Chapter4: The Income Statement and Statement of Cash Flows
Accounting changes fall into one of three categories: (1) a change in an accounting principle, (2) a change in estimate, or (3) a change in reporting entity. The correction of an error is another adjustment that is accounted for in the same way as certain accounting changes. A brief overview of each is provided here. We cover accounting changes in detail in Chapter 20.
Change in Accounting Principle
VOLUNTARY CHANGES IN ACCOUNTING PRINCIPLES. Occasionally, a company will change from one generally accepted treatment to another. When these changes in accounting principles occur, information lacks consistency, hampering the ability of external users to compare financial information among reporting periods. If, for example, inventory and cost of goods sold are measured in one reporting period using LIFO and using the FIFO method in a subsequent period, inventory, cost of goods sold, and hence net income for the two periods are not comparable. Difficulties created by inconsistency and lack of comparability are alleviated by the way we report voluntary accounting changes.
Let's suppose that in 2011 the Dearborn Corporation switched from the LIFO inventory method to FIFO. In addition to the 2011 statements, Dearborn presents two additional years of income statements and statements of shareholders' equity (2010 and 2009) as well as a 2010 balance sheet for comparative purposes. Here are the steps Dearborn would follow to account for the change.
MANDATED CHANGES IN ACCOUNTING PRINCIPLES. When a new FASB standard mandates a change in accounting principle, the board often allows companies to choose among multiple ways of accounting for the changes. One approach generally allowed is to account for the change retrospectively, exactly as we account for voluntary changes in principles. A second approach is to allow companies to report the cumulative effect on the income of previous years from having used the old method rather than the new method in the income statement of the year of change as a separately reported item below extraordinary items.
As an example of accounting for a mandated change with a cumulative adjustment, consider Marvell Technology Group LTD., a leading global semiconductor provider. Marvell adopted newly revised GAAP regarding share-based payments for its fiscal year ended January 27, 2007. The revision in GAAP, which we discuss in detail in Chapter 19, requires all companies to expense the estimated cost of employee stock options. Marvell accounted for the adoption of the new standard by including the $8.8 million, net of tax, cumulative effect of the change in its 2007 income statement as a separately reported item. Graphic 4-8 shows a portion of the disclosure note that explained the change.
Change in Accounting Estimate
Consider the example in Illustration 4-6.
When a company makes a change in an estimate that affects several future periods, such as revising its estimate of an asset's useful life, the company reports in a disclosure note the effect of that change on the current year's income before extraordinary items, net income, and earnings per share. That disclosure isn't necessary for more routine changes such as revising estimates regarding uncollectible accounts, unless the effect of the change is material.
A recent quarterly report of Saga, Inc., provides us an example. The company operates radio and television stations in 26 markets throughout the United States. Graphic 4-9 reproduces the disclosure note that described a change in the useful life of its television analog equipment.
As we discussed in a previous section, a change in depreciation, amortization, or depletion method is considered a change in estimate resulting from a change in principle. For that reason, we account for such a change prospectively, similar to the way we account for other changes in estimate. One difference is that most changes in estimate do not require a company to justify the change. However, this change in estimate is a result of changing an accounting principle and therefore requires a clear justification as to why the new method is preferable. Illustration 4-7 provides an example.p. 191
A disclosure note reports the effect on net income and earnings per share along with clear justification for changing depreciation methods.
Change in Reporting Entity
A third type of change—the change in reporting entity presentation of consolidated financial statements in place of statements of individual companies, or a change in the specific companies that constitute the group for which consolidated or combined statements are prepared.—involves the preparation of financial statements for an accounting entity other than the entity that existed in the previous period.39
Some changes in reporting entity are a result of changes in accounting rules. For example, GAAP requires companies like Ford, General Motors and General Electric to consolidate their manufacturing operations with their financial subsidiaries, creating a new entity that includes them both.40 For those changes in entity, the prior-period financial statements that are presented for comparative purposes should be restated to appear as if the new entity existed in those periods.p. 192
However, the more frequent change in entity occurs when one company acquires another one. In those circumstances, the financial statements of the acquirer include the acquiree as of the date of acquisition, and the acquirer's prior-period financial statements that are presented for comparative purposes are not restated. This makes it difficult to make year-to-year comparisons for a company that frequently acquires other companies. Acquiring companies are required to provide a disclosure note that presents key financial statement information as if the acquisition had occurred before the beginning of the previous year. At a minimum, the supplemental pro forma information should display revenue, income before extraordinary items, net income, and earnings per share.
36 FASB ASC 250–10–45–5: Accounting Changes and Error Corrections—Overall—Other Presentation Matters (previously “Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3,” Statement of Financial Accounting Standard No. 154 (Norwalk, Conn.: FASB, 2005)).
37 Sometimes a lack of information makes it impracticable to report a change retrospectively so the new method is simply applied prospectively, that is, we simply use the new method from now on. Also, if a new standard specifically requires prospective accounting, that requirement is followed.
38 If the original estimate had been based on erroneous information or calculations or had not been made in good faith, the revision of that estimate would constitute the correction of an error.
* Double the straight-line rate for five years [(1/5 = 20%) × 2 = 40%]
39 In Chapter 20 we discuss the different types of situations that result in a change in accounting entity.
40 The issuance of SFAS No. 94, “Consolidation of All Majority-Owned Subsidiaries,” [codified in FASB ASC 810 and 840] resulted in hundreds of entities consolidating previously unconsolidated finance subsidiaries.