Connect

Close
Skip to eBook contentSkip to Chapter linksSkip to Content links for this ChapterSkip to eBook links

Chapter4: The Income Statement and Statement of Cash Flows

Accounting Changes

Accounting changes fall into one of three categories: (1) a change in an accounting principle, (2) a change in estimate, or (3) a change in reporting entity. The correction of an error is another adjustment that is accounted for in the same way as certain accounting changes. A brief overview of each is provided here. We cover accounting changes in detail in Chapter 20.

Change in Accounting Principle

A change in accounting principle refers to a change from one acceptable accounting method to another. There are many situations that allow alternative treatments for similar transactions. Common examples of these situations include the choice among FIFO, LIFO, and average cost for the measurement of inventory and among alternative revenue recognition methods. New standards issued by the FASB also require companies to change their accounting methods.

 

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/818573/wh_b.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (0.0K)</a> LO6

VOLUNTARY CHANGES IN ACCOUNTING PRINCIPLES.   Occasionally, a company will change from one generally accepted treatment to another. When these changes in accounting principles occur, information lacks consistency, hampering the ability of external users to compare financial information among reporting periods. If, for example, inventory and cost of goods sold are measured in one reporting period using LIFO and using the FIFO method in a subsequent period, inventory, cost of goods sold, and hence net income for the two periods are not comparable. Difficulties created by inconsistency and lack of comparability are alleviated by the way we report voluntary accounting changes.

   GAAP requires that voluntary accounting changes be accounted for retrospectively.36 Prior to this standard, the cumulative effect on the income of previous years from having used the old method rather than the new method was included in the income statement of the year of change as a separately reported item. We no longer report the cumulative effect in the year of the change. Instead, we retrospectively recast prior years' financial statements when we report those statements again (in comparative statements, for example). For each year in the comparative statements reported, we revise the balance of each account affected to make those statements appear as if the newly adopted accounting method had been applied all along. Then, a journal entry is created to adjust all account balances affected to what those amounts would have been. An adjustment is made to the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders' equity to account for the cumulative income effect of changing to the new principle in periods prior to those reported.37

Voluntary changes in accounting principles are accounted for retrospectively by revising prior years’ financial statements.

p. 189

   Let's suppose that in 2011 the Dearborn Corporation switched from the LIFO inventory method to FIFO. In addition to the 2011 statements, Dearborn presents two additional years of income statements and statements of shareholders' equity (2010 and 2009) as well as a 2010 balance sheet for comparative purposes. Here are the steps Dearborn would follow to account for the change.

1.

 

The comparative financial statements are revised. For all three years—2009, 2010, and 2011—income statements will appear as if FIFO had been applied all along. Dearborn uses its new method, FIFO, to determine cost of goods sold, income tax expense, and net income in 2011 and recalculates the 2009 and 2010 numbers using FIFO rather than LIFO. Similarly, inventory and retained earnings in each year's balance sheet are reported using the newly adopted FIFO method. In its statements of shareholders' equity, Dearborn reports retained earnings each year as if it had used FIFO all along, and because 2009 is the earliest year reported, beginning retained earnings that year is revised to reflect the cumulative income effect of the difference in inventory methods for all years prior to 2009.

2.

 

The appropriate accounts are adjusted. Dearborn will create a journal entry to adjust the book balances from their current LIFO amounts to what those balances would have been using FIFO. Since differences in cost of goods sold and income are reflected in retained earnings, as are the income tax effects, the journal entry updates these accounts.

3.

 

A disclosure note provides additional information. Dearborn must provide clear justification that the change to FIFO is appropriate in a disclosure note. The note also indicates the effects of the change on items not reported on the face of the primary statements, as well as any per share amounts affected for the current period and all prior periods presented. In addition, the note discloses the cumulative effect of the change on retained earnings or other components of equity as of the beginning of the earliest period presented.

   We will see these steps demonstrated in Chapter 9 in the context of our discussion of inventory methods. Later, we'll revisit accounting changes in depth in Chapter 20.

