Accounting changes and errors

Typical coverage of US GAAP Adoption of a new accounting standard Change in accounting policy Change in accounting estimate Correction of errors Change in reporting entity Disclosures

Executive summary Both IFRS and US GAAP have similar recognition treatment for accounting changes, changes in estimates and corrections of errors. The required disclosures are also similar. IFRS provides an exception if it is impractical to restate financial statements for a correction of an error. US GAAP requires all material errors to be corrected by restating, and does not provide an impractical exception.

Primary pronouncements US GAAP ASC 250, Accounting Changes and Error Corrections IFRS IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors

Progress on convergence There is no convergence activity planned at this time.

Adoption of a new accounting standard US GAAP IFRS Upon adoption of a new accounting standard, the transition guidance in the standard, if any, should be followed. If no guidance is provided, then the new accounting standard should be applied retrospectively, when practical. Similar

Change in accounting policy US GAAP IFRS A change in accounting policy is defined as a change from one generally accepted accounting principle to another generally accepted accounting principle. If practical, the change should be applied retrospectively. Similar The initial adoption of an accounting principle for new events or to account for items that were previously immaterial is not considered a change in accounting. Similar

Change in accounting policy US GAAP IFRS ASC 250-10-45-6, when it is impracticable “to determine the period-specific effects of that change on all prior periods presented, the cumulative effect of the change to the new accounting principle shall be applied to the carrying amounts of assets and liabilities as of the beginning of the earliest period to which the new accounting principle can be applied. An offsetting adjustment, if any, shall be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period.” Similar: Per IAS 8, paragraph 25, “when it is impracticable to determine the cumulative effect, at the beginning of the current period, of applying a new accounting policy to all prior periods, the entity shall adjust the comparative information to apply the new accounting policy prospectively from the earliest date practicable.”

Retrospective application of a change in accounting principle example Toy Company management decides to adopt the FIFO method of inventory valuation at the beginning of 2012. Toy Company had used the average cost method for its inventory valuation since its inception on January 1, 2010. Toy Company’s accounting records are sufficient to apply the FIFO method retrospectively. Toy Company’s management concluded that the FIFO method of inventory valuation is preferable because it results in a better match of costs and revenues. The change in accounting principle will be reported through retrospective application. Toy Company’s effective income tax rate is 30%. In 2012, sales were $3,200 and selling, general and administrative expenses were $1,200. The effects of the change in inventory and cost of sales, Toy Company’s statement of income and statement of retained earnings are presented on the following slides. Prepare Toy Company’s statements of income and retained earnings for 2011 and 2012 reflecting retrospective application of the accounting change. Note that the solution will be the same under US GAAP and IFRS.

Retrospective application of a change in accounting principle example The effects of the change in accounting principle on inventory and the cost of sales are presented in the following table. Inventory determined by: Cost of sales determined by: Average method FIFO method January 1, 2010 $ – $ – $ – December 31, 2010 $100 $ 80 $ 800 $ 820 December 31, 2011 $200 $260 $1,000 $ 940 December 31, 2012 $320 $350 $1,130 $1,100

Retrospective application of a change in accounting principle example Toy Company’s statement of income, as originally reported under the average cost method, is presented below. Toy Company Statement of income (As previously reported before the change in accounting policy) 2011 2010 Sales $3,000 Cost of goods sold 1,000 800 Selling, general and administrative expenses Income before income taxes 1,200 Income taxes 300 360 Net income $ 700 $ 840

Retrospective application of a change in accounting principle example Toy Company Statement of retained earnings (As previously reported before the change in accounting policy) 2011 2010 Beginning retained earnings $ 840 $ – Net income 700 840 Ending retained earnings $1,540 $840

Retrospective application of a change in accounting principle example Example 1 solution: Toy Company’s statements of income and retained earnings, reflecting the retrospective application of the accounting change from the average cost method to the FIFO method, are presented below and on the next slide. Toy Company Statement of income 2012 2011 as adjusted Sales $3,200 $3,000 Cost of goods sold 1,100 940 Selling, general and administrative expenses 1,200 1,000 Income before income taxes 900 1,060 Income taxes 270 318 Net income $ 630 $ 742

Retrospective application of a change in accounting principle example Example 1 solution (continued): Toy Company Statement of retained earnings 2012 2011, as adjusted Beginning retained earnings as reported $1,568 $ 840 Cumulative effect of change in accounting* – (14) Beginning retained earnings as restated 826 Net income** 630 742 Ending retained earnings $2,198 *Calculated as the change in the cost of sales for 2010, net of tax (($800 - $820) x 70%) **Net income for 2011 was originally reported as $700. The new accounting method for inventory decreased the cost of goods sold by $60 and increased net income by $42.

