Most financial analysts would agree that understanding changes in accounting methods, estimates, and policies is critical for accurate trend analysis and modeling.
In this post, you'll learn the key types of accounting changes, how to spot them, and how to adjust your analysis to account for their impacts.
We'll define what accounting changes are, walk through examples of changes in principles, estimates, and methods, discuss reporting and disclosure requirements, overview approaches to implementing changes, and summarize key takeaways for financial modelers and analysts.So if you want to build more accurate models and valuations, read on.
Introduction to Accounting Changes
Accounting changes refer to adjustments made to how a company reports financial information, including changes in accounting principles, accounting estimates, and accounting methods. These changes can have important implications for financial analysis and decision making.
Defining Accounting Changes
An accounting change occurs when a company transitions to applying a different accounting treatment to certain accounts or transactions. There are a few main types of accounting changes:
- Change in accounting principle: Adopting a new accepted accounting principle, like switching from FIFO to LIFO inventory valuation. This is generally a major change.
- Change in accounting estimate: Adjusting an accounting estimate, like changing the estimated useful life of equipment from 5 to 7 years. Estimates have to be updated as new information comes to light.
- Change in accounting method: Changing how a principle is applied, like switching from straight-line to double declining balance depreciation.
Accounting changes must follow U.S. GAAP or IFRS guidelines on reporting the changes to ensure consistency, comparability, and transparency.
Why Accounting Changes Happen
There are several common reasons companies make accounting changes:
- Adoption of new accounting rules or standards issued by the FASB or IASB. For example, the new leasing standard ASC 842.
- Changes in operations or measurements that require estimates or methods to be adjusted.
- Correction of errors made under a previous accounting method.
- Determination that a new method is preferable for reporting financial performance or position.
Essentially accounting changes occur when companies need or choose to adjust how they recognize, measure, present, or disclose accounting information to stakeholders.
Potential Impacts of Changes
Accounting changes can significantly impact financial statements in these ways:
- Reported profits may increase or decrease depending on the change.
- Assets, liabilities, and equity can shift between accounts or reporting periods.
- Comparability between reporting periods is affected until the change is fully implemented.
- Trend analysis becomes less reliable due to the adjustment in accounting treatment.
Understanding why and how accounting changes occur is vital for accurately interpreting performance.
What are the 3 types of accounting changes?
Accounting changes are classified into three main categories:
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Change in accounting principle - This refers to a change from one generally accepted accounting principle to another generally accepted accounting principle. For example, switching from FIFO to LIFO inventory valuation.
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Change in accounting estimate - This refers to a change in an accounting estimate used in the financial statements. For example, changing the estimated useful life of a fixed asset or the estimate of uncollectible accounts receivable.
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Change in reporting entity - This refers to a change in the reporting entity, such as changing from consolidated financial statements to individual entity statements.
A change in accounting principle is generally considered the most significant type of accounting change. This type of change requires retrospective application to prior periods' financial statements (unless it is impracticable to do so).
Changes in accounting estimates and reporting entity are generally accounted for prospectively in the current and future periods. Prior periods are not restated for these types of changes.
All types of accounting changes require certain footnote disclosures in the financial statements to explain the change, justification, impact, etc. Proper reporting of accounting changes is important for comparability of financial statements between periods.
What is an example of a change in the accounting principle?
A change in accounting principle refers to a company switching from one generally accepted accounting principle (GAAP) to another. Some examples of changes in accounting principles include:
Inventory valuation methods
A company may change from using FIFO (first-in, first-out) to LIFO (last-in, first-out) to value inventory. This impacts the balance sheet and income statement.
Fixed asset depreciation
A company could switch from straight-line depreciation to accelerated depreciation for fixed assets. This changes how expenses are recognized over the assets' useful lives.
Bond carrying value
The method for calculating a bond's carrying value on the balance sheet could change from the straight-line method to the effective interest rate method. This changes how interest expense is recognized.
All of these changes impact the timing of expense recognition and thus a company's net income. They require disclosure in financial statement footnotes so readers can assess comparability across reporting periods. Companies generally prefer methods showing greater income smoothing from year to year.
What is an example of a change in accounting estimate?
Typical examples of changes in accounting estimates include:
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Bad debt provisions - Estimating the amount of accounts receivable that may become uncollectible in the future. A change in the bad debt estimate affects the reported accounts receivable balance and bad debt expense.
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Depreciation rates and useful lives of assets - Estimating the useful life over which an asset will be depreciated. A change in this estimate affects the depreciation expense and net book value of the asset.
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Provisions for warranty repairs - Estimating future costs to honor product warranties. A change affects the warranty liability and expense.
When these estimates change, the business adjusts its current and future financial reporting accordingly. Unlike accounting principle changes that require retrospective adjustment, changes in accounting estimates are handled prospectively.
For example, if a company changes its estimated useful life of equipment from 5 to 7 years, current and future depreciation expense would decrease. But previously recorded depreciation is unaffected. The change is justified by new information and applies only to future financial statement periods.
