Change in accounting principle inseparable from change in estimate example

I’m having trouble grasping what an inseparable Change in Accounting Principle is. In the Becker lecture, he just grazed over it and didn’t explain what it is. I know that a change in estimate is prospective, but how can I tell when a change in accounting principle is inseparable from a change in estimate. Here’s a question over it that I missed:

“At December 31, Year 2, Off-Line Co. changed its method of accounting for demo costs from writing off the costs over two years to expensing the costs immediately. Off-Line made the change in recognition of an increasing number of demos placed with customers that did not result in sales. Off-Line had deferred demo costs of $500,000 at December 31, Year 1, $300,000 of which were to be written off in Year 2 and the remainder in Year 3. Off-Line’s income tax rate is 30%. In its Year 3 financial statements, what amount should Off-Line report as cumulative effect of change in accounting principle?

a. $200,000

b. $500,000

c. $350,000

d. $0

Explanation

Choice “d” is correct. A change in method of accounting for demo costs is a change in accounting principle inseparable from a change in estimate. When a change in accounting principle is considered inseparable from a change in estimate, the change is handled as a change in estimate – prospectively. No cumulative effect adjustment is made.

Choices “a”, “c”, and “b” are incorrect since no cumulative effect adjustment is made. “

Can someone explain it so I can recognize when it is inseparable?

Viewing 12 replies - 1 through 12 (of 12 total)

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• January 7, 2014 at 10:43 pm #502830 Reply

  
  Study Monk

  Member

  I had trouble with that question to. My best educated guess is that estimates are based on unknowns. In this case they were trying to match the demo expenses to the related revenues. At first they estimated that the costs would generate revenue over two years then they decided that their estimate is bullsh*t and then change it to a direct expense in a different period. This question is tricky because it looks like they change from accounting treatment that requires an estimate to one that does not.

  In most cases estimates will allow you to play with income and expenses by using information that wouldn't of been available in that fiscal period to your advantage. If I estimated that $1,000,000 of demo costs will be allocated over the next two years and then change my mind and choose to expense them all in a 2011 my income will now be $1,000,000 higher for the next two years. Maybe I change the estimate in a way where the expense hits a period that won't be on my comparative financials. So GAAP requires that when we make decisions based on unknowns that we can't restate them in prior periods when the variables are known. Basically you can't restate estimates when the variables become known by changing accounting principles.

  January 7, 2014 at 10:43 pm #502885 Reply

  Study Monk

  Member

  I had trouble with that question to. My best educated guess is that estimates are based on unknowns. In this case they were trying to match the demo expenses to the related revenues. At first they estimated that the costs would generate revenue over two years then they decided that their estimate is bullsh*t and then change it to a direct expense in a different period. This question is tricky because it looks like they change from accounting treatment that requires an estimate to one that does not.

  In most cases estimates will allow you to play with income and expenses by using information that wouldn't of been available in that fiscal period to your advantage. If I estimated that $1,000,000 of demo costs will be allocated over the next two years and then change my mind and choose to expense them all in a 2011 my income will now be $1,000,000 higher for the next two years. Maybe I change the estimate in a way where the expense hits a period that won't be on my comparative financials. So GAAP requires that when we make decisions based on unknowns that we can't restate them in prior periods when the variables are known. Basically you can't restate estimates when the variables become known by changing accounting principles.

  January 7, 2014 at 11:16 pm #502832 Reply

  linkman311

  Member

  Thanks so much Study Monk! I think I understand it now but it helps to know I'm not the only one that was having troubles over it.

  Let me get this straight: basically if a company changes a “principle” that they have been following the past few years which could result in favorable advantages later on (say by immediately expensing a big cost), GAAP will not allow it and forces them to account for it prospectively to avoid them controlling previous years expenses (and therefore Financial Statements)?

  January 7, 2014 at 11:16 pm #502887 Reply

  linkman311

  Member

  Thanks so much Study Monk! I think I understand it now but it helps to know I'm not the only one that was having troubles over it.

  Let me get this straight: basically if a company changes a “principle” that they have been following the past few years which could result in favorable advantages later on (say by immediately expensing a big cost), GAAP will not allow it and forces them to account for it prospectively to avoid them controlling previous years expenses (and therefore Financial Statements)?

