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Financial Accounting II
Table of Contents
Unit 12 Overview: Accounting Changes & Error Corrections
12.1 Changes in Accounting Principles
12.2 Changes in Accounting Estimates
12.3 Error Corrections and Financial Statement Restatements

Changes in accounting estimates are a crucial part of financial reporting. They occur when new information becomes available or circumstances change, affecting the inputs or assumptions used in making estimates. These changes impact various aspects of financial statements, from depreciation to bad debt expenses.

Accounting for changes in estimates is done prospectively, meaning they're recognized in current and future periods. This differs from changes in accounting principles, which are often applied retrospectively. Understanding these distinctions is key to accurately interpreting and preparing financial statements.

Changes in accounting estimates

Events triggering changes in estimates

  • Changes in accounting estimates occur when new information becomes available or when there are changes in circumstances that affect the inputs or assumptions used in making the estimate
  • Common events that trigger changes in accounting estimates:
    • Changes in the useful life or salvage value of a depreciable asset (machinery, equipment)
    • Changes in the collectibility of accounts receivable (customer bankruptcies, economic downturns)
    • Changes in the amount of warranty obligations (product defects, recalls)
  • Changes in accounting estimates can also result from the resolution of uncertainties:
    • Settlement of litigation (court decisions, out-of-court agreements)
    • Outcome of a contingent event (successful product launch, natural disaster)
  • The estimation process often requires judgment and is based on the best information available at the time
    • As new information becomes available, it may be necessary to update the estimate (revised sales projections, updated market data)

Prospective application of changes in estimates

  • Changes in accounting estimates are accounted for prospectively, meaning that the change is recognized in the current and future periods affected by the change
  • The effect of the change is included in the determination of net income or loss in the period of the change and any affected future periods
  • The change in estimate is not applied retrospectively to prior periods, and previously issued financial statements are not restated
  • The nature and reason for the change in estimate should be disclosed in the notes to the financial statements in the period of the change
  • If the change in estimate affects several future periods, the effect on income from continuing operations, net income, and any related per-share amounts should be disclosed for the current period and any subsequent periods presented

Accounting treatment for changes in estimates

Prospective recognition in financial statements

  • Changes in accounting estimates are accounted for prospectively, which means that the change is recognized in the current period and future periods affected by the change
  • The effect of the change is included in the determination of net income or loss in the period of the change and any affected future periods
  • The change in estimate is not applied retrospectively to prior periods, and previously issued financial statements are not restated

Disclosure requirements

  • The nature and reason for the change in estimate should be disclosed in the notes to the financial statements in the period of the change
    • Example: "The company revised its estimate of the useful life of its manufacturing equipment from 10 years to 8 years based on recent operational data and industry benchmarks."
  • If the change in estimate affects several future periods, the effect on income from continuing operations, net income, and any related per-share amounts should be disclosed for the current period and any subsequent periods presented
    • Example: "The change in the estimated useful life of manufacturing equipment is expected to increase depreciation expense by $100,000 per year for the next 8 years."

Impact on financial statements

Income statement effects

  • Changes in accounting estimates can have a significant impact on a company's income statement
  • A change in the estimated useful life of a depreciable asset will affect the amount of depreciation expense recognized each period, which in turn affects net income
    • Example: Increasing the estimated useful life of an asset will result in lower annual depreciation expense and higher net income
  • A change in the estimated uncollectible portion of accounts receivable will affect the bad debt expense recognized each period
    • Example: Increasing the estimate of uncollectible accounts will result in higher bad debt expense and lower net income

Balance sheet effects

  • Changes in accounting estimates can also impact the balance sheet
  • A change in the estimated useful life of a depreciable asset will affect the carrying value of the asset on the balance sheet
    • Example: Increasing the estimated useful life of an asset will result in a higher carrying value due to lower accumulated depreciation
  • A change in the estimated amount of a warranty obligation will affect the warranty liability on the balance sheet
    • Example: Increasing the estimate of warranty obligations will result in a higher warranty liability and a corresponding decrease in retained earnings

Impact on financial ratios

  • Changes in accounting estimates can also affect key financial ratios, such as the debt-to-equity ratio or the return on assets ratio, which are used by investors and analysts to evaluate a company's financial performance and position
  • Example: An increase in the estimated useful life of assets will result in a higher return on assets ratio due to lower depreciation expense and higher net income

Changes in estimates vs principles

Accounting treatment differences

  • Changes in accounting estimates and changes in accounting principles both affect a company's financial statements, but they are accounted for differently
  • Changes in accounting estimates are accounted for prospectively, while changes in accounting principles are generally accounted for retrospectively (with some exceptions)
  • Changes in accounting estimates do not require restatement of prior period financial statements, while changes in accounting principles often require restatement of prior period financial statements to ensure comparability

Triggering events and justification

  • Changes in accounting estimates are typically made in response to new information or changes in circumstances, while changes in accounting principles are made when a company adopts a different accounting method for a particular transaction or event
    • Example of a change in estimate: Revising the useful life of an asset based on updated operational data
    • Example of a change in principle: Switching from the LIFO to the FIFO inventory valuation method
  • Changes in accounting estimates are considered a normal part of the accounting process and do not require justification, while changes in accounting principles must be justified as preferable and must be disclosed in the financial statements

