Chapter 4 Accounting Policies, accounting estimates and errors PDF

Chapter 4 Accounting policies, accounting estimates and errors Introduction The purpose of this chapter is to explain the main features of international standard IAS8 Accounting Policies, Changes in Accounting Estimates and Errors. This standard lays down criteria for the selection of acco...

Chapter 4 Accounting policies, accounting estimates and errors Introduction The purpose of this chapter is to explain the main features of international standard IAS8 Accounting Policies, Changes in Accounting Estimates and Errors. This standard lays down criteria for the selection of accounting policies and prescribes the circumstances in which an entity may change an accounting policy. The standard also deals with the accounting treatment and disclosure of changes in accounting policies, changes in accounting estimates and corrections of prior period errors. Objectives By the end of this chapter, the reader should be able to: define the term "accounting policy" and explain how an entity should select its accounting policies explain the circumstances in which an entity may change an accounting policy account for a change in an accounting policy and list the disclosures which must be made when an accounting policy is changed explain what is meant by an accounting estimate and account for a change in an accounting estimate define the term "prior period error" account for the correction of a prior period error and list the disclosures which must be made when a prior period error is corrected. Accounting policies IAS8 defines accounting policies as "the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements". The use 61 PART 1: Introduction to Financial Reporting of the word "policies" suggests that entities are allowed to choose between alternative accounting treatments. However, some of an entity's accounting policies will be dictated by an international standard which permits no choice of treatment. For instance: (a) IAS2 Inventories requires that inventories are measured at the lower of cost and net realisable value (see Chapter 10). (b) IAS37 Provisions, Contingent Liabilities and Contingent Assets prevents entities from recognising contingent assets and liabilities (see Chapter 12). (c) IAS38 Intangible Assets prevents entities from recognising internally-generated goodwill in their financial statements (see Chapter 6). But some standards do permit a choice. For instance: (a) IAS2 Inventories allows the cost of "interchangeable" inventory items to be assigned by using either the first-in, first out (FIFO) cost formula or the weighted average cost formula (see Chapter 10). (b) IAS16 Property, Plant and Equipment allows items of property, plant and equipment to be measured using either the cost model or the revaluation model (see Chapter 5). (c) Similarly, IAS38 Intangible Assets allows intangible assets to be measured using either the cost model or the revaluation model (see Chapter 6). International standard IAS1 (see Chapter 3) requires entities to disclose their significant accounting policies in the notes which form a part of the financial statements. Guidance on the selection of accounting policies is given in IAS8. Selection of accounting policies IAS8 provides the following guidance on the selection of accounting policies: (a) If an international standard (or IFRIC Interpretation made by the IFRS Interpretations Committee) specifically applies to an item, the accounting policy which is applied to that item should be determined by applying the relevant standard or interpretation. (b) If there is no international standard or interpretation which specifically applies to the item concerned, management should use its judgement in selecting an accounting policy that results in information which is relevant and provides a faithful represent- ation (see Chapter 2). In making this judgement, management should refer to: (i) the guidance provided by international standards and interpretations which deal with similar and related issues (ii) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses given in the IASB Conceptual Framework. Management may also consider the pronouncements of other standard-setting bodies with a similar conceptual framework to the IASB Conceptual Framework and may refer to accounting literature and accepted industry practices, as long as these do not conflict with international standards, interpretations or the Conceptual Framework. 