A company changed its inventory valuation method from FIFO to weighted-average in the current year. This change is considered a change in accounting principle. How should this change be accounted for under U.S. GAAP?
- AAs a cumulative effect adjustment to the current year's net income, with no restatement of prior periods.
- BProspectively, applying the new method to current and future periods only, with no restatement of prior periods.
- CRetrospectively, by restating prior period financial statements as if the new method had always been used, and adjusting the beginning balance of retained earnings for the earliest period presented.
- DAs an extraordinary item in the current year's income statement.
Show answer & explanationAnswer & explanation
Correct answer: C. Retrospectively, by restating prior period financial statements as if the new method had always been used, and adjusting the beginning balance of retained earnings for the earliest period presented.
A change in accounting principle, such as changing inventory methods (except for a change to LIFO, which is generally accounted for prospectively), is accounted for retrospectively. This means prior period financial statements are restated, and the cumulative effect of the change on periods prior to those presented is reflected as an adjustment to the beginning balance of retained earnings for the earliest period presented.
Why the other options are wrong
- A. Cumulative effect adjustments to current net income were used under older GAAP, but not generally for changes in principle now.
- B. Prospective application is typically used for changes in accounting estimates or changes to LIFO.
- D. Extraordinary items are rare and have a specific definition; accounting changes are not typically classified as such.
Change in Accounting Principle (Retrospective)
A change from one generally accepted accounting principle to another. Under U.S. GAAP, most changes in accounting principle are accounted for retrospectively, meaning prior financial statements are restated, and the cumulative effect is adjusted to the beginning retained earnings of the earliest period presented.
- Most changes are retrospective
- Restate prior period financial statements
- Adjust beginning retained earnings of earliest period presented
- Exception: change to LIFO is prospective
Memory trick: Principles are Retro, Estimates are Pro, and Entity changes are like a new show.