What Is Accounting Changes and Error Correction?Accounting changes and error correction refers to guidance on reflecting accounting changes and errors in financial statements. It outlines the rules for correcting and applying changes to financial statements, which includes requirements for the accounting for, and reporting of, a change in accounting principle, a change in accounting estimate, a change in reporting entity, or the correction of an error. Show
Accounting changes and error correction is a pronouncement made by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). Key Takeaways
Understanding Accounting Changes and Error CorrectionIt is imperative for financial markets to have accurate and trustworthy financial reporting. Many businesses, investors, and analysts rely on financial reporting for their decisions and opinions. Financial reports need to be free of errors, misstatements, and completely reliable. Any changes or errors in previous financial statements impair the comparability of financial statements and therefore must be addressed appropriately. Accounting changes and error correction guidance is laid out by the two primary accounting standards bodies: the FASB and the IASB. The two have different interpretations of accounting rules and principles but do work together to create some uniformity when possible. The FASB’s Statement No. 154 addresses dealing with accounting changes and error correction, while the IASB’s International Accounting Standard 8, Accounting Policies, Changes in Accounting Estimates and Errors offers similar guidance. The areas that the regulations focus on are:
The first three items fall under "accounting changes" while the latter falls under "accounting error." Accounting ChangesChange in Accounting PrincipleThe first accounting change, a change in accounting principle, for example, a change in when and how revenue is recognized, is a change from one generally accepted accounting principle (GAAP) to another. Companies can generally choose between two accounting principles, such as the last in, first out (LIFO) inventory valuation method versus the first in, first out (FIFO) method. This is a retroactive change that requires the restatement of previous financial statements. Previous financials must be restated to be calculated as if the new principle were used. The only time that financial statements are allowed to not be restated is when every possible effort to address the change has been made and such a calculation is deemed impractical. Change in Accounting EstimateThe second accounting change, a change in accounting estimate, is a valuation change. This means a material change in estimates is noted in the financial statements and the change is made going forward. An example would be a change in the depreciation method. Change in Reporting EntityThe third accounting change is a change in financial statements, which in effect, result in a different reporting entity. This would include a change in reporting financial statements as consolidated as opposed to that of individual entities or changing subsidiaries that make up the consolidated financial statements. This is also a retroactive change that requires the restatement of financial statements. Accounting ErrorsAccounting errors are mistakes that are made in previous financial statements. This can include the misclassification of an expense, not depreciating an asset, miscounting inventory, a mistake in the application of accounting principles, or oversight. Errors are retrospective and must include a restatement of financials. Accounting Principle Change vs. Accounting Estimate Change: An OverviewOne area where the Fair Accounting Standards Board (FASB), and the International Accounting Standards Board (IASB), agree is with the treatment of accounting changes. SFAS 154, Accounting Changes and Error Correction, documents how companies should treat changes in accounting principles and changes in accounting estimates, two related but different concepts. A principle determines how information should be reported, while an estimate is used to approximate information. Key Takeaways
Accounting Principle ChangeAccounting principles are general guidelines that govern the methods of recording and reporting financial information. When an entity chooses to adopt a different method from the one it currently employs, it is required to record and report that change in its financial statements. A good example of this is a change in inventory valuation; for example, a company might switch from a first in, first out (FIFO) method to a specific-identification method. According to the FASB, an entity should only change an accounting principle when it is justifiably preferable to an existing method or when it is a necessary reaction to a change in the accounting framework. Other notable changes in accounting principles can include matching, going concern, or revenue recognition principles, among others. Accounting Estimate ChangeAccountants use estimates in their reports when it is impossible or impractical to provide exact numbers. When these estimates prove to be incorrect, or new information allows for more accurate estimations, the entity should record the improved estimate in a change in accounting estimate. Examples of commonly changed estimates include bad-debt allowance, warranty liability, and depreciation. Key DifferencesAccounting principle changes can also occur when older principles are no longer accepted or when the way the method is applied changes. Changes in accounting principles are required to be applied retroactively—that is, financial statements must be restated to be presented as if the new accounting principle had been used. Only line items that are directly affected have to be restated. There are cases where a retroactive application doesn’t have to be made, which includes having made all reasonable efforts to do so, which can include not being able to make subjective significant estimates or having to have knowledge of management’s intent. Estimate changes occur when the carrying values of assets or liabilities are changed. These changes are accounted for in the period of change. Changes in accounting estimates don’t require the restatement of previous financial statements. If the change leads to an immaterial difference, no disclosure of the change is required. The Bottom LineThere are different and less stringent reporting requirements for changes in accounting estimates than for accounting principles. In some cases, a change in accounting principle leads to a change in accounting estimate; in these instances, the entity must follow standard reporting requirements for changes in accounting principles. When Should financial statements be restated?The Financial Accounting Standards Board (FASB) defines a restatement as a revision of a previously issued financial statement to correct an error. Restatements are required when it is determined that a previous statement contains “material” inaccuracy.
What requires a restatement of prior period financial statements?Restatements are necessary when it is determined that a previous statement contained a "material" inaccuracy. This can result from accounting mistakes, noncompliance with generally accepted accounting principles (GAAP), fraud, misrepresentation, or a simple clerical error.
What is the accounting treatment for a change in accounting estimate?The effect of a change in an accounting estimate is recognised prospectively by including it in profit or loss in: the period of the change, if the change affects that period only; or. the period of the change and future periods, if the change affects both.
Are changes in accounting estimates accounted for in current and future periods?Changes in estimates, such as the estimated useful like for a tangible asset or the bad debt allowance percentage, are accounted for on a prospective basis. This means that the current and future financial statements must reflect the change, but the company does not need to change historical periods.
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