Navigating ASC 606 Revenue Recognition: A Comprehensive Guide for CFOs
The Scoop on ASC 250: Accounting Changes, Restatements, Errors, and More
Accounting changes and errors can fall anywhere from mild inconvenience to four-alarm fire. To state the obvious, it really just depends on their nature and impact. Still, when a change or error is afoot – no matter where it falls on that spectrum of consequence – accounting leadership needs to know what actions to take.
That's the territory where ASC 250 exists, providing much-needed guidance on what to do when an accounting change or reporting error pops up. Therefore, although this particular accounting standard isn't exactly an area CFOs enjoy, knowing the lay of the land is still essential.
That's exactly why we're taking a deep dive into ASC 250 today, discussing what to do when accounting changes and errors go bump in the reporting night. As you'll see, while changes, restatements, and revisions might not be your favorite things to do, it doesn't mean you should lose sleep over them, either.
ASC 250 at a Glance
Think about the last few years for a moment. A global pandemic, rampant inflation, cratering supply chains, shaky labor markets – it's all enough to make the financial markets want to pack it up and call it a day.
Thankfully, the public can rely on consistent, reliable, comparable financial statements from organizations to sort it all out and maintain a clear, unobstructed view of operations. At least in theory. Because in practice, things can and do go sideways for companies, making a standard like ASC 250 an absolute necessity.
This critical accounting standard gives finance leadership a framework to follow when facing an accounting change or a necessary error correction in previously issued financial statements. Long story short – while financial statement users would obviously prefer impeccable, unimpeachable reporting, perpetual perfection just isn't realistic. And that's why ASC 250 exists.
From a real-world perspective, the year-end close process and audit preparation are usually when management identifies an area where a change in accounting principle occurred. Or, even worse, where a material accounting error – in the current or a prior period – rears its ugly head. So, on that foreboding note, let's take a closer look at ASC 250, first with accounting changes and then the dreaded accounting error.
Accounting Changes Under ASC 250
Let's start our discussion by examining the three types of accounting changes falling under the scope of ASC 250 – changes in accounting principles, estimates, and the reporting entity.
Changes in Accounting Principles
ASC 250 presumes that once an accounting principle is adopted, a business should not change it for similar transactions. Further, the guidance explicitly states that a change qualifies as a change in accounting principle if a newly issued accounting standards update (ASU) requires it or, alternatively, if the entity can justify using an alternative accounting principle as preferable.
That said, whenever the FASB issues a codification update, it typically includes transition guidance describing the applicable adoption methods. However, in the rare cases when the FASB doesn't provide such guidance, companies must adopt an accounting change to adhere to the updated standard. The same applies when a company early adopts a codification update.
Examples of Changes in Accounting Principle:
- A company currently uses the last-in-first-out (LIFO) method for inventory valuation. However, for preferability, it later decides to value inventory using the first-in-first-out (FIFO) method. This change in valuation method qualifies as a change in accounting principle according to ASC 250.
- A company amends the date it performs its annual goodwill impairment test under ASC 350. Again, this would constitute a change in accounting principle under the guidance that is acceptable so long as:
- The change is preferable
- The change does not result in a material change in the method of applying the accounting principle
- The change is disclosed
Note, however, that if an accounting policy or principle was immaterial in a prior period and the company adopts it in the current period, it does not qualify as an accounting change under ASC 250-10-20. For instance, an entity entering into its first business combination will apply ASC 805 for the first time. GAAP doesn't consider this an accounting change under Topic 250.
Mind you, our 805 example differs from a scenario where a business should have applied an accounting policy or principle but didn't. That's typically considered an error, a subject we’ll get to in a bit.
Changes to Accounting Principles When Going Public
When an entity files an IPO registration statement, it must change its accounting principles to meet the requirements for public companies. Since this type of change isn't voluntary, the entity doesn't have to evaluate whether the change is preferable.
However, some private companies may consider changing an accounting principle – for example, a private company alternative – to one required for public companies before filing an IPO registration statement. If a company voluntarily changes an accounting principle in anticipation of the filing, it must then evaluate whether the change is preferable.
