IAS 8 - Accounting Policies, Changes in Accounting Estimates and Errors (detailed review)

Objective

This standard purports to enhance and maintain the reliability and comparability of financial statements by providing guidelines for the selection and application of accounting policy, treatment of change in accounting policy and accounting estimates along with the guidance for the correction of errors. It also provides the related disclosure requirements required by the entity.

Scope

The requirements of this standard are applicable for the selection and application of accounting policy, treatment of change in accounting policy and accounting estimates along with the accounting for the correction of errors related to previous periods.

Definition

Accounting Policies

The rules, practices, bases and principles adopted by the entity in the preparation and presentation of financial statements are termed as accounting policy

Change in Accounting Estimate

It is the adjustment in the carrying value of an asset or liability as a result of review, of the current status, of the estimated future economic benefits and obligations related to the asset and liability.
Accounting estimates changes due to the availability of new and advanced information
or developments.

International Financial Reporting Standards (IFRSs)

These are accounting standards and related Interpretations, which are issued and regulated by the International Accounting Standards Board (IASB) and these encompasses:

• International Financial Reporting Standards (IFRS)
• International Accounting Standards (IAS)
• Interpretations issued by IFRIC and
• Interpretations issued by SIC

Material

The omission or misstatement of the information is considered as material, if it can, individually or collectively, effect the economic decision of the users taken on basis of the financial statements.  The information can be material by size, or nature.

Prior Period Errors

It is defined as the omissions and misstatements in the financial statements of an entity, in one or more previous accounting periods, which occurs due to failure of use of information:

• Which was available when financial statements of such accounting periods were prepared or
• Which could be available if certain procedure would have applied

This may comprise the numerical mistakes, misapplication of accounting policies, or misinterpretations of circumstances, and fraud.

Retrospective Application

It is the application of new accounting policy to the related events and transactions, such that new accounting policy had always been in application.

Retrospective Restatement

It is the correction of amounts of elements of financial statements related to recognition and measurement, such that if a previous period error had never taken place

Prospective Application

It is the application of change in accounting policy and change in an accounting estimate, to the related events and transactions after the date when the accounting policy is changed and incorporating the effect of change in accounting estimate in the current and future accounting periods.

Impracticable

if the entity is unable to apply a particular requirement of the standard, making every reasonable effort, such a situation is termed as impracticable such as when the effects of the retrospective application or restatement are not determinable

Accounting Policy

Selection and Application of Accounting Policy

The entity should consider the following guidelines for the selection and application of accounting policy for all events and transactions:

1) First the entity should refer to the relevant Standards and Interpretations issued by the IASB

2) If the guidelines for the selection and application of accounting policy are not available in the related standards and interpretations issued by IASB, for the particular event and transaction, then management is required to use its own judgment in the selection and application of accounting policy for such an event or transaction.

However, such a policy should not be in conflict with the qualitative characteristics of financial statements and should be in compliance with those qualitative characteristics given in the IASB’s frame work. The entity can use the guidance available from the following sources:

• Information available in other IFRS dealing with the similar issues
• Definition of asset, liability, income and expense given in the IASB’s frame work
• Recognition and measurement rules given in the IASB’s frame work
• Documents of other accounting standard boards
• Industry practices

This standard requires that the entity should apply the selected accounting policy consistently from one period to the next for similar events and transactions, to enable the users of financial statements in evaluation of the financial performance and position of the entity over the different periods.

Change in Accounting Policy

The entity should not change the selected accounting policy for the similar events and transactions, as it would affect the comparability of financial statements. However, the accounting policy can be change only in the following circumstance:

• When the change in accounting policy is required by an IFRS
• When management believes that change in accounting policy would result in more relevant and reliable information being reflected in financial statements

Accounting for the Change in Accounting Policy

The entity will account for the change in accounting policy in the circumstance in which change in accounting policy is allowed, as follows:

• If the change in accounting policy arises, when an IFRS requires then such change in accounting policy will be accounted for as per the transitional provision given in the that standard i.e. the relevant standard will specify how to account for the change in accounting policy, either it will have prospective application or retrospective application. However, if the relevant standard, requiring the change in accounting policy does not specify that how to account for the change in accounting policy, then such change in accounting policy will have retrospective application