Key Terms to Review (16)

GAAP: GAAP, or Generally Accepted Accounting Principles, is a framework of accounting standards, principles, and procedures used in the preparation of financial statements. It ensures consistency and transparency in financial reporting, which is essential for stakeholders to make informed decisions based on comparable financial information across different organizations.
Return on Equity: Return on Equity (ROE) is a financial metric that measures a company's profitability by revealing how much profit a company generates with the money shareholders have invested. It is calculated by dividing net income by shareholder's equity and indicates how efficiently a company uses its equity to generate profits, which is essential in understanding financial performance and decision-making.
Footnotes: Footnotes are explanatory notes placed at the bottom of a page in a financial statement or report, providing additional context or details that clarify the information presented in the main body. They play a crucial role in enhancing transparency and ensuring that users of financial statements understand the assumptions, methods, and estimates used in the accounting process, especially when there are changes in accounting estimates.
Management Discussion and Analysis: Management Discussion and Analysis (MD&A) is a section of a company's annual report that provides a narrative explanation of the financial statements, helping stakeholders understand the company's financial performance, trends, and future outlook. It serves as a bridge between the raw financial data and the strategic vision of management, offering insights into changes in accounting estimates, errors that may have occurred, and any restatements that are necessary for accurate reporting.
Salvage value: Salvage value is the estimated residual value of an asset at the end of its useful life. It represents the amount a company expects to receive when the asset is disposed of, after accounting for depreciation and other factors. Understanding salvage value is crucial when making changes in accounting estimates, as it directly influences the depreciation expense and financial reporting for long-term assets.
Inventory write-down: An inventory write-down is an accounting adjustment made to reduce the carrying amount of inventory to its net realizable value when the market value of the inventory is less than its cost. This adjustment reflects a loss in value due to factors such as obsolescence, damage, or a decline in market demand. It is important for financial reporting as it ensures that the financial statements accurately represent the company's current assets and financial position.
Revenue Recognition Adjustments: Revenue recognition adjustments refer to the modifications made to the amount of revenue recognized in financial statements based on changes in accounting estimates, business conditions, or contract terms. These adjustments are crucial for accurately reflecting a company’s financial performance and ensuring compliance with accounting standards. They help businesses adapt to new information that affects how and when revenue is recorded, thereby providing a clearer picture of financial health.
Conservatism Principle: The conservatism principle is an accounting guideline that suggests recognizing expenses and liabilities as soon as possible, but revenues only when they are assured. This principle aims to prevent the overstatement of financial health and ensures that financial statements provide a more cautious and realistic view of a company's economic situation. It helps in making prudent decisions based on a conservative outlook.
Changes in Accounting Estimates: Changes in accounting estimates refer to adjustments made to the carrying amount of an asset or liability based on new information or developments that affect the expected future benefits or obligations. These changes occur when the original estimates prove to be inaccurate due to changing circumstances, and they affect the financial statements by adjusting the amount recognized in the period of the change and future periods.
Useful Life: Useful life refers to the estimated period during which an asset is expected to be economically usable by a company. This estimation is crucial for financial reporting as it directly impacts depreciation calculations, asset management, and overall financial performance. The useful life of an asset can change based on factors like wear and tear, technological advancements, and changes in market demand.
Depreciation estimate: A depreciation estimate is an accounting calculation that determines the decrease in value of a fixed asset over time due to usage, wear and tear, or obsolescence. It plays a crucial role in financial reporting and tax calculations by allocating the cost of an asset over its useful life, allowing businesses to reflect a more accurate picture of their financial health and asset value.
Bad debt expense estimate: A bad debt expense estimate is an accounting estimation of the amount of accounts receivable that may ultimately be uncollectible, reflecting the anticipated loss from customers who are unlikely to pay their debts. This estimate is crucial for accurately reporting a company's financial position and performance, as it helps in matching revenues with their corresponding expenses, ensuring that the financial statements present a realistic view of the company’s profitability.
Balance Sheet: A balance sheet is a financial statement that provides a snapshot of a company's assets, liabilities, and equity at a specific point in time. It shows what the company owns and owes, offering insight into its financial health and stability.
Income Statement: An income statement is a financial report that summarizes a company's revenues, expenses, and profits or losses over a specific period, typically a quarter or a year. It provides key insights into the company's operational performance, allowing stakeholders to assess profitability and efficiency in generating income.
IFRS: International Financial Reporting Standards (IFRS) are a set of accounting standards developed by the International Accounting Standards Board (IASB) that aim to bring transparency, accountability, and efficiency to financial markets around the world. IFRS provides a common global language for business affairs, ensuring consistency in the financial reporting and making it easier for investors to compare financial statements from different countries.
Matching Principle: The matching principle is an accounting concept that requires expenses to be recorded in the same period as the revenues they help generate. This principle ensures that a company's financial statements accurately reflect its financial performance, linking income and related expenses for a clearer view of profitability over specific time frames.