RCMA 4: CHANGES IN ACCOUNTING TREATMENT

Changes in Accounting Treatment

Key Definitions

Prospective application - its effects should be accounted for only in the period of change and any future periods affected.
Retrospective application - requires that carrying amounts of assets, liabilities, and retained earnings at the beginning of the first period reported be adjusted for the cumulative effect of the new principle on all periods not reported.

Financial statement adjustments are required when there are changes in accounting principle, changes in accounting estimates, and changes in reporting entities. Each has a specifically described way of reporting these changes and providing year-to-year comparative statements. Errors will be corrected based on the time period that error is discovered. Keep in mind that errors are unintentional mistakes.

Accounting Changes

Changes in Accounting Principles require retrospective application. This requires the adjustment of prior-period financial statements to incorporate the effect of the new principle “as if” the new principle had been used in the prior periods. The beginning retained earnings of the earliest period presented is adjusted to reflect the effect of the change. It is not appropriate to record the cumulative effect of the change in the current year’s net income. Changes in accounting principle will change the financial ratios, so the financial ratios need to be recalculated for any prior-period.
- One type of change is the result of new guidance in the Accounting Standards Codification from the Financial Accounting Standards Board (FASB).
- Another type of change is the result of management’s election to change from one generally accepted accounting principle (GAAP) method to another, when a choice is allowed. A common example of this type of change is management electing to change from the last-in, first-out (LIFO) method of valuing inventories to the first-in, first-out (FIFO) method.
Changes in Accounting Estimates are changes in an estimated amount based on new information. This change is reported prospectively, meaning in the current period and future periods only. Prior-period statements are not restated for a change in estimate. Changes in accounting estimates will not change the financial ratios of prior periods, so no recalculation is needed.
- One example of a change in accounting estimate is to change the bad-debt percentage from 4% down to 3%. This change would be made when economic conditions have improved.
- Another example is to change the useful life of a depreciable asset from seven to ten years.
Changes in Reporting Entities occur when the financial statements represent a different reporting entity. This type of change is reported retrospectively, similar to how changes in accounting principle are reported. Prior-period financial statements are updated to reflect the financial information for the new reporting entity “as if” the new entity existed all along. The beginning retained earnings of the earliest period presented is adjusted to include the cumulative earnings differences. Changes in reporting entity will change the financial ratios, so the ratios will need to be recalculated for any prior-period adjustments.
- Presenting consolidated financial statements in place of individual ones
- A change in subsidiaries through acquisition
- A change to, or from, the equity method of accounting for an investment

Error Corrections. Errors are unintentional mistakes.

The discovery of a material error that was made in a prior period requires the correction of the error to reflect accurate retained earnings balances. This means that an error made that affected the reporting of net income or loss in a prior period be corrected by adjusting the beginning balance of retained earnings. The adjustment is made net of income taxes. Any prior-period financial statements presented for comparison purposes need to be restated to include the correction. The correction of an error will change the financial ratios for the prior-period financial statements that are presented, so the ratios need to be recalculated for any prior periods presented. Some examples include:
- Misapplication of US GAAP or IFRS
- Journal entries made to the wrong general ledger accounts or for the wrong dollar amounts
Errors have to be corrected when they are discovered. When an error is made and discovered in the current time period the correction is made at that time. This does not require any adjustments to be made other than the correction itself.

III. Summary of Changes in Accounting Treatment

When taking the CMA Exam it is important to know why accounting changes are made and how to report them. Accounting changes take the form of changes in accounting principle, changes in accounting estimates, and changes in reporting entities. Also important is when the discovery of the error is made as this will dictate how to correct it. Focus on the why and the how regarding these issues.

