Error Corrections and Restatements: ASC 250 for the CPA Exam

Error Corrections Under ASC 250

ASC 250-10-45 establishes the accounting and reporting requirements for the correction of errors in previously issued financial statements. An error in previously issued financial statements can result from mathematical mistakes, mistakes in applying accounting principles, or oversight or misuse of facts that existed at the time the financial statements were prepared. Understanding how to correct errors and distinguish them from changes in accounting estimates and changes in accounting principles is critical for the CPA FAR exam.

Types of Accounting Changes and Error Corrections

ASC 250 addresses three types of accounting changes, each with different reporting requirements:

1. Change in accounting principle: A change from one generally accepted accounting principle to another, such as switching depreciation methods. Generally applied retrospectively with cumulative-effect adjustment to beginning retained earnings.
2. Change in accounting estimate: A revision of an estimate used in accounting, such as a change in the useful life of an asset or a change in the estimate of bad debts. Applied prospectively.
3. Correction of an error: The discovery and correction of a mistake in previously issued financial statements. Requires retrospective restatement of prior period financial statements.

Change in Estimate Effected by a Change in Principle

When a change in accounting principle is inseparable from a change in estimate (such as changing from one depreciation method to another), the change is treated as a change in estimate and applied prospectively. This is because the new method is adopted based on new information about the pattern of benefit consumption.

Retrospective Restatement for Error Corrections

When an error affecting prior period financial statements is discovered, ASC 250 requires retrospective restatement. This means that comparative financial statements presented in the current period's report are restated to reflect the correction. The entity adjusts the financial statements for each prior period presented to reflect the correction as if the error had never occurred.

The cumulative effect of the error on periods prior to those presented is reflected in the opening balance of retained earnings (and other affected accounts) for the earliest period presented. The entity cannot simply record the correction in the current period's income statement; it must restate the prior periods.

Steps in Error Correction

1. Identify the error and the periods affected.
2. Calculate the cumulative effect of the error on all prior periods.
3. Restate the comparative financial statements for each period presented by correcting the specific line items affected.
4. Adjust the opening balance of retained earnings for the earliest period presented by the cumulative effect of the error on all periods before those presented.
5. Disclose the nature of the error, the effect on each financial statement line item and earnings per share, and the cumulative effect on retained earnings.

Common Types of Errors

• Errors affecting only the balance sheet: Misclassification of an asset or liability (such as classifying a long-term asset as current). These are corrected by reclassifying the items in the restated balance sheet. No income statement effect.
• Errors affecting only the income statement (counterbalancing): Some errors self-correct over two periods. For example, an overstatement of ending inventory in Year 1 causes an understatement of cost of goods sold in Year 1 and an overstatement of cost of goods sold in Year 2. If the error is discovered in Year 2, the Year 1 income statement is restated but Year 2 self-corrects. If discovered in Year 3 or later, the errors have already washed out of the income statement, but retained earnings may need adjustment for comparative purposes.
• Errors affecting only the income statement (non-counterbalancing): Some errors do not self-correct, such as failing to record depreciation. These require adjustment to both the income statement and the balance sheet for all periods affected.
• Errors affecting both the balance sheet and income statement: Such as recording a capital expenditure as an expense. The balance sheet is understated (missing asset) and the income statement is misstated (expense vs. depreciation). These require full restatement.

Materiality Considerations

Not all errors require restatement. An error is corrected through restatement only if it is material to the financial statements. Materiality is assessed from the perspective of the financial statement user and considers both quantitative and qualitative factors. Immaterial errors discovered in the current period are corrected in the current period and do not require restatement.

Disclosure Requirements

When financial statements are restated for error corrections, the entity must disclose the nature of the error, the effect of the correction on each financial statement line item (including earnings per share), the cumulative effect on retained earnings at the beginning of the earliest period presented, and, if retrospective application is not practicable for a specific prior period, the reasons and the method used.

Exam Preparation Tips

• Distinguish between changes in principles (retrospective), changes in estimates (prospective), and error corrections (restatement).
• Know the concept of counterbalancing errors and how they affect the need for restatement depending on when they are discovered.
• Practice adjusting entries for common errors: inventory cutoff errors, capitalization vs. expense errors, and failure to record depreciation or amortization.
• Understand the disclosure requirements and be prepared for questions about what must be included in the notes.
• Remember that a change in estimate effected by a change in principle is treated prospectively, not retrospectively.