Which of the following should be reported as a change in accounting estimate?
One area where the Fair Accounting Standards Board (FASB), and the International Accounting Standards Board (IASB), agree is with the treatment of accounting changes. Show
SFAS 154, Accounting Changes and Error Correction, documents how companies should treat changes in accounting principles and changes in accounting estimates, two related but different concepts. A principle determines how information should be reported, while an estimate is used to approximate information. Key Takeaways
Accounting Principle ChangeAccounting principles are general guidelines that govern the methods of recording and reporting financial information. When an entity chooses to adopt a different method from the one it currently employs, it is required to record and report that change in its financial statements. A good example of this is a change in inventory valuation; for example, a company might switch from a first in, first out (FIFO) method to a specific-identification method. According to the FASB, an entity should only change an accounting principle when it is justifiably preferable to an existing method or when it is a necessary reaction to a change in the accounting framework. Other notable changes in accounting principles can include matching, going concern, or revenue recognition principles, among others. Accounting Estimate ChangeAccountants use estimates in their reports when it is impossible or impractical to provide exact numbers. When these estimates prove to be incorrect, or new information allows for more accurate estimations, the entity should record the improved estimate in a change in accounting estimate. Examples of commonly changed estimates include bad-debt allowance, warranty liability, and depreciation. Key DifferencesAccounting principle changes can also occur when older principles are no longer accepted or when the way the method is applied changes. Changes in accounting principles are required to be applied retroactively—that is, financial statements must be restated to be presented as if the new accounting principle had been used. Only line items that are directly affected have to be restated. There are cases where a retroactive application doesn’t have to be made, which includes having made all reasonable efforts to do so, which can include not being able to make subjective significant estimates or having to have knowledge of management’s intent. Estimate changes occur when the carrying values of assets or liabilities are changed. These changes are accounted for in the period of change. Changes in accounting estimates don’t require the restatement of previous financial statements. If the change leads to an immaterial difference, no disclosure of the change is required. The Bottom LineThere are different and less stringent reporting requirements for changes in accounting estimates than for accounting principles. In some cases, a change in accounting principle leads to a change in accounting estimate; in these instances, the entity must follow standard reporting requirements for changes in accounting principles. The financial markets depend on high quality financial reporting. A fundamental pillar of high quality public financial reporting is reliable, comparable financial statements that are free from material misstatement. Accounting changes and errors in previously filed financial statements can affect the comparability of financial statements. In this publication, we provide an overview of the types of accounting changes that affect financial statements, as well as the disclosure and reporting considerations for error corrections. While the guidance included herein is not a substitute for the exercise of professional judgment or professional accounting advice, we hope that you find it a useful starting point when assessing the financial reporting ramifications of accounting changes and errors in previously issued financial statements. Accounting Standards Codification (ASC) Topic 250, Accounting Changes and Error Corrections, addresses certain circumstances that require special accounting or disclosure, including:
“Accounting changes” are those in the first three categories above. In order to understand the accounting and disclosure obligations for each of these categories, it is helpful to begin with a basic understanding of their meaning: Change in Accounting Principle
A change in accounting principle is applied for two types of changes:
Newly issued ASUs include specific transition and disclosure guidance for the period of adoption. Voluntary changes in accounting principles should be applied retroactively to the beginning of the earliest period presented in the financial statements (i.e., so that the comparative financial statements reflect the application of the principle as if it had always been used), unless it is impracticable to do so. If retrospective application is impractical, the change should be adopted as of the beginning of a fiscal year. Whether it impracticable to apply a new principle on a retrospective basis requires a considerable level of judgment.[1] BDO Insight:ASC 250 presumes that an entity will apply accounting principles consistently unless new ASUs are issued. The preferability analysis required to justify a change from one generally accepted accounting principle to another generally accepted principle also requires a considerable level of judgment and coordination with an entity’s independent accountant. An SEC registrant is required to file a preferability letter from its independent accountant concurring with its conclusion that such a change was preferable. Additional guidance and information with respect to the preferability assessment can be found in ASC 250-10-S99-4 (codified from Staff Accounting Bulletin 6.G(2)(b)1). It is important to distinguish the treatment from a change in accounting principle, as defined above, from a change that results from moving from an accounting principle that is not generally accepted to one that is generally accepted. This type of change is an error correction – refer to Section 3 for further discussion. Disclosures Change in Accounting Estimate
A change in accounting estimate is a necessary consequence of management’s periodic assessment of information used in the preparation of its financial statements. Changes in accounting estimates result from new information. Common examples of such changes include changes in the useful lives of property and equipment and estimates of uncollectible receivables, obsolete inventory, and warranty obligations, among others. Sometimes, a change in estimate is affected by a change in accounting principle (e.g., a change in the depreciation method for equipment). A change of this nature may only be made if the change in accounting principle is also preferable. BDO Insight:A critical element of analyzing whether a change should be accounted for as a change in estimate relates to the nature and timing of the information that is driving the change. Companies should carefully assess whether such information is truly “new” information identified in the reporting period or corrects inappropriate assumptions or estimates in prior periods (which would be evaluated under the error correction guidance in Section 3). For example, a change made to the allowance for uncollectible receivables to include data that was accidentally omitted from the original estimate or to correct a mathematical error or formula represents an error correction. Conversely, a change made to the same allowance to incorporate updated economic data (e.g., unemployment figures) and the impact it could have on the customer population would represent a change in estimate. Disclosures Change in Reporting Entity
