Accounting for a Change in Principle Inseparable From an Estimate

Financial reporting relies on the consistent application of accounting methods to ensure results are comparable between periods. While consistency is important, changes in business operations or the economic environment can make accounting changes necessary to provide more reliable information. The Financial Accounting Standards Board (FASB) provides a framework for these situations.

This guidance classifies adjustments into three categories: a change in accounting principle, a change in accounting estimate, and a change in the reporting entity. A complex situation arises when a change in an accounting principle is so intertwined with a change in an accounting estimate that the two cannot be separated.

Foundations of Accounting Changes

A change in accounting principle occurs when an entity switches from one generally accepted accounting principle (GAAP) to another, such as changing its inventory valuation from the LIFO to the FIFO method. This change is only permitted if the new principle is justifiable as preferable. The required treatment for this type of change is retrospective application.

Retrospective application requires restating prior period financial statements as if the new principle had always been used. This involves adjusting the carrying amounts of assets and liabilities at the beginning of the earliest period presented. A corresponding adjustment is also made to the opening balance of retained earnings.

A change in accounting estimate is a revision to a previous estimate based on new information. Examples include updating the useful life of an asset, revising its salvage value, or adjusting the allowance for doubtful accounts. These adjustments reflect that estimates are based on the best information available at the time.

The required treatment for a change in estimate is prospective application, meaning the change affects only current and future financial periods. Prior-period financial statements are not restated. The effect of the change is recognized in the period of the change and any relevant future periods.

Identifying an Inseparable Change

An inseparable change occurs when the effect of modifying an accounting principle cannot be distinguished from the effect of changing an accounting estimate. This situation is challenging because the two types of changes normally require different accounting treatments. According to ASC 250, implementing the new principle is impossible without also incorporating new estimates.

A common example involves the depreciation of long-lived assets. A company might change its depreciation method from an accelerated method to the straight-line method, which is a change in accounting principle. This change is often prompted by a reassessment of the asset’s future economic benefits, which also leads to revising its remaining useful life and salvage value—both of which are changes in accounting estimates.

These changes are inseparable because calculating the financial impact of the new depreciation method requires using the new estimates for the asset’s life and salvage value. The new annual depreciation expense is a function of both the new method and the new estimates, making it impractical to isolate the effects of each.

Another instance involves changing the amortization method for an intangible asset, like a patent. If a company determines the pattern of economic benefit has changed, it might switch from an accelerated to a straight-line method. This change in principle often coincides with re-evaluating the asset’s remaining economic life, making the effects inseparable.

Prospective Application and Disclosure Requirements

When a change in accounting principle is inseparable from a change in an accounting estimate, the event is accounted for as a change in accounting estimate. This requires prospective application, where the change is applied to the financial results of the current and future periods. Previously issued financial statements are not restated.

This involves taking the asset’s carrying amount (book value) at the date of the change and allocating it over the new remaining useful life using the new method. For example, if a company changes a machine’s depreciation method, it uses the machine’s book value at the start of the year. That value, less the new salvage value, is then depreciated over the new remaining useful life with the new method.

Accounting standards require specific disclosures in the notes to the financial statements. The company must describe the nature of the change and provide a clear reason for it, explaining why the previous method and estimates are no longer appropriate.

The disclosure must also quantify the impact on the current period’s financial results, including the effect on income from continuing operations, net income, and related per-share amounts. If the change is expected to have a material effect in future periods, a description of that change must be disclosed, even if the current impact is not material.