What Is Accounting Change?
An accounting change refers to an alteration in the accounting principles, estimates, or reporting entities applied in a company's financial statements. These modifications are a fundamental aspect of Financial Accounting, ensuring that financial information remains relevant, reliable, and comparable over time. Accounting changes are typically implemented to improve the accuracy of Financial Reporting, comply with new regulatory standards, or reflect a more appropriate representation of a company's economic reality.
Generally, accounting changes fall into three categories: changes in accounting principle, changes in accounting estimate, and changes in reporting entity. Each type has specific rules governing its implementation and disclosure, primarily dictated by bodies such as the Financial Accounting Standards Board (FASB) in the United States, which sets Generally Accepted Accounting Principles (GAAP).
History and Origin
The evolution of accounting standards is a continuous process driven by changes in business practices, economic conditions, and the need for greater transparency and comparability in financial information. Major accounting changes often arise from the efforts of standard-setting bodies like the FASB, established in 1973, to develop and improve accounting and reporting standards6, 7. For instance, a significant shift occurred with the issuance of Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606), which fundamentally changed how companies recognize revenue4, 5. This new guidance aimed to provide a more robust framework for addressing Revenue Recognition issues and to remove inconsistencies present in older standards, impacting virtually all revenue-generating entities.
Key Takeaways
- An accounting change modifies accounting principles, estimates, or reporting entities.
- Such changes are necessary for financial statements to remain accurate and relevant.
- They are categorized as changes in principle, changes in estimate, or changes in reporting entity.
- Accounting changes require specific disclosure to ensure transparency for users of financial statements.
- Standard-setting bodies continually issue new guidance, leading to accounting changes.
Formula and Calculation
An accounting change itself does not typically involve a specific formula or calculation in the way a financial ratio might. Instead, the "calculation" aspects relate to how the impact of the change is quantified and presented. For instance, a change in an accounting estimate like the useful life of an asset for Depreciation will alter the depreciation expense calculated for current and future periods.
For a change in accounting principle, the cumulative effect of the change on prior periods' Shareholder Equity is often calculated and reflected. If a company changes its Inventory Valuation method from FIFO to weighted-average, the difference in inventory value and cost of goods sold from previous periods would need to be determined to apply the change retrospectively. The adjustment often impacts retained earnings at the beginning of the earliest period presented.
Interpreting the Accounting Change
Interpreting an accounting change requires understanding its nature and its effect on a company's Financial Statements. A change in accounting principle, such as altering the method for valuing inventory, usually requires Retrospective Application. This means that prior period financial statements are restated as if the new principle had always been in use, allowing for direct comparability of financial data across periods. This restatement impacts line items on the Balance Sheet and Income Statement.
Changes in accounting estimates, such as revising the useful life of an asset or the estimated bad debt, are generally applied Prospective Application. This means the change affects only the current and future periods, without restating previous financial statements. Understanding whether a change is retrospective or prospective is crucial for accurate financial analysis. Users should examine the disclosures in the footnotes to comprehend the full impact of an accounting change.
Hypothetical Example
Consider Tech Innovations Inc., a publicly traded software company. For years, Tech Innovations used a straight-line method to recognize revenue from its long-term software development contracts. In 2025, after a review of new industry best practices and evolving guidance, the company decides to switch to the percentage-of-completion method for these contracts, effective January 1, 2025. This constitutes a change in accounting principle.
To implement this accounting change, Tech Innovations must apply the new method retrospectively. They would:
- Recalculate: Determine what their revenue and associated expenses would have been in all prior periods presented (e.g., 2024 and 2023) if they had always used the percentage-of-completion method.
- Adjust Retained Earnings: Calculate the cumulative effect of this change on their net income up to the beginning of the earliest period presented (January 1, 2023). This cumulative adjustment is then made to the opening balance of retained earnings on the Balance Sheet.
- Restate Financial Statements: Present their 2024 and 2023 Financial Statements as if the percentage-of-completion method had always been applied, ensuring comparability with the 2025 figures.
- Disclose: Clearly explain the change in the footnotes to their financial statements, detailing the nature of the change, the reasons for it, and its impact on affected financial statement line items for all periods presented.
