How to Use Prospective Effect for Accounting Changes - dummies

How to Use Prospective Effect for Accounting Changes

By Maire Loughran

With the prospective effect, companies don’t recast opening balances to show the effect of the change in accounting principle. Depending on the circumstances, prospectively is okay when there’s an impracticability exception to adjusting prior periods under GAAP.

This situation may arise when the business can’t determine the effect as a whole or can’t determine the effect to a specific financial period. In this case, the business spreads the accounting change over current and future financial statements, as needed.

To recap your GAAP guidelines for changes in accounting principle:

Use the retrospective approach:

  1. Adjust all prior-period comparative financial statements.

  2. Disclose in the year of change the effect on net income and earnings per share (EPS — basic EPS is net income divided by the weighted-average number of shares of common stock) for all prior periods you show on the comparative financials.

  3. Take the adjustment to beginning retained earnings for the earliest year you present in comparable statements.

  4. If figuring out the prior-period effect is impractical, follow GAAP’s impracticality exception:

    1. Do not adjust prior-year income.

    2. If the change in accounting principle is a change to LIFO, use the opening inventory in the year LIFO adopts as the base-year inventory amount.

    3. Disclose the effect of the change on your current year and explain why you didn’t employ the retrospective approach.