There is an underlying presumption that an accounting principle, once adopted, should not be changed for similar events and transactions. A change in principle may be caused by new events, changing conditions, or additional information or experience.
There are two circumstances when a company is required to change an accounting policy. These are:
- If the change is required by a Standard or an Interpretation; or Change in accounting principles
- If the change results in the financial statements providing more reliable and relevant information about the effects of transactions (or other events).
IAS 8 19 (b) requires retrospective application (i.e., the application of a different accounting method to previous years as if that new method had always been used) to prior years’ financial statements of changes in accounting principle, unless it is impractical to ascertain either the period-specific impact or the cumulative effect of the change [IAS 8 23]. If it is impractical to do so, the newly adopted accounting principle must be applied to the beginning balances of assets or liabilities of the earliest period for practical retrospective application. Further, a corresponding adjustment must be made to the beginning balance of retained earnings (or other appropriate equity components or net assets) for that period (it is not to be reported in the income statement). If the cumulative dollar effect of applying an accounting principle change to prior periods is impractical, the new accounting principle must be applied as if it were adopted prospectively from the earliest practical date.
It is considered impractical to apply the impact of a change in method retrospectively only if any of the following three conditions is present:
- The retrospective application requires presumptions of management’s intent in a previous year that cannot be verified.
- After making a good faith effort, the company is not able to apply the pronouncement’s requirement.
- It is impossible to objectively estimate amounts needed that (a) would have been available in the prior year and (b) provide proof of circumstances that existed on the date or dates at which the amounts would be recognized, measured, or disclosed under the retrospective application.
Note: If any of these three conditions exists, it is impracticable to apply the retrospective approach. In this case, the new accounting principle is applied prospectively as of the earliest date it is practical to do so.
An example of an impractical condition is the change to the LIFO method. In this case, the base-year inventory for all subsequent LIFO computations is the beginning inventory in the year the method is adopted. It is impractical to restate previous years’ income. A restatement to LIFO involves assumptions as to the different years the layers occurred, and these assumptions would typically result in the calculation of a number of different earnings figures. The only adjustment required may be to restate the opening inventory to a cost basis from a lower-of-cost-or-market-value approach.
Disclosure is thus limited to showing the impact of the change on the results of operations in the year of change.
As stated above, if the entity changes an accounting policy then it is required to apply the change retrospectively. In other words, it has to restate the prior periods included in the Annual Report/Financial Statements to reflect the change. This results in a restatement of the opening reserves of the oldest comaparive period included in the Annual Report/Financial Statements. If it did not apply this change retrospectively then comparability would not be achieved. Other changes of accounting policy could be:
- Overheads are classified from distribution costs to cost of sales;
- Reallocation of depreciation from administration costs to cost of sales;
The above is not exhaustive. Change in accounting principles
A change in depreciation, depletion, or amortization must be accounted for as a change in estimate affected by a change in principle.
The retained earnings statement after a retroactive change for a change in accounting principle in the oldest comparative period (mostly the reporting year minus 1, but with multi-year comparison table (for example 5 year overview)) starts as follows:
Retained earnings—1/1, as previously reported
Add: adjustment for the cumulative effect on previous years of applying retrospectively the new accounting method for long-term construction contracts
Retained earnings—1/1, as adjusted
Example Accounting principle change Change in accounting principles
Change of depreciation method Change in accounting principles
The management of Alpha initially measures its property, plant and equipment at cost, and has decided to change the depreciation method they use on their property, plant and equipment from 20% straight line to 25% reducing balance as they consider this will reflect a more realistic way the entity consumes the assets. Is this a change of accounting policy?
No. This is a change in estimation technique, the same measurement basis is used and they will simply write off the cost(s) of the asset(s) over the estimated useful life of the asset(s).
Reclassification of development expenditure Change in accounting principles
The management of Alpha have decided to reclassify development expenditure which it previously capitalised. The finance director has informed the board that IAS 38 “Intangible Assets” does not allow the capitalisation of previously recognized expenditure (those incurred before the project has been assessed as technically feasible and commercially viable). Is this a change in accounting policy?
Yes. The management have changed the recognition criteria and therefore the prior year will have to be restated to achieve comparability and the opening reserves restated, as a change in accounting policy has occurred.
Disclosures required in the financial statements Change in accounting principles
The disclosures an entity will make in its financial statements when it changes an accounting policy are:
- An explanation as of the reason for the change;
- The effects of a prior period adjustment on the previous years results; and
- The effects of the change in the policy on the previous year’s results.