Which Accounting Change Should Be Applied Prospectively?

EXECUTIVE SUMMARY

Companies have always faced a major issue of how to reflect changes in accounting methods and error corrections in financial statements. In 2005 FASB issued Statement no. 154, Accounting Changes and Error Corrections. The new rules are effective for fiscal years ending after December 15, 2006.

Under Statement no. 154, companies must retrospectively apply all voluntary changes in accounting principle to previous-period financial statements unless doing so is impracticable or FASB mandates another approach. Impracticable means the company is unable to apply the new principle after making every reasonable effort or CPAs cannot document assumptions about management's intent in prior periods or gather necessary estimates for those periods.

The pronouncement includes new rules for changes in depreciation, amortization or depletion methods for long-lived nonfinancial assets. These events are no longer accounted for as a change in accounting principle but rather as a change in accounting estimate affected by a change in accounting principle.

Statement no. 154 has significant implications for auditors, who will have to help clients implement the pronouncement and audit the retrospective applications. This will increase the work auditors perform and in turn increase audit fees. The situation will be even more complex for successor audit firms.

Although the effect on the numbers and on the financial statements is the same, financial statement users may have some difficulty understanding the difference between retrospective applications for changes in principle and retroactive restatements for error corrections.

Jack O. Hall, CPA, PhD, is professor of accounting at Western Kentucky University in Bowling Green. His e-mail address is jack.hall@wku.edu . C. Richard Aldridge, CPA, DBA, is professor of accounting and department chair at Western Kentucky University. His e-mail address is richard.aldridge@wku.edu .

Changes in accounting and financial reporting are inevitable. Most happen because in preparing periodic financial statements, companies must make estimates and judgments to allocate costs and revenues. Other changes arise from management decisions about the appropriate accounting methods for preparing these statements.

When changes are necessary, it's up to CPAs to decide how to reflect them in the financial reporting process. In 2005, FASB revisited the issue and made significant revisions to its guidance on how to treat certain changes. The result was Statement no. 154, Accounting Changes and Error Corrections, which superseded APB Opinion no. 20, Accounting Changes. Statement no. 154 is effective for fiscal years ending after December 15, 2006. This article discusses the changes Statement no. 154 brought about as well as the practical implementation issues companies and their auditors will face.

RETROSPECTIVE PERSPECTIVE
A change in accounting principle results when an entity adopts a generally accepted accounting principle different from the one it used previously. Frequently the entity is able to choose from among two or more acceptable principles. Statement no. 154 adopts a "retrospective" approach to accounting principle changes. It defines retrospective application as applying a "different accounting principle to prior accounting periods as if that principle had always been used." The term also may include the restatement of previously issued financial statements to reflect a change in the reporting entity. The statement defines restatement as revising previously issued financial statements to correct an error.

Under previous guidance, the Accounting Principles Board (APB) was most concerned about a possible dilution of public confidence in financial reporting if companies applied principle changes retroactively and restated prior years' financial statements. The APB opted for a "catch-up," or cumulative effect, approach to reporting most changes; the cumulative effect of a change on prior-year financial statements was reported on the current year's income statement in a manner similar to, but not the same as, an extraordinary item. Opinion no. 20 did not require restatement of prior-year financial statements, but did require presentation of pro forma information.

Under Statement no. 154, all voluntary changes in principle now must be retrospectively applied to previous-period financial statements, unless such application is impracticable or FASB mandates another approach. Impracticable conditions exist if a company is unable to apply the new principle after making every reasonable effort or if CPAs cannot document assumptions about management's intent in the prior periods or gather estimates needed to apply the principle in those periods.

Companies no longer will report a cumulative effect on the current year's income statement. Instead, they will report any necessary adjustment as an adjustment to the opening balance of retained earnings for the earliest period presented. FASB's retrospective approach eliminates all cumulative effect adjustments to current income and should greatly enhance the consistency and comparability of financial information over time and between companies. Since a change in principle is retrospectively applied to prior financial statements, there is a need to present pro forma information.

