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Financial Reporting

The Change Game

A review of FASB Statement no. 154.

By Joseph L. Morris
December 2005
EXECUTIVE SUMMARY
FASB HAS ISSUED STATEMENT NO. 154 PROVIDING rules for how companies should treat changes in accounting principle. The statement requires retrospective application in all comparative financial statements for prior years.

UNDER THE IMPRACTICABILITY EXCEPTION, when companies can’t determine either the period-specific or cumulative effects of a change on all prior periods presented, Statement no. 154 requires retrospective application at the beginning of the earliest period practicable.

COMPANIES SHOULD APPLY A CHANGE in accounting principle in an interim period retrospectively. A change in accounting estimate is accounted for prospectively. Accounting changes that result in financial statements of a different reporting entity are reported prospectively by restating all prior periods.

CPAs FACE A VARIETY OF IMPLEMENTATION ISSUES when applying Statement no. 154, including how to properly apply the impracticability exception and how to properly word disclosures of accounting changes to avoid giving the impression the change stems from an error or fraud.

ACCOUNTANTS MUST MOVE QUICKLY TO GAIN a working knowledge of the guidance in Statement no. 154 because the effective date is imminent. At the same time they will need to guard against having the financial markets misunderstand why they are restating prior earnings based on mandatory vs. discretionary accounting changes.

JOSEPH L. MORRIS, PhD, CPA (inactive), is associate professor of accounting, Southeastern Louisiana University, Hammond. His e-mail address is jmorris@selu.edu .

n a major shift, FASB now requires retrospective application of all comparative financial statements for accounting principle changes. Statements for prior years must be restated as if the company had always used the new principle. While there are potential financial reporting benefits in this standard, CPAs may find it challenging to implement some of its requirements.

In September 2002 FASB and the International Accounting Standards Board made a long-term commitment to converge their accounting standards. They later identified how companies report accounting changes as one of the areas where FASB could improve its guidance by converging it with the provisions of IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors. The result of this effort is FASB Statement no. 154, Accounting Changes and Error Corrections, which was issued in 2005.

Reflecting Change
Of 600 companies surveyed, here’s how many made accounting changes and error corrections affecting the income and retained earnings statements:
  Number of companies
  2003 2002 2001 2000
Income statement:        
Cumulative effect of accounting change 118 179 103 43
Adjustments to the opening balance of retained earnings:        
Prior-period adjustments 4 6 2 5
Accounting changes 4 5 1 2

Source: Accounting Trends & Techniques, AICPA, www.aicpa.org .

The new statement replaces APB Opinion no. 20, Accounting Changes, and FASB Statement no. 3, Reporting Accounting Changes in Interim Financial Statements. It focuses on how companies should treat a change in accounting principle. Previous guidance required CPAs to account for most changes by including the cumulative effect of changing to the new principle in net income. Comparative statements of prior years did not have to be restated.

With implementation approaching at yearend, CPAs have only a short time left to understand Statement no. 154. This article outlines the important provisions of the new standard and possible implementation issues companies and their financial reporting staff will face.

THE NEW REQUIREMENTS
The major types of accounting changes CPAs may encounter are listed below with the required accounting treatment under Statement no. 154. Examples of various accounting changes and error corrections are shown in exhibit 1 .

Change in accounting principle. The new statement requires what FASB calls “retrospective application” for all changes in accounting principle. Retrospective application refers to adjusting the opening balance of retained earnings or other components of equity (such as other accumulated comprehensive income) for the cumulative effect of the change on all prior periods rather than reporting it on the income statement. For example, a change from the Lifo inventory valuation method to Fifo likely would result in an upward adjustment of inventory and retained earnings. In addition, prior-year statements should be restated as if the new standard had been used for all periods presented.

CPAs should use retrospective application for “voluntary” changes in accounting principle—that is, discretionary changes companies initiate themselves because the new method is preferable. It also applies to changes required by an accounting pronouncement in the unusual instance the pronouncement does not include specific transition provisions. When a pronouncement includes specific provisions, CPAs should follow them.

