What is the a prospective change vs a retrospective change?
A prospective change means that the change needs to be accounted for on a go-forward basis (only looking forward). For example, if the company changes an estimate, then only the current year financials need to reflect the change and not the prior period financials.
A retrospective change means that the change needs to be accounted for in historical periods as well as the current and future periods. For example, if the company changes accounting principles, that requires retrospective treatment. Any prior periods that are included in the current year financial statements need to be updated to be presented consistent with the new accounting principle.
The visual below outlines the common accounting changes and whether the change should be accounted for on prospective or retrospective basis.
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How is a change in estimate accounted for in a company’s financial statements?
Changes in estimates, such as the estimated useful like for a tangible asset or the bad debt allowance percentage, are accounted for on a prospective basis. This means that the current and future financial statements must reflect the change, but the company does not need to change historical periods.
How a change in accounting principle is reflected in the financial statements?
Assuming the change in accounting principle is justified (i.e. makes sense), then the change should be reflected on a retrospective basis. This means that any prior periods that are included in the current year financial statements need to be restated to reflect the new accounting principle. For example, let’s say that the company used LIFO […]
If a company identifies an error in prior period financial statements, what should they do?
If errors are identified and they are material or cause the financial statements to be misleading, then the company should restate the financial statements and reissue them.