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Practice Questions

Part 1: Theories (5)

1. RIIZE IS 7 company is working to report changes in its accounting principles. RIIZE IS 7 explains that the company needs to use the retrospective approach in order to comply with the FASB. One of their coworkers thinks this is ridiculous. Why is it required?

a. Because when using this approach, more useful information is provided to those who use the financial statements compiled by the company

b. Because this approach requires all of the previously reported results to remain the same, which is consistent with all earlier records

c. Because itwill allow the cumulative effect to be reported on the income statement, allowing potential investors to see relevant changes

d. Because when using this approach, future useful information will be included on the financial statements to indicate future company success

2. The company you work for recently changed its method of inventory pricing from average-cost to FIFO. You are an accountant for Brooks Incorporated, and you realize that this change will dramatically affect your inventory calculations. What should you do?

a. Make the necessary changes to this year's financial statements, but do not make any changes to previous years’ inventory records.

b. Make the necessary changes to this year's financial statements, and use a retrospective adjustment to the inventory accounts to compare this year's inventory to the previous years’ inventory.

c. Calculate all-new inventory amounts for the life of the company, and re-publish all the financial statements.

d. Prepare this year's financial statements with both the old inventory method and the new inventory method so they can be directly compared.

3. When EXO Resources bought their new cutting machine in 2008, the supplier estimated that the machine would have a useful life of 20 years. However, 10 years later in 2018, it becomes obvious that the machine will no longer be useful after 12 years. How should this change be recorded?

a. The company should make an adjustment to the Depreciation Expense account for the 2018 financial statements.

b. The company should make an adjustment to the Depreciation Expense account for the years 2008- 2018 and update the financial statements accordingly.

c. The company should make an adjustment to the Retained Earnings account on the income statement for 2018.

d. The company should make an adjustment to the Retained Earnings account on the income statement for 2008 and all subsequent years.

4. Which of the following is an example of errors in financial statements?

a. While working on the financial statements, Chanyeol accidentally adds $500 when the amount was actually $50.

b. While working on the financial statements, Ningning recognizes the new estimate for a useful life of the company's new work truck.

c. While working on the financial statements, Shotaro implements a new valuation method decided on by the company.

d. While working on the financial statements, Joy makes sure to have other employees check to ensure everything isincluded.

5. So Nyeo Shi Dae (SNSD) Enterpersies began manufacturing latex-based paint in 1978. In 2008, the company developed a new high quality paint which maintains its luster for over 50 years. Due to the success of this new product, sales of the original latex-based paint have declined significantly such that the company has decided to phase out the product in early 2009. Mark Lee is the accounting manager and his primary responsibilities include the preparation and analysis of the annual financial statements. Mark has begun analyzing the annual financial transactions and wants to ensure that the operations are presented accurately for the fiscal year ending December 31, 2009. The following transactions have raised questions for Mark:

SNSD invented its new high quality paint in 2008 and received a patent in the same year. In 2008, the company expected that the new patent would have a useful-life of ten years; however, due to innovations by its competitors, SNSD has determined that the useful-life of the patent will be reduced to six years beginning in 2009.
The year-end physical count of inventory has found $24,000 of the obsolete latex-based paint product which must be written off as obsolete. SNSD is a defendant in a lawsuit concerning the durability of its old paint product line. Corporate lawyers believe that the lawsuit against So Nyeo Shi Dae will probably result in a settlement of $50,000 in mid-2010.
So Nyeo Shi Dae is also a plaintiff in a lawsuit against a competitor for stealing the manufacturing process of their new product line. Corporate lawyers believe that the lawsuit could likely result in a favorable judgment in the amount of $150,000 in 2010.

