Question

C 22-10

Researching GAAP

AICPA Adapted Sometimes a business entity may change its method of accounting for certain items. It may classify the change as a change in accounting principle, a change in accounting estimate, or a change in reporting entity. The following are three situations faced by Hyde Company relating to accounting changes.

Situation I

Hyde determined that the depreciable lives of its fixed assets are presently too long to fairly match the cost of the fixed assets with the revenue produced. Hyde decided at the beginning of the current year to reduce the depreciable lives of all of its existing fixed assets by 5 years.

Situation II

On December 31, 2015, Hyde owned 51% of Patten Company, at which time Hyde reported its investment using the cost method, owing to political uncertainties in the country in which Patten was located. On January 2, 2016, the management of Hyde was satisfied that the political uncertainties were resolved and the assets of the company were in no danger of nationalization. Accordingly, Hyde will prepare consolidated financial statements for Hyde and Patten for the year ended December 31, 2016.

Situation III

Hyde decides in January 2016 to adopt the straight-line method of depreciation for equipment. The straight-line method will be used for new acquisitions, as well as for previously acquired equipment for which depreciation had been provided on an accelerated basis.

Directions

1. For each of the preceding situations, research the related generally accepted accounting principles and prepare a short memo to the president that explains the following: type of accounting change; manner of reporting the change under current generally accepted accounting principles, including a discussion, where applicable, of how amounts are computed; effect of the change on the balance sheet and income statement; and note disclosures that would be necessary.

Answer 1

Situation I:

1.         A change in the depreciable lives of fixed assets is a change in accounting estimate.

2.         In accordance with generally accepted accounting principles, the change in estimate should be reflected in the current period and in future periods.  Unlike a change in accounting principle, the change in accounting estimate should not be accounted for by showing the cumulative effect of prior periods in current earnings or by presenting pro forma earnings data giving effect to the change as if it had been applied retroactively.

3.         This change in accounting estimate affects the statement of financial position in that the accumulated depreciation in the current and future years will increase at a different rate than previously reported, and this also is reflected in depreciation expense in the earnings statement in the current and future years.

4.         A note discloses the effect of the change in accounting estimate on income before extraordinary items, net income, and related earnings per share amounts for the current period.

Situation II:

1.         The change from reporting the investment in Patten using the cost method to using a consolidated financial statement basis is a change in reporting entity.  The change in reporting entity is actually a change in accounting principle, but the APB excluded this change from the general category to give it special reporting procedures.

2.         A change in reporting entity is effected and disclosed by restating all prior period financial statements in accordance with the method of presenting the current financial statements of the new reporting entity.  In the initial set of financial statements occurring after the change, the nature of and reason for the change must be disclosed by a note, but subsequent financial statements need not repeat the disclosures.

3.         The statement of financial position is affected by this change in that the investment account of the parent and the equity section of the subsidiary is eliminated, intercompany accounts are eliminated, and a goodwill account as well as a minority interest account may arise.

The earnings statement is affected in that intercompany transactions are eliminated and a minority interest in earnings is shown.  Also, if goodwill has been created, the earnings statement shows amortization of goodwill.

4.         The financial statements of the period of the change in the reporting entity describe by disclosure in the notes the nature of the change and the reason for it.  In addition, the effect of the change on income before extraordinary items, net income, and related earnings per share amounts are disclosed for all periods presented.  Financial statements of subsequent periods need not repeat the disclosures.

Situation III:

1.         The change in the method of computing depreciation for all fixed assets (previously recorded and future acquisitions) represents a change in accounting principle, as defined in APB Opinion No. 20.

2.         Accordingly, the cumulative effect of the change is reflected in the current-year financial statements, and the financial statements included for comparative purposes are presented as previously reported.

3.         As a result of the change to straight-line, the current-year statement of financial position reflects a lower accumulated depreciation amount and the book value of the existing fixed assets is increased.  The current-year earnings statement is affected directly in two specific areas:  depreciation expense for the current period and an additional category of contra-expense shown after extraordinary items.  The additional category of contra-expense is the cumulative effect of the change on the beginning retained earnings of the current period, as though the change had been applied in the earliest applicable period.  The amount of this item is determined by recomputing earnings and retained earnings balances for all applicable prior periods as if the change had been applied retroactively.

The difference between the recomputed retained earnings balance at the beginning of the current period and the original opening balance of retained earnings in the current period represents the contra-expense amount reflecting the cumulative effect of the change on prior year financial statements.

The APB also concluded that the effect of the change is disclosed for the current period and on a pro forma basis for all prior period financial statements included with the current financial statements for comparative purposes.  The effect of the change in each instance is disclosed for income before extraordinary items, net income, and all related earnings per share amounts.

4.         Additionally, the nature of and justification for the change is also disclosed in the notes to the financial statements.