Spoiler alert: Nobody is perfect. Not even accountants.
While accountants take pride in the accuracy of our work, sometimes we need to make a change. The first step is to determine whether the update is driven by an accounting change or an error, since that affects how financial statements, disclosures and reporting are handled.
The Financial Accounting Standards Board has a dedicated section for accounting changes and error corrections (Accounting Standards Codification 250). It explains how to address special accounting and disclosure circumstances, such as:
Here’s our breakdown:
A change in accounting principle can be mandatory or voluntary. Mandatory changes are required by newly issued Accounting Standard Updates (ASUs); voluntary changes occur when it’s preferable to switch from one generally accepted accounting principle (GAAP) to another.
Preferability is an important hurdle to clear when approving a voluntary change in accounting principle. It requires a great deal of judgement based on the facts and circumstances involved. Of note, the opportunity to save money or taxes is not valid support for preferability. Rather, a change in accounting principle is generally considered for:
Examples of voluntary changes include changes to your inventory valuation method (e.g., from LIFO to FIFO), to the method of amortizing actuarial gains and losses, to the measurement date of an annual goodwill impairment test, or to your depreciation method (e.g., from accelerated to straight-line).
Newly issued ASUs include specific transition and disclosure guidance for the period of adoption. Voluntary changes in accounting principle should always be applied retroactively to the beginning of the earliest period presented in the financial statements. This is so comparative financial statements reflect the application of the principle as if it had always been used.
If you are moving from an accounting principle that is not generally accepted to one that is, your change is defined as an error in the ACS — not a change in accounting principle. As such, follow the guidance for error corrections.
A change in accounting estimate is a change that affects the carrying amount of an existing asset or liability, or that alters the subsequent accounting for existing or future assets or liabilities. Basically, changes in accounting estimates result from new information. Examples could include changes to:
Carefully assess whether the information is truly new information identified in the reporting period or if it corrects inappropriate assumptions or estimates made in prior periods. For example, a change to the allowance for uncollectible receivables to include data that was accidentally omitted from the original estimate or to correct a mathematical or formula error is defined in ASC 250 as a correction of error, rather than a change in estimate. Conversely, a change made to the same allowance in the subsequent period to incorporate updated economic data, like unemployment figures and their impact on customers, would represent a change in estimate, assuming the information was not known or knowable on the balance sheet date.
Apply the effect of the new estimate prospectively by adjusting the current year but not any prior years presented. Disclose the change and use the new estimate moving forward.
If the change in accounting estimate materially affects net income, other appropriate captions or related per share amounts in the current period, those impacts must be disclosed. Materiality is a broadly defined judgement threshold to help you assess what amount would alter the opinion of a reasonable financial statement user. (Read an in-depth analysis of materiality on our site.)
If an error has occurred, it must be reported in the current and prior-year financial statements. Error corrections have three key steps:
An error is corrected through a Little r restatement if it is immaterial to the prior period financials but correcting the error in the current period would materially misstate the current period financial statements. A common example is an immaterial error that went uncorrected for multiple periods and aggregated into a material number within the current year. In this instance, the entity would correct the error in the current year comparative financial statements by adjusting the prior period information and adding a disclosure of the error.
Whenever previously reported financial information changes, clear disclosure of the nature and impact on the financial statements should be included in the footnotes. Column headings do not have to be labeled since the correction is immaterial to prior periods. The auditor’s opinion is generally not revised either because, by definition, the prior-year financial statements were not materially misstated.
If an error is material to the prior period financial statement, then it should be corrected through a Big R restatement. In this case, the entity is required to restate its previously issued financial statements to reflect the correction.