Page 537 - Accounting Principles (A Business Perspective)

13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock

Changes in accounting principle can materially alter a company's reported net income and financial position.
Changes in accounting principle are changes in accounting methods pertaining to such items as inventory.
Such a change includes a change in inventory valuation method from FIFO to LIFO.

According to APB Opinion No. 20, a company should consistently apply the same accounting methods from one
period to another. However, a company may make a change if the newly adopted method is preferable and if the
change is adequately disclosed in the financial statements. In the period in which a company makes a change in
accounting principle, it must disclose on the financial statements the nature of the change, its justification, and its
effect on net income. Also, the company must show on the income statement for the year of the change and the
cumulative effect of the change on prior years' income (net of tax).
According to FASB Statement No. 16, prior period adjustments consist almost entirely of corrections of

errors in previously published financial statements. Corrections of abnormal, nonrecurring errors that may have
been caused by the improper use of an accounting principle or by mathematical mistakes are prior period
adjustments. Normal, recurring corrections and adjustments, which follow inevitably from the use of estimates in
accounting practice, are not treated as prior period adjustments. Also, mistakes corrected in the same year they
occur are not prior period adjustments. To illustrate a prior period adjustment, suppose that Anson purchased land
in 2009 at a total cost of USD 200,000 and recorded this amount in an expense account instead of in the Land
account. Discovery of the error on 2010 May 1, after publication of the 2009 financial statements, would require a
prior period adjustment. The adjustment would be recorded directly in the Retained Earnings account. Assuming
the error had resulted in an USD 80,000 underpayment of taxes in 2009, the entry to correct the error would be:

May 1 Land (+A) 200,000
Federal income taxes payable (+L) 80,000
Retained earnings (or prior period 120,000
adjustments – Land) (+SE)
To correct an accounting error expensing land.
An ethical perspective:
Ace chemical company

Ace Chemical Company is a small, privately held manufacturer that has been operating at a profit

for years. The current balance in the Cash account is USD 8 million, and the balance in Retained
Earnings is USD 4 million. The company's plant assets consist of special purpose equipment that
can produce only certain chemicals. The company has long-term debt with a principal balance of
USD 10 million. Its officers (all of whom are stockholders) are concerned about the future prospects
of the company. Many similar firms have been sued by customers and employees claiming that
toxic chemicals produced by the company caused their health problems. No such suits have yet
been filed against Ace, but the officers fully expect them to be filed within the next two years.
The company's stock is not listed on a stock exchange, nor has it recently been traded. The officers
hold 70 per cent of the stock and estimate that their total stockholdings have a current market value

of about USD 8 million (although its value would be much lower if all the facts were known). They
are worried that if suits are filed and the company loses, there will not even be enough remaining
assets to satisfy creditors' claims, and the officers' stock would be worthless. Private legal counsel
has informed the officers that the company is likely to lose any suits that are filed.

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