Demystifying Accounting Changes and Error Corrections for the FAR CPA Exam
Kyle Ashcraft, CPA · 2019 CPA Exam Scores · 95 FAR · 98 BEC · 91 REG · 90 AUD
As businesses evolve, their accounting policies and estimates sometimes need to change — and occasionally errors need correcting. Knowing which treatment applies to which situation is a heavily tested area on the FAR section of the CPA exam.
What are the three types of accounting changes?
- Change in accounting principle — switching from one GAAP-acceptable method to another
- Change in accounting estimate — such as revising an asset's useful life
- Change in reporting entity — such as changing which subsidiaries are consolidated
How do you account for a change in accounting principle?
A change in accounting principle is applied retrospectively — prior periods are restated as if the new method had always been used, unless doing so is impracticable.
How do you account for a change in accounting estimate?
A change in accounting estimate is applied prospectively — it affects only the current and future periods. No prior periods are restated.
Example: A company originally estimated a machine would last 10 years, but later revises that estimate to 7 years. No prior periods are adjusted; the new depreciation expense is simply calculated going forward using the machine's remaining book value and the revised remaining life.
What happens when you change a depreciation method?
This is the single most commonly tested exception on this topic. Changing a depreciation, amortization, or depletion method looks like a change in principle — you're switching from one GAAP method to another — but GAAP classifies it as a change in accounting estimate effected by a change in accounting principle, because the two effects can't be separated. That means it's accounted for prospectively, exactly like an ordinary change in estimate: no restatement, no cumulative catch-up entry, no adjustment to beginning retained earnings.
Example: A company has depreciated a $100,000 asset (no salvage value, 5-year useful life) using straight-line for 2 years, recording $20,000 of depreciation each year. Accumulated depreciation is $40,000, leaving a $60,000 remaining book value. The company now switches to double-declining balance. There is no retrospective entry and no restatement — the company simply depreciates the remaining $60,000 book value under the new method over the remaining useful life, starting with the current period.
The company still has to justify the new method as preferable and disclose the change and its effect on net income and EPS — but that's a disclosure requirement, not a retrospective adjustment.
How do you account for a change in reporting entity?
A change in reporting entity — such as changing which subsidiaries get consolidated — is applied retrospectively, restating financial statements for all prior periods presented.
How do you correct an accounting error?
Errors are corrected retrospectively. Since a prior period's revenue and expense accounts have already been closed, the correction is made as a prior-period adjustment directly to the opening balance of retained earnings for the earliest period presented.
Example: In Year 1, revenue was overstated by $10,000 (say, from a fictitious sale that also created a $10,000 receivable that doesn't actually exist). The correcting entry in a later period is:
- Debit Retained Earnings $10,000
- Credit Accounts Receivable $10,000
Debiting Retained Earnings reduces the overstated balance back down to what it should have been; crediting the fictitious receivable removes the asset that never should have been recorded.
What are the common types of errors?
- Mathematical mistakes — miscalculations in the financial statements
- Mistakes in applying GAAP — incorrectly applying an accounting principle
- Oversight or misuse of facts — ignoring or misusing information that was available at the time
Restatement or prospective application — which applies when?
| Treatment | Applies to |
|---|---|
| Restatement (retrospective) | Changes in accounting principle, changes in reporting entity, error corrections |
| Prospective application | Changes in accounting estimate, including a change in depreciation/amortization/depletion method |
What must be disclosed?
Whenever an accounting change or error correction occurs, the entity must disclose the nature of and reason for the change, the method used to apply it, and its effect on financial statement items like income and earnings per share.
The recurring exam trap is the depreciation method change. It looks like a principle change (new GAAP method), but it's treated like an estimate change (prospective, no restatement) because separating the two effects is impracticable.
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Kyle Ashcraft, CPA scored 90 or above on every section of the CPA exam in 2019, including a 95 on FAR. He is the founder and sole instructor of Maxwell CPA Review, a complete CPA review course covering all six sections, where he creates every lecture, textbook and study outline himself.