Prospective application, in accounting and financial terms, refers to the implementation of a new accounting principle, standard, policy, or regulation to future transactions, events, or conditions, without retroactively applying it to past transactions or balances. It’s essentially forward-looking.
This concept is important when a company decides to change an accounting principle, or when a new accounting standard is issued. When a standard is adopted prospectively, it means that past financial statements are not updated or restated to reflect the new method. Instead, all changes are applied to future transactions.
For example, suppose a new accounting standard is issued regarding the method to calculate depreciation. If the standard is applied prospectively, the company would not recalculate the depreciation for the previous years using the new method. Instead, the new depreciation calculation method will be applied only to the assets purchased from the beginning of the current period onward. Any assets purchased before the current period would continue to be depreciated using the old method.
Prospective application can be contrasted with retrospective application, where the new standard or principle is applied to both current and past transactions, which might involve restating previous financial statements. The choice between prospective and retrospective application often depends on the nature of the accounting change and the specific guidelines issued by standard-setting bodies like the Financial Accounting Standards Board (FASB) or International Accounting Standards Board (IASB).
Example of Prospective Application
l+Let’s look at an example involving a change in inventory accounting method:
Scenario: XYZ Corporation has been using the First-In-First-Out (FIFO) method of inventory accounting for many years. However, in the current year 2023, due to certain changes in their operations and the business environment, they decide to switch to the Last-In-First-Out (LIFO) method as they believe it better matches their current cost flow.
XYZ Corporation decides to apply this change in accounting principle prospectively.
Example of Prospective Application:
Starting from 2023, XYZ Corporation starts applying the LIFO method to all new inventory purchases. The inventory that was on hand at the end of 2022 and previous years (which was accounted for using FIFO) is not recalculated under the new LIFO method.
So, in their 2023 financial statements, XYZ Corporation shows two separate sets of inventory – the old inventory (accounted for under FIFO), and the new inventory (accounted for under LIFO). As they sell inventory, they’ll first deplete the old inventory under FIFO, and once that’s all sold, they’ll start depleting the new inventory under LIFO.
Prospectively applying the new LIFO method means that XYZ Corporation’s past financial statements remain unchanged. This is simpler in the short term, as it avoids the need to restate past years’ financials, but it may make it harder for users of the financial statements (like investors and lenders) to compare inventory and cost of goods sold across years.
Also, it’s important to note that not all changes in accounting principle can be applied prospectively. The specifics will depend on the guidelines set forth by the relevant accounting standard-setting body (like FASB or IASB).