Retrospective vs. Prospective Accounting
Financial statements are prepared based on the company’s internal policy which is under the guideline of the accounting framework. International accounting standard (IFRS) allows the company to have a broad selection of accounting policies. The company can design their own policy which complies with guidelines and fit with their business.
Accounting policy is the basic principle, arrangement, rule, and practice that the company uses as the guideline to prepare financial statements. The policy includes the measurement, accounting method, and disclosure procedures in the financial statements. The accounting standard may provide many options regarding inventory valuation, fixed assets depreciation method, and so on. Accounting policy is the management decision in practicing the accounting standard. They may decide to use FIFO for the inventory valuation and straight line for the depreciation method.
In addition, the company also use accounting estimate which bases on management judgment. Accounting estimates the approximate amount that company record into financial statement. It is impossible or impractical to get the exact amount, so management uses the estimation for recording purposes. Any different between actual and estimate amount will be reflect in the next accounting period when company knows the exact amount. For example, company uses accounting estimates for allowance for bad debt, depreciation expense, and so on.
Both accounting policy and estimate can be changed due to the business operation as well as the situation.
Retrospective Accounting
Retrospective accounting is the accounting concept in which any change in accounting policy will impact all prior financial statements. It happens when the company has prepared the financial statement for several accounting periods. Then management decides to change accounting policy, so they need to go back and change all relevant information in the previous statements.
Management needs to amend the financial statements to ensure that the change will reflect the prior period as well. We want to ensure that all reports use the same policy which enables the user to compare from one period to another.
The retrospective concept prevents the management from changing the accounting policy to window-dressing the financial statements.
Accounting Policy is the procedure that company uses as a guideline to prepare financial statements. The company must use a consistent policy that ensures that financial statements are consistent from one period to another.
Retrospective Accounting Example
Company A establishes in 202X and they have prepared financial statements from 202X up to 202X+2. Regarding fixed assets measurement, management decide to use the cost model. Fixed assets need to record at cost less accumulated depreciation.
| Balance Sheet | |||
|---|---|---|---|
| 202X | 202X+1 | 202X+2 | |
| Cash | 850 | 1,140 | 1,910 |
| Inventory | 200 | 500 | 1,000 |
| Other assets | 500 | 800 | 700 |
| Fixed Asset | 1,100 | 1,000 | 900 |
| Total Assets | 2,650 | 3,440 | 4,510 |
| Account Payable | 300 | 350 | 400 |
| Capital | 2,000 | 2,000 | 2,000 |
| Revaluation Reserve | 0 | 0 | 0 |
| Retained Earnings | 350 | 1,090 | 2,110 |
| Total Lia & Equity | 2,650 | 3,440 | 4,510 |
| Income Statement | |||
|---|---|---|---|
| 2020 | 202X+1 | 202X+2 | |
| Revenue | 2000 | 2500 | 3000 |
| COGS | (1000) | (1100) | (1300) |
| Gross Profit | 1000 | 1400 | 1700 |
| Operating Expense: | |||
| Depreciation Exp | (100) | (100) | (100) |
| Salary Exp | (500) | (500) | (500) |
| Impairment Loss | 0 | 0 | 0 |
| Other Exp | (50) | (60) | (80) |
| Net Income | 350 | 740 | 1,020 |
In January 202X, the company purchase one machinery that cost $ 1,200 which expect to use for 12 years. The company records depreciation expenses of $ 100 per year, the company does not have any other fixed assets.
However, at the end of 202X+2, management decide to change fixed assets measurement to a revaluation model which is more suitable for the company.
Management has revalue the machinery as following:
- At the end 202X: $ 1,500
- At the end 202X+1: $ 1,300
- At the end 202X+2: $ 1,000
The change of accounting policy need to apply retrospectively, it means that we need to reverse the depreciation expense and apply the revolution model to all fixed assets. In addition, we need to revalue fixed assets and any change must recognize base on the revaluation model.
It will impact the financial statements as follows:
| Balance Sheet | |||
|---|---|---|---|
| 2020 | 202X+1 | 202X+2 | |
| Revenue | 2000 | 2500 | 3000 |
| COGS | (1000) | (1100) | (1300) |
| Gross Profit | 1000 | 1400 | 1700 |
| Operating Expense: | |||
| Depreciation Exp | 0 | 0 | 0 |
| Salary Exp | (500) | (500) | (500) |
| Impairment Loss | 0 | 0 | (200) |
| Other Exp | (50) | (60) | (80) |
| Net Income | 450 | 840 | 920 |
| Income Statement | |||
|---|---|---|---|
| 202X | 202X+1 | 202X+2 | |
| Cash | 850 | 1,140 | 1,910 |
| Inventory | 200 | 500 | 1,000 |
| Other assets | 500 | 800 | 700 |
| Fixed Asset | 1,500 | 1,300 | 1,000 |
| Total Asset | 3,050 | 3,740 | 4,610 |
| Account Payable | 300 | 350 | 400 |
| Capital | 2,000 | 2,000 | 2,000 |
| Revaluation Reserve | 300 | 100 | 0 |
| Retained Earnings | 450 | 1,290 | 2,210 |
| Total Lia & Equity | 3,050 | 3,440 | 4,610 |
We make the following adjustment:
- All depreciation must be removed as the company use the revaluation model not a cost model, so it will impact profit and retained earnings.
- Revaluation reserve: it will increase when the fixed assets’ fair value is higher than the book value. In 202X, record increase of revaluation surplus of $ 300 ($ 1,500 – $ 1,200). However, in 202X+1, in decrease to $ 100 as the asset fair value decrease from $ 1,500 to $ 1,300. In 202X+2, assets’ fair value decrease to $ 1,000, so we debit revaluation surplus $ 100 and Impairment loss $ 200.
Prospective Accounting
Prospective accounting is the accounting concept that changes in accounting estimates will impact the current and future period only. We do not modify prior year financial statements. Prospective accounting happens when the company change in accounting estimate.
Management estimates based on the available information at each balance sheet date, so it was the best estimation back then. Fast forward, we may obtain additional information which supports another estimation, so it is not necessary to change the previous report. Moreover, our current estimate may be wrong too if we receive more information in the future.
Prospective Accounting Example
Company purchase machine cost $ 8,000 and expect to use it for 8 years with zero scrap value. Accountant depreciates this machine at $ 1,000 per year as the company uses a cost model.
However, at the end of 3rd year, management expects to use the machine for only two more years as the technology update very fast, we need to keep up with the competitors.
At the end of the 3rd year, the machine’s net book value is $ 5,000 ($ 8,000 – ($ 1,000 * 3y)) as it was depreciated for 3 years already. Base on the new estimation, this balance needs to depreciate for the next two years only. Depreciation expense will be $ 2,500 ($ 5,000/2) for the 4th and 5th year if nothing change.
We do not go back to change depreciation expenses for the 1st, 2nd, and 3rd years. This depreciation calculates base on the previous estimation.
