The Framework for the Preparation and Presentation of Financial Statements, published by the IASB, identifies “comparability” as one of the four qualitative characteristics of financial statements. The Framework recognises the importance of comparing both the financial statements of an entity from one period to another as well as the financial statements of other entities. This comparison is needed in order to compare and contrast financial performance, financial position and changes in financial position.
IAS 8 deals with selecting and changing accounting policies, accounting estimates and errors. Its main objectives are to:
- Enhance the relevance and reliability of financial statements
- Ensure comparability of the financial statements of an entity over time as well as with financial statements of other entities.
Accounting policies are the specific principles, bases, conventions, rules and practices adopted by an entity in preparing and presenting financial statements.
A change in accounting estimate is an adjustment to the carrying amount of an asset or liability or the amount of the periodic consumption of an asset that results from the assessment of the present status of, and expected future benefits and obligations associated with assets and liabilities. Changes in accounting estimates result from new information or new developments and, accordingly, are not correction of errors.
Prior period errors are omissions from, and misstatements in, the entities financial statements from one or more periods arising from a failure to use, or misuse of, reliable information that:
- Was available when financial statements for those periods were authorised for issue, and
- Could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those financial statements
These errors include:
- Effects of mathematical mistakes
- Mistakes in applying accounting policies
- Misinterpretation of facts
Retrospective application is applying a new accounting policy to transactions, other events and conditions as if the policy had always been applied
Retrospective restatement is correcting the recognition, measurement and disclosure of amounts of elements of financial statements as if a prior period error had never occurred
Prospective application of a change in accounting policy and of recognising the effect of a change in accounting estimate, respectively, is:
- Applying the new accounting policy to transactions, other events and conditions occurring after the date as at which the policy is changed, and
- Recognising the effect of the change in the accounting estimate in the current and future periods affected by the change.
The existence and proper application of accounting policies are central to the proper understanding of the information contained in the financial statements, as prepared by management. A clear outline of all significant accounting policies used in the preparation of financial statements should be provided in all cases. This is especially important in situations where alternative treatments, permissible under certain IFRS, are possible. Failure to outline the accounting policy pursued by the entity in such a situation would compromise the ability of users of the financial statements to make relevant comparisons with other entities.
Accounting policies are determined by applying relevant IFRS or IFRIC and considering any relevant implementation guidance issued by the IASB.
Where there is no IFRS or Interpretation that addresses a specific transaction, event or condition, then management should exercise judgement in developing and applying an accounting policy that results in information that is relevant and reliable.
Reliable information should:
- Represent faithfully the financial position, financial performance and cash flows
- Reflect the economic substance of transactions, other events and conditions
- Be neutral
- Be prudent
- Be complete in all material respects
In this regard, when exercising such judgement, management should refer to (in this order):-
- The requirements and guidance of the IFRS’s and IFRIC’s dealing with similar and related issues
- The definitions, recognition criteria and measurement concepts for assets, liabilities and expenses in the framework
Furthermore, management can also consider (to the extent that they do not conflict with IASB standards and the Framework):
- Recent pronouncements of other standard setting bodies that use a similar conceptual framework to develop standards,
- Other accounting literature
- Accepted industry practices
CHANGES IN ACCOUNTING POLICIES
It is important for users of financial statements to be able to compare the financial statements of an entity over a period of time in order to identify trends and patterns in its financial position, financial performance and cash flows. Thus, it is important that there is consistency in the treatment of items from period to period. To help facilitate this, the same accounting policies are adopted in each period unless a change in these policies is merited.
The IAS restricts the instance in which a change in accounting policy is permissible. An entity should change an accounting policy only if the change
- Is required by a Standard or an interpretation; or
- Results in a more appropriate presentation of events or transactions in the financial statements, that is the financial statements will provide relevant and more reliable information to the user of the accounts
The standard highlights two types of event that do not result in the change of an accounting policy:
- The application of an accounting policy for transactions, other events or conditions that differs in substance from those previously occurring
- The application of a new accounting policy for transactions, other events or conditions that did not occur previously or were immaterial.
In the case of non-current tangible fixed assets, a move to revaluation accounting will not result in a change of accounting policy under IAS 8 but a revaluation as per IAS 16.
If a change in accounting policy is required by a Standard or Interpretation, then any transitional arrangements contained therein must be followed. If no such transitional arrangements are provided or an accounting policy is being changed voluntarily, the change in accounting policy must be adopted “retrospectively”. This means that the new policy is applied to transactions, other events and conditions as if the policy had always been applied.
(Prospective application is not allowed unless it is impracticable to determine the cumulative effect).
This consequently means that the comparatives presented in the financial statements must also be restated, as if the new policy had always been applied. The impact of the new policy on retained earnings prior to the earliest period presented should be adjusted against the opening balance of retained earnings.
