Financial Reporting and Analysis - B10.2302/C10.0021 - Class Notes
changes in accounting principle (ex. Straight line to accelerated depreciation)
changes in accounting estimates (ex. Useful lives of PPE, bad debts %)
cumulative Effect Accounting Change
retroactive or Cumulative Effect Indeterminable
Accounting Changes There are three types of accounting changes: (1) changes in accounting principle (ex. Straight line to accelerated depreciation), (2) changes in accounting estimates (ex. Useful lives of PPE, bad debts %, completion % for long term contracts), and (3) changes in reporting entity (ex. change from the equity method to consolidation of a subsidiary). Note that the following are not accounting changes: (1) keep the same depreciation method for old assets, but use a new method for new assets, and (2) change from an incorrect to a correct GAAP method. In this module, we will briefly discuss changes in accounting estimates and entities and accounting errors; we will focus primarily on changes in accounting principle.
Changes in accounting estimates involve no special entries. Just go forward with the new estimates, leaving past results untouched (remember estimate changes for the percentage of completion method). Sometimes it is not clear whether an accounting change is a change in estimate or a change in principle. In such cases, the change is considered a change in estimate.
Cumulative Effect Accounting Change
The primary method to handle changes in accounting principle is the cumulative effect method. This is the accounting change method described in the Chambers Development Co. Case on pages 19-22. This method is comprised of the following 3 elements: (1) Cumulative Effect line item on I/S (i.e., the AC@ in D-E-C), (2) show pro forma I/S for previous years (pro forma means applying the new method, as if it had been in use back then), but (3) do not restate prior years financial statements. Note the following points about the cumulative effect method:
(1) for the current year, pro forma income and income before D-E-C are the same. This is because the current year is under the new method. (2) The Cumulative Effect line item is empty (zero) for previous years. (3) The Cumulative Effect line item is shown net of tax (remember intra-period tax allocation).
The journal entry for the cumulative effect method and how the amount is calculated is shown on the top of page 63. The entry affects the Cumulative Effect line item and the appropriate B/S account. For example, for a switch from straight line to accelerated depreciation that increases accumulated depreciation, thereby reducing NI, the journal entry is (ignoring tax effects): DRCR
Cumulative Effect accounting change
Note that the Cumulative Effect is a DR, which reduces NI (remember, expenses are DR=s).
The important point is that the cumulative effect is isolated on the I/S, because it is a transitory component of NI.
There are some exceptions to the above method, called retroactive changes. A couple of examples are changes from LIFO (to any other inventory method) and changes in the method of long-term contracting. There are two primary differences between the retroactive changes and the catch-up method: (1) the retroactive does not show a pro-forma I/S, because the previous years I/S are restated, and (2) there is an expanded R/E statement (not shown in the text), to show the cumulative impact of the retroactive change on previous and current years= R/E. The reason for these 2 differences is that retroactive changes usually have too big an I/S impact for one year (i.e., the cumulative effect line item would be huge), so we restate prior years to put the I/S on the new method.
The journal entry for the Retroactive method is similar to the entry for the Cumulative Effect method, but the DR or CR to ACumulative Effect ...@ is replaced by a DR or CR to (beginning of year) R/E. This is because we retroactively change previous years= NI, and R/E cumulates changes in NI. Note that for both Cumulative Effect and Retroactive changes, we must calculate the cumulative difference of past income between the new vs. the old method. The only difference between the two methods is how we present this difference: aggregated into one current period amount (Cumulative Effect) or spread over past years (Retroactive). The B/S side of the entry is identical for both methods.
Retroactive or Cumulative Effect Indeterminable
Changes to LIFO (from any other inventory method) are neither cumulative nor retroactive. This is because calculating CGS under LIFO requires data (on past inventory layers) that would not be available under an alternative inventory method. Thus, calculating the cumulative difference between LIFO and the old method can=t be done, and changes to LIFO are done by:
(1) base year inventory (initial LIFO layer) is the beginning inventory in the year of the change, (2) no restatement of prior years income (this can=t be done, because you don=t know the layers), (3) disclose the effect of the switch on NI for the current year, and the reasons for omitting the cumulative effect and the pro-forma amounts for prior years.
As pointed out above, changes from LIFO are retroactive changes. All inventory changes not involving LIFO are handled by the cumulative effect method.
For a change in accounting entity, restate the financial statements of all previous periods shown, as if the new entity had existed for all these periods.