Assuming the policy change is considered material, how should it be reported and disclosed in the 2018 financial statements and what would be the effect, if any, of the accounting change on the auditor's report?
What will be an ideal response?
Based on ASC 250, there are 3 possible ways to account for the policy change: a change in accounting
principle, a change in accounting estimate, or a change in accounting error.
The best argument for considering the client’s policy change as a change in accounting principle
seems to be that the client previously used the cash method to account for tooling supplies and now
will used the accrual method of accounting. According to ASC 250, a change in accounting principle
requires that financial statements for each individual prior period presented shall be adjusted to reflect
the period-specific effects of applying the new accounting principle. However, the cash method is
non-GAAP, furthermore, ASC 250-10-45-1 states that an “initial adoption of an accounting principle in
recognition of events or transactions occurring for the first time or that previously were immaterial in their effect"
is not considered to be a change in accounting principle. Given that the prior year transactions were
considered immaterial, this suggests the client’s policy change is not a change in accounting principle.
The best argument for considering the policy change a change in accounting estimate seems
to be that the client previously estimated useful life of the supplies as zero and now the useful life is
indefinite and will be expensed as used. If the tooling supplies were a depreciable asset, then ASC 250
states that a change in the method of valuing depreciation, amortization, etc. of depreciable assets is
considered a change in estimate effected by a change in accounting principle. As such, prospective
accounting adjustments only are required. ASC 250-10-45-17 states , “A change in accounting estimate
shall be accounted for in...the period of change and future periods...A change in accounting estimate shall not
be accounted for by restating or retrospectively adjusting amounts...”
If the change qualifies as a change in accounting estimate the financial statements would be
affected as follows:
The current year’s financial statements as well as future statements will be reported consistent with
the new policy. Therefore the policy change in 2018 resulted in a $330,000 reduction in expense
(and a related increase to net income) and a $330,000 increase to other current assets when they capitalized unused tooling supplies in 2018. A footnote would be added to discuss the change.
ASC 250 does not require retrospective application to prior periods’ financial statements.
Therefore, no adjustment should be made for the $35,000 expensed in 2017, but still on hand at
the beginning of 2018.
The third way the policy change could be characterized is a change in accounting error. The prior way
of accounting for tooling supplies, the cash method, is not consistent with GAAP. As such, the change
in policy represents a correction of an accounting error. However, the client would likely argue that
past years do not represent an error as GAAP allows for the pervasive cost constraint.
Given that the cash basis is not acceptable under GAAP it seems this policy change is best
considered a correction of an accounting error. To properly account for a correction in accounting
error, the change in policy would be disclosed and when the comparative 2017 and 2018 statements
are issued, 2017 would be adjusted to show $35,000 more in other assets and $35,000 less in expense.
Similarly, the 2018 statements would show $35,000 more in expense.
However, regardless of how the change is accounted for, the impact on 2018 is similar in
magnitude because of the small amount of inventory on hand at the beginning of 2018. The primary
issue the auditor and client need to resolve is a determination of whether the effect of the change is
material and will require disclosure.
Even if the client and auditor decide to account for the change as a correction of an error, the
previously issued 2017 annual report would not need to recalled and restated because the impact on
2017 is so small. Rather the adjustment would be made to the 2017 comparative financial statements
presented in the 2018 annual report.
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