Changes in

Accounting Estimate

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 Changes in Accounting Estimate

There are three points to note when there is a change

in accounting estimate:
1. It is not an error.
2. Do not restate the prior years.
3. Follow Prospective approach.

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 Changes in Accounting Estimate

Prospective Approach
• Using new information in the current year as well as in the
future years
• Changes in accounting estimate are accounted for
prospectively which means:
o Implement in the current period and continue in
future periods
o No effect on previously reported retained earnings
• The change in estimate can affect:
o Income statement
o Balance sheet

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 Changes in Accounting Estimate

Should the change in estimate be

disclosed?
Change in estimate affecting
future periods must be disclosed
in the notes to the financial statements.
Should the changes in ordinary
accounting estimate be disclosed?
Change in estimate affecting future
periods need not be disclosed unless
they are material.

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 Changes in Accounting Estimate
Events Resulting in Estimate Changes
• Changes in the lives of fixed assets
• Adjustments of year-end accrual of officers’ salaries
and/or bonuses
• Write-downs of obsolete inventory​​
• Economic conditions​​
• Product demand
• Settlement of litigation
• Change in accounting principle that is inseparable
from a change in estimate
o To LIFO
o Depreciation method
• Revisions of estimates regarding discontinued
operations

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 Example
Step 1: Find Remaining Useful Life
Example: Change in Accounting Estimate
New total useful life: 5 Years
Facts:
Number of years elapsed: 2 Years
Carlin Company buys a truck for $90,000.
The truck is expected to last for 10 years. Remaining useful life: 5 years – 2 years
During the third year, Carlin Company : 3 years
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:
1. Create a depreciation schedule
for the life of the truck (five years).

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 Example
Step 2: Find Net Book Value for the third year
Example: Change in Accounting Estimate
No. of years passed: 2
Facts:
How much depreciation has already been
Carlin Company buys a truck for $90,000. accumulated in Year 1 and Year 2 using the
The truck is expected to last for 10 years.
original estimate useful life of 10 years?
During the third year, Carlin Company
realizes that the truck is only going to last • Depreciation for year 1: $90,000 / 10 = $ 9,000
a total of five years. The truck is depreciated • Depreciation for year 2: $90,000 / 10 = $ 9,000
on the straight-line basis and has no
estimated salvage value. $ 18,000
Net Book Value at third year = $ 90,000 - $ 18,000
Required:
= $ 72,000
1. Create a depreciation schedule
for the life of the truck (five years).

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 Example
Step 3: Find Depreciation Expense
Example: Change in Accounting Estimate
Net Book Value at third year = $ 72,000
Facts:
= $ 72,000 / 3
Carlin Company buys a truck for $90,000. = $ 24,000
The truck is expected to last for 10 years.
During the third year, Carlin Company
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:

1. Create a depreciation schedule

for the life of the truck (five years).

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 Example
Depreciation Schedule for Truck Purchased in Year 1
Depreciation Current Year Accumulated Net Carrying
Calculation Depreciation Depreciation Value

Disclose the third Year 1 $90,000 /10 9,000 9,000 81,000

year depreciation
value in the notes
as this change in Year 2 $90,000 /10 9,000 18,000 72,000
estimate affects
the current and Year 3 $72,000 / 3 24,000 42,000 48,000
future years as
well.
Year 4 $72,000 / 3 24,000 66,000 24,000

Year 5 $72,000 / 3 24,000 90,000 -

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 Example
Depreciation Schedule for Truck Purchased in Year 1
Depreciation Current Year Accumulated Net Carrying
Is this change in Calculation Depreciation Depreciation Value
estimate going to
affect quality Year 1 $90,000 /10 9,000 9,000 81,000
earnings?

