Changes in Accounting Principles
Firms occasionally change the accounting principles used to generate financial statements. Sometimes standard setters mandate the changes. Regardless of the source of the change, firms following U.S. GAAP must report amounts for the current and prior years as if the new accounting principle had been applied all along (termed retrospective treatment). The rationale for this reporting is that it results in net income amounts for the current and prior periods measured using the same accounting principles the firm intends to use in future periods, thereby enhancing the information content of reported earnings in forecasting future earnings. This treatment is in line with IFRS
Firms need not restate prior-year earnings retrospectively if it is impracticable to determine the period-specific effects of the change or the cumulative effect of the change. In this case, firms must apply the new accounting policy to the balances of assets and liabilities as of the earliest period for which retrospective application is practicable and to make a corresponding adjustment to retained earnings for that period. When it is impracticable for an entity to determine the cumulative effect of applying a change in accounting principle to all prior periods to which it relates, firms must apply the new accounting principle as if it were made prospectively from the start of the year of the change.
For example, if a firm switches from the FIFO cost-flow assumption to the LIFO cost-flow assumption for inventories and cost of goods sold, typically it is impracticable to reconstruct the effects of the accounting change on prior years. In this case, the change to the LIFO cost-flow assumption will be applied prospectively (that is, in current and future years) at the start of the year in which the accounting change takes place
Firms may choose retrospective treatment on a voluntary basis as well. For example, Exhibit 6.9 presents Apple Inc.’s Form 10-K/A to amend its 2009 Form 10-K. In the amendment, Apple explains the financial statement effects when it applied new required accounting methods to account for the iPhone and Apple TV. Prior accounting methods required Apple to defer all revenues and expenses related to sales of iPhone and Apple TV and recognize these revenues and expenses on a straight-line basis over the expected product life because Apple had promised the possibility of free future upgrades and features. The justification for deferral is typically that revenue has not been earned. New standards require Apple to recognize revenue and expenses relating to existing delivered hardware and software at the time of sale and to defer the estimated fair value of the right to receive free future upgrades and features. Apple had a choice of applying the new standards prospectively (in current and future periods) or retrospectively (adjust prior years’ results and then use the new standard in current and future periods) Apple chose retrospective application to enhance comparability. Note the huge amounts involved. Adoption of the new standards increased Apple’s revenue by $6.4 billion in 2009, $5.0 billion in 2008, and $483 million in 2007.
Changes in Accounting Estimates
Examples include the amount of uncollectible accounts receivable, the useful lives for fixed assets and intangible assets, the percentage-of-completion
Firms occasionally change the accounting principles used to generate financial statements. Sometimes standard setters mandate the changes. Regardless of the source of the change, firms following U.S. GAAP must report amounts for the current and prior years as if the new accounting principle had been applied all along (termed retrospective treatment). The rationale for this reporting is that it results in net income amounts for the current and prior periods measured using the same accounting principles the firm intends to use in future periods, thereby enhancing the information content of reported earnings in forecasting future earnings. This treatment is in line with IFRS
Firms need not restate prior-year earnings retrospectively if it is impracticable to determine the period-specific effects of the change or the cumulative effect of the change. In this case, firms must apply the new accounting policy to the balances of assets and liabilities as of the earliest period for which retrospective application is practicable and to make a corresponding adjustment to retained earnings for that period. When it is impracticable for an entity to determine the cumulative effect of applying a change in accounting principle to all prior periods to which it relates, firms must apply the new accounting principle as if it were made prospectively from the start of the year of the change.
For example, if a firm switches from the FIFO cost-flow assumption to the LIFO cost-flow assumption for inventories and cost of goods sold, typically it is impracticable to reconstruct the effects of the accounting change on prior years. In this case, the change to the LIFO cost-flow assumption will be applied prospectively (that is, in current and future years) at the start of the year in which the accounting change takes place
Firms may choose retrospective treatment on a voluntary basis as well. For example, Exhibit 6.9 presents Apple Inc.’s Form 10-K/A to amend its 2009 Form 10-K. In the amendment, Apple explains the financial statement effects when it applied new required accounting methods to account for the iPhone and Apple TV. Prior accounting methods required Apple to defer all revenues and expenses related to sales of iPhone and Apple TV and recognize these revenues and expenses on a straight-line basis over the expected product life because Apple had promised the possibility of free future upgrades and features. The justification for deferral is typically that revenue has not been earned. New standards require Apple to recognize revenue and expenses relating to existing delivered hardware and software at the time of sale and to defer the estimated fair value of the right to receive free future upgrades and features. Apple had a choice of applying the new standards prospectively (in current and future periods) or retrospectively (adjust prior years’ results and then use the new standard in current and future periods) Apple chose retrospective application to enhance comparability. Note the huge amounts involved. Adoption of the new standards increased Apple’s revenue by $6.4 billion in 2009, $5.0 billion in 2008, and $483 million in 2007.
Changes in Accounting Estimates
Examples include the amount of uncollectible accounts receivable, the useful lives for fixed assets and intangible assets, the percentage-of-completion
rate for a long-term project, the return rate for warranties, and interest, compensation, and inflation rates for pensions, health care, and other retirement benefits. Firms periodically change these estimates. The amounts reported in prior years for various revenues and expenses will differ from the amounts suggested by the new estimates. Standard setters view making and revising estimates as an integral and ongoing part of applying accounting principles. They are concerned about the credibility of financial statements if firms restate their prior financial statements each time they change an accounting estimate. Therefore, current accounting standards require firms to account for changes in estimates by using the new estimates in the current year and in future years.
