Changes in Accounting principle

An accounting change is a change in accounting principles, accounting estimates, or the reporting entity. A change in accounting principles is a change in a method used, such as using a different depreciation method or switching between LIFO (Last In, First Out) to FIFO (First In, First Out) inventory valuation methods.

Accounting changes require full disclosure in the footnotes of the financial statements to describe the justification and financial effects of the change. This allows readers of the statements, such as management, partners, and security analysts to analyze the changes appropriately, ideally to help them make more informed decisions about a business’s operations, future prospects, and investment-related matters.

An accounting principle is a general guideline to follow when recording and reporting financial transactions. There is a change in accounting principle when:

• There are two or more accounting principles that apply to a particular situation, and you shift to the other principle; or
• When the accounting principle that formerly applied to the situation is no longer generally accepted; or
• The method of applying the principle is changed.

A company generally needs to restate past statements to reflect a change in accounting principles. However, a change in accounting estimates does not require prior financial statements to be restated. In the case of an accounting change, users of the financial statements should examine the footnotes closely to understand what any changes mean and if they affect the true value of the company.

A change in accounting principle is the term used when a business selects between different generally accepted accounting principles or changes the method with which a principle is applied. Changes can occur within accounting frameworks for either generally accepted accounting principles (GAAP), or international financial reporting standards (IFRS). American companies use GAAP.

For investors, security analysts, or other users of financial statements, changes in accounting principles can be confusing to read and understand. They need adjustments in order to compare, apples to apples, the pre-change, and the post-change numbers, to be able to derive correct insights. The adjustments look very similar to error corrections, which often have negative interpretations.

Changing an accounting principle is different from changing an accounting estimate or reporting entity. Accounting principles impact the methods used, whereas an estimate refers to a specific recalculation. An example of a change in accounting principles occurs when a company changes its system of inventory valuation, perhaps moving from LIFO to FIFO.

A direct effect of a change in accounting principle is a recognized change in an asset or liability that is required in order to effect the change in principle. For example, if you change from the FIFO to the specific identification method of inventory valuation, the resulting change in the recorded inventory cost is a direct effect of a change in accounting principle.

An indirect effect of a change in accounting principle is a change in an entity’s current or future cash flows from a change in accounting principles that is being applied retrospectively. Retrospective application means that you are applying the change in principle to the financial results of previous periods, as if the new principle had always been in use.

You are required to retrospectively apply a change in accounting principle to all prior periods, unless it is impracticable to do so. To complete a retrospective application, the following steps are required:

• Include the cumulative effect of the change on periods prior to those presented in the carrying amounts of assets and liabilities as of the beginning of the first period in which you are presenting financial statements; and
• Enter an offsetting amount in the beginning retained earnings balance of the first period in which you are presenting financial statements; and
• Adjust all presented financial statements to reflect the change to the new accounting principle.

These retrospective changes are only for the direct effects of the change in principle, including related income tax effects. You do not have to retrospectively adjust financial results for indirect effects.

It is only impracticable to retrospectively apply the effects of a change in principle under one of the following circumstances:

• Make all reasonable efforts to do so, but cannot complete the retrospective application
• Doing so requires knowledge of management’s intent in a prior period, which you cannot substantiate
• Doing so requires significant estimates, and it is impossible to create those estimates based on information available when the financial statements were originally issued