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SFAS 154: Accounting Changes and Error Corrections.

Since 2002, FASB and the International Accounting Standards Board (IASB) have had formal convergence projects in the works. The two standards-setting bodies are actively engaged in harmonizing their accounting standards. One prominent example is the new SFAS 154, Accounting Changes and Error Corrections, which replaces APB Opinion 20 and SFAS 3. SFAS 154 is very similar to IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors, which was revised in December 2003. Both FASB and the IASB have modified their standards on changes and errors to achieve international uniformity and comparability in financial reporting changes and errors.

The Exhibit presents a summary of the issues addressed by SFAS 154 and how its treatment of accounting changes and errors differs from APB 20 and SFAS 3. The Sidebar illustrates two numerical applications of the new standard.

Changes in Accounting Principles

APB 20, "Accounting Changes" (1971), generally required the cumulative effect of changes in accounting principle--from one GAAP to another--to be reflected in current earnings. SFAS 154 calls for "retrospective application" for voluntary changes in accounting principle. This standard uses the term "restatement" to refer to revision of previously issued financial statements to correct an error. The new standard enhances consistency for the same company across time and improves comparability with companies that use International Accounting Standards.

Retrospective application means that a change in accounting principle is treated by restating comparative financial statements to reflect the new method as though it had been applied all along. Instead of showing the cumulative effect of the difference between the two accounting principles in the current income statement, this figure will now be reflected as a retrospective application and an adjustment to the opening retained earnings balance. Thus, the new term "retrospective application" implies that the company should apply the new standard it adopted to all periods shown unless it is impracticable to determine the cumulative effect or the period-specific effect of the change. The "exceptional" retroactive method required by APB 20 for a change from LIFO to another GAAP inventory method, a change in accounting for long-term construction contracts, and a change in accounting for the extractive industries will now be the norm for most accounting principle changes. The cumulative effect will no longer be used.

Note that SFAS 154 requires that, when practicable, retrospective application be presented with respect to the direct effects and related income tax effects of a change in principle. Indirect effects, such as changes in management compensation and certain royalties, are not to be included in the retrospective application. If indirect effects are recognized, they should be reflected in the period of the accounting change.

Changes in Methods or Estimates

Change in depreciation, amortization, or depletion method. In a significant change from existing practice, SFAS 154 requires that changes in depreciation, amortization, or depletion methods will now be viewed as changes in estimate that are effected by a change in accounting principle. As such, these changes will be handled prospectively:
  [This would] ... better reflect the fact that an entity should change
  its depreciation, amortization, or depletion method only in
  recognition of changes in estimated future benefits of an asset, in
  the pattern of consumption of those benefits, or in the information
  available to the entity about those benefits.... The Board considers a
  change in depreciation, amortization, or depletion method to be
  inseparable from the change in the estimated consumption pattern.

Change in accounting estimate. A change in accounting estimate, such as in a bad-debt allowance, a warranty liability, or the service life of an asset, is not an error, because these estimates were based on the best information available at the time. These changes will continue to be treated prospectively, as under APB 20. However, if a change in estimate affects several future periods and materially affects the current-period, disclosure of the effect of the change on current income from continuing operations, net income and the corresponding earnings-per-share figures is required.

Change from FIFO to LIFO. Under APB 20, a change from FIFO to LIFO was treated as a change in estimate, because of the difficulty of determining prior LIFO inventory layers. Under the new standard, this change may continue to be treated that way:
  If it is impracticable to determine the cumulative effect of applying
  a change in accounting principle to any prior period, the new
  accounting principle shall be applied as if the change was made
  prospectively as of the earliest date practicable.

When is retrospective application impracticable? Impracticability of retrospective application occurs, according to SFAS 154, if any of the following conditions prevail:
  After making every reasonable effort to do so, the entity is unable to
  apply the requirement.
  Retrospective application requires assumptions about management's
  intent in a prior period that cannot be independently substantiated.
  Retrospective application requires significant estimates of amounts,
  and it is impossible to distinguish objectively information about
  those estimates that:
  * Provides evidence of circumstances that existed on the date(s) at
  which those amounts would be recognized, measured, or disclosed under
  retrospective application, and
  * Would have been available when the financial statements for that
  prior period were issued.

