Intermediate Accounting, Eighth Canadian Edition

21 Chapter Accounting Changes and Error Analysis Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto Accounting Changes and Error Analysis Changes in Accounting Policies and Estimates, and Errors Types of accounting changes Alternative accounting methods

Perspectives Motivations for change IFRS and Private Enterprise GAAP Comparison Interpreting accounting changes Comparison of IFRS and private enterprise GAAP Accounting standards Adoption of IFRS Retrospective application

change in accounting policy Adoption of accounting standards for private enterprises (ASPE) Retrospective restatement correction of error Looking ahead Prospective application Summary of accounting changes 2 Accounting Changes and Error Analysis Changes in Accounting

Policies and Estimates, and Errors Types of accounting changes Alternative accounting methods Perspectives Motivations for change IFRS and Private Enterprise GAAP Comparison Interpreting accounting changes Comparison of IFRS and private enterprise

GAAP Accounting standards Adoption of IFRS Retrospective application change in accounting policy Adoption of accounting standards for private enterprises (ASPE) Retrospective restatement correction of error Looking ahead Prospective application

Summary of accounting changes 3 Types of Accounting Changes 1. Change in Accounting Policy Change in the choice of specific principles, bases, conventions, rules, and practices applied by an entity in preparing and presenting financial statements 2. Change in Accounting Estimate Adjustment based on change in circumstances on which a previous estimate was based or as the result of new information, more experience or subsequent developments 4 Types of Accounting Changes

(continued) 3. Correction of an error in prior period financial statements Omissions from or mistakes in financial statements of prior periods caused by the misuse or failure to use reliable information that existed at the time financial statements were prepared They may be intentional or an oversight 5 Changes in Accounting Policy Under IFRS, change in an accounting policy is permitted only when the change: 1. Is required by a primary source of GAAP, or 2. Results in portraying reliable and more

relevant information about effects of transactions, events or conditions 6 Changes in Accounting Policy Under accounting standards for private enterprises, there is a third type of policy change permitted (voluntary): 3. Between or among allowed PE GAAP accounting options for: Investments in subsidiaries, and investments with significant influence or joint controls Development phase expenditures on internally generated assets Defined benefit plans Income taxes Measuring equity component of certain financial

instruments 7 Changes in Accounting Policy Does not result from adoption of a: 1. Different policy necessitated by events or transactions clearly different in substance from those previously occurring 2. New policy that recognizes events that have occurred for the first time or that were previously immaterial 8 Changes in Accounting Policy Examples of situations that are not changes in accounting policy:

Adopting interest capitalization during construction of own long-term assets, when company had not previously been involved in self-construction Deferral of development expenditures when previously these expenses were expensed as they were immaterial 9 Changes in Accounting Estimates Future conditions and events and their effects cannot be known with certainty; therefore estimation requires exercise of judgement Use of reasonable estimates is essential to the accounting process and does not undermine the reliability of financial statements

10 Changes in Accounting Estimates Examples of items requiring estimates include: Uncollectible receivables Inventory obsolescence Fair value of financial assets/liabilities Useful lives and residual values of depreciable assets Liabilities for warranty costs and income taxes 11 Changes in Accounting Estimates Differentiating a change in policy and a change in estimate can be difficult For example, is a change in amortization method

a change in policy or a change in estimate? At first glance, a change in amortization method appears to be a change in accounting policy However, it is a change in estimate if it is a change in estimate of the pattern in which company benefits from the asset Where it is not clear, treat the change as a change in estimate 12 Correction of an Error in Prior Period Financial Statements Examples of accounting errors include: Change from non-GAAP to GAAP e.g. change from cash basis of accounting to accrual basis

Mathematical mistakes e.g. incorrect totaling of inventory count sheets Oversight e.g. failure to defer expenses or revenues Misappropriation of assets e.g. discovery of inventory theft 13 Correction of an Error Distinguishing between correction of an error and a change in estimate can be difficult Example: a lack of a previous years accrual of reassessed income taxes was the information overlooked (i.e. an error) or do we have more information or was there subsequent developments (i.e. an estimate)? General rule: if an estimate was calculated incorrectly due to lack of expertise, it is considered an error;

