Question

1. What do retrospective and prospective mean as they relate to Accounting changes?

2. Select a type of accounting change. Provide an example of how that change might apply to your favorite company. What are the financial statement implications of your change? Why?

Answer 1

Consistency in applying accounting policies and estimates doesn’t mean that we can’t change the policies and estimates. Accounting policies can be changed if only:

• The changes are required by Mandatory Accounting Standards (Local Accounting Standards).
• The changes can produce financial statements that give more reliable and relevant information on impact of transaction, event, or other circumstances.  

Changes in accounting policies and estimates have two treatments: retrospective or prospective. Retrospective means Implementation new accounting policies for transaction, event, or other circumstances as if it had been implemented. In other words, retrospective will effect presentation of financial statements for previous periods. While prospective means implementation new accounting policies for transaction, event, or other circumstances after new accounting policies or estimation has been implemented.

• Retrospective implementation should be applied if the new accounting standards or policies are required by mandatory accounting standards and the changes can produce financial statements that give more reliable and relevant information on impact of transaction, event, or other circumstances. In the example above, if X company in 20X2 changes the inventory valuation method from FIFO to average, so that new accounting policies should be applied retrospectively. Then, the financial statements of X company for 20X1 should be restated. And Errors may arise from mistakes and oversights or misinterpretation of information. Material prior- period errors are adjusted retrospectively (that is, by restating comparative figures) unless this is impracticable.

• Prospective implementation should be applied if there is changes in accounting estimation.

2.Accounting is a static practice -- change is rarely instituted -- so when changes are made in accounting, it is a big deal. Changes in accounting principle, accounting estimate and reporting entity are examples of the types of changes in accounting.

Example of retrospective change of Accounting Principle

ABC, Inc. started operations on 1 January 2011. It originally applied weighted-average cost-flow assumption for inventory accounting. However, after studying the flow of its products, the company’s management concluded that FIFO is a better method and it started applied it beginning 1 January 2013. You are required to work out the necessary adjustments needed to balance sheet accounts as at the date of change in policy.

The company’s income statement (under weighted-average inventory accounting method) for financial year ended 31 December 2012 and 31 December 2011 is given below:

	2012	2011
	USD in million
Sales	600	500
Cost of sales	350	275
Gross profit	250	225
Selling and administrative expenses	90	80
Profit before tax	160	145
Taxes	48	44
Net income	112	102

Under the current method, the company’s inventories amounted to $25 million and $30 million at the end of 2011 and 2012 respectively. The company’s cost of goods sold under FIFO would have been $260 million and $330 million in 2011 and 2012 respectively.

Retained earnings amounted to $102 million and $214 million at the end of financial year 2011 and 2012 respectively. Corresponding taxes payable balances were $35 million and $50 million.

Sales, cost of goods sold (COGS) and selling and general expenditures for financial year 2013 are $700 million, $410 million and $120 million. Tax rate is 30%.

Solution:

Preparing the new income statement with comparative figure is quite straightforward. We just replace the historical COGS for 2011 and 2012 and recalculate taxes.

ABC, Inc.
Income Statements
USD in million
Year	2013	2012	2011
Sales	700	600	500
Cost of sales	410	330	260
Gross profit	290	270	240
Operating expenses	120	90	80
Profit before tax	170	180	160
Taxes	51	54	48
Net income	119	126	112

The change in accounting policy will affect balances in inventory account, retained earnings account and taxes payable account.

he relevant calculations are given below.

Financial Year		2012	2011
Cost of goods sold under FIFO	A	330.0	260.0
Cost of goods sold under weighted-average	B	350.0	275.0
Decrease in cost of goods sold (~increase in inventories)	A - B	20.0	15.0
Cumulative effect (decrease in COGS, increase in inventories)	C	35.0	15.0
Inventories closing balance under weighted-average	D	30.0	25.0
Cumulative effect of difference in COGS	C	35.0	15.0
Inventories closing balance under FIFO	D + C	65.0	40.0
Taxes for the year under FIFO	E	54.0	48.0
Taxes for the year under weighed average	F	48.0	43.5
Increase in income tax expense for the year	E - F	6.0	4.5
Cumulative increase in income taxes	G	10.5	4.5
Net income under FIFO method	H	126.0	112.0
Net income under weighted-average	I	112.0	101.5
Increase in net income	H - I	14.0	10.5
Cumulative increase in retained earnings	J	24.5	10.5

Following adjustment is needed as at 1 January 2013 to restatement the retained earnings and other balance sheet account:

Inventories	35 million
Taxes payable		10.5 million
Retained earnings		24.5 million

Relevant adjusted closing balances at the end of 2011 and 2012 are presented below:

Adjusted balance sheet balance as at 31 December		2012	2011
Inventories under weighted-average	D	30.0	25.0
Effect of decrease in COGS	C	35.0	15.0
Inventories	D + C	65.0	40.0
Retained earnings under weighted-average	Given	214.0	102.0
Cumulative increase in retained earnings	J	24.5	10.5
Retained earnings under FIFO		238.5	112.5
Tax payable under weighted-average	Given	50.0	35.0
Cumulative increase in income taxes	G	10.5	4.5
Taxes payable under FIFO		60.5	39.5