The cumulative-effect approach results in a loss of comparability. Also, reporting the cumulative adjustment in the period of the change can significantly affect net income, resulting in a misleading income for example, at one time Chrysler Corporation changed its inventory accounting from LIFO to FIFO. If Chrysler had used the cumulative-effect approach, it would have reported a $53,500,000 adjustment to net income. That adjustment would have resulted in net income of $45,900,000, instead of a net loss of $7,600,000. A second case: In the early 1980s, the railroad industry switched from the retirement-replacement method of depreciating railroad equipment to more generally used methods such as straight-line depreciation. Using cumulative treatment, railroad companies would have made substantial adjustments to income in the period of change. Many in the industry argued that including such large cumulativeeffect adjustments in the current year would distort the information and make it less useful. Such situations lend support to retrospective application so that comparability is maintained.
Changes in Accounting Principle Retrospective Accounting Change: Long-Term Contracts
Illustration: Denson Company has accounted for its income from long-term construction contracts using the completed-contract method. In 2020, the company changed to the percentage-ofcompletion method. Management believes this approach provides a more appropriate measure of the income earned. For tax purposes, the company uses the completed-contract method and plans to continue doing so in the future. (Assume a 20 percent enacted tax rate.)
What Do the Numbers Mean?: Change Management (1 of 2)
Halliburton offers a case study in the importance of good reporting of an accounting change. Note that Halliburton uses percentage-ofcompletion accounting for its long-term construction-services contracts. The SEC questioned the company about its change in accounting for disputed claims. Prior to the year of the change, Halliburton took a very conservative approach to its accounting for disputed claims. That is, the company waited until all disputes were resolved before recognizing associated revenues. In contrast, in the year of the change, the company recognized revenue for disputed claims before their resolution, using estimates of amounts expected to be recovered. Such revenue and its related profit are more tentative and subject to possible later adjustment. The accounting method adopted is more aggressive than the company’s former policy but is within the boundaries of G AAP. It appears that the problem with Halliburton’s accounting stems more from how the company handled its accounting change than from the new method itself. That is, Halliburton did not provide in its annual report in the year of the change an explicit reference to its change in accounting method.
What Do the Numbers Mean?: Change Management (2 of 2)
In fact, rather than stating its new policy, the company simply deleted the sentence that described how it accounted for disputed claims. Then later, in its next year’s annual report, the company stated its new accounting policy. Similar transparency concerns have been raised when companies, like Hawthorn Bancshares, did not provide sufficient explanation about their changes to fair value accounting for their mortgage servicing rights. When companies make such changes in accounting, investors need to be informed about the change and about its effects on the financial results. With such information, investors and analysts can compare current results with those of prior periods and can make a more informed assessment about the company’s future prospects. Sources: Adapted from “Accounting Ace Charles Mulford Answers Accounting Questions,” Wall Street Journal Online (June 7, 2002); and J. Arnold, B. Blisard, and J. Duggan, “Dealing with the Implications of Accounting Change,” FEI Magazine (November 2012).
Changes in Accounting Principle Reporting a Change in Principle
Major disclosure requirements are as follows.
Nature of the change in accounting principle.
The method of applying the change, and: a. A description of the prior period information that has been retrospectively adjusted, if any. b. The effect of the change on income from continuing operations, net income (or other appropriate captions of changes in net assets or performance indicators), any other affected line item. c. The cumulative effect of the change on retained earnings or other components of equity or net assets in the balance sheet as of the beginning of the earliest period presented.
Illustration (Change in Principle—Inventory Methods): Assume that Lancer Company has accounted for its inventory using the LIFO method. In 2020, the company changes to the FIFO method because management believes this approach provides a more appropriate reporting of its inventory costs.