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Accounting Changes – What They Are and The Impacts for Financial and Taxes
Raymond Arseneau
ACCT 302 – Intermediate Accounting II
Dr. Julie Wallace
December 10, 2023
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Introduction
Accounting changes in estimates or due to errors committed in posting can be complex in
mechanics and can be complex in ethical decisions. These changes due to changes in reporting or
due to errors will arise after the fiscal period has been completed and involves returning to the
prior period to make changes or can be changed going forward.
For the accounting changes there are three types of accounting changes. These changes
are a change in accounting principle, change in accounting estimate, and change in reporting
entity. A change in accounting principle is a change from one generally accepted accounting
principle to another. Examples of this would be changing methods of inventory costing or cost
method of equity method. A change in accounting estimate would be revising an estimate
because of new information or new experience. Examples of change in accounting estimate
would be change of depreciation method, change in estimated useful life of a depreciable asset,
or change in estimate of residual value of depreciable asset. A change in reporting entity is a
change of reporting as one type of entity to another type of entity. Examples of change in
reporting entity would be consolidating a subsidiary not previously included in consolidated
statements or report consolidated financial statements in place of individual statements
(Spiceland et al, 2023).
Some of these changes can be very simple and not take too much to explain or make too
many changes in the reporting. These types of changes usually are made going forward. These
changes will not require the restatement of financial statements or changes in the past. But there
are some changes that require a lot of documentation and explanation in disclosure notes. All
changes will require a restatement of financial statements of years that are affected in the past.
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Another type of change that usually is usually not counted into the types of accounting
changes is error correction. This type of change usually has an unexpected change to both the
financial reporting and the tax reporting. Examples of error correction are mathematical
mistakes, inaccurate inventory counts, a change from cash basis to accrual basis accounting and
incorrect account usage.
Approaches to reporting accounting changes and error corrections
There are three approaches that are used in reporting accounting changes and error
corrections. These approaches are retrospective approach, modified retrospective approach, and
prospective approach.
The retrospective approach will make changes to the financial statements prior to the
change and reflect the impact of change in comparative financial statements. Each year that is
affected by the change will be restated with the corresponding changes. There are journal entries
created to make the appropriate changes.
The modified retrospective approach will only make the change to current fiscal period.
There is an adjustment to balance of retained earnings at the beginning of the period. This
approach will not restate the financial statements for the affected previous periods. This method
will make it more difficult to see how these changes effect the previous periods.
The final approach is the prospective approach. In this approach there is not a change in
previous periods or will not have an adjustment entry to retained earnings for the beginning of
the current period to show the change. This approach will have the company just make the
appropriate changes to their accounting going forward. There will not be a method to see how the
changes would affect the previous periods.
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Different methods of showing accounting changes
When making accounting changes there are different methods of displaying the changes.
When making changes or correcting errors, a common result depending on the approach will be
making adjusting entries that will call for a restatement of financial statements. These
restatements of financial statements can affect investors and how they view the company and
their methods of accounting. When restating financial statements, there can be a change in the
financial position of the company. The company can either become less or more profitable
depending on the change.
A bigger result of an accounting change is necessity of a disclosure note in their financial
statements. This disclosure note will be the explanation of how the change was made and why
the change was made. Disclosure notes can be a very important snapshot into the company and
their accounting department train of thought of how to handle their financial information.
Reasons for making accounting changes
There can be many reasons on why there are changes in the accounting information. The
most common changes are due to a company changing principles due to changes in how similar
companies are accounting for different categories. A common change would be if a company
category collectively changes the method of accounting for inventory. This can be company
changing from the FIFO method to a LIFO method due any variety of reasons. There may have
been a shift in purchasing and how much inventory is on hand. A company can change from
wanting to have a lot in stock to wanting to barely keep much extra inventory.
Another reason that a company might make a change in their accounting method that
would require a change in their financial information is if the company makes a change that
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would be able to show a company is more profitable for investors and stakeholders. Sometimes
when a company is having a downturn in their business, to try and keep their investors and
stakeholders invested changes in accounting methods will take the same financial information
and restate it in a more positive light. This can be as easy of changing when the company
recognizes revenue. This kind of change will not require a restatement of financial statements,
but would require a disclosure note. This disclosure note would have information of what method
the company is changing to and the reason of why the company is changing the recognition
method.
The most important reason to make an accounting change is that there has been a change
in GAAP or ISAF that would require a change in how the company reports a type of information.
These changes do happen from time to time and it usually depend on the business environment.
According to the BDO website, any new stated Accounting Standard Updates would include a
specific transition and disclosure guidance for the period of adoption (Austin et al, 2020).
According to an article in Contemporary Accounting Research, accrual accounting is
based on estimates, and their subsequent change or revision is inevitable and even desirable as
new information emerges (Chung et al, 2021). Changes are always happening as estimates
change. Estimates usually happen centering around changes in depreciable assets. Their residual
value may change as values of assets change. The useful life of a depreciable asset might change
due to how much use the asset is enduring. A prime example is that a plant starts out as an
operation that only utilizes two shifts, but as business picks up and the plant starts to fall behind
in orders. Then the plant might decide to change to having three operating shifts. The plant might
find this method to stay on time with production and maybe even be able to work ahead and
build up stock for certain items to battle against rush or priority orders. This extra time on the
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assets might create more wear and tear on the item. Then management notices that more
maintenance is required for the asset. This will trigger a management decision that the asset
might need to have their useful life adjusted to ensure that full depreciation is utilized for the
asset before having to replace or upgrade the depreciable asset. This change would trigger an
accounting change in depreciation.
