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Accounting changes.

One phrase that we have all chuckled over refers to "change" as the only constant in life! Accountants are subject to change, too, and must deal with change in a way that provides clients and financial statement readers with useful data for decision-making.

At first, it would appear that any change in accounting is in direct conflict with the goals of comparability and consistency of financial statements. However, changing economic conditions, new reporting requirements or newly discovered information can mean that if the change is made, financial statements will be more useful, providing a better measure of a firm's activities. So long as the change is justified on these grounds, the qualitative goals of consistency and comparability become secondary. The Accounting Principles Board issued Opinion #20 in 1971 to provide guidance and maintain consistent treatment when firms--and accountants--deal with accounting changes.

There are three main categories of changes that we might experience: 1) a change in accounting principle or method, 2) a change in accounting estimate, and 3) a change in a reporting entity.

A change from one generally accepted accounting principle to another could include changes in such things as the method of depreciation or amortization, inventory valuation, lease reporting, revenue recognition, bad debt measurement, accounting for oil and gas operations, investments or deferred taxes. (A change from a non-GAAP to a GAAP method of accounting is considered a correction of an error and is treated differently. See "Accounting Errors," pages 6-7, in the December 1990 NPA.) For most such changes, APB #20 requires that the cumulative effect of the change be shown currently as a separate income statement item. Prior years' financial statements are generally not altered, but pro forma statements are issued to show how the statements would have looked if the new method had been used.

A frequently experienced change in accounting method is the change to the LIFO method of measuring inventory. In periods of rising prices, LIFO inventory valuation will yield lower income and thus lower income taxes. This is clearly an attractive option, but favorable income tax results alone cannot be used to justify the change!

A few specific changes in accounting principles require retroactive treatment. Changing from LIFO to any other method of inventory measurement, changes in the method of accounting for long-term construction contracts and changes involving the "full cost" method of accounting for extractive industries all must show the cumulative effect of the change as an adjustment to beginning retained earnings for the earliest year presented.

Changes in accounting estimates occur often. Complete accounting information cannot always be known ahead of time and we often use estimates to provide needed data on a timely basis. The most frequently seen changes of this type are in estimates of useful life or residual value of depreciable assets. Other examples include a change in the estimate of uncollectible accounts, warranty obligations and the amount of a natural resource to be extracted. The effect of a change of this nature is shown in the current year and whatever future years are affected. No adjustment of past years or pro forma financial statements is required.

It should be noted that when both a change in estimate and a change in method occurs, APB #20 allows the change in estimate to take precedence. This might occur when new information causes a firm to revise its estimate of the residual value of a piece of equipment at the same time as it changes from double-declining balance to straight-line depreciation. By APB ruling, this would be treated as a change in estimate, with no cumulative effect or pro forma statements necessary.

Changes in reporting entity are not frequent, but when a merger or subsidiary acquisition or sale takes place, the resulting business may no longer be the same accounting entity. Financial statements, as a tool for comparison, become useless if the companies that comprise the whole have changed significantly. In order to achieve some degree of comparability, the APB requires the new entity to issue financial statements on a retroactive basis, showing what the statements would have looked like if the current entity makeup had been in place in previous years. This requirement becomes extremely complex when minority interest, inter-company transactions and differing fiscal years are factored in!

As always, disclosure in the footnotes to the financial statements will assist readers in understanding the impact of all three types of changes. The goal continues to be to provide as much consistency and comparability as possible in an environment of change.

The questions that follow will give you some practice in identifying treatment of accounting changes.

1. The concept of consistency is sacrificed in the accounting for which of the following statement of income items?

a. extraordinary items.

b. loss on disposal of a segment of a business.

c. cumulative effect of a change in accounting principle.

d. none of the above.

2. Which of the following changes would be disclosed as a change in accounting principle but reported by applying the new method retroactively as restatements of prior periods?

a. change from FIFO to LIFO method of inventory pricing.

b. change from "completed-contract" accounting to "percentage of completion."

c. change in the composition of elements included in inventory.

d. change from the straight-line method to an accelerated method of depreciation.

3. Which of the following accounting treatments is proper for a change in reporting entity?

a. restatement of all financial statements presented.

b. restatement of current period financial statements.

c. note disclosure and supplementary schedules.

d. adjustment to retained earnings and note disclosure.

4. Which of the following is the proper time period to record a change in accounting estimate?

a. current and future periods.

b. current and prior periods.

c. prior periods only.

d. current period only.

5. The effect of a change in accounting principle that is inseparable from the effect of a change in accounting estimate should be reported

a. by restating the financial statements of all prior periods presented.

b. in the period of the change and future periods if the change affects both.

c. by showing the pro forma effects of retroactive application.

d. as a correction of an error.

6. At the time Crantz Incorporated became a subsidiary of Rosen Corporation, Crantz switched depreciation of its plant assets from the straight-line method to the sum-of-the-years'-digits method used by Rosen. With respect to Rosen, this change was a

a. change in accounting estimate.

b. correction of an error.

c. change in accounting principle.

d. change in the reporting entity.

7. Pro forma effects on net income and earnings per share of retroactive application would usually be reported on the face of the income statement for a
 Change in Change in Change in
 reporting accounting accounting
 entity estimate principle
a. yes yes yes
b. yes no yes
c. no yes no
d. no no yes
 (AICPA adapted)

8. Yorick, Inc., bought a patent for $600 on January 1, 1990, at which time the patent had an estimated useful life of ten years. On February 2, 1993, it was determined that the useful life would expire at the end of 1996. What amount should Yorick recognize as amortization expense for this patent for the year ending December 31, 1993?

a. $140

b. $120

c. $105

d. $60
COPYRIGHT 1993 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Accounting Scene
Author:Wincur, Barbara
Publication:The National Public Accountant
Date:Mar 1, 1993
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