The nature of an accounting change delineates whether it will be accounted for prospectively or retrospectively. Changes in accounting principles and changes in accounting estimates are accounted for prospectively; correction of an error and changes in accounting entities are accounted for retrospectively. Memorization of the rule will get you to the correct entry, but understanding the reasons why the rule exists could help you when the scenario that your company is in doesn't fit the rule exactly.
Retrospective Application Not Possible
In some cases, retrospective application is not possible. For example, changing from the first-in first-out inventory costing method to the last-in first-out inventory costing method is a change in accounting principle and should be accounted for retrospectively. However, many companies would be unable to go back and reconstruct inventory records to reflect the last-in first-out assumption. As such, the prospective method is available, even though it is not preferred.
Changes in accounting estimates are the result of new information available to management at the time of the change in estimate. As such, the financial statements should reflect the change in estimate at the time that the new information was available. Retrospective application would make it appear that management had this information all along. Therefore, prospective application is the most faithful to the economic reality of the situation. Accounting for changes in estimates retrospectively and combining that information with financial statements that included the results of decisions made in real time could cause financial statement users to come to incorrect conclusions about the company's ability to anticipate business changes.
Number of Estimates
When financial statements are constructed, they often include estimates. If estimation wasn't allowed, companies would be in a constant fit of recalling and re-releasing financial statements. This would be an undue burden on the company and could provide information overload to investors. If the purpose of financial statements is to communicate relevant and timely information to investors, then sacrifices must be made as far as accuracy is concerned. Management's best guesses, updated going forward, provide a reasonable base for conclusion on the economic situation of the company.
Errors in the financial statements are accounted for retrospectively to bring the financial statements back to where they should have been had the error not been committed. This has the effect of correcting financial statements and reinforcing that it is in the company's best interest to spend the time to get the financial statements correct the first time, because going back and correcting the error would be both costly and, potentially, embarrassing.