A CHANGE IN ACCOUNTING PRINCIPLE
Assume ABC Co. decided during 20X6 to adopt the FIFO inventory valuation method. The company had used LIFO for both financial and tax reporting since its inception. However, it maintained records that are adequate for valuing inventories and determining cost of goods sold as if it had applied FIFO in 20X5 and 20X6. ABC made no adjustment to reflect this change in principle in 20X6 or prior years. The company is in the 30% tax bracket. The information in exhibit 1 was determined from the company's records.

Comparison of FIFO and LIFO for Inventory and Cost of Goods Sold Calculations

Date	Inventory valued by:		Cost of goods sold determined by:
	LIFO method	FIFO method	LIFO method	FIFO method
01/01/20X5	$7,200	$ 7,600	—	—
12/31/20X5	$12,250	$16,250	$360,000	$356,400
12/31/20X6	$20,500	$25,500	$390,000	$389,000

Based on these data, ABC needs to make a $5,000 entry on its books to adjust the inventory to the FIFO amount ($25,500 – $20,500). An adjustment to retained earnings will be necessary to account for the effect of the inventory method change on 20X5 net income. The difference in the beginning inventory for 20X5 would cause net income to decrease by $400, while the difference in the 20X5 ending inventory would cause net income to increase by $4,000.

On a pretax basis, 20X5 income would increase by $3,600 and after-tax income would increase $2,520 ($3,600 – (30% x $3,600)). For years before 20X5, there would be a $400 increase in pretax income, for a total pretax adjustment of $4,000 ($3,600 + $400); after taxes the adjustment would be $2,800 ($4,000 – (30%On a pretax basis, 20X5 income would increase by $3,600 and after-tax income would increase $2,520 ($3,600 – (30% x $4,000)). ABC Co. would make the adjusting entry shown below in 20X6 to implement this change in accounting principle.

Inventory		$4,000
	Income taxes payable		$1,200
	Retained earnings		$2,800

Statement no.154 requires that prior financial statements issued for comparative purposes be restated for the direct effects of the change in principle. If ABC reissues its 20X5 statements for comparative purposes with 20X6, it must restate the 20X5 income statement to what it would have been had the company used FIFO. Exhibit 2 shows the original partial income statement for 20X5, while exhibit 3 shows the restated income statement for 20X5 presented for comparative purposes with 20X6.

ABC Co. Original (Partial) Income Statement for 20X5—LIFO For Year Ended December 31

	20X5
Sales	$510,000
Cost of sales:
Beginning inventory	7,200
Purchases	365,050
Goods available for sale	372,250
Ending inventory	12,250
Cost of goods sold	360,000
Gross profit	150,000
Selling, general & administrative expenses	44,000
Income before tax	106,000
Income taxes (30%)	31,800
Net income	$74,200

The opening balance in the 20X6 statement of retained earnings should be adjusted by $2,800 to reflect the change in inventory methods. However, if the company presented a statement of retained earnings for 20X5, the opening balance would be adjusted by $280 ($400 – (30%On a pretax basis, 20X5 income would increase by $3,600 and after-tax income would increase $2,520 ($3,600 – (30% x $400)) for the impact of the change in years before 20X5. If the 20X5 balance sheet was presented for comparative purposes, inventory also would need to be restated to $16,250 to reflect the FIFO inventory valuation.

ABC Co. Comparative (Partial) Income Statement for 20X6 and 20X5—FIFO For Years Ended December 31

	20X6	(Restated) 20X5
Sales	$560,000	$510,000
Cost of sales:
Beginning inventory	16,250	7,600
Purchases	398,250	365,050
Goods available for sale	414,500	372,650
Ending inventory	25,500	16,250
Cost of goods sold	389,000	356,400
Gross profit	171,000	153,600
Selling, general & administrative expenses	48,000	44,000
Income before tax	123,000	109,600
Income taxes (30%)	36,900	32,880
Net income	$86,100	$76,720

Exhibits 4 and 5 illustrate how the company would adjust its retained earnings to reflect a change in inventory methods. Exhibit 4 shows the 20X6 adjustment while exhibit 5 reflects adjustments in comparative statements for 20X6 and 20X5.