• If the change in accounting policy arises, when the management believes that the change in accounting policy would result in more relevant and reliable information being reflected in financial statements, then such change in accounting policy will also have retrospective application

• However, following situations do not constitute to the change in accounting policy:

i) The selection and application of a new accounting policy for the events and transactions which have never occurred in the past, such as first time receipt of government grant and

ii) The selection and application of a new accounting policy for the events and transactions which are different in substance from events and transactions occurring before

The change in the above mentioned circumstances (i) and (ii) will not be treated as the change in accounting policy therefore, it will have prospective application in such circumstances.

• The measurement from cost to revaluation model of the property, plant and equipment under IAS 16 and intangible assets under IAS 38 is a change in accounting policy, but it will be accounted for as per the requirements of those standards, rather than IAS 8.

Retrospective Application

When the entity is required to apply the change in accounting policy as retrospectively, the entity will apply the accounting policy to the related events and transactions, such that new accounting policy had always been in application. It will be accounted for as follows:

a) The entity will adjust the effect of the change in accounting policy retrospectively to the extent it is possible to determine the effect of change in accounting policy in respect of the previous periods i.e. the entity is required to apply the new accounting policy in the previous periods as far back as possible.

For this purpose, the entity will apply the new accounting policy to the carrying values of related assets and liabilities as at the start of the earliest accounting period, to which retrospective application is possible, that may be the current accounting period and the resulting adjustment will be made to the retained earnings, as follows:

• If the effect of change in accounting policy relates to previous period only, the entity will restate the balances of related asset or liability in the previous period and a corresponding adjustment in the opening retained earnings of current year

• If the effect of change in accounting policy relates to prior accounting periods than the previous accounting period then the adjustment will be made in the opening retained earnings of the comparative year and the entity will also restate the balances of related assets or liabilities

b) If it is not possible to determine the period specific effect or cumulative effect of change in accounting policy in respect of the previous periods then, the entity will apply the new accounting policy from the start of the earliest accounting period from which it is practicable to do so.

Disclosures

The entity is required to disclose the following related to the accounting policy:

If the change in accounting policy arises, when an IFRS requires the entity will disclose:

• The title of the standard
• The details of in change in accounting policy
• The details of transitional provision given (if any) by the standard to account for change in accounting policy
• The effect of transitional provision upon the future periods (if any)
• The amount of adjustment related to the current year and prior periods due to the change in accounting policy
• The details of the circumstances if the retrospective applications became impracticable due to the period specific affect or cumulative effect of the previous periods

If the change in accounting policy arises, when management believes that change in accounting policy would result in more relevant and reliable information being reflected in financial statements, the entity will disclose the following:

• The details of in change in accounting policy
• The reason how the change will reflect the more relevant and reliable information
• The amount of adjustment related to the current year and prior periods due to the change in accounting policy
• The details of the circumstances if the retrospective applications became impracticable due to the period specific affect or cumulative effect of the previous periods

If the entity is not applying a standard which ahs been issued but not yet effective, the entity will disclose the following:

• The title of the standard
• Its effective date specified in that standard
• The date when entity intends to apply such standard

Accounting Estimates

These are the judgments or assumptions taken by the entity because of uncertainties attaching to the business circumstances in order to determine the carrying value of an asset or liability in the financial statements. It includes the estimation of:

• Useful life
• Residual Value
• Depreciation Method
• Fair Value
• Net Realizable Value
• Provisions

Change in Accounting Estimates

It is the adjustment in the carrying value of an asset or liability as a result of review, of the current status, of the estimated future economic benefits and obligations related to the asset and liability.
Accounting estimates changes due to the availability of new and advanced information
or developments.

Accounting for Change in Accounting Estimate

The standard requires the entity to account for the change in accounting estimate prospectively i.e. it will be applied in the year of change if it affects the current year only, in the current and future years, if it affects the both.

Disclosures

The entity is required to disclose the details and the effect of change in accounting estimate related to the current and future years both.