62  CHAPTER 4: Accounting Policies, Accounting Estimates and Errors IAS8 also stresses the need for the consistent application of accounting policies. Having selected an accounting policy in relation to an item, that policy should be applied consistently to all similar items. Changes in accounting policies IAS8 allows an entity to change one of its accounting policies only if the change: (a) is required by an international standard or IFRIC Interpretation; or (b) results in the financial statements providing reliable and more relevant information than would be the case if the accounting policy were not changed. The users of financial statements need to be able to compare an entity's financial statements from one accounting period to another. Therefore the same accounting policies should be used from one period to the next unless the above conditions are satisfied. Accounting for a change in accounting policy If a change in accounting policy results from the initial application of an international standard or IFRIC Interpretation, the change should be accounted for in accordance with the transitional provisions (if any) which are provided in that standard or interpretation. However, if there are no transitional provisions or if the change in policy has been made voluntarily so as to improve the relevance of the financial statements, IAS8 requires that the change should be accounted for retrospectively. This entails the following steps: (a) Comparative figures for the previous period (or previous periods if comparatives are provided for more than one period) must be adjusted and presented "as if the new accounting policy had always been applied". (b) The opening balance of each affected component of equity (usually retained earnings) must be adjusted. This adjustment takes place in the statement of changes in equity. Retrospective application maintains comparability between accounting periods and this approach must usually be adopted unless it is impracticable to do so. An important exception to this requirement arises in the case of property, plant and equipment (IAS16) and intangible assets (IAS38) where an entity changes from the cost model to the revaluation model. In this case, the international standards require that the change is accounted for prospectively rather than retrospectively (see Chapters 5 and 6). Additional comparative information to be presented An entity which accounts for a change in an accounting policy retrospectively must present a restated statement of financial position as at the beginning of the previous period (unless the change in policy does not have a material effect on that statement). If the entity normally provides comparative figures for the previous period only, this represents an additional requirement. 63 PART 1: Introduction to Financial Reporting EXAMPLE 1 A company began trading on 1 January 2017, preparing accounts to 31 December each year. As at 31 December 2019, the company adopted a new accounting policy with regard to the measurement of inventories. If the new policy had been applied in previous years, the company's inventory at 31 December 2017 would have been £150,000 higher than the amount originally calculated. Similarly, the inventory at 31 December 2018 would have been £400,000 higher than the amount originally calculated. An extract from the draft statement of comprehensive income for the year to 31 December 2019 (before accounting retrospectively for the change in accounting policy) is as follows: 2019 2018 £000 £000 Profit before taxation 2,600 1,900 Taxation 520 380 ––––– ––––– Profit after taxation 2,080 1,520 ––––– ––––– Retained earnings were originally reported to be £2,360,000 on 31 December 2018. No dividends were paid in any year. It may be assumed (for the sake of simplicity) that the company's taxation expense is always equal to 20% of its profit before tax. (a) Rewrite the extract from the company's statement of comprehensive income for the year to 31 December 2019, showing restated comparative figures for 2018. (b) Prepare an extract from the company's statement of changes in equity for the year to 31 December 2019, showing changes to retained earnings. Solution (a) If the new accounting policy had always been applied, opening inventory for the year to 31 December 2019 would have been £400,000 higher. This would have caused an increase of £400,000 in cost of sales for the year and a decrease of £400,000 in pre- tax profits. Similarly, pre-tax profits for the year to 31 December 2018 would have been increased by £400,000 but reduced by £150,000, giving an overall increase of £250,000. Therefore the extract from the company's statement of comprehensive income for the year to 31 December 2019 is as follows: (restated) 2019 2018 £000 £000 Profit before taxation 2,200 2,150 Taxation 440 430 ––––– ––––– Profit after taxation 1,760 1,720 ––––– ––––– These figures show an increase in profit between 2018 and 2019 of approximately 2%, whereas the original figures (which were distorted by the change in accounting policy) suggested incorrectly that profit had risen by nearly 37%. 64  CHAPTER 4: Accounting Policies, Accounting Estimates and Errors (b) Profit after tax for 2018 was originally stated to be £1,520,000. The restated figure (see above) is £1,720,000, an increase of £200,000. Profit after tax for 2017 would have been £150,000 higher if the new accounting policy had always been applied. The tax liability would have increased by £30,000 (20% of £150,000) and so profit after tax would have been £120,000 higher. In total, therefore, retained earnings at 31 December 2018 would have been £320,000 higher if the new accounting policy had always been applied. The extract from the statement of changes in equity for the year to 31 December 2019 is as follows: Retained earnings £000 Balance b/f as originally stated 2,360 Change in accounting policy 320 –––––– Restated balance 2,680 Profit for the year 1,760 –––––– Balance c/f 4,440 –––––– If the change in accounting policy had not been accounted for retrospectively, the