 Hello and welcome to this session in which we would look at accounting changes such as changes in accounting principle, changes in estimates and error correction. This topic is typically covered in a Chapter 3 or Chapter 4 Intermediate Accounting. Although they're covered early on in an intermediate accounting course, please rest assured that this topic is covered heavily in a separate chapter. What does that mean? It means although I'm going to be covering those topics today, changes in accounting principle, changes in estimate and correction of errors, the reason I am going over these three topics, it's because to explain how they relate to the income statement. Those topics by themselves, those three topics will have to be covered much, much more in details later on. So in this session, I will show you basically what you need to know. So it's very important to understand what I do today about accounting changes, changes in accounting principle, changes in estimate and corrections of errors. Now this topic is also covered heavily on the CPA exam. Whether you are an accounting student or a CPA candidate, I strongly suggest you take a look at my website, farhatlectures.com. I don't replace your CPA review course, I'm a useful addition. I provide alternative resources for you to pass the exam. Your risk is one month of subscription, your potential gain is passed in the exam. Take a look at my website to find out how well or not well your university doing on the CPA exam. Also take a look at my course catalog. I have courses that cover basically all accounting courses. My supplemental CPA material align with your Becker, Roger, Wiley, Gleam or your CPA review course. So it's easy to switch back and forth. Also if you haven't connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation like this recording, share it with other, connect with me on Instagram, Facebook, Twitter and Reddit. Now if you know anything about me, anytime I have a list, one, two, three. It means I'm going to go over this list separately, starting with changes in accounting principle. How do we handle changes in accounting principle? Well the first thing you want to keep in mind, it's retro and I'm going to explain what does that mean in a moment. And what is changes in accounting principle? The changes in accounting principle is basically going from a U.S. gap to another U.S. gap. So you're going gap to gap. So you did not make a mistake, you're just switching accounting method. Like what? Going from FIFO to LIFO and accounting for your inventory or changes from the percentage of completion method to the complete contract method and recognizing revenue. They're all gap methods, just you decided to switch. What happened if we decide to switch? We handle this switch. We handle this change retrospectively. What does retrospectively means? Means we have to go back and change prior years. So it's a lot of work. So it's hard. It's hard work to do, a lot of work to do. Okay, why? Because we have to go back and change the prior years. And let's assume we have, just for now I'm going to explain this concept, but it will appear later with you with another chapter. Let's assume the current year is 2025 and we're making the change in 2025. But for illustration purposes, we're only showing, we're only presenting 23. Let me change to a different color. We're only presenting 23, 24 and 25. But the change also affect 21 and 22. What do we have to do with those changes? We're going to compute the change and take the change, whether that change is going to increase retained earning or decrease retained earning and we adjust the beginning retained earnings of 2023, the earliest year we are presenting. Now why do we do that? This approach preserves comparability. So once we change from 50 to LIFO, now 2023 is the new method, 2024 the new method and 2025 is the new method. And any prior years where the change affect those prior years will just compute the total change and plug the whole thing, add the whole thing to retained earning or deduct it from retained earning, depending whether the change increase retained earning or reduce retained earning, whether the change increased your income, which is will increase retained earning or as a result reduce your income, it will reduce retained earning. But again, we don't have to worry about this prior years cumulative change until in a later chapter. So let's take a look at an example to illustrate this concept. Adam Eng decides in 2025 to change from LIFO, which is a gap method to the weighted average, which is also another gap method. So we're going from gap to another gap. Adam's income before taxes using the new weighted average method in 2025 is 300,000 and we are dealing with a 21% tax rate. So let's take a look at what happened with the change. In 2023, when we move from LIFO to LIFO, there was an excess LIFO over weighted average of 50,000. Now, rather than 400,000, now we have 350,000 of taxable income. And for 2024, we went from 300,000 to 270. So the total is 800,000. How do we present this? And this is the only year that are affected, 23, 24, and we're presenting 23, 24, and 25. For the new revenues, income before taxes, we use the new numbers. Simply put, we go back and we adjust. We adjust. We go back and change prior years. So notice the 350 now is our income for 2023. 