According to an article in the Journal of Business Finance & Accounting, there is mixed
evidence that estimate changes are strategically motivated to change the financial position of a
company (Beaulieu et al, 2022). I can understand when companies change estimates to be
financial beneficial for accounting advantage. Companies will change estimates so that they
appear to be financial healthier than they are. I could see this as a method of trying to attract
more investors if the company is needing capital to make improvements or upgrades and their
profitability is decreasing. Changing the company’s method of recognizing revenues or how they
account for inventory or how assets are depreciated can be a way to improve cash flow or net
income.
Errors in accounting
Errors can be a driving force of processing accounting changes. Usually through auditing,
errors are detected and must be dealt with to pass an audit. In an article concerning errors in
accounting, the article states that errors are inherent to accounting, and accountants must address
them (Christensen, 2010). Errors in accounting can facilitate restating of financial statements and
having to write disclosure notes to explain the errors. Errors are easy enough to make with
incorrect entry or mislabeling accounts or misinterpreting if an entry should be a liability or an
expense. But the main issue is that once the error has been identified the error has to be adjusted
to the correct information.
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The true issue with errors is when the error is not blatant and could pass through an audit,
but is discovered by the company. Ethical issues can arise from this practice and how to report
and correct the error. A lot of discissions that happens in accounting can be determined by the
ethical manner to proceed.
Errors in accounting entries and on financial statements can affect the financial standing
of the company as reported to the Securities Exchange Commission (SEC), stakeholders, and
investors.
Ethical ramifications of accounting changes and errors
The ethical dilemma of reporting changes and errors can be a very tricky proposition. The
ethical manner is to report all changes and errors because there must be full transparency for a
company. How can anyone ever trust a company if they are not transparent? How can a potential
investor trust a new company if you cannot look at the company’s financial statements and have
questions if the statements are correct or more importantly truthful?
Accounting firms like Enron and Arthur Anderson have brought these ethical questions to
forefront and the believability of financial statements produced by their companies. More and
more in the news there is news about individuals and corporations that will make changes to their
financial statements to gain favorable results. The results could result in more working capital for
their company or larger bonuses for executives. The changes could result in a more favorable
insurance policy for an asset or property.
If an error is found, but the error could potentially change the future of the company. The
error might show that the company is not as profitable as once thought or may not have the
capital to pursue the big expansion that was help the company get over the hump. If the errors
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are made public, then the public perception of the company could be tarnished and investors
could pull their investments or pull their support for expansion. The errors could place a
company in the crosshairs of politicians wanting to make changes to code or reporting
requirements.
If an error is discovered in the journal entries after dividends are declared that might
influence net income for a company that could substantially alter the dividends to be received by
stockholders, there would be a group of stockholders that will require an explanation and change
in company procedures to ensure that the error is not made again. So, after an event like this
there might be an ethical decision in the future on reporting errors by the company. Would a
company want to always be questioned if their statements are correct?
Income tax returns effects due to accounting changes and errors
As an individual that prepared income taxes, I can definitely testify to how errors can
effect a tax return. When I preparing taxes, I always had a percentage of clients that would be so
anxious to prepare their tax return that they would forget about a W-2 that they would require to
complete an income tax return. People would also not bring in all their documentation because of
believing that the income tax form they received was important and did not need to be reported
on their income tax return. When people that operated businesses would come in to prepare their
income tax returns, there were always people that would submit and have their income tax
returns accepted and then find a box full of receipts that needed to be reported for their return.
The good item that the Internal Revenue Service (IRS) came up with for situations like this was
the amended tax return.
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Some of the rules concerning the amended tax return is that the income tax return in
question would have to been accepted already. Then the other requirement is that income tax
return in question could not be over three years old. The amended tax returns are not just for
individuals. The amended tax return can be filed by corporations and non-profit organizations.
The amended tax return for corporations, non-profit organizations and individuals with
businesses can amend past tax returns if there is an accounting change that needs to be reported
like changes concerning depreciable assets, inventory reporting or revenue recognition.
With the amended tax return, the form is different because the form will have a column to
illustrate the original return and what was reported on the original income tax return. Then the
next column would represent the changes that are being made. The final column is the new
amounts after the change or error is corrected. This column illustrates to the IRS what the correct
return should have looked like. There is also a section on the return that allows the taxpayer to
describe the changes that were made and why the changes were made. Then when the IRS
receives the amended tax return, the IRS would need to accept the changes and either issue a
refund in the amount of the change or send a letter stating the amount due that includes penalties
and interest for filing an incorrect income tax return.
So, when pertaining to an income tax return, accounting changes and errors can have
profound affects on the taxpayer or corporation.
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Reference page
Austin, P., Brown, A., Kviz, T., & Tower, C. (2020). Accounting changes and error corrections.
www.bdo.com/insights/assurance/financial-reporting-guide-for-accounting-changes-and-
error-corrections
Beaulieu, P., Hayes, L., & Timoshenko, L. M. (2023). Changes in accounting estimates; An
update of priors or an earnings management strategy of “last resort”? Journal of Business
Finance & Accounting, 50(3-4), 622-659. https://doi.org/10.1111.jbfa.12644
Christensen, J. (2010). Accounting errors and errors of accounting. The Accounting Review,
85(6), 1827-1838. https://doi.org/10.2308/accr.2010.85.6.1827
Chung, P. K., Geiger, M. A., Paik, D. G., & Rabe, C. (2022). Do firms time changes in
accounting estimates to manage earnings? Contemporary Accounting Research, 39(2),
917-946. https://doi.org/10.1111/1911-3846.12741
Spiceland, J. D., et al. (2003).HIntermediate AccountingH(11th ed.). McGraw Hill.
https://learning.mheducation.com/static/awd/index.html?_t=1698344689198#/
