3.2.2: Changes in Accounting Estimates, Changes in Accounting Policy, and Correction of Errors
- Page ID
- 100392
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\(\newcommand{\avec}{\mathbf a}\) \(\newcommand{\bvec}{\mathbf b}\) \(\newcommand{\cvec}{\mathbf c}\) \(\newcommand{\dvec}{\mathbf d}\) \(\newcommand{\dtil}{\widetilde{\mathbf d}}\) \(\newcommand{\evec}{\mathbf e}\) \(\newcommand{\fvec}{\mathbf f}\) \(\newcommand{\nvec}{\mathbf n}\) \(\newcommand{\pvec}{\mathbf p}\) \(\newcommand{\qvec}{\mathbf q}\) \(\newcommand{\svec}{\mathbf s}\) \(\newcommand{\tvec}{\mathbf t}\) \(\newcommand{\uvec}{\mathbf u}\) \(\newcommand{\vvec}{\mathbf v}\) \(\newcommand{\wvec}{\mathbf w}\) \(\newcommand{\xvec}{\mathbf x}\) \(\newcommand{\yvec}{\mathbf y}\) \(\newcommand{\zvec}{\mathbf z}\) \(\newcommand{\rvec}{\mathbf r}\) \(\newcommand{\mvec}{\mathbf m}\) \(\newcommand{\zerovec}{\mathbf 0}\) \(\newcommand{\onevec}{\mathbf 1}\) \(\newcommand{\real}{\mathbb R}\) \(\newcommand{\twovec}[2]{\left[\begin{array}{r}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\ctwovec}[2]{\left[\begin{array}{c}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\threevec}[3]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\cthreevec}[3]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\fourvec}[4]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\cfourvec}[4]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\fivevec}[5]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\cfivevec}[5]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\mattwo}[4]{\left[\begin{array}{rr}#1 \amp #2 \\ #3 \amp #4 \\ \end{array}\right]}\) \(\newcommand{\laspan}[1]{\text{Span}\{#1\}}\) \(\newcommand{\bcal}{\cal B}\) \(\newcommand{\ccal}{\cal C}\) \(\newcommand{\scal}{\cal S}\) \(\newcommand{\wcal}{\cal W}\) \(\newcommand{\ecal}{\cal E}\) \(\newcommand{\coords}[2]{\left\{#1\right\}_{#2}}\) \(\newcommand{\gray}[1]{\color{gray}{#1}}\) \(\newcommand{\lgray}[1]{\color{lightgray}{#1}}\) \(\newcommand{\rank}{\operatorname{rank}}\) \(\newcommand{\row}{\text{Row}}\) \(\newcommand{\col}{\text{Col}}\) \(\renewcommand{\row}{\text{Row}}\) \(\newcommand{\nul}{\text{Nul}}\) \(\newcommand{\var}{\text{Var}}\) \(\newcommand{\corr}{\text{corr}}\) \(\newcommand{\len}[1]{\left|#1\right|}\) \(\newcommand{\bbar}{\overline{\bvec}}\) \(\newcommand{\bhat}{\widehat{\bvec}}\) \(\newcommand{\bperp}{\bvec^\perp}\) \(\newcommand{\xhat}{\widehat{\xvec}}\) \(\newcommand{\vhat}{\widehat{\vvec}}\) \(\newcommand{\uhat}{\widehat{\uvec}}\) \(\newcommand{\what}{\widehat{\wvec}}\) \(\newcommand{\Sighat}{\widehat{\Sigma}}\) \(\newcommand{\lt}{<}\) \(\newcommand{\gt}{>}\) \(\newcommand{\amp}{&}\) \(\definecolor{fillinmathshade}{gray}{0.9}\)Financial statements can be impacted by changes in accounting policies, changes in estimates, and correction of errors. These were first introduced in the introductory accounting course and will also be discussed in detail in the next intermediate accounting course. However, it is worth including a review at this time because they can significantly affect the financial statements.