  January 7, 2014 at 11:41 pm #502834 Reply

  Study Monk

  Member

  I think that there are some accounting principles that are not estimates that could result in more favorable financials. The main difference is estimates are made when certain information is missing and once the fiscal period closes and new information is attained you can no longer change an estimate in prior periods. You change the estimate and future periods are affected and in most cases when the change is made you still have a level of uncertainty with the new method of making an estimate. Uncertainty is the nature of estimates. Once time goes by and you become certain of events you can't go back and change them. The main reason we change most accounting principles in old periods is so the comparative financials use the same major accounting rules. The reason we don't change estimates in prior periods is because that level of uncertainty in estimates should be present in each periods financials. I hope I know what I am talking about 🙂

  January 7, 2014 at 11:41 pm #502889 Reply

  Study Monk

  Member

  I think that there are some accounting principles that are not estimates that could result in more favorable financials. The main difference is estimates are made when certain information is missing and once the fiscal period closes and new information is attained you can no longer change an estimate in prior periods. You change the estimate and future periods are affected and in most cases when the change is made you still have a level of uncertainty with the new method of making an estimate. Uncertainty is the nature of estimates. Once time goes by and you become certain of events you can't go back and change them. The main reason we change most accounting principles in old periods is so the comparative financials use the same major accounting rules. The reason we don't change estimates in prior periods is because that level of uncertainty in estimates should be present in each periods financials. I hope I know what I am talking about 🙂

  January 8, 2014 at 1:21 am #502836 Reply

  Julia_anika

  Member

  Wiley book has a very simple explanation for this topic.. in just 1 sentence. The idea is that if you can't tell whether it's a change in accounting principle or a change in estimate – treat as as a change in estimate.

  January 8, 2014 at 1:21 am #502891 Reply

  Julia_anika

  Member

  Wiley book has a very simple explanation for this topic.. in just 1 sentence. The idea is that if you can't tell whether it's a change in accounting principle or a change in estimate – treat as as a change in estimate.

  January 8, 2014 at 4:23 pm #502838 Reply

  Study Monk

  Member

  A change in the periods benefited by a deferred cost because additional information has been obtained is

  A. A correction of an error.

  B. An accounting change that should be reported by restating the financial statements of all prior periods presented.

  C. An accounting change that should be reported in the period of change and future periods if the change affects both.

  D. Not an accounting change.

  Answer C is correct. ASC Topic 250 states that a change in the periods benefited by a deferred cost should be treated as a change in accounting estimate. Changes in accounting estimates are accounted for in the period of change and future periods if the change affects both.

  If the problem has a deferred cost that occurred in an earlier period treat it as an estimate. I also noticed that in the estimate problems wiley uses the phrase “additional information has been obtained”.

  January 8, 2014 at 4:23 pm #502893 Reply

  Study Monk

  Member

  A change in the periods benefited by a deferred cost because additional information has been obtained is

  A. A correction of an error.

  B. An accounting change that should be reported by restating the financial statements of all prior periods presented.

  C. An accounting change that should be reported in the period of change and future periods if the change affects both.

  D. Not an accounting change.

  Answer C is correct. ASC Topic 250 states that a change in the periods benefited by a deferred cost should be treated as a change in accounting estimate. Changes in accounting estimates are accounted for in the period of change and future periods if the change affects both.

  If the problem has a deferred cost that occurred in an earlier period treat it as an estimate. I also noticed that in the estimate problems wiley uses the phrase “additional information has been obtained”.

  January 11, 2014 at 6:03 pm #502840 Reply

  linkman311

  Member

  Perfect, thanks guys. I feel much better about this area now. Come to think of it Julia, I feel like I've heard one of my professors say something like that in class, but I never mentioned anything about “inseparable” so I guess it just threw me off guard.

  What is a change in accounting principle inseparable from a change in estimate?

  Changes in accounting principles can include inventory valuation or revenue recognition changes, while estimate changes are related to depreciation or bad-debt allowances. Principle changes are done retroactively, where financial statements have to be restated, while estimate changes are not applied retroactively.

  Which is an example of an accounting estimate change?

  Examples of Changes in Accounting Estimate Allowance for doubtful accounts. Reserve for obsolete inventory. Changes in the useful life of depreciable assets. Changes in the salvage values of depreciable assets.

  How should the effect of a change in accounting principle which is inseparable?

  When the effect of a change in accounting principle is inseparable from the effect of a change in accounting estimate, the reporting treatment for the overall effect is as a change in estimate. Thus, the effect is reported prospectively as a component of income from continuing operations.

  How is a change in accounting principle distinguished from a change in accounting estimate effected by a change in accounting principle?

  b) A change in accounting principles is the revision of the methods of accounting treatment like recording and reporting of financial information, whereas the change in estimate is related to the change in the specific calculation of financial data.