When You Should Change Accounting Methods
The whole purpose of preparing financial statements is to give the interested external users of the financial statements relevant, comparable information to use in making their investment decisions. When a company decides that the old way of booking certain accounting events no longer gives a fair, full, and complete financial picture, it’s time to consider a change in accounting methods.
External users run the gamut, from shareholders evaluating the relative merits of buying stock in a company, to banks deciding whether to extend credit to a company.
Three types of accounting changes crop up: change in accounting principle, or a change from one generally accepted accounting principle (GAAP) to another; change in accounting estimate, or a company’s “best guess” on how to handle an accounting event that hasn’t yet come to its final conclusion; and change in reporting entity, which means the current financial statements show a different mix of companies than the ones reflected on prior years’ statements.
As with just about everything you hear in your intermediate accounting class, the Financial Accounting Standards Board (FASB) determines the specific categories in which to classify these accounting changes. Each of the three categories uses a different method to show the effect of the change on the financial statements.
Corrections of errors, which are inadvertent mistakes, don’t qualify as an accounting change.