If a careful estimate was made in a previous year which is later determined as incorrect, it is considered a change in estimate 14 Alternative Accounting Methods Three approaches have been suggested for reporting changes in the accounts 1. Retrospectively 2. Currently 3. Prospectively 15 Retrospective Treatment Also know as retroactive application Requires calculating the cumulative effect of

the change on the financial statements at the beginning of the period as if the new method or estimate had always been used An adjustment is made to the financial statements equal to this cumulative effect Results in restating all affected prior years financial statements on a basis consistent with the newly adopted policy (i.e. as if the new accounting policy had always been used) 16 Current Treatment New accounting method or estimates cumulative effect on the financial statements at the beginning of the period is calculated An adjustment is reported in current years income statement Prior years financial statements are not restated

17 Prospective Treatment Previously reported results remain; no change is made Opening balances are not adjusted and no attempt is made to correct or change past periods New policy or estimate is adopted for current and future periods only and applied to balances existing at the date of the change 18 Accounting Changes and Related Accounting Methods Type of Accounting Change Accounting Method Applied

Adoption of primary source of GAAP (Change in Accounting Policy) Apply method approved in transitional provisions section of the primary source; if none, then use retrospective application (if impractical, apply prospectively). Voluntary change in accounting policy Apply retrospectively. If impractical, apply prospectively Change in accounting estimate Apply prospectively.

Correction of an error Apply retrospectively. 19 Retrospective-withRestatement Requirements of this method include: 1. Retroactive application of the new method, including income tax effects an accounting entry is made 2. Prior-period financial statements included for comparative purposes are restated 3. Description of the change and effect on current and prior period financial statements disclosed so that statements remain comparable 20

Retrospective-withRestatement Example Given: Voluntary change to capitalizing all avoidable interest costs on self-constructed assets Year Pre-tax income from Difference in Income Interest Interest Tax Effect Income Effect Capitalized Expensed Difference 40% (net of tax) $ 600,000 $ 400,000 $ 200,000 $ 80,000 $ 120,000 180,000 160,000

20,000 8,000 12,000 Prior to 2010 in 2010 Cumulative Effect at Beginning of 2011 $ Effect in 2011: Old Policy New Policy 780,000 $ 560,000 $ $ 190,000 $ $ 200,000 200,000 $ 190,000 $

220,000 $ 88,000 $ 132,000 $ 76,000 $ 80,000 4,000 $ 114,000 120,000 6,000 10,000 $ 21

Retrospective-withRestatement Example January 1, 2011: To record retroactive change Property, Plant and Equip (net) 220,000 Future Income Tax Liability 88,000 Retained Earnings Change in Accounting Policy 132,000 22 Retrospective-withRestatement Example Income Statement BEFORE Retroactive 2011 Income before tax $ 190,000 $ Income tax expense 76,000 Net income

$ 114,000 $ EPS (100,000 shares) $ 1.14 $ Change 2010 160,000 64,000 96,000 0.96 Income Statement AFTER Retroactive Change 2011 2010 Income before tax $ 200,000 $ 180,000 Income tax expense 80,000

72,000 Net income $ 120,000 $ 108,000 EPS (100,000 shares) $ 1.20 $ 1.08 23 Retrospective-withRestatement Example Retained Earnings Statement BEFORE Retroactive Change 2011 2010 Balance at beginning of year $ 1,696,000 $ 1,600,000 Net income

114,000 96,000 Balance at end of year $ 1,810,000 $ 1,696,000 24 Retrospective-withRestatement Example Retained Earnings Statement AFTER Retroactive Change 2011 2010 Balance at beginning of year as previously reported $ 1,696,000 $ 1,600,000 Add: Adjustment for the cumulative effect on prior years of applying the new method of accounting 132,000

120,000 Balance at beginning of year as adjusted 1,828,000 1,720,000 Net income 120,000 108,000 Balance at end of year $ 1,948,000 $ 1,828,000 25 Retrospective with Partial Restatement Retroactively restating prior years financial statements requires information that may be impractical to obtain on a cost-benefit basis Some standards allow for a partial retrospective application The change in policy is applied at the

beginning of the earliest period for which restatement is possible 26 Retrospective with Partial Restatement - Example Assume that it was impractical for Denson Ltd. to determine the effects of the change in policy on specific years any further back than 2010. The journal entry to record the change in policy is the same as the one made for full restatement: January 1, 2011: To record change Property, Plant and Equip (net) 220,000 Future Income Tax Liability 88,000 Retained Earnings Change in Accounting Policy 132,000 However, years prior to 2010 are not restated 27

