A change in accounting principle is the term used when a company chooses between different generally accepted accounting principles or changes the method by which a principle is applied. Changes may occur in the accounting frameworks of 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, from apples to apples, the numbers before and after change, so that they can derive the correct information. Adjustments are a lot like bug fixes, which often have negative interpretations.
Changing an accounting principle is different from changing an accounting estimate or an accounting entity. The accounting principles have an impact on the methods used, while an estimate refers to a specific recalculation. An example of a change in accounting principles occurs when a company changes its inventory valuation system, perhaps moving from LIFO to FIFO.
Key points to remember
- A change in accounting principles refers to a company that changes its method of compiling and presenting its financial statements.
- Specifically, the business will choose between a variety of generally accepted accounting principles or change the process by which a principle is implemented.
- When a change is made, it should be applied retroactively to all previous declarations, as if the method had always been used, unless this is not possible.
- If the adoption of the new principle results in a substantial change in an asset or liability, the change should be reported in opening retained earnings.
Recording and declaration of a change in accounting principles
Whenever a change in principles is made by a company, the company should retrospectively apply the change to all previous reporting periods, as if the new principle had always been in place, unless this cannot be done. to do. This is called the “turnaround”. Keep in mind that these requirements only impact the direct effects, not the indirect effects.
If the adoption of a new accounting policy results in a material change in an asset or liability, the adjustment should be reported in opening retained earnings. In addition, the nature of any change in accounting principles should be disclosed in the footnotes of the financial statements, along with the rationale used to justify the change. The FASB issues accounting change and error correction statements that detail how to reflect changes in financial reports.