Changes in Accounting Principles

Accounting standards allow some flexibility in choice of methods that can be applied to a specific class of transactions. However, in order to prevent manipulation, a company changing its accounting policy must have a strong reason for any such change. Further, it is required to present its new financial statements as if it followed the newly adopted policy since the day it started business. In other words, accounting standards require any change in accounting policy to be presented with retrospective application. The effect of such application would be that the change will be reflected in past, present and future periods.

Under IFRS, guidance on change in accounting principles, accounting estimates and errors is provided by IAS 8. Under US GAAP, ASC 250 is the relevant standard.

Examples of changes in accounting principles.

A change in accounting principle is where the company changes the basic rules, conventions, etc. it previously used to account for similar transactions.

Following are a few examples of changes in accounting principles:

  • Any change in method used to account for inventory valuation i.e. the cost flow assumption, for e.g. any change from FIFO to weighted average method and vice versa.
  • Any change in method used to account for bonds payable, for e.g. a change from straight-line amortization method to effective interest rate method and vice versa.
  • Any change in method used to value fixed assets: i.e. from cost method to revaluation model.
  • Any change in revenue recognition method: from percentage of completion method to completed contract method.

However, application of an accounting principle for the first time is not a change in accounting principle.

Example: Retrospective Application

CAP, Inc. started operations on 1 January 2011. It originally applied weighted-average cost-flow assumption for inventory accounting. However, after studying the flow of its products, the company’s management concluded that FIFO is a better method and it started applied it beginning 1 January 2013. You are required to work out the necessary adjustments needed to balance sheet accounts as at the date of change in policy.

The company’s income statement (under weighted-average inventory accounting method) for financial year ended 31 December 2012 and 31 December 2011 is given below:

USD in million
Cost of sales350275
Gross profit250225
Selling and administrative expenses9080
Profit before tax160145
Net income112102

Under the current method, the company’s inventories amounted to $25 million and $30 million at the end of 2011 and 2012 respectively. The company’s cost of goods sold under FIFO would have been $260 million and $330 million in 2011 and 2012 respectively.

Retained earnings amounted to $102 million and $214 million at the end of financial year 2011 and 2012 respectively. Corresponding taxes payable balances were $35 million and $50 million.

Sales, cost of goods sold (COGS) and selling and general expenditures for financial year 2013 are $700 million, $410 million and $120 million.

Tax rate is 30%.


Preparing the new income statement with comparative figure is quite straightforward. We just replace the historical COGS for 2011 and 2012 and recalculate taxes.

CAP, Inc.
Income Statements
USD in million
Cost of sales410330260
Gross profit290270240
Operating expenses1209080
Profit before tax170180160
Net income119126112

The change in accounting policy will affect balances in inventory account, retained earnings account and taxes payable account.

The relevant calculations are given below.

Financial Year20122011
Cost of goods sold under FIFOA330.0260.0
Cost of goods sold under weighted-averageB350.0275.0
Decrease in cost of goods sold (~increase in inventories)A - B20.015.0
Cumulative effect (decrease in COGS, increase in inventories)C35.015.0
Inventories closing balance under weighted-averageD30.025.0
Cumulative effect of difference in COGSC35.015.0
Inventories closing balance under FIFOD + C65.040.0
Taxes for the year under FIFOE54.048.0
Taxes for the year under weighed averageF48.043.5
Increase in income tax expense for the yearE - F6.04.5
Cumulative increase in income taxesG10.54.5
Net income under FIFO methodH126.0112.0
Net income under weighted-averageI112.0101.5
Increase in net incomeH - I14.010.5
Cumulative increase in retained earningsJ24.510.5

Following adjustment is needed as at 1 January 2013 to restatement the retained earnings and other balance sheet account:

Inventories35 million
Taxes payable10.5 million
Retained earnings24.5 million

Relevant adjusted closing balances at the end of 2011 and 2012 are presented below:

Adjusted balance sheet balance as at 31 December20122011
Inventories under weighted-averageD30.025.0
Effect of decrease in COGSC35.015.0
InventoriesD + C65.040.0
Retained earnings under weighted-averageGiven214.0102.0
Cumulative increase in retained earningsJ24.510.5
Retained earnings under FIFO238.5112.5
Tax payable under weighted-averageGiven50.035.0
Cumulative increase in income taxesG10.54.5
Taxes payable under FIFO60.539.5

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