MANDATED CHANGES IN ACCOUNTING PRINCIPLES.   When a new FASB standard mandates a change in accounting principle, the board often allows companies to choose among multiple ways of accounting for the changes. One approach generally allowed is to account for the change retrospectively, exactly as we account for voluntary changes in principles. A second approach is to allow companies to report the cumulative effect on the income of previous years from having used the old method rather than the new method in the income statement of the year of change as a separately reported item below extraordinary items.

   As an example of accounting for a mandated change with a cumulative adjustment, consider Marvell Technology Group LTD., a leading global semiconductor provider. Marvell adopted newly revised GAAP regarding share-based payments for its fiscal year ended January 27, 2007. The revision in GAAP, which we discuss in detail in Chapter 19, requires all companies to expense the estimated cost of employee stock options. Marvell accounted for the adoption of the new standard by including the $8.8 million, net of tax, cumulative effect of the change in its 2007 income statement as a separately reported item. Graphic 4-8 shows a portion of the disclosure note that explained the change.

Change in Depreciation, Amortization, or Depletion Method

A change in depreciation, amortization, or depletion method is considered to be a change in accounting estimate that is achieved by a change in accounting principle. We account for these changes prospectively, exactly as we would any other change in estimate. We discuss and illustrate this approach in the next section.

Changes in depreciation, amortization, or depletion methods are accounted for the same way as a change in an accounting estimate.

p. 190

GRAPHIC 4-8
Disclosure of Change in Accounting Principle—Marvell Technology Group LTD.

   14. Stock-Based Incentive Plans (in part)

   The adoption of SFAS No. 123R [FASB ASC 718 and 505] resulted in a cumulative benefit from the change in accounting principle of $8.8 million, net of tax, as of the year ended January 27, 2007, reflecting the net cumulative impact of estimated forfeitures that were previously not included in the determination of historic stock-based compensation expense in periods prior to January 28, 2006.

 

Real World Financials

Change in Accounting Estimate

Estimates are a necessary aspect of accounting. A few of the more common accounting estimates are the amount of future bad debts on existing accounts receivable, the useful life and residual value of a depreciable asset, and future warranty expenses.

 

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/818573/wh_b.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (0.0K)</a> LO7

   Because estimates require the prediction of future events, it's not unusual for them to turn out to be wrong. When an estimate is modified as new information comes to light, accounting for the change in estimate is quite straightforward. We do not revise prior years' financial statements to reflect the new estimate. Instead, we merely incorporate the new estimate in any related accounting determinations from that point on, that is, prospectively.38

A change in accounting estimate is reflected in the financial statements of the current period and future periods.

   Consider the example in Illustration 4-6.

ILLUSTRATION 4-6
Change in Accounting Estimate

The Maxwell Gear Corporation purchased machinery in 2008 for $2 million. The useful life of the machinery was estimated to be 10 years with no residual value. The straight-line depreciation method was used in 2008 through 2010, with a full year of depreciation taken in 2008. In 2011, the company revised the useful life of the machinery to eight years.

   Neither depreciation expense nor accumulated depreciation reported in prior years is restated. No account balances are adjusted. Rather, in 2011 and later years, the adjusting entry to record depreciation expense simply will reflect the new useful life. In 2011, the entry is:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/pg190_1.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

   When a company makes a change in an estimate that affects several future periods, such as revising its estimate of an asset's useful life, the company reports in a disclosure note the effect of that change on the current year's income before extraordinary items, net income, and earnings per share. That disclosure isn't necessary for more routine changes such as revising estimates regarding uncollectible accounts, unless the effect of the change is material.

   A recent quarterly report of Saga, Inc., provides us an example. The company operates radio and television stations in 26 markets throughout the United States. Graphic 4-9 reproduces the disclosure note that described a change in the useful life of its television analog equipment.

   As we discussed in a previous section, a change in depreciation, amortization, or depletion method is considered a change in estimate resulting from a change in principle. For that reason, we account for such a change prospectively, similar to the way we account for other changes in estimate. One difference is that most changes in estimate do not require a company to justify the change. However, this change in estimate is a result of changing an accounting principle and therefore requires a clear justification as to why the new method is preferable. Illustration 4-7 provides an example.

p. 191

GRAPHIC 4-9
Change in Estimate—Saga, Inc.