ABC Co. Retained Earnings Statement for 20X6 for Year Ended December 31

	20X6
Beginning retained earnings—as previously reported	$125,800
Prior-period adjustment: Change in accounting principle, less tax effect of $1,200	2,800
Beginning retained earnings—adjusted	128,600
Add: Net income	86,100
Ending retained earnings	$214,700

Under Statement no. 154, the required disclosures for a change in principle include a description of the change and the reason for it, as well as an explanation of why the newly adopted principle is preferable. Companies also should describe the prior-period information they retrospectively adjusted and present the effect of the change on income from continuing operations and net income and related per-share amounts for the current period and any prior periods retrospectively adjusted. A company should disclose the cumulative effect of the change on retained earnings as of the earliest period. If retrospective application is impracticable, CPAs should disclose why and describe the alternative method used to report the change.

ABC Co. Comparative Retained Earnings Statements for Years Ended December 31

	20X6	(Restated) 20X5
Beginning retained earnings—as previously reported	$126,600	$51,600
Prior-period adjustment: Change in accounting principle, less tax effect of $120		280
Beginning retained earnings—adjusted	128,600	51,880
Add: Net income	86,100	76,720
Ending retained earnings	$214,700	$128,600

CHANGE IN DEPRECIATION METHOD
Statement no. 154 includes new rules for changes in depreciation, amortization or depletion methods for long-lived, nonfinancial assets. These events no longer are accounted for as a change in accounting principle but rather as a change in accounting estimate affected by a change in accounting principle. As a result, a company will show no cumulative effect of the change on its income statement in the period of change and no retroactive application or restatement of prior periods. Instead, the company allocates any remaining depreciation or amortization over the remaining life of the assets in question using the newly adopted method.

Companies may be more likely to make such changes now that a cumulative effect adjustment is not required in the year of change. The new treatment should improve financial reporting by making it easier for companies to change to a method that better reflects how they consume the future benefits of their assets.

XYZ Co. Depreciation Charges for 20X3—20X6 Double-Declining Balance Method

Year	Cost	Depreciation expense	Accumulated depreciation	Book value at 12/31
At acquisition	$5,000,000			$5,000,000
20x3		$1,250,000	$1,250,000	$3,750,000
20X4		$937,500	$2,187,500	$2,812,500
20X5		$703,125	$2,890,625	$2,109,375

Suppose XYZ Co. decided in 20X6 to change the depreciation method for certain assets to the straight-line method, where previously these assets (with a total cost of $5 million) were depreciated using the double-declining balance method. Acquired in 20X3, the assets have a salvage value of $200,000 and an estimated life of eight years. The company's policy is to take a full year's depreciation in the year of acquisition and none in the year of disposal. To effect this change, its CPA must use the double-declining balance method to determine the depreciation through December 31, 20X5, as shown in exhibit 6 . The revised depreciation per period using the newly adopted straight-line method beginning in 20X6 would be computed as shown in exhibit 7.

ABC Co. Revised Depreciation Charges Straight-Line Method

Book value, 12/31/20X5	$2,109,375
Less: Salvage value	200,000
Remaining depreciation	1,909,375
Remaining life (original life—8 years—less 3 years already used)	÷ 5
Revised depreciation expense per year	$381,875

OTHER ACCOUNTING CHANGES AND ERROR CORRECTIONS
Statement no. 154 does not change the way companies account for and report changes in accounting estimates, changes in the reporting entity or error corrections. The treatments Opinion no. 20 established in 1971 still apply. Changes in accounting estimates are the consequences of periodic presentations of financial statements; they result from future events whose effects cannot be perceived with certainty, such as estimating the useful lives of assets, and therefore require the exercise of judgment. Changes in estimates continue to be accounted for prospectively. CPAs should account for them in (a) the period of change if the change affects only that period or (b) the period of change and future periods if the change affects both. Prior periods are not restated and pro forma amounts are not reported. However, the effect on income from continuing operations, net income and per-share amounts of the current period should be disclosed for any change in estimate that affects several future periods.

A change in the reporting entity is considered a special type of change in accounting principle that produces financial statements that are effectively those of a different reporting entity. Changes in the reporting entity continue to be applied retrospectively. Companies should restate the financial statements of all prior periods presented and must include a description of the nature of the change and the reason for it, as well as the effect on income before extraordinary items, net income and related per-share amounts for all periods that are presented.

