1. Powerpoint slides by: Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Michael L. Hockenstein Commerce Department Vanier College Intermediate Accounting Thomas H. Beechy Schulich School of Business, York University Joan E. D. Conrod Faculty of Management Dalhousie University

2. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-2 Accounting Changes Chapter 22

3. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-3 Types of Accounting Changes There are three general types of accounting changes: changes in accounting policy - voluntary, at the option of management or at the request of a user - involuntary, to comply with new CICA Handbook recommendations changes in accounting estimates correction of an error in previous periods financial statements

4. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-4 Changes in Policy A change in accounting policy is a change in the way that a company accounts for a particular type of transaction or event, or for the resulting asset or liability A change in accounting policy must not be confused with adopting a new accounting policy The following are not changes in accounting policy: the initial adoption or alteration of an accounting policy necessitated by events or transactions that are clearly different in substance from those previously recognized the initial adoption of an accounting policy in recognition of events or transactions occurring for the first time or that were previously immaterial in effect

5. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-5 Changes in Policy (cont.) Accounting policies can be voluntary or involuntary a change is voluntary when management decides to make a change from one generally accepted method of accounting to another a change is involuntary when the AcSB issues a new or revised recommendation in the CICA Handbook which requires GAAP-constrained companies to alter its policy to conform to the new recommendations

6. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-6 Changes in Estimate A change in accounting estimates is a change in the application of an accounting policy to a specific transaction or event Accounting measurements are based extensively on future expectations uncollectable accounts receivable recoverable value of an asset criteria for capitalizing development costs

7. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-7 Changes in Estimate (cont.) We can never predict future outcomes with certainty and therefore accounting estimates often need revision Examples of changes in accounting estimates include: a revision in the estimate of uncollectable AR a revision in the estimated recoverable value of an asset, such as inventory or investments a change in managements judgement concerning one or more of the criteria for capitalizing development costs

8. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-8 Changes in Estimate (cont.) Changes in accounting estimates can occur for several reasons: the companys economic environment has changed, requiring a re-evaluation of the assumptions underlying many of managements accounting estimates auditors have raised questions about the application of the companys accounting policies and have requested substantiation for (or modification of) managements estimates there has been a shift in the nature of the companys business operations, so that past estimates may need adjustment to fit current business strategies

9. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-9 Correction of an Error On occasion, a company (or its auditors) discovers that there was an accounting error in a prior period If the error was material, the error must be corrected even if it has washed out over the long run inventory overlooked when the physical count was taken failed to accrue commission liabilities that had not been paid by the end of the fiscal year routine repairs were capitalized instead of being expensed

10. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-10 Correction of an Error (cont.) Errors do not arise from a change in estimate or a change in policy---they are simply mistakes Accounting errors require restatement of prior periods results, in order to comply with the qualitative criteria of comparability and consistency, even if there is no impact on the period in which the error was discovered

11. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-11 Summary: Types of Changes Basically, we can summarize an accounting change as being: a change in estimate if it is the result of new information that was not known previously a change in policy if the change was motivated by different reporting circumstances of the enterprise and there has been no material change in economic circumstances

12. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-12 Summary: Types of Changes (cont.) application of a new policy if the transactions or events are materially different from those reported previously correction of an accounting error if information has come to light that was reasonably determinable in the period in which the transaction or event was initially reported

13. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-13 Summary: Types Of Changes (cont.) Discerning the nature of the change is important for two reasons: the reporting approach for changes in accounting estimates is different from that for changes in accounting policies and corrections of errors changes in accounting estimates and error corrections normally are not disclosed and, in effect, are buried in the financial statements, while changes in accounting policies must be disclosed in the notes to the financial statements

14. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-14 Summary: Types Of Changes (cont.) When there is doubt as to whether a change is a change in policy or a change in estimate, the CICA Handbook suggests that the change should be treated as a change in estimate

15. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-15 Accounting for Changes There are three ways of reporting accounting changes in the financial statements: retroactive application with restatement of prior periods retroactive application without restatement prospective application

16. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-16 Reporting Accounting Changes 1. Retroactive application with restatement of prior periods The new accounting policy is applied to events and transactions from the date of origin of each event or transaction The financial statements for each prior period that are presented for comparative purposes are restated to reflect the new policy

17. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-17 Reporting Accounting Changes (cont.) All summary financial information for earlier periods, such as net income, total assets, earnings per share, etc., are restated as well All reported financial results after the change look as though the new policy had always been in effect

18. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-18 Reporting Accounting Changes (cont.) 2. Retroactive application without restatement (also called the current approach) The new accounting policy is applied to events and transactions from the date of origin of such items and a cumulative adjustment representing the effect of the change is made in the period in which the change is made

19. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-19 Reporting Accounting Changes (cont.) Comparative information for prior periods is not restated, either in the comparative financial statements or in five- or 10-year summaries of key financial figures (e.g., earnings per share) The summary impact of the change is stated as a one-line adjustment to retained earnings in the current period

20. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-20 Reporting Accounting Changes (cont.) 3. Prospective application The change in accounting is applied only to events and transactions occurring after the the date change Previously reported results are not restated, and there is no cumulative catch-up adjustment

21. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-21 Exhibit 22-1

22. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-22 Exhibit 22-1

23. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-23 Disclosure Requirements Accounting changes affect the consistency and comparability of financial statements, and therefore their reliability When significant changes in accounting policies or measurement occurs, readers should be warned about the changes and their impacts

24. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-24 Disclosure Requirements (cont.) The CICA Handbook recommends specific disclosures for accounting policy changes: for each change in accounting policy in the current period, the following information should be disclosed: - a description of the change - the effect of the change on the financial statements of the current period

25. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-25 Disclosure Requirements (cont.) when a change in an accounting policy has been applied retroactively and prior year periods have been restated, the fact that the financial statements of prior periods that are presented have been restated and the effect of the change on those prior periods should be disclosed when a change in an accounting policy has been applied retroactively but prior periods have not been restated, the fact that the financial statements of prior periods that are presented have not been restated should be disclosed - the cumulative adjustment to the opening balance of the retained earnings of the current period should also be disclosed

26. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-26 Disclosure Requirements (cont.) when a change in accounting policy has not been applied retroactively, this fact should be disclosed The disclosure of particulars, including dollar amounts, applies to each change in an accounting policy - it is not appropriate to net items when considering materiality a change in accounting policy that does not have a material effect in the current period but is likely to have a material effect in future periods should be disclosed

27. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-27 Disclosure Requirements (cont.) The AcSBs recommendations for reporting an error correction are similar to those for a change in accounting policy When there has been a correction in the current period of an error in prior period financial statements, the following information should be disclosed: a description of the error the effect of the correction of the error on the financial statements of the current and past periods the fact that the financial statements of prior periods that are presented have been restated

28. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-28 Prior Period Adjustments Prior to 1996, companies were permitted, under certain circumstances, to make prior period adjustments A prior period adjustment was a gain or a loss that was credited or charged directly to retained earnings instead of appearing in the income statement Since 1996 all charges and credits must flow through the income statement The only adjustments that can be made directly to retained earnings are for retroactively applied changes in accounting policy and for corrections of errors in prior periods

29. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-29 Accounting Changes: An Evaluation Many people believe that all changes in accounting policy should be applied retroactively They worry about the effect of changes on comparability Accounting changes, even those applied retroactively, may cause confusion and reduce the predictive ability of accounting information For example, at least one study has found that the accuracy of analysts earnings forecasts declined when accounting changes are made

30. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 22-30 Accounting Changes: An Evaluation (cont.) One criticism of the retroactive approach is that the cumulative effect on prior years income cannot be accurately computed Another concern is that three approaches to reporting accounting changes (retroactive treatment with restatement, retroactive treatment without restatement, and prospective treatment) are endorsed in current Canadian standards Some contend that both of the retroactive approaches (with and without restatement) are inappropriate and believe that once an income item is reported, it is final