Proper disclosure of the change in estimate, along with a justification and quantitative impact, is required under the matching principle and GAAP standards. This allows financial statement users to analyze performance over time.
What is considered a change in accounting policy?
A change in accounting principle is defined as: “A change from one generally accepted accounting principle to another generally accepted accounting principle when (a) there are two or more generally accepted accounting principles that apply; or (b) the accounting principle formerly used is no longer generally accepted."
In other words, a change in accounting principle refers to a switch from one acceptable accounting method under GAAP to another. Some examples of changes in accounting principles include:
- Switching from FIFO (first-in, first-out) to LIFO (last-in, first-out) inventory valuation
- Changing from straight-line to accelerated depreciation for fixed assets
- Shifting from capitalizing research and development costs to expensing them as incurred
These changes are usually made because companies feel the new principle better reflects their financial performance or is more preferable for tax purposes. However, not all switches qualify as changes in principle. Updates to estimates, corrections of errors, or adjustments from accounting standard changes are not considered changes in principles.
When a change in principle occurs, companies must disclose the following details:
- The nature of the change
- The reason for making the change
- How it impacts income before taxes
- The cumulative effect on retained earnings
Proper disclosure helps financial statement users understand the effects of the accounting change and make better comparisons between reporting periods. Without this information, analyses of performance trends and financial ratios would be distorted.
So in summary, a change in accounting principle refers specifically to voluntary changes from one acceptable GAAP method to another. Companies must properly disclose details to enable accurate financial analyses unaffected by the change.
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Types of Accounting Changes
Accounting changes refer to adjustments made to how a company reports financial information, such as revenues, expenses, assets, or liabilities. There are three main categories of accounting changes:
Change in Accounting Principle Example
An accounting principle refers to the specific guidelines and rules companies follow when reporting financial statements. A change in accounting principle is when a company shifts from one accepted accounting principle to another.
For example, a company may change inventory valuation methods from first-in-first-out (FIFO) to last-in-first-out (LIFO). This impacts the value of inventory assets reported on financial statements.
Change in Accounting Estimate
Accounting estimates are educated guesses companies make due to unknown information. As new data becomes available, estimates may need adjustment.
Common accounting estimate changes include:
- Useful lives of fixed assets: As assets age and degrade, their useful lives may be shortened
- Bad debt provisions: If customers pay bills slower or faster than expected, bad debt provisions need updated
These changes impact reported expenses and asset values.
Change in Accounting Method
An accounting method refers to the specific procedures and techniques used to prepare financial statements. A change in accounting method impacts how transactions are recognized and reported.
For example, a company could change revenue recognition methods from a point-in-time approach to over-time revenue recognition. This impacts when revenues and expenses hit financial statements.
Reporting and Disclosing Changes
This section covers the typical reporting requirements and disclosures around accounting changes.
How is a Change in Accounting Principle Generally Reported
When a company changes its accounting principle, it must report the change in its financial statements. Here are some key things to know:
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The change is reported in the period of the change and future periods. For example, if a change is made in 20X5, the 20X5 and future financial statements would reflect the new principle.
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The company must disclose that a change in principle has occurred and provide an explanation of the change. This is typically done in the footnotes.
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The financial statements for the period of the change (and any prior periods presented) must be retroactively adjusted to reflect the effects of the change. This allows comparability between all presented periods.
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For public companies, the change in principle must be disclosed prominently in a letter to shareholders in the annual report.
So in summary, accounting changes are reported through retrospective application in financial statements and accompanying disclosures explaining the change.
Change in Accounting Principle Disclosure
When disclosing a change in accounting principle, companies must provide certain information. Required disclosures typically include:
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The nature of the change.
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The reason for making the change.
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A description of how the new principle differs from the old one.
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The cumulative effect of the change on retained earnings for prior periods. This refers to the difference in net income that would have been reported if the new principle had always been used.
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The effects of applying the change retrospectively for each prior period presented. This means showing what net income would have been under the new principle.
So in essence, companies must explain what changed, why it changed, and quantify the impacts on historical financial statements. This allows financial statement users to fully understand the effects of the principle change.
Disclosure Examples
Here are some examples of how a change in accounting principle might be disclosed:
Change in inventory valuation method
In 20X5, the Company changed its inventory valuation method from FIFO to weighted average cost. Management believes this new principle better matches costs to related revenues. The change has been applied retrospectively, which decreased beginning retained earnings in 20X4 by $155,000 and increased 20X4 net income by $25,000.
Change in depreciation method
Effective January 20X5, the Company changed its depreciation method for property, plant and equipment from double declining balance to straight line, which better aligns with the assets' use. This change has been applied retrospectively, resulting in a $350,000 increase to beginning 20X4 retained earnings, a $120,000 increase in 20X4 net income, and a $100,000 increase in 20X3 net income.