Retrospective with Partial Restatement Any comparative financial statements prior to 2010 are not restated Without restatement, leaves the comparative financial statements as originally reported and The changes cumulative effect prior to Jan. 1, 2010 is presented as an adjustment to Jan. 1, 2010 Retained Earnings 28 Disclosures Changes in Accounting Policy For changes in policy resulting from initial application of a primary source of GAAP or from a voluntary change, the following must be disclosed:

a) For first-time application of IFRS or primary source, its title, nature of change and that made in accordance with transitional provisions, and what provisions are (including those that affect future periods) b) The nature of any voluntary change in accounting policy, and why the new policy results in more reliable and relevant information (under PE GAAP, some voluntary changes are exempt from this requirement) c) The amount of the adjustment for each financial statement line item that is affected for current and prior periods d) The reasons it was not practicable for restatement of particular periods, with a description of how the change was applied and 29 from what date Disclosures Changes in Accounting Policy For new primary sources of GAAP that are

not yet effective and have not been applied: 1. Disclose the fact that new primary source has been issued, and 2. Any reasonably reliable information useful in assessing possible impact on financial statement in the period in which it will be first applied 30 Error Correction Under PE GAAP, full retrospective adjustment is required Under IFRS, partial retrospective adjustment is allowed if full retrospective restatement is impracticable

31 Disclosures Error Correction Where a change is the result of an accounting error, companies must disclose that an error occurred in a prior period(s) and disclose, in the year of the correction: a) The nature of the error; b) The amount of the correction to each line item on the financial statements presented for comparative purposes; c) The amount of the correction made at the beginning of the earliest prior period presented. 32 Disclosures Error Correction

IFRS requires additional disclosures: Where partial retrospective restatement is made on grounds of impracticability, additional information relating to impracticability and adjustment is required Effect of correction on basic and diluted EPS for each period presented 33 Prospective Application Effects of changes in estimates are handled prospectively No changes are made to previously reported results Changes in estimates are viewed as normal recurring corrections and adjustments

Effect of a change in estimate is accounted for by including it in net income or comprehensive income as appropriate in: The period of change if the change affects that period only The period of change and future periods if the change affects both 34 Disclosure Change in Estimate Minimum disclosures are as follows: 1. The nature of the change in estimate 2. The amount of the change in estimate affecting the current period IFRS also requires disclosure of the nature and amount of any change expected to impact future periods

If it is not practicable to estimate effect, this fact is disclosed 35 Accounting Changes and Error Analysis Changes in Accounting Policies and Estimates, and Errors Types of accounting changes Alternative accounting methods Perspectives Motivations for change

IFRS and Private Enterprise GAAP Comparison Interpreting accounting changes Comparison of IFRS and private enterprise GAAP Accounting standards Adoption of IFRS Retrospective application change in accounting policy Adoption of accounting

standards for private enterprises (ASPE) Retrospective restatement correction of error Looking ahead Prospective application Summary of accounting changes 36 Motivations for Change 1. Political costs larger firms, larger profits, may become political targets; select policies to reduce profits 2. Capital structure debt/equity structure will impact accounting policies due to debt covenants

3. Bonus payments when bonuses attached to income, managers may select methods that maximize income 4. Smooth earnings gradual increase (decrease) in income to shift attention 37 Accounting Changes and Error Analysis Changes in Accounting Policies and Estimates, and Errors Types of accounting changes Alternative accounting methods Perspectives Motivations for change

IFRS and Private Enterprise GAAP Comparison Interpreting accounting changes Comparison of IFRS and private enterprise GAAP Accounting standards Adoption of IFRS Retrospective application change in accounting policy

Adoption of accounting standards for private enterprises (ASPE) Retrospective restatement correction of error Looking ahead Prospective application Summary of accounting changes 38 Adoption of IFRS Publicly accountable enterprises are required to adopt IFRS starting on January 1, 2011 (with comparative figures for previous period) IFRS 1 First-time Adoption of International Financial Reporting Standards provides guidance

on the changeover Opening balance sheet needs to comply with IFRS in effect on first reporting date Adjustments required for opening balance sheet are booked through retained earnings Additional accounting options are available on changeover 39 Adoption of Accounting Standards for Private Enterprises (ASPE) CICA Handbook, Part II, Section 1500 First Time Adoption sets out standards for initial adoption of ASPE Adoption requirements are similar to those under IFRS 40

COPYRIGHT Copyright 2010 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. 41

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