At
a recent conference on financial accounting and reporting, three participants
provided examples of similar accounting changes that they had encountered in
the last few months. They all involved the current portion of long-term debt.
The
first participant explained that it had just recently come to her attention
that the current portion of long-term debt was incorrectly calculated in the
last three years of her company’s financial statements due to an error in an
accounting software product. The second participant explained that his company
had just decided to change its definition of what is “current” to make it
closer to the “operating cycle,” which is approximately 18 months. The company
had been using “12 months from the balance sheet date.” The third participant
also acknowledged that her company has decided to change from a “12 months from
the balance sheet date” definition to one based on the company’s operating
cycle, which is now close to two years. She explained that the company’s strategic
plan over the last three years had moved the company into bidding on and
winning significant longer-term contracts and that the average life of these
contracts has now lengthened to about two years.
Instructions
(a)
As a panellist at this conference who is expected to respond to the
participants, prepare a brief report on the advice you would give on how each
situation should be handled under GAAP. Identify what steps each participant
should take and what disclosures, if any, each would be required to report.
(b)
Under proposals for new financial statement presentation, the IASB is
considering making the change that “current” would now mean 12 months,
regardless of the company’s operating cycle. This is believed to make the
statements more comparable across different companies. If this new change is
accepted, what would likely be the accounting treatment required on
implementing this change?
(a) The first case, the incorrect
calculation of the current portion of long-term debt, is related to an error
correction. Under GAAP, the company must use the full retrospective method to
correct errors by 1) restating the comparative amounts for the prior period(s)
presented in which the error occurred and 2) restating the opening balances of
assets, liabilities, and equity for the earliest period presented if the error
took place before that period. In the
year of the correction, the company should disclose
1. The nature of the error.
2. The amount of the correction to basic and fully diluted earnings per share
and to each line item on the financial statements presented for comparative
purposes.
3. The amount of the correction made at the beginning of the earliest prior
period presented.
The second case
is also considered to be an error correction. Prior period errors are omissions
or misstatements and are caused by the misuse of, or failure to use, reliable
information that existed and could reasonably have been found and used in the
preparation and presentation of those financial statements. The accounting
standard requires that the operating cycle be used, if it is more than one
year. Assuming that the company’s “operating cycle” has always been
approximately 18 months (i.e., no recent event occurred to cause a change in
the cycle), using one year to classify current and non-current assets is
failure to use reliable information to prepare financial statements. What steps
to take and what disclosures to make are the same as in the first case.
In the third
case, although it appears that the company changed its accounting policy
regarding operating cycle; it is not a change in accounting policy. This is
because a different policy is applied to transactions, events, or conditions
that differ in substance from those that were previously occurring. In other
words, using one year to classify assets and liabilities was appropriate when
the company’s business involved short-term contracts. Now, the circumstances
having changed due to the implementation of the company’s strategic plan, the
average life of the company’s contracts has now grown to about two years. Thus,
the new policy, using its “operating cycle” for classification, is appropriate
for the changed circumstances. The company should disclose the nature of the
new policy so that the readers understand what new circumstances caused the
change in classification and what impact it would have on financial statements.
(b) Whenever changes are made to a
standard, the IASB also provides transitional rules. There are two options here: a requirement for retrospective restatement
or an allowance for prospective treatment.
If retrospective restatement is required, then all prior years would be
restated implementing the new definition of what is current. This would ensure that all prior years
presented were fully comparative. But
this restatement would also take more time to gather the data and it may be
that the information is not practicably available. Prospective treatment would be less time
consuming and would not require prior period information to be gathered. In contrast, however, the prior period would
not be comparable and ratios such as the current ratio could be significantly
distorted over the comparative periods.
