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:
2012 | 2011 | |
---|---|---|
USD in million | ||
Sales | 600 | 500 |
Cost of sales | 350 | 275 |
Gross profit | 250 | 225 |
Selling and administrative expenses | 90 | 80 |
Profit before tax | 160 | 145 |
Taxes | 48 | 44 |
Net income | 112 | 102 |
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%.
Solution
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 | |||
Year | 2013 | 2012 | 2011 |
Sales | 700 | 600 | 500 |
Cost of sales | 410 | 330 | 260 |
Gross profit | 290 | 270 | 240 |
Operating expenses | 120 | 90 | 80 |
Profit before tax | 170 | 180 | 160 |
Taxes | 51 | 54 | 48 |
Net income | 119 | 126 | 112 |
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 Year | 2012 | 2011 | |
---|---|---|---|
Cost of goods sold under FIFO | A | 330.0 | 260.0 |
Cost of goods sold under weighted-average | B | 350.0 | 275.0 |
Decrease in cost of goods sold (~increase in inventories) | A - B | 20.0 | 15.0 |
Cumulative effect (decrease in COGS, increase in inventories) | C | 35.0 | 15.0 |
Inventories closing balance under weighted-average | D | 30.0 | 25.0 |
Cumulative effect of difference in COGS | C | 35.0 | 15.0 |
Inventories closing balance under FIFO | D + C | 65.0 | 40.0 |
Taxes for the year under FIFO | E | 54.0 | 48.0 |
Taxes for the year under weighed average | F | 48.0 | 43.5 |
Increase in income tax expense for the year | E - F | 6.0 | 4.5 |
Cumulative increase in income taxes | G | 10.5 | 4.5 |
Net income under FIFO method | H | 126.0 | 112.0 |
Net income under weighted-average | I | 112.0 | 101.5 |
Increase in net income | H - I | 14.0 | 10.5 |
Cumulative increase in retained earnings | J | 24.5 | 10.5 |
Following adjustment is needed as at 1 January 2013 to restatement the retained earnings and other balance sheet account:
Inventories | 35 million | |
Taxes payable | 10.5 million | |
Retained earnings | 24.5 million |
Relevant adjusted closing balances at the end of 2011 and 2012 are presented below:
Adjusted balance sheet balance as at 31 December | 2012 | 2011 | |
---|---|---|---|
Inventories under weighted-average | D | 30.0 | 25.0 |
Effect of decrease in COGS | C | 35.0 | 15.0 |
Inventories | D + C | 65.0 | 40.0 |
Retained earnings under weighted-average | Given | 214.0 | 102.0 |
Cumulative increase in retained earnings | J | 24.5 | 10.5 |
Retained earnings under FIFO | 238.5 | 112.5 | |
Tax payable under weighted-average | Given | 50.0 | 35.0 |
Cumulative increase in income taxes | G | 10.5 | 4.5 |
Taxes payable under FIFO | 60.5 | 39.5 |
by Obaidullah Jan, ACA, CFA and last modified on