Accounting Change and Error Correction Details

Accounting change requires notes accompanying the financial statements. This is essential so that the extent to which an accounting change triggered a difference in the financial reports can be established by the statement's user.

There are three different kinds of Accounting Changes, and these changes can have either positive or negative impacts on various parts of a business like its revenue. They include:

  • Change in Accounting principle - This change is usually made when an organization decides to use a Generally Accepted Accounting Principle (GAAP) that is different from the one they had been using previously. This occurrence is relatively rare because changes in principles don't occur when there are first adoptions of accounting principles caused by transactions occurring for the first time.
  • Change in Account Estimate - This change calculates the carrying amount of a liability or an existing asset (valuation change). The accounting changes for existing or future liabilities and assets on your financial statements will help you develop a better strategy concerning your finances. Estimates mostly changed include personal assets such as land, old inventory, and reserves for uncollectible receivables.
  • Change in Reporting Entity - This results from financial statements that are of a different reporting entity. An example relevant here is changing from individual to integrated reporting or altering the subsidiaries that make up a unit of entities whose results are consolidated. This kind of change is retroactive, meaning it requires the restatement of financial statements.

Error correction: These are mistakes made in previous financial statements. Examples of error correction include; prediction, oversight, misclassification of an expense, and depreciation errors. Accounting errors are retrospective; this means the inclusion of restatements of financials is a must.

Example of Accounting Change and Error Correction

Let's say a corporation appropriately changed its inventory valuation method from LIFO (last in, first out) to FIFO (first in, first out) for financial statements and income tax purposes. The change resulted in an increase of $140,000 in the beginning inventory on January 1, 2011. Assuming a 30 percent tax rate, one should first try to figure out whether the change will decrease or increase the years' net income and if there would be any retained earnings.

One can also analyze the balance sheet. If there is an increase in beginning inventory due to the change, the prior year-end inventory will automatically increase. A balance sheet's left-hand side will never increase without a corresponding increase on the balance sheet's right-hand side (or a reduction somewhere on the left-hand side). The balance sheet's right-hand side increases with more net income (increase in retained earnings) liabilities or a combination of the two.

This means net income would have risen slightly in prior years had FIFO been used. Thus, the 30% tax rate means the government will keep 30% of the income (0.30 multiplied by 140,000 USD). So, the government will receive an income tax of $42,000 (increase), and the retained earnings would be 98,000 USD (an increase) on the 2010 year-end balance sheet comparative.