimates arealways accounted for prospectively. Ifthere is doubt as to whether a changeis a change in estimate or a change inpolicy, it should be assumed to be aassumed to be achange in estimate.change in estimate.

■ The financial statement financial statement effectsof using the new estimateusually are not disclosednot disclosed, noris the factfact of the change usuallydisclosed.

■ Exceptions may arise when thechange in estimate has aparticularly substantial effect onthe reported results, particularlywhen the change results in aloss that can be separatelydisclosed as an unusual item.unusual item.

■ Some estimates are valid forone year only


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Disclosure Requirements

■ Accounting changes affect theconsistencyconsistency and comparabilitycomparability offinancial statements, and thereforetheir reliabilityreliability.

■■ CICACICA Handbook Handbook recommendsspecific disclosures for accountingaccountingpolicy changes:policy changes:CICA 1506.16-1506.21 - see popup box

■ The CICA Handbook contains nonoitalicized recommendations for thedisclosure of changes indisclosure of changes inaccounting estimates.accounting estimates.


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Disclosure Requirements

■ Disclosure of the nature and effect on the current period may be desirablefor a change in an accounting estimate that is rare or unusual accounting estimate that is rare or unusual and thatmay affect the financial results of both current and future periods, such as achange in the estimated service life of a fixed asset. CICA 1506.25

■ The AcSB�s recommendations for reporting an error correction reporting an error correction are similarto those for a change in accounting policy

All AccountingPolicy changes

AppliedRetroactively

AppliedRetroactively

ProspectiveApplication

Disclose if materialto future periods

Prior PeriodsRestated

Prior Periods Notrestated

Prior Periods Not restated

Description of thechange

The fact thatFS have beenrestated

The fact that the FSof prior periods havenot been restated

The fact that an accountingpolicy has not been appliedretroactively

Effect of the changeon the financialstatements of thecurrent period

Effect onthose priorperiods

Cumulativeadjustment to theopening balance ofthe retained earnings

Disclosure of particulars,including dollar amounts,applies to each change in anaccounting policy

Exhibit 22-6 Disclosure of a Change in AccountingPolicy MacMillan Bloedel Limited

Change in Accounting PolicyDuring the year, the Company adopted, on a retroactive basis, the new Canadian accounting requirementsrelated to the presentation of financial instruments. Under this new accounting policy, the present value ofthe interest payments on the convertible subordinated debentures is presented as long term debt with theremaining portion of the principal amount included in shareholders� equity. The interest related to theequity component of the convertible subordinated debentures is reflected as a charge to retained earnings.

Effect of Change in Accounting Policy on the Financial Statements 1996 1995Increase in long term debt $ 45 $ 47Increase in equity component of convertible subordinated debentures 105 103Elimination of previous classification of �Convertible subordinated debentures� (150) (150)Increase in net earnings 1 1

Exhibit 22-7 Summary of Recommended Disclosuresfor Accounting Changes

Type of ChangeCICA

Reference Disclosure RequiredChanges in policy − for each change that has a material effect or is likely to have a material effect in future periods

1506.161506.201506.21

− a description of the change− the effect of the change on the financial statements of the current period, without netting offsetting amounts

Plus, for changes in policy applied: Retroactively, with restatement 1506.17 −the fact that prior years� statements have been

restated Retroactively, without restatement

1506.18 − the fact that prior periods have not been restated− the cumulative adjustment to retained earnings

Prospectively 1506.19 − the fact that the change has not been applied retroactively

Change in estimate, applied prospectively

1506.25 none required; optional if the change is rare andunusual

Correction of an accounting error 1506.30 − a description of the error− the effect of the correction on current and prior periods� financial statements− the fact that prior periods� financial statements have been restated


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Cash Flow Statement

■ A change in accounting policy does not change cashflows, but it can affect the way that cash flows arereported.

■ Indeed, the efficient markets hypothesis maintains thatthe public securities markets are not fooled byaccounting policy changes because the market �seesthrough� changes in reporting that do not result from achange in cash flows

■ While a change in accounting policy will not affect thenet change in cash − the �bottom line� of the cash flowstatement − it can affect the classification of amounts inthe cash flow statement.


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Prior Period Adjustments

■■ Prior to 1996Prior to 1996, companies were permitted, under certaincircumstances, to make prior period adjustmentsprior period adjustments. A prior periodadjustment was a gain or a loss that was credited or charged directlyto retained earnings instead of appearing in the income statement.Prior period adjustments were permitted under the AcSB�sAcSB�srecommendation if four criteria were satisfied.

■ The only adjustments that can be made directly to retained earningsare for retroactively applied changes in accounting policy retroactively applied changes in accounting policy and forcorrections of errors in prior periodscorrections of errors in prior periods. Other types of prior periodadjustments must flow through the income statement

■■ Financial Reporting in Canada 1995Financial Reporting in Canada 1995, for example, found that of 42prior period adjustments reported by its sample of 300 companiesbetween 1991 and 1994, 38 were debit items and only 4 were credititems.


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USA Perspective

■ The U.S. approach for accounting policypolicy changes is sharply atvariance with the approach used in Canada.

■ The preferred U.S. practice for changes in accounting policy is notonly to use the prospective approach prospective approach instead of the retroactiveapproach, but also to report the cumulative impact of a policychange as a component of net income in the period in which thechange is made.

■ Retroactive treatment is prohibitedRetroactive treatment is prohibited, except for a short list ofspecific changes (e.g., a change from LIFO to another inventorymethod), and except when retroactive application is specificallyrequired in any new standard issued by the FASB

■ The U.S. approach is consistent with the all-inclusive incomeall-inclusive incomeconcept

■ The U.S. approach is generally out of step with other countries


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International Perspective

■ International Accounting Standard IAS 8 (revised in 1993), recommendsthat a change in accounting policy be applied �retrospectively�


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Accounting Changes: An Evaluation

■ Many people believe that allchanges in accounting policyshould be applied retroactively.

■ They worry about the effect ofchanges on comparability.

■ Accounting changes, even thoseapplied retroactively, may causeconfusion and reduce the predictiveability of accounting information.

■ For example, at least one study hasfound that the accuracy of analysts�earnings forecasts declined whenaccounting changes are made

■ One criticism of the retroactiveapproach is that the cumulativeeffect on prior years� incomecannot be accurately computed

■ Another concern is that threeapproaches to reportingaccounting changes areendorsed in current Canadianstandards

■ Some contend that both of theretroactive approaches (withand without restatement) areinappropriate and believe thatonce an income item isreported, it is final

Documents

Intermediate Accounting - mcgrawhill.ca · EXHIBIT 22-3 Sunset Corporation ... The fact that the FS of prior periods have not been restated The fact that an accounting policy has