Accounting Changes
Accounting changes represent changes in a company’s accounting methodology governing the reporting of its financial statements, and are reported net of taxes on a separate line item following extraordinary items (Exhibit 5.10).
Exhibit 5.10. Accounting Changes Represent Changes in a Company’s Accounting Methods
Source: Used with permission of McDonald’s Corporation. 2005 Annual Report, © McDonald’s Corporation, 2005.
Types of accounting changes include:
Changes Applied to New Transactions
New transactions occur only after the accounting change takes place.
No adjustments to current financial statements are required.
Example: Applying a different depreciation method to new assets.
Changes in Estimates
Can be associated with useful lives and salvage value of depreciable assets as well as value of uncollectible revenue (e.g., Bad Debt Expense is an estimate).
Changes are made only in the affected (present and/or future) period(s); past results remain as originally reported.
Retroactive Changes in Accounting Principles
If the company chooses to apply newly adopted accounting principles retroactively (to the past results), the impact of this change on prior periods is shown as a separate item on the income statement called “Cumulative Effect of the Accounting Change on Prior Periods.”
Certain events are not expected to recur, and their placement on the income statement depends on their nature and classification (Exhibits 5.11).
| Type | Classification | Description | Analytical Implications |
|---|---|---|---|
| Unusual or Infrequent | Above the line Reported pretax before net income from continuing operations. | Events that are either unusual or infrequent (but not both). Examples of unusual or infrequent item are restructuring charges, onetime write-offs, and gains/losses on sale of assets. | Management often buries these within normal operating items (COGS, SG&A, or Other Operating Expenses), so it is often difficult to identify these items. Management usually identifies these items in the annual report footnotes and the MD&A sections.
Nonrecurring charges tend to also appear in press releases. Companies have more flexibility and thus tend to go into more detail about nonrecurring charges on their unaudited press releases. Recognize that nonrecurring charges allow for management discretion and judgment, and thus, manipulation, so be aware of this in determining whether some items should not be excluded. |
| Extraordinary | Below the line Reported net of tax after net income from continuing operations. | Events that are both unusual and infrequent and material in amount. Examples are gains/losses from early retirement of debt, uninsured losses from natural disasters, loss from expropriation of assets, gains/losses from passage of new law. | Since extraordinary items are reported after net income, they do not affect operating income. Still, an analyst may want to review these to determine whether some extraordinary items should be included above the line. Some management teams are more prone to extraordinary events. |
| Discontinued Operations | Below the line Reported net of tax after net income from continuing operations. | A physically and operationally distinct business that a company has decided to but has not yet disposed of, or has disposed of in the current year. | Companies identify income and losses from discontinued operations separately from the rest of the income statement, and must restate past income statements (which included the discontinued operations) to exclude the discontinued operations for comparability. Since discontinued operations are reported after net income, they do not affect operating income. |
| Accounting changes | Below the line Reported net of tax after net income from continuing operations. | Any change in accounting methods. | Since accounting changes are reported after net income, they do not affect operating income and rarely have a cash flow impact. Prior financial statements need not be restated unless the accounting change is a change in inventory accounting method, change to or from full-cost method, change to or from the % of completion method, or any change just prior to an IPO. |