Changes in Accounting Principles

Executive Summary

Generally, this research paper is designed and created in order to understand the role and significance of financial as well as accounting information in making effective management decisions. In addition to this, it should also be noted down that, in this research study also discusses how the how to use accounting standards and principles for the management decisions. At the same time, this research report also evaluates the how multiple accounting principles cn be used in a particular business situation in order to make effective and specific management decisions in an effective and proper manner.  Along with this, it is also analyzed that, this research paper has wider scope and importance and can be used for the further research study. For instance, this research paper clearly describes and explains various kinds of changes, reasoning and methods used for changes in the accosting standards and principles. On the other hand, this paper also explores the effect or impact of such accounting changes on the financial information. Hence, this research study would be more beneficial, reliable and effective for the readers in understanding and analyzing the different accounting and financial concepts. Moreover, the readers, researchers and student can also apply these concepts in their real life.

Introduction

Management decisions play a key role in how financial information is reported for a company. One such management decision involves choosing between different accounting principles when necessary. Accounting principles are universal guidelines that are followed for recording and reporting financial events. There are times when it is necessary to change or reverse a previous management decision regarding a particular accounting principle, resulting in a required accounting change. There are various instances in which a change in accounting principle may be necessary. Sometimes there are multiple principles that can be applied to a particular situation, and a change is made to switch to a different principle. Sometimes the principle being used is no longer accepted. This paper will outline the types of changes, along with reasoning and methods behind these changes in accounting principles, and the types of effects these changes can have on financial information.

Review of Literature

An “accounting principle” is a general rule to take after when recording and reporting money related exchanges. There is a “change in accounting principle” when:

  1. There are two or all the more sound “accounting principle” that applies to a specific circumstance, and you move to the next guideline, when the “accounting principle” rules that previous connected to the circumstance is no more by and large acknowledged, you change the strategy for applying the rule.
  2. There are a few classifications of unpredictable things that may show up specifically in the organization’s money related explanations or as references to them. At the point when an organization receives an alternate “accounting principle” strategy, the decision can have a material impact on the company money related position. Thus, former money related proclamations need to mirror this change. This permits examiners, financial specialists, and loan bosses to make precise correlations when assessing the authentic execution of a company. (Accountingtools.com)

Previously accepted accounting principles are sometimes revised or clarified through pronouncements by the FASB. These changes might be made due to improved comparability in reporting, or because of the impending work between IFRS and FASB on convergence between the two. When these pronouncements are made, they usually include details as to when the changes should be made effective, and how entities should make these changes. GAAP states that in an instance where other provisions are not provided in an individual pronouncement requiring a change, the entities are to refer back to the FAS 154, the general guidelines for accounting changes and error corrections (FASB FAS 154, 2005).  In most cases, detailed provisions are provided for a specific required change within the pronouncement. A recent example of such a pronouncement can be found in the FASB Accounting Standards Update Topic 606, Revenue from Contracts and Customers.

The revision was released in May 2014. This revision was part of a joint venture between FASB and IFRS to clarify and simplify standards for reporting revenue from contracts (FASB Topic 606, 2014). Included in the revision are provisions stating the effective dates for both public and non-public entities. The revision also indicates how the required changes are to be made. The revision provides two options for retrospective application to report any changes in revenue due to these updated standards (FASB Topic 606, 2014). In this case, entities should follow the instruction within Topic 606, and not necessarily refer to FAS 154 since specific provisions are provided.

Analysis

There are two ways in which an accounting change can be disclosed. The first, and preferred method, is known as a retrospective application. A retrospective change requires all previous financial reports to be altered, so that it appears that the new method had always previously been used. Adjusted balances for the current reporting period are used in order to accurately report the change. According to FAS 154, this type of change is required, unless doing so would be impractical. Retrospective application includes three things according to the FAS 154 report. First, the cumulative effect of the change will be reflected in the asset and liability accounts at the beginning of the first presented period. Second, any offsetting adjustments to retained earnings should be made during that period as well. Finally, all financial statements for each reporting period should be altered to reflect the change (FASB FAS 154, 2005). When practical, this type or retrospective application should be used for all reported accounting changes.

When a retrospective application is not feasible, a prospective application is used. FAS 154 provide criteria to be used in determining impracticality. First, every reasonable effort must be made to apply the requirement. Second, it must be found that the intent of a managerial decision in a prior period cannot be determined. Third, it must be concluded that estimates that are required for the application cannot be determined because the information is not available (FASB FAS 154, 2005).  If all of the requirements for impracticality are met, it is permissible to apply the change prospectively. Adjustments to the current period financial reports will be adjusted for the estimated effect of the change.