Exhibit 1 : Accounting Changes and Error Corrections
Type of change Examples
Change in accounting principle Change in inventory valuation method
Change in method of accounting for long-term construction contracts
Change to or from the full-cost method in the extractive industry
Change in accounting estimate Change in the estimated useful life or salvage value of a plant asset
Change in depreciation method
Change in estimated bad debts expense
Change in estimated warranty expense
Estimating inventory obsolescence
Change in reporting entity Presenting consolidated or combined financial statements in place of financial statements of individual entities
Changing specific subsidiaries that make up the group of entities for which consolidated financial statements are presented
Changing the entities included in combined financial statements
Correction of errors Mathematical mistakes
Mistakes in the application of GAAP
Oversight or misuse of facts that existed at the time the financial statements were prepared
A change from an accounting principle that is not generally accepted to one that is generally accepted

Impracticability exception. When it is not practical to determine either the period-specific effects or the cumulative effect of the change to all prior periods presented, the statement requires companies to apply the new accounting principle to asset and liability balances as of the beginning of the earliest period for which retrospective application is practicable and to make a corresponding adjustment to the opening balance of retained earnings (or other component of equity) for that period. Companies must disclose the method used to report the change and the reason why retrospective application is impracticable.

Determining impracticability. CPAs and their employers or clients must decide when retrospective application isn’t practicable. This is the case only when any of the following conditions exist:

After making every reasonable effort to do so, the entity is unable to apply the requirement.

Retrospective application would require assumptions about management’s intent in a prior period that cannot be independently substantiated.

Retrospective application would require significant estimates of amounts, and it is impossible to distinguish objectively the information about those estimates that

— Provides evidence of circumstances that existed on the date(s) at which those amounts would be recognized, measured or disclosed under retrospective application.

— Would have been available when the financial statements for that prior period were issued.

Indirect effects of retrospective application. Retrospective application includes only the direct effects of a change in accounting principle, net of any related income tax effects. Indirect effects a company would have recognized had the newly adopted accounting principle been followed in prior periods are not included. Indirect effects can arise when a change in accounting principle affects cash flows from contractual obligations (such as current or future cash payments related to a profit-sharing plan in a prior period). If a company actually incurs and recognizes indirect effects, it should report them in the period the accounting change is made—not in the prior period.

Interim periods. Companies should use retrospective application to report a change in accounting principle made in an interim period. The impracticability exception, however, may not be applied to prechange interim periods of the fiscal year in which the change is made. When retrospective application to prechange interim periods is impracticable, the desired change may be made only as of the beginning of a subsequent fiscal year.

Change in accounting estimate. These changes are accounted for prospectively—in (a) the period of change if the change affects that period only or (b) the period of change and future periods if the change affects both. No prior periods are restated or adjusted and no pro forma amounts are disclosed.

Under Statement no. 154, CPAs must account for a change in depreciation method as a change in accounting estimate—not a change in accounting principle. Thus, a switch from an accelerated method of depreciation to the straight-line method would be accounted for the same way as a change in estimated useful life or salvage value. FASB describes this as a change in accounting estimate effected by a change in accounting principle. CPAs must disclose why the change in depreciation is preferable.

Background of Accounting Changes
Prior to APB Opinion no. 9, Reporting the Results of Operations, a variety of approaches were generally accepted to account for a change in accounting principle, practice or method. Companies could handle such a change retroactively (prior-period adjustment), prospectively (no adjustment, but with current and futures years’ amounts reallocated) or currently with a lump-sum adjustment to income. In Opinion no. 9, the APB required prospective treatment for changes in estimates, while requiring the retroactive approach for prior-period adjustments.

In Opinion no. 20, the APB adopted the lump-sum adjustment (cumulative effect adjustment to income) method for accounting principle changes, but also outlined some exceptions to the general rule that received retroactive treatment: changes involving Lifo; long-term construction contracts; the full-cost method in the extractive industries and issuance of financial statements by a company for the first time to obtain additional equity capital, to effect a business combination or to register securities. Opinion no. 20 also carried forward the Opinion no. 9 requirements for changes in estimate (prospective treatment) and prior-period adjustments (retroactive treatment).

Under Opinion no. 20, a change in an asset’s remaining estimated useful life without changing the depreciation method was viewed as a change in accounting estimate. A change from deferring certain expenditures (such as advertising costs) to expensing them as incurred (because future benefits were uncertain) was considered a change in estimate effected by a change in accounting principle. Thus, it too, was regarded as a change in estimate.