Because new estimates alone can change current period income, you should attempt to determine whether estimate changes are significant. However, often you must infer the impact of changes in estimates. For example, Chapter 8 will provide a formula for computing average useful lives of depreciable assets. If you detect an increase in average useful lives in a year in which reported earnings barely exceeded expectations, you couldrecompute depreciation expense using the prior year’s average useful life to detect whether the depreciation difference drove the increase in current period earnings. Likewise, you can monitor changes in estimated bad debts expense by reviewing the ratio of bad debts expense to sales. Whenever possible, you should compare the pattern of estimated to realized amounts to assess the extent of management’s changes in estimates and to determine whether trends will continue.
You must remember that estimates change over time for legitimate reasons. One of the main determinants of the value of accrual-based financial statements is that the amounts of reported assets and liabilities can reflect management’s beliefs. Again, knowledge of a company’s industry economics and strategy allows for a more informed judgment of whether an estimate change is warranted. You must also decide whether to use the financial statement data as originally reported for each year or as restated to reflect the new conditions. Because the objective of most financial statement analysis is to evaluate the past as a guide for projecting the future, the logical response is to use the restated data.
However, you encounter difficulties when using restated data. In their annual reports, most companies include balance sheets for two years and income statements and statements of cash flows for three years. You can calculate ratios and perform other analyses based on balance sheet data (such as current assets/current liabilities or longterm debt to shareholders’ equity) on a consistent basis for only two years. You can calculate ratios based on data from the income statement (for example, cost of goods sold/sales) or from the statement of cash flows (for example, cash flow from operations/ capital expenditures) for three years at most on a consistent basis. However, many important ratios and other analyses rely on data from the balance sheet and either the income statement or the statement of cash flows.
Because new estimates alone can change current period income, you should attempt to determine whether estimate changes are significant. However, often you must infer the impact of changes in estimates. For example, Chapter 8 will provide a formula for computing average useful lives of depreciable assets. If you detect an increase in average useful lives in a year in which reported earnings barely exceeded expectations, you couldrecompute depreciation expense using the prior year’s average useful life to detect whether the depreciation difference drove the increase in current period earnings. Likewise, you can monitor changes in estimated bad debts expense by reviewing the ratio of bad debts expense to sales. Whenever possible, you should compare the pattern of estimated to realized amounts to assess the extent of management’s changes in estimates and to determine whether trends will continue.
You must remember that estimates change over time for legitimate reasons. One of the main determinants of the value of accrual-based financial statements is that the amounts of reported assets and liabilities can reflect management’s beliefs. Again, knowledge of a company’s industry economics and strategy allows for a more informed judgment of whether an estimate change is warranted. You must also decide whether to use the financial statement data as originally reported for each year or as restated to reflect the new conditions. Because the objective of most financial statement analysis is to evaluate the past as a guide for projecting the future, the logical response is to use the restated data.
However, you encounter difficulties when using restated data. In their annual reports, most companies include balance sheets for two years and income statements and statements of cash flows for three years. You can calculate ratios and perform other analyses based on balance sheet data (such as current assets/current liabilities or longterm debt to shareholders’ equity) on a consistent basis for only two years. You can calculate ratios based on data from the income statement (for example, cost of goods sold/sales) or from the statement of cash flows (for example, cash flow from operations/ capital expenditures) for three years at most on a consistent basis. However, many important ratios and other analyses rely on data from the balance sheet and either the income statement or the statement of cash flows.
For example, the rate of return on common shareholders’ equity equals net income to common shareholders divided by average common shareholders’ equity. The denominator of this ratio requires two years of balance sheet data. Thus, it is possible to calculate comparable ratios based on average restated data from the balance sheet and one of the other two financial statements for only one year under the new conditions You could obtain balance sheet amounts for prior years from earlier annual reports, but reliance on the earlier reports results in comparing restated income statement or statement of cash flow data with non-restated balance sheet data for those earlier years. You should evaluate the likely magnitude of the effect of the restatement on ratios using prior years’ data. Apple Inc.’s 10-K/A restated revenues and net income for the years 2009, 2008, and 2007. Also, Apple
disclosed that the restatement effects on earlier years were immaterial due to limited revenues from iPhone sales prior to 2007. When a firm provides sufficient information so that you can restate prior years’ financial statements using reasonable assumptions, you should use retroactively restated financial statement data. When the firm does not provide sufficient information to do the restatements, you should use the amounts as originally reported for each year. To interpret the resulting ratios, attempt to assess how much of the change in the ratios results from the new reporting condition and how much relates to other factors. Clearly, restatements can create significant interpretation issues when analyzing historical financial data.
disclosed that the restatement effects on earlier years were immaterial due to limited revenues from iPhone sales prior to 2007. When a firm provides sufficient information so that you can restate prior years’ financial statements using reasonable assumptions, you should use retroactively restated financial statement data. When the firm does not provide sufficient information to do the restatements, you should use the amounts as originally reported for each year. To interpret the resulting ratios, attempt to assess how much of the change in the ratios results from the new reporting condition and how much relates to other factors. Clearly, restatements can create significant interpretation issues when analyzing historical financial data.
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