Hi, Else here.
And today we'll be talking about accounting changes.
In accounting, we have to deal with an uncertain future.
There are events that need to be included
in our financial statements now, such as accruals
for expenses and liabilities.
However, we don't know for sure what the amount of the expense
will be.
Instead, we use an estimate, which is really just an attempt
to quantify an uncertain future event.
The fact that financial statements include estimates
leads to three things.
One, a change may be required to reflect changing circumstances.
The circumstances that led to our estimate in the past
may now be different, so we have to change our estimate
to reflect these new circumstances.
This is called a change in accounting estimate.
Two, a change may occur in the future
due to new accounting policies.
These new policies are chosen because they reflect
current economic circumstances, meaning
that the new policy better reflects current reality.
These changes may be at the discretion of management,
a voluntary change, but they may also
be an involuntary change due to a change in accounting
standards.
This is known as a change in accounting policy.
Three, a previous estimate may have been an error.
This means that given the information
available at the time the estimate was made,
management should have known that it was wrong.
Regardless of whether the error is an accident or intentional,
maybe to bias a financial statements,
makes absolutely no difference.
This has to be fixed and it is known as an error correction.
Let's look at each of these individually
and how they are dealt with.
First is a change in accounting estimate-- also called
a change in estimate.
This is where, based on new information,
a different estimate is required for the current period
compared to the estimate that was used in a prior period.
The new estimate may change the carrying value
of an asset or a liability or it might
change the way we recognize the use of an asset.
This is always due to what is true today
or what we expect regarding future benefits.
What are some examples of changes in estimates?
There are many examples of when we make estimates in accounting
and any change to these estimates
would be considered a change in accounting estimate.
A few examples would be a change to the percentage we
use to calculate the allowance for doubtful accounts,
a change in the value of our investments
due to new market conditions, a change
in the estimated useful life of long-lived assets
or the residual value, the percentage used
to calculate warranty provisions may change,
and the value of inventory when obsolescence is an issue
may also change.
There are many other examples of changes in estimates,
because estimates are a normal part of accounting,
particularly accrual accounting, which is
required by both IFRS and ASPE.
Because a change in estimate is based on new information,
that change does not relate to prior periods
after all, when the estimate was made in the prior period,
it was the information available then that was important.
As long as the estimate in the prior period
was made in good faith using the information available
at that time, then it is acceptable
and should not be changed.
That's why a change in estimate does not require any changes
to past financial statements.
Instead, a change in estimate is treated as a perspective
adjustment, meaning the changes implemented
for the current and future periods.
Past periods are never changed.
Sometimes it is very difficult to differentiate
between a change in accounting estimate
and a change in accounting policy.
For instance, if a business changes its depreciation
method, say from straight line to declining balance,
is that a change in estimate or a change in accounting policy?
It may be true that it's a change in estimate,
because prior estimates of how the benefits would flow
to the business have changed.
Or is it a change in accounting policy,
which will result in more reliable and relevant
information with regards to the company's financial position,
performance, or cash flow?
This requires professional judgment to determine.
Under IFRS, if it is unclear whether a change is
one of policy or estimate, the change
should be treated as a change in accounting estimate.
That's very important to know with regards
to a change in estimate.
Remember, a change in estimate requires perspective adjustment
with no changes to the prior year's financial statements.
There are also no disclosure requirements
for a change in estimate as they are a normal part
of the accounting process.
Next is a change in accounting policy.
A change in policy can be either voluntary or compulsory.
If a new policy would provide more reliable and relevant
information to the stakeholders with regards to the company's
financial position, performance, or cash flows,
then it is a voluntary change in accounting policy
and it's at the discretion of management.
Note those two words--
reliable, which references faithful representation,
and relevant.
These are both fundamental qualitative characteristics.
These are critical to ensure useful financial information.
No wonder they are used to justify
a change in accounting policy.
The new accounting policy must better
reflect the economic circumstances
or the nature of the operations moving forward.
The burden is on management to explain to stakeholders
why the new method is more reliable and relevant
than the method used in prior years.
An example of a voluntary change in accounting policy
would be the movement from a FIFO
method of valuing inventory to a weighted average method.
If a new policy is due to new or changed accounting standards,
then it is considered a compulsory change.
For instance, a move from Canadian GAAP to IFRS
was a compulsory change of accounting policy.
How do we present a change in accounting policy?
Retrospective application-- sometimes
called retroactive application-- requires
that both the current year and all prior years
be adjusted to reflect the new policy.
After the change, it should look like the company never
did anything but the new policy since all prior year's
financial statements would be updated for the new policy.
This is consistent with the enhancing qualitative
characteristic of comparability.
Only by changing all the prior year's financial statements can
the financial statements remain comparable between periods,
allowing for trend analysis.
Note that a summary change flowing through equity,
more specifically retained earnings,
is provided for the earliest prior period presented.
What does that mean?
Well, if the financial reports included the current year, say
2019, and two prior years, meaning 2018 in 2017,
all three years would be updated for the change.
This means that individual account balances
would be adjusted as if the new accounting policy had always
been in place.
In addition, in the equity section of 2017,
a summary adjustment to retained earnings
would show the total impact of the change on all years
prior to 2017.
What if it's no longer possible to reconstruct all the data
for prior years because the details are
no longer available?
Or it might be true that the data is available,
but the cost of obtaining the data would be very high.
In this case, where it's impractical to provide
retrospective application, partial retrospective
application is allowed.
In this case, a summary adjustment
to retained earnings in the last comparative year where
the details can be determined is allowed.
If it is no longer possible to determine even the impact
on the opening balances of the current year,
then a change in accounting policy
would be applied prospectively.
The same way a change in accounting estimate is.
The disclosure requirements for a change in accounting policy
are extensive.
This allows the stakeholders to determine
why the change was made and how it impacts
current and prior years.
Disclosure requirements are as follows.
If that change is due to a change in standards,
full information about the change
and its impact on the financial statements.
If the change is voluntary, what the change was and why
the new policy is considered to provide
more reliable and relevant information to stakeholders,
the effect of the change on each line item
on the statements for current and prior periods.
If full retrospective application is not possible,
why it's not possible, and how the change will be handled.
Finally, what the effect on future periods might be.
This is applicable also to new standards that have been
issued, but not yet adopted.
This means that a business must disclose reliable information
on how future standards might affect the statements going
forward.
Onward to the correction of an error.
This is when in a prior period there
was a material error, either intentional or accidental.
Similar to a change in accounting policy,
retrospective application requires
that both the current year and all prior years be adjusted,
so that it is as if the error never happened.
If the error was in one of the prior periods that
is provided for comparative purposes,
the error must be corrected and the resulting change
flowed through all subsequent years.
If the error occurred in periods prior to the comparative years
shown, then the opening balances of assets, liabilities,
and equity, including a summary change to retained earnings,
must be presented.
A correction of an error must be disclosed in the notes
to the financial statements, including
an explanation of the error, the accounts and amounts changed
in all prior periods, and the amount
of the summary correction to retained earnings
in the earliest prior period provided.
In addition, if full retrospective restatement
is not possible because the details are unknown,
an explanation of why it's not possible to determine
the details and how the error was corrected
must be included in the note.
Finally, the affect of the correction
on basic and fully diluted earnings per share
must be reported for each prior period presented.
That's it for accounting changes.
Thank you so much for joining me.
In an upcoming video, I'll be demonstrating
one method you can use to solve the change in accounting policy
or the correction of an error.