Change in accounting principle definition
/What is a Change in Accounting Principle?
An accounting principle is a general guideline to follow when recording and reporting business transactions. There is a change in accounting principle under the following circumstances:
When there are two or more accounting principles that apply to a particular situation, and you shift to the other principle; or
When the accounting principle that formerly applied to the situation is no longer generally accepted; or
The method of applying the principle is changed.
You should only change an accounting principle when doing so is required by the accounting framework being used (either GAAP or IFRS), or you can justify that it is preferable to use the new principle.
Direct Effects of a Change in Accounting Principle
A direct effect of a change in accounting principle is a recognized change in an asset or liability that is required in order to effect the change in principle. For example, if you change from the FIFO to the specific identification method of inventory valuation, the resulting change in the recorded inventory cost is a direct effect of a change in accounting principle.
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Indirect Effects of a Change in Accounting Principle
An indirect effect of a change in accounting principle is a change in an entity's current or future cash flows from a change in accounting principles that is being applied retrospectively. Retrospective application means that you are applying the change in principle to the financial results of previous periods, as if the new principle had always been in use.
How to Retrospectively Apply a Change in Accounting Principle
You are required to retrospectively apply a change in accounting principle to all prior periods, unless it is impracticable to do so. To complete a retrospective application, the following steps are required:
Include the cumulative effect of the change on periods prior to those presented in the carrying amounts of assets and liabilities as of the beginning of the first period in which you are presenting financial statements; and
Enter an offsetting amount in the beginning retained earnings balance of the first period in which you are presenting financial statements; and
Adjust all presented financial statements to reflect the change to the new accounting principle.
These retrospective changes are only for the direct effects of the change in principle, including related income tax effects. You do not have to retrospectively adjust financial results for indirect effects.
When Not to Retrospectively Apply a Change in Accounting Principle
It is only impracticable to retrospectively apply the effects of a change in principle under one of the following circumstances:
You make all reasonable efforts to do so, but cannot complete the retrospective application
Doing so requires knowledge of management's intent in a prior period, which you cannot substantiate
Doing so requires significant estimates, and it is impossible to create those estimates based on information available when the financial statements were originally issued
Example of a Change in Accounting Principle
A manufacturing company previously used the First-In, First-Out (FIFO) method to value its inventory. After a detailed review, management decided to switch to the weighted average cost method starting from the new financial year. The reason for this change was to better match inventory costs with current market conditions, as raw material prices had become highly volatile. By adopting the weighted average cost method, the company aims to smooth out fluctuations in inventory costs and provide more reliable financial information to users of its financial statements. This change is considered a change in accounting principle, because it involves switching from one generally accepted accounting method to another. As required by accounting standards, the company retrospectively adjusted its prior period financial statements to reflect the change and disclosed the reason for the change, along with its financial impact, in the notes to the financial statements.
Disclosure of a Change in Accounting Principle
The following is a sample disclosure that a company might use to describe a change in accounting principle. It is based on the preceding example:
Effective January 1, 2025, the company changed its method of inventory valuation from the First-In, First-Out (FIFO) method to the weighted average cost method. Management believes that the weighted average cost method provides a more reliable measure of inventory costs and better reflects current market conditions, particularly in light of recent volatility in raw material prices.
This change has been applied retrospectively, and prior period financial statements have been restated to conform to the new accounting principle. As a result of the change, inventory as of December 31, 2024, decreased by $150,000, and retained earnings as of the same date decreased by $150,000. The effect of the change on net income for the year ended December 31, 2024, was a decrease of $25,000.
Management believes this change improves the consistency and comparability of the company's financial statements.