FAR 18 - ACCOUNTING CHANGES & ERROR CORRECTION

Question 1

What are the three types of accounting changes?

Answer 1

1. Accounting Principle - retrospective (net of tax)
2. Accounting Estimate - prospective
3. Reporting Entity - retrospective (Nonexistent in IFRS)

NOTE: Changes in Principle & Entity are to be recorded NET OF TAX. Tax amount is to be deferred.

Question 2

Change in Accounting Principle

Answer 2

Change in accounting principle if required by new accounting pronouncement or can justify the use of alternative.

Examples:

• Change in valuation for inventory (FIFO to LIFO)
• Change to or from full cost-method in extractive industry
• Change in construction accounting (completed to percentage)

Change in accounting principle is accounted for retrospectively, prior year F/S affected should be restated.

Journal Entry Example:

DR: Inventory/Asset (Total Change)

CR: Deferred Tax Liability (Effective tax rate)

CR: Retained Earnings

Question 3

Change in Accounting Estimate

Answer 3

Change in Accounting Estimates occur when a better estimate may be made.

EXAMPLES:

• Estimated useful life or SV of an asset
• A contingent liability
• Bad debt expense percentages
• Warranty expense percentages
• Change in depreciation method

Changes in accounting estimates are to be applied on a prospective basis.

Question 4

Change in Reporting Entity

Answer 4

A change in Reporting Entity occurs when a change in the stucture of an organization is made which results in F/S that represent a different or changed entity.

EXAMPLES:

• Consolidated F/S
• Change in specific subsidiaries
• Changing the entities included in combined F/S
• Change in Equity Method of accounting & consolidation

A Change in Reporting Entity should be applied retrospectively.

Question 5

Correction of an Error

Prior Period Adjustment

Answer 5

Correction of an error is similar to a change in accounting principle & to be accounted for RETROACTIVE.

EXAMPLES:

• Change from NON-GAAP to GAAP
  
  • Cash to Accrual, Direct write off to Allowance
• A mathematical error
• Mistakes in applying GAAP
• Inventory Errors

When making this change:

1. Prior periods are restated
2. Any remaining balance affects beginning Retained Earnings NET OF TAX as a prior period adjustment.

Question 6

Statement of Retained Earnings

(Presentation)

Answer 6

+Beginning RE

+/- Prior Period Adjustment (NET OF TAX)

=Adjusted Begnning RE

+Net Income

-Dividends

=Ending Retained Earnings

Question 7

Inventory Errors

Answer 7

Inventory Errors correct themselves after 2 years.

Two typical Scenarios:

If Year 1 is overstated, Year 2 will understated & Year 3 is correct.

Year 1 - (EI over, COGS under, GP over, RE over)

Year 2 - (BI over, COGS over, GP under, RE under)

Year 3 - Corrected

If Year 1 is understated, Year 2 will be overstated & Year 3 will be corrected.

Year 1 - (EI under, COGS over, GP under, RE under)

Year 2 - (BI under, COGS under, GP over, RE over)

Year 3 - Corrected