A change in reporting entity is generally limited to the following types of changes:
Changes in the reporting entity mainly transpire from significant restructuring activities and transactions. Neither business combinations accounted for by the acquisition method nor the consolidation of a variable interest entity (VIE) are considered changes in the reporting entity. Disclosures Step 1 – Identify an Error
Accordingly, a change in an accounting policy from one that is not generally accepted by GAAP to one that is generally accepted by GAAP is considered an error correction, not a change in accounting principle. Likewise, if information is misinterpreted or old data is used when more current information is available in developing an estimate, an error exists, not a change in estimate. Moreover, as it relates to the classification and presentation of account balances on the face of the financial statements, many confuse errors with “reclassifications.” Changing the classification of an account balance from an incorrect presentation to the correct presentation is considered an error correction, not a reclassification (see Section 4 below for more on reclassifications). Step 2 – Assess Materiality of Error Step 3 – Report Correction of Error
Reporting Approach Disclosures Big R Restatements Reporting Approach When the errors’ effect on the financial statements cannot be determined without a prolonged investigation (or the preparation of and auditing of the restated financial statements will simply take a longer period of time due to the nature of the errors), the issuance of the restated financial statements and auditor’s report will necessarily be delayed. In some cases, the process may cause an SEC registrant to fall behind on its periodic reports. Questions often arise about the filing approach in this situation, particularly whether each “missing” periodic report should be filed, or a comprehensive report on Form 10-K can be filed (i.e., a Super Form 10-K). The Financial Reporting Manual of the SEC’s Division of Corporation Finance contains the following guidance (see 1320.4) SEC registrants may wish to consider if they become delinquent in their filings (whether due to restatements or otherwise):
In these situations, management should work closely with its securities counsel and auditors and may need to discuss its approach with the SEC staff, stock exchanges, or other regulatory agencies about the measures to be taken given the facts and circumstances. Disclosures
Disclosures also typically include other details about the cause of the error, how it was discovered and other direct and indirect impacts of the error. SEC registrants will also need to consider the impact of and/or disclosure of the error corrections within other sections of their filings (e.g., Selected Financial Data, Management’s Discussion and Analysis (the results of operations and liquidity analysis), Contractual Obligations, etc.). When correcting the error by restating under the Big R restatement approach, an explanatory paragraph will be included within the auditor’s report with a statement that the previously issued financial statements have been restated for the correction of a material misstatement in the respective period and a reference to the footnote disclosure of the correction of the material misstatement. Additionally, an entity will need to consider the impact of such errors on its internal controls over financial reporting – refer to Section 5 below for further discussion. ReclassificationsChanges in the classification of financial statement line items in previously issued financial statements generally do not require restatements, unless the change represents the correction of an error (i.e., a misapplication of GAAP in the prior period). Reclassifications represent changes from one acceptable presentation under GAAP to another acceptable presentation. Disclosures that indicate certain prior period financial information has been reclassified to conform with the current period presentation should be reserved solely for reclassifications that do not constitute errors. Consider the following examples:
In financial statements which reflect both error corrections and reclassifications, clear and transparent disclosure about the nature of each should be included. Other ConsiderationsInternal Conrols Over Financial Reporting BDO Insight:When a Big R restatement is required, the presence of the material misstatement in previously issued financial statements will almost always result in the identification of a material weakness. When an out-of-period adjustment or Little r restatement is identified, the evaluation of what “could be material” is relevant to the assessment of whether the mitigating control operates at a level of precision that would prevent or detect a material misstatement. Pursuant to Regulation S-K, an SEC registrant should also consider:
Audit standards also require the auditor to assess the impact of identified errors on any previously issued ICFR opinions and may ultimately require the reissuance of the opinion in certain circumstances.
[2] However, plans to file a registration statement that incorporates previously filed financial statements before the prior periods are revised may impact this approach. [3] The specific disclosures and requirements to report non-reliance on previously issued financial statements can be found directly within Item 4.02 of Form 8-K and depend, in part, on which party (the registrant or auditor) determined that action should be taken to prevent reliance on the financial statements. Registrants, the audit committee and/or board or directors, and the auditors will work together on such filings to ensure the appropriate disclosures are made. [4] The interpretive release reflects the Commission’s guidance regarding Management’s Report on Internal Control Over Financial Reporting Under Section 13(a) or 15(d) of the Securities Exchange Act of 1934. Which of the following is a change in accounting estimates?A change in accounting estimate is an adjustment of the carrying amount of an asset or a liability, or the amount of the periodic consumption of an asset, that results from the assessment of the present status of, and expected future benefits and obligations associated with, assets and liabilities.
How should a change in accounting estimate be accounted for?Changes in accounting policies and corrections of errors are generally retrospectively accounted for, whereas changes in accounting estimates are generally accounted for on a prospective basis.
Which of the following is a change in accounting estimate achieved by a change in accounting principle?A change in depreciation methods is considered to be a change in accounting estimate that is achieved by a change in accounting principle. We account for such a change prospectively.
What are some examples of changes in estimates?Examples of commonly changed estimates include bad-debt allowance, warranty liability, and depreciation.
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