The following disclosures are required for a change in an accounting policy:- 1. Reason for the change
- Amount of the adjustment for the current period and for each period presented
- Amount of the adjustments required for the periods prior to those disclosed in the financial statements
- The fact that comparative information has been restated
The entity should also disclose the impact of new IFRS that have been issued but have not yet come into force.
LIMITATIONS OF RETROSPECTIVE APPLICATION
If it is considered impracticable to determine either the period-specific effects or the cumulative effects of a change in accounting policy, then retrospective application of the change need not be made.
The Standard defines the term “impracticable” to mean the entity cannot apply it after making every effort to do so. For a particular period, it is impracticable to apply a change in accounting policy if:
- The effects of the retrospective application are not determinable
- The retrospective application requires assumptions about what management’s intentions would have been at the time; or
- The retrospective application requires significant estimates of amounts and it is impossible to distinguish objectively, from other information, information about those estimates that:
- Provides evidence of circumstances that existed at that time; and
- Would have been available at that time.
Therefore, when it is impracticable to apply a change in policy retrospectively, the entity applies the change to the earliest period to which it is possible to apply the change.
CHANGES IN ACCOUNTING ESTIMATES
Because of the uncertainties that form part of everyday business, there are many items contained in the financial statements that cannot be measured precisely and thus estimates are used for these items. This is due to uncertainties inherent in business activities. In arriving at an estimate, careful consideration is made of the latest reliable information that is available at the time.
Examples of accounting estimates include among other things:
- Useful lives of property, plant and equipment (and therefore depreciation)
- Inventory obsolescence
- Fair values of financial assets / liabilities
- Bad debts
- Some provisions, e.g. provision for warranty obligations
It is acknowledged that the use of reasonable estimates is an essential part of the preparation of financial statements and consequently does not undermine their reliability. By their nature, these estimates may have to be revised periodically if the circumstances on which the estimate is based have changed. Alternatively, new information may come to light or more experience may be acquired which may necessitate a change in previous estimates in order to preserve the reliability and relevance of the financial statements.
It is important, then, to realise that the revision of an estimate is not an error nor does it relate to prior periods.
The effect of a change in an accounting estimate should be included in the period of the change if the change affects that period only or the period of the change and future periods if the change affects both. Any corresponding changes in assets and liabilities, or to an item of equity, are recognised by adjusting the carrying amount of the asset, liability or equity item in the period of change.
So, the effect of a change in accounting estimate is recognised prospectively. Prospective recognition means that the change is applied from the date of change in estimate. Previous financial statements remain unaltered. For example, a change in the estimate of bad debts affects only the current period and therefore is recognised in the current period. But a change in the useful life of a depreciable asset affects the depreciation expense for the remainder of the current period and for the future periods during the assets remaining useful life.
The nature and the amount of the change in an accounting estimate should be disclosed, unless it would involve undue cost or effort. If this is the case, then this fact should be disclosed.
Note also that it can be difficult to distinguish between a change in an accounting policy and a change in an accounting estimate. In a case where such a distinction is problematical, then the change is treated as a change in accounting estimate, with appropriate disclosure.
CORRECTION OF PRIOR PERIOD ERRORS
It is also important to recognise the difference between the correction of an error and a change in an accounting estimate.
Errors can arise in recognition, measurement, presentation or disclosure of items in financial statements. If financial statements contain errors (material errors or intentional immaterial errors that achieve a particular presentation), then they do not comply with IFRS.
Remember, estimates are approximations that may need revision as more information becomes known. For example, the gain or loss on the outcome of a contingency that could not previously have been estimated reliably does not constitute an error.
A material prior period error is corrected retrospectively in the first set of financial statements authorised for issue after its discovery. The comparative amounts for the prior period(s) presented in which the error occurred are restated. This simply means that material errors relating to prior periods shall be corrected by restating comparative figures in the financial statements for the year in which the error is discovered, unless it is “impracticable” to do so (the strict definition of “impracticable”, mentioned earlier, applies).
IAS 1 (Revised) also requires that where a prior period error is corrected retrospectively, a statement of financial position must be provided at the beginning of the earliest comparative period.
Errors can normally be corrected through the income statement of the period when uncovered unless the errors are material. In the event that the errors uncovered relate to a previous period and they are classed as material, then it is necessary to correct them as a prior period adjustment.
Only where it is impracticable to determine the cumulative effect of an error on prior periods can an entity correct the error prospectively.
The following disclosures are required for errors uncovered:-
1. Nature of the prior period error
- For each period, the amount of the correction (for each line item affected and, where applicable, the basic and diluted earnings per share)
- The amount of the error at the beginning of the earliest prior period presented
- In retrospective restatement is impracticable for a particular prior period, the circumstances that led to the existence of that condition and a description of how and from when the error has been corrected. Subsequent periods need not repeat these disclosures.