270 is our income for 2024. And obviously 2025 is using the new method, the weighted average 300,000. Now we apply the taxes 21% and we come up with net income. So this example is simple. It's because we don't have 22, 21, or 20 affected. And what do we have to do if those were affected and we are only presenting 23, 24, 25? This is what I was talking about earlier. We don't have to worry about this now. So all that you have to know for now, just to kind of review everything here. What is any changes in accounting principle going from gap to gap? The change is handle retrospectively, retrospective. And if there's any cumulative adjustment, it goes into beginning retained earning. And the reason we do this is to preserve comparability. So and obviously we have to disclose this. I don't, you know, I don't have to tell you this, but we have to tell the users we change accounting method. The second issue we have to deal with is change and accounting estimate. And we handle this prospective, prospectively, not retrospectively. Now estimates are an inherent thing in our accounting system. We always do estimates. We estimate that expense. We estimate warranty expense. We estimate depreciation in terms of years of the useful life of the asset, salvage value, so on and so forth. So it's something normal, reoccurring adjustments. Change of an estimate is not an error. So when you change an estimate, it doesn't mean you made an error because we have, if we made an error, we're going to talk about how do we deal with an error next. So changes in estimates are prospectively. Prospectively means easy. And that doesn't mean easy, but prospectively it's easier out of two retrospectively. And I'm going to explain why. Because when we make a change in estimate, we account for that change only in the current period and in future period. That's it. So simply put, we don't have to go back. And that's easy for everyone. It's easy for you as a student, and especially it's easy for people who are working in the real world. Because you don't have to go back and change financial statements from the past. It's not an easy task to do, believe me. So examples would include in changes in accounting estimate. As I said, if you're doing depreciation, the useful life of the asset is an estimate. The salvage value is an estimate. Allowance for incollectible receivable, but that expense is an estimate. Inventory obsolescence, when you estimate that number, changes in liabilities for warranties. You estimate your warranties. So that's easy. But we're going to work an example to illustrate what does it mean we handle those changes prospectively. Easy. Waste management purchase equipment for million and 20,000, which estimated to have a useful life of 10 years with a salvage value of 20,000. Depreciation has been recorded for seven years on a straight line basis. Let's stop here. Let's see what we have. So we have an asset with a cost of million, 20,000, salvage value of 20,000. Depreciable base is a million. And we depreciate this asset over 10 years. In other words, we will deduct in every year $100,000 of depreciation. We're going to have a depreciation expense, 100,000. Accumulate depreciation, 100,000. So far, so good. This is what we've been doing. In 2020, which happens to be year eight, it determined that the total estimated useful life should be 15 years. So what did we do? And the salvage value go down to zero. So we did, we said, look, we thought it's going to last us 10 years, those assets. Now we're going to extend their life to 15 years. Can you do that? Absolutely, you can do that. As long as you have a business reason, why not? Because you already, when you gave those assets 10 years, you made an estimate. Now you change your estimate. When you said the salvage value is 20,000, it's an estimate. Now you said the salvage value is zero. I'm not getting any salvage value. That's an estimate as well. That's fine. So what do you have to do? First, you have to compute all of your depreciation up to this point. We already did seven years. So 100,000 times seven is 700,000. Then we compute the new book value of the asset. The big value is the cost minus any depreciation up to this point called accumulated depreciation. Now we have a new asset with the book value of 320. Now this is our new asset. And this asset now has a useful life of eight years with no salvage value. Now we can recompute our depreciation. Book value 320 minus zero of salvage value, which will give us a depreciable base of 320. Divide this amount by eight, which is year eight, nine, 10, 11, 12, 13, 14, and 15, which is eight years left. Will give us an annual expense now of 40,000. Now our new, so this is our old depreciation. And now we're going to look at our new depreciation expense is depreciation expense 40,000, accumulated depreciation 40,000. So notice what happened. We cut down our depreciation by more than half. We went from 100,000 to 40,000 in depreciation expense. Again, is this allowed? And the answer is yes. Is this allowed to commit fraud? And the answer is no. Why am I saying this? I'm not sure if you heard of this company called Waste Management. Obviously in the US, I'm sure you heard of them because they're everywhere. But Waste Management, that's what they do. They