Disclosure Requirements for Changes in Accounting Principles
For changes in accounting principles, companies must disclose the nature of and reason for the change. This includes why the newly adopted accounting principle is preferable, as well as the method of the change, including:
- A description of the prior-period information the entity has retrospectively adjusted
- Effect of the change on the income statement and any affected per-share amounts
- Cumulative effect of the change in retained earnings and other balance sheet items
Note that if a business determines a retrospective application to all prior periods is impracticable, it must disclose the reasons and the description of the alternative method used to report the change.
Reclassifications in the Financial Statements
In many cases, a change in classification or presentation in the financials isn't considered a change in accounting principle requiring a preferability assessment. This would include, for instance, a company that previously showed selling, general, and administrative (SG&A) expenses together on the face of the income statement but now decides to separate selling from general and administrative expenses.
It’s important to note, however, that many things get characterized as reclassifications when they could actually be a change in accounting principle or even a correction of an error. Playing off the previous example, let's say a manufacturer discovers it classified certain selling expenses as cost of goods sold (COGS) instead of SG&A expenses in the income statement. Here, the reclassification required is really the correction of an error.
Further, keep in mind that when an entity makes reclassification and presentation changes, the best practice is to recast prior-period information to conform. This also aligns with the general presentation guidance from ASC 205.
Changes in an Accounting Estimate
A change in an accounting estimate entails an adjustment to the carrying amount of an existing asset or liability. It can also include a change that alters the subsequent accounting for existing or future assets or liabilities, usually stemming from new information. Some common examples of changes in an accounting estimate include:
- A change in the estimated useful life or salvage value of a long-lived asset
- Changes in estimated credit losses
- Changes in estimated liabilities for warranties
- A change in an estimate of obsolete and excess inventory
To muddy the waters a bit, there can be situations where a change in an accounting estimate results from a change in an accounting principle. For example, let's assume a company changes its method of depreciation for fixed assets. This stems from either a change in estimate of future benefits of the asset, the pattern of consumption of these benefits, or the information available to the company about the benefits.
Here, the effect of the change in accounting principle – the depreciation method – could be inseparable from the impact of the change in accounting estimate. Since these types of changes relate to the continuing process of obtaining additional information and revising estimates, they are considered a change in estimate.
Disclosure Requirements for Changes in Estimates
Entities must disclose the impact of a change in an accounting estimate on the income statement and any related per-share amounts of the current period when the change affects several future periods. This would include, for example, a change in service lines of depreciable assets.
That said, it's unnecessary to disclose the effects of estimates made each period in the ordinary course of accounting for items like uncollectible accounts or inventory obsolescence. Note, however, disclosure is required if the impact of such a change in estimate is material.
Further, when a business affects a change in estimate by changing an accounting principle, it must also include the disclosure requirements for changes in accounting principles, as previously discussed.
Likewise, suppose the change in estimate doesn't have a material effect in the period of change but is reasonably certain to have a material impact in later periods. In this case, the business must disclose a description of that change in estimate whenever it presents the financial statements of the period of change.
Accounting Treatments: Change in Estimate vs. Change in Accounting Principle
Just because an overlap between changes in estimates and changes in accounting principles might exist doesn't mean the accounting treatments are the same between the two. In fact, changes in accounting principles are generally accounted for retrospectively. In other words, you would retrospectively adjust the amounts reported in prior period financial statements.
In these cases, a company must reflect the cumulative effect of the change to the new accounting principle on prior periods via the carrying amounts of assets and liabilities as of the beginning of the first period presented. If applicable, the reporting makes any offsetting adjustment to the opening balance of retained earnings for that period.
However, a company can conclude that it's impractical to apply the effects of a change in accounting principle retrospectively if:
- After making every reasonable effort to do so, the entity is unable to apply the requirement,
- Retrospective application requires assumptions about management's intent in a prior period that cannot be independently substantiated,
- Retrospective application requires significant estimates of amounts, and it is impossible to objectively distinguish information about those estimates that both:
- Provides evidence of circumstances that existed on the date(s) at which those amounts would be recognized, measured, or disclosed under retrospective application, and;
- Would have been available when the company issued the financial statements for that prior period.
