The correction of an error in the financial statement of a prior period should be reported:
When changes are necessary, it’s up to CPAs to decide how to reflect them in the financial reporting process. In 2005, FASB revisited the issue and made significant revisions to its guidance on how to treat certain changes. The result was Statement no. 154, Accounting Changes and Error Corrections, which superseded APB Opinion no. 20, Accounting Changes. Statement no. 154 is effective for fiscal years ending after December 15, 2006. This article discusses the changes Statement no. 154 brought about as well as the practical implementation issues companies and their auditors will face.
RETROSPECTIVE PERSPECTIVE Under previous guidance, the Accounting Principles Board (APB) was most concerned about a possible dilution of public confidence in financial reporting if companies applied principle changes retroactively and restated prior years’ financial statements. The APB opted for a “catch-up,” or cumulative effect, approach to reporting most changes; the cumulative effect of a change on prior-year financial statements was reported on the current year’s income statement in a manner similar to, but not the same as, an extraordinary item. Opinion no. 20 did not require restatement of prior-year financial statements, but did require presentation of pro forma information. Under Statement no. 154, all voluntary changes in principle now must be retrospectively applied to previous-period financial statements, unless such application is impracticable or FASB mandates another approach. Impracticable conditions exist if a company is unable to apply the new principle after making every reasonable effort or if CPAs cannot document assumptions about management’s intent in the prior periods or gather estimates needed to apply the principle in those periods. Companies no longer will report a cumulative effect on the current year’s income statement. Instead, they will report any necessary adjustment as an adjustment to the opening balance of retained earnings for the earliest period presented. FASB’s retrospective approach eliminates all cumulative effect adjustments to current income and should greatly enhance the consistency and comparability of financial information over time and between companies. Since a change in principle is retrospectively applied to prior financial statements, there is a need to present pro forma information. A CHANGE IN ACCOUNTING PRINCIPLE
Based on these data, ABC needs to make a $5,000 entry on its books to adjust the inventory to the FIFO amount ($25,500 – $20,500). An adjustment to retained earnings will be necessary to account for the effect of the inventory method change on 20X5 net income. The difference in the beginning inventory for 20X5 would cause net income to decrease by $400, while the difference in the 20X5 ending inventory would cause net income to increase by $4,000. On a pretax basis, 20X5 income would increase by $3,600 and after-tax income would increase $2,520 ($3,600 – (30% x $3,600)). For years before 20X5, there would be a $400 increase in pretax income, for a total pretax adjustment of $4,000 ($3,600 + $400); after taxes the adjustment would be $2,800 ($4,000 – (30%On a pretax basis, 20X5 income would increase by $3,600 and after-tax income would increase $2,520 ($3,600 – (30% x $4,000)). ABC Co. would make the adjusting entry shown below in 20X6 to implement this change in accounting principle.
The opening balance in the 20X6 statement of retained earnings should be adjusted by $2,800 to reflect the change in inventory methods. However, if the company presented a statement of retained earnings for 20X5, the opening balance would be adjusted by $280 ($400 – (30%On a pretax basis, 20X5 income would increase by $3,600 and after-tax income would increase $2,520 ($3,600 – (30% x $400)) for the impact of the change in years before 20X5. If the 20X5 balance sheet was presented for comparative purposes, inventory also would need to be restated to $16,250 to reflect the FIFO inventory valuation.
Exhibits 4 and 5 illustrate how the company would adjust its retained earnings to reflect a change in inventory methods. Exhibit 4 shows the 20X6 adjustment while exhibit 5 reflects adjustments in comparative statements for 20X6 and 20X5.
Under Statement no. 154, the required disclosures for a change in principle include a description of the change and the reason for it, as well as an explanation of why the newly adopted principle is preferable. Companies also should describe the prior-period information they retrospectively adjusted and present the effect of the change on income from continuing operations and net income and related per-share amounts for the current period and any prior periods retrospectively adjusted. A company should disclose the cumulative effect of the change on retained earnings as of the earliest period. If retrospective application is impracticable, CPAs should disclose why and describe the alternative method used to report the change.