retained earnings figure at 31 December 2019 would still have been £4,440,000 (£2,360,000 + £2,080,000). However, the distribution of earnings over the three years concerned would have been different and misleading. Disclosure of a change in accounting policy The main disclosures required on a change in accounting policy are as follows: (a) for a change in accounting policy caused by the initial application of an international standard or IFRIC Interpretation: – the title of the relevant standard or interpretation and (if applicable) the fact that the change has been accounted for in accordance with transitional provisions and a description of those provisions (b) for a voluntary change in accounting policy: – the reasons which suggest that application of the new policy will provide reliable and more relevant information (c) for all changes in accounting policy: – the nature of the change – for the current period and for each prior period presented, the amount of the adjustment made to each affected item in the financial statements and the amount of any adjustment to the entity's earnings per share (see Chapter 23) – if retrospective application of the new policy has proved to be impracticable, a description of the circumstances that have led to this condition and a description of how (and from when) the change in policy has been applied. 65 PART 1: Introduction to Financial Reporting Accounting estimates IAS8 states that "many items in financial statements cannot be measured with precision but can only be estimated". Estimates may be required in relation to items such as doubtful receivables, the useful lives of depreciable assets, the net realisable value of inventories and so forth. IAS8 also states that "the use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability". By definition, estimates cannot be precise. Therefore an estimate made in the past may need to be revised if changes occur to the conditions on which the original estimate was based or if new information becomes available. For instance, if new information is received concerning the solvency of a customer, a trade receivable which was previously estimated to be 50% collectible might now be estimated as being only 25% collectible. IAS8 requires an entity which changes an accounting estimate to account for the change prospectively, not retrospectively. This means that the effect of the change should be dealt with in the entity's financial statements for the current period and (if applicable) future periods. But the standard does not require (or permit) the restatement of comparative figures for prior periods. This is totally different from the required treatment of changes in accounting policy. If it is difficult to distinguish a change in an accounting policy from a change in an accounting estimate, IAS8 requires that the change concerned should be treated as a change in an accounting estimate. Disclosure of changes in accounting estimates IAS8 requires disclosure of the nature and amount of a change in an accounting estimate which has an effect in the current period or is expected to have an effect in future periods. However, this requirement is subject to the materiality rule in IAS1. This rule states that a specific disclosure required by a standard or IFRIC Interpretation need not be provided "if the information resulting from that disclosure is not material" (see Chapter 3). Prior period errors Financial statements do not comply with international standards if they contain material errors. Potential errors may be discovered before the financial statements are finalised, in which case they can be corrected before the statements are authorised for issue. However, it is possible that an error may not be detected until a subsequent accounting period. Such an error is referred to as a "prior period error". IAS8 defines prior period errors as "omissions from, and misstatements in, the entity's financial statements for one or more prior periods arising from a failure to use, or misuse of, reliable information that: (a) was available when financial statements for those periods were authorised for issue; and 66  CHAPTER 4: Accounting Policies, Accounting Estimates and Errors (b) could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those financial statements". Such errors could be caused by mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretations of facts or by fraud. IAS8 requires that material prior period errors should be corrected retrospectively. The approach is similar to that adopted for a change in accounting policy and involves: (a) restating comparative figures for the prior period(s) in which the error occurred, or (b) if the error occurred before the earliest prior period for which comparatives are presented, restating the opening balances of assets, liabilities and equity for the earliest prior period presented. In any case, an entity which corrects a prior period error retrospectively must present a statement of financial position as at the beginning of the previous period (unless the correction of the error does not have a material effect on that statement). EXAMPLE 2 Whilst preparing its financial statements for the year to 31 December 2019, a company discovers that (because of an arithmetic