Prospective application of a change in accounting principle example Example 2: During 2011, Cooper Company, Inc.’s (CCI) management installed a new computerized inventory accounting system. CCI reports under US GAAP. The new system allows management for the first time to determine the specific costs for each product in the 2011 ending inventory, but not for any date prior to the 2011 year-end. CCI turns its entire inventory three times a year. There were no lower-of-cost-or-market issues with inventory in 2010 or 2011. CCI’s effective income tax rate is 50%. CCI has had 2.0 million shares of common stock outstanding since its inception in 2009. Management decided to change its accounting policy for inventory costing from FIFO to the specific-identification method in 2011. Management believes this change will better match costs and revenues and is, therefore, a preferable change. Additional information is shown on the next slide. In 2010, CCI’s accounting policy for inventory was as follows: inventory is stated at the lower of cost, FIFO or market. Assess how CCI would report this change in accounting principle under US GAAP. List any significant differences between US GAAP and IFRS.

Prospective application of a change in accounting principle example Additional information (amounts in millions): 2010 2011 Year-end inventory value using FIFO $ 10 $ 11 Year-end inventory value using specific identification NA $ 13 Cost of sales using FIFO $ 30 $ 33 Cost of sales using specific identification $ 31 Retained earnings using FIFO $110 $120 Retained earnings using specific identification Note: NA indicates the information in not available.

Prospective application of a change in accounting principle example Example 2 solution: Management cannot apply the new inventory accounting policy to the inventory balance at the end of 2010, nor to the beginning inventory balance in 2011, because the system needed to make the determination of specific identification of costs did not exist at that time. Therefore, neither the 2010 ending retained earnings balance nor the 2011 beginning retained earnings would be restated. The earliest date at which the change in accounting policy can be reflected is on the 2011 year-end balance sheet. The impact of the change is to decrease cost of sales by $2.0 million. The after-tax impact on the 2011 year-end financial information would be to increase net income and retained earnings by $1.0 million. There are no significant differences between US GAAP and IFRS.

Changes in accounting estimates US GAAP IFRS A change in estimate due to new developments or new information should be accounted for in the period of the change or in future periods, depending on the periods impacted by the change (i.e., the change should be accounted for prospectively). Similar A change in depreciation methodology on existing assets is treated as a change in estimate. Similar

Correction of errors US GAAP IFRS Generally requires that material, prior-period errors be corrected retrospectively by restating all prior reported accounts impacted by the error and recording a prior-period adjustment to the beginning retained earnings balance. Similar

Correction of errors US GAAP All material errors should be corrected by restatement. IFRS IFRS provides an exception if it is impractical. IFRS narrowly defines impractical in IAS 8, paragraph 5, as follows: “Applying a requirement is impractical when an entity cannot apply it after making every reasonable effort to do so.”

Correction of errors US GAAP All material errors should be corrected by restatement. IFRS Definition of impractical (continued): “For a particular prior period, it is impractical to apply a change in accounting policy retrospectively or to make a retrospective restatement to correct an error if: “(a) The effects of the retrospective application or retrospective restatement are not determinable; “(b) The retrospective application or retrospective restatement requires assumptions about what management’s intent would have been in that period; or

Correction of errors US GAAP All material errors should be corrected by restatement. IFRS Definition of impractical (continued): “(c) The retrospective application or retrospective restatement requires significant estimates of amounts and it is impossible to distinguish objectively information about the estimates that: “(i) provides evidence of circumstances that existed on the date(s) at which those amounts are to be recognized, measured, or disclosed; and “(ii) would have been available when the financial statements for that prior period were authorized for issue, from other information.”

Correction of errors US GAAP All material errors should be corrected by restatement. IFRS IAS 8, paragraphs 44 and 45, provide guidance when it is impractical to correct an error by retrospective restatement. The opening balances should be restated for the earliest period possible. The standard notes restatement may be limited in some cases to the current period.

Correction of an error example When preparing a comparative analysis of income tax expense in 2011, the Modern Art Company (MAC) discovered that the 2010 calculation did not include foreign income taxes of $2.0 million. Management determined this error is material and that the financial statements need to be corrected. MAC reports under US GAAP. Additional information is on the following slide. Determine how MAC should report the correction of this error in the balances shown above. List any significant differences between US GAAP and IFRS.

