4.2.2: Factors Affecting the Statement of Financial Position/Balance Sheet (SFP/BS)

Accounting Estimates, Changes in Accounting Policy, and Correction of Errors

These were discussed in the previous chapter, but a summary of the pertinent information in this chapter is warranted because of their impact on the SFP/BS.

Financial statements can be affected by changes in accounting estimates, changes due to accounting errors or omissions, and changes in accounting policies. 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 of the potentially significant effect on 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 the useful life, residual value, or the depreciation pattern used to match the use of assets with revenues earned. Other changes in estimates involve uncollectible receivables, asset impairment losses, and pension assumptions that could affect the accrued pension asset/liability account in the SFP/BS. 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 Due to Accounting Errors or Omissions

The accounting treatment for an error or omission is a retrospective adjustment with restatement. Retrospective adjustment means that the company reports treat the error or omission as though it had always been corrected. If an accounting error in inventory originating in the current fiscal year is detected before the current year's books are closed, the inventory error correction is easily recorded to the current fiscal year accounts. If the accounting records are already closed when the inventory error is discovered, the error is adjusted to the inventory account and to retained earnings, net of taxes. This results in a restatement of inventory and retained earnings in the current year. If the financial statements are comparative and include previous year's data, this data is also restated to include the error correction from the previous year.

Changes in Accounting Policy

The accounting treatment for a change in accounting policy is retrospective adjustment with restatement.

Examples of changes in accounting policies are:

• Changes in valuation methods for inventory such as changing from FIFO to weighted average cost.
• Changes in financial assets and liabilities such as FVNI, FVOCI and AC investments or certain lease obligations. 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.
• Changes in the basis used for accruals in the preparation of financial statements.

Accounting policies must be applied consistently to promote comparability between financial statements for different accounting periods. A change in accounting policy is only allowed under the following two conditions:

• due to changes in a primary source of GAAP
• may be 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.]

Changes in accounting policies are applied retrospectively in the financial statements. As with accounting errors, 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 presented. Retrospective application reduces the risk of changing policies to manage earnings aggressively because the restatement is made to all prior years as well as 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 affected asset or liability in the SFP/BS and 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).

Contingencies, Provisions and Guarantees

In accounting, a contingency (ASPE) or provision (IFRS) exists when a material future event, or circumstance, could occur but cannot be predicted with certainty. IFRS (IAS 37.10) has the following definitions regarding the various types of contingencies in accounting (IFRS, 2015).

Key definitions [IAS 37.10]
Provision: a liability of uncertain timing or amount.
Liability:

• present obligation resulting from past events
• settlement is expected to result in an outflow of resources (payment)

Contingent liability:

• a possible obligation depending on whether some uncertain future event occurs, or
• a present obligation but payment is not probable, or the amount cannot be measured reliably

Contingent asset:

• a possible asset that arises from past events, and
• whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.

IAS 37 explains that a contingent liability is to be disclosed in the financial statement notes. Figure 4.1 is a decision tree that identifies the various decision points when determining if a potential obligation should be recognized and recorded, because it meets the definition of a liability; added only to the notes, because it meets the definition of a contingent liability; or omitted altogether because it fails to meet any of the relevant criteria (Friedrich, Friedrich, & Spector, 2009).

Figure 4.1 Decision tree to determine if a potential obligation should be recognized and recorded (Friedrich, Friedrich, & Spector, 2009)

IAS 37 also states that a contingent asset is not to be recorded until it is actually realized but can be included in the notes if it is probable that an inflow of economic benefits will occur (IFRS, 2012). If a note disclosure is made, management must take care not to mislead the reader regarding its potential realization; if the potential asset is not probable, it must not be disclosed.

ASPE is similar, but the provision is usually interpreted as "more likely than not" whereas a contingent liability is one that is "likely."

Contingencies will be discussed further in the chapter on liabilities in the next intermediate accounting course.

A guarantee is a type of contingent liability because it is a promise to take responsibility for another company's financial obligation if that company is unable to do so. An example might be a parent company that guarantees part or all of a bond issuance to investors by its subsidiary company. Guarantees are not recognized and recorded because they are not probable, so they are to be disclosed in the notes. This will enable investors and creditors to assess the potential impact of the guarantee and the risk associated with it.

Subsequent Events

There is a period of time after the year-end date when economic events apparent in the new year may need to be either reported in the financial statements for the year just ended or disclosed in the notes prior to their release.

If this subsequent event is significant and relates to business operations prior to the reporting date, it is to be included in the financial statements prior to release. These would include adjusting entries such as inventory write-downs due to shrinkage, recording additional accounts payable for late arriving invoices from suppliers or correction of errors or omissions found when reconciling the general ledger accounts as part of the year-end process.

If a subsequent event is significant but relates to operations occurring after the reporting period, it is to be included in the notes. An example might be where early in the new fiscal year, there is a flood causing serious damage to buildings and equipment, if the repair or replacement costs are significant and perhaps uninsured, these costs, though correctly paid and recorded in the new year, are to be disclosed in the notes to the financial statements for the year-end just ended. This will ensure that the company stakeholders will be aware of all the information about risks that could detrimentally affect company operations.