AAT Articles

A Technical Summary of IAS 8

In this article Steven Collings takes a look at the main requirements of IAS 8 – Accounting Policies, Changes in Accounting Estimates and Errors.

Objective

The objective of IAS 8 – Accounting policies, changes in accounting estimates and errors is to establish a “benchmark” for a reporting entity to select and change its accounting policies which, in turn, deals with the accounting treatment and disclosure of changes within a reporting entity’s accounting policies and changes within its estimation techniques.

The standard itself is intended to enhance the relevance and reliability of an entity’s financial statements and the comparability of those financial statements over time and with the financial statements of other entities. The Framework, which the International Accounting Standards Board (IASB) has introduced, governs how financial statements are prepared and presented to ensure that financial statements are prepared in such a way to enable them to contain the following characteristics:

Relevance;
Reliability;
Comparability; and
Understandability.

This ensures that users of financial statements are able to make economic decisions about an entity. IAS 8 enhances these characteristics by setting a “benchmark” which management much use consistently when selecting their entity’s accounting policies.

Accounting Policies

Accounting policies are the specific principles, bases, conventions, rules and practices applied by a reporting entity in the preparation and presentation of their financial statements. For example, a reporting entity would normally have an accounting policy for the accounting of:

Fixed assets;
Depreciation;
Turnover;
Pension contributions (whether defined benefit or defined contribution);
Foreign currency transactions;
Hire purchase and leasing;
Financial instruments;
Warranties.

(Note the above list is not exhaustive and different entities will have different transactions which will result in different accounting policies).

In the absence of a Standard or an Interpretation that specifically applies to a transaction (or other event or condition), then management is to use its judgement in developing and applying an accounting policy that results in the information presented in the entity’s financial statements to achieve the four characteristics contained in “The Framework”. Note, IAS 8 always refers to the various characteristics a set of financial statements must contain.

It would be wreckless of an entity to adopt inappropriate accounting policies as the financial statements would not only mislead a user in making decisions about the financial position, financial performance and cash flows of an entity, but the financial statements would also fail to comply with IAS 8.

A company must select and apply its accounting policies consistently for similar transactions. For example, if a manufacturer of plastic-coated powder products had two products Product X and Product Y which are of a similar nature then it would be inappropriate to have Product X valued on a FIFO (first-in first-out) basis and Product Y valued on a weighted average basis. Both should be valued using the same basis, thus the accounting policy for both items of stock should be the same. If Product X and Product Y are of a dissimilar nature and function or a different class of stock, then it may well be appropriate to have two valuations attached to them. Note, however, under IAS 2 “Inventories” the use of LIFO (last-in first-out) is strictly prohibited giving only two possible valuations (FIFO and the Weighted Average basis).

Changes in Accounting Policy

There are two circumstances when a company is required to change an accounting policy. These are:

If the change is required by a Standard or an Interpretation; or
If the change results in the financial statements providing more reliable and relevant information about the effects of transactions (or other events).

So what are changes in accounting policy?

Changes in accounting policy are those changes an entity makes in accounting for and reporting its transactions and other events. A typical change of accounting policy would be an entity changing its valuation of stock from FIFO to weighted average. If the entity changes an accounting policy then it is required to apply the change retrospectively. In other words, it has to restate the prior period to reflect the change. This results in a restatement of the opening reserves. If it did not apply this change retrospectively then comparability would not be achieved. Other changes of accounting policy could be:

Overheads are classified from distribution costs to cost of sales;
Reallocation of depreciation from administration costs to cost of sales;

The above is not exhaustive.

Consider the following examples:

Example 1

The management of Alpha initially measures its property, plant and equipment at cost, and has decided to change the depreciation method they use on their property, plant and equipment from 20% straight line to 25% reducing balance as they consider this will reflect a more realistic way the entity consumes the assets. Is this a change of accounting policy?

Answer

No. This is a change in estimation technique, the same measurement basis is used and they will simply write off the cost(s) of the asset(s) over the estimated useful life of the asset(s).

Example 2

The management of Alpha have decided to reclassify development expenditure which it previously capitalised. The finance director has informed the board that IAS 38 “Intangible Assets” does not allow the capitalisation of previously recognised expenditure (those incurred before the project has been assessed as technically feasible and commercially viable). Is this a change in accounting policy?

Answer

Yes. The management have changed the recognition criteria and therefore the prior year will have to be restated to achieve comparability and the opening reserves restated, as a change in accounting policy has occurred.

Disclosures Required in the Financial Statements

The disclosures an entity will make in its financial statements when it changes an accounting policy are:

An explanation as of the reason for the change;
The effects of a prior period adjustment on the previous years results; and
The effects of the change in the policy on the previous year’s results.

Changes in Accounting Estimate

A change in accounting estimate is NOT a change in accounting policy and as a consequence, the restatement of prior period’s financial statements and opening reserves is not required. A change in accounting estimate is an adjustment of the carrying amount of an asset or liability. A typical example of a change in accounting estimate is a change in depreciation rates from (say) reducing balance to straight-line. Changes in accounting estimates result from new information or new developments and, accordingly, are not correction of errors. The effect of a change in accounting estimate must be applied by the company prospectively by including it in profit or loss in:

The period of change, if the change affects that period only; or
The period of change and future periods, if the change affects both.

It is important to understand that a change in estimation technique should not be accounted for as a prior period adjustment unless:

It corrects a fundamental error; or
Legislation, IAS or an Interpretation requires the change to be accounted for as a prior period adjustment.

Note, if it is not possible to disclose the last two points then the reason for this would be disclosed instead.

Prior Period Errors

Prior period errors are omissions from, and misstatements in, the entity’s financial statements for one or more prior periods which have arisen due to:

Error (mathematical or otherwise)
Failure to understand a ISA or Interpretation
Oversights
Misinterpretation of facts
Fraud

The above list is not exhaustive.

If an error affecting the prior period is found then the prior period(s) must be restated to amend the error which will result in the opening reserves being restated.

There are conditions which IAS 8 contains concerning errors if it is impracticable to determine either the period-specific effects or the cumulative effect of the error. In this case an entity will correct the error by:

Restating the comparative amounts for the prior period(s) presented in which the error occurred; or
If the error occurred before the earliest prior period presented (in other words the comparative year), by restating the opening balances of assets, liabilities and equity for the earliest prior period presented (the comparative period).

Steven Collings, FMAAT ACCA is Accounts & Audit Senior at Leavitt Walmsley Associates specialising in technical compliance.