Firms are at liberty to change the accounting policy applied to their financial results. Changes to accounting policy fall into three main categories:
1. Changes of Accounting Principle
2. Changes in Accounting Estimates
3. Changes in the Reporting Entities
Changes of Accounting Principle
In preparing their financial accounts, firms may select from several alternative accounting principles. For example, in depreciating its fixed assets, a firm may elect for accelerated depreciation (which front-loads the depreciation charge) or straight line depreciation (which allocates the depreciation charge evenly across all periods). Typically there is some guidance on which principle to apply, but no hard rules and so the firm should select the principle which it deems most appropriate.
If the firm subsequently decides that the original principle is inferior to an alternative principle it may change the principle applied. Such a change should be justified and explained in the notes to the accounts, and also needs to be noted in the auditor’s report.
Although firm can elect to change an accounting principle, most changes to accounting principle are due to new regulatory requirements which mandate the change.
Changes in Accounting Estimates
Firms are required to make estimates for wide variety of items in its financial accounts. For example, depreciation requires an estimate of an asset’s useful life, bad debt provisions require estimates on delinquency rates, stock requires an estimate of the current market value for that stock.
All estimates need to been examined and validated for each reporting period to ensure they remain valid. If it is determined that an estimate is no longer accurate, it will need to be adjusted. The frequency of changes in an estimate varies by the nature of the estimate, useful asset lives typically are relatively stable whereas provisions for bad debts will change regularly with the prevailing economic conditions.
Changes in estimates can be a method for firm’s to manage (or smooth) their earnings. Provisions for bad debts is a common item for managing earnings. A firm may make an overly negative estimate on bad debts during a healthy period which would reduce the earnings and create a liability (‘Allowance for Doubtful Debts’) on the Balance Sheet. The Allowance for Doubtful Debts liability can be later reversed in a period when the firm needs to improve earnings, in such a circumstance the liability is reduced and appears on the Income Statement as ‘Allowance for Doubtful Accounts’ or similar.
Some firms require extensive estimates in arriving at their revenue number. In such a circumstance the firm’s revenue (and estimates in arriving at the revenue) should be closely scrutinised. One example of this is Zynga. Zynga apportions the revenue from the purchase of virtual goods over the expected term these goods will be used over. This estimate is contingent on a lot of data internal to Zynga such as granular data on the time players are expected to play a particular game, and only the very high level data is disclosed in Zynga’s accounts.
When Zynga reduced its estimate of then life of a virtual good’s lifespan then it essentially accelerated the recognition of its revenue and boosted its current period revenue.
Financial Impact of Changes in Principle and Changes in Estimates
A change in principle or estimate will likely impact the financial results of not only the current period but also previous periods. There are two methods for handling the impact of the change – cumulative-effect (catch-up) or restatement. The restatement method requires the firm to restate its previous periods using the new accounting principle or estimate. More commonly used is the cumulative-effect method, whereby the firm rolls the cumulative net impact of the change for all prior periods into the current period. This amount appears as a separate item on the Income Statement, typically as the final item just before Net Income.
Also of interest to an analyst is the impact of the change for the current period. This is not broken out separately in the Income Statement but needs to be disclosed in the notes to the accounts.
Change In Reporting Entity
The reporting entity can be materially changed when a merger or divestiture occurs. Google is a good example of both. When Google’s purchase of Motorola was approved it restated its current and prior period accounts to include Motorola. Google subsequently divested Motorola Home, only keeping Motorola Mobility, this divestiture necessitated a further restatement of the prior periods accounts.
Note that a change in the reporting entity requires a restatement and the cumulative-effect method available for changes in accounting principle or estimate is not available.