Consistency, Changes in Accounting Principles, and Corrections of Errors
Comprehensive guidance on consistency of financial statements, accounting principle changes, error corrections, and their impacts on audit reporting for the CPA Exam.
15.3 Consistency, Changes in Accounting Principles, and Corrections of Errors
In financial reporting, users of the statements often compare results from period to period to assess performance and trends. Auditors therefore pay close attention to the consistency of accounting practices across different reporting periods. When organizations change accounting principles, adopt new estimates, or discover and correct errors, these adjustments must be handled in compliance with applicable standards. This section explores the concept of “consistency,” different categories of accounting changes, the auditor’s responsibilities for reviewing such changes, and the implications for the auditor’s report.
Importance of Consistency in Financial Statements
Consistency refers to the principle that financial statements should be comparable across multiple reporting periods. Users rely on consistent application of accounting policies to draw meaningful conclusions about a company’s performance, solvency, liquidity, and future prospects. The absence of consistency, or inadequate disclosure regarding changes in accounting principles, can diminish the relevance and reliability of financial statements.
For auditors, assessing consistency is not just about confirming that policies remained the same; it is also about ensuring that any material changes or errors are properly disclosed. If changes in policies or corrections of errors are not accounted for transparently, the auditor may need to issue an emphasis-of-matter paragraph (under AICPA standards) or an explanatory paragraph (under PCAOB standards) to inform users about the lack of comparability or the changes implemented.
Types of Changes Affecting Consistency
From an auditing standpoint, changes that can affect consistency generally fall into one of the following categories:
- Changes in Accounting Principles
- Changes in Accounting Estimates
- Corrections of Errors
Each has unique financial reporting implications and specific procedures that the auditor must perform when evaluating consistency.
1. Changes in Accounting Principles
1.1 Definition and Examples
A change in accounting principle occurs when an entity adopts a generally accepted alternative accounting principle in place of the one it previously used. Common examples include switching from:
• LIFO to FIFO inventory methods
• Completed-contract to percentage-of-completion method for revenue recognition
• Straight-line depreciation to an accelerated method
Under U.S. GAAP (FASB ASC 250), changes in accounting principle typically require retrospective application for all periods presented, unless it is impracticable to do so or the standards specifically mandate a different method.
1.2 Auditor’s Responsibilities
Auditors need to determine:
• Whether the new principle is in accordance with GAAP
• Whether the method of accounting for the change is in conformity with GAAP (e.g., retrospective application if required)
• Whether management has provided adequate disclosures explaining the nature, justification, and impact of the change
If the change in principle has a material impact on the comparability of financial statements, the auditor often includes an emphasis-of-matter paragraph alerting users to the nature of the change. The paragraph does not modify the opinion itself if the new principle and disclosures comply with GAAP; rather, it highlights that a material change has occurred.
1.3 Emphasis-of-Matter/Explanatory Paragraph
When an accounting principle change is material, the emphasis-of-matter or explanatory paragraph typically:
• Briefly describes the change and the periods affected
• States management’s justification for the change in conformity with the applicable financial reporting framework
• Indicates that the auditor’s opinion is not modified with respect to the matter, assuming the treatment is proper
1.4 Example Diagram Illustrating a Change in Accounting Principle
Below is a simple Mermaid diagram depicting a timeline of an accounting principle change from LIFO to FIFO:
flowchart LR
A[Beginning Inventory in Year 1: LIFO] --> B[Year 1 Financials: LIFO]
B --> C[Year 2 Financials: Change to FIFO]
C --> D[Retrospective Application: Restate Year 1 using FIFO if material and practicable]
D --> E[Year 2 Financials: FIFO]
E --> F[(Disclosure of Change in Notes)]
In this hypothetical scenario, the company changes to FIFO during Year 2 and restates Year 1 comparatives to maintain consistency and transparency.
2. Changes in Accounting Estimates
2.1 Definition and Nature of Estimate Changes
Accounting estimates involve management judgments about future events, such as the useful life of an asset, allowance for doubtful accounts, or fair value measurements of certain assets or liabilities. Over time, new information or changes in circumstances may lead management to revise these estimates. Because these changes relate to forward-looking judgments rather than fundamental accounting policies, they are generally accounted for on a prospective basis.
2.2 Prospective vs. Retrospective Treatment
• Changes in Accounting Estimates: Accounted for prospectively.
• Changes in Accounting Principles: Typically accounted for retrospectively (except when impracticable or otherwise directed by GAAP).
When an estimate changes, the financial statements for prior periods are not adjusted. Instead, the entity applies the new estimate to the current period and future periods, unless the change in estimate is so significant that it suggests an error in prior periods.
2.3 Auditor’s Responsibilities
The auditor examines the rationale, supporting documentation, and assumptions behind the new estimate. Crucially, the auditor must determine:
• Whether the revised estimate is reasonable
• Whether management’s judgment includes any potential bias or material misstatement
• Whether adequate disclosures are made if the change in estimate is material
The auditor typically does not issue an emphasis-of-matter paragraph solely for a change in estimate unless the change is so significant or unusual that it raises concerns about comparability or requires additional user attention.
