Accounting Changes and

Error Corrections
Accounting Errors
Detection before financial statements are
issued is the best.

Detection of errors in already issued financial

statements is covered later.
Detecting Errors
Internal controls should help prevent errors
when they are made.

Reconciliations detect errors.

Investigating Errors
When errors are detected, they must be
investigated.
To determine what the mistake was and to
correct it.
Also, to address any weaknesses in the
system so that the error does not occur again
in the future.
Three Methods of Accounting
A. Retrospective Application
Used for changes in accounting principles and
changes in reporting entity.
B. Prospective Adjustment
Used for changes in estimates and changes in
estimates effected by change in principle.
C. Restatement
Used for correction of errors in previously issued
financial statements.
Five Types of Changes/Corrections
1. Change in accounting principle
2. Change in reporting entity
3. Change in accounting estimate
4. Change in accounting estimate effected by
a change in accounting principle
5. Restatement to correct an error
1. Change in Accounting
Principle
What is a Change in Acctg. Princ.
It is a change from one accepted GAAP
method to another accepted GAAP method.

Common examples:
• Inventory
• Long-term contracts
Change Must be Justified
The new principle must be preferable to the
old method from the standpoint of financial
reporting.
In period of change, must disclose:
• The change,
• The reason for the change, and
• Explanation of why the new method is
preferable.
SEC Requirements
SEC requires the company’s independent
auditor to write a “preferability letter”.

Must indicate whether or not the change is to

an acceptable alternative that, in the auditors’
judgment, is preferable.
Steps of Retrospective Application
There are three adjustments that need to be
made:
1. For periods before the presented periods
2. To beginning retained earnings
3. To each presented period
1. Periods Prior to Presented Periods
The cumulative effect of the change to the
new accounting principle
• on periods prior to those presented
• shall be reflected in the carrying amounts
of assets and liabilities
• as of the beginning of the first period
presented.
2. Beginning Retained Earnings
An offsetting adjustment, if any, shall be made
to the opening balance of retained
earnings for that period.

This adjusts beginning retained earnings for

the effect of the change on all prior periods.
3. Each Period Presented
Financial statements for each individual
prior period presented
are adjusted to reflect the effects of applying
the new accounting principle to that specific
period.
Direct and Indirect Effects
Direct effects are required by any company
making a specific accounting change.

Indirect effects are specific to the change

within a specific company.
Newly Issued Standards
Newly issued accounting standards generally
give guidance for how to account for the
transition to the new standard.
Impracticability of Retrospective
The retrospective method should not be used
when it is impractical to do so.
1. Must have made a reasonable, but
unsuccessful, effort to do so.
2. Doing so would require making
unsubstantiated assumptions about
management decisions in the past.
3. Significant estimates are required to be
made, but are not able to be reasonably
made.
Required Disclosures
• Nature of change and why the new method
is preferable.
• Method of applying the change.
• Description of prior period information that
has been retrospectively adjusted.
• Effect of the change on net income.
• Indirect effects are described and amounts
given.
2. Change in Reporting Entity
What Is Change in Reporting Entity
Occurs when:
• Consolidated financial statements prepared
in place of individual financial statements.
• There is a change in the companies that
are consolidated.
Accounting for Change in Entity
Done with the retrospective method as just
outlined.
3. Change in Estimate
and
4. Change in Estimate
Effected by Change in
Principle
What is a Change in Estimate
As time passes, more and better information
becomes available that shows a previous
estimate was not accurate.
• Bad debts
• Warranty costs
• Depreciation estimates
Accounted for Prospectively
No changes to prior period accounts or to
beginning retained earnings.

Accounted for in the current period and future

periods.
Adjustment Process
Essentially stop, gather the new estimate and
continue accounting from that point with the
new information.
Disclosure of Change in Estimate
Should be explained in the notes to the
financial statements.
Explanation should give the reason for the
revision of the estimate and state the effects
of the change on:
• current income from continuing operations,
• net income, and
• for public companies, earnings per share.
Change of Estimate and Principle
Occurs when a change in estimate is brought
about by a change in principle.
Change in depreciation method is the most
common example.

Accounted for as a change in Estimate –

Prospectively.
Must Be Justified Change
As with a straight change in accounting
principle, a change in estimate coupled with a
change in principle also needs to be justified.
5. Correction of Error in
Previously Issued
Financial Statements
Cause of Error is Irrelevant
Errors can result from
• mathematical mistakes,
• mistakes in applying a principle,
• oversight, or
• misuse of facts.
A change from an incorrect accounting
principle to an accepted principle is also a
correction of an error.
Correcting the Error
All discovered errors must be corrected.
Steps are similar to Retrospective treatment.
1. Cumulative effect of error is reported in
beginning balances of effected accounts.
2. Adjustment made to retained earnings.
3. Each prior period presented is restated to
the now correct amounts.
Disclosure Issues of Error
Prior period restated balances are marked as
“Restated” at the top of each column.

The term “Restatement” must be used to

describe the effect of the error.

The nature of the error also needs to be

disclosed, as well is the impact of it.
Presentation in Retained Earnings
Unadjusted Retained earnings, beginning of the period xxx
+/− cumulative effect of retrospective changes in accounting
principles xxx
+/− cumulative effect of retrospective changes in reporting entity
xxx
+/− cumulative effect of restatement due to error corrections xxx
Adjusted Retained earnings, beginning of the period xxx
+ net income (or – net loss) xxx
− losses from share transactions (xxx)
− dividends declared (xxx)
Retained earnings, end of the period XXX