ASC 250, Accounting Changes and Error Corrections, tells a preparer how to account for three kinds of accounting changes and for the correction of errors in previously issued financial statements. The kind of event decides the accounting: some are applied retrospectively, some prospectively, and an error correction is not an accounting change at all. Auditors meet ASC 250 whenever prior-year numbers move, which is when the audit report, the engagement letter's scope and the client's lender all become involved.
For short definitions, see the change in principle vs estimate and restatement vs revision glossary entries.
What are the types of change and how is each accounted for?
| Event | Accounting under ASC 250 |
|---|---|
| Change in accounting principle | Allowed only if required by a new pronouncement or if the entity can justify the new principle as preferable. Applied retrospectively to prior periods unless impracticable. |
| Change in accounting estimate | Applied prospectively. Prior periods are not restated. |
| Change in reporting entity | Applied retrospectively to the financial statements of all prior periods presented. |
| Correction of an error | Not an accounting change. Corrected in prior periods; presentation and disclosure depend on materiality. |
Change in accounting principle
An entity may change a principle only if it is required by a new accounting pronouncement or the entity can justify the allowable alternative as preferable (ASC 250-10-45-2). Applying a new ASU under its transition provisions is a change required by a pronouncement, so no preferability assessment is needed. See the ASU effective dates tracker. A voluntary change needs a documented preferability argument. "It is easier" or "the new software does it this way" is not one.
Retrospective application means adjusting the carrying amounts of affected assets and liabilities at the start of the earliest period presented, with an offsetting adjustment to opening equity, and adjusting each period presented for its own effects. If retrospective application is impracticable for some periods, the standard gives alternatives that apply the change from the earliest date practicable. Disclosures include the nature of and reason for the change, including why the new principle is preferable, the method of applying it and the effect on line items.
Change in accounting estimate
A change in estimate comes from new information or changed circumstances, such as a revised useful life, a new collectability assessment or a changed warranty accrual. It is recorded in the period of change and, if it affects them, in future periods (ASC 250-10-45-17). When a change in principle and a change in estimate cannot be separated, such as a change in depreciation method, the combined effect is treated as a change in estimate.
Illustration (illustrative). An asset cost $100,000 and has been depreciated over 10 years with no salvage value, so four years of depreciation total $40,000 and the carrying amount is $60,000. Management now expects 8 more years of use. New annual depreciation is $60,000 / 8 = $7,500, against $10,000 before. Prior years are not touched.
How are errors corrected?
An error includes mathematical mistakes, mistakes in applying GAAP, and oversight or misuse of facts that existed when the statements were prepared. A change from an unacceptable method to an acceptable one is an error correction, not a change in principle.
Materiality decides the route:
- Restatement. If the error is material to previously issued financial statements, those statements are restated. Under ASC 250-10-45-23, the carrying amounts of assets and liabilities at the start of the earliest period presented are adjusted, with an offsetting adjustment to opening equity, and each prior period presented is adjusted for its own effects.
- Revision and out-of-period adjustment. If the error is not material to prior periods, the entity may either record the correction as an out-of-period adjustment in the current period with disclosure, if that does not materially misstate the current period, or revise the prior period amounts the next time they are presented. Revised columns are not labeled "as restated," and the prior audit report is not reissued.
"Big R" and "little r" are shorthand used in SEC reporting for these two routes: a Big R restatement of previously issued statements, and a little r revision of prior-period amounts. The terms come from SEC practice, not from the Codification. A private company uses the same ASC 250 framework and the same two routes without the SEC's filing consequences.
How do you evaluate materiality?
PwC's guide describes the sequence. Evaluate errors individually and in the aggregate against the period in which they arose and the period in which they are corrected. First ask whether the error is material to any previously issued statements. If not, ask whether correcting it in the current period would materially misstate the current period.
SAB Topic 1.M (SAB 99) requires both quantitative and qualitative assessment, and qualitative factors can make a small misstatement material. SAB Topic 1.N, codified in ASC 250-10-S99-2, requires use of both the rollover method (the misstatement originating in the period) and the iron curtain method (the cumulative balance sheet effect). PwC notes many non-SEC entities also use the dual approach.
