How a Account for Changes in Accounting Principle
Assuming the change in accounting principle is justified (i.e. makes sense), then the change should be reflected on a retrospective basis. Unlike the prospective treatment for changes in accounting estimate, 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. This is one of the four accounting changes that you can expect to see on the CPA Exam. It is considered impracticable to retrospectively apply the effects of a change in accounting principle under one of the following circumstances:
- You make all reasonable efforts to do so but cannot complete retrospective application.
- Doing so requires knowledge of managements intent in a prior period, which you cannot substantiate.
- Doing so requires significant estimates, and it is impossible for you to create those estimates based on information available when the financial statements were originally issued.
For example, let’s say that the company used LIFO in Year 1 and then switched to FIFO in Year 2. Without retrospective treatment, Year 1 and Year 2 inventory balances would be based on a different accounting principle. Therefore, we need to understand the reflect the change to Year 1 so that the inventory balance is on a FIFO basis, which makes it comparable to Year 2. The rest of the financial statements would have to reflect this change as well.
So we know that the Year 1 inventory balance is $75 lower on a FIFO basis, but how is this reflected in the financial statements? They would not go back to Year 1 and adjust the numbers, however, they would need to book an adjustment to the Year 2 retained earnings opening balance. Since inventory decreased $75, the company would record a debit to retained earnings for $75 and a credit to inventory for $75.
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