Explain how each of the four transactions above will affect So Nyeo Shi Dae's Income Statement:

a. Transaction 1 would decrease operating income. Transaction 2 would be classified as an “other expense” and would decrease Income Before Taxes. Transaction 3 is a loss contingency that can be reasonably estimated and would appear on the income statement. Transaction 4 is a gain contingency that can be reasonably estimated and would be recorded on the income statement.

b. Transaction 1 would decrease operating income. Transaction 2 would be classified as a “cost of goods sold” and would decrease operating income. Transaction 3 is a loss contingency that can be reasonably estimated and would appear on the income statement. Transaction 4 is a contingency that may result in a gain and would be recorded in the financial statements.

c. Transaction 1 would decrease operating income. Transaction 2 would be classified as an “other expense” and would decrease Income Before Taxes. Transaction 3 is a loss contingency that may result in a settlement and should appear in the notes but not in the financial statements. Transaction 4 is a contingency that may result in a gain but would not be recorded in the financial statements.

d. Transaction 1 would decrease operating income. Transaction 2 would be classified as an “other expense” and would decrease Income Before Taxes. Transaction 3 is a loss contingency that can be reasonably estimated and would appear on the income statement. Transaction 4 is a contingency that may result in a gain but would not be recorded in the financial statements.

Part 2: Problem Solving (5)

1. Red Velvet Co. buys a truck for $90,000. The truck is expected to last 10 years. During the third year, Red Velvet Co. realizes that the truck is only going to last a total of five years. The truck is depreciated on the straight-line basis and has no estimated salvage value. Required: Create a depreciation schedule for the life of the truck (five years).

2. AESPA Corp. failed to accrue warranty costs of $50,000 in its December 31, Year 4, financial statements. In addition, a change from straight-line to accelerated depreciation made at the beginning of Year 5 resulted in an entry of $30,000 to depreciation expense for Year 5. Both the $50,000 and the $30,000 are net of related income taxes. What amount should AESPA report as prior period adjustment in Year 5?

a. $0

b. $30,000

c. $80,000

d. $50,000

3. SUNJAEYA Corporation purchased machinery on January 1, 2022 for $630,000. The company used the sum-of-the-years’-digits method and no salvage value to depreciate the asset for the first two years of its estimated six-year life. In 2023, Ventura changed to the straight-line depreciation method for this asset. The following facts pertain:

The amount that SUNJAEYA should report for depreciation expense on its 2024 incomestatement is

a. $120,000

b. $105,000

c. $75,000

d. none of the above

4. During 2023, a construction company changed from the completed-contract method to the percentage-of-completion method for accounting purposes but not for tax purposes. Gross profit figures under both methods for the past three years appear below:

Assuming an income tax rate of 40% for all years, the affect of this accounting change on prior periods should be reported by a credit of

a. $600,000 on the 2023 income statement.

b. $390,000 on the 2023 income statement.

c. $600,000 on the 2023 retained earnings statement.

d. $390,000 on the 2023 retained earnings statement

5. F(X) Company purchased a machine on January 1, 2020, for $300,000. At the date of acquisition, the machine had an estimated useful life of six years with no salvage. The machine is being depreciated on a straight-line basis. On January 1, 2023, F(X) determined, as a result of additional information, that the machine had an estimated useful life of eight years from the date of acquisition with no salvage. An accounting change was made in 2023 to reflect this additional information. Assume that the direct effects of this change are limited to the effect on depreciation and the related tax provision, and that the income tax rate was 30% in 2020, 2021, 2022, and 2023. What should be reported in F(X)'s income statement for the year ended December 31, 2023, as the cumulative effect on prior years of changing the estimated useful life of the machine?

a. $0

b. $20,000

c. $30,000

d. $105,000

Answer Key

Theories

1. A. Because when using this approach, more useful information is provided to those who use the financial statements compiled by the company.

Explanation: Under the retrospective approach, prior period statements presented are restated “as if” the new principle had always been used. This is required as it allows statement readers to see trends in financial statement figures using similar accounting treatment. Ifthe past results are not restated, then financial statements from different years would be prepared using different methods. This reduces usefulness. In addition, the cumulative effect of all prior periods not presented is incorporated as an adjustment to the beginning retained earnings balance of the earliest period presented. Therefore, this is the correct answer.

2. B. Make the necessary changes to this year's financial statements, and use a retrospective adjustment to the inventory accounts to compare this year's inventory to the previous years’ inventory.

