What Is a Change in Accounting Principle?

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Change in Accounting Principle

Contents

A change in accounting principle involves a shift from one generally accepted accounting principle (GAAP) to another. It occurs when an entity decides that an alternative GAAP principle is more appropriate for preparing its financial statements, ensuring they present a more accurate picture of the company’s financial condition and results of operations.

Businesses may change accounting principles to improve the clarity, relevance, and comparability of their financial information.

Such changes are typically made in response to new accounting standards issued by regulatory bodies, or after determining that an alternative accounting method will better represent the financial reality of the company.

These changes require approval from an entity’s auditors and are disclosed to stakeholders through notes in the financial statements.

Example of a Change in Accounting Principle

“Modern Furnishings Inc.,” a retail furniture company, changes its inventory valuation method from the last-in, first-out (LIFO) method to the first-in, first-out (FIFO) method. This change is made to better reflect the cost of inventory sold and ending inventory in an environment of rising prices.

Before Change: Inventory valued using LIFO, where the most recently produced items are recorded as sold first.

After Change: Inventory valued using FIFO, where the oldest items are recorded as sold first.

Accounting Impact: This change results in higher reported earnings and inventory values on the balance sheet due to the lower cost of goods sold (COGS) calculated under FIFO in a rising price environment.

In this scenario, “Modern Furnishings Inc.” decides that FIFO presents a more accurate representation of its inventory costs and financial health, especially during periods of inflation.

The shift from LIFO to FIFO necessitates a retrospective adjustment to previous financial statements to ensure comparability. The company must recalculate its COGS, earnings, and inventory values for prior periods as if the FIFO method had been used all along.

This adjustment impacts the company’s reported financial position and performance, which is then reflected in its current and restated prior period financial statements.

Significance for Investing & Finance

The change in accounting principle is significant due to several factors:

Comparability and Consistency: Ensures financial statements are comparable across periods, providing a consistent basis for analysis by investors, creditors, and other stakeholders.

Transparency: Requires detailed disclosure, including the nature of the change, justification for the change, and its effects on the financial statements, enhancing transparency in financial reporting.

Regulatory Compliance: Aligns with evolving accounting standards and regulations, ensuring the entity remains in compliance with the latest accounting practices.

Impact on Financial Metrics: Affects key financial metrics and ratios, which can influence stakeholders’ perceptions, investment decisions, and credit evaluations.

In summary, a change in accounting principle is a crucial aspect of financial reporting that ensures the continued relevance and accuracy of financial statements.

By adapting to new accounting standards or recognizing that an alternative principle provides a more accurate depiction of a company’s financial status, businesses can maintain the trust of investors and stakeholders, comply with regulatory requirements, and ensure their financial reporting reflects their economic reality.

FAQ

What necessitates a company to make a change in accounting principle?

A company may need to change an accounting principle to comply with new accounting standards or when it determines that an alternative principle will provide a more accurate and fair representation of its financial condition and results of operations.

How does a change in accounting principle affect financial statements?

A change in accounting principle requires retrospective application to prior period financial statements, meaning the company must adjust its historical financial data as if the new principle had always been in use, to ensure consistency and comparability for users of the financial statements.

Are companies required to disclose changes in accounting principles to their stakeholders?

Yes, companies must fully disclose any changes in accounting principles in the notes to their financial statements, including the reason for the change, a description of the previous method, the justification for using the new principle, and the effect of the change on financial statement items.

What is the difference between a change in accounting estimate and a change in accounting principle?

A change in accounting estimate is an adjustment based on new information or developments affecting current and future periods only, whereas a change in accounting principle involves switching from one generally accepted accounting principle to another, requiring retrospective adjustment to prior period financial statements for consistency.