Conversely, an entity accounts for changes in accounting estimates prospectively. Translating that to something a bit more palatable, the company reflects the change in the same period that the change in estimate occurred. Once again, you account for a change in estimate that you can't separate from the effect of a change in accounting principle as a change in estimate.
Also, it's important to remember that voluntary changes in accounting principle or changes in estimates that you can't separate from the effect of a change in principle are only allowed if you can justify using an alternative as preferable.
So, what exactly does "preferable" mean in this context? As you might've guessed, this is yet another area where the guidance is limited. However, generally speaking, there are three criteria to think through when determining if you can consider a change preferable:
- The change must be supported by authoritative or non-authoritative support. Here, the ol' accounting standards codification from the FASB would be considered authoritative support. Alternatively, examples of non-authoritative support are:
- FASB concept statements
- AICPA Issues Papers
- International Financial Reporting Standards
- AICPA Technical Practice Aids
- Accounting textbooks, handbooks, and articles.
- Management's justification for the change must be rational. A change in accounting principle is considered rational if the change conforms with broad accounting concepts. This would include, for example, if the change results in a more accurate presentation of assets and liabilities or better matching of costs and revenues. A change would also be rational if the change results in better consistency among components of a company.
- A change can be preferable if the new accounting principle is prevalent in an entity's industry. However, it's important to note that industry practice doesn't provide significant support for some types of accounting changes, like, for instance, changes in a company's goodwill impairment assessment date. Such changes do not improve or otherwise change the comparability of financial statements among companies in an industry.
The Auditor's Role in Evaluating Preferability
We know what you're thinking – where does an auditor fit into this whole preferability thing? We're glad you asked. For SEC registrants, a company’s auditors provide a preferability indicating whether the accounting change is, in the auditor’s judgment, preferable under the circumstances. This includes evaluating whether:
- The newly adopted accounting principle is part of generally accepted accounting principles (GAAP), and;
- The method of accounting for the effect of the change conforms with GAAP, and;
- The disclosures related to the accounting change are adequate, and;
- The company has justified that the alternative accounting principle is preferable.
Preferability letters are only required for voluntary changes in accounting principles. Further, certain voluntary changes don’t warrant a preferability letter – at least in most cases – including:
- Changes to a principle more preferable as presented in the FASB codification
- Changes to a principle as a result of new events or transaction
- Changes to an alternative principle when a previous principle is no longer acceptable
- Changes to date of annual goodwill impairment test date
Changes in a Reporting Entity
Last on the changes front, ASC 250 only applies to a change in the reporting entity that is, in effect, a new reporting entity. Note, however, this isn't the same as a change in what makes up the consolidated group like, for example, acquiring a new business. Rather, certain common control transactions – like when the companies included in combined financial statements change – are common examples of a change in a reporting entity.
Accounting for a Change in the Reporting Entity
Accounting for a change in the reporting entity is very similar to a change in accounting principle. In other words, you apply the change retrospectively, where the comparative financial information presented is that of the new reporting entity. Further, there are a couple of disclosure requirements related to this type of change as well:
- Description of what the change was and the reason for the change
- Effects of the change on certain elements of the financial statements for all periods presented, including income from continuing operations, net income, other comprehensive income (OCI), and earnings-per-share (EPS)
Mitigating Financial Statement Risks with Sound Processes and Controls
So how can management head some of the risks related to changes in accounting principles and estimates off at the pass? Of course, that's where solid internal controls come into play. At both the entity and transaction levels, controls are necessary to throttle the risks of material misstatement related to changes in accounting principles.
Regarding accounting estimates, management must understand the significant assumptions, methods, data, and controls pertaining to estimates and how those controls can quickly identify necessary changes in their assumptions, methods, and data. Note our use of the word quickly – timely performance of controls of an estimation process is critical in this area.
Evaluating and Correcting Accounting Errors
Now we get to the area of ASC 250 that give CFOs night sweats – accounting errors and the impact they can have on financial statements. And we're going to begin this section of the conversation by looking at a critical concept in evaluating potential errors – materiality.
