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Chapter 14: Problem 9

Discuss any inconsistencies that are introduced when accounting principle changes occur.

Short Answer

Expert verified
Inconsistencies introduced when accounting principles change can create discrepancies in financial reporting across different periods and inconsistencies in financial statements between different companies. For example, changing the inventory accounting method from FIFO to LIFO affects cost of goods sold and the remaining inventory value, making it challenging to compare with previous years and with other companies using different methods.

Step by step solution

01

Understanding Accounting Principle Changes

Accounting principles are the rules and guidelines that companies must follow when reporting financial data. The common set of U.S. principles is the Generally Accepted Accounting Principles (GAAP). Changes in these may occur due to revisions in law, in practices or advancement in technology.
02

Discussing Possible Inconsistencies

The change in accounting principles can introduce inconsistencies in several ways. For instance, they may create discrepancies in financial reporting across different periods, making it difficult to compare a company's financial performance; they might add inconsistencies in financial statements between different companies, which makes it harder for investors and regulators to compare and evaluate corporate performance.
03

Giving Real-life Examples

For example, a change from FIFO (First In First Out) to LIFO (Last In First Out) inventory method will not only affect the cost of goods sold and the remaining inventory value, but also comparisons with previous years and other companies that continue to use different accounting methods.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

GAAP
The Generally Accepted Accounting Principles (GAAP) are a set of guidelines and standards used by companies in the United States to ensure consistency and transparency in financial reporting. GAAP provides a framework that ensures financial statements are accurate and standard across companies and industries, facilitating easier comparison and understanding for investors and stakeholders. These principles are essential because they ensure:
  • Consistency: Financial information from different companies can be compared.
  • Reliability: Users can trust that the financial information is true and fair.
  • Relevance: Information is useful for making economic decisions.
  • Understandability: Financial reports are clear and comprehensive.
However, sometimes GAAP guidelines evolve due to changes in laws, economic environments, or advancements in accounting practices, which can introduce complexities in maintaining comparability across periods or companies.
Financial Reporting
Financial reporting is the process of producing statements that disclose an organization's financial status to management, investors, and the government. These reports include the income statement, balance sheet, statement of cash flows, and statement of changes in equity. Each report serves a distinct purpose:
  • Income Statement: Shows revenues, expenses, and profit over a period.
  • Balance Sheet: Displays assets, liabilities, and equity at a specific point in time.
  • Cash Flow Statement: Summarizes cash inflow and outflow activities.
  • Statement of Changes in Equity: Details shifts in ownership interest over time.
As accounting principles change, such as shifting from FIFO to LIFO inventory methods, these changes can impact how these reports are interpreted. Investors and regulators rely on them to track performance, and inconsistencies due to accounting changes must be clearly communicated to maintain trust.
FIFO vs. LIFO
FIFO (First In First Out) and LIFO (Last In First Out) are two inventory methods used to value the cost of goods sold (COGS) and ending inventory. The choice between FIFO and LIFO affects a company's financial reporting and tax liability:
  • FIFO: Assumes the oldest inventory items are sold first. Typically results in lower COGS and higher profits during periods of rising prices because older, cheaper inventory costs are matched against current revenues.
  • LIFO: Assumes the newest inventory items are sold first. This method can result in higher COGS and lower profits if prices rise, as the recent, more expensive inventory costs are used.
Switching between these methods can significantly impact financial reporting consistency. For example, changing from FIFO to LIFO will alter past financial performances and complicate comparisons with companies that do not make similar changes.
Inconsistencies in Financial Statements
Inconsistencies in financial statements can occur when companies change their accounting principles, such as moving from FIFO to LIFO. These changes can create confusion, such as:
  • Comparability Issues: New methods may not align with historical data, making it difficult to assess trends or performance accurately over time.
  • Benchmarking Challenges: Companies that change principles may not be directly comparable to peers that follow different standards.
  • Investors' Decision-Making Impact: Investors rely on consistent financial data to make informed decisions. Changes can obscure a company's true financial health or mislead investors if not fully understood.
To manage these inconsistencies, companies must provide adequate disclosures and explanations when principles change, ensuring stakeholders can accurately interpret the impacts on financial statements.

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Most popular questions from this chapter

Match the following terms to the correct description. For each situation, describe in words (ignore the dollar amounts) what accounting treatments are required. a. Change in accounting principle, cumulative effect reported b. Change in reporting entity c. Change in accounting estimate d. Change in principle, retroactive effect reported ______1. Shipley Office Products, Inc. used equipment for three years and depreciated it on the straight-line basis. The original useful life was seven years, but after three years the company decided to change the original life to five years. ______2. American Shoe Corporation purchased all the outstanding stock of Faborini, Inc. in early 1998. American Shoe Corporation is preparing its comparative financial statements for the year ended December 1998. ______3. Sportscards USA decided to change its inventory costing method from LIFO to FIFO. ______4. The Second Time Through apparel shop has been owned by Homer Sampson. He wanted to raise capital to expand, so he decided to "go public" and offer the company stock for sale in the open market. At the same time, the company implemented an accounting change for postretirement benefits and calculated the cumulative effect of going from "pay-as-you-go" to estimating retirement benefits and accruing an expense each year.

Why would a firm that is issuing its first public financial statements have more latitude in using retroactive adjustments for the effects of accounting changes?

Why are interim reports less reliable and less useful than annual reports? In what major ways do interim reports differ from annual reports?

Identify the differences between relevance and reliability. Which would a manager emphasize? A financial analyst?

A firm has a computer that originally cost 37,500 dollars with an estimated salvage value of 17,500 dollars and an estimated life of five years. During the first two years, the firm used straight-line (SL) depreciation. In the third year, the sum-of-theyears'digits (SYD) method was adopted. a. Calculate the depreciation expense during the first two years under each method. b. What would have been the effect, before taxes, on the accounting equation if SYD had been used during the first two years instead of SL? c. Describe the general principle that must be followed to account for the difference d. What depreciation expense will be shown in the third and each subsequent year, using SYD?
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