Year 2 $90,000 /10 9,000 18,000 72,000

Yes, it increases Year 3 $72,000 / 3 24,000 42,000 48,000

the expense and
reduces the net
income. Year 4 $72,000 / 3 24,000 66,000 24,000

Year 5 $72,000 / 3 24,000 90,000 -

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 Changes in Accounting
Principle or Accounting
Entity

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 Changes in Accounting Principle
(Retrospective Application)

• Changes in accounting principle or accounting entity:

o General rule = Retrospective approach
o General rule has exceptions
• Always adjust beginning retained earnings, net of tax

Do not forget to multiply that adjustment by 1 minus the tax rate:

Adjustment × (1 – Tax rate)

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 Changes in Accounting Principle
(Retrospective Application)

• A change in accounting principle is:

o A change from one acceptable accounting method to another
acceptable accounting method.
• Non-GAAP to GAAP is a correction of an error.

Going from one acceptable method to another acceptable method:

General rule (retrospective application)

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 Rule of Preferability
• Cannot change accounting principles without justification.
• An accounting principle may be changed only if:
o required by GAAP; or
o alternative principle is preferred and presents the information more fairly.

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 Income Smoothing
• Income smoothing is NOT allowed.
• Cannot switch accounting methods in order to show lower expenses
or lower cost of goods sold.
• Change in accounting principle should be justified.
• Change should more fairly present results.

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 Cumulative Effect

If noncomparative financial statements are being presented:

1 Use new method in the year presented (2024).

2 2024 2023

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 Cumulative Effect: Noncomparative Financial Statements

1 Use new method in the year presented (2024).

2 Calculate what earnings would have been if the new method had always been used.

3 Adjust beginning retained earnings net of tax [Adjustment × (1 – Tax rate)].

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 Cumulative Effect

If comparative financial statements are being presented:

1 Use new method in all years presented

Current Year: 2024

2023

2022

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 Cumulative Effect

1 Use new method in all years presented

Calculate the cumulative effect Current Year: 2024

2 o The difference between beginning retained earnings in the first
period presented and what retained earnings would have been
if the new principle had been applied to all prior periods.

2023
3 Present cumulative effect net of tax as an adjustment to beginning
retained earnings in the statement of stockholders' equity.

Multiply adjustment by 1 minus the tax rate:

Adjustment × (1 – Tax rate) 2022

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 Cumulative Effect: Example

Illustration: Cumulative Effect of a Change in Accounting Principle

Facts:
• On January 1, Year 5, Harbor Company decided to switch to the weighted average
method of inventory accounting.
• Prior to Year 5, Harbor used FIFO to account for its inventory. Harborʹs effective tax rate
is 30 percent.
• Pretax income prior to Year 5 was $600,000 using the old method (FIFO).
• Pretax income prior to Year 5 would have been $800,000 using the new method
(weighted average).
• The cumulative effect of the adjustment is $200,000 pretax.
Required:
Calculate the cumulative effect net of income tax of the change in accounting principle
(noncomparative financial statement; only show Year 5.)

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 Cumulative Effect: Example

Noncomparative Financial Statements

Calculate cumulative effect net of tax:

1
$200,000 × (1 – 0.30) = $140,000

Adjust beginning retained earnings for Year 5:

2
Increase by $140,000

Use new method (weighted average) in Year 5

3
to calculate cost of goods sold

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 Cumulative Effect: Solution

Cumulative effect adjustment as of January 1, Year 5 $200,000

Less income tax effect at 30 percent $60,000

Cumulative effect net of income tax $140,000

The $140,000 cumulative effect net of income tax would adjust the beginning retained earnings within
the statement of stockholdersʹ equity.

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 Reporting Changes in an Accounting Principle
General Rule

• Retrospective approach
• For comparative financial statements, adjust beginning retained
earnings for the earliest year presented.

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 Exceptions to the General Rule

• Impracticable to estimate:
o If it is considered "impractical" to accurately calculate this cumulative effect adjustment, the change
is handled prospectively.
o An example is a change in inventory cost flow assumption to LIFO under U.S. GAAP.
• Change in depreciation method:
o A change in the method of depreciation, amortization, or depletion is considered to be both a
change in accounting principle and a change in estimate.
o These changes should be accounted for as changes in estimate and are handled prospectively.

