INTERMEDIATE ACCOUNTING
TENTH CANADIAN EDITION
Kieso • Weygandt • Warfield • Young • Wiecek • McConomy
CHAPTER 21
Accounting Changes
and Error Analysis
Prepared by:
Lisa Harvey, CPA, CA
Rotman School of Management,
University of Toronto
CHAPTER 21
ACCOUNTING CHANGES AND ERROR ANALYSIS
After studying this chapter, you should be able to:
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Identify and differentiate among the types of accounting changes.
Identify and explain alternative methods of accounting for accounting changes.
Identify the accounting standards for each type of accounting change under ASPE and
IFRS.
Apply the retrospective application method of accounting for a change in accounting policy
and identify the disclosure requirements.
Apply retrospective restatement for the correction of an accounting error and identify the
disclosure requirements.
Apply the prospective application method for an accounting change and identify the
disclosure requirements for a change in an accounting estimate.
Identify economic motives for changing accounting methods and interpret financial
statements where there have been retrospective changes to previously reported results.
Identify the differences between ASPE and IFRS related to accounting changes.
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Accounting Changes
and Error Analysis
Changes in Accounting
Policies and Estimates,
and Errors
•Types of accounting
changes
•Alternative accounting
methods
Analysis
•Motivations for
change
•Interpreting
accounting changes
IFRS/ASPE
Comparison
•Comparison of IFRS
and ASPE
•Looking ahead
•Accounting standards
•Retrospective application
– change in accounting
policy
•Retrospective restatement
– correction of error
•Prospective application
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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 a change in
circumstances on which a previous estimate
was based or as the result of new information,
more experience or subsequent
developments
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Types of Accounting Changes
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
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Changes in Accounting Policies
• 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 (voluntary)
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Changes in Accounting Policies
• Under ASPE, there is a third type of policy change
permitted without having to meet the reliable but
more relevant test:
3. Between or among allowed ASPE accounting options
for:
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Investments in subsidiaries, and investments with
significant influence or joint controls
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Development phase expenditures on internally
generated intangible assets
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Defined benefit plans
–
Income taxes
–
Measuring equity component of certain financial
instruments
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Changes in Accounting Policies
• 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
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Changes in Accounting Policies
• 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
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Changes in Accounting Estimates
• Future conditions and events and their
effects cannot be known with certainty;
therefore estimation requires exercise of
judgment
• Use of reasonable estimates is essential
to the accounting process and does not
undermine the reliability of financial
statements
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Changes in Accounting Estimates
• Examples of items requiring estimates
include:
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Uncollectible receivables
Inventory obsolescence
Fair value of financial assets/liabilities
Useful lives and residual values of
depreciable assets
– Liabilities for warranty costs
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Changes in Accounting Estimates
• Differentiating a change in policy and a change in
estimate can be difficult
• For example, is a change in depreciation method a
change in policy or a change in estimate?
– At first glance, a change in depreciation 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
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Correction of a Prior Period Error
• 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
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Correction of a Prior Period Error
• Distinguishing between correction of an error and a
change in estimate can be difficult
• Example: a lack of a previous year’s 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
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Alternative Accounting Methods
• Three approaches have been suggested
for reporting changes in the accounts:
1. Retrospective
2. Current
3. Prospective
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Retrospective Treatment
• Also known 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)
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Current Treatment
• New accounting method or estimate’s
cumulative effect on the financial
statements at the beginning of the period
is calculated
• An adjustment is reported in current year’s
income statement
• Prior years’ financial statements are not
restated
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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
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Accounting Standards
Type of Accounting Change
Accounting Method Applied
Change in Accounting Policy –
Adoption of primary source of
GAAP
Change in Accounting Policy –
Voluntary
Apply method approved in
transitional provisions section of
the primary source; if none, then
use retrospective application (if
impractical, apply prospectively).
Apply retrospectively. If
impractical, apply prospectively
Change in accounting estimate
Apply prospectively.
Correction of an error
Apply retrospectively.