Defining and Determining Materiality
As you know, materiality comes down to judgment, requiring each entity to consider its own circumstances. Thankfully, finance leadership can rely on guidelines and factors to perform these evaluations to keep everything on the straight and narrow.
While the interpretive guidance on materiality comes from an SEC staff interpretation – based on a Supreme Court precedent – it's still widely used by all entities in practice. Essentially, the Supreme Court held that a fact is material if "there is a substantial likelihood that the... fact would have been viewed by a reasonable investor as having significantly altered the 'total mix' of information made available."
In this context, a reasonable investor is any user of the financial statements that would rely on the statements for some type of decision-making. Generally speaking, people in this group possess, at a minimum:
- Reasonable business and financial or accounting knowledge
- An understanding that financial statements are prepared and audited with materiality in mind
- An acceptance that estimates and uncertainties are inherent in financial reporting
From leadership's perspective, it's probably best to think of this group as investors, regulators, lenders, or virtually any other reasonable person who has a valid use for a company's financial statements.
When it comes to determining materiality, the process largely depends on the entity itself. Materiality assessments aren't standardized for all entities, so different factors will influence their outcome. Granted, many companies solely focus on a quantitative measurement of materiality – like a percentage of pretax net income – but this isn't the only appropriate way to determine materiality.
Yes, quantitative measurements of baselines can certainly help guide the ultimate determination. However, an entity should consider qualitative factors as well. In other words, an error might be material due to its size alone, but in other instances, a quantitatively smaller error may be material because of its nature. Therefore, management should look through both a quantitative and qualitative lens for any assessment, but we’ll expand on that in the next section.
Also, remember that a full set of financial statements under US GAAP consists of more than your typical financial statements headliners – the balance sheet, income statement, statement of cash flows, and equity statement. Thus, the concept of materiality applies just as equally to errors in your disclosures.
The Process of Correcting Accounting Errors
Now that we have our understanding of materiality in place, let's proceed to the nitty-gritty – actually correcting accounting errors. In reality, the process distills down to three simple steps:
- Identifying the error or errors in the financial statements
- Determining the materiality of those errors
- Figuring out the right path to correct the error or errors, if at all
Since the first step is pretty obvious, let's narrow our focus to the second one – evaluating the error and whether it's material – and go from there.
Two-Step Materiality Assessment for Error Corrections
Building on our discussion of materiality, the assessment really comes down to a two-step process:
- Determining the quantitative materiality of the error identified, and;
- Determining the qualitative materiality of the error identified.
Now, since materiality typically doesn't fit into a one-size-fits-all approach, reporting entities need to think through a few areas as they determine whether an error is quantitatively material. First, focus on whether the amount or size of the errors – individually or in total – are of such magnitude that they’re inherently material to the financial statements. This could include comparing the amount of the misstatement with:
- Materiality level(s);
- Specific financial statement captions and disclosures involved, and;
- The financial statements as a whole
Note that many companies evaluate the error or errors relative to the totals and subtotals of all the statements, thinking about materiality in relation to the financial statements as a whole.
Also, preparers have three acceptable methods they can use to measure the quantitative impact of errors on the financial statements:
Iron Curtain Method
The iron curtain method assesses income statement errors based on the amount the income statement would be misstated if the accumulated amount of the errors remaining in the balance sheet at the end of the period were corrected through the income statement during that period.
The rollover method assesses income statement errors based on the amount the income statement for the period is misstated – including the reversing effect of any prior period errors – as well as any identified misstatements in the previous period that were not corrected.
Required of SEC registrants, this method essentially evaluates quantitative materiality under both the iron curtain and rollover methods, providing a more holistic perspective to financial statement users.
Keep in mind, whenever you quantify the materiality of an error to the prior period financial statements, the balance sheet and income statement effects of the error are going to be evaluated using the rollover method. Also, while non-SEC registrants can technically use any of the methods, they are encouraged to use the dual method.