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 Application of the General Rule

• Adjust retained earnings for the cumulative effect net of tax at the beginning
or the earliest period presented.
• Use the new accounting principle for all periods presented.

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 Application of the General Rule and Exception

General Rule:
Exception
Retrospective Approach

• Adjust to beginning retained • Change to LIFO

earnings, net of tax
• Change in method of
• Change in accounting entity depreciation
• Occurs when the entity
being reported on has
changed composition
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 Changes in Accounting Entity (Retrospective Application)

• Changes may be the result of:

o Mergers
o Acquisitions
o Divestitures

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 Restatement (Comparative Financial Statements)

If a change in accounting entity occurs in the current year:

• Restate all previous financial statements presented in comparative
financial statements along with the current year to reflect the
information for the new reporting entity.

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 Restatement (Comparative Financial Statements)

• ABCD – Company D is a new acquisition.

• D will be part of consolidation in 2024.
2024

• Compare apples to apples.

2023
• Adjust ABCD retrospectively.
• Consider it was part of the consolidated group in 2023 and 2022.

2022

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 Full Disclosure

• Full disclosure of the case and nature of the change should be made.
• Include changes in income from:
o Continuing operations
o Net income
o Retained earnings

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 Error Correction
(Prior Period Adjustment)

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 Error Correction (Prior Period Adjustment)
Error corrections are not
Requires restatement of financials
accounting changes.
Error corrections include:
• Corrections of errors in recognition, measurement, presentation,
or disclosure in financial statements resulting from:
o mathematical mistakes;
o mistakes in the application of U.S. GAAP; or
o oversight or misuse of facts that existed at the time the
financial statements were prepared.
• Changes from a non-GAAP method of accounting to a GAAP method of accounting
(e.g., cash basis to accrual basis), which is a specific correction of an error.

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 Error Correction (Prior Period Adjustment)
Comparative Financial Statements Presented

If comparative financial statements are

If the Year presented and financial statements for the year
Is Presented with the error are presented, merely correct the
error in those prior financial statements.

Adjust Beginning If comparative financial statements are

Retained Earnings presented and financial statements for the
of the Earliest Year year with the error are not presented (e.g.,
Presented (if the because it is too far back in years), adjust (net
Year Is of tax) the opening retained earnings of the
Not Presented) earliest year presented.

Comparative Financial Statements NOT Presented

If comparative financial statements are not presented, the error correction should be
reported as an adjustment to the opening balance of retained earnings (net of tax).
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 Accounting Changes and Error Corrections

Example: Accounting Changes and Error Corrections

Facts: In Year 4, Jordan Manufacturing discovered that depreciation expense was incorrectly calculated in Years
1 and 2. In total, $4,500,000 of depreciation expense was not recorded during these two years.
At the beginning of Year 4, Jordan Manufacturing decided to change inventory methods from the last-in first-out
(LIFO) cost flow assumption to the first-in first-out (FIFO) cost flow assumption. The following information details
the pretax income under LIFO and FIFO for Years 1 through 3.

Pretax Income Under

LIFO FIFO Difference
Year 1 $3,000,000 $3,750,000 $ 750,000 Jordan's tax rate is 40 percent.
Year 2 3,400,000 5,500,000 2,100,000
Year 3 4,100,000 6,250,000 2,150,000
Required:
1. Calculate the required adjustment for the depreciation error and indicate how this correction should be presented
in the financial statements.
2. Calculate the cumulative adjustment for the change in principle and indicate how the adjustment should be
reported in the financial statements.
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 Accounting Changes and Error Corrections
Solution:

Presentation of the depreciation error Calculate the required adjustment for

correction in the financial statement: the depreciation error:

As Jordan is presenting financial $4,500,000 × (1 – 40%) = $2,700,000

information for the current Year 4 only, The $4,500,000 depreciation not
the depreciation error should be recorded in Years 1–3 results in a
reported as an adjustment to retained $2,700,000 adjustment to beginning
earnings net of tax. retained earnings.

