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Why is changing from the cash basis to the accrual basis a correction of error?

The cash basis of accounting is considered non-GAAP, whereas, the accrual basis is GAAP and is required for financials statements for public companies. Therefore, if the company prepared their financial statements under the cash-basis, that would be considered an error. Since the company is going from non-GAAP to GAAP, the company must correct the error and restate their financial statements using the accrual basis method.

When a company corrects and error, they must record a prior period adjustment and restate the financial statements. This means that any prior period financial statements must be restated to be presented under the accrual basis.

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  • How a Account for Changes in Accounting Principle

    Assuming the change in accounting principle is justified (i.e. makes sense), then the change should be reflected on a retrospective basis. Unlike the prospective treatment for changes in accounting estimate, this means that any prior periods that are included in the current year financial statements need to be restated to reflect the new accounting principle. This is one of the four accounting changes that you can expect to see on the CPA Exam. It is considered impracticable to retrospectively apply the effects of a change in accounting principle under one of the following circumstances:  You make all reasonable efforts to do so but cannot complete retrospective application. Doing so requires knowledge of managements intent in a prior period, which you cannot substantiate.  Doing so requires significant estimates, and it is impossible for you to create those estimates based on information available when the financial statements were originally issued.  For example, let’s say that the company used LIFO in Year 1 and then switched to FIFO in Year 2. Without retrospective treatment, Year 1 and Year 2 inventory balances would be based on a different accounting principle. Therefore, we need to understand the reflect the change to Year 1 so that the inventory balance is on a FIFO basis, which makes it comparable to Year 2. The rest of the financial statements would have to reflect this change as well. So we know that the Year 1 inventory balance is $75 lower on a FIFO basis, but how is this reflected in the financial statements? They would not go back to Year 1 and adjust the numbers, however, they would need to book an adjustment to the Year 2 retained earnings opening balance. Since inventory decreased $75, the company would record a debit to retained earnings for $75 and a credit to inventory for $75.

  • How to Account for a Change in Accounting Estimate:

    Changes in estimates, such as the estimated useful like for a tangible asset or the bad debt allowance percentage, are accounted for on a prospective basis. This means that the current and future financial statements must reflect the change, but the company does not need to change historical periods. Instead, the change will be made prospectively. This means that the change will be made in the current period and all future periods. Changes in Accounting Estimates: Treated Prospectively: Management will often create estimates for components of their financial statements. Keep in mind, these will also include changes in accounting principle that are considered inseparable from a change in accounting estimate such as changes in depreciation methodology and changes in inventory methods to last in, first out (LIFO). Other changes in accounting estimate that are often seen on the CPA exam are as follows: such as:  Warranty obligations Bad debts/estimates of uncollectible receivables Changes in the useful lives of their fixed assets Obsolete inventory Pending litigation that has been settled  Changes in accounting principle that is inseparable from a change in accounting estimates (e.g. depreciation method and change in inventory to LIFO) When companies experience changes in accounting estimates, they will prospectively change their estimates on the financial statements. This means that the changes will be made in the current and future years only.  Below is an example of changes in accounting estimate, courtesy of Universal CPA Review:

  • If a company identifies an error in prior period financial statements, what should they do?

    If errors are identified and they are material or cause the financial statements to be misleading, then the company should restate the financial statements and reissue them.