Iron Curtain vs. Rollover Method Example
To illustrate the difference between the iron curtain and rollover methods, let's look at a simple example that ignores income tax impact and focuses solely on errors in the income statement and balance sheet. As a quick aside, remember that the company would also need to consider all implications to the other statements and any disclosures, like segment disclosures for public business entities.
Back to the task at hand, we're assuming a company had a long-term bonus arrangement for one of its employees, entitling them to $100 at the end of Year 4. The company inadvertently forgot to record this accrual and identifies the error in the current year – Year 4. Further, the company only presents two fiscal years of comparative financial statements and found no other errors.
Under the iron curtain method, the effect on the income statement to correct the error would be a debit of $100 to expense in the interim period and a credit to the accrued liability for the $100 at the end of Year 4 on the balance sheet. Since the iron curtain method doesn't account for any effects on prior periods, the company ignores the $75 of expenses it would have captured in retained earnings if it had recorded the bonus accrual of $25 as incurred each year.
Conversely, under the rollover method, the effect on the income statement in Year 4 and Year 3 – the years presented in the comparative financial statements – is a debit of $25 for that period's current expense only. The effect on the balance sheet would include:
- A debit or reduction of opening retained earnings in Year 3 – the earliest period presented – for $50 related to the Year 1 and Year 2 expense
- A credit to the balance sheet of $100 in Year 4 to reflect the full bonus accrual.
Once the company has quantified the error using the appropriate method, it then evaluates that error under the guidelines for quantitative materiality. Again, this step considers the materiality levels for the financial statements as a whole, which would include the impact on the subtotals and totals in the financial statements as well as the disclosures.
As another aside, if the company is private, it can use any of the methods discussed. However, if it wants to change the evaluation method, it would need to be assessed under the premise of a change in accounting principle.
Put another way, a private company could justify the change if it meant moving to a more preferred approach, but not the other way around. In general, changing from the iron curtain to the dual method is preferable since, once again, it provides a more holistic assessment. However, moving in the opposite direction can have a reverse effect, potentially eliminating some transparency and clarity for financial statement users.
Qualitative Assessment of and Accounting Error
Don't forget, the quantitative assessment is only half the battle. The back half of the two-step assessment process involves determining the qualitative materiality of the error identified. Thankfully, the SEC staff provide several factors – via SAB Topic 1.M – companies can use and practice to assess the qualitative impacts of accounting errors:
- Whether the misstatement arises from an item capable of precise measurement or stems from an estimate and, if so, the degree of imprecision inherent in the estimate.
- Whether the misstatement masks a change in earnings or other trends.
- Whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise.
- Whether the misstatement changes a loss into income or vice versa.
- Whether the misstatement concerns a segment or other portion of the registrant's business that has been identified as playing a significant role in the registrant's operations or profitability.
- Whether the misstatement affects the registrant's compliance with regulatory requirements.
- Whether the misstatement affects the registrant's compliance with loan covenants or other contractual requirements.
- Whether the misstatement increases management's compensation like, for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation.
- Whether the misstatement involves concealment of an unlawful transaction.
Now, not all factors will be relevant to every entity, and some may be more relevant than others. Therefore, this is an area that requires significant judgment. For example, for a highly leveraged company, an error in classification that inflates its interest coverage calculation – a key debt covenant – could be viewed as qualitatively material.
In terms of documenting or memorializing such assessments, a SAB 99 memo walks the user through much of the same guidance we've discussed in this hefty tome. Such a memo includes evaluation of the error from both a quantitative and qualitative perspective, and will often conclude on how the company will correct the error, if at all, based on the evaluation.
To Correct or Not Correct (an Accounting Error)
That takes us to the third and final step of error evaluations – determining if a correction is needed. Typically, companies will arrive at the appropriate conclusion by going through a series of questions:
- Is the error material to the prior period financial statements?
- If yes, a reporting entity should restate those prior period financial statements. People often refer to this type of error correction as the "Big R".
- If not, proceed to the next question.
- Is the error material to the current period financial statement?
- If yes, a reporting entity should restate and revise its prior period financial statements the next time it presents them. People often refer to this type of error correction as a revision or the "Little r."
