Changes in Accounting Principle: Definition & Impact

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  • 0:04 Changing an Accounting…
  • 0:56 When Is it Allowed?
  • 1:54 Rules for Changing
  • 2:41 Applying a Change in Principle
  • 3:51 Lesson Summary
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Lesson Transcript
Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

Changes in accounting principle generally arise because the rules of accounting allow different methods to be used for certain situations. We'll see when changes in principle are allowed and trace the impacts of a change on the financial statements.

Changing an Accounting Principle

Bob and Beth are known in the business world as turnaround experts. Their latest project is Toys 4 Everyone, a troubled toy retailer. Bob and Beth are excited about being in the toy business. 'Every parent and grandparent in America buys toys,' Beth said. 'We are going to make toy retailing work!'

One of their first major projects is a thorough review of past periods' financial statements. The old management didn't know much about toys, but they did keep honest books, Bob observed. We can get some more clues about the problems here. Beth immediately noticed something about the inventory. 'You know,' she told Bob, 'the old management were big fans of LIFO for inventory valuation because they thought it made the income look better. But the way toy costs have been jumping around in recent years, it isn't giving us a good picture. We should think about going to weighted average cost.'

When Is It Allowed?

Bob and Beth can make that change because the rules of accounting allow it. Changes in accounting principle happen when there is more than one generally accepted accounting principle that applies to a certain situation, and you change from one to another.

Inventory valuation is one of these situations where GAAP (generally accepted accounting principles) allows for several methods: LIFO, FIFO, weighted average, or specific identification. Changing the method used is allowable if GAAP requires it or, like in Beth and Bob's case, when changing methods can be justified. 'Well, we have a strong reason for making this change,' Beth said, 'so we should be good.'

Another area they can look at for a change in principle is fixed asset valuation, where accounting rules allow either historical cost or market value as acceptable. And bond carrying values are a third area, since different amortization methods are allowed.

Rules for Changing

Bob wants to make that change to inventory valuation too, so he is going through the FASB (financial accounting standards board) pronouncements, which are accounting rules, to see what they need to do. Here is what he finds:

  • The change in principle must be retroactively applied to all prior periods presented. They must be restated as if the new method was in place all along.

  • Asset and liability amounts will need to be restated, as well as the income statement items affected by the direct change.

  • Since Toys presents ten years' worth of financial statement data, an offsetting amount must be included in the retained earnings of the first year presented to reflect the impact on years prior to that.

'Looks like a lot of work,' Bob said. 'Let's get the controller in here to tell us what this means!'

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