collect garbage and they have landfield. It's so their assets consist of trucks and more fixed asset that are subject to depreciation. So what they did by playing this game, changing their depreciation numbers, they cooked their profit by $1.3 billion, billion dollar over a period, I believe seven to 10 years. So it was less than that. Over several years. But the point is they increased their profit by $1.3 billion by playing those games. Obviously they were caught and you're saying, you just said it's okay to do it. Yes, it's okay to do it as long as you do those changes and estimate in good faith. But if you're trying to cook the books using those figures to use depreciation, you'll be caught and you'll go to jail and pay a fine like Waste Management and your stock price will suffer like what happened to Waste Management. So yes, changes and estimates are allowable, but not to cook the books. That's not their purpose. Last but not least is corrections of errors. Now this is different than estimate. Now you made the mistake and error is a mistake. It result from mathematical mistake, misuse of facts, mistake in application of accounting principle, not change. You just mistake how you made the mistake of how you use. Now those changes are reported net of tax. Again, we'll talk about net of tax later on. Just need to know the reported net of tax. And what we do when we find an error, if it happened in the prior year, look, before we go on the prior year, what happened if you catch an error in the current year? So you are booking accounting transaction and you find an error. What do you do with this error? The error might have overstated your revenue or understated your revenue, overstated your expenses or understated your expenses. That's fine. You can reverse the error. You can do a journal entry and fix the error. So it's not a problem. So if you find the error in the current year, it's like water under the bridge. You'll fix the error and nothing would happen. The problem is when you don't discover this error until the following year. Then what happened is you can't go back and change your revenues and expenses because your revenues and expenses every year they are closed at the end of the year. So what do you have to do? Well, you have to compute the error and adjust beginning retained earning net of tax. Again, don't worry about net of tax here, but all you need to know is you adjust your beginning retained earning. We'll worry about this in a separate chapter. Of course, if you made an error from the prior year, for this year, you don't tell anyone you made an error, but if the error from the prior year, you disclose this because the users of the financial statements, they're gonna be confused. What happened to your numbers? Why did they change? What's that change in retained earnings? They need to know because you're gonna be adjusting retained earning. So simply put, you're gonna have beginning retained earnings and right underneath it, you're gonna have an adjustment. The beginning retained earning is 100,000 and we made an adjustment and we increased retained earning by 10,000. So everybody's gonna be asking you, what is that adjustment? Now your retained earning is 110 or your retained earning went from 100 to, let's assume the error reduced your retained earning by 10,000. Now your beginning retained earning is 90,000. So it changed. So what happened to your retained earning? Obviously you have to disclose this, but the change goes into the beginning retained earnings. So in 2025, Adam determined that it's incorrectly overstated. It's account receivable and sales by 200,000 in 2024. Now if we catch this error in 2024, we just have to reverse it. Debit sales, credit account receivable, take it out, everything is good. In 2025, it's too late to do that. So we know that revenue went up, sales revenue went up. So we have to fix that error. How do we fix the error? We debit retained earning, we reduce retained earnings and account receivable will stay with us from year to year. Remember account receivable is a real account. So we still have that 100,000, then we remove this 100,000 and we fix the problem. If it was in the prior year, we would have debit it sales if we caught it in the prior year and nobody would know. Because by the time we issue the financial statements, everything will be correct. But when we discovered the error the following year, then we have to adjust, make the adjustment to retained earning. Again, I ignored the net of tax. We'll talk about that later. It's enough for you for now. At the end of this recording, once again, I'm gonna remind you whether you are an accounting student or a CPA candidate to take a look at my material, farhatlectures.com. I don't replace your CPA review course. You keep that. You keep Peter Alento, you keep your Glim, you keep your Becker, you keep your beloved CPA review course. I can add, I'm a useful addition. I can add information, I can add resources. I can show you the material from a different perspective. And I hope that will help you on the exam. If that works for you, give it a chance, one month of subscription, invest in yourself. You like it, you keep it. You don't like it, guess what, canceled. And that's it, that's your risk. Good luck, study hard. The CPA is worth it, study hard for it.