Correction of errors. As under APB 20, the correction of an error, which may be a change from one non-GAAP method to GAAP, or a bookkeeping correction, is shown as a restatement. Error corrections are distinguished from changes in GAAP, which are considered retrospective applications. Thus, although error corrections, like changes in principles, are reflected by restating comparative financial statements along with a prior-period adjustment to the opening retained earnings balance, the term "restatement" is reserved for error changes. SFAS 154 retains accounting for error corrections as in APB 20; there is no exception due to impracticability.

Initial adoption of a new principle. SFAS 154 prescribes that initial adoptions follow the transition provisions required in the new accounting principle. If there are no transition provisions, the statement requires retrospective application to the extent possible. If retrospective application is impracticable, then the adoption is treated prospectively. Limited retrospective application is to be used if full retrospective application is impracticable.

Changes in reporting entity. Changes in reporting entity are shown as prescribed in APB 20, that is, the restatement of all comparative statements. The nature of the change in entity and the reasons for the change are described in the notes to the financial statements. In addition, the effects of changes on income before extraordinary items, net income, other comprehensive income, and related per-share amounts are disclosed for all periods presented.

Interim changes. Changes in accounting principles made in an interim period or at the end of the fiscal year are applied to all interim periods of the year of change. Disclosure of the effect of the change on income from continuing operations, net income, and related per-share amounts is required for interim periods in the year of change. If a company reports interim information and makes an accounting change during the fourth quarter of its fiscal year and does not report the data in a separate fourth-quarter or annual report, disclosure of the nature and justification for the change and the effects of the accounting change on interim statements must be made in a note to the financial statements. If it is impracticable to distinguish between the cumulative effects on prior years and the effects on the interim periods of the year of change, then the accounting principle change in the interim period is not allowed.

Summary of Disclosure Requirements

The disclosures required under the new standard are similar to those under APB 20. For voluntary changes in accounting principle, the entity must disclose the following:

1. The change in accounting principle, and why the new one is preferable.

2. The method of applying the change, including its retrospective effects on income as well as other items affected, the cumulative effect of the change in retained earnings at the start of the first period presented. If retrospective application is not practicable, the reasons why and how the change was reported.

3. If indirect effects of a change in principle are recognized, a description of them, including the total and per-share amounts reflected in the current period.

If practicable, the total indirect effects pertaining to each prior period reported.

In addition, disclosure is required for the portion of any indirect effect recorded in the current period, but related to specific prior periods shown, if it is practicable to determine this amount. When a change is made to conform to a new standard, the same disclosure requirements apply as those for voluntary changes in standard unless the new standard indicates otherwise.

Error corrections. The nature of an error must be disclosed, as well as the effect on the current and prior periods presented. In addition, if an error affects the current or prior periods presented or is expected to affect subsequent periods, the entity must disclose that comparative information has been restated, the effect of the correction by line-item and per-share amounts for all periods presented, and the amount of the adjustment to opening retained earnings.

Changes in accounting estimate. If a change in accounting estimate has a material effect on current and future periods, the nature and amount of the effect on income from continuing operations, net income, and related per-share amounts of the current period must be disclosed. For a change in estimate effected by a change in accounting principle (such as a change in depreciation, amortization, or depletion method), the entity must justify why the new method is preferable, state the effect on current and prior periods, and provide the same disclosures required for a change in accounting principle.

Effective Date

SFAS 154 becomes effective for fiscal years beginning after December 15, 2005. The effective date is in essence one year later than the IAS 8's effective date, which is January 1, 2005.

SFAS 154 and IAS 8 as revised in December 2003 are a direct result of FASB's and the IASB's commitment to converge their accounting standards. SFAS 154 modified APB Opinion 20, which was inconsistent with IAS 8, thus enhancing comparability. Other modifications of FASB standards aimed at convergence will follow. It will be interesting to see whether the new standard results in U.S. companies' making these changes more frequently. The SEC can be expected to continue to scrutinize changes in accounting principle to guard against potential abuses, such as using changes in accounting principle to manage earnings.

Robert Bloom, PhD, is a professor of accountancy at John Carroll University, University Heights, Ohio. Jayne Fuglister, DBA, is a professor in the department of accounting, Nance College of Business Administration, Cleveland State University, Cleveland, Ohio.


