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Accounting Changes and Restatements, Financial Statement Notes, and Non-G A A P Metrics

Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 5

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Learning Objectives After studying this chapter, you will understand:

How to report a change in accounting principle, accounting estimate, and accounting entity.

How error corrections and restatements are reported.

The information provided in notes to the financial statements on significant accounting policies, subsequent events, and related-party transactions.

What are typical non-G A A P performance metrics and what disclosures are required when they are presented.

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Reporting Accounting Changes

Consistency:

Means using the same accounting methods to describe similar economic events from period to period.

Enhances decision usefulness by allowing users to identify trends or turning points in a company’s performance over time.

Changing accounting methods:

Firms sometimes voluntarily switch accounting methods or revise estimates because the alternative method or estimate better reflects the firm’s underlying economics.

Accounting standards-setting bodies frequently issue new standards requiring companies to change accounting methods (mandatory).

When firms change accounting methods, it raises questions about transition methods.

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Types of Accounting Changes

EXHIBIT 5.1 Types of Accounting Changes

*Under U.S. G A A P, a change in depreciation methods is treated as a change in estimate that is achieved by a change in accounting principle.

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Change in Accounting Principle 1

A change in accounting principle occurs when:

A firm voluntarily changes from one principle to another, or

Accounting standards are revised required a new method.

U.S. G A A P requires firms to use the retrospective approach (unless it is impracticable to do so or a new standard specifies some other transition method).

Prior years’ financial statements are revised to reflect the impact of the accounting principle change (as if the new principle had been used since the company’s inception).

A journal entry is made to adjust all account balance sheet accounts as of the beginning of the current year to what their balances would have been had the new method always been used.

The entry typically requires an adjustment to the firm’s beginning Retained earnings balance to reflect the cumulative effect of the accounting principle change on all prior periods’ reported income.

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Change in Accounting Principle 2

In some cases, it is impracticable to apply a change in accounting principle retrospectively. In such cases, the cumulative effect approach is permitted. This approach may also be required with certain new accounting standards.

The balance sheet as of the first day of the year the change is adjusted to what it would have been had the firm always used the new method.

No prior-period financial statements are restated.

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Change in Accounting Estimate

Estimates are used extensively in accounting:

Uncollectible receivables.

Inventory obsolescence.

Service lives and salvage values of depreciable assets.

Warranty obligations.

Changes in accounting estimates come about because new information indicates the previous estimate is no longer valid.

When accounting estimates are changed, prior year income is never adjusted.

Prospective approach – Instead, the income effects of the changed estimate are accounted for in the period of the change and in future periods if the change affects both.

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Change in Estimate Effected by Change in Principle

In some cases, a change in accounting estimate results from a change in accounting principle.

Changes in accounting estimates that result from a change in accounting principle are accounted for as a change in estimate.

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Change in Reporting Entity

A change in reporting entity occurs when the entities comprised by the financial statements change:

Consolidated or combined statements are replacing statements of individual entities

There is a change in the subsidiaries to be consolidated or combined

A business combination accounted for under the acquisition method is specifically excluded from the definition of a change in reporting entity.

Requirements:

When a change in reporting entity occurs, comparative financial statements for prior years must be restated to reflect the new reporting entity as if it had been in existence during all the years presented.

The effect of the change on income, net income, other comprehensive income, and any related per share amounts are disclosed for all periods presented.

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Disclosure of the Expected Financial Statement Effects of Recently Issued Accounting Standards

S A B 74 requires extensive disclosures about the financial statement effects of adopting a new standard. These include:

A brief description of the new standard and adoption date

Methods of adoption allowed and the method company intends to use.

Discussion of the impact that adoption will have on the financial statements of the company.

Disclosure of potential impact of other significant matters that may result due to adoption.

S A B 74 disclosures are useful because they provide information about how new standards will change reported amounts so that forecasts can be compared to historical numbers using the same accounting methods.

