A Change in Accounting Principle Is a Change: How to Record It Properly

Accounting principles are the backbone of financial reporting, ensuring consistency and comparability across periods. Businesses sometimes find it necessary to change these principles due to reasons such as new regulations or improved practices. Properly recording a change in accounting principle is critical for maintaining transparency and accuracy in financial statements.

Qualifying Criteria for a Change in Principle

A change in accounting principle is justified only if it results in more reliable and relevant financial information. The Financial Accounting Standards Board (FASB) specifies that the new principle should enhance the clarity of a company’s financial position, performance, or cash flows. For example, switching from the Last-In, First-Out (LIFO) inventory method to First-In, First-Out (FIFO) might better reflect the flow of goods and improve comparability.

Changes may also arise from new accounting standards or amendments. For instance, the implementation of Accounting Standards Update (ASU) 2016-02 required companies to recognize lease assets and liabilities on the balance sheet. Additionally, businesses may adopt new principles to align with industry practices or accommodate significant shifts in operations, such as a manufacturing firm transitioning to a service-based revenue model.

Methods of Recording a Change

The retrospective approach is commonly used when changing an accounting principle. This method adjusts prior period financial statements as if the new principle had always been applied, ensuring comparability. For example, if a company shifts from straight-line depreciation to an accelerated method, it recalculates prior depreciation expenses and adjusts retained earnings accordingly.

This process involves recalculating historical figures, making journal entries, and addressing tax implications, such as changes in deferred tax liabilities. If full retrospective application is impractical, companies may use a modified retrospective approach, which recognizes the cumulative effect of the change in the opening balance of retained earnings for the current period. Clear documentation and justification are required for the method chosen.

Adjustments to Comparative Data

Adjusting comparative data ensures consistency by recalibrating past financial statements to reflect the new principle. The goal is to present financial information as if the new principle had always been in use, enabling stakeholders to make informed comparisons.

The process depends on the nature of the change. For example, altering a revenue recognition policy may require adjustments to both the income statement and balance sheet of prior periods, such as revenue figures, accounts receivable, or unearned revenue. Each adjustment must be documented, with explanations in the financial statement notes to clarify the impact.

Broader implications, like changes in key financial metrics such as earnings per share (EPS) or return on equity (ROE), must also be considered. Communicating these adjustments effectively helps stakeholders understand the changes and their significance.

Financial Statement Disclosures

Financial statement disclosures provide essential context for understanding the impact of changes in accounting principles. Companies must detail the nature of the change, the rationale behind it, and its effects on financial statements. Both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) require disclosures explaining the reasons for the change, the method of application, and its impact on financial metrics.

Disclosures should include any adjustments made to financial statements, such as restated prior period figures. Companies must present the quantitative effects on key line items like revenue, expenses, and net income. Additionally, implications for financial covenants or agreements tied to specific ratios should be clearly communicated to avoid misunderstandings with creditors or investors.