What Is Change in Accounting Principle?
A change in accounting principle refers to the adoption of a Generally Accepted Accounting Principle (GAAP) different from the one previously used by a reporting entity for its financial statements. These changes fall under the broader category of financial accounting and are typically necessitated by new accounting pronouncements from standard-setting bodies, a change in business operations, or a determination that a new method is preferable. Unlike a change in accounting estimate, a change in accounting principle alters the fundamental method by which transactions or events are measured and reported.
History and Origin
The framework for financial accounting, particularly in the United States, is largely governed by the Financial Accounting Standards Board (FASB), which establishes GAAP. The FASB, established in 1973, develops and issues financial accounting standards through a transparent and inclusive process designed to provide useful information to investors and other users of financial reports.11 This standard-setting process involves identifying financial reporting issues, adding projects to the technical agenda, public meetings, and issuing Accounting Standards Updates (ASUs) that amend the Accounting Standards Codification.10
Globally, the International Accounting Standards Board (IASB), formed in 2001, develops International Financial Reporting Standards (IFRS) which are used in over 110 countries worldwide.8, 9 Both the FASB and the IASB continually update their respective frameworks, leading to instances where companies must implement a change in accounting principle to comply with new regulations or to improve their financial reporting. The objective of general-purpose financial reporting, as articulated by the IASB, is to assist in the development of future standards and help preparers apply them consistently.7
Key Takeaways
- A change in accounting principle is the adoption of a new accounting method that differs from a previously applied one.
- These changes typically require retrospective application to prior periods, restating affected financial statements as if the new principle had always been in use.
- Such changes are made due to new accounting standards, a change in business operations, or a determination that a new method is preferable.
- Proper disclosure of a change in accounting principle is crucial for ensuring the comparability of financial information over time.
Interpreting the Change in Accounting Principle
When a company implements a change in accounting principle, it significantly impacts the presentation of its financial performance and position. The primary method for recognizing a change in accounting principle is through retrospective application. This means that prior period financial statements, such as the balance sheet and income statement, are restated as if the newly adopted accounting principle had always been applied. The cumulative effect of the change on periods prior to those presented is recognized as an adjustment to the opening retained earnings of the earliest period presented.
This restatement is vital for financial analysis because it ensures that financial data across different periods are presented consistently, allowing investors and analysts to make meaningful comparisons. Without retrospective application, a change in accounting principle could distort trends and make it difficult to assess true operational performance over time. The objective is to provide useful information to users of financial reports, helping them make informed decisions.
Hypothetical Example
Consider Tech Solutions Inc., a publicly traded software company. Until 2024, the company recognized revenue from long-term software licenses using a principle that allocated revenue evenly over the contract term. However, due to new industry-specific guidance issued by the FASB, Tech Solutions Inc. is now required to adopt a new principle that recognizes a significant portion of the revenue upfront upon software delivery and implementation, with the remainder recognized over time for maintenance and support.
To illustrate the change:
Old Principle (Straight-line revenue recognition):
For a $1,200,000, 3-year software license, Tech Solutions Inc. recognized $400,000 in revenue each year.
New Principle (Upfront and prorated revenue recognition):
For the same $1,200,000, 3-year license, the new principle requires recognizing $800,000 upfront (for software and implementation) and the remaining $400,000 (for maintenance) evenly over the 3 years ($133,333 per year).
Upon adopting the new principle in 2024, Tech Solutions Inc. must retrospectively apply this change to its previously issued financial statements. If the company presented financial statements for 2022 and 2023, it would recalculate and restate the revenue and related accounts for those years as if the new principle had always been in effect. Any difference in accumulated revenue or related expenses from periods prior to 2022 would be recorded as a prior period adjustment to the beginning balance of 2022 retained earnings. This ensures that when an investor compares 2024 financial results to 2023 or 2022, all periods reflect the same accounting principle for revenue recognition.
