A company changed its inventory valuation method from FIFO to weighted-average during the current year. This change is considered a change in accounting principle. How should the company account for this change?
- AReport the cumulative effect of the change in the income statement of the current period.
- BRetrospectively apply the new principle to all prior periods presented, adjusting the beginning retained earnings of the earliest period presented.
- CApply the change by restating only the prior year's financial statements, leaving earlier years unchanged.
- DProspectively apply the new principle to current and future periods only, with no adjustment to prior periods.
Show answer & explanationAnswer & explanation
Correct answer: B. Retrospectively apply the new principle to all prior periods presented, adjusting the beginning retained earnings of the earliest period presented.
Most changes in accounting principle, such as changing inventory methods (FIFO to weighted-average), are accounted for retrospectively. This means the financial statements of all prior periods presented are restated as if the new accounting principle had always been used. The cumulative effect of the change on periods prior to those presented is reflected as an adjustment to the beginning balance of retained earnings of the earliest period presented.
Why the other options are wrong
- A. Reporting the cumulative effect in the current period's income statement was the old GAAP rule, no longer applicable for most principle changes.
- C. Retrospective application requires restating all prior periods presented, not just the immediately prior year.
- D. Prospective application is used for changes in accounting estimates, not typically for principles.
Change in Accounting Principle (Retrospective)
A change in accounting principle generally requires retrospective application, meaning prior period financial statements are restated as if the new principle had always been used, adjusting the beginning retained earnings of the earliest period presented.
- Applies to most changes in accounting principles.
- Restates prior period financial statements.
- Adjusts beginning retained earnings of earliest period presented.
- Enhances comparability of financial statements.
Memory trick: Principle changes retrospectively, estimate changes prospectively, errors are restated completely.