What it means
Accounting standards often allow more than one acceptable method for the same item. A company might value inventory using first-in, first-out (FIFO), which assumes the oldest stock is sold first, or using a weighted average cost, and each method produces a different profit and balance sheet figure.
Consistency is a core principle, since readers need to compare one year with the next. For that reason a company cannot swap methods whenever it wishes and must have a good reason, normally either a new standard or a demonstrably better presentation.
When a change is made, the usual treatment is retrospective. The company restates comparative figures and adjusts the opening balance of retained earnings for the cumulative effect on earlier years, so that all periods shown are on the same basis.
Sometimes it is impracticable to work out the effect on every earlier year. In that case standards allow the new method to be applied from the earliest date possible, and the company must explain the limitation in the notes.
Disclosure is detailed. The notes must describe the nature of the change, why it is preferable, and the effect on each line item affected, so readers can see the impact on profit and equity.
Change in principle should not be confused with a change in estimate. Choosing a different depreciation method is usually treated as a change in estimate in practice, because the pattern of use of the asset has changed, while moving between inventory costing methods is a classic change in principle.
In practice
Real-world examples
Example 1
A building materials company changes its inventory costing from weighted average to FIFO because the new method better reflects the physical flow of its goods. It restates last year's comparatives and explains the effect on cost of sales in the notes. The auditors review the logic and the arithmetic before the accounts are signed.
Example 2
A listed business adopts a new revenue recognition standard that requires contracts to be recognised in stages. The company applies the new rules to its comparative year and shows the impact on opening equity. Investors can then compare the new figures with the old ones on a like-for-like basis.
Example 3
A technology company starts recognising qualifying development costs as an intangible asset instead of expensing them, because the standard it follows requires this once set criteria are met. It restates the comparative year where practicable and explains the effect on profit and equity in the notes.
Think of it
A change in accounting principle is switching methods-which usually requires restating past numbers.
Formula
Calculation
Adjustment to opening retained earnings = (Opening inventory under new method - Opening inventory under old method) x (1 - Tax rate)
A distributor moves from weighted average cost to FIFO. At the start of the current year, inventory is $460,000 under FIFO and was recorded at $440,000 under the old method, a difference of $20,000. At a 25% tax rate the after-tax effect is $20,000 x (1 - 0.25) = $15,000. Opening retained earnings in the restated accounts are increased by $15,000, the deferred tax liability rises by $5,000 and inventory is $20,000 higher.Case study
Seen in the real world
Harlow Beverages is an illustrative, fictional drinks distributor that used weighted average costing for its stock. After an upgrade of its warehouse system, the company could track the age of every pallet and found that stock was physically sold in strict order of arrival.
Management concluded that FIFO gave a truer picture of cost of sales and asked its accountants to prepare the change. The cumulative effect on opening inventory was an increase of $120,000, which after tax raised opening retained earnings by $90,000.
The illustrative accounts restated the prior year, labelled the columns clearly and added a note setting out the reason and the numbers. Because the logic was documented, lenders accepted the restated figures without changing the covenants. The finance team kept a reconciliation between the old and new numbers on file for future audits.
Watch out
Common mistakes
- Changing method simply because it makes profit look better, when standards require the change to give more reliable or relevant information.
- Applying the new method only from the current year without restating comparatives, which breaks the link between periods.
- Treating a change in estimate as a change in principle, and restating periods that should have been left alone.
Questions
People also ask
Can a company change principle whenever it wants?
No, it needs either a requirement from a new standard or a good reason that the new method is preferable, and it must disclose both.
What happens to tax?
The change often creates a temporary difference between the books and the tax return, which may lead to deferred tax adjustments or a tax filing to request approval for the change.
Does a change affect cash?
Not directly, because it changes the accounting presentation, though any tax consequences can have a cash effect.