Correction of an error example Example 3 (continued): Extracts from the statements of income and retained earnings, before correcting the error, are as follows (amounts in millions): 2011 2010 Net income before income taxes $20 $14 Income taxes 8 5 Net income $12 $ 9 Beginning retained earnings $52 $50 12 9 Dividends paid (10) (7) Ending retained earnings $54

Correction of an error example Example 3 solution: 2011 Restated 2010 Net income before income taxes $20 $ 14 Income taxes 8 7 Net income $12 $ 7 Beginning retained earnings $50 12 Dividends paid (10) (7) Ending retained earnings $52 There are no significant differences between US GAAP and IFRS.

Correction of an error example The ABC Company (ABC) has been valuing its inventory using FIFO since its inception on January 1, 2010. All inventory calculations were done manually until December 31, 2012, when a new, computerized costing system was fully implemented. The controller compared the closing inventory value at December 31, 2011, which had been calculated manually, and the opening inventory value on January 1, 2012, which had been calculated using the new computerized costing system, and noted the inventory was overstated by $2.0 million. Management doubled-checked the new inventory costing program and determined the computer program was valuing inventory properly. Management determined this error is material and that the financial statements need to be corrected. After some research of the manual inventory records for 2011 and 2010, management concluded it was impractical to determine if the error in valuing the inventory occurred in 2011 or 2010, or in both years. ABC has incurred losses since its inception and has not paid any income taxes. Additional information is shown on the following slide. Determine how ABC should report the correction of this error in the balances shown above. List any significant differences between US GAAP and IFRS.

Correction of an error example Example 4 (continued): Extracts from the statement of operations and statement of retained deficit, before correcting the error, are as follows (amounts in millions): 2011 2010 Revenue $ 30 $10 Cost of sales 20 9 Selling and administrative cost 12 10 Net loss $ (2) $ (9) Beginning retained deficit $ (9) $ – (2) (9) Ending retained deficit $(11)

Correction of an error example Example 4 solution: US GAAP does not provide an impractical exception, but instead requires the error to be corrected in the period it arose. Additional work needs to be done to determine the impact of the correction of the error on the 2010 and 2011 financial information. IFRS provides an impractical exception for correcting an error. When it is impractical to determine the period in which the error arose, the earliest period for which a determination can be made should be restated. In this example, the ending balance of the December 31, 2011, inventory should be reduced by $2.0 million and the cost of sales should be increased by $2.0 million in 2011. 2011 Restated 2011 Revenue $ 30 Cost of sales 20 22 Selling and administrative cost 12 Net loss $ (2) $ ( 4) Beginning retained deficit $ ( 9) (2) (4) Ending retained deficit $(11) $(13)

Change in reporting entity US GAAP IFRS US GAAP requires revised financial statements for the new entity for all reporting periods presented. Per Ernst & Young’s International GAAP 2012, Chapter 3, section 4.1.4: “a significant acquisition or disposal, or a review of the presentation of the financial statements might suggest … An entity should change the presentation of its financial statements only if the changed presentation provides information that is reliable and is more relevant to the users of the financial statements and the revised structure is likely to continue, so that comparability is not impaired. When making such changes in presentation, an entity will need to reclassify its comparative information … .” Similar

Change in reporting entity US GAAP Provides for combined financial statements. IFRS Does not provide for combined financial statements. Therefore, a change in reporting entity under ASC 250-10, for example, for entities under common control, would not be allowed under IFRS except under very rare circumstances involving the use of IAS 1 True and Fair Override.

Disclosures Change in accounting principle US GAAP IFRS If the change is due to new accounting guidance, that guidance should be identified. Similar Similar – a description of how the change provides more reliable and relevant information is required. See next slide for details. An explanation of why the change in accounting is preferable. The method of applying the change, which is generally the retrospective application to the earliest period presented. Similar

Disclosures Change in accounting principle US GAAP Requires disclosure of why the new accounting principle is preferable. However, virtually no guidance for evaluating the reasonableness of management’s justification for a voluntary change in accounting principle is provided. One of the few examples, ASC 330-10-30-14, discussing methods of costing inventory, offers some general guidance on preferability, as follows: “Although selection of the method should be made on the basis of the individual circumstances, financial  statements will be more useful if uniform methods of inventory pricing are adopted by all companies within a given industry.”   IFRS

Disclosures Change in accounting principle US GAAP Further, ASC 250-10-55-1 states “... preferability among accounting principles shall be determined on the basis of whether the new principle constitutes an improvement in financial reporting and not on the basis of the income tax effect alone.” Matters to consider in assessing preferability would include authoritative support, the rationale for change (conformity with broad concepts of accounting, better matching of costs and revenue) and industry practice. IFRS Requires disclosure of why the new accounting policy provides more relevant and reliable information. IFRS contains no guidance on how to assess whether or not a change in accounting policy is a “more relevant” policy. Matters to consider when assessing relevance would include industry practice, whether the policy is widely recognized and prevalent in practice and whether the change will result in more useful information.