error) its inventory at 31 December 2018 was overstated by £50,000. This is a material amount. An extract from the company's draft statement of comprehensive income for the year to 31 December 2019 (before correcting the error) shows the following: 2019 2018 £000 £000 Sales 940 790 Cost of goods sold 750 540 –––– –––– Gross profit 190 250 Other expenses 120 110 –––– –––– Profit before taxation 70 140 Taxation 14 28 –––– –––– Profit after taxation 56 112 –––– –––– Retained earnings were originally reported to be £382,000 on 31 December 2018. No dividends were paid in any year. It may be assumed that the company's taxation expense is always equal to 20% of its profit before tax. (a) Prepare an extract from the company's statement of comprehensive income for the year to 31 December 2019, showing restated comparative figures for 2018. (b) Prepare an extract from the company's statement of changes in equity for the year to 31 December 2019, showing changes to retained earnings. 67 PART 1: Introduction to Financial Reporting Solution (a) The extract from the statement of comprehensive income for the year to 31 December 2019 is as follows: (restated) 2019 2018 £000 £000 Sales 940 790 Cost of goods sold 700 590 –––– –––– Gross profit 240 200 Other expenses 120 110 –––– –––– Profit before taxation 120 90 Taxation 24 18 –––– –––– Profit after taxation 96 72 –––– –––– (b) The retained earnings column of the statement of changes in equity for the year to 31 December 2019 is as follows: £000 Balance b/f as originally stated 382 Correction of prior period error (72 – 112) (40) –––– Restated balance 342 Profit for the year 96 –––– Balance c/f 438 –––– Note: Retrospective adjustment of the prior period error reveals that profits after tax have risen in 2019. If the comparatives for 2018 had not been restated, the financial statements would have given the incorrect impression that profits after tax had fallen during 2019. Disclosure of prior period errors When an entity corrects a material prior period error, IAS8 requires that the following disclosures should be made in the notes to the financial statements: (a) the nature of the prior period error (b) for each prior period presented, the amount of the correction to each affected line item in the financial statements and, if applicable, the amount of any correction to the entity's earnings per share (see Chapter 23) (c) the amount of the correction at the beginning of the earliest prior period presented (d) if retrospective restatement is impracticable for a particular prior period, a description of the circumstances that have led to this condition and a description of how (and from when) the error has been corrected. 68  CHAPTER 4: Accounting Policies, Accounting Estimates and Errors Summary ! IAS8 deals with accounting policies, changes in accounting estimates and the correction of prior period errors. ! Accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting its financial statements. ! IFRS Standards issued by the IASB do not generally permit any choice of accounting treatment but some of the IAS Standards which were adopted by the IASB on its inception do offer a choice. Therefore an entity's accounting policies will usually be a mixture of policies required by standards and policies chosen by the entity. ! IAS8 provides guidance on the selection of accounting policies. ! Accounting policies should be applied consistently and should be changed only if the change is required by an international standard or IFRIC Interpretation, or if it results in reliable and more relevant information. ! A change in accounting policy should be accounted for retrospectively. This involves restating comparative figures for each prior period presented. Details of the change must be disclosed in the notes to the financial statements. ! A change in an accounting estimate should be accounted for prospectively and (if material) disclosed in the notes to the financial statements. ! Material prior period errors should be accounted for retrospectively and disclosed in the notes to the financial statements. Exercises A set of multiple choice questions for this chapter is available on the accompanying website. 4.1 (a) Distinguish between accounting policies and accounting estimates. (b) Explain how a change in an accounting policy should be accounted for. (c) Explain how a change in an accounting estimate should be accounted for. 4.2 (a) Explain how an entity should select its accounting policy in relation to an item if there is no applicable international standard or IFRIC Interpretation. (b) In what circumstances may an entity change one of its accounting policies? 4.3 List the disclosures which must be made if an accounting policy is changed. 4.4 (a) Explain what is meant by a "material prior period error" and explain how such an error should be corrected. (b) List the disclosures required when a material prior period error is corrected. 