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Retrospective-with-Restatement
Requirements of this method include:
1. Retroactive application of the new method,
including income tax effects using an
accounting entry
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
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Retrospective-with-Restatement Example
Given:
• Voluntary change to capitalizing all avoidable
interest costs on self-constructed assets
• Cumulative effects at January 1, 2014:
• Capitalizing interest: $20,000 + $200,000 =
$220,000
• Income tax effect: $6,000 + $60,000 = $66,000
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Retrospective-with-Restatement Example
January 1, 2014: To record retroactive
change
Buildings
220,000
Deferred Tax Liability
66,000
Retained Earnings
154,000
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Retrospective-with-Restatement Example
Income Statement BEFORE Retroactive
2014
$ 190,000 $
Income before tax
57,000
Income tax expense
$ 133,000 $
Net income
Change
2013
160,000
48,000
112,000
1.33 $
1.12
EPS (100,000 shares)
$
Income Statement AFTER Retroactive Change
2013
2014
$ 200,000 $ 180,000
Income before tax
54,000
60,000
Income tax expense
$ 140,000 $ 126,000
Net income
EPS (100,000 shares)
$
1.40 $
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Retrospective-with-Restatement Example
Balance at beginning of year
Net income
Balance at end of year
2014
2013
$ 1,752,000 $ 1,640,000
133,000
112,000
$ 1,885,000 $ 1,752,000
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Retrospective-with-Restatement Example
2014
2013
Balance at beginning of year as
$ 1,752,000 $ 1,640,000
previously reported
Add: Adjustment for the cumulative
effect on prior years of applying
the new method of accounting
140,000
154,000
Balance at beginning of year as
1,780,000
1,906,000
adjusted
126,000
140,000
Net income
$ 1,948,000 $ 1,906,000
Balance at end of year
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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
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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 2013. The
journal entry to record the change in policy is the
same as the one made for full restatement:
January 1, 2014: To record change
Buildings
220,000
Deferred Tax Liability
66,000
Retained Earnings
154,000
However, years prior to 2013 are not restated
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Retrospective with Partial Restatement
• Any comparative financial statements prior
to 2013 are not restated
• Without restatement, leaves the
comparative financial statements as
originally reported and
• The change’s cumulative effect prior to
Jan. 1, 2013 is presented as an
adjustment to Jan. 1, 2013 Retained
Earnings
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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:
• 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)
• The nature of any voluntary change in accounting policy, and
why the new policy results in reliable and more relevant
information (under ASPE, some voluntary changes are exempt
from this requirement)
• The amount of the adjustment for each financial statement line
item that is affected for current and prior periods
• The reasons it was not practicable for restatement of particular
periods, with a description of how the change was applied and
from what date
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Disclosures – Changes in Accounting
Policy
• IFRS also requires disclosures 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
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Correction of an Error
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Under ASPE, full retrospective
adjustment is required
Under IFRS, partial retrospective
adjustment is allowed if full retrospective
restatement is impracticable
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Disclosures –Correction of an
Error
• 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:
• The nature of the error;
• The amount of the correction to each line item on the
financial statements presented for comparative
purposes;
• The amount of the correction made at the beginning
of the earliest prior period presented.
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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
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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
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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
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Accounting Changes
and Error Analysis
Changes in Accounting
Policies and Estimates,
and Errors
•Types of accounting
changes
•Alternative accounting
methods
Analysis
•Motivations for
change
•Interpreting
accounting changes
IFRS/ASPE
Comparison
•Comparison of IFRS
and ASPE
•Looking ahead
•Accounting standards
•Retrospective application
– change in accounting
policy
•Retrospective restatement
– correction of error
•Prospective application
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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
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Interpreting Accounting Changes
• Accounting changes often make it difficult
to develop trend data
– Users of the financial statements should look
at accounting changes closely when they
occur and adjust trend data as appropriate
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Accounting Changes
and Error Analysis
Changes in Accounting
Policies and Estimates,
and Errors
•Types of accounting
changes
•Alternative accounting
methods
Analysis
•Motivations for
change
•Interpreting
accounting changes
IFRS/ASPE
Comparison
•Comparison of IFRS
and ASPE
•Looking ahead
•Accounting standards
•Retrospective application
– change in accounting
policy
•Retrospective restatement
– correction of error
•Prospective application
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Looking Ahead
• No significant changes are expected in the
immediate future
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