Companies still should report the correction of errors in previously issued financial statements as prior-period adjustments, with a restatement of prior-period financial statements. The carrying value of the assets and liabilities should be adjusted for the cumulative effect of the error for periods before the earliest period presented. The beginning balance of retained earnings should be adjusted for the cumulative effect of the error. Disclosures include the effect of the correction on each item in the financial statements and the cumulative effect of the change on retained earnings as of the beginning of the earliest period presented, along with any per-share effects for each prior period presented.

IMPLICATION FOR COMPANIES
Before making a voluntary change in accounting principle, companies and their CPAs should consider the benefits and costs. Calculating the information needed for retrospective application of any change will be more complex than calculating the cumulative effect of a change, since multiple years are involved. As a result, retrospective application will require greater resources and may increase audit fees. In assessing the cost-benefit trade-off of future principle changes, the controller and chief accounting officer of one Fortune 500 company said any improvements from a change in principle probably would not be worth the effort. He questioned the practicality of the new pronouncement and believes there will be fewer voluntary changes as a result of Statement no. 154. However, an audit partner at a national CPA firm disagrees and says if a change would enable a company to better communicate the results of its business to stakeholders, the company should make the change even if costs are higher, especially if it is motivated by a need for capital.

A company wishing to make a change in principle should first apprise its current auditors of the change and have them affirm that the new principle is preferable. If the company has changed auditors, it may need to take a major role in coordinating the efforts between the current (successor) auditor and the previous (predecessor) auditor. This is particularly true for public companies. The company should prepare the current financial statements under the new method and adjust prior-period statements to reflect the newly adopted principle. If the successor auditor plans to audit the adjustments to the prior financial statements, there is no need to contact the predecessor auditor. However, the company may want to involve its previous auditor since it may be more efficient and cost-effective for the predecessor to audit the adjustments. Smaller companies without in-house expertise likely will rely more heavily on their outside auditors to help them implement any change in principle.

IMPLICATIONS FOR AUDITORS
Statement no. 154 has significant implications for auditors, who soon will be helping clients implement it and auditing the retrospective applications. This will increase the audit work to be performed, since auditors will have to audit the adjustments to the prior financial statements. The increase in audit time is expected to moderately increase audit fees, particularly if a reaudit of prior-period financial statements is necessary.

Successor auditors face even greater complications. The PCAOB addressed many of these complications in its June 9, 2006, Q&A, Adjustments to Prior Period Financial Statements Audited by a Predecessor Auditor. In it the PCAOB says adjustments to prior-period statements due to changes in principles and error corrections can be audited by either the successor or predecessor auditor, but an audit of the adjustments by the predecessor auditor may be more cost-effective.

One large-firm audit partner we spoke with could not envision many situations in which the successor auditor would be in a better position than the predecessor to audit either retrospective applications of principles or restatements of errors. However, another audit partner who works primarily with private companies said nonpublic companies likely will look to the successor auditor to audit their retrospective adjustments for changes in principle. In private companies it is rare for the predecessor to be involved in error corrections in any significant way.

If the predecessor auditor audits the adjustment to the prior statements, the PCAOB says the reissued audit report should be dual-dated to avoid any suggestion the auditor examined records, transactions or events after that date. An audit by the predecessor auditor, however, does not relieve the successor of all responsibilities related to the adjustments. Since error corrections and changes in principles often affect the timing of when transactions and events are recognized in financial statements, the successor should obtain an understanding of prior statement adjustments. The successor auditor also is responsible for evaluating the preferability of the new principle and consistent period-to-period application. As a result it might be more efficient for the successor auditor to audit the resulting retrospective applications.

The PCAOB Q&A lists three factors a successor auditor might consider in deciding to audit only the adjustments to the prior-period financial statements or whether a reaudit of the prior financial statements is necessary.

The more extensive and pervasive the adjustments, the more likely the successor auditor should perform a reaudit.

Adjustments related to error corrections (retroactive restatements) justify a reaudit more often than adjustments related to a change in principle (retrospective applications). With error corrections, the successor auditor should consider the risks there might be other, undetected misstatements; adjustments related to intentional errors would particularly suggest the need for a reaudit.