So in summary, the disclosures explain the change, the reason, impacts to prior periods, and key effects on financial statement line items.
Approaches to Implementing Accounting Changes
Accounting changes can significantly impact a company's financial statements. When a change occurs, companies must carefully consider the approach for implementing it. The two main methods are retrospective and prospective treatment.
Change in Accounting Method Prospective or Retrospective
The type of accounting change determines whether it should be applied retrospectively or prospectively. Changes in accounting principles generally require retrospective adjustment, meaning the prior year's financial statements must be restated as if the new principle had always been used. This allows for comparability across reporting periods.
In contrast, changes in accounting estimates and some methods are usually applied prospectively. Only the current and future years are affected, with no restatement of previously issued financial statements. This approach is often more practical than attempting to recreate the effects of an estimate change in hindsight.
Retrospective Approach to Principle Changes
When an accounting principle is changed, retrospective application is typically required under GAAP and IFRS standards. This involves adjusting the comparative prior year's financial statements as if the new accounting principle had always been applied. By restating earlier periods, financial statement users can clearly see the impact of the change for comparison purposes.
The cumulative effect of the change is generally reflected as an adjustment to opening retained earnings on the earliest year presented. Disclosure notes also describe the impact on net income figures for each restated year. This level of transparency helps stakeholders interpret performance trends over time.
Prospective Treatment for Estimate and Method Changes
Unlike principle changes, adjustments for changes in estimates or certain methods are accounted for prospectively. The new estimate or method is applied beginning in the current period with no restatement of previously issued financial statements.
Estimates, by their nature, involve judgment about uncertain future events. Accordingly, changes represent updated projections rather than corrections of prior errors. Requiring retrospective application would be impractical and add little informational value for users.
Prospective treatment also applies in certain situations involving changes in entity status, tax law changes, or rare circumstances where retrospective application of a new method is deemed impracticable.
In all cases of prospective changes, disclosure notes highlight the impact and provide details to facilitate understanding of the financial statements. Consistent and transparent communication regarding accounting changes enables stakeholders to properly evaluate performance.
Impacts and Considerations
Trend Analysis Challenges
Accounting changes can significantly impact trend analysis and metrics like EPS growth over time. When a company changes an accounting method or estimate, it must go back and restate prior financial statements under the new method. This makes it very difficult to compare performance over time or analyze trends properly.
For example, if a company changes from FIFO to LIFO inventory accounting, net income in prior years will be restated lower under LIFO. As a result, EPS growth rates and margins may appear higher after the change, even if the underlying performance is unchanged. Analysts must normalize for these accounting changes to get an accurate picture of the business over time.
The Role of Judgement
Managerial judgement plays a major role in accounting changes. When selecting a new method or estimate, managers must weigh different alternatives and assess which is most appropriate. However, managers may also be motivated by incentives like higher EPS or smoothing earnings volatility.
As an analyst, understanding management's rationale for a change and whether it faithfully represents the economics is critical. Assessing the business context and comparing to industry norms can provide clues to the appropriateness of judgements. Discussion with management and auditors may also shed light. Documenting these assessments is key.
Audit and Compliance Considerations
Accounting changes can raise audit and compliance considerations around proper disclosure and reporting. Public companies must file an 8-K announcing material changes, provide MD&A discussion, and restate prior financials. Auditors must evaluate the appropriateness of changes and their consistent application under GAAP.
For analysts, monitoring 8-Ks for accounting changes and reading restatement footnotes carefully is important. Controversial changes may indicate higher audit or control risk. Discussions with the auditor may also provide color behind the scenes. Tracking and documenting changes aids in normalization and trend analysis.
Conclusion and Key Takeaways
To conclude, we'll summarize some key points on accounting changes and reiterate why understanding them is important for businesses.
Summary of Accounting Change Types
There are a few main types of accounting changes:
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Changes in accounting principles - Adopting a new accounting principle, such as switching from FIFO to LIFO inventory valuation. These require retrospective application and restatement of prior financial statements.
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Changes in accounting estimates - Adjustments in estimates used in financial reporting, such as useful lives of assets or uncollectible accounts receivable. These are handled prospectively.
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Changes in reporting entity - Adding or removing a subsidiary or entity from financial reporting. Requires retrospective restatement.
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Correction of errors - Fixing material errors in previously issued financial statements. Requires retrospective restatement.
Importance of Robust Reporting
When accounting changes occur, it is critical that businesses have robust processes and controls around financial reporting and disclosure:
- Ensure changes are properly reviewed and approved
- Provide clear disclosure of the change in footnotes
- Carefully assess impacts on financial statement analysis
This helps provide transparency for stakeholders interpreting financial results.
Considerations for Financial Analysis
Analysts studying financial statements over time must consider potential impacts of accounting changes on metrics like revenue growth, margins, return on assets etc.
Understanding the nature and context of changes can help analysts normalize and compare performance appropriately across reporting periods.
