In the international accounting practice, four types of accounting changes can be defined (Hall and Aldridge 2007): 1) change in accounting principles, 2) change in accounting estimate, 3) change in reporting entity, and 4) correction of an error.Investopedia (2016) defines a change in accounting principles as “a change in a method used, such as using a different depreciation method or switching from LIFO to FIFO.” Such changes may include: 1) adoption of new accounting standards, 2) changes in the costing of inventories, 3) change between cost and equity methods, and 4) change between the percentage-of-completion and completed contract methods. A change in accounting principles should take place only if it is strictly required by GAAP or IFRS, or if there is unquestionable justification in doing so. The change in principles is normally applied retrospectively to all previous periods, unless there is a strong objection against it.
Some assets cannot be measures precisely, so financial estimates use accounting estimates to determine their carrying amounts. But when new information about the assets is acquired, the estimates can be changed. Some examples include (Accounting Tools 2016): 1) allowance for doubtful accounts, 2) reserve for obsolete inventory, 3) changes in the useful life of depreciable assets, 4) changes in the salvage values of depreciable assets, and 5) changes in the amount of expected warranty obligations. A change in financial estimates does not entail the restatement of past financial reports. The accounts also should not be retrospectively adjusted, provided that such a change takes place. Nonetheless, the estimates of the current and future estimates should be appropriately adjusted. Sometimes there is no practical need to report changes in estimates. This could happen, for instance, under condition that the alterations in estimates were immaterial and did not lead to serious flaws in reported numbers. An accountant should also keep in mind that material changes in numbers may lead to flows in the future reported items such as revenues or net income. As a matter of fact, the change in estimate will concern also changes in corresponding items.
Another accounting change is a change in reporting entity. It is a change that results in financial statements that, in effect, are those of a different reporting entity (Ernst and Young 2015). These changes may take place when there are at least two scenarios: 1) there a first time need to prepare a consolidated statement instead of preparing separate statements for a number of companies, and 2) including or excluding subsidiaries from such consolidates statements. The past financial statements need to be restated, provided that the change in reporting entity takes place. At least such items as prior periods’ sales revenue, income before extraordinary items, net income and earnings per share should be appropriately modified and restated.
As a final point, according to FASB Accounting Standard Codification (ASU 2012), “the reporting of an error correction involves adjustments to previously issued financial statements similar to those generally applicable to reporting an accounting change retrospectively”. As a matter of fact, correction for an error is not considered to be an accounting change. But it is not a fraud, if it has not been done intentionally. The errors may occur in measurement, recognition or disclosure of financial statements and can be a consequence of inadequate application of accounting standards or serious mistakes in mathematical calculations. Accounting errors require restatements of the prior period financial statements. The important aspect of such restatements is that the accountant reports the cumulative effect that the error had on the financial statements.
- Accounting Tools. (2016). Changes in Accounting Estimate. Available at http://www.accountingtools.com/change-in-accounting-estimate
- Ernst and Young. (2015). Accounting changes and error corrections. Financial reporting developments: A comprehensive guide.
- Jack Hall and Richard Aldridge. (2007). Changes in Accounting for Changes. Journal of Accountancy. Available at http://www.journalofaccountancy.com/issues/2007/feb/changesinaccountingforchanges.html