Prior Period Error

It is defined as the omissions and misstatements in the financial statements of an entity, in one or more previous accounting periods, which occurs due to failure of use of information:

• Which was available when financial statements of such accounting periods were prepared or
• Which could be available if certain procedure would have applied

This may comprise the numerical mistakes, misapplication of accounting policies, or misinterpretations of circumstances, and fraud.

Accounting for Error

The entity will correct the effect of the error by retrospective restatement such as error has never occurred, to the extent it is possible to do so, as follows:

• If the error has occurred in previous period, by restating the balances in the comparative year corresponding adjustment to the opening retained earnings, of the current year

• If the error relates to the accounting period preceding the previous accounting periods, by restating the carrying values of related asset or liability along with a corresponding adjustment to the opening retained earnings, of the comparative year

If it is not possible to determine the period specific effect or cumulative effect of an error in respect of the previous periods then, the entity will restate the balances from the start of the earliest accounting period from which it is practicable to do so.

Disclosures

The entity is required to disclose the following in respect of the prior period error;

• The details of the error
• The amount of adjustment made at the start of the current or comparative year in respect of correction of error
• The details of the circumstances if the retrospective applications became impracticable due to the period specific affect or cumulative effect of the previous periods

 

Worked Examples

Example 1

AB Ltd is engaged in a manufacturing business. Up to year ended 31 December 2010 the entity was using first in first out method (FIFO) method for the valuation of inventory, but in the current year ended 31 December 2011, the director of the entity has decided to use the average costing method as they believe that this will reflect more relevant value of the inventory and as a result the entity has identified the following impact upon the value of inventory due to the change in the valuation method:

Years	Inventory increased by
	$
31 December 09	20,000
31 December 10	30,000
31 December 11	40,000

The statements of profit or loss of the current and previous year before the adjustments were:

Years	31.12.11	31.12.10
	$	$
Revenue	500,000	400,000
Cost of Sale	(200,000)	(160,000)
Gross profit	300,000	240,000
Operating Expenses	(170,000)	(130,000)
Net profit	130,000	110,000

                                                                           
The retained earnings of AB ltd were $600,000 at 31 December 2009
Required:

Redraft the statement of profit or loss and prepare the retained earnings column of the statement of changes in equity for both of the years 31 December 2010 and 31 December 2011

Solution:

As the change in the valuation method of the inventory is change in accounting policy, it will be applied retrospectively from the year of change as follows:

For each of the year, the cost of sale will decrease by $10,000 due to increase in closing and opening stock as follows:

Years	31.12.11	31.12.10 (restated)
	$	$
Revenue	500,000	400,000
Cost of Sale	(190,000)	(150,000)
Gross profit	310,000	250,000
Operating Expenses	(170,000)	(130,000)
Net profit	140,000	120,000

Statement of Changes in Equity
For the year ended 31.12.11

Years	Retained Earning
	$
Balance as at 01.01.2010	600,000
Effect of change in policy	20,000
Restated balance at 01.01.2010	620,000
Profit for the year 31.12.2010	120,000
Balance at 31.12.2010	740,000
Profit for the year 31.12.2011	140,000
Balance at 31.12.2011	880,000

Example 2

AB Ltd purchased a plant for $160,000 on 1 January 2007, which has a useful life of 8 years. However, on 1 January 2009, the entity’s engineer reported that plant has a useful life of only 2 years.

Required:

How the change in useful life of the plant will be accounted for in the financial statements of AB Ltd for the year ended 31 December 2009.

Solution:
 
As the change in useful life of the plant is a change in accounting estimate, it will be applied prospectively from the year of change as follows:

Statement of Profit or Loss	31.12.09
	$
Depreciation Expense	(60,000)

 

Statement of Financial Position	31.12.09
	$
Assets:	-
Non-current Assets:	-
Plant (Working)	60,000

 

Working:

Statement of Financial Position	31.12.09
	$
Cost at 01.01.2007	160,000
Less: Accumulated Depreciation ($160,000 – 0 / 8 yrs) × 2 yrs	(40,000)
C.V at 01.01.2009	120,000
Less: Current Year ($120,000 – 0 / 2 yrs)	(60,000)
C.V at 31.12.2009	60,000