Imagine this: A multinational tech company, TechNova Inc., used straight-line depreciation for its servers. Five years later, it discovers that a usage-based depreciation method would more accurately match revenue generation. Or picture HealthCareCo, which mistakenly capitalized maintenance expenses on its hospital beds for three years. These aren't just small slips—they ripple through financial statements and erode stakeholder trust.
Understanding "Accounting Changes and Error Corrections" is not only a crucial CPA exam topic (especially in FAR) but also a real-world must-know for ensuring financial transparency and compliance.
This blog walks you through the four major categories, explains their treatment, and provides real-life examples, CPA-tested insights, memorization hacks, and 30 practice questions with answers and explanations.
Types of Accounting Changes and Error Corrections
1. Change in Accounting Principle (Retrospective)
Definition: A change from one generally accepted accounting principle to another. It does not include adopting a new principle for a new transaction.
Common Examples:
Inventory Valuation Change: Switching from FIFO to Weighted Average.
Revenue Recognition: Moving from completed contract to percentage-of-completion method in long-term construction contracts.
Depreciation Method: Changing from straight-line to double declining balance.
Real-Life Example:
A construction firm, BuildRight Inc., initially used the completed-contract method. Over time, to reflect more accurate revenue and performance, it adopts the percentage-of-completion method. This change must be applied retrospectively — meaning prior period financials must be restated as if the new method was always used.
Journal Entry Example (Real-World Context):
Scenario: RetailCo switches from LIFO to FIFO, which results in a $30,000 increase in ending inventory and net income for prior years.
| Account | Debit | Credit |
|---|
| Retained Earnings | $30,000 | |
| Inventory | | $30,000 |
This corrects prior year inventory values and adjusts retained earnings accordingly.
2. Change in Accounting Estimate (Prospective)
Definition: A change that occurs due to new information, experience, or better insight.
Examples:
Useful Life of an Asset: Changing server life from 5 to 3 years.
Bad Debt %: Revising allowance for doubtful accounts from 2% to 5%.
Warranty Expenses: Updating based on product returns.
Obsolete Inventory Write-downs: Adjusting based on recent market demand.
Real-Life Example:
SoftSolutions revises its estimate of customer churn after analyzing updated data. It increases its allowance for refunds. Since the change is due to new insight, it is treated prospectively.
Journal Entry Example (Real-World Context):
Scenario: TechNova shortens the useful life of its servers from 5 years to 3 years, increasing annual depreciation by $10,000 starting this year.
| Account | Debit | Credit |
| Depreciation Expense | $10,000 | |
| Accumulated Depreciation | | $10,000 |
Only current and future periods reflect the updated depreciation—prior periods remain unchanged.
3. Change in Reporting Entity (Retrospective)
Definition: When the composition of the group of entities changes.
Examples:
Adding or removing subsidiaries from consolidated statements.
Mergers or acquisitions that result in different combinations.
Switching from unconsolidated to consolidated reporting.
Real-Life Example:
FinGrowth Corp consolidates new subsidiaries previously excluded. This change impacts comparability and must be applied retrospectively.
Journal Entry Impact:
No journal entry required, but prior period consolidated financials must be restated to include the new entities.
4. Error Corrections (Retrospective)
Definition: Corrections of errors from prior periods including:
Math errors
Misapplication of GAAP
Omitted information
Examples:
Capitalizing repairs that should have been expensed.
Incorrect revenue recognition in prior periods.
Overstating inventory due to calculation mistake.
Recording fictitious sales.
Real-Life Example:
HealthCareCo mistakenly treated routine maintenance as capital expenditures. This inflates assets and net income. The error is discovered in Year 4. Financials for Years 1–3 must be corrected.
Journal Entry Example 1 (Overstated Revenue):
Scenario: SalesPlus Inc. recorded unearned revenue as earned in Year 1, overstating income by $75,000.
| Account | Debit | Credit |
| Retained Earnings | $75,000 | |
| Accounts Receivable | | $75,000 |
Journal Entry Example 2 (Capitalized Expense):
Scenario: BuildFix Co. capitalized a $50,000 repair expense that should have been expensed.
| Account | Debit | Credit |
| Retained Earnings | $50,000 | |
| Property, Plant, Equipment | | $50,000 |
Comparison Table
| Type | Retrospective | Prospective | Restate Prior Periods? | Typical Example | Disclosure Required? |
| Accounting Principle | Yes | No | Yes | FIFO to Weighted Avg | Yes |
| Accounting Estimate | No | Yes | No | Change in useful life | Yes |
| Reporting Entity | Yes | No | Yes | Subsidiary addition/removal | Yes |
| Error Correction | Yes | No | Yes | Expensing vs. capitalizing repairs | Yes |
Memorization Tip: Use "PREP"
| Letter | Meaning | Treatment | Restate? |
| P | Principle | Retrospective | Yes |
| R | Reporting Entity | Retrospective | Yes |
| E | Estimate | Prospective | No |
| P | Prior-period Error | Retrospective | Yes |
Use the mnemonic “PREP like a CPA” — you PREP for restating when you deal with Principles, Reporting entities, and Prior-period errors.
Disclosure is Key
Every change or correction must be disclosed in the financial statement footnotes.
Minimum Required Disclosures:
| Topic | What to Disclose |
| Accounting Principle | Nature, justification, financial impact, prior period restatement |
| Estimate | Nature and reason for change |
| Reporting Entity | Nature of change and how comparability is affected |
| Error Correction | Nature of error, effect on income, EPS, financials restated |
Disclosure ensures transparency and helps users of financial statements make informed decisions.
30 CPA Practice Questions (Coming Next)
The next section will include:
Stay tuned for Part 2 of this blog post!
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