Practical Applications
A change in accounting principle is a critical event in financial reporting, particularly for publicly traded companies. These changes often stem from newly issued accounting standards by bodies like the FASB in the U.S. or the IASB internationally. For instance, the FASB frequently issues Accounting Standards Updates (ASUs) that mandate or permit changes in accounting principles, which then become part of GAAP. The U.S. Securities and Exchange Commission (SEC) has also worked with the FASB to incorporate certain SEC disclosure requirements into the GAAP codification to improve financial reporting.6
Companies applying a change in accounting principle must include detailed disclosures in their notes to the financial statements. These disclosures explain the nature of the change, the reason for the change, and the effects on current and prior period financial statements, including the impact on specific line items. This transparency is vital for investors and other stakeholders to understand the company's financial performance and position accurately. For example, SEC filings like Form 10-K (annual reports) and Form 10-Q (quarterly reports) require comprehensive disclosures about such changes to provide investors with timely and accurate information.4, 5
Limitations and Criticisms
While a change in accounting principle aims to improve the relevance and reliability of financial information, it can introduce challenges and criticisms. One significant concern is the impact on comparability despite retrospective application. Even with restatement, the process can be complex, and analysts must carefully assess whether the new principle genuinely provides a clearer picture or merely shifts reported numbers without reflecting fundamental economic changes. The sheer volume and complexity of accounting standards can be challenging for both preparers and users of financial statements.3
Critics also point out that while standard setters like the FASB and IASB strive for clear and consistent principles, the interpretation and application can still be subjective, leading to variations even under the same principle. The complexity of financial reporting is a recognized issue, with calls from investor groups for simplification to ensure financial reports provide truly useful information for capital allocation decisions.2 While new standards aim to enhance transparency, they can also increase the complexity of narrative disclosures in annual reports.1 Furthermore, frequent changes can impose significant compliance costs on companies, particularly for those with complex global operations or those subject to different regulatory environments, such as both GAAP and IFRS.
Change in Accounting Principle vs. Change in Accounting Estimate
A change in accounting principle is often confused with a change in accounting estimate, but they have distinct accounting treatments.
| Feature | Change in Accounting Principle | Change in Accounting Estimate |
|---|---|---|
| Nature of Change | Adoption of a different, acceptable accounting method. | Revision of an estimate used in financial statements. |
| Examples | Changing from FIFO to weighted-average inventory method, or adopting a new revenue recognition standard. | Revising the useful life of an asset for depreciation, or changing the estimate of bad debt. |
| Accounting Treatment | Generally applied retrospectively, restating prior periods, with a cumulative effect adjustment to beginning retained earnings. | Applied prospectively, affecting only current and future periods. No restatement of prior periods. |
| Impact on Comparability | Requires restatement to enhance period-to-period comparability. | Does not affect prior periods, so historical numbers remain unchanged, but future comparability is affected. |
| Justification | Required by new standards or determined to be a preferable method. | Based on new information, experience, or improved judgment. |
The key distinction lies in the application: a change in accounting principle requires restating previous financial statements to reflect the new method, whereas a change in accounting estimate only impacts current and future periods. This difference is fundamental for external audit purposes and for users performing financial analysis.
FAQs
Q: Why do companies change accounting principles?
A: Companies typically change accounting principles for three main reasons: to comply with a new accounting standard issued by a standard-setting body like the FASB or IASB, to reflect a change in the economic substance of their transactions, or because management determines that a different accounting principle is preferable and provides more relevant and reliable financial reporting.
Q: How does a change in accounting principle impact investors?
A: A change in accounting principle can significantly impact investors because it alters how a company's financial performance and position are reported. Retrospective application ensures comparability by restating prior periods, allowing investors to evaluate trends consistently. However, investors should carefully review the notes to the financial statements to understand the nature and effect of the change.
Q: Is a change in accounting principle the same as an accounting error?
A: No, a change in accounting principle is not the same as an accounting error. A change in principle involves adopting a different, acceptable accounting method. An accounting error, however, is a mistake or oversight in applying accounting principles or facts that existed at the time the financial statements were prepared. Accounting errors also require restatement but are addressed differently under GAAP.
Q: What is retrospective application in accounting?
A: Retrospective application means applying a new accounting principle to prior periods as if it had always been in use. This involves restating the financial statements for all periods presented, and adjusting the opening balance of retained earnings for the earliest period presented to reflect the cumulative effect of the change up to that point. This method enhances the comparability of financial information over time.
Q: Who governs changes in accounting principles in the U.S.?
A: In the United States, the Financial Accounting Standards Board (FASB) is the primary private-sector body responsible for establishing GAAP and, consequently, overseeing changes in accounting principles. The Securities and Exchange Commission (SEC) also has oversight authority for publicly traded companies and influences financial reporting through its regulations and interpretive guidance.