As accurate as accountants and companies try to be, mistakes are made, estimates are revised and decisions are changed. Generally accepted accounting principles handle these changes either prospectively or retrospectively. Prospective application under GAAP calls for accounting for the change going forward; in this case, no changes are made to the prior year's financial statements. Retrospective application requires that the financial statements be updated from the point the change occurred, or should have occurred, until the present day and then on a going-forward basis.
Change in Accounting Principle
A company's change in accounting principle is the changing from one appropriate accounting method to another appropriate accounting method. This does not include error corrections or adoptions of new standards. Common examples of these changes include changing from the cost to equity method for investments and changing inventory costing from first in, first out to last in, first out. GAAP requires that changes in accounting principle be applied retrospectively whenever possible. However, when it is impracticable to do so, a company may use a prospective approach. An exception exists when companies change depreciation methods; these are always accounted for prospectively.
Change in Accounting Estimate
Companies refine accounting estimates as a result of changing circumstances each time financial statements are prepared. These changes in estimates are to be recorded prospectively. Examples of common changes in accounting estimates include revision of an estimate of the useful life of equipment and changes in the expected damages from lawsuits. Changes in accounting estimates are to be recorded prospectively.
Change in Reporting Entity
Although uncommon, companies may have a change in a reporting entity. This occurs the first time a company prepares consolidated financial statements or when the companies included in the consolidated financial statements change for any reason. In this case, management is required to restate the company's financial statements for all prior periods. This is an extreme case of retrospective application.
Correction of an Error
When a company is correcting an error in previous period financial statements, including changing from an unacceptable accounting principle to one in accordance with GAAP, the company must make a prior period correction to the earliest presented financial statements. For example, if the company presented the last three years of financial statements in a comparative format and it was determined an error occurred five years ago, the company would record the prior period adjustment related to the mistake in years three, four and five in year three, would restate last year's financial statements to correct the mistake and report this year's financials correctly.