What Is Accounting Changes and Error Correction?
Accounting changes and error correction refers to guidance on reflecting accounting changes and errors in financial statements. It outlines the rules for correcting and applying changes to financial statements, which includes requirements for the accounting for, and reporting of, a change in accounting principle, a change in accounting estimate, a change in reporting entity, or the correction of an error.
Accounting changes and error correction is a pronouncement made by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB).
- Accounting changes and error correction refers to the guidance on reflecting accounting changes and errors in financial statements.
- Accounting changes and error corrections are overseen by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) in their jurisdictions.
- Accounting changes are classified as a change in accounting principle, a change in accounting estimate, and a change in reporting entity.
Understanding Accounting Changes and Error Correction
It is imperative for financial markets to have accurate and trustworthy financial reporting. Many businesses, investors, and analysts rely on financial reporting for their decisions and opinions. Financial reports need to be free of errors, misstatements, and completely reliable. Any changes or errors in previous financial statements impair the comparability of financial statements and therefore must be addressed appropriately.
Accounting changes and error correction guidance is laid out by the two primary accounting standards bodies: the FASB and the IASB. The two have different interpretations of accounting rules and principles but do work together to create some uniformity when possible.
The FASB’s Statement No. 154 addresses dealing with accounting changes and error correction, while the IASB’s International Accounting Standard 8, Accounting Policies, Changes in Accounting Estimates and Errors offers similar guidance.
The areas that the regulations focus on are:
- Change in accounting principle
- Change in accounting estimate
- Change in reporting entity
- Correction of an error in previously issued financial statements
The first three items fall under "accounting changes" while the latter falls under "accounting error."
Change in Accounting Principle
The first accounting change, a change in accounting principle, for example, a change in when and how revenue is recognized, is a change from one generally accepted accounting principle (GAAP) to another. Companies can generally choose between two accounting principles, such as the last in, first out (LIFO) inventory valuation method versus the first in, first out (FIFO) method.
This is a retroactive change that requires the restatement of previous financial statements. Previous financials must be restated to be calculated as if the new principle were used. The only time that financial statements are allowed to not be restated is when every possible effort to address the change has been made and such a calculation is deemed impractical.
Change in Accounting Estimate
The second accounting change, a change in accounting estimate, is a valuation change. This means a material change in estimates is noted in the financial statements and the change is made going forward. An example would be a change in the depreciation method.
Change in Reporting Entity
The third accounting change is a change in financial statements, which in effect, result in a different reporting entity. This would include a change in reporting financial statements as consolidated as opposed to that of individual entities or changing subsidiaries that make up the consolidated financial statements. This is also a retroactive change that requires the restatement of financial statements.
Accounting errors are mistakes that are made in previous financial statements. This can include the misclassification of an expense, not depreciating an asset, miscounting inventory, a mistake in the application of accounting principles, or oversight. Errors are retrospective and must include a restatement of financials.