CHANGE IN DEPRECIATION METHOD Companies may be more likely to make such changes now that a cumulative effect adjustment is not required in the year of change. The new treatment should improve financial reporting by making it easier for companies to change to a method that better reflects how they consume the future benefits of their assets.
Suppose XYZ Co. decided in 20X6 to change the depreciation method for certain assets to the straight-line method, where previously these assets (with a total cost of $5 million) were depreciated using the double-declining balance method. Acquired in 20X3, the assets have a salvage value of $200,000 and an estimated life of eight years. The company’s policy is to take a full year’s depreciation in the year of acquisition and none in the year of disposal. To effect this change, its CPA must use the double-declining balance method to determine the depreciation through December 31, 20X5, as shown in exhibit 6 . The revised depreciation per period using the newly adopted straight-line method beginning in 20X6 would be computed as shown in exhibit 7.
OTHER ACCOUNTING CHANGES AND ERROR CORRECTIONS A change in the reporting entity is considered a special type of change in accounting principle that produces financial statements that are effectively those of a different reporting entity. Changes in the reporting entity continue to be applied retrospectively. Companies should restate the financial statements of all prior periods presented and must include a description of the nature of the change and the reason for it, as well as the effect on income before extraordinary items, net income and related per-share amounts for all periods that are presented. Companies still should report the correction of errors in previously issued financial statements as prior-period adjustments, with a restatement of prior-period financial statements. The carrying value of the assets and liabilities should be adjusted for the cumulative effect of the error for periods before the earliest period presented. The beginning balance of retained earnings should be adjusted for the cumulative effect of the error. Disclosures include the effect of the correction on each item in the financial statements and the cumulative effect of the change on retained earnings as of the beginning of the earliest period presented, along with any per-share effects for each prior period presented. IMPLICATION FOR COMPANIES A company wishing to make a change in principle should first apprise its current auditors of the change and have them affirm that the new principle is preferable. If the company has changed auditors, it may need to take a major role in coordinating the efforts between the current (successor) auditor and the previous (predecessor) auditor. This is particularly true for public companies. The company should prepare the current financial statements under the new method and adjust prior-period statements to reflect the newly adopted principle. If the successor auditor plans to audit the adjustments to the prior financial statements, there is no need to contact the predecessor auditor. However, the company may want to involve its previous auditor since it may be more efficient and cost-effective for the predecessor to audit the adjustments. Smaller companies without in-house expertise likely will rely more heavily on their outside auditors to help them implement any change in principle. IMPLICATIONS FOR AUDITORS Successor auditors face even greater complications. The PCAOB addressed many of these complications in its June 9, 2006, Q&A, Adjustments to Prior Period Financial Statements Audited by a Predecessor Auditor. In it the PCAOB says adjustments to prior-period statements due to changes in principles and error corrections can be audited by either the successor or predecessor auditor, but an audit of the adjustments by the predecessor auditor may be more cost-effective. One large-firm audit partner we spoke with could not envision many situations in which the successor auditor would be in a better position than the predecessor to audit either retrospective applications of principles or restatements of errors. However, another audit partner who works primarily with private companies said nonpublic companies likely will look to the successor auditor to audit their retrospective adjustments for changes in principle. In private companies it is rare for the predecessor to be involved in error corrections in any significant way. If the predecessor auditor audits the adjustment to the prior statements, the PCAOB says the reissued audit report should be dual-dated to avoid any suggestion the auditor examined records, transactions or events after that date. An audit by the predecessor auditor, however, does not relieve the successor of all responsibilities related to the adjustments. Since error corrections and changes in principles often affect the timing of when transactions and events are recognized in financial statements, the successor should obtain an understanding of prior statement adjustments. The successor auditor also is responsible for evaluating the preferability of the new principle and consistent period-to-period application. As a result it might be more efficient for the successor auditor to audit the resulting retrospective applications. The PCAOB Q&A lists three factors a successor auditor might consider in deciding to audit only the adjustments to the prior-period financial statements or whether a reaudit of the prior financial