Demystifying Accounting Changes and Error Corrections for the FAR CPA Exam

Introduction

As businesses evolve, so too do their accounting policies and estimates. Occasionally, these changes necessitate revisions in the financial statements. Furthermore, errors can happen, requiring corrections. Given its prominence in the Financial Accounting and Reporting (FAR) section of the CPA exam, understanding how to account for these changes and corrections is critical.

Types of Accounting Changes

There are three primary types of accounting changes:

1. Change in Accounting Principle: From one generally accepted accounting principle to another.
2. Change in Accounting Estimate: Such as a change in the useful life of an asset.
3. Change in Reporting Entity: When the entity being reported changes, such as from a parent company to a subsidiary.

Accounting for Changes in Accounting Principles

When a change in accounting principle occurs, the entity must retrospectively apply the new accounting principle to all prior periods, unless it’s impracticable.

Example 1: Changing Depreciation Method

Suppose a company initially used the straight-line method for an asset worth $100,000 with a useful life of 5 years. After 2 years, the company switches to the double declining balance method.

Journal Entry for Recalculation: Debit Accumulated Depreciation $40,000 Credit Retained Earnings $40,000

Accounting for Changes in Estimates

These are accounted for prospectively, meaning the change affects only the period of change and future periods.

Example 2: Change in the Useful Life of an Asset

The company initially thought a machine would last 10 years but later revised its estimate to 7 years. No prior periods are adjusted. New depreciation expense is calculated based on the new useful life.

Accounting for Changes in Reporting Entity

Changes in the reporting entity are applied retrospectively by restating financial statements for all prior periods presented.

Accounting for Error Corrections

Errors should be corrected retrospectively by restating the affected financial statements.

Example 3: Correction of an Overstatement in Revenue

In Year 1, revenue was overstated by $10,000. Journal Entry to Correct Error: Debit Revenue $10,000 Credit Retained Earnings $10,000

Examples of Error Types

1. Mathematical Mistakes: Miscalculations in financial statements.
2. Mistakes in Application of GAAP: Incorrectly applying accounting principles.
3. Oversight or Misuse of Facts: Ignoring or misusing relevant information.

Restatement vs. Prospective Application

1. Restatement: Past financial statements are revised. Suitable for changes in principles and error corrections.

2. Prospective Application: The change is implemented from the current period onward. Suitable for changes in estimates.

Disclosures

When accounting changes or error corrections are made, it’s imperative to disclose the nature and reason for the change, the method of applying the change, and its effects on financial items like income and EPS.