3. Corrections of Errors
3.1 Identifying and Addressing Errors
Errors refer to unintentional misstatements or omissions of amounts or disclosures in financial statements. They may result from:
• Mathematical mistakes
• Misapplication of accounting principles
• Oversights or misuse of facts at the time of preparing financial statements
To the extent that prior-period financial statements were materially misstated, entities typically must restate comparative financial statements to correct the error. This process is known as a “restatement.”
3.2 Auditor’s Responsibilities
When errors are discovered, the auditor must evaluate:
• The materiality of the errors to current and prior financial statements
• The appropriate corrections and disclosures in accordance with GAAP (i.e., FASB ASC 250)
• Whether management’s restatement properly aligns with retrospective adjustments
If the error correction is material, the auditor should ensure the entity restates prior-period statements and adequately discloses the nature of the error, its impact, and how the correction affects previously issued financial statements.
3.3 Restatements: Reporting Considerations
When a restatement occurs, the comparative financial information is amended as if the correct accounting had been used historically. In the auditor’s report, the matter may be highlighted via an emphasis-of-matter (explanatory) paragraph if the adjustments are material or significant to users. However, if the restatement is properly accounted for and disclosed, the overall audit opinion may remain unmodified.
4. Impact on the Auditor’s Report
4.1 Determining Materiality
Not every change or error correction leads to a modification or additional paragraph in the auditor’s report. The auditor’s decision depends heavily on materiality:
• Immaterial Changes or Errors: No additional reporting paragraph is required, but the auditor still verifies that disclosures, if any, are not misleading.
• Material Changes or Errors: An emphasis-of-matter or explanatory paragraph is used to draw attention to the matter, provided it is accounted for and disclosed correctly.
4.2 Best Practices and Common Pitfalls
• Clear Policy Documentation: The entity’s choice of accounting principles should be well-documented, making it easier to identify a switch and justify it.
• Timely Correction of Errors: If errors are addressed early, they can often be resolved with minimal disruption. Delays may lead to more complex restatement procedures.
• Proper Disclosures: Both changes in principles and error corrections should include robust explanatory notes, helping ensure transparent communication with stakeholders.
Additional Considerations
Auditor’s Emphasis-of-Matter vs. Qualified Opinion
An emphasis-of-matter paragraph highlights an item of fundamental importance to users but does not affect the overall correctness or fairness of the financial statements. It differs from a qualified opinion, which arises when the financial statements as a whole are not completely in accordance with GAAP or the auditor cannot obtain sufficient evidence regarding a material matter.
Distinguishing Errors from Estimates
Management might initially classify a material misstatement as a “change in estimate” rather than an “error.” If the auditor concludes that the financial impact stems from incorrect prior accounting rather than new information and events, it should be categorized as an error. This distinction is critical to determine whether prior periods need to be restated or if the prospective approach is allowable.
Practical Example
Imagine a company with a significant patent asset initially estimated to have a 10-year useful life. After three years, the company realizes the asset is technologically obsolete sooner than expected and revises the remaining life to two years. This is a change in accounting estimate, accounted for prospectively beginning in the year of change. However, if the discovery reveals that management incorrectly applied the relevant accounting standard and materially overstated the patent’s useful life from inception, this may qualify as a correction of error, requiring retrospective restatement of prior periods.
Illustrative Mermaid Diagram: Decision Process Flow
The diagram below outlines how an auditor might analyze the nature of a change or correction:
flowchart TB
A[Change Identified] --> B{Identify Type of Change}
B --> C[Change in Accounting Principle]
B --> D[Change in Accounting Estimate]
B --> E[Error]
C --> F{Material?}
D --> H{Material?}
E --> I{Material?}
F -- Yes --> G[Retrospective Application + Disclosure + Emphasis-of-Matter (if needed)]
F -- No --> J[No Additional Reporting Requirement]
H -- Yes --> K[Prospective Application + Disclosure]
H -- No --> J
I -- Yes --> L[Restatement + Disclosure]
I -- No --> J
J[No Emphasis-of-Matter Needed]
G --> M[(Audit Opinion May Include Emphasis-of-Matter)]
K --> N[(Audit Opinion Usually Unmodified)]
L --> O[(Audit Opinion May Include Emphasis-of-Matter)]
This logic tree helps auditors navigate whether a disclosure or an emphasis-of-matter paragraph is required.
Glossary of Terms
• Change in Accounting Principle: Adoption of a generally accepted alternative principle or method that differs from one previously used, potentially requiring retrospective application under GAAP.
• Retrospective Application: Revising prior-period financial statements to reflect the new method as if it had always been in use.
• Restatement: Revising previously issued financial statements to correct material misstatements due to errors or misapplication of accounting guidance.
References and Resources
• AU-C Section 708, “Consistency of Financial Statements” – Provides auditing guidance related to consistency and changes in a client’s application of accounting principles.
• FASB ASC 250 – Governs accounting changes and error corrections under U.S. GAAP.
• SEC Staff Accounting Bulletin (SAB) 99 – Offers guidance that helps determine materiality for registrants.
• Journal of Accountancy – Articles clarifying the distinction between errors, estimates, and changes in principles.
Quiz: Consistency, Changes in Accounting Principles, and Corrections of Errors
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