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Accounting Errors and Irregularities

Accounting errors and “irregularities” can occur for several reasons:

Simple oversight.

Misapplication of G A A P (especially where judgment is required).

Intentional attempts to exploit the flexibility in G A A P.

Outright financial fraud.

Several parties are charged with discovering accounting errors and irregularities:

The company’s internal audit staff and audit committee.

External auditors.

S E C staff surveillance of filings.

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Prior Period Adjustments

Once discovered, accounting errors and irregularities must be corrected and disclosed.

Material errors discovered after the year in which the error is made are corrected through a prior period adjustment.

This adjustment results in a change to the beginning Retained earnings balance (for the year the error is detected) and correction of related asset or liability balances.

Previous years’ financial statements that are presented for comparative purposes are retroactively restated to reflect the specific accounts that are corrected.

The impact of the error on current and prior period reported net income is disclosed in the notes to the financial statements.

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Reissuance & Revision Restatements

A Reissuance Restatement – “Big R” is one where the error is so significant that investors must be alerted promptly when the error is discovered and that they should no longer rely on previously issued financial statements.

Firms must disclose the existence of the errors through a Form 8-K within four days of discovery.

A Revision Restatement – “Little R” is less severe and does not trigger the requirement of an 8-K filing because the financial statements are still reliable.

The financial statements are corrected in the next quarterly or annual report.

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Notes to Financial Statements

Notes are an integral part of companies’ financial reports.

Allow financial statement users to more thoroughly understand and interpret the numbers presented in the body of the financial statements.

Three important notes that are typically found in companies’ financial reports:

Summary of significant accounting policies.

Disclosure of important subsequent events.

Related-party transactions.

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Summary of Significant Accounting Policies

Management is often free to choose from equally acceptable alternative accounting methods.

The Summary of Significant Accounting Policies note explains the important accounting choices the reporting entity uses to account for selected transactions and accounts.

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Subsequent Events

Events or transactions that have a significant effect on a company’s financial position or results of operations sometimes occur after the close of its fiscal year-end but before the financial statements are issued.

Disclosure of these subsequent events is required if they are material and are likely to influence investors’ appraisal of the risk and return prospects of the reporting entity.

Examples include:

Loss of a major customer.

A business combination.

Issuance of debt or equity securities.

A catastrophic loss.

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Related-Party Transactions

A related-party transaction occurs when a company enters into a transaction with individuals or other businesses that are in some way connected to its management or board of directors.

Disclosure is required in a financial statement note to include

A description of the transaction,

The dollar amounts involved, and

The nature of the relationships.

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Non-G A A P Metrics

Many companies provide supplemental disclosures of non-G A A P financial metrics.

Common examples include:

Earnings before interest, taxes, depreciation, and amortization (E B I T D A).

Earnings excluding share-based compensation expense.

Earnings before restructuring charges.

Firms are permitted to present non-G A A P metrics as long as they are not given greater prominence than G A A P disclosures, are reconciled to the closest comparable G A A P metric, and are not misleading.

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Summary 1

The transition method for a change in accounting principles is most often retrospective, meaning prior financial statements are recast as if the company had always used the method to which it is changing. However, sometimes that approach is not practical or a new standard calls for a different transition method, such as a cumulative effect adjustment.

Retrospective treatment facilitates the analysis of a company’s performance over time.

Once discovered, accounting errors or irregularities must be corrected and disclosed through a restatement.

Particularly serious errors require immediate notification through an S E C filing warning financial statement users not to continue relying on the previously issued financial statements.

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Summary 2

Non-G A A P metrics are measures of performance or financial condition that are not amounts defined by G A A P, either because the exclude certain items from, say, a measure of income, or they define an amount differently than how it is defined under G A A P. Firms are permitted to provide non-G A A P metrics as long as they are not misleading, they are not presented any more prominently than G A A P measures in the financial reports, and for every non-G A A P metric presented, a reconciliation between it and the closet G A A P metric is also provided.

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