What it means
Accounting changes matter because comparability is the backbone of financial analysis. If a company quietly switches inventory or depreciation methods, this year's profit is no longer comparable with last year's, and a reader could easily credit management with an improvement that came from the accounting rather than the business.
The rules exist to make the switch visible and to keep the trend line honest. A change in accounting principle means moving from one acceptable method to another, such as changing inventory costing or revenue presentation.
Because both methods were permitted, the change is normally applied retrospectively: prior periods are recalculated as if the new method had always been used, and opening retained earnings is adjusted. A company can only make such a change if the new method is genuinely preferable, not merely more flattering.
A change in accounting estimate is different in nature and in treatment. Estimates such as useful lives, bad debt provisions, warranty accruals and residual values are revised as new information arrives, and that revision is applied prospectively, affecting the current period and future ones without touching prior statements.
Nobody was wrong before, the facts simply moved. A change in reporting entity covers situations such as presenting consolidated statements where separate ones were presented before, or altering the set of subsidiaries included.
This is handled retrospectively too, so that the comparative figures show the same group of businesses and the trend actually means something. The dividing line between a principle and an estimate can blur, and depreciation is the classic case.
Switching from straight line to reducing balance is a change in method that is inseparable from a change in estimate, and accounting standards treat it as a change in estimate, applied prospectively. Whatever the type, disclosure is required: the nature of the change, why it was made, and its effect on the reported numbers.
In practice
Real-world examples.
Example
A retailer changes the estimated useful life of its shop fit outs from twelve years to eight after a refurbishment cycle review. Depreciation rises by $410,000 in the current year, the change is disclosed in the notes, and no prior year figure is touched.
Example
A manufacturer moves from one permitted inventory costing method to another following a group wide policy alignment. Because this is a change in principle, the prior year cost of sales and closing inventory are recalculated and opening retained earnings is adjusted so the two years remain comparable.
Example
A holding company that previously published only parent entity statements begins presenting consolidated accounts after acquiring a second trading subsidiary. The comparative year is restated on a consolidated basis so that revenue growth reflects trading, not a change in what is being counted.
Formula
Calculation
For a change in estimate on a depreciable asset, the new annual charge is: Revised annual depreciation = (Carrying amount at date of change - Revised residual value) / Remaining revised useful life.
A packaging company buys a machine for $600,000 with no expected residual value and an original estimated useful life of ten years, depreciated on a straight line basis.
Original annual depreciation: $600,000 / 10 = $60,000.
After four years, accumulated depreciation: $60,000 x 4 = $240,000.
Carrying amount: $600,000 - $240,000 = $360,000.
At the start of year five, engineers advise that heavier use means the machine will last a total of eight years rather than ten, leaving four years remaining.
Revised annual depreciation: $360,000 / 4 = $90,000.
The charge rises by $30,000 a year from year five onwards. Crucially, the first four years are not restated: prior statements keep the $60,000 charge, because the estimate was reasonable on the information available at the time.Case study
Seen in the real world.
Draymont Tooling is an entirely fictional precision engineering firm used here as an illustrative example. Its board reviewed the depreciation policy on computer numerical control machinery and concluded that a five year life, set when the company was much smaller, no longer matched reality, because a servicing contract now kept the machines productive for nine years.
The finance team treated the extension as a change in accounting estimate and applied it prospectively. Carrying amounts of $2,700,000 were spread over the revised remaining lives, and the annual depreciation charge fell by roughly $480,000, which increased reported operating profit without a single extra sale.
The audit committee insisted the note explain the reason for the change and quantify the effect, and the chief executive was asked to strip the change out of the bonus calculation. In this illustrative case, the change was legitimate and well evidenced, and the disclosure is what stopped it being mistaken for a genuine improvement in trading.
Watch out
Common mistakes.
- Restating prior years for a change in estimate. Estimates are revised prospectively, and reworking earlier statements implies those statements were wrong when they were reasonable at the time.
- Changing an accounting method because it produces a better looking result. A change in principle requires that the new method is preferable on its merits, and auditors will ask for that justification in writing.
- Making the change and saying nothing in the notes. Undisclosed changes destroy comparability and are one of the fastest ways to lose a reader's trust in the whole statement.
Questions
People also ask.
What is the difference between an accounting change and an error correction?
A change moves from one acceptable treatment to another or updates an estimate, while an error correction fixes something that was wrong under the rules that already applied.
Which accounting changes are applied retrospectively?
Changes in accounting principle and changes in reporting entity, while changes in estimate are applied only to the current and future periods.
How is a change in depreciation method treated?
As a change in estimate applied prospectively, because the method and the pattern of consumption it represents cannot be separated in practice.
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