Example 1: Voluntary change in principle. One example of "retrospective application" for a voluntary change in principle would be a switch from FIFO to average cost in inventory reporting method. Under APB Opinion 20, this change was not considered to be retrospective. The "cumulative effect" on prior years' income from the changes was reported in the current income statement. There were no changes to prior financial statements presented, except to report "pro forma income," or what the income in those periods would have been had the new method been used in those periods.

Assume XYZ Company made this change in 2005, maintaining that average cost is the preferable inventory method. Net income under FIFO in 2003 was $100,000, and in 2004 it was $150,000. For the sake of simplicity, assume that XYZ began in 2003, and also assume no taxes. The corresponding income figures would have been $85,000 and $120,000, respectively, under average cost. XYZ is required to make the following journal entry in 2005:
Dr. Retained Earnings  $45,000
Cr. Inventory          $45,000

Under SFAS 154, XYZ is also required to provide a retrospective application of this change to its prior financial statements presented. Under the pre-SFAS 154 approach, the journal entry in 2005 would have been:
Dr. Cumulative Effect  $45,000
Cr. Inventory          $45,000

"Cumulative effect" is an income statement account. No retrospective application took place. Instead, the pro forma income reportable in 2003 and 2004 would have been $85,000 and $120,000, respectively, as though average cost had been applied in those years.

Example 2: Change in estimate. One example of a change in estimate effected by a change in principle is a change in depreciation method from straight-line to sum-of-the-years'-digits (SYD). Assume the firm in question considers SYD to be preferable. Under APB Opinion 20, this change was handled by reporting the cumulative effect on prior periods' income in the current income statement along with the pro forma incomes for the prior periods presented. Under SFAS 154, this change is handled entirely prospectively. Accordingly, the new method (SYD) is applied to measuring current income as of the beginning of the current period.

In 2005, XYZ Company made this switch for a truck costing $500,000 in 2003, having an expected life of five years at the time of purchase. Thus, accumulated depreciation through the end of 2004 was $200,000, and the book value of the truck was $300,000. The depreciation under SYD in 2005 is $150,000 (i.e., 3/6 x $300,000), to be reported in the income statement for this period.
EXHIBIT Old Versus New Standards for Accounting Changes and Error

                       Old Standard (APB
Issue                  Opinion 20)           SFAS 154

Change in accounting   Cumulative effect in  Retrospective application
  principle from one   net income of the     to extent possible,
  GAAP to an existing  period                corresponding adjustment to
  GAAP (no longer                            opening retained
  includes                                   earnings. If retrospective
  depreciation,                              application is
  amortization, and                          impracticable, then apply
  depletion methods)                         prospectively.
Change in              Cumulative effect in  Prospective: now viewed as
  depreciation,        net income of the     a change in accounting
  amortization, and    period                estimate, along with
  depletion method                           disclosure requirements
  reflecting a change
  in estimate
Change in accounting   Prospective           Prospective. If
  estimate (excludes                         significant, disclosure on
  change in                                  current income from
  depreciation,                              continuing operations, net
  depletion, or                              income, and EPS figures is
  amortization method                        required.
  reflecting a change
  in estimate)
Change in accounting   Prospective           Prospective from earliest
  standard when                              date practicable
  cumulative effect
  cannot be
  determined (e.g.,
  from FIFO to LIFO)
Correction of errors   Retroactive           Restatement and adjustment
                       restatement and       to opening retained
                       adjustment to         earnings
                       opening retained
Adoption of a new      NA                    Provisions prescribed by
  accounting                                 specific standards. If
  principle, with the                        none, then retrospective
  exception of SFAS                          application. If
  154                                        retrospective application
                                             is impracticable, then
                                             apply prospectively.
Change in reporting    Retroactive           Retroactive restatement
  entity               restatement
Changes in accounting  Retroactive           Retrospective application
  principles in        restatement. Not      to prior interim periods of
  interim periods      allowed if effects    the year of the change. Not
                       on prior periods of   allowed if it is
                       the same year are     impracticable to
                       indistinguishable     distinguish effects on
                       from cumulative       prior interim periods of
                       effects on prior      the year of change from
                       years (SFAS 3).       prior year.
Adoption of SFAS 154   NA                    Prospective
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Title Annotation:statement of financial accounting standards
Author:Bloom, Robert; Fuglister, Jayne
Publication:The CPA Journal
Geographic Code:1USA
Date:Mar 1, 2006
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