69 PART 1: Introduction to Financial Reporting 4.5 H Ltd began trading on 1 January 2016, preparing financial statements to 31 December each year. During 2019, the company decided to change its accounting policy with regard to one of its operating expenses. Total operating expenses calculated using the previous accounting policy and shown in the company's financial statements for the first three years of trading were as follows: £000 year to 31 December 2016 240 year to 31 December 2017 260 year to 31 December 2018 290 –––– 790 –––– If the new accounting policy had been applied in previous years, the total operating expenses would have been: £000 year to 31 December 2016 390 year to 31 December 2017 310 year to 31 December 2018 230 –––– 930 –––– Furthermore, the company's liabilities at 31 December 2018 would have been higher by £140,000 (£930,000 – £790,000). A summary of the company's statement of comprehensive income for the year to 31 December 2019 (before adjusting comparative figures to reflect the change in accounting policy) shows the following: 2019 2018 £000 £000 Profit before operating expenses 1,510 1,450 Operating expenses 190 290 ––––– ––––– Profit before taxation 1,320 1,160 Taxation 264 232 ––––– ––––– Profit after taxation 1,056 928 ––––– ––––– Retained earnings were originally reported to be £2,371,000 on 31 December 2018. No dividends have been paid in any year. It may be assumed that the company's tax expense is always equal to 20% of the profit before taxation. Required: (a) Rewrite the extract from the statement of comprehensive income so as to reflect the change in accounting policy, in accordance with the requirements of IAS8. (b) Prepare an extract from the company's statement of changes in equity for the year to 31 December 2019, showing changes to retained earnings. 70  CHAPTER 4: Accounting Policies, Accounting Estimates and Errors 4.6 Whilst preparing its financial statements for the year to 30 June 2020, a company dis- covers that (owing to an accounting error) the sales figure for the year to 30 June 2019 had been understated by £100,000. Trade receivables had been understated by the same amount. This error is regarded as material. An extract from the company's draft statement of comprehensive income for the year to 30 June 2020, before correcting this error, is as follows: 2020 2019 £000 £000 Sales 1,660 1,740 Cost of goods sold 670 730 ––––– ––––– Gross profit 990 1,010 Expenses 590 560 ––––– ––––– Profit before taxation 400 450 Taxation 80 90 ––––– ––––– Profit after taxation 320 360 ––––– ––––– The additional trade receivables of £100,000 are still outstanding at 30 June 2020. The sales figure for the year to 30 June 2020 shows only the sales revenue for that year and does not include the sales of £100,000 which were omitted from the previous year's financial statements. Retained earnings at 30 June 2019 were originally reported as £1,220,000. No dividends were paid during the two years to 30 June 2020. It may be assumed that the company's tax expense is always equal to 20% of the profit before taxation. Required: (a) Revise the extract from the statement of comprehensive income for the year to 30 June 2020, showing restated comparative figures for the year to 30 June 2019. (b) Prepare an extract from the company's statement of changes in equity for the year to 30 June 2020, showing changes to retained earnings. 71 PART 1: Introduction to Financial Reporting *4.7 J Ltd has been trading for many years, preparing financial statements to 31 March each year. As from 1 April 2019, the company decided to adopt a new accounting policy in relation to revenue recognition. If this policy had been adopted in previous years, the company's revenue for the year to 31 March 2018 would have been £350,000 higher than previously reported and trade receivables at 31 March 2018 would also have been £350,000 higher. Revenue for the year to 31 March 2019 would have been £600,000 higher than previously reported and trade receivables at 31 March 2019 would have been £950,000 higher. There would have been no effect in any earlier year. An extract from the company's draft statement of comprehensive income for the year to 31 March 2020 (with comparatives for 2019 as originally stated) is as follows: 2020 2019 £000 £000 Revenue 5,200 4,800 Operating expenses 4,100 3,900 ––––– ––––– Profit before taxation 1,100 900 Taxation 220 180 ––––– ––––– Profit after taxation 880 720 ––––– ––––– The draft financial statements for the year to 31 March 2020 show only the revenue for that year (measured in accordance with the new accounting policy) and have not been adjusted to include the additional revenue of £950,000 from previous years which now needs to be accounted for. The company's taxation expense is always equal to 20% of its profit before taxation. No dividends were paid during the two years to 31 March 2020 and retained earnings at 31 March 2019 were originally reported to be £1,605,000. Required: (a) Explain the circumstances in which a company which complies with international standards may change an accounting policy. Also explain how such a change is accounted for in accordance with the requirements of IAS8. (b) Revise the extract from the statement of comprehensive income for the year to 31 March 2020 (with comparatives for 2019). (c) Prepare an extract from the company's statement of changes in equity for the year to 31 March 2020, showing changes to retained earnings. (d) Explain why the revised statement of comprehensive income is an improvement on the draft statement. 72 Part 2 FINANCIAL REPORTING IN PRACTICE