What it means
Accounting standards often permit alternatives. A company may value inventory at FIFO or weighted average; carry property at cost or at revaluation; present its cash flow statement directly or indirectly.
Once a company has chosen, it must apply the choice consistently, because readers compare one year with the next and one company with another. A change in accounting principle is a change of that choice, and the rules exist to protect comparability when the change is made.
Two justifications are allowed. A new or amended standard may require or permit the change, in which case the standard's own transition provisions govern how it is applied, often with specific relief.
Or the company may conclude that a different permitted method gives more reliable and relevant information about its transactions, in which case it must be able to explain why. What is not allowed is a change to produce a better number: the standards and auditors treat a change whose main effect is to improve reported profit or the balance sheet, without a substantive reason, as unacceptable.
Retrospective application is the default. The company recalculates the prior periods shown in the financial statements under the new method, adjusts the opening balance of retained earnings (and other affected equity components) for the earliest period presented by the cumulative effect of all earlier periods, and presents the restated comparatives with disclosure of the adjustments to each line item.
The result is that the current year and the comparatives are on the same basis, and the reader can see the trend without a discontinuity. Where retrospective application is impracticable (the information cannot be reconstructed), the standards allow prospective application from the earliest practicable date, with disclosure.
Disclosure is extensive: the nature of the change and the reasons for it; the transition method; the amount of the adjustment to each affected line item in the current and prior periods, including earnings per share; the adjustment to opening retained earnings; and, for new standards, the effect of the adoption. New standards are often adopted with a modified retrospective approach permitted by the standard itself, under which the cumulative effect is recognised in opening equity of the year of adoption and comparatives are not restated; the recent revenue and lease standards both allowed this, and companies that used it disclosed the effect on the year of adoption.
The distinction from a change in estimate matters. A change in the useful life of an asset is an estimate (prospective); a change from cost to revaluation is a principle (retrospective, with its own rules); a change in depreciation method is treated as an estimate.
A correction of an error is also retrospective, but it is disclosed as an error, which carries a different message about the quality of past reporting. For readers, a change in principle requires care in trend analysis: figures from before the change in older reports are not comparable with restated figures, and ratios computed across the change must use consistent data.
In practice
Real-world examples.
Example
A retailer adopts the new revenue standard, restating two years of comparatives to recognise loyalty points as a separate performance obligation.
Example
A property company changes from the cost model to the revaluation model for its head office, recognising the revaluation surplus in equity and restating comparatives.
Example
A manufacturer changes from LIFO to FIFO after LIFO is prohibited under the framework it adopts, restating prior years and adjusting opening retained earnings.
Think of it
“A change in accounting principle is switching methods-which usually requires restating past numbers.
Formula
Calculation
Retrospective application: Restated prior-period figures = Figures under the new principle as if it had always applied
Adjustment to opening retained earnings (earliest period presented) = Cumulative effect of the new principle on all prior periods, net of tax
Effect on current and prior periods disclosed line by line, including earnings per share
Worked example. A distributor has used FIFO for inventory and decides, after a review of its purchasing patterns, that weighted average cost gives more relevant information because prices fluctuate and stock turns quickly. It changes principle at the start of year 3, presenting years 2 and 3 in its financial statements. Tax rate 25%.
Inventory values:
- End of year 1: FIFO $4,200,000; weighted average $3,900,000; difference $300,000
- End of year 2: FIFO $4,800,000; weighted average $4,350,000; difference $450,000
- End of year 3: weighted average $4,600,000 (FIFO would have been $5,150,000; difference $550,000)
Effect on cost of sales and profit:
- Year 2 cost of sales under FIFO was $30,000,000. Under weighted average: opening inventory $300,000 lower and closing inventory $450,000 lower, so cost of sales = $30,000,000 minus $300,000 + $450,000 = $30,150,000, an increase of $150,000; year 2 pre-tax profit falls by $150,000, after tax $112,500
- Cumulative effect at the start of year 2 (end of year 1): inventory $300,000 lower, tax $75,000 lower: opening retained earnings for year 2 reduced by $225,000
- Year 3, under the new method: closing inventory $4,600,000, opening $4,350,000 (restated); cost of sales as computed on the new basis; the year 3 figures are simply prepared on weighted average
Presentation: year 2 comparatives are restated (inventory $4,350,000; cost of sales $30,150,000; profit down $112,500; retained earnings at the end of year 2 down $337,500, being $225,000 opening plus $112,500). Year 3 is on the new basis. The disclosure note explains the change, the reason, and the effect on each line and on earnings per share for both years.
Trend check: an analyst comparing year 3 profit with the year 2 figure in last year's annual report would see a distorted trend; the restated year 2 figure is the correct comparator. The analyst also notes that the change reduced reported inventory and profit, which supports the company's stated reason (relevance) rather than suggesting a change made to flatter results.
Contrast with a new standard: had the change been the adoption of a new lease standard using the modified retrospective method, the company would have recognised right-of-use assets and lease liabilities at the start of year 3 with the cumulative effect in opening year 3 retained earnings, and would not have restated year 2, disclosing instead the effect on year 3 and the reasons the comparatives are not comparable.Case study
Seen in the real world.
A listed construction group changed its method of accounting for long-term contracts from completed-contract (recognising profit only when a project finished) to percentage-of-completion (recognising profit as work progressed), at a time when the framework permitted both for its type of contracts. The stated reason was better matching of profit to activity. The retrospective application increased the prior year's profit by $18 million and opening retained earnings by $40 million, and the current year's profit was $22 million higher than it would have been under the old method.
Analysts observed that the change coincided with a covenant test and with the vesting conditions of an executive share scheme, and that the group had argued against percentage-of-completion two years earlier when its projects were in early, loss-making stages. The audit committee's report the following year set out the evidence for the change (the group's contracts had become longer and more uniform, and its estimating had matured to the point where completion percentages were reliable) and the auditor's assessment of it. The change was accepted, but the group's share price discounted its reported profits for two years afterwards, and its chief financial officer later described the episode as a lesson that a permitted change made at a convenient moment is read as a convenient change.
Watch out
Common mistakes.
- Applying a change in principle prospectively, as if it were a change in estimate, which leaves the comparatives on a different basis and breaks the trend.
- Changing principle without a substantive reason, or at a moment that suggests the reason is the result rather than the relevance.
- Comparing figures across a change without using the restated comparatives, which produces false trends.
Questions
People also ask.
What is the difference between a change in accounting principle and a change in estimate?
A principle is a method chosen among alternatives; an estimate is a judgement about uncertain facts. Principle changes are applied retrospectively with restatement; estimate changes prospectively.
When is a change in principle allowed?
When a new standard requires or permits it, or when the new method gives more reliable and relevant information. Not to improve the reported result.
What does modified retrospective mean?
A transition method allowed by some new standards under which the cumulative effect is recognised in opening equity of the adoption year without restating comparatives, with disclosure of the effect on the adoption year.
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