 Hello and welcome to the session, this is Professor Farhad in which we will discuss accounting changes, an important topic in accounting. We make changes in accounting all the time, whether that change is a change in accounting principle, change in estimate, change because of an error, regardless, we need to preserve comparability of financial information. Simply put, when there's a change from year to year, we need to present the change so we can compare the information, the financial information from year to year. Otherwise, historical financial data would lose its relevance, we would lose the trend, so it's very important to understand how do we handle accounting changes. Specifically, we deal with three types of accounting changes, change in accounting principle, and here change in accounting principle means going from one gap method, from one gap method to another gap method. So they're both gap, they're both, both acceptable and we're going from one to the other, such as going from the average cost to LIFO for inventory, going from the completed contract to the percentage of completion. Specifically, in this session, we're going to be focusing on this type of a change, but that's not the only one, we're going to have change in accounting estimate, we'll have a separate session for that, a change in reporting entity will have a separate session for that. Also, you have to know that we have, sometime we do commit errors as humans. Errors are not considered accounting change. So errors are mistakes, whether you misapply a concept or you made a mathematical error, they're errors, they're mistakes. Also adopting a new principle for an event for the first time, or the amount was previously immaterial is not considered an accounting principle change. Sometime you might see a multiple choice question about this, just know this. There are three approaches. Again, there are three changes and we're going to be focusing on one change, change in accounting principle, and there are three approaches to deal with changes. Currently, which is deal with the change this period only currently, retrospectively. And in this session, we'll focus on retrospectively, because if there's any changes in accounting principle, we'll have to handle this change retrospectively. Therefore, we have to spend few minutes explaining, what do we mean by retrospectively? And how is retrospectively used? And obviously, we have to look at an example to apply because I'll explain in theory what does it mean, but if you don't see it in an example, it doesn't make any sense. Retrospectively means you will need to adjust the financial statement for each period presented to the same basis as the new accounting principle. So what does that mean? It means let's assume we have four-year period x1, x2, x3, and x4. And let's assume in x4, you made a change in accounting principle. And this change affecting x1, x2, x3, and x4. And you are presenting, listen to me carefully, and you are presenting x1, x2, x3, and x4. Then you have to go back and do the change in all the years. Because to preserve comparability, you have to go back to do the change in case those financial statements are presented. Otherwise, you cannot use a new method here, old method here, old method here, and old method here. If you're presenting all of them, you have to show the change. Or here's what's going to happen. Let's assume there's a change, and you are only showing, listen to me carefully now, we're changing the example now, you're only showing gear x4. So you're not showing x3, x2, and x1. However, the change affect x3, x2, and x1. So what do you do? Under those circumstances, you compute the change. You compute the change. Okay, so adjust the carrying amount of assets and liabilities at the beginning of the first year presented. So here we're assuming we're only presenting x4 and adjust the retained earning. So what we do is we go back and we do the computation for x1, x2, x3. We compute the change and all this change, whether it's changing assets or liabilities, eventually it's going to affect in the income statements. The income statements are gone. So we change retained earning. So all the change will be put into the beginning retained earning. Obviously, when I say retained earning, you're also affecting assets and liabilities related to that retained earning. But the change will be in the beginning retained earning of x4 because we are not showing x3, x2, and x1. So that's another way to do it. Also, let's assume you're only showing there's a change and that change only affect x3 and x4. It doesn't affect x2 and x1. Then just if you want to go back and present x3 and x4, you recast the financial statement showing the new method for x3 and x4. So that's an easy one. Also, sometimes we handle the change prospectively, which is going into the future and we'll see what that means later once we use it. So in this session specifically, we're going to be focusing on changes in accounting principle and changes in accounting principle are handled retrospectively. And that's the most challenging of the three changes, actually. Remember, why do we handle this? Retrospectively, we go back retrospectively to preserve comparability from one period to the other. Now, the best way is to look at an actual example. Now, before we look at an example, whether you are a student, accounting students, or a CPA candidate, that's most likely who you are if you're watching. And if you're watching, it means you are looking for some help and you found me on YouTube. That's great. Go a step further if you want additional help. Forhatlectures.com, I provide you additional resources, lectures, multiple choice, true, false, that's going to help you understand, practice, learn the material. I don't replace your CPA review course. I don't replace your accounting course. I'm a useful addition. I'm a companion to your education. Invest in yourself. Don't hesitate. Connect with me on LinkedIn if you haven't done so. Like this recording, if you're watching, it's helping you like it. It's going to help others as well and share it with other. Connect with me on Instagram, Facebook, Twitter and Reddit. So let's take a look at this example. In 20x4, Adam company changed to the percentage of completion method from the completed contract. So we want from one gap