Accounting Changes and Error Corrections
Chapter 20 Review Notes
The accounting profession has identified two main categories of accounting changes:
  1. Change in accounting estimate: these are considered to be part of the normal accounting process, not corrections or changes of past periods.
    Examples of changes in accounting estimates include bad debt expense, depreciation, residual values, and warranty obligations. A change in depreciation method is considered a change in estimate.
  2. Change in accounting principle: these involve changes from one generally accepted principle or method to another. They do not include the initial adoption of an accounting principle as a result of transactions or events that had not occurred (or were immaterial) in previous periods. Changes from principles that are not generally accepted to principles that are, count as error corrections, not changes in accounting principle.
The accounting treatment for changes in accounting estimates reflects the effect of the change only in the current and future periods. No retrospective restatement of prior periods’ financial statements is made. The treatment of changes in accounting principle, by contrast, does retrospectively restate the financial statements in accordance with the change in principle for those years included in the current year’s comparative financial statements; moreover, the change in net income for still earlier years is shown as an adjustment to the beginning balance of retained earnings for the earliest year reported. This treatment results from FASB Statement No. 154, which was adopted in May 2005 in order to make the U.S. approach to accounting for accounting changes and error corrections agree with International Accounting Standard 8. See pp. 1175 – 1184.
A business combination can drastically change the size and economic character of an accounting entity. Because of this, SFAS No. 141 requires disclosure of pro forma results, including at a minimum revenue and net income, as if the combination had occurred at the beginning of the year in which the combination took place, and also as if the combination had occurred at the beginning of the preceding year. The purpose is to enable financial statement users to perform time-series analyses of the new entity.
Error corrections are not considered accounting changes, but their treatment is specified in FASB Statement No. 154. Accounting errors made in prior years are corrected from a reporting standpoint by restating the financial statements for all years presented, and, if needed, by reporting an adjustment to the beginning balance of the retained earnings for the earliest year reported. Note disclosure of the line-by line impact of the errors is required. This is essentially the same as the treatment of changes in accounting principle.
Different types of errors differ in how easily they are corrected.
  1. Errors discovered currently in the course of normal accounting procedures are usually corrected routinely as part of the summarizing process of the accounting cycle.
  2. Errors limited to balance sheet accounts are easily corrected by ordinary journal entries when detected in the period wherein they occur; if detected later balance sheet data must be recalculated and restated for comparative purposes.
  3. Errors limited to income statement accounts should be corrected as soon as discovered, and the misstated accounts should be restated for purposes of analysis and comparative reporting.
  4. Errors affecting both balance sheet accounts and income statement accounts fall into two subgroups:
(a)Errors in net income that, when not detected, are automatically counterbalanced in the following fiscal period: Net income amounts for two successive periods are inaccurately stated and certain balance sheet accounts at the end of the first period are misstated, but the balance sheet accounts at the end of the second period will be correct.
(b)Errors in net income that, when not detected, are not automatically counterbalanced in the following fiscal period: Certain balance sheet accounts will remain misstated until correcting entries are made.
Carefully study the comprehensive example of error corrections on Pages 1187 – 1193.
Required disclosure for errors discovered subsequently to the period they affect is explained, mainly by means of an example, on pp. 1193 – 1195. Essentially, the nature of the error must be disclosed, with its effect on previously issued financial statements and the effect of the correction on current period’s net income and earnings per share; and any comparative financial statements provided must be corrected.
Note the concise summary of accounting changes and error corrections on Page 1195.

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