Changes in Accounting Estimates
Accounting is full of estimates that are based on the best information available at the time. As new information becomes available, estimates may need to be changed. Examples of changing estimates would be changing the useful life, residual value, or the depreciation method used to match use of the assets with revenues earned. Other estimates involve uncollectible receivables, revenue recognition for long-term contracts, asset impairment losses, and pension expense assumptions. Changes in accounting estimates are applied prospectively, meaning they are applied to the current fiscal year if the accounting records have not yet been closed and for all future years going forward.
Changes in Accounting Policy
The accounting treatment for a change in accounting policy is retrospective adjustment with restatement. Retrospective application means that the company deals with the error or omission as though it had always been corrected.
Examples of changes in accounting policies are:
- changes in valuation methods for inventory such as changing from FIFO to weighted average cost
- changes in classification, presentation, and measurement of financial assets and liabilities under categories specified in the accounting standards such as investments classified as fair value reported through net income (FVNI), amortized cost (AC), or fair value reported through OCI (FVOCI) (IFRS only). Details of these are discussed in the chapter on intercorporate investments, later in this text.
- changes in the basis of measurement of non-current assets such as historical cost and revaluation basis
- changes in the basis used for accruals in the preparation of financial statements
Management must consistently review its accounting policies to ensure they comply with the latest pronouncements by IFRS or ASPE and to ensure the most relevant and reliable financial information for the stakeholders. Accounting policies must also be applied consistently to promote comparability between financial statements for different accounting periods. For this reason, a change in accounting policy is only allowed under two conditions:
- due to changes in a primary source of GAAP
- applied voluntarily by management to enhance the relevance and reliability of information contained in the financial statements for IFRS. ASPE has some exceptions to this "relevance and reliability" rule to provide flexibility for changes from one existing accounting standard to another.
As a rule, changes in accounting policies must be applied retrospectively with restatement to the financial statements. Retrospective application means that the company implements the change in accounting policy as though it had always been applied. Consequently, the company will adjust all comparative amounts presented in the financial statements affected by the change in accounting policy for each prior period reported. Retrospective application reduces the risk of changing policies to manage earnings aggressively because the restatement is made to all prior years as well as to the current year. If this were not the case, the change made to a single year could materially affect the statement of income for the current fiscal year. A cumulative amount for the restatement is estimated and adjusted to the opening retained earnings balance of the current year, net of taxes, in the statement of changes in equity (IFRS) or the statement of retained earnings (ASPE). This will be discussed and illustrated later in this chapter.
Retrospective application of a change in accounting policy may be exempted in the following circumstances.
- A transitional provision of the changed standard allows the prospective application of a new accounting policy. Specific transitional guidance of IFRS or ASPE must be followed in such circumstances.
- The application of a new accounting policy regarding events, transactions, and circumstances that are substantially different from those that occurred in the past.
- The effect of the retrospective application of a change in accounting policy is immaterial.
- The retrospective application of a change in accounting policy is impracticable. This may be the case where a company has not collected sufficient data to enable an objective assessment of the effect of a change in accounting estimates and it would be unfeasible or impractical to reconstruct the data. Where impracticability impairs a company's ability to apply a change in accounting policy retrospectively from the earliest prior period presented, the new accounting policy must be applied prospectively from the beginning of the earliest period feasible, which may be the current period.
The following are the required disclosures in the notes to the financial statements when a change in accounting policy is implemented:
- Title of IFRS or ASPE standard
- Nature of change in accounting policy
- Reasons for change in accounting policy
- Amount of adjustments in current and prior periods presented
- Where retrospective application is impracticable, the conditions that caused the impracticality (CPA Canada, 2011).
Changes Due to Accounting Errors or Omissions
The accounting treatment for an error or omission is a retrospective adjustment with restatement. For example, an accounting error in inventory originating in the current fiscal year is detected within the current fiscal year while the accounting records are still open. The inventory error correction is recorded as soon as possible to the applicable accounts. However, if the accounting records are already closed when the inventory error is discovered, the error is treated retrospectively. This means that the cumulative amount due to the inventory error would be calculated and recorded, net of taxes, to the current year's opening retained earnings balance. If the financial statements are comparative and include previous year's data, this data is also restated to include the error correction. This will be discussed and illustrated later in this chapter.