Academic journal article Academy of Accounting and Financial Studies Journal

The Earnings Impact of FAS 154: An Analysis by Year, Industry and Firm Size

Academic journal article Academy of Accounting and Financial Studies Journal

The Earnings Impact of FAS 154: An Analysis by Year, Industry and Firm Size

Article excerpt


When a new accounting standard is proposed a question arises as to whether or not the impact on earnings will be significant. The recently issued FAS 154 mandates that enterprises no longer report the cumulative-effect losses and gains of a change in accounting method. Based on 1998 through 2004 data, the removal of the cumulative-effect loss or gain from the income statement would significantly impact reported earnings.


In May 2005 the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections--a replacement of APB Opinion No. 20 and FASB Statement No. 3, (FAS 154) (FASB 2005a). The new standard is part of a joint effort on the part of the FASB and the International Accounting Standards Committee to create greater convergence between U.S. and international accounting standards (FASB 2005b). FAS 154 is a substantially different method of reporting the effects of a change in accounting principle and correction of errors than its predecessor rule, Accounting Principles Board Opinion No. 20 (APB Opinion 20; AICPA 1971).

APB Opinion 20 required that in the year an entity changed accounting methods the effects of that change be reported on the income statement as a cumulative-effect gain or loss on prior years of that change in accounting principle' (here in "cumulative-effect"). The cumulative-effect gain or loss was reported as a special net-of-tax amount at the bottom of the income statement, after income from continuing operations. In contrast FAS 154 does not require nor allow the cumulative-effect to be reported on the income statement. Instead, the effects of changes in accounting principle are accounted for by "retrospective application." Under retrospective application there is no special reporting feature to the income statement in the year of change. Instead, the current-year income statement will reflect the new method. On the annual report however, any previous years' financial statements presented will show the "retrospective application" of the new method as if it had been in effect during those years. Thus, the previous years presented will be more comparable to the current year in which the new accounting method was first used.

Since FAS 154 eliminates the cumulative-effect gain or loss, we suggest that FAS 154 will have an impact on reported net income. The cumulative-effect on prior years' gain or loss required under APB Opinion 20 was the overall earnings effect on all prior years, not just the effect on the current year's net income for the year of the accounting change. Therefore, in the year an enterprise changed accounting methods the earnings impact on the income statement was potentially significant. Our research question asks, "What is the likely impact under FAS 154 of no longer reporting the cumulative-effect gain or loss?" This question is explored by examining the impact on net income if FAS 154 had been applied to fiscal years 1998-2004.

Itemizing or cataloging the specific changes in accounting principle for the over 2,600 firm-observations used in this study is not the focus of this study and is beyond its scope. However, some specific new accounting standards issued by the FASB appear to account for a substantial portion of the mandatory accounting changes that occurred during the years under study. The Accounting Trends & Techniques (AICPA 2003) revealed that during 1999-2002 fourteen different new accounting standards or Emerging Issue Task Force rulings became mandatory. This increase in cumulative-effect accounting changes appeared to mostly reduce earnings.

For an example, in 2001 the FASB issued Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations (FAS 143) (FASB 2001). This accounting standard requires that an enterprise recognize and measure the cost of the obligation to retire an asset at the end of its useful life as well as recognize imputed interest expense and the incremental amount of depreciation expense. …

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