Explanation: A change from average-cost to FIFO counts as a change in accounting principle since it is a change from one GAAP-accepted method to another GAAP-accepted method. Retrospective application is required by the FASB for changes in accounting principle. Under the retrospective approach, the new rules are used for the current period. In addition, prior period statements presented are restated “as if” the new principle had always been used. This is required as it allows statement readers to see trends in financial statement figures using similar accounting treatment. If the past results are not restated, then financial statements from different years would be prepared using different methods. This reduces usefulness. In addition, the cumulative effect of all prior periods not presented is incorporated as an adjustment to the beginning retained earnings balance of the earliest period presented. Therefore, this is the correct answer.

3. A. The company should make an adjustment to the Depreciation Expense account for the 2018 financial statements.

Explanation: This qualifies as a change in accounting estimate. When a company changes an accounting estimate, it uses that new estimate in all future calculations. No changes are made to past figures. Because a different estimate for useful life will be used starting in 2018, an adjustment to the depreciation expense account for the 2018 financial statements is necessary. Therefore, this is the correct answer.

4. A. While working on the financial statements, Chanyeol accidentally adds $500 when the amount was actually $50.

Explanation: An error in financial statements occurs when GAAP is misapplied or when a mathematical mistake is made in preparing financial statements. Accidentally adding $500 when the correct amount is $50 is a mathematical mistake. Therefore, this is the correct answer.

5. D. Transaction 1 would decrease operating income. Transaction 2 would be classified as an “other expense” and would decrease Income Before Taxes. Transaction 3 is a loss contingency that can be reasonably estimated and would appear on the income statement. Transaction 4 is a contingency that may result in a gain but would not be recorded in the financial statements.

Explanation:

Transaction 1: The change in useful life is a change in estimates that affects present and future periods only. There will be an increase in amortization that would be reported in operating expenses thus causing a decline in operating income. Change in amortizations will be reflected on current and future financial statements.
Transaction 2: As there is obsolete inventory, the category “other expense” is affected on the income statement.
Transaction 3: This loss contingency is probable and can be reasonably estimated, and therefore should appear on the income statement as an “other gain or loss.” This loss contingency should also appear in the footnotes to the financial statements.
Transaction 4: According to SFAS 5 “Accounting for Contingencies,” contingencies that may result in gains are usually not reflected in the financial statements. Therefore, since the financial impact would not be realizable until received, not including the potential gain from the lawsuit in the financial statements is the proper handling for this year.

Problem Solving

This is an example of a Change in Accounting Estimate.

2. D. $50,000

Explanation: The failure to accrue warranty costs of $50,000 in Year 4 is an accounting error that was discovered in Year 5. Because the error affected the income statement of Year 4, it is considered a prior period adjustment. The change in depreciation method is not an accounting error, and will not be reported as a prior period adjustment. Changes in depreciation methods are considered to be the same as a change in accounting estimate, and are handled currently and prospectively, not retroactively.

3. C. $75,000

Solution: [$630,000 – ($180,000 + $150,000)] ÷ 4 = $75,000

4. D. $390,000

Solution: [($800,000 + $950,000) – ($475,000 + $625,000)] × (1 – .40) = $390,000

5. A. $0

Explanation: $0, no cumulative effect, handle prospectively (change in estimate).

References:

Becker. (2022). Becker Professional Education CMA Review - Part 2: Strategic Financial Management

Gleim. (2022). Gleim CMA Review Part 2: Strategic Financial Management

Studocu. (n.d.). CH22 - ACCOUNTING CHANGES AND ERROR ANALYSIS Q AND A - CHAPTER 22 ACCOUNTING CHANGES AND ERROR - Studocu. https://www.studocu.com/ph/document/university-of-mindanao/intermediate-accounting-2/ch22-accounting-changes-and-error-analysis-q-and-a/13865632

Wiley. (2023). Wiley CMA Exam Review 2023 Study Guide Part 2: Strategic Financial Management Set (1-year access). Wiley.