method, which is the completed contract method to the percentage of completion. Now, the assumption here is, you know, what's the completed contract method is, what is the percentage of completion? If not, you can go to Forhatlectures about the revenue and look at them. Otherwise, just accept that it's a change from gap to gap and we can work with this for now. Adam believes this approach provides a more appropriate measure of the income earned and for tax purposes, the company uses the completed contract method in plan to do so in the future and assume 20% tax rate. So let's take a look at the figures and see how we approach a problem like this. For the completed contract method, which is the old method, here's our income before taxes for x4, x3 and x2. This is income before taxes. Now, these are the taxes, 20% taxes, and this is net income, which is net income after tax. This is the old method. If we compute our figures using the new method, the new method means that the percentage of completion will change the method, our revenue from for x4 goes from 200,000 to 220,000 and our taxes becomes 44,000. x3 goes from 170 to 200 and x2 go from 410 to 700,000 and obviously the taxes will change. Now, what do we need to do? We are presenting, let's assume we are only presenting x4. x4 means just we are only presenting x4. So what do we need to do? We need to compute the changes in x2, x3 and adjust the beginning retained earning of x4 because we're not going to go back and present x2, x3 and x4. If we need to do so, we need to go back and recast the financial statement, show them, show the new method, how the new method works, if that's the case. Let's compute the changes and see how we book this entry. For year x2, starting with year x2, this is the new method, this is the old method. Under the old method, income was 410,000 for that year. Income under the new method is 700,000. Our income before taxes went up, went up by 290,000. For year x3, our old income was, let's see, our old income was the completed contract, 170. Our new income is 200,000. Obviously, we are reporting more income under the percentage of completion because you would accelerate the revenue process, you would receive it earlier. Our income went up 30,000. All in all, the difference for the two years is 320,000. Obviously, we have to pay more taxes because if we earned 290,000 in income, our taxes are 58,000. If we earned 30,000 additional in income, our taxes will go up by 6. Overall, our income went up by 232,000 gross income. Taxes went up by 24,000 and net income went up by 256,000. We need to prepare the journal entry at the beginning of x4, at the beginning of x4. The difference in income is 300,000. The gross income is 320,000. Now, if you know anything about construction accounting or accounting for construction companies, you dump this change in construction and progress. This is an asset. You increase this asset, which is inventory, construction and process because this is how you do it. You will increase the asset because we have more assets. We created more asset as a result of accelerating revenues. We're recognizing more of the construction and process, more of the inventory. We credit the third tax library. We have now an additional tax library to worry about because we changed the method 64,000 and our earnings went up by 256. Now, we cannot go back and increase net income. Why? Because the prior year are closed and we're not presenting them. We are taking all the change, which is the net change is 256,000. As a result of this change, net income over the past two years, net income after taxes would have increased by 256. As a result, your retained earnings would have been higher by 256. Your retained earnings is higher. 64,000 gross revenue is 320, but you have to pay taxes. The net is 256, and you have to add to your assets construction and process 320,000. This is the entry that you make at the beginning of year X4 because we are showing X4 going forward. If we are presenting anything prior to X4, well, we have to change the financial statements and dump the change in retained earnings in the earliest year. Simply put, let's assume we're only showing year three and year four. We're only showing those two. We'll take the change, whatever change happened in X2, put it in the beginning retained earnings in X3, then we keep going. So just make sure you know that you will take the change and you will put it in the beginning retained earnings if you are not showing all the financial statements, if you are not recasting all the financial statements. What else do you have to do? Well, you have to disclose. This is important. When you make a change, you have to disclose. So we have to see how do we disclose this information? What do we disclose? Well, think about it. You're going to disclose the nature of the change. You're going to have to disclose the method. How did you change it? The method and applying the change, a description, what happened to the prior period information that was retrospectively adjusted? Just tell us. If any, especially if we are not seeing it, just show us what's happening. A change of income. What happened to the change in income? Whether it's continuing operation income from continuing operation or net income. Show me the change, the cumulative change in retained earnings. Remember, we're going to have a change in cumulative retained earnings or other component of equity. Show me the change in assets as of the beginning of the earliest period presented. So simply put, let me show you how what would look like if we are, if we did this change in year X4. Let us assume beginning retained earnings happens to be 355. Remember, we computed the change as 256. The change in retained earnings. So this is 256. So this is how we show it in the beginning retained earnings statement 256. Now the new, the adjusted retained earnings is 611 plus this year income equal to ending retained earnings. So it's not only we make the change, we have to disclose the change. What should you do now? You should go to farhatlectures.com and work MCQs, true, false, additional exercises, view lectures that's going to help you understand this topic better. I will work another example that deals with the change with inventory. Good luck, study hard, invest in yourself, the CPA is worth it.