Accounting Principle Change vs. Accounting Estimate Change: An Overview
SFAS 154, Accounting Changes and Error Correction, documents how companies should treat changes in accounting principles and changes in accounting estimates, two related but different concepts. A principle determines how information should be reported, while an estimate is used to approximate information.
- A change in accounting principle is a change in how financial information is calculated, while a change in accounting estimate is a change in the actual financial information.
- Changes in accounting principles can include inventory valuation or revenue recognition changes, while estimate changes are related to depreciation or bad-debt allowances.
- Principle changes are done retroactively, where financial statements have to be restated, while estimate changes are not applied retroactively.
- There are instances when restatements (with principle changes) or disclosures (with estimate changes) don’t have to be made.
Accounting Principle Change
Accounting principles are general guidelines that govern the methods of recording and reporting financial information. When an entity chooses to adopt a different method from the one it currently employs, it is required to record and report that change in its financial statements.
A good example of this is a change in inventory valuation; for example, a company might switch from a first in, first out (FIFO) method to a specific-identification method. According to the FASB, an entity should only change an accounting principle when it is justifiably preferable to an existing method or when it is a necessary reaction to a change in the accounting framework.
Other notable changes in accounting principles can include matching, going concern, or revenue recognition principles, among others.
Accounting Estimate Change
Accountants use estimates in their reports when it is impossible or impractical to provide exact numbers. When these estimates prove to be incorrect, or new information allows for more accurate estimations, the entity should record the improved estimate in a change in accounting estimate. Examples of commonly changed estimates include bad-debt allowance, warranty liability, and depreciation.
Accounting principle changes can also occur when older principles are no longer accepted or when the way the method is applied changes. Changes in accounting principles are required to be applied retroactively—that is, financial statements must be restated to be presented as if the new accounting principle had been used.
Only line items that are directly affected have to be restated. There are cases where a retroactive application doesn’t have to be made, which includes having made all reasonable efforts to do so, which can include not being able to make subjective significant estimates or having to have knowledge of management’s intent.
Estimate changes occur when the carrying values of assets or liabilities are changed. These changes are accounted for in the period of change. Changes in accounting estimates don’t require the restatement of previous financial statements. If the change leads to an immaterial difference, no disclosure of the change is required.
The Bottom Line
There are different and less stringent reporting requirements for changes in accounting estimates than for accounting principles. In some cases, a change in accounting principle leads to a change in accounting estimate; in these instances, the entity must follow standard reporting requirements for changes in accounting principles.