Statement no. 3 amended Opinion no. 20 and provided guidance on cumulative-effect-type changes in principle in interim periods. Changes in accounting principle made in other than the first interim period resulted in the restatement of financial information for the earlier interim periods of that year.

Change in reporting entity. Accounting changes that result in financial statements of a different reporting entity are reported retrospectively by restating all prior periods. For example, when a company presents consolidated or combined financial statements in place of statements for individual entities, a change in reporting entity has occurred.
Error corrections. Errors arise from mathematical mistakes, errors in applying accounting principles and misuse of facts that existed at the time the financial statements were prepared. CPAs must be able to distinguish between an error correction and a change in accounting estimate. The latter comes about from discovering new information or subsequent developments. A change from an accounting principle that is not GAAP to one that is is considered an error correction.

CPAs should report an error in the financial statements of a prior period discovered after their issuance as a prior-period adjustment by adjusting the asset and liability balances of the first period presented. An offsetting adjustment is made to the opening balance of retained earnings for that period. The prior-period financial statements are restated for the period-specific effects of the error.

When financial statements are restated to correct an error, CPAs should disclose its nature. The following disclosures also are required:

The effect of the correction on each financial statement line item and any per-share amounts for all prior periods presented.

The cumulative effect of the restatement on retained earnings or other components of equity as of the beginning of the earliest period presented.

A statement that previously issued financial statements have been restated.

EFFECTIVE DATE
Statement no. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Early adoption is permitted for changes and corrections made in fiscal years beginning June 1, 2005. As stated earlier, the statement does not change the transition provisions of any existing pronouncements, including those in transition as of Statement no. 154’s effective date.

IMPLEMENTATION ISSUES
CPAs will need to familiarize themselves with the new requirements and terminology in Statement no. 154. Exhibit 2 , below, compares the major provisions and terminology of Opinion no. 20 with those of the new FASB standard. Key terms are defined in a glossary below.

Exhibit 2 : Comparison of APB Opinion no. 20 and FASB Statement no. 154
Accounting change Opinion no. 20 Statement no. 154
Change in accounting principle Current method (cumulative effect of changes recognized in net income)
Included change in depreciation, amortization or depletion method
Retroactive/prospective method for certain exceptions
Prior financials not restated, but supplemental pro forma disclosure required
Retrospective application method (cumulative effect of change adjusts beginning retained earnings)
Does not include change in depreciation, amortization or depletion method
Prior financials restated
Impracticable exception: Apply at the earliest date practicable
Change in accounting estimate Prospective method Prospective method
Includes change in depreciation, amortization or depletion method
Change in reporting entity Retroactive method Retrospective application method
Correction of errors in prior periods Retroactive method
Prior-period adjustment
Prior financials restated
Restatement method
Prior-period adjustment
Prior financials restated

One implementation issue relates to the impracticability exception. According to the new statement, a company must make “every reasonable effort” to apply a change in accounting principle retrospectively before concluding it cannot determine the effects of the change. Yet, FASB has not clearly defined “reasonable effort.” CPAs and their employers or clients will have to use their professional judgment. If CPAs cannot estimate restated amounts in prior periods due to inadequate records—as might happen with a change in inventory valuation method—retrospective application should be used starting with the first period practicable.

Exhibit 3 : Retrospective Application of a Change in Accounting Principle

The new standard likely will increase the number of accounting changes applied retrospectively. As a result CPAs will need to carefully word the disclosure of why the company is restating prior periods. Restatement for an error correction or SEC-mandated adjustment sends a significantly different message from that of a discretionary change in accounting principle; some investors or analysts could confuse retrospective application of an accounting change with restatements stemming from errors or fraud. Exhibit 3 illustrates the retrospective application of a change in accounting principle. Exhibit 4 , below, illustrates the reporting for an accounting change when determining the cumulative effect for all prior years is not practicable.

