Changes in Accounting Principle

What is a change in accounting principle? This is when a company changes from one generally accepted accounting principle to another generally accepted accounting principle. One example of this would be when a company changes from using the percentage of completion method of accounting for their construction contracts to using the completed contract method. Another example would be a company changing their depreciation method from the straight-line method to an accelerated method of depreciation.

Since financial statements are often examined for the current year and previous years, the reporting of a change in accounting principle is very important. If not disclosed and reported properly, the evaluation of the financial statements may be skewed. There are three possible methods for reporting a change in accounting principle. These are to report the change retroactively, currently, or prospectively. The method to be used depends on the type of change in accounting principle you are dealing with.

There are three categories of changes in accounting principle, and each type is handled differently. The three categories are cumulative-effect type accounting changes, retroactive-effect type accounting changes, and a change to the LIFO (last-in, first-out) method of inventory valuation. Cumulative-effect type accounting changes are to be reported using the current or catch-up method. Retroactive-effect type accounting changes would be reported using the retroactive method. A change to the LIFO method of inventory is reported using the prospective method.

A cumulative-effect type change in accounting principle is reported using the current method. This means that the prior period financial statements being included for comparison are not restated. On the income statement, between extraordinary items and net income, the cumulative effect of the accounting change would be reported. Pro forma amounts for any periods presented must be reported as supplemental information on the financial statements or the notes, or in a separate schedule.

A retroactive-effect type change in accounting principle is reported using the retroactive method. This means that the company computes the cumulative effect of using the new method on the financial statements at the start of the period. The prior period financial statements being presented are restated using the new accounting principle. If the cumulative effect would go back farther than the periods presented in the financial statements, an adjustment would be made to the beginning retained earnings of the earliest year being presented.

A change to the LIFO method of inventory requires reporting using the prospective method. This means that the beginning inventory amount for the year the change is adopted is used as the base-year inventory for the future. The reason for this is that it would not be practical to restate the prior periods’ income. The company needs to disclose the reason for changing to the LIFO method of inventory valuation in the financial statements.

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