Change in Accounting Principle

Involves a change from one set of GAAP rules to another.

Involves changes made to existing accounts, not for

simply adopting new GAAP for a new account.
e.g. Switch from LIFO to FIFO for existing inventory
is a change in accounting principle.
Choosing FIFO for a completely separate set of new
inventory is not a change in accounting principle
(even if the old inventory is accounted under LIFO).
 Change in Accounting Principle

Three ways to handle change in accounting principle:

Record the Cumulative Effect: Go back and collect

all changes from prior years and then report as an
item, net of tax, in the income statement. Do not
restate prior years’ income statements.
Record the Retroactive Effect: Go back and restate
prior years’ income statements.

Make no adjustments at all. The past is the past and

only future net income will be affected by the change
in principle.
GAAP has generally adopted cumulative effect, except
under special circumstances.
 Change in Accounting Principle

Special Circumstances:

When a cumulative effect adjustment would result in

unreasonably dramatic changes in net income for the
current year, GAAP allows for a retroactive
adjustment.
• A change from LIFO to another method
• A change in method on long term construction contracts
• A new company prior to an initial stock sale (IPO)
• A change to or from full-cost method for extractive firms.
• A FASB pronouncement requiring retroactive adjustment

Make adjustments directly to Retained Earnings for prior years.

 Change in Accounting Estimates

We often have to update our estimates:

• Amount of Receivables estimated not collectable

• Amount of Inventory that will be obsolete
• Assets’ useful lives and salvage values
• Amount of liabilities for estimated contingencies
• Amount of recoverable mineral or oil reserves

Changes in estimates happen prospectively; there are no

prior period or cumulative adjustments made.
The effects of these changes will occur in current or future
periods.
 Change in Accounting Estimates
Example of change in estimate:
Joe bought a car on Jan 1, 2000 for $24,000.
Estimated useful life on purchase date: 7 years
Estimated Salvage value on purchase date: $3,000
On Jan 1, 2001, he revised the useful life down to 5 years.
Depreciation Exp. (purchase date estimates, SL) =
($24,000 - $3,000) / 7 years = $3,000 per year
Accumulated Depreciation as of change of estimate date = $3,000

After change of estimate, depreciate remaining book value-

salvage value over remaining useful life:
($24,000 - $3,000 - $3,000) / (5-1) years = $4,500 per year
Hist Cost – Accum Depr. – Salv. Value Useful life – years already used
 Change in Accounting Entity

If there is a change in accounting entity, the new entity

must restate all prior financial statements as if they were
under the new entity status.

• Consolidating two or more companies into one

• Changing the companies covered within consolidation
• Accounting for a pooling of interests merger/acquisition

Note: this does not include simply shutting down, creating

or purchasing another business (which is a change in real
business entity).
 Error Corrections

Error corrections for prior financial statements are adjusted

directly to the beginning balance of Retained Earnings in
the current year.

• Change from non-GAAP to GAAP

• Mathematical errors
• Changes due to poor or improper estimates
• Misuse of facts
 Types of Errors

Counterbalancing Errors:

Errors that correct themselves, or offset in the following period.

e.g. Failing to record accrued wages payable/wages expense.
Overstates net income in current period and understates net
income in next period (when corrected).

Non-Counterbalancing Errors:
Errors that take more than one period to correct themselves.
e.g. Immediately expensing construction project avoidable
interest instead of capitalizing into the asset.
Understates net income in current period and overstates net
income over depreciable life of asset. Finally corrects when
asset is fully depreciated.
 Types of Errors
Counterbalancing Errors
Assume we discover the error in the second, or offsetting, period.
If the second year books are already closed, do nothing,
since the error has already reversed itself.

If the second year books have not already closed, make an

adjustment to the Beginning value of retained earnings.
1st: Determine what effect the error had on 1st period
Retained Earnings (same as 1st period Net Income)

2nd: Create the journal entry to undo the effect in the 2nd pd.
This will restate Beginning Retained Earnings back to
its appropriate level.
 Types of Errors
Counterbalancing Errors
Example: Beaver Stadium ticket office notices in 2001 that it
had accidentally credited ticket revenue instead of unearned
ticket revenue for $160 at the end of 2000 when it received
prepayment for season tickets. 2001 books are not closed.

1st: Effect on 1st period is overstated revenue and Retained

Earnings. Therefore, 2nd period Beginning Retained
Earnings is overstated.
2nd: Create the journal entry to undo the effect in the 2nd pd.
Retained Earnings $160
Ticket Revenue $160

Credits Revenue to
Reduces Beg. Ret Earns appropriate period
 Types of Errors
Counterbalancing Errors
Example: Paterno Corp. forgot to recognize accrued salary
expense and accrued salary liability of $200,000 at the end of
2000. The error is discovered in 2001 before the books are
closed.
1st: Effect on 1st period is understated expense which
makes Retained Earnings overstated. Therefore, 2nd
period Beginning Retained Earnings is overstated.
2nd: Create the journal entry to undo the effect in the 2nd pd.
Retained Earnings $200,000
Salary Expense $200,000

Reduces the expense that

Reduces Beg. Ret Earns was shifted to 2nd period
due to error.
 Types of Errors
Counterbalancing Errors
Example: Abercrombie and Fitch undercounted its ending
inventory for 1999 by $10,000. It discovered this error in 2000
before its books were closed.
1st: Effect on 1st period is overstated COGS which
makes Retained Earnings understated. Therefore, 2nd
period Beginning Retained Earnings is understated.
2nd: Create the journal entry to undo the effect in the 2nd pd.
Merch. Inventory $10,000
Retained Earnings $10,000

Corrects the understate-

Corrects the undercount in ment in Beg. Ret. Earns
Merchandise inventory
 Types of Errors
Non-Counterbalancing Errors
Since these errors do not automatically correct in the next
period, an adjustment must be made regardless of whether the
books are closed.
Computing the adjustment requires more complicated
analysis and depends on whether the books have been
closed.
 Types of Errors
Non-Counterbalancing Errors

Books not yet closed:

Basically do the same adjustment as before.

Books already closed:

Basically do the adjustment as before, except back out a

correction for the current year.
 Types of Errors
Non-Counterbalancing Errors
Example: Jones Corp. bought a truck for $10,000 with a 5 year useful life, no
salvage value, SL depreciation on Jan 1, 2000.
The company inadvertently recorded the $10,000 as an expense instead of an
asset on the date of sale.
The error was discovered in 2001 and the books were not closed for that year.

Effect of error in 2000:

Truck expense overstated by $10,000
Depreciation expense understated by $2,000
Net effect: overstated expenses (understated RE) by $8,000
Correction in 2001:
Adjust RE for
Truck $10,000 understatement
Retained Earnings (Prior Pd. Adj.) $8,000
Add the truck accts. Accum Depr. Truck $2,000
to the books at the
Correct balances
 Types of Errors
Non-Counterbalancing Errors
Same example, yet the error was discovered in 2001 and the books were
closed for that year.
The effect of error in 2000 has not changed:
Truck expense overstated by $10,000
Depreciation expense understated by $2,000
Net effect: overstated expenses (understated RE) by $8,000
However, we must now also consider the additive effect of the error on 2001:
Depreciation expense understated by another $2,000
Net effect: overstated expenses (understated RE) by only $6,000
Correction in 2001:
Adjust RE for
Truck $10,000
understatement
Retained Earnings $6,000
Add the truck accts. Accum Depr. Truck $4,000
to the books

This now adjusts for 2 years of accum. depr.