Exhibit 4 : Reporting an Accounting Change
Assume BBB Co. changed its accounting principle for inventory measurement from Fifo to Lifo effective January 1, 2005, based on the rationale that the Lifo method is preferable. The company reports its financial statements on a calendar yearend basis and has used the Fifo method since its inception. BBB Co. determines that it is impracticable to determine the cumulative effect of applying this change retrospectively because records of inventory purchases and sales no longer are available for all prior years. However, the company has all of the information necessary to apply the Lifo method on a prospective basis beginning in 2002. Therefore, BBB Co. should present prior periods as if it had (a) carried forward the 2001 ending balance in inventory (measured on a Fifo basis) and (b) applied the Lifo procedures to its existing inventory layers beginning January 1, 2002.

FASB acknowledged there will be costs involved with retrospective application of a change in accounting principle beyond those previously required to develop pro forma disclosures of the effects on prior periods. Roughly half the exposure draft respondents said the costs of retrospective application to preparers would outweigh the benefits to users. CPAs should be aware these may include (a) costs of amending previous reports with the SEC, (b) costs of reaudits due to predecessor auditor issues and (c) time and effort necessary to apply the new accounting method to prior periods. Implementation costs could even be a disincentive for a company to make a voluntary change to a preferable accounting method.

SOME CONTROVERSY REMAINS
Some observers are concerned wholesale retrospective restatements will dilute public confidence in financial statements. Because of the recent accounting scandals, the markets tend to punish companies that restate prior earnings. Will the market distinguish between mandatory and discretionary accounting changes? In its comment letter on the ED Lockheed Martin said: “Mandating restatements by every company each time a significant accounting standard changes…does not lead to an expectation of increased investor confidence. Nor will it ever result in achievement of the Holy Grail of comparability over time.”

Then there is the provision that companies can implement retrospective application in a limited form. If it is not practicable to determine either the period-specific or cumulative effect of the change on prior years, the company may apply the new principle prospectively as of the earliest date practicable. Some fear the impracticability exception could produce false comparability—users may believe they are comparing financial information prepared on the same basis when actually, companies may have retrospectively applied a new accounting principle differently based simply on their ability to do so.

LEARNING CURVE
CPAs must move quickly since they have only the remainder of 2005 to obtain a working knowledge of Statement no. 154. The major change it imposes is the retrospective application of a change in accounting principle. Especially challenging will be restating prior financials for the period-specific effects of the change. CPAs will need to help their employers and clients determine when retrospective application is impracticable. FASB may find it necessary to issue additional guidance on this part of its new standard. Whether Statement no. 154 enhances the comparability of financial statements at a reasonable cost remains to be seen.

Glossary of Key Terms
Accounting change. A change in an accounting principle, an accounting estimate or the reporting entity.

Change in accounting principle. A change from one generally accepted accounting principle to another when there are two or more such principles that apply or when the principle formerly used is no longer generally accepted. A change in the method of applying an accounting principle also is considered a change in accounting principle.

Change in accounting estimate. A change that has the effect of adjusting the carrying amount of an existing asset or liability or altering the subsequent accounting for existing or future assets or liabilities. A change in accounting estimate is a necessary consequence of the assessment, in conjunction with the periodic presentation of financial statements, of the present status and expected future benefits and obligations associated with assets and liabilities. Changes in accounting estimates result from new information.

Change in accounting estimate effected by a change in accounting principle. A change in accounting estimate that is inseparable from the effect of a related change in accounting principle.

Change in reporting entity. A change that results in financial statements that effectively are those of a different reporting entity.

Direct effects of a change in accounting principle. Recognized changes in assets or liabilities necessary to effect a change in accounting principle.

Error in previously issued financial statements. An error in recognition, measurement, presentation or disclosure in financial statements resulting from mathematical mistakes, mistakes in the application of GAAP or oversight or misuse of facts that existed at the time the financial statements were prepared.

Indirect effects of a change in accounting principle. Any changes to current or future cash flows of an entity that result from making a change in accounting principle that is applied retrospectively.

Restatement. The process of revising previously issued financial statements to reflect the correction of an error in those statements.

Retrospective application. Applying a different accounting principle to one or more previously issued financial statements, or to the statement of financial position at the beginning of the current period, as if that principle had always been used, or a change to financial statements of prior accounting periods to present the statements of a new reporting entity as if it had existed in those prior years.

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