Illustration (illustrative). A company omitted an annual accrual of $30,000 in each of 20X1 through 20X4. Pre-tax income is $1,000,000 each year. Rollover effect each year: $30,000 / $1,000,000 = 3%. At the end of 20X4, the cumulative misstatement is 4 x $30,000 = $120,000, and recording a catch-up in 20X5 would make 20X5 expense $30,000 + $120,000 = $150,000. Measured as a cumulative amount against income, the iron curtain effect is $120,000 / $1,000,000 = 12%. The 3% annual rollover amount might be immaterial on its own. The 12% cumulative amount, or the effect of a catch-up on 20X5, may not be. If it is not material to prior periods but a 20X5 catch-up would materially misstate 20X5, the prior periods are revised rather than the correction run through current income. Qualitative factors, such as a covenant ratio, a bonus target or a trend reversal, can change the answer.
What must be disclosed for a restatement?
PwC summarizes the disclosure paragraphs:
- ASC 250-10-50-7: that previously issued statements were restated to correct an error, the nature of the error, the effect on each affected line item and per-share amount for each prior period, and the cumulative effect on retained earnings or other equity components at the start of the earliest period presented.
- ASC 250-10-50-8: the gross and net-of-tax effects on prior-period net income in the annual report for the year of the adjustment and in interim reports issued that year.
- ASC 250-10-50-9: for a single period presented, the effect on beginning retained earnings and prior-period net income. When multiple periods are presented, disclose the effects for each period.
Later annual reports generally need not repeat the disclosure. Private companies generally issue the restated statements with a reissued audit report, or reflect the restatement in the next comparative statements, and tell users not to rely on the prior statements.
What does the auditor do?
Auditors evaluate the error as a misstatement under AU-C 450 and consider the effect on the prior-period opinion and on any previously issued reports. If financial statements already issued contain a material error discovered after the report date, AU-C 560 governs subsequent discovery. AU-C 708 addresses how a material change in accounting principle, or a correction of a material misstatement in previously issued statements, is communicated in the auditor's report, generally through an emphasis-of-matter paragraph (see AU-C 706). The auditor also communicates the error to those charged with governance under AU-C 260.
Where do preparers and auditors get stuck?
These are practice observations, not findings from a published source:
- Running a correction through current-year income when the prior period is materially misstated.
- Calling an estimate change a principle change to avoid a question about the original estimate.
- Evaluating each year's error separately and never in the cumulative.
- Labeling revised columns "as restated" when the error was immaterial, or omitting the label when it was material.
- No preferability support for a voluntary change in principle.
- A change in depreciation method documented as a principle change, with retrospective restatement the standard does not call for.
Frequently asked questions
What is the difference between a restatement and a revision?
A restatement corrects previously issued statements that are materially misstated and is labeled as such. A revision corrects immaterial errors in prior period amounts the next time they are presented, without the "as restated" label.
Is a change in estimate restated?
No. A change in estimate is applied prospectively.
Is a change in depreciation method a change in principle?
When the effect of the change in principle cannot be separated from the change in estimate, as with a depreciation method change, ASC 250 treats the combined change as a change in estimate.
Which disclosures does a restatement require?
The nature of the error, the effect on each affected line item for each prior period, the cumulative effect on opening equity, and net income effects, under ASC 250-10-50-7 through 50-9.
Does a private company use SAB 99 and SAB 108?
They are SEC guidance. Many non-SEC entities use the same dual approach to evaluate materiality.
Sources
- FASB, Accounting Standards Codification Topic 250, Accounting Changes and Error Corrections: 250-10-45-2, 45-17, 45-23; 250-10-50-7 through 50-9; 250-10-S99-2. https://asc.fasb.org
- SEC, Staff Accounting Bulletin Topic 1.M (SAB 99) and Topic 1.N (SAB 108). https://www.sec.gov
- PwC Viewpoint, Financial statement presentation guide, section 30.7, Correction of an error.
- Deloitte DART, Roadmap: Initial Public Offerings, section 3.7, Restatements and corrections of accounting errors.
- AICPA, AU-C section 708, Consistency of Financial Statements; AU-C section 560.
Related
- Change in accounting principle vs estimate
- Restatement vs revision
- Materiality in auditing
- Adjusting journal entries in an audit
- Uncorrected misstatements
- Summary of uncorrected misstatements template
- Summary of uncorrected misstatements tool
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