One such accounting change that is likely to occur involves long-term investments. When accounting for long-term investments, there are two types of methods used to determine the value of the stock shares, the cost method and the equity method. Under the cost method, the investment is recorded at the historical cost as a non-current asset (FASB ASC 325, n.d.). If the equity method is used, the beginning historical cost is adjusted proportionately for the investee’s profit or loss, causing an increase or decrease in the value of the asset for the investor. According to GAAP, the equity method must be used if the investee has purchased 20% or more of the voting stock of the investee. There is an exception to this rule only if the investor can show evidence that they are unable to exercise significant influence over the investee (FASB ASC 323, n.d). This may occur, for example, if the investee refuses to give control to the investor. This type of situation must be documented by the investee. If the level of ownership falls below the 20% required for significant influence, the entity will be required under GAAP to stop accruing its part of the earnings and losses. If the level of ownership rises above the 20% requirement, the entity is required to begin using the equity method to account for the value of its investment (FASB ASC 325, n.d.). Significant influence can be affected by either the investor buying or selling a portion of its voting stock, or by the investee issuing additional shares. In both cases, the change in accounting principle will need to be accounted for.

In a contracting business such as the construction industry, there are two acceptable methods for recording long-term contracts. It may become necessary for a company to switch methods, causing an accounting change. The completed contract method recognizes revenue only when the contract is completed. A long-term contract is defined by the IRS as one that is not completed within the same year it began. Using this method, revenue is deferred until the contract is complete, while overhead is immediately expensed. The other method that can be used is called the percentage of completion method. This method records revenue by the percentage of the project that is completed. The project is billed periodically according to this ratio, and revenue is recorded as it is billed. Using this method, expenses should more closely match with revenues. Any over/under billings are recorded to either a liability or an asset account, and are reconciled at project completion.  Switching from the completed contract to the percentage of completion method will cause changes in yearly net income from the previously deferred revenues. While this change should be recorded retrospectively to prior years, complete information may not be available to properly record these changes. The company is still required to adjust net income for the current period in which the change is made.

There are two ways changes in accounting principles can effect financial reporting. A direct effect is recognized when a change in an asset or liability is required in order to implement the change. For example, if a change is made in the method used to value inventory, the direct effect would be the difference in the recorded cost of the inventory. Under GAAP, all direct effects must be accounted for retrospectively, unless impracticality is declared (FASB FAS 154, 2005). The entity would be required to retrospectively change the financial reports to reflect this new inventory balance, as if the method had always been used. The first set of financial reports will include a balance that reflects this change. Also, an increase or decrease in income tax liability would be considered a direct effect, as well as any change in deferred tax assets or liabilities.

Any change that occurs in current or future cash flows from these accounting changes is known as indirect effects. Under GAAP, indirect effects are not required to be reported retrospectively. These types of changes are only reported within the period that the accounting change took place (FASB FAS 154, 2005). An employee profit sharing plan that is based on revenue would be an example of an indirect effect. These indirect effects would be required to be included in a disclosure note in the financial reports for the period in which the change took place.

One of the most common accounting changes to take place is a change in the way inventory cost is recorded. Two of the most popular costing methods are the last in first out (LIFO) and the first in last out (FIFO) methods. Other methods include the average cost, specific identification, and retail methods of costing. Of the methods, LIFO is the most controversial. Due to tax advantages under the LIFO method, the IRS conformity rule states that if the LIFO method is used for tax purposes, it must also be used for financial reporting (JournalofAccountancy.com). This prevents companies from using the LIFO method to reduce taxes payable while using a different method to increase net income on financial reports. The LIFO method is not accepted under IFRS international reporting standards. This is one of the greatest differences between GAAP and IFRS. With the possibility of convergence between IFRS and GAAP in the future, many companies will eventually be required to find an alternative method to LIFO. More companies continue to switch from the LIFO method as action towards IFRS and GAAP convergence continues. This action will cause entities to retrospectively report accounting changes for the change in principle.

Recommendations

Accounting changes should only occur on rare occasions, where the company can justify the change with facts showing that the change is preferable. Under FAS 154, disclosure of the effects of the change on net income and relatable amounts is required.  An example of such a disclosure can be found regarding the corporation AEGON when announcing a change in accounting principles to a fair value approach in 2007. The report states, “This change will ensure AEGON’s financial statements better reflect the economic matching of its assets and liabilities” (AEGON, 2007).  The report goes on to justify the change by claiming to increase the transparency of their financial results for investors and analysts (AEGON, 2007). Transparency and comparability are two important focus factors behind many accounting principles. A change can usually be justified as preferable if the change will increase the transparency and/or comparability of an entity’s financial reports. Changes should not be made merely at the will of the company, or in order to unfairly alter financial information.

Summary and Conclusions

As stated previously, changes in accounting principles should only happen under certain circumstances when the change can be validated. In addition to this, it can also be concluded that, modification in the wide range of accounting standards and principles should be valid and as per the proper circumstances. Hence, the changes or alternation in the accounting principles should be according to pre-determined criteria and should produce valid results and outcomes in an effective and proper manner. On the other hand, it can also be concluded that, in order to handle various and specific transactions, the standards, rules and guidelines of GAAP should be followed and used properly.

Accounting regulations such as GAAP provide detailed guidelines on when and how these transactions are to be handled. These types of changes can have a great income on financial reports, and the requirements to adjust for the change can be cumbersome. Before making decisions regarding accounting principles, management should be well informed on the impact the different principles will have on financial information, and make educated decisions as to which principles and interpretations should be used for a particular entity.