   Change in Accounting Estimate

   In the second quarter of 2008, the Company reviewed the estimated useful lives of its television analog equipment. This review was performed because of the Federal Communications Commission's (“FCC”) mandatory requirement that all television stations convert from analog to digital spectrum by February 2009. As a result of this review, the Company's depreciation rate of its analog equipment was increased to reflect the estimated period during which these assets will remain in service. In accordance with FASB 154, “Accounting Changes and Error Corrections,” [FASB ASC 250–10–45–17] this change of estimated useful lives is deemed as a change in accounting estimate and has been accounted for prospectively, effective April 1, 2008. The effect of this change in estimate was to decrease net income approximately $347,000 and decrease basic and diluted earnings per share by $.07 for the year ended December 31, 2008.

 

Real World Financials

ILLUSTRATION 4-7
Change in Depreciation Method

The Maxwell Gear Corporation uses the double-declining balance (DDB) depreciation method for most of its equipment. In 2011, for consistency with other firms in the industry, the company switched from the DDB method to straight-line depreciation for a large group of equipment purchased at the beginning of 2009. Maxwell purchased this equipment at a cost of $50 million. The machinery has an expected useful life of five years and no estimated residual value.

   When the change occurs, the company does not revise either depreciation expense or accumulated depreciation reported in prior years. No account balances are adjusted. Rather, in 2011 and later years, its adjusting entry to record depreciation expense simply will reflect the new depreciation method (straight-line). In 2011, the adjusting entry is ($ in millions):

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/pg191_1.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

   A disclosure note reports the effect on net income and earnings per share along with clear justification for changing depreciation methods.

Change in Reporting Entity

A third type of change—the change in reporting entity presentation of consolidated financial statements in place of statements of individual companies, or a change in the specific companies that constitute the group for which consolidated or combined statements are prepared.—involves the preparation of financial statements for an accounting entity other than the entity that existed in the previous period.39

   Some changes in reporting entity are a result of changes in accounting rules. For example, GAAP requires companies like Ford, General Motors and General Electric to consolidate their manufacturing operations with their financial subsidiaries, creating a new entity that includes them both.40 For those changes in entity, the prior-period financial statements that are presented for comparative purposes should be restated to appear as if the new entity existed in those periods.

p. 192

   However, the more frequent change in entity occurs when one company acquires another one. In those circumstances, the financial statements of the acquirer include the acquiree as of the date of acquisition, and the acquirer's prior-period financial statements that are presented for comparative purposes are not restated. This makes it difficult to make year-to-year comparisons for a company that frequently acquires other companies. Acquiring companies are required to provide a disclosure note that presents key financial statement information as if the acquisition had occurred before the beginning of the previous year. At a minimum, the supplemental pro forma information should display revenue, income before extraordinary items, net income, and earnings per share.




36 FASB ASC 250–10–45–5: Accounting Changes and Error Corrections—Overall—Other Presentation Matters (previously “Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3,” Statement of Financial Accounting Standard No. 154 (Norwalk, Conn.: FASB, 2005)).

37 Sometimes a lack of information makes it impracticable to report a change retrospectively so the new method is simply applied prospectively, that is, we simply use the new method from now on. Also, if a new standard specifically requires prospective accounting, that requirement is followed.

38 If the original estimate had been based on erroneous information or calculations or had not been made in good faith, the revision of that estimate would constitute the correction of an error.

* Double the straight-line rate for five years [(1/5 = 20%) × 2 = 40%]

39 In Chapter 20 we discuss the different types of situations that result in a change in accounting entity.

40 The issuance of SFAS No. 94, “Consolidation of All Majority-Owned Subsidiaries,” [codified in FASB ASC 810 and 840] resulted in hundreds of entities consolidating previously unconsolidated finance subsidiaries.

2011 McGraw-Hill Higher Education
Any use is subject to the Terms of Use and Privacy Notice.
McGraw-Hill Higher Education is one of the many fine businesses of The McGraw-Hill Companies.