Disclosures Change in accounting principle US GAAP IFRS Conceptually, there is no significant difference between US GAAP and IFRS. However, subtle differences arising from the interpretation of preferable versus relevant and reliable could result in different conclusions on the appropriateness of the change in accounting.

Disclosures Change in accounting principle US GAAP IFRS The amount of the adjustment relating to periods before those included in the financial statements. Generally, this is to the beginning retained earnings for the earliest year presented in the financial statements. In US GAAP, this is referred to as the cumulative effect of the change in accounting policy adjustment. Similar The impact of the change on the affected financial statement line items. Similar If retrospective application of the new accounting policy is not practical, a disclosure must be provided that explains why this is the case and which periods have been restated Similar

Prospective application of a change in accounting principle disclosure example Using the information from the example beginning on slide 15, draft CCI’s accounting policy footnote for inventory as it should appear in the comparative 2010 and 2011 financial statements. List any significant differences between US GAAP and IFRS.

Prospective application of a change in accounting principle example Example 5 solution: In 2010, inventory is stated at the lower of cost, FIFO or market. During 2011, management installed a new, computerized inventory accounting system that allowed management for the first time to determine the specific costs for each product in the 2011 ending inventory. Effective with the 2011 year-end, CCI began valuing its inventory at the lower of the specific cost or market. CCI’s management believes that the specific-identification method results in a better match of costs and revenues. The cumulative effect of this change on retained earnings at the beginning of 2011 is not determinable, nor are the pro forma effects of retroactive application of the specific-identification inventory costing method to prior years. If the specific-identification method of valuing inventory had not been used in 2011, the inventory value would have been reduced by $2.0 million. The effect of this change on the 2011 results was to increase net income by $1.0 million, which is also the cumulative effect on retained earnings at the end of 2011, or 50 cents per common share. There are no significant differences between US GAAP and IFRS.

Disclosures Change in accounting estimates US GAAP IFRS Generally, no separate disclosure of changes in estimates is required unless the change is viewed as material to understanding the current year’s financial statements or the impact on future periods is expected to be material. Similar

Disclosures Correction of errors US GAAP IFRS The nature of the error and the periods affected. Similar The impact on each financial statement line item restated, including the impact on earnings per share, if applicable. Similar The cumulative impact of the restatement on the earliest year restated. Similar

Disclosures Correction of errors US GAAP Requires restatement to correct an error. IFRS Provides an impractical exception to a restatement for correcting an error. If a company uses the impractical exception, it should disclose why it is impractical to restate and how and for which period the error has been corrected.

Correction of an error disclosure Example 6 Using the information from the example beginning on slide 24, draft MAC’s required financial statement disclosures related to the correction of this error. List any significant differences between US GAAP and IFRS.

Correction of an error example Example 6 solution: MAC failed to record foreign income expenses of $2.0 million in 2010. The financial statements for 2010 have been restated as follows to correct this error (amounts in millions): As reported 2010 Correction of error Restated 2010 Net income before income taxes $14 $ – Income taxes (5) (2) (7) Net income $ 9 $ (2) $ 7 Beginning retained earnings $50 9 7 Dividends paid – Ending retained earnings $52 There are no significant differences between US GAAP and IFRS.

Correction of an error disclosure Example 7 Using the information from the example beginning on slide 29, draft ABC’s required financial statement disclosures related to the correction of this error. List any significant differences between US GAAP and IFRS.

Correction of an error disclosure Example 7 solution: US GAAP: A disclosure regarding the correction of the error should be prepared once ABC has identified the impact on each of the years reported. IFRS: ABC implemented a new computerized costing system in 2012, which resulted in a determination that the December 31, 2011, ending inventory was overstated by $ 2.0 million. After some research of the manual inventory records for 2011 and 2010, management concluded that it was impractical to determine if the error in valuing inventory occurred in 2011 or 2010, or in both years. Therefore, the earliest point at which the correction of the error could be recorded was December 31, 2011.

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