statements is necessary. The more extensive and pervasive the adjustments, the more likely the successor auditor should perform a reaudit. Adjustments related to error corrections (retroactive restatements) justify a reaudit more often than adjustments related to a change in principle (retrospective applications). With error corrections, the successor auditor should consider the risks there might be other, undetected misstatements; adjustments related to intentional errors would particularly suggest the need for a reaudit. When the predecessor auditor is less cooperative and responsive to questions and limits access to the prior audit’s documentation, a reaudit likely is required. It’s highly unlikely the successor auditor would audit the adjustments for an error correction without a reaudit. One partner told us he had seen situations where the predecessor had little reason to consent to reissuing the report on the prior financial statements, thereby forcing the successor to reaudit. When the successor auditor audits only the adjustments related to a change in principle or error correction, the limited nature of the audit work should be clearly disclosed. The successor’s report should state that he or she is not providing any assurance on the prior financial statements as a whole. With regard to error corrections, questions may arise as to whether the predecessor auditor may reissue a report on the prior statements. The PCAOB says the report may be reissued if the predecessor determines the prior-period statement reports are still appropriate, except for the error correction. In deciding whether the prior statements are still appropriate, the predecessor auditor should consider the nature and extent of the adjustments, whether management has withdrawn the prior statements and whether the errors were intentional. Even if the successor audits the adjustments, the predecessor should do additional work before reissuing the report on prior-period financial statements, including reading the current-period financial statements, comparing the adjusted prior-period statements with those originally issued with the report and obtaining representation letters from both the company and the successor auditor. If the successor audits the adjustments, the predecessor’s reissued report on the prior financial statements should be modified to clearly show the reissued opinion applies only to the prior statements before adjustment and that the predecessor auditor has not audited the adjustments. The predecessor’s reissued report should carry the same date as the original audit report to avoid any implications the predecessor auditor was involved with the adjustments. IMPLICATIONS FOR FINANCIAL STATEMENT USERS Since the numbers and treatments for changes in principles and error corrections now will look much the same, except for the disclosures, there also is the potential that financial statement preparers may misapply Statement no. 154 by showing an error correction as a change in principle. With both adjustments now going to retained earnings, preparers might try—intentionally or unintentionally—to mask an error correction as a voluntary change in principle. Such misapplications would mislead financial statement readers, since error corrections usually raise concerns, while most readers view principle changes as a good thing. Preparers and auditors should be familiar with the differences between changes in principle and error corrections. Auditors in particular need to understand the potential for misapplications and carefully review the nature of the restatements and related disclosures.
REPORTING CONSISTENCY Consistency and comparability in cross-border financial reporting also were significant factors in FASB’s decision to change the reporting of accounting changes. FASB and the IASB identified accounting for changes under Opinion no. 20 as one area that could be improved and brought into agreement with international standards. Statement no. 154 brings U.S. standards into compliance with IAS 8, Accounting Policies, Changes in Estimates and Errors, and is a positive move toward the development of a single set of high-quality global accounting standards. How should correction errors be reported in the financial statements?How to report an error correction. Reflect the cumulative effect of the error on periods prior to those presented in the carrying amounts of assets and liabilities as of the beginning of the first period presented; and.. Make an offsetting adjustment to the opening balance of retained earnings for that period; and.. How should a correction of an error from a prior period be treated in the financial statements?Prior Period Errors must be corrected Retrospectively in the financial statements. Retrospective application means that the correction affects only prior period comparative figures. Current period amounts are unaffected.
Where should prior period adjustments reported?Prior Period Adjustments are made in the financial statements. These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.
How are prior period adjustments reported on the financial statements?You should account for a prior period adjustment by restating the prior period financial statements. This is done by adjusting the carrying amounts of any impacted assets or liabilities as of the first accounting period presented, with an offset to the beginning retained earnings balance in that same accounting period.
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