This ensures that investors and analysts can compare Tech Innovations' performance consistently across years.
Practical Applications
Accounting changes are a recurring feature in financial reporting, driven by evolving business environments and the need for more accurate financial representation. Public companies, in particular, frequently encounter accounting changes due to updates from standard-setting bodies. For example, the adoption of ASC 606 on Revenue Recognition and ASC 842 on leases significantly altered how many companies recognized revenue and reported lease obligations, respectively3. These changes impacted various industries, requiring extensive adjustments to internal systems and reporting processes.
Analysts and investors use the disclosures about accounting changes to ensure proper evaluation of a company's performance. For instance, when analyzing a company's Cash Flow Statement or profitability trends, understanding the impact of an accounting change is critical to avoid misinterpretations of financial performance. The Securities and Exchange Commission (SEC) provides the EDGAR database, a vital resource where users can access company filings and review detailed disclosures about any accounting change.2 These disclosures ensure that market participants have access to the necessary information to perform a comprehensive Audit or their own financial analysis.
Limitations and Criticisms
While accounting changes aim to improve financial reporting, they are not without limitations and can face criticism. One primary concern is the potential impact on financial statement comparability, even with retrospective application. While retrospective application attempts to achieve comparability, the underlying economic events being reported may not be perfectly analogous across periods due to the change in presentation.
Another criticism revolves around the complexity and cost of implementing significant accounting changes. Companies often incur substantial expenses related to retraining staff, upgrading accounting software, and restating prior financial data. For example, the transition to new revenue recognition standards was a considerable undertaking for many businesses, demanding significant resources and effort to comply.
Furthermore, the subjective nature of some accounting changes, particularly those involving estimates, can be a point of contention. Management judgment plays a significant role in determining estimates like asset useful lives or impairment charges, which can introduce variability and potentially impact the reliability of the reported figures if not exercised carefully within acceptable Materiality thresholds. External critics sometimes point out that differences in accounting standards globally, such as between GAAP and International Financial Reporting Standards (IFRS), can lead to challenges in cross-border financial analysis, even as efforts are made towards convergence1.
Accounting Change vs. Accounting Error
The distinction between an accounting change and an accounting error is crucial in financial reporting due to their differing treatment and implications. An accounting change is a deliberate, justifiable modification to an accounting principle, estimate, or reporting entity, made to improve the relevance or reliability of financial statements. These changes are forward-looking or retrospectively applied as per accounting standards, and they reflect an improvement in how financial information is presented.
In contrast, an Accounting Error is an unintentional misstatement or omission in financial statements resulting from mathematical mistakes, misapplication of accounting principles, or oversight. Errors are corrections of past mistakes, not improvements in methodology. Accounting errors require immediate correction and typically involve restatement of prior financial periods to rectify the misstatement, impacting retained earnings directly in the period of correction. The key difference lies in intent and justification: accounting changes are intentional improvements, while accounting errors are unintentional mistakes that need to be corrected to ensure financial statements accurately reflect the company's position.
FAQs
What are the three types of accounting changes?
The three types of accounting changes are changes in accounting principle, changes in accounting estimate, and changes in reporting entity.
How is a change in accounting principle treated?
A change in accounting principle typically requires Retrospective Application. This means that financial statements from prior periods presented are restated as if the new accounting principle had always been in effect, and the cumulative effect of the change on periods prior to those presented is adjusted to the opening balance of retained earnings.
What is the difference between an accounting change and an accounting error?
An accounting change is a deliberate adjustment made to improve the relevance or reliability of Financial Reporting. An accounting error, however, is an unintentional mistake or omission in the financial statements that must be corrected.
Why do companies make accounting changes?
Companies make accounting changes to comply with new accounting standards (like updates to Generally Accepted Accounting Principles), to reflect a more accurate or appropriate presentation of their financial position, or to better align with industry practices.
Where can I find information about a company's accounting changes?
Information about a company's accounting changes is disclosed in the footnotes to its Financial Statements and in its periodic reports filed with regulatory bodies like the SEC, which are publicly available through databases such as EDGAR.