- If not, you generally will correct the error as an "out-of-period" adjustment.
- An out-of-period adjustment is appropriate after one concludes the prior period financial statements were not materially misstated, and correcting the error in the current reporting period will not have a material impact, considering any other potential uncorrected misstatements in the current period.
"Big R" Restatements
Suppose a company concludes that a "Big R" restatement is necessary. In that case, it should begin by notifying the financial statement users they should no longer rely upon those statements and that a restatement is imminent. The company should reissue the statements in question as soon as possible.
As far as the restatement itself goes, it's really accomplished in just a few steps:
- Adjust opening balances to the earliest period presented as necessary, including opening balances on the balance sheet and changes to opening equity.
- Make prior period adjustments to correct errors and reflect the correct amounts in the appropriate disclosures.
- Label each financial statement column impacted "as restated" and include sufficient disclosure in the footnotes, including labeling disclosures as restated where impacted.
Further, ASC 250 provides prescriptive guidance on disclosing material errors in previously issued financial statements. In general, the disclosures should include:
- A statement that the previous issuance of financial statements has been restated along with a description of the error or errors.
- Impacts to net income for each period presented, including any tax effect, implications to each affected financial statement line item, and any per-share impacts
- Disclosure of the cumulative effect as of the beginning of the earliest period
According to the SEC, the disclosures should facilitate as much transparency as possible, where changes and corrections should be easy for financial statement users to understand. Also, if an entity does not present comparative financial information, it must disclose the impact on the opening balance of retained earnings and net income – including the related income tax effect – for the immediately preceding period.
"Little r" Revisions
The revision process differs from restatements in that reissuance isn't as critical since the prior period statements aren’t materially misstated. Instead, entities can then issue them as comparative financials.
The correction process is the same as a restatement, where you adjust the opening balances of the earliest periods presented, adjust incorrect prior period amounts and disclosures, and provide disclosures in the notes about the errors in the revisions.
Note that one key difference between revisions and restatements is the addition of column headings to the face of the financial statements, unnecessary with a "Little r" but necessary with a "Big R." So, for example, you wouldn't change the columns on the prior period balance sheet to state "as revised" for a revision, but you would for a restatement by including "as restated" language.
Final Thoughts on Accounting Errors
We've been through quite the journey, haven't we? We promise the finish line is in sight, but we're not quite there yet since we still have a few insightful nuggets to convey.
Once you identify an error – whether material or immaterial – you should then consider if and how the identified error affects the design and effectiveness of any related internal controls. In fact, evaluating internal controls would be necessary even if the error doesn't result in a restatement or adjustment to prior period financial statements.
To that point, an error indicates that some aspects of the internal control design or operational effectiveness were not properly functioning. Like all control deficiencies, management would need to determine if it should characterize it as a significant deficiency or material weakness.
Yes, this requires a bit of judgment. Still, it's important to consider the existence of mitigating controls and whether they are precise enough to prevent or detect a potential material misstatement. Keep in mind, when a restatement occurs, an accompanying material weakness or multiple material weaknesses are almost always a certainty.
Circumstances Specific to SEC Registrants
First and foremost, if you are an SEC registrant that restates and reissues financial statements to correct a material error, the SEC requires you to file a timely Form 8-K and meet other applicable requirements under Regulation S-K. Likewise, you would also need to file an amended form – 10-KA, for example – to reflect these changes, in addition to the 8-K.
Also, thanks to a recently adopted SEC rule, listed issuers will be required to have a written policy for recovery of incentive-based compensation received by the issuer's current or former executive officers in the event of a restatement. Mind you, this applies to both “Big R” restatements and “Little r” revisions, basically implementing the previous mandate under Dodd-Frank requiring the SEC to adopt such policies.
And that's all we have on ASC 250, at least for the moment. Granted, despite these insights going on ad infinitum, we still didn't cover everything. That doesn't mean, however, that if you face an accounting change or error correction, it's just you, the guidance, and several sleepless nights. Our experts here at Embark are always ready to help you clear whatever accounting hurdles you face, ASC 250 or otherwise. So let’s talk.