💰Intermediate Financial Accounting II Unit 10 – Accounting Changes & Error Corrections

What's This Unit About?

• Focuses on how companies handle changes in accounting principles, estimates, and reporting entities
• Covers the proper procedures for correcting errors discovered in previously issued financial statements
• Emphasizes the importance of consistency and comparability in financial reporting
• Discusses the impact of accounting changes and error corrections on financial statements and ratios
• Explores the disclosure requirements for accounting changes and error corrections
• Highlights the role of professional judgment in determining the appropriate treatment of changes and errors
• Provides real-world examples and case studies to illustrate the application of concepts

Key Concepts and Definitions

• Accounting changes involve a change in accounting principle, estimate, or reporting entity
• Accounting principle refers to the specific accounting method used to recognize, measure, and report financial information
• Accounting estimate is an approximation of a financial statement element, item, or account in the absence of a precise means of measurement
• Reporting entity is the business unit for which financial statements are prepared
• Error corrections involve restating previously issued financial statements to correct material misstatements
• Retrospective application requires adjusting prior period financial statements as if the new accounting principle had always been used
• Prospective application applies the new accounting principle to transactions, events, and circumstances occurring after the date of change
• Cumulative effect is the difference between the old and new accounting principles applied to prior periods

Types of Accounting Changes

• Change in accounting principle occurs when a company adopts a different accounting method for a specific type of transaction or event
• Examples of changes in accounting principles include switching from LIFO to FIFO inventory valuation or from straight-line to accelerated depreciation
• Change in accounting estimate results from new information or developments and affects the current and future periods
• Examples of changes in accounting estimates include revising the useful life of an asset or adjusting the allowance for doubtful accounts
• Change in reporting entity happens when the composition of the reporting entity changes, such as in a merger or acquisition
• Correction of an error is not considered an accounting change but rather a restatement of previously issued financial statements

Handling Error Corrections

• Errors can arise from mathematical mistakes, misapplication of accounting principles, or oversight
• Material errors require restatement of prior period financial statements
• Immaterial errors can be corrected in the current period without restatement
• Restatement involves adjusting the affected financial statement line items and disclosing the nature and impact of the error
• Comparative financial statements should be presented as if the error had never occurred
• Companies should implement internal controls and review processes to prevent and detect errors timely

Reporting and Disclosure Requirements

• Accounting changes and error corrections require specific disclosures in the financial statements
• For a change in accounting principle, companies must disclose the nature of and justification for the change, the method of applying the change, and the effect on income statement line items and earnings per share
• Changes in accounting estimates are accounted for prospectively and require disclosure of the effect on income statement line items and earnings per share
• Error corrections require disclosure of the nature of the error, the effect on each financial statement line item and earnings per share, and the cumulative effect of the error on retained earnings
• Disclosures should enable users to understand the impact of changes and errors on the financial statements and compare the company's performance over time

Real-World Examples and Case Studies

• In 2018, General Electric (GE) restated its financial statements for 2016 and 2017 due to accounting irregularities in its power segment
• The restatement resulted in a $2.2 billion reduction in retained earnings and a$1.5 billion decrease in net income for the affected periods
• In 2019, Molson Coors Brewing Company changed its method of accounting for shipping and handling costs from the gross method to the net method
• The change was applied retrospectively, resulting in a decrease in both net sales and cost of goods sold, with no impact on net income
• In 2020, Walmart changed its accounting principle for inventory valuation from LIFO to FIFO to better align with its business model and provide more meaningful financial information
• The cumulative effect of the change was an increase in retained earnings of $2.2 billion as of the beginning of fiscal 2020

Common Pitfalls and How to Avoid Them

• Failing to distinguish between a change in accounting principle and a change in accounting estimate
• To avoid this, carefully evaluate the nature of the change and consult with accounting professionals or the company's auditors
• Incorrectly applying the retrospective or prospective approach to accounting changes
• Ensure a thorough understanding of the appropriate application method for each type of change and maintain detailed documentation
• Inadequate disclosure of accounting changes and error corrections in the financial statements
• Review disclosure requirements and engage with the company's auditors to ensure compliance and transparency
• Overlooking the impact of accounting changes and error corrections on key financial ratios and performance metrics
• Perform a comprehensive analysis of the effects on relevant ratios and metrics, and communicate the implications to stakeholders
• Neglecting to implement proper internal controls and review processes to prevent and detect errors
• Regularly assess and strengthen internal controls, conduct thorough reviews of financial statements, and foster a culture of accountability and attention to detail

Practical Applications and Tips

• When encountering an accounting change or error, first determine its materiality to assess the appropriate course of action
• Maintain clear and organized documentation of all accounting changes and error corrections, including the rationale, calculations, and supporting evidence
• Engage with the company's auditors early in the process to ensure proper treatment and disclosure of changes and errors
• Use accounting changes and error corrections as opportunities to enhance the company's financial reporting processes and internal controls
• Communicate the impact of changes and errors to stakeholders, such as investors and analysts, in a clear and transparent manner
• Stay updated on evolving accounting standards and guidance related to changes and errors, and proactively assess their potential impact on the company's financial statements
• Leverage technology and data analytics tools to identify anomalies, detect errors, and support the implementation of accounting changes
• Foster a culture of continuous improvement and learning within the accounting and finance functions to prevent and address changes and errors effectively