What is a Change in Accounting Principle?

Change in Accounting Principle

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Change in Accounting Principle

A change in accounting principle refers to a shift from one generally accepted accounting principle (GAAP) to another GAAP when preparing an entity’s financial statements. This change occurs when a company voluntarily decides that the new principle provides more relevant or reliable information or when an existing accounting standard is updated, replaced, or superseded by a new standard issued by the accounting standard-setting body.

Accounting principles are the fundamental guidelines and concepts that form the basis for preparing and presenting financial statements. They are essential for ensuring the consistency, comparability, and reliability of financial reporting.

When a company changes its accounting principle, it is generally required to apply the new principle retrospectively, meaning it should restate the financial statements for prior periods as if the new principle had always been in place. This restatement allows users of financial statements to compare the company’s financial results across different periods consistently.

However, in some cases, retrospective application may be impractical or not required by the accounting standards. In such instances, the change in accounting principle is applied prospectively, affecting the current and future periods only.

It is important to distinguish a change in accounting principle from a change in accounting estimate or a change in accounting policy. A change in accounting estimate refers to an adjustment made to the reported financial figures due to new information or improved knowledge that affects the assumptions used in previous financial statements. A change in accounting policy refers to a shift in the method or approach used to apply an accounting principle in the preparation of an entity’s financial statements. These changes are generally treated differently in financial reporting.

Example of a Change in Accounting Principle

Let’s consider an example of a change in accounting principle involving revenue recognition.

A software company has been following the percentage-of-completion method for recognizing revenue from its long-term software development contracts. Under this method, the company recognizes revenue over time as the work progresses, based on the proportion of the project completed.

However, the Financial Accounting Standards Board (FASB) issues a new accounting standard that requires companies to recognize revenue from software development contracts using the completed-contract method. Under the completed-contract method, the company recognizes revenue only when the software development project is fully completed and the final product is delivered to the customer.

In this example, the shift from the percentage-of-completion method to the completed-contract method represents a change in accounting principle, prompted by a new accounting standard.

To implement this change, the company generally needs to restate its financial statements for prior periods as if the completed-contract method had always been used, ensuring consistency and comparability across different reporting periods. This restatement may involve recalculating the revenue, expenses, and related financial ratios for the affected periods.

However, if retrospective application is deemed impractical or not required by the accounting standards, the company may apply the change in accounting principle prospectively, meaning it will use the completed-contract method for the current and future periods only, without restating the prior periods’ financial statements.

It is crucial for the company to disclose the nature of the change in accounting principle, the reasons for the change, and the financial impact of the change in its financial statements’ notes. This disclosure allows users of financial statements to understand the effects of the change on the company’s financial performance and position.

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