Earnings before taxes have been Expense that overstates the net
overstated as a result of the unrecorded income is not recorded. The
depreciation expense. beginning retained earnings are
adjusted downward.
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 Accounting Changes and Error Corrections

Example: Accounting Changes and Error Corrections

Facts: In Year 4, Jordan Manufacturing discovered that depreciation expense was incorrectly calculated in Years
1 and 2. In total, $4,500,000 of depreciation expense was not recorded during these two years.
At the beginning of Year 4, Jordan Manufacturing decided to change inventory methods from the last-in first-out
(LIFO) cost flow assumption to the first-in first-out (FIFO) cost flow assumption. The following information details
the pretax income under LIFO and FIFO for Years 1 through 3.

Pretax Income Under

LIFO FIFO Difference
Year 1 $3,000,000 $3,750,000 $ 750,000 Jordan's tax rate is 40 percent.
Year 2 3,400,000 5,500,000 2,100,000
Year 3 4,100,000 6,250,000 2,150,000
Required:
1. Calculate the required adjustment for the depreciation error and indicate how this correction should be presented
in the financial statements.
2. Calculate the cumulative adjustment for the change in principle and indicate how the adjustment should be
reported in the financial statements.
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 Accounting Changes and Error Corrections
Solution:
The following information details the pretax income
Presentation of the change in accounting under LIFO and FIFO for Years 1 through 3.
principle in the financial statement:
Pretax Income Under
LIFO FIFO Difference
The change in accounting principle (from
LIFO to FIFO) should also be reported as Year 1 $3,000,000 $3,750,000 $ 750,000
an adjustment to retained earnings net of Year 2 3,400,000 5,500,000 2,100,000
tax.
Year 3 4,100,000 6,250,000 2,150,000

Retrospective approach

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 Accounting Changes and Error Corrections
Solution:
The following information details the pretax income
Calculate the cumulative adjustment under LIFO and FIFO for Years 1 through 3.
for the change in principle:
Pretax Income Under
The sum of the increases in pretax LIFO FIFO Difference
income in Years 1–3 as a result of the Year 1 $3,000,000 $3,750,000 $ 750,000
change is $5,000,000
Year 2 3,400,000 5,500,000 2,100,000
($750,000 + $2,100,000 + $2,150,000),
and the net of tax adjustment is: Year 3 4,100,000 6,250,000 2,150,000

$5,000,000 × (1 – 40%) = $3,000,000

• LIFO to FIFO: Change in principle, use
retrospective approach.
• FIFO to LIFO: Change in estimate, use
prospective approach.

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 Accounting Changes and Error Corrections
Solution:
1. Presentation of the depreciation error correction in the
financial statement:
• The depreciation error (prior period adjustment) should be reported
as an adjustment to retained earnings net of tax.
2. Presentation of the change in accounting principle in the
financial statement:
• The change in accounting principle (from LIFO to FIFO) should also be reported
as an adjustment to retained earnings net of tax.
o Calculate the cumulative effect of that change in the accounting principle.

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 Accounting Changes and Error Corrections
Solution:

1. Calculate the required adjustment 2. Calculate the cumulative adjustment

for the depreciation error: for the change in principle:

The $4,500,000 depreciation not The sum of the increases in pretax

recorded in Years 1-3 results in a income in Years 1–3 as a result of the
$2,700,000 adjustment to beginning change is $5,000,000 ($750,000 +
retained earnings: $2,100,000 + $2,150,000), and the net of
tax adjustment is:
$4,500,000 × (1 – 40%) = $2,700,000
$5,000,000 × (1 – 40%) = $3,000,000

Net of tax change to beginning retained earnings = Increase of $300,000

Changes from non-GAAP to GAAP is a specific correction of

an error = Prior period adjustment.
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