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Change in Accounting Principle

Moneyzine Editor
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Moneyzine Editor
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January 11th, 2024
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Change in Accounting Principle

Definition

The term change in accounting principle refers to the adoption of an accounting method that differs from that used in the past. When an alternate accounting method is chosen, the impact on the company's financial statement must be shown in the current accounting period as well as retrospectively.

Explanation

There are several categories of irregular items that may appear directly in the company's financial statements or as footnotes to them. When a company adopts a different accounting method, the choice can have a material effect on the company's financial position. For this reason, prior financial statements need to reflect this change. This allows analysts, investors, and creditors to make accurate comparisons when evaluating the historical performance of a company.

Examples of such changes include switching from a FIFO inventory valuation method to LIFO, or changing the company's depreciation method from declining balance to straight line. These changes are frequently looked upon with suspicion by the financial community, since they can be used by management to inflate earnings.

Disclosure of such changes in accounting principles includes both notes to the current financial statement as well as tables demonstrating the impact of the change on prior periods.

Example

Company A changed their depreciation method from declining balance to straight line. The cumulative effect of this change (net of income taxes) is $30,000. Before this change, Company A's financial statement indicated net income of $2,500,000. The impact of this change on Company A's income statement would be:

Income Before Changes in Accounting Principles

$2,500,000

Cumulative Effect of a Change in Depreciation Method

$30,000

Net Income

$2,530,000

Note: Cumulative effects of a change in accounting methods would appear in the income statement after any Extraordinary Items.

Related Terms

  • Materiality Constraint
    The term materiality refers to an accounting constraint that is used to determine the relative importance or value of an item to one of the company's financial statements. If an item is not deemed significant enough to influence the decision-making process of an individual examining the company's financial statements, then that item is not considered material.
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  • Extraordinary Items
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  • Changes in Accounting Estimates
    The term changes in accounting estimates referrers to those estimations that require revision based on the availability of new and better information in the current accounting period. Changes in accounting estimates can involve revenues, expenses, liabilities and assets; and are corrected prospectively in the financial statements of a company.
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  • Changes in Reporting Entity
    The financial accounting term changes in reporting entity refers to a switch from one type of reporting entity to another. Changes in reporting entity can fall into several categories, including a change in subsidiaries, the number of companies combined into a consolidated report, as well as the mix of companies appearing in a consolidated report.
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  • Accounting Changes
    The term accounting changes is used to describe three categories of changes disclosed in the financial statements of a company. Accounting changes can include: a change in accounting principal, accounting estimates, and reporting entities. Disclosures should include a description of the change as well as its effect on financial statements.
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  • Correction of an Error in Financial Reports
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