Retrospective Application
“Retrospective application” refers to a principle in accounting where a change in accounting policy, or the correction of an error, is applied to previous financial periods – as if the new method or correct method had always been used. This approach provides financial statement users with a consistent basis for comparison across periods.
When an accounting standard mandates retrospective application, it typically involves:
- Adjusting the opening balances of assets, liabilities, and equity for the earliest period presented.
- Adjusting comparative amounts for each prior period presented.
However, there are practical limitations, and in some cases, full retrospective application may not be required or even possible.
For example, if a new accounting standard is introduced and it requires retrospective application, a company that has been in business for 50 years wouldn’t typically need to adjust all 50 years of financial statements. Instead, they would adjust the earliest year presented in their comparative financial statements and make corresponding changes to opening balances.
Example of Retrospective Application
Let’s delve into a more concrete example regarding the retrospective application, specifically focusing on a change in accounting policy:
Scenario: Change in Inventory Accounting Method
Imagine SuperTech Corp., a tech company that sells electronic devices. For years, they’ve been using the Last-In-First-Out (LIFO) method for inventory valuation. However, in 2023, they decide to switch to the First-In-First-Out (FIFO) method because they believe it provides a more accurate reflection of their inventory costs given the nature of their business.
This change in accounting policy requires a retrospective application according to accounting standards.
Steps for Retrospective Application:
- Recompute Inventory Balances for Prior Years: SuperTech would have to re-evaluate its ending inventory balances for prior years using the FIFO method.
- Adjust Opening Retained Earnings: The cumulative effect of the change, as of the beginning of the earliest year presented, would be adjusted in the opening retained earnings for that year. For example, if the change resulted in an increase in the inventory value by $100,000 for the year 2021, then the opening retained earnings for 2021 would increase by this amount (considering tax impacts).
- Restate Comparative Financial Statements: The financial statements for prior years (like 2021 and 2022) presented in the 2023 annual report would be restated. This means that the cost of goods sold, inventory balances, and related tax effects would be adjusted for those years to reflect the FIFO method.
- Disclose the Change: In the 2023 financial statements, SuperTech would disclose the nature and reason for the change, the fact that previous years have been restated, and the impact of the change on items like inventory, cost of goods sold, net income, and retained earnings for each year presented.
Results of Retrospective Application:
After the adjustments, anyone reviewing SuperTech’s 2023 financial statements could compare the inventory costs, gross margins, and profits of 2021, 2022, and 2023 on a like-for-like basis, as if the company had always been using the FIFO method. This comparability is the primary goal of retrospective application.
Note: In the real world, full retrospective application might come with certain practical exemptions or reliefs, especially if it’s too challenging or costly to gather all the necessary data for restatement. Always refer to relevant accounting standards or guidelines for specific requirements and details.
