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Accounting Principle Change vs. Accounting Estimate Change: An Overview
Accounting involves recording financial transactions. Companies are required to file complete financial statements that are consistent and precise. But, there may come a time when a company’s accounting department has to make changes to its reporting. Two types are the accounting principle change and accounting estimate change.
Although both are considered accounting changes, the two are different. An accounting principle change occurs when a company adopts a new accounting principle. An accounting estimate change involves the adjustment or reassessment of the amount of an asset or liability.
Key Takeaways
- 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. A change in accounting principles means the entity chooses to adopt a different method from the one it currently employs. As such, 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. Other notable changes in accounting principles can include matching, going concern, or revenue recognition principles, among others.
According to the Fair Accounting Standards Board (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.
Important
An accounting principle change is simply a change in the way financial information is calculated.
Accounting Estimate Change
An accounting estimate change is “a change that has the effect of adjusting the carrying amount of an existing asset or liability or altering the subsequent accounting for existing or future assets or liabilities.”
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. Some other common instances of accounting estimate changes include accounting for obsolete inventory and credit losses.
Note
Accounting estimate changes relate to an asset’s depreciation or bad debt allowances.
Special Considerations
The FASB and the International Accounting Standards Board (IASB) agree with the treatment of accounting changes.
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.
Key Differences
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 retrospectively—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 retrospective 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 know 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.
What Are the Different Types of Accounting Changes?
The term accounting changes refers to any modifications that an entity makes to its accounting of financial transactions. There are three types of accounting changes that a company can make. These changes occur in accounting principles, accounting estimates, and the reporting entity.
What Are Generally Accepted Accounting Principles?
Generally accepted accounting principles are accounting rules and standards that most U.S. corporations follow. They are used by companies when they prepare, present, and report their financial statements. GAAP ensures that corporate financial statements are consistent and complete.
What Are the Golden Rules of Accounting?
There are three golden rules of accounting. They are;
- Debit losses and expenses while crediting all gains and income
- Debit the receiver and credit the giver
- Ensure you debit whatever comes in and credit everything that goes out
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.