What does a retrospective change to the financial statements mean?
When there are accounting changes, a company can either approach those changes on a prospective or retrospective basis. The approach ultimately depends on the type of change. When a company prepares it financial statements, there are often historical periods presented next to the current period. If the accounting change requires retrospective treatment, then those historical periods need to be updated to reflect the change so that they are comparable to the current period.
The two main changes that require retrospective treatment include a change in accounting principle and a change in reporting entity.
Change in Accounting Principle: 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 restate 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.
Change in Reporting Entity: This primarily addresses the fact that two financial periods needs to include the results for the same legal or reporting entities. For example, let’s say that the Year 1 results for Tahoe Ventures did not include the financial results for Truckee Mountain (an unconsolidated subsidiary). However, in Year 2, the results for Truckee Mountain will be included in the consolidated financials for Tahoe Ventures. Tahoe Ventures would need to restate the Year 1 financials to include Truckee Mountain so that the two periods are comparable. Otherwise, there will be an artificial increase in sales/profitability that could mislead investors!
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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.