Change in Accounting Principle: Worked Example and Journal Entry

A change in accounting principle is a switch from one generally accepted accounting principle to another, such as FIFO to weighted-average inventory costing. Under U.S. GAAP (FASB ASC 250), a company generally applies a change in accounting principle retrospectively. A new standard’s transition provisions take precedence, and retrospective application can be limited when it is impracticable. Under full retrospective application, you revise every prior year presented and adjust the opening retained earnings of the earliest year for the after-tax effect of earlier years.

Quick translation: GAAP means generally accepted accounting principles, the rules U.S. companies follow. FIFO means first-in, first-out. FASB is the Financial Accounting Standards Board, which writes those rules, and ASC 250 is the section of its Accounting Standards Codification that covers accounting changes.

This matters because a change in measurement can make earnings look different even when the underlying business activity has not changed. A consistent basis helps students and financial statement users compare years. This tutorial walks through the reporting mechanics you will meet in intermediate accounting and in the Financial Accounting and Reporting (FAR) section of the CPA Exam.

Key takeaways

• A change in accounting principle is a justified switch from one generally accepted method to another. A voluntary change is allowed only if the new method is preferable.
• The default treatment is retrospective application: every prior year presented is revised to the new method.
• The after-tax effect of years before the earliest year presented adjusts that year’s opening retained earnings. It never runs through current net income.
• A change in depreciation method is the exception. It is treated as a change in estimate and applied prospectively.
• In the Cedar Supply example below, the cumulative effect is ($6,000 + $4,000) × 75% = $7,500.

What qualifies as a change in accounting principle?

Under FASB Accounting Standards Codification (ASC) 250, a change in accounting principle is a switch from one generally accepted accounting principle to another. It applies when a company has two or more acceptable principles to choose from, or when the principle it was using is no longer accepted. Changing the method of applying a principle counts too.

Three situations look like a principle change but are not:

• Adopting a principle for the first time because the transaction is new to the company, or was immaterial before.
• Adopting or modifying a principle because the new transactions are clearly different in substance from earlier ones.
• Switching from a method that is not GAAP to one that is GAAP. That is the correction of an error.

For example, a company may replace first-in, first-out (FIFO) inventory costing with weighted-average costing (course overview). FIFO assigns the earliest purchase costs to the goods sold first; weighted-average uses an average unit cost. Both can be acceptable, but choosing the more favorable profit number is not sufficient justification for switching.

A voluntary change requires support that the new method is preferable. When a new standard requires a change, its own transition rules come first. FASB publishes each new standard as an Accounting Standards Update, and the update explains how to make the transition.

For revised collection losses, see how to record a change in accounting estimate. For a calculation mistake in previously issued statements, see the prior period adjustment journal-entry examples.

Exam trap: a new depreciation method is not treated as a principle change

Changing a depreciation, amortization, or depletion method looks like a switch between two acceptable methods. An example is moving from straight-line to an accelerated method, which records more depreciation in the early years.

ASC 250 treats it differently. It is a change in accounting estimate effected by a change in accounting principle, so you apply it prospectively, to the current and future periods only. No prior years are revised and there is no retained earnings adjustment. The company still has to justify the new method as preferable.

Change in accounting principle example: FIFO to weighted-average

Hypothetical example. Cedar Supply adopts weighted-average inventory costing on January 1, 20X9. It previously used FIFO, documents why the new method is preferable, and has the records needed to apply it retrospectively. The company began operations in 20X7. Assume a constant 25% income tax rate and no permanent tax differences. The following figures are annual pretax income amounts, not inventory balances.

Step 1: Use the new method for every year presented

The comparative income statements report $58,000, $48,000, and $72,000 of pretax income. Do not retain FIFO income in 20X7 and 20X8 while reporting weighted-average income in 20X9. That mixture would defeat the purpose of retrospective application.

Step 2: Calculate each year’s tax expense and net income

For this simplified example, net income = income before tax × (1 − 25%). Apply the tax rate separately to each year’s recalculated income.

Step 3: Separate the earlier cumulative effect

The after-tax reduction through 20X8 is ($6,000 + $4,000) × 75% = $7,500. This amount reduces retained earnings at the beginning of 20X9 when only 20X9 statements are presented. It is not an extra expense deducted from 20X9 net income of $54,000.

Which beginning retained earnings balance changes?

The answer depends on the comparative periods presented. Retained earnings is accumulated net income less dividends and other applicable adjustments. Moving an effect to the wrong opening balance can count it twice.

The $4,500 amount is $6,000 × 75%; the $3,000 amount is $4,000 × 75%. Together they explain the same $7,500 accumulated reduction. A current-ledger adjustment and a comparative presentation are two views of that effect, not two separate losses.

What is the journal entry for a change in accounting principle?

The table above shows the presentation. Cedar also needs one entry in its 20X9 ledger to bring the opening balances onto the new method.

Two extra assumptions for this entry. First, inventory cost is the only thing that differs between the two methods, and Cedar began in 20X7. So the $10,000 total pretax difference through 20X8 is also the amount by which weighted-average inventory is lower than FIFO inventory on December 31, 20X8. Second, Cedar’s tax return keeps using FIFO. That makes the tax effect a deferred tax asset, which is a future tax saving recorded as an asset.

Inventory drops by the full $10,000. The deferred tax asset picks up the $2,500 tax effect. Retained earnings absorbs the remaining $7,500. Notice that no income statement account appears in the entry.