When the predecessor auditor is less cooperative and responsive to questions and limits access to the prior audit's documentation, a reaudit likely is required.

It's highly unlikely the successor auditor would audit the adjustments for an error correction without a reaudit. One partner told us he had seen situations where the predecessor had little reason to consent to reissuing the report on the prior financial statements, thereby forcing the successor to reaudit.

When the successor auditor audits only the adjustments related to a change in principle or error correction, the limited nature of the audit work should be clearly disclosed. The successor's report should state that he or she is not providing any assurance on the prior financial statements as a whole. With regard to error corrections, questions may arise as to whether the predecessor auditor may reissue a report on the prior statements. The PCAOB says the report may be reissued if the predecessor determines the prior-period statement reports are still appropriate, except for the error correction. In deciding whether the prior statements are still appropriate, the predecessor auditor should consider the nature and extent of the adjustments, whether management has withdrawn the prior statements and whether the errors were intentional.

Even if the successor audits the adjustments, the predecessor should do additional work before reissuing the report on prior-period financial statements, including reading the current-period financial statements, comparing the adjusted prior-period statements with those originally issued with the report and obtaining representation letters from both the company and the successor auditor.

If the successor audits the adjustments, the predecessor's reissued report on the prior financial statements should be modified to clearly show the reissued opinion applies only to the prior statements before adjustment and that the predecessor auditor has not audited the adjustments. The predecessor's reissued report should carry the same date as the original audit report to avoid any implications the predecessor auditor was involved with the adjustments.

IMPLICATIONS FOR FINANCIAL STATEMENT USERS
Statement no. 154 also has consequences for financial statement users. Under Opinion no. 20, knowledgeable readers understood the difference between a change in principle and how it was accounted for and an error correction and how it was accounted for, principally by the location in the financial statements and through disclosures. With both adjustments now made to equity, financial statement readers may be confused—that is, they may interpret a change in principle as an error correction and view the restatement negatively. Although the effect on the numbers and financial statements is the same, it will take time for financial statement users to understand the difference between retrospective applications for changes in principle and retroactive restatements for error corrections. Initially, companies and their auditors may need to carefully explain in footnote disclosures the exact nature of the circumstances necessitating the change.

Since the numbers and treatments for changes in principles and error corrections now will look much the same, except for the disclosures, there also is the potential that financial statement preparers may misapply Statement no. 154 by showing an error correction as a change in principle. With both adjustments now going to retained earnings, preparers might try—intentionally or unintentionally—to mask an error correction as a voluntary change in principle. Such misapplications would mislead financial statement readers, since error corrections usually raise concerns, while most readers view principle changes as a good thing. Preparers and auditors should be familiar with the differences between changes in principle and error corrections. Auditors in particular need to understand the potential for misapplications and carefully review the nature of the restatements and related disclosures.

When considering whether to make a voluntary change in accounting principle under Statement no. 154, make sure the benefits outweigh the costs. However, if a change better communicates financial results to stakeholders, a change may be justified even if it increases costs.

Before making a change in accounting principle, apprise the company's current auditors of the change and have them affirm that the new principle is preferable to the old one.

Because of the sometimes difficult relations between successor and predecessor auditors, CPAs at companies that have changed auditors should take the lead in coordinating efforts to implement a change in accounting principle or correct an error.

REPORTING CONSISTENCY
In issuing Statement no. 154, FASB appears to have rejected the APB's concern that the retrospective application and restatement of previously issued financial statements might erode investor confidence in financial reporting. Instead, FASB seems more concerned about the consistency between accounting periods and the comparability of financial statements among different companies. FASB said the improved consistency and comparability would enhance the usefulness of financial information by facilitating the analysis and understanding of more comparative accounting data.

Consistency and comparability in cross-border financial reporting also were significant factors in FASB's decision to change the reporting of accounting changes. FASB and the IASB identified accounting for changes under Opinion no. 20 as one area that could be improved and brought into agreement with international standards. Statement no. 154 brings U.S. standards into compliance with IAS 8, Accounting Policies, Changes in Estimates and Errors, and is a positive move toward the development of a single set of high-quality global accounting standards.