Issues in accounting: accounting changes & error corrections: SFAS No. 154 has some new rules for accounting changes and error corrections. Briefly, it requires retroactive application of such events. However, the revised standard could lead certain firms to violate their debt covenants

RMA Journal, The, Sept, 2005 by Alan Reinstein

In May 2005, the Financial Accounting Standards Board (FASB) issued Statement No. 154, Accounting Changes and Error Corrections. (1) SFAS No. 154 applies to all voluntary changes in accounting principles. Entities should now retrospectively apply to prior periods' financial statements voluntary changes in an accounting principle wherever practicable.

Accounting Principles Board (APB) Opinion 20 had required entities to recognize most such changes of accounting principles in net income of the period of the change and to show the cumulative effect of such changes to the new accounting principle. SFAS No. 154, which enhances the consistency of financial information between periods, results largely from the FASB's work with the International Accounting Standards Board to develop a single set of high-quality, comparable accounting standards to help improve cross-border financial reporting.

While correcting an error in prior financial statements is not an accounting change, reporting of error corrections involves adjusting previously issued statements, which formerly were reported as retrospective accounting changes. SFAS No. 154 requires accounting for changes in methods of depreciation, amortization, or depletion for long-lived, nonfinancial assets as a change in accounting estimate affected by a change in an accounting principle. APB 20 had required reporting such events as changes of accounting principles; to simplify this implementation, SFAS No. 154 completely replaces APB 20 and SFAS No. 3 by carrying forward (without change) many of these former provisions, including reporting changes in accounting estimates, changes in the reporting entity, corrections of an error, and justifications for changing an accounting principle on the grounds that it is preferable, as well as SFAS No. 3 provisions relating to accounting changes and error corrections in interim financial statements.

Determining Impracticability

Retrospective application is deemed impracticable if its effects cannot be determined, if it assumes (rather than independently substantiates) management's intent in a prior period, or if it assumes significant, unverifiable prior-period estimates. Entities also should make every reasonable effort to apply retrospective changes before calling such effects indeterminable.

If the cumulative effect of the change in an accounting principle is determinable but impracticable to ascertain the specific effects of an accounting change in any presented prior period, entities should apply the change in accounting policy to the balances of assets and liabilities as of the start of the earliest period for which retrospective application is practicable. They also should adjust the opening balance of that period's retained earnings or other components of equity, such as accumulated other comprehensive income. If it is impracticable to determine the cumulative effect of applying a change in an accounting principle, they should disclose the method used to report the change and show why retrospective application is impracticable.

Changes in Depreciation

Methods

SFAS No. 154 requires accounting for changes in depreciation method as a change in estimate, not as a change in accounting principle (as required under APB 20). But, since a principle is involved, changes in depreciation methods become changes in estimate "inseparable" from a change in principle whose preferability must be justified. Thus, entities should account and justify (for example, citing new economic conditions) changing from an accelerated to the straight-line method of depreciation similar to changes in estimated useful life or salvage value.

Retrospective Application

Entities should record the effects of retrospectively applying voluntary changes in accounting principles that alter current or future cash flows only in the period of the voluntary change. They should exclude interactions between changes in accounting principle and contractual obligations that can cause such "indirect effects" of retrospective application. For example, if an entity must make profit-sharing payments based on prorata net income, retrospectively applying voluntary changes in accounting principle increases net income over prior years' payments. If the plan requires paying accrued balances, it should expense the indirect effect in the period of the voluntary change and not as a prior-period financial statement adjustment. The plan's financial statement notes would disclose the amount of any indirect effects recorded in the period of the change, noting the part attributable to each prior period presented if determining the amounts is practicable. If the plan did not require paying the incremental amount but it still decided to pay it, similar accounting and disclosures would occur.

Disclosures of Restatements

SFAS No. 154 distinguishes between retrospective application for changes in accounting principle and restatement for correction of an error. Restated financial statements to correct errors should disclose the nature of the error. Entities also should disclose 1) the effect of the correction on each financial-statement line item and any per-share amounts affected for the current period and all prior periods presented; 2) the cumulative effect of the restatement on retained earnings or other components of equity as of the beginning of the earliest period presented; and 3) a statement that previously issued information were restated. They also should carefully disclose the reason for the restatement because SFAS No. 154 will likely increase the number of retrospectively applied accounting changes and error corrections.