Prove it with retained earnings

Assume Cedar has never declared a dividend.

Quick check: the adjusted opening balance of $79,500 equals 20X7 and 20X8 net income under the new method, $43,500 + $36,000.

Want to watch a retained earnings adjustment worked out on screen? Professor Farhat’s 13-minute retrospective application lesson on YouTube covers the cumulative adjustment, deferred taxes, and beginning retained earnings. Its example uses older construction-contract methods, so focus on the mechanics.

When is retrospective application limited?

When it is impracticable

Impracticable means the company cannot apply the new method to past years even after making every reasonable effort, for example because the old records no longer exist. ASC 250 gives two fallbacks:

• If the total effect on past years is known but the year-by-year amounts are not, apply the new method to the opening balances of the earliest year for which it can be done. The offset goes to that year’s opening retained earnings.
• If even the total effect cannot be determined, apply the new method prospectively from the earliest date practicable. A switch to LIFO (last-in, first-out) is the classic illustration, because rebuilding old inventory layers is often not possible.

Direct effects vs. indirect effects

Retrospective application covers only the direct effects of the change, including the related income tax effects. In Cedar’s case, that is the lower inventory and the deferred tax asset.

Indirect effects are different. An example is a bonus or royalty that is based on reported income. These are not pushed back into prior years. If they are actually incurred, they are recorded in the period the change is made.

Common mistakes and reporting notes

• Using the old method’s net income. Start with pretax income under the new method before calculating tax.
• Deducting the cumulative effect again. Earlier effects do not become a separate current-year expense.
• Calling the change an error. A justified switch between acceptable methods is different from correcting incorrect accounting.
• Treating a depreciation method change as retrospective. It is a change in estimate effected by a change in principle, so it is prospective.
• Forgetting the tax effect. The retained earnings adjustment is net of tax: $10,000 × (1 − 25%) = $7,500, not $10,000.

CPA Exam tip: accounting changes and error corrections are tested in FAR, Area III (Select Transactions) of the AICPA Blueprint. Expect two steps. Classify the change first, then compute the opening retained earnings adjustment net of tax.

One more thing. Older study materials may show the cumulative effect as a separate line on the income statement. That was the rule under APB Opinion 20. FASB Statement 154 replaced it for changes made in fiscal years beginning after December 15, 2005, and the effect now goes to opening retained earnings.

In the notes, disclose the nature of and reason for the change, why the new method is preferable, how the change was applied, its effect on the affected line items and any per-share amounts, and the cumulative effect on opening retained earnings (ASC 250-10-50-1). This example assumes full retrospective application is practicable. The section above on limits covers what happens when it is not. See our Accounting Standards Codification (ASC) 250 accounting changes and error corrections guide for the broader framework.

Practice: test the calculation

1. What net income should Cedar report for 20X8?

Answer: $36,000. Use the new method’s $48,000 pretax income and subtract $12,000 tax. The old FIFO figure is not the comparative amount after the change.

2. Only 20X9 is presented. Where does the $7,500 effect belong?

Answer: beginning retained earnings. It relates to 20X7 and 20X8. Current-year net income remains $54,000 under the stated assumptions.

3. Does a revised equipment life receive the same treatment?

Answer: no. A useful-life revision based on new information is an estimate change. Apply the revised estimate to the current and future periods affected.

Frequently asked questions

What is the difference between a change in accounting principle and a change in accounting estimate?

A principle change is a switch between two acceptable accounting methods and is applied retrospectively, so prior years are revised. An estimate change updates a number, such as a useful life, because of new information. It is applied prospectively, so only current and future periods change.

Is a change in depreciation method a change in accounting principle?

Not for reporting purposes. ASC 250 treats it as a change in estimate effected by a change in accounting principle. It is applied prospectively, but the company must still justify the new method as preferable.

What is the journal entry for a change in accounting principle?

Adjust the affected asset or liability, record the related deferred tax effect, and put the after-tax difference in opening retained earnings. In the Cedar Supply example: debit retained earnings $7,500, debit deferred tax asset $2,500, credit inventory $10,000.

Does a change in accounting principle affect current-year net income?

The cumulative effect of earlier years does not. It goes to opening retained earnings. Current-year net income is simply measured under the new method.

When can a company change an accounting principle?

Only in two cases: a new FASB standard requires the change, or the company can justify that an allowable alternative method is preferable.

Does retrospective application mean the company used an incorrect method?

No. In this example both methods are acceptable. Earlier figures are recalculated to make the comparison consistent.

Is every accounting principle change retrospective?

No. First check specific transition guidance and the applicable impracticability provisions. This tutorial illustrates the general rule when full retrospective application is practicable.

Why is the retained earnings effect after tax?

Retained earnings accumulates net income. Under the example’s assumptions, a $10,000 pretax reduction produces a $7,500 reduction after the 25% tax effect.

Sources and standards cited

Current U.S. GAAP is in the FASB Accounting Standards Codification, Topic 250. The FASB’s original Statement 154, paragraphs 5–7 and 17, provides public historical background for the principle-change rules now codified.

New to ASC paragraph numbers? Our FASB Codification guide explains how they work, and What Is GAAP? covers the rules behind them.

About the author

Mansour Farhat, CPA, CIA, DBA, is the founder of Farhat Lectures. He teaches financial accounting, intermediate accounting, and CPA Exam topics through on-demand video lessons, worked examples, and practice questions used by accounting students and CPA candidates. More about Professor Farhat · Farhat Lectures on YouTube