On the previous post, I have discussed about Changes and Correction of Errors Journal Entry, there are three areas where changes may occur in the accounting ; (a) in the principle; (b) in the estimates; and (c) in the reporting entity. The change in accounting principle has been included on the previous post. Therefore I come with the rest through this post.
Change In Accounting Estimates
There are a number of situations in accounting that require the use of estimates. Examples include un-collectibility of accounts receivable, liabilities for estimated warranty costs, and the salvage values and lives of plant assets.
If often happens that estimates need to be revised as a result of new information. Such changes in accounting estimates are handled differently from changes in accounting principles. Prior statements are not revised, correction entries are not made, and the cumulative effect of the change is not recorded. Instead, the change affects only the future (and this period if the revision is made before the end of the period). In short, this change is neither retroactive nor current, but “prospective” in nature.
The reason why the accounting profession prescribed this treatment is that such changes occur frequently, and would thus require continual retroactive or catch-up entries. This would make the financial statements difficult to read and interpret.
If a change is made in the estimated useful life or residual value of a plant asset, then for the future, the new depreciation would be calculated based on the following:
Result: No adjustment or correction entries would be made for the depreciation taken so far.
Royal bali Corp. purchased a machine on January 1, 19X1, for $100,000. At that time it was thought the machine would have a life of 10 years and a residual value of $10,000.
Thus the annual depreciation taken was $9,000 [($100,000 – $10,000) / 10].
Early in 19X5 the company realizes that the total life of the machine is only 8 years and the residual value is only $8,000. Since 4 years have already passed (19X1–19X4), there are another 4 years still remaining. The book value at this time is $64,000, as indicated by the following T-accounts:
The annual depreciation for 19X5, 19X6, 19X7, and 19X8 is:
Result: No correction entries are made to correct the depreciation of prior years.
If a change has to be made and it is unclear if it is a change in principle or a change in estimate, it should be considered a change in estimate.
[Info_Box]The treatment just discussed for changes in estimates only applies if the original estimate was calculated with proper care. It does not apply if the estimate was determined without proper care or in bad faith. In such cases, the change is considered to be a correction of an error, which requires different treatment. Correction of errors is discussed later in this post.[/Info_Box]
Changes In Reporting Entity
Some accounting changes result in financial statements that are the statements of a new or different entity. Examples include presenting consolidated statements instead of statements for each individual company, changing the specific subsidiaries that make up a consolidated group, and accounting for a pooling of interests.
The financial statements in the year of the change should describe the nature of the change and the reason for the change, and the statements for all prior periods presented should be restated to reflect this new entity.
The effect of the change on net income and earnings per share should be disclosed for all periods presented.
Up-coming post: Journal Entry for Correction of Errors and counterbalancing